Benchmark Index in Mutual Funds

What is a Benchmark Index

A benchmark index is a reference point that helps you understand how the corresponding fund is performing. Let’s understand this concept in more detail and see how it can be used to measure fund performance.

Benchmark in Mutual Funds

When it comes to mutual funds, a benchmark serves as an indicator used for assessing the  performance of a mutual fund. A comparison of benchmark’s performance with the fund’s performance will help the investor understand how the fund has performed. Usually, an investment needs to be at least for a year so that it can be benchmarked for its performance. This duration allows the time for the benchmarking to be meaningful.

Significance of Benchmark in Mutual Funds

Outperforming funds returns surpass benchmark returns while underperforming ones fall short. 

Assume an Equity fund generates 12% CAGR across three years while its benchmark, i.e. Nifty 50 generates 10.5% for the same period. In this case, the fund is said to have outperformed the benchmark. The excess return with respect to the benchmark is termed as ‘Alpha’.

In the present case, the Alpha is 1.5% i.e. 12% – 10.5%. 

There are also funds that just replicate/ track  the performance of an underlying index. 

An index is a portfolio of companies that represent a part/section of the capital markets. Indexes are used as benchmarks to analyze the movement and performance of different market segments. These funds are called Index funds. 

Individual investors may find it hard to invest in all of the individual holdings part of the index.Also, active funds may generally be more expensive than Index funds. Therefore, index funds are offered as a low-cost way for investors to invest in a comprehensive index portfolio that is diversified, gaining exposure to a specific market segment of their choosing. 

Benefits of a Benchmark Index

Here are the key advantages of using a benchmark index:

• Performance Evaluation: Comparing a mutual fund’s return directly with the benchmark index can help in assessing its performance.
• Fund-to-Fund Comparison: You can compare different funds within the same category by utilizing benchmarks. For instance, if Fund 1 outperformed the benchmark by 5% and Fund 2 by 7%, making investment decisions may become straightforward.
• Assessing New Funds: Evaluate the potential performance of a newly launched fund using a benchmark. Since these funds lack a track record, the chosen benchmark may provide an indication of expected returns.

Examples of Benchmarks

Before we go through the different benchmarks available, let’s understand a few other concepts such as - market capitalization, large cap, mid cap and small cap companies. Market capitalization shows how much a company is worth as determined by the total market value of all outstanding shares. A company's market cap is calculated by multiplying the total number of outstanding shares that trade in the market with the current market value per share.

Large Cap refers to the top 100 companies listed in the stock market based on market capitalization.

Mid Cap refers to the companies that are ranked from 101 to 250 in terms of market capitalization.

Small Cap refers to the companies ranked from the 251st position and after in terms of market capitalization.

Some of the commonly used benchmarks across different market caps are:

Nifty 50 Index is a broad-based index consisting of the top 50 companies listed on the National Stock Exchange (NSE) of India. ^[1] Over the last 27 years, the Nifty 50 has become the most widely used benchmark for exchange traded products on the Indian equity market. It has gained immense popularity among domestic and international investors who rely on it to track the performance of the Indian equity market and make informed investment decisions. 

The Nifty LargeMidcap 250 Index aims to reflect the performance of the large and midcap companies listed at NSE with 50% weight allocated to each segment. Investing in this index offers a simple & optimized way to invest passively in the Indian equity market while diversifying across various companies, sectors and market capitalizations. ^[2] The Nifty LargeMidcap 250 Index covers approximately 84% of the full market capitalization, around 87% of the free-float market capitalization as of Sept 29 2023. 

^[3] Index Methodology

^[4] NSE Indices Limited (formerly known as India Index Services & Products Ltd. - IISL), a subsidiary of NSE, provides a variety of indices and index related services for the capital markets. The company focuses on the index as a core product.

Nifty equity indices comprise broad-based benchmark indices, sectoral indices, strategy indices, thematic indices and customised indices. NSE Indices Limited also maintains fixed income indices based on Government of India securities, corporate bonds, money market instruments and hybrid indices. 

1. Broad Market Indices
2. Sectoral Indices
3. Thematic Indices
4. Strategy Indices
5. Fixed Income Indices
6. Multi Asset Indices

Appropriate Benchmarks across different fund categories 

AMFI has declared the list of benchmark indices intended to be used by Asset management Companies (AMCs) as 1st tier benchmarks. The list is here.

For example, the appropriate benchmark for a liquid fund is the “NIFTY Liquid Index  A-I” (NSE Index Name). 

Concept of TRI in Mutual Funds 

TRI stands for Total Return Index. The TRI includes and factors in for dividends as well. When we buy a stock of a company, there are two sources of income – 

1. Stock price appreciation or capital gains
2. Dividend income from the stocks

Also, there are two different kinds of index charts, the regular index chart and the total returns index (TRI) chart. The regular index chart captures only the price appreciation of the index. It does not capture the dividends issued by the index constituents. To get a sense of real returns an investor earns, one has to factor in for the dividends received by the company. Hence, SEBI mandated the use of TRI for evaluating the performance of the mutual fund in 2018. 

So when we look at the Nifty 50 chart, we are essentially looking at just the price appreciation chart, but when we are looking at the Nifty 50 TRI, we are looking at both price appreciation, and the dividends received. 

Conclusion 

Thus, every mutual fund scheme has a corresponding benchmark which is used to evaluate the returns of the mutual fund. It provides a suitable indicator to judge the performance of individual funds against the broader market and also aids in choosing a suitable fund scheme for investment. 

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

Please note that this article or document has been prepared on the basis of internal data/ publicly available information and other sources believed to be reliable. The information contained in this article or document is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party in any manner. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article or document.

Source: 
[1] Nifty 50: Journey to 20,000
[2] Nifty LargeMidcap 250: Balance between Large and Mid Cap segment
[3] Index Methodology
[4] Methodology document for Equity Indices