Shining a Light on Indexes – How to Help Investors Better Achieve Their Goals (July 2020)
A Report from the Value Equities Investment Committee | PDF
“What is the appropriate benchmark for your strategy?”
This is a question frequently posed to an investment manager. Before this question can be answered, it is necessary to gain a solid understanding of the strategy by examining the manager’s investment philosophy and how it is applied in the investment process, and, more specifically, how it is expected to perform throughout a full business cycle.
At Confluence Investment Management, our investment philosophy for the domestic value equity strategies was adopted in mid-1994 at our predecessor firm and continues to be implemented more than 25 years later. The approach is focused on understanding and valuing individual businesses with the emphasis on owning competitively advantaged businesses at attractive prices. It is a fundamental approach that views risk as losing money, or more precisely, the probability of a permanent loss of capital. Today, it is the foundation for all six of our domestic value equity strategies.
It is an approach borne from the belief that as investment managers we manage risk, not returns. Returns are the byproduct of an investment process and how well it is deployed. Our philosophy and process are centered around individual businesses with the intent of owning a collection of superior entities in a concentrated manner and then allowing them to compound over long periods.
Our energy has never been focused on managing to a benchmark or index as it is not additive to the investment process. Furthermore, we do not view tracking error as a measure of risk. Quite the contrary, active investors should welcome tracking error as it is the only way to outperform an index. This is not to say that we are not mindful of the indexes; we are, and it is perfectly reasonable to compare us to an index. But it is equally important to understand how an index is constructed to better understand the applications and limitations when using that index as a benchmark to measure an investment manager.