Investing in a mutual fund is a good way to create wealth over the long term. Considering the number of mutual funds available in India, choosing the fund that’s right for you can be very challenging. One of the factors that you need to look at when selecting a mutual fund investment is its performance against its benchmark. But then, what is a benchmark in a mutual fund, and how important is it? Read on to find out all about it.
What is the Benchmark?
In the context of a mutual fund, a benchmark is an index that’s used as a reference point to compare the fund’s performance. Mutual fund houses generally assign a benchmark index to each of their funds to measure how well their fund has performed relative to the benchmark over a period of time.
As per the rules framed by the Securities and Exchange Board of India (SEBI), it is mandatory for mutual fund houses to declare a benchmark index for every mutual fund in India.
Importance of Benchmarking
The primary aim of every mutual fund house is to ensure that their fund generates returns higher than that of the broader market. Benchmarking enables both the fund house and the investors to easily compare the returns of the mutual fund with those of the benchmark index.
A mutual fund is said to have outperformed the market if it generates returns higher than that of its benchmark index. On the other hand, if a mutual fund generates returns lower than its benchmark, it is said to have underperformed the market.
The importance of benchmarking goes far beyond just performance comparison. Here are a few other reasons that make benchmarking a crucial aspect of mutual fund investments.
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Brings Transparency and Accountability
With a benchmark index, investors can easily identify outperforming and underperforming funds. Such a high level of transparency encourages fund managers to be more mindful of their actions and ensures that they are accountable in the case of mismanagement.
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Provides an Insight into the Risks
Benchmarking provides investors with keen insights into the various risks and rewards involved with investing in mutual funds. For example, the risk-to-reward ratio is said to be favourable if a fund has outperformed the broader market consecutively.
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Helps Evaluate Investment Strategy and Fund Manager’s Performance
With a benchmark in a mutual fund, investors can determine whether the investment strategy employed by the fund manager works or not. It also gives them an idea of the fund manager’s performance. For instance, if a mutual fund is underperforming in the market consistently over a few years, it may be a sign of a failure on the part of the fund manager or the entire investment strategy as a whole.
How Does Benchmark Work in Mutual Funds?
When analysing the performance of mutual funds, most investors tend to only look at the absolute returns that the fund has delivered. However, to get an idea of how the fund has performed through the years, you need to compare the fund’s returns with the benchmark index. Here’s an overview of how a benchmark works in mutual funds.
- Fund managers choose a benchmark index that is relevant to the fund’s investment strategy and objectives.
- Using a wide range of strategies, fund managers aim to track or outperform the benchmark index that they’ve chosen for their fund.
- Investors can determine the relative performance of a mutual fund by comparing its returns to the returns of the benchmark over a specific period.
- Additionally, mutual funds also often communicate their performance relative to the benchmark in reports and marketing materials to help investors make informed investment decisions.
Now that you know how benchmarks work, there are certain other concepts you need to know. Fund managers may, under certain circumstances, change the benchmark for a fund. Such a change is often due to shifts in the fund’s investment strategy or changes in the market environment.
Also, while benchmarks are useful for performance comparison, you should be aware that the chosen benchmark may not always perfectly represent the fund’s asset allocation or investment strategy.
Benefits of Benchmark in Mutual Fund
The use of benchmarks in mutual funds provides a plethora of advantages to both investors and fund managers. Here’s a quick overview of some of the key benefits.
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Performance Evaluation
As you’ve already seen above, the most obvious benefit that benchmarks offer to both investors and fund managers is performance evaluation. Such evaluation helps you make informed decisions based on how the fund has performed relative to its benchmark.
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Accountability
Benchmarks create a level of accountability. Investors can easily evaluate whether the fund manager is meeting the stated objectives and expectations and make more informed decisions with respect to their investments.
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Risk Assessment
Benchmarks also assist in assessing the risk of a mutual fund. Tracking error, a metric that measures how closely a fund’s performance aligns with its benchmark, provides insights into the fund’s risk relative to the market.
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Portfolio Diversification
Benchmarks help investors assess how a mutual fund’s portfolio is diversified. By comparing the fund’s composition with that of the benchmark, investors can understand how well the fund is aligned with their desired level of diversification.
How to Evaluate Mutual Fund Performance Against its Benchmark Index?
Measuring the performance of a mutual fund against its benchmark index is simple. All you need to do is take the returns generated by the mutual fund over a particular period. Then, compare the result with the returns generated by the benchmark index over the same period to check if the mutual fund has outperformed, underperformed or is in line with the benchmark.
