Widely read:
Do you remember the exam system in school and college where you had to score a minimum of 35 to pass an examination? The more you got, the more intelligent you were. The passing mark—whether it is 35 per cent or 40 per cent—is the benchmark that a student has to cross.
Fund managers too have such a test to pass. Take the case of a fund manager who generated a return of negative 16 per cent in the past three months and was happy with his performance. Before you begin to doubt his intelligence or run to withdraw your money from his fund, please understand that the fund manager has a reason to be satisfied—he surpassed his benchmark.
Let us now understand what benchmarking means and see why it can make your investments look better, or worse, at different times. The returns of mutual funds—or other financial instruments—are measured with reference to a benchmark. A benchmark is a frame of reference, a context and a standard that allows us to check whether the performance has been good or bad. To comprehend the concept of benchmark better, you must know what a fund manager's job is.
A fund manager is not paid because he or she generates 15-25 per cent returns. Managing money isn't all that tough. You could close your eyes; invest your money proportionally in the 30 scrips representing the BSE Sensex and go to sleep. And when the market rises, your returns will rise too. This is a passive approach which index funds follow. All other mutual funds are actively managed. The basic job of a fund manager is to administer funds in such a way that over a period of time the fund can deliver higher returns than the underlying market. This necessitates taking decisions about sectoral exposure and which stocks to pick. It entails understanding how a particular sector and its scrips will perform and the upside as well as the downside.
Fundamentally, this involves studying the past performance and forecasting the future performance of companies to gauge how the market will price their shares. Overall, this exercise is carried out within a framework of how much risk a fund is willing to take for earning a particular return.
As a representative of the market, the fund chooses a benchmark. This will be an index, whose composition is in accordance with the fund's objectives. Obviously, the benchmark will be backed by a reputed organisation, which will make changes in the index in line with the market needs. Thus, many equity funds select the BSE 200 as their benchmark. These equity funds will then seek to generate returns superior than the benchmark. So, as the fund manager strives to beat the benchmark, investors too must track the fund's performance in this context. Absolute returns are of no consequence while judging the performance of a fund manager.
We hope now you are in a better position to understand the behaviour of a fund manager who has lost 16 per cent. The performance of his investments was better than the benchmark, which in fact lost about 22 per cent. So, when you read headlines screaming funds have performed poorly and this is with reference to negative returns, take it with a pinch of salt. Check the performance against the benchmark. If the fund has fallen more than the benchmark, then you have a reason to worry. Also, if it didn't rise more than the benchmark when the market has had a good run, feel sad. And if this performance repeats over a reasonably long period, feel angry and look at another AMC.
Remember, in the end basically it is all about relative performance.
This article was originally published on April 26, 2003.
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