DEFINITION of Benchmark Error
Benchmark error is a situation in which the wrong benchmark is selected in a financial model. This error can create large dispersions in an analyst or academic's data, but can easily be avoided by selecting the most appropriate benchmark at the onset of an analysis. Tracking error can be confused for benchmark error, but the two measures have distinctly different utilities.
BREAKING DOWN Benchmark Error
To avoid benchmark error, it is important to use the most appropriate benchmark, or market, in your calculations, when creating a market portfolio under the capital asset pricing model (CAPM). If, for example, you want to create a portfolio of American stocks using the CAPM, you would not use the Nikkei — a Japanese index — as your benchmark.
Accordingly, if you want to compare your portfolio returns, you should use an index that contains similar stocks. For example, if your portfolio is tech-heavy, you should use the Nasdaq as your benchmark, rather than the S&P 500.
A benchmark, also called an index or proxy, is a standard against which the performance of a security, mutual fund, investment strategy or investment manager can be measured. As a reference point, it's important to select a benchmark which best represents the risk-return profile of a fund or strategy under analysis. As an example, for an investment manager with a large cap value mandate, it would be inappropriate to compare the fund's results to an index focused on the small cap growth universe. In a sense, although they're both tied to equity markets, it would be like comparing apples to oranges.
Today, thousands of benchmarks have been created to accommodate the myriad of investment options available. Some of these include traditional equity and fixed income strategies, as well as more sophisticated hedge fund, derivative, commodity and futures benchmarks.
Investors and financial advisors keep a close eye on their investment portfolios and their benchmarks to see if the portfolio is tracking close to the benchmark. Style drift is a problem for active investment strategies because the fund is drifting from the fundamental characteristics of its benchmark. Thus, investors' portfolios could be moving away from their desired risk tolerances or holdings investments they otherwise don't want.