Why now is the time to take relative risk

It’s important to start with the principle that the primary purpose of a benchmark is not to guide your holdings, but to measure your performance. Effectively it is your tool for looking at the opportunity cost of capital. That means you want to choose an index that is unambiguous, investible, measurable, and appropriate for your objectives. There are subtleties to observe here – there is no perfect index, they are all slightly different – but for equities we typically use the MSCI All Countries World, and for bonds we use the Bloomberg Barclays Global Aggregate. These are fully investible indices that are created by independent third parties, and both give a good approximation of the opportunity set in their respective asset classes.

The reason a benchmark is primarily a measure of performance, is that at the end of the day, absolute returns are what determine your purchasing power. It might make us look good, but clients can’t spend relative performance. So if you’re thinking in absolute terms, it’s crucial not to be wedded to benchmarks; because as we all know, indices themselves are not passive. They are constantly changing, with constituents being added or removed according to certain rules. Let’s take the S&P 500 at the moment; right now it doesn’t include the tenth largest stock in the US, Tesla. When Tesla does enter that index, that will materially change the structure of the index and how it performs.

Now, if you were to invest in a passive, market cap weighted index – say the S&P 500 – all you can say for certain is that it is a low transaction alternative to active investing, it’s a way to minimise transaction cost, but does that mean it’s the right thing to do? The answer is it can be, but not always. And that’s because indices have a tendency to go to extremes; they are not always consistently diversified. Take for example the peak of the dotcom bubble, that was the moment that indices held their biggest weight to technology and telecommunications stocks. Similarly, indices had their largest weights to energy and financials in 2007, just before the Great Financial Crisis. By buying or investing according to an index, you are always investing in the things that have done best, but when you get to extremes it means that you can end up being highly concentrated in the most expensive sectors. By just having a low relative risk to a benchmark, you can end up with a great deal of absolute risk.

This is a pertinent point in today’s market. The example everyone knows is the FAANGS, and their dominance over the S&P 500, but the concentration goes further. Take the MSCI World (note, not the All Countries World), this sounds like a broadly diversified global portfolio, but around 70% of it is US stocks. It’s easy to think that that has always been the case, but go back to the late 80s and Japan was the largest single country weighting to the MSCI World, at about 40%. What we know now, is that this was the peak for the Japanese economy, and as an investor, all you had to do was be underweight Japan from this point onwards and you would have beaten the MSCI World by that one decision alone.

Fixed income carries even more surprises for investors, because what you buy with a fixed income index changes both in terms of duration and in yield. Right now the Bloomberg Barclays Global Aggregate Index yields around 90 basis points, while in 2000 it yielded around 6%. But if we look under the hood at the bonds themselves, the duration in the early 2000s was around 4.5, and now it is over 7. So now, not only are you expecting lower returns, you’re taking more risk for the privilege.

When we look at our own portfolios, the under and overweight positions can be quite large, and that’s because of the extent to which these key indices have become distorted. For example, we are in relative terms very underweight duration, and within equities, very underweight the US. There have been few such times in the last decade when the need to position away from major indices has been so acute; those who adhere too closely to them for fear of taking relative risk, will be taking on far more absolute risk, wittingly or not.

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