Using Benchmarks in Investing

A benchmark is a standard or measure that can be used to analyze the allocation, risk, and return of a given portfolio. Individual funds and investment portfolios will generally have established benchmarks for standard analysis. A variety of benchmarks can also be used to understand how a portfolio is performing against various market segments.

Investors often use the S&P 500 index as an equity performance benchmark since the S&P contains 500 of the largest U.S. publicly traded companies. However, there are many types of benchmarks that investors can use, depending on the investments, risk tolerance, and time horizon.

Understanding Benchmarks

Benchmarks include a portfolio of unmanaged securities representing a designated market segment. Institutions manage these portfolios known as indexes. Some of the most common institutions known for index management are Standard & Poor’s (S&P), Russell, and MSCI.

Indexes represent various investment asset classes. A benchmark can include broad measures, such as the Russell 1000 or specific asset classes like U.S. small-cap growth stocks, high-yield bonds, or emerging markets.

Many mutual funds in the investment industry use indexes as the base for a replication strategy. Mutual funds contain pool of investment funds that are actively-managed by portfolio managers and invested in various securities, such as stocks, bonds, and money market instruments. Fund money managers attempt to produce capital gains or income for the fund's investors. 

Exchange-traded funds (ETFs) also use indexes as the base for a passive replication strategy. ETFs typically track an index, such as the S&P 500 for equity ETFs. ETFs invest in all of the securities of the underlying index, which is why they're considered passively managed funds.

Investing in a passive fund is primarily the only way that a retail investor can invest in an index. However, the evolution of ETFs has brought about the introduction of smart beta indexes, which offer customized indexes that rival the capabilities of active managers. Smart beta indexes use advanced methodologies and a rules-based system for selecting investments to be held in a portfolio. Smart beta funds represent essentially the middle ground between a mutual fund and an ETF.

Managing Risk

To help manage risk, most people invest in a diversified portfolio that includes numerous asset classes, generally using equities and bonds. Risk metrics can be used to help understand the risks of these investments. Risk is most often characterized using variability and volatility. The size of the change in portfolio value measures volatility. Investment funds that contain commodities, which have larger moves up and down in value, have an increased amount of volatility. Variability, on the other hand, measures the frequency of the change in value. Overall, the more variability, the greater the risk.

Several measures are used to evaluate portfolio risk and reward, including the following:

Standard Deviation

Standard deviation is a statistical measure of volatility by calculating the variance in price moves of an investment to the mean or average return over a period. The greater the variance between each price of the investment and the mean; the greater the price range or standard deviation. In other words, a higher standard deviation indicates more volatility and greater risk.

Beta

Beta is used to measure volatility against a benchmark. For example, a portfolio with a beta of 1.2 is expected to move 120%, up or down, for every change in the benchmark. A portfolio with a lower beta would be expected to have less up and down movement than the benchmark. Beta is usually calculated with the S&P 500 as the benchmark.

Sharpe Ratio

The Sharpe Ratio is a widely used measure of risk-adjusted return. The Sharpe ratio is the average return earned more than a risk-free investment, such as a U.S. government bond. A higher Sharpe ratio indicates a superior overall risk-adjusted return.

These measures are commonly reported with managed investment funds and also by index providers.

Portfolios and Benchmarking

Fund companies use benchmarks as a gauge for the performance of a portfolio against its investing universe. Portfolio managers will generally choose a benchmark that is aligned with their investing universe. Active managers seek to outperform their benchmarks, meaning they look to create a return beyond the return of the benchmark. It is important to keep in mind however that an investor cannot necessarily invest in all of the securities of an index and therefore all investing comes with some associated fees that will detract from the return of an index.

Investors can also use individual indexes combined with risk metrics to analyze their portfolios and choose portfolio allocations. Below are three of the most common benchmarks for analyzing and understanding the market environment and various investment opportunities.

The S&P 500

Overall, an investor may want to use the S&P 500 as a benchmark for equities since it's the best gauge for large U.S. publicly-traded companies. The S&P is the most widely used benchmark for equities and is typically the litmus test for a portfolio's or fund's performance.

The Bloomberg Agg

The Agg or the Bloomberg U.S. Aggregate Bond Index is an index that measures the performance of various fixed income securities, including corporate bonds, U.S. government bonds, asset-backed securities, and commercial mortgage-backed securities that are traded in the United States. The Agg is used by bond traders, mutual funds, and ETFs as a benchmark to measure the relative performance of the bond or fixed income market.

U.S. Treasuries

U.S. Treasury securities are bonds that typically pay a fixed rate of return and are backed by the U.S. Treasury. Treasuries are considered as safe an investment as possible. Many investment funds and portfolio managers use short-term Treasuries, such as ones maturing in one or two years as a benchmark for the risk-free rate of return. In other words, if an investment portfolio isn't earning, at a minimum, the rate equivalent to a one-year Treasury security, the investment is not worth the risk for investors.

To help determine an appropriate investment benchmark, an investor must first consider their risk. For example, if you are willing to take a moderate amount of risk (your profile is a six on a scale of 1-10) an appropriate benchmark could be a 60-40% allocation that includes:

• 60% in a Russell 3000 Index investment, focused on a market capitalization-weighted index universe that includes large-, mid- and small-cap U.S. stocks.
• 40% in a Bloomberg U.S. Aggregate Bond Index investment, which includes a universe of U.S. investment-grade government and corporate bonds.

In this scenario, an investor would use the Russell 3000 Index as a benchmark for equity and the Bloomberg Agg as a benchmark for fixed income. They may also want to use the Sharpe Ratio to ensure that they are optimally diversified and achieving the greatest reward in each allocation for their risk.

Comprehensive Risk Considerations

Risk is a central component of all investing decisions. By simply using the performance and risk metrics of an index in comparison to investments, an investor can better understand how to allocate their investments most prudently. Risk levels usually vary across equity, fixed-income, and savings investments. As a rule, most investors with longer time horizons are willing to invest more heavily in higher-risk investments. Shorter time horizons or a higher need for liquidity—or the ability to convert to cash—will lead to lower-risk investments in fixed-income and savings products.

With these allocations as a guide, investors can also use indexes and risk metrics to monitor their portfolios within the macro investing environment. Markets can gradually shift their levels of risk depending on various factors. Economic cycles and monetary policies can be leading variables affecting risk levels. Active investors who use appropriate benchmarking analysis techniques can often more readily capitalize on investment opportunities as they evolve. Comparing the performance and risk of various benchmarks across an entire portfolio or specifically to investment fund mandates can also be important for ensuring optimal investing.

The Bottom Line

Benchmarks are tools that can be used in a variety of ways for investors. All managed funds will have an established benchmark for which to measure the performance of the fund.

Investors can also go beyond standard uses of benchmarking. Using indexes to allocate investments to passive funds with specific portfolio allocations can be one advanced use of benchmarking. Active investors may also choose to follow an array of benchmarks across the risk spectrum, analyzing these benchmarks along with risk characteristics to ensure that their investments are optimally placed with the lowest risk and highest return possible. Benchmark and risk metric monitoring also allows investors to potentially identify opportunities for shifting portfolio investments to take advantage of market opportunities.

Overall, considering different benchmarks simultaneously with their risk characteristics can be a simple technique for all types of investors. Using benchmarks can be very valuable in analyzing current and potential investments. It can also be an effective way to ensure that an investor’s portfolio is optimally diversified and aligned with their goals.