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Ty, what did you shoot today?

Oh, Judge, I don’t keep score.

Then how do you measure yourself against other golfers?

By height.

Benchmarking … is important. It is one of many basics that most traders ignore, or do in an ignorant fashion. It is related to evaluating performance metrics, but it’s not the same thing as measuring performance.


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You know, you should play with Dr. Beeper and myself. I mean, he’s been club champion for three years running and I’m no slouch myself.

Don’t sell yourself short, Judge, you’re a tremendous slouch.

In a game of golf, the score is the performance metric. The benchmark is something else; it’s what you judge whether a score is good, or not, by comparison to. Being the club champion means that performance in the tournament ranking is the metric, and the composite performance of tournament participants is the benchmark. If somebody talks about their handicap, they are applying a performance metric to the benchmark of “par.”

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This is a hybrid. This is a cross, ah, of Bluegrass, Kentucky Bluegrass, Featherbed Bent, and Northern California Sensemilia. The amazing stuff about this is, that you can play 36 holes on it in the afternoon, take it home and just get stoned to the bejeezus-belt that night on this stuff.

Some benchmarks, apparently, involve multitasking.

In trading, there are two basic types of benchmark: relative and absolute.

Relative benchmarks mean that performance is measured against an index, a category, or some other measurement that moves from year to year, as the market moves. There are two separate reasons why this might be done; in the case of money managers, the index is supposedly representative of the trading style used, and in the case of many individual investors, the index is the alternative investment choice, if the portfolio was unmanaged.

The idea behind measuring a manager against a relative benchmark comes from the idea that we shouldn’t hold things against the manager, if those things were outside the manager’s control. The best gold sector fund manager in 1981 had a tough row to hoe! Relative benchmarking says, “hey, it’s not your fault, let’s see how you did against the other guys in the same type of fund!” The poorest-quality manager in emerging market funds has probably given the best-quality manager in U.S. domestic diversified funds a good clock cleaning, performance wise, but how did they each do against their respective benchmarks?

The problem many people have is assigning the proper benchmark. Is the proper benchmark the index that approximates the universe of investable issues for that fund? Is that by default the S&P 500, the Russell 1000, the DJ Total Market? Usually this comes up as a problem when the manager can broadly diversify.

For example, what is the benchmark for a hedge fund? Is it the hedge fund index? Which hedge fund index? What about merger arbitrage funds? Stat arb funds? Global Macro? If the improper benchmark is selected, for example, measuring a stat arb fund against the S&P 500, our metrics might make us believe that the fund’s management added value when it didn’t, or didn’t add value when it did.

Alpha and Beta are functions of a benchmark’s excess returns over the risk-free rate, against the manager’s excess returns over the risk-free rate. It’s a mouthful, but it boils down to needing: (1) the return of “cash” over the time period, (2) the return of an appropriate relative benchmark over the time period, with “appropriate” being a problematic word, (3) the manager’s returns over the time period, and (4) a computer to do the linear regression on. I find it very unfortunate that “alpha” and “beta” have entered into the vernacular, because nowadays it’s almost impossible to know exactly what most pundits, bloggers, and scholars mean when they use the terms, unless you ask them - and then you still may not know, because THEY can’t define it! Outside of the regression equation used as a means to evaluate a return series, the words “alpha” and “beta” are meaningless. I include them here because, when used mathematically and correctly, they are benchmarking functions that might possibly be useful.

For retail traders, often the relative benchmark is the alternative investment. This is actually a pretty easy selection – ask yourself, “Self,” because that’s what I call myself when I talk to myself, “Self, what would you buy and hold if you weren’t playing the home game?” And there’s your relative benchmark.

We might argue whether the rate on cash varies enough from year to year to be considered a “relative” benchmark, but it’s my post, so I’m including it here as a relative benchmark, and various performance metrics use cash (or the “risk-free rate”) as a benchmark, the Sharpe Ratio being one of them. The Sharpe Ratio is a comparison to the risk-free rate as a benchmark, providing either the odds that the return is statistically better than cash, or the odds of making money if using leverage at cash to fund the system, depending on how you look at it.

But wait, there’s more! What about … absolute benchmarks?

With an absolute benchmark, the target return or performance is constant regardless of what the market around it does. This doesn’t mean the benchmark is set in stone for decades, it could be revisited annually, but the benchmark is set irrespective of the broader market moves.

I can think of two good reasons to set an absolute benchmark. First, if the goal is set based on a minimal desired outcome, and second, if the goal is set based on a backtested strategy result.

Imagine “Mr. Retired” who needs to spend, this year, about 4% of his investable wealth to live life as he is accustomed. Further, he anticipates his style of life will increase in costs at 4% a year. Perhaps he should set something around +8.2% as a minimum benchmark? Maybe even crank a little compounding into the mix, so that his “cushion” in times of equity drawdown or unforeseen expenses will grow? This absolute benchmark is set based on a need or desire. If the index posts a +25% that year, “Mr. Retired” is still happy if he gets his steady, consistent +8.2%, because that’s his benchmark.

Now take “Mr. Day Trader,” who needs to make 40% on his stake to meet expenses. He had darn sure put some compounding and cost of living in his benchmark, and then carefully consider whether he’s got the capital to trade for a living, considering his rather high absolute benchmark.

Finally, take “Mr. System Developer” who has tested a system over a long time period. It would make sense that his benchmark isn’t set on a need or desire, but is set based on what he believes the system is capable of providing. In this case, perhaps the index returns a typical +10% in total return, and “Mr. System Developer” makes a +18% that year. Is he happy? Not if his benchmark is +25%, he isn’t!

Benchmarkin’ ain’t easy, but it’s necessary. Is your benchmark a relative one, or an absolute one? And why?