BENCHMARKS CAN BE THE PROBLEM Benchmarks were first used as a guide for assessing performance, but have become the driver of decisions rather than a reference point. Consider the global bond benchmark: the more bonds a country issues, the greater its relative weight in the benchmark and the more of those bonds a portfolio will own, regardless of whether they are an attractive investment. Japan provides a good example. Its debt to GDP ratio has more than doubled over the last 20 years and currently stands above 200 per cent, while the country’s tax revenue is now less than the amount of debt it issues each year. Moreover, it is expected the over 65 demographic will comprise one-third of the population by 2050. Japanese government bonds comprise 28 per cent of the Barclays Global Sovereign Bond Index by exposure, and 40 per cent in terms of risk. Typically in Australia, conservative funds would hold approximately 15–17 per cent in international bonds. This means any fund that uses a sovereign-only benchmark potentially holds more than 5 per cent Japanese government bonds as a ‘risk free’ position. Over-emphasising the importance of benchmarks in active management can also compromise performance.
Sometimes managers are unwilling to move away from the benchmark for fear of negative performance and resultantly falling out of favour with investors. As a result of this ‘career risk’, short-term performance measures can prevail over long-term investment opportunities. This is a very real and problematic phenomenon. Some of the world’s best managers lost their jobs during the tech boom because they could not see the ‘value’ in tech stocks. They were eventually proved correct, but not after being fired by investors for lagging the benchmark. Ultimately, institutional investors aim to generate real returns. This is the supreme measure, not an arbitrary reference point defined by others. The inherent problem is that, at times, we may look different to everyone else.
ACTIVE MANAGEMENT Active management is derided in many circles as too hard, too expensive and too disappointing. Hedge funds have been castigated as an extreme version of this: they charge higher fees, demand a lot of due diligence and at times deliver disappointing results. But it’s worth reassessing what active management really means. It is about sourcing returns from the underlying skill of managers. It depends on some element of market inefficiency, such as: • Insurance – investors paying a premium to protect themselves from unwanted outcomes (currency hedging and ‘downside protection’ strategies) • ‘Buy high, sell low’ behaviour, particularly in periods of distress • Non-investment related reasons such as benchmarks, credit ratings and risk classifications If we think about active management across the entire global market, and concentrate on the inefficiencies described above, hedge funds should be the first port of call for investors. Ibbotson’s empirical research supports this hedge fund record and, importantly, also allows for survivorship bias, self-selection and backfill bias (see table 1).