Is Cash the Best Benchmark?

Lex in the Financial Times writes of the apparent 'Wimbledonisation' of the City of London. According to the Office of National Statistics, foreigners and 'other financial institutions' own 45% of the FTSE 100, compared to 36% in 1999. If domestic investors have been and remain largely unable to see the fundamental attractiveness of their own equity market, more fool them.

Lex suggests that 'the activity of UK plc is even less patriotic', citing UBS estimates that 32% of FTSE 100 non-financial sales are now domestic, compared to 51% in 1999. What this has to do with patriotism is anyone's guess - the purpose of a company is surely to enrich its shareholders by doing business wherever it can add value, and if the bigger markets are outside the UK, so be it.

Lex further wonders aloud whether UK savers should abandon FTSE 'as a benchmark for efficient asset allocation'. Both the logic and the language of Lex's thoughts look somewhat tortured, but questions about the attractiveness and relevance of the world's major indices are undoubtedly vital ones for all investors.

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The issue of benchmarking is always relevant, but often fudged by investment practitioners. When markets are rising, investors crave relative returns, and everyone worships at the altar of beta. But when markets are falling, investors with any sense seek absolute returns, and alpha becomes the only game in town.

Some other pertinent questions: should 'growth' investors be tracking an index of what are effectively large- or mega-cap stocks? And is the macro asset allocation debate clouded by overly simplistic top-down assumptions about the attractiveness of asset classes rather than pragmatic assessment of absolute and relative value within asset classes?

The FTSE 100 was inaugurated in January 1984 with a base level of 1000, reflecting the aggregate market valuation of the 100 most highly capitalised companies traded on the London Stock Exchange. There is almost certainly more institutional capital benchmarked to the FTSE All-Share, but the FTSE 100 still has its followers. Whether investment institutions should be benchmarked to any equity index is another question.

The arguments in favour of index-tracking have been well aired. Perhaps the single most compelling argument is cost. Passive indexation represents a low-cost, albeit crude way, of gaining longer term market exposure. When so-called active fund managers are effectively closet index-trackers, the passive route is obviously superior. Research published by the WM Company in April 2004 indicated that over the previous 20 years, 82% of active funds failed to beat the FTSE All-Share. Investors seeking broad market exposure over a relatively long period of time are likely to be well served by exchange-traded funds, where - unlike in active funds - total expense ratios remain extremely competitive.

On this topic, we note with some disgust the rate at which traditional fund managers and investment consultants have quietly been hiking fees irrespective of their economic value added - the ultimate impact on client returns will be doubly baleful in a low nominal return environment.

It is tempting to conclude that since the recent rise of hedge funds, conventional hangers-on in the financial markets, eyeing those 'alternative' management and performance fees, have simply elected to juice their own remuneration because they can get away with it - at least for the time being. This does tend to support the thesis that, uniquely within global markets, investment management is the only sector wherein increased competition drives fees up. Perhaps the alternative conclusion is that the investment management market is simply grotesquely inefficient and bankrolls too many worthless intermediaries.

Where index-tracking becomes a contentious strategy is within the context of flat or poor markets. It is evidently undesirable to be locked into a falling market. Since market direction is inherently unforecastable over at least the short term, but Anglo-Saxon equity markets have delivered the best returns of any asset class over a century or more, index-tracking 'appears' to be the least worst, and certainly the most cost-effective solution, to equity investing over the longer term. But perhaps the equity market itself is the wrong benchmark, at least for investors with aversion to downside risk - that is, most of them.

Unconstrained investors will likely have come to broadly the same conclusion. The benchmark that makes most intuitive sense, arguably for the widest number of investors - and which need not be restricted to equity risk but which can equally address debt and alternative investments - is cash. Cash, or any short term deposit, is the only asset class that cannot lose value in nominal terms. So it is perfectly possible to marry a 'long-only' equity strategy with an absolute return investment philosophy.

The 'absolute return' is, of course, in this context, an aspiration rather than a guarantee. Such an approach requires rigorous discipline - particularly in managing downside volatility - and is likely to involve a more concentrated portfolio from which 'unacceptable' stocks and perhaps even entire sectors or sub-sectors are actively excluded, on the grounds that prospective returns do not tally with the attendant risks.

Ultimately, success in 'long-only absolute return' will be a function of the skills and (perhaps contrarian) talent involved. As opposed to traditional 'long-only' mandates, wherein investment returns are primarily if not exclusively dependent on the beta of the market.

One particular aspect of 'absolute return' equity investing worthy of comment is that it avoids the implicit moral hazard that surrounds indexation - the requirement blindly to own stock irrespective of its fundamental attractiveness, or lack of it. Capital markets 'want' to be efficient - the lazy and artificial support for poor quality companies perpetuated by equity indexation is, in an otherwise acutely Darwinian market, both an anachronism and a disgrace. But as we know from an investment management industry that has an alarming tolerance for mediocrity or worse, it's not a perfect world.

Tim PricSenior Investment StrategisAnsbacher & Co Ltd.