Indices

Most major stock markets, industrial sectors, and geographical regions have one or more indices designed to serve as a proxy for market performance. Some of the indices are broad, some are narrow, and some are concentrated in a sector or industry. Indices may be called averages. Indices may be stock weighted, capitalization weighted, or otherwise configured. An index fund is a mutual fund holding shares in proportion to their representation in a market index such as the S&P 500, or close enough to closely approximate the index in performance. Inflation-indexed bond funds are a special type of mutual fund which may or may not be index funds. An index option is a call or put option based on a stock market index.

An index fund is passively managed. In contrast, most mutual funds are actively managed by an investment manager or team. Likewise, a self-directed individual investor actively selects stocks directly without the assistance of an investment manager. Some investors become activists to influence companies in order to create shareholder value where company management performance is unsatisfactory from the shareholders' perspective.

Performance Evaluation

Market indices can be used as benchmarks for performance comparisons. An investment manager or individual investor can compare his or her investment results with an appropriate benchmark. In the U.S., the Wilshire 5000 is a broad equity index. Globally, the Dow Jones World Stock Index, the Dow Jones Global Titans Index, and the Morgan Stanley World Index are broad equity indices. A broad cap-weighted index transformed into gold by weight might make an interesting barometer of global capital markets.

Performance results of standardized fund categories appear regularly in the financial press. The most commonly used benchmarks for U.S. diversified equity funds are the Dow Jones Industrial Average and the Standard & Poor's 500 Common Stock Index, the S&P 500. The Wall Street Journal yardsticks and benchmarks are an example. The number of size and style fund categories that outperform the S&P 500 declines as the holding period increases from one to three to five years. Although the ten-year returns are not reported here, it is expected that none of these categories outperforms the S&P 500 for a ten-year holding period.

Absolute and comparative performance may be measured. The performance of companies or funds and of their managers can be measured. Absolute performance evaluation is fairly straightforward, but comparative performance evaluation is problematic.

A comparison is a quadruple. It involves (1) a company or mutual fund, or a manager, whose performance is to be evaluated, (2) an appropriate benchmark for its objective and another benchmark for its peers or rivals, (3) a metric of performance such as total return with reinvested dividends after expenses and before taxes and before adjustments for inflation, and (4) an appropriate holding period for the specific investor's time horizon. Thus, a statement about comparative performance is necessarily a statement about four effects, all of which are confounded.

To illustrate the problems with comparative performance, consider some extreme hypothetical examples chosen to emphasize the point. If a mutual fund has a negative total return but is less negative that its benchmark and all of its peers, then the comparative performance of the fund and its current manager gets the highest score, but their absolute performance gets a low score. Likewise, if a company has an unprecedented high positive return on equity but is less positive than its benchmark and all of its peers, then the comparative performance of the company and its management team gets the lowest score, but their absolute performance gets a high score.

No single quantitative measurement can adequately reflect either return or risk for all investors. We don't consider so-called risk-adjusted return because it involves statistical definitions of risk derived from academic capital asset pricing models that are not relevant to common sense meanings of risk. In our approach, risks are specific perils, and the single greatest continuous risk to investors is price-level inflation. For several years, the U.S. Treasury has been selling inflation-indexed bonds with variable returns adjusted for price-level inflation in the U.S. economy. The metric of inflation-indexed bonds is not just total return but real return.

How does an investor monitor his or her investments to know when it is time to sell if performance is not satisfactory? We suggest that each investor consider personal investment horizon, personal goals at time of purchase, and personal expectations of future performance. We also suggest using both an absolute and a comparative measure of performance. For example, an investor might have an absolute long-term goal of 12% per annum total return which is 2% higher than the historical total return on stocks of about 10% per annum, and also a comparative short-term goal of 2% higher than the calendar year total return of an appropriate market index such as the S&P 500 without dividends reinvested and after expenses.

Another extreme hypothetical example may illustrate this point. An investor with a 20-year investment horizon buys some shares in Noname Equity Fund. In the most recent five years, the fund is up 80%, the appropriate market benchmark is up 120%, and the appropriate peer group is up 160%. Absolute performance is higher than the goal of 12% per year (76% in five years). Comparable performance is lower than the appropriate benchmarks for the past 1-year and 3-year as well as the 5-year holding period. But the cumulative return from date of initial purchase eight years ago to the present is 15% per annum. In this case, the long-term goal is still being met, although the short-term goals of 1, 3, and 5 years have not been met. A long-term investor might well hold, recognizing that the quadruple is confounding the comparative performance measure.

In the same example, by a quirk of arbitrary calendar breakpoints both of the comparative benchmarks for the market and for peers may have unstable returns and be less than the Noname Fund return (1) if a market capitalization-weighted, stock-weighted, or random benchmark in used; or (2) if the metric of performance is changed (a) from return with reinvestment of capital gains and income dividends to return without such reinvestment, (b) from return before expenses to return after expenses, (c) from return before tax to return after tax, (d) from return before adjustment for inflation to return after adjustment for inflation, or (e) from the current metric to some combination of these changes; or (3) if the beginning and ending dates of comparison are shifted; or (4) if margin loans are included.

Absolute performance is much less arbitrary. It is a triple: (1) a fund or manager, (2) a metric of performance, and (3) a holding period. Single measures are not advisable. For many investors, the best single metric is total return per annum, after selling and operating expenses, after taxes, adjusted for inflation, from date of purchase to present.

Long-term investors appreciate the difference between recognized gains and realized gains. Recognized gains are merely "paper" profits recorded for accounting purposes, but realized gains are taxable events with cash consequences. Because the stock market is a zero-sum game in game theoretic terms, paper gains and losses can occur suddenly with corresponding changes in investor perceptions. Thus, paper profits are not real wealth and create no real wealth effect

Investors who chase short-term performance put pressure on fund managers to trade more often to create more favorable quarterly reports. These short-term gains come at the expense of higher portfolio turnover, higher trading costs, and higher capital gains taxes. This in turn leads to shorter holding periods by investors who have unclear goals and inadequate criteria of fund performance.

The real question is why an investor would choose an actively managed mutual fund? Actively managed funds in comparison to index funds have higher expenses, higher portfolio turnover, lower tax efficiency, less funds invested with cash balances, and inferior net returns. Index funds are a recent innovation that enable an investor to literally buy the market.

If you must invest in an actively managed fund, then you might start by looking at a chart of the most recent three bull phases and last three bear phases, i.e., the latest three complete bull-bear market cycles. For comparison, this can be overlaid with the inception to date performance of the fund of interest and the manager of interest using the performance metric that most closely matches your goals.

If there is less historical data than covers three full stock market cycles with comparable manager tenure, it may be difficult to reach any sound conclusions about expected future performance. Making judgments with insufficient data might prove hasty. For more about actively managed funds, see mutual funds.