The Hindu Business Line : Style benchmarks

MY FRIEND'S father had parked some money with a portfolio management scheme . The Scheme has returned 40 per cent for a certain period in 2005 against a 25 per cent movement in the Nifty index. Naturally, my friend's father was overjoyed, as the manager had outperformed the index by 15 percentage points. Unfortunately, such a comparison is not always correct.

Suppose your portfolio manager buys stocks in the pharma sector. Would it be correct to compare the portfolio performance to that of the Nifty index? The risk of investing in pharma companies is not the same as the that associated with holding stocks in the Nifty index.

So, if a portfolio has exposure to mid-cap technology stocks, it should be benchmarked to an index that has only such mid-cap stocks. Such an index is called a style benchmark. That is, the index reflects the investment style of the portfolio manager.

Often, the style benchmark is one of the indices provided by the BSE or the NSE. When such benchmarks are not appropriate, the portfolio manager or an external agency may construct a proprietary benchmark index.

But why are style benchmarks important? It helps you measure the excess return, or the alpha as it is called, that the manager generates.

When you compare the portfolio performance with the wrong index, you may mistakenly conclude that the manager has generated alpha. Since generating alpha is difficult, you may have to pay higher management fees.

That is what happened to my friend's father. When he later calculated the returns against an appropriate benchmark, he found that the manager had under performed the index by 5 percentage points!

(The author is Head, Research, Navia Markets.)

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