A benchmark is a standard against which investment performance is measured. Choosing the right benchmark is critical - the wrong benchmark makes performance comparisons meaningless.
Beginner
What It Means
A benchmark is your measuring stick. It answers: “Compared to what?” When you say your portfolio returned 12%, the natural question is whether that’s good or bad. A benchmark provides context.
Common Benchmarks
| Asset Class | Common Benchmarks |
|---|
| US Large-Cap Stocks | S&P 500 |
| US Total Market | Russell 3000, Wilshire 5000 |
| US Small-Cap | Russell 2000 |
| International Developed | MSCI EAFE |
| Emerging Markets | MSCI Emerging Markets |
| US Bonds | Bloomberg US Aggregate |
| 60/40 Portfolio | 60% S&P 500 / 40% Bloomberg Agg |
Portfolio Example
Your US large-cap portfolio returned 12% this year. How did you do?
| Benchmark | Return | Your Performance |
|---|
| S&P 500 | 10% | Beat by 2% |
| Russell 1000 | 11% | Beat by 1% |
| Nasdaq | 15% | Underperformed by 3% |
Why It Matters
Without a benchmark, you can’t evaluate performance. A 15% return sounds great, but not if the market returned 25%. A 5% return sounds weak, but not if the market lost 10%.
Advanced
Benchmark Characteristics
A good benchmark should be:
| Characteristic | Description |
|---|
| Investable | Can actually buy the benchmark |
| Measurable | Returns can be calculated |
| Appropriate | Matches the investment mandate |
| Unambiguous | Clearly defined constituents |
| Specified in Advance | Not changed after the fact |
| Reflective of Opportunities | Represents available investments |
Benchmark Mismatch
Benchmark mismatch is comparing a portfolio to an inappropriate benchmark. A small-cap value fund shouldn’t be compared to the S&P 500 - it should be compared to a small-cap value index.
- Comparing global funds to US-only benchmarks
- Comparing concentrated portfolios to broad indices
- Comparing multi-asset portfolios to equity-only benchmarks
Index Construction Methods
| Method | Description | Examples |
|---|
| Market-Cap Weighted | Larger companies = bigger weight | S&P 500, MSCI |
| Equal Weighted | All stocks weighted equally | S&P 500 Equal Weight |
| Price Weighted | Higher price = bigger weight | Dow Jones |
| Factor Weighted | Weighted by factor scores | Smart beta indices |
| Fundamentally Weighted | Weighted by earnings, sales | FTSE RAFI |
Custom Benchmarks
When no standard index fits, create a custom benchmark:
Example Custom Benchmark:
- 50% S&P 500
- 30% MSCI EAFE
- 20% Bloomberg Aggregate
This matches a global balanced portfolio better than any single index.
Benchmark-Relative Metrics
| Metric | Formula | What It Measures |
|---|
| Active Return | Portfolio - Benchmark | Raw outperformance |
| Tracking Error | Std Dev of Active Return | Consistency of difference |
| Information Ratio | Active Return / TE | Risk-adjusted outperformance |
| Beta | Sensitivity to benchmark | Market exposure |
Benchmark Hugging vs. High Active Share
| Behavior | Active Share | Tracking Error | Fee Appropriateness |
|---|
| Closet Indexer | Low | Low | Overpaying |
| True Active | High | Higher | Appropriate if skilled |
| Index Fund | Very Low | Very Low | Appropriate |
Gaming Benchmarks
Managers may choose easy-to-beat benchmarks:
| Tactic | Example |
|---|
| Cash Drag | Compare equity fund to cash-heavy benchmark |
| Style Mismatch | Growth fund vs. broad market |
| Survivorship | Compare to indices with failed stocks removed |
Always verify that the benchmark is truly appropriate for the strategy. Outperformance vs. the wrong benchmark is meaningless.
Peer Benchmarking
Alternative to index benchmarks:
| Approach | Pros | Cons |
|---|
| Index Benchmark | Clear, investable | May not match strategy |
| Peer Group | Compares similar strategies | Survivorship bias, varying strategies |
