Selecting a specific benchmark is an individual decision, but there are some minimum standards that any benchmark under consideration should meet. To be effective, a benchmark should meet most, if not all, of the following criteria:
- Unambiguous and transparent – The names and weights of securities that constitute a benchmark should be clearly defined.
- Investable – The benchmark should contain securities that an investor can purchase in the market or easily replicate.
- Priced daily – The benchmark’s return should be calculated regularly.
- Availability of historical data – Past returns of the benchmark should be available in order to gauge historical returns.
- Low turnover – There should not be high turnover in the securities in the index because it can be difficult to base portfolio allocation on an index whose makeup is constantly changing.
- Specified in advance – The benchmark should be constructed prior to the start of evaluation.
- Published risk characteristics – The benchmark provider should regularly publish detailed risk metrics of the benchmark so the investment manager can compare the actively managed portfolio risks with the passive benchmark risks.