Relevant Benchmarks

Quick Answer

A benchmark must match the portfolio's investment style, asset class, and risk profile, or the comparison misleads. Benchmark types include market index, peer group, absolute return, and custom blend, alongside common named indices such as the S and P 500, Russell 2000, MSCI EAFE, and the Bloomberg U.S. Aggregate Bond Index.

Choosing the right benchmark matters: the wrong one can make a mediocre manager look brilliant or a skilled manager look terrible. This page covers benchmark types, common named benchmarks, index weighting methods, and how to select the right benchmark for a given portfolio.

What Are the Benchmark Types?

Market index benchmark compares performance to a representative index, such as the S and P 500 or Russell 2000.

Peer group benchmark compares a manager's performance to other managers in the same investment category, such as ranking among large-cap growth managers.

Absolute return benchmark targets a fixed return regardless of market conditions, such as CPI plus 3 percent. Common for hedge funds and liability-driven portfolios (like pension funds) that must meet a specific return obligation.

Custom blend benchmark combines multiple indices weighted to match a portfolio's actual asset allocation, such as 60 percent S and P 500 and 40 percent Bloomberg U.S. Aggregate Bond Index for a 60/40 balanced portfolio.

What Are the Common Equity Benchmarks?

Benchmark: S and P 500. What it covers: 500 large-cap US stocks. Weighting: Market-cap weighted.

Benchmark: Russell 2000. What it covers: 2,000 small-cap US stocks. Weighting: Market-cap weighted.

Benchmark: Wilshire 5000. What it covers: Total US equity market. Weighting: Not applicable.

Benchmark: MSCI EAFE. What it covers: Developed international markets (ex-US, ex-Canada). Weighting: Market-cap weighted.

Benchmark: NASDAQ Composite. What it covers: All NASDAQ-listed stocks. Weighting: Not applicable.

Benchmark: Dow Jones Industrial Average (DJIA). What it covers: 30 large-cap US stocks. Weighting: Price-weighted.

Benchmark: Consumer Price Index (CPI). What it covers: Inflation. Weighting: Not applicable (used for real return comparison).

Key points:

Market-cap weighted means larger companies have more influence on the index's return.

Price-weighted means higher-priced stocks have more influence, regardless of company size.

The Wilshire 5000 is the broadest US equity benchmark, often used as a proxy for the total US stock market.

The MSCI EAFE excludes the US and Canada, making it the standard international developed-market benchmark.

The CPI is used as a benchmark for comparing real (inflation-adjusted) returns.

Exam Tip: Gotchas

The DJIA is price-weighted, NOT market-cap weighted. The S and P 500 is market-cap weighted. If the exam asks which index uses price weighting, the answer is the Dow Jones Industrial Average.

What Is the Common Fixed-Income Benchmark?

Bloomberg U.S. Aggregate Bond Index ("the Agg"): covers the broad investment-grade US bond market. This is the standard fixed-income benchmark.

How Do Index Weighting Methods Work?

Method: Market-cap weighted. How it works: Larger companies have more influence. Example: S and P 500, MSCI EAFE.

Method: Price-weighted. How it works: Higher-priced stocks have more influence. Example: DJIA.

Method: Equal-weighted. How it works: All components weighted equally. Example: S and P 500 Equal Weight Index.

How Do You Select the Right Benchmark?

The benchmark must match the portfolio's investment style, asset class, and risk profile. Using an inappropriate benchmark is misleading and overstates or understates manager performance.

A small-cap portfolio should be measured against the Russell 2000, not the S and P 500.

An international equity fund should be measured against MSCI EAFE, not a domestic index.

A bond portfolio should be measured against the Bloomberg Aggregate, not an equity index.

Exam Tip: Gotchas

The exam will test whether you can select the appropriate benchmark for a given portfolio. A manager of a small-cap value fund should NOT be compared to the S and P 500 (large-cap blend). Always match the benchmark to the portfolio's style and asset class.

How Does Excess Return Over a Benchmark Differ From Alpha?

Both measure outperformance, but they are not the same number, and the exam tests the difference.

Measure: Excess return over the benchmark. Formula: Portfolio return minus benchmark return. What it adjusts for: Nothing. It is a raw comparison.

Measure: Alpha. Formula: Actual return minus CAPM expected return. What it adjusts for: Systematic risk, through the portfolio's beta.

A portfolio returning 12 percent against a benchmark returning 9 percent has a 3 percent excess return over that benchmark.

That 3 percent is not alpha. Alpha requires the CAPM expected return, which needs the risk-free rate, the market return, and the portfolio's beta.

Excess return says the portfolio beat the benchmark. It does not say whether the portfolio beat it after accounting for the risk taken, which is what alpha answers.

Exam Tip: Gotchas

Portfolio return minus benchmark return is excess return, not alpha. The exam offers this subtraction as a distractor in alpha questions. See the Returns section for the CAPM calculation alpha actually requires.

Alpha depends on which benchmark you choose, because beta is measured against that benchmark. The same portfolio can show positive alpha against one index and negative alpha against another. That is a reason to select the benchmark carefully, not evidence that either result is wrong.

What Should You Check on Exam Day?

The four benchmark types: market index, peer group, absolute return, and custom blend.

Absolute return benchmarks (such as CPI plus 3 percent) target a fixed return, common for hedge funds and liability-driven portfolios.

Custom blend benchmarks combine indices to match a portfolio's actual allocation.

The DJIA is price-weighted; the S and P 500 and MSCI EAFE are market-cap weighted.

Match the benchmark to the portfolio's investment style, asset class, and risk profile: small-cap to Russell 2000, international to MSCI EAFE, bonds to the Bloomberg U.S. Aggregate.

Portfolio return minus benchmark return is excess return, not alpha; alpha requires the CAPM expected return, which needs the risk-free rate, the market return, and beta.