Performance of a mutual fund scheme or PMS portfolio is assessed with reference to a benchmark. There are various benchmarks available; the designated benchmark is the one with nearest correspondence with the composition of the portfolio. However, this comparison with a benchmark is never perfect. It is to give an indication that if you were invested in the benchmark portfolio, how much you would have earned.
Recently, mutual funds were told to compare their performance with total return index (TRI) as against the regular benchmarks like Nifty or Sensex, as these take into account only the price of the stocks and not the dividend payout. The regular indices are known as price return index (PRI) as these are based on the price of the stocks. The logic was, the outperformance claimed by the mutual fund schemes was not fair, as they get dividends from their stock-holdings whereas Nifty or Sensex is based on price only. The dividend yield, i.e. dividend as a percentage of the market price of the stock, in the Indian context, is about 1.5% but over a long period of time, the compounded impact comes into effect.
Why is the comparison not perfect? The composition of the index itself is subject to change, though not as frequently as your fund. For example, Sensex was initiated in 1986 with the base year as 1978-79 = 100, which was the first reference point. Most of the stocks that were part of initial Sensex are out now, replaced by new companies, though the number of stocks remain 30. The change in composition from time to time is done to reflect the changes in the economy and market; some companies fade out and other companies gain importance and market capitalisation. Nifty 50 index computation is similar; the base date is November 1995 = 1000 and there is a once-in-six-months Nifty reconstruction policy. The indices regularly tracked by market participants are PRI, and the TRI is calculated by adding back the dividend. So, while comparing a fund with an index, we are comparing a dynamically managed fund (other than index or passive funds) with a set of stocks representing majority market capitalisation, subject to occasional change. Sometimes identification of the benchmark itself is a question, for instance, for flexi- or multi-cap funds which invest across large-, mid- and small-cap stocks.
As an investor, you have a choice of funds from the actively managed ones, and you would like to pick the best performer. Even if all the funds in your portfolio have outperformed the benchmark, you are not bothered so much about comparison with index. You would wish, you had held a higher proportion of the top performing fund, which has ‘beaten’ the peer group. Hence, from your perspective, it is the peer group of funds or products and comparison inter-se, over a reasonably long period of time, to pick your basket. There are certain so-called absolute return products, where the objective is to generate returns in all market conditions. In a prolonged bear market, it is difficult to generate positive returns, in spite of the partial short positions in the portfolio. These products claim outperformance in prolonged bear phases by losing less than the index. Here also, you would like to pick the most consistent ‘absolute return’ product, i.e. you would go by peer group comparison.
Globally, there is marked shift from actively managed funds to passive ones, i.e. index funds. However, the Indian context is different. There is enough outperformance of the indices and it makes sense to invest in actively managed funds, to participate in the growth story. You have to match the fund objective with your investment objective, and do an inter-se comparison of the funds or products in that category, to pick your basket.
Ultimately, what matters to you is the return from your portfolio. You do need to gauge the performance of your funds and for that you need a perspective, which is the relevant benchmark. That apart, you need not perform a rigorous analysis as it is about a perspective only. You don’t take home returns from the benchmark, unless you are invested in an index fund. You are paying a higher expense to the manager in an asset management company or a PMS or an alternative investment fund, as compared to index funds, for not only outperforming the index but for generating peer-group alpha. The simplest and popular method is to look at returns over various horizons like 1-year, 3-years, or others. A better way of doing it is calculating ‘peer group information ratio’, which is returns from the product over the peer group, divided by standard deviation. This gives the variability-adjusted peer group outperformance.