Financial Education

Investors measure performance against a number of metrics, some of which can be considered valid benchmarks and others of which cannot.

Absolute return can be an objective (I want to earn 10% annually.) However, a 10% return is not investable and therefore does not make a valid benchmark.

Manager universes are useful comparisons after the fact. But they investments made by the manager universe are not specified in advance so managers cannot use skill to perform better.

Broad market indices meet most of the criteria for benchmarks, and are suitable provided they reflect the manager’s style.

Style indices (such as the S&P 500 Growth Index) are well known, easily understood and widely available. They are generally appropriate as benchmarks, with a couple of caveats:

• Style definition can be ambiguous and may be inconsistent with the manager’s investment process
• Some style indices have larger weights in particular securities or sectors than a manager would consider prudent

Benchmarks based on factor models relate one or more systematic sources of return to the returns on the account. The capital asset pricing model is a single-factor model in which the factor is the market risk premium. Factor models can be useful for performance evaluation because they identify the sources of return and can provide insight as to a manager’s style. However, they are ill suited as benchmarks because the securities are not specified in advance, they are ambiguous, and managers probably do not think in terms of factors when making their decisions.

Returns based benchmarks compare a manager’s return to the returns of several style indices to solve for the combination of styles that best explains the manager’s return. They meet many criteria for being valid benchmarks, but the mix of underlying styles may not reflect the manager’s investment process.  If the manager rotates among styles rather than keeping a relatively constant mix it would be inappropriate.

Custom benchmarks weight the manager’s universe in a fashion that reflects the manager’s weighting style. Custom benchmarks meet all criteria of valid benchmarks and are useful for performance evaluation. However, they can be expensive to construct and maintain, and lack of transparency could be a concern.

For more information, see all articles on: Asset Allocation, Investment Returns, Performance Measurement, Portfolio Management

See also:

Types of Alternative Investments

Types of Managed Futures Accounts

Commodity Benchmarks

Macro Performance Attribution

Benchmarks for Investments in Real Estate