In the investment world, the truth is seldom pure and rarely simple. The strength of global equity markets between 2003 and 2008 was interpreted by many to be ‘tangible evidence’ that company and economic fundamentals around the world were robust. Bond yields were historically low, inflation relatively benign, corporate profit growth was being achieved year-on-year and stock market returns were strong. On the face of it: economic utopia, pure and simple.
However, the events of the past year have proved otherwise. The aftermath of unprecedented credit-fuelled consumer spending and irresponsible fiscal policies that enabled developed economies, particularly the UK and US, to grow only by living well beyond their means will weigh on us all for years to come. Stock markets have tumbled around the world as investors have taken fright and reassessed their exposure to risk.
Those investors who constructed portfolios based on benchmark weightings rather than fundamental analysis have been particularly exposed. They would, of course, have made money riding the bull market (2003-2008), but, as Warren Buffett would say: “It is only when the tide goes out that you know who was swimming naked.”
Benchmark strategies are momentum strategies by another name and create a herd mentality. The fear of underperforming can encourage taking benchmark positions to reduce risk. However, by their very nature, indices are backward-looking and tell you very little about the financial stability or prospects for any country or company.
By way of example, China and India currently constitute a very small proportion of the MSCI World Index, yet both economies are seen as key drivers of global growth for decades to come. A snapshot of the MSCI World Index at the end of 2006 reveals that there was a 26% weighting in financial stocks, many of which were US and UK banks. This is purely a reflection of the growth in the share prices of many of these banks as investors focused on soaring profits rather than the increasing opaqueness of off balance sheet funding and falling lending criteria. Remember in 1990 when Japan accounted for 45% of the world index? Heaven help anyone who invested so much in that country at that time.
There are just a couple of examples of why investors should ignore indices in portfolio construction, and concentrate on using first-hand research to find good quality companies with long-term prospects. After all, your clients’ money is being invested in the fortunes of the individual companies, rather than the countries’ fortunes per se.
It is only by knowing an investment intimately that one can have the confidence to take a decisive bet against a benchmark – and it is only by deviating from a benchmark that one can hope to outperform it. This is known as active stock-picking.
