Never Mind The Benchmarks

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Hello and welcome to the latest edition of EchoTel Conversations.
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I'm Gerald Ashley, and once again I'm joined by my good friend and colleague George Cooper.
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George, good morning.
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Morning, Gerald.
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Good to talk again.
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Indeed.
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You didn't ask how I am today, but you can probably tell I've got a little bit of a cold.
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So apologies to listeners if I sound overly husky, but um hopefully I'll be all right.
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Now we have um we have a slightly uh tongue-in-cheek title for this podcast today, um, and it alludes to a famous album that was launched almost exactly 48 years ago in October 77.
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And our take on this Sex Pistol album is to call it um Nevermind the Benchmarks.
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Okay, and this may only appeal to a few aging rockers listening to this, but it is the idea that what is going on with benchmarks, are they too um front and centre of the investment community?
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And I think between us, we may come up with some thoughts that in some ways they may even be damaging.
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With that thought in mind, George, obviously people always think about passive investment versus active management.
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Um, do you want to give us a quick view of the the landscape of this?
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Yeah, I mean I uh first of all, I'll I'll um hold my hand up and admit that benchmarking has been a a bit of a hobby horse for me for a couple of decades.
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It's been one of my sort of rants.
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I think I think benchmarking has gone too far, and it's I think it's doing things that are quite damaging to the economy in ways that people don't quite appreciate.
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Uh and of course, first there was benchmarking and then the move to extreme benchmarking, you know, index tracking funds where there's no deviation at all, entirely passive management, in other words.
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I think these this movement uh has undermined the purpose of of the asset management of the investment management industry generally.
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Has it turned out to be um what looks like a clever shorthand for investment decisions, but once again with um unexpected consequences?
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Well, yes.
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I mean, it first of all, I I would say if you're going for a benchmark, if you give your fund manager a benchmark, in the process of giving the benchmark, what you're really doing is taking back the vast proportion of the risk onto yourself.
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It's your decision.
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The whatever the fund manager does, if they're active, there'll be a little bit of deviation.
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If they're passive, there'll be basically no deviation at all.
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And that means that you're the fund manager.
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Yeah, you've made the investment decision.
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Now, that's that's fine in a lot of cases, but often when you make that decision, you might have a a good reason for doing it now, but often you leave the you you leave your investment in in the fund for years, the world changes, and you never really revisit that investment decision.
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So that's just a sort of caveat.
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You when you're buying a an index fund or a benchmark fund, you're not really paying for fund management, you're paying for investment execution, if you like.
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You're paying for implementation rather than rather than management.
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Yeah.
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And and as you say, the world constantly moves, and you can be left hugging a benchmark that is drifting away from bare one say market reality.
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Yeah, so I I I mean, before we before we started the call, I just I put a few different benchmarks on on one of my Bloomberg charts.
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And you know, just by by way of of reference, the another thing that with benchmarking is you know, people say, well, well, active managers tend to underperform their benchmarks, so don't use active managers.
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That's fair, but what you're doing in that process is you're not saying which benchmark to use.
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So you say just go passive, go to a benchmark, but then which benchmark?
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You know, people forget that there's thousands.
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So so you you you feel that you've outsourced the decision, but you haven't really, because you've you've still got to make that call on which benchmark or index or whatever to to use.
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Um I I you did send me that graph, and I think we'll we'll stick it in the show notes because it is quite instructive as to the the difference in returns depending on which benchmark you use.
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Yeah, so I mean j just to give an idea of how important it is, if we go back over, say, a 20-year period, so we start in 2004, if you'd picked an S ⁇ P 500 benchmark, your money would have grown about ninefold.
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So you'd have done quite well.
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But if you'd picked, say, the FTSE benchmark, which a lot of people in the UK do, your money would have only just tripled, which would which is actually a pretty poor return over a 20-year period.
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Now, the other thing that you've you've got to remember is if we go back 20 years, put yourself in in the shoes of somebody twenty years ago, think, well, what would what would the logical decision be there?
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Perhaps you would have said, maybe you had great foresight and you would have said, well, China's going to be the great success story.
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China's going to outgrow every other economy in the world, which it pretty much has done.
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Well, for the first about 12 years of that period, China would have outperformed the SP, but still pretty mediocre returns.
