Apples to apples Comparing performance numbers

Remember back in school when the teacher handed back exams and you were delighted to get a 92 (unless you're from an overachieving family)? But then you learned that the average on the exam was a 95. You still may have been pleased, but a lot of air was let out of your balloon.

It's the same with mutual fund performance numbers: They don't mean much until they're compared to the averages. A 15 percent return sounds great until you learn that the return from the relevant index market average was 25 percent during the same period.

The trick is picking the correct benchmark to compare to. Dozens of market indexes and fund category averages measure various components of the market. You always want to compare a fund's returns to its most appropriate benchmark. It isn't fair to compare the performance of an international stock fund to that of a U.S. stock market index, just as it isn't fair to compare a sixth grader's test results on a given test to those of a tenth grader taking the same test. (See Chapter 12 for a list of benchmarks and an explanation of what markets they measure.)

You know that context matters, and mutual fund companies realize this. So in their marketing literature, fund companies usually compare their funds' returns to selected benchmarks. Keep a wary eye on these comparisons. In the great American advertising tradition, fund companies often pick benchmarks that make it easy for their funds to look good.

Here are some examples of the games funds play to make themselves look a lot better than they really are.

During 1994, the Strong Short-Term Bond Fund ran ads claiming to be the number one short-term bond fund. (I'd show you the ad, but Strong refused permission to reprint it.) The ads featured a 12-month comparison graph that compared the Strong fund's yield to the average yield on other short-term bond funds. The Strong Short-Term Bond Fund, according to the graph, consistently outperformed the competition by 2 to 2.5 percent! And, gosh, with a vibrant, solid name like Strong, how could you go wrong?

As you see in Chapter 8, where I discuss all you need to know about bond funds, a bond fund must take a lot more risk to generate a dividend this much higher than the competition's. And if it's taking that much more risk, then the fund needs to be compared to its true competition — which, in Strong's case, would be other funds whose investments take similarly high risks. This fund isn't a bad fund, but it isn't nearly as good as the ad would have had you think.

This fund was on steroids! The Strong Short-Term Bond Fund was not comparable to most other short-term bond funds because

Iv0 A high percentage of its bonds were not high-quality: Historically, about 40 percent of its bonds are rated BBB or below.

v0 Many of its bonds are not short-term bonds: Strong invests in mortgage bonds that are more like intermediate-term bonds.

You also should be suspicious of any bond fund claiming to be this good with an annual operating expense ratio of 0.80 percent. With expenses that high (as I explain in Chapter 8), you know that it has to take higher risks than supposedly comparable funds to make up for the drag of its expenses.

Strong's ad also claimed that its bond fund was ranked number one for the year. If a fund takes more risk than the funds it compares itself to, then sure, during particular, brief periods, it can easily end up at the top of the charts. But how strong a long-term performer is this "number one" fund? Over the previous five years, including the year the ad was so proud of, Strong's fund had underperformed most short-term bond funds.

As I explain in Chapter 8, short-term bond funds managed by companies such as Fidelity, PIMCO, and Vanguard charge far lower operating expenses, take less risk, and generate equal or better returns than this fund does.

During much of 1994, ads for the Warburg Pincus Growth & Income Fund similarly trumpeted its superior performance — claiming to be the number one growth and income fund for the year and number four out of 180 funds for the previous five years. Sounds great, doesn't it? (I'd show you the ad, but, like Strong, Warburg Pincus refused to give permission to reproduce it.)

Most growth and income funds invest in U.S. companies, primarily larger ones. This fund, however, would have been more appropriately called the Warburg Pincus Global Growth Fund, because its prospectus showed that this fund had invested about 20 percent overseas and 40 percent in small company stocks.

The average growth and income pays dividends of around 3 percent, whereas this fund was paying only 0.2 percent at the time of its ad. Thus, a huge amount of this fund was focused on relatively growth-oriented, rather than dividend-oriented, securities.

Like the Strong Short-Term Bond Fund, the Warburg Pincus Global Growth (& Income) Fund is not a bad fund. But it's hardly as superior as the ad implies.

^ftBf/y Some mutual funds choose comparative benchmarks for the sole purpose of ^ ^"¿X making themselves look good. More than a few investment advisors who jjj[| j manage money do the same, as Chapter 20 makes clear. In Chapter 12,1 talk more about matching up funds to their relevant benchmarks and recognizing which benchmarks don't really apply at all.

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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