Sep 27, 2017 04:17 PM IST | Source:

Why mutual funds should opt for total return index as benchmark

Total return index captures dividends and show true picture of fund manager’s performance.

Why mutual funds should opt for total return index as benchmark

Jitendra PS Solanki

Recently, DSP Black Rock Mutual Fund made a very interesting decision- moving their benchmark to Total Return (TR) Index. It’s a praiseworthy move considering the benefit of having TR index as benchmark. Globally, S&P 500 is based on total return index and here BSE Sensex and Nifty do have TR Indices. But, until now, price-based index was followed for the purpose of benchmarking. As a large mutual fund makes a switch, it will be interesting to understand as an investor how this moves makes a difference to your investments.

The TR index

An index in general is a basket of securities and any change in the index value is actually the cumulative change in the prices of these securities. A price-based index captures the movement of prices but leaves the dividends and interest earned from these securities. The total return index is contrary to this. It captures not only the movement of prices but also the dividend or interest earned and is assumed to be reinvested in the security. So the total return index has two variants deriving the returns:

1. The capital appreciation from the movement of prices

2. The dividends/interest which is assumed to be reinvested

Significance of dividends

Dividends earned on stocks is essentially the picture of cash flow of a company. The company which has a good dividend paying history is considered to be profitable, mature and rewarding its customers. Returns from these companies tend to be much steady. In benchmarking against price based index this aspect is left behind and the focus is only the capital appreciation and fund managers performance on alpha generation is assessed accordingly. Focusing on price appreciation may be good for traders but does not reflect the true picture for investors when a company is rich in cash and does pay regular dividend.

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How total return index benefits?

For investors the true picture of their earnings is reflected through total return index. Here it is assumed that the dividends or interest is reinvested in the scheme and added to the capital appreciation. Thus the return from total return index is going to be higher than the price based index. In the short term it may not vary much but when you look at long term returns between these two variant then total return index does show the extra returns.

We have Total Return Index version of BSE Sensex and below is the comparison chart with price based index. You can see the return difference where the total return index is reflecting what the investor is going to take at home which is the true picture.
1 year 3 year 5 year 10 year
Total Returns
S&P BSE SENSEX (TR) 12.98 7.48 14.39 9.12
Price Returns
S&P BSE SENSEX 11.52 6.00 12.73 7.55

Data as of Aug 31, 2017

The total return index benchmark is going to be beneficial in many ways. One it will give investors the actual earnings what they will take home. Secondly fund managers will have to work harder to deliver alpha now which is welcome move for investors as the fund managers will be relying on more accurate information for their performance. How much they are able to deliver consistently is yet to be seen but moving to TR index as benchmark will surely add to a more transparent and precise performance scenario in mutual funds industry.
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