What is a Benchmark?

Oct 10, 2023 By Triston Martin

A benchmark is an indicator utilized by institutional and private investors to assess a portfolio's return and risk to determine its performance in other markets. The benchmarks used to analyze standard types include the S&P 500, Barclays US Aggregate Bond Index Russell 2000, and the S&P United States REIT for real property. Investors assign standards to their portfolio managers, who evaluate the portfolio results and make investments with the anticipated performance in the investor's mind.


Understanding Benchmarks


Benchmarks are a collection of unmanaged securities representing an identified market segment. The institutions manage these portfolios, referred to as indexes. The most popular institutions for index management include Standard & Poor's (S&P), Russell, and MSCI. The indexes cover a variety of different investment asset classes. A benchmark can comprise broad measures, like Russell 1000, for instance. Russell 1000 or specific asset classes such as U.S. small-cap growth stocks or high yield bonds.


Many mutual funds within the investment industry employ indexes to establish replication strategies. Mutual funds are pools of investment funds overseen by portfolio managers and invest in various securities like bonds, stocks, and instruments in the market for the money. Money managers attempt to earn cash flow or capital gains for fund investors.


ETFs, also known as exchange-traded funds (ETFs), use indexes to create an inactive replication strategy. ETFs usually are based on an index, for instance, that of the S&P 500 for equity ETFs. ETFs are invested in all the securities that make up the index, which is why they're passively managed funds.


A passive fund is the only way an individual investor can put money into an index. But the growth of ETFs has led to the development of smart beta indexes that offer customized indexes that compete with the performance of active fund managers. Smart beta indexes employ sophisticated methods and a system based on rules for deciding which investments should be part of the portfolio. They are the middle space between mutual funds as well as an ETF.


Management of Risk


To reduce risk, most investors invest in a diversified portfolio that includes various asset classes, mostly by investing in bonds and equity. Risk metrics can be utilized to assess the risk of these investment options. Risk is typically measured by the degree of volatility and variation. The magnitude of the fluctuation in the portfolio's value is a measure of volatility. Investment funds that include commodities with larger fluctuations in value exhibit more volatility. Variability, however, is the measure of the change frequency in value. The more variation there is the greater risk. There are a variety of measures used to measure risk and reward. These include the following:



Standard Deviation


Standard deviation can be described as a measure of volatility calculated by calculating the variation in price movements of an investment compared to the average or mean return over time. The greater the difference between the price of each investment and the mean, the larger value of the range or the standard deviation. Also that a greater standard deviation means more risk and more volatility.


Beta


Beta is a measure of the level of volatility compared to an established benchmark. For instance, a portfolio with an alpha of 1.2 is likely to move by 120% upwards or downwards for any change made to the benchmark. A portfolio with a lower beta will be expected to show lower up and down movements compared to the benchmark. Beta is typically calculated using an S&P 500 benchmark as the base.


Benchmarks of Portfolios


An appropriate benchmark should be matched to the investor's style of investing and the portfolio's expected returns. It is the case that certain benchmarks are suitable for specific portfolios, but in the same way, they are not suitable in other portfolios. For instance, benchmarks like the S&P 500 can be used as an indicator for a portfolio that includes the largest-cap US stocks. However, it is important to note that this benchmark S&P 500 will not be an appropriate measure of an investment portfolio in international companies in emerging markets. The benchmark could provide inaccurate information to investors and portfolio managers.


The most well-known gauges of portfolio returns and risk include market indexes, such as the Russell 1000, Russell 2000 as well as Russell 2000, the Dow Jones Industrial Average, and the S&P 500. Other benchmarks are specific to particular industries, the security class (such as small-cap growth stock), and different market sectors. Another option is to utilize different portfolios to create benchmarks to evaluate its performance.


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