What is a significant drawback of returns-based benchmarks?

Returns-based benchmarks are constructed using historical return data to determine the characteristics of an investment portfolio. One significant drawback of these benchmarks is that they may result in unacceptable style exposure. This occurs because returns-based benchmarks often assess performance based on past returns without adequately reflecting the current portfolio's investment style or strategy. As a result, a portfolio’s performance might be compared to an inappropriate benchmark that does not align with its actual investment strategy, leading to misleading conclusions about performance.

For instance, if a portfolio is predominantly invested in growth stocks but is benchmarked against a broader index that includes value stocks, the performance attribution may be skewed, creating an inaccurate picture of the management's effectiveness. This issue highlights the importance of ensuring that the selected benchmark accurately captures the investment style and objectives of the portfolio, which can be challenging with returns-based benchmarks.

In contrast, while other options present valid points, they do not directly identify the significant drawback associated with returns-based benchmarks. For example, minimal observation time and ease of construction may be advantages rather than drawbacks, and the fact that such benchmarks do not hold positions in securities is indicative of their nature but does not inherently point to a flaw in their use. Therefore, the challenge of style exposure stands out as a notable limitation in the