Hello, this is Inigo Fraser Jenkins from AllianceBernstein. In this video, we discuss our recent note on the future of benchmarks, which we have titled, “Too Much Certainty Is a Terrible Thing.”
Benchmarking might sound like a curious topic, but we think the subject will attract more attention in the future. We are in an industry that loves benchmarks and is awash with them, but are the current benchmarks any good? What might a better approach look like?
There are more than 2.5 million equity indices, more than 60 times the number of listed stocks in the world. Perhaps this provides an illusion of precision, but we think it might utterly miss the point of how benchmarks can help.
Coming at this from a very different angle, we would note that a major shift is happening in the way capital is raised in the modern economy overall. For at least 70 years, public markets and bank credit have been the principal sources of capital. The marginal dollar of investment capital raised today is much more likely to be in private markets. This might not be a concern when considering the benchmark for an individual investment, but for the industry overall, it would be odd if this increased role of private capital wasn’t reflected.
Benchmarks have often been couched in terms of financial market indices. This made sense when the returns of financial assets strongly outperformed real assets but could be short-sighted if it is harder to beat inflation in a new economic regime.
The epiphany is that a natural cross-asset benchmark is impossible.
A 60:40 allocation to stocks and bonds has often been treated as a benchmark. Indeed, its return relative to inflation has been very strong over the last four decades. But our expectation is that a return is set to fall, and the volatility of such an approach will rise. This is especially the case relative to inflation. Moreover, taking the other angle that we mentioned earlier, the lack of private assets in 60:40 looks anomalous given their role in capital provision.
Central to the topic of benchmarking is the question: what is risk? Is risk to be measured as the volatility of returns? Or deviation from a benchmark? Or is it related to the chance of losing purchasing power? Most investment activity ultimately takes place to meet a need set in the real economy. Therefore, we suspect that a loss of purchasing power might be the biggest risk.
This leads to the idea of a required return as a benchmark, with inflation taking a larger role. In our note we also look at required retirement outcome as describing a path for returns over a working lifetime.
This is for the long term. Over short horizons, comparing to inflation might not be appropriate. After all, for long-term investors, their “inflation hedge” does not need to correlate to inflation, it just needs to describe a path to positive real returns.
When hiring an investment manager, a benchmark should reveal whether active decisions add or detract value. Here we suggest that a multivariate approach is appropriate, with the important metric being idiosyncratic alpha over and above both a broad market and a cheap set of factor strategies.
There has been a profusion of benchmarks in finance in recent decades. However, this may have obscured the point of having them. We see investors as curators of return streams, which is a more generalized view than being tied to asset classes.
The emergence of a new regime of higher inflation, and a secular rise of private capital, casts benchmarks in a new light and suggests a change is needed. This will alter perceptions of risk and points to a shift in strategic allocations, likely in favor of real assets.
Thank you for your time.
