Making a better benchmark: A practical guide to effective market representation
Benchmarks play an important and informative role along every step of the investment process. Economists use them to analyze economic trends, and investors make decisions based on those economists’ forecasts. Nearly all types of investors use benchmarks to evaluate the performance of their investment portfolios, and institutional investors in particular use them to conduct risk analysis, develop investment policies and create asset allocation strategies.
Benchmarks are also used as a basis for investable products such as mutual funds and ETFs that allow for passive investment in a specific market, market segment or asset class. No matter the use case, it is important to recognize that a benchmark’s primary purpose is not to achieve a certain level of performance. At the most basic level, a benchmark should function as a measure of the market’s characteristics and performance—it should effectively represent how the market has behaved over time.
This paper outlines three principles essential to a benchmark’s ability to effectively represent a market or market segment; objective construction methodology, modular market segmentation, and reliable maintenance and governance.
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