What is Benchmark?
A benchmark is a point of reference against which you can measure the performance of a security, mutual fund or investment. The benchmark comprises an unmanaged group of securities. These groups of securities become a benchmark for a stock or mutual fund. The performance of the stock or mutual fund is measured in comparison to the benchmark. For example, benchmarks are broad market indices like BSE Sensex and CNX Nifty.
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What is Benchmark in Mutual Fund?
A benchmark in a mutual fund is an index used to measure the fund’s overall performance. The comparison indicates how much a fund has earned instead of how much it should have earned.
All mutual funds aim to generate benchmark returns at the least. And if the fund beats its benchmark, it is considered to have performed well. A fund underperforming in comparison to its benchmark can be a cause of concern.
Furthermore, it is important to evaluate the fund’s performance against its benchmark over the long term. Short term returns are highly volatile, and hence it is not advisable to compare the short-term performance.
Following are some of the examples of popular benchmarks:
- Nifty 50: It comprises top 50 stocks by market capitalization. Large-cap funds have Nifty 50 TRI as their benchmark.
- BSE Sensex: The Sensex comprises top 30 stocks by market capitalisation. Therefore, large-cap funds track BSE Sensex TRI as their benchmark.
- Nifty Midcap 250: It comprises top 250 midcap stocks. Mid-cap funds track Nifty Midcap 250 as their benchmark.
Why the Benchmarking is Important in Mutual Funds?
- Mutual funds are market-linked instruments, and therefore, are highly volatile. The performance and returns largely depend on the financial market movements. With the help of a benchmark, you will be able to assess the fund’s performance.
- Choosing a benchmark for a fund depends on factors such as market capitalisation, sector or thematic strategies.
- Having a benchmark for a mutual fund will help you understand the type of fund, its potential returns, and the risk associated with it. For example, a fund with Nifty Midcap 100 as its benchmark is more volatile than a fund with Nifty 50 as its benchmark. In other words, mid cap funds are riskier/ more volatile in comparison to large cap funds.
- If the fund’s returns are greater than the benchmark, the fund has outperformed its benchmark. While, if the fund has generated less returns than its benchmark, then it has underperformed.
- If the benchmark performance fell by 10% and the fund’s NAV fell only by 6%, then it means the fund has outperformed the benchmark. Simply put, the fall in the fund’s performance is lesser in comparison to its benchmark index’s fall.
- Having a benchmark will help compare the performance of two different funds in the same category. For instance, Fund A outperforms the benchmark by 5%, and Fund B underperforms the same benchmark by 3%. Looking at the comparative performance, it is easier to decide which fund is performing better.
- A benchmark will help you estimate the possible returns from a new fund (with no history or track record). However, such a comparison will only help estimate the potential returns and does not guarantee future returns.
- Financial ratios will help in comparing the performance of a mutual fund with its benchmark. The ratios help analyse the outperformance or underperformance of a fund.
Explore: What is Factor Investing?
With the help of financial ratios, you can analyse the performance of a mutual fund against its benchmark. The following are some of the important ratios that you should consider while comparing a fund to its benchmark:
- Alpha: Alpha is a metric that compares the performance of a mutual fund to its benchmark. The measure shows the outperformance or underperformance of the fund against its benchmark. A positive value indicates the fund has outperformed its benchmark. While a negative number indicates underperformance.
- Beta: Beta measures a fund’s sensitivity to the stock market movements. A fund with a beta greater than one means it is more volatile than its benchmark. On the contrary, if the beta is less than one, the fund is less volatile than its benchmark. However, when the beta is one, the fund moves in tandem with its benchmark/ market.
- R-Squared: R-squared is a statistical measure that determines how much of a fund’s movement may be attributed to market or benchmark’s fluctuation. It ranges between 0 to 100, indicating no correlation to a strong correlation with the market.