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The first part of this discussion focused on setting up an investment portfolio.  While the suggested portfolios are basic, it is surprising that a portfolio structured specifically for you by a financial professional will differ only marginally.  The only way that you can tell if the investment advice is well worth the fee is to have some sort of “measuring stick”.  The most common benchmark that financial professionals will point out to you is the S&P 500 index to see how your stock allocation performed.  While using the S&P 500 may have been good back in the 1980’s during the typical infancy of debating the merits of active versus passive investing, the financial services world has progressed quite a bit.  Just using one basic stock index and one basic bond index is not the standard, especially when it comes to institutional investors.  Now for the fees you are paying, there is no reason why your financial professional cannot construct a customized benchmark to measure your performance.

Over a decade ago, institutional investors started to use what is referred to as a blended benchmark.  A blended benchmark is an average performance bar that takes into consideration the asset classes in which your portfolio is invested.  When I worked within a Performance Monitoring department at a major brokerage firm, all high net worth clients had blended benchmarks.  Why?  Well, your financial professional will assess your risk tolerance and financial goals and then recommend a number of investments.  When he/she allocates a portion of your portfolio to stocks, they rarely will tell you to invest only in large company stocks (jargon is large cap like Microsoft, Apple, IBM, Pfizer, General Electric, etc.).  The portion of your portfolio allocated to stocks is likely to include domestic small cap, mid cap stocks, and even international or emerging markets stocks.  Thus, it would not make sense to measure your investment performance only using the S&P 500 index.  That would be comparing apples to oranges.  The reason you go to a financial professional is to get his/her advice and normally are recommended active fund managers that try to outperform various index returns.  That is the value which he/she provides to you.  Because you should always remember that you could just buy an index mutual fund or ETF that invests in all the securities included in any particular index.

Well, let’s look at an example to put the blended benchmark concept in context.  We can analyze a relatively simple portfolio.  Start with a portfolio that has $1 million which is allocated 70% stocks ($700,000) and 30% bonds ($300,000).  Furthermore, the portfolio breaks down as follows:  30% domestic large cap stocks, 10% domestic mid cap stocks, 5% domestic small cap stocks, 25% international stocks, 25% investment grade corporate bonds, and 5% high yield bonds.  As a general rule of thumb, smaller companies have the ability to grow their profits faster than large companies, and high yield bonds have higher coupons (interest rates) than investment grade corporate bonds.  With that being said, the more reward you can obtain, the higher the risk of loss there is.  As I mentioned before, the S&P 500 index is the “bogey” for stock market performance for most financial professionals.  However, the S&P 500 index measures most of the largest companies in the United States.  In the scenario I laid out above, 40% of your portfolio is invested in stocks that are not part of that index.  Therefore, it really would not make sense to utilize the S&P 500 index to measure your performance.  You would prefer a benchmark that is quite similar to the investments you actually own, right?  Otherwise, it is similar to giving an Olympic sprinter a 4 second head start in the 100 meter dash.  The race barely lasts 10 seconds, so the individual who got the jump will always win everything being equal.  That does not make a lot of sense to say that the winner of the 100 meter dash is the best in this analogy.  The race measures the performance of one runner that gets a break and all the other sprinters  are way behind the eight ball to start off.  Getting back to stocks, why would you want to compare the performance of your emerging markets stocks to the S&P 500?  How do you calculate a blended benchmark?  We can turn to this now.

In the aforementioned, hypothetical portfolio, we need to pick indexes that match up with the investments recommended.  For example, we would like to see as follows: 40% S&P 500, 10% S&P 400, 5% Russell 2000, 25% MSCI EAFE, 25% Barclays US Aggregate Bond, and 5% Markit iBoxx Liquid High Yield.  In practice, there are other indexes you can choose. One illustration is that you could substitute the S&P 600 for the Russell 2000 index.  This index measures the performance of small cap stocks, so you can view them as being interchangeable.  The average financial professional will just tell you how well your investment portfolio did over the year in terms of performance.  They tend not to break things down into smaller chunks, especially when it is not favorable to do so.  They might even tell you your 70% stock allocation beat the S&P 500 by 3%.  That is really good, right?  Yes, but there is no context here because of your other stock investments.  A blended benchmark gets around that problem.  The simple way to calculate a blended benchmark is to multiply the percentage of your holdings with the total annual return of the investment of the relevant indexes.  The resulting amount is what your portfolio would have returned if you had only invested in passive investments (i.e. ETFs or index mutual funds).  That is what is referred to as a blended benchmark because it shows how well the financial professional’s investment recommendations did against the average performance of all stocks in that index.  Using actual performance returns from 2012, the return on the S&P 500 was 16.0%, the return on the S&P 400 was 17.9%, the return on the Russell 2000 was 16.4%, the return on the MSCI EAFE was 17.3%, the return on the Barclays US Aggregate Bond was 4.2%, and the return on the Markit iBoxx Liquid High Yield was 14.2%, respectively.  The blended benchmark performance would be 15.1% (calculated as: (40% * 16.0% + 10% * 17.9% + 5% * 16.4% + 17.3% * 25% + 4.2% * 25% + 5% * 14.2%).  Thus, a blended benchmark is nothing more than a weighted average of the performance of each index which comes from your percentage allocation in your investment portfolio.  If your financial professional selected actively managed funds and your 2012 return was 12.0%, you would probably be quite pleased.  However, you must always remember that you could have invested in ETFs or index mutual funds that purchased all the securities in the index.  Your return using this allocation example would have been 15.1% minus the expense ratios of each ETF or index mutual which would probably be no more than 0.2%.  Therefore, your net return would have been 14.9%.  Now you never want to trust backdated portfolio examples.  My example is meant to illustrate you that you underperformed the index averages by 2.9% on a relative basis.  Why does this occur in practice?

