Price Vs Total Return Index

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1 ArthVeda - Research and Product Development Authors Ashwini Shami ashwini.shami@arthveda.co.in Rohit Kumar rohit.kumar@arthveda.co.in Vipul Badjatya, CFA vipul.badjatya@arthveda.co.in Vikas Gupta vikas.gupta@arthveda.co.in Story of How Index Funds Outperform Benchmark Index funds are designed to efficiently track the performance of the benchmark. For example, an S&P 500 tracker fund should closely replicate the performance of S&P 500 index. As the fund has to incur trading and other expenses, performance should ideally lag the benchmark return. However, we have seen that in India, sometimes index funds display much higher returns as compared to benchmark. How is it possible? The answer may lie in the choice of the benchmark used for comparing the relative performance. As per construction methodology, benchmarks can be either Price Return Index (PI) or Total Return Index (TRI). Have you ever wondered what the difference is between these variants in terms of calculation? Which one should be used while comparing the performance of funds relative to benchmark? These are some of the questions which we will try to address in this article. Price Return Index (PI) Vs. Total Return Index (TRI) Price indices are calculated using the price performance of constituents and it completely ignores the dividend payouts by companies. On the other hand, total return indices include the dividends while calculating the index performance. Total return indices account for ordinary cash dividends and are generally applied on the ex-date. Regular cash distributions are generally not considered in price return indices, except for capital repayments and special dividends which are deemed extraordinary. We can break up the return coming from total return index in two components price index performance and performance impact due to dividend. Total return index performance = Price index performance + performance impact due to dividend. Going by the above formula, we can conclude that total return index performance is higher than the price index performance. Major index providers such as MSCI, S&P, FTSE, etc. calculate two variants of total return indices Gross Total Return (reinvest full dividend without deducting any taxes) and Net Total Return (reinvest dividend after deducting the taxes). Tax rates are defined for each of the countries and are generally the maximum tax rate applicable for international investors. Power of compounding The difference in total return and price return can be substantial over a few year period due to the compounding effect. Illustration below tries to explain it. To keep it simple, we will analyze a 3 year period where the performance of price index return is 10% and total return is 12%.

2 Period PI Return Dividend Impact TRI Return Cumulative Return - PI Cumulative Return - TRI Year % 2.0% 12.0% 10.0% 12.0% Year % 2.0% 12.0% 21.0% 15.4% Year % 2.0% 12.0% 33.1% 40.5% For a 3 year period, the difference between price index and total return index is 7.4% (40.5% %) which is resulting due to compounding of dividend impact over 3 year period. We have also compared actual 3 year return of 2 widely tracked indices MSCI World and S&P 500. For both these indices, we have observed that the difference between price and TR indices are huge. Index Name Price Return (last 3 years) Total Return (last 3 years) Difference MSCI World 33.0% 44.5% 11.5% S&P % 60.5% 9.9% Source: MSCI and S&P, Note: 3 year period ending 11 Sept 2013 Nifty is a price index and hence doesn t include the dividends in the calculation. However, Nifty TR index levels are also available on the NSE website. We have compared the 2 series in the below chart. Difference between PI and TRI is huge even for Nifty. - PI vs TRI Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul-13 Rebased TR Rebased PI Source: NSE website We also checked fund factsheets of Indian fund houses who are managing index funds. Surprisingly, some of them are using NIFTY as the benchmark which doesn t take into account dividend reinvestment. Few of them even use BSE Sensex as additional benchmark and completely ignore Nifty total return index. This doesn t make sense and may misrepresent the actual performance to the potential investors. 2

