Benchmarks: Selecting a Benchmark

With the vast number of benchmarks to choose from, deciding which one, or which combination of indexes, to use as a benchmark can be difficult. (For more basics on benchmarks, please see Benchmarks: Basics.) But this decision is critically important for several reasons.

First, portfolio risk and return will be heavily influenced by the benchmark. When portfolio managers construct a portfolio, they typically take the securities in the benchmark as a starting point from which to take active positions in an effort to add value.

Second, the benchmark indicates not only the kinds of securities that should be included in the portfolio, but also the types of securities that should not be in the portfolio. For example, choosing a government bond index as the benchmark for a fixed income portfolio is a strong indicator its holdings should not include many securities with a high degree of risk. Choosing a small cap stock index, such as the Russell 2000, means an investor is not seeking exposure to the large companies in the Dow Jones Industrial Average.

Third, some benchmarks are better suited to specific investment goals than others. For an investor whose primary goal is capital preservation, an important criterion for a bond index might be credit quality. If the portfolio is intended to offset liabilities that change with interest rates, the most important consideration when selecting a benchmark might be the benchmark’s interest rate sensitivity (or duration), rather than its prospective returns.

Selecting the right benchmark can be particularly important for investors looking to invest in international securities. Because foreign currency exposure can affect the value and the volatility of a portfolio, global securities can serve two distinctly different purposes, depending on whether the foreign currency exposure is hedged or unhedged.

A global investor who wants to take a position on currency by investing in foreign holdings would use an unhedged index – one that is exposed to changes in currency values. For example, an investor who believes that the U.S. dollar will weaken may choose to invest in securities denominated in other currencies because they will increase in value if the dollar falls. However, investors seeking capital preservation or to meet liabilities typically opt for indexes that hedge currency risk and avoid the volatility that currency investing can bring.

The Main Considerations in Benchmark Selection

Given the importance of selecting the right benchmark, here are some key questions to answer before making a choice.

• What are your overall performance goals, and what is your tolerance for volatility, or risk?

Investors should evaluate their return goals and risk tolerance before selecting an index. An investor with a low risk tolerance will most likely select an index with a shorter duration or higher credit quality. An investor looking for a high return may select an index with a track record of high long-term returns, which might also exhibit performance volatility and carry the chance of negative absolute returns over shorter time periods.

Investors seeking to meet long-term liabilities with their investments should consider not only the pattern of cash flows associated with their liabilities but also the risk factors that can cause changes in liabilities. For example, liability-driven investors who choose to invest in fixed income could work with an asset manager to create a custom benchmark composed of a combination of government bonds, index-linked bonds, swaps and corporate bonds that closely matches the risk factors of the liabilities. Such a custom index could potentially provide a better fit than existing indexes while also providing flexibility to adapt to changes in the liability stream over time.

What Makes a Good Benchmark?

Selecting a specific benchmark is an individual decision, but there are some minimum standards that any benchmark under consideration should meet. To be effective, a benchmark should meet most, if not all, of the following criteria:

Unambiguous and transparent – The names and weights of securities that constitute a benchmark should be clearly defined.

Investable – The benchmark should contain securities that an investor can purchase in the market or easily replicate.

Priced daily – The benchmark’s return should be calculated regularly.

Availability of historical data – Past returns of the benchmark should be available in order to gauge historical returns.

Low turnover – There should not be high turnover in the securities in the index because it can be difficult to base portfolio allocation on an index whose makeup is constantly changing.

Specified in advance – The benchmark should be constructed prior to the start of evaluation.

Published risk characteristics – The benchmark provider should regularly publish detailed risk metrics of the benchmark so the investment manager can compare the actively managed portfolio risks with the passive benchmark risks.

With benchmarks today covering all types of assets and investment strategies, it makes sense to choose carefully and only after deciding one’s investment goals and risk tolerance.

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.

This material contains the current opinions of the manager and such opinions are subject to change without notice.  This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.