What are benchmarks and indices?

When investors want to establish how their investments are performing, it can be helpful to compare them against a ‘benchmark’ or ‘index’ (or ‘indices’ in plural).

Comparing the performance of an investment

There are two ways of looking at a financial return – either on an absolute or on a relative basis.

An absolute return is simple to understand – a fund or investment pot has risen or fallen by a certain amount over a period of time. But many investors will want to understand the context of that performance – how well has their investment performed when compared with similar funds run by other investment managers, or with wider financial markets?

Some investment firms will run portfolios on an ‘unconstrained’ basis, meaning they will aim to maximise returns without reference to a specific benchmark. Even so, returns are likely to be compared to a broad measure such as a global index like the MSCI All Country World Index, or a ‘composite’ market index, which is made up of a selection of different areas of the market, or an economic measure like inflation.

What’s the difference between a benchmark and an index?

Often used interchangeably, there are differences between the two...

At the risk of adding a little confusion, an index can be used as a benchmark. Continuing the example above, the UK bond market could be represented by the MSCI UK Government Bond Index (an index published by MSCI to track this segment of the bond market). This index could then be used as the benchmark for a UK bond fund.

The evolution of financial indices

In the late nineteenth century, the first lists detailing daily share price moves were provided by US financial publisher Dow Jones. The index of the same name became the most recognised index globally for almost a century.

As financial markets have developed, so has the range of indices available. Ultimately, though, these are hypothetical portfolios which investors can use to gauge the performance of their own investments.

And while indices initially covered just shares, there are now indices covering the whole range of financial instruments, such as fixed income, commodities, and currencies, as well as alternative assets. Some of these indices continue to be operated and updated by publishers such as the Financial Times, Nikkei and S&P.

Demand for different indices has continued to grow, especially for financial assets that do not trade on centralised exchanges, such as fixed income (bonds) or commodities (like oil and gold). The result is that banks such as JP Morgan or financial data providers such as Bloomberg regularly generate new indices for investors reference.

Well-known stock market indices:

Choosing an appropriate benchmark to measure investment performance

It’s an obvious point, but worth stating – whatever benchmark is chosen should be relevant when applied to the underlying investments. For example, it would not be helpful to use indices like the MSCI All Country World Index or the MSCI Emerging Markets Index as the benchmark for a portfolio of investments focused on shares in developed economies only. The investment characteristics of these regions will differ considerably, making the comparison unhelpful.

For similar reasons, it doesn’t make sense to measure the performance of bond or real estate investments against an index which tracks share prices. Specialist indices such as the JP Morgan Global Aggregate Bond Index or the MSCI World Real Estate Index could be more appropriate.

Can you invest in an index?

Investors cannot invest directly in an index as it only tracks the performance of a range of assets. However, index funds were devised in the mid-1970s, and allow investors to gain exposure to the assets in an index which will then rise and fall in line with the real index. Since their introduction, they have proved highly popular and now account for about half of all total US fund assets. A key reason for their popularity is that they are ‘passively managed’, meaning that costs are reduced as there is no need for a fund manager to make investment decisions – the fund is simply tracking an existing index.

Exchange Traded Funds (ETFs) are a form of index fund which have also proved very popular, but offer greater flexibility as they can trade throughout the day (unlike index funds which are priced once a day). ETFs have now developed across asset classes, with many focusing on specific investment themes or strategies. Collectively, index funds and ETFs can be referred to as ‘trackers’.

There are drawbacks in relying only on passive funds, including:

• Passive funds’ key characteristic (that they mimic the behaviour of benchmarks) means they cannot provide any protection when markets fall sharply.
• Because indexing is a passive process, there is no control over the mix of individual share holdings. If a share or sector becomes attractively valued for example, there is no mechanism to buy more, or vice versa.
• This inflexibility extends to the suitability of the passive fund(s) owned. Does the mix of underlying assets always represent the most suitable choice based on an individual investor’s appetite for risk? The attractions of a low-cost investment approach can be eroded if the fund is unsuitable.

How will indices and benchmarks feature in my investments?

When you invest, your investment manager may indicate an index or benchmark to which you can compare the performance of your investments over time. This should provide helpful and relevant context for your investments.

Passive tracker funds might also play a role within your investment portfolio, as a cost-effective way to track certain markets, themes or sectors. They could be blended within a range of asset types like shares, bonds and alternative assets.

If you’d like to find out more about the different aspects of investing, please explore the other topics featured in our Learning Zone.