Level | Advanced
What do you mean by Benchmark Indices? What are the factors that impact them?

Any performance can be measured only against a standard or reference. The benchmark for a team batting second in a cricket match is the score achieved by the team that batted first. Only if it scores more, the team batting second is said to have performed well. For a student, the minimum pass mark or grade is the benchmark to measure his performance. Alternately, his performance can also be evaluated with reference to that of his classmates. It hence becomes evident that performance cannot be evaluated in a vacuum and has to be done with reference to some external standard or expectation. This standard is what is referred to as a benchmark in investment. Any investment product has to match or better the performance of its identified benchmark to justify the fees and charges that it collects from the investors.

Which are the main benchmark indices?

Indian equity indices like S&P BSE Sensex, NSE Nifty, BSE 200, BSE midcap index, BSE small cap index, Nifty 500 are common among equity mutual funds. These indices are compiled and maintained by the respective stock exchange owned entities. Debt funds are usually benchmarked to the appropriate CRISIL index.

Why do we need different benchmarks for different mutual fund schemes?

Mutual fund schemes invest in various assets like debt, equity, gold, etc. It is therefore pertinent that there cannot be one common benchmark for all investment products. An equity fund may have the S&P BSE Sensex as its benchmark whereas a debt fund may have a composite bond fund index as its benchmark. Put simply, apples and oranges cannot be compared. We need to compare one apple with another apple, not with an orange.

Having an inappropriate benchmark leads to poor comparison. For example, a large cap mutual fund scheme needs to be benchmarked with a large cap index like the Sensex or the Nifty index. If it is benchmarked against a midcap index, the comparison is going to yield no useful information and any action initiated on the basis of such a comparison will lead to poor investment results.

What affects index performance?

An index is a compilation of similar investment securities. Its performance therefore depends predominantly on the performance of its constituents. Apart from this, the design of the index also influences its performance. For example, an equity index may be constructed either on a free-float market cap basis (shares of the company available for trade in the market) or on a total market cap basis (market value of all shares issued by the company). Such differences too impact their performance. Macro-economic conditions like inflation, GDP growth, etc. also have a bearing on the index performances.

How are indices used in investment choices?

Benchmark indices can be good reference points in judging a mutual fund scheme’s investment style apart from its performance. The market capitalization, constituents and other such information of an equity index can reveal a lot about its risk characteristics and performance potential. Similarly, benchmark debt indices can provide information on the maturity profile of the mutual fund scheme. Benchmarks are also good reference points to assess the volatility of your mutual fund scheme.

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Key Takeaways

  1. Performances can be measured only in comparison to a standard or reference.
  2. Such a reference is termed as the benchmark in investment.
  3. Different mutual fund schemes have different benchmarks based on their assets and other relevant characteristics like market capitalization, investment style, etc.