Benchmarking is part of modern life. Whether you’re deciding on a school for your child or a hospital for your operation, comparing holiday packages, or checking that you’re not overpaying for gas or car insurance, you need to see how the different options measure up.
Asset management should, of course, be no different. Consumers need to see, in black and white, exactly what they’re paying and the value they’re receiving in return. Anyone who’s read last year’s FCA report on competition in the sector will know it isn’t that easy, not least because it’s so hard to work out the different fees and charges entailed.
There is, though, another crucial issue that receives much less attention, and that’s the lack of effective benchmarking.
Under MiFID II, asset managers are required to show how all of their funds have performed relative to their respective benchmarks. Unfortunately, as recent research by the consumer group Better Finance showed, many funds don’t. In fact, along with Ireland and Luxembourg, the UK has the lowest rate of compliance in Europe.
But there’s an even bigger problem. Even in cases where investors can compare a fund’s performance with the benchmark, it often misleads them. That’s because fund managers get to pick their own benchmark. It’s not surprising that given a choice between two different benchmarks, they’re going to choose the one that’s easier to beat.
This isn’t the place to discuss the relative merits of active and passive investing, but one of the advantages of a passive fund is that it does what it says on the tin. If, for example, you buy a FTSE-AllShare index tracker, or a US small-cap index fund, you know what you’re buying.
Actively managed funds, by contrast, can be very messy. Most active equity funds, for instance, mainly to provide liquidity, will include an element of cash or bonds. Another issue is so-called style drift. For example, a fund that invests primarily in the UK may choose to gain exposure to European stocks, then emerging market stocks and so on. This “flexibility” is usually dressed up by marketing departments as a positive thing; in fact it means investors often end up taking on more risk than they thought they were signing up for.
More concerning, however, is evidence that consumers are being deliberately misled. A new study by Martijn Cremers, Jon Fulkerson and Timothy Riley found that 26% of US funds had a benchmark discrepancy. Relative to the benchmark in the prospectus, funds underperformed by an average of 0.33% a year; but compared to the appropriate benchmark, they underperformed by 0.78% a year.
The biggest discrepancies, the authors found, were among large-cap funds. Academic research has established that small-cap stocks tend to outperform large-caps over the long term, albeit at greater risk. By gaining exposure to small-cap stocks, then, a large-cap fund manager can make it look as though they’ve outperformed through skill, when all they’ve done is benefit from the small-cap premium.
“A substantial number of funds,” Cremers, Fulkerson and Riley concluded, “have a prospectus benchmark that on average is easier to outperform compared to the benchmark implied by their holdings”. In such cases, they say, the chosen benchmark “understates risk and, consequently overstates relative performance”.
“Further, we show that funds benefit from that overstatement, as investor flows respond to performance relative to the prospectus benchmark even when a fund has a benchmark discrepancy.”
This isn’t a sustainable situation. Benchmarks are supposed to aid transparency for consumers; but, to a large extent, they’re only adding to the opacity surrounding the value (or lack of it) that actively managed funds provide.
What then is the answer? There are many in the industry who would prefer to downplay the importance of benchmarks, or even ignore them altogether; tellingly, they often work for the fund houses whose benchmark-beating records are particularly poor.
No, benchmarks are hugely important. In fact we need to take them far more seriously. Regulators should punish firms that withhold the relevant information, and especially those that deliberately choose an easier benchmark than they should.
Fund houses also have to be totally transparent about the investment style of each of their funds, and make it plain to investors that, depending on what the manager chooses to invest in, their risk exposure may well increase over time.
Proper benchmarking is crucial to maintaining competition in asset management. It needs to be given more priority.
