In financial markets, a benchmark is an indicator used to evaluate the state of the market or its segments. Most often stock indices play the role of benchmarks. In a broader sense, the benchmark can be the price of a commodity such as crude oil or gold.
Comparing the dynamics of the movement of benchmarks of different markets allows you to identify the dynamic of different markets and sectors and decide on the purchase or sale of relevant assets.
What Are Benchmark Indices?
These are standards that are used to analyze the efficiency of managing a unit investment fund. Most often the yield of the fund with the growth rate of the national stock index is compared. The US indices for stock-oriented funds are the Dow Jones Index, S&P 500, and NASDAQ. The indices for bond funds are represented by the Lehman Brothers Aggregate Bond Index and other numerous indices. In Europe, the fund performance is measured against the FTSE indices, such as Eurofirst, Developed Europe, and Europe 350, as well as the Euro Stoxx 50 and 600. Asia uses the S&P Asia 50 index as a benchmark.
Each investment fund has its own benchmark index. If you study documents on mutual funds that you own, you may notice that investment companies compare performance against such indices. Fund managers can choose their own indices, but they have to be credible.
How to Use Benchmark Indices
The benchmark is not only informative but also brings practical benefits to investors who are faced with the choice of financial instruments for investment. To determine how profitable a particular financial instrument can be, it is enough for an investor to look at its dynamics regarding the selected index.
Suppose a global market is a benchmark. Even if the national stock market has slightly sunk against it, it is still considered stable. Only significant deviations are taken into account. If national indices have sunk more than a benchmark, it is said about the "oversold" and "undervalued" markets. If the market grew at a significantly faster pace than the benchmark, it is said that it is "overbought" and "overvalued". In general, a benchmark can be defined in the form of both a market index and individual financial instruments.
Open End Funds
The purpose of an open-end fund is to repeat the structure and profitability of the selected index. An index that is most appropriate in terms of structure and investment strategy is chosen as a benchmark for such a fund. In the case when a suitable index does not exist or when the existing public index does not meet the requirements for open-end funds, the company independently calculates the relevant index.
The fund's portfolio does not copy the index, but rather serves as a guide and starting point for the portfolio formation. A comparison of the real profitability of the fund with potential profitability, as shown by the benchmark, allows defining the degree of efficiency in managing a particular fund. The only exceptions are index funds, which, by definition, seek to recreate the structure of the index and show the yield as close as possible to the yield of the corresponding index.
A benchmark index is a standard serving as a reference point to measure the performance and profitability of investment funds. Each fund has its own benchmark, typically calculated against the growth rate of the national stock index. For example, in the US these are the Dow Jones Index, S&P 500, NASDAQ, and Lehman Brothers Aggregate Bond Index. In Europe, the FTSE indices, such as Eurofirst, Developed Europe, and Europe 350 are used, as well as the Euro Stoxx 50 and 600. There are also open-end funds that use the indices of other funds as a reference for their own benchmarks.
Benchmark indices can help investors with the choice of financial instruments for their portfolio.