In "Portfolio Strategies for Outperforming a Benchmark" (appearing in Handbook of European Fixed Income Securities published by John Wiley & Sons in 2003),
the authors, William Lloyd and Bharath K. Maniumm, set forth the following six major principles for a good bond market index:
Principle 1: Relevant to the investor.
Principle 2: Representative of the market.
Principle 3: Transparent in rules with consistent constituents.
Principle 4: Investible and replicable.
Principle 5: Based on high data quality.
Principle 6: Independent.
Explain why each of these principles is important in creating a bond market index.
Principle 1 is important because a good bond market index needs to consider the investor's preferences and needs. 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. Principle 2 is significant because any bond index that does not represent the market can take on firm specific risks and idiosyncratic risks leading to suboptimal performance due to insufficient diversification. In brief, a good benchmark should provide an accurate picture of the market it claims to represent.
Principle 3 is essential because a bond index should be managed in such a manner so that its rules are clear and interpretable. One of the definitions of a bond index is the it is a rule-based collection of bonds. Thus, it is imperative that the rules governing the bond index are transparent and applied objectively in a consistent fashion. Principle 4 is important because a good bond fund must pick suitable investments (investible criterion) and must actually represent a chosen bond index that can be accuracy reproduced (replicable).
Principle 5 is important because the bond index must contain bonds of high quality that meet the required standards and also blended in a manner to maximize the investor's investment.Principle 6is a key to a good bond fund investment because we want to satisfy the independent investments by individuals and companies as well as their independent goals.
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