The terms "benchmarks" and "indexes" are often used interchangeably, but they are actually unique terms that describe different things. This Q&A aims to help readers understand the basic roles of indexes and benchmarks, and the desirable attributes of each.
What is an index?
An index is a statistical tool designed to measure performance over time. For instance, the Dow Jones Industrial Average (DJIA) is a securities index designed to measure the performance of 30 blue-chip stocks chosen in part to represent the American economy. On the other hand, the Consumer Price Index is an economic index designed to measure inflation as experienced by everyday shoppers. All indexes are defined by their objectives and methodologies, which together determine their relative strengths and weaknesses.
What is a benchmark?
A benchmark is something that serves as a standard by which others are measured or judged; it is a point of reference from which measurements may be made. In investing circles, almost all benchmarks are indexes, although not all indexes are benchmarks. That's because indexes are developed for a variety of purposes by many different entities, while benchmarks are chosen by people who want to be measured (such as portfolio managers) or by people who do the measuring (such as pension plans or plan consultants). Deciding which index is a "proper" benchmark is often a heated topic of debate among players in the investment arena.
Broadly speaking, a benchmark is an index that serves as the measurement yardstick for a portfolio by comparing portfolio characteristics such as returns, risk, component weights and exposure to sectors, styles and other factors to the benchmark.
What makes for a "good" index?
A good index has a well-defined objective and a methodology that best satisfies that objective. The methodology should be rules bases and transparent. For instance, the Dow Jones Wilshire 5000 (DJW 5000) seeks to measure the performance of all U.S. stocks on the primary exchanges. The methodology is based on prepublished rules and is transparent, i.e., there is no ambiguity as to what makes a stock eligible to be included in the index. (The DJW 5000 methodology can be downloaded at www.djindexes.com.) In addition, a good index will have an objective that takes potential users' needs into consideration.
Shouldn't "investability" be one of the attributes of a securities index?
Not necessarily. The DJW 5000, for instance, is sometimes criticized for holding illiquid stocks that make it hard to invest in. But the objective of the DJW 5000 is to measure the performance of the entire U.S. stock market, not the investable portion of that market. As the broadest measure of the domestic stock market, the DJW 5000 provides a reference point for the "passive opportunity cost" of not investing in U.S. equities for investors making an allocation to other investment opportunities. Since the DJW 5000 does not exclude any stock, the index does not have to justify a selection process.
That said, investability very well could be one of the objectives of an index, especially if it is to underlie an investment product. The Dow Jones Select Micro Cap Index is a perfect example. The index was created in part to serve as the underlying index for an investment product providing exposure to microcap stocks. Therefore, the methodology seeks to measure the performance of liquid and high-quality micro cap stocks, but at the same time is rules-based and transparent. The index also could be an appropriate yardstick to measure the performance of an active domestic micro cap equity manager. It would be a much better "performance benchmark" for such a manager than the DJW Micro Cap Index (which includes, approximately, the 2,500 smallest stocks in the DJW 5000), which instead would be the appropriate selection universe for that manager.
By the way, you can't "invest in" an index. You can invest in a fund or other product that is based on an index.