The Importance of Understanding your Benchmark

Recent SEBI guidelines have highlighted the issue of flawed benchmark usage in the Indian mutual fund industry. Globally funds are required to be transparent and provide complete information around their investment philosophy and within that requirement of transparency. The fund manager is given the leeway to choose their own appropriate benchmark.

First, in this context, it is important to understand the role of a benchmark. Quite simply, the benchmark that an active fund manager chooses mirrors the investment philosophy of the fund. This means that if the fund’s purpose is to invest in largecap stocks, then an appropriate benchmark should be designed to capture only largecap stocks. In this manner, the active manager’s performance can be clearly judged to see if the specific active strategy that has been adopted has value besides a simple index of large cap stocks. The fund manager’s skill in picking stocks will then become clearly evident. Similarly if the fund purports to invest in infrastructure stocks, then the benchmark should be an infrastructure index. Benchmarking against indices like the S&P BSE 100 or the S&P BSE 200, when the investment purpose is far more specific in terms of size, sector, or factors, is an inappropriate use of benchmarks.

Recently, SEBI laid out guidelines defining top 100 listed stocks by total market capitalization, the next 150 as mid cap and the following 250 as small cap stocks. All fund managers are required to choose stocks within these ranges for their various large cap, midcap or small cap funds. There are some buffers built in to avoid large turnover and additional costs, but the idea is to enforce clarity and symbiosis around benchmark and stock selection. A large cap strategy should focus on investing in large cap stocks and should not depend on buying mid cap stocks to give it the alpha over a benchmark. The true value of an investment strategy is not judged against the total market performance but over an index which has similar rules, providing the performance against a generic use of that approach. When choosing funds for investing, investors need to understand the nuances of benchmark selection so that they can make an informed judgement of the value they are paying for and getting over a period of time.

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