Benchmarks have their own importance in each and every sphere of life. Whenever there comes a question of performance evaluation, Benchmarks come into picture. Be it evaluating student grades, Employee Performance, etc. Benchmarks play an important role.
It would not be possible to compare or evaluate anything with standalone information in isolation without any Benchmark.
For instance, you are told that Student A scored say, X% marks, how are you going to compare it? Either you would require the score of any other student or the past exam marks to evaluate or compare the performance, right?
So, if you are comparing this score with that of the past exam’s then, in a way you are treating it as a Benchmark. So, one may say that,
Benchmarks are pre-set standards, against which the performance of a variable can be measured or evaluated.
Same is the case with mutual fund performance as well. In order to make sense out of the performance data of mutual funds, or to ascertain it’s reliability, it is important to compare it with the performance of peers or the market as a whole.
Mutual Fund Benchmarks facilitate this comparison, acting as a point of reference for performance evaluation. In this post, we will discuss benchmarks that equity mutual funds track.
SEBI has made it mandatory for all Mutual Fund Houses to declare the Benchmarks for every mutual scheme they have, to help investors make better and informed investment decisions.
(Also Read: Types of mutual funds)
Mutual Fund Benchmarks and the type of Fund :
SENSEX: meaning, Sensitive Index. You are happy when you see Sensex going up and say that the economy is doing well. Similarly, when Sensex constantly goes down, you feel worried and say that the economy is in bad shape!
It is the Benchmark Index of the Bombay Stock Exchange (BSE). It comprises the (free float) market capitalization of 30 largest, financially sound and actively traded companies (stocks) on BSE. It is a representative of almost all sectors of the economy. The composition is reviewed every year in June and December.
It can be used as a Benchmark to track the performance of large cap funds.
NIFTY: or, National Stock Exchange Fifty. Also known as NIFTY50. It is the weighted average of market cap of Top 50 companies traded on NSE.
It comprises more listed companies (50 stocks) compared to Sensex (30 stocks) and has a more diversified portfolio. It can also be used as a Benchmark to track the performance of large cap funds or index funds.
Some other important equity mutual fund benchmarks are summarized in the table below:
You can also find the Benchmark of the fund in the fund factsheet, research websites, etc. (Also Read: How to interpret an Equity Mutual Fund Fact sheet?)
Importance or Significance Mutual Fund Benchmarks:
Mutual Fund Benchmarks and Fund Performance:
Let’s say, you have invested in XYZ Large-cap Fund and it has generated a return of 15% over the last one year. But how would you say that your fund has performed well or not? How would you gauge the fund performance?
Here lies the significance of Mutual Fund Benchmarks. Let’s look at another metric, you read in the newspaper, over that period the Benchmark of the fund (SENSEX) has shown a growth of 12%.
Now you can easily say that your fund has performed well. In other words, it has outperformed its benchmark.
On the other hand, if your fund gave a return of 8%, then it is evident that it has shown underperformance with respect to it’s Benchmark.
Now, what if the fund has also delivered a 12% return, same as Benchmark? Well, this situation would also in a way be considered as underperformance. Since, the aim of an active fund is to beat the benchmark, not just replicate it.
Above is the case when markets are rising. There is another angle to see underperformance or outperformance of a fund. In falling markets, if the fund has managed to contain the downside risk i.e. the fund has shown less downturn compared to the benchmark, then also it is said to have outperformed the benchmark.
In the above example, let’s say your fund registered a fall of 15% and the benchmark has come down by 20%, over that period. This is also an outperformance, then benchmark.
So, we can say that if,
Mutual Fund Benchmarks and Fund Manager Efficiency:
In a way, Benchmarks also help ascertain how efficiently the fund manager has managed the fund showing outperformance, beating the benchmark and making justice to the expense ratio, the cost of investment which includes fund manager fees too.
(Also Read: Expense Ratio in mutual funds)
With index funds getting popular, it becomes really important for the fund manager to outperform the benchmark, not only in the bull phase but also when the markets turn bearish.
(Also Read: Does Passive Investing makes sense in India?)
In finance terms, the excess returns generated over and above the mutual fund benchmark, owing to the fund manager’s active management, is known as the Alpha of the fund.
When you are comparing funds or analysing fund performance, you should also look at the Alpha of the fund. Ideally, it should be greater than 1, over a long-term (5 or 10 years) horizon.
But, at times it may happen that funds may show underperformance, because of various reasons, we need to see that if peer funds are also performing the same way? The overall markets are not performing well?
(Also Read: 5 ways to compare and select mutual funds)
If this is not the case and this particular fund is showing constant underperformance, then clearly it is a matter of concern and calls for some action.
Mutual Fund Benchmarks and Fund Volatility:
Benchmarks can also help determine the volatility of the fund. We can use Beta to determine how volatile or in other words, risky the fund is in comparison to it’s Benchmark. It indicates how the fund responds to the benchmark movements.
(Also Read: 5 best things to do in volatile markets)
The Beta of the Benchmark is always 1. So, if a fund has a Beta of greater than 1, it is more volatile than Benchmark and if it is less than 1, it is less volatile.
Let’s say, XYZ fund has a Beta of 1.1, it means that, when the benchmark rises by 100%, the fund shows a rise of 110% and if the benchmark falls by 100%, the fund NAV decreases by 110%, which makes it riskier;
(Also Read: Types of Risk in Investments and how to manage them?)
And, ABC fund has a Beta of 0.9, which means when the benchmark rises by 100%, the fund rises by only 90%, 10% less than the benchmark and vice versa, which makes it less riskier.
So, in a way Generally mid and small cap funds have a higher Beta than Large cap Funds. Index funds have a Beta closest to the Benchmark.
Mutual Fund Benchmarks: Bottom Line:
Mutual Fund Benchmark is an important tool while comparing funds. It not only helps compare the fund performance but also gives an idea of the risk the fund carries. So, before making any investment decision, it would be wise to compare it with its Benchmark over risk and return parameters, over a long-term horizon.
Is nifty 50 a mutual fund benchmark? does it comprise of the next 50 stocks waiting to enter the nifty?
Both Nifty and Nifty 50 are one and the same. It comprises of the top 50 stocks of NSE. In case you wanted to know about Nifty Next 50, these are the stocks below the top 50 stocks.
When investing in a mutual fund, how does Sensex matter? What is the difference between investing in ETF and Options?
Sensex is one of the Indices that equity mutual funds track, for performance evaluation. It consists of the top 30 stocks listed on the Bombay Stock Exchange (BSE).
ETFs and Options both are different things. ETFs are just like mutual funds. They are also a basket of securities that generally replicate the underlying index like Sensex. Although, these are listed and can be traded on the stock exchanges.
Options on the other hand are derivative instruments, based on the value of underlying securities such as stocks. An options contract offers the buyer the opportunity to buy or sell—depending on the type of contract they hold—the underlying asset on a future date at an agreed price.