Benchmarks are often misused by investors and advisors. They can be useful tools, but there are inherent dangers that investors need to be aware of.

A benchmark is defined as a standard by which a particular investment can be measured. Generally, broad stock and bond market indices are used for this purpose. For example, many investors choose to compare the stock portion of their portfolio to the S&P 500. However, unless you are invested only in large cap US stocks, this would not be an accurate comparison.

The degree of accuracy for any benchmark depends on how related it is to the investment you are comparing it to. For instance, the S&P 500 is a perfect benchmark for comparing an S&P 500 index fund. An investor can discern the success of the fund by comparing how well the fund did to the actual index – which should be the performance of the underlying stocks minus the fees charged by the fund.

A benchmark loses its accuracy to the same extent your investments deviate from the actual benchmark. To the extent your portfolio deviates from the benchmark, you would expect higher or lower returns. Said another way, the only perfect benchmark for any portfolio is that portfolio itself.

Smart investors understand the relationship between risk and reward. They understand that different asset classes have different risks and therefore different potential rewards. The Three Factor model tells us that small and value stocks have higher risks and therefore higher potential rewards. So an investor who chooses to tilt his portfolio toward those factors can expect a higher return over time.

So if a manger of a large cap growth fund holds some smaller and more value oriented stocks in his portfolio, he can show better results over the long haul when compared to a large cap growth index. This perceived outperformance is often falsely claimed as alpha by the manager of the fund. Alpha is defined as excess return over a similar investment with similar risk characteristics. Research has shown that when appropriate benchmarks are used, alpha virtually disappears over the long haul. Further research shows that alpha achieved over the short term is attributed to manager luck rather than skill.

Make believe Alpha

Many firms will often take advantage of this knowledge and choose benchmarks that they are likely to outperform. For example, The S&P is widely known and followed, so many investment professionals use it as a benchmark. As you can see from the graph below, the S&P 500 falls in the lower right hand quadrant and the highest returns are found in the upper right hand quadrant. This means that the S&P 500 has a slightly higher risk and lower reward when compared to the total market.

The further you tilt your portfolio towards small and value stocks, the more outperformance you can expect over time.

So if your current portfolio is compared to the S&P 500 and it holds stocks other than large cap US stocks, you should ask your advisor to compare each stock component to a more appropriate benchmark. Odds are if they do, all of their “outperformance” will disappear – and then some. That is, if there was any outperformance to begin with…