Flawed Benchmarks Hurt Portfolio Managers' Performance
March 22, 2004
Managers should not benchmark the performance of their growth and value portfolios to the Standard & Poor's or Barra growth and value indexes, a recent study in the Journal of Investment Consulting maintains. The reason? The benchmarks are flawed.
The indexes classify every stock in the S&P 500 as either growth or value stocks, according to the study, "Structural Imperfections in the Algorithm of Certain Equity Style Indexes." Twice a year, Standard & Poor's calculates the price-to-book ratio for each stock, and then ranks the stocks from highest to lowest. Then the research firm divides them so that there is roughly equal market capitalization for the top and bottom groups. The stocks in the top group become the growth index, while the stocks in the bottom group make up the value index.
Lynn Cohn, manager of index portfolio services at Standard & Poor's, New York, could not comment on the study until Standard & Poor's has evaluated the research.
The authors of the study, however, said that the S&P index should be replaced. "S&P and Barra should go back to the drawing board and come up with different versions of those indexes," said Dorla Evans, Ph.D., a finance professor at The University of Alabama in Huntsville, and co-author of a study published March 2004 in the Journal of Investment Consulting.
The flaw in that system is most obvious during long-term bull or bear markets, when stocks near the middle of the rankings shift from one index to the other.
"During the dot-com bull market of the late 90s, for instance, the market capitalization of growth stocks started booming," Evans said. "They were driving up the total market cap so fast that it changed the split point. Several stocks that were growing pretty rapidly dropped into the value index.
As a result of moving growth stocks into the value category, the value index started "to take off, not because the value stocks are doing well but because you've included a group of growth stocks among the value index," Evans said. "Complaints by many value managers during the dot.com boom that they were being unfairly fired may in fact have been legitimate," said Kenneth Scislaw, founding principal of Scislaw Capital Management, Tuscaloosa, Ala., and the study's lead author. "Since many of these managers were terminated by their institutional clients, this study underscores the need for a closer examination of performance benchmarks by the investment consulting community."
Evans calls for benchmark indexes that are growth, value or neither. The study also evaluated the Russell, Wilshire Large Cap and Wilshire Target indexes. The Wilshire Target Index was the most precise benchmark, the study indicated.
Money managers agree that something has to be done about the S&P/Barra index. Grant Rawdin, president of the Westcott Financial Advisory Group, Philadelphia, said a number of fund managers have expressed their concerns to him about being compared to this index because it mixes growth and value. Rawdin manages $700 million in client mutual funds. Instead, Radwin compares the performance of his clients' mutual fund portfolios to the Dimension Fund Advisors (DFA) growth and value indexes.
DFAs takes an active approach to benchmarking, rather than splitting up the S&P 500 in half, Rawdin said. "In reality, you might have just 100 value stocks and 400 growth stocks in the S&P 500, but the S&P/Barra indexes don't look at it that way," he said.
Keith Yoder, a portfolio manager with Caterpillar Investment Management, Peoria, Ill., with over $3 billion in pension and mutual fund assets under management, said style drift is a problem with any benchmark index. He prefers to measure his portfolio against the Russell style indexes because they use a different methodology than the S&P Barra indexes.
"The study makes some good points," Yoder said. "It was a difficult period for value managers in 1998 and 1999. It was hard to stay with the indexes [S&P and Barra]. On the flip side, in 2000 and 2001, it was easier for value managers to beat the index," Yoder noted.
Even though he has personal reservations, Yoder says his clients still tend to consider the S&P/Barra indexes the benchmark of choice. It is clearly defined and easy to use. But he added that "you have explain to clients that the manager is sticking with a specific investment style, while the benchmark index drifts."
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