How has your investment performance been for the last one, five and 10 years? Unfortunately, when asked that question, investors often provide casual observations like "OK", or "pretty good". The truth is that most investors have no idea how they are doing because they have no benchmark against which they compare their investment portfolio's performance.

When was the last time you played golf, tennis, basketball, or any other competitive sport? Did you walk away saying we did "OK" compared to the other team? No - you kept score! Shouldn't you be keeping score the same way when investing? The most efficient way to do this is to employ an investment benchmark and compare it to the performance of your investment portfolio. Read on to find out how to do this.

Setting Benchmarks
What's an appropriate benchmark? A good investment benchmark will have the following characteristics:

  1. It will be appropriate and will be agreed upon in advance.
    The benchmark you select should be consistent with your risk/return objectives and constraints. There should also be an understanding in advance between you and the investment manager that the agreed upon benchmark is representative of the manager's underlying investment strategy and that he or she takes responsibility for the risk-adjusted performance of your portfolio as compared to your benchmark. (For related reading, see Personalizing Risk Tolerance.)

  2. It will be investable.
    You should be able to forgo active management and invest in the benchmark. Do not compare your investment performance to a benchmark that you cannot replicate in the real world. Benchmarks that contain a lot of small, illiquid securities or that have high turnover should be scrutinized. A good way to judge whether your benchmark can be replicated in the real world is to see if there is an index fund or an exchange-traded fund (ETF) available that matches your selected benchmark. (For more insight, check out Benchmark Your Returns With Indexes.)

  3. It will be properly weighted.
    If you are using an index as a benchmark, you should make sure that the index is weighted to reflect a passive (buy-and-hold) investment strategy. Market cap weighted indexes, such as the S&P 500 Index, do not require constant rebalancing and are consistent with a passive investment strategy. Other popular weighting schemes, such as price-weighting or equal-weighting, require constant rebalancing and are not consistent with a passive investment strategy. (For more insight, see Market Cap, Equal Weight And Fundamental Indexing.)

  4. It will be transparent and easy to understand.
    The benchmark you use should have clear, published rules governing things like the criteria used for adding and deleting holdings from the benchmark.It should also have historic holdings and performance data available. This will allow you and your investment manager to better match a benchmark to your investment goals; it will also assist the manager with the portfolio management process.

Different Types of Investment Benchmarks
There are several different types of benchmarks that should be considered when looking for the right one against which to compare your portfolio.

  1. Absolute Benchmark: This is simply a rate of return objective. An example of this would be a minimum required rate of return or actuarial return. This type of benchmark is easy to monitor and understand, and can be agreed upon in advance. The downside is that it can lack passive investable alternatives.

  2. Style Specific Indexes: These indexes represent a specific area or manager discipline in an asset class category. An example of these would be large or small cap and value or growth indexes. Because these indexes are concentrated in one area, their exposure to certain sectors or stocks may be too narrow. This narrow exposure may cause some investment managers to deem these style-specific indexes inappropriate as benchmarks.

  3. Broad Market Indexes: These Indexes reflect a broad market, be it a domestic stock, bond index, or a global stock. Most people are familiar with these indexes. Some examples would be the S&P 500, Russell 3000, Lehman Aggregate, the MSCI World and the MSCI Europe, Australasia and Far East (EAFE) indexes. Many investment managers' disciplines are not this broad, which could make the benchmark a poor match for their investment strategies.

  4. Investment Manager Universe Average: This is the average investment manager performance from a broad universe of managers with the same discipline. This type of benchmark is good for comparing your investment manager to his or her peers, but it is not investable because the average investment manager in the universe is not known in advance. This type of benchmark is prone to survivorship bias as poor performing managers/mutual funds are always fired/closed over time. (To learn more about manager performance, read How's Your Mutual Fund Really Doing?)

  5. Custom Benchmark: This benchmark is made up of one or more indexes or groups of securities weighted to reflect an investor's optimal asset allocation, style mix, or investment strategy. For example, a portfolio with a 60% U.S. stock and 40% U.S. government bond split could be assigned a custom benchmark made up of 60% of the Standard and Poor's 500 Index and 40% of the Lehman U.S. Treasury Index. Custom benchmarks are great for investors with more complex investment objectives and constraints and investment managers with narrow niche strategies. Custom benchmarks can be time-consuming to build and rebalance, but are usually worth the effort.

