For long, most equity mutual funds in India have found it quite easy to stay a hop, skip and jump ahead of the index to which they are benchmarked. Part of the credit must go to skilled fund managers, no doubt. But credit must also go to the funds choosing easy benchmarks.
Most Indian funds measure themselves up against pure Price Indices, as opposed to Total Returns indices. But recently, two fund houses — DSP BlackRock and Edelweiss — decided to rock the boat and use the Total Return index to measure their performance. Quantum Mutual Fund has been doing this for years.
What is it?
A Total Return index is a benchmark that captures both the price movements and the dividend payouts of its constituent stocks.
As an investor in shares, you make your returns from two sources: appreciation in the traded price of the share and the dividends you receive from the company. Returns on an index like the Nifty50 thus depend both on the price movements of the 50 stocks and the dividends that the companies pay out.
But in India, the default stock indices everyone uses is the Price Index, which ignores the dividend component. So when you read headlines about the Nifty50 shooting up by 200 points for the day, it the Nifty50 Price Index that is being referred to. But as an investor owning the Nifty50, you should actually be tracking the moves of the Nifty50 Total Returns index, which also factors in the dividends received.
The Nifty50 Total Returns Index is calculated by assuming that the dividends declared by the Nifty50 companies are reinvested in their respective stock, on the day they go ex-dividend. The NSE disseminates plain Price as well as Total Return indices for all the benchmarks available on the exchange.
Why is it important?
Dividends may not appear to be a big source of returns to the ordinary investor, given that the annual dividend yield for Nifty companies stands at less than 1 per cent today. But dividend payouts, if reinvested over time, can make quite a significant difference to the investor’s returns through the magic of compounding.
In the five-year period between August 2012 and August 2017, the Nifty50 Index delivered a 13.5 per cent annual return based on price gains alone. But the Total Returns for the same index, after assuming re-investment of dividends, works out to 15.2 per cent per annum. The Nifty500, which has more mid-cap companies delivered 16 per cent on a pure price basis, but for its Total Return was 17.7 per cent.
This gap between price and Total Returns in fact tells you why not counting the dividends suits money managers just fine; they can set a lower bar on the returns that they need to make to ‘outperform’ the market.
Why should I care?
If you directly dabble in stocks, it would pay for you to measure your portfolio’s performance against the Total Return Indices rather than the plain-vanilla indices that are commonly used, so that you don’t lose track of dividend receipts.
If you’re a mutual fund investor, you usually make the choice between an actively managed fund (where the fund manager buys stocks outside the index and thus charges a much higher fee) and a passive one (where the fund simply mirrors an index at low cost), based on the active fund’s ability to beat the index. If you use a price index to make this comparison, you may end up making a wrong choice.
The bottomline
In long-term investing, 1 per cent is a big number.