The benchmark made me do it

Whose risk are we really managing?

Over the past few months, I’ve travelled the country speaking with advisers and, particularly, practice owners about markets, portfolio construction and risk. One theme keeps coming up. And it’s getting louder.

“We can’t afford to deviate too far from the benchmark.”

The logic is understandable. If you look different and underperform, you have explaining to do. If you own the benchmark and the market falls, well, the market fell. It is safer. Easier to defend. Easier to explain.

But safer for whom?

What struck me in these conversations was that the risks themselves were generally well understood.

Advisers know equity markets have become increasingly concentrated. They know a relatively small number of companies have driven a disproportionate share of recent returns. And they know that if this concentration unwinds, the impact on benchmark returns could be significant.

These are the known knowns. The known unknown is what causes the concentration to unwind, when, by how much and for how long.

How did we get here?

There are several forces at work.

In Australia, Your Future, Your Super and performance benchmarking have created powerful incentives to manage portfolios relative to benchmarks. The payoffs are asymmetric: outperformance offers limited upside for advisers, practices and super funds, while underperformance can have significant career, business and reputational consequences.

At the strategic asset allocation level, there has also been increasing convergence around common industry assumptions and frameworks. Then, within asset classes, the pressure to minimise tracking error encourages greater use of passive and benchmark aware strategies. Each decision may make sense individually. Collectively, however, they can produce something quite different:

Conformity, uniformity and an erosion of investor choice. Similar asset allocations. Similar investments. Similar underlying exposures. Similar risks. And increasingly, similar outcomes.

The benchmark doesn’t know your client

This is where advisers need to be careful.

A benchmark measures relative investment performance. It does not determine whether a portfolio is appropriate for an individual client. The benchmark doesn’t know that your client is retiring next year. It doesn’t know their tax position, liquidity requirements or capacity to withstand a major drawdown.

And it certainly doesn’t know whether they can emotionally tolerate watching their portfolio fall 30%.

Concentration deserves a conversation

Let’s consider US equities.

Higher strategic allocations to global equities have coincided with extraordinary concentration within US markets and enormous investment in AI infrastructure, semiconductors and hyperscaler capital expenditure.

That doesn’t mean US equities should automatically be underweight.

It means advisers should understand what they own.

Some simple questions are worth asking:

•  What is my client’s aggregate exposure to US equities across all their entities? 
•  How much exposure do they have to the same companies, sectors and economic themes through different investments?
• How much of their recent return has come from a relatively narrow group of securities?
• What happens to their portfolio if that trade reverses?
• Is that concentration consistent with their objectives, risk tolerance, liquidity requirements, income needs and tax position?

The objective isn’t to avoid concentration at all costs. It is to ensure concentration is intentional, understood and appropriate for the client.

Tracking error isn’t the only risk

This is perhaps the bigger issue.

Our industry has become exceptionally good at measuring investment risk relative to benchmarks: tracking error, peer-relative performance, asset allocation deviations and factor exposures. But clients don’t experience risk relative to a benchmark. They experience risk in dollars.

A retiree forced to sell assets after a significant market decline to fund living expenses doesn’t particularly care that their portfolio performed exactly in line with its benchmark.

Similarly, an investor may achieve the benchmark return while receiving a poor after tax outcome.

And finally, low tracking error doesn’t necessarily mean low risk. A concentrated portfolio can hug the benchmark while still delivering a very bumpy ride in absolute terms.

Career risk is not client risk.

There is a genuine conflict here for advisers.

Deviating from consensus creates business risk. Being different requires explanation. And being different and wrong can create uncomfortable conversations. I understand why conformity is attractive. But the adviser’s role is not simply to minimise the probability of having a difficult conversation. It is to exercise judgement on behalf of the client.

Best-interest obligations ultimately require advisers to consider the client’s

circumstances and provide appropriate advice. A benchmark can be an important input into that process. It shouldn’t become the defence for the outcome.

Maybe the biggest risk is looking exactly like everyone else.

There is nothing inherently wrong with passive investing, benchmarks or US equities.

The danger comes when benchmark awareness becomes benchmark dependence — when managing relative risk for career or business reasons begins to override managing the client’s actual risks, goals and objectives. That potential conflict of interest needs to be recognised honestly.

If an adviser consciously concludes that a benchmark-heavy, concentrated portfolio is appropriate for a particular client, that is one thing.

But “everyone else owns it” and “if it goes wrong, we can just blame the market” are not client objectives.

The benchmark knows the market. The adviser knows the client. That distinction matters.

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