I was recently interviewed by Money magazine on the subject of benchmark rebalancing. Let's say your strategy is 70% equities and 30% bonds, and you are using the S&P 500 for the equity component and the Barclay's Agg for bonds. At some point, because market conditions have shifted, you underweight stocks, overweight bonds, and put some of your money into cash, so that your portfolio is now 40% stocks, 50% bonds, and 10% cash. Do you (a) introduce a cash index into the mix and (b) rebalance?
This is the difference between tactics and strategy. If your long term strategy is 70% equities and 30% bonds, and this tactical move is temporary (however we define "temporary"), I'd say that you leave the benchmark as it is. The main reason is that THIS is your strategy and you want to be able to determine if the tactical move was a good one or not. If you changed the makeup of the benchmark and rebalanced, it would be more difficult to assess whether or not the shift was a good one.
Here's another example: you're entirely in stocks but have decided to avoid the financial sector for the next few months: should your index reflect this shift?
The answer: No! If you make the index ex financials, then you won't know if this tactical move was a good one or not.
I recall a few years ago, Frank Sortino spoke of a manager who invested in Japan and who had superior performance, but had a high tracking error. The reason for the high tracking error: he avoided Japanese banks, thus the makeup of the portfolio was significantly different enough from the benchmark to produce this large tracking error. A prospective client liked the performance but not the tracking error. The manager's reply: well, we could invest in some bad banks if you'd like. Wrong answer! The right one would have been to rerun the tracking error against the index, ex financials, to demonstrate how the investor did against the index with the same mix; but this would only be to mollify the prospective client's concerns about the high tracking error, and to clearly demonstrate its source. He could go further and provide attribution that would highlight where the outperformance came from. But the index, for comparison purposes, should remain with financials.
Tactics vs. strategy: it's important to keep these points in mind when considering changes to the benchmark.