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It's only strangely, in about the last decade that the SP's really started to outsine, and that's in a time when China is still growing and becoming more economically important.
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So you've got a lot of challenges in picking those benchmarks, because even if you get the right economy, you might not get the right market result.
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So I could I could um either at the professional level or as an individual, I'm I'm forced into making some form of choice.
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I suppose some people would go for a sort of weighted so-called world index, yeah.
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Um, would which may help in that situation.
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But nevertheless, um I suppose lurking in the background, there's also currency.
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Depending on what your home currency is, that that's gonna have an impact as well.
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Yeah, and so it's gonna be very different from different perspectives.
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If you're in a if you're in a weak currency, then you know world world equities are gonna look good for you.
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If you're in a stronger currency, uh they'll they'll look less good.
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But to to be honest though, the my big gripe with benchmarks is not really so much the equity benchmarks and what and what they do for investor returns, it's more what benchmarking does to the economy.
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Right.
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And I I think benchmarking actually is I think it's making financial markets more volatile, which is bad for investors, um, but it's it's also bad for the economy.
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But of course, nobody notices this because you if you're measuring against the benchmark and the benchmark's more volatile, big deal.
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You know, you're marking your own homework.
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So that's one aspect.
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But the other one, which is again something that I think no nobody really thinks about, there's a relatively small amount of money managed against equity benchmarks.
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There's a huge amount of money managed against bond benchmarks.
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Yes, press coverage is always about individuals in trackers and equity tracking and all the rest of it.
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But in terms of scale, the the bond market's far, far bigger.
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Yeah, the the bond market's far, far bigger.
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Now, if you had if you had invested in uh one of the the higher risk, and therefore it should have been one of the higher return bond benchmarks, which is the the long-dated US Treasury benchmark, and and you'd gone in for something like the what's called the TLT fund, the 20-year plus uh US Treasury fund, in 20 years you would have barely doubled your money, which is you know a pretty terrible result.
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Pretty poor.
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It it is, but and you you think about what you're doing if you're buying the bond benchmark.
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When you're buying an equity benchmark, at least generally, the benchmark is spreading your money out according to the market cap weighting of the equities.
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So you put more money into bigger companies than smaller companies, they're bigger because they're more successful.
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So that's that's not unreasonable.
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You're you're weighting your your capital according to the assessment the market is giving to the value of the firm.
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But if you're doing it with bonds, if you're going into a market cap-weighted bond fund, what you're really doing is you're weighting your assets according to the amount of liabilities that a government or a company has got.
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So you're giving more money to the most profligate borrowers.
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Which is quite extraordinary if you think about it, really.
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I mean, it is it's um upending what the logic should be.
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Yeah.
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And and this is this is where I I think this process is is basically making my industry sort of suffer from dereliction of duty.
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Because what collectively what the what the asset management industry should be doing is allocating capital efficiently in the economy.
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If you've got a a profligate borrower or a or a company that's potentially in a market bubble, you should be looking at the future returns and you should be withdrawing capital from the excessive borrowers or the the companies that are on extreme overvaluations.
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Uh and and trying to, if you like, sort of clip the wings and and reduce the amplitude of the of the swings.
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But once you start benchmarking, that doesn't happen.
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You you effectively encourage more borrowing, um, and you you you pour fuel on the fire of a stock market bubble.
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So I think this This is as I say, it's destabilizing the economy.
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I it's a very difficult thing to prove statistically.
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But my feeling is that since we've become more and more enthralled with benchmarks, I think the stock market has had a greater propensity to experience bubbles, and the v the volatility of asset markets has gone up, and the average return of asset markets has gone down.
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So I think that's really where the problems lie.
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Yeah, that's quite a that's quite a charge, actually, isn't it?
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Uh and and it it's it's effectively turning everybody into a more sort of short-term horizon as well.
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Two two elements that strike me in this, which of them are sort of psychological behavioral finance angle, is of course, by definition they create herding.
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So nothing succeeds like success, so everybody piles into every you know, sort of concentrated around winners within the index.
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Um we're seeing that in an extraordinary degree in the United States at the moment, with the so-called magnificent seven, maybe eight, depending where you you cut the line.
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That's one element.
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And that that there's also a psychological marketing trick going on here, which is um relative returns versus absolute returns.
