“A portfolio that deviates too far from the composition of the reference benchmark poses a career risk for the fund manager,” he said. “If the portfolio performs too strongly or underperforms for too long, the manager will be fired.”
In response to that incentive, he said, fund managers will tend to invest in more and more of the same stocks and become less active over time. The result is a dynamic towards the largest stocks in an index, which more and more managers are viewing as names they cannot afford not to invest in.
The benchmarking industry, he further argued, has become extremely self-referential as benchmarks are designed to mimic other benchmarks as closely as possible. An example of the harmful effects of this trend can be seen in the area of ESG investing.
“In theory, ESG investors should be driven not only by financial goals, but also by ESG-specific goals. Therefore, their portfolios should be very different from a traditional index like the MSCI World, ”he said.
The ideal state, he said, should be for ESG investors to have a much different capital allocation than traditional investors, effectively driving investments towards more sustainable use. But after visiting a major ETF provider’s website and comparing the portfolio weights of the largest companies in his MSCI World ETF to the weights of those companies in his various ESG ETFs, Klement found essentially no difference.