Do benchmarks in portfolio reports convey the wrong message?

    On the face of it, including benchmarks-indices of performance for different economic sectors-in portfolio reports sent to clients would seem to be a way of adding value. But is it the right move from a business standpoint?
    It is if you're an asset manager. If you intentionally compete against others to gather and manage assets, if you see it as your job to outperform certain investment markets, then benchmarks aren't optional-they're essential. But is that the business the average, independent RIA or financial planner is in?
    Some would seem to argue that it is. According to Scott Leonard of Leonard Wealth Management Inc. in Redondo Beach, Calif., "I feel that if we are being paid to manage money, then we have a responsibility to show both results and relative performance." Many financial advisors, like Leonard, see investing as such a critical piece of the overall advisory process that the manner in which they communicate investment results to their clients may be quite similar to that of the pure asset manager.
    Not everyone wants the hassle, though. Says Kathleen Cotton of Cotton Financial Advisors Inc. in Lynnwood, Wash., "I've thought of [adding benchmarks to clients' portfolio reports] in the past but trashed the idea as just one more thing to have to explain to my clients-that is, why we did or didn't over- or underperform the benchmark. If returns are adequate, then benchmarks aren't necessary, as they just focus a client on performance even more than does the quarterly report with returns [that clients already receive]."
    But why not focus clients on returns and benchmarks? Aren't they critical to the planning process? Says Michael Horwitz, of Life Strategies Financial Planning in Austin, Texas, "Benchmarking puts the focus on the wrong criteria of success: performance relative to an external standard. Instead, the question for an individual client should be something like, 'What is the most certain way to achieve the 3% real rate of return called for in my retirement projection?' This type of question puts the emphasis on something the advisor has control over, reducing risk, rather than outperformance, which the advisor has little or no control over."
    In other words, perhaps portfolio returns should be compared with only one thing: the client's plan. That is, what return does the client require to prevent him from running out of funds given the lifestyle he desires? Benchmarking returns may seem to add value, but don't they change the target, inappropriately, from the client's plan to an external performance measure?
    Perhaps this is all moot, though, if we have a legal obligation to provide benchmarks. Says Bedda D'Angelo of Fiscal Conditioning Inc. in Chapel Hill, N.C., "If the planner charges a fee for assets under management, has the ability to place trades through a custodian on either a discretionary or nondiscretionary basis, and if the portfolio is to conform to an investment policy statement, then I believe the planner may have a legal duty to deliver SEC- or AIMR-compliant reports that require comparison to one or two benchmarks representative of the portfolio."
    Good points. They ask or imply the questions: Are independent RIA portfolios subject to AIMR compliance? If so, does AIMR compliance require the reporting of benchmarks? And, if the answer is "yes," then how should we construct those benchmarks?
    The answers to the first two questions, says Tom Orecchio, a chartered financial analyst with Greenbaum and Orecchio Inc. in Old Tappan, N.J. are, "It depends." Explains Orecchio, "The average RIA isn't even required to send his clients portfolio performance or risk reports. If an advisor claims to be AIMR-compliant, however, AIMR, now the CFA Institute, has performance reporting guidelines for him to follow."
    The CFA Institute wants to ensure that investors receive accurate, complete and meaningful comparative information. "Its standards say that CFA charterholders must comply if they communicate an individual's performance," says Orecchio. And CFA charterholders advertising their performance must keep composites of "like" portfolios and follow the reporting standards for those composites. "The Institute's requirements apply to the netting out of fees, compounding and benchmarking, among other things," adds Orecchio.
    Does the SEC require registered advisors to report performance according to AIMR standards? "No," says Orecchio, "there are no SEC requirements to follow AIMR standards. Although the CFA Institute standards represent the 'gold standard' for the industry, they are voluntary except in that situation where CFA charterholders advertise performance. The average, independent RIA managing money is not required to comply with these standards." The SEC enters the fray with various requirements primarily when an RIA custodies assets or advises a registered investment company, like a mutual fund, according to Orecchio.
