The term ‘benchmark’ originated from the cobbling industry; customers’ foot shapes were marked onto a bench prior to the shoes being made. Our industry has always struggled to measure success with the intuitive gauge, both ignoring risk and failing to provide a comparator.
In the past, the industry has used peer groups and indices to provide this comparator reference. These have their limitations and Square Mile feels that low-cost passive funds can be employed as more appropriate performance reference points. Nevertheless investors need to seek benchmarks with appropriate risks otherwise they take a chance on a journey that may become unnecessarily uncomfortable.
One of the problems of any performance measurement is that as soon as the criteria are set, it influences the behaviour of those being assessed. No one would follow a lemming jumping from a cliff, yet misaligned objectives combined with investors’ propensity to herd can result in the financial equivalent.
In the 1990s many pension fund managers slavishly managed their portfolios versus the institutional CAPS survey. Unsurprisingly, the top funds were those with the most aggressive positioning and competitive forces obliged institutional managers to scramble up the risk scale during the extended bull market of the 1990s. Something similar happened in the IMA (now the IA) multi-asset sectors; many funds in the balanced sector ended up persistently running equity positions close to the 85 per cent sector limit. The post-millennium bear market proved to be a particularly uncomfortable for many investors as a result.
This is one of the reasons why Square Mile dislikes peer group benchmarking. However, even formal market indices are not without issues. There are often practical impediments preventing investors from replicating the performance of indices. Index producers are often forced to make various assumptions about tax rates, trading costs and timings of cash flows/corporate actions. In practice, passive investors cannot always fully replicate index performance, even before fund management fees.
Active managers have come under much criticism in the press for failing to add value (and indeed, by the industry’s regulator in the recent asset manager review). Comparisons are made versus the index despite the fact that a passive strategy could not match the index return.
It should not come as a surprise that passive funds tracking the FTSE All Share index persistently underperform each and every year. What is less widely known is that UK active managers can beat the index. In fact, despite widespread insinuations otherwise, investors would have been better off investing in the average active UK equity fund as opposed to an average UK equity passive fund over virtually any rolling three year period of the last 15 years.
Since the index return is unobtainable, it rather makes sense for investors to compare active funds versus what is obtainable. The obvious answer would be a suitable low-cost passive fund. Square Mile believes investors should be doing this when they consider allocations between active and passive strategies in their portfolios.
Investors also need to think very hard whether the index represents a benchmark with a compatible level of risk that they seek. For instance, many gilt funds are measured with reference to the All Stocks Gilt index and accordingly managed with relatively tight duration parameters around this. However, it would be purely coincidental if the 11-year average duration provided by this index matched the appropriate level of interest rate risk suitable for a client’s portfolio. Equally it does not square that a client with ‘an average’ appetite for risk should be matched with a portfolio that is 50/50 bonds and equities.
Fortunately the world has moved on from considering that passive investments represent the ‘low risk’ option. However, investors may be ignoring the technical risks inside an index and whether they represent a suitable benchmark from a risk perspective. We fear that far too many investors are taking shoes from the shelf merely because these are readily available rather than having due consideration for whether they genuinely represent a true fit.