Mutual fund scheme performance

"The fund gave 18%" means nothing until you know what the market gave, over what period, and against which index. This chapter is about judging performance honestly: the right benchmark, the right comparison, the right time frame, and the rules SEBI imposes on how fund houses present numbers. It is a favourite source of conceptual questions.

Benchmarks: price return versus total return

A benchmark is the index a scheme is measured against. It should match the scheme's asset class, market cap segment and style, so that any difference reflects the manager's decisions rather than a mismatch. A large cap fund is benchmarked to the Nifty 100 or BSE 100, a mid cap fund to a mid cap 150 index, a corporate bond fund to a CRISIL or Nifty corporate bond index, and a hybrid fund to a blended index in the scheme's equity-debt proportion.

Indices come in two versions. A price return index (PRI) tracks only the prices of the constituent stocks. A total return index (TRI) also assumes dividends paid by the constituents are reinvested, so it is higher by the dividend yield, roughly 1 to 1.5% a year for Indian large caps. Since February 2018 SEBI requires all schemes to benchmark against the TRI, because the fund itself receives and reinvests dividends; comparing a fund's return with a PRI flattered the fund by the dividend yield every year.

From December 2021 SEBI introduced a two-tier benchmark structure. The tier 1 benchmark reflects the scheme's category, with one broad index per category (for instance, all flexi cap funds against the Nifty 500 TRI). The optional tier 2 benchmark reflects the scheme's specific strategy within the category, such as a value index for a value fund. Tier 1 makes peer comparison fair; tier 2 shows whether the strategy worked.

Comparing a scheme with its benchmark and peers

The basic test is the excess return over the benchmark across several periods: 1, 3, 5 and 10 years and since inception. One period is noise; outperformance in most periods is evidence. Two refinements:

• Rolling returns: instead of one point-to-point return, compute the 3-year return starting on every day over, say, the last 10 years, and look at the average, the worst, and how often the fund beat the benchmark. This removes the luck of the chosen start date.
• Peer group: compare only within the same SEBI category, since categories carry different risk. A small cap fund beating a large cap fund tells you about the category, not the manager. Quartile rankings within category, and the fund's rank consistency, are useful.

The comparison must hold other things constant: the same plan (regular with regular, direct with direct), the same option (growth), the same dates, and the same return measure (CAGR). Performance should also be looked at in falling markets separately: downside capture (how much of the benchmark's fall the fund suffered) matters more to most clients than upside capture.

The quantitative measures in practice

The previous chapter defined the ratios; here is how they are used. The Sharpe ratio ranks funds in the same category on return per unit of total risk and is the first filter. The Treynor ratio suits an investor whose other holdings already diversify away fund-specific risk. Alpha isolates the manager's contribution.

The simple excess return understates this manager, because the fund took only 90% of the market's risk and still beat it. A fund with a beta of 1.3 that returned 16% would show +2% simple excess but an alpha of 16 − (6 + 1.3 × 8) = −0.4%; it beat the index by taking more risk, not by skill.

For index funds and ETFs the measures are different. The goal is to match the index, so the metrics are tracking error (the volatility of the daily difference between fund and index returns; SEBI caps it, with a widely used limit of 2% annualised) and tracking difference (the fund's return minus the index return over a period, which is mostly the expense ratio plus cash drag). A lower number is better on both. For ETFs the gap between market price and NAV also matters.

Two further indicators from the factsheet: the portfolio turnover ratio, which shows how much of the portfolio was bought and sold in the year (high turnover means transaction costs and a trading style), and the expense ratio, which is the one component of future return that is known with certainty.

SEBI's rules for presenting performance

The SEBI advertisement code standardises how fund houses may show returns, so that the exam can test it:

• Returns for periods of one year or more must be shown as CAGR; for periods under a year, as absolute returns without annualising. Liquid and overnight funds may show simple annualised returns for 7, 15 and 30 days.
• Performance must be shown for the 1, 3 and 5 year periods and since inception, each alongside the benchmark TRI for the same period, and also as the value of ₹10,000 invested.
• For a scheme in existence less than a year, no performance may be advertised; for one between one and three years, only the available periods.
• When a fund manager's performance is shown, the performance of all schemes managed by that manager must be disclosed or referenced.
• Every performance disclosure carries the statement that past performance may or may not be sustained in future and is not a guarantee of future returns.
• Rankings and awards may be cited only if the ranking entity and methodology are disclosed and the ranking is not based on a short or selective period. IDCW payouts cannot be presented as return.
• Advertisements may not promise or imply assured returns, and the riskometer and product label must be shown.

The distributor's own communications are held to the same standard through the code of conduct. Quoting a fund's best one-year number while omitting the benchmark, the period and the disclaimer is mis-selling, however true the number is.

Reading consistency, not peaks

The question a distributor should be able to answer is not "which fund did best last year" but "which fund has beaten its benchmark in most rolling periods, with a drawdown the client can live with, at a cost that leaves most of the alpha with the client". A fund with a long-tenured manager, a stable process and third-quartile-or-better rankings in bad years often serves a client better than the current table-topper. Performance is one input into scheme selection, which the final chapter puts together.