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Picking the right benchmark.

Helping to keep client's investments on course.

Every CPA who invests client assets in mutual funds has, at one time or another, been asked some tough questions. Buoyed by stories of bull market millionaires, optimistic investors are easily disappointed. When the phone rings and a client asks, "Why didn't my fund perform as well as fund X?" CPAs need to know how to respond.

That's where benchmarking comes in. Many naive investors compare virtually every mutual fund they own with the S&P 500 or with the Nasdaq. But these benchmarks are not all-inclusive and generally should be used only for large capitalization growth/consistent earnings funds--or funds made up of strong blue-chip stock offerings from large companies. When assessing the performance of a small capitalization growth fund that specializes in stocks from small companies in hot industries. comparing the fund's performance with the S&P 500 is virtually meaningless; too many outside factors can skew the results. CPAs should understand how benchmarking works so they can recommend that clients rely on a benchmark that will provide a meaningful comparison.


Benchmarking works hand in hand with asset allocation to achieve the best returns possible. By determining the right asset allocation, a CPA is charting a course toward meeting the client's goals; with well-chosen benchmarks, CPAs have a compass that can quickly tell even a novice investor when he or she is off course.

Say, for instance, a retired client wants to create a fairly conservative investment portfolio. You agree to put 20% of her assets in a large cap value fund--one that specializes in choosing bargain stocks with low price--earnings (P/E) ratios from among the offerings of large U.S. companies. After comparing the fund's return with the S&P 500 for the past three quarters, the client is disappointed. "Choose another fund," she says, one that beats the S&P. You do as she asks; the new fund performs well for one quarter and then drops dramatically.

What went wrong? To begin, the client was using the wrong benchmark. A large cap value fund almost by definition initially does not perform as well as the S&P 500. Value fund managers practice the art of buying good stocks when they're down--or when they have a historically low P/E ratio--with the intention of getting more for the client's money and preventing downside risk. The Russell 1000 Value Index, instead of the S&P 500, would have been a better yardstick to judge the client's investment.

Without the benefit of a working compass, you and your client can lose sight of her goals. Determined to beat the S&P, she traded the comfort of slow and steady gains for dramatic profits and got caught in a market downturn. Using the right benchmark might have saved the client from this unpleasant experience by keeping her satisfied with her more stable fund.

Keeping a client's asset allocation on target isn't the only reason for CPAs to identify and use an appropriate benchmark. To add value to a client's portfolio, the CPA must constantly monitor the performance of his or her holdings. When you pick the right benchmark, you can judge the performance of the fund's manager more accurately. Otherwise, the client runs the risk of selling a fund that's actually performing well simply because its performance doesn't match the S&P 500.

To choose proper benchmarks, CPAs should thoroughly analyze each fund manager's investing style and make a careful reckoning of the fund's assets. The steps outlined below can help you to get started.

Identify the fund's asset class. If the client is buying a mutual fund that invests in U.S. companies, your first step should be to determine the fund's asset class. (International and worldwide funds aren't included in this analysis.) While this may seem remarkably easy, many investors overlook this preliminary step when they select a benchmark.

You can usually find a fund's asset class listed in the fund prospectus. (Alternatively, research the fund at Basically, asset classes categorize funds in two fundamental ways. First, they break the fund down by size: large cap funds traditionally invest in companies capitalized at $9 billion or above; small cap funds invest in companies with assets under $1.5 billion. Mid cap companies, obviously enough, are growing companies that fall between the two.

With the market run-up in the last few years, classifying companies as large, mid or small cap has become more difficult. For this reason, Morningstar no longer uses the fixed capitalization numbers cited above. Instead, Morningstar separates 5,000 of the largest domestic stocks into five market capitalization groups. The top 1% are categorized as giant, the next 4% are large, the next 15% are mid, the next 30% are small and the remaining 50% are micro. Stocks outside the 5,000 stock group also are classified as micro cap stocks.

No matter what size the fund, all fund managers adhere, at least to some degree, to one of two investment philosophies. Value investors look for stocks that are "on sale." They buy shares they believe are underpriced--perhaps because of cyclical changes that affect all industries from time to time or because a company is in a slower growth sector. On the other hand, growth investors specialize in hot or emerging markets and companies with high P/E, price-to-book and price-to-cash-flow ratios.

