Post SEBI’s update regarding the benchmarking of mutual funds and measuring their performance, the benchmark has shifted from Price Return Index to Total Return Index. The process has shifted since February 2018 and has brought about a lot of transparency,
With PRI focusing only either on the capital gain or loss leaving aside the dividends, TRI ensures a holistic picture of the fund in the process of comparing and benchmarking. Let us see what they are and how do they differ in detail.
The process of comparing and analyzing a mutual fund against the market indices which are the prevailing market securities is called benchmarking. A benchmark is also called as an index and in value equals the sum of its components. The price of changes with respect to each other i.e. when the sum of components changes, the benchmark price also changes.
It serves as a reference point for mapping the performance of a fund and a fund is called to be an outperforming fund if it showing a better performance than its reference point or benchmark. On the other hand, if the fund performs poorly and below the set benchmark, then it is called an underperforming fund.
When you invest in mutual funds, the returns are generated in two ways: by capital appreciation and dividends. Capital appreciation refers to the increase in the share price of the fund as compared to the price it was at when you invested. Especially equities rely on both capital appreciation and dividend pay-out. But until February 2018, only capital appreciation was used to map the performance of a fund.
The Price Return Index parameter only took into consideration the capital appreciation aspect which is only half the story. Reinvested dividends play a major role in equities since they are invested over the longer term. When these dividends are paid out, it increases the overall return of equities hence ranging much higher than the benchmark. The total return index is one such index that takes into consideration the overall factors while mapping the performance of a fund.
With the introduction of TRI, the transparency and credibility of funds have increased multi-fold. If you compare two identical portfolios of securities then you will find that the one measured on TRI will always show greater returns than the one mapped over the Price return index.
Using PRI used to be misleading due to overstating the performance of a mutual fund which made more people invest in the funds owing to exceptional performance. Using TRI has brought the scenario to a more credible one where the overall picture is taken into consideration and actual statistics are reflected to investors.
It is very important for you as an investor to know the actual scenario of market pricing and where your investments stand in this mapping. Upon the implementation of TRI, there have been a lot of cases where the previously overperforming fund is now underperforming due to the change in parameters, exposing the reality. This will also affect your style of investing i.e. active or passive.
Conventionally when PRI was used as the measuring parameter, a large number of funds outperformed their benchmarks but as and when the AUM grew for them, their return shirked and performance saw a downward curve. In crux, the alpha of those funds started decreasing bringing down the overall returns.
Finally, if you observe that your previously outperforming fund is now underperforming, you must review your investment portfolio and purge out consistently underperforming funds. Make sure your portfolio is balanced and aligned perfectly with your goals.
This article was published on groww.in and has merely been reproduced here.
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