Indexes

When thinking about performance, it’s interesting to note what we are trying to compete against. In most cases our benchmark is some kind of index or basket of indexes. So how are the constituents of an index chosen? For example the FTSE All Share index is basically a market capitalisation weighted index of the largest 350 stocks trading on the London Stock Exchange. There is low turnover and no human decision. The S&P 500 is determined based on several non human factors such as Liquidity, Four Quarters of Positive Net Income, Market Cap, Sector Representation and Lack of Representation. However, despite their simplicity the majority of fund managers have trouble beating these benchmarks. Which leads me t ask, are we doing something wrong and if so what is it?

To me, the idea of placing too much emphasis on benchmarking in the short term is ill founded and adds to informational noise which in turn causes irrational behaviour. Trying to magically outperform something that is uncontrollable over the short term kind of signals to me that there are some serious misunderstandings in what is trying to be achieved. In the short term it is inevitable that we may underperform the market and it should be expected. Until we can accept this can we then, and only then start to understand how to beat the market. As I have written before, an investment process is one which works over the long term by the fact that the process is weighing the probabilities in the user’s favour. As with the coin flipping example in the “Process vs Outcome” post, it is only once we give the process a chance can we start to realise the probabilities associated with the process - over the long term.