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Find the Right Benchmark to Judge Your 401k Investment Success


When it comes to investing our hard-earned dollars in mutual funds, we all want to keep up with the Joneses. You can tell if your mutual fund's return is competitive by measuring it against a "benchmark" -- a group of securities similar or identical to the ones in the fund, known as an index.

Well-known benchmarks include the Dow Jones Industrial Average, NASDAQ, and the S&P 500, but these are not appropriate measures for all mutual funds. There are dozens of different stock and bond indexes, made up of all kinds and sizes of companies and securities. How can you know which one to choose?

Anyone who watches television or listens to the radio has heard these immortal words: "The Dow Jones Industrial Average rose (or fell) by (blank) today to close at (blank)." The same goes for the S&P 500 and NASDAQ. When the indexes are up, stockholders rejoice. When they are down, sad faces abound. Is this rational?

Yes and no. All indexes are not created equal, and they do not necessarily move up or down at the same time. The Dow and the S&P 500 are considered to be representative of the broader market, while NASDAQ features newer companies and a more narrow focus, particularly technology firms.

What's more, the Dow and the S&P 500 may be good indicators of the direction of the overall market, but they may not address your particular collection of investments. The Dow and the S&P 500 do not include every large-cap company, nor do they include small-cap stocks, bonds, or strictly international stocks; although, many of the companies in the S&P 500 have international operations.

Indexes and Asset Classes

In finding an appropriate benchmark for your investment, it helps to know what asset classes you hold. There are no hard-and-fast rules about what constitutes an asset class, but the following list is a good starting point.

These asset classes can be further divided into smaller categories that might indicate region or investment style, such as a fund that only invests in Latin America, or only in high-tech. For example, a fund that holds domestic mid-cap value stocks would probably have its performance analyzed in relation to the S&P MidCap 400. Or, a fund with European small-cap or large-cap holdings might use the Morgan Stanley Capital International Europe, Australasia, Far East Index (MSCI EAFE) as a benchmark.

Let's take a look at the well-known indexes and how to interpret them.

The Big Three

Dow Jones Industrial Average: The Dow Jones Industrial Average (DJIA) is the oldest index, and a prominent and oft-cited barometer of U.S. economic performance. In fact, it is somewhat surprising to note that it is comprised of just 30 companies. These aren't just any companies, though -- they are blue-chip companies (high quality, with proven growth and dividends over time) that are generally considered to be a good representation of the U.S. economy. All trade on the New York Stock Exchange.

The DJIA is a "price-weighted" average, meaning that companies with higher stock prices have a greater impact on the overall average. If one or two of the most expensive stocks go up while the others fall, the index could actually close higher at the end of the day despite the fact that 28 or 29 companies closed lower. Some market analysts argue that this makes the Dow somewhat misleading as a market indicator. Also, stock price is not necessarily indicative of the health of a company.

Although it has been suggested that the Dow needs revamping to include stocks that are more representative of the sectors driving today's economy, such as technology and services, most analysts consider it to be a good general barometer of stock market trends.

What's more, the stocks listed on it are very liquid (they are traded frequently), so the movement of this index is generally based on very recent data.

As a general rule, if on the same day there is a big difference between the DJIA and the S&P 500, the latter is probably a more reliable indicator of how the broader market is doing.

S&P 500: The Standard & Poor's 500 Composite Stock Price Index (S&P 500) is -- surprise! -- made up of 500 companies. (Don't feel silly if you weren't sure about this -- according to Standard & Poor's many people aren't.) Chosen by a committee, these companies are leaders in the broad sectors of the economy, though they are not necessarily the largest companies in the U.S.

The S&P 500 is a "market-weighted" index. It is based on the market value, or capitalization, of companies -- the total number of shares owned by stockholders multiplied by the price of one share. The index's value is calculated by adding the market values of the 500 stocks and dividing the total by an "index divisor" that is calculated to make the index values comparable over time.

Because the S&P 500 is a market-weighted index, companies with larger capitalization have more impact on its movement. While capitalization may well be a more accurate indication of a company's health than is price, the movement of market-weighted indexes also needs to be taken with a grain of salt.

