Although comparing fund managers’ performance against a benchmark index can be useful to measure performance, it should not be the starting point for portfolio construction, according to experts.
Passive funds that track an index are a great tool for investors who want a cheap way to access the growth of public markets, but the fund management industry’s obsession with benchmarks can lead to unexpected issues, according to Lazard Asset Management’s Steve Wreford.
“What is a benchmark? It's basically investing by size, so a benchmark tells you a lot about the past and what's happened before,” he said.
“But the past as we know from every financial disclosure is not necessarily an indicator of the future. So, by definition you are anchoring a portfolio to the past when investing is all about understanding the future.
“This is a fundamental framing bias.”
Wreford said another issue with benchmarks is that it has changed the way the fund management industry and portfolio managers think about the concept of risk.
He said: “Today, many parts of the industry that are benchmark-centric, they think about risk as being dialling these little dials up and down versus a benchmark – and that’s the risk you are taking.
“I think that's at odds with the ultimate goal that many investors want, who would see risk as the permanent loss of capital.
“There seems to be to me a bifurcation there between what the end investor actually wants, and in many ways, what the industry is serving up.”
He said another unexpected consequence of benchmarks is that it has encouraged short-term behaviour from portfolio managers.
“Benchmarks are useful for initiating a conversation, but as those conversations become more and more frequent it drags investors towards the short term as they start to worry about that deviation versus the benchmark,” he explained.
“Many portfolio managers can end up in a situation where, quarter-by-quarter, they're worried about deviating too much from the benchmark because those conversations come first.
“That is very much at odds with where the big money is made in markets: which is over the long term.”
Even if you disagree with the notion that benchmarking performance is detrimental, Wes Crill, PhD, head of investment strategists at Dimensional Fund Advisors, said that the indices that funds choose to benchmark their performance against, can themselves be problematic.
He argued that the infrequent rebalancing of indices means that the index will often drift from its original intention of providing investors exposure to their desired asset class.
By way of example, he pointed to the rise of ‘meme’ stocks GameStop and AMC at the start of 2021. After their stock prices experienced a huge run-up amidst a retail-driven short squeeze, the companies eventually became priced as large-cap growth stocks.
Yet by the end of May, they represented 1.5% of the Russell 2000 Value Index – an index designed to give exposure to small-cap value stocks.
“On the scale of size discrepancies, this is akin to 7-foot-6-inch former NBA star Yao Ming visiting a kindergarten class,” Crill said.
“However, investors in strategies tracking the Russell 2000 Value Index may be surprised to learn the list of holdings inconsistent with the index’s definition goes much deeper, an outcome of the style drift potentially occurring with most index-based approaches due to infrequent rebalancing.”
At the end of every June the Russell indices are reconstituted: additions and deletions are made to the list of constituents according to the indices’ rules.
For example, the Russell 2000 Value Index constituent list is updated to generally include only value companies below the 1,000th-largest stock in the Russell 3000 Index.
“What happens in between these reconstitution events? Imagine skipping lawn mowing duty for a few months and you’ll get the picture,” Crill said.
He pointed to a graph showing the Russell 2000 Value Index’s holdings at the end of June 2020 after its reconstitution and another showing its holdings at the end of May 2021 just before its next reconstitution.
Size and relative price of Russell 2000 Value Index holdings
Source: Dimensional Fund Advisors
In June 2020 after the reconstitution, most of the holdings fell into the small-cap value category as seen in the chart on the left. But 11 months later, the chart on the right shows how many of the index’s holdings drifted up in both market cap and relative price.
By the end of May 2021, nearly 16% of the index’s weight was accounted for by stocks among the largest 1,000: the domain of Russell’s large-cap indices.
“While GameStop is not the only growth name in the index, its tiny book-to-market ratio of 0.03 combined with its $16.5bn market cap give it a Yao Ming-like presence in the northwest corner of the style chart,” Crill said.
He warned that by simply following an index that rebalances once a year, it can lead to unintended style drift.
He said: “Research tells us the relative performance of small-cap value tends to be delivered by a small subset of the asset class and can show up in bunches.
“Both insights are relevant for style drift: infrequent rebalancing can reduce the likelihood of holding the stocks that deliver the premium as well as blunt one’s exposure to the asset class at inopportune times, potentially reducing an investor’s participation in strong runs for small-cap value stocks.”
Instead, he suggested that daily portfolio management could prevent this style drift – but admitted that this would be prohibitively expensive for a strategy rigidly tracking an index.