Fund managers are not perfect. Whilst there are many who are looked up to as investing gurus on news channels, they are still susceptible to bad incentives.

One is caused by the benchmark that they measure their fund performance against. It is quite easy for a fund manager to say that their fund has outperformed the generic benchmarks such as the Nifty and the Sensex. But sometimes the stocks that have been invested in actually lie outside the basket of companies that are part of the Nifty or Sensex – meaning that you as an investor are taking on different risks and should accordingly expect different returns.

There are two things to look out for as an investor when thinking about benchmarking.

The first is why a certain benchmark has been selected for a particular portfolio. This is a bit easier when thinking about mutual funds because the rules quite narrowly define what stocks can be invested in certain categories of mutual funds. However, it is still very important to compare apples to apples. A good benchmark offers an investor the opportunity to correctly track the performance of a portfolio and see if an active fund manager is actually beating their stated benchmark.

The second thing to consider is the career risk that comes to the fund manager with benchmarking. Once a fund manager has his or her fund tied to a particular benchmark, it is typically the case that their bonuses and performance will be linked to that. For these fund managers, the risk of making a bad decision and a wrong investment can lead to a drop in their pay and possibly even put their careers at risk. 

It is much safer for a fund manager to closely track the defined benchmark with small changes here and there to the portfolio. This is called closet indexing – and it is the reason why you see the rise of passive investing. If a fund manager is hugging the benchmark, that means he will most likely get benchmark returns. However, after taking out fees, it means that he will underperform the market. This is why passive investing has been such a powerful trend – if you are going to get index fund returns, you might as well get them at the lowest cost.

When looking at actively managed funds, it is very important to understand the impact that the selection of the benchmark has on correctly identifying the risk and return of the fund and it is also important to check how different the stocks in the portfolio are from the underlying benchmark. Only then will you know if your actively managed fund is truly giving you alpha.