Mutual Fund Unlocked: Importance of benchmark

Mutual fund investments are subject to various analysis. It is immaterial whether you are an active or a passive investor. One such analysis is the comparison of the funds' performance to their benchmarks. Comparison to the benchmark puts the fund's performance in context and tells you whether the fund manager has been successful or not in beating the benchmark.

A mutual fund's benchmark is usually an index that is chosen by a fund house to serve as a standard for its returns. Benchmarks are basically standards or reference points whereby a financial instrument's performance can be measured. Market regulator SEBI (Securities and Exchange Board of India) has made it mandatory for fund houses to declare a benchmark index for their funds. Some of the popular benchmarks are Nifty and Sensex.

Benchmark becomes important because it helps an investor to evaluate his investment performance. A benchmark serves as a reliable and consistent gauge of performance and helps in asset allocation. Benchmark helps in framing the expected return and risk of various category of funds. This historical data of risk and return helps allocate assets accordingly.

Normally a widely available index is used as a Benchmark. For some hybrid funds that invest in both equity and debt, a combination of indices is used for benchmarking the performance. These benchmarks are usually representative of the general market returns. To perform on par with a benchmark doesn't usually require too much skill in terms of stock picking or sector allocation on the part of the fund manager. He just needs to imitate the benchmark. Therefore, an investor needs to select those funds that have consistently beaten their benchmarks. This does not mean that any fund beating benchmark should be selected. In some cases, it has been seen that the fund manager chooses a benchmark that does not comply with his fund’s investment style hence he may be showing outperformance based on the inappropriate benchmark.

Hence, before investing in a fund you need to understand the fund’s benchmark and how closely the fund follows the investment style of that benchmark and then check its outperformance or underperformance.