A mutual fund scheme is required to have a benchmark. SEBI wants every fund to choose and share comparative performance with this chosen benchmark.
A benchmark is typically a publicly available market index such as the Sensex, Nifty 50, Nifty 500, BSE Mid cap, etc. This is true for equity funds. In case of debt or hybrid funds, some institutions, such as CRISIL, create custom indices that they funds can use for the purpose.
A benchmark ideally should have similar portfolio characteristics as the fund which intends to use it.
Now, here’s a question.
What is the usefulness of this benchmark performance comparison?
The comparison with the benchmark allows a base level evaluation of a fund’s performance. In popular view, an actively managed fund is expected to do better than the benchmark. After all, if the fund can’t even consistently beat its benchmark, which has similar portfolio characteristics, then what’s the point of holding such a fund.
It is better to switch to a better performing fund. And if no active fund can outperform, then it makes sense to simply buy an index fund based on that particular benchmark. Active fund management doesn’t deserve your money.
However, this comparison method has its own pitfalls.
First, comparing a mutual fund performance with an incorrect benchmark can be defeating.
Take for example, Parag Parikh Long Term Value Fund. The fund has a mandate to invest across the world and across market caps. And what benchmark does the fund use? It is Nifty 500.
Given that the fund invests 70% odd in Indian Stocks, this is a workable benchmark but not its true one. A more relevant benchmark would be a World Index, if there is one.
Then there are large & mid cap funds, which choose a pure large cap benchmark such as Sensex. It is a good reference point but not a completely relevant one. A better comparison is with say BSE 200 index.
Second, the benchmark performance data used for this purpose is limited to price information. It does not reflect the total return (including dividends, bonus, etc.). A mutual fund scheme would receive all these benefits for the holdings it has.
This allows funds to get away by showing outperformance against just the price index. Ideally, they should use the total returns index of the benchmark to make a fair comparison. Read more about this phenomenon and how to do the correct comparison here.
Third, some funds turn this whole benchmark theory on its head with a very smart but scammy strategy – closet indexing.
The world of closet indexing
You would be surprised to know that funds use a closet indexing strategy. Just pick an index, create a fund and then buy stocks very similar to the index with some variation. With this little adjustment, a fund manager can produce a higher return than the index and command a higher fee for active management.
While it appears smart, it is not. It is the weakness of the index to be able to allow closet indexing to happen.
Beware! This is a smart way but only to extract more fees from you. In the long run, the index will become smarter, hopefully, or the fund manager will fail to consistently use the strategy. The scheme will die for lack of performance. By the time you detect it, the fund will have made its money and you will move on to another “performing” fund, without complain.
Should all this get you worried?
There are bad apples everywhere. Fund management is no different. The thing that should really worry you, as an investor, is whether the fund is consistently following through its stated investment mandate and strategy. Benchmark or no benchmark, if the process is right, the results are likely to be right too.
And of course, don’t make recent returns the only parameter to base your fund selection on.