Financial Shenanigans

Drilled into us from the very get-go of our being we are taught how to discern between what is right and what is wrong. Beginning through learning, experiences, and education, we develop a nuanced understanding of ethical choices. Consider the child who learns that sharing toys fosters cooperation (right) while stealing them from your fellow peer elicits conflict (wrong). This ongoing process of discernment shapes our moral compass, guiding us through the complexities of decision-making in a diverse and ever-evolving world. By the time we hit later adulthood, we ought to have a very robust understanding of ethics. However, there is a problem whose veil has impacted many of us for quite some time. The concept of the previously mentioned ethics that govern our daily lives becomes mangled and warped when we enter into a professional arena. Suddenly, there is seemingly a need for a distinction between "ethics" and "business ethics." Adding financial gain, ego, and pride into the equation only further divides the two in practical nature. In an arena where no one is looking over their shoulder, many financial managers tend to manipulate their performance reporting by relying on business ethics to make benchmark comparisons.

Benchmarks are critical reference points that help investors, stakeholders, and market participants gauge the performance of a particular investment, strategy, or fund. They are objective standards against which the success or failure of financial endeavors is measured. Common benchmarks include market indices like the S&P 500, MSCI ACWI, fixed-income indices, or custom benchmarks tailored to specific investment strategies. In short, they serve as one tool to answer the question, "Could I have replicated the manager's performance on my own, while bearing less costs?"

Common ways in which we may see benchmark manipulation are listed below:

Selective Benchmarking: Managers may choose benchmarks that do not accurately reflect the risk and return characteristics of their investment strategy over the life of the investment period. This allows them to present a more favorable performance comparison. Worse yet, managers may choose benchmarks that measure performance via differing statistical calculations. A classic example is that of private market funds comparing their internal rate of return (IRR) to that of the performance of the public stock market which is traditionally calculated via compound annual growth rates (CAGR). Typically, selective benchmarking manifests when managers elect to choose benchmarks that closely mirror their portfolio at the time of presentation rather than determining a performance benchmark at the inception of the investment period.

Cherry-Picking Periods: Financial managers may selectively only showcase specific time periods when their performance was strong, conveniently omitting periods of underperformance. By focusing on the best-performing segments, they may create a distorted picture of consistent success. Be wary of reporting periods that begin on oddly specific dates that do not coincide with the beginning of the investment period, as well as reporting periods that do not run current to today's date. Markets tend to fluctuate over long cyclical periods for various reasons, and it does not take a genius to generate large gains from the bottom of the cycle to its peak.

Hidden Costs: Manipulative financial managers may understate the true costs associated with their investment strategies. By intentionally neglecting to include fees, transaction costs, or other expenses, they can make returns appear higher than an investor within their strategy may have experienced in reality. Each and every time we look at a benchmark comparison, be certain to look for the disclosure that indicates the presented performance is net of fees.

Window Dressing: Managers engage in window dressing by strategically adjusting their portfolio holdings at the end of reporting periods to include safer assets than what was present within the portfolio over the entirety of the period. This creates a misleading impression of the portfolio's overall health and is unsustainable in nature. A manager who deviates from their investment policy in favor of chasing superior returns over short time horizons is bound to experience unexpected volatility. Be wary of performance wherein underlying positions closely mirror benchmarks but seemingly generate superior returns each period. If a manager does not have an identifiable investment strategy that manifests itself through a unique portfolio construction, we may be bearing more risk than we intend to do so.

While benchmarks serve as valuable tools for evaluating investment performance, the complexities and potential for manipulation underscore the advantages of an alternative approach – choosing not to benchmark an investment strategy. This unconventional stance embraces the idea that each investment strategy should be evaluated on its own rather than against predetermined standards. By eschewing benchmarks, financial managers can focus on the unique goals, risk tolerances, and time horizons of their investors, fostering a more tailored approach. In short, managers ought to clearly lay out their returns projections alongside an expected timeframe, and be judged solely against what they set out to do. This strategy encourages flexibility, innovation, and a commitment to long-term value creation without succumbing to the pitfalls of benchmark-driven decision-making. Ultimately, the superiority of not benchmarking lies in the ability to navigate the financial landscape with genuine independence, prioritizing the interests and objectives of investors above the constraints of arbitrary standards.

At the beginning of our journey together, Virtue Capital Group elected to benchmark itself against the MSCI ACWI, an all-world equity index that sets out to capture the returns of public equities across the globe. As our investment strategy has unfolded, this benchmark is unfit for future comparison. While our portfolio has outperformed this measure since its inception, proudly we announce we will not be utilizing benchmarks moving forward. We ought to be evaluated by our ability to generate pleasant returns for you on our investments, nothing more and nothing less.