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3 Big Changes that will impact Mutual Fund Investors

Big Changes in Mutual Fund

Last few months have been very dynamic and interesting for the mutual fund industry.

3 big changes have taken place that are going to impact all mutual fund investors and how they take their investment decisions in future.

If you are a little confused about what these changes are, then let me calm you down.

Maybe you have already heard about them but not understood their impact fully. Or it might have slipped off your mind as the impact may not be immediate or even short term. Nevertheless, I feel that these 3 changes need to be understood by you as long-term mutual fund investors.

So without wasting more time or making it a very long post, I will try to highlight what these changes are.

By the way, I have already written about two of these changes in super detail earlier. I will share the links two those articles shortly.

So what are these changes?

  1. Introduction of Long-Term Capital Gains Tax (LTCG) on equity
  2. Categorization & Rationalization of existing funds
  3. Use of TRI or Total Return Index for benchmarking of funds

If all three seem boring and too technical to you, then please hold on (and don’t close the window).

These are important changes. These are not just administrative changes that will have no impact on you. These three (yes…all three of them) will impact you and have a role to play in how much wealth you will create. So it makes sense to understand these changes.

Please. 🙂

Your money. Your responsibility.

I hope you are still reading.

Let’s get into these changes now…

1) Introduction of Long-Term Capital Gains Tax (LTCG) on equity

Unlike earlier years, your profits (capital gains) from equity after 1 year will now be taxed. So the actual money that you get in hand will be little lesser than what you would have got in a zero-LTCG regime.

But I won’t get into the details about LTCG tax here.

I have already addressed the impact of LTCG tax on long term investors in a super detailed post mentioned below:

Real impact of LTCG tax on long term equity investors

So I strongly recommend you read that post if you haven’t already.

It’s a little long but that should not stop you from reading it as its important. Bookmark it and read it when you have made time for it. Also read, How to find exact mutual fund NAV of 31 January 2018 for grandfathering of LTCG?

2) Categorization & Rationalization of existing funds

The regulator SEBI has ‘forced’ the fund houses to clean up their acts and make their fund offerings more logical, simpler to understand and more investor-friendly. This also forces the fund houses to be truthful to what they are offering.

This might seem just like a cosmetic change upfront to many. But it isn’t. This is one of the biggest change in Mutual fund space in recent years.

This will directly impact your investments as some of the funds will see big changes in their portfolio. And if you are MF star-rating lover, then please note that this will also impact how much returns some of the earlier 5-star rated and popular but now ‘rationalized’ funds will deliver.

So if you are an existing investor of any of these funds, then you will be impacted. So logically speaking, you should sit up and take notice of this change.

Want more details to understand it?

I have written a huge article on this.

Here is the link to that article:

Real impact of the NEW Categorization & Rationalization of existing mutual funds that YOU have Invested in

Please read it. Like the first one, this too is important even if you don’t feel it is right now.

That brings us to the last one…

3) Use of TRI (Total Return Index) for benchmarking of funds

(I haven’t written about this topic. So I will tackle it here itself in some detail)

This is another important development. It won’t put more money in your pocket directly. But it can help you take better decisions when picking right mutual funds – which in turn can put more money in your pocket eventually. 🙂

I will explain myself in a bit.

The respected regulator SEBI has asked all mutual fund houses to adopt the Total Return Index (TRI) to benchmark their schemes.

According to the regulator (and many others), this is a more appropriate way to measure the performance of such financial products. Here is a link to SEBI’s circular on TRI adoption for benchmarking fund mutual performance – Link

Till now, most equity mutual fund schemes have been benchmarked to the Price Return variant of the Index (PRI).

So what is the difference between this new animal TRI and the old PRI?

When you invest, there are 2 components of the total return you can make from your investments. First is ofcourse capital appreciation, And the second is the dividends from that investment.

If you only consider capital appreciation, then it means you are looking at PRI version. But if dividends are factored in too alongwith the capital appreciation, then that’s TRI – Total Returns.

