George Latham, Managing Partner and CIO of WHEB Asset Management and Mike Clark, Founder of Ario Advisory and member of WHEB’s Independent Investment Advisory Committee challenge conventional benchmark orthodoxy and suggest a way forward
The debate around the so-called ‘tyranny of the benchmark’ is not new. Yet it continues to be revisited time and again as a cause of short-term thinking which creates a perverse incentive for fund managers. However, nothing seems to change. Few are prepared to challenge the existing orthodoxy of portfolio construction and the role of benchmarks. The status quo is maintained. This must change.
What are benchmarks for?
A starting point is to try to understand why benchmarks exist. What should their purpose be? It is widely agreed there exists an asymmetry of information between fund managers (as agents) and asset owners (as principals). The principals are often pension fund trustees on whom rests the responsibility of fiduciary duty, which is designed to ensure that decisions are made in the best interests of the trustees’ beneficiaries. Over a long period of time, those interests have become progressively less well aligned with those of the fund managers that they employ. So how are trustees supposed to hold fund managers to account, to make sure that they can demonstrate to their beneficiaries that they have done the right thing and discharged their fiduciary duty? Financial markets are complex systems. Trustees have limited resources at their disposal, certainly fewer resources than the fund managers they are supposed to be holding accountable. A benchmark makes this uncomfortable responsibility more manageable. Give the fund manager a benchmark and tell them to beat it. Then ask them to regularly report on how they are doing and the answer is simple and straight forward. Ahead of the benchmark? “Well-done, we look forward to our next meeting.” A bit behind? “We need to keep an eye on you…” Behind again? “You’re fired!!”.
A Fund Manager’s behaviour is driven by incentives
The problem is that this approach fails what is known as Goodhart’s Law[i]. This was first popularised during the 1980’s by economist Charles Goodhart who observed “when a measure becomes a target, it ceases to be a good measure.” WHEB’s target is to provide an attractive balance of risk and return (and impact, of which more later) from investing in global equities. A typical measure of how well we are achieving that target is our performance against the MSCI World Index. An alternative measure might be the performance of other funds trying to achieve the same thing, i.e. the peer group, in WHEB’s case the IA Global Equity sector. A longer term measure might be based on absolute return, related to the equity risk premium, for example. There is no real reason why one of these is any more appropriate than the other.
The problem comes when this measure becomes the target against which the fund manager is are judged. Primarily, fund managers don’t want to get fired. Therefore, they don’t want their (short term) performance to be too far away from the target, for fear of standing out for all the wrong reasons. As a result, rather than being a target to beat, the benchmark has often come to define the default portfolio and thus to determine the starting point for its overall composition. Risk measurement is thereby perverted, with risk usually measured by the level of deviation from the benchmark. This completely overlooks the risk embedded within the benchmark. Then, because trustees need to be seen to monitor and hold fund managers to account on a regular basis, quarterly reporting on relative performance is the key driver of short term behaviour by fund managers, with all the much discussed wider problems this creates for the underlying economy[ii]. To move away from this position, we must start to consider how pension fund trustees can be held more accountable for the total risk, and resulting outcomes, of their respective pension funds.
Lazy target setting, allowing a benchmark to have autonomous influence in portfolio construction is a poor starting point, and drives a range of behavioural problems. The index itself is a better guide to the past than it is to the future. More than half the stocks that made up the Fortune 500 in 2000 have now ceased to exist. That is not to say that all of these stocks have failed. Some have, and others have been taken over. But it hardly builds conviction that this is a stable basis from which to build a long term forward looking portfolio. We have recently seen significant concerns voiced over the health of the UK pension fund industry because £1 in every £8 of income received by UK pension funds comes from Royal Dutch Shell, where cash-flow has been under increasing pressure due to rising capex and falling returns[iii]. The reason why the average pension fund has such high exposure to Shell? Because it is one of the largest stocks in the dividend paying benchmark. The use of benchmarks, and the resulting passive index funds, creates a backwards looking mentality. It also leads to herding and an increased exposure to what has already become more expensive, inflating bubbles. Importantly, it doesn’t always help to create the desired exposure. Many UK pension funds will use the FTSE All Share index as a benchmark because it is seen as representative of the UK economy. This has created some perverse exposures to Central Asian mining companies in the past, which have little relation to the UK economy. This mind-set is also an obstacle to innovation and change. It is very difficult to raise money for investments that are considered ‘off-benchmark’, as this represents a higher risk to the fund manager.
This article is not the place to go into details, but we note that traditional finance theory struggles to cope with herding, bubbles, and the behaviour of all the other actors in the system. It tends to assume market returns are a given (in a probabilistic sense), and we simply choose a level of risk with specified ex ante outcomes. But those ex ante outcomes are based on past data, and a particular modelling view. Why do fat tails come along rather too often? Why do investors herd? Those who make decisions based on traditional finance theory alone struggle with the implications of these real world questions. Newtonian mechanics was struggling until Einstein came along. It’s early days but systems theory, complex adaptive systems, emergent behaviour and other concepts are all part of a developing dialogue which is only just beginning to reach – and perhaps influence – investor decision makers.
As discussed above, risk analysis has too often focused on risk relative to benchmark, or sometimes risk relative to other managers. Many investors own a benchmark (or significant) position in a stock to avoid the risk of underperforming. Risk is often analysed as tracking error – which is literally suggesting that the lowest level of risk is an index tracker fund! This is lazy thinking and undermines a truer focus on overall risk in terms of portfolio diversification, liquidity risk, governance, transparency, maturity profile, valuation and the risk of a permanent loss of capital. Investors, asset owners and fund managers, need a framework in which they spend more time worrying and thinking about what they do own and where they have allocated capital, rather than fretting about what they don’t own. Benchmarks tend to anchor that anxiety by making the decision not to invest in a stock as important as choosing what stocks to own.