Identify the fund manager's "substyle." In addition to investing according to either a value or growth philosophy. fund managers tend to follow a substyle. For example, both the Janus 20 Fund and the Dreyfus Appreciation Fund are large cap growth funds. But beyond this surface similarity, the two funds are very different. The Janus 20 Fund is an "earnings momentum" fund specializing in volatile, high-risk stocks that trade at extreme multiples and exhibit very high growth rates--often between 20% to 30% or more a year. Internet companies are prime examples of the companies an earnings momentum fund manager might buy. As stock prices start to go up, earnings momentum investors tend to jump on the wave and try to hold onto the stock until the wave starts to fade.

On the other hand, the manager of the Dreyfus Appreciation Fund follows the "consistent earnings" substyle. Such funds tend to :include lots of blue-chip stocks from well-established companies that outpace the rest of the market. They tend to trade at slightly higher ratios than most large cap stocks and also have higher growth rates. IBM is a good example of such a company.

Depending on a fund's asset class, a fund manager can follow a number of other substyles. To determine a fund manager's substyle, examine the following four factors in the fund's prospectus or quarterly report or check out the fund on the Morningstar Web site. These criteria will help pinpoint a manager's substyle in funds of any size, from large cap to small cap.

* P/E ratio. A fund's P/E ratio is the weighted average of the P/Es for all the fund's holdings, with larger stock positions calculated to have a greater influence. Funds with a high P/E ratio typically are growth funds. For instance, the Janus 20 Fund, an earnings momentum growth fund, had a P/E of 48.9 in May 2000. Investors generally are willing to pay more to have higher P/E stocks in a portfolio because they expect the value of the stocks to rise.

Analyzing a fund's P/E ratio is particularly valuable when you compare it with the P/E ratio of the appropriate benchmark. For instance, the Janus 20 Fund's P/E is, as expected, way above the S&P's May 2000 P/E of 37.1. But when a CPA compares Janus's P/E to the Russell 1000 Growth's P/E, he or she will get much more relevant information: The CPA can then deduce that the Janus fund manager is actually taking more risk, as are other earnings momentum managers who have concentrated positions in hot sectors. Depending on the client's financial goals and risk aversion, this fund manager's gamble can be good or bad--but at least you're in a position to help the client make an informed decision.

* Overall holdings. Many investors are interested in just the top 10 fund holdings. As their adviser, you can't stop there. To aggressively manage a client's portfolio, you need to track the fund manager's major purchases on a quarterly basis. In addition to helping you pick the best benchmark for a given fund, tracking a fund's holdings also can help you detect a phenomenon called style drift--often the bane of sound asset allocation. (See sidebar.) The key to analyzing a fund's holdings is twofold: Look at what sectors me manager is investing in and monitor the size of the companies in the portfolio. Since fund managers are constantly buying and selling, look at the fund's activities at least quarterly. Two resources available to CPAs for monitoring this information include and Morningstar Principia Pro, a software program.

* Price-to-book ratio. This figure is calculated by dividing the current per share stock price by the book value per share. As with the P/E ratio, a mutual fund's price-to-book ratio is the weighted average of all of the fund's holdings. This ratio is particularly useful when analyzing funds that either specialize in the financial industry or have heavy industrial holdings; it is less useful for evaluating funds that specialize in health care and technology. Certain value funds typically have fairly low price-to-book ratios, of perhaps 2 to 1 or 3 to 1. Growth funds, on the other hand, generally have very high price-to-book ratios. For instance, in June 2000 the Marsico Focus Fund had a price-to-book ratio of 15.1 to 1.

* Price-to-cash-flow ratio. CPAs can also evaluate a manager's substyle by comparing a company's stock price with its cash flow for the previous fiscal year. Again, for a fund this ratio is the weighted average of the fund's stock holdings. The price-to-cash-flow ratio is a particularly valuable tool when earnings are not a good indicator of value--as is the case with most technology funds or funds that specialize in other industries where companies typically have large up-front expenses. In such instances the price-to-cash-flow ratio can provide a measure of the market's expectations regarding a mutual fund's future health. High ratios indicate investor optimism in the portfolio holdings. Value funds tend to have lower price-to-cash-flow ratios. Growth funds generally have higher price-to-cash ratios.


