Home / How benchmarks get in the way of returns

(pictured: Paul Woolley) 

Paul Woolley, the former GMO fund manager and founder of the Centre which bears his name, believes that market-cap benchmarks cause “chronic mispricing” and impair fund performance.

Woolley told the annual conference at the University of Technology Sydney last week, that market-cap benchmarks “cause inversion of risk, short-termism, momentum trading, bubbles and crashes” with “secular over-valuation”. Pretty much the root of all evil.

He believes that capitalism is failing because asset owners delegate their investment management irresponsibly.

“The key is where asset owners, or trustees, delegate to their external fund managers,” Woolley said. “Agents [managers] have better information but have different objectives to the principals [trustees]. The principals are uncertain of the agent’s ability and the agent tries to demonstrate its competence.”

He said that the problem started with the trustees writing contracts which had market index benchmarks and tracking error constraints embedded.

“The agents have a fox hole to hide in and a clear basis to be measured and rewarded for performance… One of the biggest anomalies is that it results in over-pricing of high-risk assets and under-pricing of low-risk assets. And high-risk assets are driven up more than low-risk assets are driven down.”

Most managers used momentum in their process to protect against business risk, he said. For instance, at GMO in the late 1990s, when the tech market was running wild, about 30 per cent of the manager’s style was momentum and the other 70 per cent value. But that 30 per cent was still insufficient to stop the manager from under-performing. It lost about 40 per cent of its assets under management during the tech bubble and took several years to recover. Nevertheless, momentum has tended to outperform all other styles over the past three or four decades, Woolley said.

Ron Bird, who organizes the Paul Woolley Centre conference and is also a former GMO manager, said that most managers today were not very concerned about valuations. His estimate was that only 20-25 per cent of fund managers were of a fundamental value style, compared with almost all managers back when he started in the industry in the 1970s.

The preliminary results of recent research at UTS showed that:

• As one would expect, the tracking error constraints reduce the return/risk opportunities for investors
• Tighter tracking error requires a manager to hold many more stocks in the portfolio – in fact managers are forced to hold many stocks which they believe will underperform the market, and
• Although the initial findings are weak, there is a suggestion that tighter tracking error constraints drive the portfolio towards holding more high momentum stocks, with the impact of value/growth being inconclusive.