What it is:
A benchmark is a feasible alternative to a portfolio against which performance is measured.
How it works/Example:
Let's assume you compare the returns of your stock portfolio, which is a broadly diversified collection of small-cap stocks and is managed by Company XYZ, with the Russell 2000 index, which you feel is an accurate universe of feasible alternative investments. If Company XYZ's portfolio returns 5.5% in a year but the Russell 2000 (the benchmark) returns 5.0%, then we would say that your portfolio beat its benchmark.
Benchmarks help an investor communicate his or her wishes to a portfolio manager. By assigning the manager a benchmark with which to compare the portfolio's performance, the portfolio manager will make investment decisions with the eci's performance in mind.
The most commonly used benchmarks are market indexes such as the Dow Jones Industrial Average, the S&P 500, or the Russell 2000. However, there are dozens of other market indexes out there that focus on specific industry sectors, security classes, or other market segments. Investors also use other portfolios, mutual funds, or even pooled accounts to construct benchmarks. LIBOR is one of the most widely used benchmarks for short-term interest rates, and the Fed controls another common interest benchmark known as the Fed Funds rate.
A good benchmark should appropriately reflect the portfolio's investment style and strategy as well as the investor's return expectations. For example, the Russell 2000 may be an appropriate benchmark for a portfolio investing exclusively in small-cap domestic stocks, but it may be inappropriate for a portfolio investing in bonds and international REITs. Comparing a portfolio to an inappropriate benchmark could yield misleading information. The portfolio may look fantastic compared to one benchmark but lag considerably behind another. It is difficult to benchmark some portfolios effectively, especially real estate portfolios, where each asset is unique. Further, it is important to compare a portfolio with its benchmark over a long period of time.
Portfolio managers vary in their benchmark strategies. For example, passive managers seek to replicate their benchmarks. This is the strategy behind index mutual funds, which replicate broad market indexes or indexes of securities with special characteristics. Actively managed portfolios on the other hand, seek to beat benchmark returns but generally require added risk and expertise to do so.
Venture capitals frequently receive incentive fees if their portfolios exceed the benchmark return. However, it is important to structure these incentives in a manner that does not motivate a manager to unduly increase the portfolio's risk.
Why it matters:
Comparing a portfolio's returns to a benchmark is a way to measure a portfolio manager's skill. It answers the question, "What value was added by the manager's decisions." The difference in the portfolio and benchmark returns, called tracking error, quantifies this. Tracking error gives investors a sense of how "tight" the portfolio in question is around its benchmark or how volatile the portfolio is relative to its benchmark. As a result, benchmarks not only measure returns, they help measure risk and help the investor determine whether the added return adequately compensates for the risk involved.
Benchmarking lies at the heart of the controversy between passive and active management. Passive managers often note that active managers frequently fail to match or beat their benchmarks, and they question the reliability of active managers' methods for recognizing and predicting trends. Many passive managers espouse the efficient market hypothesis, which says that stock prices are random and already reflect all available information (thus concluding that it is impossible to always beat a benchmark).
Regardless, active managers who have beaten market benchmarks often enjoy a large and loyal following among investors. However, consistently beating those benchmarks remains a big challenge as does defining what benchmark they should beat in the first place.