For an aspiring female swimmer to compete in the 2024 Olympics, they require a 100m freestyle time of 53.61s. To achieve this, they must perform benchmark testing at different periods during their training to compare performance and to measure improvement. The benchmark is established at the beginning and sets the standard for their goal performance during training.  

Using benchmarks to measure investment performance is similar. If you are an active investor, you will seek to achieve positive relative return compared to your benchmark. In contrast, a passive investor will seek to replicate the benchmark, and therefore achieve a relative return of zero compared to the benchmark.

Benchmarks are traditionally indexes. An index tracks the performance of a broad asset class, such as all listed stocks, or a narrower slice of the market, such as technology stocks. For example, the Nasdaq-100 index is a stock market index made up by 100 of the largest non-financial companies listed on the Nasdaq stock exchange. Indexes are an un-managed hypothetical portfolio of holdings that track returns on a buy and hold basis. They do not have transaction costs, custody and management fees, or real-world costs such as tax.  

Why then, do individual investors try to benchmark their performance against something that cannot be replicated? Why don’t investors benchmark their performance against something realistic, something “actually” investable and something which they can match if they choose to do so? Here is where Exchange Traded Funds (ETFs) come in.  

ETFs are created by large institutions and designed to provide investors with the opportunity to invest in a certain market, sector, or strategy, with little or no effort. ETFs are managed by large institutions who purchase and rebalance the fund, accordingly. A suitable ETF example is the Invesco QQQ, which tracks the Nasdaq-100 index.  

If an investor wishes, they can just purchase the ETF, or they can manage their portfolio themselves, and judge how they have performed compared to it. Either way, their portfolios are subject to actual costs, and if it turns out they cannot “beat the market”, they know it’s down to their investment decisions, not the fact that the comparative index cannot be replicated. An ETF is therefore just like a 100m freestyle time. It is an actual time, performed by a real person, in a real pool, with real world conditions.

Tracking error measures the difference between the performance of an index and an ETF trying to replicate that index. The below shows the difference between the Nasdaq Composite Index and QQQ over a 1-year period, where the difference in performance being close to 1.2%. Tracking error is a prime example as to why an index can never be perfectly replicated.  

Yahoo Finance, 2023

Check out some common ETFs below that can be used instead of an index as a benchmark:

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