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Morningstar.com's Interactive Classroom

Course 202
Benchmarks

Introduction

Weightlifter Matthias Steiner hoisted more than 1,000 pounds in two lifts to claim the gold medal at the 2008 Beijing Olympics. He didn't lift perfectly at the event, the 310-pound athlete was nonetheless able to best his peers that day to take the top honors.

The maximum weight that you can lift is often regarded as the definitive statement of your strength. Yet what actually constitutes a "good" bench-press depends on the person: A 5'5" man or woman who can bench-press 150 pounds may have a superior strength-to-bodyweight ratio compared with a 6'2" man or woman who can bench-press 250 pounds.

The same relativity holds true when examining a mutual fund's performance. What constitutes a "good" return depends on your needs and the type of fund. That's where benchmarks come in to play.

Your Personal Benchmark

Start by determining your personal benchmark. In fitness terms, that might mean getting strong enough to carry your 3-year-old around town without getting winded, or it might mean building up enough endurance to climb a mountain. In investment terms, it means setting a benchmark for the returns required to reach your investment goal, whether it is a long-term goal (retirement) or a short-term goal (buying a new house in two years).

Say you want to retire in 30 years. You may know how much money you have to invest today, you can anticipate how much you'll be able to invest in the future, and you have a rough idea how much you'll need in retirement. After crunching the numbers, let's say you find that you need an 6% return per year to meet your goal. That's your personal benchmark.

By knowing that benchmark, you can immediately rule out funds that rarely meet that hurdle each year, such as most bond funds. You can also rule out funds that can sometimes return much more than your personal benchmark, because they probably present an added risk. That would include volatile fund types, such as emerging-markets funds or technology sector funds. Why take on all that extra, unnecessary risk?

Indexes as Benchmarks

The most common type of performance benchmark is a market index a preselected group of securities. Such indexes are usually tracked by the media and the investing community as indicators of the health of national and international stock and bond markets. Of course, there's no consensus on the single best index to use for investing purposes. The Dow Jones Industrial Average (DJIA) may be the index that heads the stock market report on the evening news, but it's rarely used as a performance benchmark for stock mutual funds. Why? Because it's so narrow: It includes just 30 large-company stocks, so it isn't all that indicative of the health of the overall stock market.

The index you'll hear about most often in mutual fund circles is the Standard & Poor's 500 Index, which includes 500 major U.S. companies. The larger the company, the greater its position in the index. Because the stocks in the S&P 500 are chosen to cover a range of industry sectors, the index often paints a clearer picture of the overall market than the Dow Jones Industrial Average.

Yet despite its widespread appeal, the S&P 500's focus on large companies means it's not representative of the entire market and smaller stocks' performance in particular. It's therefore inappropriate to measure a fund that doesn't buy large companies, such as Fidelity Low-Priced Stock (FLPSX) or T. Rowe Price Small-Cap Stock (OTCFX), against this benchmark only. Nor should you compare a foreign-stock fund like Vanguard International Growth (VWIGX) with the S&P 500; that fund doesn't even own any U.S. stocks. And don't try to stack bond funds up against a stock-fund index like the S&P 500. This advice sounds like common sense, but investors make inappropriate comparisons all the time.

So what indexes can you use to make appropriate comparisons? The Russell 2000 Index, which tracks smaller U.S. companies, is a good tool to evaluate many small-company funds, while the MSCI EAFE ( Europe Australia Far East) Index, which follows international stocks, is a good measuring stick for foreign funds. The Barclays Aggregate Bond Index is a good gauge for most taxable-bond funds. There are dozens of other indexes that segment the market even more, focusing on inexpensive large-company stocks or pricey small-company stocks, regions of the world such as Europe or the Pacific Rim, or even particular areas of the bond market. We include appropriate indexes for each fund on Morningstar.com.

Peer Groups as Benchmarks

The second type of benchmark you can use is peer groups, or funds that buy the same types of securities as your fund. Compare funds that buy large, undervalued companies with others with the same style so-called large-value funds. Or compare those that buy only Latin America stocks with other funds that only buy Latin America stocks. That way, you're comparing apples to apples.

Morningstar categories are suitable peer-group benchmarks for most mutual funds. Depending on what a fund owns, it can land in one of more than 40 Morningstar categories. If a fund's portfolio features large-company stocks with high earnings growth, the fund is categorized as a large-growth fund. If the fund brims with smaller companies that are inexpensive, it lands in the small-cap value category. If U.S. government bonds with comparatively short maturities populate the portfolio, the fund qualifies as a short-term government-bond fund.

What's so great about peer-group comparisons? They give you another way to examine a fund's performance. Consider Fidelity Blue Chip Growth (FBGRX). The fund's returns lagged the S&P 500 in the early 2000s. Against that benchmark, the fund looked like a dog. But against its peers, the fund looked pretty good, especially in 2001 and 2002, when it lost less than its rivals. Of course, losing less than other funds is cold comfort for investors, but the fact that Fidelity Blue Chip Growth trailed the S&P 500 in the early 2000s isn't so much a reflection on the fund as it is on the relatively weak performance of large-growth stocks. After all, the S&P follows more than growth stocks; it has a hefty dose of value stocks, too. Fast forward to more recent time: Over the trailing five years through May 2011, large-growth funds have outperformed large-value, and this fund has beaten both the S&P 500 and more than 85% of its peers.

Our Approach

When evaluating funds, select several benchmarks. Begin with your personal benchmark, and be sure that any investment you're considering can match your needs. Then compare the fund with a widely accepted index, such as the S&P 500, to get a sense of its performance on the broadest level. Finally, look to peer-group benchmarks to see if the fund is good at what it does.

Quiz 202
There is only one correct answer to each question.

1 Once you've calculated your personal benchmark, choose a fund that:
a. Usually returns less than that benchmark.
b. Usually returns more than that benchmark.
c. Usually returns about the same as the benchmark.
2 Which is the best index to use when analyzing a U.S. large-company fund's performance?
a. The Dow Jones Industrial Average.
b. The S&P 500 Index.
c. The MSCI EAFE Index.
3 Which is the best index with which to compare a small-company fund's performance?
a. The S&P 500 Index.
b. The Russell 2000 Index.
c. The Barclays Aggregate Bond Index.
4 Fund X underperformed the S&P 500 by five percentage points per year during the past five years, after beating the index by just as much in the three previous years. Fund X:
a. Is a lousy fund.
b. Probably owns something other than large-company stocks.
c. Probably looks bad versus its Morningstar category, too.
5 What's the most appropriate benchmark to use when analyzing a large-cap growth fund?
a. The S&P 500 Index.
b. Morningstar's large-cap growth category.
c. The Dow Jones Industrial Average.
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