In common parlance, a benchmark is a reference point or a yardstick against which something is measured. Now, it is important to track the performance of your investments to know if you’re making the right decisions.
Private and institutional investors use benchmarks to analyse a portfolio’s performance. These benchmarks are also used to understand market trends and the latest happenings in different sectors.
Let’s discuss what a benchmark is, its type and why benchmarks are important.
You will Learn About:
What is a benchmark?
In the finance world, the term benchmark refers to a standard against which a fund’s or financial security’s performance is measured.
Different financial instruments have different benchmarks against which their performance is measured. Various benchmarks can be used to understand how a portfolio is performing. For instance, Nifty 50 is a benchmark index that tracks the performance of blue chip companies. Another example is the NIFTY bank, which is a benchmark that tracks the performance of listed Indian banks.
A financial instrument is considered worthy of investment if it outperforms its benchmark. If its returns are below the benchmark, investors are better off investing in the benchmark than the asset.
Return on equity: Highlights
- A benchmark is a measure that can be used to assess security or a mutual fund’s performance. Different asset classes have different benchmarks.
- Benchmarks are crucial because they provide a yardstick to compare an investment’s performance. They are also useful for detecting trends and market moods.
- A fund is considered to have underperformed if the returns are lower than its benchmark and vice versa.
- A benchmark error is not the same as a tracking error.
Why are benchmarks important?
The following are some reasons why benchmarks are important in investing:
- A benchmark can help assess the performance of an asset, fund and or portfolio.
- Most managed funds have a standard benchmark against which they can be compared. This helps aid investing decisions.
- Benchmark indices can help measure the overall performance of the stock market or a particular economic sector.
- They can act as a reference point to evaluate the risk and return from a portfolio.
- Governments, central banks and economists use benchmarks to study the overall mood of the market/market segments/sectors and monitor trends.
Types of benchmarks
Fundamental and thematic are two types of benchmark indices that differ in how they are constructed and what type of stocks they include. Let’s read them in detail.
- Fundamental
Under fundamental benchmarking, market capitalisation is the main ‘fundamental’ criteria used when filtering stocks. They may also use elements like book value or revenue.
They typically serve as a benchmark for passively managed funds, helping investors who look for exposure to stocks with strong fundamental characteristics.
- Thematic benchmark
Under thematic benchmarking, fund managers create customised benchmarks for the funds based on a specific theme or sector.
For instance, if the fund invests in the ESG (Energy, Social and Government) theme, the fund benchmark would be a thematic index like the Nifty 100 ESG Index. Similarly, for funds investing in the housing theme, the Nifty Housing Index would be the thematic benchmark that managers can use.
Thematic benchmarks do not represent the overall market and are rather used by investors looking to invest in a particular theme.
What is a benchmark error?
Benchmark error is the use of an incorrect benchmark or standard when evaluating portfolio performance. This can lead to an overestimation or underestimation of a portfolio’s performance, misguiding an investor.
Sometimes, a portfolio’s asset mix may also result in a substantial benchmark error. Investors may choose reference standards that do not adequately reflect the holdings in their portfolios, making them ineffective references. Benchmark errors can happen here because even though the investor has tracked the investment portfolio’s performance and the benchmark, the comparison is not meaningful.
Such errors can cause significant concerns for investors and portfolio managers, who must use due diligence while evaluating the performance of their portfolios to avoid such issues.
Benchmark errors are often confused with tracking errors. But tracking error is a different concept. In simpler terms, it is the difference between the portfolio’s and the benchmark’s performances. This kind of error is typically seen when dealing with ETFs, mutual funds, and more.
What is a benchmark index?
All asset classes have unique indexes that assess how well or poorly they behave in the market.
Benchmark indices or stock market indices assess and compare the performance of the stock market as a whole or of a particular sector of the stock market. They are used to track the performance of a group of stocks and provide investors with a way to compare the performance of their portfolios to the broader market.
For instance, mid-cap and small-cap funds are benchmarked against CNX Midcap and Smallcap; Nifty 50 TRI is the benchmark for the top 50 stocks by market capitalisation. In fact, even cryptocurrencies have benchmarks, reinforcing their importance.
Sectors like Pharma, Energy, FMCG, Financial Services and even Infrastructure have their own benchmarks. In fact, Nifty also has a benchmark called NIFTY Fixed Income indices for fixed-income instruments that include bonds and Government securities.
Conclusion
The benchmark behaves as a standard for how well a fund or a portfolio performs. You can compare your fund’s performance with concerned benchmarks to make better investment decisions. If your fund’s performance is in line with the benchmark, that’s a sign that the fund is performing well. Remember, different asset classes have different benchmarks.
