One of the odd features of the fund management business, particularly that bit of it that looks after our pensions, is the lingering tyranny of the benchmark. Money managers are often measured - and rewarded - relative to an index like the FTSE All-Share or the Morgan Stanley EAFE (basically a global equity index that excludes the US). The cult of the benchmark means that many money managers rarely stray from investments that mimic the index that they are following.
The tired old joke is that so long as you lose less money than the average of your competitors, you can still be a winner. Unkind accusations of "closet indexing" are sometimes levelled at managers whose investments cling tightly to the benchmark. Questions are often asked about how such managers can justify the fees that they charge as "active" investors.
Benchmarking leads directly to a mind-set that is always relative: the manager will always ask how he is doing relative to somebody else. He will not be as concerned with the absolute question, "have I made or lost money for my clients". As with most things in the investment world, the fad that was benchmarking was pushed to extremes. The growth of hedge funds (explicitly advertising themselves as absolute return managers) and index funds (fund management at a fraction of the cost of the traditional guys) represents a reaction to the extremes of relative fund management styles. And this counter-revolution will almost certainly go too far as well.
To be fair to traditional asset managers, they are often victims rather than culprits: historically, much of the nonsense surrounding the benchmarking craze has been the fault of another layer of intermediaries, often invisible to the ordinary punter, called "consultants". The firms that advise pension funds on matters such as manager selection and choice of benchmark come in various shapes and sizes. Critics believe that some of the consultants are at least partly responsible for one or two of the more damaging fads that grip the industry from time to time, not least of which has been benchmarking.
Ultimately, however, responsibility for the way in which money is managed lies with the owner of that money. If our pension funds are victims of fashion and fad, it is actually our fault. If consultants and asset managers do not always act in our best interest it is because, at the very least, we allow them to behave in this way.
Sometimes we actively encourage them: the obsession with relative short-term performance often stems directly from the customer - who should know better. As clients - and therefore the paymaster - of these businesses we have the power to change behaviour but, historically at least, we rarely exercise it. There have been plenty of reasons for this, not least of which has been the inertia of many pension fund trustees.
But things are changing. Hedge and tracker funds are the most visible manifestations of progress, of course, but the mindset of many participants in the traditional asset management business has moved on to embrace some aspects of the absolute returns game. The crude links to simple stock market indices are slowly disappearing, to be replaced by much more appropriate performance measures. The temptation to focus far too much on short-term returns remains irresistible for many, but some people now recognise that time is a vitally important ingredient in the mix.
Old-fashioned money managers might look at current circumstances and decide that turmoil in the Middle East, rising US and UK interest rates, high oil prices and slowing growth - particularly in the US - means that performance league tables for the coming quarter will be dominated by "defensive" stocks, ones that traditionally do better when markets are trading sideways or falling. These defensive stocks - which traditionally include things like pharmaceuticals, tobacco companies and food producers - will still go down if the market is about to collapse, but if the past is any guide, they will fall by less than the overall market. The investor will still lose money.
Similarly, an absolute return manager with an eye on the next three months might think about selling "cyclical" stocks short and, like his traditional counterpart, go long of more defensive names. This manager might also keep a lot of his client's money in cash and bonds, as well as making a bet that slowing US growth will lead to another fall in the dollar.
If he gets involved at all, the modern asset manager will - because his performance over the next three months is no longer as important as it was in the past - leave all this kind of trading to his TAA (tactical asset allocation) team. Specialist TAA managers mimic the activities of the absolute returns manager, often using derivative-based strategies. Our modern manager will stick to his knitting: if his mandate is, say, to invest in global companies that produce a superior return over at least five years, that is what he will do. I don't know of too many examples of this, but I believe that such managers should be given a mandate relative to something called the equity risk premium: they should be paid relative to how much they beat the bond market by. In our low inflation world this is akin to setting an absolute return standard, one that is almost certain to be positive, provided that the time period is long enough.
Pension fund assets have increasingly been split between different investment specialities, relative to a benchmark more appropriate to the needs of the fund. Some portion might be given to an indexer (or an "enhanced" indexer); another slug might be put into a hedge fund, with the remaining "actively managed" money given to somebody who will do precisely what is asked (and charged) for: aggressive management. All of these managers might be separate businesses or they could be contained within one integrated operation.
Anybody that contributes to an institutional pension fund needs to ask questions about the way in which the money is being managed. Are the highest standards being met?
