COLUMN-Benchmarking ourselves, and the economy, into the ground -James Saft

By James Saft

March 29 The problem in our financial markets, and by extension in our economy, lies in our fund managers.

Specifically, the benchmarks used to judge and reward fund managers fail at their most elemental task: protecting investors and deploying capital where it will be best used.

That's the radical assertion of Paul Woolley, a veteran IMF official and fund manager, and Dimitri Vayanos, of the London School of Economics, in a newly published paper. (here)

The arrangements under which most of the world's money is managed pair a false assumption - that markets are efficient - with a counter-productive set of incentives that all but compel fund managers to cook up financial bubbles.

By judging fund managers on benchmarks based on the market capitalization of companies, we end up rewarding those who manage their own career risk.

Worst of all, we badly serve money owners, who lose out in the end, and the economy, which suffers under-investment in the most productive companies and over-investment in so-called "hot stocks." The result: boom and bust.

Those looking for an explanation of secular stagnation in the economy might want to take note.

"Above all the present system has been bolstered by the academic theory of efficient markets. The victims are the economy and the ultimate asset owners who are dispersed, unaware of what is being perpetrated against them and powerless," Woolley and Vayanos write.

"Capitalism is in danger of dying by its own sword unless the present absurdities are recognized and addressed."

Strong words, but a look at the results produced during the era of greatest growth of benchmarked fund management tends to bear them out.

At its base, and like its close cousin, the idea of "shareholder value maximization," the use of market-capitalization benchmarks is the negative spillover of the efficient market hypothesis. That is the idea that stocks and bonds are perfectly priced to reflect the best guess of their actual ability to create income and value.

But as markets are not efficient, and are made less so by assuming they are, we end by destroying value.

A large proportion of fund managers are tasked with beating a market-cap index without taking too many huge bets, or beating an index of other fund managers' performance. Even those managers without those benchmarks are subject to them, as investors follow the market and the competition and judge accordingly.

In theory, this is supposed to keep fund managers honest, giving investors clear standards by which to judge and minimizing the conflicts of interest inherent in giving money to someone whose skills and probity you cannot know in advance.

In practice, benchmarking as now employed ends in distortion.

Consider the situation of a fund manager who underweights a hot stock, because she believes it has gone past its likely fundamental value. The more the stock goes up, the more she lags her index or peers and the more likely she is to lose the account. Being only human, she, therefore, will cut her underweight and buy in. That drives over-valued stocks even higher, a phenomenon exploited by momentum investors, who game those tethered to benchmarks by buying what just went up and selling what just went down.

All of this, the authors argue, explains the otherwise hard-to-fathom anomaly of riskier stocks underperforming safer ones, something we've seen in U.S. stocks over the past 70 years and in many other asset classes. It also helps to explain why stocks tend to keep traveling in the same direction, called momentum. Managers crowd into highly volatile, highly risky stocks, which become over-priced and ultimately underperform. Dotcom bubbles ensue, with the attendant costs to savers and the economy.

Meanwhile, the asset management industry enjoyed a profit margin of 39 percent in 2014, according to consultants BCG, more than double that of the much-reviled pharmaceutical sector.

So now that we find ourselves here, what do we do?

Woolley and Vayanos argue that the key lies in value investment strategies, which try to exploit differences in fundamental value and market pricing. While value tends to do better, it requires patience, achieving better risk-adjusted returns only over the medium or longer term.

This is especially true in current markets, which are distorted every few years by the latest hot-stock phenomenon. This, unfortunately, requires a leap of faith by savers, who are by design giving their money to people who might outperform the broad markets perhaps over only 10 years. This requires nerves of steel and the willingness not to watch financial television.

The upside, however, is more money for retirement for the saver and a bigger, more smoothly growing economy for everyone.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by Dan Grebler)