While selecting any mutual fund for investment, how could we gauge if it is performing well or not? We use benchmarks to give its performance some perspective as the returns of the benchmark provide a base for comparison. The benchmark returns also act as a hurdle rate that fund managers are expected to overcome. And the returns in excess of the benchmark are generally referred to as ‘Alpha’. We can say that the fund is performing well if it manages to beat its benchmark for that particular period and we can gauge how much better, by reviewing the Alpha. According to SEBI, each fund is mandated to associate itself with a specific benchmark, which is decided as per the strategy that the fund follows.
Historically, most fund houses used the Price Return Index as a benchmark for their schemes. In January 2018, SEBI issued a circular making it mandatory for fund houses to benchmark a scheme’s performance to the Total Return Index (TRI). As a result, now all funds have to follow the TRI benchmark, with effect from February 01, 2018. So, let’s take a closer look at these indices - PRI & TRI.
PRI captures only the changes in the prices of constituents of the benchmarking index. It thus includes only the capital appreciation and ignores the dividends paid by the companies, which form part of the index. Mutual funds include dividends in their NAVs. Following the PRI, therefore, was misleading for investors to the extent of the dividends paid in the benchmark.
TRI takes into account the capital gains as well as all dividend payments that are generated from the basket of constituents that make up the index. It is assumed that the dividend receipts are reinvested into the index. Hence, TRI is more appropriate as a benchmark for comparison with the performance of mutual fund schemes.
To understand the actual difference between both, let us consider the example of the S&P BSE Sensex. The table below shows how the two compare -
|1 Year||3 Years||5 Years|
|S&P BSE SENSEX||9.93||12.11||11.77|
|S&P BSE SENSEX – TRI||11.27||13.60||13.33|
Source: ACE MF Data as on Dec-04-18
Over 5 years, the S&P BSE Sensex delivered a CAGR of 11.77% and the S&P BSE Sensex-TRI generated a CAGR of 13.33%. The additional 1.56% CAGR is because of the dividend declared by the constituents of the index. To illustrate further, in 5 years, Rs 1 lakh will become Rs. 1.87 lakhs as per the TRI benchmark whereas with the PRI benchmark, the same will become Rs. 1.74 lakhs. The difference of Rs. 13,000 is attributed to the dividends that the index constituents have declared in these 5 years.
The table below shows the benchmark returns of large, mid & small cap categories. It can be observed that the large-cap category is the most affected by benchmarking against TRI as the difference in PRI & TRI is the highest in the large-cap category.
|1 Year||3 Years||5 Years|
|NIFTY 100 - TRI||6.53||13.38||14.32|
|Nifty Midcap 150||-9.02||12.09||20.30|
|Nifty Midcap 150 - TRI||-8.28||13.11||21.61|
|Nifty Smallcap 250||-23.62||5.21||17.44|
|Nifty Smallcap 250 - TRI||-22.94||6.14||18.58|
Source: ACE MF & NSE Data as on Dec-04-18
A fund manager’s performance is judged by the alpha that is generated by the fund. Alpha is the return over and above the return of the benchmark. With applicability of TRI, the returns of the benchmark have gone up, raising the bar for the fund managers. If we continue with the example of S&P BSE Sensex, for a 5-year duration, the fund manager will now have to generate a return higher than 13.33% as against 11.77% in order to outperform the benchmark. The alpha generated by the fund manager will be reduced to the extent of the difference in returns of the TRI & PRI. For e.g., let us say a fund was generating an alpha of 3% a year, that outperformance will now come down to 1.44% with TRI.
Benchmarking mutual fund performance against an appropriate market index is necessary. Globally, mutual funds are benchmarked against TRI as this gives a true indication of how well a fund is managed. It will provide investors with a correct picture of a fund’s performance against the benchmark. Thus, investors will benefit from the adoption of the TRI benchmark.
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