Defining investment outperformance: You’ve got strong opinions

You don’t agree on how to define outperformance by stock funds, the focus of my latest poll. You expressed your disagreement in votes as well as in your comments on my blog post, some of which I’ve quoted verbatim below.

Outperformance poll results

Almost 30% of you said that an advantage of even one basis point (0.01%) was enough for an investment to claim outperformance. Close to 20% put the break point at 10 basis points (bps). Overall, more than two-thirds of you said there was an absolute level at which asset managers could claim outperformance.

For the rest of you, it seemed that outperformance was relative. Twelve percent defined an investment’s outperformance in terms of “a certain percentage of its benchmark.” The rest of you–21%–said outperformance was defined by “None of the above.”

Here are the poll answers and the percentage replies:

* 1 basis point (0.01%): 29% of all votes
* 10 bps: 18%
* 25 bps: 0%
* 50 bps: 6%
* 100 bps: 15%
* A certain percentage of its benchmark’s return: 12%
* None of the above: 21% (Percentages may not total 100 because of rounding)

The minimalists’ approach

“Technically, a mere 1 bp excess return should arguably count for ‘outperformance,'”wrote David Spaulding of the Spaulding Group in his comment on my blog. His comment was echoed by Jeff McLean, Ph.D., who said, “I believe that a stock, fund, or variable annuity that outperforms a benchmark by any margin, no matter how small, can claim outperformance.”

Consider the benchmark

John Lowell said he’d like a manager’s performance to exceed the benchmark by at least one standard deviation, but preferably 1.5 standard deviations, before he applied the term outperformance. “To really be outperforming, I’d like to see them outperform by at least 1 standard deviation 3 years out of 5 and cumulatively over the 5-year period.”

Some of you who commented on my blog took issue with the idea of comparing performance net of fees with the performance of a benchmark that’s not reduced by fees. Here’s what Frazer said:

For example, if you have a fund with a 50BPs expense ratio being compared with the SP500 (which investors can access via ETF with an 8BPS expense ratio), you should subtract the fees from both numbers to get an accurate view of relative performance by the manager.

In this case, the fund would need to outperform the SP500 by 42BPS to claim “outperformance” over the benchmark.

I imagine that the SEC doesn’t like this approach. What marketer wouldn’t do this if it were legal?

Then, there’s the issue of what benchmark to use. Steve Smith said, “Leaving aside the degree of outperformance, two baseline criteria are also required: 1) choosing the proper benchmark (i.e. “best fit” index) and 2) having a very high (mid-90%) R squared.”

Remember the client

The financial advisors who responded to my poll said that “outperformance” is meaningless if client goals aren’t considered.

David B. Armstrong, CFA, said

I define outperformance as this – when an investor’s portfolio does better then the return required by the financial plan to meet the investors goals – that’s outperformance.

Moderately outperforming the return required in a financial plan is probably ok – most investors can get away with that safely from time to time. It’s when your outperformance is like going 95 mph in a 65 mph zone that investors have a problem. How many investors experienced a ticket or a wreck in their portfolios in late 2008? Or better yet – how many advisors sat in the back seat of the car and let their clients drive 95 mph…drunk!

Stephen Campisi, CFA, agreed, saying “…outperformance is really not about return; it’s about having more money than you need to meet your tangible financial goals.”

Campisi also suggested that fiduciary responsibility comes into play. “As fiduciaries, we need to start thinking in terms of our loyalty standard, and start thinking about meeting the client’s financial goals – and these are money goals. So, we need to “show them the money” and when we talk about return we need to show them an internal rate of return over a long period. We need to show them the return that incorporates their beginning wealth, the money they were able to pull out of the portfolio for their goals, and their ending wealth. Then (and only then) will we be acting in the best interests of the client.”

My take on this issue

I like the idea of defining outperformance relative to client goals. This is an area where financial advisors and asset management firms focused on separate accounts can improve. However, if you’re a fund company producing investment performance reports for a diverse group of investors, you lack information about client goals. So you’ve got to define outperformance relative to a benchmark.

Thank you, commenters!

I’m grateful to everyone who commented–both on my blog and in a lively discussion on the members-only Financial Writing/Marketing Communications LinkedIn Group. You made me see new dimensions to this issue. I love learning from you.

Thank you–and please continue the conversation!