    So how about benchmarks? "Again, the short answer is no," says Orecchio, "unless the advisor is claiming to be AIMR [CFA Institute]-compliant. Then there are reporting requirements including but not limited to how to address survivorship bias, representative accounts, portability issues, varying time periods, construction and maintenance of composites, calculation of returns, presentation of investment results and disclosure." And, he adds, some of these Institute standards are actually recommendations, not hard and fast requirements.
    Bottom line: The vast majority of advisors reading this article are not required to even report performance to their clients, much less benchmark that performance. Suppose, like Leonard or D'Angelo, you want to show benchmarks anyway. How should it be done?
    Some advisors say you should select one or more benchmarks most comparable to the asset categories used in the client's portfolio. Doug Heimforth isn't one of them, however. Owner of Heimforth Wealth Management in Los Altos, Calif., he says, "Comparing most portfolios with sundry indexes like the S&P 500, NAREIT or Lehman Domestic Bond Index will not be meaningful. One must use custom benchmarks based upon asset class allocations similar to the clients' strategic allocations and constructed with actual asset class returns and volatility."
    Most advisors who have studied the issue would probably agree with Heimforth. What he proposes is more work but also more appropriate, if the purpose of a benchmark is to provide an external measure against which to compare a customized portfolio. (And, unless you've placed 100% of a client's assets in an S&P 500 fund or a money market, you've created a customized portfolio).
Without a legal requirement to provide benchmarks, though, the issue becomes one of image and marketing. How do you want clients and would-be clients to perceive what you do? Are you walking like an asset manager and talking like an asset manager? If so, clients will perceive you to be an asset manager.
    What's wrong with that? Plenty, for some advisors. The typical planning engagement today is ideally one of trust, competence, longevity and, yes, dependence. That is, the prospect becomes a client; the client finds you competent in the financial advice you render and builds trust in you; and, as a result, he voluntarily comes to depend upon you and remains a client for a long, perhaps indefinite, period of time.
    Do you have a better chance of establishing this type of relationship if your service is a narrowly focused one of pure asset management, or one of comprehensive advice geared toward the life your client wants to have? In which scenario is a client more likely to remain a client when markets dip and your investment performance suffers? Sure, investments play a role. So do estate planning, tax planning, getting your clients to save more, and so on. But all of these things are merely a means to an end-again, that life your client wants to have.
    Of all these means, some are more controllable than others but none is completely under your control. Tax laws change in unpredictable ways, making estate and tax planning and even the selection of the best retirement plan for your client challenging, at best. Investment markets fluctuate so that clients' required returns are earned over time, but seldom in every year.
    Which type of uncontrollable event is more likely to undermine you as a trusted advisor? Arguably, investment market fluctuations, because clients perceive us as having some idea of the direction markets will take, whether we actually do or not. For some inexplicable reason, we aren't expected to know what Congress is going to do, but we are expected to be able to produce decent investment returns and, if we've really mismanaged client expectations, to outperform the market.
    Most RIAs won't find anything particularly new in this thinking. Yet, they will persist in focusing their clients on the one service they can control the least. They do so by reporting and discussing performance too frequently, which distracts the client from the perception that his advisor has a broader expertise than just asset management, and by providing benchmarks, which say to the client his advisor is attempting to outperform an external standard. They also do so by using an asset-under-management fee structure rather than a structure-like retainer fees-that implies the advisor's service is broadly based.
    The client wants a certain kind of life and you've accepted the job of helping him get it. If you must use benchmarks, benchmark the client's progress toward that life. In that context, his last quarter's performance vis-a-vis some equity index doesn't have much relevance.   

David J. Drucker, M.B.A., CFP, a financial advisor since 1981, sold his practice 20 years later to write, speak and consult with other advisors under his new banner: Drucker Knowledge Systems. Learn more about his latest books, Tools & Techniques of Practice Management (National Underwriters, 2004) and The One Thing... You Need to Know from Each of Industry's Most Influential Coaches, Consultants and Visionaries (The Financial Advisor Literary Guild, 2005), at