Environmental, social, and governance fund managers would deliver stronger performance if they weren’t tied to mainstream indexes, according to new research.
The working paper from the Centre for Economic Policy Research found that benchmarking an ESG fund against a standard market index — like the S&P 500 — imposes constraints on fund managers which results in average ESG scores and hurts returns.
The finding was part of a larger study looking at the effectiveness of traditional benchmarking in asset management, from academic researchers Anil Kashyap, Natalia Kovrijnykh, Jian Li, and Anna Pavlova.
As the paper explains, when global investors issue their trillions of dollars’ worth of capital to portfolio managers, they often use benchmark indexes to assess managers’ performance and determine compensation. In a general equilibrium setting — when supply and demand create an optimally balanced economy — basing a manager’s compensation on benchmarks protects them from risk and incentivizes them to invest in higher-risk assets, according to the study.
“Let’s say I’m not benchmarked: If I am a manager and I experience a negative return, it's my fault, and I will be penalized in my pay,” Kovrijnykh told Institutional Investor. “But if I’m evaluated relative to a benchmark, let’s say my benchmark goes down 10 percent and I’m down 10 percent. It’s not my fault. It’s the market.”
The findings may seem like the perfect rationale for benchmarking. But, in addition to offering managers protection from risk, benchmarks also create a crowding effect, inflating asset prices and reducing expected returns. According to the researchers, current incentive-based contracts — in which asset managers are rewarded based on their performance relative to benchmarks — don’t take into account the fact that prices may react to their existence.
“These contracts are usually looked at by individual trustees, and while they are individually optimal, they may not be optimal for the entire society,” Kovrijnykh said. “They don’t take into account that, if everybody has the same kind of contract, everybody would be investing in the same kind of assets, pushing up their prices and lowering their expected returns.”
In response, researchers approached the model through the lens of a “socially optimal contract” or, in other words, a level of benchmarking that would be optimal for all of society and would swerve the crowding. In the hypothetical scenarios with socially optimal contracts, the ideal contract opted for less incentive provision and less benchmarking.
“Contracts incentivize the managers to invest more in stocks with higher alpha as well as stocks in the benchmark. This boosts prices and lowers returns, making the marginal benefit of alpha-production lower for everyone,” the report said. “The social planner, who internalizes the effects of contracts on equilibrium prices, opts for less incentive provision, less benchmarking, and lower asset management costs.”
The researchers also applied this model to ESG, which they described as “one of the fastest growing segments in asset management.” After finding that current industry benchmark practices result in average ESG scores for portfolios, they argued that investors would be better off using ESG-centered benchmarks to incentivize managers.
“The manager should be benchmarked to an ESG benchmark that will tilt overweight green stocks and underweight browns,” Kovrijnykh said. “But, then we looked at how this is done in practice, and there is only a handful of ESG benchmarks. If you look at assets under management following these benchmarks, they’re nothing. They’re very, very small relative to the huge industry that ESG is becoming.”