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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.
Editor's note: This article was
excerpted from Wall Street 201, an investment education course
developed by mPower. The entire course will soon be available
online, at the 401Kafé.
Learn even more about this topic with
The Encyclopedia of Personal Finance.
Click here!
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