When it comes to investing, gains are good, and losses are bad. But how can we tell just how good or how bad our gains and losses are? That’s where benchmarking comes in.
What Is a Benchmark and How Does It Work?
In general, a benchmark is a standard against which something is compared. In investing, a benchmark is usually a stock index or a basket of securities against which the performance of one’s own investment portfolio can be compared.
Essentially, investors (and professional fund managers) use benchmarks—like the S&P 500 stock market index, for instance—as baselines against which to compare the performance of their own investments. Alternatively, an investor could choose to use an ETF or mutual fund as their benchmark since these represent real baskets of securities that produce real gains and losses.
Why Are Benchmarks Important?
An 8% increase in portfolio value over the course of a year might sound impressive, but what if the entire stock market (as measured by a total market index like the Wilshire 5000) went up in value by 10% that same year? In that case, an 8% increase in portfolio value would actually be indicative of underperformance.
This is why benchmarks are so crucial in the investing world. Not only do they allow individual investors to evaluate their own decisions; they also provide a barometer against which investors can compare the past performance of hedge funds, mutual funds, and ETFs they are considering putting their money in.
What Are the Most Common Types of Benchmarks for Investors?
Most often, investors use a stock index as the benchmark against which they compare the performance of their portfolio. For the average investor with a portfolio of equities diversified across company size and industry, any “total market” index can serve as a functional benchmark. Two of the most popular are the S&P 500, which tracks the 500 largest publicly traded American-listed companies and is weighted by market cap, and the Wilshire 5000, which tracks every publicly traded American-listed company and is also weighted by market cap.
In other cases, however, an investor may want to use a more specific index as their benchmark. For instance, an investor who only trades stocks in the industrial sector may use an industry-specific benchmark like the S&P 500 Industrials Index. Another investor who only trades smaller-sized companies might use the Russel 2000, a popular small-cap market index.
How Do Benchmarks Work for Mutual Funds?
The Securities and Exchange Commission (SEC) requires all mutual funds to select and disclose at least one “appropriate broad-based securities market index” against which to compare fund performance. This allows prospective investors to examine the degree to which the mutual fund has outperformed or underperformed the stock market in the past. Mutual funds with more specific focuses (e.g., the materials sector) can but are not required to provide a second, “narrow benchmark” that more closely matches the fund’s stated goals (e.g., the S&P 500 Materials Index).
According to a 2022 paper published by the SEC, “[r]esearch consistently shows that investors prioritize information on [past] investment performance.” Of course, past performance is not always indicative of future results, but a good reputation can go a long way when it comes to attracting investor dollars.
How Do Benchmarks Work for Hedge Funds?
Interestingly, hedge funds, which are similar to mutual funds but are only available to institutional investors and accredited investors (not retail investors), are not required to provide a benchmark index, although many choose to do so anyway in order to attract and retain clients.
Hedge funds, however, tend to use derivatives, quantitative trading, and other advanced trading strategies, so comparing their performance to a simple stock index may not be particularly meaningful, although it can be a good way to find out how effective their trading strategies are at beating the market.
What Are the Limitations of Investment Benchmarks?
Comparisons are most meaningful when the two or more things being compared are relatively similar—this makes it easier to spot any important differences. So, when it comes to investment benchmarks, it’s important to compare oranges to oranges, so to speak, rather than comparing oranges to mangoes.
For Individual Investment Portfolios
As mentioned above, for the average passive investor who creates a well-diversified portfolio of equities across industries and company sizes, any broad market index can serve as a solid benchmark. Small-cap (e.g., Russel 2000) or industry-specific (e.g., Dow Jones U.S. Auto Manufacturers Index) indexes, therefore, would be inappropriate benchmarks for this sort of investor.
On the other side of the coin, a total market index like the Wilshire 5000 would not be appropriate for an investor who only purchases specific types of equities like small-cap stocks, transportation stocks, or growth stocks.
In general, if an investor doesn’t have a solid understanding of their focus or strategy, it can be difficult to pick an index that can accurately serve as a good benchmark against which to compare portfolio performance.
For Mutual Funds and Their Investors
When it comes to the benchmarks provided by mutual funds, investors should be cautious, as the SEC rules that govern these disclosures are somewhat lax and may present the opportunity for fund managers to selectively represent fund performance by switching out benchmarks at will.
Fund managers can change their fund’s listed benchmark whenever they choose, but they must disclose the previous benchmark for a full year. This means that after a year has passed since the change, new investors may be unaware of the switch, as the fund’s prospectus will compare its entire past performance to the new benchmark. Of course, fund managers make money by attracting and retaining investors, so it behooves them to select the most advantageous broad-market benchmark index available, which may not be the most similar to the fund’s own composition and weighting.
For this reason, investors should examine a mutual fund’s holdings and weightings carefully and attempt to find a similarly composed index or fund against which to compare its past performance before deciding to invest.
Which Investment Apps Offer Benchmark Overlay Charts?
Most modern investors use some sort of digital platform, whether mobile or desktop, to choose investments, manage their portfolios, and graph their portfolio performance. Many of these digital brokerage apps and websites allow users to plot the performance of a benchmark index or fund over the graph of their own portfolio’s performance, allowing for a handy visual comparison.
Many investment apps offer both free and premium versions, and in some cases, benchmark overlay graphs may only be available to premium account holders. Robinhood’s free version, as of this article’s latest update, offers benchmark overlay functionality to all users.
