Is it too early for the total return index?
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At the 4th edition of the annual Mint Mutual Fund Conclave, total return index (TRI) as a performance benchmark was discussed at length. Three asset managers benchmark the performance of their equity schemes against TRI of the underlying benchmark now. Should others follow?
At the conclave, G. Mahalingam, whole time member, Securities and Exchange Board of India (Sebi), acknowledged better transparency in the move by fund houses who have adopted TRI as a benchmark. However, some of the panellists also spoke about the practical impediments in making this change.
Unlike a price return index (PRI), which simply represents change in market value of securities, TRI also includes the value of dividends in equity and coupon payouts in case of bonds, for determining the return over a defined period. This is a more accurate benchmark for mutual funds as they also earn through these cash payouts, which get reinvested in the fund. While fixed income or debt indices are already published as TRI, in case of equity, the use of a PRI is more prominent in the domestic market. Using a TRI means that fund managers have to generate excess returns to cover cash payouts, and beating the price index alone won’t suffice.
According to Akash Jain, associate director, global research and design, S&P BSE Indices, “Benchmarking against a TRI is a widely followed practice in most developed markets for measuring performance of active funds and also for passive products such as ETFs.”
In the domestic mutual fund industry, Quantum Asset Management Company Pvt. Ltd started using S&P BSE 30 TRI as a benchmark for its Quantum Long Term Equity Fund from 2006; the other two asset management companies (AMCs)—DSP BlackRock Investment Managers Pvt. Ltd and Edelweiss Asset Management Ltd—have moved to this format in September 2017.
Given that the Indian equity market is not yet at peak efficiency in terms of price discovery and liquidity, the question raised is whether it is too soon to introduce a new concept without a very meaningful consequence for investors?
Is it premature to being in TRI?
Since Quantum AMC started using S&P BSE 30 TRI as benchmark more than 10 years ago, it’s hard to argue it is a premature change.
Quantum Long Term Equity Fund has delivered an annualised return of 15.17% since inception, till 31 August 2017, as compared to S&P BSE 30 TRI index annualised return of 11.46% for the same period. However, practical hurdles may act as a deterrent in its adoption.
According to Nilesh Shah, managing director, Kotak Asset Management Co. Ltd, “The disclosure itself is good for investors, but limitations should be considered. A fund holds cash while an index does not…adjustments for an index happen at the end of the day, but a fund incurs an impact cost. In emerging markets like India, there are frequent changes in index composition.... Moreover, dividend yield is not significant when compared to some developed market indices.”
In growing economies like India, the dividend yield for large companies is limited. Investor focus is more on earnings-growth led price appreciation. The dividend yield for S&P 500 Top 50 Index, as on September 2017 was 2.14% compared to 1.17% for Nifty 50 and 1.22% for S&P BSE 30. While developed market funds use TRI, some emerging market funds, managed by global AMCs, prefer to use PRI.
According to Vikas Gupta, chief executive officer and chief investment strategist, OmniScience Capital, “For many emerging market indices, values of TRI were not available and visible until a few years ago. For domestic indices too this data was not available in the public domain. In 2013, once S&P took over, we asked for TRI values for BSE indices; our study shows that many mutual funds are unable to create alpha when compared against a TRI.”
The relative disadvantages of holding cash and impact cost are not unique to using TRI; they are present even while benchmarking against a price index. Impact cost refers to the cost incurred in case of large transactions due to lack of liquidity in the market at that given point in time. It can be argued that using PRI is compensation for returns lost due to market inefficiencies. But should the return difference between TRI and its price index be ignored?
According to Jain, “For the last 1 year, S&P BSE 30 price index returned 12.3% compared to 13.7% for the TRI, which is significant for investors. PRI as a benchmark is, in a way, setting a modest target for active fund managers.”
The S&P Indices Versus Active Funds (SPIVA) India Scorecard, maintained by Asia Index Pvt. Ltd (A BSE and S&P Dow Jones Indices venture) shows that over the 1-year period ending June 2017, 53% of large-cap funds underperformed S&P BSE 100 TRI.
While fund managers deal with market inefficiencies, active management has flexibility in portfolio construction vis-a-vis a benchmark. For example, a large-cap fund with Nifty 50 or S&P BSE 30 as its benchmark can hold 15-20% in mid-caps. This enables excess returns when compared against a large-cap benchmark.
The debate between using PRI or TRI gets sharper after the recent Sebi guidelines on categorization of mutual funds. As scheme composition becomes more true to label, expectation is that excess return over the index for large-cap funds, specifically, can shrink.
Jimmy Patel, chief executive officer, Quantum Asset Management, said: “We found that using TRI was the right performance indicator for investors. A counter argument is that holding cash means that a fund loses on relative performance. But today many funds have high cash because of market valuations. This is the nature of active management. This doesn’t mean that we shirk our fiduciary duty.”
Kalpen Parekh, president, DSP Blackrock Investment Managers Pvt. Ltd, said, “Accuracy in showing relative performance is even more important now that appetite for equity investing...and return expectations are high.”
Mint Money take
Switching from PRI to TRI will make the job harder for equity fund managers; they will need to generate that extra return to continue maintaining a suitable alpha over the benchmark. What we know for certain, is capturing the price-plus-dividend return for a scheme and comparing it only with the price return of the index, falls short of being accurate.
Right now a minority in the industry uses TRI as a performance benchmark, so, it might seem premature. However, there is no material reason to not use it either. Till now the regulator has not intervened in this choice, so each asset manager is free to decide the level of performance disclosure it wants to adopt. At the same time, investors should be made aware of this difference in benchmarking performance.