Give me that old-time religion
Are you ready for the imminent collapse of the index theory of investment? The success of this theory over the past five to 10 years has given it immense credibility. No one would deny that investing in the index has been a brilliant strategic move and those who followed it have reaped the reward of being early.
But now the position is very different. The self-inflation of the index leaders has led in many cases to extreme over-valuations. The simple fact is that most of the long-term growth holdings are closely held. It would not be untypical for 80% of such shareholdings to be in firm hands. The cult of the index has led managers to try to replicate the 100% weighting in a 20% pool of traded stock. Obscene over-valuations resulted.
One day the market wakes up to discover that its favourite stocks are discounting earnings five years out. In an uncertain world, in which equities certainly contribute their part, five years is too long a "fetch" for institutional investors – let alone private individuals. At that point in time any tremor or uncertainty has a dramatic effect as investors try to reduce their over-exposed positions in terms of risk for particular overvalued shares or fashionable sectors of the market.
It is a scenario for which few are ready. Are trustees prepared? Are consultants prepared for this undermining of their basic strategy? Are investment directors confident that they can respond to the new situation? Of course, many investment directors never subscribed to the index cult, but have focused instead on bottom-up stock-picking. Some stuck to the traditional risk spreading by holding many securities. Their day may be coming.
At the same time there are all too many management houses where the business manager has defined risk as departing from the index weights. Those managers are about to be taught the oldest lesson of all: that there is no comfort in consensus. (Consensus is the index at any point in time.) A different form of consensus is also the basis of the WM or CAPS universe, alternatives that have proved equally flawed. The religion of the index cult brooks no heresy and it is heretical to suggest that there is any other valid methodology.
But is it a heresy to preach the fundamental wisdom of risk diversification? The City of London and the Scottish investment trusts in particular believed that 100 stocks of 1% each, or thereabouts, was a sound way of investing in equities. They were right. Admittedly the focus of modern research has suggested that 100 shares may be too many. (It is fashionable to reduce that number to 75 or even 50 in a typical investment trust portfolio.) Diversification inevitably means that the size of market capitalisation is relatively unimportant compared to spreading the opportunities as well as the risks of an equity portfolio.
Diversification policies have led to the under-weighting of large capitalisation stocks and the over-weighting of the medium capitalisation and small capitalisation stocks. This has caused proponents of his approach to under-perform the index year after year. Does that mean that the basic philosophy was wrong? In my opinion it does not. It simply points to the fact that when an artificial measurement is enshrined for strategic purposes, then such a policy is going to under-perform.
It could be, however, that it is the index that is wrong. That thought is indeed heretical in the investment world of today. It does not mean to say that it is untrue, nor that the truth will not reassert itself. Indeed this is becoming apparent.
When the investment results are out it may be seen that traditional management has out-performed the index by a significant margin. This is because the favoured few reached unsustainable multiples of their future and prospective earnings. When such companies falter the market will be all the more unforgiving.
Significant falls have taken place recently in many stocks such as Marks & Spencer, Glaxo, Boots and BP Amoco. And across the Atlantic look at falls in IBM, Walt Disney, Gillette, Coca-Cola and other industry giants. They portend not a bear market across the whole market, but a deflation of excessive valuation on a case-by-case basis. The Financial Times almost daily carries news of setbacks triggered by what is no more than the reverse of fashion in the face of some disconcerting unexpected news.
It is time to bury the word "benchmark", which has become so enshrined as an all-purpose answer to all investment questions. As a uniform measure it is useful – but only as a unit of measurement. It could be helpful to talk instead of reference points which can serve a variety of purposes. An index reference point is necessary. A competitive universe reference point is necessary. A strategic neutral reference point is necessary. An absolute return over cash may be necessary. A customised strategy reference point may be necessary to meet customised needs. The all-purpose benchmark is a term that has out-lived its usefulness.
John Morrell is chairman of John Morrell Advisory Services in London