What is Benchmark and How Can Investors Use Benchmark Effectively?

What Is a Benchmark?

Anything that acts as a standard against which all other things are compared is called a benchmark. Benchmarks are used by investors to evaluate the performance of stocks, mutual funds, Exchange Traded Funds (ETFs), etc. They play a very critical role in the world of investing.

In the stock market, a particular index is used as the benchmark to evaluate sectoral performance, similar-sized companies, etc. This helps a portfolio manager to understand whether his investment strategy has underperformed or outperformed the benchmark index. For example, the Nifty Bank index comprises the largest and most liquid banking shares listed on the National Stock Exchange (NSE) and thus portrays a picture of the entire banking sector’s performance.

Moreover, an index is an unmanaged (no human involvement) benchmark, which is why it is deemed as the default standard and tracked on a daily basis to pit against the other securities in evaluating their performance. When actively managed funds are compared with such passive benchmarks, the true picture comes to light. Even investors can make a comparative analysis and figure out whether their fund managers are actually adding any value to their investments.

A benchmark also aids fund managers in gauging whether their investments are deployed in riskier or safer securities. Sometimes a benchmark may even be a combination of market indices. Indices track many different asset classes such as real estate, commodities, etc.

How does Benchmark works?

When a stock is compared with a benchmark index (of a sector, industry, or market segment), a difference appears in its performance. This is known as ‘tracking error.’ It can either be positive or negative and is recorded as a standard deviation percentage.

In actively managed portfolios, the tracking error shows up when the fund manager makes an investment call as he tries to continuously improve the portfolio’s returns. If the investment decision is correctly made, the resulting tracking error is positive. And if not, then it is negative.

This comparison is, however, not possible in the case of a diversified portfolio as a single benchmark index does not suffice. Such analysis involves a part-by-part comparison of the portfolio based on how the asset allocation is done.

Irrespective of whether the portfolio is actively managed or passively, it may contain some securities that are not tracked by the benchmark index. This may happen because the index might be using securities that are much harder to buy. In such cases, the fund manager replaces it with a security that is similar in nature to the one being used in the benchmark index. Such decisions help in reducing tracking errors.

Sometimes, it may happen that the securities comprising the benchmark index may be replaced by the governing body. This happens when the security gets downgraded based on certain metrics. These securities are then replaced by other similar securities that are performing better and growing faster. If a fund manager has to make the same replacement for an actively managed portfolio, he incurs a cost. But the replacement in the index does not cost anything, which then ends up adding to the tracking error.

At times, fund managers may not even follow the replacement done in the index and choose a security based on their own research and analysis. Such decisions that do not match the benchmark index are attempts to beat it by outperforming it.

Are there benchmark standards to consider?

A plethora of benchmarks are available at our disposal. Choosing a specific one to suit our investment needs can become a tedious job. In order to make this easier, here are a few things to consider before making that choice:

• Investment Objective & Risk Appetite:

  Investors must have a defined return in mind, beyond which greed must not get the better of them. When the returns are set in their minds, they need to figure out how much are they willing to risk in the process of trying to beat the market returns. Lower risk tolerance implies that you should choose benchmarks that track securities with a very good credit rating, and vice versa.

• International Investment: 

  If you wish to take your investment global, you should know that the foreign exchange rates also fluctuate every day. In such cases, you should choose an ‘unhedged index,’ which factors in these gyrations with lesser diversification. But if your goal is capital preservation, then a ‘hedged index’ should be followed, which is more diversified and a safer bet.

Conclusion:

Investors must remember that no matter which benchmark index they choose to follow, it must have all details explicitly mentioned. It should be a transparent index with all historical data available. Moreover, the index returns should be computed daily such that an accurate comparison can be made with the portfolio securities.