How to Benchmark Your ETF Investments

A key aspect of investing is measuring your results is considering how much has your portfolio gained or lost over a given period of time. This information in and of itself is meaningful, but it doesn’t tell the whole story.

It’s important to also measure your performance against some sort of benchmark to determine how well your portfolio’s performance compares to an alternative or a standard. In this article, we’ll look at why you should set a benchmark and how to pick this target.

Understanding Relative Performance

Relative performance tells you how your portfolio stacks up against a benchmark. No benchmark is the end-all-be-all, but it can be a good starting point. If your portfolio is underperforming its overall benchmark over most time periods it should at least raise some questions that cause you to take a closer look at what you are doing, or how the advisor you’ve hired is managing your money.

Relative performance also pertains to individual holdings, especially with mutual funds and ETFs. For example, if you are looking to invest in an actively managed ETF, it makes sense to track its performance over time against a passive mutual fund or ETF that tracks a mid-cap benchmark like the S&P 400 index, the Russell Midcap Index, or the Wilshire US Midcap Index. Has the actively managed fund outperformed over time? Is the extra expense that the active fund charges offset by superior performance or lower risk over time?

Another way to look at the relative performance of a fund or ETF is to see where it ranks relative to its peers in the same asset class or category. Morningstar ranks funds and ETFs within their appropriate category so this comparison can be pretty easy to make.

Benchmarks and risk

Performance isn’t the only benchmark; risk should come into play as well. Either at the individual holding level or at the portfolio level, how do your investments stack up against a benchmark?

For example, a diversified portfolio might still be compared to a single benchmark like the S&P 500 in terms of the percentage of the benchmark’s return the portfolio captures compared to its relative risk. One way to look at this could be to compare the portfolio’s beta compared to the S&P 500. A beta of 1.0 would say that the portfolio will move in lockstep with the index. A beta of 0.7 says that the underlying portfolio will likely go up or down 70% as much as the index.

If your portfolio has a beta of 0.7 but consistently earns 80% of the return of the S&P 500, you are doing well on a risk-adjusted basis. Portfolio tools like those offered by Morningstar and other sites can help with this type of measurement. This is also a good question to ask your financial advisor.

Common ETF Benchmarks

S&P 500

The S&P 500 is one of the most widely followed stock market indexes. It is widely quoted on cable financial news networks and in the financial press. For many individual investors and professionals, it serves as the de facto investing benchmark.

The S&P 500 is a measurement of the 500 largest U.S. stocks and the stocks represented are weighted by their market capitalization. This is the sum of the share price of each stock times the number of shares outstanding.

Because the S&P 500 is market-cap weighted, the largest stocks can be inordinately weighted in the index. A recent look at the holdings of the SPDR S&P 500 ETF (SPY) that tracks the index shows that the top ten holdings in the fund comprised just over 30% of the portfolio as of January 2024.

Dow Jones Industrial Average

The Dow Jones Industrial Average, often referred to as “the Dow,” is a price-weighted index that consists of 30 large, blue-chip U.S. companies. Investors that want to set their benchmark against the largest, somewhat safest equities can pick the Dow as their benchmark.

The Dow is made up of companies that are leaders in their respective industries and are considered representative of the overall U.S. economy. In some ways, The Dow includes household names such as Apple, Boeing, and Goldman Sachs, and it can also somewhat benchmark against a semi-diversified portfolio since the companies within the Dow are not all within the same industry.

Russell 2000 Index

If an investor is holding a lot of small-cap stocks, they may do well to set their benchmark target as the Russell 2000 Index. The Russell 2000 Index comprises of 2,000 of the smallest companies within the broader Russell 3000 Index. These smaller firms often have higher growth potential but may also be more volatile.

It’s important to point out that this benchmark would carry with it vastly different companies than above. For instance, a benchmark of the top 30 firms within the Dow will react to broader market changes very differently than how the top 2,000 companies may be performing.

Bloomberg U.S Aggregate Bond Index

Investors don’t just hold stocks. They can also hold fixed-income securities. The Bloomberg U.S Aggregate Bond Index is a widely accepted benchmark for the U.S. investment-grade bond market. Comprising a mix of government, corporate, and mortgage-backed securities, this index reflects the overall performance of high-quality fixed-income instruments. Some ETFs (like the iShares Core U.S. Aggregate Bond ETF) seek to replicate the returns of this index.

Price of commodity

The last example provided in this article will be that of a specific commodity or tangible good. For example, the price of gold bullion can be used as a benchmark. In response, the SPDR Gold Trust ETF is designed to track against this price.

Benefits of Setting Benchmarks

Setting an investment benchmark for an ETF offers a bunch of advantages for investors and fund managers. First, benchmarks provide a standard for evaluating the performance of the ETF. This means investors can assess how well the fund has performed relative to the broader market or a specific sector. For example, a 10% return may sound good, but what if a comparable investment yielded 15%?

Second, an investment benchmark serves as a guide for strategic decision-making. It helps with setting portfolio allocation and diversification because it makes it easier for an investor to decide their objectives and risk tolerance. For instance, an investor may look at a benchmark to determine what sort of return they should expect; then, they can back into their long-term goals and risk tolerance to make some tweaks.

