3 min
21-October-2024
Benchmarking mutual funds is an important practice that can be helpful for both investors and fund managers. The benchmark in a mutual fund is essentially a market index against which the fund’s performance is measured. It gives investors insights into just how well the fund has performed, enabling them to make informed investment decisions.
This article will delve into the meaning of a benchmark in mutual funds, the importance of having a benchmark and how it can be used to evaluate fund performance effectively.
What is a benchmark in mutual funds
A benchmark in mutual funds is a market index such as the Nifty 50 or BSE 100. Asset Management Companies (AMCs) assign a benchmark to their mutual funds as a reference point to enable investors to compare the fund’s performance against the index. In addition to providing insights to investors, the benchmark also helps fund managers assess their strategies’ effectiveness and make adjustments, if necessary.When choosing the benchmark for a mutual fund, AMCs often consider a plethora of different factors. These factors include the fund’s asset allocation, risk profile and investment strategy, among others. For instance, the benchmark for a large-cap mutual fund is usually the Nifty 50, Nifty 100 or the Sensex.
Selecting the right benchmark is important since it ensures accurate performance evaluation and risk assessment. An inappropriate benchmark may lead to ineffective comparisons and potentially misguided investment decisions.
How does benchmarking work in mutual funds?
Now that you are aware of the meaning of a benchmark in a mutual fund, let us look at how it works.Assume an Asset Management Company launches a new mid-cap mutual fund. The fund consists of 15 of the top companies in the Indian mid-cap segment. The AMC assigns the Nifty Midcap 150 as the benchmark market index for the fund. The primary objective of the mid-cap mutual fund is to deliver returns that beat the benchmark index.
Both investors and fund managers can compare the fund’s performance against its benchmark index periodically to get an idea of how the fund is performing.
Let us say that the returns produced by the mid-cap mutual fund over 6 months are 8%, whereas the returns of the Nifty Midcap 150 are just 7%. Since the fund's performance exceeds that of the benchmark, it is considered to have outperformed the market.
However, had the Nifty Midcap 150 produced returns of 9% or more, the fund’s performance would not have performed as well as the market index. In this case, the fund would be considered to have underperformed the market.
Ideally, such comparisons must be drawn over multiple periods to get a comprehensive overview of the fund's performance.
Importance of benchmarking in mutual funds
Benchmarking is often viewed as a crucial aspect in the context of mutual funds. Here are some reasons why having a benchmark in a mutual fund is important.Enhances transparency and accountability
By providing a clear and objective standard for measuring fund performance, benchmarking enhances transparency and accountability significantly. Investors can quickly get an idea of how the mutual fund has been performing relative to its benchmark index. It also helps them understand whether the fund manager’s strategies are working and if the fees charged by the fund are justified or not.Provides insights into the risks
Benchmarking is important because it provides investors with in-depth insights into the various risks associated with a mutual fund. For instance, a fund that consistently underperforms its benchmark index indicates higher investment risk and poor management. On the other hand, a fund that consistently outperforms its benchmark indicates effective risk management.Helps evaluate investment strategy and fund manager’s performance
Benchmarking is crucial for evaluating the effectiveness of a fund's investment strategy and the performance of the fund manager. Investors can determine whether the fund manager’s decisions are adding any value beyond what could be achieved with passive index investing.For example, assume there is a large-cap fund that generates lower returns compared to its benchmark index of Nifty 50. This could suggest an ineffective investment strategy and no value addition by the fund manager since investors could have earned better returns by simply opting for a passive Nifty 50 index fund instead.
How to use a benchmark in mutual funds?
