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Why Mutual Fund Investors Must Care About This New Benchmark

What’s TRI? It’s something a mutual fund investor should know.

TRI, or Total Return Index, tracks both the capital gains of a scheme and assumes that any cash distribution, such as dividends, are reinvested back into the index. Markets regulator SEBI released a circular on Jan. 4 asking fund houses to benchmark a scheme’s performance against the TRI.

The objective, as highlighted by SEBI, is to help investors compare the performance of a scheme with the benchmark in a fairer manner.

A quick look at the difference between Nifty returns over the last 17 years, compared to the total returns (as per TRI), will suggest that it will become harder for a mutual fund to show significant outperformance versus the benchmark.

Why Mutual Fund Investors Must Care About This New Benchmark

“TRI is a good move as it will get fund managers to become more active, and will align us with global market practices,” Leo Puri, managing director at UTI Asset Management, said on this week’s BQMutualFundShow. The total return gives a true and fair picture of the performance of an entity, he said.

Here are edited excerpts from the conversation.

Active fund managers create significant alpha. Does this SEBI move diminish the ability of an active fund manager to show quantum of returns that they can generate in a large-cap fund?

No. It certainly doesn’t diminish that. It will probably to some extent sharpen the differentiation between active and passive, but it will not diminish the ability of active funds to outperform. It will bring into strong focus the investment process and discipline a particular fund house chooses to achieve alpha.

When you are running a passive fund, typically you will have periods where funds have done well, and in a sense gets overvalued, tend to be overbought and stocks that have not done well tend to get undervalued. So, over time you start to get a distortion in the way that passive index is built up. An active manager can clearly see through this and start to identify where the value lies and shift that weightage around. So, they can start buying undervalued stocks in a contrarian fashion and vice versa which clearly a passive manager cannot.

Simply buying large cap as an index constituent on its own is not the full answer. Corporate governance also matters a lot.

The weightage in the index doesn’t reflect corporate governance. Over the time, a good fund manager knows that they need to track and understand corporate governance philosophy which will have a bearing on the long-term ability of the stock to generate returns regardless of their index weightage.

In India and many other markets too, you will find very large cap stocks that are not in the index but are available for managers to buy, either because of new segments coming into a market or the size of the universe. For example, in India, we have insurance companies and asset management companies coming to the market at a reasonable size of Rs 20,000-80,000 crore valuations. They are not in the index at this point but can be interesting. Gas utilities is another example. So, that again becomes a source of actively seeking out alpha. Because of all these reasons, large caps will remain an active and healthy hunting ground for those seeking alpha.

There will be periods where mid caps tend to strongly outperform. You take much more risk when you do that clearly.

There is survivorship bias here because as you look back, you only look at mid-cap and small-cap companies which have grown and those which have fallen by the wayside and become shell companies tend to get ignored.

Large-cap companies do have a certain advantage in terms of market position, ability to attract talent, ability to shape their industry, make investments, provide strategic leadership and that can be valuable. They have the ability to institutionalise higher standard of governance in some cases. If you are able to identify that, then it gives you the outcome which relative to risk could be far superior for a typical retail investor. So, we must not allow ‘recency’ to overtake us in the debate between large cap and mid cap. Even, in the large-cap segment, there will be plenty of room for alpha. So, it is very premature to call the death, if you like, of large-cap alpha at this point. We are many years ahead of us where good investment managers, and investment managers with disciplined investment process will continue to identify sources of value for investors.

Will the new norms by SEBI help an investor to discern between a pure play large-cap fund versus a fund termed a large-cap fund but with a flavour of mid caps? Will that be beneficial for an investor?

Yes. These are all very investor-friendly moves by SEBI. The total return index is investor friendly. The decision to clarify labeling in the mutual fund industry is also very investor friendly if it is implemented properly.

Now, you will have to define the specification of your investment mandate much more clearly. So, if it is a large- or mid-cap fund, there is clear definition around what percentage will be in large and mid cap and you should adhere to it and that will be uniform across all fund houses, thereby reducing the arbitrage that some fund managers had.

Secondly, your index will co-relate to that particular fund mandate. So, you can’t choose a large-cap index and run a mid-cap fund and then claim excessive alpha and use that to push your fund to unsuspecting investors, as has happened in past.

You will now have to choose an appropriate index which will narrow the alpha. To the extent that you are taking more risk, the index will reflect those outcomes and you will outperform against a more appropriate index.

So, the total return index and appropriate categorization with clear scheme mandates and clear benchmarks, all are good for the long-term health of the mutual fund industry and most of us welcome that as responsible manufacturers.

We have seen a significant rise in ETFs and ETF-linked products. Do you think this is happening because of the gush of funds coming in across classes? Are these products well understood?

There is a difference between global experience and Indian experience. The gush into passive is largely a global phenomenon. It is not Indian phenomenon. In India, you had the unique situation where the Employee Provident Fund decided to invest solely in ETFs. About 90 percent of flows in ETFs in India, therefore, being driven by a single investor. There is no widespread movement to shift from active to passive.

Having said that, passive funds will play a growing role in the portfolio of many investors over time.

If you do see the emergence of an advisory segment, they will end up recommending passive funds as they construct a portfolio for the clients. They do play a useful role there. You may be saving anything from 100-150 basis points in fees which is not a bad amount of margin to have. That means an active fund needs to generate additional 150 basis points over the benchmark and over the index. Index funds are typically cheap. There will be additional pressure from those managers who are actively managing portfolios to distinguish themselves. You will see an emergence of growth of advisors in India in a low-cost index fund and portfolio construction.

But the top quartile large-caps will continue to have over 2-3 percent alpha over time. Against total index and net of fees, if you can generate 100-150 basis points alpha, then that could be considered very good anywhere in the world, particularly when you get the benefits of compounding. Imagine holding a portfolio for 8-10 years which have given you 150 basis points year-on-year, then you can compute what the benefits of that might be. So, we will focus our core skills of building active management in UTI. But we will also manage, manufacture and build products like ETFs because we know that there will be demand for them from advisors constructing portfolios at low cost.