After a CPA has determined a fund's asset class and analyzed the fund manager's investment style, it's time to match the fund with the appropriate benchmark. All of the hard work now will pay off because the right benchmark can help eliminate the window dressing some fund managers present to investors. You won't have to just take the fund manager's word for how well he or she is doing--the right benchmark enables you to make an unbiased judgment based on hard numbers, putting all fund managers on an equal and unbiased playing field.

Remember, no benchmark is absolutely perfect. For instance, an active mutual fund has some liquid holdings and also incurs expenses. The majority of benchmarks do not assume these internal costs. In addition, returns for indexes depend in part on how the index average is calculated. This is because the calculation can be done using any one of three different methods--equal weighting, market weighting or dollar (price) weighting. Each method will produce a different return even when the underlying securities are identical.

As you choose a fund's benchmark, keep the following considerations in mind:

* Identify the benchmark in advance.

* A good benchmark should not be too easily beaten.

* Be prepared to change benchmarks if the fund manager's style drifts.

Here are some benchmarks CPAs will find helpful in advising their clients. From this list, you should be able to choose a fairly apt yardstick for almost any mutual fund. Because there are literally dozens of other benchmarks available, however, this list is by no means exhaustive.

* The Morningstar Asset Class Average. In each asset class (large cap growth, small cap value, etc.), Morningstar provides an index average. While Morningstar's benchmarks are more accurate--for most funds--than is the S&P 500, each index is only as good as Morningstar's categorization of the funds. Morningstar benchmarks are not foolproof.

* The Russell 2000 Index. Probably the best known index used to measure small cap performance, the Russell 2000 consists of the lower two-thirds, in terms of capitalization, of the Russell 3000 Index, which is composed of all major publicly traded U.S. companies. The Frank Russell Co., originator of the index, further breaks the index down into the Russell 2000 Growth and the Russell 2000 Value.

* The Russell 1000 Index. Another benchmark from the Frank Russell Co., this index consists of the largest 1000 companies in the Russell 3000 and is a commonly used yardstick for large cap funds. This benchmark also breaks down into the Russell 1000 Growth and the Russell 1000 Value.

* The Wilshire 4500 Completion Index. An extremely broad index based on the Wilshire 5000 stock index, with stocks from the S&P 500 removed. This index is a good benchmark for small and mid cap stocks, although it can be imprecise simply because of its immense size. (Despite the fact that the index is named the Wilshire 4500, it actually uses weighted returns from approximately 6,500 companies.)

* Lipper Equity Income Index. This index is designed to benchmark funds that seek high current income and growth of income. Lipper has compiled the index with stocks from the 30 largest funds it has identified that use this investment strategy. The index is a good measure for large cap value stocks with a yield substyle.

* Lipper Growth and Income Index. Another Lipper index, it is composed of 30 stocks, this time from the 30 largest funds (as identified by Lipper) that combine a growth-of-earnings orientation with an income requirement level or rising dividends. This index is a good benchmark for large cap value's growth-at-a-reasonable-price substyle.

* S&P 500. The granddaddy of indexes, the Standard & Poor 500 is an index of 500 stocks chosen for market size, liquidity and industry group representation. Although Morningstar compares all mutual funds with the S&P 500, CPAs should use it as a benchmark only for large cap growth funds with a consistent earnings substyle.

* Nasdaq 100 Index. This exclusive index reflects Nasdaq's largest industries across major industry groups, including technology, telecommunications and retail or wholesale trade. Eligibility for inclusion in the index includes a minimum average daily trading volume of 100,000 shares. The Nasdaq is a good benchmark for large cap growth funds, particularly those with an earnings momentum substyle.

After you have selected the best benchmark for each mutual fund your client has invested in, try to come up with an overall benchmark to mirror the mutual fund portion of his or her investment portfolio. You might try using a weighted average technique. For instance, if 80% of a client's mutual fund holdings are in large cap growth funds and 20% are in small cap value, you might calculate the overall benchmark with an 80/20 weighted average, based, respectively, on the Nasdaq 100 Index and the Russell 2000 Value Index. This will help the client understand how his or her holdings are performing in aggregate.


