To Benchmark, Or Not To Benchmark? Paul Roberts

Assessing the relative performance of an investment portfolio is a tricky business. A return on your equity fund of, say, 5% might ‘feel’ like a good return, but is it? If similar funds (or indeed equity markets in general) returned only 3% over the same period, then yes, it is a good return, but if other funds generated 8%, then perhaps not so much.

Benchmarks should help investors judge how well or poorly an investment has done, but they should not necessarily be treated as the last word in performance assessment, particularly if an investor’s focus is on the generation on income and preservation of capital, rather than maximum absolute returns. Even if a fund has an income-target, that will offer some meaningful performance measure, but even then, how does the income generated compare to what could have been delivered if the monies had been invested elsewhere while being exposed to similar risks?

Our review of fund performance tends to look at the consistency of returns, after all our clients are typically looking for stability and certainty against which to set budgets, forecast long-term capital plans and in the delivery of services.

Stratospheric financial market returns can be great for news headlines and economic confidence, but as many investors would have seen in 2020 and into 2021, if you are holding a global equity income fund, reading that the S&P500, or some similar often-used index/benchmark, reaching newer highs does not necessarily translate into your investment reaching new highs, which is one reason not to get too hung on these types of narrow comparisons.

However, benchmarks still abound, often stated as a direct measure for investors to judge their fund’s performance, but at other times what the fund manager will refer to as a ‘comparator’, suggesting a softer, less direct, measure against which to make an appraisal. This can, for instance, be where the fund’s investment objective and strategy do not attempt to replicate the benchmark. 

So, despite the difficulties of meaningfully assessing performance using benchmarks, for investors who wish to review in greater detail, what should be considered when assessing both performance against the benchmark and the benchmark itself?

At its most basic level, a benchmark is a collection of securities or risk factors which represent the investment characteristics of an asset category or a fund manager’s investment process. In terms of the asset category, a benchmark can be seen as a collection of securities the manager would own if the fund were invested in a single passive fund, such as the FTSE 100 index. Active managers then typically aim to achieve higher returns than the investor could otherwise obtain from choosing to invest passively in a basket of those securities or index.

For a benchmark to be a valid tool against which to judge performance, it should have some basic properties which investors are aware of when determining if it allows useful and meaningful comparisons. These include being:

Unambiguous – are the names of the index and, if a hybrid, their weights which comprise the benchmark clearly defined?

Investable – could an investor choose to passively hold the benchmark stocks if they do not want to pay for active fund management?

Measurable – can the return achieved by the benchmark be easily calculated on a frequent basis? If not, meaningful performance comparison is going to be difficult, if not impossible.

Appropriate – is the benchmark consistent with the strategy of the fund? If the fund is focused on investing in UK-based large market capitalisation companies, does the benchmark reflect this?

Specified in advance – has the benchmark been specified from the start of the investment period and has it remained the same throughout the performance time horizon being analysed?

If the answer to the properties above is ‘no’, this compromises the benchmark’s effectiveness as an investment management tool and investors should question its relevance and appropriateness.

Some types of benchmark are more straightforward and easier to understand than others, with among the most common being a broad market index such as the FTSE 100 or FTSE All Share. These types of benchmarks would tend to comply with the properties above, but investors should be wary of a benchmark not being appropriate for a fund’s style, such as a small-cap fund using the FTSE 100 as a benchmark which clearly does not represent the fund’s investable universe.

Judging other types of benchmark are more difficult such as absolute return or minimum target return which while easy to understand, it is generally unclear as to what passive investable alternatives are available against which to judge performance for taking the same risks. Moreover, a benchmark based on median fund manager performance might be measurable, but the median manager cannot be specified in advance or is investable, nor is a passive alternative to the median manager can only identified after the investment period has ended.

Despite their issues, benchmarks (and ‘comparators’) remain in common use and can certainly serve a purpose as a tool for investors to assess performance. However, as has hopefully been outlined above, for that assessment to be meaningful and appropriate is not always as straightforward as might be hoped. If an investment is achieving an investor’s long-term goals, then perhaps that is a good enough performance assessment, after all, without a fully functioning crystal ball, consistently achieving the best possible returns year after year among many alternatives will be next to impossible.

Related Insights:

What are the Alternatives?

Counterparty Due Diligence

The S Factor