Understanding benchmark index and its importance in mutual funds

A benchmark refers to an index against which the performance of a mutual fund is evaluated. There are several types of benchmarks used by mutual funds in India, each with their own characteristics and relevance. For instance, the Nifty 50 serves as a benchmark for several large-cap and index funds. SEBI regulations mandate that mutual fund firms in India disclose a benchmark index for each mutual fund. This benchmark serves as a reference point for assessing a fund’s performance and its response to market trends.

In this article, we will learn more about benchmark indices and their significance to mutual fund investors.

• Table of contents

1. Importance of benchmarking in mutual fund investment
2. What is tracking error?
3. Type of benchmarks in India

Importance of benchmarking in mutual fund investment

The objective of most mutual fund schemes is to match or beat market returns. Benchmarking plays a crucial role in assessing this. When the scheme returns are higher than the benchmark returns, the scheme is considered to have outperformed its benchmark. When the returns are lower than the benchmark, the scheme is considered to have underperformed its benchmark.

Comparing mutual fund performance to the benchmark helps investors gauge how their investment stacks up against the standard performance of the broader segment or category. This is measured by a metric known as tracking error

What is tracking error?

Tracking error indicates the degree of divergence between the performance or a fund and that of its benchmark index over a specific period. A higher tracking error indicates greater deviation from the benchmark, while a lower tracking error suggests closer alignment with the benchmark.

Type of benchmarks in India

Broad market indices: These benchmarks represent the overall market performance and are often used by equity funds. Examples include:

• BSE Sensex: Comprises 30 large-cap stocks listed on the Bombay Stock Exchange (BSE). It is one of India's most widely tracked indices.
• Nifty 50: Consists of 50 large-cap stocks listed on the National Stock Exchange (NSE) and is another popular benchmark for equity funds.
• Nifty 100: Comprises the top 100 companies by market capitalisation listed on the NSE and represents a broad spectrum of large-cap stocks.
• BSE 100: Consists of the top 100 companies listed on the BSE based on market capitalisation. It is another common benchmark for large-cap funds.
• Nifty Midcap 100: Includes the top 100 mid-cap companies listed on the NSE and serves as a benchmark for some mid-cap funds.
• BSE Midcap Index: Includes mid-sized companies listed on the BSE and is another widely followed index for mid-cap funds.
• Nifty Smallcap 100: Includes the top 100 small-cap companies listed on the NSE and is used as a benchmark for small-cap equity funds.
• BSE Smallcap Index: Comprises small-cap companies listed on the BSE, it is another benchmark for small-cap funds.

Sectoral/thematic indices: These benchmarks track the performance of specific sectors or themes and are relevant for mutual funds centred on those sectors or themes. Examples include:

• Nifty Bank: Comprising banking sector stocks listed on the NSE, it is used by funds focusing on the banking sector.
• Nifty IT: Consisting of information technology sector stocks listed on the NSE, it serves as a benchmark for funds investing in the IT sector.

Strategy indices: These are designed based on investment strategies, quantitative models or trading approaches. Examples include Nifty 50 Arbitrage and Nifty Equity Savings.

Hybrid indices: Hybrid mutual funds with both debt and equity allocations may benchmark their performance against a composite debt and equity index or a multi-asset index.

Conclusion

Benchmarks serve as performance metrics for investment portfolios or mutual funds and help investors make informed decisions. Do note that a single instance of under or overperformance may not be an accurate representation, but consistent underperformance could be a cause for concern. It is also useful to compare a scheme’s performance against other funds in the same category. Always consult a financial advisor before entering or exiting a scheme. SIPs are a popular way to invest in mutual funds. Explore using a one time SIP calculator to estimate your potential returns.

FAQs:

What role does a benchmark play for mutual funds?

benchmark serves as a reference point for evaluating a mutual fund's performance compared to the overall market. It helps investors to assess fund performance and make decisions about investment strategies and fund selection.

Why is it crucial to evaluate a scheme's performance against its benchmark?

Assessing a mutual fund's performance against its benchmark across various timeframes helps gauge its market outperformance. This comparison helps in selecting appropriate mutual fund schemes aligned with desired returns and risk tolerance.

What is tracking error?

tracking error is the difference between a fund’s performance and that of its benchmark. If the tracking error is zero, it means the fund has matched its benchmark’s performance. A positive tracking error indicates outperformance, and a negative tracking error indicates negative performance. Active funds will have high tracking error as compared with passive funds.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
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