When you invest in mutual funds, you are reminded time and again that “mutual fund returns are subject to market risks”. Naturally, you may feel that if your scheme is subject to market risks, it should be delivering market linked returns, since risk and return are two sides of the same coin. But how can you gauge whether a scheme is in fact delivering returns that are in line with the market or not? Here’s where benchmarking comes in.
What is benchmarking? The performance of a mutual fund scheme can be gauged in comparison to a benchmark index or indices. For such purposes, a benchmark index is one which contains broadly similar instruments to those that a scheme sets out to invest in. So, for instance, an equity fund may be benchmarked against the BSE 100 if its objective is to invest in a portfolio of stocks that are similar to those comprised in the index, in terms of diversity, market capitalization, etc. Similarly, a sector specific fund may choose to compare its performance to an appropriate sector specific index.
If the fund offers returns that are better than those presented by the index, it can be said to have outperformed its benchmark. Conversely, if it has given returns that are lower than the index, it has underperformed.
Benchmarking of diversified equity based funds can be done against the Sensex, Nifty, BSE100, BSE 500, CNX S&P 100, etc., depending on the stated objective of the scheme itself. Similarly, the performance of a sector specific fund can be compared to that of the CNX IT, Bank Nifty, BSE Pharma index, to name a few, according to the sector which it invests in. There are also a number of debt fund indices designed by CRISIL and other neutral agencies. These can be used to benchmark the performance of debt funds.
Importance of benchmarking Over the past four years, benchmarking has gained prominence due to the spectacular growth in the AUM of mutual funds and the importance attached to the rate of return generated by schemes in the context of the category to which they belong.
For example, let’s say you have invested in ABC mutual fund and have been rewarded with a CAGR of 25 per cent in the NAV of your fund. In isolation, an appreciation of 25 per cent per year would make any investor more than happy. However, when the performance of the fund is compared with the benchmark index as well as the performance of other funds following the same benchmark, it may create a completely different impact. You may realize that the index as a whole has displayed a CAGR of 40 per cent and other similar funds have also delivered returns in that range. Suddenly, your 25 per cent growth may not look so good any more. What you can draw from the comparison is the fact that good market conditions and not efficient fund management has been responsible for your return.
Caveat While benchmarking can give you some good insights about the performance of your mutual fund, it cannot be your only yardstick for measuring performance, especially if the composition of the benchmark index varies substantially from that of the portfolio holdings of your fund. When a diversified equity fund, which is temporarily overweight in the mid cap segment, is being compared with the Sensex it is bound to result in an inaccurate conclusion. This is because the Sensex is mainly comprised of large cap stocks. Accordingly, be sure to do a benchmark comparison alongside other performance indicators to get a truer picture of where your fund stands.
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