Mutual Fund Scheme Performance

Performance is the first thing an investor asks about and the easiest thing to misread. This unit covers the machinery that makes a scheme's return mean something: the benchmark it is measured against, which variant of that index the comparison uses, the figures that describe how faithfully a fund tracks what it claims to track, and the rules on how all of it must be published. A distributor who can explain why the higher return is the weaker result is doing the job; one who reads out the top of a one-year return table is not. It starts with the benchmark, because without one there is nothing to compare against.

Why a benchmark matters

A return on its own cannot be judged. Twelve per cent is excellent if the relevant index did six, and poor if it did eighteen. The benchmark is what converts a number into information, which is why every scheme names one in its offer document and reports against it.

The benchmark also has to be the right one. Comparing a small-cap scheme with a large-cap index tells you about the difference between small and large companies, not about the fund manager. Like for like is the whole condition.

Past performance, and what it is not

Every scheme communication carries the line that past performance may or may not be sustained in future, and it is not a formality. Returns are the outcome of conditions that do not repeat, and a period that flattered a strategy can end without warning.

This is also a compliance point rather than only a conceptual one: a distributor may not present past returns as an indication of future returns, and may not guarantee anything. Several questions in this unit are that principle wearing a different hat.

Price return index and total return index

An index can be quoted two ways. A price return index tracks only the movement in the prices of its constituents. A total return index adds the dividends and interest those constituents pay, on the assumption that the money is reinvested in the index. The gap between the two is not decorative: over the years a scheme is held, a dividend yield compounding inside the index moves the comparison materially.

That matters because a scheme's NAV already contains the same income. When a company in the portfolio pays a dividend, the money reaches the fund and shows up in the NAV. Measuring a NAV that includes income against an index that excludes it flatters the fund and rewards nobody's skill. SEBI closed the gap: a scheme's performance is benchmarked to the total return variant of the index chosen as its benchmark, and the benchmark itself has to be aligned with the scheme's investment objective, asset allocation pattern and investment strategy.

Older indices create one complication. Total return values do not always exist as far back as a scheme's inception. In that case the comparison uses a composite CAGR: the price return index up to the date total return values became available, and the total return index from then on. It is a stitched figure, and a candidate who has understood why it is stitched has understood the whole point of the distinction.

Tracking error and tracking difference

Tracking error is the annualised standard deviation of the difference between the daily returns of the index and the daily returns of the fund's NAV, computed on a rolling one-year window, or on whatever data exists where the fund is younger than that. It answers a narrow question about an index fund or an ETF: how faithfully does this scheme do the one thing it promised to do? It says nothing about whether the index itself was a good place to be.

No fund replicates an index exactly, and the reasons are ordinary operating facts rather than failures:

• The scheme bears expenses. The index does not.
• Cash held to meet redemptions sits out of a rising market.
• Index changes are rebalanced with a delay and at a dealing cost, whereas the index switches constituents at a stroke.
• Inflows and outflows have to be invested or funded at traded prices, not at the index's closing levels.

Tracking difference is the plainer cousin: the annualised difference between the return of the index and the return of the fund's NAV, which is simply how far behind the fund finished. The two answer different questions and can move in opposite directions. A fund that lags its index by a steady, predictable margin has a large tracking difference and a small tracking error. SEBI treats them separately as well. Index funds and ETFs other than debt ones disclose tracking error daily on the AMC's website and on AMFI's, and it is subject to a cap, with any breach caused by circumstances beyond the AMC's control to be brought to the trustees along with the corrective action taken. Debt index funds and ETFs are held instead to a ceiling on annualised tracking difference averaged over a year, disclosed monthly for a set of standard periods and since the date of allotment. The current limits are in paragraph 4.5.4 of the Master Circular and are worth reading there, since figures of this kind are revised by circular rather than by amendment to the Regulations.

One inversion catches people. For a passive scheme, a low tracking error is the whole objective. For an actively managed scheme it means something close to the opposite: a manager whose returns barely depart from the benchmark is holding something very like the index while charging for judgement.

Choosing the benchmark, and where the numbers appear

Benchmarks are decided by the AMC and the trustees, and a later change has to be recorded and reasonably justified. For several categories the structure is two-tiered: the first-tier benchmark reflects the category the scheme belongs to and comes from the list AMFI publishes, while an optional second-tier benchmark reflects the investment style or strategy the manager runs within that category. The guiding principles follow the asset class. Equity and debt schemes take a broad market index representative of the category, money market and liquid schemes take a suitable money market instrument or a combination of them, thematic and sectoral schemes take a single benchmark because the theme has already narrowed the field, and index funds and ETFs take the index they replicate. A fund of funds investing in a single scheme uses that scheme's benchmark.

Where performance is published is prescribed rather than left to the AMC. Scheme returns against the benchmark's total return index are disclosed on AMFI's website in CAGR terms over one, three, five and ten years and since inception, updated daily from the previous day's NAV, with shorter windows down to seven days added for overnight, liquid, ultra short duration, low duration and money market schemes, whose investors hold for weeks rather than years. Schemes in existence for less than a year are otherwise exempt. Advertisements follow their own rules under the advertisement code: CAGR for at least one, three and five years and since inception, point-to-point returns on a standard investment of ten thousand rupees, figures computed to the month-end preceding the advertisement, a statement of whether the numbers are for the regular or the direct plan, and a footnote where the same fund manager did not run the scheme throughout. A scheme less than six months old may not show past performance at all. Separately, equity schemes disclose an information ratio daily, which sets the return earned over the first-tier benchmark against the volatility of that excess return.

What the examination tends to ask here

Judging by the published sub-topics, the questions here turn on distinctions rather than arithmetic. Expect scenarios that supply a scheme's stated objective and several candidate indices, where only one matches the category and asset allocation, and expect the price return and total return variants to be asked as a reason rather than a formula: why the total return version is the fair comparison, and which way a comparison drifts when it is made against the price return one. Tracking error is easy to set questions on precisely because it is easy to confuse with three other things, namely tracking difference, the volatility of the fund itself, and a measure of the manager's skill. The disclosure rules are specific enough to be tested literally, so it is worth knowing where performance appears, over which periods, and what has to accompany a return figure in an advertisement. Underneath all of it sits the standing prohibition on presenting past performance as an indication of future returns, which is a compliance answer wherever a question offers a plausible-sounding forecast as an option.