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Proper fund comparisons
A guide to benchmarking your fund

I spoke with an investor recently who felt rattled by the beating his U.S. equity fund has taken over the past eighteen months. While he's held it for a few years, he found little comfort in the fact it still managed to squeak ahead of the S&P 500 C$ over the past five years. I didn't think anything of it until he told me which fund he held. It was then that I was reminded that most fund investors aren't comparing their funds to relevant benchmarks and that this investor had done much better than he realized, in relative terms at least. Finding an appropriate benchmark of comparison is very difficult in the world of mutual funds - a fact that should draw investor attention.

Purpose of benchmarks

Benchmarks are held out as measuring sticks to gauge the performance of individual funds and entire portfolios. For individual funds, most data services use a single standard benchmark against which to compare a relevant group of funds. For instance, most compare the performance of diversified Canadian equity funds to the TSE 300 Canadian stock index. Seems pretty straightforward, right? No really. When choosing a benchmark for your fund, many factors can come into play - like a manager's biases, the fund's investment policy, and changing mandates.

Canadian equity funds

The foreign content limit is what makes most Canadian equity funds incomparable to any Canadian stock index, like the TSE 300 or S&P/TSE 60. A Canadian fund can earmark up to thirty per cent of its assets for foreign investments, based on cost. If the foreign stocks do better than the rest of the portfolio, that percentage could easily surpass the thirty per cent threshold based on market value. The result: nearly sixty per cent of Canadian stock funds have more than ten per cent in foreign stocks or equivalent exposure.

Empire Elite Equity is a good Canadian equity (segregated) fund, which invests primarily in mid-to-large Canadian stocks. Its foreign stock content looks small on the surface at just over six per cent. However, it also holds about twelve per cent in index futures and about the same amount in cash. This fund's true foreign exposure is closer to thirty per cent of its assets. Less than three quarters of its assets are in Canadian stocks, making a comparison to a pure Canadian stock index rather meaningless. Instead, a benchmark of seventy-five per cent TSE 300 and twenty-five per cent MSCI World Index C$ would be much more appropriate. (The MSCI World index tracks global stocks.)

Two more examples include Dynamic Focus Plus Canadian Class (with just forty-four per cent in Canadian stocks) and Synergy Canadian Growth (with less than sixty per cent in Canadian stocks).

These are just a few examples of the many that exist. None of these should be compared to only one index. Rather, a customized composite is best when comparing performance of most Canadian stock funds.

U.S. equity funds

Investment policy refers to the mandate that drives the fund's asset mix. That U.S. equity fund I mentioned at the beginning of this column is the Janus American Equity. It's a pure growth fund that invests mostly in U.S. stocks. However, this fund has a very unique mandate that allows it to hold up to thirty per cent in non-U.S. stocks - a rarity in this category. Compared against the S&P 500 C$, it's ahead 14.9 vs. 13.5 per cent annually for the five years ended September 30, 2001. Such a thin margin of outperformance over a five-year period makes it nearly impossible to distinguish between random luck and manager skill.

While the fund currently has about seventeen per cent in non-U.S. stocks, it should be compared against the following benchmark: sixty per cent S&P 500 C$; thirty per cent MSCI EAFE (Europe, Australia, Far East) C$; and ten per cent cash (Scotia McLoed T-Bill index, applicable GIC rates, high interest savings accounts, etc. can all be used as a proxy for cash.) Why not base it on current holdings - i.e. seventeen per cent overseas stocks? Because its investment policy allows it to go up to thirty per cent. Hence, that should be the fund's longer-term benchmark.

Upon closer inspection, this fund has trounced its more appropriate benchmark by a huge margin - 14.9 to 9.6 per cent annually for the same five-year period. While five years still isn't enough to attribute this gap to manager skill with a good level of certainty, the much larger gap of outperformance, 5.3 per cent per year, makes it more likely due to astute money management.

Think index funds are easier to compare? Think again. Take a look at the TD U.S. RSP Index fund. It's a fund that uses index futures to get exposure to the S&P 500 index, without counting as foreign content. If you go to globefund to look up this fund's performance, it is compared against the S&P 500 C$ index. Using their information, the fund trails the index by a wide margin - minus 0.16 vs. plus 3.21 per cent annually, for the three years ending September 30, 2001.

However, this fund's currency policy (i.e. it hedges the U.S. dollar) makes it more comparable to the US dollar version of that index. Comparing TD U.S. RSP Index with its more appropriate benchmark, S&P 500 US$, we get a return of minus 0.16 per cent annually for the fund, vs. minus 0.59 per cent pear year for the index for the same three-year period. Looking at the wrong index could lead an investor in this fund to believe it has done a poor job of tracking the index, when in fact it's done a very good job.

To revisit the currency issue with RSP eligible foreign funds, take a peek at my August 27, 2001 article for a refresher.

Changing mandates and styles

Revisiting the issue of foreign content illustrates how challenging proper benchmarking can be longer-term. More than ten years ago, the foreign content limit was ten per cent. By the mid-1990s, it had risen to twenty per cent. In 2000, it went to twenty-five per cent and starting this year, it was bumped up to thirty per cent. For funds with a policy of maximizing foreign content, the varying foreign content limits necessitate varying benchmarks - adjusted accordingly for the respective years.

How do you know which benchmark is best suited to your fund? Use the prospectus as your starting point. Many now have more customized benchmarks in the portion listing fund-specific information. For instance, many prospectuses show balanced funds compared against a benchmark of forty per cent TSE 300, forty per cent Scotia McLoed Universe Bond Index; fifteen per cent MSCI World; and five per cent cash. Once you've consulted that important document, you should use free online resources to check fund content - or ask your advisor.

Proper benchmarking is an important issue for institutional money managers, who run money for pension plans, corporate clients (including mutual funds), charities, and foundations. In fact, money managers are hired and fired based on their performance relative to a customized benchmark and adherence to a mandated style.

There's nothing wrong with funds with flexible mandates and mixed histories. However, if you're basing your investment decisions at least in part on historical performance, make sure that history is viewed in the proper context.

Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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Disclaimers: Consult with a qualified investment adviser before trading. Past performance is a poor indicator of future performance. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, financial advice or recommendations. The information on this site is in no way guaranteed for completeness, accuracy or in any other way. More...