Here's why: In the late 1990s, investors have shown themselves willing to pay high prices for some growth-oriented stocks -- stock in companies that are expected to have consistent and reliable earnings. As these (large-cap) stocks have risen sharply, so has the market in general. But, these stocks make up a relatively small proportion of the market as a whole.

Investors often use the S&P 500 as a benchmark for their investments, but not always correctly. For example, it would not be an appropriate benchmark for judging performance of small-cap stocks. Or, to judge performance of a value-oriented large-cap fund, one might get a more accurate reading by using a value-oriented benchmark such as the S&P Barra Value Index.

NASDAQ Composite Index: Created in 1971, the NASDAQ Composite Index measures the performance of more than 5,000 U.S. and non-U.S. companies traded "over the counter" through NASDAQ (the National Association of Securities Dealers Automated Quotation --- the "electronic stock market").

Its wide base makes NASDAQ attractive as a market indicator. However, keep in mind that the NASDAQ Composite comprises mostly newer companies and is particularly weighted toward the technology sector.

Hence, for example, on June 21, 1999 NASDAQ closed up 1.7 percent; while both the Dow and the S&P 500 were down, by 0.7 percent and 0.32 percent, respectively. Analysts judged that NASDAQ rose on that day because of investor optimism about future earnings for computer companies, while the other two indexes fell as a result of increases in long-term bond yields. (A classic rule of economics is that stock prices fall when long-term bond yields rise, because investors take their money out of stocks and put them in bonds.)

Other Popular Indexes

Russell 2000: The Russell 2000 is a small-cap index devised by the Frank Russell Company, an investment management firm. The Russell 2000 is a popular benchmark for small-cap mutual funds.

As its name suggests, this index is made up of 2,000 companies. It is really a subset of a larger index, the Russell 3000, which ranks the top 3,000 U.S. companies in terms of capitalization. The Russell 2000 comprises the 2,000 smallest companies in that index.

According to the Company, the Russell 3000 represents approximately 98 percent of the U.S. equities market that is available to individual investors. The Russell 2000 is approximately 11 percent of that.

Frank Russell Company has a total of 18 indexes, some of them broken down into growth and value indexes. It reviews the composition of these indexes once a year.

Wilshire 5000: The Wilshire 5000 Index has traditionally been a benchmark used by institutional investors, but we mention it here because it is increasingly showing up in the mainstream financial press. Its stated policy is to include all U.S.-based equities with readily available price data. Don't be fooled by the name -- the index actually holds more than 7,000 companies, according to Wilshire.

Wilshire, an asset management company, has a number of other indexes. These also include the Wilshire 4500 Equity Index, which is the 5000 minus the companies in the S&P 500.

Lehman Brothers Aggregate Bond Index: Lehman Brothers is a leading global investment bank. Its Aggregate Bond Index is widely used to measure performance of regular-grade, U.S. bond funds. However, it would not be an appropriate yardstick to measure performance of short-term or high-yield bonds, or foreign bonds. These should be measured against relevant benchmarks.

Morgan Stanley Capital International Europe, Australasia, Far East Index (MSCI EAFE): Often referred to simply as "EAFE" (pronounced ee-fuh), this index was created in 1969 with 14 countries, and now is made up of 21 countries. This is a popular benchmark for international funds. Keep in mind that there are a number of country-specific or region-specific funds that can be used as well.

Finding an Appropriate Benchmark

If you know the "style" of your fund (value or growth) and details about its capitalization range, a bit of research might net you the most precise benchmark for your investment. There is a great deal of information on the Internet; a good starting point might be the Web sites of the companies that create the indexes.

In addition to the indexes already mentioned, others include the S&P Barra Growth and Value Indexes, the S&P MidCap 400 and SmallCap 600, the Wilshire Small Cap, and the NASDAQ 100. There are also indexes for different geographic regions, for socially responsible funds, and emerging market funds.

If you are not sure whether your mutual fund has a specific style, you could try the following rule of thumb: measure large-cap funds against the S&P 500; small-cap funds against the Russell 2000; international funds against the EAFE; and bond funds against the Lehman Brothers Aggregate Bond Index.

This is for educational purposes only. The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

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