Winning a Loser’s Game

In 1975, Charles D. Ellis explained that active investment managers are destined to lose, on average. This point is unequivocal, but it led people to ask questions about the role of active management rather than how we define winning and losing in this context.

Rightly, the job of the active manager has not been made redundant, as some (Fama-followers, mostly) have erroneously predicted. Markets cannot function properly with purely passive participants – Grossman and Stiglitz (1980) lay out an elegant counterargument to the Fama line of reasoning. There will always be a role for analysts and active managers. But they will continue to lose, as judged with reference to a benchmark. Beyond the injuries it inflicts on the egos of a majority of fund managers, this focus on benchmarks is not healthy for the important role investment management plays in allocating capital and pricing risk.

Firstly, benchmarks unfairly favour the big and punish the small. Companies in consolidated industries have a higher likelihood of being included in a widely-followed benchmark such as the S&P 500 or FTSE 100. In industries with a large number of small companies, raising external capital is more expensive in aggregate; even if the businesses are less risky, the inefficiency of pricing that comes about through a lack of attention makes this so. It is harder for these companies to grow, so the size issue is somewhat self-fulfilling.

Secondly, benchmarks reduce the cost of equity for inferior companies and can counteract the efficient pricing of risk when it matters most. If a stock with the potential for a lot of volatility (for example, a company that is close to bankruptcy) is in an index, a manager that is measured against that index may feel compelled to hold it. If he or she does not and the price jumps, investors who interpret the manager’s underperformance as a lack of ability will take their money and walk. But, given the choice, the manager would not invest.

Finally, benchmarks amplify market crashes. Following them encourages momentum in prices. Stocks that do well represent a bigger percentage of the index and it becomes harder for those that are on the sidelines to justify staying there. While this can lead to investors befriending trends, sustained runs that are not grounded in fundamentals are often tantamount to a mispricing of risk, and a crash typically follows at some point.

To what do we owe the obsession with benchmarking? To a large extent the answer lies in our inconsistent relationship with the (largely debunked) Modern Portfolio Theory, which argues that the best way to invest is passively in “the” market portfolio. That has many different interpretations. In the strictest sense, holding the market portfolio means buying some of every investable asset. But, in the real world, that’s not feasible, so we arbitrarily combine the biggest 100 or 500 companies into a substitute for the market, or for subsets thereof.

This substitution creates a distortion between the insiders and outsiders which sits at odds with the theory that inspires the process. The perfunctory attempt to use a reference point inspired by a flawed theory as a yardstick for active funds should not sit at the heart of the capital allocation machine.

The best investors in the world are not bound by the constraints of a benchmark, by design. They invest in businesses, not in the market, and through intelligent analysis try to understand the risks, which the MPT wrongly assumes are known. Most will not reference portfolio theory in what they do and you will, therefore, find proportionally fewer of them among Ellis’ losers.

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