Market Review: Relative vs Absolute

I begin every New Year with a reflection on the past one.  Many times I am happy with what I have done and where I am headed both personally and professionally. But as I reflected on my professional life, I realized that these past few years I have been forced to work in a world where relative performance is not only encouraged, but rewarded.  As I reflect on that issue in this blog, I hope that you reflect on what it means to you and your financial future.

Relative performance is what Wall Street has engrained into every investor’s mind as the benchmark to which each advisor should be measured.  I freely admit that we are no different.  We have created model portfolios for our clients that have a benchmark rate of return.  A money manager is a success if his performance is better when compared to or relative to his benchmark index.  Thus, in 2008 when the market was down 39%, a money manager was a “success” if his portfolio was ONLY down 35%.  Don’t get me wrong, I am not against measuring performance and I am not someone who believes every kid should get a trophy just for participating; I am questioning whether or not there is a better way to measure success in this business.

As we began this new company, these are the questions that we asked ourselves.  Should our success be measured relative to some other index or measured absolutely?  I would argue that absolute return is a much better measure of success than a relative one.  In every financial plan I have ever seen there is an expectation that the client’s accounts will grow each year by 8-10%.  Not 8% if some index returns 8%, but 8% absolutely year in and year out until the client retires.  If the goal is to get 8-10% a year absolutely and the portfolio returned -35%, that would be an awful year in absolute terms.  But in relative terms, if the relative index returned -39%, I beat my goal by 4%.  Not a bad performance, relatively speaking.

Hedge fund has become a dirty word in financial circles, but for all the faults of hedge funds, you cannot fault them on this: they are measured by absolute return and get paid based on whether or not they achieve an absolute return each year.  A mutual fund manager gets paid his investment fee no matter the return of his portfolio each year.  Obviously, if his return is poor for long enough investors will no longer invest in the fund.  A hedge/alternative fund manager only gets paid when he meets an absolute performance goal. The pressure to perform and the benefits for performance are much greater.  This is why all the math whizzes from MIT are starting hedge funds, not mutual funds.

I am not proposing that we throw out all the old measuring sticks and start over with new ones or that we run out and put all of our money in hedge funds.  I am purely reflecting on how I can become a better money manager by thinking in absolute terms instead of relative ones.  Maybe I am naïve, but none of my clients live on Wall Street.  When the funds they were invested in lose 35%, the whole relative return argument falls flat.  My goal this year, and every year that I am lucky enough to manage money, will be to get clients a return that is not relative to anything except achieving their financial goals.