As an investment advisor, my performance is benchmarked to infinity and beyond. My beloved clients can log on and view all their holdings (including even those I don’t manage) sorted into seven categories and fifteen sub-categories. Each of these categories and sub-categories is assigned a benchmark that lets clients track me like a bloodhound.
My clients can see these results every morning over their Cheerios if they are so inclined — for any particular security, or category or sub-category, or for their accounts as a whole. In case they missed it, I also write them quarterly letters summarizing all of the above.
This whole process — which I set up — is a little bit nutty. I’m not sure what the point of all this benchmarking is, or what clients are supposed to do with all this data. It metacommunicates that paying attention to performance vs. benchmarks is important. But is it?
No, it’s not.
For example, my US Small/Value Equity category is matched against the Total US Stock Market. The benchmarks are usually represented by funds clients could buy on their own without conjuring up a factor-based strategy like I do. This decision is arbitrary. I could also benchmark small/value stocks against a small/value stock index. But what if my stocks are smaller or more valuey than the benchmark index? Is it still a fair benchmark? If I pursue this logic to its extreme, I end up benchmarking everything to itself.
Consider: Tesla has been on fire lately. Should it be benchmarked to a broad stock index? Or, to a group of automotive stocks? Or, should it be benchmarked to technology stocks or momentum stocks? Perhaps it should be benchmarked against electric car companies like BYD. In the end, there’s no company exactly like Tesla. But the more we benchmark it to itself, the more the benchmark disappears like a charmed quark and we are left with nothing.
At a macro level, financial theory suggests that we all should be benchmarked against the global market index: the portfolio of all assets in the world weighted by their market prices. Assuming that we could calculate this (it’s a big spreadsheet), there are still problems, because we can only use the assets that are readily investable. What about all the residential real estate on here on Spaceship Earth? Or the value of the minerals under the soil? Or our human capital? Whether we take out a microscope or a telescope, the whole process seems more rather than less arbitrary the closer/farther we look.
How little we know
Academics are still debating whether Warren Buffett, the greatest genius investor of all time, is really any good, because he could be just a statistical outlier. Maybe all those Chairman’s letters are bunk, the delusions of a fellow with a series of good spins at the roulette wheel who came to believe his philosophy was possessed of super-powers.
Here’s my point, and you aren’t going to like it: If statisticians still can’t decide whether Warren Buffett is skillful or just a lucky duck after sixty years, how are we going to be able to tell whether that confident-looking guy managing our money for the last five years is any good?
The answer is, we can’t. We will go to our graves not knowing whether he was Einstein or an empty suit. And so, for that matter, will he.
Looking at performance is an exercise in futility, made worse because it misleads us into believing that we are doing some kind of meaningful due diligence. At most we will be able to conclude that he seems to be lucky or unlucky, so far. But that’s not what we thought we were deciding, now, is it? If he’s only lucky, that is a problem, because luck can run out, especially when we need it the most. Whereas skill, if it is skill, might presume to endure and he could lead us like Mark Trail through some dark night of the stock market’s soul.
But then — what is the investment committee to do? As Cliff Asness points out, these groups often review 3-to-5 year track records to size up the cut of a manager’s jib. As Cliff might say, this is not only wrong, it’s backwards. If anything, after 3-to-5 years, however dubious a strategy the manager has been following, it is likely to regress to the mean. The mighty will be brought low; the meek will inherit the earth. This is why investment consultants notoriously destroy value to the tune of about 1% a year (or maybe they’re just unlucky?).
Why, then, do I go through the expense and bother of benchmarking?
Back in the day, I used to get brokerage statements with zero mention of benchmark performance.
As time passed, I started to get statements using a bogus index, like a Dow Jones Industrial Average that didn’t include reinvested dividends. Then, this turned into too much information: I received statements with a dozen indexes cited: S&P 500, MSCI EFAE Index, Barclay’s Bond Aggregate, the LIBOR rate, all over the map of Benchmarkistan — only with no way of weighting or relating these to the performance of my account. They might as well have sent me a copy of the Wall Street Journal.
Surprise: all these were bald attempts to obfuscate poor (expensive) performance. I knew I didn’t want to be like these guys. My hope is that if clients know all the data is available, that paradoxically they wouldn’t worry too much about it or obsess over every last detail. Because in the end, I suspect that the system I set up is more of a distraction than an aid.
What is the investor to do?
1) Be the benchmark. Simply index everything and forget the rest. We still need to choose the right index funds and allocate our money among them. These choices will be highly consequential, for good or evil. When markets are down, if we have chosen wisely, we can console ourselves with the sentiment that most other investors are doing worse.
2) Invest by strategy. Some strategies have demonstrated long-term historical and cross-validated outperformance. They are underpinned by economic intuition, perhaps paying a premium for our assuming an economic risk or psychological discomfort. Value investing strategizes that buying companies when they are beaten down or cheap by conventional metrics leads to better long-term returns than buying companies that are expensive and glamorous. This doesn’t work every day or quarter or year or every five years, but over the long term we expect it to work out in our favor. As with indexing, price matters and execution matters. When markets are down, we console ourselves with the thought that in the long run we have a good chance to beat the index.
If we invest by strategy, it behooves us to understand what we are doing well enough to ride out the meaningful differences between our returns and the market benchmarks. In practice, we will only care when we underperform, but that will also be the most expensive time to change course. Whether we decide to become the benchmark or follow some strategy, comparing our performance to a benchmark is irrelevant or, at worst, potentially dangerous. If we have trailed the market by several percentage points a year for the past few years, does this mean our well-considered strategy should now be abandoned? No, that would b e a mistake. Our time would be better spent understanding our strategies and focusing on certainties like expenses, taxes, and its overall suitability to our purposes. But that takes work.