ABCs of Evaluating Funds: Are You Using the Right Benchmark?

CATEGORIES: Investment Planning

When Selecting Funds Its Not all About Fees
When measuring investment performance, it is important to do so on both an absolute and a relative basis. Absolute performance is of course a critical measure in relation to your own financial objectives – if your retirement plans depend on an annual return of 6% then what matters is hitting that 6% target, not whether your portfolio was better or worse than a relevant performance benchmark.  But relative performance matters too – after all you need to evaluate how the assets you have chosen are doing and for that you need some kind of universe against which to compare them.

Market indexes are one example of a  a useful performance benchmark. If you own mutual funds, for example, it’s no use thinking your positive mutual fund performance is stellar, when it’s in fact underperforming a comparative index. In this post we discuss some ways you can ensure you are using the right benchmarks for the right purposes.

Let’s start with one of the most common mistakes that investors make – and I’m talking here about professional investment advisors and managers who really should know better. That mistake is the indiscriminate use of the S&P 500 as a catch-all proxy for “the stock market”, so that just about any equities portfolio (and even more egregiously, equities portfolios with a large fixed income component) is invariably compared to this index. Why is this a mistake, and if it is incorrect why do so many people swear by this benchmark? We’ll address the second question first – there is no fathomable reason for the S&P 500’s popularity other than familiarity, tradition and perhaps a desire not to stand out from the crowd (professional money folk can be distinctly herd-like in this way).

Now to the first question of why it is a mistake. The S&P 500 is not a “broad market” benchmark in the true sense of the word – it is a large cap index. Consider the following table comparing the returns of a selection of equities benchmarks. The period analyzed here is the ten years from January 1, 2001 to December 31, 2010. The figures are annualized total returns (capital gains plus dividends):

Russell Top 200 Megacap: 0.18%

S&P 500:                           1.31%

Russell 1000 Large Cap:     1.83%

Russell 2000 Small Cap:     6.33%

Russell 3000 All Cap:          2.16%

To see what’s going on here let’s consider what the Russell indexes shown here represent. The Russell 3000 contains 3,000 stocks ranked by market capitalization, which are then divided into subsets. The Russell 1000 contains the 1000 stocks with the highest market cap, and the Russell 2000 contains the remaining 2000. The Top 200 is a subset of the Russell 1000.

Given this breakdown, you can see that using a large cap index to measure “the market” can be unhelpful since the market is not only made of large cap stocks.

So what benchmark should you use? That depends on what is in your portfolio. If you have a selection of very general, broad-based US equities funds  with no particular capitalization bias you probably want to use the Russell 3000. If you have a fund that explicitly advertises itself as large cap or small cap then you want to use the applicable benchmark – S&P 500 or Russell 1000 for large cap, Russell 2000 for small cap. Now you may be thinking: what about that other famous index, the Dow Jones Industrial Average? After all, just about every financial news segment of an evening news program leads off with the “Dow”. Ah, but that index actually contains just 30 stocks, and they are all very large cap. Unless you have a fund that limits its stock picks to names in the DJIA, you are best off ignoring this benchmark for evaluation purposes.

What if you have lots of non-US stocks in the portfolio? Perhaps the most complete set of international market benchmarks can be found in the MSCI Barra indexes. MSCI Barra divides the world into developed, emerging and frontier markets along with several specialty subsets. The MSCI All World Index would be the right one to use if you have a bit of everything. MSCI EAFE is a traditional “developed market” benchmark that includes Europe, Australasia and Far East, while MSCI EM is a good proxy for emerging markets.

For properly diversified portfolios that contain both equities and fixed income, a good way to benchmark performance is through a simple blend of a stock index and a bond index in the same proportion as the portfolio’s own weighting. For fixed income, the Barclays Aggregate Bond Index (US or Multiverse depending on what you have in the portfolio) is a useful benchmark.

Here is an example of how to construct such a blend. Assume that you have a portfolio with approximately 60% exposed to stocks (US + international broad-based) and 40% exposed to bonds (US only). You want to create a blend reflecting this target weighting. First of all, select the indexes. The MSCI All World is probably a good one for the equities component and the Barclays US Aggregate will work for the fixed income portion. Let’s just do a simple calculation for one-year performance. Assume that for the last 12 months the MSCI All World returned 10% and the Barclays Aggregate returned 5% (these are hypotheticals only and do not reflect actual market performance). Multiply the equities return by the equities weight: 10% x 60% = 6%. Do likewise for the bonds: 5% x 40% = 2%. Add together the results: 6% +  2% = 8%, and that is the benchmark number against which to compare your portfolio’s actual performance for that same time period.

Any good service offering mutual fund ratings or investment research should typically show the appropriate benchmark. If not, take care that you don’t ignore the relevant benchmarks when evaluating funds performance. As we said earlier, measuring relative performance does not tell you how much closer you are to your financial goals. But it can give you some good insights into what is working and what is not working, so that you can make the adjustments that may in fact put you in a stronger position to reach those goals.

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About the Author

Katrina Lamb is a CFA for Jemstep. She has over 25 years experience in economics, finance, international development and management strategy, with a strong focus on global markets. She provides a voice of clarity, logic, and reason in an environment characterized by high uncertainty.

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One thought on “ABCs of Evaluating Funds: Are You Using the Right Benchmark?

  1. Pingback: Understanding Correlation and Covariance. And What it Means for Your Portfolio. | The Better Investor @Jemstep

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