The last major reform that we saw with respect to mutual funds was in the mid to late 2000s when the mutual funds were first allowed into derivatives and later the imposition of entry loads was banned by SEBI mutual fund regulations. The first measure led to MFs becoming a critical player in the institutional F&O market while the latter was largely investor friendly and led to the rise of direct plans, which are more cost-effective for mutual fund investors.
Currently the SEBI guidelines for mutual fund is considering two key changes to make mutual funds more transparent.
- Firstly, the regulator is planning to shift all the funds to benchmarking their performance based on the Total Returns Index (TRI) rather than on the absolute returns index.
- Secondly, SEBI is planning to push through a major consolidation of schemes with similar characteristics so that the fund message becomes clearer to the investor.
Let us look at these two points in greater detail:
Shifting to Total Returns Index (TRI) for benchmarking mutual funds
Currently, mutual fund performance is benchmarked based on absolute returns. Let us assume that you are benchmarking the performance of an equity mutual fund against the Nifty for the last one year. If the Nifty 1 year back was at 8200 and the level of the Nifty today are at 9900, then the absolute return of the index will be 20.73%. The equity fund will be benchmarked based on these returns. So if during the same period, the equity fund has given a return of 22.75% then the fund would have outperformed the benchmark by 202 basis points.
The big drawback in the above calculation is that while the fund has been receiving dividends from the equity stocks that it has been holding, we are not considering the dividends received had you held on to the portfolio of index stocks for the last 1 year. Let us assume that the Nifty has a dividend yield of 1.50%, which has been the average dividend yield that the Nifty has enjoyed over the years. Under the TRI, the new benchmark returns will be 22.23% (20.73% + 1.50%). Now the outperformance of the equity fund has come down from 202 basis points to just 52 basis points.
What is Total Return Index?
A total return index (TRI) is different from a price index because it assumes that cash distributions such as dividends are reinvested back into the fund. A price index only considers price movements (capital gains or losses) of the securities that make up the index, while a total return index includes dividends, interest, rights offerings and other distributions realized over a given period of time. Looking at an index’s total return displays a more accurate representation of the index’s performance.
Here’s what you need to know about the TRI:
- TRI will provide investors a more realistic benchmark to evaluate the performance of the fund. When equity funds receive the dividends but do not consider the dividend on the benchmark, the fund manager gets an unfair advantage. The TRI will overcome that bias.
- It puts fund manager performance in a much clearer perspective. In the above example, the fund manager’s performance looks a lot more vulnerable when the TRI is considered as the outperformance comes down from 202 bps to just 52 bps.
- It needs to be remembered that the TRI is not just adjusted for dividends but also for rights and buybacks which have an impact on shareholder value. When these corporate actions are also factored into the TRI, the investors get a much more transparent basis for deciding on which mutual funds to buy.
Consolidation of Mutual Fund schemes on a realistic basis
This aspect has been under discussion within the MF committee of SEBI and is likely to see a decision soon. Currently, for any investor choosing from among 38 AMC with nearly 3000 schemes and over 20,000 plans is hardly an exciting job. The primary confusion arises because within the same AMC, you have multiple schemes with the same asset mix and similar investment objective. That is not only confusing for the investor but also results in additional products without any differentiation. For example, a large AMC may have an equity fund, a growth fund, a capital appreciation fund and an asset builder fund; and all these funds may essentially be equity diversified funds. That is surely a lot of duplication.
What the SEBI proposes to do is to clearly define categories like equity, large cap, mid cap, small cap, sectoral funds, thematic funds etc. Each AMC will be allowed to have only one scheme under each of these categories. If a fund has multiple schemes under the same categorization, as stated in the example above, the AMC will either have to consolidate these schemes or they will have to shut down additional schemes with similar asset mix. SEBI will classify mutual fund schemes under 3 broad categories viz. Equity, Debt and Hybrid and all funds will have to adhere to this definition.
How fund reclassification will benefit investors?
- It will simplify the task of fund selection for the investors and the mutual fund advisors. Having zeroed down on your asset mix and the AMC of your choice, you will not have to worry about which equity or debt scheme to choose.
- A large fund has economies of scale and that can get passed on to the investors in the form of lower expense ratio. As John Bogle proved, even a small reduction in the expense ratio can make a big difference tot long term returns.
- There will be greater onus on the AMC to show performance under each category and the portfolio of the fund will have to broadly reflect the investment philosophy and the strategy of the fund. Measurement of performance becomes a lot simpler!
Both the steps proposed by SEBI are a welcome shift towards greater transparency among mutual funds. With the Angel Bee app you can make the best of this positive shift towards transparency by suggesting the best mutual fund investments.