January 7, 2018

SEBI kills the golden goose (for mutual funds)

SEBI, yesterday, delivered perhaps the biggest reform India has seen this decade. While this should have been the banner headline of the pink papers, if not all papers, unfortunately, it has found space only in the back pages of some of them.

SEBI has now directed all mutual funds to use total return indices (TRI) as benchmarks instead of price return indices (PRI), that almost everyone (~80% of AUM) uses today and nearly everyone (~95% AUM) used till just a few months ago.

BTW, India is the last of the major global economies to implement this rule.

What is the difference between a PRI and a TRI?

Simply put, PRIs ignore dividends, while TRIs include dividends and therefore TRIs outperform PRIs by the amount of the dividend.

Now let’s do the same in a lengthy way. Let us say, there are only 2 stocks available in the market — stock Ambani and stock Adani. Let’s also assume they both have a price of 100 and the companies are of the same size. So the index for our market would have 1 stock each of Ambani and Adani and would be at 200.

Now, let us assume there is a mutual fund that has 0.33 stocks in Ambani and 0.67 stocks in Adani. So, the mutual fund NAV too is at 200.

Over the year, let’s assume both stocks move to Rs. 150 each. At the end of the year, while Ambani decides to pay Rs. 10 in dividend, Adani pays nothing. Ambani’s stock moves down to Rs. 140, because Rs. 10 has been paid to all the shareholders as a dividend. The way a PRI is calculated, the price of this index will be 290 (140 + 150). Because, a PRI doesn’t take the dividend into account. A TRI however does. So, the Rs. 10 that came as dividend is used to buy stocks in Ambani and Adani in the proportion of 14:15 and the index itself will remain at 300 (140 + 150 + 10).

What happened with our mutual fund though? Well, the fund gets Rs. 3 in dividend, which remains in the fund and in the NAV. So, the fund NAV too moves to 300.

As you can see the fund made no extra return. If I owned one stock each in Ambani and Adani, I have the same 300 in money — 290 in stocks and 10 in cash in the form of dividend. But the mutual funds used to compare themselves to the PRI, so they claimed — we turned Rs. 200 into Rs. 300 (50% return), while the index moved from 200 to only 290 (45%). So we made 5% in alpha.

SEBI has now forced mutual funds to compare themselves to the TRI, which moved to 300 too. So the alpha for the same fund now is simply zero.

SEBI just killed the golden goose.

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