Defending Financial Advisers

Due to the post-election stock rally many financial advisers and portfolio managers may have to defend themselves for having underperformed this year.  In this article, I provide a few lines of defense that can be used to calm unhappy investors.

Since the time that academia got involved with finance, financial advisers, portfolio managers, stock pickers and traders are under constant attack. The main weapon that academia but also some journalists use to attack finance practitioners is market underperformance. Academics in need of tenure credits and honors to advance their status have relentlessly attacked finance practitioners especially in the last two decades. Some journalists, in an effort to also advance their status have used papers from the academic community to also attack practitioners with the end result of raising some ignorant-about-investments professors to the status of an authority.

This is all disgusting because most of the types who orchestrate the attacks have never traded systematically, never managed a portfolio for clients and never had to deal with investors. Yet, they dare to get involved with twisted math and incomprehensible statements and try to convince the public that finance practitioners are doing a bad job because they underperform the market.

However, consistently underperforming the market may be natural, especially when market rallies are fueled by government-sponsored stock buybacks and other convoluted schemes of free money.

Not that anyone needs defense but just in case, I provide below evidence of why underperformance is natural and how portfolio managers and financial advisers should deal with unhappy investors at the end of this year.

For example, year-to-date the S&P 500 total return, which is used as a benchmark by academics and journalists, is up 12.9% while a 60/40 portfolio invested in SPY and TLT is lagging behind by about 540 basis points, as shown in the chart below:

The underperformance is significant and can make investors unhappy but there is defense. Portfolio managers should show the following chart to investors:

Created with Portfolio Visualizer

The chart compares the performance of the 60/40 portfolio to a passive index fund tracking the S&P 500 total return. The adviser can point to the fact that over the longer-term, the annualized return of the fund (CAGR) matches that of the benchmark although during strong uptrends, the portfolio lags behind. Specifically, the portfolio CAGR is 10.10% and for the benchmark it is 10.12%. Commission impact is minimal in the case of annual rebalancing.

However, over the longer-term, the risk-adjusted performance of the portfolio is superior. Maximum drawdown of the benchmark is 51% versus 27% for the portfolio. Both the Sharpe and Sortino ratios are also significantly higher. This example shows that unhappy investors in the 60/40 allocation during the dot com rally and before the financial crisis in effect avoided “uncle point”, which means getting out with a large loss due to extreme pain. The 60/40 portfolio has protected investors well from such pain so far. Although we cannot know whether the future will be like the past, there is high probability it will be.

Next, let us consider a few more interesting arguments below. For example, the S&P 500 total return since 1986 is about 10.25%.  This means an investor in the index in 1986 (with dividend reinvested) and someone who (hypothetically) accepted an interest rate of 10.25% compounded annually are making the same total return at this point, as shown in the chart below:

The hypothetical investment at a constant annual return is a straight line and has by definition the same final value as that of the index, as shown in the above chart. The indicator pane shows the deviation of the rolling CAGR of the index from the final CAGR. It may be seen that investors who accepted the constant annual return grossly unperformed the index return in the 1990s and before the financial crisis. Only in recent years there is slight outperformance.

The conclusion is that longer-term investors in sound portfolio allocations and funds will face periods of underperformance but when the market corrects there are gross adjustments.  For example, consider the possibility of a 50% drop in 2017, which we hope will never happen. In that case CAGR for S&P 500 total return since 1986 will drop to 7.6%, as shown in the chart below:

In this case a return of 7.61%, compounded annually, has consistently underperformed the index but suddenly final values match. This means that a portfolio manager who has been accused of underperforming the market consistently by a large margin suddenly may become a hero because he avoided a painful 50% drop.

All of the above means that portfolio managers, financial advisers and even traders should be judged on a case-by-case basis and only when they finally close their books for good and retire. General statements about the markets and underperformance of practitioners made by academia and financial media can be classified under noise because of the reasons mentioned in the beginning of this article. Evaluating funds, advisers and their performance is a complex task and metrics always depend on their future values, not only on past. Investors should ignore the financial media and academic types and work closely with a competent financial adviser and there are many around who do an excellent job.

If you have any questions or comments, happy to connect on Twitter: @mikeharrisNY

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