Mutual fund returns: Reaching your money goals is more important, not beating benchmarks

For example, a large cap mutual fund scheme is likely to have either the Nifty 50 or Sensex 30.

Despite many mutual funds underperforming the category average and their benchmarks, the returns are still quite reasonable when taken in an isolated fashion. For example, despite being laggards some schemes deliver 13-14 percent annualised returns over a five-year period.

Such returns may be enough for your portfolio and for you to reach your goals, regardless of the benchmark’s performance.

Is beating the scheme benchmark a reliable basis for selection or should you stick with the fund if it meets your return objective?

Do you need a benchmark?

When you look at the return of a fund without considering the benchmark’s performance, it gives an incomplete picture. With volatility in performance it is possible that a managed fund portfolio underperforms its benchmark for some time.

Critics of benchmarking argue that such underperformance is natural. It’s when such underperformance continues for more than 2-3 years you need to question as to why you must pay a fund management fee for a portfolio that is unable to beat the benchmark. Of course, you do have the option of investing in index funds.

Some active funds indiscriminately align portfolios to the benchmark composition rather than making active selection. Thus, the performance is very similar to that of a low-cost index fund. Hence, when you invest in actively managed funds, you must demand a level of outperformance compared to the benchmark, at least over the medium term time frame of 3-5 years.

A required return approach works for the portfolio

A benchmark helps in keeping your active fund within the risk boundaries defined in a category and in setting the minimum standard of performance.

When you chase returns, you will look only for the top performing scheme every year with no cohesive strategy or risk profiling.

This is where you need to apply a ‘required’ return approach in defining the potential portfolio return. The return your fund generates depends on the category it invests in and the active risk the fund manager takes. However, the potential return on your portfolio is defined by your financial goals and your risk tolerance. The latter is an absolute return which can be achieved by having the right asset allocation. So, you can construct your portfolio with funds that can deliver returns for reaching your goals within defined timelines.

For example, if 80 percent of your financial goals are likely to materialise after 10 years, you will have a higher allocation to equity with the objective of inflation-plus returns in the long term. On the other hand, if your goals are mostly 2-3 years away, then you will stick to stable return fixed income investments. The return objective is aligned with the prevalent interest rate environment.

Individual product investments should have benchmarks to guide the investor towards the lowest cost alternative and also to guide fund managers for delivering excess return for the fee they earn. However, gauge your portfolio performance not by the benchmark return, but rather against your expected return at the start as complemented by the asset allocation you have chosen. Don’t confuse the portfolio’s return requirement, which is aligned to your goals, with the managed mutual fund benchmark’s performance.