The main features of benchmark are discussed in the previous article. In this article, we would investigate into the pros and cons of benchmarking.
Benchmark is a performance indictor for fund managers and investors, which encourages asset managers to strive for relative returns. Management fees of active managed funds are generally higher than those of passive managed funds. Fund managers of active managed funds trend to be stock-picking, aiming to attain excess returns, thus more time is needed for active management. In the perspective of fund managers, benchmark is an “enemy” that they need to beat down and surpass in order to reasonably charge a higher management fee and performance fee. For investors, benchmark provides them a standard in measuring funds’ performance and the reasonableness of management fees.
Benchmark provides the market a standard to compare the performance and risk of different asset classes, helping investors to choose an investment that suits them. Most of the benchmarks are differentiated by their investment asset classes and regions. For example, the MSCI World Index is used to evaluate the performance of global stock markets while the JP Morgan Global Government Bond Index is used to measure the global bond markets. And the Dow Jones Industrial Average is used to represent the performance of US stock market while the MSCI Emerging Market Index is used to measure emerging markets’ performance. Investors can choose a suitable funds to invest in by understanding the potential returns and risks of each asset class through benchmarks.
Index funds would track with the benchmark, which provides a low-cost option for the public. Index funds, such as exchange-traded funds (ETFs), are passive funds, forming by simulating the asset allocation of a benchmark. Index funds only need to bear systematic risk and literally have no non-systematic risk. Index funds bring cost-effectiveness to both fund managers and investors. For fund managers, less time and effort is needed to construct an index funds as literally they just need to simulate the benchmark. For investors, index funds require lower management fees and have no non-systematic risks literally.
Although benchmark brings various benefits to investors, it also has some disadvantages. Benchmark limits fund managers’ scope of investment and lowers the flexibility of portfolios, thus it hinders fund managers to capture potential opportunities. Benchmark reflects a fund’s investment style and objective. For example, if a fund is based on the MSCI European Small Cap Index, its portfolio should be mainly invested in European small-cap stocks, even though the fund manager believes that it is not a good time to invest in this sector or there are another better options.
Besides, the approach of calculating returns for benchmark and fund may be different, resulting in giving a wrong reference to investors. Price return and total return are the two major approach to measure investment performance. Price return only reflects the return of capital (ie. price changes). And total return reflects both the return of capital and the return of income (such as interest income, etc.). Unfair comparison is resulted if the approach to present returns are distinct between benchmark and fund.
Benchmark brings both pros and cons to investors. However, it is worth noting that most of the disadvantages of benchmark can be avoided. As long as the benchmark is carefully selected and is consistent with investors’ own investment objectives, it will be a good reference indicator for investors to measure potential returns and risks.