Investors use indexes as benchmarks, or yardsticks of investment return. These benchmarks can help you evaluate the performance of the overall market, particular market sectors and industries, individual securities, and active invest- ment management. For example, you can measure the performance of a large-cap stock portfolio of US companies against the S&P 500, the DJIA, the MSCI Large-Cap 300, or the Russell 1000.
What’s more, since the goal of an active investment manager, whether he or she is overseeing a portfolio of individual investments or an actively managed mutual fund, is to provide a stronger return than the relevant index, you can evaluate the manager’s results against that same standard. You’ll find that some managers out- perform some of the time, but only a few of them are able to do so over extended periods.
Just because an investment outperforms its benchmark in a particular year doesn’t necessarily mean it’s right for your portfolio. You still want to evaluate each investment in light of your risk tolerance, time horizon, and overall investment strategy. Similarly, an investment that misses its benchmark from time to time may still be a smart addition to your portfolio if it helps you diversify.
Not all benchmarks are indexes. Long-term bond yields, for instance, are commonly measured against the yield of the 30-year US Treasury bond. Similarly, the benchmark for cash equivalent investments is the return on the 13-week US Treasury bill.
Just as individual investors use market indexes to evaluate the returns their investment advisers are providing, institutional investors—including pension funds, endowments, and mutual funds— use benchmarks to evaluate the professional
Contributions from the book Index Investing in this press release are used with permission from Light Bulb Press.