Total Returns – The Better Benchmark

Once in a way, one comes across a Mutual Fund that decides to take the bull by the horns when it comes to transparency. Mutual fund are products that are sold on the basis of past performance – the better the fund performs against its peers and the benchmark it targets, the easier to sell.

While active management (to which we are a votary of) is seen as a failure in countries such as United States, in India, its a thriving industry thanks to funds that are able to beat the Indices they follow by a margin that is large to even visualize.

Fore example, lets take the best fund in the Multi Cap space out there – ICICI Prudential Value Discovery Fund. This fund is the top performing fund among  Multi Cap funds with 10 year CAGR returns of 17.80% versus its benchmark, the BSE 500 which has generated 9.32%.

BSE 500 index represents nearly 93% of the total market capitalization on BSE.  NIFTY 500 Index represents about 95.2% of the free float market capitalization of the stocks listed on NSE.

But growth funds when bench-marked against the Index do not really give the accurate comparison for growth funds have the luxury of Dividends. When companies pay out Dividends, the stock price gets adjusted (theoretically) to provide for the pay-out.

But unless it a extra-ordinary dividend (wherein Dividend is greater than 10% of the stock price), the price of the stock is adjusted as it would have been in case of Bonus or Split. Most companies though give out Ordinary Dividends and this is simply deducted from the stock price without any adjustment.

Let me give a example of how this works.

Assume a Index of 50 stocks and having a value of 1000. For sake of simplicity, lets assume that on a single day (ex-date), all 50 stocks go ex-dividend with each company having given out exactly 2% of their stock price as Dividend.

All things being equal on this date, all stocks will open 2% lower and in turn the Index will see a 2% decline. But this decline is not real as the investor receives the amount equivalent and hence not necessarily a loss. A growth mutual fund on the other hand just adds this to income.

So, while the Index would have fallen by 2%, the fund would have remained steady. This would mean that the fund is now out-performing the Index by a measure of 2%. The fund manager with this new money can re-invest (remember, he gets the Dividend payout) into the same stocks and hence compounding the returns over time.

Enter Total Returns Index

The above anomaly can give rise to funds that aren’t really market beaters being able to claim to be better than the Index when it may not truly be the case. Total Returns Index is a virtual Index wherein the Index manager is assumed to have re-invested the dividends back into the same shares. In the above example, this would mean the fund would take the 2% dividend paid out and re-invest bring the fund value back to 1000.

How much difference can this make? Well, take a look at the chart below which plots Nifty 500 with Nifty 500 Total Returns Index

The difference over time as the chart depicts above can be phenomenal. Not surprisingly then most funds prefer to benchmark against the Index rather than Total Returns.

Of course, an added impenitent to measuring their performance against Total Returns was the fact that NSE till very recently gave out only data for Nifty 50 Total Returns. The only fund to have bench-marked itself against Total Returns was Quantum Long Term Equity Fund.

But as friend in the Industry said, “their name doesn’t (really) ring a bell in the AMC space”.

Other than Quantum, other funds have for long given it a pass. This even as many have generated returns better than Total Returns Index (which any-way cannot be invested into given lack of Instruments).

This seems to be changing. On 23rd August 2017, DSP Blackrock has taken the first step to benchmark its funds against Total Returns Index. This is a step in the right direction and DSP needs to be applauded for taking the Initiative.

While Quantum has always been the leader, its nice to see a fund house that is several times larger than Quantum take similar initiatives. We can only hope that other larger funds now follow suit and start measuring themselves against Total Return Indices of their respective benchmarks.

The last few decades have belonged to active management but nothing remains static and with growing fund size and better participation in equities, its only the best in business who shall thrive.