Benchmarks: decision support for mutual fund investment

Gauging performance

Community school boards use standardized tests to gauge how their students perform in relation to national averages. On an even more basic level, your local weather forecasters can check the accuracy of their predictions by measuring temperatures and rainfall. As a mutual fund investor, you also have tools available to gauge the performance of your investments. Such tools are known as market benchmarks. The challenge, however, is choosing the tool that most accurately serves your purpose.

What are investment benchmarks?

The dictionary defines a benchmark as "a point of reference for measurement." Market benchmarks are used by individual investors, portfolio managers, and market researchers to determine how a particular market or market sector performs. Often cited in news reports, market indexes can be especially helpful to mutual fund investors by offering market "standards" to help them evaluate the risk and the return history of their own investments. Of course, past performance is not indicative of future results. Also, investors should remember to compare their mutual fund to the index that best tracks securities comparable to the fund's holdings, and to use an appropriate time frame.

Identifying the appropriate index for money market, bond, and equity funds

The appropriate index for your needs is not always easily identified by its name or popularity. For example, most people have heard of the Dow Jones Industrial Average, since its closing figures are quoted nightly on news broadcasts. However, many people may not be aware that the Dow tracks only 30 stocks of some of America's largest companies -- not a very reliable source for comparison if your fund's holdings include small-capitalization or international companies.

For each category of mutual fund, there are several popular indexes:

For money market funds*

IBC's Money Fund Report Averages: These benchmarks track the averages of taxable and tax-free money market fund yields on a 7- and 30-day basis.

* An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency.

For bond funds

Barclays Aggregate Bond Index. A combination of several bond indexes, Barclays indexes are among the most widely used benchmarks of bond market total returns.

10-Year U.S. Treasury Bond. The yield on this long-term U.S. government bond is often looked to as the standard bond yield for long-term bond investments.

Bond investments are subject to interest rate risk so that when interest rates rise, the prices of bonds can decrease and the investor can lose principal value.

For equity funds

Standard & Poor's Composite Index of 500 Stocks (S&P 500). A broad-based, unmanaged measurement of the average performance of 500 widely held industrial, transportation, financial, and utility stocks. Many people believe that this, among the most often cited indexes, includes the 500 largest stocks on the New York Stock Exchange. Not true: In fact, it includes the stocks of companies that are or have been leaders in their respective industries, and that are listed on other major U.S. exchanges as well. The industry weightings in the S&P 500 are selected to reflect the components of gross domestic product.

The Nasdaq Composite Index. This large index (over 2,800 issues) was created in 1971 to measure all domestic common stocks that are traded on the Nasdaq exchange that are not part of the National Market System.

Morgan Stanley Capital International's Europe, Australasia, Far East (EAFE) Index. The most prominent of the indexes that track international stock markets, the EAFE is composed of companies considered representative of 21 European and Pacific Basin countries.

Equity investments are subject to market risk including loss of principal.

Other high profile indexes include:

Value Line Composite Index (stocks)

Russell 2000 Index (small-cap stocks)

Citi 3-Month T-bill (money markets)

Dow Jones World Stock Market Index (major international markets, including U.S.)

Barclays Global Aggregate Bond Index (global bond index) 

Commonly Used Benchmarks
To gauge ...   You might refer to ...
Money Market Funds   IBC's Money Fund Report Averages
Bond Funds   Barclays Aggregate Bond Index
    10-Year U.S. Treasury Bond
Equity Funds   S&P 500 Index
    Nasdaq Index
    MSCI EAFE Index

Navigating the maze: Read your prospectus

As noted earlier, the key to navigating the maze of benchmarks is to know which one best tracks securities similar to the holdings in your fund. But remember that you don't have to be an experienced market researcher to find out which benchmark is for you. Most mutual fund prospectuses, annual reports, and SAIs (statements of additional information) list the comparable index, usually in the "investment objective" section.

Often, a fund that tracks more than one sector or asset class may list more than one index to reference. For example, a balanced fund may reference both the Barclays Bond Index and the S&P 500 Index to measure its bond and stock holdings, respectively. Finding the appropriate index is yet one more example of why it's so important to read a prospectus carefully before investing in a fund.

Though benchmark indexes are not actively managed or available for investment purposes, some funds actually hold the same securities that are in the index. Known as index funds, these funds are managed with a "passive" style: The fund manager only needs to monitor the holdings in the benchmark index and make adjustments in the fund accordingly. Generally, the objective of an index fund is merely to maintain performance standards similar to the index that it tracks, whereas other funds often seek to outperform their benchmark indexes. Index funds can sometimes offer lower management fees because of their passive management style.

Decision support vs. deciding factors

While indexes can be a way to gauge how a mutual fund generally performs in relation to the overall market, they shouldn't be the deciding factor in determining if a fund may meet your needs and objectives. When evaluating a fund, ask yourself:

  • Does the fund's objective seek to meet your investment needs?
  • How long will your money be invested in the fund? Though past performance cannot guarantee future results, consider the performance record of the fund over a similar time frame.
  • How well can you withstand fluctuations in the value of your investment over time?

The benchmark listed in your fund's prospectus may give you a good idea of what to expect from your mutual fund. However, remember that standardized tests are just that -- standardized. They are not meant to represent individuals and their needs and financial circumstances.

Your financial professional can help you evaluate an investment in terms of your personal objectives and risk tolerance, and can also show you how to use a benchmark index in an effective way.

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Please always consider the charges, risk, expenses, and investment objectives carefully before purchasing any financial product, including mutual funds or variable annuities. For a prospectus containing this and other information, please contact a financial professional. Read it carefully before you invest or send money.

This article is provided for your informational purposes only.

Please be advised that this material is not intended as legal or tax advice.  Accordingly, any tax information provided in this material is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer.  The tax information was written to support the promotion or marketing of the transactions(s) or matter(s) addressed and you should seek advice based on your particular circumstances from an independent advisor.

Please be advised that this materials is not intended as legal or tax advice. Accordingly, any tax information provided in this material is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer. The tax information was written to support the promotion or marketing of the transactions(s) or matter(s) addressed and you should seek advice based on your particular circumstances from an independent advisor.

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