What it means
A benchmark answers the question "compared with what?" If a fund returned 9% in a year, that sounds good until you learn the market it invests in returned 12%. The benchmark turns a raw figure into a judgement about whether the result was strong, average or weak.
In investing, benchmarks are usually market indices, such as a broad share index for equity funds or a bond index for fixed income funds. The manager's return is compared with the index return over the same period, and the difference is often called active return.
A fair benchmark should match the fund's style, region, risk level and currency. In business, benchmarking compares a company's own measures with peers or best performers.
These can include gross margin, cost per hire, delivery times, customer retention or overhead as a percentage of revenue. Management teams use the results to spot gaps and decide where to improve.
Benchmarks also appear in contracts and pay. Loan margins may be set above a reference rate, bonus plans may reward performance relative to a peer group, and fund fees may depend on beating an index.
Because so much depends on the choice, an inappropriate benchmark can reward or punish managers unfairly. The nuance is that a benchmark is only as useful as it is comparable.
An index of large companies is a poor yardstick for a small-company fund, and an industry average that includes very different business models can mislead. Always check that the comparison is like for like.
Finally, a benchmark should be reviewed over a sensible time frame. One quarter of lagging an index may be noise, while three years of consistent shortfall is a pattern.
Investment committees usually set a review period in advance so that decisions are not driven by short-term swings.
In practice
Real-world examples
Example 1
A pension trustee reviews three fund managers at the annual meeting. Each manager reports its return against the same benchmark index. The trustee sees that only one beat the index after fees, and puts the other two on watch. She asks each manager to explain the gap in writing before the next meeting.
Example 2
A logistics company compares its delivery cost per parcel of $4.80 with an industry survey average of $4.20. The gap of $0.60 per parcel, across 2 million parcels a year, is worth $1.2 million. The operations team launches a route optimisation project. Management sets a target to close half of the gap within a year and tracks progress every month.
Example 3
A software start-up compares its 3% monthly customer churn with a published range for similar businesses. It finds that comparable firms lose around 1% to 2% a month. The founder asks customer success to investigate why customers leave in the first 90 days. Within two quarters, a better onboarding process brings churn down to 2%.
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
Active return = Portfolio return - Benchmark return
A fund of $500,000 earns a return of 9% over a year, while its benchmark index returns 7%. Active return = 9% - 7% = 2%. In dollars, the fund earned 500,000 x 0.09 = $45,000 and the benchmark would have earned 500,000 x 0.07 = $35,000, so the manager added $10,000 relative to the benchmark.Case study
Seen in the real world
Stonebridge Wealth is a fictional investment firm that reported a 6% return on its global equity fund and described it as a good year. A client asked how that compared with the market, and the firm admitted that the index it normally used had returned 10%.
In this illustrative scenario, the client reviewed the numbers and noted that the fund was meant to track the global index closely. The firm's explanation, that it held more defensive shares, did not justify a four-point shortfall. The client moved half its money to a lower-cost index fund and asked Stonebridge to state the benchmark clearly in every report.
Stonebridge accepted the request and now publishes the benchmark, the fund return and the difference on the first page of each quarterly report. The firm found that the clearer reporting actually improved client trust, even in quarters when the fund lagged.
Watch out
Common mistakes
- Choosing a benchmark that flatters the result. Pick the benchmark before the period starts, not after you see the returns.
- Comparing against a benchmark with a different risk level. A cautious fund should not be judged against an aggressive index.
- Ignoring fees and costs. Benchmarks are often gross of fees, while investors earn returns after fees.
Questions
People also ask
What is a good benchmark?
One that is relevant, measurable, investable and agreed in advance, and that matches the style and risk of what is being measured.
Is a benchmark the same as a target?
No, a benchmark is a reference for comparison, while a target is a goal set by management.
How often should benchmarks be reviewed?
At least annually, or when the strategy of the fund or business changes.
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