Comparison universe: Evaluate Managed Portfolios or Fund Performance

What is a comparison universe?

There is a massive amount of investment portfolios and funds out there. Sometimes, some of them have similar mandates and objectives serving as a performance benchmark. So, companies like Morningstar and Lipper made a grouping of these, and we call it the “comparison universe.” These companies have the comparison universes that most people use. Thanks to these, we can easily measure every managed portfolio or fund and the average for every peer group member. Before proceeding, know that we have two ways to evaluate a professionally managed portfolio or fund performance. Let us start:

• Index benchmark. It is no secret that all mutual funds or professionally-managed portfolios aim to go beyond an index’s performance that best represents its stock choices. A mutual fund comprised mostly of energy stocks tells us that the goal of meeting or beating S&P 500 Energy Index performance simultaneously.
• Comparison universe. It compares the performance of a fund or portfolio with the average performance of a similar portfolio universe.

The big two

Are you familiar with Thomson Reuters? It is the current owner of the Lipper group who was the pioneer in creating comparison universes to compare relative performances of fund managers. A fund manager who goes beyond its peer universe has the right to a performance beyond the Lipper Group average. Aside from the Lipper group, we also have Morningstar Inc. in Chicago. It is a financial services company that also makes comparison universe groups.

There is no significant difference between the two, and these are the companies that most financial firms use for reference. They both make separate universes for large- and small-cap funds — even those in between. They do comparison universes for international funds and other assets like stocks and investment-grade bonds. Not only that: they can also track universes of blended funds. These blended funds combine stocks, bonds, and different high-yield investments like preferred stocks.

Should I use a comparison universe or not?

Let us start with the good things. Lipper and Morningstar create relevant comparison universes while considering the size of the money management firm related to assets under management or fund. For instance, a fund manager handling stock funds might beg to disagree. The best managers will most likely figure in the high quartile of their comparison universes. This is always consistent and not only for a few quarters or years. Comparison universe also gives a whole other type of benchmark. Portfolios that always go beyond their index benchmark but constantly fall behind their comparison universe might be a problem. Is it in the wrong comparison universe, or is the benchmark very easy to beat? The fund may routinely take on many relative risks than what is reflected in the index.

On the other hand, many critics say that either of the two comparison universes is too wide to measure fund performance effectively. For instance, a value stock fund manager might beg to disagree with a direct comparison of the fund’s performance with the large comparison universe of Morningstar. Also, the comparison universe might set extremely high benchmarks that are unrealistic. It can happen by emitting ill-performing managers that are not in the business anymore. It is also possible by including assets merged with the assets of other managers. We call this issue “survival bias.”