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So, you know, the idea, well, bad luck, your your fund dropped by nine percent, but actually we did very well because the index dropped by eleven.
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Well, I'm still down, and okay, in relative terms that's okay.
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In absolute terms it's a disaster.
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And but as we know, there's a huge sort of dynamic in the way people judge things, um, in terms of their earnings and their status and everything else, and we do it in relative terms.
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Am I better off than my neighbour?
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Am I you know, is my brother-in-law doing better than me?
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All those sort of relative elements uh are are addressed, whilst ignoring the absolute return.
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Yes.
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Um again, it basically lets my industry uh sort of hide behind the benchmark and and not not really do the job that's need that investors need doing.
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And and by that I mean whoever you are, whether you're a big institution or a or a you know little individual saving for your retirement or saving for your deposit on your house or or whatever, what you need is for your investment to grow faster than inflation.
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If it's not growing faster than inflation, then your money's actually losing value.
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And you know, when I say you need it to grow faster faster than inflation, I think inflation is as asked is systematically underreported for for various different reasons.
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Maybe we do a podcast on that at some point.
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But I if the official target is two percent, at the moment most inflation around the world is running well above that, three or four percent.
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I think the real inflation for most people is probably closer to about five percent.
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So what you need is a decent margin above that to achieve investment success.
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And if you've achieved that, then it's it's job done.
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And I think this is much more what investment managers should be focused on.
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They should be focused on delivering returns above inflation so that you're growing your capital for your clients in real terms, and then the investors themselves should be looking at benchmarks and saying, Well, how are you doing?
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Yeah.
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So I think they should give the manager the objective of right, beat inflation by a decent amount.
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Let's see how you do it, and let's see how that compares with other other benchmarks and other approaches.
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Now that's a very painful, that's a very painful mandate to receive as a investment manager.
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I'd much rather say, look, I I'll um I'll beat the S P 500, and I what I actually do is I go away and I create a fund that pretty much is the S P 500 with a few bits on the side or different weightings where I think I'm just going to edge ahead of the index.
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And this so-called, what should we call it, index hugging, um, I still pick up a nice management fee for.
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So why should I want to do your inflation thing?
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You know, the the reason the reason the industry has evolved the way it has done is because it's it's much safer to s to say to say to your clients, right, give me a benchmark uh and I'll do something pretty close to that.
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Whereas if you if you say, Okay, what do you really need, and the client comes back and says, Well, I need I need inflation plus about seven percent actually, then you've got to you've got to do a lot more thinking as to how you can do that.
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Now, there's been an interesting test this year, I think, in the equity markets of uh of benchmarks and indexes, in that the famous now or famous uh Trump tantrum in April caused equity markets to sell off very rapidly.
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I think most people involved in management got a little bit greyer after managing money through that period, and then it actually came back relatively quickly as um Mr.
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Trump started rowing away from his initial pronouncements.
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But what is interesting to note is that people still seem to be willing to hang on to their index investments.
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So maybe it wasn't a prolonged enough shock for people to say, hang on a moment, what the hell are we doing?
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Yeah, I I don't think this is going to change.
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This is as I say, I'm just reflecting that I think it does have adverse consequences for the economy.
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I think it is.
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It's leading it's leading to more volatility, more bubbles, and because of course the governments then have to come out uh or come into the markets and start bailing out companies and economies after a bubble bursts, that then causes them to print more money.
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So I think over time it's also going to lead uh to more inflation.
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So it has it has a lot of knock-on effects.
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There's another there's another aspect to it as well that I think is is kind of interesting.
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And Elon Musk has been uh banging on about this in the last couple of days.
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Uh he he's been criticizing the the voting companies um which which do the proxy voting on behalf of a lot of index funds.
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So Musk has been campaigning for his uh trillion dollar pay package and complaining that some of these funds are not are not voting for his trillion dollar pay package.
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Now, frankly, I don't think they should, but that's by the by.
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I think his criticism of having outsourced voting institutions voting on behalf of indexed funds or benchmarked funds, I think that's quite reasonable.
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Because if you think about what's going on, you've got a load of tracking funds that are saying to investors, look, we can keep your the cost of managing your money very low because we don't need to have experts looking at the companies.
