That changed with the tech-fueled bull market and the mutual [investment] fund boom. Folks sitting in bars, barbershops, and baseball parks kept an eagle eye on the Nasdaq Composite and heatedly debated whether active managers could beat the S&P 500.
In the fund industry itself, the increased level of competition and the growing popularity of index funds led firms to closely monitor each manager's record versus the index that served as the fund's benchmark. Much
more readily than before, lagging that target, even over a relatively short period, could bring an uncomfortable grilling from the boss--or a pink slip [made redundant].
As a result, more and more funds assembled portfolios that looked suspiciously like the index itself. But while such index huggers reduce their risk of lagging their benchmarks, they cost much more than true index funds yet have little chance of beating them by much.
And, as fund-company executives Ted Truscott of American Express and Kim Goodwin of State Street Research noted at a panel at the 2003 Morningstar Investment Conference [see link on right] last week, penalizing managers for "tracking error" can hurt fund shareholders in the long run, as it induces managers to stick close to their index even if they correctly judge the components of the index to be overvalued and ripe for a fall.
Bring on the darts
Into this picture comes consulting firm Hewitt Bacon & Woodrow with a bold proposition: Dump the indexes and instead compare fund performance against a basket of stocks chosen by a computer. According to The Financial Times, the firm says British pension funds --which are notorious for their reluctance to deviate from the indexes--should adopt an "unconstrained" benchmark consisting of hundreds of portfolios built randomly by a software program.
This proposal takes The Wall Street Journal's dartboard contest to the next level. For years, that paper ran a regular feature in which money managers tried to pick companies that would outperform a handful of names chosen by throwing a dart at the newspaper's stock listings. The managers were judged on whether their picks had beaten the dart's portfolio, not an index.
A joke or an improvement?
Should U.S. mutual funds consider making this change? That suggestion might sound fanciful. After all, index benchmarks are so firmly entrenched that it seems impossible to reject them. And even if they're flawed, it might be silly to replace them with randomly chosen portfolios. But the idea is worth thinking over, for it does address some real problems.
Indeed, as the consulting firm notes, using randomly constructed benchmarks would reduce the incentive for index hugging. Actively managed funds would at least have to be more creative to earn the added fees they charge.
One can even argue that software-selected portfolios would be more appropriate benchmarks, because they would more accurately represent the broad investment choices available to the manager. (That would be true even if the dartboard portfolios were limited to a particular type of stocks that reflected a fund's mandate.)
On the other hand
That doesn't mean the proposal has no shortcomings. For one thing, index-tracking funds wouldn't disappear, so regardless of which benchmark an actively managed fund chooses, it still must compete against those cheaper rivals because they represent real-world alternatives for investors.
Because few, if any, "dartboard-tracking funds" could be created to mimic the performance of the complex software-built portfolios, the existing popular indexes thus would retain their roles as de facto benchmarks.
Second, even if investors might dislike paying high fees for an index hugger, some might like the predictability that results when funds at least keep an eye on an index with a publicly known composition. The consultant's approach would mean that shareholders would have no idea what the components of their fund's benchmark are at any particular time.
Also, for larger funds, the software program would have to eliminate many stocks from consideration because they lack sufficient trading volume to make them true options for the fund's manager. In some cases, the resulting universe might not be all that different from the S&P 500, though the weightings of course could be.
Another way to foil index huggers
I wouldn't jump to institute the change just yet. The proposal is useful, though, in forcing some important issues to the fore and proposing a solution. But other approaches might be better.
In fact, the best way to foil index huggers is a tool already available to investors: Don't buy them. Own index funds, or own talented active managers that truly go their own way, but steer clear of funds that don't deviate much from their benchmarks but charge as if they do.
This article was originally published on www.morningstar.com on July 1st 2003. Gregg Wolper is a senior analyst at Morningstar.com. He welcomes e-mail but cannot respond to financial planning questions. He can be reached at gregg.wolper@morningstar.com.
