Benchmarks are an important part of choosing which mutual funds and fund managers to go with, so here’s how they work and how you should use them.
Definition and Examples of a Benchmark
Benchmarks are a collection of stocks or bonds used to compare against and gauge the relative performance of a stock, fund, or portfolio. A benchmark is generally an index that includes stocks or bonds of a certain size, industry classification, or geographic location. The most commonly used benchmark is the Standard & Poor’s (S&P) 500. There are also benchmarks for everything from municipal bonds in California to stocks in Japan to high-dividend-yield stocks. Or you can skip the hassle of finding a good fund manager and invest directly in the benchmark itself with index ETFs. So if you’re investing in a high-growth stock fund, for example, you shouldn’t compare it with that California muni bond index. The table below shows how the Ark Innovation ETF (ARKK) uses benchmarks in its summary prospectus:
How a Benchmark Works
Funds will compare their own performance with a benchmark in their prospectuses as ARKK did above. That’s where your work starts. You need to decide if the benchmark the fund is using is appropriate, or if there is a better option. It’s also important to make sure you have the most recent numbers—the ARKK prospectus uses numbers that are outdated by close to two years. Here’s ARKK’s summary of its investment objective, “ARKK is an actively managed ETF that seeks long-term growth of capital by investing under normal circumstances primarily (at least 65% of its assets) in domestic and foreign equity securities of companies that are relevant to the Fund’s investment theme of disruptive innovation." The fund does focus on domestic and foreign securities, so the world index could be appropriate for a benchmark. However, its focus on high-growth stocks implies that it would invest in small-, mid-, and large-cap stocks—not just the large caps included in the S&P 500. Let’s see if this benchmark returns list from Vanguard has a better option. The Russell 3000 growth index, which measures the performance of a comprehensive list of growth stocks in the U.S. would be appropriate. Look at the comparison below (you could re-create this using your broker’s chart program) between ARKK and the selected benchmark: ARKK is clearly outperforming any benchmark we use. Note that the chart comparison does not adjust the fund’s returns for taxes and fees. Benchmarks also can be used to compare another measure of performance. Russell’s fact sheet for its index also shows the average price/book, dividend yield, and earnings per share (EPS) growth of its constituent stock list. This is important if you’re looking at a specialized fund made up of high dividend-yield stocks or value stocks. If you only want yield and the index has a higher yield, invest in the index.
What It Means for Individual Investors
Legg Mason fund manager Bill Miller famously beat the S&P 500 every single year from 1991 to 2005. That’s when his performance fell off a cliff. Over the last five years he managed the fund, investor withdrawals slashed its assets under management (AUM) from about $77 billion to $800 million. That’s not the end of the story. After Miller beat the S&P for 15 years and then was nearly driven almost out of the industry, he started his own fund management company and has beaten the S&P 500 again over the last 10-, five-, and one-year periods. The moral of the story is that while performance relative to a benchmark is useful, you have to consider other factors as well. Miller’s performance likely signed its own death warrant. He beat the S&P for so many years that he attracted more money than he could manage well. Now that he is back to managing a smaller fund, he’s beating the benchmark again. Additionally, pay attention to a fund’s fee structure, make sure you agree with its philosophy, and be aware of tracking error—the standard deviation difference between a sequence of portfolio returns and the returns of the benchmark the portfolio is based on or related to. For index funds, tracking error can be due to trading costs or other friction.
