Mutual fund benchmark. Learn how to select the best funds for your investment portfolio using benchmark indexes.
In this article, I am going to explain what is a benchmark index, how to use it to make investment decisions, and evaluate the performance of mutual funds and index funds. I will also give examples of relevant benchmark indexes and of corresponding mutual funds and ETFs that track them.
Choosing the right fund for your investment portfolio can be a daunting task. With dozens of investment options available, most investors end up lost when demanded to make a choice. As a result, ETFs and mutual funds end up being selected by a combination of poor factors like:
- Past performance benchmark: “if it has performed well in the past, then it should do in the future.”
- Family and friends: “if they are investing in it, it can’t be a bad choice,” or “if I lose money, at least it won’t be alone.”
- Bank or broker staff: “he knows what he is doing,” or “I better trust the bank, they know more than me.”
Unfortunately, the hard truth is that:
- Past performance is not a guarantee of future performance.
- Most times, family and friends know as much or less about money as we do.
- Bank and brokers are looking at their interests, not yours.
Therefore, to make a strong investment strategy, we must educate ourselves and understand how to use benchmark indexes in our favor.
In fact, a key deciding factor to use when choosing a mutual fund, or any other investment, is the benchmark it uses. In this article, I will show how to choose a mutual fund or an exchange traded fund.
You might already have seen the word benchmark when reading a mutual fund fact sheet. Most people don’t give a second thought to it, but in reality, it is the first thing you should assess.
What is a benchmark index:
A benchmark is a standard against which the performance of the investment will be measured. In other words, the benchmark index represents the standard investment for that asset class. As such, it is a critical piece of information that must be used when choosing your mutual fund.
For example, let’s say you have your retirement savings money invested in a fund of bonds in the U.S. After one year, you want to know if the fund returns were good. One way of doing so is to compare it with the S&P U.S. Treasury Bond Index, which is a broad, comprehensive, market-value weighted index that seeks to measure the performance of the U.S. Treasury Bond market.
Think off the investment benchmark index as the minimum return you should expect for that particular investment.
How to choose a benchmark index
When you have cash available to make an investment, a good exercise is first to choose the index that represents the market performance that you want to invest in. Once you have done that, then look for investments that use that index as a benchmark.
When deciding how to choose a mutual fund benchmark index, you must think in a broad sense. Instead of thinking about specific companies, start considering industry types, countries, company sizes, and market classifications.
Try to match these thoughts with the performance objective of your investment. You probably don’t want to invest your emergency funds into volatile developing world stocks. But to do so with a portion of your retirement savings might be ok.
Whenever I have money sitting idle in my savings account, here are the questions I ask myself to choose a mutual fund benchmark index:
- What kind of asset classes do I want to invest in? Stocks and bonds, funds and ETFs, real state, inflation tickers, commodities.
- Where do I want to invest? U.S. market, my home town, developed countries, Asia, small companies.
Once I have these questions answered, it is time to select the benchmark that best reflects my choices.
For the purpose of this exercise, let ‘s the following scenario:
- What kind of asset classes do I want to invest in?
- Where do I want to invest?
- 70% on the U.S. market, and
- 30% in global markets or international stocks.
U.S. Stocks Benchmark Index
There are several U.S. stocks benchmark indexes. The main ones are the NASDAQ Composite (IXIC), the Dow Jones Industrial Average (DJI), and the S&P 500 (GSPC).
If we look at the past five years, we can see that all three indexes are well correlated, although the NASDAQ Composite has performed significantly better in recent years.
The NASDAQ outstanding performance over the past five years is due to the high weight given to tech companies such as Facebook, Alphabet, Amazon, Apple, and Microsoft are traded here.
The correlation between the three indexes means that even if we invest in all three of them, we will not be diversifying our investment. During a crisis period, all of them will fall together, as can be seen in the graph.
Looking at 5YR returns alone, one would choose the NASDAQ Composite as the index to represent the U.S. stock market. Would that be an appropriate choice? Maybe, let ‘s have a closer look at each one of the benchmark indexes.
DJI Benchmark Index: Down Jones Industrial Average
The Dow Jones Industrial Average measures the stock performance of the 30 largest companies listed in the United States.
