Benchmarks are important for equity investment. If you buy exchange-traded funds (ETFs) or index funds, you want to know how closely the fund reflects the benchmark index. If you buy an active fund, you want to find out whether the fund consistently outperforms the benchmark index. In this article, we discuss how the benchmark you choose should change depending on the goals you are investing for.
target criteria
You should first decide your benchmark and then choose a suitable fund based on that. The benchmark you choose should represent all or a substantial proportion of the market capitalization of a stock listed on an exchange. Why? Your objective of investing in equities is to improve the expected return on your goal-based portfolio.
If you invest all your savings in bank deposits, your savings should be sufficient to achieve your goal, considering the diminishing returns.
By allocating some of your savings to equities, you can increase the expected return on your portfolio.
Note that you are betting on equities as an asset class, not on individual sectors or styles. Therefore, a fund that is the benchmark for a broad-cap index will suffice.
The logic is the same, whether you are pursuing the goal of buying a home or funding your child’s education during your working life. Hence, your choice of benchmark is not dependent on your life goals.
Your preferred benchmark should be NSE 500 index, broad-cap index or S&P BSE 500 index.
If broad-cap funds are short on a benchmark, or don’t like such funds, you can consider large cap funds benchmarked to Nifty 50 or BSE Sensex. This is because a large-cap index occupies a substantial proportion of the market capitalization of all stocks on an exchange.
Your investment life spans from the time you start investing till you are alive. You generally take on more risk when you’re young, and even less after retirement, than when you’re nearing retirement.
Still, during your investment life, you should invest in equities. You can choose how much to invest in equities and not whether to invest in equities or not. As you age, your objective shifts from intermediate goals such as buying a home to eventually saving for retirement and then fulfilling life post-retirement. Your choice of benchmark should remain the same throughout your investment life. Why?
During your working years, investing in equities allows you to free up cash flow in excess of your monthly income to meet your current consumption. This is because of the higher expected return on equities as compared to bonds. During your retirement, the higher anticipated return on equity can help offset inflation-related stress on your cash flow; Higher inflation can mean higher healthcare and living expenses.
Therefore, whether you are an executive officer or retired, you want to invest extensively in equities to get high returns. Note that the benchmark of your choice is independent of whether you choose a passive fund or an active fund.
Conclusion
Your equity allocation is a primary driver for increasing the expected return of your portfolio. The next important driver is your benchmark of choice.
In the end, it is your choice whether to invest in an active fund or a passive fund for your goal-based portfolio. The more important your goal, the more should be your inclination towards passive funds.
Remember this: The fund that outperforms its appropriate benchmark depends on the skill and luck of the portfolio manager. You also need skill and luck to choose a suitable active fund!
(The author provides training programs for individuals to manage their personal investments)
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