by John Markese

Typically, investors accumulate mutual fund investments—and now also exchange-traded fund (ETF) investments—in brokerage accounts, 401 (k) plans, IRAs and other retirement plans. These funds, and other investments, form the basis of our financial plans and are the vehicles that drive our financial goals.

In order to make sure we are on track to achieve these goals and to assess our investment decisions, we have to measure:

• How well our funds have done individually, and
• How well our fund portfolio has performed as a whole.

That’s where benchmarking comes in, and all benchmarking is relative.

Benchmarking Basics

There are two basic ways to benchmark your funds and your portfolio:

1) Comparison to an index fund, or

2) Comparison to the average performance of funds with the same investment approach.

The charm of index funds as benchmarks is that they have extremely low expenses, always remain fully invested and are broadly diversified within their investment category. And they are also an alternative investment to an actively managed, non-index fund investment.

The other benchmark, an average of actively managed funds in the same investment category, is a peer group comparison. But even within a peer category there are significant differences in investment style and risk, requiring a careful look at the fund and how it stacks up, in terms of portfolio composition, to the category peer group.

The ultimate goal is to minimize benchmark error by selecting appropriate benchmarks that will give a true relative performance reading.

How It Works

To illustrate benchmarking approaches, an example mutual fund portfolio is detailed in Table 1.

The portfolio weights (the percentage of the total portfolio) for each mutual fund are based upon market values at the beginning of the period that will be used in the comparison. Weightings based on the ending period would distort the comparison by double-counting the investment performance of the portfolio because portfolio weights change over time and reflect portfolio performance during the period.

The returns reported in Table 1 are total returns for the period, and include reinvestment of all distributions of income and capital gains. The returns for the portfolio, peer category averages, and benchmark index funds are all before taxes and net of all fund expenses, but do not reflect any front-end or back-end loads, redemptions or individual investor incurred brokerage fees.

The example portfolio in Table 1 is well diversified, without any forays into more exotic fund investments. It includes only actively managed funds, rather than index funds, to highlight the benchmarking process for an individual investor. Similarly, the funds used in the example have been chosen with a specific growth or value approach within a stock-capitalization size category, mid-cap value for instance, to further explain the details of benchmarking. However, keep in mind that many fund choices are actually a blend of both growth and value approaches. Lastly, although none of the funds in our example is an exchange-traded fund, the comparison benchmarking process would be exactly the same if those kinds of funds had been included.

Given the fund portfolio, the next step is to match up an appropriate index fund benchmark to each fund. For our index benchmarks, all Vanguard index funds are used for simplicity and due to the broad offering of index funds by Vanguard, a fund family that pioneered indexing. [For sources of information on index funds and index fund returns, see the box on page 14 ].

Appropriate Benchmarks

Finding an appropriate benchmark index fund match for a diversified domestic stock fund requires you to determine the investment approach and cap size of the fund. This classification can be determined by reading the fund prospectus, consulting a source such as Morningstar, or using AAII materials such as the Individual Investor’s Guide to the Top Mutual Funds. the Quarterly Low-Load Mutual Fund Update or the on-line Top Mutual Funds Guide—Plus . which gives investment category and a full page of data on all the no-load and low-load funds we track (available at AAII.com). For non-diversified stock sector funds, an index fund equivalent is usually not available and the benchmark alternative is the category average.

For diversified international stock funds and for diversified emerging markets funds, there are broad-based index funds in those categories that can be used as benchmarks. With single-country funds or regional stock funds, the benchmark comparison most often would have to be made against a category average peer group. However, European and Pacific stock index funds exist and can be used if they match up to the portfolio holdings of your regional fund. For bond funds, the three key variables for benchmarking are issuer, quality and maturity. Benchmark bond index funds are only easy to find in the general bond category.

For U.S. government bond funds, the nature of U.S. government bonds makes an index fund rare. Municipal bond funds, whether national or state specific, also do not have readily available benchmark index funds due to the fragmented nature of the municipal bond market and inactive trading. For these funds, along with mortgage-backed, corporate, and high-yield bond funds, you would turn to category averages for use as benchmarks.

Maturity matching for benchmarking bond funds is crucial and the maturity designations for bond funds of short term, intermediate term and long term should determine the appropriate bond index fund benchmark. Unfortunately, mortgage-backed, municipal, corporate and U.S. government bonds all behave differently even if the maturities of the bonds are similar, so you really can’t cross-index among these categories. An intermediate-term corporate bond fund will act differently than an intermediate-term U.S. government bond fund.

A Benchmarked Portfolio

In Table 1. the example portfolio of funds is matched one-on-one with index funds. For example, the American Century Income and Growth fund, a large-cap growth-value blend fund, is matched up with the Vanguard Index 500 fund, based on a large-cap growth-value blend index. The Dreyfus Small Company Value fund is matched with the Vanguard Small Cap Value Index fund and so on.