Using Benchmarks in Investing

A benchmark is a standard or measure that can be used to analyze the allocation, risk and return of a given portfolio. Individual funds and investment portfolios comprehensively will generally have established benchmarks for standard analysis. A variety of benchmarks can also be used to understand how a portfolio is performing against various market segments. Investors often use the S&P 500, Barclays Agg and one-year Treasury and when analyzing investments across the risk spectrum.

Benchmarks include a portfolio of unmanaged securities representing a designated market segment. These portfolios are known as indexes and are managed by an institution. Some of the most common institutions known for index management are Standard & Poor’s (S&P), Russell and MSCI.

Indexes represent various investment asset classes. A benchmark can include broad measures, such as the Russell 1000 or specific asset classes like U.S. small-cap growth stocks, high-yield bonds or emerging markets. Many mutual funds and exchange-traded funds (ETFs) in the investment industry use indexes as the base for a passive replication strategy. Investing in a passive fund is primarily the only way that a retail investor can invest in an index. Market evolution has also brought about the introduction of smart beta indexes offering customized indexes that rival the capabilities of active managers. Smart beta indexes use advanced methodologies to identify the best investment in a particular market segment.

To help manage risk, most people invest in a diversified portfolio that includes numerous asset classes, generally using equities and bonds.  Risk metrics can be used to help understand the risks of these investments. Risk is most often characterized using variability and volatility. Volatility is measured by the size of the change in portfolio value. Investments, for example, commodities which have larger moves up and down in value, increase the volatility. Variability measures the frequency of the change in value. Overall, the more variability, the greater the risk.

Measures of Risk

Several measures are used to evaluate portfolio risk and reward including standard deviation, Beta and Sharpe ratio.

• Standard deviation is a statistical measure of volatility. A higher standard deviation indicates more volatility and greater risk.
• Beta is used to measure volatility against a benchmark. For example, a portfolio with a beta of 1.2 is expected to move 120%, up or down, for every change in the benchmark. A portfolio with a lower beta would be expected to have less up and down movement than the benchmark. Beta is usually calculated with the S&P 500 as the benchmark. (See also: Understanding Beta.)
• The Sharpe Ratio is a widely used measure of risk-adjusted return. The Sharpe ratio is the average return earned in excess of a risk-free investment, such as a U.S. government bond. A higher Sharpe ratio indicates a superior overall risk-adjusted return.

These measures are commonly reported with managed investment funds and also by index providers.

Benchmarks are used by fund companies as a gauge for the performance of a portfolio against its investing universe. Portfolio managers will generally choose a benchmark that is aligned with their investing universe. Active managers seek to outperform their benchmarks and provide alpha above and beyond the return of a benchmark. It is important to keep in mind however that an investor cannot necessarily invest in all of the securities of an index and therefore all investing comes with some associated fees that will detract from the return of an index.

Investors can also use individual indexes combined with risk metrics to analyze their portfolios and to choose portfolio allocations. Across the market, the S&P 500, Barclays Agg and one-year Treasury are three of the most common benchmarks for analyzing and understanding the market environment and various investment opportunities.

Overall, an investor may want to use the S&P 500 as a benchmark for equity, the Barclays Agg as a benchmark for fixed income and the one-year Treasury as a comparison for their liquid savings. Equity, fixed income and savings can all have more granular options as well. To help determine an appropriate investment benchmark, an investor must first consider their risk. For example, if you are willing to take a moderate amount of risk (your profile is a 6 on a scale of 1-10) an appropriate benchmark could be a 60-40% allocation that includes:

• 60% in a Russell 3000 Index investment, focused on a market capitalization-weighted index universe that includes large-, mid- and small-cap U.S. stocks.
• 40% in a Barclays Aggregate Bond Index investment, which includes a universe of U.S. investment-grade government and corporate bonds.

In this scenario, an investor would use the Russell 3000 Index as a benchmark for equity and the Barclays Agg as a benchmark for fixed income. They may also want to use the Sharpe Ratio to ensure that they are optimally diversified and achieving the greatest reward in each allocation for their risk.

Risk is a central component of all investing decisions. By simply using the performance and risk metrics of an index in comparison to investments, an investor can better understand how to most prudently allocate their investments. Risk levels usually vary across equity, fixed income and savings investments. As a rule, most investors with longer time horizons are willing to invest more heavily in higher risk investments. Shorter time horizons or a higher need for liquidity will lead to lower risk investments in fixed income and savings products.

With these allocations as a guide, investors can also use indexes and risk metrics to monitor their portfolios within the macro investing environment. Markets can gradually shift their levels of risk depending on various factors. Economic cycles and monetary policies can be leading variables affecting risk levels. Active investors who use appropriate benchmarking analysis techniques can often more readily capitalize on investment opportunities as they evolve. Comparing the performance and risk of various benchmarks across an entire portfolio or specifically to investment fund mandates can also be important for ensuring optimal investing.

Benchmarks are tools that can be used in a variety of ways for investors. All managed funds will have an established benchmark for which to measure the performance of the fund against.

Investors can also go beyond standard uses of benchmarking. Using indexes to allocate investments to passive funds with specific portfolio allocations can be one advanced use of benchmarking. Active investors may also choose to follow an array of benchmarks across the risk spectrum, analyzing these benchmarks along with risk characteristics to ensure that their investments are optimally placed with the lowest risk and highest return possible. Benchmark and risk metric monitoring also allows investors to potentially identify opportunities for shifting portfolio investments to take advantage of market opportunities.

Overall, considering different benchmarks simultaneously with their risk characteristics can be a simple technique for all types of investors. Using benchmarks can be very valuable in analyzing current and potential investments. It can also be an effective way to ensure that an investor’s portfolio is optimally diversified and aligned with their goals.