Investors rely on benchmarks for data – but benchmarks can also represent investment opportunities in themselves. So how can we identify companies whose benchmarks are likely to have staying power?
Read this article to understand:
- The role of network effects in the power of benchmarks
- How successful benchmarks are embedded in an ecosystem of users
- The factors that can limit benchmarks’ efficiency or cast them into irrelevance
In Sapiens: A brief history of humankind, author and historian Yuval Noah Harari wrote about the strength of shared myths, which allowed the creation of mass networks of cooperation between people.
Cities, countries and even empires are sustained by social norms based not on instinct but on belief in shared myths. These shared beliefs make them very strong – a vast majority of people would have to stop believing in them for them to disappear.
“[T]he dollar, human rights and the United States of America exist in the shared imagination of billions, and no single individual can threaten their existence,” wrote Harari.1
Benchmarks – something we refer to for their quality or the information they contain – also rest on this notion of shared beliefs. A product becomes the benchmark for quality in its sector and companies compare their results with those of peers in a given benchmark.
Benchmarks play a particularly important role in financial markets. Investment funds follow benchmarks because of the shared belief that they are accurate, offer a relevant peer comparison and provide the best representation of the markets in which the funds invest. But benchmarks can be of interest to investors in another sense, as the companies that offer them may represent a compelling investment proposition.
Benchmarks as a business have attractive economic characteristics
“Benchmarks as a business have attractive economic characteristics,” says Francois de Bruin, global equity fund manager at Aviva Investors. “They are low cost to create (often a spreadsheet will do); once created can be sold multiple times; are central to the assets they support, resulting in recurring contractual cash flows; are very difficult to displace once adopted as the industry norm; have limited maintenance costs; and grow as their customers grow.”
In this article, we explore different types of benchmarks and how they are created, delve into their economics and discuss the pitfalls that can endanger their supremacy.
Benchmarks and network effects
Benchmarks can be differentiated following two axes (see Figure 1):
1. Direct versus indirect
Direct benchmarks are created to set a norm, standard or reference. They are maintained and stated in advance. Examples include market benchmark indices and credit ratings. Indirect benchmarks become a standard as a by-product of offering a particularly useful product or service, such as Adobe Photoshop, which is considered the benchmark for image-editing software. “Indirect” in this case refers to the fact benchmarking isn't the company’s primary business (for example, Google is in the business of search, and Adobe creative design), but it nevertheless enjoys similar intangible economic properties and benefits to a direct benchmark business. In particular, it will tend to reap marketing advantages as customers promote its product as being the best-in-class offering, giving rise to increased demand free of charge to the company.
2. Infrastructure versus improvement
Infrastructure benchmarks are critical to how an industry or product functions, like pricing information, while improvement benchmarks aim to challenge the status quo or prompt better standards. Benchmarks created by non-governmental organisations to create a “race to the top” are a good example, including the World Benchmarking Alliance and ChemSec’s ChemScore.2,3
However they are created and used, benchmarks rely on widespread trust in their quality and usefulness. This means accepted benchmarks are both a consequence and a beneficiary of “network effects” (see Supercharge me: The power of network effects). Investors use MSCI indices, for example, because a large majority in the financial industry uses and understands them.
“If someone wants a global equity fund, and ours uses a well-established and popular benchmark like the MSCI All Country World Index (ACWI), we'll more likely turn up on the client or consultant’s search,” says Stuart Empson, equity investment director at Aviva Investors. “If we had a bespoke benchmark, for example, we possibly wouldn’t turn up on searches and that could be a barrier to distribution.”
A benchmark only deserves the name once it has been widely adopted, and this adoption in turn gives it relevance and staying power.4 When building a network, it is a question of achieving critical mass; while benchmarks can be built from scratch, having an existing network of influence will boost their chances of being adopted and maintained.
In addition, large benchmark operators tend to benefit from access to substantial amounts of data. By drawing on the information gleaned from their networks, they can often create new benchmarks that are relevant for particular use-cases – even niche ones.
“A good example is an insurance broker called AJ Gallagher, which focuses on regional insurance clients in the US,” says de Bruin. “In a small town in, for instance, Iowa, there is often no benchmark to appropriately price insurance for the five deep fryers running in your burger joint. But because AJ Gallagher has thousands of brokers across these regional towns, it has the collective information to provide at least some form of benchmark.”
A benchmark must keep evolving and innovating to maintain its position
As with other network effects, innovation is key. A benchmark may become the gold standard thanks to a first-mover advantage, but it must keep evolving and innovating to maintain its position. If a company can do this, it should be able to retain a competitive moat and therefore benefit from significant pricing power.
“While pricing pressure is widespread in the industry, MSCI’s ability to continue to innovate and increase its relevance has underpinned its ability to increase prices with volumes,” says de Bruin. “Network effects set the flywheel of benchmarks in motion, specifically around innovation and acceptance, which drive more innovation and deeper acceptance.”
