Good investment performance is the result of adopting a sound investment methodology.
In studying the elements of performance, I have been struck by the consequence of an obsession with indexes. The automatic use of an index as a strategy benchmark is particularly damaging.
Managers make their "bets" in terms of departing from the values in their given benchmark. This introduces a strong index-tilt or bias that imparts index values to portfolios. The drift toward the index prompts the question: Why should anyone pay active management fees for index performance when there is the alternative of paying a passive management fee for a passive, i.e. index, performance?
Certain pension funds have been lured by the attractions of the index. It is one of those actions that, while rational for an individual fund, is disastrous when adopted by all or a majority. It is a sad fact that collectively trustees feel most protected by investing in the index. No blame attaches if it falls. Yet, as Adam Smith saw, it is the function of risk capital to take risk and reap reward. To attempt to extract risk from the investment process is to deny its economic purpose.
The business of investment is about identifying opportunity, and bearing the accompanying risk. Prices reflect the opportunity for profit. It follows that to interfere with the free market function is to damage the wealth of nations, by eroding the wealth creation process. By silencing the price signals in the secondary market, indexation impedes proper discrimination in the primary financing markets.
One reason for the growth of the index cult is that damage to the system is not readily apparent. The evidence of misallocation of risk capital is subtle. It is apparent in the irrational moves of the share prices of companies that are included in, or excluded from, the index. It is evident in the growth of the hedge funds that exploit the market inefficiencies that indexation encourages.
Managers compound the problem. Haunted by the possibility of client defection, they slip into a policy of making small bets against their given index-based benchmark. Yet the shadow of the passive manager is always at their shoulder.
2 purposes of benchmarks
A cardinal error of existing methodology is to have confused the two distinct purposes of a benchmark. The "ex-post" role measures past performance. As a common measure, an index is acceptable for comparing performance, and performance attribution is often addressed in relation to the index. By contrast, the "ex-ante" strategy benchmark is forward-looking and crucial for performance enhancement. It represents the objective investment opportunity adjusted for relevant structural factors. It also properly reflects the particular strengths of the "house."
In terms of international investment, this error in methodology has been particularly damaging. The commonly accepted Morgan Stanley Capital International Europe Australasia Far East Index is generally accepted as being flawed as a benchmark for international investment. It has acquired credibility through being the longest-running act in the business. Its general use as a benchmark for global, EAFE, or regional mandates has conferred a bias in international portfolios that reflects the flaws of the index itself, most notably a gross overweighting of Japan that is most apparent when adopted for Pacific mandates. Nonetheless, we have to accept that it has become the industry standard. Some 65% of U.S. international mandates are based on the EAFE index.
Setting a strategy benchmark
The way to outperform the EAFE is to accept the two distinct roles of a benchmark and to adopt a performance-enhancing strategy benchmark for setting neutral weightings.
The formulation of a strategy benchmark requires each investment firm to make its own assessment of the neutral international investment opportunity with regard to the various relevant structural factors. These include:
*The elimination of crossholdings to arrive at the "investible universe."
*The purchasing power parity of the exchange rate - to adjust for overvalued currencies.
*The growth rate of the economy - which underpins all equity investment prospects.
*The relationship between gross domestic product and market capitalization - to allow for privatization programs in emerging markets.
None of these factors is reflected in the EAFE index.
How then is investment management performance to be judged? The strategy benchmark is the primary measure for the individual manager. The manager will be judged by his or her ability to add value against a given benchmark and the firm should seek to reward the manager by reference to this measure. Measurement against the median of the competitor universe results in a judgment on both the management firm, in designing the strategy benchmark, and the portfolio manager in adding value to that benchmark. Finally, because indexation is an ever-present alternative, results can be compared with the index. That is the proper order of priorities in any assessment of the anatomy of performance. Attribution analysis follows a similar path.
Those who decided to go the index route internationally using the EAFE index have suffered serious loss because of the overweighting of Japan, and because of the inherent index bias toward buying the dear currency and underweighting the undervalued currency. Exchange rates, not set by investment considerations and dominated by cross-boundary market inefficiencies, introduce a high level of risk to any international index used as a basis for international investment.
New look at emerging markets
The teaching on emerging markets has been particularly misguided. The definition of emerging markets as set by the World Bank is not a sensible criterion for investing in emerging markets.
A more intelligent approach to emerging markets is first of all to include only those markets that do not belong in the mainstream. To classify Hong Kong, Singapore or Malaysia as emerging markets was nonsense, as much as it was to so classify South Africa. Today, one might well question whether Taiwan and Thailand are truly emerging markets.
It might be sensible to have different emerging market universes depending on the size of the investing fund because liquidity is a real issue. It needs emphasizing that investment in emerging markets requires a long-term commitment. It is a matter of compound arithmetic, where the winner is the one who leaves his money on the table.
It is this approach that makes the logical case for considering emerging markets to be a separate asset class. As for a suitable strategy benchmark for emerging markets, attention should be paid to the GDP and market capitalization. Privatization programs make this particularly relevant.
Conclusions
A sound political economy requires the support of a stock market in tune with the processes of wealth creation. The allocation of risk capital in response to the pricing of opportunity is a key function of healthy capitalism. It requires a longer time frame, which is the hallmark of investment as opposed to speculation. Short-term trading destabilizes the pricing mechanism and damages the capital investment potential so essential to sustaining wealth creation. Short-term measurement has encouraged short-term trading. By contrast, while indexed capital has a long time frame, it frustrates the dynamic function of the stock market.
The consulting profession has been drawn to the mathematical precision that can be found in an index. A similar precision can be found in the ex-post results of a peer group. To these certainties, consultants add a degree of overanalysis. It can obscure some assumptions that deserve critical scrutiny. As John Maynard Keynes famously wrote in his "General Theory": "It is better to be approximately right than precisely wrong."
The anatomy of performance has a lot to do with factors that cannot be reduced to mathematical numbers. Experience and common sense are more reliable guides to setting sound strategy and achieving superior performance.
John Morrell is head of John Morrell & Associates, a consulting firm in London.
