Mutual Fund Scheme Performance — NISM V-D

A 5-mark chapter V-D separates out from scheme selection. Performance means nothing without a fair yardstick, so this chapter is about benchmarks: what makes a benchmark appropriate, why SEBI moved every scheme onto Total Return Indices in 2018, and the risk-adjusted measures (Sharpe, Treynor, alpha) and tracking error a distributor uses to judge a fund honestly.

Foundation

A benchmark is the standard against which a scheme's performance is judged — a large-cap fund against a large-cap index, a gilt fund against a government-bond index. An appropriate benchmark is chosen from the scheme's investment OBJECTIVE, its investment STRATEGY and its ASSET-ALLOCATION pattern — never from its past returns (choosing a benchmark to flatter history is circular). Crucially, indices come in two variants. A Price Return Index (PRI) captures only the capital-gains (price) movement of its constituents. A Total Return Index (TRI) also adds the dividends/interest the constituents pay. Because a mutual fund actually receives and reinvests those payouts, TRI is the fairer comparison — so with effect from 1 February 2018, SEBI mandated that all mutual fund schemes be benchmarked against Total Return Indices.

Deep Dive

Raw return is not enough — two funds returning 12% are not equal if one took far more risk. Risk-adjusted measures fix this. The Sharpe ratio = (return − risk-free rate) ÷ standard deviation — excess return per unit of TOTAL risk (higher is better). The Treynor ratio uses beta (systematic risk) in the denominator instead of standard deviation. Alpha is the return over and above what the benchmark (adjusted for beta) would predict — the manager's value-add. Standard deviation, beta and variance on their own are risk MEASURES, not risk-ADJUSTED return measures — a favourite exam distinction. For an index fund, the right question is not "did it beat the market?" but "how faithfully did it copy the index?" — measured by TRACKING ERROR, the standard deviation of the fund's return differences from its benchmark. Low tracking error is a virtue for a passive fund; it would be meaningless for an active one.

Worked example

Worked example — PRI vs TRI, and picking the measure (A) Why the benchmark variant matters An equity index rises 10% in price over a year and its constituents pay ~1.5% in dividends. • PRI return ≈ 10.0% (price only). • TRI return ≈ 11.5% (price + dividends). A fund that returned 11% "beats" the PRI (10%) but TRAILS the TRI (11.5%). Pre-2018 it looked like an outperformer; against the mandated TRI it is a laggard. Same fund, opposite verdict — which is why SEBI moved everyone to TRI. (B) Which measure? • Judging a standalone equity fund on the volatility the investor actually feels → Sharpe ratio (uses standard deviation). • Judging a fund as one sleeve of a diversified portfolio → Treynor / alpha (use beta). • Judging an index fund's faithfulness to its benchmark → tracking error. Raw return alone answers none of these.

Advanced

The benchmarking choices carry real consequences a distributor must be able to explain. The PRI→TRI shift quietly raised the bar: against a PRI (which ignored dividends), a fund looked better than it should; against a TRI (which includes them), the same fund's outperformance shrinks or vanishes. So a fund that "beat its benchmark" pre-2018 might merely be trailing once dividends are counted — the shift increased transparency. On measure selection: use the Sharpe ratio when total volatility is what the investor feels; use Treynor/alpha when judging a component of a diversified portfolio where only systematic (beta) risk matters; use tracking error only for passive/index funds. Picking the wrong measure — or, worse, the wrong benchmark — can make a mediocre fund look like a star. The distributor's job is to hold the fund to the RIGHT yardstick.

Regulatory references

SEBI circular mandating Total Return Index (TRI) benchmarking — effective 1 February 2018
SEBI norms on scheme benchmarking and performance disclosure
Index methodology (PRI vs TRI variants)

Common mistakes & pitfalls

Choosing a benchmark from a scheme's past returns — benchmarks come from objective, strategy and asset allocation, not history.
Comparing a fund to a PRI — since 2018 the mandated (and fairer) benchmark is the Total Return Index.
Treating standard deviation, beta or variance as risk-ADJUSTED return measures — they are risk measures; Sharpe/Treynor/alpha are the risk-adjusted ones.
Judging an index fund by outperformance instead of tracking error — a passive fund's job is to copy, not beat, the index.

Frequently asked

What is the difference between a Price Return Index and a Total Return Index?

A PRI captures only the price (capital-gains) movement of its constituents. A TRI adds the dividends/interest they pay. Because funds receive those payouts, TRI is the fairer benchmark — mandated for all mutual fund schemes since 1 February 2018.

Which measure tells me how closely an index fund tracks its benchmark?

Tracking error — the standard deviation of the fund's return differences from its benchmark. Low tracking error means faithful replication, which is exactly what a passive fund should deliver.

Is the Sharpe ratio a risk measure or a risk-adjusted return measure?

A risk-adjusted return measure: excess return over the risk-free rate per unit of total risk (standard deviation). Standard deviation, beta and variance are the plain risk measures it is built from.

Practice questions

Click each question to reveal the answer and explanation.

Q 1

Which of the following is a measure of the risk-adjusted returns of a mutual fund scheme?

(a)Standard deviation
(b)Beta
(c)Variance
(d)Sharpe ratio

Correct: (d) Sharpe ratio

The Sharpe ratio is a risk-ADJUSTED return measure (excess return per unit of total risk). Standard deviation, beta and variance are plain risk measures — the trap is that they are all "risk" words but not risk-adjusted RETURNS.

Q 2

Which of the following CANNOT be used to select a scheme's benchmark?

(a)The scheme's investment objective
(b)The scheme's investment strategy
(c)The scheme's asset-allocation pattern
(d)The scheme's past returns

Correct: (d) The scheme's past returns

A benchmark is chosen from what the scheme is designed to do — objective, strategy and asset allocation. Choosing it from past returns is circular (you'd pick whatever index the fund happened to beat), so past returns cannot drive benchmark selection.

Q 3

Which index takes into account all dividends generated by its constituents in addition to capital gains?

(a)Total return index
(b)Price return index
(c)Dividend return index

Correct: (a) Total return index

A Total Return Index (TRI) adds constituent dividends to capital gains; a Price Return Index (PRI) counts only price movement. SEBI has mandated TRI benchmarking for mutual funds since February 2018.

Q 4

Which is the most appropriate measure of how closely an index fund tracks its benchmark?

(a)Treynor ratio
(b)Tracking error
(c)Total Expense Ratio (TER)
(d)Assets Under Management (AUM)

Correct: (b) Tracking error

Tracking error measures the deviation of a fund's returns from its benchmark — the natural yardstick for a passive/index fund's faithfulness. Treynor is a risk-adjusted return measure; TER and AUM say nothing about tracking.

Educational purposes only. The numbers, returns, and examples used in this lesson are illustrative. Past performance does not guarantee future results. Mutual fund and securities investments are subject to market risks. This lesson is not investment advice; for advice tailored to your circumstances, consult a SEBI-registered Investment Adviser. Read our full disclaimer.