The use of benchmarks is essential for measuring performance in various fields, including sports and investments. In the investment industry, benchmarks help investors evaluate the performance of their fund managers. However, there are practical limitations in comparing active funds to their benchmarks, such as investment limits and transaction costs. Benchmarks are not readily available for all types of funds, so asset management companies often choose or create a benchmark that fits their fund’s description.
A yardstick is essential for measuring any performance, and to gauge whether it is good or bad. For instance, an athlete aspiring to compete in the Olympics has to clear the qualifiers, prior to the final event. In the final event, the performances of that day become the benchmark. Even with reference to that benchmark, rating the performance as good or otherwise is a matter of perspective.
The same goes for investment products. Investors want to know how their fund manager has performed. This cannot be done in isolation, hence a benchmark is required. Usually, it is a standard benchmark, provided by the exchange such as NSE or BSE or a neutral agency like a credit rating agency.
Where a popular benchmark is not available, a customized one is run as a mandate by the product manufacturer to the index provider. For Target Maturity Funds, which are debt funds with a defined maturity date, a customized benchmark is prepared, as there is no readily available benchmark answering that description.
As per the Securities and Exchange Board of India (Sebi) regulation, a mutual fund (MF) scheme has to set a primary benchmark for its performance, and an additional benchmark which is more bespoke. Sebi does not dictate what the benchmark should be; the asset management company (AMC) decides that. Though there is no guideline as such from Sebi, the AMC chooses the benchmark that fits the given description of a fund.
In reality, tailor-made benchmarks are not available for the many funds on offer. For example, for a large cap fund, the benchmark may be Nifty 100 Index or BSE 100 Index. For a small cap fund, it could be Nifty 100 Smallcap Index or Nifty 250 Smallcap Index or BSE Smallcap Index or BSE 250 Smallcap Index, as decided by the AMC. For an international (US) fund, it may be say S&P 500. For a debt fund, it would be the relevant Crisil or Nifty index.
The usage of benchmark is for performance comparison. Over the last few years, active funds have underperformed their benchmark, giving rise to an ‘active’ debate. There are certain practical limitations in running an active fund as against the benchmark it is being compared with.
For one, there are sectoral and issuer level investment limits for MF schemes. The limit for a MF scheme per issuer is 10%. When one dominant stock runs up and the weightage is more than 10% in the index, it becomes a drag for a fund being compared with the index. It is not only about the cap of 10%, but the fund manager may take a conscious decision to not exceed an internally decided limit for exposure. Sometime earlier, a large cap stock was rallying in the market but most actively-managed-fund managers decided to avoid that stock. This was due to certain corporate governance question marks and risk perception. Indices, however, are run on a pre-decided algorithm, including that stock which was rallying. Many a times, the AMC runs a cash component in a fund to meet redemption pressure. This becomes a drag when the market is rallying as the returns from the cash component is lower than stocks at that point of time. In a MF scheme, there are recurring expenses, known as TER, or total expense ratio.
An index tracks the price movement of the underlying instruments and the payouts, usually in the form of dividends. There is no ‘expense’ to be incurred by the index. That apart, there are transaction costs in MFs, for purchase and sale of instruments. There may be liquidity or impact cost of transactions whereas an index has to just track the market price movements. In a regular plan, there is the additional component of distribution remuneration.
It is operationally not easy for investors to replicate the index by themselves. They will need to purchase stocks in the same proportion as in the index. It has to be tracked for changes, for rebalancing. Net-net, there is a price for everything. To give an analogy, for my travel, I can either hail a cab on my own or use a ride-hailing app. The app provider would charge extra because it has to exist commercially and I would pay the charge if I see value in its proposition.
Source: https://www.livemint.com/money/personal-finance/the-significance-of-benchmarks-in-evaluating-investment-performance-a-matter-of-perspective-11688576752978.html