A benchmark, a group of companies chosen to represent a certain part of the market, serves as a comparison point for both companies and funds and their investors. It aims to level the playing field for investors by allowing them to compare performance of funds in the same peer group or category.

Mainstream UK funds may use the FTSE All-Share index as a benchmark. This index contains about 750 of the largest companies that are listed on the UK stock exchange.

Specialised funds tend to use more specific indices that will reflect the sectors in which they invest. A healthcare fund may use the S&P Healthcare index while the MSCI World Financials index could be the most appropriate for a financials fund.

One way to measure the riskiness of a fund is to gauge the tracking error of the fund against an index benchmark. Tracking error can be a confusing term as it has a different meaning in passive fund management – the management of funds which track stockmarket indices - than it does with active fund management. Simply put it describes how much the returns from a fund will vary from those of its benchmark. In the context of passive management, tracking error describes how well a fund tracks its benchmark. Investors would want as small a tracking error as possible with a passively managed fund.

In the context of active management, tracking error is a misnomer. Here it describes how far the fund manager has strayed from its benchmark. This is not an error, just a method of measurement that is useful in performance assessment. A high tracking error means the fund moves less in line with the index, which could be positive or negative depending on the bets the manager has taken.

Fund managers

A herd mentality can exist just as easily with fund managers as it can with investors. With an actively managed fund it may be difficult to assess how much freedom the manager has to make his own decisions about asset allocation and how much he may be captive to benchmark movements.

The two types of benchmarks used by fund management groups are peer benchmarks and index benchmarks. Peer benchmarks refer to a fund’s competition in its category: for example comparing the performance of one UK smaller companies fund to another. Index benchmarks are the scientifically developed ones such as the FTSE and MSCI indices that are discussed in further detail below.

A fund manager can measure the performance of his fund versus all the other funds with the same investment objective. He does this by comparing his fund to the average of the sector (category) in which his fund is grouped. In this way he has a basis for measuring how well or poorly his fund is doing compared to those of his peers. Of course he can only find out what his competition has done rather than what they are planning.

Standard Life primarily focuses on peer group benchmarks. Alan Burton, the managing director of mutual funds at Standard Life Investments and chairman of the Association of Unit Trusts and Investment Funds (AUTIF) , says: “Most of the benchmarks we measure ourselves on are the AUTIF sector benchmarks and the relative performance in those sectors. Internally the asset class manager might well set up other indices for the fund manager to perform against.”

Index benchmarks

An index benchmark provides a different kind of comparison. With one, a manager can compare the performance of his fund against stockmarket averages. Take for example an actively managed UK equity fund benchmarked against the FTSE All-Share index. It is impractical for the fund to hold all 758 companies listed on the index so the manager would wind up with the 50-100 he believes have the most potential. By comparing how his fund has done to the FSTE All-Share he gets an idea of how his selections are performing.

Index benchmarks are also an aid in fund construction. Take a North American fund benchmarking itself against the S&P 500. Not only does the index provide a breakdown by company but also a breakdown by sector such as industrials, financials and technology.

The fund manager can use the index as a guide to what percentage of his fund should be in each sector. It does not mean he must have the same weightings but it lets him know how they are represented within the index. This also holds true for the weightings of individual firms.

Benchmarks are an important tool in the process of fund construction at SG Asset Management. It monitors the tracking errors of its funds quite closely to make sure that they are aware of all the bets they are taking. This way compensatory measures can be taken where needed.

“The asset allocation committee may be saying we want to be in banks but that doesn’t mean we have to hold the four largest firms. We won’t go hugely under or overweight a sector but within the sectors we will pick which companies we want to get that sector exposure”, says Mik Bates, a director of SG Asset Management. “We expect that stock selection to be of a much greater impact on the performance of the fund than the sector weighting.”

The usage is quite balanced at Schroders. The performance targets for its retail business are first quartile performance against the competition and it finds that in most instances there is a well-defined set of competition.

“I use indices as an interim stage for getting from the objectives of the business to how funds are constructed”, says David Gasparro, the chief investment officer for retail funds.

“I think it is appropriate to target a level of performance against an index. The first question is to ask if the fund is set to outperform the index or is the tracking error way too high? Of that tracking error, the absolute risk that you are running, how much is stock-specific and how much is sector, how much is country and how much is style? Look at all of the positions of the fund against the index and say is the balance sensible and reflection of our ability to add value?”

