Benchmark indifference is demand flow critical…old hat not new!

I was just reading an article in the Canadian Investment Review, “Time to toss your benchmark to the curb”, which discussed the performance of benchmark indifferent managers and the out performance of fundamental indexing versus traditional market cap indexing.  Now if you have been stuck in some efficient market nirvana for the better part of your working life you might find this all a bit of a shock.  But this is old hat , not new!

The truth of the matter is that this is the “same old same old” demand flow argument rehashed, meaning that demand flow impacts equilibrium values, pushing sectors, market cap, stocks and even styles, at times, far above and far below their equilibrium values: it is all in the correlation and the relative price movement, and hence the price and the return.

You still need a benchmark to assess your performance and to allow those who are looking to buy into your performance to assess your performance, because whether you are benchmark agnostic or not, you are still market relative.  Indeed, benchmark agnostic investors have more reason to compare themselves to the major market benchmarks, since this is what represents the weighted average money flow, and if you are benchmark agnostic you are playing the money flow game: buying, if you are contrarian, when the tide has gone out and reaping the dividends, and waiting for it to come back in and selling when the tide is high.

People need to know your relative position to the benchmark and your performance relative to the benchmark to assess not just the fact that you out perform, but your own place in the cycle and the value of your place in the cycle.

Anyone who has a value biased investment discipline has always known that the index itself does not represent the best value at any one point in time, most of the time.  This is a given and it is where the main thrust of mutual fund industry arguments about the value of active investment reside.  But, anyone who knows about value knows that the timing of the tide itself is not certain and you can be left, beached like a whale, for a long while.  The 1990s was a time when the tide was out for a great deal of time for value investors, but the cycle reasserted itself in the early 2000s. 

I myself developed an equilibrium benchmark approach to asset allocation in the mid to late 1990s that was based on the assumption that at any one point in time there was a bounded  equilibrium allocation of markets and that significant deviations from these bounded allocations represented a contrary buying opportunity. 

There was one key point in the article over which I disagreed:

“What we find is that no matter what methodology you use to determine weighting, if it’s the type of methodology that leads to a fairly diversified, not too concentrated portfolio (in other words a sensible portfolio), and if the methodology isn’t market-price dependent, almost any methodology will outperform cap-weighting over a reasonable horizon.”

It ignores the following:

Risk 1 – Equilibrium values are bounded which means that – based on a given stage in the cycle, historical risk relationships, price relatives and long term return realities + a given set of economic return assumptions which may or may not equal future relationships and outcomes- they are fuzzy and carry a latent performance risk.   In other words there will be times when the benchmark may be correct.

Risk 2 – Actual values deviate from equilibrium values all the time.   Some of the time the differences are truly extreme (meaning that contrary positions are few and far between), while at other times the differences are slight, and none existent when the paths of demand flows cross.  In other words, the benefits and risks of such a strategy vary and you need to be aware of the relative valuations and the position of the style with respect to the cycle.  

Risk 3 – the more the market cycles away from the index the more once out of equilibrium positions resemble the market cap index and the more you cycle away to differentiate yourself from the market the greater the allocation and the more you resemble the market cap index.  Fundamental value cannot be held by all.

This is all old hat dressed up as something new by those who have recently seen the light!

Hat tip – Ken Kivenko

Leave a Reply