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 (generate positive alpha)
Think of it this way: A benchmark answers the question, "Could I have just bought an index fund instead?" If the manager's returns lag the benchmark after fees, the answer is yes.
Common Benchmark Indices
| Benchmark | What It Tracks |
|---|---|
| S&P 500 | 500 large-cap U.S. equities |
| Russell 2000 | Small-cap U.S. equities (smallest 2,000 stocks in the Russell 3000) |
| MSCI EAFE | International developed market equities: Europe, Australasia, Far East (excludes U.S. and Canada) |
| Bloomberg U.S. Aggregate Bond Index | U.S. investment-grade bonds (Treasuries, corporates, mortgage-backed securities, agencies) |
| MSCI Emerging Markets | Emerging market equities (China, India, Brazil, etc.) |
Exam Tip: Gotchas
- S&P 500 is for large-cap U.S. stocks only. It does not apply to small-cap, international, or bond portfolios.
- 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 the entire U.S. market.
- Bloomberg Aggregate Bond Index is for investment-grade U.S. bonds. It does not cover high-yield or international 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.
Selecting 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
- 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
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 Benchmark Selection Matters
- 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 has not failed; bonds and stocks are different asset classes
- 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.