Selecting a Benchmark
What You Should Know
Selecting a Benchmark
A benchmark used in investing is a standard against which the performance of an individual bond or group of bonds can be measured. Different types of benchmarks are chosen for different investments by individual investors and financial professionals—the benchmark might be an index, an interest rate such as LIBOR or EURIBOR, or the yield on a particular government bond such as on a US Treasury bond. For example, if an investor uses an index to track a specific segment of the bond market, the changing value of the index indicating a stronger or weaker performance is also the standard against which the investor measures the performance of a particular bond, bond fund or bond portfolio. Note that individual investors can use benchmarks to evaluate performance of personal investments or investments that are managed by financial professionals connected to a pension or other retirement investment account.
In a different way, individual investors and financial professionals also often use benchmarks to discern broader expectations about the direction of the markets or the economy. For example, benchmark interest rates and the setting of those rates by European Central Bank; the UK Central Bank; the US Federal Bank, and other European system central banks, are closely watched by the markets because setting these rates are a prime way for central banks to manage inflation. Commercial banks use EURIBOR, LIBOR and central bank discount rates as benchmarks for the interest rates they charge on other financial instruments and products, including commercial and consumer loans.
There are two major types of benchmarks used in setting investment performance benchmarks—fixed rate or absolute benchmarks and relative benchmarks.
An example of an absolute or fixed benchmark scenario:
An investor sets an annual rate of return that s/he wants to achieve (for example, 6%). This annual rate of return might be required for the investor to meet his/her retirement goals. If the annual rate of return on the investment portfolio (for example 5%) doesn’t meet the benchmark rate of return of 6% that the investor wanted then the portfolio is underperforming relative to that benchmark set by the investor.
However, the fact that the investor’s portfolio under performed the absolute benchmark he set doesn’t help the investor understand what actions s/he should take to improve the situation nor does the fact that the portfolio was underperforming against the benchmark tell the investor why that was the case—perhaps that sample 5% return resulted from bad investment decisions or it could be because the bond market is temporarily down and the returns will be back up to the sample 6% the investor benchmarked when the market improves. The investor needs additional information.
At such a time, a relative benchmark might help.
The investor can compare the investment performance of his own portfolio to one or more standard market indices or measurements (relative benchmarks) he selects in order to gauge the success of his own strategy in meeting his investment objectives. A relative benchmark can tell an investor about the performance of his/her investment portfolio against a market index that might be trying to achieve a similar goal more successfully than the investor. It is important in choosing a benchmark to be sure that it reflects what you the investor are trying to accomplish. Selecting, for example, an index that is trying to achieve 4% annual return does not help the investor whose goal is to have a 6% annual return. Selecting an index that tracks performance among international bonds will not help you if you have decided you are only going to invest in European government bonds.
An index is a way to report change in a financial market, collective markets, or an economy, usually expressed as a percentage and as points of change (up (+) or down (-). There are many market and economic indices, each tracking and measuring a different set of data that is predetermined; each index also tracks change from a specific starting date. Investors and financial professionals may use a particular index as a performance benchmark against which to measure the return of investments that are similar to those measured by the index. Indices may be “weighted” which means that certain factors in the data are given more significance or weight in the index.
InvestinginEurope.org has a number of market indices on the site. You can find out more about each index in each bond market by clicking on the icon “?” button in the upper right hand corner of the chart. You can also see more data behind the charts by clicking on “See data.”
Note that these indices track returns of bond investments assuming a buy and hold scenario—they don’t try to figure out which of the investments they are tracking are best or most valuable. This represents a so-called “passive” investing approach. If an investor is using an active approach to investing, s/he can benchmark whether an active approach is adding value to the portfolio and if so, from which aspects.