Blindly tracking a benchmark does investors no favours

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Ryan Modesto, CFA, is Managing Partner at 5i Research, a conflict-free investment research provider for retail investors offering research reports, model portfolios and investor Q&A. 5i Research provides content under an agreement with The Globe and Mail, which receives royalty compensation. Try it.

At first glance, many are likely to be skeptical at the idea of the wide use of benchmarks being a bad thing. Most would be correct to be skeptical, as having some sort of way to gauge the performance of money managers is a key aspect to understanding what type of investment or fund you are buying and whether you are getting your money's worth. Without some sort of benchmark, it would be very difficult to determine if management fees were justified or if an investor would just be better off with a passive investment strategy. Sometimes, however, blindly tracking a benchmark does investors no favours, especially in the case of Canadian investors.

Before jumping into the issues with benchmarking, we first need to understand why it is done. A benchmark is meant as a point of reference for the investor. If a certain exposure or industry is being targeted, there needs to be a way to determine if the exposure is being matched. The intention is not necessarily to beat the benchmark; in fact, if the performance greatly differs from the benchmark it usually means that an inappropriate benchmark is being used. So if an investor's total portfolio consists of a 50/50 split between stocks and bonds, comparing the performance to the S&P/TSX composite makes little sense. The benchmark should actually be the weighted performance of an appropriate fixed income index and equity index. This can get convoluted quickly, but rarely does using the TSX or S&P 500 act as an appropriate benchmark for most investors. So how can this be bad for investors? Just look at the TSX composite.

No real reason to match portfolio to composition of TSX

Many forget that most benchmarks, such as the TSX composite, are quite arbitrary in their composition. The TSX composite is simply a representation of the Canadian economy, which, as can be seen below, is dominated by energy, financials, industrials and materials. All of these sectors also happen to be economically sensitive, which adds to volatility. There is no real reason why investors should have over half of their investment portfolio allocated toward financials and energy (~54% of the TSX), which is likely to be the case if you are benchmarking against the TSX. Unfortunately, investors have been suffering over the past few months (or more) because of this Canadian bias toward energy, financials and materials. Comparing your portfolio to the TSX is one thing, but if an investor or manager is matching the industry exposures of the portfolio to the TSX (as would be expected when using the TSX as a benchmark), you have all of a sudden made an 'overweight' decision on financials and resources. There is no reason to do this aside from the fact that everyone else is doing it.

Diversify Away from Human Capital

Human capital is an interesting concept that rarely gets talked about. Essentially, it is the value of your future income, today. Since the Canadian economy is dominated by energy and financials, it is probably safe to assume that a large degree of jobs held by Canadians are, in one form or another, related to these two industries. The question becomes this: If your primary income or way of life is at the mercy of the ups and downs of a single industry, should you also be doubling down on this industry through your investment portfolio (AKA financial capital)? Those employed in the energy and/or financial sectors that follow the TSX as a benchmark are essentially doubling down on these industries. Yes, when times are good they will be quite good, but it unfortunately works both ways.

Funds only manage to the benchmark

This is an interesting self-fulfilling prophecy. Since most funds are evaluated relative to the TSX as a benchmark, all of these funds are structured in a way that largely mirrors the TSX. Managers then make relatively small tweaks to individual stocks that are preferred or disliked or tweaks to a specific industry that they are bullish or bearish on. Yes, this will result in some drifting from the TSX (good or bad) but the problem is that the performance remains largely anchored by the above-mentioned industries that dominate the Toronto stock exchange. Since most managers are paid and evaluated based on performance of the TSX as well as to one another, most managers largely mirror the TSX. Sticking ones neck out and diverging from the crowd too much puts ones job at risk as well as setting them up to stand out from the crowd. Standing out from the crowd can be a good thing if the fund is doing well, but if it works the other way, it can be disastrous to funds assets under management. It is hard to blame managers too much for this, as everyone wants to remain employed, but does help to highlight the issue that too much of a focus on the TSX as a benchmark can create.

Unfortunately, it is hard to know what the solution to this problem is, if any. Reducing the accountability of money managers would be a step backward yet concentrating Canadians assets into two to four sectors also makes little sense aside from the argument of 'that's just the way it is'. It is likely best solved through baby steps, starting with an understanding that just because a country or benchmark is composed a certain way, it does not mean that Canadian investors need to follow it in their personal portfolios and in turn have their retirement prospects be at the mercy of the energy and financial sectors.

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