As a mutual fund investor, you have probably heard about a certain fund (maybe yours) “beating its benchmark”, or “underperforming against its benchmark”. So what is this ‘benchmark' and how important is it?

North American Indices

A benchmark for mutual funds is often an index of stocks, bonds or money market instruments against which a given mutual fund is measured in terms of performance. The returns of North American equity funds are often compared against certain high-profile indices. In the United States these include the Standard & Poor's (S&P) 500 [large companies], the S&P Midcap 400 [mid-sized companies], and the Russell 2000 [small companies]. In Canada, the most frequently referenced benchmark for equities is the large-company index, the S&P/TSX Composite.

Bond funds in Canada are often measured against the Scotia Capital Markets Universe Bond Index (SCUBI). Whereas the S&P/TSX Composite Index is made up of the stocks of the companies that are listed on that exchange, the SCUBI is made up of 750 bonds, reflecting the Canadian bond market. With money market funds, the benchmarks in Canada and the United States are often the 91-Day Treasury Bill indices of the respective countries. Balanced funds (which offer a mix of any combination of equity, fixed-income or money market investments) are compared against a blend of benchmarks that reflect the fund's composition (i.e. 60% equity, 30% fixed income, 10% money market).

Beware of What You Compare

In Canada, fund company returns against index benchmarks can be reviewed at these web sites: www.globefund.com and www.morningstar.ca . At these sites, you will come across additional return comparisons to a ‘category' or ‘group average'. The category or group average means that a comparison is being made to the performance of similar funds, rather than an index of similar securities. This gauges the fund manager's success against his or her peers. However, two Canadian equity funds may share the words “Canadian equity”, but could be vastly different in the stocks used to make up the fund, so this can be, if not an apples to oranges comparison – perhaps oranges to tangerines. For example, a Canadian equity fund may have a ‘value' or ‘growth' investment style – both are Canadian equity, but have vastly different compositions and returns. You should also be aware, some funds get lumped in a peer group simply because the fund universe in Canada is too small, which is why, in Canada, the U.S. small-cap and U.S. mid-cap funds are combined into one category.

Measure of Past Performance

A benchmark is a tool that allows investors to gauge how a fund has performed in the past against a measure of similar securities. It can be useful to see if the fund's manager has been successful in beating or meeting the benchmark's performance, and that he or she had been able to navigate the fund through past volatile markets. Yet, like the comparison against similar funds, the benchmark index can be quite different in composition from the fund itself, unless, of course, it is an index fund designed to recreate a fund of the same investments of the index.

No Guarantees

It is important to stress that performance against a benchmark can only provide a glimpse into the past and past performance is not a guarantee of future returns. There are many other factors that investors should consider before investing in a fund. Any investment that you and your advisor consider for your portfolio must be suitable for your risk tolerance and investment objectives based on your investment experience and knowledge, your attitude toward investing, and your financial goals.

Diversify Your Portfolio

And in any market environment, it is important that you, together with a trusted advisor, develop a complete portfolio strategy - one that compasses mutual funds that are geographically diversified, across industries and especially asset classes (equity, fixed income, and cash. ) This strategy of diversification can help you achieve maximum returns while also offering comprehensive downside protection.

For more information, contact John Klotz., B.A., CFP., CLU., CH.F.C., RHU. John is Vice President of Financial Services at LMS Prolink Ltd. You can reach him at johnk@lms.ca or phone (416)-595-7484 ext. 305