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Importance of benchmarks in mutual fund investing
April 1, 2010

In this article, we seek to explain the benchmarks and how important they are in mutual fund investing


Author : iFAST Research Team



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Every month a factsheet is released by fund houses to update mutual fund investors on the funds’ performance and various details about the fund.  In fact, factsheets show you how the fund has performed in comparison to a relevant ‘benchmark’. This important piece of data helps put the fund’s performance in context and tells you whether the fund manager has been successful or not in beating the benchmark.

As such, it is important to understand the significance of benchmarks and how to use them in making investment decisions. In the next few sections, we shall explore these issues.

What are benchmarks? And how do you interpret them?

Benchmarks are basically standards or reference points whereby a financial instrument’s performance can be measured. Simply put, the existence of a benchmark (for a mutual fund) is to measure the fund’s true performance. 

Generally, benchmarks are selected from widely establish indices.  For example, a mutual fund investing into Indian equity market can use the Sensex or Nifty as a benchmark. Sometimes, funds with unique investment focus may use a customised benchmark for comparison. For example, a balanced fund investing 70% into equity and 30% into  bonds can use a customised index comprising of Sensex (weighted 70%) and CRISIL Composite Bond Fund Index (weighted 30%) as its benchmark for comparison.

Most benchmarks are constructed using a widely available index or a combination of indices. These benchmarks are usually representative of the general market returns. To perform on par with a benchmark doesn’t usually require too much skill on the part of the fund manager – he just has to literally mimic the index. Hence, as a mutual fund investor, you should invest in funds that beat their benchmarks on a consistent basis.

Appended below is an example of such details:

Source: Reliance Fund Factsheet

Let’s use an example to illustrate. In 2010, a fund returned 55%. This is a respectable number when you look at the fund’s returns in isolation. However, if the benchmark returned 70% in the same period, it means your fund has underperformed. On the other hand, if the benchmark returns 30%, it means your fund has outperformed.

In a bear market, a fund that gives -10% returns against the benchmark returns of -30% indicates significant ‘outperformance’. As such, an investor should view a fund’s performance together with the benchmark to understand the bigger picture.

Why do we need benchmarks?

A benchmark is needed mainly to evaluate the fund manager’s performance. Outperforming a well-selected benchmark consistently should be every fund manager’s aim.

With the development of financial markets in the recent decade, there are many other instruments like Exchange Traded Funds or Index funds available to retail investors. These instruments usually have low charges and replicate the market returns exactly. Hence, more investors are asking why they should pay more by investing in a managed mutual fund that underperforms an index when they might as well pay less for an index fund with better performance.

As such, benchmarks play an important role in evaluating a fund manager’s performance. Consistent underperformance against the index is a valid reason for an investor switching funds or looking for investment alternatives.

The abuse of benchmarks

Fund managers are well-aware that their performance is evaluated against certain benchmarks. In some cases, to hide their poor performances, they might choose a less stringent benchmark to use as comparison.

For example in US, with growth stocks out of favour in recent years, those managers with growth mandates found themselves lagging behind the broader market. To change the image of underperformance, some managers started to adopt growth-oriented benchmarks, such as the Russell 1000 Growth, rather than a broader market measure such as the S&P 500. As a result, their performance against the benchmark looked much better.

Apart from adopting a less stringent benchmark, some fund managers may adopt an incorrect benchmark altogether. For example, a balanced fund investing 65% in equity and 35% in bonds should ideally use the CRISIL Balanced Funds Index comprising of the S&P CNX Nifty Index (weighted 65%) and the CRISIL Composite Bond Fund index (weighted 35%) as its benchmark for comparison. However, with the recent run in equity markets, the fund’s allocation has now changed to 85% in equity and 15% in bonds (assuming the fund manager did not rebalance). The previously ideal benchmark has now become an inappropriate measure for comparison. Based on the inappropriate benchmark, the fund manager’s outperformance could be significant during bull markets.

How to determine a suitable benchmark for your fund?

The rule of thumb should be that the fund’s performance be judged by the broadest index available. A growth fund investing in India’s equity should be evaluated the same way as a value-oriented fund investing in India’s equity – against the Nifty. The reason for doing so is simple. Since it is a fund manager’s decision to adopt a particular style of investing, he should also be rewarded or penalised through the same yardstick which is  best represented by adopting the same benchmark for evaluation.

Another suitable benchmark would be the Fundsupermart All-Equity Fund Index (FEFI). By collating all the equity funds available on the platform, the FEFI is a good representation of the median performance of all fund managers in India. Assuming the fund you invested in outperform the FEFI, it means that your fund manager has outperformed the average fund manager in India (which is good).

To understand more about FEFI, please click here.

With so many different investment mandates and focuses, a prudent investor must be mindful when selecting a suitable benchmark to evaluate their fund’s performance.

Conclusion

A Benchmark is an important tool that investors use when evaluating a fund’s performance. When benchmarks are correctly selected, they are useful and effective in sieving out the better funds from those that are mediocre performing ones. In a bid to mask poor performance, some fund managers may adopt a less stringent benchmark or incorrect benchmark. Hence, investors must be mindful of that when evaluating a fund against its benchmark.

 


Disclaimer: iFAST and/or its content and research team’s licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's scheme information document including statement of additional information. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer on the website.Please read our disclaimer in the website.


 


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