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Right.
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So the the fees are very much lower, etc.
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etc.
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Yeah.
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So so we've got nobody, you know, they they make a they make a virtue of saying we've got nobody that knows anything about the companies you're invested in.
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Yeah.
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That then gives you a corporate governance problem because nobody's overseeing what the uh what the management is doing.
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This is this is another disconnect in finance, and that they're always worrying, aren't they?
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This is a disconnect between shareholders and the management.
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And one's reminded of the disconnect in the credit markets 20 years ago with all sorts of complex derivatives that basically disconnected lenders from borrowers, and there wasn't the same sort of oversight.
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Seems very similar.
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Yeah, economists call it a uh the principal agent problem.
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In other words, the the the principal is not getting the correct response from their agents, the management of the company.
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So what's now happened is a lot of firms now outsource the voting decisions of their sh of the shares they hold to other companies who then vote on entirely non-economic grounds.
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And as as as Musk has pointed out, and I think quite rightly, the the two big voting companies, especially in the US, have effectively been captured by the woke agenda and have started to vote for all sorts of things that are not economic in nature.
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So so you've got a very vocal activist minority that's suddenly um very close to the controls of voting uh on behalf of very large blocks of shareholders.
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Yeah.
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And and they are asking companies to do things which cost money and and hurt investment returns, which nobody has any oversight of, and nobody is able to measure how how much returns, how much of the returns are being impeded by, if you like.
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So so what's happening is the decisions are being made that says the investors should be paying a certain amount of money, a certain amount of their returns should go to doing good for the environment or doing good for society.
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Yeah, yeah.
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How much?
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If the market should return 10%, should should we be cutting those returns by 1%, 2%, 3%?
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We don't even know how much they're they're being cut by.
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And there's no oversight of that.
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So I think that's a that's a big problem.
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I'm I'm kind of reminded of uh one thinks of the huge um flow of funds into ESG type funds, and now equally the political uh atmosphere has changed and there's quite a flow out from them.
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Not only was it the political atmosphere, it was the fact that if you looked at non-ESG uh areas uh did extremely well.
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And I know some people will, you know, say shock horror, you shouldn't be investing in them, but certainly there was a period of time in the last two or three years if you uh got into the oil companies, got into defence industry, there once say tobacco and related areas, they massively outperformed ESG funds.
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And so there's a combination, maybe a little bit of politics and also investors voting with their feet and walking away from this.
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But I think your point is well made that the overall structure is still in place, and there's this rightly named passive lump of shareholders who are passive in the sense that they have no say of how the management of the company works.
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Yeah.
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And and we and we don't know the we don't know the cost of this.
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There's also a question of should uh should the fund management industry really be the policeman of these decisions?
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Here I think we get into a another problem because uh if a company's really let's say uh a company is polluting, if it's polluting and causing significant damage to uh to the environment, then uh really the government should be stepping in with uh with legislation or additional taxation to pay for uh the the cleanup, the me remediation of that pollution.
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Yeah.
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If we pretend as an industry that we can police this by our our voting response, it's just it's creating a a false idea.
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It's a it's it's simply false.
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Also it's a bit it's a bit open-ended, isn't it?
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Where do you in it it's not just environmental stuff, it's maybe gender balance, it may be all sorts of uh other elements to the firm.
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And again, with very activist groups jumping up and down, it i if they get any sort of leverage over this voting, um cannot be good for shareholders at all.
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So it's it's it's the usual problem.
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You can't serve two masters, can you, really?
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I yes, I I think it I think effectively in by by accepting this mantle, by by the fund management industry accepting this idea that uh that we can control these things, we're we're effectively letting government off the hook.
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There there are certain things that should be regulated, but we should recognise that they do cost money, and we should make a decision as to whether that money is worth spending.
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Is it is it worth um paying a higher tax rate in order to clean up the environment, or is it not?
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If we if we leave it to uh my industry, frankly, um I know a lot of people in the industry, I don't think that we are collectively the best moral policeman in the world.
00:25:08.640 --> 00:25:21.759
Well, we've pulled out quite a few few threads here in our half an hour of of looking at this, and I think I'm drawn to your comment a f uh a few minutes ago when you say none of this is going away.
