The term benchmark is often used and misused in the investment world. What exactly is a benchmark and why is choosing the correct benchmark so important when it comes to evaluating one’s investment performance?
Simply put, a benchmark is a standard or point of reference to which things may be compared or assessed. When it comes to your portfolio, solely knowing your performance isn’t as informative as also knowing how you performed relative to a valid point of comparison or benchmark. For instance, if you gained 10% for the year you might feel good. However, if the “market” gained 15%, you suddenly don’t feel as good.
In the investment world, a benchmark can be different things. It can be an index like the S&P 500 that represents a cross-section of the market. Or it can be something blended/customized to more accurately assess a blended/diversified portfolio. At the end of the day, for something to be a valid benchmark, it must meet the following criteria (SAMURAI):
- Specified in advance: determined in advance of an evaluation period
- Appropriate: consistent with investment style
- Measurable: readily calculable on a frequent basis
- Unambiguous: identities and weights of securities are clearly defined
- Reflective of current investment options: have current knowledge of securities in the benchmark
- Accountable: there is accountability for the constituents of the benchmark
- Investable: it is possible to invest in the benchmark itself
Let’s use the S&P 500 as an example. Does it meet the benchmark criteria? It is certainly a well-known, well-specified index. It represents the 500 largest publicly traded companies in the U.S. stock market so it’s consistent with an investment style. It’s calculated every day. At any given time, it’s possible to know which 500 stocks are in the index and in what proportions. And it is possible to invest directly in the index through an exchange traded fund like the iShares S&P 500 or a mutual fund like the Vanguard 500. The S&P 500 is definitely a benchmark.
How does this benchmark talk relate to BDF’s investment strategy? Every quarter we report to clients on their performance. We illustrate how they did in an absolute sense and how they did relative to different indexes or benchmarks. One of those indexes is the S&P BMI (Broad Market Index) Global. It represents the global stock market and is comprised of over 12,000 holdings across 49 countries. It’s been a publicly available index since 1994 and its value/performance is calculated every day. Yet does it meet all the criteria? The answer is no. Where the S&P BMI Global falls short is that Standard & Poors does not publicize the identities and weights of the securities in the index and therefore, there are no ETFs or mutual funds that invest in the index. So, the S&P BMI Global is neither unambiguous nor investable.
As a result, we will switch from the BMI to the MSCI ACWI (All Country World Index) as a benchmark for the global stock market. Although the ACWI covers 47 countries and has fewer overall holdings than the BMI, it meets all the benchmark criteria. ACWI is much more transparent in terms of its holdings (identities and proportions). The ACWI is investable as there are several ETFs/funds that capture the index. Furthermore, its allocation to large companies and small companies better represents the true global market. Despite the small differences in how the BMI and ACWI are composed, they move in lock-step the majority of the time.
Benchmarks can be boring but are an essential component to investing as they offer a true way to evaluate how your portfolio has performed. To do that well, using benchmarks that are appropriate, transparent, and meet all the criteria, is critically important.