This is a scary obsession that has taken over the world of professional investing: the need to compare success to benchmarks. This trend, which I’m going to call “benchmarkism,” is altering incentives and pushing a lot of institutional investors in the wrong way. Let’s look into how to get out of this benchmark trap and start spending smarter, with the goal of steady long-term wealth growth.
What Made the Benchmark Popular ?
Investing standards became popular in the late 1800s when Charles Dow created the Dow Jones Industrial Average. When that happened, standards didn’t play a big part. Diversified funds like Robeco’s show that investors were mostly interested in returns. Before many years after Robeco was formed in 1929, benchmarks had no effect on the company’s funds.
Benchmarks didn’t become the main way that investors measured success until the efficient market hypothesis became popular in the 1960s. These days, beating benchmarks is often seen as the only way to be successful, putting aside the most basic rules of investment, which are to keep your money safe and make a good return. Compared to the past, investors are focusing more and more on short-term success.
Historical Lesson of Fisher Black
Focusing on relative return over risk control is not a new idea. Fisher Black, who helped create the capital asset price model (CAPM), tried to start a low-risk equity fund at Wells Fargo in the early 1970s. His studies showed that low-beta stocks could get profits similar to those of the market while posing less risk to assets. Using the idea of “winning by losing less,” the fund hoped to make money. Although, it didn’t take off.
Surprisingly, defensive, low-volatility strategies didn’t really take off until the dot-com boom burst in 2000 and the financial crisis of 2008. In the early 2010s, a lot of money was poured into a number of very famous low-volatility exchange-traded funds (ETFs).[1] Black’s idea is more important now than it was then. Defensive tactics have shown they are strong by doing better during bad times, like in 2022. However, because these strategies are based on relative performance, they often don’t look as good when compared to a standard that is becoming more concentrated in bullish markets, like the current US tech rally of 2024.
How benchmarking can hurt more than just one thing?
Not only do benchmarks affect individual accounts, but they also affect a lot more than that. A lot of institutional investors are stuck with stocks because they only care about beating the standard. Overestimating dangerous investments and undervaluing safer ones can happen when this is the only thing that people think about. As technology stocks got more and more weight in the markets, they became way too expensive. This was very clear during the tech bubble in the late 1990s.
Even worse, regulatory systems can make people act in this way even more. In places like the Netherlands, business pension funds have to explain why their performance is different from the benchmark. Funds that take a more defensive approach are often punished for this. What is the “Your Future, Your Super” rule in Australia? It forces investors to stick to benchmark-like returns, even if it’s not in the best long-term interest of their beneficiaries.
As a result, professional investors have duties to their clients and are watched over by regulators, so they can’t lower the absolute risk in their stock portfolio to keep up with a more concentrated benchmark. This is true even in markets where there are speculative bubbles or systemic instability.
Index Committees and What They Do
Another important thing to think about is the impact of standard providers like MSCI. When they choose which stocks or countries to include in an index, these groups have a lot of power. Their choices, which are often influenced by pressure, have huge effects on the flow of investments around the world. For example, since 2018, local Chinese stocks have been included in global indices. This has caused investors from all over the world to put money into China, even though there are problems with government and geopolitical risk.
Index companies are also trying to get their standards built into the rules that govern the industry. Recently, Brussels made changes to the Sustainable Finance Disclosure Regulation (SFDR) to include Paris-aligned benchmarks. These changes show how the subjective decisions of index providers can affect the flow of large amounts of money. But these measures don’t always match up.
For example, Nexans, a company that is important to the energy shift, was left out of the Paris-Aligned High Yield Index because it releases carbon into the air. On the other hand, Ford Motor, an automaker that mostly runs on carbon fuels, was included. These kinds of problems show the dangers of depending too much on benchmarks.
Is There a Way Out of Benchmarks Unchained?
How can buyers get out of the trap of the base price? Within the last ten years, sustainable and impact investments have grown a lot. When tobacco or fossil fuel stocks are left out, for example, normal benchmarks are often not followed. People who invest in sustainability have to rethink the role of standards as more investors use them. They can’t just say, “It’s in the index” to defend their financial choices anymore.
Rethinking financial goals is prompted by this change. And by considering sustainability factors and the effect of their investments, investors are beginning to look beyond just risk and return, adding a third dimension: sustainability. As a result, benchmark dependence can be lowered, total risk can be prioritized, and a better understanding of “knowing what you own” can grow.
Not as good as Marxism?
The debate on benchmark investment began in 2016 with an interesting piece by Sanford C. Bernstein & Co. called “Why Passive Investment is worse than Marxism.” This similarity was too strong, but it brought up an important question: speculators or investors? Who will set market prices?
If professional investors stick too closely to benchmarks, a small group of busy players will set market prices more and more. The people in this group are very important, but that doesn’t mean they will make markets work better. As we saw with the 2021 GameStop short squeeze, speculative small investors taking on high-risk positions can push prices to bubble levels and leave behind more careful investors who are focused on the basics. When investors stick to benchmarks, markets become less stable because capital is allocated based on how an index is put together instead of facts.
Changes to rules and investment guidelines
To fully break free from the benchmark trap, rules and financial principles need to be rethought on a larger scale. When judging success, regulators could pay more attention to absolute risk rather than relative risk. For long-term risk management, this would be more important than short-term tracking mistakes. Instead of focusing on how close a portfolio is to the benchmark, investors can make more careful, risk-aware choices by looking at how volatile or resilient it is during market downturns. (ii)
Also, pension funds and other institutional investors often go over their investment ideas again. When benchmarks are too strict, they can get in the way of the fiduciary duty to protect and grow capital over the long run. Managers can stay focused on long-term growth and capital protection by reviewing benchmarks on a regular basis. This will keep them from getting sidetracked by short-term discussions of relative performance.
Back to the Basic Benchmark
Ultimately, ignoring the standard is the best way to beat it, at least in the short term. Investors should follow Warren Buffett’s famous rule, “Don’t lose capital.” By focusing on absolute returns and avoiding danger that isn’t necessary, investors can stay away from the problems that benchmarkism causes.
For example, small caps or defensive stocks that aren’t well represented in benchmarks can often be great investment chances, especially when the market is very concentrated like it is now. Additionally, bonds that go from being investment grade to high yield, called “fallen angels,” can become very cheap because buyers are forced to sell them to meet benchmarks. Contrarian investors can take advantage of these errors in the system by making investments.
Thus, an investor’s edge might not come from being smarter but from having fewer limits. Despite what you might think, investors can find hidden value and achieve long-term performance—even better than the benchmark—by focusing on fundamentals and important risks like losing capital instead of being fixated on benchmarks.