3 Fund Fund Return Benchmark return (NIFTY) Fund A 11.85% 10.67% Fund B % Period: June 30, 2012 to June 30, 2013, Source: Company website Which one to use PI or TRI? Suppose a fund has given a return of 35% in the last 3 years. If it compares itself against the price index (above table), we will observe an outperformance (35% % =1.9%). However, if we compare it with respect to the total return index, the fund has underperformance (35% % = underperformance of 5.5%). Funds receive cash dividends and reinvest most of it in the same way it is done in total return indices. If we take price performance for comparing the relative performance of any fund, it may be deceptive as it will show the fund in a positive light as compared to the index. Hence total return seems to be a better representation of the actual benchmark. Globally most of the ETFs use total return indices as their underlying index. For example, ishares, biggest ETF player in the world, generally uses total return variant for their ETFs. Arthveda Fund Management Ltd. (AVFM) has recently launched Alpha L50 fund which aims to generate alpha i.e. higher returns with lower risk vis-a-vis its benchmark index. Back tested results of the fund delivers superior returns while comparing with Nifty TR index over different investment horizons. Details of multi period performance analysis can be accessed via the Arthveda research report titled Beating Nifty50 through ArthVeda Alpha L50 A study performed by Arthveda that analysed Indian mutual funds performance only signifies the importance of choosing the correct benchmark index while evaluating the performance of mutual funds (MFs). Returns from a set of 82 large cap MFs were compared and ranked separately with Nifty PI as well as with Nifty TRI. Multiple holding periods of 1yr, 2yr, 3yr, 4yr, 5yr, 6yr, 7yr and 10yr were considered over a period of ten years ( ) to ensure a completely generalized analysis. This is also a sufficiently good measure as a higher rank suggests a consistent performance over a longer period. Table given below shows that one out of three MFs outperformed when compared with Nifty PI portfolio. But, this outperformance number falls significantly to 1 out of 5 if MFs were to be compared with the Nifty TRI portfolio. In percentage terms, around 66% MFs underperformed when the returns were compared with Nifty PI portfolio. However, when the returns were compared with Nifty TRI portfolio then around 80% MFs underperform. This indicates the importance of keeping an appropriate benchmark and how choosing a price index as the benchmark can incorrectly project a superior performance. Holding Period No. of Funds Nifty PI Rank Outperformed w.r.t PI Nifty TRI Rank Outperformed w.r.t TRI 1YR % 20 23% 2YR % 13 16% 3YR % 13 18% 4YR % 12 19% 5YR % 7 12% 3

4 Holding Period No. of Funds Nifty PI Rank Outperformed w.r.t PI Nifty TRI Rank Outperformed w.r.t TRI 6YR % 8 17% 7YR % 10 24% 10YR % 8 30% Average 34% 20% Source: Arthveda, Crisil, NSE website The above study not only indicates the real performance of large cap MFs, but also helps us understand an important aspect of Indian financial market s efficiency. For long, it has been believed that Indian financial market, belonging to a developing country, is inefficient and it is possible to beat it through active fund management. Even the table above shows that a good 34% MFs were able to outperform the market. This is though possible only if Nifty PI is kept as the benchmark index. Interestingly, if Nifty TRI, a much more relevant benchmark, is used then the outperformance is only 20%. Moreover, none of the MFs has outperformed consistently over a long period. If an adjustment is made for consistency, we would get an outperformance number consistent even with developed markets. The obvious question that rises now is that if Indian markets are fairly efficient and beating the market is not possible over a long period of time then how can one optimize returns? Arthveda s L50, an enhanced index fund holds the answer to this question. The rule based and structured value investing approach adopted by L50 ensures higher risk-adjusted returns in different market conditions. Holding Period No. of Funds Nifty TRI Rank Outperformed w.r.t TRI L50 Rank Outperformed w.r.t L50 1YR % 14 15% 2YR % 11 13% 3YR % 12 16% 4YR % 10 15% 5YR % 6 10% 6YR % 6 12% 7YR % 6 13% 10YR % 5 17% Average 21% 14% Source: Arthveda, Crisil, NSE website The table above shows the ranking of L50 in a group of 82 MFs and Nifty TRI portfolio. L50 performed consistently better across various holding periods, outperforming 86% of all vs. 79% for Nifty TRI portfolio. Note that L50 always uses Nifty TRI as a benchmark to compare its returns. 4

