The obvious need is to compare the performance of the fund against an indicator
When measuring performance, there is always a need for a yardstick or an indicator to gauge the performance. Mutual funds are no different, where every fund scheme has a benchmark that it follows to showcase its performance. Normally, the benchmark is an index made of securities against which the fund’s performance is benchmarked. There are benchmarks like the popular S&P BSE Sensex, the CNX Nifty and so on those are used frequently.
There is also benchmark in case of debt instruments such as Crisil Bond fund index and Crisil Short Tem index and so on, when a fund invests in a portfolio of government securities rated corporate bonds. There is a certain mutual fund scheme that may have uniquely created indices, which clearly indicates how the performance of the funds will measure up compared to it.
Benchmark use: The primary need for a benchmark is to know how the fund has performed compared to it. So you have funds that beat the benchmark, funds that underperform the benchmark and some that just about match the benchmark performance. For a fund to beat its benchmark, it has to invest in securities that are able to achieve a superior return compared to the benchmark. This is possible by investing in securities that are not in the benchmark or by following a different allocation to the benchmark universe. For instance, a fund with Nifty as the benchmark is not restricted to invest in the Nifty constituents in the same proportion as the index.
Benchmarks are also useful to compare funds that use similar benchmarks for meaningful peer comparison. This way mutual fund can lay claim to being a better performer compared to a peer because it manages to outperform the benchmark better. These are just some of the benefits of knowing and using benchmarks when investing in mutual funds. The performance of the fund you wish to invest in compared to its benchmark will indicate how the fund does over different market cycles for you to make up your mind to invest.
While benchmark as a performance indicator is a good idea, do not be blinded only by how much more the fund has earned over the benchmark in a rising market. You should also check how the fund does when the markets are down, because that will give a balanced view on the fund performance during market downturns. The only instance when you need to definitely know how the fund is faring compared to the benchmark is in the case of exchange traded funds or ETFs, which actually imitate the benchmark index even in weightage and allocations, which gives a clear picture of how the investment in the ETF compares to the benchmark.