Risk managers

Those at the fund management companies who decide the risk levels of a fund range also use benchmarks but in a slightly different way. Martin Veasey, the head of investment risk at Gartmore, finds peer group benchmarks, although useful in other ways, lacking because of their retrospective nature. He is more interested in shaping fund portfolios going forward. In these cases he needs to look at scientifically put-together benchmarks such as the MSCI and FTSE ones:

“We won’t slavishly try to replicate our fund alongside the index but we will say what is the tracking error we expect to be running in the future compared to it. In the circumstances where we have got deviation on a sector basis we check that analysis out against the index.”

“We ask ourselves is that a stance we actually mean to take as opposed to something that has developed in the investment portfolio over the last month or so?”

Yet with specialised funds benchmarks can be less useful.

One area where both an index and a peer group benchmark may not provide an accurate comparison of performance is with focus funds. These hold a more concentrated portfolio [to learn more about focus funds read Focus funds in perspective] of the shares of perhaps 20-40 companies.

“The benchmark becomes very much less relevant”, says Richard Boardman, the director of risk modelling at Royal & SunAlliance Investments. “This is more about the best ideas the fund manager is pursuing at any one time during any one day.

“Investors can expect that performance may well be over the short time periods more volatile than the peer group. Over the longer period we are hoping to pick the real winners that will ultimately drag the performance record of the fund a long way from where that peer group median is.”

Main players

The key index providers for most of the UK market are FTSE , which is jointly owned by the Financial Times (FT) and the London Stock Exchange (LSE), Morgan Stanley Capital International (MSCI) and for those investing across the Atlantic, Standard and Poor’s (S&P).

In the daily business reports UK investors are told how much indices like the FTSE 100 , the S&P 500 or the Nasdaq rose and fell. The table below highlights some of the most prominent:

Index	Description
CAC 40	The CAC 40 Index is an index containing 40 major French companies listed on the Paris Bourse.
XETRA DAX	The Deutsche Aktienindex (DAX) is an index made up of the 30 largest German companies listed on the Frankfurt Stock Exchange.
Dow Jones	Founded in 1896, the Dow Jones Industrial Average comprises 30 large, liquid companies traded on the New York Stock Exchange. This most commonly quoted index contains a balanced range of blue chip companies.
FTSE 100	The FTSE 100, started in 1984, is an index comprised of the 100 largest companies by market capitalisation on the LSE. The FTSE 100 replaced the FT 30 as the mostly commonly quoted index on the LSE.
FTSE All-Share	The FTSE All-Share Index contains about 750 of the largest companies on the London Stock Exchange.
MSCI World Index	The MSCI World Index is a global index containing 1,375 companies from 19 countries. It covers about 60% of the market capitalisation of world stock exchanges.
Nasdaq	The Nasdaq Composite Index measures the market value of all the domestic and foreign common stocks listed on the Nasdaq Stock Market.
S&P 500	The S&P 500 is an index containing 500 of the largest, most creditworthy American companies.

The constituents of the indices are reviewed on a regular basis at which point companies are added or dropped from the list. Readers may remember the flurry when the FTSE 100 was last reviewed in June particularly concerning the dropping of Railtrack.

Falling from the FTSE 100 has more of a psychological effect than a practical one says Graham Colbourne, the director of markets development at FTSE. Being a member is an indication of power in the market rather than of how much money will be invested in the firm.

“Most funds in the UK and 80% measured by value are benchmarked against the FTSE All-Share so whereas Railtrack fell out of the FTSE 100 it did not mean that a lot of investors were likely to sell the shares.”

Mr Colbourne says: “We try to make the FTSE indexes as transparent and predictable as possible. We have firm review dates each quarter. Also we have tried to put as much structure in the process as we can so people can follow what we are doing and don’t get any surprises.”

Morningstar benchmarks

To ensure consistency for investors researching funds within its categories Morningstar uses the series of MSCI indices. Each category has its individual index against which the funds are compared.

On the total returns page of the Morningstar Quicktakes the performance of the fund relative to its index (+/- Index ) and its category (+/- Category ) is shown. The index figure shows the performance of that single fund against the MSCI index Morningstar has designated for that category. The category number details how the fund has performed compared to the average of all of the funds in its category.

In addition, investors can find more information about the risk characteristics of their funds on the Rating and Risk page of the Morningstar Quicktake reports.