If you have invested in mutual funds, you must be familiar with the term 'benchmark'. If you have ever wondered what it stands for, bench mark is and independent reference point against which you compare a mutual fund's performance or security. Since 2012, it is mandatory for fund houses to declare a benchmark. Some of the common benchmarks include CNX Midcap, CNX Small Cap, Sensex, NIFTY etc. benchmark indices allow investors to compare the performance of their fund against the broader market.
Significance of a benchmark:
When a scheme is compared against a benchmark, it indicates:
- The performance of the fund
- Risk involved in the scheme
- Skill set of the fund manager
- The kind of stock holdings
- Consistency in performance.
- How much your fund earned vs. how much it should have earned
How does benchmark benefit the investors?
It is always advised that when you are evaluating your fund's performance, do not just consider the fund in isolation but rather compare it against its benchmark return. Let me illustrate why: Say you are investing in scheme A. for the past few months you have been receiving decent returns from it and your investment is growing. But if you compare it with its benchmark, you find that while its NAV has increased in value, it has never outperformed its benchmark value. Meaning, your fund has been consistently underperforming the whole time and you have lost potential income by not choosing to invest in a better performing fund. Hence, evaluate your fund's performance constantly. A fund that doesn't beat its benchmark regularly shouldn't be in your portfolio. Also, a fund that makes similar returns as its benchmark is also considered as underperforming fund since it every fund's basic goal is to beat its benchmark. A benchmark index therefore helps the investors decide whether to stay invested in a fund, redeem it or make new investments.
A benchmark provides a perspective and a measuring rod against which you can compare your fund returns. Every fund manager targets to beat the benchmark in the long term. And so, based on the results you can understand the fund manager's abilities.
Benchmark indices indicate how risky a fund is. For example, a fund with large-cap index will be suitable for investors who wish to be less risky with their money. A benchmark thus gives a fair idea about the security of the fund so that investors can choose funds based on their risk horizon.
When comparing a fund with its benchmark, consider the long-term performance of the fund and not just the immediate performance of the fund. Take into account, the data for up to 5 – 10 years. Look for the fund's consistency by calculating how often it has beaten its benchmark in the past.
However, experts advise that benchmark index is just one way to choose a fund. It is suggested that the investor also take their own risk profile and return expectations into account before making an investment decisions.