07/06: Comparing Performance
One of the slickest games on Wall Street is to compare the performance of a portfolio against an index that does not have the same characteristics. Have you ever fallen victim to this?
Imagine that during 2004 you had an investment portfolio managed by your friendly brokerage firm. You understand that the stocks were managed according to a "value" style. Typically this means that the stocks will have lower than market valuations, better than market dividend yields and lower than market price-to-book ratios. Often this is described as buying at a discount to real valuation.
So far so good.
At the end of 2004 you receive an investment update with a report on the broker's stewardship. It shows that you have a total return of 17% for the year (net of all fees). You are very pleased. Reading further in the report you discover that the broker has compared its performance to the Russell 1000 Value Index which had a total return of 16.5%. Using this yardstick you are even more pleased!
Is there anything wrong with this picture?
More questions need to be asked of the broker. The most important question for comparison purposes is this: Does the portfolio reflect the characteristics of the Russell 1000 Index? Alternatively, if the portfolio is invested in a mix of large and mid and small cap value stocks is this the right benchmark to use?
This is important because in 2004 the Russell 1000 Value (large cap) Index returned 16.5% while the Russell 2000 Value (small cap) Index returned over 22%. If the portfolio matches the large cap profile you should be pleased. If, on the other hand, the portfolio is all samll caps then you have under-performed by about 5%!
Investment professionals sometimes use an index that shows their work in the best light even though it may not be the best fit for comparison's sake. Be informed, ask questions and compare apples to apples.
OSF
June 7, 2006
Imagine that during 2004 you had an investment portfolio managed by your friendly brokerage firm. You understand that the stocks were managed according to a "value" style. Typically this means that the stocks will have lower than market valuations, better than market dividend yields and lower than market price-to-book ratios. Often this is described as buying at a discount to real valuation.
So far so good.
At the end of 2004 you receive an investment update with a report on the broker's stewardship. It shows that you have a total return of 17% for the year (net of all fees). You are very pleased. Reading further in the report you discover that the broker has compared its performance to the Russell 1000 Value Index which had a total return of 16.5%. Using this yardstick you are even more pleased!
Is there anything wrong with this picture?
More questions need to be asked of the broker. The most important question for comparison purposes is this: Does the portfolio reflect the characteristics of the Russell 1000 Index? Alternatively, if the portfolio is invested in a mix of large and mid and small cap value stocks is this the right benchmark to use?
This is important because in 2004 the Russell 1000 Value (large cap) Index returned 16.5% while the Russell 2000 Value (small cap) Index returned over 22%. If the portfolio matches the large cap profile you should be pleased. If, on the other hand, the portfolio is all samll caps then you have under-performed by about 5%!
Investment professionals sometimes use an index that shows their work in the best light even though it may not be the best fit for comparison's sake. Be informed, ask questions and compare apples to apples.
OSF
June 7, 2006
