An investment benchmark is a standard against which the performance of a portfolio or investment counsellor can be measured. Whatever the difference between the performance of the portfolio and the benchmark, it's important to determine why the portfolio performed the way it did.
For instance, if a portfolio outperformed its benchmark, did the investment counsellor take more risks than the benchmark? Did wise asset allocation decisions generate the outperformance? In periods of underperformance, was the outcome driven by the asset allocation decisions, or by a large cash position that created a drag on performance?
It's also important to evaluate performance over time, beyond a single quarter or year. Because investment styles depend on financial market conditions, investment counsellors should be evaluated over complete market cycles.
The CFA Institute, a global association of investment professionals, has developed guidelines that can help in crafting an effective benchmark for your portfolio. They recommend:
Selecting a benchmark for a portfolio that invests in a single asset class is relatively straightforward. For instance, a portfolio invested in Canadian large-cap stocks could be benchmarked against the S&P/TSX Composite, which tracks the universe of domestic large-cap stocks.
A multi-asset class portfolio, however, may require a customized benchmark in order to capture the performance of the investment counsellor in each asset class. A customized benchmark can help in assessing the allocations of capital across various asset classes, and may combine several market indices and weight them to create an aggregate blended benchmark. The performance of the entire portfolio can be measured against this.
A key consideration is the degree of specificity required in the benchmark to capture both asset and sub-asset classes. One option is to construct a benchmark of indices that capture broad asset classes, such as equity or fixed income investments. So if the portfolio's equity component beats the equity index over a long time period, the investment counsellor typically can be credited with astute asset allocation decisions within this broad equity asset class.
Alternatively, the benchmark could combine indices that measure sub-asset classes, like large-cap equity, mid-cap equity, small-cap equity and emerging market equity. Combining a larger number of indices allows for the measurement of the performance of each constituent part of the portfolio.
When selecting the underlying indices that will be used as benchmarks, it's important to consider the way in which each index is constructed. A market-cap weighted index will be skewed toward the performance of the largest capitalization companies. In today's S&P 500 index, the performance of the index's largest market-cap stock, Apple (AAPL), has a greater impact on its performance than a smaller market-cap stock.
A price-weighted index, such as the Dow Jones Industrial Average Index, weights its constituent stocks based on their prices. For example, a Dow stock trading at $50 has five times the weight of a $10 stock.
Measuring the effectiveness of asset allocation decisions requires the index weights in the benchmark be held constant. Generally, this is done in one of two ways:
One drawback to a static benchmark approach is that it may prove difficult to identify whether a portfolio's performance is due to asset allocation decisions or to the performance of specific managers within the overall asset allocation. However, assuming the investment counsellor is making both asset allocation and fund manager decisions, a static benchmark holds the investment counsellor accountable for all decisions and reflects the total value the manager is providing the institution.
Consider the following questions when comparing investment performance to a benchmark:
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