Time to churn for cost conscious after introduction of total return index

The Securities and Exchange Board of India (Sebi) has made it compulsory for all mutual funds to benchmark their schemes against the total return index (TRI) through a circular dated January 4. Until now, a few fund houses such as DSP BlackRock, Edelweiss and Quantum were voluntarily benchmarking their returns against the TRI. But now all fund houses will have to adopt this global best practice.

Price return indices (PRIs), which fund houses have been using so far, capture only the capital gains and losses of the index constituents. But funds also receive dividend payments from the securities they hold in their portfolios. This makes it easier for fund managers to beat the PRI. For instance, if the dividend yield of a portfolio is 1.5 per cent, its fund manager gets a 1.5 percentage point head start. Now, with the dividend income getting reflected in the TRI, fund managers will have a tougher time beating their benchmarks. Fund houses have to comply with this directive from February 1, 2018.
 

Fund Facts

— 82% of active large-cap funds are outperforming their benchmarks over three-year period currently; average margin of outperformance: 2.59 percentage points
 

— 57.5% of active mid- and small-cap funds are outperforming their benchmarks over three-year period; average margin of outperformance: 3.80%
 

— If outperformance falls, consider moving to lower-cost fund options
 

—  While average expense ratio of regular large-cap funds is 2.43%, that of their direct counterparts is 1.44%
 

—  Average expense ratio of large-cap index funds is 0.89%, while that of large-cap ETFs is 0.21%

Experts view this as an investor-friendly move. "Investors will be able to judge if their fund manager is actually generating an alpha, in the truer sense," says Radhika Gupta, chief executive officer, Edelweiss Mutual Fund. Nilesh Shah, managing director, Kotak Asset Management, is of the view that this is a good move from the investor's point of view. At the same time, he points to a couple of handicaps that fund managers already face vis-a-vis the index. "A fund manager has to deal with redemptions, so he has to keep a portion of his open-end fund's portfolio in cash. An index does not have to deal with redemptions. Also, when an index changes, it can include or exclude a stock easily - within a day. In a fund portfolio, such adjustments can't happen within a day because there is an impact cost involved," he says. Shah adds that the TRI is better suited for developed markets, where dividend is a significant component of return. In most emerging markets, he says, fund performance is compared with the PRI.

The alpha generated by active funds may come down with the switch to TRI. "Large-cap funds, where the average alpha has already come down to 3-4 percentage points, will be especially affected. The dividend yield in this category is higher at around 1.5 per cent. The impact on mid- and small-cap funds will be smaller since they generate higher alpha while the dividend yield of funds in this category doesn't exceed 0.5-0.7 per cent," says Gupta.

If fewer active funds are able to beat their benchmarks, or are able to beat them by a smaller margin, it will affect the type of funds investors choose to invest in. "The higher expense ratio investors are willing to pay in active funds is justifiable only if their outperformance is fairly large. As the number of funds that outperform reduces, the probability of being able to identify outperformers will decline. There could then be a greater incentive to use lower-cost, passive funds like index funds and exchange-traded funds," says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors. Gupta suggests that active large-cap funds may have to reduce their expense ratios, as her fund house has already done. Shifting to direct funds, which have a lower expense ratio, will also help.

Once the TRI is introduced, investors should reassess the funds they hold. "Investors may find that some of the funds they hold have underperformed the TRI. They should axe these funds from their portfolios only if underperformance is over the long term. They shouldn't allow themselves to be swayed by short-term underperformance," says Dhawan.