There are several reasons why this might occur.  Firstly, actively managed funds have higher expenses.  The asset manager must pay for research analysts, the cost of trading, overhead for the facility and computer systems, and for marketing.  Secondly, actively managed funds are rarely fully invested.  This only means that asset managers like to have cash on hand to make additional purchases.  Therefore, they will not have all their money in securities, so they do not capture all of the performance return of the market.  Thirdly, active managers usually have a broad mandate in terms of the securities they can purchase.  If you look closely within the prospectus, the asset manager has a great deal of leeway.  For example, a domestic equity fund is usually allowed to invest in international stocks.  Lastly, a passive investment portfolio has the advantage of having set allocation.  What I mean by this is you will always be invested at any given time in the asset classes you choose.  You will not have excess cash or have an active manager trying to time the financial markets (i.e. trying to determine the best time to buy stocks and/or bonds).  All of these headwinds create difficulties for actively managed funds.  Now when you compare your actively managed portfolio in total, it is very difficult/challenging to have all your active managers outperform their respective benchmarks.  As I have pointed out in the past, very few active managers are able to beat their benchmarks over the long term.  In our example above, your financial professional would have to select six active managers that could collectively beat the indexes.  Not all will, so you need to have a couple active managers significantly outperform their respective indexes to make up for performance by others that lag the benchmark.

One of the important things to ask your financial professional is about a blended benchmark and an audited composite in accordance with Global Investment Performance Standards (GIPS).  A composite is just a historical record of the performance of the financial professional’s recommendations.  When working with a financial professional from a major Wall Street firm or even local brokerage houses, they tend to have model portfolios.  The different model portfolios are meant to account for your specific risk tolerance and financial goals.  It is extremely important to ask for the performance of that model portfolio and ensure it is a GIPS audited composite.  GIPS is just a set of rules on how to calculate and depict investment returns.  If your financial professional does not have a GIPS audited composite, you should ask further questions.  If they do have a GIPS audited composite, it is important to make sure the length of time measured is long enough.  A performance record that is five years or older should be your bogey.  Why?  Some financial professionals have really great performance but only recently.  You would like to see how their portfolio recommendations do during different market conditions.  In addition, a GIPS audited composite will help you verify what your financial professional is telling you.  For example, if your portfolio really lost a lot during the 2008 financial crisis, you may pick a financial professional that tells you they never would have had you invested in such a large proportion of stocks.  That may be so, but you need to know how his/her clients did during the same period.  Another thing to remember is that many financial professionals avoid losses by selling securities at the first hint of bad news or uncertainty.  Well, financial markets always have a component of uncertainty, and financial professionals can be late to allocate your portfolio back to an ideal weighting of stocks.  There were many financial gurus that advised clients to sell stocks during 2008, but they never got back into the stock market until quite recently.  The S&P 500 index not only recovered the losses, but it has set record highs.  Remember that you do need to protect against principal losses; however, if you have a long time horizon, it also is important to ride out the minor bumps, noise, and storms.  Trying to time the market for the optimal moment to buy stocks and/or bonds is usually not successful over the long term.

You should definitely have your own blended benchmark if you choose to invest yourself and build a portfolio.  On the other hand, if you choose to have a financial professional guide you through the process, he/she should provide you with a blended benchmark as well.  If you are paying fees to the financial professional that should just be an automatic service.  You must have that discussion.  If your financial professional is reluctant to show you a GIPS audited composite, says it is too difficult to calculate a blended benchmark, or, worse yet, he/she says it is not important, I would drill down and ask further questions.  Red flags should be coming to mind because, as you have seen above, a blended benchmark is quite easy to calculate.  I prepared the figures for the aforementioned, hypothetical portfolio in 30 seconds using Excel.  Now using Excel and going through the math may seem difficult to you, but a brokerage firm specializes in mathematical calculations.  It should be no problem whatsoever.  If it is a problem due to technological issues, I would be leery.  If a financial professional says that this type of service is only offered to high net worth clients, you should tell him/her that a blended benchmark should be an automatic service.  They are not new; the concept has been around for well over a decade.