A hybrid fund benchmarked to a 65/35 equity-debt index runs only 45% net equity by hedging with arbitrage positions. It lagged by 3% in a year the equity market rose 25%. Is that underperformance or benchmark misfit, and what benchmark would be fair?

It is benchmark misfit, not underperformance. Holding 45% net equity instead of 65% explains about 3.7 points of lag in a year equity rose 25%. Against a fair benchmark matching its real exposure, about 15.0%, the fund's 15.7% is about 0.7 points ahead. The fair benchmark is a hybrid index with roughly 45% equity, which is how a dynamic asset allocation fund behaves.

Imagine a cautious driver judged against a racing driver's lap times. He will always look slow on a clear track and brilliant in the rain, and neither result says much about his driving. A benchmark is only a fair judge if it takes roughly the same risks as the fund; otherwise it measures the difference in risk, not the manager. Samyukta's fund is labelled against a 65/35 index but behaves like a fund with 45% equity. In a year the equity market rose 25%, the label alone guaranteed a lag.

Build a benchmark that holds what the fund holds: 45% equity at 25%, 25% arbitrage at 6.5% and 30% debt at 7%. That fair benchmark returns 15.0%, so the exposure gap explains 3.7 points of lag, more than the whole 3 points. The fund's 15.7% is about 0.7 points ahead of what its own exposure would have earned passively, so the manager's stock and bond choices added value. One year is a small sample; the point is the method, not a verdict on skill.

Run the same fund through a year when equity falls 20%. The 65/35 benchmark returns -10.55%, while the fair benchmark returns -5.28%. With the same manager skill, the fund returns about -4.6% and beats its label benchmark by 6.0 points, praise it has not earned any more than it earned this year's blame. A misfit benchmark cuts both ways, so distributors who drop the fund now would be the same ones adding it after the next fall, at the wrong moment each time.

Why would a fund hold 70% gross equity but hedge a third of it? Often to stay inside a category's equity floor, which also affects how the fund is taxed, while running a cautious portfolio. Check the scheme information document and the current category and tax rules rather than assuming them. The fair yardstick is a hybrid index with roughly 45% to 50% equity, which is how dynamic asset allocation funds are usually benchmarked. Tell the distributor the fund is doing what its holdings imply and doing it slightly better than passive; the problem is that it is shelved next to aggressive hybrids. Keep it, but present it to clients as a moderate-risk fund, and ask the AMC whether the stated benchmark should change.