The importance of market benchmarks in mutual funds

Are relative returns important for mutual funds? Some financial advisors say that investors should be concerned only about absolute returns. If investors are able to meet their financial goals through mutual funds, it does not matter how the fund performed against the market or their peers in the interim. In the final analysis, as we approach the end of our investment horizon, absolute return is all that matters. However, relative return is very important in monitoring progress on the journey to our investment goal. Let us understand how.

Suppose you need to earn 15% annualized return on your investment to meet your retirement goal which is 30 years away. The expected annualized return is based on the historical performance of the asset class, inflation etc. For the sake of simplicity let us assume you have invested in only one mutual fund scheme. Once you have made the investment, how will you monitor progress to know that you are on track? If the fund gives you 15% annualized returns in the first 2 or 3 years, will you be happy? If the market grows at a CAGR of 17% while your fund gives 15% returns, you cannot be happy because when the market falls, your fund will also give low or negative returns dragging the annualized return below your expectation.

Equity market returns are volatile; in some years you will get very high returns, some years you will get low returns and in some years you will even get negative returns. However, if your fund is able to beat the market on a consistent basis, it should give you a high level of confidence that, you will be able to meet your investment objective. Let us discuss this in bit more details.

Mean reversion is a widely accepted theory explaining long term asset price behaviour. In very simple terms, the theory suggests that returns eventually move back towards the mean or average. This average can be a long term historical average return or it can be tied with other relevant metrics like long term GDP growth, industrial growth etc. Therefore, irrespective of short term volatility, in the long term, the market growth will revert back to some long term average. If you form expectations based on long term asset class returns and your fund is able to beat the market consistently, then it is logical that in the long term the investment will be able to meet your expectation. It is important to explain three important points here.

Firstly, the definition of long term varies from investor to investor. Some investors think a time period of 3 years or more is long term. If you compare the last 3 years annualized trailing returns of equity mutual fund categories with last 5 years or 10 year returns, you will see that the returns are quite different. Clearly a 3 year investment is therefore not long term and it would be unwise to form expectations based on 3 year performance. In a high growth economy like India, with a rapidly maturing stock market, defining long term in the context of mean reversion is quite difficult. However, a 10 year period can be considered long term.

Secondly, you should understand in practical terms, what we mean when we say that, your fund should beat the market consistently. You cannot expect the fund manager to beat the market every month or even every quarter. Your fund manager aims to beat the market and as a result will be overweight or underweight on certain sectors or stocks relative to the market index. Therefore it will outperform the market in some months / quarters and underperform in other months / quarters. If your fund manager is able to beat the market consistently every year or even most years it should be considered good performance.

Finally, let us discuss what we mean by market. In colloquial terms the Sensex and Nifty are used as market proxies. However, you should know that, Sensex and Nifty comprise of the largest market capitalization stocks in India, and as such, do not represent the entire market. Your mutual fund scheme portfolio is likely to have stocks which are not part of Sensex or Nifty. It is important that you use the relevant market benchmark when evaluating the relative returns of your mutual fund scheme.

Bombay Stock Exchange and National Stock Exchange have defined market benchmarks representing different market cap segments and sectors. Examples of different market cap based benchmarks in BSE are BSE-100 index (representing the top 100 market cap stocks), the broader BSE-500 index, BSE Midcap Index (for midcap stocks), BSE Small Cap Index (for small cap stocks) etc. Similarly in NSE we have CNX – 100, CNX -500, CNX Midcap Index. If you have invested in a large cap fund, the BSE – 100 or CNX – 100 may be the relevant benchmarks. For a midcap fund, BSE Midcap or CNX Midcap may be the relevant benchmarks. These indices are priced on a continuous basis and you can see index returns by going to Mutual Fund Benchmark Monitor in our MF Research Section.

The stock exchanges also have sectoral indices representing different industry sectors. Examples of sectoral indices in BSE are Bankex, BSE Auto Index, BSE Capital Goods Index, BSE IT Index, BSE Pharma Index, BSE FMCG Index etc. Similarly in NSE we have Bank Nifty, CNX Auto, CNX IT, CNX Pharma etc. These indices are relevant if you are investing in sector funds or thematic funds.

You need not analyze the portfolio of a mutual fund scheme to identify the relevant benchmark for the fund. The benchmark is mentioned in the scheme information document and factsheet. You can also find out the benchmark of any fund by going to the Mutual Fund Selector tool in our MF Research Section. Type the first few letters of the scheme name in the search box, select the appropriate scheme from the selection and then click on submit. You will reach a page where you have detailed information on the scheme. In the top section of the page, you can see the scheme benchmark.

I have often seen investors and financial advisors comparing the returns of a fund with another fund. Such comparisons are often misinformed and do not reveal any useful insight because you may be comparing apples and oranges. Some schemes have very concentrated portfolios, whereas others may have diversified portfolios. Outperformance or underperformance of one fund versus another may be explained by the company concentrations in the two portfolios and how market conditions affected them during the period in question. Fund managers may employ different investment styles making comparison difficult. On the other hand, relative performance versus the benchmark may provide valuable insights on risk and fund manager outperformance.

The risk of a fund relative to the benchmark is measured by a metric known as beta. You can look up the beta of a fund by going to the detailed page of the scheme (using our Mutual Fund Selector tool). If the beta of a fund is more than 1, it is more volatile than the benchmark; if the beta is less than 1, it less volatile than the benchmark. Within the same asset category (e.g. large cap funds) you will find funds with different betas. A fund with high beta is not bad and a fund with low beta good. Beta will help you form return expectations. If beta is high, you can expect higher returns in up markets but also be prepared for more downside in corrections. Lower beta will reduce risk, but you should also expect lower returns.

You should know that, the performance of a fund relative to the benchmark cannot be explained by beta alone. There is a factor which explains the difference between returns expected based on beta and the actual returns. This factor is known as alpha. Alpha is the excess returns which a fund generates after factoring in the risk (beta). Alpha is the fund manager’s value-add. You can look up the alpha of a fund by going to the detailed page of the scheme (using our Mutual Fund Selector tool). Higher the alpha, higher is the value-add by the fund manager. A fund manager who consistently beats the benchmark in different market conditions is generating alphas for the investor. You can see the performance of a fund versus the benchmark in different years in the detailed page of the scheme.

In our MF Research Section you can use a variety of tools to see the fund performance on different parameters versus the benchmark. For example, using our Rolling Return vs Benchmark tool you can compare the rolling returns of a mutual fund scheme across different time-scales and rolling return periods versus the benchmark. Using our Market Capture Ratio tool you can see how a mutual fund scheme performed versus benchmark in up markets and down markets separately.

Conclusion

You will find Top Performing Funds in many investment blogs on the web. Every year you will find new names making it to the Top Performing Funds list and some existing names dropping out. Even if you invested in top performing funds after a lot of research, you cannot expect these funds to be in the top 5 or top 10 forever. But if your mutual fund schemes are able to outperform their market benchmarks on a consistent basis, across different market conditions, chances of you meeting or exceeding your investment goals are quite high.