12.3 Basis of Choosing an Appropriate Performance Benchmark

The Criteria

A benchmark is fit for purpose when it satisfies several conditions simultaneously.

It must match the mandate

The benchmark must reflect what the scheme is required to invest in:

A mismatch in any of asset class, market capitalisation, duration, credit quality or geography produces a comparison that measures the mismatch rather than the manager.

It must be investable

An investor must in principle be able to buy the index through a passive vehicle. A benchmark that cannot be replicated is not a genuine alternative, and comparison against it is meaningless.

It must be independently published and rules-based

The index should be constructed and maintained by an independent index provider according to published, objective rules covering constituent selection, weighting and rebalancing. An index whose composition can be adjusted at someone's discretion is not a benchmark; it is an opinion.

It must be transparent

Constituents, weights and methodology must be publicly available so that the comparison can be examined.

It must be consistently applied

The same benchmark, applied across periods, on a total return basis. Changing the benchmark mid-stream and presenting a continuous performance series conceals the change.

How SEBI Removed the Discretion

Under the two-tier framework, Tier 1 benchmarks are prescribed at category level and AMFI publishes the list. An AMC therefore cannot choose a flattering index for its large cap scheme; every large cap scheme is measured against the same one.

Tier 2 remains at the AMC's option and reflects its particular strategy within the category. Because it is chosen rather than prescribed, a Tier 2 benchmark deserves the scrutiny that Tier 1 no longer requires: is it a genuine description of the manager's approach, or an index the scheme happens to beat?

What Goes Wrong with a Mismatched Benchmark

Illustration. A scheme mandated to invest predominantly in mid caps is benchmarked against a large cap index. In a year when mid caps return 26% and large caps 14%, the scheme returns 24%.

• Against the large cap index, it appears to have outperformed by 10 percentage points
• Against a mid cap index, it in fact lagged by 2 percentage points

The apparent outperformance came entirely from the capitalisation mismatch. No skill was demonstrated, and in fact the scheme trailed its true opportunity set.

This is why benchmark appropriateness is examined as a topic in its own right, and why the standardisation of Tier 1 mattered.

Composite Benchmarks for Hybrid Schemes

A hybrid scheme needs a benchmark blending its mandated proportions — for example an index composed 65% of an equity index and 35% of a debt index for an aggressive hybrid scheme. The blend should reflect the mandated allocation. Where a scheme's actual allocation drifts materially from the blend, the comparison weakens, which is one reason dynamic asset allocation schemes are difficult to benchmark meaningfully.

Changes of Benchmark

A change must be disclosed and explained. Legitimate reasons include:

• A change in the scheme's category following a regulatory redefinition
• Availability of a better-constructed index for the segment
• Alignment with the prescribed Tier 1 benchmark for the category

The illegitimate reason is switching to an index the scheme has been outperforming. Because the change must be disclosed, it can be identified — but only by someone who reads the disclosure. A distributor reviewing a scheme's long-term record should check whether the benchmark against which it is presented has been constant throughout the period shown.

Who Builds the Benchmarks

Indian equity and debt benchmarks are constructed by specialist index providers — principally the index subsidiaries of the two exchanges — which publish a methodology document for every index and operate an index policy committee that applies it. Three construction features matter when judging whether a benchmark is appropriate:

• Weighting. Most broad Indian equity indices are weighted by free-float market capitalisation, meaning only shares actually available for trading count, not promoter or locked-in holdings. A scheme that weights positions by conviction will therefore diverge from its benchmark even when it holds identical stocks.
• Periodic reconstitution. Constituents are reviewed on a published cycle and changed according to objective eligibility rules. Because the review is scheduled and announced, the benchmark's composition is knowable in advance — the opposite of a discretionary list.
• Capping. Sector and thematic indices commonly cap individual constituent weights so that a single dominant stock does not become the index. Where a scheme is prohibited from taking positions the index carries uncapped, tracking will diverge for structural rather than skill-related reasons.

The Benchmark Risk-o-Meter Test

Since the risk-o-meter of the benchmark must be disclosed alongside the scheme's own, appropriateness can be checked without any calculation. If a scheme sits at Very High and its supposed benchmark sits at Moderate, the two are not describing the same opportunity set, whatever the category label says.

A Four-Question Check

Before accepting a performance comparison, ask:

1. Is the benchmark the prescribed Tier 1 index for the scheme's category?
2. Is it stated on a Total Return basis?
3. Has it been the same benchmark throughout the period presented?
4. Do the risk-o-meter readings of scheme and benchmark sit close to each other?

A comparison that fails any one of these is not evidence about the manager. It is evidence about the comparison.