Simple Price Index Vs Total Return Index Vs Principal Return Index

 

In mutual funds there are two broad categories : Actively Managed Funds and Passively Managed Funds (also called as Index Funds).

Following are the expectations from an Actively Managed Fund Manager:

• The Fund manager has to make tactical calls and make suitable, timely investment decisions – resulting in reducing losses and maximizing profits. As a result, the alpha generation is expected. More the alpha, better is the fund managers ability.
• But to support the Fund Manager in making appropriate investment decisions, huge machinery of co-fund managers, analysts and sector specialists are required. As a result the expense ratio of actively managed funds are more.
• The success of the actively managed fund is visible, since it is compared to the benchmark index. More is the outperformance, better is the fund management ability.
• In India actively managed funds dominate the Mutual fund industry for two reasons:
• The alpha generation is more and investors like more returns though at a bit higher risk.
• The index itself is not inclusive and doesnot capture the overall growth of the economy. For instance in Nifty Index, there is no representation from Agriculture industry.

At present, the  they use is : SIMPLE PRICE INDEX – irrespective of the fact if it is Nifty or sensex or midcap index. Here the price points across different time period is used to calculate the returns – absolute or annualized. This method of index calculation ignores the dividends received by underlying stocks. But this is what SEBI has prescribed and most of the Mutual Fund Houses has been following it.

DSP Blackrock Mutual fund has proposed that it would adopt TOTAL RETURN INDEX. Here the Dividend received is added to the benchmark returns. The result is : Nifty’s 3 years Simple annualized returns has been 7.60%. Whereas the Total Return Index is 9.03%. The difference of 1.43% is due to the dividends. And if an actively managed funds had generated 12% during this period, the alpha of 4.40% has now shrunk to 2.97%. And in a few occasion, there could have been nil alpha or negative alpha!. In such case, it makes all sense to switch to better performers or atleast to passively managed funds.

Kotak MF has been one step ahead – It practices PRINCIPAL RETURN INDEX calculation for Benchmarks. Here the dividends are added back to the index and the returns are calculated. This narrows the alpha even further.

SEBI has taken note of the development and is contemplating Total Return Index as a Norm. The honeymoon seems to be over for Fund Managers. It is time they start delivering on their commitments – Alpha Generation!