What is a benchmark in mutual funds and how does it work?

What is a benchmark in mutual funds and how does it work?

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If you have ever invested in mutual funds, you have probably heard the word “benchmark.” A benchmark is a standard by which a mutual fund scheme’s performance is evaluated. According to the regulatory measures put in place by the Securities and Exchange Board of India (SEBI), the disclosure of a benchmark index is required in India. But you might still be unclear on what exactly is a mutual fund benchmark and how it affects the amount you invest. So, let’s find out.

What is a benchmark in mutual funds? 

An index used to gauge a mutual fund’s overall performance is known as a benchmark. The comparison shows how much a fund has made instead of how much it should have made. This might be contrasted with the initial return on the investment. In 2012, SEBI made it necessary for fund houses to establish a benchmark index for each scheme.

For this, broad and market-segment stock and bond indices are typically employed; even cryptocurrencies have benchmarks, underscoring the need to have a standard against which to measure the performance of an asset.

Importance of a benchmark in mutual funds

  • A benchmark allows investors to compare the performance of the mutual fund investment to that of the larger market. The fund house often sets an objective to outperform the benchmark index.
  • A benchmark can compare two separate funds in the same category. It will be simpler to choose which fund to invest in if, for instance, Fund ABC performs 3% better than the benchmark while Fund XYZ performs 6% better.
  • The benchmark also represents the type of risk present in a portfolio. If a standard market index is available as a benchmark, you can examine it and learn more about its risk, which may help you better comprehend the return and risk of the mutual fund scheme.
  • You can use a benchmark to determine the potential returns from a new fund. However, a comparison of this kind may only be used to predict potential returns; it cannot ensure future profits.

How does a benchmark work?

The broadest index available should be used as the standard by which to evaluate the performance of the fund. A growth fund investing in Indian stocks should be assessed against Nifty similarly to a value-oriented fund. The justification is straightforward.

The amount an investment has grown to in absolute terms is the return. The return you receive from the equity market is frequently unpredictable; you may occasionally accept huge or meagre returns.

The mutual fund demonstrates a significant departure from the benchmark, which may or may not be favourable. A fund made out of comparable equities has the potential to perform significantly better or worse than the benchmark. The term “volatility” refers to these deviations. Investors can determine this by looking at the “beta” or “standard deviation” of the fund.

While the fund managers wantto beat the benchmark over a reasonable time frame, theymay not consistently be able to outperform the stock market. But if the fund manager is consistent with pay-outs and outperforms the benchmark over time, the demand for the fund rises.

Conclusion 

Benchmarks also show the state of a market; you can check the performance of the equity market overall or observe how a specific sector is doing. The many benchmarking indices available for mutual fund schemes help give you key information on the fund’s portfolio and performance. In this manner, you can be better prepared to decide on an investment based on your return expectations and financial goals.

 

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