What is a benchmark?
– A benchmark is a standard reference — usually an index — used to measure how an investment, fund, or portfolio performs over time relative to a representative market or asset class. In investing, benchmarks let you compare returns, volatility, and risk characteristics to a relevant yardstick.
Key definitions (jargon explained)
– Index: a published list of securities and a rule for aggregating their prices into a single performance series (e.g., S&P 500).
– Market-cap weighting: a method that assigns greater weight to larger companies by their market value (shares outstanding × price).
– Free-float market-cap: like market-cap weighting but counts only shares available to public investors (excludes locked-up shares).
– Beta: a measure of sensitivity of an asset’s returns to movements in its benchmark; beta = Covariance(asset,bench) / Variance(bench).
– R-squared (R²): the proportion of an asset’s return variability explained by the benchmark (ranges 0–1).
– Active return: the difference between an investment’s return and its benchmark’s return.
– Tracking error: the standard deviation of the differences between an investment’s returns and its benchmark’s returns.
Major types of benchmarks
– Equity (stock) indexes — examples: S&P 500
, Russell 2000 (small‑cap U.S.), MSCI EAFE (developed markets ex‑U.S.), and FTSE 100 (U.K. large caps).
Other major benchmark types
– Fixed‑income indexes — examples: Bloomberg Barclays U.S. Aggregate Bond Index, ICE BofA U.S. Corporate Index. These track a broad set of bonds and typically subgroup by credit quality, maturity, or sector.
– Multi‑asset and total‑return benchmarks — composites that combine equities, bonds, cash and sometimes alternatives; used for balanced funds or model portfolios.
– Style and sector benchmarks — e.g., MSCI Value, MSCI Growth, S&P 500 Financials; useful when evaluating managers that target a particular investment style or industry.
– Factor and smart‑beta benchmarks — constructed to capture systematic drivers (value, momentum, low volatility); can be rules‑based rather than pure market‑cap weighted.
– Inflation and currency benchmarks — Consumer Price Index (CPI) for inflation, or currency‑adjusted indexes for investors focused on real or currency‑hedged returns.
– Private‑market and illiquid asset benchmarks — e.g., NCREIF for commercial real estate, HFRI for hedge funds; these often use appraisals or reporting conventions that differ from daily‑priced public indexes.
– Absolute‑return and custom benchmarks — targets such as “LIBOR + 3%” or bespoke policy benchmarks tailored to an institutional investor’s liabilities.
How benchmarks are used (practical checklist)
1. Performance measurement: calculate active return (Rp − Rb). Example: if a portfolio returns 12.0% and its benchmark returns 8.0%, active return = 4.0 percentage points.
2. Risk attribution: decompose sources of return relative to the benchmark (sector bets, stock selection).
3. Risk sizing and limits: set tracking error limits or sector exposure caps relative to the benchmark.
4. Fees and incentives: align manager compensation with benchmark‑relative outperformance, after costs.
5. Asset allocation & policy construction: use a policy benchmark to reflect strategic targets across asset classes.
Key metrics and worked examples
– Active return = Rp − Rb.
Example: Rp = 12.0% (0.12), Rb = 8.0% (0.08) → active return = 0.12 − 0.08 = 0.04 (4.0%).
– Tracking error (TE) = standard deviation of (Rp,t − Rb,t) across t periods.
Worked numeric example:
Differences over 5 quarters: 1.0%, −0.5%, 2.0%, −1.0%, 0.5% → in decimals: [0.010, −0.005, 0.020, −0.010, 0.005].
Mean difference = (0.010 − 0.005 + 0.020 − 0.010 + 0.005) / 5
= 0.020 / 5 = 0.004 (0.4% per quarter).
Now compute the tracking error (TE), i.e., the standard deviation of these active-return differences.
Step 1 — deviations from the mean
– 0.010 − 0.004 = 0.006
– −0.005 − 0.004 = −0.009
– 0.020 − 0.004 = 0.016
– −0.010 − 0.004 = −0.014
– 0.005 − 0.004 = 0.001
Step 2 — squared deviations
– 0.006^2 = 0.000036
– (−0.009)^2 = 0.