What is a benchmark?

While benchmarks are used in numerous industries and trades, in the world of investing it represents a cross section of securities designed to give the investor or financial professional a glimpse of a particular portion of the market. Sometimes, these benchmarks index the entire globe, encompassing every sustainable and viable marketplace exchange. In other instances, the benchmark might focus on industries in a specific sector, such as oil production or extremely small companies. This at-a-glance information gives the investor an opportunity to adjust their holdings or determine how well they have done.

Why do ETFs and index mutual funds use a benchmark?

The concept of an index, whether used by a mutual fund or ETF is to provide a low-cost, transparent and close-to-matching performance (less fees) of the specific market it is attempting to mimic. Not all benchmarks are created equal, with some using the size of a company as the method of ranking how the security falls into the index. Others use fundamentals (such as sales or dividends) to create an index. Some indexes are created based on factors (such as growth or value) and still others treat every company in the index equally (large companies and small receive the same percentage of the benchmark). A well constructed index will give the investor exactly what they are looking for: performance they can gauge.

How is a benchmark constructed?

Here is where it gets tricky and quite a bit more complicated. Each benchmark uses a different methodology. It is at this point where we’ll focus on the index provider at hand, MSCI. This company employs two different types of methods in determining how their indices are built. For the equity indexes, it uses a price adjustment factor. This method, without getting too terribly technical was designed by economist Etienne Laspeyres and is based on not only price of a security now compared to the price in the previous period but the impact inflation has on it.

Does how the benchmark is built matter?

Benchmarks can actually increase the long-term performance of a particular index fund or ETF. Each benchmark faces an annual reconstitution or rebalancing. At this point, depending how the company builds the benchmark, the fund seeking to own the same securities will be impacted. You may find that the benchmark’s construction will provide a better return based on how it is built.

Should you pick your index fund or ETF based on the benchmark they use?

The short answer to that question is yes. In most instances, each index is seeking to track the market in such a way as to provide the best return possible for the investor while spreading the risk over a wide swath of the market and doing it without using an actively managed strategy. Because ETFs and index funds essentially leave this sort of heavy lifting to companies like MSCI, they pay a fee for the research and analysis that goes into the benchmark. Some fund families, such as Vanguard are focused on providing the most inexpensive product to its investors. Others, such as iShares are looking to offer their investors a better performance even if it costs a few hundredths of a percentage point more.

What sort of indices does MSCI create?