Do you remember back in school, when you went back to your parents with your exam results? If it was a particularly hard paper and you scored 60%, your first line of defence would be to bring up the toughness of the paper. Then you may have backed this up by saying that most of your friends scored lower or that the class topper, who scored 68% wasn’t very far off from your own score. You would have called it unfair if your parents didn’t listen to your arguments and chastised you for your low marks.
Now think about your large-cap mutual fund that is down 8.7% in the one-year period. Would it now be fair to say it is a bad fund? Like you measured your performance against your classmates, a mutual fund’s performance should also be compared to a standard. That standard is called the fund’s benchmark.
What is it?
By simple definition, a benchmark is a yardstick or standard against which something can be measured. For a fund, the benchmark is a stock market or bond market index whose returns the fund aims at beating.
For example, if the fund is a large-cap equity fund, it will choose a large-cap index as its benchmark. This can be the Sensex, the Nifty 50, or the BSE 100 or the Nifty 100. An MIP will have the CRISIL MIP Blended index as its benchmark. So taking the above example – the fund that lost 8.7% would be perfectly good if its benchmark lost 11.8%. Because an index is a nothing but a collection of stocks and securities, remember that the benchmark can also incur losses.
Why is it useful?
The benchmark is useful in two ways. The first way is as explained above – it is the standard to which a fund is held and its performance measured. The benchmark gives meaning to a fund’s returns. A fund has performed well if it beats its benchmark consistently. A fund’s performance will come in by its stock selection and its sector weightage relative to its benchmark.
The second way a benchmark is useful is that it gives an idea of where a fund invests, or the type of portfolio it will have. Consider SBI Bluechip and Franklin India Bluechip. They are both large-cap funds. SBI Bluechip’s benchmark is the BSE 100 and the Franklin fund’s benchmark is the Sensex. The BSE 100 (which represents the top 100 stocks by market capitalisation) is broader than the Sensex (which represents the top 30 stocks by marketcap).
Thus, Franklin India Bluechip is more constrained in where it can invest and will have much larger stocks in its portfolio than SBI Bluechip. Sometimes, large-cap funds can have even broader benchmarks such as the BSE 200, meaning that the universe of stocks the fund can invest in is that much more. Similarly, Birla Sun Life Dynamic Bond index is benchmarked against the CRISIL Short Term Bond index, suggesting that it will more or less stick to instruments with a short maturity profile.
Note that a fund can and does deviate from its benchmark. It can, for example, have stocks outside the benchmark index or have different sector weights. What the benchmark does is broadly indicate how the fund’s portfolio will be.
So next time, don’t dismiss the benchmark. Use it!
Blog source: http://www.fundsindia.com/blog/mutual-funds/fundsindia-explains-what-is-benchmark/8803