Benchmark Definition
This article is helpful for understanding the concept of a benchmark. It is simply a refence portfolio that one may use for comparison on go forward basis.
BTW, I think the market is way overloaded with passive investing in index funds. This was grounded intellectually in the efficient market hypothesis and CAPM. It was believed that one could not reliably do better on a risk-adjusted basis than the "market portfolio." This devalued active investment and trained a large segment of investors that they could do no better than hold a cheap index fund.
In the US, the SP500 became privileged as the "market portfolio." But as any Tesla investor knows the SP500 applies specific filters to exclude some of the best performing stocks. The fact that QQQ has handily beaten SPY for the last 10 years should challenge the beliefs that undergird passive index fund investing. It should not be possible under EMH and CAPM. And specifically under CAPM, we ought to be able to explain this difference in performance based on beta. Well, according to my Merrill-Lynch sources, SPY has a beta of 0.97, while QQQ has a beta of 0.95. As far as CAPM is concerned these two portfolio have about the same risk. So this does not explain why for the past 5 years QQQ has had about double the return of SPY. If SP500 really was the theoretically correct "market portfolio," this should not be happening.
So what explains the difference? For one, Tesla (and other growing stocks) has been excluded from SPY while included in QQQ. If we look at actively managed ARKK, it has a beta of 1.13. So its risk level (per CAPM) is only slightly elevated relative to QQQ and SPY. And yet it's 5-year performance was about 10% and 18% points above the two respective benchmarks. This should not be happening if you believe the passive investment orthodoxy. But we see that it does happen because of how stocks like Tesla get excluded or weighted in these indexes. ARKK has been overweighted in Tesla and other innovative companies, this is the point of active management.
All this become much easier to understand if we reject the Efficient Market Hypothesis. In my view the market has systemically undervalued disruptive innovators like Tesla. The flipside is that the market has systemically overvalued companies on the wrong side of disruptive innovation. Fossil fuel related industries (oil&gas, auto) are subject to disruption that Tesla thrives on. The SP500 is much more exposed to these fossil-based industries. Notably oil & gas has underperformed the SP500 for a good number of years, thus dragging performance of SPY down especially over the last 5 years.
Obviously, one can have lengthy discussions about which stocks are boosting the indexes or driving them down. But I'd like to argue that the EMH is especially unreliable specifically where disruptive innovation is at play. As we have all witnessed with the Covid-19 pandemic the novelty of a pathogen poses risks that are very hard to navigate. As we learn more about Covid-19, treatments become more effective, preventative strategies become more efficient. We may even have a vaccine eventually. As the novelty wears off, society learns how best to adapt to it. EMH has to do with how quickly the market can react to information. The novelty of innovative technology is what makes it so disruptive. The market may well react quickly to information about a novel technology, but that does mean that it can accurately interpret that information or that potentially impacted businesses know how to adapt to the novel tech. It is common for a disrupted industry to underestimate just how quickly or perniciously a novel tech will impact them. Automakers still think they have an abundance of time to keep turning a profit on ICE. The oil industry still thinks peak oil demand is more than a decade away. Industry insiders are likely to be overconfident in how they appraise the risks, and many investors are likely to buy into beliefs of leaders in mature industries. So the whole set up leads to a systematic overestimation of the value and durability of BAU in the face of disruptive change, even as there is systemic undervaluation of potentially disruptive innovators. On a daily basis, Tesla investor battle the forces of FUD. Sadly, an efficient market can be moved as much by misinformation as from sound information. This is because the interpretive lens of the market is not yet familiar enough with the disruptive innovators to know how to filter out noise from reliable signal. The novelty of Tesla and its many technologies is a big part of what FUD is able to exploit. For example, one can think that EVs are inferior in all sorts of ways, and a whole genre of FUD plays on this. But when one actually has experience driving a Tesla, it can radically transform that person's outlook on the viability and attractiveness of EVs. The "EVs are inferior" FUD loses effectiveness. I would say the person who has actually driven a Tesla is in a much better position to value an investment in Tesla accurately. In terms of EMH, the market is reacting to information in real time, but I would suggest that the interpretation of that information changes as investors gain experience, especially direct personal experience, with a novel technology.
For another example, Tesla share price used to drop sharply with every report of a fire. The market was very efficient at reacting quickly to this information, but it was lousy at interpreting the significance of such reports. The novelty of EV battery fires led traders to think that such events signaled a much lower value for Tesla. Now, the market shrugs off such a report because it can now interpret such an event as having no materiality to the value of Tesla. The double standard was frustrating. ICE vehicles have many fires everyday, but this has no impact on legacy automakers. The difference in interpretation had everything to do with the novelty of li-ion battery powered vehicles.
So my thesis is that EMH does not rule out the difficulty market participants have in interprting information particularly as it pertains to novel technology and disruptive innovation. Thus, innovation and disrupted industries can be systemically mispriced. This is why QQQ can regularly outperform SPY. Also the active investment practices of ARK Invest and many others who invest single name disruptive innovators like Tesla can outperform even QQQ. In short, innovation disrupts even passive investing.
