Relative Comparisons

Most of these are qualitative checks rather than formulas, and the exam tests them just as heavily: a beautiful 10-year return chart is meaningless if the wrong benchmark, a departed manager, or a changed strategy is behind it. Two of the comparisons do need arithmetic, and they are worked through below.

What Makes a Benchmark Appropriate?

A benchmark is a standard against which fund performance is measured. The appropriate benchmark must match the fund's investment style and asset class.

• Funds should be compared to an appropriate benchmark index matching their investment style
• Large-cap U.S. equity fund vs. S&P 500
• International equity fund vs. MSCI EAFE
• Bond fund vs. Bloomberg Aggregate Bond Index
• Benchmark comparison, adjusted for the fund's beta, reveals whether the manager adds value (alpha) or underperforms on a risk-adjusted basis

Exam Tip: Gotchas

Use the right benchmark. Comparing a bond fund to the S&P 500 is inappropriate. The benchmark must match the fund's asset class and investment style.

Why Does Manager Tenure Matter?

• Length of time the current portfolio manager has managed the fund
• Short tenure may mean past performance is not attributable to the current manager
• Manager changes can signal shifts in investment strategy or approach

Think of it this way: Past performance belongs to the person who generated it. A fund's 10-year track record is irrelevant if the manager who achieved it left two years ago.

Exam Tip: Gotchas

Past performance of a mutual fund may be irrelevant if the portfolio manager recently changed. Always check manager tenure before relying on historical returns.

How Do You Measure a Manager Against the Benchmark?

Once you have decided that a track record belongs to the current manager, the exam often asks you to do the arithmetic before you judge. Two measures carry over from Portfolio Performance Measures.

Chain-link the returns across the tenure; do not average them. Turn each year's return into a growth factor, multiply the factors, then subtract 1.

• A fund returns 12% in its manager's first year and -4% in the second: 1.12 × 0.96 = 1.0752, so 7.52% over the tenure
• Its benchmark returns 8% and -2% across the same years: 1.08 × 0.98 = 1.0584, so 5.84%
• Outperformance for the tenure: 7.52% - 5.84% = 1.68 percentage points

Adjust for risk before you credit the manager. Raw outperformance ignores how much systematic risk the manager accepted to get it. Alpha is the actual return minus the return the capital asset pricing model (CAPM) expected, where the expected return is Rf + β(Rm - Rf).

• A fund returns 10%, its benchmark returns 8%, the risk-free rate is 3%, and the fund's beta is 1.10
• CAPM expected return: 3 + 1.10(8 - 3) = 8.5%
• Raw outperformance is 2.0 percentage points, but alpha is only 1.5 percentage points

Exam Tip: Gotchas

Never average yearly returns to judge a tenure. Averaging 12% and -4% gives 4% a year, which implies 8.16% across two years, above the true compounded 7.52%. The simple average overstates whenever returns move up and down. Averaging also hides the risk question: a fund can beat its benchmark on raw return and still deliver a smaller alpha, or a negative one.

The full formulas and the other return measures live in Portfolio Performance Measures, under Returns.

How Does a Change in Investment Policy Affect Comparisons?

• A fund may change its investment objective or strategy (requires shareholder vote for fundamental changes)
• Past performance data becomes less relevant after a significant policy change
• Investors should review the prospectus for any recent changes

What Is Investment Style, and What Is Style Drift?

• Morningstar-style boxes classify funds by: size (large/mid/small) and style (value/blend/growth)
• Style drift - when a manager deviates from the stated investment style
• Active vs. passive (index) management affects fee levels and expected tracking

Exam Tip: Gotchas

A change in investment policy makes prior performance data unreliable. Similarly, style drift is a red flag: if a fund's holdings no longer match its stated strategy, the adviser should investigate.

Which Securities Indexes Are Used as Benchmarks?

• S&P 500 - 500 large-cap U.S. stocks (market-cap weighted)
• Dow Jones Industrial Average (DJIA) - 30 blue-chip stocks (price weighted)
• Nasdaq Composite - all Nasdaq-listed stocks (tech heavy)
• Russell 2000 - small-cap U.S. stocks
• Wilshire 5000 - broadest U.S. equity index (total market)

Indexes are unmanaged and do not incur fees; comparing a fund's returns to an index without adjusting for fees is misleading.

What Should You Check on Exam Day?

• Match the benchmark to the fund's asset class and investment style; a mismatched benchmark (bond fund vs. S&P 500) makes the comparison meaningless.
• Check manager tenure before trusting a historical track record; a short-tenured manager cannot claim credit for older returns.
• Chain-link the yearly returns across a tenure rather than averaging them, then compare the result to the benchmark over the same years and adjust for beta using alpha.
• A significant change in investment policy or noticeable style drift both make past performance less reliable going forward.
• Know the standard index roster: S&P 500, DJIA, Nasdaq Composite, Russell 2000, and Wilshire 5000, and remember indexes carry no fees of their own.