Benchmark

A benchmark is the reference point an investment's results are compared with, most often a published market index made up of the same kind of holdings. On its own a return is a number; set beside a benchmark it becomes a result, because the comparison separates what the market did from what the manager did.

The word itself is ordinary English, and the SEC's investor glossary has no entry for it. What the securities rules define instead is a narrower thing with a name of its own. Form N-1A, the registration form every mutual fund and most exchange-traded funds use, requires a fund's shareholder report to show its average annual total returns beside those of an "appropriate broad-based securities market index" for the same periods. So in fund documents the general idea of a benchmark arrives as a specific regulatory object, and the conditions attached to it are the part worth knowing.

Form N-1A defines the required index in four moves, and each one closes a gap. Instruction 6 to Item 27A(d)(2) says an appropriate broad-based securities market index "is one that is administered by an organization that is not an affiliated person of the Fund, its investment adviser, or principal underwriter, unless the index is widely recognized and used." That is the independence condition. It then defines the adjective: a broad-based index "is an index that represents the overall applicable domestic or international equity or debt markets, as appropriate." That rules out a narrow slice chosen because the fund happens to look good against it. Third, the index is adjusted "to reflect the reinvestment of dividends on securities in the index," so income counts on both sides of the comparison. Fourth, and least intuitive, the instruction says to reflect those dividends "but do not reflect the expenses of the Fund." The index is therefore an un-costed yardstick measured against a fund whose reported return is net of what it charges.

The change-of-index rule is the one that reveals what the others are for. Instruction 8 provides that if a fund uses an index different from the one used for the immediately preceding period, it must explain the reason for the change and compare its results against both the new and the former index. A fund cannot quietly retire an unflattering comparison, because the switch itself becomes disclosure. Instruction 7 works the other way and is worth knowing so the requirement is not misread as a ban: a fund is encouraged to compare its performance with more narrowly based indexes reflecting the sectors it invests in, and may add another broad index or even a non-securities index such as the Consumer Price Index, so long as the comparison is not misleading. The broad-based index is a floor, not a ceiling.

Outside fund disclosure, a benchmark is whatever the person quoting it says it is, and that is where the reader has to do the work. A portfolio holding stocks and bonds together cannot be judged against a stock index, because most of the difference will come from the mix rather than from the choices inside it. A fund holding small companies compared with an index of large ones is being measured against a different market. The test is whether the yardstick is made of the same material as the thing being measured, over the same period, with income counted the same way on both sides.

Pick the comparison first, then measure. For a fund, the comparison is already chosen and printed: the shareholder report shows the fund's average annual total returns for the 1-, 5- and 10-year periods beside the same figures for its broad-based index, and the report also carries a line graph tracking a hypothetical $10,000 investment in that index over the last ten fiscal years. For a portfolio someone assembles themselves, the comparison has to be built to match the mix, which usually means blending indexes in the same proportions as the holdings.

A hypothetical example of the un-costed yardstick, which is the single most common source of confusion. A fund's benchmark index returns 9.00% over a year, with the dividends on the index's securities reinvested and no expenses deducted, because the instruction says to leave them out. The fund holds essentially what the index holds and its portfolio earns the same 9.00% before costs. Its total annual operating expenses are 0.60% of assets. The return it reports is roughly 8.40%, so it trails its own benchmark by about 0.60 percentage points, which is 60 basis points, without a single security having been selected differently. The gap is the cost of ownership showing up in a comparison where only one side pays it.

Pros

• Converts a bare return into a result by supplying the missing half of the comparison.
• In fund disclosure the comparison is standardized and required, so it does not depend on the fund choosing to make it.
• The independence and broad-based conditions make the yardstick harder to select for flattery.
• The change-of-index rule turns a switch of benchmark into something the reader can see and question.

Cons

• The index is measured without the fund's expenses while the fund's figure is net of them, so the two sides are not paying the same costs.
• A broad-based index can be a poor match for a specialized fund, which is why funds are encouraged to add narrower comparisons rather than rely on the required one alone.
• A benchmark chosen for a self-assembled portfolio is chosen by the person being measured, and nothing standardizes it.
• Comparing a mixed portfolio with a single-asset index measures the mix rather than the decisions inside it.
• An index cannot be bought directly, so its return is not an outcome anyone actually received.