Naturally, the returns of a total return index will always be higher than that of a price index.

Let’s now come back to the mutual funds.

The MFs receive dividends on the stocks they hold in their portfolios and this dividend is re-invested into the scheme. So ideally, they should compare their performance with Total Returns Index. That would be fair. But as I said earlier, they use PRI or Price-only Index.

How does it change the depiction of fund manager’s ability?

Suppose a Rs 100 invested in a fund becomes Rs 120.

The PRI index (which is generally used) to benchmark has grown itself from 100 to 112 in meantime. So in this case, the outperformance over and above the benchmark is Rs 8 = (Rs 120 – Rs 112).

On the other hand, TRI includes dividends and hence will be higher than PRI. Suppose it is 116. Obviously, the outperformance over and above the benchmark is now reduced to just Rs 4 = (Rs 120 – Rs 116).

Here is a simplistic summary:

Total Return benchmark Indian mutual funds

What has happened and why have fund managers been using PRI till now?

As returns appear lower in case of a PRI, it is easier for a fund to show higher out-performance against it. Read the previous statement again.

So when the fund compares itself with a PRI, it shows a much higher outperformance than it is actually doing (when compared with TRI). 🙂 🙂

PRI doesn’t capture the dividends which are available for the fund. TRI does that.

This gap between the price-only returns and Total-Returns in a way tells that by avoiding the recognition of dividends (in TRI), it actually helps the case of fund managers as they can set a lower bar on the returns that they need to make to ‘outperform’ the benchmark! 🙂

This might seem bad but luckily, SEBI has taken care of this by forcing fund houses to adopt TRI now. I am sure that if SEBI had not pushed the fund houses, most MFs would have continued to use PRI benchmarks. To be fair, few fund houses had already adopted the TRI for benchmarking even before the regulations came. Cheers to them!

I did some number crunching with Nifty50 data of last 10 years (Apr-2008 to Mar-2018).

The Nifty returned 7.87% over this 10-year period, while it’s TRI version returned 9.16% over the same duration.

Now suppose the fund you invested in gave a return of 10% in the same period. If you use PRI, then outperformance is 2.13% whereas if you use TRI, the outperformance over benchmark reduces to just 0.84%.

Nifty Total Return benchmark mutual funds

It is still outperforming the benchmark, but as you might have noticed, the outperformance (or what fund managers take credit for and become celebrities) can go down significantly due to change in benchmarks.

Hence, TRI is more appropriate as a benchmark to compare the performance of mutual fund schemes. And going forward, atleast some of the funds will have a tougher time beating this benchmark – something that they were able to do easily earlier. This pushes fund managers to work harder to generate real alpha (outperformance) and not rely on technical differences between TRI and PRI to artificially bloat their alphas.

But nothing is perfect.

Some people are saying that even the TRI is not perfect.

Why?

Because mutual funds have to keep some liquid cash aside too – for liquidity needs and in search of better opportunities. And the index – which is the benchmark does not have to keep this cash! So if this cash component of the fund is slightly large, then it can drag down the overall performance of the fund. And this reality is not captured by the TRI.

So it seems that the PRI was overstating performance while the TRI is ‘slightly’ understating it when compared to the index. 🙂

This is true to an extent. But I don’t buy the argument completely as cash was held even under the PRI regime. This is nothing new that is introduced in the TRI regime. Isn’t it?

As I said, nothing is perfect. So we really cannot ignore the investor-friendliness of using TRI over PRI for benchmarking.

But it is important to highlight something here:

The use of Total Returns version of the Index for benchmarking has absolutely no impact on the actual returns generated by the mutual funds. It is just done to ensure that fund performance is compared more accurately against a correctly chosen benchmark.

I know what you are thinking.

If this doesn’t impact the actual returns, why should we even be bothered?

