Fund Performance - Keep An Eye But Don't Chase

Although past performance is certainly not an indication of future results, there are some clues to be found about the quality of a fund by correctly measuring its past performance. Usually, what will be discerned through a careful study of past performance is that not many mutual funds actually deliver anything close to what their advertisements claim.

Relativity holds true when examining a mutual fund's performance. What constitutes a "good" return depends on your needs and the type of fund. That's where benchmarks come in to play.

Personal Benchmark

It means setting a benchmark for the returns required to reach your investment goal, whether it is a long-term goal (retirement in 25 years) or a short-term goal (paying kid’s college fees in 7 years). By knowing that benchmark, you can immediately rule out funds that rarely meet that hurdle each year, such as most bond funds. You can also rule out funds that can sometimes return much more than your personal benchmark, but take extra, unnecessary risk.

Indexes as Benchmarks

When looking at a mutual fund's past performance, a good and necessary step is to identify its Morningstar style box. Morningstar has broken down the world of domestic mutual funds into small-, medium-, and large-cap funds and by objective -- growth, value, or blend. The Morningstar style box looks like a tic-tac-toe board, as such:

Once you know which "style box" a fund is in, you can compare it with the other mutual funds that are similarly classified, and in many cases to a relevant index fund.

The index you'll hear about most often in mutual fund circles is the Standard & Poor's 500 Index, which includes 500 major U.S. companies. Yet despite its widespread appeal, the S&P 500's focus on large companies means it's not representative of the entire market and smaller stocks' performance in particular. It's therefore inappropriate to measure a fund that doesn't buy large companies The Russell 2000 Index, which tracks smaller U.S. companies, is a good tool to evaluate many small-company funds, while the MSCI EAFE( Europe Australia Far East) Index, which follows international stocks, is a good measuring stick for foreign funds. The Barclays Aggregate Bond Index is a good gauge for most taxable-bond funds.

Peer Groups as Benchmarks

The second type of benchmark you can use is peer groups, or funds that buy the same types of securities as your fund. This is another place where you can use the knowledge of Morningstar style box.

Compare funds that buy large, undervalued companies with others with the same style—so-called large-value funds. Or compare those that buy only Latin America stocks with other funds that only buy Latin America stocks. That way, you're comparing apples to apples.

Why don’t we just stick with index comparisons? Remember we are long term investors. There are times when entire fund category underperforms the corresponding index but we can not write them off because of this. In that case we use the peer comparison to figure out the best fund in the group. Peer benchmarking is important when you are trying to diversify you are portfolio. If a category underperforms today it doesn’t mean that you drop that category entirely from your portfolio. Underperformance of large value funds in 2000 is an excellent example. Same category outperformed S&P 500 by miles in 2009.

The best approach is to use all the benchmarking judiciously because even though past performance does not guarantee future results but a fund that trounces its peers and sits in top quartile generally tends to repeat the performance for next few years till you see one of the multiple red flags. But ensure that you don’t end up overrating the performance. Only pick the ones which have faced the test of time and outperformed peers and benchmark both in bear and bull market.

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