James Frazee is chief investment officer at H&F Capital Investors. Frazee hires a third- party adviser to develop a custom benchmark for three actively managed balanced funds he oversees: Fund X, Fund Y, and Fund Z. (Balanced funds are funds invested in equities and bonds.) The benchmark needs to be composed of 60% global equities and 40% global bonds. The third-party adviser submits the proposed benchmark to Frazee, who rejects the benchmark based on the following concerns: Concern 1: Many securities he wants to purchase are not included in the benchmark portfolio. Concern 2: One position in the benchmark portfolio will be somewhat costly to replicate. Concern 3: The benchmark portfolio is a float-adjusted, capitalization-weighted portfolio.
Which of Frazee’s concerns best justifies his decision to reject the proposed benchmark? A Concern 1 B Concern 2 C Concern 3
Concern 1 would imply that the benchmark is not representative of the investable universe and as a result it would not likely provide any reasonable measure of comparison. For example, if you were a fixed income manager, would you want your portfolio performance to be benchmarked against an equity index?
Edit: unless of course you were hoping to show your ability to outperform equity markets with a fixed income portfolio that is!
Hi @S2000magician , can you help me understand why the benchmark must be capitalization-weighted? For example, why can’t it be equal weighted?
Is it because the actively managed portfolio is effectively ‘cap’ weighted? E.g., if I have Stock A and Stock B in my portfolio, and Stock A comprises 90% by market value of my portfolio, a 5% increase in price of Stock A will increase my portfolio by much more than a 5% increase in price of Stock B?
So this is similar to how the mega tech stocks in the S&P 500 move the index much more than the other smaller stocks.