Last Updated on October 8, 2023 at 1:48 pm
I received this interesting question from R Siva Prasad: “Sir, While selecting/screening a mutual fund, you advise to compare it with benchmarks. But I want to compare with Mutual Funds in the same category. As long as my fund is on top in the category why do I have to think about the benchmark? And if a mutual fund is beating its benchmark, but not top in the category, how can I choose it. Anyway, the benchmark is for the AMC to justify their returns. But as an investor, I have to see the top of the category. Am I right Sir?”
“Am right?” Unfortunately, it is not a simple Y/N and how the comparison is made (either wrt benchmark or category “peers”) is important and that is what we shall discuss in this post.
Comparing a fund with a benchmark
Here the comparison is between an actively managed portfolio (the fund) and a passively managed one (the benchmark or the index). Naturally, the fund house will not only choose a benchmark that is easy to beat but also at every available opportunity, show the world the “excess returns” their fund has obtained wrt the index.
From the investor’s point of view, such a comparison is essential because of expenses involved. Over time, fund management expenses can compound to a huge amount. Therefore, if a fund (or most funds in a category) is unable to “beat” a benchmark in terms of return and risk, then I might as well invest in the index itself.
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For example, the Nifty Next 50 index is amusingly hard to beat in term or returns (pretty easy in terms of risk) and therefore it is a benchmark Index that no mutual fund seems to use! You can use the monthly screeners to hand-pick the very few funds that have beat Nifty Next 50 on both counts.
As an investor, before I compare a fund with a benchmark, I need to ask if the benchmark is relevant. That is, does it have the kind of stocks the fund will invest most of the time.
As a first step, the benchmark chosen by the AMC can be used. An actively managed fund should consistently outperform its chosen benchmark where dividends assumed to be reinvested (total returns index). Then we can choose another benchmark which in our opinion that the fund ought to have outperformed.
Comparing a fund with its category peers
The first question to ask is, how justified is the categorization itself? We make the mistake of relying on Value Research, MorningStar, Moneycontrol or Crisil’s idea of binning funds in various categories. Unfortunately, most funds do not have a cap bias. We just think that they do. Practically all fund classifications are arbitrary. In the sense that the members in a category are not similar in the way they manage the portfolio.
So the notion of a “category peer” is arbitrary. It is only an opinion (so is the choice of a benchmark!).
Similarly saying that a particular fund is a category topper is also merely an opinion. Taking it seriously can be detrimental to mental health.
The second question to ask is, how should I compare category peers?
Whether we compare a fund with an index or a fund with another fund, the duration considered makes all the difference. I may be investing in a fund for the last 10 years and its last 3Y peer ranking maybe “25” while its peer ranking from the date of investment maybe say, “3”.
As an investor, we must be clear about the distinction between choosing a mutual fund and reviewing a mutual fund.
While choosing a fund we can use the last 3Y,5Y,7Y performance data wrt benchmark or peers. This is readily available in all fund portals.
However, while reviewing a fund that we currently hold the only comparison that makes sense to me is from the date we invested in. Most fund portals offer interactive graphs to enable fund vs index comparison from a specific date.
If you wish to make such a comparison with all funds in a category then you can try this tool: A Tool To Compare Mutual Fund Performance The Right Way! (a few funds may have changed categories. So tread with caution).
What should I do?
If you value your peace of mind, have a particular goal and a specific rate of return for that goal, then all you need is to compare the fund with a benchmark. Nothing beneficial could come out of a category comparison, imo.
If your return expectations are low, you may not any comparison! Unless something is seriously wrong with your fund.
This picture nicely sums up the troubling with comparing one fund with another.
If you must compare funds, then I would suggest that at least switch out completely. That is if you find a “better” fund that than the one you currently hold, completely shift to the new fund. So that after a couple months you can find that you old fund is now better!
If you must compare fund, at least have a fairly relaxed comparison rules (top 125 instead of top 5). Else your portfolio would either be a mess or you would be switching funds as often as you invest.
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