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For Mutual Funds 'Total Return Index' Is The New Benchmark

As you are aware, mutual fund schemes benchmark the returns generated, against the performance of the index. For example, a large cap fund would compare its performance with that of the Nifty 50 or the BSE Sensex. Likewise, a mid cap fund would benchmark itself against say Nifty Midcap 100.

The idea is to inform the investors, whether the fund managers have been able to beat the markets or not... and if so by how much. This out-performance is known as alpha.

Reason to do so is pretty simple and straightforward:

Only if the fund manager is able to deliver higher returns than the market — i.e. create meaningful alpha — would you invest in such a scheme. Else, you might as well invest in a low-cost index fund and earn returns equivalent to the markets. Why pay a fund manager, if s/he can't offer something extra?

The question, however, arises whether
a) the benchmark chosen for comparison closely corresponds to the nature of mutual fund scheme; and
b) whether the benchmark returns have been correctly calculated or not.

It is obvious that you cannot compare apples with oranges i.e. you cannot compare the performance of a large cap fund with a Midcap Index. It won't give you the correct picture about the performance of the scheme.

Though this point about comparing like-to-like is clear and transparent, there have been instances where the wrong benchmark has been used.

SEBI, vide its latest circular 'Benchmarking of Scheme’s performance to Total Return Index' dated Jan 4, 2018, has stipulated that "Selection of a benchmark for the scheme of a mutual fund shall be in alignment with the investment objective, asset allocation pattern and investment strategy of the scheme."

This, of course, is the minor point of the aforesaid circular.

As the subject of this circular indicates, the main purpose is to benchmark the scheme’s performance to the Total Return Index (TRI).

Let's understand this (relatively) less prevelant concept of TRI proposed by SEBI.

Presently, most of the mutual fund schemes use "Price Return variant of an Index (PRI)" as the benchmark returns. This PRI captures only the capital gains generated by the given index (i.e. the gains in the share prices of the companies that comprise that index).

For example, if Nifty 50 has gone up from say 8,000 to 10,000 in 3 years, the average annualized return of the market works out to 7.72% p.a. This is also known as the CAGR (or Compounded Annual Growth Rate).

SEBI's logic, and rightly so, is that this simple calculation of the increase in value of index DOES NOT account for all the dividends and other payments that the shareholders "additionally" received from the underlying companies during this period.

How to compare the mutual fund's performance vis-a-vis the index.

Whereas the NAV of the mutual fund — which is used to calculate the returns of any mutual fund scheme — INCLUDES even the dividends and other payments received by the scheme.

Consequently, comparing the returns of a given scheme with PRI is not correct (one includes the dividends and the other does not).

Therefore, as per SEBI "Total Return Index (TRI) is more appropriate as a benchmark to compare the performance of mutual fund schemes." TRI will include both the capital gains and other receipts such as dividends and other payouts.

Since the logic is quite simple and clear, I will not go into the mathematics stipulated by SEBI in its circular. That's not really relevant.

What is more relevant here is: whether this concept of TRI or Total Return Index rightly helps us to make more meaningful comparison, and thereby choose our funds in a better manner or not.

Here's what Mr. Nilesh Shah, Managing Director, Kotak Mutual Fund had to say on this subject.

Logically, TRI is correct from an investor's point of view.

Practically, however, there are issues with TRI too. If PRI was not a perfect benchmark, then even TRI is not one.


... fund managers have to keep a small percentage of corpus as cash, but indices don't
... indices can include or exclude a stock in a day, but fund portfolios cannot do so
... there is no impact cost for indices for stock adjustments, mutual funds have to bear this cost

As we can see, we are moving from one imperfection to another.

Earlier, the PRI (Price Return Index) OVER-STATED the performance of the mutual fund scheme vis-a-vis the index.

Now, the TRI (Total Return Index) will UNDER-STATE the performance of the mutual fund scheme vis-a-vis the index.

Besides, dividends form a very small percentage of the total returns. So, adding them is not going to make any significant difference to the total returns.

Historical data shows that the index returns based on TRI have been around 1.5% more than the index returns calculated on PRI basis. So, all this discussion is about a mere 1.5% difference.

Moreover, frankly speaking, as a mutual fund advisor I have NEVER compared the performance of a mutual fund scheme with the index.

Instead, I have ALWAYS relied on the peer group comparison, to select the funds where I would put MY MONEY (and of those whom I advice). And, of course, various other factors such as portfolio characteristics, risk parameters, consistency of performance, fund size and much more, to determine which are the best mutual funds to buy.

In short, all this shift from PRI to TRI is just a minor change and can be well ignored.

For your information, these guidelines are effective from Feb 2018.

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