What is a Benchmark?

Stock markets

by Tanushree Jaiswal Last Updated: May 01, 2023 - 09:49 pm 2.3k Views
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A benchmark is basically a set standard metric against which something is measured. An investor can typically use a benchmark, like say the performance of an index, to gauge how the mutual fund or a bunch of stocks they may have invested in, have performed over a certain period of time, in relation to that benchmark.

Similarly, benchmarking can be used to measure the performance of other asset classes such as debt, real estate and even bullion, so as to ascertain whether a portfolio of assets has managed to beat the benchmark, perform in line with it or has performed poorly in comparative terms.  

Understanding Benchmarks

Any kind of a benchmark, such as an index, is created by bunching together various stocks, assets or any other instruments, whose collective performance defines the overall performance of the benchmark.

A case in point is the Nifty 50 index, which measures the performance of the stocks of the top 50 listed companies on the National Stock Exchange. These stocks are chosen on the basis of their market capitalization. Similarly, the other main market index, the BSE Sensex, includes the top 30 scripts listed on the Bombay Stock Exchange.

Typically, while creating an index or a benchmark, companies or assets of a certain defined type, or fitting into a certain criteria are chosen.

Equity Indexes

As stated above, the Nifty 50, which lists the top 50 Indian listed companies, was created by the BSE. On the other hand, the Sensex was created by the BSE. These are the two biggest exchanges in the country.

Internationally, the S&P 500, which indexes 500 of the biggest companies in the US by market capitalization, is perhaps the most prominent stock market index in the world. It was created by Standard & Poor's.

The other major US-based indices that are followed globally are the Dow Jones Industrial Average and the Nasdaq.

Indexes are typically based on specific metrics and valuation techniques that are used to filter and include their constituent elements.

Mutual fund investors often use these equity indices to benchmark the performance of their funds.

Apart from these broad based indices, are several sectoral ones like the Nifty Bank and Nifty IT indices, which gauge the performance of a basket of stocks in particular sectoral

Thematic indices include mid-cap and small cap indices as well as growth and value indices.

Fixed Income Indexes

While equity-based indices track the performance of specific baskets of stocks, yields of debt instruments like government and corporate bonds, treasury bills and debentures are tracked by fixed-income indices.

Investors typically use these debt investment instruments as a hedge against the volatility in the equity market. Moreover these instruments also help people generate steady and stable incomes over long periods of time.

Some of the most well recognized fixed income indices across the world include the Bloomberg Aggregate Bond Index, the Bloomberg Capital U.S. Corporate High Yield Bond Index, and the Bloomberg Capital U.S. Treasury Bond Index.

Commodity Indexes

Much like stocks and bonds, commodity indices measure the performance of a basket of commodities. These commodities could be connected thematically or not, depending on how the index has been prepared. Globally, the Bloomberg Commodity Index tracks more physical commodity futures across five sectors- energy, agriculture, livestock and industrial and precious metals.

How is a benchmark calculated?

As mentioned above, different indexes use different methodologies to their performances. These could vary from market capitalization as in the case of the Sensex and the Nifty to weighted averages of commodity prices and interest rate averaging in the case of others.

How to measure mutual fund performance against benchmark?

The performance of a mutual fund can be judged on the basis of whether it has underperformed or outperformed their benchmark index. Apart from measuring its performance against benchmark indices, mutual fund performances are also analysed by using metrics such as its NAV, which should ideally not fall more than that of its benchmark index.

Financial Ratios

Financial ratios are typically ratio based systems that are used to measure the performance of mutual funds. These financial ratios are themselves based on some sort of benchmarking index that could vary basis whether the fund is a large cap, mid-cap or a small cap fund.

The three most important ratios used while evaluating mutual funds are-

Alpha: This measures the difference between the expected return and the actual return given by a mutual fund over a given period of time. Alpha typically indicates the value addition a fund manager has made while generating a better than benchmark return.

Beta: This is a measure of the volatility of the mutual fund via-a-vis that of the benchmark to which it subscribes. This effectively measures the risk associated with the fund. A high beta indicates higher risk, while a lower beta indicates lower risk. A Beta ratio of more than one is considered risky while that below one is considered less risky.

R-squared: This is a ratio whose value goes from 0 to 100. It represents how well correlated the fund’s performance is vis-a-vis its benchmark. 0 indicates no correlation while 100 indicates maximum correlation.

FAQs

Is the S&P 500 a good benchmark?

The S&P 500 is one of the best known and most followed indices across the world. It captures the performance of the top 500 US stocks by market capitalization. As such, it captures a large part of the performance of the biggest capital market in the world.

So, by that count, not only is it an extremely important index, but is also a veritable gauge of the performance of the US market.

What is the best stock benchmark?

Different benchmarks measure different aspects of a stock market. So, it is not possible to point out the best stock benchmark. In the Indian context, the NSE Nifty 50 and the BSE Sensex are two of the broadest indices that offer the best gauge to measure the performance of the stock market.

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About the Author

Tanushree is a seasoned professional with 6 years of experience in the Fintech and Edtech industry.

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