Absolute Return Vs Total Return - Benefits of Total Return Index in Mutual Funds | Motilal Oswal
Absolute Return Vs Total Return - Benefits of Total Return Index in Mutual Funds | Motilal Oswal

Absolute returns vs total returns - why it matters to mutual funds

In its last Board meeting, SEBI asked all the equity funds to benchmark their performance on the basis of Total Returns Index (TRI) rather than the absolute returns index (ARI) that is being used currently. What exactly is the difference between absolute return and total return? How does absolute return vs. total return stack up as performance measurement measures of mutual fund performance? What is the absolute return formula and what is the total return formula. Remember, Indian mutual funds use the ARI to measure their performance and effective February 01st 2018 they will be shifting to the TRI to measure this performance.

Absolute Returns versus Total Returns: How they differ conceptually?
 Absolute returns are nothing but the point to point returns. So if the price of the stock on 1st Jan 2017 was Rs.200 and the price was Rs.240 on 31st Dec 2017 then the 1 year absolute return will be

                20% = {(240-200)/200} x 100.

Absolute returns purely consider the price movement from one point to another. We can use absolute returns for calculating 3 months returns, 6 months returns, 1 year returns, 3 year returns or 5 year returns. In case of tenure longer than 1 year, it is advisable to use the CAGR (compounded annual growth rate) to get a clearer picture.

Total returns are the same as absolute returns with the only difference being that it also considers the impact of dividends. Let us go back to the previous example and let us assume that the company also declared a dividend of Rs.5 during the year. Total returns will consider these dividends too. So the Total returns on the stock now will be as under..

              22.50% = {(240+5-200)/200} x 100

As we can see, the total returns on the stock are higher because the dividends are also considered whereas in the first case the dividends were not considered. But why is this distinction so critical for measuring the performance of mutual funds..

Why is the Total Return a better measure for mutual funds than absolute returns?
Before we get into the technicalities of the calculations for Total Returns and Absolute returns let us first understand how an equity mutual fund functions. A mutual fund holds shares on behalf of its unit holders. Any dividends declared by the company accrue to the mutual fund. Secondly, any profits booked by the mutual fund on sale of shares also accrue to the mutual fund. Lastly, when stocks appreciate, the notional profits also contribute to the NAV of the fund. So when we calculate the returns on a mutual fund as the point-to-point NAV then we consider the dividends received, the profits booked and the notional profits that have not been booked.
We now come to the question of benchmarking the mutual fund performance against the index. That is where the dichotomy arises when you consider absolute returns. The absolute point-to-point returns of an equity mutual fund consider dividends and price appreciation. But in case of indices like Nifty and Sensex, the point-to-point returns only capture the price movement and not the dividends received by the index stocks. This could result in a situation where the returns of the index tend to get understated. That means the equity fund’s outperformance vis-à-vis the index tends to get overstated to the extent of the dividend yield on the index. Total Returns Index overcomes the problem by adding up the dividend yield to the index returns to give a more reliable picture.

TRIs can reduce the outperformance claimed by equity funds..
As mutual funds shift from ARI to TRI for benchmarking mutual fund performance, the investors will get a clearer picture. Let us understand how the shift from ARI to TRI will make a difference to the way fund performance is measured..
 

Fund and Index (ARI)Amount and ReturnsFund and Index (TRI)Amount and ReturnsNAV of Fund X - Jan 01Rs.20NAV of Fund X - Jan 01Rs.20NAV of Fund X - Dec 31Rs.26NAV of Fund X - Dec 31Rs.26ARI for Fund X30%TRI for Fund X30%    Nifty Value – Jan 0110,000Nifty Value – Jan 0110,000Nifty Value – Dec 3112,700Nifty Value – Dec 3112,700ARI for Nifty27%ARI for Nifty27%      Dividend Yield on Nifty2%  TRI for Nifty29% (27% + 2%)    ARI outperformance3% (30% - 27%)TRI Outperformance1% (30% - 29%)

 
When one looks at the above tabular comparison, the importance of the TRI over the ARI becomes much more obvious. In case of the fund, the equity fund receives the dividends and the capital gains and hence the change in the NAV reflects the ARI and the TRI for the equity fund X. In case of the Nifty index, the TRI is 29% as against the ARI of 27% when the 2% dividend yield on the index is considered.
The real impact is on the outperformance. As per the ARI formula, the equity fund has outperformed the benchmark by 3% which looks quite impressive. But if you look at the TRI then the fund outperformance falls to just 1% and now the fund almost looks like a market performer rather than a market outperformer. Equity funds across the board are likely to feel the pressure of shifting from ARI to TRI as their relative outperformance versus the index will come down. Mutual Fund investors will get a clearer picture of the performance and that is the key takeaway!
 

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