A benchmark can define the risk return profile of an investment strategy for a portfolio of stocks, fixed income or any other asset class or combination of asset classes. A well-defined benchmark provides the transparency and measurability that investors need to judge the performance of the strategy they are invested in. An active manager will have his own secret sauce or strategy for building up his portfolio with an accompanying right to keep the strategy a secret. It is the performance benchmark which provides the transparency that is an essential tool for investors to understand the outcome of the active managers’ investment decisions.

For some time in the Indian market, the selection of a performance benchmark by active managers has not advanced at the same pace as the development of the underlying trading strategy. As mutual funds gained acceptance as investment vehicles of choice, and as a multitude of investment strategies were brought to the market via different mutual funds, selection of benchmarks suffered from a legacy issue. When the mutual fund industry was in its infancy using the S&P BSE 100 as a benchmark for any kind of long only equity portfolio was de rigor. The idea behind this approach was that the fund expected to give better than market returns and since the market returns could be defined by a benchmark index like the S&P BSE 100, there was sufficient transparency for the market.

However, there are several nuances to benchmark selection. There are two sources of returns to a portfolio. The popular well understood return of a portfolio come from gains in asset valuation, or in simple parlance, increase in stock prices. The stocks in the portfolio go up, leading to an increase in the value of the portfolio. In addition, returns also come from the dividends or interest paid out by constituent securities in the portfolio. Studies have shown that on average, a third of the total returns of a portfolio come from the dividends earned. Indices or benchmarks are calculated in two main formats; one is the price return format, where only gains or losses from a change in prices of assets or component stocks is included. The other format is the total return version, where the value of dividends/interest earned proportionate to the weight of the stock held in the index is added to the sum of the price movements. The total return format provides the complete picture of the value of gains (or losses) from a portfolio. Benchmarking fund returns only to the price return index and showcasing dividend/interest returns as portfolio strategy gains is misleading for investors. The true picture of the value of a portfolio strategy only emerges when the total returns of a benchmark are taken into account for comparison purposes.

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As mentioned earlier, there are two components of a portfolio, one is the returns and the other is a risk component. In the heady rush of extraordinary gains which the Indian stock market has witnessed in the last decade, investors frequently ignore the risk built into any portfolio strategy. Any risk profile is acceptable provided it is disclosed and understood by investors. Problems can arise when the risk profile is not understood because of benchmark selection. Going back to our earlier example, the S&P BSE 100 is an index capturing the large cap stocks in the Indian stock market. If the portfolio consists of a mix of large-cap, mid-cap or small-cap stocks that creates an additional risk component which is not visible to the investor. Size, sectors, geographies all create a unique risk which are distinct for each asset class. It is accompanied by potential return differentials too, but all of these aspects should be clearly understood by investors so that they can make informed decisions.

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The Securities and Exchange Board of India (Sebi) recently issued two mandates which are to be implemented in early 2018. Firstly, Sebi requires all mutual funds benchmark to a total return version of relevant index, so that dividend or interest returns are fully incorporated in the benchmark and fund performance can be measured against the total returns a fund achieves. Secondly, Sebi is seeking to simplify the mutual fund market by defining the asset class of each fund as equity, debt, hybrid, solutions oriented and others. By requiring defined categories, disclosures will be enhanced as the investment objective and strategy and benchmark will now be clearly aligned. Finally, to ensure a uniform investment universe, Sebi also mandated the size categorizations for equity schemes based on full market capitalization; large cap companies are those ranked from 1 to 100, mid-cap the 101st to 250th and small cap being defined as those from 251st in rank. Asset managers were given a grace period to realign their funds in accordance with these changes.

These mandates have brought about a sea change in the level of transparency and measurability of Indian mutual funds, providing investors with clarity in a funds’ objective, the method it is using to achieve the objective and the variations that exist between each fund and its strategy.

Alka Banerjee is CEO, Asia Index Private Ltd

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