By using the benchmarking measures described here, CPAs can be sure they have invested their client's mutual fund dollars with savvy and due diligence. After all, anyone can choose short-term winners by investing in Morningstar funds with a five-star rating or by looking at a fund's recent returns. By setting up a benchmarking system, CPAs can keep a watchful eye on the performance of their clients' long-term portfolios. Such persistence ultimately can help clients make their dreams become reality. And it should also make it easier for CPAs to have the right answer when they field calls from clients concerned about fund performance.



* MANY NAIVE INVESTORS COMPARE VIRTUALLY EVERY mutual fund with the S&P 500 or the Nasdaq. But these benchmarks aren't all-inclusive and should be used only for certain kinds of funds. For other funds, CPAs need to select another benchmark to make a meaningful performance comparison.

* TO SELECT STRONG BENCHMARKS, CPAs SHOULD analyze each fund manager's investing style and make a careful reckoning of the fund's assets. Part of this process can be done by identifying the fund's asset class and the manager's investment substyle--the secondary approach he or she uses to manage the fund.

* EXAMINING SEVERAL KEY RATIOS WILL HELP CPAs identify a fund manager's investment substyle. These include the price-to-earnings ratio, the fund's overall holdings, the price-to-book ratio and the price-to-cash-flow ratio.

* FINDING THE RIGHT BENCHMARK WILL ENABLE investors to make unbiased judgments about a mutual fund's performance. Even then, no benchmark is absolutely perfect. There are a number of benchmarks for CPAs and their clients to choose from, including those published by Morningstar, the Russell 2000 Index, the Russell 1000 Index, the Wilshire 4500 Completion Index, the Lipper Equity Income Index, the S&P 500 and the Nasdaq 100.

* USING THE RIGHT BENCHMARK CAN HELP CPAs make sure their clients' mutual fund dollars are invested in a way that will help meet their goals and objectives.

Identifying a Manager's Substyle

These criteria can help the CPA identify and understand the implications of a mutual fund manager's investment substyle. Both the growth and value categories apply to all sizes of capitalization.

* The following substyles are in the growth category:

Earnings momentum. Earnings momentum funds are for investors who have an appetite for risk. Typically, these stocks have high P/E ratios, high price-to-book ratios and high price-to-cash-flow ratios as well as extremely high growth rates. An earnings momentum portfolio usually is full of cutting-edge technology companies that are trading at extreme multiples. Earnings per share, revenues and stock sales that increase by 50% a year are common.

Consistent earning. A fund manager with a consistent earnings substyle specializes in established blue-chip companies that have a higher growth rate than most other large cap companies. To identify them, took for slightly above-average ratios and holdings in long-term Wall Street icons, such as IBM, Johnson & Johnson and GE.

* The following substyles are in the value category:

Growth at a reasonable price. This substyle is one of several that bridge the gap between a growth investment strategy and a value investment strategy. Although growth-at-a-reasonable-price adherents typically buy growth stocks, they try to find stocks that are undervalued. The managers are buying companies "on sale."

Contrarian. Followers of this substyle are hard-core value investors. Inveterate bargain seekers, they look for companies with potential in the market sectors that are down instead of up. The last place a contrarian would invest is in an Internet company. Instead, he or she might purchase stocks from Owens Corning, a maker of building materials currently trading at four times earnings, compared with the S&P 500, which currently has a P/E ratio of 37.1. Believing the market is overreacting, contrarians put money into companies that have just suffered losses because of bad publicity. Typically, a mutual fund managed by someone with a contrarian substyle will have extremely low ratios across the board. The fund's weighted-average P/E ratio, price-to-book ratio and price-to-cash-flow ratios all will be way below the S&P 500 average.

Yield. A fund manager who specializes in a yield substyle invests in stocks that pay higher dividends, as a percentage of the stock's value, than most other stocks. Typically, a yield fund manager invests heavily in bank stocks. A good current example is Bank One, currently trading at ratios below the S&P 500 but with current yield of 5.6%--well above the market's yield of approximately 1%.

