Getting the right benchmarking conditions

Mutual funds constantly compare their performance so that investors have an idea about the manner in which their money is performing. This ensures that there is an opportunity to evaluate between various investment options at different points of time.

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This calls for specific action on the part of the investor so that the overall situation is understood well.

Benchmarking

The route adopted for comparisons in mutual funds is through the concept of benchmarking. Every mutual fund scheme has a particular index that is kept as the benchmark by the fund. The performance of the scheme over various periods of time is then compared with the performance of the benchmark.

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Displaying a better performance than the benchmark is the aim and objective of most fund managers. This means rising more than the benchmark when there are gains and falling less than the benchmark when there are losses.

Often there is a situation where the investor is left a little surprised and does not understand how a particular situation has developed and hence they need to know a few factors that are vital when considering the selection of the benchmark.

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Measurable

One of the first points that have to be followed in ensuring that there is a proper selection of the benchmark is by deciding on the index for comparison.

This has to be done in such a manner that there is ease of measurability over various periods of time. This means that there has to be easy availability of the figures of the index and at the same time they have to be available in such a manner that necessary calculations and use is also convenient.

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For example if there is a mutual fund scheme that declares its net asset value (NAV) on a daily basis, but then there has to be a benchmark for this scheme whose value is available daily rather than once a week or even once a month. This is essential so that when a comparison has to be made then proper values are available for the process.

Representative

The benchmark that has been chosen has to be actually representative of the scheme that is being compared. This will ensure that similar things are being considered rather than there being a comparison between different things just for the sake of having the entire exercise.

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There are various options that are available for the purpose of selecting the benchmark and the right one has to be chosen. For example if there is a mid cap scheme that is available with a mutual fund than this has to be compared with a mid cap index rather than a large cap index.

This will ensure that there is similar comparison that is being done. If this is not representative in a proper manner than there would be divergence and the investor would not get a correct picture of the whole situation. This kind of position has to be avoided and hence there has to be care taken in the matter.

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Situational change

Another factor that cannot be forgotten by any investor is the fact that every situation can be different and hence the position for that particular situation has to be considered.

Things that might work in one place might not work elsewhere and hence this will have to be kept in mind. For example in most diversified equity schemes the benchmark would be indices that are broad-based in nature. This does not mean that only broad based indices would be the right choice in all circumstances.

Benchmarking basics

* Effective comparison has to be possible with the benchmark

* Regular measurement of the benchmark is necessary

* The index has to be representative

* Different indices can be benchmarks under varying circumstances

* Selection also depends upon the use of the index

* Run the existing benchmark on these factors

* If they are satisfied use the chosen benchmark by the fund

* If not then select another benchmark for effective comparison

 If the scheme is different then there might be a need to ensure that the benchmark also changes. For example a fast moving consumer goods fund might need a FMCG index, which is sectoral in nature to be the benchmark rather than a broad based one.

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Matter of choice

There are a large number of choices available for the selection of the right benchmark and hence this need not be popular indices known to the investor. This could mean that the index is one that is commonly being used by a particular market like it is done in the bond market.

This might not be well known among the investors but since it is a standard in the market this can be used as a benchmark. This might be necessary in areas other than equities.

Position

The investor has to see whether these basic factors are taken care of in the entire benchmarking process. If this is done then there can be the necessary work on comparing the performance and then coming to an investment decision.

However, this might not be the case in every situation and if the investor feels that the benchmark is not adequate then the onus is on the investor to ensure that they select another benchmark that they can use for the purpose of their calculations. This is vital to ensure that they make the best choice in an informed manner.

Arnav Pandya is a Chartered Accountant and a management graduate from IIM Bangalore with a specialisation in Finance. He is also a Certified Financial Planner with experience of over a decade in the field of personal finance.

The views expressed in the article are the author's and not of Sify.com.

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