Investors use indexes as a way to compare the performance of an investment (or portfolio of investments) to the performance of the market that investment belongs to. They want to know how they've done compared to the index: better, as well, or worse. That's why the indexes are known as benchmarks. One thing to note - you can't directly invest in an index. There are ETFs and Mutual Funds out there that are set up to track an index, but you'll need to read the prospectus for details.
The Standard & Poor's 500 Index (S&P 500) is the benchmark for large cap stock mutual funds' and ETFs' performance. That's because it includes many of the stocks that this type of fund holds in its portfolio. You can also measure a fund or ETF against other indexes, like the ones provided by Morgan Stanley Capital International (MSCI) and Morningstar, Inc. There are also indexes that serve as benchmarks for bond funds, a variety of other investments, and investment strategies.
All indexes are governed by a strict set of rules that cover which securities may be included in a particular index, how the index is calculated, how it's maintained and updated, and how to fix any discrepancies.
What a benchmark shows
Benchmarking against an index is really the best way to objectively evaluate investment performance. For example, suppose your portfolio of large-cap stocks gained 8% in a particular year. That might seem great, but if the S&P 500 gained 20% that same year, your portfolio of large-cap stocks seriously underperformed its benchmark.
Of course, any portfolio can have a good or a bad year. But if your investment mix underperforms its benchmark year after year, it may be time to make some changes. On the other hand, if your portfolio of mid-sized company stocks held steady in a year that the S&P MidCap 400 lost 10%, you might decide that you've done well under the circumstances, even though your return was flat.
Apples to apples
You have to be sure you're looking at the right benchmark if your comparison is going to give you good information. If you measure the performance of one category of investment against the benchmark of another, you may not have the best information. For instance, let's say you wanted to check in on the performance of your small-cap US equity portfolio. You'd want to choose an index that tracks small-company stocks, such as the S&P 600 or the Russell 2000. A large-cap benchmark, such as the S&P 500, may not be the best comparison. That's because from year to year large-cap and small-cap stocks tend to report different returns.
The same warning applies when you gauge bond fund performance against a benchmark. For example, the annual return on long-term US Treasury bonds is likely to be very different from the return reported for high-yield corporate bonds or general obligation (GO) municipal bonds.
A two-way street
You can use benchmarks to measure performance, as well as to rate the suitability of an investment you're considering for your portfolio.
Let's say you want to diversify a stock portfolio that has mostly domestic stocks, and you're considering adding an international mutual fund or ETF. As part of your research, you can compare the performance of the international funds you're researching to the performance of the MSCI EAFE (Europe, Australasia and Far East), for example. Keep in mind, however, that past performance is no guarantee of future results.
An actively managed mutual fund often includes "beating its benchmark" as one of its investment objectives. That is, it wants to outperform the index that best aligns with its investment portfolio.
However, just because an investment outperforms its benchmark in a particular year doesn't necessarily mean it's right for your portfolio. You should still look at each investment in light of your risk tolerance, time horizon, and overall investment strategy.