What is mutual fund benchmark & its importance

A scheme’s benchmark is an index that is decided by its fund house to serve as a standard for the scheme’s returns

December 24, 2012 11:57 IST | India Infoline News Service
While investing in mutual funds or any other financial products, we seek opinion from our relatives or friends and then invest. Hardly do we understand the importance of making informed decisions. Most of us do not understand the significance of using a benchmark for the purpose of effective comparison. Capital market regulator SEBI (Securities and Exchange Board of India) has made it mandatory for fund houses to declare a benchmark index.

Benchmark returns will give you a standard by which to make the comparison. It basically indicates what the fund has earned against what it should have earned. One can say that the benchmark’s returns are the MF schemes target and the scheme is expected to have done well if it manages to beat its benchmark.

A scheme’s benchmark is an index that is decided by its fund house to serve as a standard for the scheme’s returns. Some well-known benchmarks are the BSE Sensex and NSE Nifty for funds that invest in large-company stocks. A benchmark gives lay investors an opportunity to compare the performance of their investments with that of the broader market. Similarly, a fund house can also set target returns and try hard to perform better than the benchmark index. A fund's returns compared to its benchmark are called its benchmark returns.

When the market rises or falls, the fund will be impacted. Assume fund ABC is a diversified equity fund which is benchmarked against the Sensex. Thus, returns of fund ABC will be compared with those of the Sensex. Suppose, markets are doing well and the Sensex is gradually moving upwards, then anything less than excellent returns from fund ABC would actually be upsetting.

If the Sensex rises by 12% over one year and the fund ABC’s NAV (net asset value) grows by 10%, then fund ABC has outperformed its benchmark. On the other hand, if the NAV of the fund rises only 6%, then it has underperformed its benchmark. Thus, if the fund does better than Sensex, it has outperformed the benchmark and vice-versa.

Now, if the Sensex declines 8% over one year and during the same period, the fund’s NAV declines 6%, then the fund is said to have outperformed the benchmark.

Outperformed or underperformed

If fund performs > Benchmark = Fund has outperformed
If fund performs < Benchmark = Fund has underperformed

Remember, the duration to judge the benchmark should be at least one year. Also, the difference between the fund and benchmark performance should be considerable. You can’t say that a fund has underperformed its benchmark just because its returns were 10%, while the benchmark rose 9.8%. The difference between the fund and benchmark performance is not considerable.

Checking whether the fund has outperformed its benchmark is not the only criterion to select the scheme. But it is one of the important factors to invest in mutual fund schemes. You should verify if a mutual fund has outperformed its benchmark over several years with considerable difference.

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