Beware of Style Drift

When benchmarking a fund, there is grave danger for CPAs who check the fund's returns against that benchmark every quarter, and--feeling happy with the results--simply leave the benchmark in place. Why? Because fund managers have a tendency to abandon their investment substyles in order to post better returns. On the surface, that may not sound like such a big deal. But unfortunately, when a fund manager engages in style drift, he or she can undermine a client's asset allocation.

Let's say a client decides to invest half of his mutual fund dollars in a large cap value fund, with the remaining 50% going into a large cap growth fund. Over the past couple of years, the large cap value market has struggled and returns have been low. As a result, the large cap value fund manager might try to sneak several large cap growth stocks into the portfolio to boost returns. He or she might even succeed. But if the large cap growth market falters, the client could be in for a rough ride. More important, the client is now overexposed in growth stocks.

Style drift can also skew the results of the benchmarking process. In the example above, for instance, a value fund that's boosting performance by adding growth stocks undoubtedly will beat its benchmark. But the increase in investor risk may make the fund an inappropriate investment.

To protect clients against style drift, regularly check the holdings of each mutual fund. Don't stop at the top 10 holdings; examine the entire portfolio. In addition to monitoring in which industry sectors the fund manager is investing, also take note of the capitalization of the fund's holdings. In some instances, a large cap growth manager will buy small cap stocks when the large cap market has taken a downturn. In other cases, a fund manager can start by specializing in the small cap market, only to have the dollar value of the stocks in his or her portfolio reach the mid cap level, converting the fund into a mid cap fund. Baron Asset, managed by Ron Baron, is an example of such a fund.

In addition, be cautious when investing in a multi cap fund. These funds, by design, allow the fund manager free reign; a multi cap manager can purchase virtually any kind of stock available. Morningstar has not yet developed a multi cap classification. As a result, multi cap funds often end up in the wrong asset class, are extremely difficult to benchmark and can also undermine a client's asset allocation.


Selected American

The process of choosing the right benchmark is more difficult for some funds than it is for others. While some funds practically scream out their manager's substyle, others have fund managers who use a substyle that is subtler or that has elements of several different substyles.

Take the case of Selected American, a mutual fund offering from Davis Selected Advisors. In choosing a benchmark for this fund, the first step is to look at the fund s asset class. Morningstar classifies it as a large cap value fund. But when you analyze the fund's ratios, a mixed pattern emerges. Selected American's portfolio has an average P/E ratio of 31.7. When you compare this with the P/E ratio of the S&P 500, which comes in at 37.1, you can see the fund definitely has a value slant because its P/E is lower. But the numbers do not reflect the extremes of a pure value fund, which might typically have a P/E ratio of 20.

In analyzing Selected American's price-to-book ratio, you can detect the same trend: the fund's price-to-book ratio comes in at 7.7, which compares with the S&P's price-to-book ratio of 10.55. Again, the ratio suggests a slight value tilt on the part of the fund above the S&P 500. This indicates Selected American has some growth characteristics, as well. The fund manager, like many of his or her peers, does not follow one pure investment model.

The next step is to analyze Select American's holdings. When you look at the fund's sector weightings, as calculated by Morningstar, you see that 31.1% of Selected's portfolio is in technology stocks and 41% is in financial companies. The picture gets even more complicated. While financial stocks are often the bread and butter of value investor's, technology stocks are usually part of a growth portfolio--they're simply too speculative for hard-core value devotees. To clarify how the fund manager operates, dig into Selected's individual holdings. The top 5 holdings, from top to bottom, are American Express, Texas Instruments, Hewlett Packard, Citigroup and Morgan Stanley Dean Witter. This breakdown supports the view that the fund manager, while still basically a value investor, has one foot in the growth than typical value stocks. From this analysis, we can conclude that Selected American's substyle is growth at a reasonable price. The best benchmark? Lipper Growth and Income.

JOHN S. BATTAGLIA, JR., CPA, is president and chief operating officer of the ARIS Corporation of America in State College, Pennsylvania. His e-mail address is RICHARD C. MUSAR, CPA, is vice-president, relationship development, for ARIS. His e-mail address is
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Title Annotation:benchmarking mutual funds
Author:Musar, Richard C.
Publication:Journal of Accountancy
Geographic Code:1USA
Date:Aug 1, 2000
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