Benchmark in Mutual What It Is, Types, and How to Use Them

You can do this little experiment yourself. 

You can select any Mutual Fund of your preference. I specifically chose IDFC Core Equity Fund, Growth, with a Rs.10,000/- monthly SIP commencing from 1st Jan 2014 and lasting for a duration of five years until 1st Jan 2020.

I employed an SIP calculator (Moneycontrol) to assess the results of a Systematic Investment Plan in this fund. This was the outcome –

There are a couple of things you will notice here – 

1.     The CAGR (or XIRR to be particular) is 8.84%
2.     The total amount invested is Rs.7,30,000/- across 73 months. 
3.     The total number of units acquired is 20,772.43 
4. The value of the investment after 73 months of regular investment is Rs.9,52,000/- 

This is a typical SIP experience. Now let’s try it with IDFC Core Equity Fund, Direct, Growth.

Here is how the performance looks like – 

It’s simple to compare the performance of the direct option with the regular one – I’ve provided you with a handy table to make it even easier.

In the direct fund, you have accumulated 19,982 units, which is slightly fewer than regular funds. However, as discussed in the preceding chapter, direct funds typically have a higher value per unit than regular funds.

It’s clear that the investment value in direct mode is Rs.9,99,527/- whereas the regular fund stands at Rs.9,52,000/-.

In comparison with the initial outlay, this difference of Rs.47,527/- is about 6.51%. So where could this cash be headed?

The money is going to the distributor that gave you advice to begin a 10,000/- SIP five years ago.

Evidently, the returns are higher in the direct fund because the distributor does not earn a commission. This is clearly seen when you look at the XIRR – 10.47% in comparison to 8.84%, which is of the Regular plan.

Every year, 1.63% of the value of your investment is paid in commissions; this means that your investment is not allowed to grow unhindered.

Treat yourself to the benefits of direct funds by making the switch today.

– Benchmarking and TRI

Let’s take a moment to cover ‘Benchmarking’ in relation to mutual funds.

Benchmarking can be likened to the aspirant athlete X; it is used in the mutual fund world to gauge performance. Just like X seeks to get better and push his own boundaries, the performance of a fund is looked at in comparison to the standard.

X is putting in great effort in preparation for an imminent running contest. X has their sights set on more than only claiming first place in the 100-metre dash; they are determined to come out ahead of Y, a fellow aspiring runner from the town next door.

During the practice, X completed a 100-metre run in 14.5 seconds. Is he well-placed to come out victorious?

It’s impossible to give a definitive answer without knowing how long Y takes to cover the same course. Suppose it takes 13 seconds; then what?

The question on everyone’s mind is: who will take the prize? It’s clear that Y is the frontrunner.

We were able to answer this by benchmarking X and Y against each other. Without knowledge of either person’s speed, it would not be possible to predict the victor.

This is known as benchmarking, which enables us to gauge performance.

The same goes with Mutual Funds. 

Every mutual fund attempts to outperform its benchmark by generating superior returns.

This snapshot highlights that DSP’s Equity Opportunity Fund uses Nifty 250 Index (TRI) as its benchmark.

A large-cap equity fund generally attempts to outperform the Nifty 50 Index. Returns can be measured over a period ranging from 3, 5, or 10 years.

1.     The MF generates higher returns than the benchmark; then the fund is said to outperform 
2. The MF generates lower returns compared to the benchmark; then the fund is said to have under-performed 

This context highlights that if an Equities fund has yielded a 12% CAGR over the course of 3 years and its benchmark, the Nifty 50, achieved 10.5%, the fund can be said to have outperformed. The excess return related to its benchmark is referred to as ‘Alpha’.

In this case, the Alpha is 1.5% i.e. 12% – 10.5%. 

In the photograph above, you may have observed the “TRI”bit. This short version of ‘Total Return Index’ incorporates dividends when stock is purchased. Keep in mind that when investing in a company, there are two possible sources of profit –

1.     Price appreciation or capital gains
2. Dividend income

Now, consider the regular index chart that everyone checks. This captures only price appreciation of the index, missing out the dividends issued by its constituents. To get an idea of real returns earned by investors, we have to include these dividends as well. The Total Returns Index (TRI) accounts for this, allowing one to look at both price appreciation and dividends received when they check Nifty 50 TRI. In other words, when viewing Nifty 50 chart we’re just seeing price appreciation but Nifty 50 TRI shows both this and the dividends received.

Have a look at a comparison of Nifty 50 and Nifty 50 TRI, the blue line is TRI and red is Nifty 50 – 

I want to bring attention to the fact that TRI has posted an absolute return of 942%, which is significantly higher than Nifty 50’s 738% in the same period. The purpose of this is to give you three pieces of information.

