What are benchmarks and do they matter?

In schools you come across the word ‘benchmarking’ a lot. Head teachers and governors have to benchmark their establishment’s resources against those of other schools to make sure they are producing the best outcomes for their pupils. Said pupils’ progression in areas such as language and numeracy is also benchmarked against a set of standards to see how they are doing.

It’s a term that’s often bandied around when it comes to our investments, and it too is to measure performance – comparing one investment against another

Using sector averages as a benchmark

Every time a fund’s performance is mentioned, it is almost always in relation to a ‘benchmark’ – usually its sector average or a market index.

When we talk about sector averages we are usually talking about sectors created by either the Investment Association (in the case of open-ended funds) or the Association of Investment Companies (in the case of investment trusts)

These associations have basically grouped sets of funds together to make it easier to compare like for like. Comparing a fund to its sector average can then show the investor how well the fund has performed compared to its peers. For instance, most open-ended UK equity funds like IFSL Marlborough Special Situations fund reside in the IA UK All Companies sector.

These sector comparisons are not necessarily foolproof, however. There are some sectors – such as IA Specialist, for instance – which play host to a whole range of differing mandates, from country-specific equity funds, to multi-asset portfolios, to funds which only invest in certain industries.

What would be the sense in comparing the performance of Sanlam Global Artificial Intelligence fund with AXA Framlington Biotech, Ninety One Global Gold or Cohen & Steers Diversified Real Assets – for example?

Using stock markets indices as a benchmark

Another way to assess how well a fund has performed is to compare it to a stock market. Most UK equity funds will be ‘benchmarked’ against the FTSE 100 or the FTSE All Share. By comparing a fund with one of these indices, you can see whether the fund has performed better or worse than the market – whether or not the fund manager has been able to add value and boost returns.

When a fund is ‘unconstrained’ it means it may use a benchmark index for reference but in reality it will look very different. For instance, the FTF Martin Currie European Unconstrained fund will use the MSCI Europe index as the investment universe for idea generation, but the fund has no regional, country or sector constraints. It can also invest in non-index stocks if they meet the investment criteria.

When a fund isn’t aiming to beat a stock market

There are other funds which have benchmarks that aren’t broad market indices. The IA Targeted Absolute Return or IA Volatility Managed sectors, for instance, are home to a wide variety of funds which aim to provide positive returns over different time frames and with differing levels of volatility.

A prime example of this is David Coombs’ Rathbone Strategic Growth Portfolio, which targets a total return of between 3% and 5% above inflation over at least a five-year period. The manager has chosen this target instead of a conventional benchmark because – regardless of what a group of assets is doing – he simply wants to keep investors’ money safe and make it work harder than cash.

So long as investors are aware of the aim of funds with less conventional benchmarks, this can actually offer a very clear and efficient way for investors to monitor their fund’s performance.

Are benchmarks useful?

Generally speaking, benchmarks have varying levels of usefulness to the end investor – it all depends on whether they’re seeking an absolute return or a relative return. After all, a fund could have comfortably outperformed a struggling benchmark and still lost investors’ money over a given time frame. By the same token, plenty of funds without a set benchmark may have underperformed the broad market index that looks most relevant to them, but they may in fact have an absolute return focus.

It’s all about getting under the bonnet of each fund and ensuring that the fund is doing exactly what it should be doing. And, for vehicles where a benchmark is relevant, having a point of reference can be a useful tool indeed.

This article was first published in February 2018 and edited for republication in May 2023.