Definition and Examples of a Benchmark
Benchmarks are a group of stocks or bonds used to compare and evaluate the performance of a mutual fund or stock. Benchmarks include stocks that are of the same relative size as the mutual fund, although there are also benchmarks based on industry and geographic locations.
How a Benchmark Works
Funds compare their performance to the benchmark in the brochures they issue. This is where your task begins. You need to decide whether the benchmark the fund is using is appropriate, or if there is a better option. It’s also important to ensure that you have the most up-to-date numbers — the ARKK brochure uses numbers that are nearly two years old.
What It Means for Individual Investors
Legg Mason fund manager Bill Miller is known for outperforming the S&P 500 index every year from 1991 to 2005. That’s when his performance took a sharp downturn. During the five years he managed the fund, its assets under management fell from about $77 billion to $800 million due to investor withdrawals.
This is not the end of the story. After Miller outperformed the S&P for 15 years and nearly left the industry, he started his private fund management company and outperformed the S&P 500 again over the past ten, five, and one-year periods.
What matters to individual investors is the fund’s performance compared to the benchmark. However, you should also take other factors into account. Miller’s performance may be the reason for his own dip in performance. He outperformed the S&P for many years, attracting more money than he could manage well. Now that he runs a smaller fund, he is outperforming the benchmark again.
Additionally, you should pay attention to the fund’s fee structure, ensure that you agree with its philosophy, and be aware of tracking error — the standard deviation difference between the return sequences of the portfolio and the benchmark on which the portfolio is based. For index funds, tracking error can result from trading costs or other friction.
Takeaways
A benchmark is a list of stocks or bonds used to compare to the performance of a mutual fund. It’s very important to choose the right benchmark to measure your fund’s performance. And remember that comparing benchmarks is not everything. Make sure the fund also has good prospects.
Source: https://www.thebalancemoney.com/what-is-a-benchmark-5205805
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