A better way to assess risk
So how do we assess total risk, and determine the asset allocation which flows from the total risk decision? At present, the process often just ignores wider investment beliefs, or treats our implicit finance beliefs as a given. When setting strategy, we consider market risk and return, beta, and when managing and evaluating a particular portfolio we pore over alpha. A lot. But how do our investment beliefs relate to the goals and aspirations of the savers we serve, the pensioners of the future? Too often, the answer is “not really at all”. We define and evaluate the mission in terms of narrow financial returns, and short term returns at that. Can it be otherwise? Yes. Leading asset owners around the world have recognised that they really need to think and then act in a way that is aligned with the time horizon of the pool of capital they direct. They have set out investment beliefs which cover, unsurprisingly, investment returns, but also acknowledge other issues such as climate risk. Establishing such beliefs, and being confident that they can be implemented meaningfully, requires hard work, stamina and a willingness to unlearn some of the things trustees have been taught, usually by traditional investment consultants. No longer does asset allocation simply fall out of a “choose your risk tolerance” exercise. There is active interest in the real world outcomes of the entities where the asset owner’s capital is invested. The impact, in real economy terms, has become a metric.
This is a revolution
This mind set views risk differently. No longer do asset owners decide the level of beta risk, set their strategy in terms of standard benchmarks, and either employ investment managers to invest actively to beat the benchmarks (a relative-risk task), or invest passively in line with an (inappropriate?) benchmark. Now they view climate change risk, for example, as a risk that permeates the whole portfolio and needs to be integrated into the investment process from outset. Does the asset owner believe public policy and regulation might begin to price carbon (aka CO2 emissions) in a way that the market does not currently acknowledge? Some do. They may view it more as an uncertainty issue than a risk issue, but they want to reduce their exposure to the related risk, and they seek to do that. It’s financial. They specify their own “better beta”.
Finding a way forward
Where do benchmarks fit into all this? Currently, an investment benchmark is almost synonymous with a market index. The benchmark specifies the default risk/return stance of an investment manager’s portfolio. It ensures the asset owner can segment their (beta) strategy into manageable chunks of assets which become investable capital in the investment manager’s hands. And we might conflate a combination of portfolio benchmarks into an asset owner’s strategic benchmark, in a bottom-up way. Instead of this, what if we start from their investment beliefs? A benchmark then becomes a tool to measure the asset owner’s progress towards their goals, which flow from their beliefs. We might firstly think of the benchmark as their desired capital market exposures. This could include “low carbon”. Or we might go further.
We might want to evaluate the asset owner’s energy exposure against an IEA (International Energy Agency) future scenario. Suddenly, we are looking at long term risks in a different, richer, way. Let us remember that asset allocation is a risk allocation exercise, before it is an asset allocation exercise. However, we tend to think of risk in asset allocation terms, largely because asset classes are readily definable, in a way that risk drivers are not. A fascinating recent paper by CUSP[iv] teaches us the way metrics can shape how we address an issue. Sometimes metrics need to compete in terms of the differing views of the world they promote. Investment management needs some new metrics – impact metrics.
One of the key conclusions in Mercer’s 2015 paper ‘Investing in a time of Climate Change’[v] was that the differential in market returns between sectors as a result of climate change was likely to be more significant than the equivalent effect on asset class returns. This means it will become more important to select exposure to the right sectors of the economy, than it is to allocate between equities, bonds, property and cash. Traditional benchmarks and the asset allocation process do not cater for this, and so a new approach is required.
The role of Impact
Sir Ronald Cohen, co-founder of Apax Partners Worldwide and Chairman of the Global Social Impact Investment Steering Group, stated that “in the 19th century we learned to measure investment return, and in the 20th century we measured risk and return. In the 21st century we will start to measure risk, return and impact.”[vi] All economic activity can be thought of as having some kind of social or environmental impact. In a financialised market (driven by benchmarks) this is considered irrelevant, but increasingly academic and business theorists argue that such externalities do have an effect on economic performance. Michael Porter, originator of the concept of Porter’s Five Forces, has more recently focused his efforts on developing the concept of ‘shared value’.[vii] Businesses that create ‘shared value’ for a broad range of stakeholders – including wider society, the environment, employees and customers – are likely to be more resilient and more profitable in the longer term.
The straightjacket of traditional benchmarks has severely hindered these sorts of issues from being considered in asset allocation, stock selection and portfolio performance reporting because they don’t fit the way we frame the goals of the system. The way we think about the purpose of our investments needs to change. We need to find better ways of enabling asset owners to invest in and express positive impact through their portfolios. This can be done if the (standard) benchmark is relegated to being just one key performance indicator among several to be used as a measure of how a longer-term and more holistic ‘mission’ is being achieved. Building on the work of current leaders, several of whom find the UN’s Sustainable Development Goals[viii] (SDGs) a helpful framing, we must find a better way of expressing this mission, the longer term goals of an asset owner – be it a pension fund, an endowment or a family office. A mission is more effective as a form of words which describe the objective, as opposed to a single metric. We can then develop key performance indicators which allow a level of quantification and rigour to monitor progress towards the mission.
Measuring and reporting the impact outcomes of our investments against such objectives is the way forward to develop a more holistic understanding of risk and return. Understandably, there are as yet no agreed standards on how to quantify this. They will undoubtedly evolve. We will need to ensure that the instinctive and reductive desire of the finance industry to quantify and compare does not end up falling foul of Goodhart’s Law all over again.
[ii] See for example The Kay Review of UK Equity Markets and Long-Term Decision Making, 2012
[vi] Sir Ronald Cohen, speaking to the UNPRI In Person Conference, London, Sept 2015