The Basics of Benchmarks
The most common type of performance benchmark is a market index that is a preselected group of securities. In the United States, the most common benchmarks for index funds are the S&P 500, Russell 2000, Barclays Capital US, and the Aggregate Bond Index. The performance of the fund against the benchmark is measured in a unit called beta. Essentially beta is how closely the fund matches the performance of the market, if a beta is 1.2 then investors can expect 20% higher returns in an up market, or vice versa, a 20% decline in a downward market.
Different investors seek different returns; investors that are seeking outperformance will typically be attracted to actively managed funds, while those seeking a more conservative return, will want to look at index funds.
If you’re not sure where to start when it comes to comparing funds, see our guide on How to Research Mutual Funds.
Differences Between Index Funds and Actively Managed Funds
As a result, according to the S&P Indices Versus Active Funds Scorecard, between 1998 and 2013 only 25.6% of the active funds currently in existence outperformed their benchmarks. The funds that did outperform the index funds were typically large-cap growth funds that beat their Russell 1000 Growth Index. What is similar between the benchmarks for index mutual funds and actively managed mutual funds is that in either case a benchmark is used as a standard against which the performance of the mutual fund can be measured.
Learn more about What a Mutual Fund Manager Does.
How Does a Benchmark Influence Bottom Line Returns?
Lastly, benchmarks can be anything and as such should only be used as one tool in assessing a mutual fund’s return. Furthermore, comparing to the wrong benchmark will distort a fund’s performance. One should look at the total return and the expense ratios along with the track record of the fund when making investment decisions as well.
With the S&P 500, the larger the company the greater its position in the index. Another thing to consider is that if a mutual fund is focused on small companies or on foreign stocks, it would be unfair to compare the returns of the fund to the S&P 500 and so there are benchmarks appropriate for those funds as well.
Some of the most common market benchmarks are:
- S&P 500
One of the most important market indexes, the S&P 500 represents 500 of the largest U.S. corporations chosen for market size, liquidity, and industry grouping. It is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of large cap companies.
- Russell 2000 Index
The Russell 2000 index is the most common benchmark for small-cap mutual funds. It is an index measuring the performance of 2,000 small-cap stocks in the Russell 3000 index, which is made up of the 3,000 biggest US stocks. The Russell 2000 is a benchmark for small-cap stocks in the US. To put this into perspective, the largest market cap in the index is around $5 billion.
- Barclays Capital US Aggregate Bond Index
This index covers the investment grade, fixed rate, and taxable areas of the bond market. This is the broadest measure of the taxable U.S. bond market and is to fixed income investors what the S&P 500 is to stock traders. It is a major indicator for the overall health of the fixed income investing market. To invest in an ETF that seeks to track this benchmark, check out BND.
- MSCI EAFE Index (Morgan Stanley Capital International)
This is an index that is designed to measure the equity market performance of international developed markets. It is the older international stock index and follows a selection of stocks from 21 developed markets excluding the U.S. and Canada. Those 21 markets are: Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, the United Kingdom, Israel, Australia, New Zealand, Singapore, Hong Kong and Japan. EAFE stands for Europe, Australia, and Far East.
That being said, if faced with two similar mutual funds that measure different benchmarks, investors should look at the historical total return of each fund, but also the MER to determine which fund to invest in. The benchmark, while important, is only there to give a snapshot of the performance of the fund and a representation of the market it is measuring.
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