1.     For an index, its TRI avatar is always more valuable since it factors in dividends. 
2.     MF’s use TRI as a benchmark; this is a recent phenomenon though. Earlier, MFs were benchmarking against just the price appreciation chart. 
3. It’s not easy to beat the TRI index. 😊 

Alright, now that we have laid a foundation for our discussion for benchmarking, let’s take this discussion a bit deeper. 

– Weights matter

Consider this, there are two mutual fund managers, A & B. 

A handles a large-cap fund and compares its performance to that of the Nifty 50 TRI. Meanwhile, B is responsible for an Equity multi opportunity fund whose performance is benchmarked against the Nifty 500 TRI.

Which mutual fund manager here is likely to struggle to outperform their benchmark?

Nifty 50 consists of fifty large-cap stocks, while Nifty 500 expands on this list by including an additional 450 stocks.

It intuitively appears to be a more difficult feat to beat the Nifty 500 TRI. With more stocks, reduced volatility and consequently limited drawdowns, its diversification lends it an additional layer of complexity.

It isn’t like that, however. There is an intriguing explanation for this. Let me elucidate.

You may create an imaginary index, referred to as the ‘High 5’. The index contains the top five stocks from five various sectors, as follows –

The index has a starting value of 1000; the Base Split column presents the split of this based on the respective weight of the stocks.

With this, you start off your index. After a few days, due to changes in the stock prices, there is also a corresponding variation in its value. I have assigned random stock price values to the five stocks included in the High five index –

The stock price shift has caused an alteration in the individual base values, resulting in a transformation of the entire index. We can observe that the beginning value of 1000 has risen to 1,081.72, accounting for an absolute return of 8.17%.

We’ll leave the high five indexes untouched – no modification of stocks, reference stock prices, or initial value of the index.

Let’s shift our focus to adjusting the weights assigned to different stocks, and have a look at the results in the snapshot below.

We can observe that the weights have shifted. Biocon, for instance, went from 10% to 20%, while Bajaj Auto switched from 18% to 40%. Furthermore, the same transformation happened with all the other stocks.

The weights have shifted, resulting in a new base value of 1,056.51 and a decrease of returns to 5.65% from 8.17%. Despite no alteration in stocks, these changes are still evident.

What does this mean? 

The most important factor when investing in indexes is the weighting of stocks. It doesn’t matter whether there’s 50 or 500 stocks in the index, what concerns investors is which stock has more weightage.

In the Nifty 500, nearly 45% of the weightage is attributed to the top 10 stocks, and 65% to the top 25. When considering up to the 50th stock, around 85-90% of the weightage is taken into account.

The other 450 stocks are present for the sake of having them there.

To gain a better perspective, it is advisable to assess the performance of Nifty 50 TRI and Nifty 500 TRI over a period.

This chart illustrates the 10-year rolling return of both Nifty 50 TRI and Nifty 500 TRI, beginning in 2005.

And the one below is the 5-year rolling return – 

The graphs are generated by my good friend, Shyam from Stockviz. 

It’s noteworthy that the return/drawdown profiles are quite comparable. There was a minor distinction between Nifty 50 and Nifty 500 from 2005 to 2007, however it soon vanished. Ever since then the returns have generally been similar across both these indices, underlining that the addition of 450 stocks in Nifty 500 has very little impact.

While I’ve not discussed other indices such as Nifty 100 or Nifty 250, you can expect something similar. 

The inquiry is this – what effect would it have if the measure was Nifty 50 TRI or Nifty 500 TRI?

Well, nothing. 

This could have implications for mutual fund investors. Perhaps some readers of this article have already deduced this.

Don’t be concerned with the notion of benchmarking MFs. As an investor, you should have a practical view of what your MF investments are likely to yield. This should act as your measuring stick for the investment instead of something determined by an AMC.

Everything else is noise according to me. 

Ultimately, it is important to have realistic expectations when investing in life. For instance, if you primarily put money into a large-cap fund, you should anticipate performance more indicative of the asset class and not that of small-caps.

If the fund you’ve invested in is continually falling short of the index, that usually indicates an issue. In this case, it’s a smart idea to review or replace it.

Your aptitude in examining a fund and defining realistic goals from your expenditure eventually defines you as an MF investor. The following chapters will then focus on how to recognize your personal financial aspirations, construct an MF portfolio, and set reasonable expectations.

In the upcoming chapter, we will aim to wrap up our conversation concerning Mutual fund metrics and then move on to discussing goals and portfolios.

Be sure to keep up to date.