How to Benchmark Passive Investment

Have you ever thought about how you can compare your ETF portfolios? Comparing your ETFs with a standard gauge performance to have similarity with your investment objectives is a crucially important task. This article sets the scene, underscoring the necessity to compare and give valuable insights for investors in benchmarking ETFs.

Relative Performance Analysis

It is important to know how well your investments perform on an index. If you are failing to keep pace, fear not - all you need is some well-informed analysis. Relative performance analysis tools are handy when comparing different mutual funds or ETFs since they enable users to understand how their stocks compare with others available in the market.

If looking at an actively managed ETF, think about comparing its performance with a passive mutual fund or ETF based on a mid-cap benchmark, such as the Nifty Midcap 150 TRI. Is there any evidence suggesting that the active fund has always done better than the passive one? This will help you determine whether its cost justifies extra returns or additional risks connected with investing in instruments.

Comparing your portfolio to an index like the Nifty 50 is just like considering consistency and return simultaneously as factors of risk. One of the ways that investors compare their returns and risks against those from other assets is by considering how much their behaviour is related to the general market fluctuation known as beta. For instance, if its beta is 1.0 then that implies investment is moving at the same rate as the market does.

It said that the index is more volatile than the portfolio. It’s like this, out of the Nifty Midcap 150 TRI’s 80% gain, you captured 70% with a beta equal to 0.7; in other words, you have delivered good results with lower risks. Therefore, whenever a beta value is less than one, it implies that the involved investment’s movement is less than market activity but goes up higher when it drops below this point. Therefore, familiarising oneself with betas for your portfolio allows you to know its risks should there be any modifications in the markets.

Commonly Used Benchmarks in India

S&P BSE 500 TRI: Bombay Stock Exchange Limited constructed an index, consisting of 500 scrips w.e.f. August 9, 1999. The BSE-500 index represents nearly 93% of the total market capitalization on the BSE. BSE-500 covers all 20 major industries of the economy.

NIFTY Midcap 150 TRI: Nifty Midcap 150 represents the next 150 companies (companies ranked 101-250) based on full market capitalisation from the Nifty 500. This index intends to measure the performance of mid-market capitalisation companies. The Nifty Midcap 150 Index is computed using the free float market capitalization method.

NIFTY Smallcap 250 TRI: Nifty Smallcap 250 represents the balance of 250 companies (companies ranked 251-500) from the Nifty 500. This index intends to measure the performance of small market capitalisation companies. The Nifty Smallcap 250 Index is computed using the free float market capitalisation method.

Active Vs Passive ETF

Index funds or put simply, ETFs are passively managed funds that mirror the performance of the specific benchmarks of several companies as stated by the asset allocations they have set. On the other hand, you find that actively managed funds involve making investment decisions to outperform benchmarks by fund managers themselves. Precise comparison of performance may only be possible with the correct choice of benchmarks within active ETFs even though they outshine index counterparts through better returns.

Advantages and Disadvantages

Setting an investment benchmark for an ETF offers numerous benefits to both investors and fund managers:

1. Provides a standard for evaluating ETF performance, guiding strategic decision-making.
2. Determines portfolio allocation and diversification, aiding investors in navigating the investment landscape.
3. Enhances communication and transparency between fund managers and investors by clearly conveying investment goals and strategies.

However, there are limitations to consider when setting an ETF benchmark:

1. Benchmarks can be inflexible, failing to adapt to evolving market conditions.
2. ETFs with innovative strategies or a focus on emerging markets may prove more volatile than the benchmark.
3. Benchmarking may not cover all risk implications, such as liquidity risk, tracking error, and market impact, potentially leaving investors unaware of certain pitfalls.

Example

Consider the following portfolio -

Let’s take hypothetical results

On a weighted average basis, the portfolio had a return of 5.45% for this hypothetical period versus a weighted average return for the blended benchmark of 6.40%. This type of analysis should be done for various periods such as the trailing quarter, year, three years, five years, ten years, etc. For a short period, underperformance might not reveal much, but over extended periods, underperformance might indicate a trend.

Conclusion

A benchmark is important because it tells you how your investments are doing relative to others, comparing them across whole portfolios or with just one asset. For ETFs, the index or sector they follow determines the standard by which they are measured. Passive ETFs are intended to replicate what is happening to benchmarks; conversely, their active counterparts work towards surpassing them.