How to use the mutual fund benchmark while investing

Himanshu Srivastava, Senior Research Analyst, Morningstar said that returns must always be contextualized; viewing them in isolation is completely misleading. Every single mutual fund scheme has to specify a benchmark index against which the fund’s performance can be viewed. But having an index simply because the regulator has mandated it defeats its purpose. The comparison of returns with a benchmark would be meaningful only if the latter reflects the fund’s investment philosophy.

“It would be pointless for a mid-cap fund to be benchmarked against, say, the Sensex, which is a large-cap index. Benchmarking a sector fund against a general market index is also misleading,” he said

The significance of a benchmark index is to provide a perspective and relevant yardstick to measure mutual fund returns.  This enables investors to gauge a fund manager’s investment capabilities, as every fund manager aims to outperform the fund’s benchmark index over the long term.

How mutual fund benchmark helps in understanding the scheme?

The fund houses select benchmark indices on the basis of market capitalisation and sectoral or thematic strategies of the respective funds. For example, large-cap funds would have large cap indices, such as BSE SENSEX, BSE100, Nifty 50 or Nifty 100 as their benchmark indices. Similarly, mid-cap funds would have Nifty Midcap 100 or Nifty Midcap 150 as their benchmark indices while infrastructure funds would use Nifty Infrastructure or BSE India Infrastructure India.

Manish Kothari - Director & Head of Mutual Funds, Paisabazaar.com said that large-cap companies have lower downside risk, funds with large-cap indices as their benchmark would suit investors with low risk appetite. Similarly, funds with mid or small-cap indices with suit those having higher risk appetite. "Thus, benchmark indices give investors a fair idea about the portfolio composition of the fund and thereby, take optimum investment decisions after considering their risk appetite and return expectations," he added.

Kothari also gave an example, if a mutual fund scheme delivers significantly higher returns than its benchmark index or falls lesser than its benchmark index during a market downturn, then it is considered to have outperformed its benchmark index. Similarly, a mutual fund scheme consistently outperforming its benchmark index over several periods indicate consistency in its performance. However, an actively managed fund generating a similar return as of its benchmark index is considered as an under-performance as the fund has failed to meet its basic objective of beating its benchmark index for which it charges higher fund management fee. “Thus, benchmark indices can be highly useful in deciding whether to make fresh investments, remain invested or redeem a mutual fund," he advised.

Why should you compare the scheme’s performance with the benchmark?

First, investors should know that SEBI has made it mandatory for fund houses to declare benchmark index for each of their mutual fund schemes to allow investors to compare their fund performances with that of the broader market.

Adding to it, Agrawal said that it is important to compare the performance of the scheme with respect to its benchmark to check if it has outperformed or underperformed in different time periods. “An equity scheme might have given 12% annualized returns over the last couple of years and the market index too would have moved up by a similar rate during this period. In such a case the scheme has not generated additional returns over and above the market index. This serves as an important parameter while choosing which scheme to invest,” he said.