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.
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.
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.
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 <a
href=”http://www2.myto.com/money/tidd_fs.cfm?source_id=&id=989914”>August
27, 2001 article</a> for a refresher.
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, B.Comm.,
CFP, CFA is Senior Investment Analyst with Sterling Mutuals Inc. He can be
reached at dhallett@sterlingmutuals.com Sterling Mutuals Inc. is registered as a
mutual fund dealer in Ontario, British Columbia, and Manitoba.