Beware Benchmark Constraints

Today I write about benchmarking. (Note also this timely article on the topic from Abnormal Returns.)

I’m not a big fan of benchmarking. The idea behind a benchmark is one of three things:

1. A description of the non-controllable aspects of what a manager does. It reflects the universe of securities that a manager might choose from, and the manager’s job is to choose the best securities in that universe.
2. A description of the non-controllable aspects of what an investor wants for a single asset class or style. It reflects the universe of securities that describe expected performance if bought as an index, and the manager’s job is to choose the best securities that can beat that index.
3. A description of what an investor wants, in a total asset allocation framework. It reflects the risk-return tradeoff of the investor. The manager must find the best way to meet that need, using asset allocation and security selection.

When I was at Provident Mutual, we chose managers for our multiple manager products, and we would evaluate them against the benchmarks that we mutually felt comfortable with. The trouble occurred when a manager would see a security that he found attractive that did not correlate well with the benchmark index. Should he buy it? Often they would not, for fear of “mistracking” versus the index.

Though many managers will say that the benchmark reflects their circle of competence, and they do well within those bounds, my view is that it is better to loosen the constraints on managers with good investment processes, and simply tell them that you are looking for good returns over a full cycle. Good returns would be what the market as a whole delivers, plus a margin, over a longer period of time; that might be as much as 5-7 years. (Pity Bill Miller, whose 5-year track record is now behind the S&P 500. Watch the assets leave Legg Mason (LM).)

My approach to choosing a manager relies more on analyzing qualitative processes, and then looking at returns, to see that the reasons they cited would lead to good performance actually did so in practice.

Benchmarking is kind of like Heisenberg’s Uncertainty Principle, in that the act of measurement changes the behavior of what is measured. The greater the frequency of measurement, the more index-like performance becomes. The less tolerance for underperformance, the more index-like performance becomes.

To the extent that a manager has genuine skill, you don’t want to constrain him. Who would want to constrain Warren Buffett, Kenneth Heebner, Marty Whitman, Michael Price, John Templeton, John Neff, or Ron Muhlenkamp? I wouldn’t. Give them the money, and check back in five years. (The list is illustrative, I can think of more…)

What does that mean for me, though? The first thing is that I am not for everybody. I will underperform the broad market, whether measured by the S&P 500 or the Wilshire 5000, in many periods. Over a long period of time, I believe that I will beat those benchmarks. Since they are common benchmarks, and a lot of money is run against them, that is a good place to be if one is a manager. I think I will beat those broad benchmarks for several reasons:

• Value tends to win in the long haul.
• By not limiting picks to a given size range, there is a better likelihood of finding cheap stocks.
• By not limiting picks to the U.S., I can find cheaper stocks that might outperform.
• By rebalancing, I pick up incremental returns.
• Industry analysis aids in finding companies that can outperform.
• Avoiding companies with accounting issues allows for fewer big losses.
• Disciplined buying and selling enhances the economic value of the portfolio, which will be realized over time.
• I think I can pick good companies as well.

I view the structural parts of my deviation versus the broad market as being factors that will help me over the long haul. In the short-term, I live with underperformance. Tactically, stock picking should help me do better in all environments.

That’s why I measure myself versus broad market benchmarks, even though I invest more like a midcap value manager. Midcap value should beat the market over time, and clients that use me should be prepared for periods of adverse deviation, en route to better returns over the long haul.