Goodhart's Law and the folly of using Investment Benchmarks

Charles Goodhart is an Economics Professor from the London School of Economics. He said that "Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes" One interpretation is that when a measurement becomes a target, it ceases to be a good measure. 

I was expecting to lose money when I ploughed my trainer's fees into the portfolio created by my third batch of students. After all, the Capricorn effect is long over and REITs have already completed a fairly good run in the markets.

Furthermore, the worse decision we made as a class was to keep First Reit in our portfolio. It subsequently lost me about 7+% over the span of less than a month, likely due to the perceived problems from its sponsors. Interestingly, the class kept it in the portfolio even when their senior batch happily excluded it from the final list of stocks to buy into.

So I was quite surprised that my portfolio is still on positive territory today.

Frasers Logistics and Industrial Trust did very well  not because it was especially well run but because it was expected to be joining the FTSE EPRA/NAREIT Global Developed Index. The news of its inclusion in the index came out on 4 March 2019, about slightly more than a week after I built the portfolio. It's full inclusion will occur on 19 March 2019.

Interestingly the positive movement in the counter began as early as 27 February 2019.

This phenomenon explains the relevance of Goodhart's Law. As investors rush into REIT ETFs and begin benchmarking their performance against popular indexes. It becomes possible for smart investors to follow news on the inclusion of a REIT in a major index and then perform trades based on that fact by front-running the index investors. Passive investing based on a benchmark, thus, makes someone a patsy.

This is possibly one of the more convincing arguments active fund managers will level against ETF passive investing and you can bet your bottom dollar that they have a personal interest to spread this story around, even inducing their salesmen lapdogs to do the same. Sadly, from my perspective, the alternative to active investing is not passive investing, but DIY investing. Even if benchmarking becomes an investing trend that can be exploited by some front-running, the cheapest way to do it is to trade in the counter directly.

Over the next few days, we shall see whether Goodhart's Law to hold true over Frasers Logistics & Industrial Trust. If Goodhart's law is correct, we should see Frasers Logistics revert to lower value after 19th March 2019.