A benchmark serves a crucial role in investing. Often a market index, a benchmark provides a starting point for a portfolio manager to construct a portfolio and directs how that portfolio should be managed on an ongoing basis from the perspectives of both risk and return. It also allows investors to gauge the relative performance of their portfolios; an annual return of 6% on a diversified bond portfolio may seem strong, but if the portfolio’s benchmark returns 7% over the same time period, the bond portfolio has fallen short of its goal. The number of benchmarks is virtually endless, and selecting the right one is not always easy. To try to simplify the selection process, we examine in this blog what a benchmark is, how it is calculated, and why portfolio performance may differ from that of the benchmark. Benchmarks should be investable, but it is possible that a universe of shares and bonds (securities) in a benchmark may be so broad that it would not be practical to purchase all of them. In other cases, a benchmark may contain securities that are difficult to purchase.
In most cases, investors choose a market index, or combination of indexes, to serve as the portfolio benchmark. An index tracks the performance of a broad asset class, such as all listed stocks, or a narrower slice of the market, such as technology company shares. Because indexes track returns on a buy-and-hold basis and make no attempt to determine which securities are the most attractive, they represent a “passive” investment approach and can provide a good benchmark against which to compare the performance of a portfolio that is actively managed. Using an index, it is possible to see how much value an active manager adds and from where, or through what investments, that value comes.
These are among the most widely followed stock indexes, or benchmarks:
FTSE100: U.K. Market capitalisation-weighted index of the 100 largest U.K. companies traded on the London Stock Exchange (e.g. BT Group PLC, GlaxoSmithKline PLC, Rolls Royce PLC, BP PLC, Vodafone PLC, AstraZeneca PLC)
DJIA : U.S. Price-weighted average of 30 large publicly traded U.S. “blue chip” stocks (e.g. Intel, Alcoa, IBM)
Hang Seng Index: Hong Kong. Free float-adjusted market capitalisation-weighted index of the 45 largest companies on the Hong Kong stock market. (e.g. Cathy Pacific, FoxConn)
MSCI World Index: Global Equities. Free float-adjusted market capitalisation index consist of 24 developed market country indexes, 6000 companies.
NASDAQ Composite: U.S. More than 3,000 technology and growth domestic and international based companies on the NASDAQ stock market (e.g. Oracle Corporation, Cisco Systems, Yahoo, Google, Sybase)
Nikkei 225: Japan. 225 leading stocks traded on the Tokyo Stock Exchange (e.g. Sony, NTT, Toshiba, NEC)
S&P 500: U.S. 500 leading companies in the Large-Cap segment of the U.S. equities market. (e.g. AT&T, JP Morgan Chase, ExxonMobil)
Numerous other equity indexes have been designed to track the performance of various market sectors and segments. Because stocks trade on open exchanges and prices are public, the major indexes are maintained by publishing companies like Dow Jones and the Financial Times, or the stock exchanges. Fixed income securities do not trade on open exchanges, and bond prices are therefore less transparent. As a result, the most commonly used indexes are those created by large broker-dealers that buy and sell bonds, including Barclays Capital (which now also manages the indexes originally created by Lehman Brothers), Citigroup, J.P. Morgan, and BofA Merrill Lynch. Widely known indexes include the Barclays U.S. Aggregate Bond Index, tracking the largest bond issuers in the U.S., and the Barclays Global Aggregate Bond Index of the largest bond issuers globally. Actually, bond firms have created dozens of indexes, providing a benchmark for virtually any bond market exposure an investor might want. Barclays Capital alone publishes more than 30 different bond indexes. New indexes are often created as investor interest grows in different types of portfolios. For example, as investor demand for emerging market debt grew, J.P. Morgan created its Emerging Markets Bond Index in 1992 to provide a benchmark for emerging market portfolios.
Indexes also exist for other asset classes, including property (real estate) and commodities