There is a need to understand this difference between total return and price return. And it is because when you are picking good mutual funds to invest in, one of the many important criteria is to see how is the fund’s consistency with respect to its benchmark. As since beating the benchmark will be slightly tougher now, this factor will play its role in the proper selection of good mutual funds to invest in for the long term.

Let me remind that beating benchmarks is not the only factor in fund selection. There are several others which are important enough.

Another thing to note here is that changeover to TRI in no way means that fund managers will not beat their benchmarks. It only means that the number of funds beating the same benchmarks will be reduced in years to come. This fact will get a further push as SEBI’s directive to rationalize mutual funds has asked fund houses to just have one fund per category.

On a related note, some people are of the view that since beating benchmarks will be tougher, its best to go for index funds. There is no clear-cut answer here, to be honest.

Index fund is a beautiful product. More so now. But still, good fund managers will continue to do better than those index funds.

But the margin of their outperformance will get reduced to some extent. And as the years progress, the difference (or outperformance) will get reduced on a category basis. I will still not write off active equity funds as I believe that proper fund selection can increase the probability of finding index-beating and proper-benchmark beating funds.

But I agree, that the time for index funds will come soon.

And now more than ever, it’s true that an Index fund may not beat a good fund manager. But it will surely beat a bad one. 🙂

Why is SEBI pushing for so many changes in the Mutual Fund industry?

Many followers of the MF industry (me included) can vouch for the fact that the last few months have been quite eventful for the industry as a whole.

Implementation of LTCG on equity gains by the government, rationalization of schemes and forcing adoption of TRI by SEBI – these are not small developments.

And as far as I can make out, the future will see more announcements of such regulatory measures.

As you might have guessed by now, these are being done to ensure that the industry remains investor-friendly and curb misselling to some extent.

The industry is growing by leaps and bounds and as more and more people are joining the mutual fund bandwagon believing that #MutualFundSahiHai, it is only rightful that the regulator is doing its bit to nudge the industry to clean up and take a moral high ground.

I hope this article that focuses on use of Total Returns Index for benchmarking by mutual funds and other two focusing on tax on LTCG from equity and Categorization & Rationalization of Mutual Funds were able to give you the clarity that you need to have regarding these changes.

For common people, the Mutual funds are the best investment option to create wealth in the long run. And with new changes, it is expected that industry will be better regulated and investors will have the right information to ask the right questions from their fund managers.

Inspite of these 3 changes, nothing changes in how you should go about managing your money. Know yourself and your financial goals. Get yourself a good financial plan that gives you a roadmap to invest properly. And then, stick to the plan and continue monitoring your investments properly. That’s all that is needed.

So happy investing.

If you have any questions pertaining to these developments or want to take professional help in creating a solid financial plan (details here), please contact me.

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Written by Dev Ashish

Founder - Stable Investor Investing | Personal Finance | Financial Planning | Common Sense

3 comments

  1. Thanks Dev for the article and for your stylish handwritng :))) and its too good to read,
    “an Index fund may not beat a good fund manager. But it will surely beat a bad one. 🙂” .. Nice one,
    I personally feel they ( Fund Managers) are not accountable to the investors present day, Most of them just did whatever they felt good for themselves 😛 ))))) , so I think these moves are really good and will bring more tranperency to the industry.
    Keep writing and educate us….

    1. Thanks Milan 🙂

      The moves are expected to bring in the guardrails that were always needed. Lets keep our fingers crossed that in this new regime, our fund managers are able to deliver as they have been delivering till now. 😉

  2. Splendid write up Dev

    >> good fund managers will continue to do better than those index funds

    The million rupee question can somebody identify this so called good fund managers which are rotating and seasonal, Fund managers have emotions, they ask for raise, they quit, they join the competitors or even start their own PMS(new trend lately)
    Finding the best performing fund is a oxymoron. What is top today tomorrow will be forgotten fund tomorrow. for example please see what has happened to hdfc star fund manager and the hdfc top 200.

    Why not index fund instead, The last few years data is totally tilting towards passive investments, SPIVA report for example illuminates that the time for passive investments have come.

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