XYZ Mid-cap Equity Fund delivered a 15% compounded return over five years ending August 28, 2017.
Seems like a good fund, doesn’t it?
Only a few financial products are capable of generating double-digit returns, that too, over a five-year period..
The S&P BSE Sensex delivered a return of 12% compounded over the same period. Superficially, the performance of the mid-cap fund appears better than the widely tracked market index.
But what if we told you that a more appropriate benchmark index—the S&P BSE Mid Cap index—generated a return of 21% over the same period? Now, the scheme’s return of 15% does not sound as impressive.
Benchmarking mutual fund performance against an appropriate market index is necessary. This gives a true indication of how well a fund is managed.
If a scheme follows a multi-cap strategy and is benchmarked to a large-cap index, like the Sensex or Nifty 50, investors may not have a true picture. Over the long term, a multi-cap portfolio enhanced with wealth-creating mid-caps, may always outperform a pure large-cap one. Hence, broader indices such as the S&P BSE 200 or the Nifty 500 would be benchmarks that are more appropriate for a multi-cap scheme. The stock universe in these indices would cover large-caps and some mid-caps as well, forming an appropriate yardstick.
This is why it is important to check whether a mutual fund scheme is benchmarked to an appropriate index.
Drawback of commonly used benchmark indices
Even if one chooses an appropriate benchmark, there is an inherent drawback in the common benchmarks available.
An investor’s total return from investing in equities evolves out of the capital gains from price movements of stocks in the portfolio and in the form of dividends.
Take for example, Hindustan Zinc, an erstwhile Public Sector Unit involved in mining zinc and silver. Over the past year, the price of the stock appreciated by 25% to Rs 284 as on August 29, 2017 from Rs 228 a year ago. But, during the year, the company paid out a dividend of Rs 29.4 per share. If we addback the dividend, the total returns generated goes up to 37%.
While the mutual fund Net Asset Value (NAV) is a factor of stock price and dividends received, most benchmark indices are solely price indices. That is, they only represent the performance based on stock prices. Hence, with the dividends included, mutual funds have a better chance of outperforming their chosen price benchmark.
The need for a Total Return Index
To see the true and complete picture, dividends received from the constituent stocks of an index need to be factored in the final index value. Understanding the need to have dividends included to reflect the true value generated by a stock portfolio, the stock exchanges introduced a Total Return Index (TRI) for their flagship index’s—the S&P BSE Sensex TRI and the Nifty TRI.
If we consider the compounded returns, the S&P BSE Sensex delivered a return of 12% over the past five years ending August 28, 2017. The dividend infused index, the S&P BSE Sensex-TRI, generated a return of 14%. Yes, the additional 2% compounded return is thanks to the dividend declared by the constituents of the index.
Thus, the TRI diminishes the alpha (returns over the benchmark) generated by equity mutual fund schemes. This will help investors assess the scheme’s performance better. Over the past few years, the dividend yield of Indian stocks averages about 1%-2% per annum; accordingly, the total returns are enhanced by a similar extent.
According to news reports, the Securities and Exchange Board of India (SEBI) wants the mutual fund industry to benchmark the returns of its equity schemes against a total return index. This will bring about “greater transparency”, the source quoted.
Mutual Funds using the TRI as a benchmark
Recently, DSP BlackRock Mutual Fund garnered publicity when it announced it would benchmark the performance of its schemes to the Total Return Index. Though a good move, it is yet to officially announce which TRI it will utilise and for which schemes.
Presently, only the data of the Nifty TRI and the S&P BSE Sensex TRI are freely available. These would be appropriate benchmarks for large-cap oriented schemes.
Among other fund houses that use the TRI to benchmark their scheme performance are Quantum Mutual Fund and IDBI Mutual Fund. IDBI Mutual Fund uses a TRI for its index schemes – IDBI Nifty Index Fund and IDBI Nifty Junior Index Fund.
Quantum Mutual Fund is the first and till now the only fund house to use the TRI as a benchmark for its equity diversified schemes. Quantum Long Term Equity Fund and Quantum Tax Saving Fund are benchmarked to the S&P BSE Sensex TRI, while Quantum Nifty ETF is benchmarked to the Nifty TRI.
Should you solely rely on benchmark relative performance when selecting mutual fund schemes?
While it is important to have a yardstick to gauge the performance of a mutual fund scheme, it should not be the only criterion for selection. Therefore, irrespective of the performance of the scheme versus its benchmark, other quantitative and qualitative factors need to be analysed before zeroing in on the right scheme.
PersonalFN follows a stringent scoring model, which ensures that the scheme is tested on various quantitative as well as qualitative parameters, and then accordingly compared and scored vis-à-vis its peers. Only the schemes able to pass through our rigorous assessment and achieve the maximum composite score on all parameters (based on pre-specified weightages) make it to our recommendation list.
If you need research backed recommendations to select the potentially best mutual fund schemes for your portfolio,opt for PersonalFN's FundSelect research reports. Our superlative guidance will certainly help you on the path to wealth creation. You can be rest assured about the ethical and unbiased nature of this service.
Always remember, the Systematic Investment Plan (SIP) route to investing in equity mutual funds adds to the convenience, and additionally helps to deal with market volatility through rupee-cost averaging.
At the same time, it is pertinent to note that not all equity mutual funds may be investment worthy to start an SIP. Hence, you need to narrow down to a list of funds that have performed remarkably well under SIP.
Backed by strong research-driven processes, PersonalFN will soon publish a research report of mutual funds that are optimised for SIP investments. Stay tuned to know more!
