Are Benchmarks the Problem?
The massive rise in indexes is fueling the relative measurement mania. It is hard to believe, but today there are 2.4 million indices vs 43,000 companies. This unbalanced ratio only exacerbates the investment behavior of chasing short-term performance, just moving capital rather than investing in companies. Our accountability measurement system constantly compares short-term past performance relative to benchmark performance, resulting in active managers being commonly hired or fired at the wrong time in the cycle. Rob Arnott, Vitali Kalesnik and Lillian Wu cite in their paper “The Folly of Hiring Winners and Firing Losers,” published in The Journal of Portfolio Management, that chasing past performance costs end investors 80 to 150 basis points annually.11
It's Not ESG; it’s Time
Environmental, Social and Governance (ESG) factors have become a hot topic in the investment industry. However, the debate around ESG is mired in political divides and ignores the important economic motives of uncovering economic risks and opportunities.
It is a simple fact that 70 percent of the world’s population has been added to the planet since 1950, having an enormous impact on our natural system.12 Alex Edmans from the London Business School notes we may be coming to the end of ESG as we know it today, stating “ESG is not special or something separate…. ESG factors are critical to a company’s long-term success. Considering long-term factors when valuing a company is not ESG investing, it is investing.”13
Investors are recognizing that this is much more complicated than passive exclusion of ESG factors. Understanding all the risks that can have a material impact to the value of the underlying company is imperative and these investment decisions are active decisions. But as noted before, not every investor is committed to the research required to understand the underlying business or able to withstand the short-term pressure to have long-term conviction.
“The Win-Win That Wasn’t”
The shifting landscape of the investment industry is not just a concern for investors. Companies, too, are feeling the pressure to adapt and respond to these changes. In recent years, the traditional paradigm of shareholder primacy – the idea that a corporation's primary responsibility is to its shareholders – has come under scrutiny.
Milton Friedman first introduced shareholder primacy in 1970. The theory states that “Corporations are run to maximize profits to stockholders and to be highly responsive to their demands, this in turn would benefit all of society” – what he called a “win-win.” But the world and the markets look entirely different today, and according to the economic theorists Leo E. Strine, Jr. and Aneil Kovvali from the University of Chicago, Friedman’s perspective is actually “the win-win that wasn’t.”15 Analyzing shareholder and stakeholder results, Strine and Kovvali present an abundance of evidence that shareholder primacy has failed. Though they show how the theory hasn’t worked, what was missing in their argument were reasons why it couldn’t work:
- The low cost of capital and the extended rise of risk assets.
- The rising level of passive since 1970, every company gets financing by simply being in the benchmark.
- The move to a short-term measurement system built on beating benchmarks.
It is highly unlikely that Friedman ever imagined any of these, and now consumers, regulators and investors are demanding a stakeholder view of their businesses. And companies that successfully navigate this shift can reap significant benefits, as well as seeking resilient returns for long-term investors, this is not new.
Build Trust
In 2015, State Street conducted another global study on the asset management industry called the "Folklore of Finance,” and its main theme is more applicable now than when it was written.
They argue, as illustrated in the below chart, that the industry spends too much time on the things that don't in fact add value to generating long-term returns or meeting investors’ long-term goals.