Academic journal article Journal of Accountancy

Picking the Right Benchmark

Academic journal article Journal of Accountancy

Picking the Right Benchmark

Article excerpt

Helping to keep client's investments on course.

Every CPA who invests client assets in mutual funds has, at one time or another, been asked some tough questions. Buoyed by stories of bull market millionaires, optimistic investors are easily disappointed. When the phone rings and a client asks, "Why didn't my fund perform as well as fund X?" CPAs need to know how to respond.

That's where benchmarking comes in. Many naive investors compare virtually every mutual fund they own with the S&P 500 or with the Nasdaq. But these benchmarks are not all-inclusive and generally should be used only for large capitalization growth/consistent earnings funds--or funds made up of strong blue-chip stock offerings from large companies. When assessing the performance of a small capitalization growth fund that specializes in stocks from small companies in hot industries. comparing the fund's performance with the S&P 500 is virtually meaningless; too many outside factors can skew the results. CPAs should understand how benchmarking works so they can recommend that clients rely on a benchmark that will provide a meaningful comparison.


Benchmarking works hand in hand with asset allocation to achieve the best returns possible. By determining the right asset allocation, a CPA is charting a course toward meeting the client's goals; with well-chosen benchmarks, CPAs have a compass that can quickly tell even a novice investor when he or she is off course.

Say, for instance, a retired client wants to create a fairly conservative investment portfolio. You agree to put 20% of her assets in a large cap value fund--one that specializes in choosing bargain stocks with low price--earnings (P/E) ratios from among the offerings of large U.S. companies. After comparing the fund's return with the S&P 500 for the past three quarters, the client is disappointed. "Choose another fund," she says, one that beats the S&P. You do as she asks; the new fund performs well for one quarter and then drops dramatically.

What went wrong? To begin, the client was using the wrong benchmark. A large cap value fund almost by definition initially does not perform as well as the S&P 500. Value fund managers practice the art of buying good stocks when they're down--or when they have a historically low P/E ratio--with the intention of getting more for the client's money and preventing downside risk. The Russell 1000 Value Index, instead of the S&P 500, would have been a better yardstick to judge the client's investment.

Without the benefit of a working compass, you and your client can lose sight of her goals. Determined to beat the S&P, she traded the comfort of slow and steady gains for dramatic profits and got caught in a market downturn. Using the right benchmark might have saved the client from this unpleasant experience by keeping her satisfied with her more stable fund.

Keeping a client's asset allocation on target isn't the only reason for CPAs to identify and use an appropriate benchmark. To add value to a client's portfolio, the CPA must constantly monitor the performance of his or her holdings. When you pick the right benchmark, you can judge the performance of the fund's manager more accurately. Otherwise, the client runs the risk of selling a fund that's actually performing well simply because its performance doesn't match the S&P 500.

To choose proper benchmarks, CPAs should thoroughly analyze each fund manager's investing style and make a careful reckoning of the fund's assets. The steps outlined below can help you to get started.

Identify the fund's asset class. If the client is buying a mutual fund that invests in U.S. companies, your first step should be to determine the fund's asset class. (International and worldwide funds aren't included in this analysis.) While this may seem remarkably easy, many investors overlook this preliminary step when they select a benchmark. …

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