The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

SELECTING THE BENCHMARK INDEX

Selecting a benchmark by which to measure performance can be as important as the individual investment decisions themselves. The benchmark index is the basis against which all allocation decisions are made, including duration and curve positioning among others. Not only is the index used as a way to evaluate the relative performance of the manager, but it should be considered the best “passive” way to achieve the goals of the fund. If an inappropriate benchmark is selected relative to the goals of the fund, the manager may perform well against the index but fall short of the desired level of return of the fund. We discuss examples of this later in the chapter.

In the current environment there are myriad index providers, each with a different set of qualifying criteria defining the market. Selecting the appropriate index depends upon the needs of the fund. There are some widely recognized academic principles of what constitutes a good index. The major ones are discussed in the following sections. Later in the chapter, we discuss the pros and cons of defining a custom index and methods to accomplish that task while applying the principles described next.

Principle 1: Relevance to the Investor

Any index chosen as a benchmark must be a relevant investment for the investor. One of the most common examples of relevance is the quest to avoid a “natural concentration” between the business risk of the sponsoring entity and the invested portfolio. For ...