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FRM Part II · FRM Exam Part II · Portfolio Performance Evaluation

A pension fund evaluates an active equity manager by comparing returns with a custom benchmark. Which characteristic is essential for the benchmark to be considered valid for performance evaluation?

A valid benchmark is investable and specified in advance, so the manager's results can be compared with a feasible passive alternative. Benchmarks built after the fact, or chosen for high past returns, do not reflect the mandate and distort the evaluation of skill.

  1. AIt is investable, so the manager could have replicated it at low cost, and it is specified in advanceCorrect
  2. BIt is the broad market index with the highest historical return over the past decade
  3. CIt is constructed after the period ends to match the manager's actual holdings
  4. DIt contains only the securities the manager held at the start of the period and never changes

Explanation

A valid benchmark must be unambiguous, investable, measurable, appropriate to the mandate, reflective of current investment opinions, and specified in advance. An ex-post benchmark built from the manager's own holdings would mechanically flatter or hide performance, so it is not valid. Choosing the highest-returning index ignores mandate fit.

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