Total return index is a more transparent benchmark

It takes into account dividend payout of constituent stocks to help investors with better ideas

DSP Blackrock Mutual Fund announced recently that all its active equity funds will be benchmarked against total-return indices. So far, only Quantum Mutual Fund benchmarked its equity funds against a total return index. Their use is widespread in developed markets. Experts say using a total return index as benchmark is a more transparent way of showcasing fund performance. 

Most equity funds in India are benchmarked against price-return indices. The Nifty, Sensex and most other indices we come across are price-return indices. “Price indices are designed to track only the capital appreciation or price change of their underlying constituents. A total return index, on the other hand, reflects the full benefit of holding an index's constituents over a given time frame — capital appreciation and cash dividends,” says Akash Jain, associate director, global research and design, S&P BSE Indices.

An example will illustrate the difference between the two types of indices. Over the past five years, the Nifty has given a return of 13.19 per cent annualised while the Nifty-TRI (total return index) has given a return of 14.57 per cent, a difference of 1.38 percentage points. This additional return of the Nifty-TRI was derived from the dividend payouts made by the index’s constituent stocks.

When a fund’s return is compared against a price-return index, the fund manager gets a small advantage, which makes it easier for him to beat his benchmark. Each year, the stocks that he has invested in declare dividends that get added to his portfolio return. But the price-return index his fund is benchmarked against does not factor in the returns from dividends. “Using the price-return index is in a way setting a modest target for active funds to achieve,” says Jain.

If more fund houses were to adopt the practice of benchmarking their fund returns against total return indices, the alpha (outperformance) generated by their funds would shrink. 

Suppose that a fund gave an annualised return of 16.89 per cent over the past five years. Compared to the Nifty, it generated an outperformance of 3.7 percentage points. But compared to the Nifty-TRI, its outperformance shrinks to 2.32 percentage points.

Nonetheless, as Kalpen Parekh, president, DSP Blackrock Mutual Fund, says: “Comparing a fund’s return against the total return index gives a truer picture of the alpha being generated by the fund manager. It is a more transparent way of showcasing returns.”

If the practice of benchmarking funds’ returns against total-return indices gets widely adopted, the number of funds that beat their benchmarks could also reduce, with implications for whether investors should move from active to passive funds. When we ran the numbers for returns over the past five years (see table), the percentage of funds that outperformed does shrink when you move from a price-return index to a total return index. But, a significantly high percentage of funds still managed to beat the TRI. 

Says Kaustubh Belapurkar, director-manager research, Morningstar Investment Adviser India: “Active fund management can still provide a lot of value in the Indian context. A fairly large number of large-cap funds will continue to beat their benchmarks (even if funds were to shift to TRI). And, in the mid- and small-cap segment, there is a lot of alpha to be generated, so most funds in that category would continue to beat their (total return) benchmarks.” 

If you see the outperformance of your fund shrink owing to a shift to a total return benchmark, one smart strategy would be to shift to a direct fund, so that the lower expense ratio provides a boost to your fund’s return.