Types of benchmarks. Now, benchmarks come in many forms, and we'll go through some of the major types here. First of all, indexes, as we mentioned the most widely used, the most widely available benchmark, but they're not perfect. In certain circumstances, the manager strategy or style may be different, considerably different than the style in the index that's used. An example is a small cap US equity manager using the S and P 500 benchmark that would clearly violate the appropriateness criteria. Next, absolute. While benchmarks are generally a relative comparison, there are instances when there is an absolute return objective used as a benchmark, and an example is an actuarial rate of return assumption or a minimum return target that a fund tries to achieve. And that absolute return objective could coincide with a spending requirement for an individual or an endowment, for example. Now, unfortunately, absolute return objectives are not investible, so it does not satisfy the benchmark validity criteria. Next universe of managers, which is pretty straightforward. It's just a peer group of other portfolios or other managers with a similar style and strategy to compare the portfolio to. Next, style indexes. This is obviouslya subset of the index category but it includes more narrow niches to correspond with various portfolio strategies. Examples are growth value, short duration or credit quality. Now, the Frank Russell Company, Standard & Poor's, MSCI are companies that produce the most widely used US style indexes. And while a little less common, you'll also see style indexes for international non-US holdings. Next factor based. Now here we're matching the risk factors of a strategy in a portfolio to the benchmark. Now, the simplest form of a factor model is a one factor model actually known as the cap and market model. But in the end, the portfolio is benchmarked against the required return, given the level of beta exposure and the other factors within the model. And last, custom benchmark. Here, any combination of indexes, weightings, holdings can be used to benchmark the portfolio. And custom benchmarks are great for investors with more complex investment objectives and constraints or investment managers with unique strategies. The downside, of course, are that they're more difficult to construct and to maintain proper ratings as asset prices move from day to day.
