Fixating on reference indexes could be detrimental to active fund managers and efforts to advance ESG, argues investing expert
Over the past decade, investors have increasingly embraced benchmarks to get low-cost exposure to the broad stock market, as well as a way to hold high-cost active managers’ feet to the fire. But as helpful as they have been for investors, are broad benchmarks turning into a crutch?
That was the view of Joachin Klement, CFA, in a recent blog post published by the CFA Institute.
While Klement agreed that fund manager performance has to be evaluated, he argued that measuring it against a benchmark determined by a specific index erodes fund managers’ ability and willingness to think independently.
“A portfolio that strays too far from the composition of the reference benchmark creates career risk for the fund manager,” he said. “If the portfolio underperforms by too much or for too long, the manager gets fired.”
In response to that incentive, he said, fund managers will tend to invest in more and more of the same stocks, and turn less active over time. The upshot is a dynamic toward herding into the largest stocks in an index, which more and more managers will see as names they can’t afford to not invest in.
The benchmarking industry, he argued further, has become extremely self-referential, with benchmarks being designed to track other benchmarks as closely as possible. One example of the harmful effects of that trend, he said, can be seen in the realm of ESG investing.
“Theoretically, ESG investors should be driven not just by financial goals but also by ESG-specific targets. So their portfolios should look materially different from a traditional index like the MSCI World,” he said.
The ideal state of things, he said, should be for ESG investors to have substantially different capital allocations from traditional investors, effectively pushing investment toward more sustainable uses. But after visiting the website of a major ETF provider and comparing the portfolio weightings of the largest companies in its MSCI World ETF with the weightings of those companies in its various ESG ETFs, Klement found essentially no difference.
“The good thing about this is that investors can easily switch from a conventional benchmark to an ESG benchmark without much concern about losing performance,” he said. “But the downside is that there is little difference between traditional and sustainable investments … [W]hat’s the point of the ESG benchmark? Where is the benefit for the investor?”
He also noted that if Amazon had been benchmarked against its industry peers back in 2001 or 2002, when its share price collapsed by 80%, then it would likely have been advised to behave more like its more successful competitors, which would have effectively derailed the business from its trajectory of ultimately changing the world.
“Benchmarking ESG benchmarks against conventional benchmarks is like benchmarking Amazon against other retail companies,” Klement said. “It will kill Amazon’s growth and turn it into another Barnes & Noble.”
