Total Returns Index (TRI) – an appropriate benchmark to compare fund performance

Financial institutions have come a long way since the aftermath of Global Financial Crisis in 2008. As asset management companies and fund houses battle to grab a larger share of corpus from increasingly knowledgeable investor cohort, more and more emphasis has been laid on building customer confidence and trust, financial transparency and ethics. In a recent survey by CFA, ‘From Trust to Loyalty: A Global Survey of What Investors Want’, majority (~38%) of the retail customers chose ‘Trust on asset managers/firm’ as their primary reason while picking an asset management firm.

More recently, one such step in achieving financial transparency is a decision by DSP Blackrock Mutual Fund & Edelweiss Mutual Fund to opt for Total Returns Index (TRI) as the benchmark to measure the performance of their funds. Prior to DSP Blackrock & Edelweiss Mutual Fund, Quantum mutual fund adopted the TRI benchmarks to compare the returns of their funds. Such a move by fund houses is in the right direction towards global convergence on usage of fair and transparent benchmarks – to gauge performances of assets under management.

What is Total Returns Index (TRI)?

There are two sources of returns on equity investments: capital gains and cash dividends. The cash dividends received are typically reinvested by mutual funds to generate further returns on net assets. For instance, The PRI (Price Returns Index) version of NIFTY 50 for the year 2016 delivered a return of 3.01% and the 50 underlying stocks paid an aggregate dividend of 1.47%, thus the TRI version of the index delivered 4.48% return during the year. Historically, most of the domestic funds have used PRI, to compare their funds’ performances, which considers only capital gains (price appreciation) thus ignoring dividend returns. Total Returns Index (TRI) captures both – price appreciation and cash dividends to reflect all sources of returns in equity portfolio. The Net Asset Value (NAV) calculated by mutual funds also reflects both these sources of returns. Using TRI for fund performance comparison is thus a more appropriate, fair and prudent benchmarking practice.

Global emphasis on usage of total return index benchmarks for performance comparison

Globally, the emphasis on transparency has been on a rise as indicated by the guidelines issued by various capital market regulators. In the United States, Securities and Exchange Commission (SEC) regulations published in 1998 mandates that all funds report performances using appropriate benchmarks which consider reinvestment of dividends for index computation (read TRI). Most of the asset managers in the United States claiming a large part of the industry AUM use Total Returns (TR) indices as benchmarks to measure the performances of their funds. Below is the summary of 5 such asset managers and few of their top funds and corresponding benchmarks.

Similarly, European Securities and Markets Authority (ESMA) mandates that funds where distributable income of funds is reinvested and when several versions of benchmarks are available. The benchmark with reinvestment of revenues (read TRI) should be used for performance analysis.

NIFTY50 Total Returns Index (TRI) vis-à-vis NIFTY50 Price Returns Index (PRI)

 Exhibit 2 given below shows the two variants of NIFTY50 index – TRI and PRI. As observed, the values for the 2 variants diverge due to reinvestment of cash dividends. As on 31^st October, 2017, the NIFTY50 TRI returned 14.10% per annum against 12.52% per annum of NIFTY50 PRI (since 30^th June, 1999) – a healthy difference of ~158 bps per annum.

Return and risk performance of NIFTY 50 PRI and NIFTY 50 TRI

Exhibit 3 shows return and risk performance of NIFTY 50 PRI and NIFTY 50 TRI for 1,3,5,7 years and since inception. The TRI variant has averaged an excess return over PRI variant in the range of 131 bps to 158 bps per annum, underlining the importance of dividend re-investment and its corresponding compounding effect. By using the PRI variant as a benchmark index (instead of TRI variant), most of the mutual funds tend to overstate their historical alpha (excess return over benchmark) by more than 130 bps per annum.

Performance analysis of domestic funds using NIFTY PRI and TRI benchmarks

Exhibit 4 shows comparison of mutual funds’ performance with PRI and TRI variants of NIFTY benchmarks across 5,10, 15 years period and since inception (30^th June 1999). Only growth based schemes with at-least 1 year history are considered for analysis.

Performance of schemes is analyzed for the period between 30th June 1999 and 31st October 2017 for 5, 10, 15 years period and since inception.

Observation

• Since their inception, out of the 384 funds (with min history of 1 year) that use NIFTY benchmarks,
  • 290 (or ~76%) funds outperformed their corresponding NIFTY price return index (PRI) benchmarks during the schemes’ existence
  • However when compared to the TRI variant, only 219 (or ~57%) funds could outperform
  • Thus, 71 funds that claimed outperformance against PRI benchmark, actually underperformed when compared to a more appropriate benchmark (read TRI). Thus there is a 24% drop in number of funds failing to outperform due to transition of benchmark from PRI to TRI.
  • Of these 71 funds, major drop in number of funds outperforming the TRI benchmark was witnessed in case of broad-based funds using market cap based indices. These include funds using NIFTY 50 (drop of 36% funds), NIFTY Next 50 (drop of 100% of funds), NIFTY 200 (drop of 44% funds), NIFTY 500 (drop of 18% funds), NIFTY 100 (drop of 26% funds) and NIFTY Free Float Midcap 100 (drop of 7% funds). Only a nominal drop observed in case of sector based funds using NIFTY Bank and NIFTY Commodities indices as benchmarks. Strategy or Theme based funds did not witness any drop in number of funds outperforming the TRI benchmark. All these funds continue to outperform the TRI benchmark as well.
• Based on similar analysis for last 5, 10 and 15 years (for funds with min history of 5, 10 and 15 years respectively), the drop in number of funds outperforming the benchmark works out to be 16%, 27% and 8% respectively. The large drop (of 27%) in case of 10 year period can largely be attributed to the 2007-08 global financial crisis.

Exhibit 5 shows comparison of mutual funds’ performance (since inception of individual schemes) with PRI and TRI variants of NIFTY benchmarks. Exhibit shows extent of alpha (excess return) earned by funds beating the TRI variant analyzed during funds’ existence (for funds with min history of 1 year)

• Of the 219 (or 57%) schemes that outperformed TRI benchmarks
  • For 92 schemes (or 42% of the 219 schemes), the average excess returns over TRI benchmark is less than 3% per annum, with rest of the 127 schemes (or 58% of the 219 schemes), outperforming the TRI benchmarks by more than 3% per annum.

Conclusion:

Global convergence on usage of total returns index (TRI) as a benchmark should be considered, with an emphasis on transparency. The popularity of total returns index (TRI) vis-a-vis price returns index (PRI) for benchmarking fund performance has been on a rise. Although, PRI can be tracked on daily basis to gauge the performance of capital markets through popular indices, TRI represents an appropriate benchmark to compare the performances of funds where the distributable income (dividend) is reinvested. Mutual funds using TRI instead of PRI is a benchmarking practice that’s more prudent, appropriate and aligned with global best practices.

About the author:

 Mr. Shulin Satoskar, is currently the Assistant Manager, Products Development at NSE. He is a distinguished alum from TAPMI, Manipal, batch of 2014-16.