The Curse of Benchmarks, Part II

The Big Idea Wednesday's column detailed the claim, by Dimitri Vayanos and Paul Woolley, that using market-cap-weighted benchmarks (such as the S&P 500) to track portfolio managers creates distortions in financial markets.

They argue that when a large, volatile security in an index surges in value, investment managers who are underweight in that holding are punished thrice. Not only do their funds' relative performances suffer, as they do not fully participate in a meaningful gain in the index, but those managers face awkward questions about why they missed the opportunity. In addition, because the security now makes up a larger chunk of the index, the funds have become even more underweight. The managers are sorely tempted to rectify matters by buying into the winners.

(I use neutral words like "holding" and "security" because the authors intend their thesis to apply across asset classes, not only to stocks.)

This, states the duo, many managers do. This performance-chasing by investment managers who have an eye on the benchmarks further boosts the price of the big winners, so that they become temporarily overpriced. Recognizing this pattern, short-term traders jump into the fray, acquiring the fashionable securities as they rise in price, with the intent of exiting when they fall (thereby leaving the underweight managers as the suckers holding the bag).

Over time, the authors aver, such trend-seeking behavior harms the long-term performance of the the market's higher-volatility issues. Their prices get pushed up to unsustainable, fundamentally unjustifiable, levels, which depresses their future returns. Conversely, this process helps low-volatility securities and rewards the "value" stock style. The paper binds several disparate observations into a single overarching theory. It's nothing if not ambitious.

Different Angles I'll skip the authors' formal framework. It's good that they offered one, but there's no use in wading through it. That job lies beyond my ability, and likely yours as well, unless you possess a finance Ph.D. (An MBA/CFA is insufficient for the task.) Besides, the math can be right and the hypothesis wrong. Nobody quarrels with the calculations that underlie William Sharpe's Nobel-winning Capital Asset Pricing Model--but, as Vayanos and Woolley themselves point out, that model's predictions have not been met. The CAPM scheme was too parsimonious; it missed key drivers of the market's behavior.

The same surely holds true for Vayanos-Woolley scheme. The financial markets have many investors other than benchmark-prodded professional investment managers. There are professional investors who have a longer-term perspective (for example, Warren Buffett), individual security owners, strategic holders who own issues for economic or political reasons, and so on. Even among that investment subset of professional managers that fit the authors' description, there are many incentives that affect behavior besides the one the authors advance.

For example, most fund managers are permitted neither to leverage nor to leave a specified investment universe. So, how to outgain the index (or peers)? One simple answer is to own the investment universe's most-volatile securities, as per standard investment theory that an extra level of risk means an extra level of expected returns. The fund manager who stretches for risk will seek high-beta stocks when investing in equities, long bonds as a Treasury manager, and lower-quality credits as a corporate-bond manager. We've now explained the Vayanos-Woolley findings without using the Vayanos-Woolley theory.

Probably both views are correct. And more. In the bond market, for example, retail investors crave yield. If two mutual funds have similar total returns, and roughly similar levels of volatility, the higher-paying fund will attract more assets. This knowledge drives portfolio managers toward longer and lower-quality bonds. Thus, for fixed income, a yield-seeking explanation could replace the two total return concepts given in the paragraph above.

There are more possibilities. Consider long Treasuries in the mid-1980s. A new, extremely popular flavor of mutual fund had been created: the "government-plus" bond fund. In two short years, those funds emerged from infancy to command more than $50 billion (real money back in the day), including the largest mutual fund that had ever existed. The funds succeeded by passing off the proceeds of call options that they sold as "income." (Those payouts were actually short-term capital gains.) The longer the bond, the higher the price of the call option that was sold, and therefore the larger the fund's "dividend" checks.

Thanks to the invention of the government-plus fund, the Treasury marketplace temporarily became a race to own the riskiest, biggest-moving securities in that investment arena. Once again, the reason was other than what the authors offered.

More, Please Make no mistake; there's something to the Vayanos-Woolley argument. There may even be many things to it. But I cannot judge the tale's strength without seeing more empirical evidence. For example, we know that professional management has grown its market share over the past half-century, such that a much higher percentage of U.S. stock-market dollars are controlled by investment professionals and much less by retail investors. By the authors' logic, this process should have degraded the returns for higher-volatility strategies while boosting those for momentum investors.

Has that occurred? Are volatile issues faring worse now than in the late 1960s and early 1970s? Is momentum doing better? Those and several other questions spring to mind--questions that require further investigation.

I share the authors' faith in investment strategies that favor lower-volatility securities. At the least, such portfolios will have stabler prices and thus will be easier for investors to own. At most, they will echo history in returning above expectations, so that despite their lower risk levels their gains are equal to those of the higher-volatility issues. However, absent future proof, I am skeptical that they have captured the sole--or even the primary--reason why. There appear to be more things going on.

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.