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ETF Specialist

Performance Evaluation Tool Kit

The appropriate tools may help investors distinguish luck from skill.

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Most investors pay lip service to the idea that past performance is not indicative of future results. But it's tempting to use past performance to gauge manager skill and form expectations for the future. Unfortunately, raw performance doesn't say much about skill. An unskilled manager can outperform if he is lucky (or vice versa) or takes more risk to boost returns, which may not continue to pay off in the future. While raw performance does not tell the whole story, it is possible to uncover useful information from past performance with the appropriate tools.

Selecting the appropriate benchmark is one of the most crucial steps of performance evaluation. The benchmark should be transparent, investable, and representative of the fund's investment style. The most appropriate benchmark is not necessarily the one listed on the fund's prospectus. For example,  Dodge & Cox Income's (DODIX) primary prospectus benchmark, the Barclays U.S. Aggregate Bond Index, skews more heavily toward government bonds and is not truly representative of the fund's investment style as a result. In fact, the return pattern of the Barclays U.S. Credit Index more closely fits the fund's over the past decade. Because this fund is taking more credit risk than the Barclays Aggregate Bond Index, it should earn higher returns as compensation, but that does not mean the manager is doing a good job. It is easy to take more credit risk at lower cost through a corporate-bond index fund. While it may not be possible to find a perfect benchmark, it is important to identify and control for differences in risk between the benchmark and the fund.

Alex Bryan does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.