| How to Use Benchmarks continued... |
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| Customized Benchmarks |
| Some professional managers, finding that existing benchmarks are inadequate proxies for their styles, choose to build customized or blended indexes instead. Many bond managers create customized indexes, for instance, reflecting the fact that a given bond fund may invest in a complex mix of fixed-income sectors and duration ranges not necessarily captured in a single index. Blended indexes also work well for hybrid or asset-allocation funds, where several asset classes may be at play in a single offering. It's not unusual to find customized benchmarks in pure-equity environments, though: Fidelity uses a host of internally created benchmarks to track its many funds (including specialized sector funds). Customized benchmarks are generally available and useful only to institutional money managers, but even then they can create their own kinds of problems. Van Kampen American Capital jettisoned its customized benchmarks, for example, because the company found it too difficult to explain them to shareholders and the public. |
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| Absolute Benchmarks |
| Sometimes, the only benchmark you need to set is a personal one. In fitness terms, that might mean getting strong enough to carry your three-year-old around without getting winded, or it might mean building up the power and endurance to climb Mount Rainier. In investment terms, that means setting a benchmark for the returns you need in order to reach certain goals, whether it's a long-term goal like retirement, a short-term goal like a new house, or some other determination, such as a return five percentage points better than the rate of inflation. |
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| This approach to benchmarking is appealing for several reasons. It allows an investor to forgo the short-term mentality that often arises when comparing performance against the S&P 500. You may be less inclined to drop your favorite mutual fund because it trailed the S&P by 10 percentage points when you recognize that its 23% absolute gain still meets your baseline expectations. This is especially worth considering in light of the S&P 500's phenomenal results over the past five years; when that index eventually regresses to a lower level of performance, you will still have the same investing needs as before. Absolute benchmarks also avoid the hyperfragmentation that sometimes occurs when using peer-group comparisons. It's easy to lose sight of the forest when you're staring at the branches: Perhaps your emerging-markets fund has beaten the group average over the past 10 years, but is that really doing you much good if it's only managed to return 6% per year? |
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| When it comes to selecting and using benchmarks, individual investors actually hold some advantages over professional money managers. As an individual, you are not beholden to boards of directors, shareholders, or media scrutiny. If you do not match the returns of an arbitrarily chosen benchmark, you are not subject to a reduction in pay or the possibility of dismissal. Individuals can usually afford to be more patient and to view performance from a variety of perspectives. Probably the best option is to select several benchmarks and examine the performance of individual funds and your overall portfolio on a periodic basis, perhaps annually or semianually. Look at a widely accepted index like the S&P 500 to get a sense of performance on the broadest level, but don't stop there. Look at peer-group benchmarks to see if your fund does a good job at its particular style. Finally, set your absolute benchmark--subject to variation, of course, depending on your changing needs--and make sure that at a minimum your funds are pulling their weight at this level. Benchmarks won't pump up your portfolio in and of themselves, but they'll help you make sure your funds are keeping up with the competition. |
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