Benchmark Heist
If you thought it could not get worse, a new paper suggests that investment managers are rampantly indulging in what I could see as a benchmark heist. They are systematically going back in time and choosing a benchmark with the poor performance of up to 5% lower and representing the results in a better light, somehow magically eeking out the last minute gain, touching the finishing tape.
Mullally and Rossi have done such a comprehensive study that even if SEC does not do anything, and we don’t have whistleblowers coming out of the closet and admitting that they [or their asset management company] have been indulging in this unfair practice and they are willing to accept fines, the integrity of the capital markets has been effected. I don’t want to think about the world outside the U.S, the developing, the emerging, and the frontier world, where there is even weaker precedence of punishment.
The industry has reached a new low that it’s better to sink with the ship than come out and say, yes, let’s begin the clean-up. Ultimately, if you misrepresent performance to the investor, the investor you are supposed to safeguard, what code of ethics and standards of professional conduct are you following?
Dinah Wisenberg Brin, feature pointed me to the SSRN paper. The authors go about systematically illustrating the ethical breach. They go and calculate the difference of the newly added benchmarks from the existing benchmarks over 1,5,10 year past returns and found it to be negative up to 5%. This means managers were consciously going back in time and cooking the performance books, by finding a suitable benchmark to overstate performance, look more attractive, and keep fund flows intact. Because the more attractive the performance, the better it is to lure the common Joe, who will put his hard earned money into the fund. If the managers would have taken the suitable benchmark, they would have lost 10% above the market, over 10 years, gross of fees.
The performance misrepresentation [which is a mild word] continues by choosing peer-based benchmarks, because of the effect of fund fees. This gives the managers an advantage of up to 14% over 10 years. Peer-based benchmarks are chosen even if they are not related to investment style. The objective for managers was clearly to inflate relative past performance. Above that 60% of the time, the benchmark changes do not reflect what is relevant for investment style. Most of the changes are done at the individual fund level, not at the family of funds level [Which seems obvious as managers won’t like to alert the investors and raise more questions]. The managers strategically chose mismatched benchmarks that they anticipate outperforming.
Funds are run for hot styles, dropped as they go out of fashion, packaged for superior relative performance by changing the benchmark, and pursuing a hot style again, in an endless loop. The managers were working on looking in the past and had limited skill and interest in anticipating the future. The newly chosen benchmarks did not explain the investment styles. The funds with the highest expense ratio, and broker-sold funds, were more likely to engage in the practice.
Poor investors and asset owners, naturally took the bait, as fund flows poured in after the benchmark change and petered out as the cycle of underperformance continued. SEC’s loophole that the managers exploit revolves around “appropriate broad-based securities market index”. If the regulator gives a passive broad playing field to the active manager, the rule can’t do much, but be exploited by those who want their fees, year after year, for underperformance. The agency risk in the industry can’t go out without stricter rules, fines and punishment.
The following CFA and CAIA code of ethics and standards of professional conduct were breached.
1 Professionalism [B,C,D]. Till the time SEC closes the loophole, it’s hard to say if 1A is broken.
2 Integrity of Capital Markets. A and B do not offer coverage to the case above and hence needs an upgrade. The above may not be a case of material non-public information or direct market manipulation. But if the asset manager [member] misrepresents to the extent of making it an industry-wide practice, the member has consciously harmed the integrity of capital markets. Poor funds, repackaged attractively should be a financial crime.
3 Duties to Clients [A, B, C, D breached]
4 Duties to Employers [C breached]. We can’t assume here the CEO does not know what the risk manager or CIO is doing.
5 Investment Analysis, Recommendations, and Actions [A, B breached]. Misrepresented performance record retention [5 C] is essential for tracking unfair practice.
6 Conflicts of Interest [A is breached]. How would a manager explain to the client in plain language?
"Dear Client, for the last 30 years, I have breached an SEC loophole, though it was a conflict of interest because you were paying me fees for the hopeful alpha while I was repackaging the funds, so I can make them attractive for you to reinvest."
The Benchmark Changing Manager
Suddenly, I have a newfound respect for honest underperforming asset managers. If you are the honest 40% of the group that does not beat the market despite misrepresentation, you should pat your back. You have honestly underperformed. And there is no shame in that. You can sleep at night, that you are not contributing to the unfair practices done by your peers and you are giving good ethical culture to your kids. I also wonder about the asset owners [Pension funds, Endowments, Sovereign Funds, Foundations, Family offices], what kind of due diligence process do they really have, if they did not detect this practice earlier.
The amusing part of the study was that managers had to do some anticipation to choose an underperforming benchmark, which recently had become a hard job because it was not clear whether size would beat value or vice versa. The paper does not talk about style drift and expected it is a necessity for managers.
We have indeed reached a nadir when it comes to ethics. You can assume that if your fund manager changed the benchmark and has given you annualized 1% average excess return over the last 10 years, there is a 60% chance that he/she misrepresented performance, and is playing the misrepresentation game. Till the time he is not beating the market by an excess return greater than 14% over 10 years, there is a small chance of unfair play. You can be more sure of unfair play, if the expense ratio is higher and you are buying a broker-sold fund.
End of the day, it’s not the manager who is losing sleep, it’s you, the asset owner and investor, suffering agency risk. Because it is you, who don’t understand alpha. Because, it’s you who thinks, your asset manager is smarter than you are. Because it’s you, who refuse to educate yourself, about your investment.
There are easy solutions.
1] Understand Alpha
2] Pay Only for Alpha
3] Don’t invest in a fund that changes its benchmark.