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| Benchmark |
What It Is:
In the finance world, a benchmark is a feasible alternative to a portfolio
against which performance is measured
How It Works/Example:
Let�s assume you compare the returns of your stock portfolio, which is a
broadly diversified collection of small-cap stocks and is managed by XYZ Company, with the Russell 2000 index, which you feel is an accurate universe of
feasible alternative investments. If your XYZ Company portfolio returns 5.5% in
a year but the Russell 2000 (the benchmark) returns 5.0%, then we would say that
your portfolio beat its benchmark.
Benchmarks help an investor communicate his or her wishes to a portfolio
manager. By assigning the manager a benchmark with which to compare the
portfolio�s performance, the portfolio manager will make investment decisions
with the benchmark�s performance in mind.
The most commonly used benchmarks are market indexes such as the Dow Jones
Industrial Average, the S&P 500, or the Russell 2000. However, there are dozens of other
market indexes out there that focus on specific industry sectors, security
classes, or other market segments. Investors also use other portfolios, mutual
funds, or even pooled accounts to construct benchmarks. LIBOR is one of the most
widely used benchmarks for short-term interest rates, and the Fed controls
another common interest benchmark known as the Fed Funds rate.
A good benchmark should appropriately reflect the portfolio�s investment style
and strategy as well as the investor�s return expectations. For example, the
Russell 2000 may be an appropriate benchmark for a portfolio investing
exclusively in small-cap domestic stocks, but it may be inappropriate for a
portfolio investing in bonds and international REITs. Comparing a portfolio to
an inappropriate benchmark could yield misleading information. The portfolio may
look fantastic compared to one benchmark but lag considerably behind another. It
is difficult to benchmark some portfolios effectively, especially real estate
portfolios, where each asset is unique. Further, it is important to compare a
portfolio with its benchmark over a long period of time.
Portfolio managers frequently receive incentive fees if their portfolios exceed the benchmark return. However, it is important to structure these incentives in a manner that does not motivate a manager to unduly increase the portfolio�s risk.
Why It Matters:
Comparing a portfolio�s returns to a benchmark is a way to measure a portfolio manager�s skill. It answers the question, �What value was added by the manager�s decisions?� The difference in the portfolio and benchmark returns, called tracking error, quantifies this. Tracking error gives investors a sense of how �tight� the portfolio in question is around its benchmark or how volatile the portfolio is relative to its benchmark. As a result, benchmarks not only measure returns, they help measure risk and help the investor determine whether the added return adequately compensates for the risk involved.
Benchmarking lies at the heart of the controversy between passive and active management. Passive managers often note that active managers frequently fail to match or beat their benchmarks, and they question the reliability of active managers� methods for recognizing and predicting trends. Many passive managers espouse the efficient market hypothesis, which says that stock prices are random and already reflect all available information (thus concluding that it is impossible to always beat a benchmark).
Regardless, active managers who have beaten market benchmarks often enjoy a large and loyal following among investors. However, consistently beating those benchmarks remains a big challenge as does defining what they should beat in the first place.
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