Mastering Mutual Funds: How Scheme Benchmarks Impact Your Returns

Mutual fund schemes are designed to invest in the market for the benefit of unit-holders. But how can we truly gauge the performance of a scheme?

A mutual fund benchmark is a standard index against which a mutual fund’s performance is measured. It reflects the performance of a relevant market segment and helps investors gauge how well their fund is performing compared to the broader market or specific sector

What makes a benchmark credible? First and foremost, it should align with the scheme’s investment objective. The securities or variables used in the benchmark calculation must accurately reflect the type of portfolio the scheme intends to build.

It should also be consistent with the scheme’s asset allocation pattern and investment strategy. As Warren Buffett wisely noted,

                          “Risk comes from not knowing what you’re doing” 

A well-chosen benchmark provides clarity, helping to assess the scheme’s performance effectively.

A credible benchmark is also one that’s calculated by an independent agency, ensuring transparency and regular updates. Typically, benchmarks are constructed by entities like stock exchanges, credit rating agencies, securities research firms, or financial publications.

For index funds, selecting a benchmark is straightforward; the scheme’s objective is to track a specific index, making that index the natural choice as its benchmark. But what about other types of schemes? Here, the process is more subjective.

The Asset Management Company (AMC), in consultation with the trustees, determines the appropriate benchmark. This benchmark is then specified in the Scheme Information Document (SID), ensuring that both the scheme’s performance and the benchmark’s performance are presented side by side.

Can a benchmark change over time? Yes, it can. The need to update a benchmark may arise for various reasons; perhaps the investment objective of the scheme has evolved, the index has been restructured, or a more suitable index has become available.

In such cases, the AMC may opt to change the benchmark after consulting with the trustees, provided that the change is well-justified and documented.

Mutual fund schemes are required to disclose the benchmark index or indices against which the scheme’s performance is compared. This transparency helps investors make informed decisions by understanding how their investments are performing relative to the market.

Benchmarks are crucial because they provide a point of reference to assess the performance of a mutual fund. They help investors understand whether a fund is meeting its investment objectives and if the fund manager is adding value beyond the market average.

Table of Contents:

• Key facts about mutual fund benchmarking, as mandated by SEBI
• Comparing PRI and TRI: A Guide for Investors
• Key Factors in Selecting an Appropriate Performance Benchmark
• Benchmark of Mutual Fund schemes: Key Principles to Follow
• Type of Scheme and Benchmark Structure
• Final Takeaway

Key facts about mutual fund benchmarking, as mandated by SEBI

1. Alignment with Investment Objectives: SEBI mandates that a scheme’s benchmark must align with its investment objective, asset allocation, and strategy. This ensures that performance comparisons are relevant and meaningful.
2. Benchmarking with Total Return Index : To provide a comprehensive view of performance, SEBI requires mutual funds to benchmark their schemes against the Total Return Index , which includes both capital gains and dividends.
3. Composite CAGR for Periods Lacking TRI Data: When TRI data isn’t available for the entire period, SEBI requires funds to use a composite CAGR, combining Price Return Index  data with TRI data for a consistent and accurate performance assessment.

Comparing PRI and TRI: A Guide for Investors

In the past, mutual fund schemes were benchmarked against the Price Return Index (PRI), which only captured capital gains. But was this enough to truly assess performance? PRI overlooks a key component of dividends.

To address this, SEBI introduced a significant change on February 1, 2018: mutual funds are now benchmarked against the Total Return Index (TRI). But why was this shift necessary?

TRI offers a more comprehensive measure of performance by including not just capital gains but also dividends and interest payments from the index constituents. This adjustment ensures a fairer and more accurate comparison.

By factoring in dividends, TRI provides a clearer reflection of the true returns generated by a mutual fund scheme.

Consider this: if a scheme’s performance, including dividends, were compared to a benchmark like PRI that excludes them, it would create an artificial advantage. The shift to TRI addresses this issue, marking a step toward greater transparency in the mutual fund industry.

Does this mean that fewer schemes will appear to outperform their benchmarks? Yes, but not because their performance has declined; rather, the comparison is now more accurate. The difference between PRI and TRI returns is essentially the dividend yield, which has historically ranged between 1.5% to 2.5% in the Indian market.

This move to TRI represents a more accurate and transparent way of assessing mutual fund performance, aligning the benchmarks with the true returns that investors should consider.

Key Factors in Selecting an Appropriate Performance Benchmark

When selecting a benchmark for performance comparison, what should be your main considerations? SEBI provides clarity on this in their January 4, 2018 circular. But how do you ensure that the benchmark truly reflects the scheme’s intent?

The benchmark must be chosen based on three key factors:

• The scheme’s investment objective
• The investment strategy of the scheme
• The scheme’s asset allocation pattern

These elements, all detailed in the Scheme Information Document, guide you in selecting a benchmark that genuinely mirrors the scheme’s goals and strategy, ensuring a fair and accurate performance comparison.

Benchmark of Mutual Fund schemes: Key Principles to Follow

How can mutual fund benchmarks be made more consistent and transparent? SEBI’s October 27, 2021, circular introduced a two-tiered benchmarking system to address this need.

• First-Tier Benchmark: This benchmark reflects the overall category of the mutual fund scheme, ensuring that comparisons are relevant within the scheme’s broad category.
• Second-Tier Benchmark: This benchmark captures the specific investment style or strategy of the Fund Manager, offering a more detailed comparison within the category.

By adopting this two-tiered approach, SEBI aims to provide a more nuanced performance evaluation. Additionally, all benchmarks will now use Total Return Indices, which include both capital gains and dividends. This change ensures that investors get a more comprehensive and accurate picture of how their schemes are performing.

Type of Scheme and Benchmark Structure

1. Income/Debt Oriented Schemes

• Tier-1 Benchmark: A broad market index specific to the category, such as the NIFTY Ultra Short Duration Debt Index or CRISIL Ultra Short Term Debt Index for ultra-short duration funds.
• Tier-2 Benchmark: Custom benchmarks based on the investment style or strategy, such as the AAA Bond Index.

2. Growth/Equity Oriented Schemes

• Tier-1 Benchmark: A broad market index relevant to the category, like the S&P BSE 100 Index or NSE 100 Index for large-cap funds.
• Tier-2 Benchmark: Custom benchmarks reflecting the investment style or strategy, such as the Nifty 50 Index.

3. Hybrid and Solution Oriented Schemes

• Benchmark: A single benchmark, either a broad market benchmark where available or a bespoke benchmark created for the scheme, applicable across the industry.

4. Thematic/Sectoral Schemes

• Benchmark: A single benchmark will be used, as these schemes are tailored to specific themes or sectors, aligning directly with their characteristics.

5. Index Funds and Exchange-Traded Funds (ETFs)

• Benchmark: A single benchmark is applicable, as these funds are designed to replicate the performance of an underlying index.

6. Fund of Funds (FoFs)

• Single Fund FoFs: If a FoF invests in only one underlying fund, the benchmark of that underlying fund will be used.
• Multiple Fund FoFs: If a FoF invests in multiple funds, a broad market index will be applied to provide a relevant performance comparison.

Final Takeaway

How do you truly measure mutual fund performance? By using relevant benchmarks, as mandated by SEBI. Ensure your benchmarks:

1. Align with Objectives: Are they in sync with your scheme’s goals?
2. Include Total Returns: Do they account for both capital gains and dividends?
3. Reflect the Right Category: Are they specific to your scheme’s type and strategy?

These steps provide a clearer view of your fund’s performance, helping you make more informed investment choices.