A recent S&P Indices Versus Active Funds (SPIVA) report indicated that about 82 per cent of Indian large-cap mutual fund (MF) schemes have underperformed the S&P BSE 100 over the past five years ending December 2021. Much of the reaction was directed around the performance of active funds. However, very little discussion was had around the topic of benchmarking itself. For example, is S&P BSE 100 the applicable benchmark for all large-cap schemes? To simplify MF investing, over the last few years, SEBI has introduced various changes in this space that include having the right benchmarks, too. Here’s what you must know about MF benchmark, regulations, and ways of comparing MF returns with their reference indices.

Benchmark and its importance

Let’s assume that a MF scheme has delivered a return of 60 per cent in 2021 and in 2022, it gives -20 per cent. One might conclude that the fund performed exceptionally well in 2021 and performed badly in 2022. However, what if Nifty 50 TRI moved up 80 per cent in 2022 while it moved down 40 per cent next year. Compared to Nifty 50 TRI, the fund underperformed in 2021 and outperformed in 2022. The MF should not be seen in isolation, and it must be compared with the return of a suitable index representing the risk profile and asset allocation of the fund called benchmark index.

Regulations

In recent times, SEBI has made many changes to rules in index benchmarking. One, from 2018, all fund houses are supposed to benchmark their scheme’s returns with their respective TRI (Total Return Indices) due to dividends being reinvested as that makes for fair comparison. So, funds found it tougher to beat benchmarks.

Two, in December 2021, SEBI directed fund houses to use two-tiered structure for benchmarking various MF categories, wherein they specified the indices which fund houses can use as a tier-1 benchmark in order to standardise the process and thereby make comparison easier for investors. Here, the first-tier benchmark is reflective of the scheme’s category, which should be as per SEBI directive, and the second-tier benchmark, which can be any as per fund manager/fund house’s discretion, should be the one demonstrating the fund manager’s investing style/strategy within the category. For instance, every large-cap scheme is supposed to have Nifty 100 TRI or S&P BSE 100 TRI as its first-tier benchmark. However, if the fund manager here decides to invest only in top-50 large-cap stocks, he can have Nifty 50 TRI as second-tier benchmark for the fund. There are certain schemes such as multi-cap fund and solution-oriented schemes for which there is no regulatory requirement to have a specific benchmark, while AMFI has recommended certain benchmark indices which an investor can consider for comparison. Also, for schemes based on a specific theme or sector, only a single benchmark is required for comparison.

How you must compare

You can compare scheme performances on a point-to-point or a rolling return basis vis-à-vis their benchmarks. Point-to-point numbers compare returns of MFs with benchmark on a, say, five-year CAGR basis. However, as point-to-point comparison is specific to that whole five-year period, it might not show the whole picture as the volatility isn’t captured here. Rolling return negates this issue.

For instance, if you are considering investing in Kotak Blue-chip Fund regular plan, which is benchmarked against Nifty 100 TRI, you might compare the fund’s last 10-year performance rolled on five-year basis. Here, you can get multiple five-year CAGR of the fund ranging from, say, 2012-2017, 2013-2018 to 2016-2021 which you can compare to that of the benchmark and check if the fund has consistently beaten the benchmark for most of these periods.

Along with comparing returns with benchmark, one needs to check that to the extent to which the movements of MF schemes align with that of the benchmark index. This is measured by R-squared which is in the scale of 0-100 percentage with 0 representing lowest correlation and 100 - highest correlation with benchmark. An actively managed MF scheme with R-squared close to 100 means that the fund manager is simply attempting to replicate benchmark returns by maintaining stock allocations quite similar to that of benchmark and thereby not trying to beat the benchmark for which higher expenses are charged.

For passive funds such as index funds and ETFs, it is important for a fund to replicate the underlying benchmark index. On account of reasons such as mutual fund expenses, cash balance requirement and issues in buying/selling underlying index stocks, a passive fund might not be able to provide its investors the exact returns as generated by the benchmark index it tracks.

Last Words

In the last few years, it has been seen that fewer active MF schemes have been able to outperform their benchmarks which might be attributed to SEBI rule changes such as bringing in TRI. For an investor deploying money in actively managed MF schemes, it becomes very important that fund managers beat the benchmark consistently, as ultimately a higher expense ratio is attributable to payment for a fund manager’s skills. If the fund is not able to outperform the benchmark on a consistent basis, investors might be better off investing in index funds or ETFs.

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