A key aspect of investing is measuring results and how much your portfolio gained or lost over time. Measuring performance against a benchmark helps determine how your portfolio compares to an alternative or a standard.
Key Takeaways
- Investors can compare investment results to a benchmark index.
- The appropriate benchmark for an ETF depends on what index or sector it tracks.
- The S&P 500 is a benchmark index for broad-based portfolios and ETFs like the SPY.
- Passive ETFs try to mimic the benchmark's performance, while actively managed ETFs attempt to beat it.
Relative Performance
Relative performance shows how your portfolio compares against a benchmark. An underperforming portfolio relative to its benchmark will raise some questions that cause you to take a closer look at your investments or your financial advisor. Relative performance tools are used for individual holdings, especially mutual funds and ETFs. Morningstar ranks funds and ETFs within their appropriate category for easy comparison.
An investor looking to invest in an actively managed ETF may track its performance over time against a passive mutual fund or ETF that tracks a mid-cap benchmark like the S&P 400 index, the Russell Midcap Index, or the Wilshire US Midcap Index. Has the actively managed fund outperformed over time? Is the extra expense that the active fund charges offset by superior performance or lower risk over time?
Risk
Risk should be evaluated along with performance. A diversified portfolio can be compared to a single benchmark like the S&P 500 based on the return the portfolio captures and its relative risk. An investor may compare the portfolio’s beta to the S&P 500, where a beta of 1.0 means the portfolio moves in tandem with the index.
A beta of 0.7 means the underlying portfolio will likely go up or down 70% as much as the index. A portfolio with a beta of 0.7 but with earnings of 80% of the return of the S&P 500 means the investor is successful based on risk.
A beta of 1.0 indicates that price activity is strongly correlated with the market. A beta value less than 1.0 means that the security is theoretically less volatile than the market. A beta greater than 1.0 indicates the price is more volatile than the market.
Types of Benchmarks
S&P 500
The is one of the most widely followed stock market indexes and serves as a de facto investing benchmark. The S&P 500 measures the 500 largest U.S. stocks, and the stocks represented are weighted by their market capitalization, the sum of the share price of each stock times the number of shares outstanding.
As of Jan. 2024, the SPDR S&P 500 ETF (SPY) that tracks the index shows that the top 10 holdings in the fund comprised just over 30% of the portfolio.
Dow Jones Industrial Average
The Dow Jones Industrial Average, often referred to as "the Dow," is a price-weighted index consisting of 30 large, blue-chip U.S. companies. The Dow includes companies that are leaders in their respective industries and are considered representative of the overall U.S. economy, such as Apple, Boeing, and Goldman Sachs.
Russell 2000 Index
If an investor is holding small-cap stocks, they may do well to set their benchmark target as the Russell 2000 Index. The Russell 2000 Index comprises 2,000 of the smallest companies within the broader Russell 3000 Index. These smaller firms often have higher growth potential but may also be more volatile.
Bloomberg U.S Aggregate Bond Index
Investors can also hold fixed-income securities. The Bloomberg U.S Aggregate Bond Index is a widely accepted benchmark for the U.S. investment-grade bond market. Comprising a mix of government, corporate, and mortgage-backed securities, this index reflects the overall performance of high-quality fixed-income instruments. Some ETFs, like the iShares Core U.S. Aggregate Bond ETF, seek to replicate the returns of this index.
Commodity
An ETF can track a specific commodity or tangible good. The price of gold bullion can be used as a benchmark, and the SPDR Gold Trust ETF is designed to track against this price.
Passive ETFs vs. Actively Managed ETFs
- Passive ETFs are commonly referred to as index funds, which track specific benchmarks. Passive ETFs aim to replicate the benchmark's performance and the fund's asset allocation is based on this goal.
- Actively managed ETFs introduce a dynamic element, as fund managers actively make investment decisions to surpass benchmark returns. While these funds have the flexibility to beat benchmarks, the selection of a benchmark is critical for evaluating performance.
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Benefits and Limitations
Setting an investment benchmark for an ETF offers advantages to investors and fund managers. Benchmarks provide a standard for evaluating the performance of the ETF and serve as a guide for strategic decision-making. They determine portfolio allocation and diversification and can enhance communication and transparency between fund managers and investors since they provide a clear standard for conveying investment goals and strategies.
Setting a benchmark for an ETF but may not always be a perfect match. Benchmarks can be inflexible. Markets are always on the move, but investors don't revise benchmarks often. ETFs with innovative strategies or a focus on emerging markets may prove more volatile than the benchmark. Benchmarking doesn't always cover the implications of risk. Factors like liquidity risk, tracking error, and market impact are sometimes hidden when conducting the benchmark's risk assessment.
Retirement Planning
For retirees or those approaching retirement, benchmarks help determine the optimal balance between risk and stability. A conservative investor may favor a benchmark that includes a higher allocation of bonds and stable dividend-paying stocks to mitigate market volatility. The investor can then imitate the benchmark, realizing that its actual risk and return may vary but should be pretty close to the goals they're setting.
A young investor with more time to save for retirement can aim for long-term capital appreciation, like the Russell 2000, while someone prioritizing income preservation could lean towards a more conservative benchmark with a higher allocation to bonds. ETF benchmarks play a vital role in guiding income-generating assets. As investors transition into retirement, they may rely on dividends. Benchmarks can set the expectation that the investors can expect as they move forward with retirement and have a sense of what sort of monthly income they will earn.
Example
Consider the following portfolio weights:
Let’s look at some hypothetical results:
On a weighted average basis, the portfolio had a return of 5.45% for this hypothetical period versus a weighted average return for the blended benchmark of 6.40%. This type of analysis should be done for various periods such as the trailing quarter, year, three years, five years, ten years, etc. For a short period, underperformance might not reveal much, but over extended periods, underperformance might indicate a trend.
Why Are ETF Benchmarks Important for Investors?
Benchmarks act as a yardstick against which investors can measure the returns and risks of an ETF. These benchmarks help set expectations and allow investors to decide which ETFs align with their investment goals and risk tolerance.
How Can ETF Benchmarks Guide Asset Allocation Strategies?
ETF benchmarks guide asset allocation strategies by providing a framework for investors to diversify across different asset classes and sectors. Investors often use benchmarks representing various market segments to allocate assets strategically, apportioning certain sections of their assets based on what they expect to happen based on that benchmark.
What Is the Difference Between an ETF Benchmark and an Index?
While the terms are sometimes used interchangeably, an index refers to a statistical measure of the changes in a portfolio of securities, while an ETF benchmark is a specific index that an ETF aims to replicate or track.
The Bottom Line
Using a benchmark helps determine how your investments are performing on a relative basis, either on the portfolio level or the individual holding level. The benchmark for an ETF depends on what index or sector it tracks. Passive ETFs aim to mimic the benchmark's performance, while active ETFs try to beat it.
