Benchmarking is the process of comparing your investment portfolio to a market index. Investors should carefully assess benchmark selection. This is especially important for multi-asset portfolios subject to periodic rebalancing and cash distributions. A well-chosen benchmark is like a compass that can quickly tell an investor when he or she is off course.
Common portfolio benchmarks include headline indexes, like the S&P 500 index and the NASDAQ 100 index. There are also benchmarks for narrow slices of the market, like healthcare technology stocks. Moreover, you can use a benchmark composite, which combines two or more benchmarks. Finally, there are ‘horse race benchmarks’, which average the performance of multiple funds or advisors. Regardless of type, all benchmarks are ‘passive’ in nature. They track returns on a buy-and-hold strategy with no active effort to rebalance the portfolio.
Benchmarking selection serves many purposes:
The CFA institute supports financial analysts with industry standards. They define a benchmark as “a recognized index, a composite of similar assets or indices, or a peer group of similar funds.” They also qualify good benchmarks as having the following features:
Selecting a benchmark can be complicated. First, there are many indexes to choose from with lots of overlap from different benchmark providers. Meanwhile, some yardsticks may come up short if liquidity management and retirement distributions is your focus.
Consider the case of an investor who expects to retire in 2025 as depicted in green in the chart below. Her investment portfolio allocates funds among a combination of assets. The portfolio includes equity, bond, and money market securities. The portfolio also combines active risk response to limit downside risk and to preserve capital. The investor’s return and risk profile is compared to a range of benchmark indexes.
At first glance, there is no benchmark in the bond space (yellow dots) or the equity space (blue dots) that matches the investor portfolio. The S&P 500 index, for example, has a very different asset composition and risk/return profile. The same is true for the Aggregate Bond Index.
In this case, the investor may be a candidate for a peer group benchmark, like the 2025 Target Date Fund. The fund has an asset allocation that is roughly similar. However, the investor’s objectives and investment style are different. In response, a composite benchmark may be more appropriate. The following table and chart shows the investor portfolio versus a set of benchmark portfolios that vary the amount of stocks, bonds and cash by risk appetite.
In this case, the portfolio labeled ‘Moderate Aggressive’ best aligns to the client portfolio given the tactical allocation of 60% equities, 30% bonds and 10% cash.
Benchmark construction should consider the following:
Benchmark selection can enhance your investment experience. It is an integral part of your investment policy and, when identified in advance of any performance period, a good benchmark will facilitate portfolio construction, rebalancing and performance management.