What is Benchmark in Mutual Fund & Its Importance

The standard against which the performance of an MF scheme is measured is known as a benchmark. In India, the declaration of a benchmark index is compulsory, according to the regulatory guidelines implemented by the SEBI or Securities and Exchange Board of India.

The benchmark is constituted by an unmanaged group of securities. These become a benchmark for a stock or MF scheme. Here, the performance of the stock or the MF scheme is measured against the benchmark. For instance, broad market indices like National Stock Exchange (NSE) Nifty and Bombay Stock Exchange (BSE) Sensex are benchmarks that invest in large-company stocks. CNX Smallcap, S&P BSE 200, and CNX Midcap are some other examples of benchmarks. 

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What is the benchmark in mutual fund?

A benchmark in mutual funds is an index against which the performance of a fund is measured. It serves as a comparative metric to evaluate a fund manager’s effectiveness in generating returns relative to the market. Ideally, a mutual fund should try to match its benchmark’s returns.

Benchmarks are typically indices, such as the Nifty 50 or BSE Sensex, representing a specific market segment and are determined by the fund house. For instance, an equity mutual fund focused on large-cap stocks may use the Nifty 50 as its benchmark.

If a fund consistently outperforms its benchmark, it indicates effective management and a good investment strategy. Conversely, underperformance might indicate a need for review. Benchmarks help investors gauge potential risks and returns, ensuring they make informed investment decisions.

Importance of benchmarking

Benchmarks can be a handy tool while comparing MF schemes as the benchmark returns mutual funds are indicative of how much your fund has earned in comparison to how much it should have. Typically, your MF scheme’s target should be the benchmark’s return. If your MF scheme beats the benchmark, it is considered to have done well.

You can gauge the performance of your scheme by reviewing whether your funds have beat the benchmark. If the returns exceed the benchmarked values, then your scheme has outperformed. And if the benchmark collates higher returns than your MF scheme, your funds have underperformed.

The fund house determines your MF scheme’s benchmark index. So, if a fund is underperforming against its benchmark, investors should reconsider investing in it.

The MF schemes are directly affected by the peaks and slumps of the market. For instance, if diversified equity mutual fund schemes are benchmarked to Sensex, then the returns will be measured against Sensex's performance. Here, when the market is bullish and the money movement of Sensex is positive, then an adeptly managed fund should collect market-beating returns.

Furthermore, before investing, it’s prudent to review the mutual fund’s performance in comparison to its benchmark over the longer term. That’s because short term returns can be highly volatile; hence, comparing short-term performance can give false hope.

Fund houses generally choose benchmark indices depending on various factors such as market capitalization, sectoral or thematic strategies of the investment, etc. Typically, large-cap funds are more suited to beginner investors and investors with a relatively lower risk appetite. On the other hand, small and mid-cap funds are better suited to sophisticated investors and investors with a higher risk appetite.

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How to measure mutual fund performance against benchmark?

You can evaluate the performance of your mutual fund by analysing the returns generated against its benchmark. If the returns exceed the benchmark, then your fund has outperformed. In contrast, if the benchmark has registered higher returns than the mutual fund, then the fund has underperformed.

You can also evaluate the NAV to determine the performance. If the benchmark index has recorded a consistent fall over time where your fund’s NAV fell too, but by a much less percentage, this means that the fund has outperformed the benchmark.

Over to you

The different types of benchmarking indices available for the MF schemes provide you with a clear-cut perspective about the fund’s performance and portfolio. This way, you are more informed to make an investment decision depending on your return expectations.

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FAQs

Why are financial benchmarks important?

Financial benchmarks are crucial as they provide standards for measuring performance of an investment, helping investors assess the potential of investments and fund managers. They also allow easy comparison of different funds and investment strategies.

How is a benchmark calculated?

A benchmark is calculated by taking the average returns of a specific group of securities or an index over a certain period. To calculate the benchmark, the fund manager will first identify the index that aligns with the fund’s strategy and determine the period over which the benchmark will be determined.

How do you measure the performance of a mutual fund against its benchmark?

To measure performance, compare the mutual fund's returns over specific periods against the benchmark's returns. If the fund’s performance exceeds the benchmark, the fund is said to have outperformed. If the performance of the fund is below the benchmark, the fun has underperformed.

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

An index is a collection of stocks representing a specific market segment, while a benchmark index serves as a reference for measuring the performance of mutual funds or investment portfolios.

What is benchmark return in MF?

Benchmark return in mutual funds refers to the return achieved by a benchmark index over a specified period. It acts as a standard for evaluating a fund's performance, helping investors gauge its potential.