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Comparisons to Other Mutual Funds Can Be Misleading

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The mutual fund industry is highly competitive and very lucrative. Fund managers earn fees through "expense ratios" charged by their funds. These fees add up to big bucks. According to one report, in 2010 there were thirty stock fund classes with assets greater than $10 billion. Collectively, those funds would collect a whopping $3.9 billion in fees for the following year, assuming an average expense ratio of 0.548 percent. With revenues like that, it is not surprising that publicly traded funds have huge pretax margins. The same report noted that T. Rowe Price had a pretax margin of 37.1 percent. Federated Investors was 27.7 percent and Gamco (which offers the well-known Gabelli Funds) reported 35.6 percent.

In an effort to capture more assets and keep those profits flowing, fund families engage in extensive advertising, intended to demonstrate how well their funds performed. I was struck by this statement on the web page for T. Rowe Price: "100 percent of our Retirement Funds beat their 5-year Lipper average as of 12/31/11."

That does seem pretty impressive. As regular readers of my blogs are well aware, I advocate purchasing index funds and avoiding actively managed funds (where the fund manager attempts to beat a designated benchmark). My views are based on the overwhelming research indicating that actively managed funds are statistically likely to underperform index funds over the long term. This research is summarized here.

All of the retirement funds offered by T. Rowe Price are actively managed funds. Its web page extols the ability of its "global research team" to engage in "bottom-up research" in order to "enhance returns".

Since 100 percent of its retirement funds beat their 5-year Lipper average, investors could believe that T. Rowe Price has found a way to consistently "beat the market". Is this accurate?

Not if you understand how the use of benchmarks can be misleading.

Lipper mutual fund averages are benchmarks that measure the performance of funds in a given category against other funds in that category. The fact that all of the retirement funds managed by T. Rowe Price beat their Lipper averages means they were better than the average performance of the other funds measured by Lipper. While interesting, it tells you nothing about how those funds performed against their benchmark indexes.

Morningstar assigns a benchmark index to each mutual fund it rates. This is the index against which the performance of a given fund can be measured. These indexes are assigned by the Morningstar fund analyst team, based on its Morningstar category. It is the index the Morningstar analyst team believes is the most appropriate benchmark for the Morningstar category.

The performance of a fund against its appropriate index is a more accurate way to evaluate the performance of a mutual fund. Think of it this way. If the average 8th grader can run a 100 yard dash in 20 seconds and your child took 40 seconds, you might be concerned. However, if the only information you had was that your child was better than the average in his class (and the average in his class was 45 seconds), you might believe he was in great shape.

Using data from Morningstar (for example see here), Index Funds Advisors calculated the returns for the five-year period ending December 31, 2011 of the T. Rowe Price Retirement funds against their analyst assigned benchmark. This was the same period used by T. Rowe Price to measure performance against the Lipper average. We measured the performance of all 33 T. Rowe Price Retirement Funds. The results were surprising. None of them equaled (much less beat) their Morningstar analyst assigned benchmark. Underperformance ranged from 0.84 percent to 1.73 percent (annualized). Only twelve of these funds are available for direct purchase by individual investors.

Representatives for T. Rowe Price disagree. They believe the Lipper results give investors "... a valid apples-to-apples comparison." They also note you can't purchase the Morningstar benchmarks so the use of them doesn't represent a valid comparison. Finally, they quarrel with the benchmarks assigned to their funds by Morningstar and believe their custom benchmarks are more accurate. Their funds outperform their customized benchmarks.

If fund families want to brag about the performance of their funds against their peers, that's fine. But you should insist on knowing how they did against an appropriate benchmark (whether you believe that benchmark is the one set by a third party like Morningstar, or the fund family itself). Otherwise, your portfolio could be out of breath at the finish line.

Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of "The Smartest Investment Book You'll Ever Read," "The Smartest 401(k) Book You'll Ever Read," "The Smartest Retirement Book You'll Ever Read" and "The Smartest Portfolio You'll Ever Own." His new book is "The Smartest Money Book You'll Ever Read." The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.