The most straightforward conventional method involves comparison of the performance of an investment portfolio against a broader market index. The most widely used market index in the United States is the S&P 500 index, which measures the price movements of 500 U.S. stocks compiled by the Standard & Poor’s Corporation. If the return on the portfolio exceeds that of the benchmark index, measured during identical time periods, then the portfolio is said to have beaten the benchmark index. While this type of comparison with a passive index is very common in the investment world, it creates a particular problem. The level of risk of the investment portfolio may not be the same as that of the benchmark index portfolio. Higher risk should lead to commensurately higher returns in the long term. This means if the investment portfolio has performed better than the benchmark portfolio, it may be due to the investment portfolio being more risky than the benchmark portfolio. Therefore, a simple comparison of the return on an investment portfolio with that of a benchmark portfolio may not produce valid results.
A second conventional method of performance evaluation called ”style-comparison” involves comparison of return of a portfolio with that having a similar investment style. While there are many investment styles, one commonly used approach classifies investment styles as value versus growth. The ”value style” portfolios invest in companies that are considered undervalued on the basis of yardsticks such as price-to-earnings and price-to-topic value multiples. The ”growth style” portfolios invest in companies whose revenue and earnings are expected to grow faster than those of the average company.
In order to evaluate the performance of a value-oriented portfolio, one would compare the return on such a portfolio with that of a benchmark portfolio that has value-style. Similarly, a growth-style portfolio is compared with a growth-style benchmark index. This method also suffers from the fact that while the style of the two portfolios that are compared may look similar, the risks of the two portfolios may be different. Also, the benchmarks chosen may not be truly comparable in terms of the style since there can be many important ways in which two similar style-oriented funds vary.
Reilly and Norton (2003) provide an excellent disposition of the use of benchmark portfolios and portfolios style and the issues associated with their selection. Sharpe (1992), and Christopherson (1995) have developed methods for determining this style.