Benchmark: Basics

A benchmark serves a crucial role in investing. Often a market index, a benchmark provides a starting point for a portfolio manager to construct a portfolio and directs how that portfolio should be managed on an ongoing basis from the perspectives of both risk and return. It also allows investors to gauge the relative performance of their portfolios; an annual return of 6% on a diversified bond portfolio may seem strong, but if the portfolio’s benchmark returns 7% over the same time period, the bond portfolio has fallen short of its goal.
The number of benchmarks is virtually endless, and selecting the right one is not always easy. To try to simplify the selection process, we examine :

• What is a benchmark?
• How is a benchmark calculated? and
• How and why might a portfolio’s performance differ from its benchmark?

In "Benchmarks: Selecting a Benchmark ", we also look at the factors to consider when trying to find the best benchmark for an investment portfolio.

What is a Benchmark?

In most cases, investors choose a market index, or combination of indexes, to serve as the portfolio benchmark. An index tracks the performance of a broad asset class, such as all listed stocks, or a narrower slice of the market, such as technology company stocks. Because indexes track returns on a buy-and-hold basis and make no attempt to determine which securities are the most attractive, they represent a “passive” investment approach and can provide a good benchmark against which to compare the performance of a portfolio that is actively managed. Using an index, it is possible to see how much value an active manager adds and where – that is, through which investments - that value is added.

The following are among the most widely followed share indexes, or benchmarks:

Index	Origin	Description
DJIA	U.S.	Price-weighted average of 30 large publicly traded U.S. "blue chip" stocks
FTSE100	U.K.	Market capitalization-weighted index of the 100 largest U.K. companies traded on the London Stock Exchange
Hang Seng Index	Hong Kong	Free float-adjusted market capitalization-weighted index of the 45 largest companies on the Hong Kong stock market
MSCI World Index	Global Equities	Free float-adjusted market capitalization index consist of 24 developed market country indexes
NASDAQ Composite	U.S.	More than 3,000 technology and growth domestic and international based companies on the NASDAQ stock market
Nikkei 225	Japan	225 leading stocks traded on the Tokyo Stock Exchange
S&P 500	U.S.	500 leading companies in the Large-Cap segment of the U.S. equities market.
UBS Australia Composite Bond Index	Australia	Capitalization-weighted index consisting of AUD government, semi-government fixed interest securities, as well as investment grade corporate issuers.

Numerous other equity indexes have been designed to track the performance of various market sectors and segments. Because shares trade on open exchanges and prices are public, the major indexes are maintained by publishing companies like Dow Jones and the Financial Times, or the stock exchanges.

Fixed income securities do not typically trade on open exchanges, and bond prices are therefore less transparent. As a result, the most commonly used fixed income indexes are those created by large broker-dealers that buy and sell bonds, including Barclays Capital (which now also manages the indexes originally created by Lehman Brothers), Citigroup, J.P. Morgan, and BofA Merrill Lynch. Widely known indexes include the Barclays U.S. Aggregate Bond Index, tracking the largest bond issuers in the U.S., the UBS Australia Composite Bond Index and the Barclays Global Aggregate Bond Index of the largest bond issuers globally.

Actually, bond firms have created dozens of indexes, providing a benchmark for virtually any bond market exposure an investor might want. Barclays Capital alone publishes more than 30 different bond indexes. New indexes are often created as investor interest grows in different types of portfolios. For example, as investor demand for emerging market debt grew, J.P. Morgan created its Emerging Markets Bond Index in 1992 to provide a benchmark for emerging market portfolios.

Indexes also exist for other asset classes, including real estate and commodities, and these may be of particular interest to investors concerned about inflation. A couple of examples are the Dow Jones U.S. Select Real Estate Investment Trust (REIT) Index and the Dow Jones-UBS Commodity Index. 

How is a Benchmark Calculated?
Index Methodologies: Market Capitalization and Alternatives
The major index providers use specific, predetermined criteria, such as size and credit ratings, to determine which securities are included in a particular index. Index methodologies, returns and other statistics are usually available through the index publisher’s website or through news services such as Bloomberg or Reuters.

Instead of averaging stock or bond prices, indexes typically weight each component, with the most common weighting based on market capitalization. Companies with more equity or debt outstanding receive higher weightings and therefore have greater influence on index performance. Big price swings in the stocks or bonds of the largest companies can create big price movements in an index.

To reduce the volatility that may result from market cap weighting and potentially improve performance, alternative indexing methodologies have emerged in recent years. Among these, fundamental indexing, developed by PIMCO subadviser Rob Arnott and Research Affiliates, selects and weights components using fundamentals such as sales, cash flow, book value and dividends.

Bond indexes using market cap weighting can have a troubling twist: The most influential components may also have the biggest debt loads, which can be a sign of deteriorating finances. In part to avoid overexposure to highly indebted countries and companies, PIMCO introduced a bond index in 2009 based on gross domestic product, called the PIMCO Global Advantage Bond Index (GLADI)TM, which attempts to identify investment opportunities in fast-growing economies. GLADI also includes more instruments than a typical bond index, such as swaps and inflation-linked bonds. Markit LLC, an independent and unaffiliated leading financial information services company and global index provider, administers and calculates the GLADI index.

How and why Might a Portfolio Perform Differently to its Benchmark?
Measuring Performance: Tracking Error
The difference between the performance, or investment return, of an individual portfolio and its benchmark is known as tracking error. Typically reported as a standard deviation percentage, tracking error may be positive as well as negative.

When a portfolio is actively managed, tracking error may reflect the investment choices made by the active manager in an attempt to improve performance. If the active manager is successful, tracking error is positive and the portfolio outperforms the benchmark; if not, the portfolio underperforms its benchmark.

An investment portfolio, whether actively or passively managed, may hold securities different from its benchmark for other reasons. For example, the benchmark may contain so many securities that it is impractical to hold them all, or it may contain securities that are hard to buy, prompting the portfolio manager to substitute similar securities. In either case, tracking error may result.

Tracking error can also occur when the components of an index change. A bond may be replaced in an index due to a credit downgrade or a stock may be replaced with that of a faster-growing company. Active managers replicating such changes incur trading costs, while the indexes do not, thus creating tracking error. Active managers may also choose to make “off benchmark” allocations to certain sectors in an effort to outperform the benchmark index.

Investors should be aware of the holdings in their portfolios compared with those in their benchmarks in order to understand why their portfolios may perform differently.

An investor should carefully consider the underlying risks contained in an index and their risk tolerance when evaluating an index. All investments contain risk and may lose value.