On Benchmarks

Capital Research & Management is one of the smartest, best-run, and most successful mutual-fund management firms in the business (Capital runs the American Funds).  In yesterday's WSJ story on mutual-fund streaks($), however, a Capital vice president appeared to invoke some weak logic when explaining a fund's performance relative to that of the benchmark:

"We don't manage the fund with the objective of trying to beat the benchmark," says Drew Taylor, a vice president at Capital Research & Management Cos., which oversees the American Funds. The objective, instead, is to deliver, "over long periods of time, current income and growth to shareholders."

There is no shame in trying to provide "current income and growth to shareholders."  But it does matter how the fund performs relative to the appropriate benchmark.  Given the wide availability of low-cost passive funds designed to track almost every conceivable benchmark, the only reason for fund customers to pay higher fees for active stock-picking services is to try to beat appropriate benchmarks.  If an active fund fails to do this, it has cost the fund-holder money relative to the cheaper passive product, no matter how much "income and growth" it has generated. 

The fact that most mutual-fund buyers don't understand this allows many fund companies to fall back on an intellectually weak defense ("It's okay that we lagged the benchmark, because we weren't trying to beat it.")  This, in turn, allows the active fund industry to continue to coin money while its stock-picking services actually subtract value from most clients' portfolios. 

There is no fraud or subterfuge here: Most active fund companies are just taking advantage of fund-customers' ignorance to set low success hurdles for themselves.  But because the vast majority of active funds underperform low-cost passive funds, the most client-oriented move for most fund managers would be to fire themselves and put their clients in passive funds.  For obvious reasons, few will do so.

UPDATE

As I noted at the top of this piece, Capital has one of the best records in the business.  One reader (see comments) suggests that most of its funds have, in fact, beaten the benchmarks, and with far lower volatility.  If this is true, the firm has accomplished what the vast majority of fund managers cannot, and therefore deserves every bit of its reputation. 

Comments

[steve]

if someone is going to pay a load of 5+%, they're not that concerned or understanding of the benchmark issue.

[Henry Blodget]

Given the damage a 5% load does to the return, I suspect it's the latter.

[John]

The great thing is. They do beat most of the benchmarks year in and year out for the past 73 years. Oh yeah...with a third of the volatility.

[Henry Blodget]

Capital has done a lot better than most firms and deserves every bit of its reputation (especially if, as you suggest, the volatility is much lower). I wasn't suggesting that their performance was bad, just taking issue with the idea that the benchmarks are irrelevant.

[direct shares]

I agree that Capital has exceeded benchmarks since 1934. It seems that Capital has something that other fund managers do not. Though Capital surpassed benchmarks, it does not mean that benchmarks are irrelevant. The success of fund managers is irrelevant without the benchmark.