Benchmark obsession undermines investor returns

Sir John Templeton, the pioneering global investor, argued that the aim of investing was quite simply “maximum real returns”. Over time this simple but powerful objective has been lost. This is all the more surprising because, clearly, real returns matter to the end investor, particularly in current markets. Pensions are paid from real returns not relative ones.

So where did the concept of relative performance originate? It probably stemmed from good intentions (as do most bad ideas). Why pay active fees if the managers don’t deliver returns above a passive benchmark? However, this idea has morphed into an unhealthy obsession with pigeon-holing managers into niche buckets.

The late great value investor Bob Kirby opined: “Performance measurement is one of those basically good ideas that somehow got totally out of control. In many cases, the intense application of performance measurement techniques has actually served to impede the purpose it is supposed to serve”.
Investment committees spend an inordinate amount of time discussing decisions such as which small-cap growth manager to hire.
Yet often they fail to devote the same energy to discussing the asset classes to choose. They should spend more time selecting the asset classes. After all, the extra performance from a good manager over an asset class is unlikely to be much more than the icing on the cake.
Perhaps this neglect of the importance of asset class decisions stems from the fact that such discussions are inevitably harder than discussing the relative merits of a beauty parade of managers. Often discussions on asset classes degenerate into debates over the economic outlook.
Sadly this is largely an investment dead end. There is no evidence that anyone can read the economic tea leaves consistently well. As if that wasn’t difficult enough, even if you got the economics right, you still have to work out how the markets will react, and which assets will benefit.
Many institutional investors have their asset allocation dictated to them from asset liability studies, or simply implement a fixed ‘strategic’ asset allocation, thus abdicating responsibility for any discussion on asset classes. There is also a tendency to view ‘strategic’ as meaning static. This assumption needs challenging.
When a pensions plan appoints a manager with an investable benchmark they inadvertently create incentives to alter the manager’s behaviour.
Suddenly everything becomes relative, so the manager starts to think about relative valuation (ie is the asset I’m buying cheap relative to the benchmark?), relative risk (ie. I mustn’t deviate too far from my benchmark as I will be taking on ‘tracking error’), and, worst of all, relative return (ie. I did a good job because I only lost 30 per cent of your investment, and the benchmark was down 50 per cent). So while an investable benchmark makes measuring performance an easy task, it isn’t necessarily good for focusing the manager’s mind on generating real returns. Relative benchmarks are often employed to the detriment of real returns and the preservation of capital.
Thankfully, there is a simple, although not easy (to borrow Warren Buffett’s phrase), alternative – to use a value approach across a wide range of assets. Buy when an asset is cheap, and sell when an asset gets expensive – buy low and sell high, a sensible approach to both the preservation and growth of capital.
Valuation is the primary determinant of long-term returns, and the closest thing we have to a law of gravity in finance. For instance, buying assets when they are expensive (high price/earnings ratios in the equity space and low yields in the bond space) tends to result in low returns. In contrast, buying cheap assets generally leads to high long-term returns. So moving your assets in response to valuation signals makes sense.
Of course, there is a downside to this style of investing. In order to pursue a value-driven approach you need two key traits – patience and a willingness to be contrarian. Unfortunately these traits are in rare supply, and become almost extinct when people act in groups (such as committees).
Let’s end as we began with a quotation from Sir John Templeton: “If you buy the same securities as other people, you will have the same results as other people. It is impossible to produce a superior performance unless you do something different from the majority. To buy when others are despondently selling and to sell when others are greedily buying requires the greatest fortitude and pays the greatest reward”.
James Montier is a member of GMO’s asset allocation team and the author of several books including Behavioural Investing: A Practitioner’s Guide to Applying Behavioural Finance