What is a 'Benchmark'
A benchmark is a standard against which the performance of a security, mutual fund or investment manager can be measured. Generally, broad market and market-segment stock and bond indexes are used for this purpose.
BREAKING DOWN 'Benchmark'
When evaluating the performance of any investment, it's important to compare it against an appropriate benchmark. In the financial field, there are dozens of indexes that analysts use to gauge the performance of any given investment including the S&P 500, the Dow Jones Industrial Average, the Russell 2000 Index and even competitor funds. Mutual fund investors may use Lipper indexes, which use the 30 largest mutual funds in a specific category, while international investors may use MSCI Indexes.
Setting a benchmark can help an investor communicate with their portfolio manager what they’re hoping to achieve with their investment, so that the portfolio manager will make decisions with the investor's goals in mind. While a benchmark can help a portfolio manager, it’s important that the benchmark being set is right for the investors goals.
An investor's benchmark should reflect the amount of risk he or she is willing to take, the amount to be invested, and the cost the investor is willing to pay. A benchmark should also mirror the investment style of the portfolio. As stated above, mutual funds, international investors, and other investors use different indexes as benchmarks for their investment portfolios because the type of investments they’re making are of a different nature. Some portfolios are hard to find benchmarks for, like real estate portfolios, where each investment is different in nature.
Some managers seek simply to meet benchmarks, while others work to beat them. While beating a benchmark can make investors happy, providing too much of an incentive to do so can force a manager to take undue risk with a portfolio.
Passive or Active Management
Disagreements about the value of benchmarks can in some ways be chalked up to a difference in fundamental questions about management style. Managers who subscribe to the Efficient Market Hypothesis (EMH) claim that it is essentially impossible to beat the market, and then by extension, the idea of trying beat a benchmark isn’t a realistic goal for a manager to try and meet. Nonetheless, active managers who manage to beat benchmarks do enjoy a certain loyalty from investors despite the difficulties of replicating those types of returns on a regular basis.
History of the Term
The term ‘Benchmark’ has its etymological roots with cobblers who used it in reference to the measure of a persons foot for shoes. The measurement was usually taken by placing the customers foot on a bench and making marks in order to take the measurement.