Thursday, October 25, 2012

Benchmark Obsession

Writing in the Financial Times in September 2011, GMO investment strategist James Montier wrote a piece titled "Benchmark Obsession Undermines Investor Returns".

Montier discussed the fact that the investment community, and the investors they serve, are obsessed with "beating the benchmark".

Using the S&P 500, or some other widely followed index, managers are judged on their relative performance as to whether they have carried out the duties to which they were assigned, regardless of whether their investment approach matched the risk appetite of their clients.

Yet lost in the relative performance game is the basic overriding objective for any investor:  having more money in the future than they have today.  This is usually combined with a secondary, but very important objective: not losing money.

Here's how Montier put it:

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.

(I've always liked that thought: "Maximize Real Returns".)

Most of us have no idea, for example, what the relative return of the funds in our 401(k) has been - we are only interested in the bottom line.

The same is true when we think about the value of our houses - no one has the slightest idea of how the change in your home's value compares to any index, only whether the potential selling price is higher than what we paid for it.

Yet when we sit down to evaluate investment alternatives, or select an investment manager, inevitably the conversation turns to "How did they do relative to the benchmark?".

I was reminded again of the absurdity of this approach when I saw this article on the CBS Marketwatch website yesterday.

According to the article, 98% of municipal bond funds can claim they beat their benchmark (woe if you are in the unlucky 2% that did not!).

Here's what the article said:

In the muni-bond fund universe, those odds are much better. In fact more than 98% of funds beat their benchmark, according to a new study from professors at three U.S. Universities that measured risk-adjusted returns for 124 open-end funds going back to 1992. That staggering success, however, may have less to do with a manager’s investing prowess than the yardstick he’s using, according to co-author Haiwei Chen of the University of Texas, Pan American. “You need to look beyond when they tell you, ‘We beat the benchmark,’” he says.

It seems to me that most investment decisions would be best focused on which asset class offers the best risk/reward trade-offs, and allocate capital accordingly.

I'll end with a thought from the great value investor Bob Kirby, quoted in Montier's column:

"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."