5 L50 35% 30% 25% 20% 15% 10% 5% 0% 29.1% 23.3% 26.7% 26.4% 25.1% 24.0% 22.0% 21.9% 21.1% 20.2% 1YR2 YR 3YR4 YR 5YR Holding Period Source: Arthveda, Crisil, NSE website L50 also beats Nifty TRI portfolio over various holding periods (refer above chart). L50 gave consistently higher returns over 1yr, 2yr, 3yr, 4yr and 5yr holding periods over a long period of 10 years. Hence it can be concluded that L50 generates consistent alpha by utilizing an enhanced index approach. For detailed analysis, please refer to the report titled Beating Nifty50 through ArthVeda Alpha L50 S&P and CRISIL conduct a study (SPIVA) measuring the performance of actively managed funds against their relevant S&P index benchmarks. As per the report for 2012, more than 53% of the large cap index funds underperformed their benchmark, S&P CNX Nifty. Benchmark is price index and hence not the best measure of performance comparison. SPIVA report for developed markets (example: US) use total return indices instead of price index which is a much more logical choice. Conclusion We believe that TR indices provide a better view of relative performance and should always be used to compare the relative performance. Globally TR indices are used for this purpose. In India, Nifty, which is a price index, is generally used for relative comparison of funds which doesn t show us the correct picture. Most of the funds which show outperformance with respect to Nifty actually underperform when Nifty total return index is used as benchmark. Investors should also be aware of the right choice of benchmark to make their decision wisely. 5

6 About ArthVeda ArthVeda Fund Management Pvt. Ltd. is in the business of asset management with a focus on alternative investment funds covering asset classes such as real estate, infrastructure, fixed income, traded markets, agriculture, debt and unlisted equities. ArthVeda is an associate company of Dewan Housing Finance Ltd (DHFL). DHFL is the third largest housing finance company in India and is listed on the Bombay Stock Exchange and National Stock Exchange. The objective of ArthVeda is to manage funds (designed by our in-house research team) that offer ample opportunities for extracting alpha, i.e. high risk-adjusted returns, from asymmetric risk-return opportunities. The company believes in Value Investing and predominantly follows this principle in all its investment-decisions across asset classes. ArthVeda s investor-focused approach is guided by its belief in transparency and high standards of corporate governance. Disclaimer This document is not an offering document for any securities or units of any kind and should not be seen as solicitation for investments. The document is intended for illustration and information purposes for intended user only. Further, the contents of this document are provisional and may be subject to change. This document is produced solely to the specified recipient for the purpose of its internal use. This document may not be transmitted, reproduced or made available to any other person. The information contained herein is proprietary and confidential and may not be disclosed to third parties or duplicated or used for any purpose other than the purpose for which it has been provided. Any unauthorized use, duplication or disclosure of this document is prohibited by law. Certain information included in this document is based on information obtained from sources considered to be reliable, however, the accuracy of such information cannot be guaranteed and further such information may be incomplete or condensed. No liability is assumed for the relevance, accuracy, or completeness of the contents of this document. This document is subject to the more detailed information specified in the disclosure documents and client service agreement. Investors must read and agree to the contents of the documents, including all risks highlighted therein, prior to making any investment related decisions. Before making an investment, each potential investor should make its independent assessment and inquiries. Document may include predictions, estimates or other information that might be considered forward-looking while these forward-looking statements represent our current judgment on what the future holds, they are subject to risks and uncertainties that could cause actual results to differ materially. Investors are cautioned not to place undue reliance on these forward-looking statements. Neither ArthVeda Fund Management Ltd., nor any person connected with it, accepts any liability arising from the use of this material. The recipient of this material should rely on their investigations and take advice from their professional advisors opinion, if any, expressed are our opinions as of the date appearing on this material only. We endeavour to update the material on a regular basis. However there is no regulatory compulsion for us to do so. Investments in equity markets are subjected to market risk and there is no guarantee that the investment objective of the strategy will be achieved. Please read the strategy related documents (Disclosure and Client Service Agreement) carefully. Investors should consult their tax and investment advisors before investing. 6

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