Benchmark & its importance in Mutual Funds

Here are some of the critical points on Benchmark & its importance in Mutual Funds:

Benchmark & its importance in Mutual FundsBenchmarks have found a place everywhere. From Data Analytics to Investing, benchmarks reveal a lot about the data. These set the standards against which performance of variable is measured. Standalone data figures often convey limited meaning. Benchmarks act as a yardstick to facilitate understanding of any phenomenon.

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Let’s take mutual funds as an example. You come across an Asset Management Company promo showing that the fund gave X% return in last 3years or 5 years. How to know whether to invest in that fund or not? How do you ascertain the reliability of the fund performance?

At this juncture, Benchmarks would assist decision-making.

Benchmarks are points of reference that conveys how the mutual fund has performed compared to the peers and the market as a whole. You may perceive benchmark as an unmanaged group of securities setting broader paradigms for a mutual fund. These help to reveal the credibility of the fund. It explains the growth potential of the investment haven.

SEBI has made it mandatory for mutual funds to declare the benchmark. In India, the BSE Sensex and the Nifty act as the traditional benchmarks for mutual fund investments. Other indices are CNX Midcap, CNX Smallcap, CNX IT, CNX 500, BSE 200, BSE 100, etc.

It’s important to select a large-cap index to analyse the performance of a large-cap fund. Similarly, small-cap fund returns need to be compared against the small-cap index. Based on the performance, you should decide when to enter or exit from a mutual fund scheme.

Mutual Fund Performance vis-à-vis Benchmark

Suppose your fund generates a return of 30% whereas the Sensex yields 40% returns. It means your fund underperformed the benchmark. Conversely, your fund gave 50% returns while the Sensex generated only 30%. In this situation, your fund outperformed the benchmark.

Benchmarks are relevant not only in bull runs but also during bear runs. Consider a fund that lost 20% as compared to 30% fall in the benchmark. In this too, the fund outperformed the benchmark. Hence, when a fund makes minor losses than the index, you may perceive it as an outperformer.

Benchmark & its importance in Mutual Funds

There are situations when the fund yields similar returns as the benchmark. Even such cases are regarded as fund underperformances. It is because your main aim of mutual fund investing is to beat the benchmark indices. If your fund can’t do that, then it’s not the one for you.

Also read: Risk vs Volatility: Here’s the difference

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Benchmarks and Fund Manager Efficiency: A Relation

Mutual Fund investing involves cost by way of the expense ratio. The expense ratio is inclusive of the fund manager’s fees. Ideally, he needs to strategize the entire affair in a manner that the fund gives superior returns. Fund returns are said to be superior when these consistently beat the given indices and peer returns.

Otherwise, what’s wrong with investing in Index Funds? Here, the context is the superiority of active investing over passive investing. If a fund performs at the same level as the benchmark, then there’s no use of a fund manager.

So, benchmarks also help in ascertaining whether the fund manager’s working efficiently or not. There might be times when your fund underperforms the benchmark. You need to observe the overall market condition and peer fund performance. Suppose the markets are rising and peer funds are beating the benchmark. It’s a clear sign that something’s wrong with your fund only.

To get a deeper insight into fund performance, you may look into Alpha of the fund. Alpha refers to the excess fund returns over benchmark return owing to fund manager’s contribution.

Hence, while analysing fund performance, do give a look to its Alpha. Alpha can be used in two ways.

Compare fund’s alpha with fund’s expense ratio. Alpha should be higher than the expense ratio. If fund’s expense ratio is, say 1%, then Alpha needs to be higher than 1% to justify the investment.

When you need to select from an array of funds, choose the one with the highest Alpha.

The Unflinching Benchmark & the inextricable Beta: an Explanation

Betas have always been an inseparable part of the Benchmark. Beta refers to the relative volatility of fund returns. It indicates the quantum of loss or gains in fund returns due to benchmark movements. In a way, beta explains the riskiness of a fund on the benchmark.

The beta of the benchmark is always 1. If beta of the fund is more than 1, then it shows that fund is riskier than the benchmark. Suppose beta of small cap fund is 1.7. It implies that fund gives 70% higher returns than benchmark during bull runs. Also, the fund loses 70% more than benchmark during bear runs.

Benchmark & its importance in Mutual Funds
If beta of the fund is less than 1, it is less risky than the benchmark. Suppose beta of the large-cap fund is 0.9. It means that if benchmark rises 100%, fund underperforms & rises by only 90%. If benchmark loses 100%, then fund makes 10% lesser losses than the index.

If beta of the fund is equal to 1, then it’s as risky as the benchmark. Usually, Index Funds have a beta equal to 1 and replicate benchmark returns.
You need to choose a fund which is in line with your risk appetite. Small-cap funds & Mid-cap funds have higher beta values than large-cap equity funds.

Benchmark & the R-squared parameter: The Interpretation

R-squared of the fund shows a correlation between fund movements and the benchmark. It helps to ascertain the direction of fund returns vis-à-vis benchmark returns. The value of R-squared lies between 0 and 1.

A fund which has R-squared equal to 0 moves in a direction opposite to the benchmark. While, a fund having R-squared equal to 1 moves in the same direction of the benchmark. The higher the value of R-squared, the greater it replicates benchmark movements.

The value of R-squared is considered along with Beta to derive an accurate interpretation.

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Final Words

Benchmark is a critical tool to gauge fund performance. The only catch is that you need to pick an appropriate benchmark to avoid misinterpretations.

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