Using benchmarks in investing

A benchmark is a standard or measure that can be used to analyze the distribution, risk, and return of a given portfolio. Individual funds and investment portfolios typically have established criteria for standard analysis. You can also use various tests to understand how a portfolio performs in different market segments.

Investors often use the S&P 500 Index as a benchmark for stock performance because the S&P Index consists of the 500 largest publicly traded companies in the United States. However, there are many types of benchmarks that investors can use, depending on the investment, risk tolerance and time horizon.

Understanding Tests

Benchmarks include a portfolio of unmanaged securities representing a specific market segment. Institutions manage these portfolios, known as indexes. Some of the most common institutions known for managing indexes are Standard & Poor's (S&P), Russell and MSCI.

Indices represent different classes of investment assets. The benchmark may include broad metrics such as the Russell 1000 or specific asset classes such as small-cap U.S. emerging stocks, high-yield bonds or emerging markets.

Many mutual funds in the investment industry use indexes as the basis for their replication strategy. Mutual funds are a pool of investment funds that are actively managed by portfolio managers and are invested in a variety of securities such as stocks, bonds and money market instruments. The fund's financial managers attempt to provide capital appreciation or income to the fund's investors.

Exchange traded funds (ETFs) also use indexes as the basis for a passive replication strategy. ETFs typically track an index, such as the S&P 500 for stock ETFs. ETFs invest in all the securities of an underlying index, so they are considered passively managed funds.

Investing in a passive fund is primarily the only way a retail investor can invest in an index. However, the evolution of ETFs has led to the emergence of smart beta indexes, which offer customized indexes that rival the capabilities of active managers. Smart Beta Indexes use advanced methodologies and a rules-based system to select investments to place in a portfolio. Smart beta funds are essentially a middle ground between a mutual fund and an ETF.

Management of risks

To help manage risk, most people invest in a diversified portfolio that includes multiple asset classes, typically using stocks and bonds. Risk metrics can be used to help understand the risks of these investments. Risk is most often characterized by variability and volatility. The size of the change in portfolio value measures volatility. Investment funds that hold commodities whose prices fluctuate significantly up and down are subject to increased volatility. On the other hand, volatility measures the frequency of changes in value. In general, the more variability, the higher the risk.

Several metrics are used to assess the risk and reward of a portfolio, including the following:

Standard deviation

Standard deviation is a statistical measure of volatility calculated by calculating the deviation of an investment's price movement from the average or average return over a period. The greater the deviation between each investment price and the average; the larger the price range or standard deviation. In other words, a higher standard deviation indicates greater volatility and greater risk.

Beta

Beta is used to measure volatility relative to a benchmark. For example, a portfolio with a beta of 1.2 is expected to move 120% up or down whenever the benchmark changes. A portfolio with a lower beta is expected to have less up and down movement than the benchmark portfolio. Beta is typically calculated using the S&P 500 index as a benchmark.

Sharpe ratio

The Sharpe ratio is a widely used measure of risk-adjusted return. The Sharpe ratio is the average return over the return on a risk-free investment such as U.S. government bonds. A higher Sharpe ratio indicates higher risk-adjusted total returns.

These measures are typically reported by managed investment funds as well as index providers.

Portfolios and benchmarking

Fund companies use benchmarks as a measure of a portfolio's performance relative to its investment environment. Portfolio managers typically select a benchmark that is appropriate for their investment area. Active managers strive to outperform their benchmarks, meaning they strive to generate returns that exceed the return of the benchmark. However, it is important to keep in mind that an investor may not necessarily invest in all of the securities in an index, and therefore any investment is subject to some associated fees that reduce the return of the index.

Investors can also use individual indices in combination with risk measures to analyze their portfolios and select portfolio allocations. Below are the three most common criteria for analyzing and understanding the market environment and various investment opportunities.

S&P 500 Index

In general, an investor may want to use the S&P 500 Index as a benchmark for stocks because it is the best indicator for large U.S. public companies. The S&P is the most widely used benchmark for stocks and is generally a litmus test for evaluating the performance of a portfolio or fund.

Bloomberg agency

Agg or Bloomberg US Aggregate Bond Index is an index that measures the performance of a variety of fixed income securities, including corporate bonds, US government bonds, asset-backed securities and commercial mortgage-backed securities, that are traded in the United States. Agg is used by bond traders, mutual funds and ETFs as a benchmark to measure the relative performance of the bond or fixed income market.

US Treasuries

U.S. Treasury securities are bonds that generally pay a fixed rate of return and are backed by the U.S. Treasury. Treasury bonds are considered the safest investment possible. Many investment funds and portfolio managers use short-term Treasury bonds, such as those with a maturity of one or two years, as a benchmark for the risk-free rate of return. In other words, if an investment portfolio does not earn at least the equivalent of one year's worth of Treasury security, the investment is not worth the risk for investors.

To help determine an appropriate investment benchmark, an investor must first assess his or her risk. For example, if you are a moderate risk taker (your profile is a six on a scale of 1 to 10), a suitable guideline might be a 60-40% distribution, which includes:

• A 60% investment in the Russell 3000 Index, focused on a market-cap-weighted index universe of large-, mid- and small-cap U.S. stocks.
• 40% investment in the Bloomberg US Aggregate Bond Index, which includes a universe of investment grade US government and corporate bonds.

In this scenario, the investor would use the Russell 3000 Index as a benchmark for equities and Bloomberg Agg as a benchmark for fixed income. They may also want to use the Sharpe ratio to ensure they are optimally diversified and get the greatest reward each time they spread their risk.

Comprehensive risk consideration

Risk is a central component of all investment decisions. Simply by using the performance and risk of an index relative to an investment, an investor can better understand how to allocate their investments most wisely. Risk levels generally vary between investments in stocks, fixed income and savings. Generally, most investors with longer time horizons are willing to invest more in higher-risk investments. Shorter time horizons or a greater need for liquidity (or the ability to convert it into cash) will result in less risky investments in fixed income and savings products.

Guided by these allocations, investors can also use indexes and risk measures to monitor their portfolios in a macro investing environment. Markets may gradually change risk levels depending on various factors. Economic cycles and monetary policy can be key variables influencing the level of risk. Active investors who use appropriate benchmarking techniques can often be more willing to capitalize on investment opportunities as they develop. Comparing the performance and risk of various indicators across a portfolio or specifically to investment fund mandates can also be important to ensure optimal investment.

Bottom line

Benchmarks are tools that investors can use in different ways. All managed funds will have a set benchmark against which the fund's performance can be assessed.

Investors can also go beyond the standard use of benchmarking. Using indexes to allocate investments to passive funds with specific portfolio allocations can be an advanced benchmarking option. Active investors can also select a range of criteria across the risk spectrum, analyzing these criteria along with risk characteristics to ensure their investments are optimally placed for the lowest risk and highest possible return. Monitoring benchmarks and risk indicators also allows investors to potentially identify opportunities to change portfolio investments to take advantage of market opportunities.

Overall, considering different indicators along with their risk characteristics can be a simple method for all types of investors. Using benchmarks can be very helpful when analyzing current and potential investments. It can also be an effective way to ensure that an investor's portfolio is optimally diversified and aligned with their goals.