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Benchmarking has become circular
Note: This article originally appeared in the CFA Institute Enterprising Investor blog on 18 August 2021.
Time and again throughout my career I have ranted about the nonsense of benchmarking in all its forms. By now I have given up on the hope that we will ever leave benchmarking in business or investments behind, so I don’t expect this post to change anything except to make me feel better. So, indulge me for a minute or come back tomorrow…
I had a conversation recently with a friend about an organisation that we are both intimately familiar with and that has changed substantially over the last couple of years. In my view, one mistake the organisation made was to hire a strategy consulting firm to benchmark the organisation to its peers. Alas, the outcome of that exercise was to be more like their peers in order to be successful and as a result the organisation engaged in a cost-cutting and streamlining exercise in an effort to increase ‘efficiency’. And guess what, thanks to that effort many people now think that what made that organisation special has been lost and they are thinking about no longer being a customer of it.
The problem with benchmarking a company against its peers is that it is typically the fastest way into mediocrity. Strategy consultants compare companies that have a unique culture and business model to its peers and tell these companies to adopt the same methods and processes that made their peers successful in the past. But benchmarking a company that is about to change the world is outright stupid. In 2001 and 2002 Amazon’s share price dropped 80% or so. If Jeff Bezos had asked McKinsey what he should do, they would have told him to be more like Barnes & Noble.
Name a single company that has turned around from being a loser to a star performer or even changed the industry it is active in based on the advice of strategy consultants…
Or as Howard Marks put it so clearly: “You can’t do the same thing as others do and expect to outperform.”
Which brings me to investing, where pension fund consultants and other companies have introduced benchmarking as a key method to assess the quality of a fund’s performance.
Of course, if you are a fund manager your performance needs to be evaluated somehow, but why does it have to be against a benchmark set by a specific market index? The result of being benchmarked against a specific index is that fund managers start to stop thinking independently. Having a portfolio that strays too far from the composition of the reference benchmark means that a fund manager creates career risk. If the portfolio underperforms by too much or for too long, the manager gets fired. So, the result is that over time, fund managers invest in more and more of the same stocks and become less and less active. And that creates herding, particularly in the largest stocks in an index because fund managers can no longer afford not to be invested in these stocks.
Ironically, by now, the whole benchmarking trend has become circular because benchmarks are designed to track other benchmarks as close as possible. In other words, benchmarks are by now benchmarked against other benchmarks.
Take for instance the world of ESG investing. Theoretically, ESG investors should be driven not just by financial goals but also by ESG-specific goals. So their portfolios should look materially different from a traditional index like the MSCI World. In fact, in an ideal world, ESG investors would allocate capital differently than traditional investors and thus help steer capital to more sustainable uses.
So, I have gone to the website of a major ETF provider and looked at the portfolio weights of the companies in its MSCI World ETF with the weights in its different ESG ETFs. The chart below shows that there is essentially no difference between these ETFs, sustainable or not.
Portfolio weights of the largest companies in a conventional and several sustainable ETFs of the same provider
The good thing about this is that investors can easily switch from a conventional benchmark to an ESG benchmark without much concern about losing performance. That helps getting institutional investors to switch.
But the downside is that there is little difference between traditional investments and sustainable investments. If practically every company qualifies for inclusion in an ESG benchmark and then has roughly the same weight in that benchmark as in a conventional benchmark, then what’s the point of the ESG benchmark? Where is the benefit for the investor? Why should companies change their business practices when they will anyway be included in an ESG benchmark with minimal effort and don’t risk losing any of their investors?
ESG benchmarks that are benchmarked against conventional benchmarks is like benchmarking Amazon against other retail companies. It will kill Amazon’s growth and turn it into another Barnes & Noble.