Many advisors know what benchmarking is and how to use it. Many advisors think they know what benchmarking is and aren't fully sure how to master it. Which one are you? Do you follow portfolio benchmarking methodology and protocols, like a Samurai warrior, or do you just throw punches? In either case, it is useful to recall the essential attributes of benchmarks taught through the mnemonic Samurai1:
• Specified in advance: The benchmark is specified prior to the evaluation period.
• Appropriate: It is consistent with the manager’s investment style or area of expertise.
• Measurable: The return is readily calculable on a reasonably frequent basis.
• Unambiguous: Identities and weights of securities are clearly defined.
• Reflective of current investment opinions: The manager has current knowledge of the securities in the benchmark.
• Accountable: The manager should be aware and accept accountability for the constituents and performance of the benchmark.
• Investable: It is possible to simply hold the benchmark.
These attributes can be gleaned and analyzed with the wealth of knowledge available, and powerful tools to bring them into practice. Mastering benchmarks has two benefits: You can make informed decision when selecting investments, and you improve communication with your clients through better accountability and expectations. As you review last year’s performance and prepare for the new, now is a perfect time to educate yourself and your clients about appropriate benchmarks for their investments.
Market indices are readily available and fulfill most of the desirable attributes for benchmarks, however it is still your duty to understand the indices and ensure that the index selection is appropriate.
To start with, make your client aware of the most common market indices and how they relate to their investments. Note that the ubiquitous S&P 500 index, representative of U.S. large-cap stocks, is only a portion of the investable equity market. U.S. small-cap stocks, international developed markets and the U.S. corporate bond markets can be tracked by the Russell 2000 index, the MSCI EAFE index and the Barclays US Aggregate index, respectively. The above are just examples of popular indices; you should visit these providers websites to consult the definition of the indices, how they are constructed, and what other indices are available. Also, make sure to use indices reporting total return (including dividends and capital gains) in order to accurately reflect performance.
After you show your clients how each asset class can be associated with an index, there are further steps you can take to present performance in a fair, realistic manner.