All portfolios, whether they are stock or bond portfolios, are compared to benchmarks to gauge their performance; indices or peer group statistics are used to monitor the success of each fund.
As composites, the indices can be thought of as similar to polls: a polling firm that seeks to understand what a certain population thinks about a certain issue will ask representatives of that cross-section of the population. Similarly, a stock or bond benchmark that seeks to measure a certain portion of the market will simply compile the values of representative stocks or bonds.
Portfolio construction refers to the manner in which securities are selected and then weighted in the overall mix of the portfolio with respect to these indices. Portfolio construction is a fairly recent phenomenon, and has been driven by the advent of modern portfolio theory.
1. Passive investors or index funds
Portfolios that are constructed to mimic the composition of various benchmarks are referred to as index funds. Investors in index funds are classified as passive investors, and investment managers who manage index funds are often called “indexers.” These funds are continually tinkered with to ensure that they match the performance of the index. For equities, the S&P 500 is the benchmark that is most commonly indexed.
2. Active investors
Portfolios that are constructed by consciously selecting securities without reference to the index are referred to as active portfolios. Active portfolios adhere to their own investment discipline, and investment managers actually invest in what they think are the best stocks or bonds. They are then compared, for performance purposes only, to the pre-selected index that best represents their style. For instance, many large-capitalization active value portfolios are compared to either the S&P 500 Value index.(It is important to note that while active portfolios are still compared to indices, they are not designed specifically to mimic the indices.)
3. Alternative methods
Variations of active and passive portfolios are present throughout the marketplace. There are enhanced index funds that closely examine the benchmark before making an investment. These portfolios mimic the overall characteristics of the benchmark and make small bets that differentiate the portfolio from its index. Another type of popular portfolio construction method is sector investing. This is essentially a portfolio that is comprised of companies that operate in the same industry. Common sector portfolios include technology, health care, biotechnology and financial services.