What is the difference between SBI Magnum Global Fund and SBI Magnum Bluechip Fund? While the former invests significantly in medium- and small-sized companies, the latter is a large-cap fund that invests in large and well-established companies.

Graphics: Yogesh Kumar / Mint

What is the similarity between the two apart from its SBI parentage? Both are benchmarked against the same index, BSE 100, though their investing mandate is different.

So, can the performance of a mid-cap and a large-cap fund be benchmarked against the same index? Unlikely. But as per the rules by the Securities and Exchange Board of India (Sebi)—or the lack of them, depending on where you are sitting—equity funds are free to choose their own benchmark.

What is it?

A benchmark is, typically, a stock market index that every MF scheme is mandated to compare its own performance with. While Sebi has mandated fixed benchmark indices for debt funds, it has given the freedom to equity funds to choose their own benchmarks.

A benchmark serves two purposes. One, it gives you a point with which you can compare your fund. Two, it sets a minimum standard of performance for your fund manager, who would usually not want to go below that. After all, you pay up to 2.5% of your corpus to your fund manager.

The fund managers need to get their trustees’ approval before finalizing a benchmark index for equity funds.

Does it matter?

Let’s say, you invest in a scheme and it returns 50% in 2010. How do you decide whether the performance is good or bad? Here’s where your benchmark index comes in.

Every time you open your fund’s fact sheet, you will get a snapshot of your fund’s performance over various time periods. You also get to see your benchmark fund’s performance across the same time periods. Your first check point would be to compare your fund’s performance with that of its benchmark index.

Although, typically, funds do not prefer to veer too far from their benchmark indices, especially in falling markets, they venture away to find stocks that may not be there in your benchmark index but those that your fund manager believes would do well.

“A benchmark index defines the universe of stocks in terms of market capitalization. It, therefore, defines the characteristics of a fund," says Kenneth Andrade, head (investments), IDFC Asset Management Co. Ltd.

There’s another reason why your fund’s benchmark index matters. Usually, we compare a fund’s performance with other funds. However, comparing a fund’s performance with that of the one having a different objective or strategy may give you a wrong picture. You need to compare apples with apples. For instance, Fidelity Equity Fund (FEF) and DSP BlackRock Top 100 (DT100) are both large-cap equity funds. But the former can invest in scrips across market capitalization, while the latter sticks to the top 100 scrips by market capitalization. FEF’s benchmark index is BSE 200, while DT100 benchmarks itself against BSE 100 index.

What really happens

Although fund managers swear by benchmarks and place a lot of importance on them, in reality, there is a disconnect between funds and their benchmark indices. Many mid-cap oriented and large-cap oriented funds have the same benchmark indices. Largely, there are three problems with this.

First, many funds invest in scrips across market capitalization. Different schemes in this space have different benchmarks. For instance, UTI Opportunities Fund is benchmarked against BSE 100, while Fortis Opportunities Fund is benchmarked against BSE 200. Not just benchmarks, they also differ in style. While the former is large-cap oriented, the latter is mid-cap oriented, as per MF tracker Morningstar classification. Says a fund manager, on conditions of anonymity: “Most multi-cap funds benchmark themselves against indices such as BSE 100 or BSE 200 as no benchmark index truly captures their style. The relevance of benchmarks in this case, where funds are so dynamic, goes down."

Dhirendra Kumar, CEO, Value Research, a mutual fund tracker, adds: “A large-cap fund that invests 15% of its corpus in small-cap scrips drastically adds risk." Such funds, Kumar says, can outperform the Sensex in rising markets, but underperform in falling markets.

Second, some MFs that were launched seven to eight years ago started off their diversified equity funds then. As the industry grew and launched funds with sharper focus, such as dedicated large-cap or dedicated mid-cap funds, many older schemes sharpened their focus, too. They, however, stuck to their old benchmarks. SBI Magnum Global Fund, which started as a diversified fund, has turned into a mid-cap fund, but continues to be benchmarked against BSE 100, an index that is typically used by large-cap funds as a benchmark.

Third, experts doubt the capability of benchmark indices themselves. Kumar feels that beating the benchmark is not as great an achievement as it ought to be. “For instance, not all globally competitive companies and businesses are present in the Sensex yet. On the other hand, the 30 shares in the Dow Jones index of the US are all globally competitive businesses," he says.

What it means for you?

It’s good to have a benchmark index to get a broad sense of how your fund is performing, unless it’s a thematic or a sectoral fund. These funds are too concentrated and, therefore, benchmark indices are useless.

However, even if you’re invested in a diversified fund, don’t get too elated to see your fund outperforming its benchmark index. While consistent underperformance across market cycles are red flags, it’s better to check your fund’s performance against similar peers.