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Against the Odds

11 April 2019 by Anthony Hilton

Against the Odds

Measuring an index of stocks against the performance of an asset manager is a widely used technique, however it is not without controversy

Benchmarking is where an index of stocks is created in order to measure it against the performance of an asset manager. As such it is the most widely used of such measures, and one would have thought, largely uncontroversial. After all, if there were no benchmarks, there would be no passive investing, no trackers, and no exchange traded funds.

But Paul Woolley, of the PW Centre at the London School of Economics, regards benchmarking as ‘the original sin of investing.’ 

It has been recognised to cause undesirable feedback effects in many areas of human organisation, such as healthcare, education, policing, and executive pay, Woolley says. It is also true that monetary indicators immediately misbehave when they are co-opted for policy purposes or Goodhart’s Law as it is known.

There is concern now that a similar phenomenon is occurring in asset management. A new academic paper by him and two colleagues suggests that benchmarking to market cap indices can bring about the inversion of the relationship between risk and return.

Basically asset managers have a business risk if they do not beat their benchmark but the risk is asymmetric. If they under-weight of a stock and it is going up, then it hurts much more that if they are over-weight but the stock halves.

Asset managers shift from being under-weight to neutral (or even over-weight) if the market goes against them. This is in contrast to other asset managers who are already over-weight the stock and are happy to let their profits run and do not need to sell. The under-weight managers do not have any stock to buy other than by forcing the price up. Nobody else is selling.

In theory a stock should be bought for cash flow reasons – the dividends and earnings will be thought likely to increase over time. If the stock was under-weight that would suggest that the opposite was the case and earnings and dividend would be flat. 

But in this case the asset manager has to suspend judgement and buy the stock anyway because otherwise he would be well adrift of his benchmark. In this way the stock becomes mispriced. The highest priced securities do not yield the highest returns in spite of what it says in the Capital Asset Pricing Model.

In fact this model, and its counterpart, the efficient market hypotheses, assume everything is rational and therefore they predict perfection. The fact is however that what is rational for an asset manager is not necessarily rational of an asset owner. The risk of losing his job will make the asset manager do things which he would not normally do, and buy stocks which he would normally not buy.

Now Woolley’s model endeavours to explain what is actually happening to markets, unlike the idealised EFM and CAPM models which are still used by everybody but do not explain any of the flaws. And these idealised models are also used when company executives are thinking about the social impact of what they do.

The asset manager assumes that their stock market activities are privately and socially beneficial because the share price is where is should be. If however the asset manager realises that the share price is inflated by mispricing, it follows that social mispricing also happens.

At the corporate level, asset mispricing can cause perverse incentives in corporate decision makers. As long as the share price is seen as the fundamental value of the business, that is what the company will aim for.  But if the shares are driven by a wedge which separates the market price from the fundamental value of the business, management faces a dilemma. Do they target the share price in the short term or the future profits over the longer term?

Several of the strategies which can boost the share price in the short runs are incompatible with the long term prosperity and sustainability of the business. They include buy backs and leverage near the top of the cycle, accounting accruals to flatter current profits, cutbacks to capital spending and to research and development. The tension can also encourage the equivalent of performance chasing in fund managers where the company tries to keep up with its peers regardless of the risks involved, and inevitably comes unstuck. Banking just before the financial crises was like that.

Company executives and asset managers are often in an unholy alliance. The asset managers misprice the shares and then the executives follow suit.

It is clearly not in savers’ interests to pay vast fees for what are fundamentally distorted markets – and then pay further vast fees to asset managers who say they can make money out of these distortions. That however is the long and the short of it. The finance industry gets fees from both sides; companies, particularly those with pension funds, pay twice over.

Anthony Hilton is Financial Editor of the London Evening Standard 

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