What it means
A number on its own says little. A fund that returned 12% did well if the market returned 8% and badly if it returned 20%.
A factory with a 4% scrap rate is efficient if the industry runs at 7% and wasteful if best practice is 1%. Benchmarks supply the comparison.
The choice of benchmark is therefore a decision with consequences, and a poorly chosen one produces the wrong conclusions: a global equity fund measured against a domestic index, or a luxury retailer measured against discount-store margins, is being judged by an irrelevant standard. In investment, the benchmark should match the fund's mandate: the same asset class, region, style and risk.
Performance is then reported as relative return (fund return minus benchmark return) and, more usefully, as risk-adjusted measures such as alpha, information ratio and tracking error. The benchmark also defines what passive investing means: an index fund's aim is to match the benchmark at minimum cost, and an active fund's fee is justified only by beating it after costs.
Because benchmarks are so central to fees and careers, their selection and any change to them are scrutinised by investors and regulators. In business, benchmarking is the practice of comparing processes and results with those of other organisations, competitors, industry averages or internal units, to identify where performance falls short and what better looks like.
External benchmarks come from industry surveys, published accounts, consultants and trade bodies; internal benchmarks compare branches, plants or teams with the best performer in the group. The value lies less in the number than in the investigation it prompts: why does the best plant achieve 98% on-time delivery when ours achieves 91%, and what would it take to close the gap?
Benchmarks have limits. Averages hide the spread, and being average is not a goal.
Comparisons across businesses with different models, scales or accounting policies mislead unless adjusted. And a benchmark can become a ceiling: an organisation that reaches the industry average may stop, when the leaders are far ahead.
The best use of a benchmark is to ask a question, not to answer one.
In practice
Real-world examples.
Example
A pension fund sets its equity manager a benchmark of the world equity index and pays a performance fee only on returns above it.
Example
A hospital benchmarks its average length of stay for hip replacements against national data and finds it two days above the median, prompting a review of discharge planning.
Example
A software company benchmarks its sales and marketing spend as a percentage of revenue against a survey of peers at the same growth stage and concludes it is underinvesting.
Think of it
“A benchmark is like a yardstick for measuring performance. Just as you measure height against a ruler, you measure investment returns against a standard.
Formula
Calculation
Relative Return = Portfolio Return minus Benchmark Return
Tracking Error = Standard deviation of (Portfolio Return minus Benchmark Return) over time
Information Ratio = Average Relative Return / Tracking Error
Performance Gap (business) = Benchmark Value minus Own Value, expressed in units or as a percentage of own value
Worked example 1, investment. A European equity fund returned 9.5% in a year. Its benchmark, a broad European equity index, returned 7.0%. Over the last five years the fund's annual relative returns were +2.5%, minus 1.0%, +3.0%, +0.5% and +2.5%.
- Relative return this year = 9.5% minus 7.0% = +2.5%
- Average relative return over five years = (2.5 minus 1.0 + 3.0 + 0.5 + 2.5) / 5 = 1.5% a year
- Tracking error (standard deviation of the five relative returns) = about 1.7%
- Information ratio = 1.5% / 1.7% = 0.88
An information ratio approaching 1.0 is generally regarded as strong: the manager has added return consistently relative to the risk taken away from the benchmark. If the fund's fee is 0.8% a year, the net relative return of 0.7% still favours the fund, though less decisively.
Worked example 2, business. A regional logistics company benchmarks its cost per delivery against an industry survey:
- Own cost per delivery: $9.40
- Industry median: $8.10
- Top quartile: $6.90
- Gap to median = $1.30 per delivery (16% above median); gap to top quartile = $2.50 (36% above)
- On 1,200,000 deliveries a year, reaching the median would save $1,560,000; reaching top quartile would save $3,000,000
The company investigates the top-quartile operators and finds that their route density is higher and their vehicle utilisation 12 points better, which points to route planning and depot consolidation rather than to wages, where the company had assumed the gap lay.Case study
Seen in the real world.
A mid-sized manufacturer had used its own prior year as its only benchmark for a decade, and each year's modest improvement was reported as success. A new finance director obtained an industry benchmarking study and found the company in the bottom quartile on inventory turns (3.1 against a median of 5.5), on-time delivery (86% against 94%) and administrative cost as a share of revenue (14% against 9%). The gaps had been growing for years while the company congratulated itself on beating last year.
The board set targets at the industry median within two years and top quartile within four, visited two of the top-quartile companies to see how they operated, and rebuilt planning and administrative processes accordingly. Inventory turns reached 5.2 in two years, releasing $4 million of cash; on-time delivery reached 95%; and administrative costs fell to 10%. The finance director's comment was that the company had been running a race against itself and calling every finish a win.
Watch out
Common mistakes.
- Choosing a benchmark that does not match what is being measured. A mismatched benchmark makes performance look better or worse than it is.
- Treating the average as the goal. The average is where half the competitors are worse; the leaders define what is possible.
- Comparing figures without adjusting for differences in accounting, scale or business model.
Questions
People also ask.
How do I choose an investment benchmark?
Match the fund's asset class, geography, style and risk. The benchmark should be investable, transparent and representative of the fund's opportunity set.
What is the difference between a benchmark and a target?
A benchmark is a comparison point derived from the market or from peers. A target is a level the organisation chooses to aim for, which may be set relative to a benchmark.
Where do business benchmarks come from?
Industry surveys, trade associations, consultants, published financial statements of competitors, and internal comparisons between units. External data must be checked for comparability.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%