Always check the benchmark

Welcome to Lake Wobegon, where all the women are strong, all the men are good-looking, and all the children are above average - Garrison Keillor, A Prairie Home Companion

We all like to think of ourselves as being better than average. Let’s face it, whether it’s driving, cooking or deciding who should take the penalties when the scores are level after extra time, most of us think we’re pretty good.

The truth, of course, is that, regardless of the activity, half of us have to be below average.

This phenomenon is sometimes known as the Lake Wobegon Effect, after the author and broadcaster Garrison Keillor, who famously poked fun at people’s reluctance to see things as they really are. And it’s certainly alive and well in the investing industry.

All the time we hear pension funds, asset managers, investment consultants, and financial advisers say, “We’ve beaten the market by x percent.” Most people simply take their word for it, and I used to be one of them.

But anyone with a passing knowledge of academic finance, the SPIVA scorecard from S&P Dow Jones Indices or Morningstar’s Active/Passive Barometer knows to take these sorts of claims with at least a pinch of salt.

Very few funds outperform

Why? Because only a tiny proportion of investors outperform, on a cost-and-risk adjusted basis, over the long term. Dr. David Blake from The Pensions Institute, who led a detailed study of active fund performance in Britain and the United States, says the proportion of active managers who really are “stars” is around 1%. And even those very few winners, he says, claw back any value they add for themselves in the fees they charge.

I don’t doubt for a moment that there are advisers and consultants who have beaten the market. Statistically, they must exist. But they’re in an exceedingly small minority. And most — yes, most — investment professionals who claim to have outperformed over meaningful timeframes actually haven’t.

Nor am I suggesting that all these professionals who wrongly claim to have beaten the market in the long run are telling fibs. Most of them, I’m sure, genuinely think they have done. No, the problem is that, in the vast majority of cases, investment returns are not independently verified — and it’s a huge problem worldwide.

New study of US public pensions

A new paper looks at both the stated and the actual performance of public pensions in the US, which self-report their investment returns each year with no independent analysis. Crucially, they use performance benchmarks of their own devising, which often lack transparency.

Author Richard Ennis analysed the performance of 24 pension funds in the ten-year period to the end of June 2020. On average, he found, the trustees paid an eye-watering 1.3% of the asset value in fees and charges.

Over those ten years, they underperformed a simple passive investment strategy by 1.41% a year. Yet those same funds report that they outperformed benchmarks of their own devising by an average of +0.3% a year for the same period.

True, there are limits to our ability to interpret these results. The sample of 24 funds is less than half the number of large state-wide public pension funds in the US. We’re also talking about a single ten-year period. Nevertheless, as Ennis concludes, “the results paint a decidedly unflattering picture of the stewardship of public pension funds.”

He goes on: “If $4.5 trillion of public pension fund assets are underperforming by 1.4% annually, it would amount to an outright waste of $63 billion a year, money that could well be applied to the payment of benefits or the reduction of taxes.”

Benchmarks need far more attention

For Ennis, the key takeaway from his research is that we need to pay far more attention to the benchmarks used to measure investment performance.

“Public pension funds use benchmarks of their own devising,” he says, “describing them variously as ‘policy’, ‘custom’, ‘strategic’ or ‘composite’ benchmarks… (They) are often opaque and difficult to replicate independently… They are subjective in several respects, rendering their fashioning something of a black art.

“Moreover, they are devised by the funds’ staff and consultants, the same parties that are responsible for recommending investment strategy, selecting managers, and implementing the investment program. In other words, the benchmarkers have conflicting interests, acting as player as well as scorekeeper.

“To state the obvious, perhaps, (these) benchmarks generally do not measure up to the standards of objectively determined, passively investable benchmarks used by scholars and serious practitioner-researchers.”

Not just a US phenomenon

Of course, we should not assume that this propensity to exaggerate past performance is unique to the US.

As the FCA’s recent review of its Assessment of Value regime shows, the reporting of returns by UK fund managers leaves much to be desired. Astonishingly, some firms assessed the gross performance of their funds, rather than net performance, as required by the AoV regulations.

Other firms assessed net performance but only for one of the unit classes available — typically the wholesale unit class with the lowest charges. This meant that potentially poor performance experienced by more expensive unit classes was not being assessed.

Another failing was that fund houses operating multi-asset funds (MAFs) or funds of funds (FoFs) justified fees based solely on the performance of these funds relative to peer groups of other MAFs or FoFs. In other words, they failed to demonstrate how active management of those funds had either enhanced performance or reduced risk relative to single asset class funds.

Be extremely sceptical

The message, then, is simple: there are all sorts of ways that pension funds and financial professionals can make their past performance look better than it really is. Ideally, all returns should be properly, and independently, scrutinised, and that will probably never happen.

For now, the only thing investors and their advisers can do is to treat stated returns with extreme scepticism. Always do your due diligence — and start by checking the benchmark used.

ROBIN POWELL is Editor of The Evidence-Based Investor.