Curse of the Benchmarks
- Vayano and Woolley
- A version of the paper can be found here.
- Want a summary of academic papers with alpha? Check out our Academic Research Recap Category.
- h.t., J. Zaccardi.
Obsession with short-term performance against market cap benchmarks preordains the dysfunctionality of asset markets. The problems start when trustees hire fund managers to outperform benchmark indexes subject to limits on annual divergence… Benchmarking causes, first, the inversion of the relationship between risk and return so that high volatile securities and asset classes offer lower returns than low volatile ones. Second, it fosters the pursuit of momentum strategies, which then earn profits at the expense of benchmarked funds…
The paper highlights a fact that almost every single advisor recognizes — you will most likely be pegged to a benchmark by your client. This creates a principal / agent conflict, where the principal (owner of capital) wants the agent (money manger) to compound their investments at the highest after-tax ROR as possible; however, the principal is going to assess the agent’s ability relative to a benchmark and the assessment periods are frequent (e.g., quarterly, annually, and so forth). In fact, the authors have another working paper (which I highlighted here) discussing the same topic. At the outset, this sounds reasonable. However, it causes conflicts.
Consider the following example, where the agent (money manager) has 2 potential investment options:
- With 98% certainty, you are going to beat the index by 5% over the next 10 years. The other 2% of the time, you will lose to the index by 1%. However, you know that 3 of the years you may lose by as much as 8%! So while the long run expected returns are quite high, the return path to get there is very noisy and volatile.
- With 50% certainty, you are going to beat the index by 1% over the next 10 years. The other 50% of the time, you will lose to the index by 0.50%. In any given year, you will be +/- 0.25% relative to the index. Here, the long run expected returns are comparatively lower, but the return path is stable.
Now, from a mathematical and economist perspective, there is an easy solution — calculate the expected value.
- Expected Value = beat index by (0.98%)(5%) + (2%)(-1%) = beat index by 4.88%
- Expected Value = beat index by (0.50%)(1%) + (50%)(-0.5%) = beat index by 0.25%
Any rational long-term investor would pick option 1! It’s a slam dunk. However, the agent (money manager) knows that picking option 1 is risky to him as an agent, as he might lose his job if the principal (owner of money) loses faith in his strategy in the short run. Note: the authors have a more extensive paper that maps delegated asset management and the principle/agent conflict outlined to help explain value (long-term reversal) and momentum (intermediate-term continuation).
Ever wonder why smart beta products run rampant in the marketplace? They serve a great purpose to advisors by providing exposure to an active strategy, but do so with lower deviations from standard benchmarks (i.e., similar to example 2 above). But most smart beta products are more expensive than you think and over the long-term cause lower absolute performance (with lower benchmark deviation).
The paper additionally talks about contract terms, and gives some suggestions. One such suggestion has to do with value investing. Below is a snippet from their contract terms for value:
Manager skills are best measured by comparing performance against the results of other managers committed to the value style. Over the longer term and therefore covering one or more valuation cycles, this would provide a convincing demonstration of ability and in the shorter term would help to explain underperformance against market indices when bubbles are forming. Periodic underperformance against the universe of non-value managers would be a positive sign that the fund was being run in the manner intended. Work needs to be done by the consulting community to start gathering the relevant data for peer comparisons. Performance fees should only be paid on the basis of long-term results.
Having an advisor has a cost, but can definitely be beneficial to one’s portfolio. We are fans of truly active investing — as opposed to closet-indexing — but as this paper highlights, being pegged to a benchmark causes principal/agent problems that make truly active investing difficult. Indeed, benchmark requirements coupled with short-term horizons, ironically, serve as poison for investors who allocate to active funds. The only solution is to marry active strategies with investors who are educated and can internalize the fact that sustainable active investing has to be difficult.
Perhaps the best news for long-term active investors is that benchmarking and delegated asset management is becoming more prevalent, not less.