Understanding Benchmarks in Mutual Funds

In financial markets, benchmarks are essential for evaluating mutual fund performance. They serve as a standard or reference point, typically represented by a market index like the BSE Sensex or NIFTY 50, against which mutual fund returns are compared.

This comparison helps investors assess the risks and returns of their investments relative to the broader market. This article explores the importance of benchmarks, SEBI’s double-benchmark system, and methods for measuring mutual funds against these benchmarks to make informed investment decisions.

Importance of benchmarking funds

Market dynamics significantly influence mutual funds as they primarily invest in market-linked securities, subjecting their performance to market fluctuations. Benchmarks provide a standard for measuring a fund’s performance, allowing investors to assess risks and returns within the same category.

A benchmark helps set a “gold standard” for what the fund is earning versus what it should have earned. To accurately evaluate performance, it is advisable to maintain a minimum investment duration of one year to analyse risk and returns better.

If a fund generates returns higher than its benchmark, it has outperformed; if it generates lower returns, it has underperformed. For instance, if a benchmark’s performance decreases by 5% and the fund’s NAV drops by only 3%, the fund has outperformed.

Benchmarks also facilitate the comparison of two funds within the same category, allowing investors to evaluate risk and return factors. However, while benchmarks help analyse potential returns, they do not guarantee success.

Note: Past performance may not be indicative of future results.

SEBI’s double-benchmark system for mutual funds

Do you know that most equity and debt funds use diverse benchmarks within the same category? Investors struggle to accurately compare funds, as the benchmarks do not always provide a fair reference point for performance evaluation.

SEBI’s Solution

SEBI introduced a dual structure for benchmarking mutual funds from January 1, 2022, to address this issue. Open-ended mutual funds – debt or equity – must adopt a standardised benchmark that reflects the fund category on a broader aspect.

Types of Benchmarks:

• Standard Benchmark: Market participants in a similar category choose a common benchmark, which is communicated to SEBI through the AMFI.
• Bespoke Benchmark: Funds may adopt a second ‘bespoke’ benchmark that reflects the fund scheme’s investment strategy. This is optional for AMCs.

How to check the benchmark for mutual funds?

Checking the benchmark for a mutual fund is a straightforward process. Investors can find the benchmark information in the mutual fund’s offer document, scheme information document (SID), or factsheet provided by the fund house. Most mutual fund websites and financial data platforms also offer details about each fund scheme’s benchmark(s).

What benchmark should you use?

The selection of an appropriate benchmark depends on various factors, including the mutual fund’s investment objective, asset class, and investment strategy. Ideally, the benchmark should closely align with the fund’s investment universe and provide a relevant comparison for evaluating performance.

Examples:

• For an equity mutual fund that primarily invests in large-cap stocks, compare its performance against benchmarks like the BSE Sensex or Nifty 50.
• For a debt mutual fund investing in government securities, benchmarks such as the CRISIL Composite Bond Fund Index or the NIFTY Gilt Index would be suitable.

It is important to note that selecting an inappropriate benchmark can lead to misleading performance comparisons.

Therefore, investors should carefully consider the fund’s investment style, asset class, and objective before choosing a benchmark for evaluation.

How do you measure your funds against benchmarks?

Measuring a mutual fund’s performance against a benchmark involves comparing the fund’s returns with the benchmark’s returns over a specific period. This helps investors assess whether the fund has outperformed or underperformed the benchmark. Financial ratios are commonly used to analyse a fund’s overall performance.

Key Financial Ratios

• Alpha: It represents an investment’s excess return compared to its benchmark index, adjusted for risk. It measures how well an investment strategy has performed in relation to the broader market.
• Beta: Assesses a fund’s sensitivity to market movements compared to its benchmark. A beta greater than one indicates higher volatility than the benchmark, while a beta less than one indicates lower volatility.
• R-Squared: Determines how much of a fund’s movement can be attributed to market or benchmark fluctuations. Higher values indicate a stronger correlation.

Example: XYZ Growth Fund vs. NIFTY50 Index

To illustrate these concepts, let’s consider the XYZ Growth Fund and its benchmark, the NIFTY 50 Index.

Alpha Calculation:

Alpha = Fund Return − (Risk-free rate + Beta X (Benchmark return – Risk-free rate))[4]

Assumptions:

• Fund Return: 12.6%
• Risk-free rate: 7%
• Beta: 1.2
• Benchmark return: 10%

This gives us an alpha of 2%. After adjusting for risk, the fund has outperformed its benchmark index by 2%.

Beta Interpretation:

• Beta = 1.2: The XYZ Growth Fund is expected to be 20% more volatile than the NIFTY 50 Index. Higher volatility can mean higher potential returns but also higher risk.

R-Squared Interpretation :

• R-Squared = 0.85: This suggests that 85% of the XYZ Growth Fund’s movements can be attributed to fluctuations in the NIFTY 50 Index, indicating a strong correlation with the market.

Interpretation:

• Positive Alpha (2%): Indicates better returns than the benchmark.
• Beta (1.2): Implies higher volatility, which means higher potential returns and risk.
• High R-squared (0.85): Indicates a strong correlation with the market.

This example demonstrates how financial ratios like alpha, beta, and R-squared provide insights into a mutual fund’s performance relative to its benchmark. Understanding these ratios helps investors make informed decisions. However, it’s essential to consider multiple factors and consult a financial advisor before making investment decisions.

Frequently Asked Questions (FAQs):

What is a benchmark in mutual funds?

A benchmark in mutual funds is a standard or reference point used to evaluate a fund’s performance. It represents a specific market index or set of criteria against which the fund’s returns are compared.

Who decides the benchmark for mutual funds?

The fund house or manager typically decides the benchmark for a mutual fund. It is selected based on the fund’s investment objective, asset class, and investment strategy.

What are the criteria for selecting a benchmark?

The criteria for selecting a benchmark include alignment with the fund’s investment objective, relevance to the fund’s investment universe, and representativeness of the market segment or asset class the fund invests in.

What is a benchmark error?

A benchmark error is a situation where the selected benchmark does not accurately represent the fund’s investment universe or objective. It can occur if the benchmark is too broad or narrow, leading to inaccurate performance comparisons.

How are Tier-2 benchmarks more helpful in making better decisions?

Tier-2 benchmarks provide more specific information about a mutual fund’s investment strategy. The tier-2 benchmark indicates the investment style of the fund manager and their total returns index, which can help investors choose a fund based on their goals and risk tolerance. These benchmarks can help investors to select funds based on their investment universe and strategy.

Disclaimer:

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

Mutual Fund distribution services are offered through Dezerv Distribution Services Private Limited, a wholly owned subsidiary of Dezerv Investments Private Limited (collectively referred to as “Dezerv”) with AMFI Registration No.: ARN- 248439.

In the preparation of this blog, Dezerv has used information developed in-house and publicly available information and other sources believed to be reliable. The information contained in this blog is for knowledge purposes only and not a complete disclosure of every material fact and terms and conditions. While reasonable care has been made to present reliable data in this blog, Dezerv does not guarantee the accuracy or completeness of the data. The information / data herein alone is not sufficient and shouldn’t be used for the development or implementation of an investment strategy.

It should not be construed as investment advice to any party. Actual results may differ from expressed or implied performance due to market uncertainties.

External advice: Please consult your legal, tax and financial advisors to determine the implications or consequences of your investments in such mutual fund schemes or before making any investment decisions.