Last, benchmarks can enhance communication and transparency between fund managers and investors. They provide a clear standard for conveying investment goals and strategies. It’s sometimes hard for investors to comprehend the fund’s objectives; benchmarks contribute to helping investors identify the sources of a fund’s outperformance or underperformance and bolsters transparency.

Limitations of Benchmarks

Let’s dive into the downsides of benchmarking for ETFs. First, many ETFs are a bit like rebels—they don’t neatly fit into the standard benchmark categories. Trying to find a benchmark for them is like searching for a needle in a haystack that may or may not ultimately fit the thread you’re trying to use. When setting benchmark, be mindful that there not always be a perfect benchmark match.

Next, benchmarks can also be somewhat inflexible. Markets are always on the move. However, you likely won’t change your benchmark every other day. This can be a bit tricky, especially for ETFs with innovative strategies or a focus on emerging markets. Investors need to be savvy and make sure their benchmarks aren’t stuck in the past.

Last but not least, benchmarking doesn’t always cover implications of risk. Benchmarking gives you a glimpse of risk-adjusted returns, but it doesn’t cover all the bases. Things like liquidity risk, tracking error, and market impact are sometimes hidden when doing a benchmarking risk assessment. As you pick your benchmark, be aware that there’s just going to be differences that may or may truly represent the level of risk you are actually taking on.

Benchmarking and Retirement

One very specific use case of benchmarking an ETF relates to retirement planning. Retirement planning is a critical phase of financial management, and ETF benchmarks make it so people can be more comfortable when saving for retirement.

For retirees or those approaching retirement, benchmarks become crucial in determining the optimal balance between risk and stability. For instance, a conservative investor may favor a benchmark that includes a higher allocation of bonds and stable dividend-paying stocks to mitigate market volatility. The investor can then choose to try and mimic or imitate the benchmark, realizing that it’s actual risk and return may slightly vary but should be pretty close to the goal(s) they’re setting.

Long-term goals also play a pivotal role in retirement planning and benchmarking ETFs. An investor who is younger and has more time to save for retirement can aim for long-term capital appreciation (i.e. Russell 2000), while someone prioritizing income preservation could lean towards a more conservative benchmark with a higher allocation to bonds. The point here is benchmarks are very niche and specific to every person’s goals, regardless of their risk tolerance or investment timeline horizon.

One more note on benchmarks and retirement relates to dividends. ETF benchmarks play a vital role in guiding income-generating assets. As investors transition into retirement, they may need dividend income to live off of. Benchmarks can set the expectation that the investor can expect to see, meaning the retiree can move forward with retirement and have a sense of what sort of monthly income they’ll be able to live off of.

Benchmarks and Passive/Active Investing

ETFs come in two varieties: passive or active. Passive ETFs, also known as index funds, meticulously track specific benchmarks. They try to replicate the benchmark’s performance. In this approach, the chosen benchmark acts as a blueprint, and the fund’s asset allocation is based off of this. The allure of passive ETFs lies in their transparency and simplicity, as investors expect these funds to closely mirror the benchmark’s performance.

Conversely, actively managed ETFs introduce a dynamic element, as fund managers actively making investment decisions to surpass benchmark returns. While these funds have the flexibility to try and outearn benchmarks, the selection of a benchmark is critical for evaluating performance. For instance, an aggressive fund manager may generate a return of 8%. However, if the benchmark yielded 11%, perhaps they were overly aggressive and lost potential gains based on poor investment decisions.

The very important factor to consider here is the difference between the two. Passive ETFs aim to hit the benchmark, while actively managed ETFs try to beat it. Therefore, investors need to think about their risk tolerance and how a benchmark slots into this when choosing between the two. For some, it’s great to meet the benchmark. For others who are willing to take risks, they may try to beat it.

ETF Benchmarks and Diversified Portfolios

The S&P 500 might be a fine benchmark if all of your investment holdings are large-cap, domestic U.S. stocks. That essentially is what the S&P 500 tracks.

Most investors, however, have portfolios that are diversified beyond domestic large-cap stocks. For example, your portfolio might also include asset classes like mid-cap stocks, small-cap stocks, international stocks, bonds, and/or cash. Even within those asset classes, equities might fall into categories like growth, value, or blend for large, mid, and small caps, as well as international stocks. On the international side, equities can also track developed markets or emerging markets. There are many sub-asset classes for bonds as well.

The point is that the benchmarks used should do a better job of tracking where you are actually invested, as well as the percentage of your portfolio that is invested in these areas.

Example of ETF Benchmark

As an example, let’s look at a portfolio that is invested as follows:

If we take this example a step further, let’s look at some hypothetical results:

On a weighted average basis, the portfolio had a return of 5.45% for this hypothetical period versus a weighted average return for the blended benchmark of 6.40%. This type of analysis should be done for various periods of time such as the trailing quarter, year, three years, five years, ten years, etc. For a shorter period of time, underperformance might not really tell us much, but over longer periods of time, underperformance might indicate a trend.

The Bottom Line

Using a benchmark is a good way to determine how your investments are performing on a relative basis, either on the portfolio level or the individual holding level. Raw investment performance on its own only tells part of the story.