All investors in mutual funds make the investment so as to achieve their financial and savings goals. Hence, it is essential for all investors to have an understanding on how to gauge the performance of the varied schemes that they have put their hard-earned money into.
There are several different methods that can used to evaluate and measure performance of the mutual funds. It can be volatility of the scheme returns, the goal of absolute return, or a simple comparison with peers or similar mutual funds. It may however be noted that one of best and most reliable methods to check MF performance is via comparison of the scheme returns to its benchmark.
In other words, a benchmark can be described as a standard which can be employed to measure or assess the performance of a specific mutual fund scheme. Benchmarks are generally given by independent third-party service providers.
In India, the 3 main organizations that provide a large majority of the benchmarks used by MF schemes are the BSE, NSE, and CRISIL. Both the NSE and the BSE create, preserve, and publish different equity indices. CRISIL also does the work of independently publishing different indices such as fixed income indices, etc.
Some of the most popular and common indices used by equity oriented MF schemes BSE (Sensitive) Index, BSE 100, CNX Nifty, CNX 500, and/or BSE 200. For debt, a majority of mutual funds make use of the fixed income indices of CRISIL such as CRISIL Composite Bond Index or CRISIL Liquid Index. CRISIL Balanced Fund Index is usually used as benchmark in case of balanced funds.
A benchmark is constructed by shortlisting a list of eligible companies, debt securities, and other kinds of assets. They then get ranked as per different parameters such as liquidity, market capitalization, and turnover/volume, etc. A well-researched and well-studied proprietary methodology is then used for shortlisting securities and deciding weightages.
Index values subsequently get calculated and later published. Index values typically are available for 5 to 10 years, or even more. As per the market conditions, weights, index constituents, and even the methodology may be changed periodically.
The performance of varied mutual funds is then published in comparison to the benchmark in the monthly fact sheets of the MF schemes. This is presented in a format that is pre-specified and mandated by SEBI.
In most cases, if a mutual fund’s yields are higher that the returns of the benchmark during a similar time frame, then the fund is said to be managed well. One of the most important points to remember when comparing yields is the fact that the MF benchmark index values capture purely the returns of the underlying index portfolio. It does not consist of expense ratio component, while MF schemes do charge fees and expenses.
The NAV of mutual funds are adjusted for expense ratio. It can thus be said that the yields of a mutual fund scheme are net of expense ratio and that benchmark index returns do not consist of expense ratio element. This factor therefore has to be taken into account by investors while comparing the scheme returns with the benchmark yields.
The other major factors which trigger variance in the yields of mutual fund schemes vis-à-vis the benchmark include the fund manager’s active management of the scheme, cash levels, and outflows and inflows into the fund.
Making the right kind of comparison
Investors have to be careful when comparing MF returns due to the 3 factors. Use of benchmark can be considered as an activity that compares oranges to oranges, which means comparison within an equivalent asset class. Therefore, investors should not use an equity benchmark to measure the performance of a debt MF scheme.
It is also important to note that absolute return is not guaranteed by benchmarks. Even the yields of benchmarks can be negative as per the movements in the market.
Underperformance or outperformance of a mutual fund against its benchmark may not necessarily be an indicator of the scheme’s ranking amongst its peers as being worst or best. The process of ranking against peer group is an altogether different process.
But one must not forget the fact that verifying the benchmark returns of the scheme is definitely one of the best ways to verify how well or bad the MF investment is doing.