Evaluating the performance of actively managed mutual funds generally involves comparing a product’s results with some passive benchmark (the SEC requires that funds select a benchmark for comparison purposes) that follows the same investment “style” as the fund’s portfolio (such as the S&P 500 for large-cap stocks, the S&P MidCap 400 for midcap stocks and the S&P SmallCap 600 for small-cap stocks).
This practice can create problems, as funds can choose benchmarks with less exposure than they do to factors that historically have provided premiums (such as market beta, size, value, momentum, profitability and quality). Thus, the benchmarks have lower expected returns.
This misleading practice is important because, as Berk Sensoy’s study, “Performance Evaluation and Self-Designated Benchmark Indexes in the Mutual Fund Industry,” which appeared in the April 2009 issue of the Journal of Financial Economics, shows, “almost one-third of actively managed, diversified U.S. equity mutual funds specify a size and value/growth benchmark index in the fund prospectus that does not match the fund's actual style.”
Unfortunately, the same research also shows that when allocating capital, individual investors emphasize comparisons relative to the mutual fund’s self-selected benchmark, not its true, risk-adjusted benchmark. It’s clear that fund companies strategically choose a benchmark that will drive fund flows.
Martijn Cremers, Jon Fulkerson and Timothy Riley contribute to the literature on mutual fund performance relative to self-selected benchmarks with their May 2018 study, “Benchmark Discrepancies and Mutual Fund Performance Evaluation.”
They used a holdings-based procedure to determine whether an actively managed fund has a “benchmark discrepancy”; that is, a benchmark other than the prospectus benchmark that better matches a fund’s actual investment strategy.
To accomplish this objective, they identified the benchmark that has the lowest active share with the fund’s holdings. They considered a fund as having a benchmark discrepancy if its benchmark mismatch was at least 60%. Their calculations revealed 26% of funds in their sample had a benchmark discrepancy. The authors’ data covers the period 1991 through 2015.
Following is a summary of their findings:
- If the prospectus benchmark and risk-adjusted benchmark are different in month t, then the probability they will still be different in month t+12 is 86%.
- Funds with a benchmark discrepancy tend to be managed more actively, having a higher active share. They also tend to be younger, have fewer assets, and are more expensive. They also tend to be small-cap and midcap funds.
- Relative to the prospectus benchmark, funds on average underperform by 0.33% per year, which is not statistically distinguishable from zero (t-stat = -1.06). However, funds underperform by 0.78% per year relative to their appropriate benchmark, which is statistically significant (t-stat = -2.87).
- For funds with a benchmark discrepancy, the prospectus benchmark typically understates the fund’s factor exposures. Thus, the prospectus benchmark is easier to beat than a benchmark with the same factor exposures as the fund.
- For mismatched funds, the average return of the more appropriate, risk-adjusted benchmark is 1.5% per year (t-stat = 3.20) higher than the prospectus benchmark’s average return.
- Traditional factors (market beta, size, value and momentum) explain about a third of the average difference in returns between the more appropriate benchmarks and the prospectus benchmarks. Including nontraditional factors along with traditional factors explains about 87% of the average difference in returns. Among nontraditional factors, the Fama-French profitability factor (RMW) has the largest impact.
- The findings were strongest among large-cap funds with a benchmark discrepancy, with the prospectus benchmark overstating risk-adjusted performance by 2.41% per year (t-stat of 2.10), all of which can be explained by exposure to traditional as well as nontraditional factors. In other words, large-cap funds with a benchmark discrepancy tend to own smaller-cap stocks than their prospectus benchmarks indicate.
- The benchmark discrepancies have a significant economic impact on performance evaluation as well as capital allocation, as investors generally focus on fund performance relative to the prospectus benchmark when allocating capital, even when a fund has a benchmark discrepancy.