You have been retained by a wealth managementfirm to advise on the selection of a benchmarkfor its client who has made the decision to investin only U.S. investment-grade corporate bonds

One of the firm's managers recommended that amarket-capitalization-weighted investment-gradecorporate bond index be selected. The managerargued that by doing so the client would know theinvestment characteristics of the benchmark anddetermine if they are within the client's risk tolerance.

What is meant by the investment characteristicsof the benchmark?

Benchmarks are used to determine relative performance of portfolios and securities. When a manager recommends a benchmark, the manager must first review the characteristics associated with good benchmarks. According to industry experts, a valid and effective benchmark must exhibit the following investment characteristics. First, it must be investable. The option should exist to invest in the benchmark as a replacement to the portfolio being considered. For example, it is not possible to invest in the bond fund that will produce top results come year-end, but it is possible to invest in the two-year treasury. Second, it must be suitable.The benchmark's main characteristics are in harmony with those of the portfolio being measured against it. For example, a mortgage-backed securities portfolio is compared to a mortgage-backed bond index. Third, it must operate under an informed opinion. The investments in the benchmark and how they behave are understood, so the performance of the portfolio against the benchmark can be explained. Fourth, it must be clear-cut.To avoid vagueness for a benchmark, a manager should make sure the name and weight of the index or peer group are clearly defined. Fifth, it must be specified in advance. This means the benchmark is selected/constructed before comparing portfolio accomplishments. Altering the benchmark after the fact can exaggerate or play down performance comparisons.