A recent Standard & Poor's report that concluded that most actively managed funds have underperformed the index over the medium term has led Aberdeen Asset Management to warn against closet benchmark huggers. Aberdeen notes that in global equities, for example, the report identifies that the index outperformed 76.15% of international equity funds over the last five years as of June 2009.
"Many active managers are in fact closet benchmark huggers, sticking close to the benchmark weights and then charging an active fee. The result is benchmark-like returns but with a higher fee," says Stuart James, a Sydney-based Aberdeen senior investment specialist. "By sticking near the benchmark they are attempting to negate the risk of significantly underperforming it. However, with this approach they negate the possibility of significantly outperforming it as well."
James says the industry's fixation with performance tables and the increasingly short-term investment horizon of investors has led to a culture of fear of underperforming among fund managers.
"Unless you accept short-term underperformance you can't hope to outperform in the long-term," he says. "To outperform the benchmark you have to step away from it."
Aberdeen is known for taking a classic buy-and-hold approach, keeping its portfolio turnover at a minimum. It is not uncommon for the fund house to maintain its exposure in a company for 10 years.
James emphasises that, as benchmarks are retrospective, they provide no indication of where the best opportunities will lie in the future. A benchmark based approach is one where a biggest is best mentality prevails, but in reality the largest component of the MSCI All Countries World Index with a weighting of around 50% is the US, which was the worst performing market in the index over the last five years, he says.
What should also be of concern to investors, James says, is that slavish benchmark hugging can also lead managers to become momentum driven because, as a sector or individual stock performs, it becomes a larger part of the index.
"Both the overt index funds and the closet benchmark huggers are then enticed to buy more, potentially driving prices even higher," he says. "In effect this increases their weight to stocks that have already outperformed leading to the very real possibility that investors will be holding maximum exposure just before the inevitable correction."
James was also notes what he considers to be another myth: that index investing is a zero risk position.
"Certainly by hugging the index your relative risk of underperforming the market is zero or approaching zero," he says. "However in absolute terms you are still exposed to the risk of the market and, as we all know, markets and indexes go down as well as up."
Investors need to be aware that an index approach equals exposure to the full impact of corrections, as well as upturns, he says.
James recommends that rather than blindly following an index, investors should rely on quality research.
"In the current environment, for example, it is more important than ever to use a range of appropriate valuation and quality measures," he says.
James notes that price-to-earnings ratios are becoming less relevant given that earnings forecasts are only just beginning to be downgraded and the profit outlook is increasingly uncertain. Other measures such as price-to-book are becoming all the more pertinent, he says.