Benchmark is that which can be measured and used as a yardstick/standard to compare others’ value. In finance, a benchmark, in the form of indices, is the point of reference for things like financial performance, returns, and a fund manager’s performance..
An equity stock exchange’s performance (including the stocks of the companies listed on it) is measured in relation to its flagship index, which will that exchange’s benchmark. The index gets built in a representative way to act as the benchmark such as the NSE’s Nifty and the BSE’s Sensex.
For sectors within an exchange, say the banking sector on the NSE, an effective benchmark would be the sub-index, Bank Nifty.
Benchmarks tell us how the respective financial markets are doing and let’s us gauge the performance of the players within them, as a result.
Without a benchmark to measure progress against, performance evaluation becomes a relative term. A 6 percent return on a diversified equity stock portfolio in a month might be impressive only if we know the larger stock market (or the benchmark) to have declined in the same month. If the benchmark rose by 20 percent, then the portfolio’s gains pale in comparison.
Some of the properties of an ideal benchmark are:-
- Unambiguous — The benchmark should be unambiguous and defined precisely.
- Representative — The benchmark should have a fair representation of the different kinds of constituents in its market/exchange in order to truly represent it.
- Investable — The benchmark should be investable, ie. an investment manager can passively invest in the benchmark.
- Appropriate — The benchmark should reflect the investment mandate. For measuring the performance of a debt fund, the benchmark should not be an equity index.
- Measurable – The returns of the benchmark should be readily available and easily measured. So, the data on the benchmark index should be regularly published, preferably in real time.