00:25:21.759 --> 00:25:27.440
We we we've got tracker funds, we've got indexation benchmarks, all the rest of it.
00:25:27.440 --> 00:25:31.119
Um one last thought on this then, George.
00:25:31.119 --> 00:25:42.480
Is there to use the common parlance a tipping point where index funds become so big that they start to dislocate the rest of the stock market?
00:25:42.960 --> 00:25:44.559
I think we're already there.
00:25:44.559 --> 00:26:17.680
I think, you know, I I look at I look at what's going on in particularly the the artificial intelligence infrastructure boom, the the rate at which we're building data centers, the the concentration of of capital in the in the bigger companies that are building the data centers, and the fact that a lot of those companies are now using their own market cap in order to fund that building.
00:26:17.680 --> 00:26:33.039
So they they're it's um it's been called circular financing, where basically NVIDIA can use its market cap to fund its own customers, which obviously then boosts its revenue and boosts its market cap again.
00:26:33.279 --> 00:26:35.039
We've we've been here before.
00:26:35.039 --> 00:26:38.559
Um I know people always go on about the dot-com era.
00:26:38.559 --> 00:26:44.319
People nowadays say, oh, it's a bit different because uh these companies are profitable this time around.
00:26:44.319 --> 00:26:49.200
But last time around we had huge misallocation of capital.
00:26:49.200 --> 00:26:53.200
The one that always comes to mind my mind is dark fiber.
00:26:53.200 --> 00:27:02.880
Everybody decided they needed to put glass fiber networks in everywhere, and at one stage uh the capacity was about ten times the demand.
00:27:02.880 --> 00:27:16.079
Now you can reasonably argue that over the following years that got absorbed and was used, but at the time it was probably um an investment mistake or s or certainly far too early.
00:27:16.480 --> 00:27:23.680
Yeah, I I suspect we've got the same problem happening now in the in the data center boom.
00:27:23.680 --> 00:27:35.440
But uh you know, part of what we've been talking about to today is my industry, the investment management industry, is not policing that because they don't need to.
00:27:35.440 --> 00:27:35.920
Yeah.
00:27:35.920 --> 00:27:50.799
Because if you measured against a benchmark and the benchmark says allocate capital to this, and and the debt benchmarks say, hey, these guys want to borrow a lot of money, so therefore, market cap weighted, you should give them more more debt, you should fund that borrowing.
00:27:50.799 --> 00:27:56.720
It it just all sort of runs on its merry way without without supervision.
00:27:56.720 --> 00:28:01.279
So I I think um I think this is this is already happening.
00:28:01.279 --> 00:28:05.599
I think this is why we're getting, frankly, more bubbles and bigger bubbles over time.
00:28:05.920 --> 00:28:06.160
Okay.
00:28:06.160 --> 00:28:10.880
Well that's um I know we always try to end on an optimistic note.
00:28:10.880 --> 00:28:15.759
Um depending where you sit in the market, that's either optimistic or pessimistic.
00:28:16.160 --> 00:28:29.200
I uh funnily enough, I think I think for those that are are willing to to do the work, I think there's reason to see optimism in this because I I think what it's done is polarized the market.
00:28:29.200 --> 00:28:37.839
You've got a a lot of the market that's now extremely overvalued, and a lot of the market that I think is extremely undervalued.
00:28:37.839 --> 00:28:41.680
In the office we call this the the bubble and the anti-bubble.
00:28:41.680 --> 00:28:44.079
Um so I think the opportunities are there.
00:28:44.480 --> 00:28:50.000
So as ever, as you say, if you if you do the work, it's um it's not all closed out.
00:28:50.000 --> 00:28:52.880
There are plenty of avenues going forward.
00:28:52.880 --> 00:29:04.000
Um right, we've come to that part of the show where we do our book recommendations, though you have um you've warned me you're not going for a book, you're going for a film this time.
00:29:04.000 --> 00:29:05.839
As ever, I'll go first.
00:29:05.839 --> 00:29:14.799
Um it's a book from 2006, though it sounds and feels and reads as if it was written much more recently.
00:29:14.799 --> 00:29:18.640
It's called The Origin of Wealth by Eric D.
00:29:18.640 --> 00:29:19.599
Beinhocker.
