Understanding Benchmarks – Part 1


Benchmarks are indices used for measuring the performance of a particular strategy or total portfolio. The goal of most money managers and investors is to outperform their respective benchmark. However, caution should be exercised so as not to rely too heavily on benchmark comparisons especially over short-term investment periods.

With my thirty-four years of experience managing portfolios, I would offer the following recommendations when utilizing benchmarks to measure the success of your investments.

1)      Understand the composition of the underlying benchmark.  When evaluating the performance of an individual investment strategy, an investor should consider whether the benchmark index’s composition delivers an accurate representation to the intended market segment. I can’t help but recall the late 1990’s as an example when the ten largest stocks in the S&P 500 comprised roughly 40% of the index.  I spent all of two years trying to defend what would normally be considered good equity performance from a diversified portfolio, yet appeared pitiful when compared to the robust returns of the technology-laden S&P 500.

2)      Utilize a weighted portfolio  benchmark that mirrors the long-term strategic asset allocation of the portfolio.  The landmark 1986 study by Brinson, Hood and Beebower, “Determinants of Portfolio Performance” argued that asset allocation accounts for roughly 94% of the returns in a portfolio, leaving market timing and stock selection to account for only 6%.  In other words, the performance of any underlying component to its respective benchmark is a secondary concern to the total portfolio performance in relation to its weighted benchmark.

3)      Be long-term in perspective.  The financial markets are extremely dynamic with varying degrees of correlation among most traditional asset classes.  Thus, market conditions in the short-term may create significant variations in performance to the portfolio benchmark.  It is commonplace to measure the success of any investment strategy over a full business cycle, typically five years or longer.

4)      Do not look at returns in a vacuum.  Over longer periods of time, a portfolio may appear to have underperformed the return of its weighted benchmark.  Yet, upon closer examination, it may have experienced less variation in the interim returns; i.e. lower risk. Professional managers utilize a tool called the Sharpe ratio to compare risk-adjusted portfolio returns to the respective benchmark.  The higher the Sharpe ratio, the more efficient the portfolio results.

Benchmark reporting has taken on greater importance in the money management industry and Legacy Trust has gladly accepted the responsibility to provide meaningful comparisons for our clients when assessing the performance of their investment portfolio.  However, benchmark comparisons should not be taken merely at face value, especially over short-term investment periods.