Beating the benchmark

Smart Investor, February 2008

So your fund has beaten its benchmark. Fantastic! Time to celebrate, and spend your windfall. Well, not necessarily; just because a fund beats its benchmark doesn’t necessarily mean it’s made money. It may even have gone down. You need to take a closer look before you go spending.

A benchmark is something against which a fund’s performance is measured. Usually, it’s an index; for an Australian equities product, it’s typically the S&P/ASX200, which gives the most accurate indication of how the Australian market as a whole is performing. A benchmark is handy because how else are you to draw a conclusion about how your fund is doing?

To stick with the Australian equities example, if you are paying a fee to an active fund manager, you at least want them to be doing better than the index is doing. So that’s usually the benchmark for its performance:  the fund is expected to generate a return over and above what the market itself has been generating.

The problem is that benchmarks don’t tell you everything and beating them is no guarantee of good performance. In the last bear market, which ran until mid 2003, it was common to hear managers boasting of their outperformance of their benchmark – despite the fact that they had actually lost money. If the market loses 10 per cent and you only lose 8 per cent, and you’re a manager who is judged relative to the benchmark, then you stand to be applauded and rewarded despite ending up with far less money than you started out with.

There are other shortcomings of benchmarks, too. One is that they’re not always that appropriate. The single most damning example of this is the most famous index in the world, the Dow Jones Industrial Average. The Dow has a hell of a brand name, but it’s a hopeless index: it contains just 30 stocks yet purports to represent an entire market; is weighted by price rather than size, which gives higher priced stocks much more influence on the overall index than lower priced ones (currently IBM, the highest priced, has a bigger impact than ExxonMobil, the biggest); and its component stocks don’t even start trading at the same time of day. “It’s a really good example of a bad benchmark,” says Symon Parish, director and portfolio manager at Russell Investment Group.

But the biggest issue about benchmarks is the degree to which supposedly active fund managers are required to mirror them. It is common, for example, for a manager to be told that on any given stock they can take a position that is up to, say, three percentage points different from the market, but otherwise have to stay in line with it. This is called taking an overweight or underweight position. But let’s say you, as a manager, really think BHP Billiton (which accounts for about 13% of the Australian market) is due a big fall. Under these investment parameters, you would still have to have it account for 10% of your portfolio, even though you don’t like it. You’re not really free to follow your convictions. Similarly, if you thought the whole market was going to fall and you would rather take all the money out and put it in cash for a while, under a benchmark-based approach you wouldn’t be able to do that. And, inevitably, there will be periods of time when markets fall. The reverse is true too: there would be a maximum commitment you could make to any particular stock no matter how good you thought it was.

The advantage of a benchmark-hugging fund is that it’s never really going to surprise you all that much: by looking in the paper at what the market’s doing, you know you’re going to be within a few per cent of that.

But these days it’s becoming increasingly common to use an investment style that ignores these benchmarks and simply tries to make money.

A broad term commonly used for this approach is absolute return. It’s a treacherous thing to define, though. “It’s a loose term these days,” says James Falkiner, CEO of Falkiner Global Investors. “In the old days it meant a fund that was expected to make a positive return in pretty much any market environment.” That’s a common claim of hedge funds, and some people tend to think that the two terms are synonymous. “In more recent times it has come to mean being benchmark unaware: accepting that from time to time there will be negative returns but that in most market cycles you aim to make a positive return.” Falkiner itself, a boutique asset manager, is an example of this latter approach: it can, for example, move to significant positions in cash if there are not good value stocks to buy. “We go to the sale, and if there are no goods at the price we want, we just sit on our cash,” he says. “A benchmark tracking fund would still fundamentally be seeking to be fully invested.”

 This is an increasingly popular approach with boutique fund managers, who feel that unshackling themselves from a benchmark gives them a free rein to invest in what they really want to invest in. Platypus Asset Management, for example, calls itself a high conviction absolute return fund manager. What that means is that it invests in relatively few stocks (typically 25 to 30 at any given point in time) and ignores benchmark weightings.

