The bad & beguiling nature of benchmarking
The investment industry’s obsession with measurement, performance and comparisons has always struck me as odd.
The fact that investment professionals expend so much time and energy devising various measures and comparative statistics seems at odds with what they should be focused on, which, of course, should be generating absolute returns that correspond with their client’s needs and constraints.
Among others, one of the industry’s worst fixations is with benchmarking.
Of course we all need to be evaluated in some fashion but I fear the emphasis on benchmarking and comparing quarterly or annual returns to a benchmark is distracting investors from their ultimate goal of generating acceptable returns compared to their long term investment objectives.
I’ll briefly go through a few areas where I believe benchmarking is misapplied.
Relative valuation overshadows absolute valuation.
One of the major risks with our focus on benchmarking is that it leads us to focus on wrong principals of investing. One such aspect is an increasing focus on “relative” valuation versus “absolute” valuation.
A simple example will suffice. Let’s say your benchmark index is on the rise. You as a manager are afraid your relative performance will lag significantly if you stay in cash, when maybe this is the prudent thing to do.
As a result, your business may suffer as clients and potential clients see returns below the benchmark. This fear of “underperformance” could force you to make a poor investment decision, because absolute valuations are unattractive and come with higher risk, simply in order to keep up with your benchmark.
Would you buy more stocks at 45 times earnings or four times earnings? Should you buy a stock at 45 times earnings just because the market is trading at 60 times earnings?
Risk is not “tracking error” Tracking error refers to the deviation of returns from one’s benchmark. It is a gauge of how much you are either ahead or behind your measured index. Unfortunately this, again, forces a relevant focus and not an absolute one.
In this environment its best to be fully invested 100 percent of the time regardless of the investment valuation levels and investment opportunity set.
How you differ from a measurement tool seems less important than whether you are meeting your personal financial goals. Benjamin Graham said it best: there is only one true risk — permanent loss of capital.
Return becomes relative focused rather than absolute focused Being down “only” 20 percent because your benchmark was down 40 percent is not, in my opinion, a win. I would feel uncomfortable sitting in front of a client telling her how well she had done because she lost less money than some benchmark.
The reliance on ranking obscures true drivers of long-term excellence
Some of the world’s greatest managers underperformed for years during the technology bubble.
But when that bubble burst in 2000, they performed spectacularly, outperforming the market in spades. If investors and consultants simply picked the best managers to invest in they would have done themselves and clients a disservice.
According to research conducted by Robert W, Baird & Co: “ … approximately 85 percent of the top managers had at least one three-year period in which they underperformed their style benchmark by one percentage point or more. In fact, on average, they underperformed during six separate rolling three-year periods (out of a total of 29). About half of them lagged their benchmarks by three percentage points (on average, three separate times) and one-quarter of them fell five or more percentage points below the benchmark for at least one three-year period.”
The problem with focusing solely on relative performance is that most investors will focus on shorter periods of time and chase short-term performance to the detriment of long-term gains. Investors need to focus on the investment manager’s philosophy and process. It’s important that it is consistent with your requirements and objectives.
I fear the industry’s constant obsession with benchmarking continues to move us further down the road to a world of relativeness.
This world is all about measurement and not adherence to fundamental investing objectives consistent with client’s needs.It causes a distorted view that focuses on relative risk, return and valuations metrics. Our goal as investors should be to assess an investment portfolio in absolute terms and, more importantly, in relation to how it meets our personal investment goals and objectives.
Nathan Kowalski is the chief financial officer of Anchor Investment Management Ltd.