Stephan Langen: The sense and nonsense of benchmarks

October 10, 2023

^{This column was originally written in Dutch. This is an English translation.}

By Stephan Langen, Head of Portfolio Management at ASN Impact Investors

As investors, we may be too fixated on benchmarks. When an investment technique becomes a goal in itself, we limit ourselves too much. Then the real, sustainable objectives disappear from view.

I'll be honest: sometimes I need a push in the right direction. For example, when I'm not sure which subject to write on. This week I read Annebeth Roor-Wubs' column here with the headline: 'Not the average, but the deviant'. It was just the push I needed. It's wonderful how a young, free spirit questions the established order of economic models and benchmarks.

And she's right.

The world of investment management focuses blindly on indices and benchmarks. We are overdoing it with attributions and introducing a focus on risk, 'active risk', that ignores what is intended with the actual portfolio. The index is nothing more or less than the market.

Hundreds of indices

However, that ignores the fact that there are hundreds of indices to choose from, each representing a different market. As soon as you introduce a benchmark, the portfolio is expected to be constructed with the benchmark as a starting point. But is that always the case?

What if sustainability is your starting point? 'Active risk' ignores sustainable objectives. It only concerns deviations in sectors, regions and countries. You are expected to 'brush that away', either through higher concentrations in shares in the sectors or regions that do qualify, or by adjusting your benchmark: the customized benchmark.

So you adjust the risk of the portfolio to the benchmark, or you adjust the benchmark to the risk of the portfolio. Do you still get it? Me neither. It does nothing for the real risk of the strategy or the intended investment objectives.

I hear you say: take a sustainable benchmark. However, the problem with this is that these hardly correspond to a truly sustainably constructed universe. The sustainable benchmarks that are available often focus on climate policy, but never include human rights, for example. Not to mention ESG benchmarks as a suitable alternative. The top 10 of those benchmarks consist of exactly the same (Big Tech) names as conventional benchmarks.

From mind fixed to mind shift

We investors continue to wander around in established principles. For convenience, I call this 'mind fixed'. What we investors need is a mind shift. If we are serious about dealing with climate and biodiversity risks and seriously considering human rights in investment choices, we should not be limited by the established routine I outlined above.

Anyone who consistently deals with sustainability understands that this concept cannot be interpreted seriously by adhering to existing risk perception and market indices. The goal is to make more sustainable choices and mitigate sustainable risks, so that we make a difference in the real world.

Not investing in the oil and gas sector entails short-term deviations (positive and negative) compared to the broad market index. Certainly, that increases the tracking error. So what? It reduces the footprint of the portfolio, it sends a signal to the market that oil and gas companies do not fit into a sustainable, zero-carbon economy. A goal that is worth pursuing in terms of both risks and returns in the longer term.

Embrace the different

All in all, investment technology is a means, not an end in itself. High tracking error has never killed anyone, high emissions and PFAS do claim victims. I have never earned a euro from a benchmark, but I have earned a euro from the sustainable portfolio in which I invest.

Truly sustainable portfolios start with sustainable objectives. The portfolio construction process is aimed at achieving these sustainable objectives. Investment technology then serves those objectives. I completely agree with Annebeth Roor-Wubs: economic models are a strong simplification of the complex world. Financial-economic principles are no exception to this. Risk really encompasses more than the standard deviation of returns and deviation from a self-chosen index.

So make that shift from fixation on investment techniques to intrinsic goals and embrace the deviant, if you want a truly sustainable portfolio.

Stephan Langen is Head of Portfolio Management at ASN Impact Investors. The information in this column is not intended as professional investment advice or as a recommendation to make certain investments.