Avoiding the Benchmark Trap

In a recent Barron’s issue, a money manager was critical of a particular stock but said he owned it, although he was underweighted.

Comments of this kind from portfolio managers have grown so familiar that they pass by us almost unnoticed. In truth, they ought to set off alarm bells. Every portfolio manager has a fiduciary responsibility to try to preserve client capital and generate positive returns over time. Why would an “active” manager who is deeply skeptical about a company’s prospects own any of its shares at all? Why does the mere inclusion of a company or an entire economic sector in a market index make it a worthwhile—or an obligatory—investment? At First Eagle Investment Management, we believe the answer is the benchmark trap.

In this paper, we examine the damage that benchmark-dominated investing has inflicted on institutional investors’ portfolios and cite evidence that the awareness of these negative effects is growing. We conclude by outlining what we feel are the advantages of absolute-return-oriented, benchmark-agnostic strategies.

The emergence of benchmark-dominated investing

Over time, stock market indices have served a variety of purposes. The Dow-Jones Industrial Average, for example, was launched in 1896 to track how well U.S. industry was performing. It was not until the 1960s that stock market indices—especially the S&P 500—began to play a new role as benchmarks for measuring portfolio manager performance. In 1968 A.G. Becker, a Chicago investment bank that had acquired an early mainframe computer, introduced its Green Book tables comparing the performance of institutional investment managers to the relevant market indices. The Green Books demonstrated that with the application of sufficient computing power, indices could be a good yardstick for measuring manager performance.

Over time, however, benchmarks came to play a different, and damaging role—not just as a measuring device, but as a driver of investment decisions. In the case of passive funds (or index funds), this is entirely expected. But actively managed funds presumably represent rational investment decision-making. Why, then, would “active” investment managers purchase some stocks solely because they are included in a benchmark, even if they recognize those stocks as being significantly overvalued?

 

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