A mutual fund benchmark is highly useful when comparing the performance of the mutual fund with that of the broader market. Only then can an investor know if the fund outperformed the market, matched the market, or underperformed.

To start, there are actively managed funds that try to outperform a benchmark, and there are index funds whose portfolio mirrors the components of a market index. For example, the Vanguard 500 Index Fund Liquid error: internal has investments in all 500 companies in the S&P 500 index.

The most common type of performance benchmark is a market index that is a preselected group of securities. In the United States, the most common benchmarks for index funds are the S&P 500, Russell 2000, Barclays Capital US, and the Aggregate Bond Index. The performance of the fund against the benchmark is measured in a unit called beta. Essentially beta is how closely the fund matches the performance of the market, if a beta is 1.2 then investors can expect 20% higher returns in an up market, or vice versa, a 20% decline in a downward market.

Different investors seek different returns; investors that are seeking outperformance will typically be attracted to actively managed funds, while those seeking a more conservative return, will want to look at index funds.

If you’re not sure where to start when it comes to comparing funds, see our guide on How to Research Mutual Funds.

Index funds follow an index and seek to match its returns while actively managed funds seek to outperform an index. They can be the same index, or different indexes depending upon the type of mutual fund and the type of investments it is holding. It is important to note that over time, passive index funds have outperformed actively managed funds due to less taxes and lower fees.

As a result, according to the S&P Indices Versus Active Funds Scorecard, between 1998 and 2013 only 25.6% of the active funds currently in existence outperformed their benchmarks. The funds that did outperform the index funds were typically large-cap growth funds that beat their Russell 1000 Growth Index. What is similar between the benchmarks for index mutual funds and actively managed mutual funds is that in either case a benchmark is used as a standard against which the performance of the mutual fund can be measured.

Learn more about What a Mutual Fund Manager Does.

Benchmarks allow investors to make important investment decisions before investing in a mutual fund, and even after, investors can use them to monitor the performance of the fund. However, benchmark performance data does not take into account the risk taken to generate the returns. Benchmarks also do not allow a comparison of after-tax rates of returns, thus even passive index funds cannot exactly match the returns of the index.

Lastly, benchmarks can be anything and as such should only be used as one tool in assessing a mutual fund’s return. Furthermore, comparing to the wrong benchmark will distort a fund’s performance. One should look at the total return and the expense ratios along with the track record of the fund when making investment decisions as well.

There is no consensus on what makes for the best index to use for investing purposes. The Dow Jones Industrial Average (DJIA) may make headlines, but it is rarely used as an index due to its limited nature. It only follows 30 large companies and so the S&P 500 has a better finger on the pulse of the market.

With the S&P 500, the larger the company the greater its position in the index. Another thing to consider is that if a mutual fund is focused on small companies or on foreign stocks, it would be unfair to compare the returns of the fund to the S&P 500 and so there are benchmarks appropriate for those funds as well.

See also A Guide to the Different Types of Mutual Funds.

Some of the most common market benchmarks are:

• S&P 500
  One of the most important market indexes, the S&P 500 represents 500 of the largest U.S. corporations chosen for market size, liquidity, and industry grouping. It is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of large cap companies.

• Russell 2000 Index
  The Russell 2000 index is the most common benchmark for small-cap mutual funds. It is an index measuring the performance of 2,000 small-cap stocks in the Russell 3000 index, which is made up of the 3,000 biggest US stocks. The Russell 2000 is a benchmark for small-cap stocks in the US. To put this into perspective, the largest market cap in the index is around $5 billion.

• Barclays Capital US Aggregate Bond Index
  This index covers the investment grade, fixed rate, and taxable areas of the bond market. This is the broadest measure of the taxable U.S. bond market and is to fixed income investors what the S&P 500 is to stock traders. It is a major indicator for the overall health of the fixed income investing market. To invest in an ETF that seeks to track this benchmark, check out BND.

• MSCI EAFE Index (Morgan Stanley Capital International)
  This is an index that is designed to measure the equity market performance of international developed markets. It is the older international stock index and follows a selection of stocks from 21 developed markets excluding the U.S. and Canada. Those 21 markets are: Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, the United Kingdom, Israel, Australia, New Zealand, Singapore, Hong Kong and Japan. EAFE stands for Europe, Australia, and Far East.

• Vanguard Total Stock Market Index (Liquid error: internal )
  More comprehensive than the S&P 500, the Vanguard Total Stock Market Index holds 3,770 stocks and captures over 99% of the U.S. equity market by capitalization. For a similar ETF that also tracks a total stock index, look at VTI.

Indexes are valuable, but they fail to show the performance results for a real portfolio. With a mutual fund there are management expense fees, averaging 1.3% to 1.5% for passive funds, and higher for actively managed funds. With actively managed funds there are higher tax consequences as well that can eat into returns.

That being said, if faced with two similar mutual funds that measure different benchmarks, investors should look at the historical total return of each fund, but also the MER to determine which fund to invest in. The benchmark, while important, is only there to give a snapshot of the performance of the fund and a representation of the market it is measuring.

Check out the Cheapest Mutual Funds for Every Investment Objective.

Do mutual fund benchmarks matter? In a way, yes, but before investing, investors should always look at their risk tolerance and their investment goals first. After that, benchmarks can be a useful tool than can show how well the mutual fund is performing against the market and against its peers, assuming that the fund matches with the same type of benchmark. It is important, however, to compare the mutual fund to a proper benchmark, and to realize that to perfectly match an index is hard to do with fees and tax considerations.