So Fund Managers Are Beating the S&P. Big Deal!

You should be more concerned about how your funds are doing against their peers.
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Forget the sports section. Just skim the financial pages if you want to read overworked, over-the-top headlines about an upset: "Unloved underdogs (insert any well-worn verb here, such as pummel, thrash, trounce or, my personal favorite, pulverize) heavyweight favorite!"

Yeah, in the just-ended second quarter, after years of humiliation during which all but a handful had trouble keeping pace, a majority of active managers finally outperformed the

S&P 500

.

Predictably, industry insiders and fund fans cheer, "Our day has come," while index enthusiasts and do-it-yourselfers wonder, "What happened?"

Here's what I say: Who cares?

No question the swing in many fund categories has been dramatic:

The fact that actively managed funds, many of which carry a small-cap or value bias, outpaced the S&P for a few months is perhaps a sign that market sentiment shifted in the short term, maybe longer. (And you can likely look for fund flows to follow.)

But stop right there. Don't automatically assume anything else. Are fund managers all of a sudden better stock pickers? Did they get Ph.D.s from

MIT

or

Peter Lynch

brain transplants?

Of course not. Nor can you presume that the funds beating the S&P are now the ones to own or that those falling behind need a heave-ho.

This is a good time to bring up the importance of using the proper benchmark or the correct yardstick for measuring your fund's performance. And the S&P is basically useless as a standard unless you're judging a large-cap U.S. fund. That's because the index, which is market-cap weighted, is essentially a large-cap lookalike: the bigger the stock, the more its influence on the index. The really big stocks, with capitalizations of more than $25 billion, make up two-thirds of the S&P 500's value.

So if you're suddenly ready to congratulate that manager you were cursing a few months ago, think again. "Does it beat the S&P?" simply is not the first question to ask about a fund's performance.

Well then, what is? How do you best assess the small-cap and mid-cap funds (nearly half of all equity funds) without the S&P? And what about international funds? There are the usual suspects: Either the

Russell 2000

or

S&P SmallCap 600

is better for small-cap funds;

S&P MidCap 400

is popular for mid-caps. Various

Morgan Stanley Capital International

indices are helpful in tracking international funds.

MSCI Emerging Markets

can be useful. With more diversified international funds, I usually look at the

MSCI EAFE Ex-Japan

. It tracks the big stock markets of Asia, Europe and the Far East, excluding Japan.

But there are problems with these secondary indices too. Mainly, they don't take into account the style a manager uses (e.g., growth or value), which can go in and out of favor as much as stock size. Without looking at relative performance (against peers), you don't really get a full picture. Consider

(ALIFX)

Alliance International. In 1996, it beat the MSCI EAFE, but lagged nearly 80% of its foreign stock peers. In 1997, it was even with the index, but nearly three-quarters of its competitors did better. But last year, when it was behind the index by 10 points, it ranked higher against similar stock funds.

The real question: How does a fund stack up against comparable funds?

This is almost as easy to answer as checking out progress against the S&P 500.

Lipper

will roll out a new set of fund categories later this year, but for now, I think its fund groupings are too vague. I usually rely on

Morningstar

instead. Its categories are very specific (mid-cap value or small-cap growth, for example), weighing both the market cap of a fund's holdings as well as a manager's style, and performance is ranked in several trailing time periods.

This isn't to say you should avoid keeping an eye on the widely watched S&P 500. (How can you? It and the

Dow Jones Industrial Average

are the true stars of business news programs.) But the fund industry should hold its smug "I told you so." A "win" for active managers says as much about sector shifts as it does about their success in stock-picking.

Still hungry for an underdog upset? Better to stick with the sports pages (check out

St. Louis Cards

rookie Jose Jimenez*) rather than the stock pages.

Mutual Interest

Don't you love these reports about declining mutual fund expenses? First, the industry, through the

Investment Company Institute

, tells us our expenses are down. Then, a story in

The New York Times

quotes mutual fund consulting firm

Kanon Bloch Carre

, saying the average expense ratio took a dip over the past six years. Cause for celebration? Not exactly. While those numbers are accurate, they don't tell the whole truth. Because they are asset-weighted calculations, they are much more a reflection of shareholder demand for lower expenses than of the industry's desire for price competition. We are flocking in droves to low-cost index funds and lower-cost funds and families.

I'll know that concern for cost is widespread among fund firms when:

  • They start phasing out 12b-1 marketing fees. (Get this logic: You pay for marketing and distribution designed to attract assets to make your fund bigger. As we all know, bigger isn't necessarily better -- in fact, it almost always isn't.)
  • We start seeing lower fees for trading funds online. Our stock-trading buddies get a break when they go online; so should we.

* All slightly stretched sports analogies are from my deskmate,

TSC

TV producer

Gary Schreier

, who talks baseball (when he's not talking bonds) much of the day. That reminds me: Thanks for all your nice email inquiring about our new TV show. "TheStreet.com" debuts on

Fox News Channel

at 10 a.m. EDT July 17. Cast of characters includes

James Cramer

,

Herb Greenberg

,

Gary B. Smith

,

Dave Kansas

and

Adam Lashinsky

, so we promise to have a lively debate, to say the least!

Brenda Buttner's column, Under the Hood, appears Thursdays. At time of publication, Buttner held no positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks or funds. While she cannot provide investment advice or recommendations, Buttner appreciates your feedback at

TSCBrenda@aol.com.