Why Benchmarks Lead to Bubbles

London economists argue that benchmarks encourage managers to invest in assets as prices go up, even when securities have no fundamental value.

Measuring performance relative to benchmarks has inverted the relationship between risk and return, London School of Economics (LSE) researchers have argued.

“Capitalism is in danger of dying by its own sword unless the present absurdities are recognized and addressed.”Not only does benchmarking cause high-volatility securities and asset classes to offer lower returns than low-volatility ones, it also gives rise to sector bubbles and herding behavior, according to finance professor Dimitri Vayanos and research fellow Paul Woolley.

“Obsession with short-term performance against market cap benchmarks preordains the dysfunctionality of asset markets,” they wrote. “The problems start when trustees hire fund managers to outperform benchmark indexes subject to limits on annual divergence.”

The duo acknowledged that there are benefits to using a benchmark as part of a given mandate, including that it offers a point of comparison for the fund’s returns and provides a defined objective for the manager.

However, they argued that benchmarking exacerbates inefficiencies in the market by rewarding momentum strategies, wherein short-term investors acquire popular securities as they rise in price, with the intent of selling when they begin to fall.

Meanwhile, long-term managers who are underweight these superficially rising assets suffer as being underweight causes them to underperform the benchmark.

“If a security doubles in price and the investor is half-weight, the mismatch doubles; if he is double-weighted and the price halves, the mismatch halves also,” Vavanos and Woolley wrote. “Underweight positions in large, risky securities therefore have the greatest potential to cause a manager grief.”

According to Vavanos and Woolley, this need to satisfy the tracking constraints of a benchmark forces value managers to buy bubble stocks they know to be over-priced.

“The overall market becomes permanently over-valued and prone to sector bubbles,” they wrote.

Rather than relying on a market-cap benchmark, the LSE economists said asset owners should compare manager performance against that of value investors. That way, managers are incentivized to invest on the basis of fundamental value rather than momentum.

 “Capitalism is in danger of dying by its own sword unless the present absurdities are recognized and addressed,” they concluded.

Related: Does Your Benchmark Choice Matter? & The Benchmark Causing Headaches for High Yield Investors