What Is Benchmark Error?
Benchmark error is a situation in which the wrong benchmark is selected in a financial model, causing the model to produce inaccurate results.
This type of error can be easily avoided by selecting the most appropriate benchmark possible when configuring the model. Although benchmark error is sometimes confused with tracking error, the two terms have distinct meanings.
- Benchmark error is a situation in which the wrong benchmark is selected in a financial model, causing the model to produce inaccurate results.
- Investors and managers alike try to minimize benchmark error in order to ensure that they have an accurate understanding of their relative investment performance.
- An appropriate benchmark is one that matches the region, industry, volatility, market capitalization, and liquidity of the securities in a portfolio, along with other factors.
Understanding Benchmark Error
A benchmark, also called an index or proxy, is a standard against which the performance of a security, investment strategy, or investment manager can be measured. It is therefore important to select a benchmark that has a similar risk-return profile of the security, strategy, or manager in question. Otherwise, the analysis could produce conclusions that are misleading and unreliable.
Today, investors have thousands of benchmarks to choose from. These include not only traditional equity and fixed income benchmarks, but also more exotic benchmarks created for hedge funds, derivatives, real estate, and other types of investments.
The choice of an appropriate benchmark is important to investors and investment managers alike. Investors and managers keep a close eye on their investment portfolios and their benchmarks to see if their portfolio is performing in line with their expectations. If the portfolio’s performance deviates significantly from the benchmark chosen, it may indicate that style drift has occurred. In other words, it might indicate that the portfolio has drifted away from its desired risk tolerance and investment style.
Examples of factors considered when selecting an appropriate benchmark include the region, industry, volatility, market capitalization, and liquidity of the securities in question.
Real World Example of Benchmark Error
Alison is constructing a portfolio of American technology stocks using the Capital Asset Pricing Model (CAPM). When considering what benchmark to use, she rejects using the Japanese Nikkei index as her benchmark because she determines that it is an inappropriate comparison for American stocks and would therefore introduce benchmark error.
Instead of the Nikkei index, Alison decides to use the Nasdaq index as her benchmark, which represents prominent American technology companies that are similar to the companies she intends to include in her portfolio.