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Primary, Best Fit, and Category Indexes

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Primary, Best Fit, and Category Indexes

Understanding and choosing the index that fits the analysis is vital in fund evaluation. K⁴ Fund Selection Plus includes Primary, Best Fit, and Category Indexes. Although they all sound as if they’d be appropriate, they differ substantially and the choice can have a significant impact on the results of the evaluation.

Primary Index

The Primary Index is a broad measure Morningstar assigns to a number of similar categories. Whether you’re analyzing large cap value, mid cap growth or small cap blend, the S&P 500 is the Primary Index for all. In fact, it’s the Primary Index for all domestic stock funds (with the exception of Specialty-Precious Metals). Along the same lines, the Lehman Brothers Aggregate is the Primary Index for all taxable bond categories. The Primary Indexes in Fund Selection are:

S&P 500 - Domestic Equity, Specialty Equity (excluding Precious Metals), Conservative Allocation, Moderate Allocation, Convertibles
MSCI EAFE NDTR_D - Specialty-Precious Metals, Foreign Equity, World Equity, Regional Foreign Equity, Emerging Markets Equity, World Allocation
Lehman Brothers Aggregate Bond - Domestic Taxable Fixed Income, High Yield Fixed Income, World Fixed Income, Emerging Markets Fixed Income, Other Fixed Income
Lehman Brothers Municipal Bond - National Municipal, High Yield Municipal
Dow Jones 60% Global Portfolio - Target Date

The Primary Index is a good measure for a broad range of funds, but it may not be truly representative of a specific Category, particularly if that Category’s performance has been significantly different than that of the broad market.

Best Fit Index

The Best Fit Index is probably the most misunderstood. That’s a little odd, because it really is what its name says: the best fit index. A fund’s Best Fit Index is the index with the highest correlation with the fund over the most recent 36 months as measured by R². Morningstar regresses a fund’s monthly excess returns against the monthly excess returns of several well-known market indexes in order to assign a Best Fit Index to each individual fund. A Best Fit Index can have a tight correlation with individual funds. The problem is that other funds in the same Category may (and probably do) have different Best Fit Indexes. This makes it difficult to meaningfully compare the funds against one another.

Category Index

The Category Index is the index that most appropriately represents a particular Morningstar Category. Klein Decisions assigns a well-known market index to each Category to serve as a basis for comparison for all funds within that Category. For example, the Russell equity indexes are used for each domestic equity Category. For a complete list of all the Category Indexes in K⁴ Fund Selection, click here. The Category Index applies to all funds within the category. Although it may not be as tightly correlated with any of them as the individual fund’s Best Fit Index, it does provide meaningful comparison between funds.

How to Choose

Some of the factors available in K⁴ (e.g., alpha, beta, and R²) are based on excess return to an index. In those instances, you must decide which index to use: Primary, Best Fit, or Category. Because they may differ, the calculations based upon them will, too. This will ultimately affect the results of your scenarios.

There are instances where each of the indexes is most appropriate. In order to decide which to use, think about the type of fund you are seeking in the scenario. Your answer will point you toward the appropriate benchmark. If you’re looking for the funds in a specific category (e.g., mid cap core), the Category Index is what you’ll need. It will provide a common basis to compare each of the funds and is representative of the returns for that specific category. Not only will the alpha and beta values be consistent, they’ll also be more meaningful.

If you’re not tied to one category or Stylebox but are instead looking for funds to represent the broader market, the Primary Index is the most appropriate. The S&P 500 is often viewed as a proxy for the market. As such, it is a logical means of comparison for funds from differing styles and capitalizations. When particular areas of the market outperform, an analysis relying upon alpha will naturally tilt towards funds investing in those categories. This is exactly what you’d want. (The beta and R² values will not be as meaningful in an all cap search.)

The Best Fit Index should be your choice if you’re seeking funds that closely track a specific index. This might be the case if your asset allocation models are based upon various indexes serving as proxies for their particular sectors of the market. In that case, you’d want to find funds that closely mirror them. To do this, use “R² (Best Fit Index)” as one of your factors. You’ll probably also want to make “alpha (Best Fit Index)” and “beta (Best Fit Index)” factors as well.

An Example

Suppose you want to create a scenario analyzing funds in the mid cap blend Category. Also suppose alpha, beta, and R² are included as factors in the scenario. Table 1 below shows the Primary, Category, and Best Fit Indexes for four funds in the Category:

Table 1: INDEXES
Fund	Primary	Best Fit	Category
RS Value A (RSVAX)	S&P 500	Russell Mid Cap Value	Russell Mid Cap
Kinetics Paradigm (WWNPX)	S&P 500	Russell Mid Cap Value	Russell Mid Cap
IMS Capital Value (IMSCX)	S&P 500	DJ Wilshire 4500	Russell Mid Cap
Fidelity Leveraged Company Stock (FLVCX)	S&P 500	Morningstar Small Cap Core	Russell Mid Cap

Because these are all domestic equity funds, the S&P 500 is their Primary Index. The Russell Mid Cap Value Index is the Best Fit Index for RS Value and Kinetics paradigm. The Dow Jones Wilshire 4500 is the Best Fit for IMS Capital Value, and the Morningstar Small Cap Core is the best fit for Fidelity Leveraged Company Stock. Interestingly, the Russell Mid Cap, the Category Index for all four funds, isn’t the best fit for any of the funds.

Now consider each fund’s 3-Year Alpha calculated against their Primary, Best Fit, and Category Indexes:

Table 2: 3-YEAR ALPHAS
Fund	Primary	Best Fit	Category
RS Value A (RSVAX)	7.50	-0.20	4.05
Kinetics Paradigm (WWNPX)	10.02	3.16	6.84
IMS Capital Value (IMSCX)	-0.30	-1.39	-3.68
Fidelity Leveraged Company Stock (FLVCX)	7.36	5.89	2.57

Alpha is a comparative factor, measuring the difference between a fund’s actual returns and its expected performance given its level of risk as measured by beta. As Table 2 clearly demonstrates, the value for alpha is extremely dependent on the benchmark index. Compare especially the values versus the Primary Index and the Best Fit Index. As shown, the index selection can yield dramatically different comparative results when alpha is a heavily weighted factor in the scenario. Remember, define the type of analysis you need, and then use the flexibility of K⁴ to compare to the best index.