Fund vs Benchmark: Why It Matters
Evaluating a fund's raw return in isolation is meaningless โ you need context. A 10% annual return looks impressive until you learn the benchmark returned 12%. Alpha is the difference between a fund's return and its benchmark, and it represents the value (or cost) of active management. Over long periods, even small alpha differences compound dramatically.
Cumulative excess return: (1 + Fund%)^N โ (1 + Benchmark%)^N. A fund earning 2% annual alpha over 10 years adds 21.9% in cumulative excess return. On a $100,000 investment, that's $21,900 in extra gain โ but only if the fund consistently achieves that alpha. SPIVA data shows most active managers fail to do so net of fees.
Frequently Asked Questions
Information ratio (IR) = Alpha รท Tracking Error. It measures how consistently a manager delivers excess returns relative to active risk taken. An IR above 0.5 is considered good; above 1.0 is excellent.
Always use net-of-fees returns for fair comparison. An active fund charging 1.5%/year needs to generate 1.5%+ gross alpha just to break even with a free index fund. Expense ratios matter enormously over time.