Importance of benchmark performance while selecting a suitable mutual fund scheme

Investing in mutual funds can be a smart way to potentially grow your savings. However, there are many criteria that an investor must consider before choosing the right mutual fund investment in India. One of these factors is the benchmark performance of the mutual fund. But what does this mean, and how can it help an investor make better investment decisions?

Let’s take a closer look.

• Table of contents

1. What is benchmark performance?
2. Why is benchmark performance important?
3. How to pick mutual fund based on benchmark performance?
4. How to invest in mutual fund based on benchmark performance?
5. How to use a benchmark in mutual funds?
6. How to measure mutual fund performance against its benchmark

What is benchmark performance?

A benchmark in mutual funds is a standard against which the performance of a mutual fund is measured. It is usually an index that represents a particular segment of the market. For instance, a mutual fund investing in large companies might use an index of large companies as its benchmark.

Why is benchmark performance important?

Benchmark performance is essential for two main reasons:

• Comparison: It helps you compare the performance of different mutual funds.
• Evaluation: It helps you to evaluate how well the fund manager is doing.

How to pick mutual fund based on benchmark performance?

Understanding the role of benchmark performance in selecting a mutual fund is crucial for making informed investment choices. Here are some ways in which benchmark performance can help you select the right mutual fund:

Performance measurement: Benchmarks serve as a measuring stick. By comparing a mutual fund’s performance against a relevant benchmark, you can assess how well the fund is managed. This comparison tells you if the fund is delivering value relative to the broader market trends.

Risk assessment: Benchmarks help in understanding the risk profile of a mutual fund. By comparing the fund’s performance against its benchmark during different market phases (upturns and downturns), you can assess how risky the fund is. Funds that closely track their benchmarks typically exhibit lower risk.

Understanding the investment strategy: The choice of benchmark by a mutual fund can help you understand its investment strategy. For example, a fund benchmarked against a small-cap index likely invests in smaller companies, while one benchmarked against a bond index focuses on fixed-income securities. Understanding this helps align your investment with your financial goals and risk tolerance.

Consistency check: Regular benchmark comparison helps investors check the consistency of a fund’s performance. A mutual fund that consistently outperforms its benchmark over various market cycles is often seen as a reliable choice. On the other hand, investors should be cautious of funds that underperform or show inconsistent performance compared to their benchmarks.

Comparison with other funds: By evaluating how different funds perform against the same benchmark, you can identify which funds are outperforming within a particular category. This helps in choosing a fund that not only performs well in absolute terms but also stands out among other funds in that category.

Informed decision making: For new investors, understanding benchmarks is important to learn about the market. It encourages the habit of researching and analysing market trends, leading to more informed and strategic investment decisions.

How to invest in mutual fund based on benchmark performance?

Investing in mutual funds in India based on benchmark performance involves:

• Understanding the benchmark: Know what index the mutual fund uses as its benchmark. Use benchmarks to measure performance and assess the risk level of the fund.
• Comparing past performance: Look at how the fund has performed compared to its benchmark over the years. This involves not just looking at the returns over the years but also understanding how the fund has performed during various market cycles.

How to use a benchmark in mutual funds?

Follow these three steps to use benchmarks as a valuable tool to assess mutual fund performance and support informed decision-making.

Step 1: Identify the relevant benchmark

Mutual fund schemes mandatorily need to disclose their benchmarks. The benchmark is an index that has a portfolio composition aligned with that of the fund. Investors can use that as a reference.

Step 2: Monitor performance regularly

Once the right benchmark is identified, compare the fund’s performance against it over time. Reviewing returns across different periods, such as 1 year, 3 years, and 5 years, can provide insights into how the fund has performed relative to the market. Regular comparison helps track consistency and identify trends.

Step 3: Evaluate risk and return

When analyzing a fund’s performance, it is essential to consider both risk and return. While higher-risk funds may offer greater potential returns, they also carry a higher chance of losses. Evaluating these factors can help in making informed investment choices.

Benefits of having a benchmark in mutual funds

Benchmarks provide essential context for evaluating mutual fund performance. Here are the key advantages:

Assessing performance: A benchmark serves as a reference point to measure a fund’s performance. It helps investors determine whether a fund is achieving its objectives in relation to the broader market or its specific category.

Improving transparency and accountability: Benchmarks enhance transparency by offering an objective measure of a fund’s results. They hold fund managers accountable for their investment choices.

Supporting informed decisions: Comparing a fund’s performance with its benchmark enables investors to make well-informed investment choices. This comparison helps determine if a fund aligns with their risk tolerance and financial goals.

How to measure mutual fund performance against its benchmark

Here’s how you can evaluate a mutual fund’s performance in relation to its benchmark:

Compare returns across different time periods: Assess the fund’s performance over various durations, such as 1 year, 3 years, 5 years, and since inception. Compare these figures with the benchmark’s returns over the same periods.

Calculate excess returns: Determine the difference between the fund’s returns and those of its benchmark. A positive excess return indicates the fund has outperformed the benchmark, whereas a negative one suggests underperformance.

Evaluate consistency of results: Review whether the fund has consistently outperformed or underperformed its benchmark. A fund that regularly exceeds its benchmark may suggest strong management, though this does not guarantee future results.

Assess risk-adjusted returns: Use indicators like the Sharpe ratio and Sortino ratio to evaluate the fund’s returns in relation to the risk taken.

Conclusion

Choosing the right mutual fund is crucial for your investment success. When it comes to selecting the right mutual fund in India, it’s not just about finding the fund with the highest returns, but about understanding its performance, risk, consistency, and strategy alignment. By using benchmark performance as a guide, you can make more informed decisions about where to invest your money. Investing based on benchmark performance requires a balanced approach, one that uses both quantitative analysis and qualitative judgement. It is about understanding the performance of the mutual fund in the broader context of market dynamics, risk tolerance, and personal investment goals.

FAQs:

What is a mutual fund benchmark?

A mutual fund benchmark is an index used to measure the fund's performance.

Why is it important to compare a mutual fund to its benchmark?

It helps in evaluating the fund manager's performance and in making investment decisions.

Can a mutual fund outperform its benchmark?

Yes, if the fund manager makes wise investment choices, a fund can outperform its benchmark.

Do mutual funds have benchmarks?

Yes, mutual funds mandatorily need to have a relevant benchmark. These benchmarks are indices that reflect the market or sector the fund invests in. They serve as a reference point for assessing the fund’s performance, helping investors gauge how effectively the fund aligns with its target market.

How does benchmark performance impact mutual fund selection?

Benchmark performance allows investors to evaluate how a fund performs in comparison to the relevant market segment. Consistently exceeding the benchmark may indicate effective management, though past results do not guarantee future outcomes. Analyzing a fund’s returns relative to its benchmark helps assess its efficiency and potential reliability, aiding in investment decisions.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.