CAGR: When measuring mutual fund performance with its benchmark, most investors tend to use absolute returns. However, using absolute returns may not always give you an accurate picture. The Compound Annual Growth Rate (CAGR), on the other hand, is a more accurate measure of the returns produced by a mutual fund since it accounts for the duration of investment.
Here’s a hypothetical example of how to use the benchmark in your mutual fund performance calculations.
Let’s say that you wish to invest in a blue-chip equity fund. The benchmark for the fund is the broad market Nifty 50 index. The mutual fund returns (CAGR) over the 1-year, 3-year and 5-year periods are 8%, 12% and 14% respectively.
Similarly, the returns (CAGR) of the Nifty 50 index over the same 1-year, 3-year and 5-year periods are 7%, 11% and 12% respectively. As you can see, the blue-chip equity fund has consistently outperformed its benchmark, making it a good investment option to consider.
Financial Ratios: Mutual fund experts are known to use a few financial ratios to measure the performance of a fund against its benchmark index. Three of the most commonly used ratios are Alpha, Beta and R-squared. Here’s a short overview of each of these metrics and what they signify.
- Alpha
Alpha is a metric that indicates the excess return a mutual fund generates compared to its expected return. A positive alpha indicates that the fund outperformed its expected return, whereas a negative alpha indicates that the fund is underperforming. In addition to using the metric to measure mutual fund performance, many investors also use it to gain insights into the fund manager’s skill.
- Beta
Beta is a metric that measures the volatility or systematic risk of a mutual fund relative to the broader market. It gives you an idea of just how sensitive a mutual fund is to the movement of the broader market. A beta of 1 suggests that the mutual fund is likely to move in tandem with the market. A beta of greater than 1 suggests that the mutual fund is more volatile than the broader market, whereas a beta of less than 1 suggests that the fund is less volatile than the market.
- R-squared
R-squared is a statistical metric that gives you an insight into the correlation between the fund’s performance and its benchmark index. R-squared ranges between 0 and 100, with 0 indicating zero correlation between the fund and its benchmark and 100 indicating complete correlation. A high R-squared figure indicates that the fund closely follows the benchmark in performance and vice versa.
Conclusion
With this, you should now know what a benchmark in a mutual fund is and its importance. To summarise, benchmarking is an important exercise that fund houses undertake. It lets you evaluate the performance of the fund easily, enabling you to make sound investment decisions. Additionally, it also encourages fund houses to be more transparent and take accountability for their investment actions.
FAQs
What is a benchmark in mutual funds?
In the context of mutual funds, a benchmark is a market index against which the performance of a fund is measured. The comparison of a fund’s performance with its benchmark index allows investors to evaluate the success of the fund’s investment strategy and the fund manager’s potential.
What is the benchmark in SIP?
A SIP or systematic investment plan cannot have a benchmark since it is merely an investment method through which you can invest in a mutual fund or an exchange-traded fund (ETF). Only mutual funds and ETFs can have benchmarks, not SIPs.
Why do Asset Management Companies (AMCs) use benchmarks?
AMCs often use benchmark indices to compare the performance of their mutual funds and provide context to the returns generated by the funds. Benchmarking can be very useful for investors since it enables them to quickly evaluate the returns provided by a mutual fund against the returns produced by the benchmark index.
How do AMCs select the benchmark for their mutual funds?
Generally, AMCs choose a benchmark index that closely aligns with their mutual funds’ objectives and asset allocation pattern. This makes comparing the returns of the funds with the benchmarks more accurate and meaningful.
Can a mutual fund change its benchmark?
Yes. A mutual fund AMC can choose to change the benchmark of a fund at any point in time. However, such changes are very rare. Furthermore, AMCs often communicate such benchmark changes to the investors along with the reasons for the change.
What does it mean if a mutual fund outperforms its benchmark?
If a mutual fund outperforms its benchmark, it means that the fund has generated returns that are higher than that of the benchmark index. It is considered as a positive sign for investors. Ideally, a fund should consistently outperform its benchmark index.
What should I do if a mutual fund underperformed its benchmark consistently?
If a mutual fund underperformed its benchmark, it means that the fund has generated returns that are lower than that of the benchmark index. In such cases, it is advisable to liquidate your investments from the underperforming mutual fund and reinvest the proceeds elsewhere. However, before liquidating your investments, remember to thoroughly analyse the reasons for underperformance.
