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.
Benchmarks
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.
| Fund Type | Appropriate Benchmark |
|---|---|
| Large-cap U.S. equity | S&P 500 |
| Small-cap U.S. equity | Russell 2000 |
| Technology-focused equity | Nasdaq Composite |
| Blue-chip / price-weighted | Dow Jones Industrial Average (DJIA) |
| U.S. investment-grade bonds | Bloomberg U.S. Aggregate Bond Index |
| International equity | MSCI EAFE (Europe, Australasia, and Far East) |
- A fund that outperforms its benchmark has 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.
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.
Manager Tenure
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.
Putting It Together
When evaluating a pooled investment for a client, advisers consider:
- Performance vs. benchmark - Is the fund beating or trailing its appropriate index?
- Consistency - Are returns stable or volatile relative to the benchmark?
- Manager tenure - Has the person responsible for the results been there long enough for the track record to be meaningful?
- Fees - Is the performance sufficient to justify the fund's expense ratio and any sales loads?