What is a Benchmark?
Benchmark is an index which is used to measure a Mutual Fund’s overall performance. It provides an indicative value of how much one’s investment should have earned, which can be compared against how much it has earned in reality. Ideally, a Mutual Fund’s target should be to match its benchmark return.
Usually, a particular investment’s benchmark index is determined by the fund houses. It is considered as the base standard of that scheme’s return. There are several different fund houses in India that offer benchmarking data for smallcap, midcap, and large-cap equity funds, including indexes like CNX Midcap and Smallcap, BSE 200, NIFTY, Sensex, etc.
Declaration of a benchmark index is necessary for all types of investment options in India. The Securities and Exchange Board of India, SEBI, enforces this regulation on the financial market.
Importance of Benchmarking
The performance of Mutual Funds varies depending on the fluctuation of the financial market. Benchmark in Mutual Funds provides an established platform to compare one’s returns; for example, if an equity fund is benchmarked against Sensex, its return can be compared with the performance of Sensex.
Outperforming funds provide better returns than the benchmarking value, whereas underperformed funds return less than its benchmark value.
Fund houses select benchmark indices based on several factors like sectoral or thematic strategies of that particular investment or even its market capitalisation. Usually, large-cap funds would suit investors with a lower risk appetite, whereas small and mid-cap funds are better for veteran investors and individuals with higher risk appetite. The different types of benchmarking indices available for these different funds offer a clear perspective about the portfolio and performance of these funds, allowing an investor to make a suitable decision depending on their return expectations.
Ideally, an investment should have a tenor of at least a year to be benchmarked for its performance. It offers ample time to measure the risk associated with the type of stock holding. It also allows benchmarking tools to assess the fund allocation, risk profile, and return of a particular portfolio.
Benchmarking index to create a fund portfolio is usually created based on a few factors. These include –
- Risk profile – Benchmark models are primarily based on the risk profile of a particular investor. An individual’s age, tenor in the fund market, financial resources, and several other factors are judged to determine the actual risk profile. Fund houses plot a scale depending on that data to judge the risk profile.
Moreover, the volatility and variability of Mutual Funds are also calculated while determining its risk profile. These indicate the time and holding potential for change in portfolio value, as well as the frequency of any change in its value.
- Asset allocation – An overall asset allocation model is created to reflect a particular investor’s risk profile to find a suitable benchmark for him or her. These can include diversified portfolios to allocate funds into multiple asset classes.
Allocation can be done using larger indices, or by dividing the entire value into small or mid-sized indices for better evaluation. One can also use a different benchmarking index for different types of Mutual Funds to get a better understanding of the performance and investment horizon.
It is important to use the most appropriate benchmarking whenever comparing funds to ensure best portfolio management under all condition. It will allow an individual to avoid any error while determining the benchmark in Mutual Funds.
How to Measure Mutual Fund Performance against Benchmark?
Performance of a Mutual Funds scheme can be analysed depending on whether they have outperformed, or underperformed, of their benchmarking index. There are also additional measures that can be used to determine its performance; if an investment’s benchmarking index consistently downgrades over a time period, along with that fund’s NAV, then the fund has outperformed its benchmark. However, the NAV should fall at a lesser percentage than its benchmarking index.
Fund houses also use several ratio based systems to evaluate the performance of a Mutual Funds. These ratios are primarily based on some type of benchmarking index depending on whether it is a large, small, or mid-cap fund. Here are some of the ratios used to measure investment characteristics.
- Alpha – It is a formula devised to calculate the difference between the expected vs the actual return of a particular Mutual Funds. It is calculated depending on the extra return created by an investment after it fulfils its risk criteria.
Alpha is also used to determine the value-addition of a fund manager’s performance. Usually, a higher Alpha indicates that the fund manager is likely to have a better market value. Fund managers consistently beating the benchmark even in a diverse market scenario are the ideal one to generate great value for the investors.
- Beta – Beta ratios determine the risk associated with a particular fund depending on its benchmarking index. Funds with a Beta ratio of more than one are usually considered volatile, whereas a Beta ratio of less than one is considered less risky in comparison with its benchmarking index.
Beta ratios can differ depending on the large, small, and mid-cap investment within the same asset category. It provides a stable base to calculate the expected returns of that particular investment.
R-squared – R-squared measures the performance of a fund affecting its benchmark. It is based on a percentage of 0 to 100, with 0 representing the lowest correlation and 100 being the exact, hence the best match with the benchmarking standard.