That’s not to say it doesn’t compare itself against a benchmark. Like many products from boutique managers, Platypus charges a performance fee, the logic being that if the fund is doing well then the managers do very well too, but if the fund isn’t doing well then they don’t make as much money. In order to calculate this fee, the fund has to outperform the S&P/ASX 300 index.  “We are not constrained to an index in terms of investing, but we do for our fee get benchmarked,” explains Simon Bonouvrie, portfolio manager at Platypus.

Many multimanager groups also like the idea of absolute return. Todd Kennedy is head of pan-Asia active equities at State Street Global Advisors. He sees the importance of benchmarks – “it’s important to know what the target is so you can measure success” – and says that a benchmark is “a good starting point.” But it’s not the whole picture. “You have to get to the core reasons people are investing. The target is usually not outperforming an equity index, it is to make returns above and beyond cash. When you put money in a fund, you would like to see it go up.” In his view, therefore, the best instruction you can give to a manager is to expect them to make money above cash. He calls this a total return approach, and State Street increasingly is giving its managers mandates based on that objective.

Kennedy reckons it works: in the Australian market, his research suggests that using a total return approach one can come up with a portfolio that produces the same level of return as the market, but for 2% less risk; or involve the same level of risk but generate up to 9% additional return. Among the reasons it can do this are because total return removes what he calls “the dead weight of certain large stocks that may be unattractive” (for example, allowing an investor to avoid bank stocks completely if they think that’s the right thing to do, even though banks represent a huge part of the Australian market).

But not everyone is convinced by the merits of absolute or total return approaches. “Absolute return as a concept is very sound,” says Peter Walsh, director at Putnam Investments. “But the important thing for the investor is that risk isn’t concentrated in one particular area. You can be left with very concentrated risks that could surprise you when markets turn.”

Parish adds: “It’s very hard to time when the market is going to go down. A lot of managers who call themselves absolute return have held cash in their portfolios over the last four years while the market has gone up 140%. You would have been better off holding the index.”

He adds: “A very tricky issue is how you tell if a manager who calls themselves absolute return is going a good job. If the market is up 30% and they have done 25, is it a good or a bad outcome?”

Even fans of this investment approach admit there is a downside. “You end up with a portfolio that will have a very high tracking error to an index,” says Kennedy (a tracking error refers to how widely divergent a fund’s returns are compared to the returns from the market itself). “You need to have a fairly strong constitution at times when performance is deviating significantly from what the majority of other people’s performances are.”

Another important issue for investors to consider is how much weight to place on past performance. It’s easy to find out how any mutual fund has done in the past if it’s been around long enough, but investors are counselled against chasing last year’s winners and expecting them to outperform again. As Walsh puts it: “Last year’s winner in performance tends to become next year’s winner in flows.” But in practice it is exceptionally rare for a fund to be top of the pile two years in a row.

“We used to do studies on this all the time,” says Parish, “and it became so much of a truism it wasn’t worth continuing. If you take the universe of fund managers and split it into quartiles based on one year’s returns, with the first quarter the best 25% and the fourth quarter the worst, and then look at how it performed next year, the top quartile is more or less evenly spread across the four quartiles. You can’t buy last year’s performance.”

Still, seeing that a fund has a track record of delivering is obviously well worth doing; it’s just dangerous to read too much into it. A fund that has consistently been a top performer over a period of years is clearly worth a closer look, but even that is not conclusive. Bonouvrie thinks looking at past performance is “absolutely key, but there is a caveat there. If you’re looking at the performance over the last three to five years, you want to make sure the people who were around to deliver that are still there. It all comes down to the abilities of people making the money.”

To find out all this information in the first place, investors will either have to use independent research, or delve in detail into the product disclosure statements and prospectuses that funds put out. In here they will find detailed information on investment style, including benchmarks; here or on the fund website they can also find information on long term returns. But these documents, too, can be something of a minefield – so take a look at the article on page xx, which talks you through a few examples.