The value of the index is the sum of the price of one share of stock for each company divided by a factor that changes whenever one of the component stocks has a stock split or stock dividend.
As it only includes 30 companies and is not weighted by market capitalization and is not a weighted arithmetic mean, many consider the Dow not to be a good representation of the U.S. stock market
It is the second-oldest U.S. market index, and the Industrial portion of the name is mostly historical, as many of the modern 30 components have little or nothing to do with traditional heavy industry.
IXIC Benchmark Index: NASDAQ Composite
The NASDAQ Composite is a stock index that includes more than 3.000 common stocks and securities listed on the Nasdaq stock market.
The NASDAQ Composite is calculated using a market capitalization weighting method. This means that the largest companies listed on this exchange have the most significant impact on the final value of the index.
Due to the nature of companies that trade in here, the composition of the NASDAQ Composite is heavily weighted towards information technology companies.
The heavyweight on tech companies is what brought the NASDAQ Composite to outperform the S&P 500 and the Down Jones Industrial average on the 5YR plot.
On the other hand, this tendency also contributed to the crash of the NASDAQ Composite with the tech bubble in the 2000s, bringing several investors to bankruptcy. As you can see in the picture below, it took 15 years for the index to recover from the crash.
SPX Benchmark Index: S&P500
The S&P 500 is a stock market index that measures the stock performance of the 500 largest U.S. companies.
The average annual total return of the index, including dividends, since its inception in 1926, has been 9.8%. The index has posted annual increases 70% of the time. However, there were several years where the index declined over 30%.
The S&P 500 is a capitalization-weighted index, and the performance of the 10 largest companies in the index account for 21.8% of its performance.
It is one of the most commonly followed equity indices, and many consider it to be one of the best representations of the U.S. stock market.
The best U.S. Stocks Benchmark Index
Let’s go back to our investment objective. At the start of this article, we have decided to invest in the U.S. Stock Market.
Our objective is, therefore, to choose the index that best represents the U.S. Stock Market as a whole.
When we looked at the details of each of the indexes, we saw that the NASDAQ Composite is heavily dependant on tech firms. Similarly, the Down Jones Industrial Index covers only 30 companies and does not take market capitalization into account.
The S&P 500, on the other hand, covers a wide range of sectors, has a consistent track record, and is widely recognized as the best picture of the U.S. stock market.
Therefore our choice of the best mutual fund benchmark index to reflect the U.S. stock market will be the S&P 500.
Global stocks benchmark index
Global stock market indexes track stock prices from all around the world. The top three providers of Global Indexes are:
- FTSE Rusell
- Standard & Poor’s
- Morgan Stanley Capital International
Let’s have a look in detail at the Global Equity Index Series, which is one of my favorite benchmark indexes.
GEIS Benchmark Index: FTSE Global Equity Index Series
FTSE Russell is the trading name of London Stock Exchange Group (LSEG) subsidiaries. They are responsible for several well spread indexes, including the FTSE 100 Index and Russell 2000 Index.
As we are interested in Global Markets, let’s have a look at the FTSE Global Equity Index Series or GEIS.
FTSE GEIS it a group of several indexes. The series provides a robust global equity index framework with the versatility to tailor to our investment view.
It includes over 16,000 large cap, mid cap, small cap, and micro cap securities across 49 developed and emerging markets globally, with a wide range of modular indexes available to target specific markets and market segments. Several mutual funds and index funds use one of the GEIS subsets as their performance benchmark.
Below you can see how the different indexes are structured. Notice how comprehensive are the options, you can choose a diversified portfolio like the FTSE All-World or a more targeted approach like the emerging market option or the small cap index fund.
We will stick with the FTSE All-World Index. It covers a $45.7 trillion net market cap on 3,243 large and mid-cap stocks on the developed and emerging markets.
FTSE All-World Index
The FTSE All-World Index is a market-capitalization-weighted index representing the performance of the large and mid-cap stocks from the FTSE Global Equity Index Series.
It covers 90-95% of the global investable market capitalization, meaning that by investing in it, you are basically following the trend of the worldwide capital market.
The index covers Developed and Emerging markets and is used as a benchmark in several investment products, such as funds, derivatives, and exchange-traded funds.
