Money talks

By Chris Evers

Investment benchmarks are tools that summarize the performance of a broad market to gauge the relative performance of a specific investment.

Benchmarks provide important perspective. By measuring the performance of an investment against the proper benchmark, investors can see how well their investment has done relative to the overall market in which they are investing.

The most commonly used benchmarks are indexes that consist of securities with similar characteristics. Examples include the Standard & Poor’s 500 index, which contains large-cap U.S. stocks, the Barclays U.S. Aggregate bond index (high-quality U.S. bonds) and the MSCI EAFE (international stocks). Each benchmark represents the performance of a specific investment universe.

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Benchmarks can be used to evaluate the performance of mutual funds as well as a broadly diversified portfolio.

As with any tool, a benchmark’s effectiveness depends on when and how it is used. Using the S&P 500 to measure the quality of stock selection in a mutual fund that invests in Europe is a bit like weighing an apple with a ruler. Conclusions from mismatched comparisons can lead to poor investment decisions.

Such comparisons are most telling over long periods. Over short periods, it is more difficult to discern whether outperformance was from skill or fluke and whether underperformance was an outlier or symptomatic of poor investment management.

A common pitfall when working with a benchmark is to compare only investment returns, but it is also important to compare the risk of an investment to its benchmark. An investment that provides 75% of the return of its benchmark while taking only 50% of the risk can add value to an account. Notably, for fixed-income investments, the safety of principal and stability of returns are often more important than higher returns at greater risk. Such information enables investors to select mutual fund managers who have outperformed their benchmark on risk-adjusted measures after accounting for expenses.

As investment advisors, we use benchmarks every day to help make sure that clients’ investments and portfolios are allocated to optimize return and risk. Holding mutual fund managers and ourselves accountable to the correct benchmarks helps us guide investors rationally and objectively.

Benchmarks can provide valuable perspective on both individual investments as well as portfolios.

How benchmarks are used to analyze the performance of a mutual fund:

  • Investors can compare a mutual fund’s annualized return to its benchmark over various periods to gain perspective on a fund manager’s performance.
  • Measuring how a fund held up against its benchmark during a down market can suggest how it would perform relative to the benchmark during the next sell-off.
  • By comparing risk characteristics, such as the fund’s beta, to the benchmark, investors can measure the historic risk profile of the fund.
  • Noting where the fund deviates from the benchmark’s sector or stock weightings can indicate where managers are perceiving value in the market.

How benchmarks are used to analyze the performance of a portfolio:

  • By measuring the performance of a balanced portfolio of 60% stocks and 40% bonds to a custom benchmark of 60% S&P 500 and 40% Barclays U.S. Aggregate, investors can judge the quality of their fund manager’s selections.
  • When investors deviate from their benchmark weightings, for example by moving the portfolio to 65% stock and 35% bond, they can compare to the original 60/40 benchmark to discern whether they have been justifiably rewarded for the incremental amount of risk

Chris Evers is a registered representative and associate at Landaas & Company.

(initially posted Feb. 25, 2016)

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