Last week, this column carried a primer on how to read a mutual fund fact sheet. This fact sheet gives not only the returns that your fund makes but also the benchmark's return for the period. What are these ‘benchmarks'?

A fund's benchmark is its comparable set. When comparing the performance of one fund against another, it will be incorrect to compare their returns if their portfolios are structured differently. Holding a balanced fund with exposure to debt, one can't grumble that the fund didn't match up to the mark of an equity-focused fund or a benchmark like Sensex. So, while choosing a benchmark, one has to pick a relevant universe.

Choosing a benchmark

Fund houses normally specify the benchmark index in the fact-sheet. In cases you aren't comfortable with the fund's choice, you can choose one from the established indices in the market. CRISIL, a leading rating agency, has standard indices for fixed income and hybrid (debt and equity mix) funds. CRISIL Balanced Fund index (represents S&P CNX Nifty — 65 per cent and CRISIL Composite Bond Index — 35 per cent) for example, is used as benchmarks to compare returns of equity-oriented balanced funds. For diversified equity funds, which invest in a mix of large and mid-cap stocks, one can pick up broader market indices such as the BSE 500 or CNX 500.

Fund managers who work on broader equity market themes generally benchmark themselves against the Sensex or Nifty (or the other S&P CNX equity indices). Those with a unique investment theme, however, construct their own benchmarks with a combination of indices. To rightly assess a fund's performance, an investor needs to understand the structure and composition of benchmarks too.

Outgrowing the benchmark

Every fund has a mandate to adhere to. Taking leeway within the defined limits for equity and debt exposure or within limits set for mid-cap and small-cap exposure, fund managers churn their portfolios to outdo their benchmarks. In such circumstances, sometimes, the benchmark becomes an inappropriate universe for comparison.

For example, a balanced fund with a mandate to have a minimum 65 per cent equity exposure with the balance in debt can choose CRISIL Balanced Fund index as a benchmark. But over a period when the equity-debt proportion of the fund goes to 80:20, the returns will be in sharp contrast to the benchmark.

Outdoing the benchmark

Well, if you ask, “should I be happy if my fund meets the benchmark return?” the answer lies in whether the fund is actively managed or not. For a fund that is actively managed by the fund manager, beating the benchmark is the minimum criteria. An actively managed fund comes at a higher fund management fee and looks to actively churn the portfolio to achieve a return higher than the benchmark. The additional fee is for the fund manager's promise to deliver returns superior to the benchmark. A sustained underperformance of the fund here calls for a re-look at the choice of funds.

However, keeping up with benchmark is good enough in case of a ‘passively' managed fund. These funds invest in the same constituents of the benchmark index in exactly the same proportion, trying to mirror the returns of the benchmark. While choosing an index fund, however, look for funds that have relatively low tracking error.

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