Time and time again throughout my career, I have denounced the absurdity of benchmarking in all its forms. Now I’ve given up hope that business and investing will leave practice behind, so I don’t expect this post to change anything except make me feel better.
So do me a favor for a minute or come back tomorrow. . .
I recently spoke with a friend about an organization we both know intimately that has changed significantly over the past two years. In my opinion, one of the mistakes made by the organization was to hire a strategic consulting firm to benchmark the organization against its peers.
Alas, the result of this exercise was the determination that the organization needed to be more like its peers to succeed. As a result, the organization embarked on a cost-cutting and streamlining exercise with the aim of increasing “efficiency”.
And guess what? Thanks to these measures, many people now think that what made this organization special has been lost and are thinking of no longer being its client.
The problem with benchmarking a company against its peers is that it tends to be the quickest path to mediocrity. Strategy consultants compare companies with unique cultures and business models to their peers and tell them to adopt the same methods and processes that have made their peers successful in the past.
But comparing a company that is about to change the world is sheer madness. In 2001 and 2002, Amazon’s stock price fell about 80%. If Jeff Bezos had asked the Big Three consultants what he should do, they would have told him to be more like Barnes & Noble.
Name a single company that went from loser to winner or even changed its industry based on the advice of strategic consultants. . .
Or as Howard Marks, CFA, put it so clearly:You cannot do the same as others and expect to perform better.”
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, the performance of the fund manager has to be evaluated one way or another. But why should it be compared to a benchmark established by a specific market index?
When compared to a specific index, fund managers stop thinking independently. A portfolio that deviates too much from the composition of the benchmark creates career risk for the fund manager. If the portfolio underperforms too much or for too long, the manager is fired. So, over time, fund managers invest more and more in the same stocks and become less and less active. And that creates a herd, especially in the larger stocks of an index. For what? Because fund managers can no longer afford not to be invested in these stocks.
Ironically, the whole benchmarking trend has become circular. Benchmarks are now designed to follow other benchmarks as closely as possible. In other words, benchmarks are now compared to other benchmarks.
Take for example the world of environmental, social and governance (ESG) investing. Ideally, ESG investors should be motivated not only by financial goals, but also by specific ESG goals. Their portfolios should therefore be significantly different from a traditional index such as the MSCI World. In fact, in an ideal world, ESG investors would allocate capital differently than traditional investors and thus help direct capital to more sustainable uses.
So I went to the website of a major exchange-traded fund (ETF) provider and compared the company portfolio weightings of its MSCI World ETF with the weightings of its various ESG ETFs. The chart below shows that there is almost no difference between these ETFs, sustainable or not.
Portfolio Weights (%) of Largest Companies: Sustainable ETFs vs. Conventional ETFs
The good thing about this is that investors can easily switch from a conventional benchmark to an ESG benchmark. without worrying too much about losing performance. This helps convince institutional investors to make the move.
But the downside is that there is little difference between traditional and sustainable investments. If every company qualifies for inclusion in an ESG benchmark and then has roughly the same weight in that benchmark as in a conventional index, then what is the ESG benchmark for? Where is the advantage for the investor? Why should companies change their business practices when they will anyway be included in an ESG benchmark with minimal effort and not risk losing any of their investors?
Benchmarking ESG benchmarks against conventional benchmarks is like comparing Amazon to other retail companies. It will kill Amazon’s growth and make it another Barnes & Noble.
To learn more about Joachim Klement, CFA, do not miss 7 mistakes every investor makes (and how to avoid them)And Risk profiling and toleranceand sign up for her Klement on investment comment.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
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