What is benchmark index in mutual fund? Meaning, right usage, benchmark error, etc.

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Benchmark is an index against which mutual fund performance is measured. SEBI in the year 2018 mandated mutual fund companies to declare their benchmark index for respective schemes in SID (full form of SID is Scheme Information Document). This tool is very useful for new investors because this information is easy to use as well as readily available.

What is benchmark index in mutual fund

What is benchmark index in mutual fund?

Benchmark is an index against which mutual fund performance is measured.

For Example, Nifty 50 is the benchmark index for large-cap funds, so if the rate of return over a 3 years period is 15% of the benchmark & during the same time a large-cap fund achieved a return of 16% it means the fund has outperformed its benchmark & vice versa.

Why is the benchmark important?

Benchmarks are the yardstick to compare returns delivered by a mutual fund. So it is particularly important to check how mutual funds are performing compared to it.

For investors who are new to mutual funds investing can use it to compare their return against the benchmark to keep a check. 

Also, the management fees of mutual funds schemes are high as compared to investment in an index fund, so if the funds are not performing well an investor is better off investing in an index fund.

How to use a benchmark in a mutual fund?

Suppose Nifty 50 is the benchmark index of your chosen mutual fund. 

If the benchmark index delivers a return of 15% over a period of 1 year & your mutual fund delivers a return of 17% over the same period this means that your fund has outperformed the benchmark index.

During the same period of 1 year if the benchmark goes down by 10% & the mutual fund scheme goes down 5% this also means your scheme has outperformed the index.

Also if the mutual fund scheme delivers the same return as the benchmark index it also denotes that the scheme has underperformed, because mutual fund schemes charge higher management fees as compared to the index funds.

Benchmarks should not be the only criteria for choosing a scheme, other factors should also be taken into consideration.

Related Topic – What is exit load on mutual funds? 

What is a benchmark error?

Benchmark error simply means the mutual fund scheme has not chosen the right benchmark for its scheme. For E.g. A large-cap has kept BSE 500 as its benchmark, this is called a benchmark error. This can result in the wrong conclusion of the return achieved by the mutual funds.

Also, some mutual fund companies may select Nifty 50 for their large-cap scheme & some schemes may choose Nifty 100, this creates confusion.

How to choose a benchmark index? & How to Overcome the Problem of an Inappropriate Benchmark?

Expert research institutions like Value Research and Morningstar provide benchmarks for every scheme available in the market, investors can use the information provided there. 

An investor can also set his own benchmark for a particular category of the scheme, e.g. for all large-cap funds Nifty benchmark mutual funds. Also, an individual investor can choose a benchmark index that suits his risk portfolio & asset allocation strategy.

From February 1, 2018, the Securities and Exchange Board of India (SEBI) mandated that all benchmarks should be shifted from the Price Index to the Total Returns Index (TRI). Mutual fund schemes are benchmarked to the total return variant of an index as this provides more accuracy than a price index because it takes dividends into account.

Some of the ratios used to measure investment characteristics

a.Beta 

Beta determines how much is a fund risky as compared to its benchmark. A fund is said to be volatile if its beta is more than 1. If the beta is less than 1 then the fund is less volatile as compared to the benchmark index.

Here, a lower or higher beta does not mean a fund is good or bad. A fund with a higher beta means during a rising market it will outperform the benchmark, but during a market downturn, it will underperform. Funds with lower beta have less risk & deliver a lower returns.

b.Alpha

Alpha measures the excess return generated by a fund over its expected return of a particular mutual fund scheme. It is calculated depending on the extra return delivered by a fund over its risk criteria. 

Higher alpha means a fund manager is delivering higher value addition. Fund managers who consistently deliver a higher return over the benchmark during different market scenarios are more likely to outperform the benchmark in the future.

c.R-squared 

R-squared measures the performance of a fund affecting its benchmark. It is based on a percentage of 0 to 100, with 0 representing the lowest correlation and 100 being exact.

For E.g If a fund’s R-squared is 100, it means that it perfectly correlates with its benchmark index. If the R-squared of a fund is 0 it means the fund is completely in contrast to the benchmark.

For more information on ratios go here

Conclusion

The time duration for comparing the return of a mutual funds scheme against its benchmark should be at least of one year. Also comparing the return of a benchmark index to a mutual fund scheme is important because index funds charge very low management fees as compared to the actively managed funds.

Benchmark is only one of the criteria for assisting a fund’s potential return based on past performance, but even with these numbers, we can’t guarantee that your funds will always outperform the index.

Disclaimer

I am not a SEBI registered investment advisor. This article is for information purposes any scheme or company name mentioned here is just for example & not a recommendation. 

Mutual Fund investments are subject to market risks, read all scheme related documents carefully. The NAVs of the schemes may go up or down depending upon the factors and forces affecting the securities market including the fluctuations in the interest rates. The past performance of the mutual funds is not necessarily indicative of the future performance of the schemes. 

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