Do Benchmarks Distort the Markets?

Big Thoughts Many believe that using index benchmarks to score, measure, and govern fund managers is harmful for fund performance. The process of comparing a fund's holdings and total returns with those of an index, the critics state, constricts the manager's investment freedom. If a portfolio differs significantly from the index, its manager is questioned as to why. Should that difference hurt rather than help the fund's returns, those queries become second guesses. Eventually, the manager faces the very real danger of being fired.

Two London-based authors have taken the common idea that benchmarks hamper fund managers one very large step further. In Curse of the Benchmarks, Dimitry Vayanos and Paul Woolley argue that using market-capitalization-weighted benchmarks damages more than just fund managers. The practice, they claim, hurts the financial markets themselves. It leads to mispricing, which creates "the misallocation of capital at the micro level, and crises and contractions in the macro-economy." Hampering fund managers in such a fashion is "wealth destroying."

That is a large, broad claim. Its boldness raises the possibility that the authors may be a bit wobbly--a concern heightened by the fact that Curse appears not in an independent journal, but at a research center that bears Mr. Woolley's name. (If handed a forum, any clown can get published.) But their credentials are excellent. Dr. Vayanos is professor of finance at the London School of Economics, and Dr. Woolley is a fellow at the same university who has held senior posts at, among other places, the International Monetary Fund and the investment firm GMO. If the two gentlemen are potty, they have hidden their condition well.

The authors believe that their conclusions hold across asset classes. However, they tend to use stock-specific terms. In my synopsis of their argument, given below, I will do the same. But this should also apply to bonds, as well as to any other liquid asset:

1. In any market-capitalization-weighted index, the securities that are particularly large and volatile dominate proceedings. If those issues enjoy a "positive earnings shock," their subsequent gains will boost the index's value. Fund managers who made the mistake of underweighting those giant winners will likely trail the benchmark--and face questions of why they erred.
2. As those huge stocks become even huger, the underweight funds become even more underweight. Their managers feel pressure to buy some shares of those companies, so that their portfolio looks more like that of the overall market, the queries subside, and--should the hot stocks stay hot--the performance gap decreases.
3. Many fund managers concede to that pressure. For professional reasons, they "buy bubble stocks they know to be overpriced."
4. These buy orders further inflate the price of the giants (gas giants, the authors might say). The result is that "high beta and high volatile securities become significantly overpriced whereas low beta and low volatile stocks become underpriced."
5. As "the first effect is stronger than the second," the "overall market becomes permanently overvalued and prone to sector bubbles."
6. Momentum traders exacerbate the problem. Understanding how the benchmark-chasing process operates, momentum traders "exploit" the actions of the underweight managers, by zooming in to catch those stocks on the way up and then dumping them near their peak. When the bubble stocks eventually fall, as they must, it is the benchmark-chasing managers who suffer most.

In short, the authors offer a grand unified theory. Their benchmarking concept connects three apparently unrelated market observations: 1) that low-volatility stocks (or low-beta, if you prefer) perform better than expected as predicted by the capital asset pricing model, 2) the existence of price momentum, and 3) the long-term outperformance of value stocks.

In addition, their benchmarking thesis encompasses the popularly held notion that during past 20 years, the stock market has levitated to an unjustifiably high level. This claim is far from proven--how could it be?--but it is widely believed, most often by followers of the Shiller CAPE Ratio. But there are many others.

Curse of the Benchmarks is a relatively breezy read, being but 17 pages in length and containing no equations. Its looks are deceiving, however. A previous paper, Asset Management Contracts and Equilibrium Prices, offers the formal support for the authors' thesis, and it doesn't kid around. A sample paragraph:

Proposition 4.4 (Effect of Agency Frictions on Aggregate Market) Suppose that A > ρ ρ+¯ρ , B = 0, and that one of the following conditions holds: (i) σs = 0, and (σi , ηi) = (σc, ηc) for all i or (σi , θi) = (σc, θc) for all i. (ii) (bi , e¯i , σi , ηi) = (bc, e¯c, σc, ηc) for all i, and θi can take only two values. Following an increase in the private-benefit parameter A, the expected price of the aggregate market increases ( ∂E(Sηt) ∂A > 0), and the expected return decreases both in share ( ∂E(dRηt) ∂A < 0) and dollar ( ∂E( dRηt E(Sηt) ) ∂A < 0) terms.

Yes, these guys are serious.

Next column, my thoughts on the matter.

Wrong Villain February's column, Index Funds: Presumed Guilty, chronicled how active fund managers tend to blame index funds for, well, pretty much everything. (Plagues and locusts aren't the half of it.) The article's main subject was a shareholder letter from hedge fund manager William Ackman, who suggested that much of the market's oddities came not from manager benchmarks, as the authors featured in this column would have it, but rather from the practice of index investing.

While Ackman's argument was more reasonable than some, I nonetheless believed that it fell prey to the facts. One item that I failed to mention, however, was the stock that he used as his example. Because it fell between the cracks of various indexes, Ackman wrote,

Bad example. Valeant's stock has plunged from $85 at the time of that letter to $31 today, and for reasons that have very, very little to do with the existence of indexing. If at all.

The New White Meat Grocery stores aren't what they used to be. First came venison, then hare. Now the local market regularly features ... ground camel.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.