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Measuring U.S. Equity Manager Performance
Benchmarks and Weighting
Once an investor has settled on an asset-allocation plan — determining how to split money between equities, fixed-income, real estate and the like — a significant element of investment strategy remains.
The selection of a particular mutual fund or specific money manager can be just as critical to a portfolio's overall performance as the decision on how to diversify investments.
If evaluating a mutual fund and its manager seem as simple as checking returns and monitoring a fund's top 10 holdings, "you're not likely to discover what you really need to know," says Russell's Kelly Haughton.
Using indexes and understanding stock weighting can help fill in the relative performance gaps that absolute returns ignore.
Looking only at a fund's absolute return for any given period won't reveal how capable the fund manager has been. It is relative performance — how a manager stacks up against the broad market or a particular asset class or sector — that counts.
No fund manager can withstand market forces and the economic forces behind them. But in periods of market stagnation or decline, the best managers minimize losses and sometimes eke out modest gains. Conversely, in go-go periods like the late '90s, almost anyone can provide solid gains. The best managers maximize them.
A manager with a losing quarter may have done a great job. Only performance relative to an appropriate benchmark provides an accurate picture of the fund's merit and the manager's stock-selecting ability.
A complete picture goes beyond relative performance, though. A fund manager's style and the kinds of stocks the manager believes will do well also should be considered. Here again, many investors make a major mistake.
True Yardsticks
Determining the market's performance requires an accurate, objective assessment of the market's make-up. That's why savvy investors select a reliable index to serve as a benchmark for performance analysis.
Enter the Russell 3000® Index. Russell maintains this index, comprised of approximately the top 98% of investable U.S. securities based on market capitalization, to get a broad representation of the U.S. market. Russell also tracks market segments through more than 24 other indexes, broken down by capitalization and value/growth characteristics.
The Russell index methodology is continually gaining wider acceptance. More large institutional investors now use the Russell 3000, or one of its sub-indexes, to evaluate their managers' performance. Haughton explains, "Russell indexes offer objectivity and realism through a methodology we carefully developed over the years and continue to refine and post publicly. What makes Russell indexes effective isn't breadth of coverage but the methodology we use."
For example, to accurately reflect market activity, the Russell 3000 represents only stock shares that are likely to be traded. So it excludes closely held shares, like the ones Bill Gates holds in Microsoft and isn't likely to sell. Russell also provides state-of-the-art performance measurement tools and style indexes.
"Russell benchmarks enable our professional manager research staff and analysts worldwide to effectively assess manager performance," says Haughton.
Checking the Right Top 10
A benchmark like the Russell 3000 serves as a target for active fund managers who seek to beat it by over-weighting or under-weighting selected stocks in their portfolios. Buying more of a particular company gives a fund a higher percentage of its assets in the company than the percentage of the index the company represents. Managers see greater potential in these stocks so they over-weight them vs. the benchmark.
Many investors, however, look only at a fund's 10 largest holdings in absolute terms — the actual dollars invested and percentage of the portfolio each stock represents. "But," cautions Haughton, "what's revealing is the relative weighting."
Consider an example in which General Electric stock constitutes 1% of a fund's portfolio. Given that the Russell 3000 represents 3,000 stocks, you might think that the manager really likes GE. But, Haughton advises, "GE makes up about 2.54% of the capitalization of the Russell 3000. The manager is betting against GE by under-weighting its stock."
An investor reading a prospectus or annual report will generally see only absolute dollar amounts and the percentage each stock makes up of the portfolio. Comparisons to a relevant index for weighting evaluation generally aren't listed.
Understanding how a manager has performed relative to the market and how the fund weights its stock picks, provides a good sense of relative performance.
Copyright© Frank Russell Company 2002. All rights reserved. See Legal Information.
Date of first use: June 14, 2002.
This is a publication of Frank Russell Company. It should not be construed as investment, legal, or tax advice. The contents are intended for general information purposes only, and you are urged to consult your own investment, legal, or tax advisor concerning your own situation and any specific investment questions you may have. For further information about these contents, please contact Frank Russell Company. Frank Russell Company, a Washington, USA, corporation, operates through subsidiaries worldwide.
Russell 3000® Index — Measures the performance of the 3,000 largest U.S. companies based on total market capitalization, which represents approximately 98% of the investable U.S. equity market.
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© Russell Investments 1995-2008. All rights reserved.
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Russell Investment Group is a Washington, USA corporation, which operates through subsidiaries worldwide, including Russell Investments, and is a subsidiary of The Northwestern Mutual Life Insurance Company.
Indexes are unmanaged and cannot by invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.
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