Figure 1: Benchmark dynamics
Source: Aviva Investors, January 2023.
Benchmarks and ecosystems
While some benchmarks aim to improve industry practices and others are created to attract business – such as the price information provided by AJ Gallagher – the most interesting benchmarks from an investment perspective are those that can be sold, such as indices and credit ratings. Their economics are attractive, as benchmarks are asset-light, relevant and investable.
Thanks to the network effect, the more people use a benchmark, the more it becomes relevant
“You build it once and sell it many times and, thanks to the network effect, the more people use it, the more it becomes relevant,” says de Bruin. “The power of brands like S&P 500 or MSCI gives the operating companies pricing power and durability.”
Maintaining branding power and network effects requires entrenching benchmarks at the heart of an ecosystem of users. Identifying companies that operate benchmarks which are relied upon by a diverse network of customers is therefore a good way to identify businesses that are likely to remain strong and resilient into the future.
For example, MSCI places pension funds (the ultimate asset owners) at the apex of the ecosystem for its equity benchmarks. Pension funds demand benchmarks for their assets (directly or via their investment consultants and advisers); asset managers must then adopt those same benchmarks, as must the wider trading system (exchanges, dealers, etc.) to implement transactions, as well as data providers, custodians and consultants. In turn, each group then conducts its own activities. For instance, asset managers need benchmarks for the performance of exchange-traded funds (ETFs), banks for developing derivative products, and so on. All this further entrenches the benchmark. (For fixed-income markets, MSCI places insurers at the apex but the ecosystem dynamics are the same.)
Rating agencies charge issuers to rate them and end-users to access their research and views
Credit ratings work in a similar way. Issuers need them to give investors an idea of their creditworthiness and obtain funding, while investors use credit ratings to select bonds or loans, risk managers to ascertain their quality, and even governments to plan their budgets. This results in a whole ecosystem reliant on the information the ratings agencies provide, making them compelling businesses from an investment perspective.
“Rating agencies run a very clever model,” says Carmen Altenkirch, emerging markets sovereign analyst at Aviva Investors. “They charge issuers to rate them and end-users to access their research and views.”
Risks to benchmarks
Despite the power of benchmarks, there are some risks to consider when investing in benchmark operators. Regulatory changes can affect the usefulness of benchmarks, for example.
The historic dominance of the major credit rating agencies was in part a function of the fact that, before the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the legal regime had ensured an oligopoly for the three largest agencies: S&P Global, Moody’s and Fitch Ratings. These were the only ones to be nationally approved in the US and Europe at the time.
Regulatory changes can affect the usefulness of benchmarks
Post-financial crisis, funds are no longer required by US law to maintain ratings from nationally recognised organisations, although the major ratings agencies have been able to maintain the trust of their customers by becoming more transparent in the way they allocate ratings.5
“After the global financial crisis and the introduction of new regulation in major markets, the rating agencies have become much more transparent about their process,” says Altenkirch. “For example, Fitch now publishes its sovereign models and clearly explains how its qualitative assessment impacts the rating.”
In addition, the prudential regulatory regimes – Basel and Solvency II – put in place to prevent another global financial crisis have hardwired credit ratings into regulatory capital requirements. The credit rating agencies are therefore more profitable now than they were before the 2007-’08 crash.6,7
But not all benchmark operators can adapt and, over the longer term, structural changes may render some benchmarks less useful, or even irrelevant. The Bretton Woods monetary order, for example, collapsed in the 1970s amid the costs of the Vietnam War, the oil shock and rampant inflation. The benchmark was simply not equipped for these unexpected shocks.
If you are looking back and using benchmark weights as a guide, that can be unhelpful
Similarly, the backwards-looking nature of benchmarks such as equity indices may render them less helpful as climate change threatens a period of rapid, disruptive, multi-sector transition. Those who use benchmarks – such as investors hoping to gauge risk – will have to be confident the metrics can adapt to these shifting circumstances.
“We’re going to see lots of volatility, not only in pure economic terms, but in terms of companies coming through that are providing solutions; and previously well-established companies that may not be prepared for a transition rapidly losing market share and becoming a much smaller part of the benchmark,” says Tayler. “If you are looking back and using benchmark weights as a guide, that can be unhelpful.”
Nevertheless, the world will still need benchmarks, and so these sorts of structural shifts could present opportunities for existing operators, as well as risks to their models.
The emergence of new benchmarks will need to be established on credible principles
The emergence of new benchmarks will need to be established on credible principles, which will have to be accepted by users and the broader ecosystem to allow for widespread adoption. This means those benchmark operators that already enjoy credibility among customers and benefit from access to relevant data may be well-positioned to adapt.
One way to approach benchmarks as an investment theme, then, is to seek out those operators that already fulfil the needs of a wide user base – and have the capacity to tailor their offering when circumstances shift. Those that can leverage their brand strength on behalf of their customers, and ensure client needs are met with innovation, should continue to prosper.