Good benchmarks increase the proficiency of performance evaluation, highlighting the contributions of active managers, and enhance plan sponsors' ability to control risk. Bad benchmarks obscure the contributions of managers and can lead to inefficient allocations of plan assets. Yet, despite the importance of benchmark quality, and the advances that have been made in the construction and application of customized benchmarks, benchmark quality has remained a neglected issue.
Several criteria can be used to evaluate the appropriateness of a manager's benchmark. Specifically, (1) the benchmark should contain a high proportion of the securities represented in the managed portfolio. (2) The proportion of the benchmark's market value allocated to purchases during periodic re-balancing i.e., benchmark turnover should be low.
(3) The manager's active position as defined by the benchmark-that is, the managed portfolio's allocation to a security less the weight of the security in the benchmark-should be mostly positive (a condition not satisfied by most capitalization-weighted indexes). (4) The benchmark's percentage allocations to securities should represent investable position sizes, given the manager's total assets.
(5) The variability of the manager's active return as measured against the benchmark should be lower than his active return as measured against a market portfolio. (6) The correlation between the extra-market returns of the managed portfolio and those of the benchmark, which relates the manager's performance adjusted for the market to the benchmark's performance measured against the market, should be significantly positive. At the same time, (7) the correlation between the extra-market returns of the benchmark and the managed portfolio's returns adjusted for the benchmark's returns should be close to zero. Finally, (8), the style exposures of the managed portfolio and the benchmark, as defined by a multi-factor risk model, should be similar.