It's not enough to simply pick good mutual funds and hope that your money will grow. You need constant evaluation and comparison to keep your investment program on track. That means measuring your fund's performance not only on its own, but also in comparison to a benchmark. But knowing which benchmark to compare your fund with can be a tricky business, even for the fund managers themselves.
A recent study from the University of Southern California shows that 42% of actively managed domestic stock funds list benchmarks in their prospectuses that do not match their investment style. No wonder investors have a hard time deciding on a relevant benchmark! Fund management is well aware that its results are being compared to benchmark indexes. In many cases, managers can most easily beat their benchmark by simply changing the index to which their fund is compared.
For example, with growth stocks out of favor in recent years, most growth managers have found themselves lagging the broader market. So many such managers have started comparing fund results to a growth-oriented benchmark, such as the Russell 1000 Growth, rather than a broader market measure such as the S&P 500. Results look much more favorable when measured against the growth benchmark's lower bar.
Similarly, customized benchmarking has become increasingly popular. Many funds now track more obscure or proprietary indexes created by their own management. This trend is especially pronounced with some newer exchange-traded funds. The ever-narrowing segments these ETFs track have prompted the creation of new benchmarks. In many cases, investors don't even know what companies these indexes actually contain -- let alone whether the indexes are appropriate for them.
Looking at the bigger picture
In general, I think the move toward more specialized and narrow benchmarks just adds to investor confusion. The many funds comparing themselves to inappropriate benchmarks in the first place only compound the problem. But Fools know to keep the broader picture in mind when comparing performance results.
In general, you should compare your fund to the broadest possible market index, even if you own a growth or value fund. By choosing to focus on a given style of stock, your manager is making a conscious decision to move to one side of the investment spectrum. Shouldn't he or she be punished or rewarded accordingly?
Over the long run, style-specific differences in the market average out, and growth and value tend to perform roughly the same. Comparing your growth or value fund to a style-specific benchmark can be important in the short run, but you should never stop matching your fund against the market as a whole.
For most large-cap domestic stock funds, the old standby S&P 500 index is wide enough to capture the workings of the overall market. The Dow Jones Industrial Average, though popular, is much too narrow to make sense as a proper benchmark, with its disproportionate weight on high-priced stocks such as IBM
For small-cap mutual funds, the Russell 2000 index should be your preferred benchmark. If you own mid-cap funds, try consulting the Russell Mid-Cap index. Again, be aware of how the growth and value subsets of the market perform (as tracked by the Russell 2000 Growth and Russell 2000 Value indexes), but keep your focus on the broader market.
If you own international stock funds, the MSCI EAFE index should be your first choice as a benchmark. Just be aware that there are no emerging-market components here; you might want to check on that segment of the market separately, using the MSCI Emerging Markets index.
Broad fixed-income investors would do well to compare performance of their bond funds to the Lehman Brothers Aggregate index, which includes a measure of performance for government, mortgage-backed, asset-backed, and corporate bond issues. If your bond fund is more specialized, such as a high-yield or municipal bond fund, you'll want to find more specific indexes, of course.
There are many funds for which these benchmarks may not make sense, but for most diversified investors, they're a good place to start. While fund managers may compare their own results against any number of benchmarks, do your own homework, and make sure you know which indexes are the best fit for each of your funds. That way, you'll have fewer surprises when evaluating fund performance.
We set the benchmark for further Foolishness:
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