We often say the market has gone up or down or is volatile. But have we ever thought what is this market and how do we assess the market? We use indices that represent the overall market.

You must have heard of the S&P BSE Sensex or NSE Nifty 50. These are all indices of different exchanges that represent a market or a section or market.

These indices help you assess the market scenario and gauge the mood of the market. These indices also work as a reference line for investors while investing as they seek to beat the returns generated by these indices. In such a situation, the index is referred to as the benchmark.

In this blog, we seek to discuss what is a benchmark, how to identify a benchmark and also understand the utility of the benchmark.

Read on!

What Is A Benchmark?

Benchmark is a tool that provides indicative return against your portfolio. The portfolio can be a portfolio of equity, debt, or even mutual funds. Benchmark acts as a reference line for investors to understand how the fund or portfolio is performing against an index that defines the market or section of the market.

As an investor, the following is your objective –

  1. Protect the capital
  2. Beat inflation
  3. Outperform the benchmark (reference line)

Thus, the benchmark helps you understand your performance and grades it relative to a baseline.

Some of the most commonly used benchmarks are – S&P BSE Sensex (includes the 30 large companies of the Bombay Stock Exchange(BSE)), S&P BSE Small-Cap (consists of the small-cap companies of the BSE), S&P BSE 200 (includes the top 200 companies of the BSE), NSE Nifty50 (includes 50 most valuable companies of National Stock Exchange).

Importance Of Benchmarking

In the investing environment, every asset class is impacted by a wide range of factors. Thus, it is natural that your portfolio or fund that comprises of different securities across asset class will tend to behave differently at different times.

Thus, as an investor, you try to benchmark or compare your portfolio/fund with the index or benchmark that best replicates your fund or portfolio.

For example, if you are large-cap investor, you would benchmark your portfolio or fund against BSE Sensex or Nifty 50 or BSE 100 and the likes.

Benchmarking helps you compare your fund’s performance at different times and also enables you to understand the short-comings of your portfolio against the benchmark. This entire exercise allows you to take corrective action in the best interest of the portfolio.

Importance Of Benchmark While Selecting A Scheme

While evaluating a fund for investment, considering the benchmark is one of the first things you do.

While assessing the return profile of a fund, you seek to see if the fund has outperformed the benchmark or not. Also, you try to see if the outperformance is consistently achieved or not. As an investor, you tend to mention the volatility in alpha. Alpha is nothing but the outperformance against a benchmark.

Alpha = Portfolio Returns – Benchmark Returns

To measure the volatility of alpha, an investor tends to use tracking error.

Lastly, investors also need to know how the fund is performing during the different market time, for example, during the upmarket time, down the market time and the likes. An investor or a fund manager may use ratios such as upmarket capture or downmarket capture to understand how the fund behaves in a different time.

How To Measure The Performance Of A Fund Or Portfolio Against A Benchmark?

As highlighted in the previous section, you can gauge the performance of your portfolio or fund in multiple ways. You may try to find out the outperformance your fund has delivered against the benchmark. Besides, you can see outperformance during the different market cycle and the likes.

Remember, outperformance doesn’t mean matching the performance to the benchmark. It involves generating higher returns against the benchmark by a few percentage points.

Following are some ratios that you may consider to measure the performance of your fund against the benchmark –

Beta

Beta measures risk against the benchmark. It helps you understand the volatility against the reference line. If Beta is greater than 1, the fund or the portfolio is considered to be aggressive, and if the Beta is below 1, it is considered to be conservative.

An ideal investor who is investing based on fundamentals should seek to have a beta close to 1 to ensure that the portfolio is balanced and the returns are generated through the selection of securities and not the allocation of funds to different sectors and segments.

Alpha

As highlighted above, alpha is nothing but the excess returns and is measured as the difference between the actual performance and the expected return. It reflects the value add by the fund manager.

In addition to higher alpha, sustenance of alpha over time is essential as it reflects the suitability of the fund’s investment philosophy.

R-squared

R-squared measures the performance of a fund pertaining to the benchmark. It is denoted in percentage and is typically between 0 and 100.

R-squared defines the correlation of a fund or portfolio with its benchmark. If a fund has an R-squared of 0, it means the fund or the portfolio does not correlate its benchmark. On the other hand, if the r-squared is 100, it shows that the fund/portfolio matches the benchmark exactly.

Let us now consider an example.

If your portfolio has generated 60% returns in 2017 and the Sensex move 50% during the near, the portfolio outperformed the benchmark by 10%. But if you made only 40% returns against 50% by Sensex, the portfolio underperformed the benchmark by 10%.

Points To Ponder

While comparing a fund to its benchmark, the minimum duration an investor should consider is at least a year as it shows different market cycle and gives a proper comparison throughout the year. Also, an analyst or investor should not have a fixed alpha in mind while analyzing a fund. The alpha sought should be justified and should be relative to macro conditions and should have been offered by peers in a similar range. Lastly, a sense on the expense ratio is essential to understand the returns expected net of fees against the benchmark.

Disclaimer: The views expressed in this post are that of the author and not those of Groww.