Benchmarking Investments and Managers

In investment practice, we use benchmarks as

  • reference points for segments of the sponsor’s portfolio,
  • communication of instructions to the manager,
  • communication with consultants and oversight groups (e.g., a board of directors),
  • identification and evaluation of the current portfolio’s risk exposures,
  • interpretations of past performance and performance attribution,
  • manager selection and appraisal,
  • marketing of investment products, and
  • demonstrations of compliance with regulations, laws, or standards.

A benchmark should reflect the investment process and the constraints that govern the construction of the portfolio. If the benchmark does not reflect the investment process, then the evaluation and analysis that flow from the comparison with the benchmark are flawed.

Benchmarks communicate information about the set of assets that may be considered for investment and the investment discipline. They provide investment managers with a guidepost for acceptable levels of risk and return and can be a powerful influence on investment decision making.

Benchmarks help analysts measure the effectiveness of a manager’s decisions to depart from benchmark weights.

Asset-Based Benchmarks

Absolute. An absolute benchmark is a return objective that aims to exceed a minimum target return. An example would be the minimum acceptable return (MAR) that is used in computing the Sortino ratio.

  • Simple and straightforward benchmark.
  • Absolute return objective is not an investable benchmark.

Broad market indexes. There are several well-known broad market indexes that are used as benchmarks (e.g., S&P 500 for U.S. common stocks).

  • Well recognized, easy to understand by clients, and widely available.
  • Unambiguous, generally investable, measurable, and may be specified in advance.
  • Appropriate to use if it reflects the current investment process of the manager.
  • Manager’s style may deviate from the style reflected in the index

Style indexes. Investment-style indexes represent specific portions of an asset category. Four well-known U.S. common stock style indexes are (1) large-capitalization growth, (2) large-capitalization value, (3) small-capitalization growth, and (4) small-capitalization value.

  • They are widely available, widely understood by clients, and widely accepted.
  • If the index reflects the manager’s style and it is investable, it is an appropriate benchmark.
  • Some style indexes can contain weightings in certain securities and sectors that may be larger than considered prudent.
  • Differing definitions of investment style can produce quite different benchmark returns, making them inappropriate benchmarks.

Factor models involve relating a specified set of factor exposures to the returns on an account. A well-known one-factor model (CAPM) is the market model where the return on a portfolio is expressed as a linear function of the return on a market index.

A generalized factor model equation would be:

  • RP = ap + b1F1 + b2F2 + … + bKFK + ε


RP = periodic return on an account

ap = “zero factor” term, representing the expected value of RP if all factor values were zero

Fi = factors that have a systematic effect on the portfolio’s performance;

i = 1 to Kbi = sensitivity of the returns on the account to the returns generated from factor iε = error term; portfolio return not explained by the factor model

Some examples of factors are the market index, industry, growth characteristics, a company’s size, and financial strength. The benchmark portfolio (normal portfolio) is the portfolio with exposures to the systematic risk factors that are typical for the investment manager. The manager’s past portfolios are used as a guide.

  • It is useful in performance evaluation.
  • It provides managers and sponsors with insight into the manager’s style by capturing factor exposures that affect an account’s performance.
  • Focusing on factor exposures is not intuitive to all managers or sponsors.
  • The data and modeling are not always available and may be expensive to obtain.
  • It may be ambiguous because different factor models can produce different outputs, leading to misspecification.

Returns-based benchmarks are constructed using (1) the managed account returns over specified periods and (2) corresponding returns on several style indexes for the same periods. Those return series are submitted to an allocation algorithm that solves for the combination of investment-style indexes and most closely tracks the account’s returns.

  • Generally easy to use and intuitive.
  • Meets the criteria of a valid benchmark.
  • Useful where the only information available is account returns.
  • The style indexes may not reflect what the manager owns or what the manager or client would be willing to own.
  • Enough monthly returns would be needed to establish a statistically reliable pattern of style exposures.
  • Will not work when applied to managers who change style.

Manager universes. The median manager or fund from a broad universe of managers or funds (that follows a similar investment process) is used as the benchmark. The median manager is the fund that falls at the middle when funds are ranked from highest to lowest by performance.

  • It is measurable.
  • Manager universes are subject to “survivor bias,” as underperforming managers often go out of business and their performance results are then removed from the universe history.
  • Fund sponsors who choose to employ manager universes must rely on the compiler’s representations that the universe has been accurately compiled.
  • They cannot be identified or specified in advance, so it is not investable; thus, it’s not an acceptable benchmark.

Custom security-based benchmarks are designed to reflect the manager’s security allocations and investment process.

  • Meets all the required benchmark properties and all the benchmark validity criteria.
  • Allows continual monitoring of investment processes.
  • Allows fund sponsors to effectively allocate risk across investment management teams.
  • It can be expensive to construct and maintain.
  • A lack of transparency by the manager (e.g., hedge funds) can make it impossible to construct such a benchmark.

Properties of a Valid Benchmark

The choice of benchmark often has a significant effect on the assessment of manager performance. Investment managers should be compared only with benchmarks that reflect the universe of securities available to them. A valid benchmark must satisfy certain criteria.

  • Unambiguous—The individual securities and their weights in a benchmark should be clearly identifiable.
  • Investable—It must be possible to replicate and hold the benchmark to earn its return.
  • Measurable—It must be possible to measure the benchmark’s return on a reasonably frequent and timely basis.
  • Appropriate—The benchmark must be consistent with the manager’s investment style or area of expertise.
  • Reflective of current investment opinions—The manager should be familiar with the securities that constitute the benchmark and their factor exposures.
  • Specified in advance—The benchmark must be constructed prior to the evaluation period so that the manager is not judged against benchmarks created after the fact.
  • Accountable—The manager should accept ownership of the benchmark and its securities and be willing to be held accountable to the benchmark.

Evaluating Benchmark Quality

A portfolio return can be broken up into three components: market, style, and active management.

  • P = M + S + A


P = investment manager’s portfolio return

M = return on the market index

S = B − M = excess return to style; difference between the manager’s style index (benchmark) return and the market return—S can be positive or negative

A = P − B = active return; difference between the manager’s overall portfolio return and the style benchmark return

This relationship recognizes first that the manager’s style benchmark can earn more or less than the market.

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