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Mutual-Fund Benchmarks: Choosing a Yardstick
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You wouldn't expect a professional golfer to beat a basketball player in a one-on-one game of hoops. And it's unlikely even the best painter in your art class ranks with Picasso. Evaluating anything--whether it's athletes or artists or mutual funds--means putting it up against the proper competition.
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Maybe some of your funds trailed the S&P 500 index last year, for instance. Before you go dumping them, consider that the S&P 500 may not be the right index to rate every fund against. Because it tracks only large companies, it's unfair to compare it with, say, a fund that invests in the stocks of small companies. Instead, you want to measure the fund against an index that follows similar investments, its peers, or--better yet--both. That's what investment folks mean when they say you should compare your fund with an appropriate benchmark.
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There are indexes for every part of the market, including bonds and foreign stocks. For instance, you can compare your small-company fund with the Russell 2000, which tracks the overall performance of 2,000 of the smallest U.S. companies. If your fund looks good next to it, chances are your manager is doing a nice job. You can find the best index for your fund in its Morningstar report.
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You also want to know how your fund did versus similar funds. Morningstar slices funds up into different categories precisely so you can do that. If your fund returned 20%, you might be happy. But if the average fund in its category returned 27%, you'd want to know why the fund fell short. Again, you can find this performance information in the Morningstar report for your fund.
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