Why Benchmarks Lead to Bubbles | Chief Investment Officer

Measuring performance relative to benchmarks has inverted the relationship between risk and return, London School of Economics (LSE) researchers have argued.

“Capitalism is in danger of dying by its own sword unless the present absurdities are recognized and addressed.”Not only does benchmarking cause high-volatility securities and asset classes to offer lower returns than low-volatility ones, it also gives rise to sector bubbles and herding behavior, according to finance professor Dimitri Vayanos and research fellow Paul Woolley.

“Obsession with short-term performance against market cap benchmarks preordains the dysfunctionality of asset markets,” they wrote. “The problems start when trustees hire fund managers to outperform benchmark indexes subject to limits on annual divergence.”

The duo acknowledged that there are benefits to using a benchmark as part of a given mandate, including that it offers a point of comparison for the fund’s returns and provides a defined objective for the manager.

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However, they argued that benchmarking exacerbates inefficiencies in the market by rewarding momentum strategies, wherein short-term investors acquire popular securities as they rise in price, with the intent of selling when they begin to fall.

Meanwhile, long-term managers who are underweight these superficially rising assets suffer as being underweight causes them to underperform the benchmark.

“If a security doubles in price and the investor is half-weight, the mismatch doubles; if he is double-weighted and the price halves, the mismatch halves also,” Vavanos and Woolley wrote. “Underweight positions in large, risky securities therefore have the greatest potential to cause a manager grief.”

According to Vavanos and Woolley, this need to satisfy the tracking constraints of a benchmark forces value managers to buy bubble stocks they know to be over-priced.

“The overall market becomes permanently over-valued and prone to sector bubbles,” they wrote.

Rather than relying on a market-cap benchmark, the LSE economists said asset owners should compare manager performance against that of value investors. That way, managers are incentivized to invest on the basis of fundamental value rather than momentum.

“Capitalism is in danger of dying by its own sword unless the present absurdities are recognized and addressed,” they concluded.

Investment consultants and other advisers are a sticking point in asset management’s embrace of environmental, social, and governance (ESG) investing, according to a report from the United Nations Principles for Responsible Investment (UNPRI).

Asset owners should make explicit reference to ESG requirements when appointing advisers, the UNPRI said.

“Most consultants are not actively supportive of ESG or responsible investment and so tend not to proactively raise the issue.”Currently, consulting firms typically employ specialists or “small teams” focused on responsible investment, rather than incorporating the principles throughout their processes. This is despite a growing number of asset managers embracing ESG.

“These are usually established as separate advisory centres rather than being integrated into all investment advisory services, which results in ESG being an additional service and cost,” the report said.

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“Most consultants are not actively supportive of ESG or responsible investment and so, in the absence of explicit demand from their clients, tend not to proactively raise the issue,” Isaac Ramputa, chair of South African pension fund association Batseta, told the UNPRI’s report. “Asset owners need to proactively engage with investment consultants and they should require them to explicitly look at ESG and responsible investment when evaluating and recommending investment managers.”

Consultants interviewed by the UNPRI’s researchers reiterated Ramputa’s assertion that asset owners rarely raise responsible investment issues with them.

“When appointing investment consultants and legal advisers, asset owners should ask them to explain how ESG factors and responsible investment are integrated into the advice that they provide,” the UNPRI said. “Asset owners should also ensure that ESG issues and responsible investment are standing items in consultant meetings.”

However, while ESG is likely to become a “hygiene factor” in all manager searches, “it is unlikely that all investment managers would be expected to have ESG capabilities as an integral part of how they deliver investment performance,” according to Nico Aspinall, head of UK DC investment consulting at Willis Towers Watson.

“Investment consultants generally focus on the core expertise of the investment manager—i.e. what are their core competencies, how do they add value—and generally believe that investment managers should build their business around this core expertise,” Aspinall said. “Put another way, investment consultants see ESG as one set of skills/competencies that an investment manager might bring to the table.”

There is some evidence that attitudes are evolving: Over the next two to three years, 56% of managers expect high demand for ESG-oriented products from foundations, according to a report by Cerulli Associates and the US Sustainable Investment Forum.

In addition, more than half of consultants surveyed “are evaluating and, in some cases, recommending impact investments to their private wealth and institutional clients,” Cerulli added.

Investment consulting giant Mercer released a report last year detailing what would happen to financial assets under various climate change scenarios. Cambridge Associates issued a report on the same theme in December, arguing that “markets are likely to see many more cycles in which investors can capture returns.”