What is a benchmark mutual fund? Importance of benchmark

A benchmark in mutual funds measures the overall performance of the fund against a set standard in the market.

Let us explain! We all have a “Sharma Ji Ka Beta” in our lives, who has always been ‘our benchmark’ for the best academic performance, best campus placement, or the one who possesses the best car, etc.

He is used as the SI unit for Success by our Indian parents. Similarly, the Mutual Funds are also compared with their respective Benchmarks, to assess their performance. 

What is a benchmark?

Benchmark in mutual fund or finance parlance is an index or a group of unmanaged stocks which are used to assess the fund’s performance, which is directly linked to the efficiency of its fund manager.

Market indices like Sensex, Nifty, and others, serve as benchmarks with which the annualized returns generated by the funds are compared against.

For example, ABC fund generates an annualized return of 12.3%, whereas its benchmark generates 15% annualized returns, then the fund has clearly underperformed. 

SEBI mandates the declaration of benchmarks to the fund houses (Asset management companies that manage mutual funds such as HDFC, ICICI Prudential, etc.).

This aids the investor in making an informed choice about investing or exiting from the fund. The current return assessment of the benchmark returns incorporates the dividends to provide accurate information to the investor.

Fund houses select the benchmark that they would like to beat, by considering various factors such as –

1. Market Capitalisation

If the investment strategy of the fund is to majorly invest in large-cap securities, then it would compare itself with the Nifty 50; if it is a Small-cap fund – S&P Small Cap Index, etc.

(Link to refer to the information on mutual funds, their benchmarks, and annualized returns) 

2. Sector/Thematic

Focus where a mutual fund invests only in a specific sector of the economy such as energy, infra, real estate, etc.

One can use the benchmark to have a common yardstick for the funds that are in the same category (Large-cap, Small-cap, Mid-cap, etc).

For example, Mutual fund A outperforms the index or benchmark by 6% whereas Mutual Fund B beats it by 2%; hence providing a vivid picture to the investor. 

How is this a report card of the fund manager?

Mutual funds promise to deliver a higher return than the market on your invested amount (also called “beating the market”) and even charge a management fee known as expense ratio for the same.

The fund manager actively sells, buys, hunts for opportunities to pounce, and takes informed choices on the behalf of thousands of investors invested in the fund.

If a mutual fund is delivering lower returns when compared to its benchmark – an index, it indicates that one would have earned more by investing in an Index fund (passive fund) which mirrors the stock allocation in the indices.

Hence, the performance against the respective benchmark becomes the report card of the efficiency of the fund manager.

Benchmarks should be used to assess the performance of the fund only after a reasonable duration of 1 year. This also provides a larger window to measure the risk associated with the fund.

One also needs to assess the consistency in performance. For example, due to market downturns, the index has declined by 20%, but if the fund has declined by 15%, and also outperformed the benchmark in previous years, it can be considered for investing. 

Conclusion

There could be a Benchmark error, where the mutual fund compares itself against a wrong yardstick. This could lead to an incorrect evaluation of the performance due to the large difference in the returns.

However, as an investor, I could compare the returns of the fund with the category average which abides by the same rules of asset allocation (E.g., large-cap funds are required to invest 60% of the total portfolio into large-cap/ blue-chip companies).

For example, I would like to invest in a Small Cap fund, hence taking an average of the returns of the Small Cap funds, I arrive at an average that shows if my fund has outperformed or underperformed with respect to its peers).

One can also compare the annualized returns with benchmarks provided by research institutions such as Morningstar. They conduct detailed research into the investment portfolio, assess the asset allocation, and declare the appropriate benchmark. (Link to an example of Morningstar tool to assess fund performance)