Evaluating the Use of Custom Benchmarks in Performance Evaluation

XYZ Investment Advisory is a firm managing $500 million in assets for clients primarily comprised of high-net-worth individuals. The firm uses a multi-asset investment strategy with investments including U.S. equities, international equities, fixed income securities, and alternative investments. At the end of the fiscal year, the firm’s portfolio achieved a return of 9%, while the relevant market benchmark (the 60/40 stock-bond index) returned 7% over the same period.

However, the firm is considering changing its performance evaluation process. The portfolio manager argues that the current benchmark is inadequate because it does not accurately reflect the firm’s investment strategy, which includes alternative investments not captured by the 60/40 index. As a result, the firm is contemplating establishing a custom benchmark that incorporates a more suitable mix of asset classes, including private equity, hedge funds, and other alternatives.

Discuss the advantages and disadvantages of using a custom benchmark for XYZ Investment Advisory. Additionally, provide recommendations on how the firm should proceed in evaluating its performance in light of this potential change.