Peer group comparison

There are two ways to ask whether a fund has done well.

One is to compare it with an index. The other is to compare it with other funds doing the same job. That second one is peer group comparison, and the workbook says measuring excess return this way is very popular.

The appeal is obvious. An index is not managed by anybody. Other funds are. If every large-cap fund had a hard year, a manager who lost a little less was arguably good at their job.

The workbook then adds the warning that carries the marks. Peer funds may be managed differently even when they sit in the same category. And a fund can beat its peers simply by taking much more risk than they did. So the comparison has to look at return and risk together, not return alone.

What a peer group is. Section 5.5.2 defines peer group returns as those of other similar portfolios or funds which are also actively managed. That is the difference from a benchmark: a mutual fund is an actively managed portfolio, while a benchmark index is not managed at all.

The two conditions the workbook attaches.

1. Comparability. There may be dissimilarities in the way the funds are managed, and these differences have to be kept in mind while comparing. The comparison is meaningful for peer funds following similar strategies and styles of investing.
2. Risk, not just return. A fund may outperform its peers but may have taken significantly higher risks to generate the returns, and that level of risk may be unacceptable to some investors.

Which risk measures to pair it with. The chapter supplies them in section 5.3. Standard deviation quantifies how much a fund's actual returns fluctuate around its own average, and the workbook explicitly says comparing a fund's standard deviation with that of other similar investments helps an investor judge its risk level. Beta measures volatility attributable to systematic risk against an index whose beta is 1. And the Sharpe ratio — (investment return minus risk-free rate) divided by standard deviation — puts return and risk into a single number, which is what makes it the natural tool for a peer table.

What drives the differences you will see. Section 5.5 lists them: the fund's investment objective and therefore its asset class; the strategy (active or passive, aggressive or conservative, concentrated or well diversified); and the investment style of the manager. Two funds in the same category can differ on all three, which is exactly why a raw peer ranking can mislead.

In the NPS. Section 5.6.3 gives the pension-fund equivalent and a specific instruction: consolidated NAV and return data for every Pension Fund is available on the NPS Trust website, and a subscriber comparing funds should look across the full current panel, not a subset.

Four mid-cap funds, one year, same category.

Illustrative figures, applying the workbook's Sharpe formula to a peer table.

On return alone, Fund A wins by 2.5 percentage points. On the workbook's own test — return and risk — Fund B wins, and comfortably. Fund A's standard deviation is nearly double Fund B's, so almost all of its extra return was bought with extra volatility.

Mr Menon, 57 and five years from retirement, is the investor the workbook has in mind when it says the risk may be unacceptable to some investors. He is in the pre-retirement stage, where preservation matters more than the top of a one-year league table. Fund A's 22 standard deviation is the wrong risk for his stage even though it is the right number at the top of the return column.

And before any of this is trusted, the comparability test: if Fund A is in fact running a concentrated portfolio while B, C and D are well diversified, the four are not peers following similar strategies, and the ranking is measuring two different products against each other.

Chapter 5, section 5.5.2 (Performance of Portfolio Relative to Peer Group Performance), is short — which is exactly why its two sentences are examined closely. Section 5.5.1 handles the benchmark comparison, and the two are usually set against each other. Section 5.6.3 adds the NPS version: compare across the full panel of Pension Funds on the NPS Trust website.

Expect: what do peer group returns represent (other similar, actively managed portfolios), what must be kept in mind while comparing peers (dissimilarities in how the funds are managed, and risk as well as return), and a scenario in which the top-returning fund is the wrong answer because its risk is higher. The workbook's own sample question — that a fund's risk and return are explained by its asset class, its strategy and its investment style, all three — sits in the same section.

• A peer group is other actively managed funds; a benchmark is an unmanaged index. The workbook draws this line directly, and swapping the two is the most common error in the section.
• Outperforming peers is not enough. The fund may have taken significantly higher risk to do it. Compare return and risk — standard deviation, beta or the Sharpe ratio.
• Same category does not mean same strategy. Funds in one peer group may be managed very differently, and the workbook says those dissimilarities must be kept in mind.
• An active fund is expected to beat the index in both directions — rise more in a rising market and fall less in a falling one. That test belongs to the benchmark comparison, not to the peer comparison.
• Compare the whole panel, not a convenient few. The instruction is explicit for NPS Pension Funds, and the same logic defeats a hand-picked peer set anywhere else.
• Higher standard deviation is risk in both directions. The workbook notes that an investment counts as risky when returns vary either way, even though investors treat only downside variation as risk.