1. What is a Benchmark?
Benchmarks are a handy tool for effective comparison as the benchmark returns are indicative of how much your fund has earned against how much it should have earned. Your mutual fund schemes target should be the benchmark’s return, and if your fund manages to beat the benchmark, it will be considered to have done well. It is the fund house that determines the scheme’s benchmark index. This goes on to serve as a standard for the scheme’s returns. The Bombay Stock Exchange (BSE) Sensex and the National Stock Exchange (NSE) Nifty are some well-known benchmarks that invest in large-company stocks. S&P BSE 200, CNX Smallcap and CNX Midcap are some other benchmarks.
2. Importance of Benchmarking
The funds are impacted by the rise and fall of the market. If a diversified equity fund, xyz, is benchmarked against the Sensex then the returns of the xyz funds will be compared to the performance of the Sensex. When the market is faring well and the movement of the Sensex is headed upwards, then it is imperative that a well-managed fund deliver good returns.
Assume that the Sensex rises by 14 percent and your xyz funds Net Asset Value (NAV) also grows by 12 percent in the same year, it means that your fund has outperformed the benchmark. But if the NAV of your funds had risen only 8 percent while the Sensex grew by 14 percent, it would mean that your fund underperformed its benchmark.
In short, if your fund performs better than the Sensex then it means that it has outperformed the benchmark, and vice-versa. If one the other hand the Sensex fell 10 percent and during the same period your fund’s NAV declined by 4 percent, it means that your fund outperformed the benchmark.
FYI: Outperformed or underperformed
A fund has outperformed when it performs > Benchmark
A fund has underperformed when it performs < Benchmark
Key points to keep in mind
a) The duration to measure/judge the benchmark must be at least a year
b) There must be a significant difference between the performance of the fund and its benchmark
c) The management fee for actively managed funds will be higher than passively managed ones.
3. What are the criteria to select a scheme?
Evaluating a fund to see whether it has outperformed its benchmark or not is not the measure to select a mutual fund scheme. It is, however, one of the most important factors that you must take into account before investing in mutual funds. As an investor, it is a good idea to go through the performance history of the fund back to a few years and see if it has managed to outperform its benchmark with a significant difference or not.
4. How do I measure the performance of my mutual funds against its benchmark?
You can gauge the performance of your mutual fund scheme by analyzing whether your funds have delivered a higher return than the benchmark. If the return exceeds the benchmark then your funds outperformed. And if the benchmark registers a higher return than your fund then your funds have underperformed.
Also, if the benchmark index recorded a consistent fall over a period of time in which your fund’s NAV fell too, but by a much lesser percentage than the benchmark index, then your fund has again outperformed the benchmark.
FYI: As per financial planners, an actively managed fund delivering returns equal to the benchmark denotes underperformance as, despite the fee charged by the fund manager, the returns are equal to an index that is managed passively.
5. Financial ratios
Some of the ratios used to measure the performance of a mutual fund are listed below. You may also visit ClearTax for more details on Financial Ratios.
The risk of a fund with regards to the benchmark is determined by Beta. A fund is said to be more volatile than its benchmark if the value of the Beta is more than 1. If the value of Beta is less than 1, it means its volatility is less than that of the benchmark. You may find funds with differing Beta’s within the same asset category of say, large-cap funds. Here, a fund with a high Beta or a low Beta doesn’t necessarily mean bad or good respectively. Beta here enables you to have a measure of your expected returns. You may expect high returns when the market is doing well and the Beta is high, but at the same time, you must also be prepared for a downside. There will be a reduction of risk with low Beta, but this will also mean low returns.
Note: Beta is not the only measure of a fund’s performance.
This formula helps explain the difference between the actual return and the expected return that is based on Beta. It is simply the excess returns generated by a fund post factoring in the Beta/risk. This also serves as the fund manager’s value-add. With higher alpha, higher is the fund manager’s value-add. When a fund manager beats the benchmark consistently in diverse market scenarios, he generates alpha’s for you, the investor.
This is a measure of an asset or fund’s performance pertaining to the benchmark. It is denoted as a percentage between 0 and 100. If a mutual fund has an R-squared of 0, it means it has no correlation to its benchmark at all. If a fund moves with an R-square of 100 it means that it matches its benchmark exactly.
Remember, benchmarks give you a platform to measure your fund’s potential based on past performance, but even with these numbers you can’t be guaranteed that your funds will always top the market. You will be a successful investor if you are able to outperform the market consistently as this will allow you to meet your investment goals in the long run.