How useful are MSCI Benchmarks?
There is so much talk about the awesomeness of benchmarks and how they are leading the passive revolution, proving again and again how active managers should go home because they don’t beat these simple benchmarks constructed in 1871. But there is little talk about, whether these benchmarks are useful?
The Indexing or Passive narrative is something like this. “Of course, there is a benchmark for everything—if one does not fit your needs, there are 1,299,999 more Indexes for you to choose from. Eventually one of the colour shades will fit your portfolio, and then you can proudly underperform us and prove our amazingness.”
This narrative of brilliance is a spin, which does not stand up to simple common sense tests. But then, nothing can ever be useless for a man who looks for good in things and people. However, when you make a claim of greatness, you need to be able to defend that greatness.
Recently, we embarked on an exercise to build a model with quality-screened ADRs in the US to get some emerging market exposure, considering they have been beaten down for over 20 years versus the U.S. markets. We went about looking at the listed ADRs, screening them for quality and value, spending some real CFA hours to come to an investable preferred universe. Once we had the universe, we went about building the E&R ADR Index and comparing it to the relevant benchmark.
Now, one may ask, why did you need a benchmark if you are already building one? The answer is simple. The industry does not know about Exceptional & Rich now, but it will in the years ahead. Hence, Exceptional & Rich has to gain industry acceptance, license to a few dozen funds, get a few billion dollars tracking it, and then we may not have to benchmark our benchmark to prove our brilliance, but until then, we have to look for a benchmark for our benchmark. Sounds silly, but that’s the way it is.
So we went benchmark hunting for our benchmark. Of course, we knew that MSCI ACWI Ex USA could work out, but it has 2300 components, and benchmarking a smaller universe of 200 stocks with a 2300 component universe seemed like an impossible task. But then we noticed that MSCI World Ex USA with 900 stocks behaved similarly to the MSCI ACWI Ex USA with 2300 stocks. Such different MSCI benchmarks, which I assumed are licensed to different kinds of asset managers—one looking at developed markets and another at emerging markets, which naturally are two different mandates—were so similar to each other in performance and risk characteristics. Not only that, but the top 10 components also had an overlapping five stocks:
Nestle, AstraZeneca, Novartis, Novo Nordisk, ASML Holdings.
The risk was similar, the max drawdown was similar, and the indexes were designed for different mandates but were so similar to each other over the last 20 years of performance. Now MSCI may want to tell us that it’s not their fault that two different indices are coincidentally behaving similarly. It is indeed not their fault.
The bias comes from the 1871 flawed Indexing methodology (Laspeyres method). We totally agree with MSCI that it’s all about the methodology, but then if the methodology makes an apple look like an orange, then what’s the use of the methodology as a holy grail benchmark for an asset manager to show outperformance? From an asset manager’s perspective, he(she) may want to build an emerging market fund but it does not matter, whether the benchmark is the World or the World with emerging markets in it, it’s all the same.
The truth is that most of the benchmarks, be it MSCI, S&P, or STOXX, are rendered useless if they rely on the market capitalization method, which makes everything similar to the few big stocks, everything for the MCAP is like the magnificent 7. In the case of Ex USA, we can chose the magnificent 7 from the world without USA.
This is the thesis for Exceptional & Rich Indexes. We are here to create a level playing field for the Active Industry, which finds it hard to call the bluff of the Market Cap Indexes, which rule the passive world, but in truth are useless and broken and in simple words, not proper benchmarks.
When one of our team members took the CAIA charter, he went through the literature on Benchmarking well featured in the readings and memorized the characteristics which made for a good benchmark. He calls it AIR MOUS.
A for Appropriate, I for Investable, R for Reflective, M for Measurable, O for Owned, U for Unambiguous, S for Specified
Today’s benchmark are not appropriate, they are not reflective and they are ambiguous. In 1990, Bailey et al. pointed out that bad benchmarks obscure the contributions of managers and can lead to inefficient allocations of plan assets. He also said that benchmark quality has remained a neglected issue.
The truth of outperformance is that the industry is not serious about solving it, if it was, we would bury the market cap methodology and suddenly there will be outperformance everywhere and the world would be a better place. But because you can’t relegate stone age Indexes, redesign the passive management industry and undo 100 year old of mass perception, you got to use Science and technology to turn the tables. Play your part. Educate yourself about benchmarking and next generation Indexing. Be a part of the revolution so that our children don’t have to suffer underperformance and unnecessary risk.
Bibliography
Bailey et. al, Evaluating Benchmark Quality, 1 May 1992 Financial Analysts Journal Volume 48, Issue 3
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