What are benchmarks and do they matter?

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.

For instance, most UK equity funds reside in the IA UK All Companies sector. Comparing a fund to its sector average can then show the investor how well the fund has performed compared to its peers.

These sector comparisons are not necessarily fool-proof, 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.

Where would be the sense in comparing the performance of an Indian equity portfolio – such as GS India Equity Portfolio – to a sector-specialist fund – such as Polar Capital Global Insurance – for example?

Therefore, 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 be able to boost returns.

Some funds will omit having a benchmark altogether, however. This can, in a small handful of cases, be a way to disguise underperformance. However, there are lots of different reasons why some funds may not need – or should not have – a benchmark.

When a benchmark is more of a target

Some funds are ‘unconstrained’, which means they can invest almost any amount in any stock, regardless of what an index is doing. This can be a good thing, as it gives the manager more freedom to show their conviction. For instance, Thomas Moore – who heads up the Standard Life Investments UK Equity Income Unconstrained fund – has 10% more invested in the financials industry relative to the FTSE All Share index. It can therefore be difficult to compare such funds directly to an index – even if it appears to be relevant at first glance.

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 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.

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.

The views of the author and any people interviewed are their own and do not constitute financial advice. However the knowledge that professional analysts have analysed a fund or trust in depth before assigning them a rating can be a valuable additional filter for anyone looking to make their own decisions. Before you make any investment decision make sure you’re comfortable and fully understand the risks. If you invest in fund or trust make sure you know what specific risks they’re exposed to. Past performance is not a reliable guide to future returns. Remember all investments can fall in value as well as rise, so you could make a loss.