India’s securities regulator is considering changing the way mutual fund performance is reviewed, in line with global standards on calculating net asset value (NAV) and returns.

To ensure an accurate assessment of returns, the performance of financial products such as mutual funds are compared to that of capital markets. If you’ve chosen to invest in an equity mutual fund instead of investing in individual stocks, it makes sense to use an index such as the Nifty or Sensex to judge whether you’re outperforming the market.

Of course, there are many other indices that comprise India’s stock market. The standard for a specific fund will vary depending on the type of fund and its objectives.

What’s important to know is that companies do different things with their earnings - some offer dividends to investors, while others reinvest those dividends. Some companies don’t offer dividends at all. All of these scenarios affect how mutual funds are benchmarked and the way NAV is calculated.

What are the proposed changes?
According to the latest legal news, the Securities and Exchange Board of India (SEBI) wants to align the way mutual funds’ NAVs and benchmark indices treat corporate actions such as dividends.

The NAV of mutual funds includes the value of dividends. But under the current system, equity mutual funds are only benchmarked against principal return indices such as the Sensex and Nifty, neither of which factor dividends received from constituent stocks into their returns.

This paints a distorted picture: if an index doesn’t consider the dividend yield in its returns, comparing it to an equity scheme that does results in an inaccurate reading - sometimes the reading is off by up to two percentage points.

That’s why SEBI is considering benchmarking mutual funds to total returns indices for a more accurate representation of equity schemes. Total returns indices are like any other indices, except in addition to tracking a security’s price movement and capital gains, they assume that dividends are reinvested into the index.

As part of this move, SEBI may implement a uniform calculation that’s more reflective of the fair valuation the regulator is keen to uphold.

How will this affect my portfolio?
Using total return indices as a benchmark can add between 1.25% to 2% to performance annually over principal return indices. This is the standard measurement used in most countries.

However, some experts question the certainty of using total returns indices as a measure of success. That’s because not all equity mutual fund schemes distribute dividends.

As well, analysts say a change in the benchmarks will be more noticeable in large-cap rather than mid-cap funds, since they outperformed their respective benchmarks by 2.25% over a three-year period.

For more Indian stock market news, visit BloombergQuint.