Question

Most sources report alphas and other metrics relative to a standard benchmark, such as the S&P 500. When might this method be an appropriate comparison?

Answer 1

The broad market index such as S&P 500 has been used as the benchmark in many cases. Every large mutual fund houses uses this index for many purposes.

It can be used to know the performance of fund managers. Whether they have performed good or bad can be indicated by this. If the manager's return is more than index, then he is said to be outperform the market. If it is less than the market return, then he is underperform the market and if the both returns are similar, then he's performance is at par with the market.

Many a times, the investor want to know the risk in his investment compared to the market. So, he uses metrics like alpha to know the relative ups and downs of his investment compared with the index.

A passive investor to neutralize the risk of being compared with the market, he replicate all the composition in his investment similar to the market index. He will include all the securities or the weight of the securities will be similar to market index. In this way, the individual return is similar to the market return and he will saved from comparison.

It can also be used in taking out information from the market. If we want to know the return for longer periods of a particular security, then this index can be used. Market return information can be taken out from this. So, we can use it for making lots of informational decisions.