What is the importance of benchmark in mutual fund?

When you invest in mutual fund, you must have heard about ‘benchmark’. It is a very common term used in mutual fund investments. But do you what it actually means? Benchmark is a comparison tool or standard, against which your mutual fund’s performance is measured. Basically, it indicates how much your fund has performed against how much it should have performed. As per SEBI’s mandate, every fund house must announce a benchmark index against the funds. Based on the mutual fund scheme, a benchmark is set which is independent.

The target of your mutual fund’s scheme must be the benchmark. If your fund crosses the benchmark return, then it will be considered to outperform the benchmark. Usually, the fund house select a benchmark depending on the investment objective and pattern of asset allocation of the fund.

How to use benchmark to evaluate fund’s performance?

A benchmark is a criterion which measures the fund’s performance through its returns. Also, it indicates the performance of the fund manager whose main goal is to outperform the fund’s performance over a long period of time.

Some of the common benchmarks are- National Stock Exchange (NSE), Bombay Stock Exchange (BSE), S&P BSE 200, CNX Midcap etc.

Lets take an example to explain it.

If an equity fund is benchmarked against the Sensex. Lets consider that the Sensex raised by 15% and the NAV of your fund has grown by 18% in the same financial year. So, your fund has performed well or out-performed the benchmark index. However, if the NAV has grown to 10% only, then your fund has under-performed the benchmark index.

Understanding the benchmark index

The benchmark index must be in sync with the fund’s investment objective to make the comparison of your fund’s return with the benchmark index a meaningful one.
It is very misleading on the part of investors, if the benchmark is set against a general market index. For example- if a mid-cap fund set its benchmark against a large-cap index, say, Sensex.
If a large-cap fund has set the benchmark as NIFTY 100 TRI, it reflects the asset allocation and the level of risk involved.
Benchmark also signifies a fund manager’s performance over a considerable period of time.
Benchmark gives you detailed information on the composition of your fund’s portfolio.

Key things you should know about benchmark

Benchmark index helps you to decide whether you should keep investing in a fund, or start a new investment or redeem a fund.
A fund is said to have outperformed the benchmark index, if the fund has given a higher return as compared to the benchmark index. Also, if the fund has given a lower return than the benchmark when the market was down.
If a fund is said to have consistent performance against the benchmark index, then definitely, it has outperformed the benchmark over a considerable period of time. So, you can invest in this fund to earn handsome return.
When you are comparing a fund’s return with its benchmark, you must consider a time period of minimum 3 to 5 years.
If a fund’s benchmark is inappropriate, then you must evaluate the fund against its average performance rather than its benchmark index.
A considerable difference between your fund’s performance and the benchmark index must be there.
Its very important to note that, if a fund which is actively managed generates a same return as that of its benchmark index, it will be treated as under-performance of the fund. This is because, the fund has been unsuccessful in generating higher return than its benchmark for which it has charged fund management fee.