Academic research explains how benchmarking induces investment managers to buy overvalued highly volatile assets. This makes markets inefficient and may even lead to a negative relation between risk and return. It also offers opportunities for investment strategies. First, value investors can exploit the market’s proclivity to overvalue high-beta and high-volatility assets. Second, momentum traders can exploit the flows of funds in the benchmarked industry.
Vayanos, Dimitri and Paul Woolley (2016), “Curse of the Benchmarks”, London School of Economics, Financial Markets Group Discussion Paper, No. 747.
The below are excerpts from the papers Headings, links and cursive text have been added.
This post ties in with other research arguing that institutional asset managers are “pro-cyclical”. This research is summarized in the third section of our overview on systemic risk from institutional asset management.
The post also relates the subject of price distortions and rebalancing, which is summarized as part of our overview on price distortions.
Why benchmarking is widely used
“Fund management these days is mostly conducted by professional managers (agents) acting for asset owners (principals). Delegation creates asymmetric information: agents have better information and different objectives compared with principals, and principals are uncertain of the competence and diligence of agents…The seemingly obvious solution is to benchmark the portfolio to an appropriate market cap index, including constraints on the margin by which annual returns may diverge from index returns. A typical instruction would be for the manager to aim for rolling returns three percentage points over benchmark returns, subject to an annual tracking error (standard deviation) of, say, plus and minus six percentage points. This limits the potential damage done by an incompetent manager taking excessive risk. It also has the advantage of comparing the return of the fund with the default option of passive investment in the index. For the fund manager, it provides a well-defined objective and a clear basis for measuring his contribution.”
How benchmarking induces inefficient flows
“The terms under which most professional investment is handled ensure that markets are not efficient.”
“To comply with tracking constraints, a manager must control how far the composition of the portfolio departs from that of the index. He has to be most vigilant of underweight positions in securities with large weights in the index, especially those with volatile and rising prices. If a security doubles in price and the investor is half-weight, the mismatch doubles; if he is double-weighted and the price halves, the mismatch halves also. Underweight positions in large, risky securities therefore have the greatest potential to cause the manager grief. The effect is strongest when an industry sector or entire asset class is involved.”
“Managers who were underweight to start with now find their mismatch has increased and need to make additional purchases to satisfy their tracking constraint. This describes the plight of value managers forced to buy bubble stocks they know to be over-priced…The initial price rise to the new valuation level is thus amplified, making these stocks both more expensive and more volatile. There is an opposing force upon stocks suffering negative shocks but the effect is stronger for stocks that increase in price because they account for a larger fraction of market movements.”
“When agency frictions increase and managers are accorded less freedom, benchmarking results in an even steeper inversion and a greater propensity for bubbles. There is no clearer demonstration of how asset owners’ attempts to reduce their private risks exacerbate the riskiness of the overall market.”
On the herding incentives for benchmarked mutual funds also view post here.
The inversion of risk-return relation
“The practice of benchmarking, amplified by momentum, drives high risk stocks up and their future returns down, while low risk stocks are pushed down and their prospective returns up. Benchmarks based on market cap will therefore be skewed towards high risk, low return securities. Similarly, global benchmarks will have an over-allocation to high risk, low return markets.”
“The result is that high beta and high volatility securities become significantly over-priced whereas low beta and low volatility stocks become under-priced. The first effect is stronger than the second, implying that the overall market becomes permanently over-valued and prone to sector bubbles.”
“Calibration…shows that the effects of benchmarking can be powerful enough to cause inversion of risk and return on the scale observed in empirical studies. Specifically, the predictions are in line with the empirical observation of an inverse relationship between a security’s return and its total volatility (i.e., market-related plus idiosyncratic risk), as well as between its beta (market-related risk) and return.”
“Empirical studies from as far back as the early 1970s have shown either that there is no observable link between beta and return, or that the correlation is inverse…Studies of U.S. stocks over 70 years and international stocks over 23 years, report the relationship between beta and return to be flat, and that between beta and alpha as negative.”
How benchmarking subsidizes momentum trades
“Benchmarking…fosters the pursuit of momentum strategies which then earn profits at the expense of benchmarked funds…Momentum traders know that they can enjoy the early stage of the price rises and rely on benchmarkers coming in as buyers at the late stage. Benchmarked funds are the sacrificial counterparties and without them momentum traders would struggle to make a living.”
“Asset owners have to learn about the ability of managers from the accumulating evidence on performance. They eventually withdraw funds from underperforming managers causing them to sell shares that have mostly done badly, thereby amplifying the price declines. Outperforming managers receive inflows and increase their holdings of assets that have been doing well. Fund flows and price adjustments take place gradually and in a manner consistent with momentum.”
“Once momentum enters the pricing system investors have the choice of two strategies. They can follow fund flows and pursue momentum strategies, hoping to sell before reversal sets in. Alternatively they can take advantage of mispricing created by over-shooting and adopt value strategies. Momentum is a short-term approach because trends are typically short-lived and pay-offs established quickly. Value calls for patience while waiting for prices to revert to fair value.”
“Unconstrained momentum investors are free to select the timing of their trades whereas benchmarked funds are captive buyers of securities with rising prices. Momentum traders can exploit this predictability. The implication is that benchmarking to market cap both fosters momentum and is gamed by it. Earlier it was shown that benchmarking leads to the inversion of the relationship between risk and return as well as to the over-valuation of the entire market. Momentum investors compound the buying and selling pressure and amplify the distortions caused by benchmarkers.”
“Momentum within equity and bond markets and among asset classes has been extensively documented over the past 30 years…Academic and practitioner research has repeatedly confirmed not only the presence of serial correlation in equity prices, but that it obeys a surprising regularity. So much so that studies are able to describe the optimal lookback (the period of rising price before purchase) and holding period. Optimal periodicities for both lookback and holding periods are found to be quite stable at 6-8 months over many decades and in most national markets.”