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The Rio Olympics are in full force and the performances we have witnessed thus far from Michael Phelps, Katie Ledecky and others have been awe-inspiring.  The Olympics Games are a wonderful tradition, allowing people across the globe to support their home country and marvel at athletic accomplishments that seem impossible to the Average Joe.  Unfortunately, not everybody plays fair these days as performance enhancing drugs play an ever-increasing role in amateur and professional sports alike. Like anything in life, it’s a shame when a few bad apples spoil the bunch.  As Josh Brown points out in his tweet below, PEDs aren’t exclusive to sports:

The article referenced above focuses on mutual funds that have boosted their performance by marking up the valuation of private stocks, like Uber and Airbnb, held in their portfolio.  There is nothing illegal about what they’re doing as mutual funds a) are allowed to own illiquid securities up to a certain minimal threshold and b) are required to attach a valuation to said securities in order to price the fund as a whole on a daily basis.  But as Larry Swedroe points out in the article, a lofty markup during good times could end up hurting investors in the end if a market downturn forces a manager to significantly mark down an unlisted security.  This is just one of many examples of how one might “juice” their returns on an absolute, relative, or risk-adjusted basis. Here are a few other common tactics that are used all too often:

  • Moving the goalposts: Perhaps the oldest trick in the book, you can twist just about any data set to fit your narrative by changing the start and/or end dates for performance.  Michael Batnick nails this concept with a post over at his blog.
  • Portfolio window dressing:  Another “oldie but not-so-goodie” is an attempt by a portfolio manager to disguise their mistakes  by selling their biggest losers as a quarter or year comes to a close.  This typically also involves a last-ditch effort at outperformance by using the proceeds to add to high-flying positions with the potential for large gains.  Much like a magician using slight of hand, window dressers hope to keep your eyes focused on all the “winners” they hold so that you fail to notice them lagging the benchmark.
  • Reporting performance gross of fees: Mutual Funds, ETFs and other registered investment vehicles are required by law to report net of fee performance to investors so there is no worry there.  But I have heard stories of financial advisors reporting their end clients’ overall portfolio returns gross of their management fees.  The problem with that is that investors can’t eat gross of fee performance and displaying as such can be somewhat misleading.
  • Inappropriate benchmarks:  The easiest way to jump over as hurdle is to start with a very low hurdle. When reviewing benchmarks being used for your investments, be sure that they properly represent the asset (or mix of assets) they are being compared to in terms of their risk/return characteristics as well as overall fit.  Selecting a proper benchmark at the position level can be relatively straightforward exercise, whereas assigning a blended one for a diversified portfolio is a bit more complicated.  To borrow a quote from Einstein, my belief here is that it should be as simple as possible, but not simpler.  This way, any credit (or blame) related to active decisions (factor tilts, regional biases, use of non-traditional strategies, etc.) can be attributed to the person managing the portfolio.
  • Improper use of backtests: Backtests in and of themselves are not inherently a bad thing and can be quite useful in hypothetical portfolio modeling.  But we should all respect their limitations.  As the name implies, backtests are inherently…you guessed it, backward-looking and therefore not representative of an actual investor experience.  There’s a joke in our business that no one has ever seen a bad backtest.  Research Affiliates did an interesting study, looking at backtested indices that were eventually packaged into investable ETFs.  The average index exhibited superior recent paper performance, but as you can see below that hypothetical outperformance magically disappeared the minute there was any real money behind it.

If you engage with a financial professional of any sort, or are considering doing so, you would be wise to keep an eye out for any of the red flags above.  The investment industry at large is filled with honest, hard-working people that do right by their clients.  But in finance – perhaps more than any other industry – a few bad actors can damage the reputation of the whole and make it more difficult for those who put their clients’ interests first to develop and maintain trust.  When it comes to selecting someone to provide you financial advice or manage your money, ask the right questions to ensure they act with integrity and transparency in how they report and communicate investment performance.  In other words, no “enhancements” necessary.

U.S. mutual funds boost own performance with unicorn mark-ups (Reuters)

Moving The Goalposts (The Irrelevant Investor)

About the author

Phil Huber, CFA, CFP®

Phil is the Head of Portfolio Solutions for Cliffwater, a leading alternative investment adviser and fund manager. Prior to joining Cliffwater in 2024, Phil was the Chief Investment Officer for Savant Wealth Management, a multi-billion dollar wealth management firm. Phil has been involved in the financial services industry since 2007. He earned a bachelor’s degree in finance from the Kelley School of Business at Indiana University. He is a member of the CFA Society of Chicago. More about me here. Twitter: @bpsandpieces

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