How good are financial advisors at measuring the performance of mutual fund managers? Among retail investors, the use of inaccurate yardsticks like fund ratings and peer-group comparisons is fairly common.
Hopefully, advisors aren't making many, if any of, the same mistakes.
Let's examine three better ways to successfully judge fund performance.
1. Don't use peer group analysis
Many mutual fund analysts lead their followers astray by focusing on mutual-fund performance relative to its corresponding peer group. In truth, the correct measure should be fund performance versus a corresponding benchmark index.
"Peer group" comparisons are dangerous," explains William F. Sharpe, a Nobel Prize winner in economics. "Because the capitalization-weighted average performance of active managers will be inferior to that of a passive alternative, the former constitutes a poor measure for decision-making purposes. And because most peer-group averages are not capitalization-weighted, they are subject to additional biases."
How would this work in a real-life application?
For instance, you should compare international stock funds to international stock yardsticks like the MSCI EAFE Index (EFA).
Likewise, small- and mid-cap stock funds should be benchmarked to small- and mid-cap index funds like the S&P MidCap 400 (MDY) or the iShares Russell 2000 Index Fund (IWM). Since ETFs tracking these benchmarks are readily available, monitoring relative performance is fairly easy.
Remember to always compare apples with apples and oranges with oranges. And finally, always make sure you compare performance over the same time period.
2. Beware of closet indexers
Do your clients own active mutual funds that aren't really that active?
