When it comes to determining whether or not a fund is a successful institutional investor, there is a widespread tendency (of which I am guilty) to look at a fund’s outputs; to compare its annual or even quarterly returns against those of others and come to some assessment of the value of the decisions made by management. It seems logical to do so, but is this a healthy practice?
Before I tackle this question, let me first offer up a clear description of my biases: I think long-term investment is good for society. I think a long-term investor is one that fosters sustainable economic growth through investments in a (not overly) diversified portfolio of assets that has a laser focus on building companies (rather than owning financial products). So that’s me; nice to meet you.
With this in mind, let me repeat the question: Should we be benchmarking long-term investors against anybody? I’m not sure. As I see it, no two institutional investors have identical risk budgets, liability profiles, mandates or portfolios. So what good does it do to shame or praise them for short-term performance? Let’s discuss.
Today, institutional investors of all stripes rely on benchmarks. Here are a few reasons why:
- Benchmarks establish a return expectation, which guides both the behavior of sponsors / Boards (in terms of the resources provided) and the behavior of portfolio managers / staff (in terms of the actual deployment of capital).
- Benchmarks allow for an objective assessment of performance, which is perceived to be important for testing organizational efficiency and staff competency.
- Benchmarks help calculate performance-based compensation, which is a crucial tool for recruiting and retaining the talented staff required.
- Benchmarks clarify and refine mandates, which helps to focus the organization on its long-term goals.
So there are plenty of good reasons for investors to consider implementing a benchmark or series of benchmarks; they offer accountability and transparency into the sometimes-murky-world of investing.
But what if you’re a long-term investor, like the China Investment Corporation, and you have a formal mandate to generate returns over a 10-year time horizon or even longer? What role should benchmarks play in this case? Should you set up a series of market-based benchmarks with the idea that you will try to assess the success or failure of your long-term strategies... in the short term? Is that a valuable thing to do?
In thinking about how to answer this question, I’m reminded of some unconventional wisdom that I gleaned (lord only knows where and when) from two decorated Future Fund Alumni, Tony Day and David Murray, about the importance of inputs and letting go of outputs. No doubt I’ll fail to do justice to the nuances of their position, but as I understand it they viewed finance as being far too random a world to interpret anything meaningful about long-term positions from short- and medium-term data. In other words, short-term benchmarking was not necessary and, because it could distort the behavior of agents, potentially counterproductive.
What was important, I think these two gents may have said at one point somewhere, was focusing on the rigor and credibility of the investment decision-making inputs. In other words, making successful long-term investment decisions was really about reflecting on qualitative and empirical data points and building a narrative around a potential investment. The idea here was to ‘tell stories’ that would, first and foremost, discredit the opportunity. Those opportunities that could withstand a full frontal assault by well-researched skeptics... those were good ideas worth pursuing.
As you might imagine, the world described above is not one where you get to take your data and run it through a Nobel Prize winning financial model (‘Powered by E.M.H. – the most trusted name in finance’) so as to have a machine tell you what to buy and what to sell; quite the contrary. This is a world where you have to have trust in your convictions and work hard enough ex-ante to have faith, ex-post, that you made the right decision.
Anyway, I understand the appeal of benchmarks. There is great comfort that comes from being out in front of your peers at an intermediate checkpoint. But this does NOT necessarily mean you’ll still be winning the race when you cross the finish line.
What color pen do you think Bruno Iksil or John Paulson use when they’re asked to write down their lifetime performance as of today? Red or black? And three years ago?
I’m not saying we can give up completely on benchmarks, but I think we can be a bit more sensible with how they are designed and used (e.g., bespoke reference portfolios?). The construction of benchmarks inevitably generates unintended incentives within institutional investors. A poorly set benchmark can distort the behavior of internal teams and, as such, cause the organization to deviate from its over-arching mission. So setting benchmarks can be one of the single most important decisions an institutional investor makes.
(As someone smarter than me once said, tail risk hedging is a widespread acknowledgement that models are flawed. And if models are flawed, what’s the likelihood that benchmarks are flawed as well? Discuss.)
What I am saying is that extending the time horizon of investors will require that they give up on heuristics and an over-reliance on established theories and supplement them with a set of “beliefs” about the world. This won’t be easy, but it is (at least in my biased opinion) worth a try.
(Cue a long and fascinating discussion of the importance of ‘investment beliefs’!)
