Performance evaluation of investment portfolios is a multi-step process. It first involves validating a portfolio’s stated benchmark. The next step is attributing the source of alpha; alpha is the excess returns that an active portfolio generates over an appropriate benchmark. The final step involves analysing the alpha to decide on investing in the fund. Such a clinical approach is best left to investment-performance analysts. As an individual investor, it is important you understand why an appropriate benchmark is crucial and how research providers can bridge industry-best practices in performance evaluation with SEBI’s categorisation of funds.

Similar risk, higher return

Suppose you want to invest in a large-cap active fund whose benchmark is the Nifty 50. The fund must typically generate positive alpha irrespective of the Nifty 50 Index rising or sliding. So, when the index tanks, the fund should provide lower negative returns.

Importantly, an active fund must generate positive alpha taking similar risk as its benchmark index. That is why best-practice evaluation requires analysts first test whether a fund is true to its benchmark index. But that argument may not work in India. Why? Large-cap active funds, for instance, can allocate 20% outside of the large-cap space as large-cap funds are defined as ones that invest at least 80% in large-cap stocks.

While this definition allows such funds to include mid-cap stocks in portfolios, it changes the nature and characteristic of alpha; for you will be comparing a portfolio with many large-cap stocks and some mid-cap stocks with a benchmark index with only large-cap stocks. Are blended benchmarks better in capturing the characteristic of alpha?

Conclusion

A blended benchmark for large cap funds can be created with 80% weight for a large-cap index and 20% weight for a mid-cap index. This assumes a large-cap fund will invest only in mid-cap stocks in addition to large-cap stocks. What if funds drift to small-cap stocks? Suffice it to know returns-based analysis may be more optimal here. Similar analysis can be done for mid- and small-cap active funds. As retail investors, we cannot build such benchmarks or make such analysis. It is better third-party research providers offer performance analysis reports to retail investors for understanding fund alphas.

(The author offers training programmes for individuals to manage their personal investments)

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