What is a benchmark?
A benchmark is a performance standard against which the returns from a security, mutual fund or portfolio manager can be assessed. For example, mutual fund products are required to showcase performance versus a suitable benchmark; a diversified equity fund uses a broad index such as BSE 500 or S&P CNX 500 as a benchmark. In fixed income, an income fund uses Crisil Composite Bond Fund index as a benchmark.
Why is a benchmark important?
Returns earned from investing in any asset class or product can be looked at in two ways-absolute and relative returns. Absolute returns are simply a return objective. This is like a minimum rate of return identified by an investor and their adviser. It is easy to understand and monitor, but not enough to evaluate performance.
As an investor you must also know how the asset class has performed and how other products within that asset class have performed. That's why the need for a benchmark. So if your fund has given a 15% return over five years, but the benchmark to which it belongs has given 25% over the same period and the category average is also around that number, then you know your fund has underperformed and it's better to exit.
Which benchmark is appropriate?
To be able to make a correct decision, ensure that you use the appropriate benchmark. A benchmark should ideally be in line with the risk-return profile of the product you invest in. For example, if you invest in a large-cap fund, the performance benchmark should ideally be a large-cap index such as S&P Nifty or BSE Sensex. Crisil Liquid Fund index can be an appropriate benchmark for liquid and ultra short-term funds, which have a portfolio of certificates of deposit and commercial papers.
Compare performance only against a benchmark that is investible. This means you can't compare the performance of listed bonds with returns offered on unlisted bonds even if you own both types of securities. Also, the benchmark should have precise and published (for investors to see) guidelines and rules. Given these, you will know the methodology of adding and deleting holdings form a benchmark and you will have historical values and holdings available for performance comparison.
Can you create a benchmark?
Where a suitable benchmark is not available, you can create your own benchmark. For example, for a fund investing in Chinese and Indian stock markets, you can take representative indices (a Chinese equity index and an Indian equity index) and combine them by taking proportionate investment weightage. Similarly, you can create other benchmarks based on the asset class you are investing in and your overall portfolio allocation.
Whichever way you do it, it is essential to compare returns from an asset or a product with its peers to understand whether it is under-performing or outperforming the market.