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How to Use Benchmarks in Investing

A benchmark is a standard or measure used to analyze a given portfolio’s allocation, risk, and return. Individual…
How To Use Benchmarks In Investing

A benchmark is a standard or measure used to analyze a given portfolio’s allocation, risk, and return. Individual funds and investment portfolios will generally have established benchmarks for standard analysis. Various benchmarks can also be used to understand how a portfolio performs against various market segments.

Investors often use the S&P 500 index as an equity performance benchmark because it contains 500 of the largest U.S. publicly traded companies. However, investors can use many benchmarks depending on their investments, risk tolerance, and time horizon.

KEY TAKEAWAYS

  • A benchmark is a standard or measure used to analyze a given portfolio’s allocation, risk, and return.
  • Various benchmarks can also be used to understand how a portfolio performs against various market segments.
  • The S&P 500 index is often used as a benchmark for equities.
  • U.S. Treasuries are used for measuring bond returns and risk.

Understanding Benchmarks

Benchmarks are portfolios of unmanaged securities representing a designated market segment. Institutions manage these portfolios, which are known as indexes. 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 like the Russell 1000 or specific asset classes like U.S. small-cap growth stocks, high-yield bonds, or emerging markets.

Many mutual funds in the investment industry use indexes as the base for a replication strategy. Mutual funds contain pools of investment funds that are actively managed by portfolio managers and invested in various securities, such as stocks, bonds, and money market instruments. Fund money managers attempt to produce capital gains or income for the fund’s investors.

Exchange-traded funds (ETFs) also use indexes as the base for a passive replication strategy. ETFs like the S&P 500 for equity ETFs typically track an index. These ETFs invest in all the underlying index securities, considered passively managed funds.

Investing in a passive fund is the primary way that a retail investor can invest in an index. However, the evolution of ETFs has brought about the introduction of smart beta indexes. These offer customized indexes that rival the capabilities of active managers. Smart beta indexes use advanced methodologies and a rules-based system for selecting investments to be held in portfolios. Smart beta funds represent the middle ground between a mutual fund and an ETF.


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Important: Various benchmarks can also be used to understand how a portfolio performs against various market segments.

Managing Risk

Most people invest in a diversified portfolio with numerous asset classes to help manage risk. They generally use equities and bonds. Risk metrics can help them understand the risks of these investments.

Risk is most often characterized by variability and volatility. The size of the change in portfolio value measures volatility. Investment funds that contain commodities with larger moves up and down in value have increased volatility.

Variability measures the frequency of the change in value. Overall, the more variability, the greater the risk.

Several measures are used to evaluate portfolio risk and reward.

Standard Deviation

Standard deviation is a statistical measure of volatility. It calculates the variance in price moves of an investment to the mean or average return over a period. The greater the variance between each investment price and the mean, the greater the price range or standard deviation. A higher standard deviation indicates more volatility and greater risk.

Beta

Beta is used to measure volatility against a benchmark. 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 have less up-and-down movement than the benchmark. Beta is usually calculated with the S&P 500 as the benchmark.

Sharpe Ratio

The Sharpe Ratio is a widely used measure of risk-adjusted return. It’s the average return earned more than 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 index providers.

Portfolios and Benchmarking

Fund companies use benchmarks to gauge a portfolio’s performance against its investing universe. Portfolio managers generally choose a benchmark aligned with their investing universe. Active managers seek to outperform their benchmarks, creating a return beyond the benchmarks.

However, an investor can’t necessarily invest in all the securities of an index because all investing comes with some associated fees that will detract from the return of an index.

Investors can also analyze their portfolios and choose portfolio allocations using individual indexes and risk metrics. Three benchmarks are commonly used to analyze and understand the market environment and various investment opportunities.

The S&P 500

An investor may want to use the S&P 500 index as a benchmark for equities because it’s the best gauge for large U.S. publicly traded companies. The S&P is the most widely used benchmark for equities. It’s typically the litmus test for a portfolio’s or fund’s performance.

The Bloomberg Agg

The Agg or the Bloomberg U.S. Aggregate Bond Index measures the performance of various fixed-income securities. These include corporate bonds, U.S. government bonds, asset-backed securities, and commercial mortgage-backed securities traded in the United States.

Bond traders, mutual funds, and ETFs use the Agg as a benchmark to measure the relative performance of the bond or fixed-income market.

U.S. Treasuries

U.S. Treasury securities are bonds that typically pay a fixed rate of return, and the U.S. Treasury backs them. Treasuries are considered to be as safe an investment as possible.

Many investment funds and portfolio managers use short-term Treasuries maturing in one or two years as a benchmark for the risk-free rate of return. An investment isn’t worth the risk if the rate cannot beat a one-year Treasury security.

Examples of Benchmarking

Investors must first consider their risk to help determine an appropriate investment benchmark. An appropriate benchmark could be a 60% to 40% allocation if you’re willing to take a moderate risk because your profile is a six on a scale of 1-10. It would include:

  • 60% in a Russell 3000 Index investment that’s focused on a market capitalization-weighted index universe that includes large-, mid-, and small-cap U.S. stocks
  • 40% in a Bloomberg U.S. 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 Bloomberg Agg as a benchmark for fixed income. They should also use the Sharpe Ratio to ensure that they’re optimally diversified and achieve the greatest reward for their risk in each allocation.

Comprehensive Risk Considerations

Risk is a central component of all investing decisions. By comparing an index’s performance and risk metrics to investments, investors can better understand how to allocate their investments prudently.

Risk levels usually vary across equity, fixed-income, and savings investments. Most investors with longer time horizons are willing to invest more heavily in higher-risk investments. Shorter time horizons, a higher need for liquidity, or the ability to convert to cash will lead to lower-risk investments in fixed-income and savings products.

Investors can also use indexes and risk metrics to monitor their portfolios within the macro investing environment using these allocations as a guide.

Markets can gradually shift their risk levels 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 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 to ensure optimal investing.

FAQs

1. What Is an Index in Investing?

Ans: An index is effectively a benchmark. It measures changes in a securities market based on statistics. An index fund is a pooled investment vehicle that tracks specific indexes. Many mutual and exchange-traded funds (ETFs) track and mimic the performance of indexes, so they’re considered safer than other types of investments.

2. What Is an Exchange-Traded Fund, and Should I Invest in One?

Ans: An ETF is a pooled investment vehicle funded by numerous investors who receive an interest in the fund that’s typically proportionate to their contributions. An SEC-registered advisor firm usually manages the fund. Some ETFs, such as index funds, are passively managed and track markets. Others are more actively managed and traded more consistently.

Whether you should invest in an ETF and which type of fund would work best for you depends on your appetite for risk, but ETFs are generally considered safe investments.

3. What Does Volatility Mean in an Investment?

Ans: Volatility measures how frequently and by how much the price of a given security shifts over a designated period. It affects long-term investors because their goal is growth over the years. However, it can create a bumpy, nerve-wracking road for short-term investors who want to buy in or out of the market at a specific, imminent time.

The Bottom Line

Benchmarks are tools that can be used in various ways for investors. All managed funds will have an established benchmark by which you can measure the fund’s performance.

Investors can also go beyond standard benchmarking. One advanced use of benchmarking is using indexes to allocate investments to passive funds with specific portfolio allocations. Active investors may also follow an array of benchmarks across the risk spectrum, analyzing these benchmarks and risk characteristics to ensure their investments are optimally placed with the lowest risk and highest return possible.

Benchmark and risk metric monitoring also allow investors to identify opportunities for shifting portfolio investments to take advantage of market opportunities.

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 effectively ensure an investor’s portfolio is optimally diversified and aligned with their goals.

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