Alpha is the excess return a portfolio generates over an “appropriate” benchmark. An “appropriate” benchmark means a fund’s alpha will be useful for evaluation only if it holds stocks from the chosen benchmark. Regulation allows large-cap funds to invest not more than 20% in stocks outside of the benchmark. So, comparison of a large-cap fund’s performance to its benchmark may not be technically meaningful. Previously in this column, we discussed why a blended benchmark (say, 80% large-cap and 20% mid-cap index) may be optimal. Such blended benchmarks are not easy to create for individual investors. In this article, we discuss when it is acceptable, though not necessarily accurate, to compare large-cap fund performance to its large-cap benchmark.
Relative performance
Relative performance is important for active funds. This relative performance works at two levels. At the first level is the comparison of the fund’s performance with its benchmark index. This determines the fund’s alpha. Is the fund true to its benchmark? If not, it is preferable to create an appropriate benchmark to evaluate the fund. At the second level is peer comparison. How has the fund performed relative to its peers in the large-cap style universe? It is this comparison that we discuss below.
Enabled by the SEBI regulation, most large-cap funds invest in mid-cap stocks within the 20% limit. But the decision to invest outside the benchmark is choice of a fund manager. A fund manager will invest in mid-cap stocks only if she believes that mid-caps will outperform large-cap stocks. So, choosing to invest outside the benchmark is an active decision. This decision can result in positive alpha, which is function of both skill and luck. Hence, comparing a fund’s alpha with its peers without adjusting for the outside-benchmark investment may be acceptable.
Conclusion
It is accurate to evaluate a large-cap active fund using an appropriate blended benchmark.
The argument is that the fund must have outperformed the benchmark despite carrying similar risk. This argument is meaningful if you are investing in large-cap funds to achieve your life goals. Why? Exposure to mid-cap stocks can be risky.
A blended benchmark can help you understand how strongly the fund’s returns are related to the mid-cap stock performance.
When you are investing surplus cash in a large-cap fund, it is more practical to use the given benchmark, as the primary objective is to earn consistently higher alpha returns compared with peers.
(The author offers training programmes for individuals to manage their personal investments)
Published on March 16, 2026