Conclusion
Comparing the risk-adjusted performance of your investment portfolio to an investment benchmark helps quantify the value that you or your investment manager add by pursuing active investment management. With the recent proliferation of indexes and the creation of ETFs, there are now many combinations of benchmarks that can be matched to reflect your investment objectives. Because investing should always be viewed as a marathon and not a sprint, you need to have patience in trying to best your chosen benchmark - and be prepared to be humbled if it proves to be tough to beat.

Related Articles
  1. Mutual Funds & ETFs

    ETF Analysis: iShares Asia 50

    Read more about BlackRock's iShares Asia 50 Fund, an ETF that follows the four "Asian Tiger'' nations plus China.
  2. Fundamental Analysis

    Explaining the Central Limit Theorem

    Central limit theorem is a fundamental concept in probability theory.
  3. Retirement

    What's a 401(a) Plan?

    A 401(a) plan is a type of money-purchase retirement plan set up by an employer.
  4. Investing

    Build a Retirement Portfolio for a Different World

    When it comes to retirement rules of thumb, the financial industry is experiencing new guidelines and the new rules for navigating retirement.
  5. Mutual Funds & ETFs

    ETF Analysis: WisdomTree International LargeCp Div

    Learn more about the WisdomTree International LargeCap Dividend fund, an income-based international equities ETF that focuses heavily on the United Kingdom.
  6. Investing

    Automating Your 401(k) is Easier Than You Think

    If you like automation, you should check out these features that many 401(k) plans offer.
  7. Retirement

    What's a Defined Contribution Plan?

    A defined contribution plan is a company retirement plan that specifies the amount of money contributed to it.
  8. Mutual Funds & ETFs

    ETF Analysis: United States Gasoline Fund

    Learn about the United States Gasoline Fund, the characteristics of the exchange-traded fund, and the suitability and recommendations of it.
  9. Mutual Funds & ETFs

    ETF Analysis: United States 12 Month Oil

    Find out more information about the United States 12 Month Oil ETF, and explore detailed analysis of the characteristics, suitability and recommendations of it.
  10. Mutual Funds & ETFs

    ETF Analysis: ProShares Ultra Nasdaq Biotechnology

    Find out information about the ProShares Ultra Nasdaq Biotechnology exchange-traded fund, and learn detailed analysis of its characteristics and suitability.
RELATED TERMS
  1. Cost Accounting

    A type of accounting process that aims to capture a company's ...
  2. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s ...
  3. Supply

    A fundamental economic concept that describes the total amount ...
  4. Principal-Agent Problem

    The principal-agent problem develops when a principal creates ...
  5. Exchange-Traded Fund (ETF)

    A security that tracks an index, a commodity or a basket of assets ...
  6. Discount Bond

    A bond that is issued for less than its par (or face) value, ...
RELATED FAQS
  1. Are mutual funds considered retirement accounts?

    Unlike a 401(k) or Individual Retirement Account (IRA), mutual funds are not classified as retirement accounts. Employers ... Read Full Answer >>
  2. Can mutual funds invest in IPOs?

    Mutual funds can invest in initial public offerings (IPOS). However, most mutual funds have bylaws that prevent them from ... Read Full Answer >>
  3. Why is my 401(k) not FDIC-Insured?

    401(k) plans are not FDIC-insured because they are typically composed of investments rather than deposits. The Federal Deposit ... Read Full Answer >>
  4. Why are IRA, Roth IRAs and 401(k) contributions limited?

    Contributions to IRA, Roth IRA, 401(k) and other retirement savings plans are limited by the IRS to prevent the very wealthy ... Read Full Answer >>
  5. What are the best ways to use your 401(k) without a penalty?

    The best way to use your 401(k) retirement savings account is to take normal distributions after you reach retirement age. ... Read Full Answer >>
  6. Can I take my 401(k) in a lump sum?

    Establishing a retirement savings plan during your working years is a necessary part of comprehensive financial planning. ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!