LOS g: Summarize the steps involved in constructing a custom security-based benchmark.

Q1. Which of the following is least likely to be a step in the construction of a custom security-based benchmark?

A)   Use the same assets for the benchmark as the manager.

B)   Rebalance the portfolio on a periodic basis.

C)   Minimize misfit risk for the benchmark.

Q2. Which of the following is least likely to be a step in the construction of a custom security-based benchmark?

A)   Calculate the historical mean and standard deviation for the benchmark.

B)   Use the same weights for the benchmark as the manager.

C)   Identify the manager’s investment process.

Q3. Which of the following statements best describes the steps required to construct a custom security-based benchmark?

A)   Identify the manager’s investment process including asset selection and weighting; use the same assets and weighting for the benchmark; assess and rebalance the benchmark on a predetermined schedule.

B)   Identify the manager’s investment process including asset selection and weighting; use representative assets and long run average weightings for the benchmark; assess and rebalance the benchmark on a predetermined schedule.

C)   Identify the manager’s investment process including asset selection and weighting; use the same assets as the manager and the long run average weighting for the benchmark; assess and rebalance the benchmark on a predetermined schedule.

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Q1. Which of the following is least likely to be a step in the construction of a custom security-based benchmark?

A)   Use the same assets for the benchmark as the manager.

B)   Rebalance the portfolio on a periodic basis.

C)   Minimize misfit risk for the benchmark.

Correct answer is C)

Misfit risk results from differences between the manager’s normal portfolio and the broader asset class benchmark. In a custom security-based benchmark, there will be and should be misfit risk if the manager’s style is different than the broad market and if the custom benchmark accurately reflects the manager’s style.

Q2. Which of the following is least likely to be a step in the construction of a custom security-based benchmark?

A)   Calculate the historical mean and standard deviation for the benchmark.

B)   Use the same weights for the benchmark as the manager.

C)   Identify the manager’s investment process.

Correct answer is A)

Although calculating the historical mean and standard deviation for the benchmark is something that many portfolio managers will do, it is not specified as one of the steps in the construction of a custom security-based benchmark.

Q3. Which of the following statements best describes the steps required to construct a custom security-based benchmark?

A)   Identify the manager’s investment process including asset selection and weighting; use the same assets and weighting for the benchmark; assess and rebalance the benchmark on a predetermined schedule.

B)   Identify the manager’s investment process including asset selection and weighting; use representative assets and long run average weightings for the benchmark; assess and rebalance the benchmark on a predetermined schedule.

C)   Identify the manager’s investment process including asset selection and weighting; use the same assets as the manager and the long run average weighting for the benchmark; assess and rebalance the benchmark on a predetermined schedule.

Correct answer is A)

The three steps required to construct a custom security-based benchmark are as follows:

1. Identify the manager’s investment process including asset selection and weighting.
2. Use the same assets and weighting for the benchmark.
3. Assess and rebalance the benchmark on a predetermined schedule.