SEBI Introduces New Structure for Benchmarking Mutual Funds: How Will it Help Investors?

The Association of Mutual Funds in India (AMFI) will soon notify the indices to be followed by asset management companies as first tier benchmarks. It will also notify the indices to be used by open-ended debt mutual fund schemes as their first-tier benchmark, based on the Potential Risk Class Matrix. The second-tier benchmark is optional and can be decided by the asset management company. All the benchmarks should necessarily be Total Return Indices (TRI) .

For instance, every large-cap mutual fund scheme will have the broader large-cap market index such as Nifty 100 - TRI or S&P BSE 100 - TRI as their first-tier benchmark. The large-cap scheme can decide the second-tier benchmark which they feel best represents their investment style/strategy. So, if a large-cap fund invests only in top 50 large cap stocks, it could have Nifty 50 - TRI as its second-tier benchmark.

Similarly, for debt mutual fund category, all the funds in the Ultra Short Duration category will have Nifty Ultra Short Duration Debt Index or CRISIL Ultra Short Term Debt Index as first tier benchmark. And if an Ultra Short duration scheme invests predominantly in AAA rated securities it could have Nifty AAA Corporate Bond Index as second tier benchmark to indicate its investment strategy.

SEBI has prescribed the following guiding principles for other categories:

1) For hybrid and solution-oriented schemes there will be single benchmark. The benchmark will be a broad market benchmark wherever available or a customised benchmark will be created for schemes, which will then be applied across industry.

2) Thematic/Sectoral schemes will have a single benchmark as the characteristics of these schemes are already tapered according to the theme/sector. Index Funds and ETFs will also have a single benchmark as these schemes replicate an underlying index.

3) For Fund of Fund schemes investing in a single fund, the benchmark of the underlying scheme will be used. However, in case of Fund of Fund scheme investing in multiple schemes, the broad market index will be applied.

The afore-mentioned framework will come into effect from January 01, 2022.

How will investors benefit from the new benchmarking norms for mutual fund schemes?

As you know selecting the right scheme plays a key role in making your investment successful. SEBI's new rule is a positive move that can make this crucial step easier for investors.

Consider this, there are various schemes in the Mid-cap fund category. Some schemes are benchmarked against the Nifty Midcap 150 - TRI index while others have Nifty Midcap 100 - TRI as their benchmark. These indices have generated returns at 80% and 82.7%, respectively, in the last one year.

Now let us assume that two schemes Fund A and Fund B are benchmarked against Nifty Midcap 150 - TRI index and Nifty Midcap 100 - TRI, respectively. Both the schemes have generated returns of 85% each during the same period. But since Fund A is benchmarked against Nifty Midcap 150 - TRI index it has an outperformance of 5 percentage points over its benchmark, while Fund B has generated an alpha of around 2 percentage points.

Thus, depending on the performance of the index that a particular mid-cap fund is benchmarked against, the outperformance of a scheme can differ significantly making it look better or poor compared to its peers. Therefore, it may not be fair to compare the two schemes based on the returns that they have generated over their respective benchmarks.

A common first-tier benchmark can give investors a realistic picture of the performance of schemes within a category. Moreover, the optional second-tier benchmark will give an idea about the investment strategy/style as well as the asset allocation that the scheme will follow. This can make it easier for investors to select a scheme suitable to their risk profile.

Therefore, SEBI's move can potentially make it easier for retail investors to compare and select suitable schemes within a category.

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Warm Regards,
Divya Grover
Research Analyst

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