Definition
A benchmark is a standard or point of reference against which the performance of an investment, mutual fund, or investment manager can be measured. Typically, it’s represented by a specific market index, like the FTSE 100 or the S&P 500. Investors and fund managers use benchmarks to assess the success of their investment strategies by comparing their returns to relevant market standards.
What is a benchmark?
A benchmark is essentially a yardstick against which the performance of an investment or portfolio can be compared. It provides a focus for investment decisions and a means to assess the effectiveness of an investment strategy.
For example, if you are a long-distance runner aiming to qualify for a major marathon, the qualifying time standard set by the marathon acts as a ‘benchmark’. The runner’s training times are compared against this standard to gauge their potential for qualifying. Similarly, comparing a portfolio’s performance with a benchmark like the FTSE 100 helps investors evaluate how well the investment is doing in the broader market context.
Common types of benchmarks
- Market indexes: These include the FTSE 100, which tracks the top 100 companies on the London Stock Exchange, or the S&P 500 in the US. The MSCI World Index, which tracks large and mid-cap stocks across 23 developed countries, might be used as a benchmark for a global equity fund.
- Custom benchmarks: Tailored benchmarks created to match a fund’s specific investment strategy or sector. For example, a fund specialising in green technology might create a custom benchmark that includes companies from the renewable energy sector to measure its performance accurately.
- Peer groups: Comparing performance with a group of similar funds or investments. A UK equity income fund might be compared against similar UK equity income funds to see how it ranks in performance and dividend yield.
The role of benchmarks in investment strategies
Benchmarks play a pivotal role in shaping investment strategies. They are instrumental in goal setting, risk assessment, and guiding asset allocation decisions.
For instance, a fund manager may aim to outperform a specific benchmark, or an individual investor might use a benchmark to understand whether their portfolio is aligned with their risk tolerance and investment objectives. If the fund’s returns exceed the index, it indicates the manager’s strategy is effective. Conversely, underperformance might prompt a reassessment of the investment approach. The performance of a mutual fund or a personal investment portfolio against a chosen benchmark can significantly influence investment decisions, like rebalancing the portfolio or altering the investment strategy.
If you ever find yourself looking at fund factsheets on an investment platform or directly from a fund manager, it’s likely that one of the first charts you’ll come across is how that particular fund has performed against chosen benchmarks.
Choosing the right benchmark
Selecting an appropriate benchmark is vital. It should align with the investment’s objectives, risk profile, and the sectors or markets it invests in. An incorrectly chosen benchmark can lead to misleading performance assessments.
Whereas it can be more common for market indices to be used as a general barometer for fund performance, if you are an investor who is really focused on sustainable and green investments, you would choose a benchmark that reflects sustainable investment principles, such as the FTSE4Good Index, rather than a general market index.
Limitations of benchmarks in investment analysis
While benchmarks are helpful, they’re not perfect. They may overlook certain risks or nuances of an investment and can lead to an overemphasis on short-term performance. Therefore, they should be used as one of many tools in assessing investments, not the sole indicator.
If you’re training for a triathlon, using a benchmark from only running races might not give you the full picture of your overall performance. Similarly, if an investment fund that takes on higher risk for potentially higher returns might outperform a conservative benchmark in good times but underperform in bad times, showing the limitation of using a single benchmark.
Benchmarks in the context of personal investment goals
Choosing benchmarks that align with your individual investment goals, time horizon, and risk tolerance is essential for personal investors. This alignment ensures that the performance measurement is relevant and meaningful to the investor’s specific situation. If you’re saving for a short-term goal, you’d choose a benchmark that reflects more conservative, less volatile investments, whereas long-term goals might align with benchmarks capturing broader market growth over time.
So, if your goal is to save for a house in five years, your benchmark might be a mix of bond and equity indices that reflects your time frame and risk tolerance rather than a high-risk, tech-focused index.
Meanwhile, a UK retiree looking for steady income from their investments might use the FTSE UK Dividend+ Index as a benchmark. This index tracks the performance of the highest dividend-paying UK stocks and is known for its focus on companies with stable and high dividend payouts. By comparing their income-focused portfolio against this index, the retiree can gauge how well their investments generate regular, reliable income compared to some of the top dividend payers in the UK market.
Conclusion
Benchmarks play a vital role in the investment world, providing a means to measure and compare the performance of investments. However, their use should be balanced with other factors and considerations to ensure a holistic investment analysis and decision-making approach.
