Indexes as benchmarks

Investors use indexes and averages as benchmarks, or yardsticks of investment return. These benchmarks can help you evaluate the performance of the overall market, particular market sectors and industries, individual securities, mutual funds, and ETFs.

For example, you can measure the performance of a large-cap stock fund against the S&P 500 — the standard benchmark for large-cap equity performance – because it includes many of the stocks that this type of fund holds in its portfolio. You can also measure the fund against one of the Lipper large-cap mutual fund indexes — Growth, Core, or Value, depending on the fund’s investment objective — and against a number of other indexes, including those provided by Morgan Stanley Capital International (MSCI) and Morningstar, Inc. Of course, the fund’s return can also be measured directly against the performance of funds that are its primary competitors.

What a benchmark shows

Since there’s no absolute measure of investment performance, comparing your investments to benchmarks is really the only way to evaluate your results. For example, suppose your portfolio of large-cap stocks gained 8% in a particular year. That might seem fine. But if the S&P 500 gained 15%, that means your portfolio of large-cap stocks underperformed its benchmark by a wide margin.

Of course, you may want to give your large-cap portfolio a year or two to live up to your expectations. But if your investment mix underperforms its benchmark year after year, it may be time to rethink your strategy. On the other hand, if your portfolio of mid-sized company stocks held steady in a year that the S&P MidCap 400 lost 10%, you might decide that you’ve done well under the circumstances, even though your portfolio didn’t realize any gains.

Different Benchmarks

Not all benchmarks are indexes or averages. Long-term bond yields, for instance, are commonly measured against the yield of the 30-year US Treasury bond. Similarly, the benchmark for cash equivalent investments is the return of the 13-week US Treasury bill.

Apples to apples

One thing you want to avoid is measuring the performance of one asset class or subclass against the benchmark of another. For instance, let’s say you are trying to evaluate the performance of your small-cap portfolio. In that case, an index that tracks small-company stocks, such as the S&P 600 or the Russell 2000, would be a much more accurate yardstick than a large-cap benchmark, such as the S&P 500.

From one year to the next, large-cap and small-cap stocks may report significantly different returns. For instance, in 2001, large-company stocks lost almost 12% of their value, while small-company stocks gained almost 23%. In 2007, on the other hand, large caps gained 5.49%, while small caps lost 5.22%, more than a ten percentage point spread.

The same caution applies when you evaluate bond performance against a benchmark. For example, the annual return on long-term US Treasury bonds tracked by a one-bond portfolio is likely to be very different from the return reported for high-yield corporate bonds or 12- to 22-year general obligation (GO) municipal bonds.

A two-way street

Just as you use benchmarks to measure performance, you can use them to evaluate the suitability of an asset class or subclass you’re considering adding to your portfolio.

Let’s say you want to diversify a stock portfolio that contains predominately large-cap stocks and you’re considering adding a small-cap mutual fund or ETF. As part of your research, you can compare the performance of the individual small-cap funds you’re investigating to the historical performance of this class overall as recorded by the S&P 600 or the Russell 2000. The benchmark will show where a particular fund fits in the universe of similar funds. (Keep in mind, however, that past performance is no guarantee of future results.)

You can also gauge how the particular characteristics of small-caps — for instance, their risk-return profile and volatility — compare to the behavior of equities included in a broader index, such as the Russell 3000 or S&P Composite 1500. Those indexes track a combination of small and large caps. The Russell 2000 is part of the Russell 3000 and the S&P 600 is included in the S&P Composite 1500.

Remember, too, that when you’re evaluating a specific mutual fund, it’s smart to compare its past performance to its target index over a number of years, rather than focusing on a single year in which the fund might have fared significantly better or worse than its benchmark.

Institutional benchmarks

Institutional investors use benchmarks as well: When an actively managed mutual fund aims to “beat the market,” its goal is to outperform the index that best matches its investment portfolio.

Some benchmarks are designed specifically for institutional investors, who use them to compare international markets, evaluate asset allocation models, determine standards for returns-based style analysis, and perform a number of other analyses. These indexes are governed by a strict set of rules that cover, among other things, the market capitalization of the stocks that may be included in a particular index.

The bigger picture

Just because an investment outperforms its benchmark in a particular year doesn’t necessarily mean it’s right for your portfolio. You still want to evaluate each investment in light of your risk tolerance, time horizon, and overall investment strategy. Similarly, an investment that misses its benchmark from time to time may still be a smart addition to your portfolio if it helps you diversify.




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