A benchmark is a point of reference for measuring performance. A choice of benchmark can greatly influence decisions throughout the investment process. When selecting investments such as mutual funds or separately managed accounts (SMAs), we can use benchmarks to assess a fund manager’s skills and track record. If your performance as an advisor will be measured against a benchmark, the choice of benchmark is doubly important.

Single-index benchmarks are widely used but seldom appropriate for these tasks, because they don’t reflect the investment’s nature and purpose. The advisor or his client who uses these benchmarks will incorrectly assess performance.

As an alternative, blended benchmarks provide an appropriate reference for manager selection and performance attribution.

Single indices are inappropriate benchmarks

Popular indices such as the S&P 500 are ubiquitous and readily available, but they are usually a poor choice for benchmarking assets and portfolios. We will use a balanced mutual fund to illustrate the issue. This analysis would be the same for a balanced portfolio that you manage for a client.

Our example fund’s objective is to seek regular income, conservation of principal and opportunity for long-term growth. The fund invests 70% of its assets in U.S. equities and the remaining 30% in U.S. investment-grade fixed-income securities. The following chart compares the trailing one-year cumulative returns of the fund against a U.S. equity index (S&P 500 total-return – “TR”) and a U.S. bond index (Barclays US Aggregate).

The fund seems to have performed well, but even if the S&P 500 TR index seems a close match, neither of the indices is an appropriate benchmark to give us a reliable measure of merit.

Benchmark

We can substitute a balanced portfolio for the balanced fund described above to illustrate the problem when your performance as an advisor is incorrectly interpreted by your client. When reviewing his or her periodic statement, the client may inquire why the portfolio ”underperformed the market.”

What makes a valid benchmark?

Before we describe a practical solution to our needs, it is useful to recall the essential properties that an investment benchmark should possess. These qualities are easily remembered through the acronym SAMURAI1:

  • Specified in advance: The benchmark is specified prior to the start of the evaluation period.
  • Appropriate: The benchmark is consistent with the manager’s investment style or area of expertise.
  • Measurable: The benchmark’s return is readily calculable on a reasonably frequent basis.
  • Unambiguous: The identities and weights of securities are clearly defined.
  • Reflective of current investment opinions: The manager has current knowledge of the securities in the benchmark.
  • Accountable: The manager is aware and accepts accountability for the constituents and performance of the benchmark.
  • Investable: It is possible to simply hold the benchmark.

 

Single indices satisfy most properties but are not necessarily appropriate, as shown in our balanced-fund example. Style indices (large vs. small cap, growth vs. value) are problematic because the definition of investment style may be ambiguous or inconsistent with the manager’s investment process. Peer rankings lack many of the properties listed above. They are not known in advance and also are subject to survivorship bias (underperforming funds are more likely terminated).

See full article on What Makes a Valid Benchmark? by Christophe Gauthron, CFA, Advisor Perspectives.