​Benchmark index in mutual funds: Meaning and Importance

The benchmark index for a particular mutual fund scheme is the index against which the scheme intends to measure its performance. For example, the NIFTY 50 index which contains stocks of companies that are ranked amongst the top 50 in terms of market capitalisation. This is the index against which many large-cap funds are benchmarked. In other words, the large-cap fund will try to match the performance of this benchmark. At times, it may over-perform, and at other times it may underperform the benchmark.

It is mandatory for all mutual fund schemes to declare the index against which their performance is benchmarked. And rightly so, the scheme information document mentions the benchmark index of the mutual fund scheme.

What is a benchmark index?

A benchmark index is like a collection of stocks or other instruments that shows how a specific market or part of the market is doing. It's a way to check how well an investment portfolio is doing compared to the whole market or a particular section of it.

You can use a benchmark index to see if the investments in a portfolio are making more or less money than a certain market or part of the market. This is useful for investors because it helps them figure out if their investments are doing better or worse than the overall market.

The whole point of a benchmark index is to give a common way to see how well investment portfolios are doing. When we compare the money made by an investment portfolio with the money a benchmark index could have made, we can know if the investments are doing better or worse than the market.

Benchmark indices are also great for deciding if investment managers are good at making more money than what the market usually makes.

Importance of Benchmark Index

Benchmarking can serve as a useful tool when evaluating different mutual fund (MF) schemes. Benchmarks provide a reference point for assessing how well a mutual fund has performed in relation to what it should have earned. In most cases, a mutual fund's goal should align with the benchmark's performance. If a mutual fund surpasses the benchmark's performance, it is considered a strong performer.

You can assess your scheme's performance by evaluating whether your funds have outperformed the benchmark. If the returns surpass the benchmark values, your scheme is deemed to have excelled. Conversely, if the benchmark achieves higher returns than your MF scheme, your funds are considered to have underperformed.

Additionally, its wise to assess a mutual funds performance relative to its benchmark over a longer time frame before making an investment decision. Short-term returns can be highly volatile, potentially leading to misleading conclusions.

The selection of benchmark indices by fund houses considers factors such as market capitalization, sectoral focus, and thematic investment strategies. Generally, large-cap funds are suitable for those investors who are seeking lower risk exposure. Conversely, small and mid-cap funds are better suited for experienced investors who are willing to take on higher levels of risk.

How to use the benchmark to gauge a fund’s performance?

Fund performance is measured in various ways. The first one that comes to mind is alpha or a return a mutual fund has generated over and above its index. However, another measure of performance is beta, which measures how sensitive a fund is when compared to the market or its benchmark in a mutual fund context. Typically, market volatility is measured between 0 and 1, with 1 being the volatility of the benchmark. A mutual fund with a volatility under 1 carries more stability than its benchmark index.

Further, there are other criteria to keep in mind while measuring a mutual fund against its benchmark. These include:

• One should consider the long-term returns of both the mutual fund and its benchmark when comparing instead of looking at short-term returns.
• A smart way to also evaluate a mutual fund with its benchmark is to observe the returns over 2-3 market cycles; this will give you a perspective of the fund’s upside and
• downside performance. It will also place the market’s returns in the immediate context of the fund’s performance.
• The market goes both ways, as do indexes and mutual funds. It is as important to measure the troughs or bear periods of a market as it is to measure the size of their peaks formed on charts during a market’s bull period.
• Standard deviation, or a mutual fund’s return variation in comparison to its average return, is a helpful measure to understand how it performs across changing market cycles.

Conclusion

A benchmark index may help you in gauging the fund’s performance, but it is relevant to look at the more holistic picture. It is advisable to consider other measures of performance like alpha, beta, and standard deviation also and then take a call. Please feel free to contact your mutual fund distributor for any further queries.

FAQs

What Is Benchmark in Mutual Fund?

In mutual funds, the benchmark index is a baseline indicator against which to measure market category performance. There is a benchmark index for each market category - whether it is a small cap, large cap, or even a hybrid fund. Actively managed mutual funds are considered good investments if they generate a greater return than their benchmark index. This return is called ‘alpha’, and it is a meaningful reason that drives investments in actively managed mutual funds.

Another measure for a mutual fund to show performance is moderated or less risky than the benchmark index. The volatility of an index is called ‘beta’, and it is typically measured at 1. Now, a mutual fund with a beta of less than 1 is less sensitive to market conditions. A mutual fund with a beta of more than 1 is likely to be more volatile to market conditions.

One can easily calculate the alpha and beta of a fund and compare it to the benchmark index for context and quality of performance.

What is the importance of Mutual Fund Benchmark?

A mutual fund benchmark is a critical point of reference that helps investors evaluate how well a fund is performing. It serves as a performance standard, enabling comparisons between the fund's returns and those of a particular market or sector. This aids in assessing whether the fund is meeting its goals and how effectively it's managed. The benchmark can also help investors make informed choices by providing a basis for understanding a fund's historical performance and aligning it with their investment objectives. Additionally, it offers transparency and accountability, guiding fund managers in demonstrating their strategy's effectiveness. Overall, a benchmark is a vital tool for gauging a mutual fund's relative success and its alignment with investor expectations.

How Do You Measure the Performance of a Mutual Fund Against Its Benchmark?

You can measure a mutual fund’s performance against its index. While this can be done visually as well, there are some considerations.

• Market cycles, and that the mutual fund performs near its benchmark during turbulent market periods (beta) downside and performs higher than the benchmark it during its upside (alpha).
• Alpha, or higher returns for a fund from its index, is a common measure. However, beta, or comparative sensitivity of a fund to its index and standard deviation, or a fund’s variation in returns compared to its average returns are also key measures.
• To have a long-term perspective on the market and the returns when evaluating the fund in the context of its benchmark index.
• Risk-return ratios for both market volatility (sharpe) as well as downside risk (sortino).
• Once you have these counts or measures in place, you get a holistic sense of your fund’s performance compared to its benchmark.

What is the difference between an index and a benchmark index?

While an index can be any selection of stocks that represent a category in the stock or equity markets, a benchmark index acts as a measure of performance for a mutual fund as it overlaps with the universe a mutual fund invests in. For example, the Nifty50 is an index. However, it is a benchmark index for large cap funds, although it is not a benchmark index for mid cap or small cap mutual funds.

More simply put, an index can be broad or narrow based on its target market and the assets that construct it. However, for an index to be a benchmark index, it needs to be formed from assets that mirror the investable universe of the market category it represents. So, a small cap benchmark index should be made of small cap stocks - that way, it can form a basis for comparison with small cap mutual funds.