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An investment benchmark is a standard against which the performance of a portfolio or investment counsellor can be measured. Whatever the difference between the performance of the portfolio and the benchmark, it's important to determine why the portfolio performed the way it did.

For instance, if a portfolio outperformed its benchmark, did the investment counsellor take more risks than the benchmark? Did wise asset allocation decisions generate the outperformance? In periods of underperformance, was the outcome driven by the asset allocation decisions, or by a large cash position that created a drag on performance?

It's also important to evaluate performance over time, beyond a single quarter or year. Because investment styles depend on financial market conditions, investment counsellors should be evaluated over complete market cycles.

Best Practices for Constructing a Benchmark

The CFA Institute, a global association of investment professionals, has developed guidelines that can help in crafting an effective benchmark for your portfolio. They recommend:

  • Establishing a benchmark before the start of the investment period. An investment counsellor who chooses a benchmark at the end of the period could select one that shows the most favourable comparison.
  • Making sure the benchmark is appropriate for the portfolio management style. For example, if the investment counsellor will be investing in large and small-cap stocks, then the S&P 500 would be a poor benchmark, as it only captures the performance of large-cap stocks.

Benchmarking Multi-Asset Class Portfolios

Selecting a benchmark for a portfolio that invests in a single asset class is relatively straightforward. For instance, a portfolio invested in Canadian large-cap stocks could be benchmarked against the S&P/TSX Composite, which tracks the universe of domestic large-cap stocks.

A multi-asset class portfolio, however, may require a customized benchmark in order to capture the performance of the investment counsellor in each asset class. A customized benchmark can help in assessing the allocations of capital across various asset classes, and may combine several market indices and weight them to create an aggregate blended benchmark. The performance of the entire portfolio can be measured against this.

A key consideration is the degree of specificity required in the benchmark to capture both asset and sub-asset classes. One option is to construct a benchmark of indices that capture broad asset classes, such as equity or fixed income investments. So if the portfolio's equity component beats the equity index over a long time period, the investment counsellor typically can be credited with astute asset allocation decisions within this broad equity asset class.

Alternatively, the benchmark could combine indices that measure sub-asset classes, like large-cap equity, mid-cap equity, small-cap equity and emerging market equity. Combining a larger number of indices allows for the measurement of the performance of each constituent part of the portfolio.

Keep an Eye on How the Indices are Constructed

When selecting the underlying indices that will be used as benchmarks, it's important to consider the way in which each index is constructed. A market-cap weighted index will be skewed toward the performance of the largest capitalization companies. In today's S&P 500 index, the performance of the index's largest market-cap stock, Apple (AAPL), has a greater impact on its performance than a smaller market-cap stock.

A price-weighted index, such as the Dow Jones Industrial Average Index, weights its constituent stocks based on their prices. For example, a Dow stock trading at $50 has five times the weight of a $10 stock.

Weighting the Indices

Measuring the effectiveness of asset allocation decisions requires the index weights in the benchmark be held constant. Generally, this is done in one of two ways:

  • Dynamic Reweighting. With this approach, the indices are reweighted at the beginning of each measurement period. This enables organizations to measure the effectiveness of the active managers chosen for each segment of the overall portfolio against the benchmark, while the impact of the active asset allocation decisions made by the investment counsellor is eliminated from the comparison between portfolio and benchmark performance. A dynamic reweighting approach helps organizations that utilize actively-managed mutual funds assess how well the managers performed.
  • A Static Policy Benchmark. With a static benchmark, the weighting of each of the constituent indices is held constant at the level that reflects the long-term targets for the investment of the portfolio. This approach allows for measuring the effect of asset allocation decisions within the portfolio. For example, if the investment counsellor has maintained an overweight allocation of U.S. large-cap equities relative to the policy benchmark, and U.S. large-cap equities outperformed other asset classes, the comparison to the benchmark would capture this outperformance.

One drawback to a static benchmark approach is that it may prove difficult to identify whether a portfolio's performance is due to asset allocation decisions or to the performance of specific managers within the overall asset allocation. However, assuming the investment counsellor is making both asset allocation and fund manager decisions, a static benchmark holds the investment counsellor accountable for all decisions and reflects the total value the manager is providing the institution.

Comparing Investment Performance to a Benchmark

Consider the following questions when comparing investment performance to a benchmark:

  • What benchmark is being used, and why was it chosen?
  • How did both the portfolio and the benchmark perform? By how much did the portfolio outperform or underperform the benchmark?
  • What does the benchmark measure and how does that compare to the portfolio's investment strategy?
  • How is the benchmark constructed and how might that have influenced its performance?
  • Were the index weights in the benchmark held constant or reweighted, and how might that have influenced its performance?
  • How did the degree of risk in the portfolio compare to that of the benchmark?

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