To measure a fund manager’s ability to beat the market or assess the added value from a particular investment strategy, performance must be compared with that which could have been obtained in some simple or passive manner. This comparison is known as the benchmark. Selecting an appropriate benchmark requires thought by both the fund manager and the client.
It should fulfil three conditions. First, it should be representative of the entire set of securities in the fund manager’s universe. Second, the benchmark should be investable. Third, it should be specified in advance (a characteristic notoriously not possessed by a peer group benchmark). With these conditions, a benchmark should represent the same asset class as the portfolio and have a similar risk. Finally, a benchmark should represent an appropriate target to measure investment skill from the client’s perspective.