The Basics Of Mutual Fund Performance Comparison

When evaluating mutual fund performance, it’s easy to get bogged down in irrelevant details.  Fund A performed better than Fund B over the past 3 years.  Furthermore, Fund C beat the S&P 500 over the past five.  So buying Funds A and C is a no-brainer, right?  Not necessarily.

How To Make A Valid Mutual Fund Performance Comparison

Comparing Apples To Oranges

The statement above “Fund A performed better than Fund B over the past 3 years” tells us absolutely nothing about which mutual fund is a better investment.  Perhaps Fund B is a bond mutual fund and Fund A is an aggressive growth stock mutual fund.  In any bull market, of course Fund A will out-perform!  It’s an aggressive growth stock fund!  The relative performance of these two funds depends entirely on the time period.  From 2000-2003, Fund B would undoubtedly have beat the pants off Fund A because it’s a more conservative choice and bonds tend to do out-perform stocks in bull markets (as they did recently).  Comparing the performance of a stock and bond fund is ridiculous.

Almost but not quite as ridiculous is comparing the performance of two stock mutual funds that invest in different segments of the market, for example comparing a domestic versus international mutual fund (see the five best international mutual funds).  Over long periods of time, domestic and foreign markets are expected to generate roughly equivalent rates of return;  however, domestic and foreign markets are not perfectly correlated, nor will they probably ever be (although some disagree with me on this point).  Therefore, it seems silly to compare the two over short periods of time.  If Fund A invests in U.S. stocks and Fund B invests overseas, Fund B will of course out-perform during periods when international stocks yield higher returns (such as 2003-2008) and Fund A will of course out-perform during periods of U.S. dominance (such as the late 90’s).  It has absolutely nothing to do with skill and so shouldn’t be a basis of comparison.

Choose The Right Index

We see above that Fund C beat the S&P 500 index over a period of 5 years.  Sound impressive?  It might be, if Fund C happens to be a large-cap growth mutual fund.  The S&P 500 index, you see, is composed of 500 of the largest and most important companies in the United States.  Since it is a market-cap-based index, it tends to have a slight growth bias as well.  If Fund C is not a large-cap blend or large-cap domestic growth fund, this feat may not be so impressive.

What if Fund C were a small-cap value fund?  Small-cap stocks have a theoretical return advantage, according to Fama/French.  Since small-cap stocks tend to be riskier, investors will demand a higher rate of return in order to hold them.  Thus, over (very) long periods of time, small-cap stocks have exhibited a small but relatively consistent performance advantage over large-cap stocks.  That said, the relationship between small and large stocks fluctuates, just as it does between domestic and foreign stocks.  During periods when small-cap stocks out-perform (such as 2003-2008), practically all small-cap mutual funds would have beat the S&P 500.  During periods when large-cap stocks out-performed (such as the late 90’s), most small-cap mutual funds would have under-performed the S&P 500.  Again, it has nothing to do with skill, it’s just a by-product of which asset class currently has the upper hand.

How Do You Know Which Index To Use?

The best index to compare any mutual fund to is the index that most closely matches the asset class it invests in.  Bond funds should be compared to a bond index of similar duration and credit characteristics.  Small-cap mutual funds should be compared to a relevant small-cap index.  Large-cap value funds should be compared to a relevant large-cap value index, and foreign funds should be compared to the most relevant international index.  As it turns out, very rarely is the S&P 500 a good point of reference to determine how well a mutual fund has performed.

If you have a free Morningstar account (and every investor most definitely should), you can see how well a fund has performed both against a popular broad benchmark (usually the S&P 500 for domestic and EAFE for international stocks) and a far more relevant best-fit index (which is what you should really pay attention to) by clicking the Performance tab.

Comparing One Mutual Fund To Another

When comparing mutual funds, you should only compare funds that invest in the same sector of the market.  Small-cap value funds to small-cap value funds, large-cap emerging market funds to large-cap emerging market funds.  Comparing funds from wildly-different asset classes can easily lead you astray.