At the Financial Times, Paul Woolley explains a troubling phenomenon in investing that he calls “the curse of the benchmarks.” He writes:
All investing boils down to a choice of two distinct strategies implemented in a variety of ways. One is buying securities that are priced cheaply in relation to their expected future cash flows, which is what everyone assumes is done with their savings.
Bizarrely, the other is almost the exact opposite: buying securities whose prices have recently been on the rise or that have already gone up most, both without reference to fundamental value. Another version of this, though present on a lesser scale, is selling assets that have recently been going down in price.
This second strategy has its origins in what might justifiably be termed “the curse of the benchmarks”. Most large funds delegate to external asset managers by setting index benchmarks, often with limits on how far returns should stray from the index return. Benchmarking is now shown to amplify mispricing by forcing managers to chase prices instead of fundamental value.
Trend-riding momentum investors successfully game this response, pushing prices higher knowing that benchmarkers are likely to come along later and be prepared to pay more. Price-only investing explains much of what is going wrong in financial markets. It is also the essence of short-termism.
When investors obsess about prices, corporate bosses are encouraged to do the same. With the added incentive of early-exercise stock options, they seek to maximise the company’s share price instead of building the business for the future. Among the ways to do that are reducing capital expenditure and research and development, focusing on quick pay-off projects, share buybacks and raised debt levels.
Read more here.
