A benchmark, in investing, is a standard against which the performance and risk of a fund, portfolio or manager is measured. Most benchmarks are market indices, such as the S&P 500 for large US shares or a broad bond index for a bond fund, but a benchmark can also be a group of similar funds, a blend of indices, or a target such as inflation plus a set margin.
Benchmarks give returns a context. A fund that gained 8% in a year when its market rose 12% has lagged, even though it made money. Benchmarks are also the reference point for risk statistics such as alpha, beta, R-squared and tracking error. The word has a second, related meaning in markets: a reference rate or price used to settle contracts, such as SOFR, which replaced LIBOR for US dollar contracts.
Benchmark in plain terms
A runner who finishes a race in 50 minutes cannot tell whether that was good without knowing the course and the field. Fifty minutes over 10 kilometres on a flat road is ordinary; on a steep mountain trail it might win.
A benchmark is the course record for an investment. It shows what an investor could have earned by simply buying the whole market the fund works in, usually at very low cost. If the fund does better than that, its manager has added something. If it does worse, the investor would have been better off with a cheap fund that just follows the benchmark. Choosing the right course matters: comparing a bond fund with a stock index is like timing a swimmer against runners.
Types of benchmarks
- Broad market indices. Indices covering a whole market, such as the S&P 500, the MSCI World or a total bond market index. These are the most common benchmarks for funds.
- Style and sector indices. Narrower indices for growth or value shares, small-cap stocks or individual sectors, used to judge specialist funds more precisely.
- Blended benchmarks. Weighted mixes such as 60% equities and 40% bonds, used for balanced funds and multi-asset portfolios.
- Peer groups. Averages or rankings of similar funds, such as Morningstar categories or Lipper classifications. These show how a fund did against realistic alternatives after costs.
- Absolute targets. Cash plus a margin, or inflation as measured by the Consumer Price Index (CPI) plus a margin, often used by hedge funds, target-return funds and pension funds.
A good benchmark is investable, transparent, specified in advance and matched to the fund's actual opportunity set. If any of these is missing, a fund can appear to beat its benchmark simply because the comparison was poorly chosen.
Benchmarks in US fund disclosure
In the United States, the Securities and Exchange Commission (SEC) requires mutual funds and ETFs to show performance against a benchmark. The fund's summary prospectus includes a bar chart of annual total returns and a table of average annual returns over one, five and ten years (or since launch), compared with an appropriate broad-based securities market index.
Under the SEC's tailored shareholder report rules, adopted in October 2022 with a compliance date of 24 July 2024, each fund's annual shareholder report must also show a line graph and table of performance against such an index. The SEC defined an appropriate broad-based index as one representing the overall applicable domestic or international equity or debt market. A fund may add narrower indices that better match its strategy, but a narrow sector index cannot serve as the main comparison. SEC staff guidance allows, for example, municipal bond funds to use a broad index of the municipal market.
Benchmarks in other jurisdictions
In the European Union, UCITS funds that are managed against a benchmark must name it in their offering documents and show their past performance alongside the benchmark's. The EU Benchmarks Regulation (Regulation (EU) 2016/1011), which applied from 1 January 2018, governs the providers that produce benchmarks used in financial contracts and funds, and the United Kingdom kept an equivalent regime after Brexit, supervised by the Financial Conduct Authority (FCA).
Problems and criticism
- Mismatched benchmarks. A fund that holds many mid-cap stocks but compares itself with a large-cap index may look skilled in years when smaller companies do well, simply because of the mismatch.
- Benchmark switching. Changing the benchmark after a poor period can flatter the record. Regulators and the CFA Institute's Global Investment Performance Standards (GIPS) require benchmark changes to be disclosed.
- Costs. Indices bear no fees or trading costs, so even a perfect index fund lags its benchmark by roughly its expense ratio.
- Benchmark hugging. Managers judged only on relative performance may keep portfolios close to the index to avoid standing out, producing "closet index funds".
- Relative versus absolute. Beating a benchmark that fell 30% still means a loss, which matters to investors who need a set amount by a set date.
Despite these limits, a benchmark remains the simplest test of whether active management, with its higher fees, has earned its keep. Measures such as the Sharpe ratio complement it by asking how much risk was taken to reach a given return.