The significance of benchmarking

The performance of a mutual fund scheme cannot be done in isolation and it has to have some reference point or yardstick for comparison. The index to which the scheme is benchmarked provides such a reference point for comparison of the performance. If the scheme gives higher returns than the benchmark’s returns, it is said to have outperformed the benchmark during a given period of time; however, if it gives lower returns than that of the benchmark, the scheme is said to have underperformed the benchmark.

Also, it is absolutely necessary to compare the scheme’s performance with an index that has constituents that are similar (if not the same) to that of the scheme’s portfolio of holdings. Just as apples cannot be compared with oranges, one cannot compare the performance of a scheme against the performance of an index having a totally different set of constituents as compared with the scheme’s portfolio of holdings. Hence, one cannot compare the performance of a small-cap fund or infrastructure fund with that of Sensex.

This is because all companies constituting the index are large-caps and, therefore, there cannot be any comparison between the performance of an index comprising the large-cap stocks and performance of schemes comprising of small-cap or infrastructure stocks. Hence, it is absolutely essential that the scheme is benchmarked against a suitable index for a fair comparison. So, a small-cap fund should be benchmarked against Nifty Small-Cap index and an infrastructure fund should be benchmarked against Nifty Infrastructure index. The selection of a scheme’s benchmark is usually done on the basis of asset allocation, risk level, market capitalisation, investment philosophy and investment objective of the scheme.