Benchmark index

Then most important type of benchmarking from the point of view of investors, is the benchmarking of the performance of funds and portfolios.

Funds usually choose an index to be their performance benchmark. The index will match the region or sector the fund invests in. A British technology fund might choose one of the Techmark indices, whereas an emerging markets fund may choose one of the MSCI indices.

The use of indices as benchmarks is one of the reasons why so many different indices exist: they need to match the variety of funds. Even so, some funds and portfolios are better served by using a composite of several indices.

One danger this brings is that it tempts managers to track their benchmark index (and thus avoid the risk of under-performing) rather than genuinely trying to beat it: supposedly actively managed funds thus become closet trackers.

Indices are not perfect benchmarks for performance measurement. Limitations include the range available (although this can be overcome by using synthetic indices specially calculated for a specific portfolio). Another, difficult to resolve, problem is that changes in composition introduce a form of survivorship bias and, if not carefully used, benchmark look-ahead bias.

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