A benchmark, or index, is essentially a basket of securities in which portfolio managers and their investors compare investment performance.

There are many broad indexes available including the S&P 500, Dow Jones Industrial Average, Barclays Aggregate Bond Index, Russell 2000, etc.

The objective in choosing an appropriate benchmark is using an index or group of securities that is most comparable in terms of style, historical volatility, market cap, yield, etc, etc.

A combination or ratio of multiple indexes can also be assembled to further synchronize with an investment strategy.

In effect, moves in the market that influence a particular portfolio should also produce an equivalent move in a suitable benchmark.

An asset manager’s ability to “beat” the benchmark has unfortunately become a be-all and end-all of score keeping for too many investors.

While the retail investor can use benchmarks as a guide, it is important they understand certain inadequacies that come along with this type of evaluation if no other due diligence is performed.

How does a manager beat a benchmark?

There are many types of risk when investing in the market, but for practical purposes, let’s focus on two distinct types of risk found in every actively managed portfolio.

Systematic risk, such as owning stocks in general, is risk that cannot be diversified away. The market compensates investors for taking on systematic risk with a premium, or potential return which is proportionate with the amount of risk taken on.

This is a constructive kind of risk which allows us a return on our assets above the risk-free rate, over time.

Active risk is that which is associated with the investment decisions of the asset manager. This risk includes specific stock selections, market timing decisions, block trade execution styles, etc.

Active risk is measured as the annualized standard deviation of the monthly difference between portfolio return and benchmark return. This is also referred to as the tracking error.

Active managers will overweight positions which they feel offer the most attractive return over a period of time. The further a manager moves from the benchmark with its portfolio positioning, the more active risk is being taken on.

A higher level of active risk results in a higher probability its return will differ from the benchmark.

This means the portfolio can underperform to the degree in which it outperforms.

The benchmark paradox is such that the greater an asset manager outperforms a benchmark, the greater the portfolio has likely strayed from that benchmark, making it no longer a suitable measure of comparison.

TLDR, a better goal might be to simply replicate a benchmark at the lowest possible cost, done : )