Relevant Benchmarks

With all these return measures in hand, the final question is: how do you know if a portfolio actually performed well? You need a benchmark: a standard of comparison that tells you whether the manager added value or simply rode market momentum.

What Is a Benchmark?

• A benchmark is a standard index or composite against which portfolio performance is measured
• Must be appropriate for the portfolio's investment strategy, asset class, and style
• Allows investors and advisers to determine whether a manager is adding value through active management
• Active managers are measured by their ability to outperform the benchmark on a risk-adjusted basis (e.g., generate positive alpha); beating the benchmark's raw return and having positive alpha are related but not identical, since alpha compares actual return to the return predicted by the capital asset pricing model (CAPM) for that level of risk

Think of it this way: A benchmark answers the question, "Could I have just bought an index fund instead?" If the manager's raw returns lag the benchmark after fees, that's a strong signal the answer is yes, though a full risk-adjusted comparison (alpha) is the more precise test.

What Are the Common Benchmark Indices?

Exam Tip: Gotchas

• S&P 500 is for large-cap U.S. stocks only, and it is a blend index. It does not isolate value or growth style, so it is not the best match for a large-cap value or large-cap growth fund even though it matches geography and cap size. Use the Russell 1000 Value or Russell 1000 Growth Index for those.
• MSCI EAFE excludes the U.S. and Canada. It covers international developed markets only.
• Russell 2000 is for small-cap. A common mix-up is confusing it with the Russell 3000, which covers roughly 98% of the investable U.S. equity market by capitalization.
• Bloomberg Aggregate Bond Index is for U.S.-dollar-denominated, investment-grade, fixed-rate taxable bonds available in the U.S. market. It does not cover high-yield bonds.
• Positive alpha means risk-adjusted outperformance, not just higher raw returns. The manager beat the benchmark after accounting for the level of risk taken.

How Do You Select an Appropriate Benchmark?

A portfolio should be compared to a benchmark with similar characteristics:

• Style: A value fund should be compared to a value index, not a growth index or a blend index. A large-cap value fund's benchmark is the Russell 1000 Value Index, not the S&P 500, since the S&P 500 blends growth and value stocks
• Market capitalization: A small-cap fund should be benchmarked against the Russell 2000, not the S&P 500
• Geography: An international fund should use MSCI EAFE or MSCI Emerging Markets, not a domestic index
• Asset class: A bond portfolio should be compared to a bond index, not an equity index

What Are Custom (Blended) Benchmarks?

• Multi-asset portfolios may need a custom benchmark that blends multiple indices
• Example: A 60/40 portfolio might use 60% S&P 500 + 40% Bloomberg Aggregate Bond Index
• The blend should reflect the portfolio's actual target allocation

Why Does Benchmark Selection Matter?

• An inappropriate benchmark can make results misleading
• A small-cap manager who beats the S&P 500 during a small-cap rally may look skilled, but the correct comparison is the Russell 2000
• A bond manager who underperforms the S&P 500 hasn't necessarily failed on that comparison alone; bonds and stocks are different asset classes, so the manager should be judged against an appropriate bond benchmark instead
• Advisers have a responsibility to select benchmarks that provide a fair and meaningful comparison

Exam Tip: Gotchas

• Comparing a small-cap fund to the S&P 500 (a large-cap index) is a classic example of an inappropriate benchmark. The exam frequently tests whether you can spot a mismatched benchmark. Match the benchmark to the portfolio's style, cap size, and geography.

What Should You Check on Exam Day?

• A benchmark must match the portfolio's style, market capitalization, geography, and asset class; e.g., large-cap value needs the Russell 1000 Value, not the blended S&P 500.
• S&P 500 = large-cap U.S. blend; Russell 2000 = small-cap U.S.; MSCI EAFE = international developed (excludes U.S. and Canada); Bloomberg U.S. Aggregate = investment-grade U.S. bonds; MSCI Emerging Markets = emerging-market equities.
• Comparing a small-cap fund to the S&P 500 is the classic mismatched-benchmark trap.
• Multi-asset portfolios often use a custom blended benchmark reflecting the actual target allocation, though a published multi-asset index can also be the benchmark.
• Active managers are judged by their ability to generate positive alpha (risk-adjusted outperformance versus what CAPM predicts) relative to the appropriate benchmark, which is related to but not identical to a higher raw return.