Chapter 8. Return, Risk & Performance of Funds

Learning Objectives

This unit is an invaluable guide to understanding the risk and return aspects of mutual fund schemes. Here, you will understand the nitty-gritty of how to calculate the returns from a mutual fund, and gain an overview of how risk can be measured. Benchmarking and risk adjusted returns are other key concepts discussed in this unit.

The portfolio is the main driver of returns in a mutual fund scheme. The underlying factors are different for each asset class.

Fundamental Analysis and Technical Analysis are two disciplines of securities analysis. Fundamental Analysis entails review of the company’s fundamentals viz. financial statements, quality of management, competitive position in its product / service market etc. Technical analysts study price-volume charts of the company’s share prices.

It is generally agreed that longer term investment decisions are best taken through a fundamental analysis approach, while technical analysis comes in handy for shorter term speculative decisions, including intra-day trading. Even where a fundamental analysis-based decision has been taken on a stock, technical analysis might help decide when to implement the decision i.e. the timing.

Growth investment style entails investing in high growth stocks. Value investment style is an approach of picking up stocks which are valued lower, based on fundamental analysis.

In a top-down approach, sector allocation is the key decision. Stock selection is important in bottom-up approach.

The returns in a debt portfolio are largely driven by interest rates and yield spreads.

If the portfolio manager expects interest rates to rise, then the portfolio is switched towards a higher proportion of floating rate instruments; or fixed rate instruments of shorter tenor. On the other hand, if the expectation is that interest rates would fall, then the manager increases the exposure to longer term fixed rate debt securities.

This additional return offered by a non-government issuer, above the yield that the government offers, is called yield spread. Better the credit quality, lower the yield spread.

Gold is a truly international asset, whose quality can be objectively measured. The value of gold in India depends on the international price of gold (which is quoted in foreign currency), the exchange rate for converting the currency into Indian rupees, and any duties on the import of gold.

Unlike gold, which is a global asset, real estate is a local asset. It cannot be transported – and its value is driven by local factors.

Returns can be measured in various ways – Simple Returns, Annualised Returns, Compounded Returns, Compounded Annual Growth Rate. CAGR assumes that all dividend payouts are reinvested in the scheme at the ex-dividend NAV.

SEBI guidelines govern disclosures of return by mutual fund schemes.

Loads and taxes pull the investor’s returns below that earned by the Scheme. Investor returns are also influenced by various actions of the investor himself.

Risks in mutual fund schemes would depend on the nature of portfolio, its liquidity, outside liabilities and composition of unit holders.

Fluctuation in returns is a measure of risk. Variance and Standard Deviation are risk measures for all kinds of schemes; beta is relevant for equity; modified duration and weighted average maturity are applicable for debt schemes.

Benchmarking is a form of relative returns comparison. It helps in assessing under-performance or out-performance.

Choice of benchmark depends on scheme type, choice of investment universe, choice of portfolio concentration and the underlying exposure.

Sharpe Ratio, Treynor Ratio and Alpha are bases to evaluate a fund manager’s performance based on risk-adjusted returns.

Quantitative measures are based on historical performance, which may or may not be replicated in future. Scheme evaluation is an art, not a science.

Classification of Equity Shares:

• Classification in terms of Market capitalization: Large-Cap, Mid-Cap & Small-Cap Capitalization companies.

• Classification in terms of Earnings: Earnings of the companies are generally classified on the basis of their market price in relation to one of the following measures:

Price/Earning Share:

• It is the price of a share divided by the earnings per share, and indicates what the investors are willing to pay for the company’s earning potential.

• Young and/or fast growing companies usually have high P/E ratios. Established companies may have lower P/E

Dividend Yield:

• DY of the stock is the ratio of dividend paid per share to current market price.

• Low P/E stocks usually have high dividend yields.

Cyclical Stocks:

• These are shares of companies whose earnings are correlated with this state of the economy.

Growth Stocks:

• These are shares of companies whose earnings are expected to increase at above normal market level.

• They reinvest the profit.

Value Stock:

• These are stocks of companies in mature industries and are expected to yield low growth in earnings.

Portfolio Management:

• Portfolio Management has two styles: 1. Passive 2. Active

• Passive Fund Management: There are mutual funds that offer stock index funds whose objectives is to track a specified share index and offer returns equal to the return from that index. The investment style is passive only in the sense that the fund manager does not have to go through the process of stock selection.

• Active Fund Management: There are two basic investment styles in active fund management: Growth Investment Style: Invest only in growth stocks which give above average earnings growth. Value Investment Style: Invest in companies that are currently undervalued in the market, but whose worth they estimate will be recognized in the market valuations.

• Securities Research in Active Fund Management: Following are the three major categories are in Securities Research.

• Fundamental Analysis: It involves research into the operations and finances of a company.

• Technical Analysis: It involves the study of historical data on the company’s share-price movements and trading volume.

• Quantitative Analysis: It uses mathematical models for equity valuation and may use fundamental and technical information. Now a day’s computer based models (exclusively made sophisticated high level software) are uses for such analysis.

• Portfolio Management Organization Structure: Three types of skilled employees in the equity portfolio management function:

• Fund Managers: They take overall decisions on asset allocations industry exposures.

• Security Analysts & Researchers: They support the fund managers with continuous tracking of the funds target sectors, companies and the overall markets. Both fundamental and technical analyses are performed by the analysts.

• Security Dealers: Executes the actual buy and sell orders originated by the fund managers.

• Debt Instruments: Following are the debt instruments available in the market

• Certificate of Deposit (CD): CD is issued scheduled commercial banks. It’s having maturity period of 91 days to one year.

• Commercial Paper: This is a short term, unsecured instrument issued by corporate bodies to meet short term working capital requirements. These instruments can be issued to individual, banks, companies etc.

• Corporate Debentures: These are issued by manufacturing companies with physical asset as secured instruments in the form of certificates. They are assigned a credit rating by rating credit agencies.

• Floating Rate Bonds: These are short to medium term interest-bearing instruments issued by financial intermediaries and corporations. Maturity of these bonds is 3 to 5 years.

• Treasury Bills: Treasury bills are also called as T-Bills. These are short term obligations issued through the RBI by the government of India at a discount for 91 days to 364 days. Theses are issued through an auction procedure. The yield is determined on the basis of bids tendered and accepted.

• Bank/FI Bonds: These are negotiable certificates issued by FI such as the IDBI/ICICI etc. Theses have been issued both as regular income bonds and as discounted long term instruments (deep discount bonds)

• Public Sector Undertakings (PSU) Bonds: These are medium and long term obligations by public sector companies in which the government share holding is generally greater than 51%. Some PSU bonds carry tax exemptions having minimum maturity of 5 years for taxable bonds and 7 years for tax free bonds.

SEBI guidelines in different investments:

• A mutual fund is not allowed to own more than 10% of any company’s equities.

• This is to prevent MF fund sponsors trying to acquire control pf any company through fund investment route.

• A scheme may invest in another scheme under the same AMC without charging any fees, provided investments limits of 5% of the NAV of Mutual Fund.

• This limit does not apply to a fund of fund scheme.

• Debt securities should be rated as investment grade by at least one recognized rating agency.

• Mutual funds are allowed to buy and sell only delivery based securities. Mutual funds are not allowed to advance any loans but may lend securities as per SEBI stock lending regulations.

• Mutual funds are restricted to invest not more than 25% of the net assets of any of mf schemes to the companies of sponsor.

• A fund of funds invests in schemes of other mutual funds. But a normal mutual fund scheme cannot invest in any FOF scheme. Also, a FOF scheme cannot invest in another FOF scheme.