A benchmark is a point of reference for a measurement. It is a surveying term that originated from the chiseled horizontal marks made on a monument which had a known location and elevation and which served as a reference point. In all cases the mark is used by subsequent surveyors to establish the exact elevation of nearby points.
In the investing world, a benchmark is a standard against which one can compare the performance of a stock or portfolio. The most widely known benchmark is the Dow Jones Industrial Index.
In investing there are two major types of benchmarks, a fixed rate (also called an absolute benchmark) and a relative benchmark. The performance of a market index provides the point of reference for the relative benchmark.
Absolute or fixed benchmark.
As an example, an investor might have a personal benchmark of 7% which is the rate of return he or she wants to achieve. This might be the annual rate of return that is required from the investment portfolio to meet retirement goals. If the investor earns this rate of return he will be able to retire and live his retirement years as planned. If he earns less than this average rate of return it means he may have to spend less in retirement or work a few years longer before retiring.
If the benchmark is 7% and the investment portfolio returned an average of 4% per annum over the last five years, then the portfolio is underperforming relative to the 7% benchmark. The information, although helpful, does not by itself show what action the investor should take to get his portfolio on track to achieve long term goals. It does not show how well the investor managed his portfolio or if the investment strategy should be changed. The rate of return may have been a reflection of a poor stock market over the last number of years. In this case a strong recovery in the stock market may bring the performance back on target. The rate of return might also have resulted from a bad decision in setting the asset mix, or alternatively the money may have been poorly managed. More information, and a relative benchmark, is needed to answer these questions.
Relative Benchmark.
A relative benchmark tells you the performance of investment portfolio compared to a market index.
As an example, assume that an investor bought a mutual fund that was invested in Canadian stocks. Over the last 5 years the mutual fund showed an annualized return of 8%. Was that fund a good choice among all the other funds that the investor could have purchased? Did the fund manager do a good job in adding “value”? Let’s assume that over the same period of time, the most commonly used performance benchmark in Canada; the S&P/TSX Composite Index returned 10% per year.
Compared against the benchmark the mutual fund clearly underperformed by 2% per year. The fund manager did not add value as anyone could have invested in the benchmark through an index fund or an exchanged traded fund (ETF) and almost matched the performance of the benchmark. This information will help the investor decide to keep or sell the fund in order to get the investment portfolio back on track.
Without the benchmark, without having something to compare performance of the investment to, an investor might not know that he is under performing and may therefore delay taking corrective action for several years. It is important for investers to know how they have performed against both benchmarks.
Investment Benchmarks for Canadian Investors
Canadian investors have different benchmarks to use depending on what they want measure and the asset class they want to compare to.
Rather than using an absolute benchmark of say 7%, many large pension plans would use a benchmark relative to the rate of inflation. So a benchmark might be the rate of inflation as measured by the consumer price index (CPI) plus 4%. So if the average rate of inflation was 2.5% over 5 years then the benchmark over that period would be 6.5%. Over the long term protecting the purchasing power of the investment is very important and therefore having a relative benchmark based on inflation is often appropriate.
Some of the common benchmarks for the different asset classes are in the table below.
| Asset Class |
Benchmark |
| Cash |
Scotia Capital 91 Day T-bill Return Index |
| Fixed Income |
Scotia Capital Bond Universe Total Return |
| Canadian Equities |
S&P/TSX Composite Total Return Index |
| US Equities |
S&P500 Composite Total Return Index in Canadian $ |
| Equities for rest of world |
MSCI EAFE Total Return Index in Canadian $ |
Conclusion
In the process of managing money wisely, measuring the performance of an investment portfolio and comparing it against a benchmark are two of the most important actions an investor can take. This action helps to determine if the investment plan or strategy is on track, it is used in part to make a decision to fire or hire an investment manager, and it allows the investor to take corrective action before it is too late.
Ken Hawkins & Warren MacKenzie
http://www.secondopinions.ca
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