On 4 January, the market regulator Securities and Exchange Board of India (Sebi) issued a circular on the benchmarking of mutual funds. According to the circular, mutual funds are required to benchmark the performance of a scheme with the total return variant of the chosen index, also known as the total return index (TRI). Currently, most mutual funds use the price return variant of the index, or price return index (PRI) for benchmarking performance.

After the announcement, some media houses have reported that mutual fund investors could see a reduction in the performance of their investments vis-à-vis the indices they are benchmarked against. Certain reports have also insinuated that exchange-traded funds (ETFs) might turn more attractive than mutual funds. This has led to apprehension among many retail investors about the soundness of their mutual fund investments and whether they should consider switching to ETFs.

So, how does the Sebi announcement affect mutual fund investments? Should investors switch to ETFs? To answer these questions, we need to better understand the different benchmarks and analyse the impact of the announcement on the performance of mutual funds.

Any investment in a listed security generates return in two ways: capital gain, which is an accrued return due to an increase in the market price of the security, and cash distributions, such as the payment of dividend and interest by the issuing company. An index typically comprises a basket of securities chosen according to a predefined criterion. For example, the Bank Nifty index represents the 12 most liquid and large capitalized stocks from the Indian banking sector which trade on the National Stock Exchange

What is the total return index?

TRI captures both components (capital gain and cash distributions) of the return by assuming that all cash distributions of the constituent securities of the index are reinvested into the index. As against that, PRI only captures the capital gains of the index constituents and ignores cash distributions.

Thus, PRI provides an incomplete picture of the index return. If constituent stocks in an equity index pay dividends, TRI would be higher than PRI by a percentage equal to the dividend yield. How large is this difference in India? Morningstar, an investment research and investment management firm, has reported that TRI of typical Indian indices is around 1.5% higher than PRI.

What are the advantages of using TRI?

Mutual funds around the world commonly use TRI for performance benchmarking. However, most mutual funds in India use PRI, which makes it easier (by around 1.5% for typical indices) for mutual fund schemes to “beat the index" and potentially misleads unsophisticated investors. Since TRI is a more accurate and appropriate way to measure the performance of an index, the announcement is an unqualified positive for all investors. With this announcement, Sebi has moved the mutual fund industry in India closer to global best practices. The move towards accuracy and transparency is a positive signal for developed market investors looking to invest in India.

Next, the benchmarking of a mutual fund scheme against TRI presents an accurate picture of the “alpha" generated by the fund vis-à-vis the chosen index. Alpha is calculated as the difference between the actual return of the mutual fund and that of the index, and is an indicator of the selection and market-timing skills of the fund manager. If benchmarking is done against PRI, the alphas of many mutual fund schemes and fund managers appear inflated.

A recent study by Morningstar India analysed the performance of large-cap funds as compared to relevant market benchmarks. The study found that over a five-year period, TRI of S&P BSE 100 was 16.11% as compared to PRI of 14.46%, 165 basis points higher (a basis point is one-hundredth of a percentage point). Not surprisingly, the number of mutual funds beating the index fell from 85% to 58% when their performance was compared to TRI instead of PRI.

Should investors switch to ETFs?

An important point to note from the preceding discussion is that the Sebi announcement has no impact on the actual return generated (percentage change in net asset value) of mutual funds. It is merely a move to accurately benchmark their performance. As can be seen from the Morningstar report, 58% of mutual funds still beat the index even after comparison with TRI. However, management fees charged by actively managed mutual funds are around 2% higher than those charged by passively managed ETFs.

The question then becomes: how have mutual funds performed as compared to ETFs in India, net of management fees?

An article in Mint last year, “Why active funds beat the markets in India" by Nilesh Gupta and G. Sethu, provides an answer. Gross annual returns by active mutual funds (net of management fees) have exceeded Nifty TRI by 11.4% in the last 21 years and 5.2% in the last five years. Overall, mutual funds remain a more attractive investment than ETFs, but the actual returns depend on whether an investor is able to consistently select and invest in high-performing mutual funds.

It is also imprudent to assume that this outperformance will continue forever. “As the market cap of the mutual fund industry grows and markets become more efficient, we may see a compression in mutual fund alphas," says Dhaval Kapadia, director (portfolio specialist), Morningstar India. Investors will have to actively monitor mutual fund performance in the future. For now, there is no cause for concern.

Rohan Chinchwadkar is an assistant professor of finance at IIM, Trichy.