00:29:19.599 --> 00:29:35.279
Beinhocker is a sort of consultant-turned academic, and it's the subtitle or the strapline that explains what's going on with this book, and it's called Evolution, Complexity and the Radical Remaking of Economics.
00:29:35.279 --> 00:29:37.839
I've had this book on my shelf for many years.
00:29:37.839 --> 00:29:57.519
I didn't buy it in 06, I probably bought it two or three years later, but it's it's the first what I found was really good explanation of how complexity science is a way of thinking about markets and the economy, and it has some uncomfortable um conclusions.
00:29:57.519 --> 00:29:59.839
Some things are just not predictable.
00:29:59.839 --> 00:30:04.240
And um it may even be fruitless to try.
00:30:04.240 --> 00:30:10.480
And that there will always be surprises, even in what look to be sort of stable conditions.
00:30:10.480 --> 00:30:16.000
Um so as I say, The Origin of Wealth by Bine Hocker, um, it's a bit of a tone.
00:30:16.000 --> 00:30:27.519
It's another one of these uh four or five hundred page jobs, but it's it is a light read, it's not highly technical, no frightening mathematics, but so I recommend it.
00:30:28.559 --> 00:30:29.039
Very good.
00:30:29.039 --> 00:30:34.880
I incidentally, when it comes to huge economics books, I I blame both Smith and Marx.
00:30:34.880 --> 00:30:41.680
I think they both tended to to waffle horribly, and and other economists have copied that.
00:30:41.680 --> 00:30:45.599
But anyway, that's uh that's another little rant.
00:30:45.599 --> 00:30:49.680
So I'm going I'm as you said, I'm not gonna go for a book this time.
00:30:49.680 --> 00:30:51.440
I'm going to go for a movie.
00:30:51.440 --> 00:31:00.880
And this is a 2011 movie with uh Amanda Seafried and Justin Dimbalake of uh of all people.
00:31:00.880 --> 00:31:03.519
And the movie is called In Time.
00:31:03.519 --> 00:31:07.279
Uh this is one of my favorite sci-fi movies.
00:31:07.519 --> 00:31:08.480
Ah, right.
00:31:08.880 --> 00:31:21.920
And the reason the reason I particularly like it this one is because being a bit obsessed with monetary systems, the movie is actually about uh another monetary system.
00:31:21.920 --> 00:31:26.799
In in this movie, time is the system of money.
00:31:26.799 --> 00:31:31.519
Oh uh specifically how much time you've got left to live.
00:31:31.920 --> 00:31:38.160
Oh, it's another one of these before you get executed or disposed of or whatever.
00:31:38.160 --> 00:31:38.559
Yeah.
00:31:38.960 --> 00:31:39.440
Yeah.
00:31:39.440 --> 00:32:03.359
So you uh you're forced to keep earning in in order to keep living, and of course there's there's some people that um there's some people in the movie that have so much time they're effectively immortal, and then a sort of underclass that are literally living paycheck to paycheck, and they're sort of there there's the guys who are sort of running up a down escalator, I guess, uh effectively.
00:32:03.359 --> 00:32:04.319
Yeah.
00:32:04.319 --> 00:32:15.200
So I uh the movie is the movie's entertaining, but the um the monetary system of time uh is uh is also quite provocative.
00:32:15.200 --> 00:32:35.359
And uh what made me think about this movie again to uh to recommend it today, of course, is uh the made system in Canada now, which um I will just leave it there, but I would say maybe uh maybe we're starting to implement an element of what's in the movie.
00:32:35.359 --> 00:32:38.000
So I'd recommend people uh watch that.
00:32:38.480 --> 00:33:00.559
Well, I um this prompts one final thought is that maybe a podcast for the future, other than the one you mentioned earlier, talking about inflation, we should talk about the relationship between time and money, because that they're two tend to be fixed sort of axes in people's minds, but of course they're in in truth they're very fluid and all over the place.
00:33:00.559 --> 00:33:14.400
Um, George, well I think we gave a fairly good run round on benchmarks without being too much like aging punk rockers, and um I think that will do us this time, and look forward to talking to you again.
00:33:14.400 --> 00:33:14.960
Thank you.
00:33:15.279 --> 00:33:17.039
Okay, until the next time, Gerald.
00:33:17.039 --> 00:33:17.839
Talk later.