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Investment -Benchmarks and Relative Returns
Benchmarks and Relative Returns
By measuring relative returns — that is, returns compared to an appropriate benchmark — investors can decide if they could have made more money in other investments for a similar degree of risk. Assessing returns on a relative basis allows investors to analyze their opportunity cost and determine whether their investments are delivering suitable returns.
Many investors wish to compare the performance of their fund with that of a financial market benchmark, such as a stock index. It is widespread practice in all businesses, and indeed in many spheres of life, to benchmark or compare performance. Olympic sprinters, for instance, may compare themselves to a time benchmark or a close competition. Beating the time standard or the rival allows them to determine how they are performing.
" " Fund managers may use a benchmark not only for assessment, but some, such as index fund managers, may also manage their funds to a benchmark. This means that managers must periodically compare the composition and performance of their funds with the composition of a financial market index, such as the FTSE 100 Index or the S&P 500 Index. For investors, understanding the financial market index that a fund uses as a benchmark can offer them some sense of the return and risk that they can expect from investing in that fund.
When choosing a manager for a separately managed account mandate, institutional investors will often define the financial market benchmark that they intend to use to judge the performance of the investment manager. For example, a US stock manager may be asked, or ordered, to actively manage a portfolio of US equities for a client and instructed that they will be ‘benchmarked against’ the S&P 500. As another example, a manager may simply be a passive index fund manager tracking the S&P 500 as the reference index. Alternatively, a manager can be given a specific mandate reflecting style or sector preferences. In this situation, a style or sector index may be chosen as the suitable benchmark.
To assist investors reach their objectives, a benchmark should meet specific requirements.
Investable
The benchmark should be constituted of assets that can be bought and sold by the fund manager. For passive fund managers, it would be impossible to match the benchmark if it featured assets that they could not buy. For active fund managers, not being able to invest in some of the benchmark’s components could limit their potential to outperform it.
Compatible
The benchmark should have an appropriate composition and level of risk for the investor. In other words, it should meet the investor’s objectives. For example, for investors who desire to invest in assets that carry little credit or default risk, a financial market index of government bonds might be compatible (based on previous performance) with investor preferences. A benchmark composed of corporate bonds would not be compatible.
Transparent
The guidelines regulating the construction of the benchmark should be explicit. This transparency should extend to the weighting of individual benchmark constituents, to the mechanism used to generate benchmark returns, and to the process used to add and remove constituents to and from the benchmark over time.
Pre-Specified
The benchmark should be defined before an investment is made so that the fund management is aware about the fund’s objectives and so the fund manager may create a portfolio accordingly.
Indices
Several companies publish financial market indexes that allow investors to compare the total return earned by a fund with that generated by the wider market.
For most equities exchanges across the world, there is at least one index that represents the bulk of its stocks. In addition to these broad indices, stock indices that evaluate performance of industrial sectors are also available, both within a given country and globally. These indices make it possible, for instance, for investors to compare the performance of a fund of global information technology (IT) equities with the performance of a fund of Indian IT stocks, as long as the indexes have been built using the same technique.
Index providers also supply a wide selection of bond indexes. Bond indices are offered for several types of issuers located in various locations, including in developed and emerging countries. In addition to aggregate bond indices that are designed to cover the bond market as a whole, bond indices exist for bonds classified by maturity, credit rating, currency, and industry, among other categories. Many index providers, such as FTSE International, S&P Dow Jones, and MSCI, produce indexes for practically every asset class, including cash, currencies, commercial property, hedge funds, private equity, and commodities, as well as for bonds and equities.
Relative Returns
The large selection of financial market indices available enables investors to compare the performance of their fund over time against an independent benchmark. In brief, a benchmark index allows investors to evaluate relative returns.
Some investors compare their fund’s performance with that of the fund’s peers. For example, investors may compare the performance of one European equities fund with that of other European equity funds.
Each fund is granted a performance ranking within its particular sector of the financial markets. Funds that are in the top 10% of performers among their peers during a certain period are said to be top-decile performers. Funds’ performance is often collected and assessed by independent organisations, such as Morningstar, who then publishes the data, allowing investors to examine the rankings of their particular funds relative to those of other funds that they may have chosen.
