Professional Development

Avoiding the Performance Trap

FEATURING

Chris Gies
Senior Vice President of Advisor Education, Capital Group

Briefcase

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Key Takeaways

  • Insight: Advisors can fall into a performance trap where the success of clients’ portfolios are measured against benchmark or indexes, rather than whether the portfolio met clients’ goals.
  • Implication: Focusing on results relative to benchmarks can lead to dissatisfaction among clients and distract from advisors’ true value.
  • Implementation: Discussing how clients made progress toward their goals, rather than their portfolios’ results against a benchmark, may help strengthen the client-advisor relationship.

The S&P 500 Composite Index returned nearly 8% on average annually during the 20 years ending in 2016. However, the average equity fund investor saw returns of less than 5% during the same period[1]. The measurement of investment returns against benchmark indexes has become a growing obsession in the wealth management industry in recent decades. How has this impacted advisors and clients? The way advisors talk to clients has evolved such that often, the focus of communications have been around how the client’s portfolio has performed relative to a benchmark index or style box.

Investors’ Results Tend to Lag the Market’s
20-year annualized returns of investors, on average, usually trail the market returns


Unfortunately, this tendency has created a “performance trap” in which financial advisors’ perceived value is based largely on whether clients’ portfolios outperform broad market indexes — even if this measurement has little relation to clients’ actual goals. This performance trap can damage relationships with clients and hurt the growth of your firm.

This isn’t to suggest that relative performance and measures of risk-adjusted return aren’t important. In fact, an advisor should always be working to maximize return and limit volatility within the client’s level of risk tolerance and time frame. The problem, however, lies in the fact that focusing too much on performance in communicating with clients obscures the true value that an advisor provides. Most clients did not hire an advisor to outperform a benchmark, but rather, clients hire advisors to help them achieve their financial goals. Thus, to avoid the performance trap and the client dissatisfaction that often accompanies it, it is important to re-orient client communications and portfolio management around the results which help clients reach their goals.

The Threat of “Systematic Dissatisfaction”

Underlying the performance trap is systematic dissatisfaction on the part of clients who compare their investment results against the returns of a widely followed market index. A simple example would be if the S&P 500 is up 15% one year, but a client’s portfolio is up “only” 12%, the client might be disappointed, even though their portfolio doesn’t precisely track the index and includes bonds and cash. Conversely, if the S&P 500 is down 15% in a given year, but the client’s portfolio is down just 12%, the client has beaten the index, yet remains unhappy. After all, losing money never feels good, and many clients will express their unhappiness by blaming their financial advisors.

The growing threat of the performance trap coincides with advisors’ misuse of Modern Portfolio Theory and the Efficient Frontier, concepts that were introduced in Harry Markowitz’s seminal paper that was published in 1952. Since then, advisors have become increasingly focused on measuring their worth in terms of performance relative to benchmarks and measures of risk-adjusted returns, such as the Sharpe ratio[1]. Don Phillips’ work to develop Morningstar’s now-famous Style Boxes in 1992 added to advisors’ and clients’ focus on how portfolios were performing relative to a style-specific index.

Are Markowitz and Phillips to blame for the performance trap that many advisors now find themselves in? Certainly not. In fact, these constructs have been very helpful in enabling investors to conceptualize important abstract constructs. The problem lies in the fact that these tools have been misused in the industry. Markowitz and Phillips have both said that their respective tools were intended to be descriptive (i.e., assessing the characteristics of a portfolio) rather than prescriptive (i.e., providing guidance for how a portfolio should be constructed). It’s important to remember that asset allocation is about finding the correct combination of investments given the goals of an investor, rather than maximizing returns versus a benchmark.

Escape the Performance Trap: Refocus Your Client Communications

It is important to realize that advisors are usually putting themselves in the performance trap via their communication with clients. While some clients are naturally inclined to think about relative performance and risk-adjusted returns, most of them do this only because they have been conditioned to do so. When we lead with discussions about relative performance, it is natural for clients to assume that is what they should focus on.

Getting out of the performance trap — and refocusing clients’ attention on the areas where you add the most value — requires an intentional effort on an advisor’s part to refocus portfolio construction and client communications efforts around clients’ goals. It is also important to rethink how to discuss risk with clients. Risk is not the same as volatility and standard deviation, advisors should talk about risk in the context of how a client should view it — the risk that they won’t achieve their goals. A client’s investment goals will help dictate how detailed an advisor should be with their discussions regarding risk. However, in the end, it is important to communicate to clients how their goals can be reached and what hazards they may face along the way.

When it comes to client communications, here are some examples of messaging that steers away from relative performance and toward helping clients achieve their goals:

Be Recognized for Your Value

Ultimately, the performance trap, if not dealt with, can be very damaging to the strength of advisor-client relationships and RIAs’ ability to grow and retain assets. By moving a practice toward a model that focuses on client goals, advisors can be recognized for the true value they provide and, in turn, clients may reward that value with loyalty and even referrals.

By developing a process to help clients establish and prioritize their goals, you can then structure your portfolio management techniques and client communications around these goals. In essence, you will be talking the “same language” as your clients. And you will notice how this language doesn’t focus on benchmarks, standard deviation or other measurements that provide the dangerous “bait” found in the performance trap.

  GOALS-BASED APPROACH
 
Initial meeting with prospects Ask questions such as, “What goals are most important to you and your family, and how do you think a financial advisor can best help you reach those goals?” Showcase your track record by pointing to examples of how you have helped clients attain similar goals.
 
Onboarding: meeting with new clients Help clients to articulate their goals in detail and then prioritize them as essentials, enhancers or endowments. Discuss what required investment confidence level is appropriate for each goal. 
 
Quarterly or monthly portfolio statements Create graphics that illustrate clients’ progress toward their goals. Show whether the portfolio is still within the required confidence level for each goal.
 
Annual meetings with clients Update clients on whether they are on track to achieve each of their goals within the required confidence level. If not, discuss potential changes, such as extending the time frame or adjusting the level of contributions, which can get the portfolio back on track.


Be Recognized for Your Value

Ultimately, the performance trap, if not dealt with, can be very damaging to the strength of advisor-client relationships and RIAs’ ability to grow and retain assets. By moving a practice toward a model that focuses on client goals, advisors can be recognized for the true value they provide and, in turn, clients may reward that value with loyalty and even referrals.

By developing a process to help clients establish and prioritize their goals, you can then structure your portfolio management techniques and client communications around these goals. In essence, you will be talking the “same language” as your clients. And you will notice how this language doesn’t focus on benchmarks, standard deviation or other measurements that provide the dangerous “bait” found in the performance trap.

1“Quantitative Analysis of Investor Behavior, 2016,” DALBAR, Inc. www.dalbar.com

2The Sharpe ratio uses standard deviation and excess return to determine reward per unit of risk. The higher the number, the better the portfolio’s historical risk-adjusted performance.

Chris Gies is a manager for advisor education and sales force development at American Funds, where he focuses on training high-level advisors through his role as a national speaker.
 


 

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Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. This information is intended to highlight issues and should not be considered advice, an endorsement or a recommendation.