To effectively use a benchmark in mutual funds, you must follow the three steps listed below.Step 1: Select an appropriate benchmark
In the case of mutual funds, the Asset Management Company (AMC) will automatically assign a benchmark. However, you can also select an appropriate benchmark of your own as well. When choosing a benchmark index, remember to ensure it aligns with your fund’s investment objectives, risk profile, asset allocation method and investment style.Step 2: Compare performance regularly
Once the appropriate benchmark is chosen, the next step is to evaluate the fund’s performance against the benchmark over different periods. Comparing the performance over multiple time frames gives you a more accurate picture of the fund’s performance and consistency.Step 3: Assess risk and returns
When using a benchmark to compare fund performance, you must ensure you consider both the return and the risk associated with achieving the said returns. A fund that outperforms the benchmark may do so only because it takes significant risks compared to the benchmark. Such a situation may not be ideal for risk-averse investors.Benefits of having a benchmark in mutual funds
Having a benchmark in mutual funds offers a plethora of different benefits. Let us look at some of the key advantages.A benchmark provides a clear and objective standard for evaluating fund performance.
Benchmarking helps investors make well-informed investment decisions by enabling them to understand how well a fund has performed relative to the market.
Benchmarking also encourages fund managers to align their strategies with the prevailing market conditions.
It enables you to compare two seemingly different mutual funds with the same benchmark market index.
How to measure mutual fund performance against its benchmark
Although most investors tend to measure mutual fund performance based on the returns it produces relative to its benchmark index, there is also another way to evaluate performance. Here is a quick overview of the method that many expert investors use.Using financial ratios
Many investors use financial ratios to gain insights into how a mutual fund has performed compared to its benchmark. Some of the key metrics they use include alpha, beta and R-squared. Each of these financial ratios provides different insights into a fund. For example, alpha is used to determine if a fund has outperformed or underperformed its benchmark, whereas beta is used to determine the fund’s volatility and susceptibility to market movements.What are the ratios used by fund houses during benchmarking?
As you have already seen, fund houses and investors use ratios such as alpha, beta and R-squared when benchmarking mutual funds. Let us try to understand what these ratios are and what they represent.Alpha
Alpha is a metric that is used to gain insights into whether a fund has generated returns over its benchmark or not. A positive alpha indicates that the mutual fund has outperformed its benchmark, whereas a negative alpha indicates that it has underperformed.Beta
Beta, meanwhile, is a metric that can indicate how volatile a fund is compared to its benchmark. For example, a fund with a beta of 1 is likely to move in tandem with the benchmark. On the other hand, a fund with a beta of more than 1 is likely to be more volatile than the benchmark, whereas a fund with a beta of less than 1 is less volatile.R-squared
R-squared is a statistical measure that gives you insights into just how correlated the performance of a fund is relative to its benchmark. The metric operates on a scale of 0 to 100, with 0 indicating that a mutual fund has no correlation and 100 suggesting that the fund is fully correlated to its benchmark. Investors often prefer a high R-squared value since it essentially means that the mutual fund’s performance matches its benchmark.Common benchmarks used in mutual funds
Here is a table outlining some of the most common benchmark market indices that AMCs use for their mutual funds.How to overcome the problem of an inappropriate benchmark?
Sometimes, Asset Management Companies may end up assigning an inappropriate benchmark to their mutual fund schemes.For example, let us take the case of a large-cap equity mutual fund with the Nifty 50 as its benchmark index. However, looking at the asset allocation, you find out that the fund has more in common with the Nifty 100 index instead. This is a classic example of an AMC selecting an inappropriate benchmark.
Selecting an inappropriate benchmark for a mutual fund can have a plethora of disadvantages. From misleading performance evaluations to poor investment decisions, the consequences can be severe.
Fortunately, it can be easily overcome by comparing the returns of the large-cap mutual fund with the correct benchmark index, which in this case is the Nifty 100. This is a practice that many market experts and analysts follow.
Alternatively, you can also compare the fund’s performance with the category average to find out just how well your investments have performed. If your fund has performed better than the category average, then it is advisable to stay invested. If not, you may consider switching to a different fund.
Conclusion
With this, you must now be aware of the concept of a benchmark in mutual funds and how important it is for performance assessment. It also helps you understand the various risks associated with investing in mutual funds and encourages you to make effective investment decisions.On the Bajaj Finserv Mutual Fund Platform, you can find more than 1,000 different mutual funds from some of India’s leading AMCs. You can also compare mutual funds with one another on the basis of performance and other metrics before making a decision. Additionally, the platform also provides tools such as a mutual fund calculator to help you estimate the amount of return you are likely to get at the end of your preferred tenure.
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