“Is my portfolio performed well?” Most of the investors may have this query. Performance valuation is always being conducted with a benchmark. According to Hong Kong Investment Funds Association, benchmarks are well-established and commonly used indices (or group of securities) that seek to be representative of the markets in which the securities trade. Benchmarks provide investors a measuring standard to evaluate the performance of funds or their own portfolios.
Functions of Benchmarks
Benchmarks show investors the investment style of a fund. Investment style can be divided by asset class, it is mainly divided into equity style, balanced style and bond style. Besides, investment style can also be divided by geographic factors, such as developed region, emerging markets, Asia Pacific and US etc. Understanding the investment style of a fund or portfolio allows investors to choose a suitable investment. For example, conservative investors can choose bond funds or funds that mainly invested in developed countries. On the contrary, aggressive investors can choose equity funds or funds that mainly invested in emerging market.
Benchmarks provide a comparative reference for investors. The performance of fund or portfolio should not just measured by its absolute return, but also should consider its relative return. During economic boom, most of the securities would have positive returns. A good portfolio performance should not only limited to a positive return, but also should have a relatively higher return than that of market (ie. Benchmark), vice versa.
Features of Benchmark
Benchmark has six main features, including unambiguous, investable, measurable, specified in advance and owned.
- Unambiguous: The identities and weights of securities or factor exposures constituting the benchmark should be clearly defined. Investors can understand the performance difference between their own portfolios and the market through evaluating the underlying assets of the portfolio and the index.
- Investable: All the securities that constitute the benchmark should be possible for the fund managers or investors to invest in. In the order word, It is possible for portfolio managers or fund managers to conduct a passive management.
- Measurable: The return of benchmark should be readily calculable on a reasonably frequent basis, letting investors can compare their portfolios’ performance with the benchmark quantitatively.
- Appropriate: The benchmark should be consistent with the manager’s investment style or area of expertise. For example, the benchmark of a US equity portfolio or funds should be also US-equity-related, such as S&P 500 or Dow Jones Industrial Index.
- Specified in advance: The benchmark should be specified prior to the start of an evaluation period and known to all interested parties. It prevents the fund managers’ incentive to conceal the fund’s bad performance by using an inappropriate benchmark.
- Owned: The investment manager should be aware of and accept accountability for the constituents and performance of the benchmark. And it is encouraged that the benchmark be embedded to the investment process of investment managers.