What is a benchmark?

I recently conducted a GIPS(R) (Global Investment Performance Standards) verification for a client who uses the S&P 500 as the benchmark for a hedge fund. But given that the hedge fund isn't constrained to S&P 500-like securities but can invest in all kinds of assets, is this truly an appropriate “benchmark”? Even though the firm has a “goal” to beat the S&P 500, is it fair to compare the fund to it? I would say “no.” Hedge funds are usually thought of as “absolute investments” that don't have benchmarks, per se. But on what can I base this position?

If we turn to the GIPS 2010 standards’ glossary we find the following definition for the word “benchmark”: “A point of reference against which the composite’s performance and/or risk is compared.” Based on this definition, the client would have grounds to say that the S&P 500 is fine. But I think that the wording here is incomplete. One must venture to the section on Presentation and Reporting to really understand what is meant by “benchmark.” In ¶ I.5.A.1.e, we find “The benchmark must reflect the investment mandate, objective, or strategy of the composite.”

Benchmarks serve as a way to determine if the manager performed well. Too often we see the wrong ones employed. I recall an advertisement that appeared in January 2000 touting how 39 of a fund family's mutual funds had outperformed the S&P 500. Included were global and style funds that had no relevance to the S&P 500 and would not give any valid indication as to whether or not the funds had done well or not. Unless the manager actually manages against the benchmark such that the benchmark reflects the mandate, objective and strategy, it is inappropriate to use.

In this case the fund can invest in commodities, industries, currencies, and derivatives; the S&P 500, of course, cannot. I am tempted to say "pick on somebody your own size." To show the S&P 500 as a reference is fine, just as many hedge funds also show a bond index or even the consumer price index; these are merely for reference purposes only. And this should be clear. Most hedge funds are "absolute" investments for which sadly there really aren't relevant benchmarks.