Investment Basics

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 article what a benchmark is, how it is calculated, and why portfolio performance may differ from that of the benchmark. A second article, "Benchmarks: Selecting a Benchmark", discusses the factors to consider when trying to find the best benchmark for an investment portfolio. Benchmarks should be investable, but it is possible that a universe of 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.

What Is a Benchmark?
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 stocks. 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:

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 real estate and commodities, and these may be of particular interest to investors concerned about inflation. A couple of examples are the Dow Jones U.S. Select Real Estate Investment Trust (REIT) Index and the Dow Jones-UBS Commodity Index. 

Index Methodologies: Market Capitalization and Alternatives
The major index providers use specific, predetermined criteria, such as size and credit ratings, to determine which securities are included in a particular index. Index methodologies, returns and other statistics are usually available through the index publisher’s website or through news services such as Bloomberg or Reuters.

Instead of averaging stock or bond prices, indexes typically weight each component; the most common weighting is based on market capitalization. Companies with more equity or debt outstanding receive higher weightings and therefore have greater influence on index performance. Big price swings in the stocks or bonds of the largest companies can create big price movements in an index.

To reduce the volatility that may result with market cap weighting and potentially improve performance, alternative indexing methodologies have emerged in recent years. Among these, fundamental indexing, developed by PIMCO subadviser Rob Arnott and Research Affiliates, selects and weights components using fundamentals such as sales, cash flow, book value and dividends.

Bond indexes using market cap weighting can have a troubling twist: The most influential components may also have the biggest debt loads, which can be a sign of deteriorating finances. In part to avoid overexposure to highly indebted countries and companies, PIMCO introduced a bond index in 2009 based on gross domestic product, called the PIMCO Global Advantage Bond Index (GLADI)^TM, which attempts to identify investment opportunities in fast-growing economies. GLADI also includes more instruments than a typical bond index, such as swaps and inflation-linked bonds. Markit LLC, an independent and unaffiliated leading financial information services company and global index provider, administers and calculates the GLADI index.

Measuring Performance: Tracking Error
Tracking error measures the dispersion of portfolio returns in excess of its benchmark and, therefore, the consistency of a manager’s excess performance. Tracking error is always a positive number, defined as follows: tracking error = annualized standard deviation of monthly excess returns

Note that a manager does not necessarily have tracking error simply because of outperformance or underperformance. By the above definition, a manager who outperformed (or underperformed) by, for example, exactly 20 basis points every single month would have zero tracking error, despite a positive (or negative) alpha.

There are several possible sources of tracking error. For reasons of liquidity, portfolio size, and also a manager’s active views, an investment portfolio may hold securities different from its benchmark. When expressing active views within a portfolio, a manager aspires to outperform the benchmark, deliberately seeking returns different from the index. Additionally, the benchmark may contain so many securities that it is impractical to hold them all, or it may contain securities that are hard to buy, prompting the portfolio manager to substitute similar securities.

Investors should be aware of the holdings in their portfolios compared with those in their benchmarks in order to understand why their portfolios may perform differently.

An investor should carefully consider the underlying risks contained in an index and their risk tolerance when evaluating an index. All investments contain risk and may lose value.