More benchmarks in the world than stocks – how it can affect you

The number of indices benchmarking portfolio performance in the world now far exceeds the actual number of stocks in the world. This is patently absurd. Benchmarks and indices were first created to collate and measure the performance of a basket of securities. Now, you could have one basket for every security and still have too many.

This raises the question of what benchmarking is meant to achieve, and the effects of the proliferation of benchmarks on how capital is invested.

A value for the major US stock market index, the Standard & Poor’s 500, was first published in 1923 with a small number of stocks, expanding to 90 stocks in 1926 and then in 1957 to its current 500 companies. The number of benchmarks has blossomed since then, across virtually all asset classes and investment types.  

Benchmarks and indices are largely two ways to refer to the same thing – a basket of securities that have a common thread and can therefore be combined and tracked. For example, the S&P 500 combines the performances of 500 publicly traded US domestic companies listed on the New York Stock Exchange or the high-tech NASDAQ index, using weightings determined by the index’s owner. A similar process is used for the Australian stock market’s benchmark Standard & Poor’s/ASX 200 index.

According to broker Alliance Bernstein, there are already over a million indices in the world and the number is growing exponentially due to lack of barriers to index creation and a perception of high demand. The total number of stocks in the world, by contrast, is approximately 43,000 though with the number of liquid ones closer to just 3000.

The establishment of benchmarks provides two major functions – the ability to track the performance of one set of securities versus itself and versus other indices over time, and to benchmark an investment manager’s performance versus their agreed index.

The acceptance of benchmarking over the past few decades as the way to measure investment performance has turbocharged the development of more indices that cut the pie in more ways. At the same time, market players can also use indices as the basis of their investment products. You can’t actually invest in an index itself, but companies do offer index-based products that synthetically track the performance of a particular index and give investors the returns produced by the index, less a fee. It is also this factor that has produced the constellation of new index-based products.

For investment managers that are active (ie do not passively look to recreate the performance of an index), each period, either short or longer term, they check their investment returns – what was their performance in raw terms as a percentage? Did they make money or lose money for their investors?

With that information digested, some managers will move on to checking their relative performance versus their identified index. In the language of the industry, did they beat the benchmark’s performance or did their benchmark beat them? This is an indicator of how much value the manager has added over the benchmark over a given period of time.

But this post-period checking can turn into pre-period portfolio adjustments. Instead of the manager looking at returns versus the relevant index produced as a result of their portfolio construction, managers – cogniscent of how damaging it can be to their business to underperform the index – can construct their portfolios prior to the investment period in question in such a way that there is less risk that they will underperform. Managers can ‘hug’ an index, buying stocks to weightings similar to the index, apart from some exceptions, to reduce the chance of underperformance.

As long as investors know what they are getting is an ‘index plus’ portfolio, we don’t think that is necessarily a bad thing. However, our view is that if a manager describes themselves as active then that is what they should be.

We describe ourselves as a benchmark-unaware, unrestricted, long term active manager that finds market anomalies around the world. Our exposure to industry sectors, geographic regions or market capitalisation is determined solely by our conviction in the risk/reward opportunities that we identify within portfolio guidelines. Rather than invest in hundreds of securities, our global equities fund typically holds 25-45 businesses, centred on six to eight core investment propositions, as we think that is the best way to achieve acceptable returns on our clients’ capital.

Although you will see mentions of a benchmark in some reporting of our performance, this is a descriptive tool only for our clients, and the constituents of an index or their weightings do not play a role in how our portfolios are constructed.

We believe that long term blended investment returns produced by markets alone are going to be lower than they have in the past so many people saving for retirement or other significant goals are not going to meet their objectives. That is why we believe investors need credible, high-conviction managers that don’t rely on an index to satisfy their long-term goals.

Source: PM Capital