Using the right benchmark to select your investment funds
Excellent, we have selected two renowned benchmark indexes! As per the asset allocation strategy we chose at the beginning of this post, we will diversify and split our capital in two:
- 70% U.S. Stock Markets – Following the S&P 500
- 30% Global Stock Markets – Following the FTSE All-World Index
Now it is time to select an investment that uses these indexes as a benchmark.
There are several options we can choose from, and they will change depending on the country you are located in. Overall, they can be divided into two categories:
- Actively managed funds – active management aims to generate more returns than the index. Mutual funds usually fall into this category.
- Passively managed funds – passive management will try to follow the index. ETFs usually fall into this category.
Trying to beat the market by choosing an actively managed fund might bring extra returns, but will also bear more risks. Active funds generally have a combination of less liquidity and higher fees than passively managed funds.
Good actively managed mutual funds usually have a high entry cost and typically are not open for investment all the time. The performance of the best mutual funds will be heavily dependant on the mutual fund manager ability to beat the market.
Another key difference between passively and actively managed funds is that ETFs can be traded like stocks, while mutual funds only can be purchased at the end of each trading day based on a calculated price. Usually, ETFs have lower management fees and mutual funds.
Depending on the country and bank you are operating with, you might have access to good mutual funds that will track the indexes we have chosen with a premium return over it.
For our case, let’s stick with passively managed options. Our objective here is to follow the market, and of course, pay as little as possible to do so. Therefore we will choose one ETF for each of our indexes.
ETF Index Fund: iShares Core S&P 500
The iShares Core S&P 500 ETF USD Acc is an index fund managed by Black Rock, an American global investment management corporation based in New York City. Choosing a strong fund manager is important to ensure indexing is properly done and fees are low, in this aspect Blackrock is the leading investment company.
The investment objective of the fund is to deliver the net total return performance of the Benchmark Index (being the S&P 500 Index), less the fees and expenses of the fund.
As an ETF, the iShares Core S&P 500 is traded in the stock market. There are several codes for it, depending on the stock exchange you work with.
The investment policy of the fund is to invest in a portfolio of equity securities that match the S&P 500 Index. That means that by investing in it, you will be, in reality, buying a fraction of each of the 500 stocks that makes up the index.
ETF Index Fund: Vanguard FTSE All-World
The Vanguard FTSE All-World UCITS ETF is another ETF. Vanguard Group is a fund management company. It is ranked as the largest provider of mutual funds and the second-largest provider of exchange-traded funds in the world, after BlackRock’s iShares.
The fund aims to provide long term growth, by tracking the performance of the FTSE All-World Index.
To achieve its investment objective, the fund will invest directly in shares of companies that make up the FTSE All-World Index.
Our final portfolio return
We have invested 70% of our investment capital into S&P 500 and the remaining 30% into FTSE All World Index.
Looking back on the past 5YR, our ETFs had the following performance;
- iShares Core S&P 500 ETF: 5YR return of 68,05%
- Vanguard FTSE All-World ETF: 5YR return of 74,36%
Therefore our portfolio will have a 5YR return of: 70% * 68,05% + 30% * 74,36% = 69,94%.
The returns from both funds were quite similar. That is because, over the period we analyzed, the US has dominated the global market. As you can see in the graph below, both funds were well correlated over the past 5 years.
As we are envisioning a buy and hold long term investment (10+ years), the 30% portion on FTSE All-World is designed to shield us from a shift of performance from the US to international markets. We have diversified our investment portfolio to ensure robust capital gains in the long term.
BONUS TIP: When choosing any investment fund, keep an eye on the applicable management fee and expense ratio.
The expense ratio of a fund is the total percentage of fund assets used for administrative, management, advertising, and all other expenses. In order words, the expense ratio is the annual fee that all funds or exchange-traded funds charge their shareholders. Expense ratios of 1% per annum mean that each year 1% of the fund’s total assets will be used to cover expenses. You can find the expense ratio, net asset and asset value on the fund prospectus.
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About the author:
Hi, I am Leblon Blue. Mid-thirties senior manager on a large corporation. Happily married for seven years and waiting for my first kid. I have dedicated my past 15 years to build an engineering background and a stable career. After working in Europe, Scandinavia, and Latina America, I am now based in the Persian Gulf, where I manage the performance of a large corporation that operates in the region.