Benchmarks and Relative Returns
By measuring relative returns — that is, returns compared to an appropriate benchmark — investors can decide if they could have made more money in other investments for a similar degree of risk. Assessing returns on a relative basis allows investors to analyze their opportunity cost and determine whether their investments are delivering suitable returns.
Many investors wish to compare the performance of their fund with that of a financial market benchmark, such as a stock index. It is widespread practice in all businesses, and indeed in many spheres of life, to benchmark or compare performance. Olympic sprinters, for instance, may compare themselves to a time benchmark or a close competition. Beating the time standard or the rival allows them to determine how they are performing.
" " Fund managers may use a benchmark not only for assessment, but some, such as index fund managers, may also manage their funds to a benchmark. This means that managers must periodically compare the composition and performance of their funds with the composition of a financial market index, such as the FTSE 100 Index or the S&P 500 Index. For investors, understanding the financial market index that a fund uses as a benchmark can offer them some sense of the return and risk that they can expect from investing in that fund.
When choosing a manager for a separately managed account mandate, institutional investors will often define the financial market benchmark that they intend to use to judge the performance of the investment manager. For example, a US stock manager may be asked, or ordered, to actively manage a portfolio of US equities for a client and instructed that they will be ‘benchmarked against’ the S&P 500. As another example, a manager may simply be a passive index fund manager tracking the S&P 500 as the reference index. Alternatively, a manager can be given a specific mandate reflecting style or sector preferences. In this situation, a style or sector index may be chosen as the suitable benchmark.
To assist investors reach their objectives, a benchmark should meet specific requirements.
Investable
The benchmark should be constituted of assets that can be bought and sold by the fund manager. For passive fund managers, it would be impossible to match the benchmark if it featured assets that they could not buy. For active fund managers, not being able to invest in some of the benchmark’s components could limit their potential to outperform it.
Compatible
The benchmark should have an appropriate composition and level of risk for the investor. In other words, it should meet the investor’s objectives. For example, for investors who desire to invest in assets that carry little credit or default risk, a financial market index of government bonds might be compatible (based on previous performance) with investor preferences. A benchmark composed of corporate bonds would not be compatible.
Transparent
The guidelines regulating the construction of the benchmark should be explicit. This transparency should extend to the weighting of individual benchmark constituents, to the mechanism used to generate benchmark returns, and to the process used to add and remove constituents to and from the benchmark over time.
Pre-Specified
The benchmark should be defined before an investment is made so that the fund management is aware about the fund’s objectives and so the fund manager may create a portfolio accordingly.
Indices
Several companies publish financial market indexes that allow investors to compare the total return earned by a fund with that generated by the wider market.
For most equities exchanges across the world, there is at least one index that represents the bulk of its stocks. In addition to these broad indices, stock indices that evaluate performance of industrial sectors are also available, both within a given country and globally. These indices make it possible, for instance, for investors to compare the performance of a fund of global information technology (IT) equities with the performance of a fund of Indian IT stocks, as long as the indexes have been built using the same technique.
Index providers also supply a wide selection of bond indexes. Bond indices are offered for several types of issuers located in various locations, including in developed and emerging countries. In addition to aggregate bond indices that are designed to cover the bond market as a whole, bond indices exist for bonds classified by maturity, credit rating, currency, and industry, among other categories. Many index providers, such as FTSE International, S&P Dow Jones, and MSCI, produce indexes for practically every asset class, including cash, currencies, commercial property, hedge funds, private equity, and commodities, as well as for bonds and equities.
Relative Returns
The large selection of financial market indices available enables investors to compare the performance of their fund over time against an independent benchmark. In brief, a benchmark index allows investors to evaluate relative returns.
Some investors compare their fund’s performance with that of the fund’s peers. For example, investors may compare the performance of one European equities fund with that of other European equity funds.
Each fund is granted a performance ranking within its particular sector of the financial markets. Funds that are in the top 10% of performers among their peers during a certain period are said to be top-decile performers. Funds’ performance is often collected and assessed by independent organisations, such as Morningstar, who then publishes the data, allowing investors to examine the rankings of their particular funds relative to those of other funds that they may have chosen.
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