Investment 101: Asset Classes and Blended Benchmarks
by Kelly Pedersen, CFP®
Large-Cap, Mid-Cap, Small-Cap… What’s the Difference?
Market Capitalization (“Cap”) by definition:
“The value of all the outstanding stock shares of a company.”
We can separate companies by size to be able to compare them more “apples to apples.”
- “Large-cap” corporations: Those with market capitalizations of $10 billion and greater. Those with $50 billion and more can even be called a “mega-cap.”
- “Mid-cap” corporations: Those with market capitalization between $2 billion and $10 billion.
- “Small-cap” corporations: Companies that have between $250 million and $2 billion of market “cap.”
Separating companies by size is necessary because each of these classes tend to grow differently, have unique risk attributes and act differently in various types of markets.
Large-caps tend to be less volatile during rough markets as investors fly to quality and stability and become more risk-averse. They also tend to grow a bit more slowly, on average, than mid-cap companies.
Mid-caps and small-caps are usually a bit more volatile, but also have much larger opportunities for growth (quickly)! On the flip-side, they tend to decline in value more and much faster in rough markets. They also can lead the way in growth in a recovering market.
Small-caps are typically small companies that haven’t hit a maturity in their company service or product. They typically have a lot of growth potential, but also a much higher opportunity of failing since they are usually young companies.
Putting a portfolio together with each of the asset classes and then adjusting the weightings of those asset classes is the process called asset allocation. It is a prudent fundamental in investment management.
We as advisors typically use a “benchmark” to give our investment portfolios something of a base to compare performance. Typically, the S&P 500, the Dow Jones, MSCI EAFE and the Barclays Aggregate Bond Index are some the most common benchmarks used. Often though, clients are unfamiliar with what those benchmarks are and how we blend them together to get an “apples to apples” comparison for our portfolios. Here are some definitions for you.
What is a benchmark?
Benchmarks include a group of stocks representing a designated market segment, like an asset class (large-cap, mid-cap, small-cap to name a few). A benchmark is a point of reference for measuring performance. The choice of benchmark can greatly influence decisions throughout the investment process. For example, when selecting investments such as mutual funds or SMAs, you use a benchmark to assess the fund manager’s skills and track record.
- The S&P 500 is a stock market index that tracks the stocks of 500 large-cap U.S. companies. It represents the stock market’s performance by reporting the risks and returns of the biggest companies. Investors use it as the benchmark of the overall market, to which all other investments are compared.
- Use: Compare a large-cap stock or mutual fund to the S&P 500 to get a baseline of how that manager is performing.
- The MSCI EAFE Index is an international stock market index that is designed to measure the equity market performance of developed markets outside of the U.S. and Canada. The EAFE acronym stands for Europe, Australasia and Far East.
- Use: Compare an International stock or mutual fund to the MSCI EAFE to get a baseline of how that manager is performing.
- The Barclays Capital U.S. Aggregate Bond Index is an index of bonds. The bonds represented are medium term with an average maturity of about 4.57 years.
- Use: Compare a bond or bond mutual fund to the Barclays Index to get a baseline of how that manager is performing.
But what if you want to compare a portfolio of many stocks or managers? Say the portfolio has 60% large-cap stocks, 10% international stocks and 30% bonds. It wouldn’t be prudent to compare it to JUST the bond index or JUST the large-cap index. This is where we blend indexes to create a “blended benchmark.”
In the example above, we would take the returns of the S&P 500 at a rate of 60%. Then we would add the returns of the MSCI EAFE at a rate of 10% and lastly, add the returns of the Barclays Aggregate Bond Index at a rate of 30%. By “blending” the returns of each of these indexes at the same “rate” or “proportion” of your personal investment portfolio, it gives you a solid benchmark to compare how your portfolio is performing. This is called a blended benchmark.
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