In this article, iFAST Research Team seeks to explain the benchmarks and how important they are in mutual fund investing
Every month a factsheet is released by fund houses to update mutual fund investors on the funds’ performance and various details about the fund. In fact, factsheets show you how the fund has performed in comparison to a relevant ‘benchmark’. This important piece of data helps put the fund’s performance in context and tells you whether the fund manager has been successful or not in beating the benchmark.
As such, it is important to understand the significance of benchmarks and how to use them in making investment decisions. In the next few sections, we shall explore these issues.
What are benchmarks? And how do you interpret them?
Benchmarks are basically standards or reference points whereby a financial instrument’s performance can be compared. Simply put, the existence of a benchmark (for a mutual fund) is to compare the fund’s true performance.
Generally, benchmarks are selected from widely establish indices. For example, a mutual fund investing in Indian equity market can use the Sensex or Nifty as a benchmark. Sometimes, funds with unique investment focus may use a customised benchmark for comparison. For example, a balanced fund investing 70 per cent in equity and 30 per cent in bonds can use a customised index comprising of Sensex (weighted 70 per cent) and CRISIL Composite Bond Fund Index (weighted 30 per cent) as its benchmark for comparison.
Most benchmarks are constructed using a widely available index or a combination of indices. These benchmarks are usually representative of the general market returns. To perform on par with a benchmark doesn’t usually require too much skill on the part of the fund manager – he just has to literally mimic the index. Hence as an investment advisor, you should advice your clients to invest in funds that beat their benchmarks on a consistent basis.
Let’s use an example to illustrate. In 2010, a fund returned 55 per cent. This is a respectable number when you look at the fund’s returns in isolation. However, if the benchmark returned 70 per cent during the same period, it means your fund has underperformed. On the other hand, if the benchmark return is 30 per cent, it means your fund has outperformed.
In a bear market, a fund that sees its value fall by 10 per cent against the 30 per cent fall in the benchmark indicates significant ‘outperformance’. As such, an investment advisor should view a fund’s performance together with the benchmark to understand the bigger picture.
Why do we need benchmarks?
A benchmark is needed mainly to evaluate the fund manager’s performance. Outperforming a well-selected benchmark consistently should be every fund manager’s aim.
With the development of financial markets in the recent decade, there are many other instruments like Exchange Traded Funds or Index funds available to retail investors. These instruments usually have low charges and nearly replicate the market returns. Hence, there are questions about why should fund houses be paid more by investing in a managed mutual fund scheme that underperforms an index when they might as well pay less for an index fund with better performance.
Benchmarks play an important role in evaluating a fund manager’s performance. Consistent underperformance against the index is a valid reasons for you to advice your client to switch funds or look for investment alternatives.
The abuse of benchmarks
Fund managers are well-aware that their performance is evaluated against certain benchmarks. In some cases, to hide their poor performances, they might choose a less stringent benchmark to use as comparison.
For example in US, with growth stocks out of favour in recent years, those managers with growth mandates found themselves lagging behind the broader market. To change the image of underperformance, some managers started to adopt growth-oriented benchmarks, such as the Russell 1000 Growth, rather than a broader market measure such as the S&P 500. As a result, their performance against the benchmark looked much better.
Apart from adopting a less stringent benchmark, some fund managers may adopt an incorrect benchmark altogether. For example, a balanced fund investing 65 per cent in equity and 35 per cent in bonds should ideally use the CRISIL Balanced Funds Index comprising of the S&P CNX Nifty Index (weighted 65 per cent) and the CRISIL Composite Bond Fund index (weighted 35 per cent) as its benchmark for comparison. However, with the recent run in equity markets, the fund’s allocation has now changed to 85 per cent in equity and 15 per cent in bonds (assuming the fund manager did not rebalance). The previously ideal benchmark has now become an inappropriate measure for comparison. Based on the inappropriate benchmark, the fund manager’s outperformance could be significant during bull markets.
How to determine a suitable benchmark for your fund?
The rule of thumb should be that the fund’s performance be judged by the broadest index available. A growth fund investing in India’s equity should be evaluated the same way as a value-oriented fund investing in India’s equity – against the Nifty. The reason for doing so is simple. Since it is a fund manager’s decision to adopt a particular style of investing, he should also be rewarded or penalised using the same yardstick which is best represented by adopting the same benchmark for evaluation.
With so many different investment mandates and focuses, a prudent advisor must be mindful when selecting a suitable benchmark to evaluate a fund’s performance.
Conclusion
A benchmark is an important tool that advisors use when evaluating a fund’s performance. When benchmarks are correctly selected, they are useful and effective in sieving out the better funds from those that are mediocre performing ones. In a bid to mask poor performance, some fund managers may adopt a less stringent benchmark or incorrect benchmark. Hence, advisors must be mindful of that when evaluating a fund against its benchmark.
Courtesy: iFAST Financial India Pvt Ltd ifastfinancial.co.in