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manager typically is looking at his competitors’
latest returns because, in the words of renowned
economist John Maynard Keynes, “wisdom teaches
that it is better for reputation to fail conventionally
than to succeed unconventionally”.
The working paper shows that the effects of
benchmarking are powerful enough to cause the
inversion of risk and return on the scale observed
in empirical studies. It also demonstrates that the
tighter the tracking error constraints that are applied,
the more pronounced the price distortions become.
There is no clearer demonstration that asset owners’
attempts to reduce their private risks exacerbate the
riskiness of the overall market.
One might imagine that there would be plenty of
investors eager to exploit the higher returns offered
by low-risk securities and that their
buying would go some way to correcting the
distortion. But ‘unbenchmarked’ funds are equally
attracted to high-risk stocks because they are seen
to offer the best chance for short-term, momentum-
type gains. This is especially true of hedge funds,
benchmarked to cash but eager to appease their
clients with short-term gains.
HOW FUNDS SHOULD RESPOND?
Market cap benchmarking is therefore skewing
the composition of indexes and representative
portfolios towards high-risk and low-return assets to
investors’ detriment. Even passive portfolios suffer
from this effect. But the costs are compounded for
active managers because they are obliged to chase
securities whose prices are rising irrespective of their
fundamental value. They are effectively forced into a
momentum strategy for a significant portion of the
Benchmarking is introduced to control the risk
taken by managers but ends up damaging returns.
The objective is to find a way of giving the manager
unbiased scope to invest in cheap stocks, while at
the same time leaving the asset owner with ample
oversight of the manager’s actions.
For a start, a benchmark should be chosen that
has no ugly feedback effects; examples might be
cash, the local consumer price index, or growth of
global gross domestic product plus local inflation.
Performance should be measured against these
economic indicators over the medium and long run
and rewarded on a strictly medium or long run basis,
such as rolling five-year returns.
Next, other ways must be found to monitor
managers’ actions. The key to successful long-
term investing is the insistence on investing based
on buying cheap stocks. There are only two basic
strategies for investing: momentum and fundamental
value. Momentum follows fund flows and ignores
the cash flows, or the earning power of assets,
whereas value investing is based on estimates of cash
flows and ignores fund flows.
Momentum is suitable only for short-horizon
investors, while fundamental value wins in the
medium and long-run . This is hardly surprising
because momentum investors buy after prices have
risen, whereas value investors buy after prices have
fallen or cash flows have risen. Freeing managers
from market-cap benchmarking leaves them greater
scope to focus on fundamental value, but asset
owners need to monitor managers carefully on
turnover (high turnover gives a momentum investor
away), and trading patterns to ensure that is what
they are doing.
Funds gain a private advantage from adopting
these principles of investing, even to the point of
there being an early mover advantage. Above all, the
real economy benefits from the more efficient pricing
of securities markets, better allocation of capital and
less likelihood on bubbles and crashes.
Dr. Paul Woolley is chairman of the advisory board
and senior fellow at The Paul Woolley Centre for the
Study of Capital Market Dysfunctionality, London
School of Economics and Political Science.
Table 1: Beta anomaly
US equities, 1970-2011
Global equities, 1984 -2011
Source: GMO Boston.
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