Relative Comparisons

The final piece of evaluating pooled investments is measuring how they actually perform. Individual fund returns mean little without context; advisers must compare performance against appropriate benchmarks and consider the manager behind the results.

What Is a Benchmark?

A benchmark is a standard index used to evaluate a fund's performance. The key principle: the benchmark must match the fund's investment style and asset class.

• A fund that outperforms a properly matched benchmark, after accounting for risk, fees, and the measurement period, may have added value through active management
• A fund that consistently underperforms its benchmark may not justify its management fees
• Comparing a bond fund to the S&P 500 (or an equity fund to a bond index) is meaningless; the benchmark must reflect what the fund actually invests in

Exam Tip: Gotchas

• Always match the benchmark to the fund's investment objective. A small-cap fund should be measured against the Russell 2000, not the S&P 500. Mismatched benchmarks make performance look artificially good or bad.

What Are the Key Securities Indexes?

• S&P 500: Tracks 500 large-cap U.S. stocks; market-capitalization weighted; the most widely used benchmark for U.S. equity funds
• Dow Jones Industrial Average (DJIA): Tracks 30 large-cap blue-chip stocks; price-weighted (higher-priced stocks have more influence); less representative than the S&P 500 but widely quoted
• Nasdaq Composite: Tracks all stocks listed on the Nasdaq exchange; heavily weighted toward technology companies
• Russell 2000: Tracks 2,000 small-cap U.S. stocks; the standard benchmark for small-cap funds
• Bloomberg U.S. Aggregate Bond Index: Tracks the U.S. investment-grade, fixed-rate bond market including Treasuries, corporates, mortgage-backed securities, and asset-backed securities; the standard benchmark for bond funds

Exam Tip: Gotchas

• The DJIA is price-weighted, not market-cap-weighted like the S&P 500. This is a frequently tested distinction.
• The Bloomberg U.S. Aggregate Bond Index covers investment-grade bonds only. It does not include high-yield (junk) bonds.

Why Does Manager Tenure Matter?

Manager tenure refers to how long the current portfolio manager has been running the fund:

• Longer tenure: Past performance is more attributable to the current manager's decisions and investment approach
• Shorter tenure: Past performance may reflect a previous manager's strategy; less relevant for evaluating the fund's current direction
• A recent manager change is a red flag when relying on historical returns to make investment decisions

Think of it this way: If a fund has a strong 10-year track record but the current manager has only been in place for 6 months, those returns tell you very little about what to expect going forward.

Exam Tip: Gotchas

• Manager tenure affects how much weight to give historical performance. A new manager means past returns are less predictive of future results.

What Else Breaks a Track Record?

A manager change is one way a past return stops describing the fund you are buying. Two others do the same thing, and the exam treats them as distinct.

A change in investment policy. A fund's stated objective, strategy, or policies can change. When that happens the pre-change performance was produced by a different strategy, so the record before and after the change is not comparable. It can also make a fund that was suitable for a client unsuitable, because the client was matched to the old mandate.

Style drift. A fund's stated style is the approach it says it follows: growth or value, large-cap or small-cap, active or passive, domestic or international. Style drift is when the fund's actual holdings move away from that stated style. Two consequences:

• It defeats the comparison, because the benchmark and the peer group were chosen to match the stated style, not the holdings
• It can unbalance a client's allocation, because the adviser sized the position around the style the fund advertised. A small-cap sleeve that drifts large-cap quietly leaves the client underweight small-cap

Think of it this way: a policy change is the fund announcing it is now a different fund. Style drift is the fund becoming a different fund without saying so.

Exam Tip: Gotchas

• A policy change is disclosed; style drift is something you have to detect. Both break comparability of the track record, and both can turn a suitable holding into an unsuitable one.

How Do You Put It All Together?

When evaluating a pooled investment for a client, advisers consider:

1. Performance vs. benchmark: Is the fund beating or trailing its appropriate index?
2. Consistency: Are returns stable or volatile relative to the benchmark?
3. Manager tenure: Has the person responsible for the results been there long enough for the track record to be meaningful?
4. Policy changes and style drift: Is the fund still running the strategy that produced the record, and still holding what its stated style says it holds?
5. Fees: Is the performance sufficient to justify the fund's expense ratio and any sales loads?

What Should You Check on Exam Day?

• Match the benchmark to the fund's asset class and style: S&P 500 (large-cap), Russell 2000 (small-cap), Nasdaq Composite (tech-heavy), DJIA (blue-chip), Bloomberg U.S. Aggregate Bond Index (investment-grade bonds)
• The DJIA is price-weighted; the S&P 500 is market-cap-weighted
• The Bloomberg U.S. Aggregate Bond Index covers investment-grade bonds only, not high-yield
• Short manager tenure makes historical fund performance less predictive of future results
• A change in the fund's stated objective, strategy, or policy breaks comparability of the track record and can make a suitable fund unsuitable; style drift does the same thing silently