Written By:
Cody Mendenhall, CFP®, Executive Director
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Benchmarks – Why, How, and Which to Use?
Last Updated: August 19, 2015
Why you need a benchmark
A common question from plan sponsors is “why do I need a benchmark?” Let’s answer this with an example. Let’s assume an investment in the small growth asset class returns 7 percent over the past 12 months. Most plan sponsors would consider a 7 percent return good. However, if the asset class small growth returned 10 percent then the investment does not look so good. It is important for plan sponsors to have a benchmark because without one they are only relying on absolute returns which can be deceptive.
How to choose a benchmark
How to choose a benchmark is another concern for plan sponsors. A benchmark should be representative of the investment it is chosen to represent, the asset class. It is imperative to select a benchmark to represent an asset class, not select a benchmark to match an investment.
Common benchmark choices include:
Which benchmark to use
Let’s assume a plan sponsor elects to use index benchmarks. The final question is which index benchmark to use. This is a more difficult task than one might think. To properly assess the representativeness of a benchmark a plan sponsor must know how it is constructed. As an example, let’s compare two index benchmarks that claim to represent the same asset classes: Russell Indices and the CRSP (Center for Research in Security Prices) Indices.
| Index Benchmark | Peer Group Benchmark | Custom Benchmark |
| This is a group of securities that represent a certain segment of the market (asset class). Returns are calculated by averaging the returns of securities within the index and weighting them based on market capitalization | This calculates the average performance of investment managers within different asset classes. In essence, is an investment manager beating the average investment manager (top 50%). Common forms of peer group benchmarks include Morningstar Categories and Lipper Averages. | When an investment manager cannot find a standard benchmark to represent the current investment set, a custom benchmark commonly used in asset classes that are a mixture of several asset classes (ie. balanced, allocation, or target date). The benchmark consists of combining 2 or more benchmarks. |
- The Russell index is comprised by weighting all U.S. stocks from largest to smallest capitalization. The largest 1,000 stocks constitute the Large Cap asset class and the smallest 2,000 constitute the Small Cap asset class. The determination between value or growth is more complex, but ultimately utilizes metrics like book-to-price ratio, earnings per share (EPS), Return on Assets (ROA), and debt-to-equity.1
- The CRSP ranks all U.S. stocks by market cap as well but does not limit the index to 3,000 stocks. Instead it sets breakpoints and bands. For example, the Large Cap represents the top 85%, Small Cap the bottom 2%, and Mid Cap representing the remaining. The growth or value metrics used include price-to-book, forward and trailing earnings/price, dividend yield, and sales/price. CRSP keeps 100% of each stock in its respective style index until it passes through a buffer zone. At that point, CRSP moves 50% from one style index to the other. The remaining half will be transferred at a later date.2
