Benchmarks and Universes Part 2: The Rules of Underperformance
Institutional money management was born about 40 years ago as a result of two important events and a consequence. Congress enacted the Employment and Retirement Investment and Security Act (ERISA), which gave an important nudge to the institutional management of pension funds in stocks and bonds. Around the same time, the SEC deregulated brokerage commissions. These events encouraged brokers to become money managers as the fee for managing money became more attractive than the earnings from commissions on stock trades. As a consequence, investors began to look for someone to help them evaluate the performance of their money managers, and the consulting industry was born. Investors had a key question – how do I know if my money manager is doing a good job? The answer was to compare the performance of a stock portfolio to the S&P 500, an index of the stock market developed by Standard and Poor’s. Unlike the Dow Jones Industrials, which consists of only 30 stocks, the S&P was a broad index of 500 stocks constructed in a manner similar to a real portfolio.
|Napkin #11 (1999)|
From the outset money managers had difficulty keeping pace with the S&P 500, and began making excuses for their underperformance. Managers who focused on cheap stocks (value) claimed that the index didn’t capture their investment style. Growth managers had similar complaints about the S&P 500. Managers who made their living buying small companies pointed out that the S&P 500 measured the performance of large companies rather than small ones. As a result, consultants began developing all kinds of specialized indices that more closely resembled the styles and practices of money managers. Similarly, fixed income investors needed a benchmark to evaluate performance of their managers, so a wide variety of bond indices came into being. Despite the proliferation of benchmarks, the average manager continued to underperform.
What have we learned from benchmarks over the last four decades?
1. The average money manager cannot beat a well-constructed benchmark over any meaningful time period. For most managers, fees and trading costs eat up any advantage the manager generates over an index.
2. If managers consistently beat an index, there’s probably something wrong with the index. In other words, the managers have found a way to game the index. For example, bond managers have consistently beaten the Barclays Aggregate Bond Index by investing in high yield (“junk”) bonds. Junk bonds are not included in that index, so the manager is not “fishing in the same pond” as the index.
3. As indices have proliferated, money managers have become adept at finding benchmarks that cast them in a favorable light, at least for a while. Consultants, banks, brokers, and academics have been responsible for developing the wide array of benchmarks. After a year or two of favorable performance either rule 1 (underperformance) or rule 2 (poorly constructed index) will apply to most money managers.
4. Most clients and their consultants fire their managers well before they can determine if the manager has skill or not. In fact, investors and consultants spend way too much time evaluating money managers over meaningless periods of time such as quarterly results. Firing and hiring managers is an expensive process that further detracts from investment performance.
5. Hedge funds are one of the great inventions of all time. Not only do they command higher fees than comparable forms of money management, they also operate in ways that defy the development of decent benchmarks. In other words, it is almost impossible to judge if a hedge fund is truly adding value or not.
6. Investors would be far better served investing in well-constructed index funds, rather than hiring active money managers. This rule does not apply to private equity and real estate funds as there isn’t an investible index for illiquid investments.
A benchmark (an index of representative stocks or bonds) is one way to evaluate a money manager’s performance. Tomorrow we’ll look at universes, which measure a manager against his competitors.