Emerging markets: benchmarks lesson not learned
Benchmarks investing is as widespread as it is flawed. Markets are not efficient, so passive hugging of benchmarks is not risk free. Moreover, in emerging markets many of the opportunities are off-benchmark opportunities. Benchmark investing increases risks and lowers returns.
The vast majority of the world’s capital is allocated based on the prescriptions of the Efficient Market Hypothesis (EMH). This theory states that it is impossible to beat the markets, because all knowable information is already fully embedded in the price. It follows that active investing is inefficient and that benchmark hugging is the way forward.
The EMH is both extremely popular and often wrong. It is abundantly clear that markets are far from being efficient. Asset bubbles of frightening proportions regularly rip through G10 markets. In emerging markets, bonds are still being traded as if they are far more risky than G10 bonds, despite long-established and demonstrably stronger credit fundamentals. Emerging market bonds were sold heavily in 2008-09 and again in 2011, yet in both cases the problems had nothing to do with emerging markets per se, and there were few reasons to expect asset quality in emerging markets to fall.
Asset price volatility is clearly not the same as risk. So much for market efficiency. But why do markets then continue to allocate on such a flawed framework? Enter the Inefficient Market Hypothesis (IMH). This theory says that markets are inefficient and that they will stay inefficient, because market participants refuse to acknowledge the inefficiency. This refusal in turn leads to a prediction that investors will repeat their mistakes again and again.
The reasons why investors refuse to acknowledge the obvious inefficiency of markets in the face of overwhelming evidence include abundant information asymmetries, behavioural biases, the structure of the investor base, weaknesses in finance theory and agency problems.
Most managers stick to well-worn practices of risk management, which revolve around the use of benchmarks for measuring performance and risk. Assuming efficient markets, allocations can be based on past return and volatility of benchmark indices. A manager is then selected based on a tolerance for tracking error around the benchmarks. Since passive investing (benchmark tracking) is the optimal strategy it follows that departures from benchmarks are necessarily risky and require a risk budget.
‘Benchmark risk’ is equated with actual risk. Passive investors are seen as not taking risk, because their tracking error is zero versus the ‘risk neutral’ or ‘risk free’ allocation.