Evaluation of Mutual Funds

8/7/2019 Evaluation of Mutual Funds

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Index

1. Executive Summary 22. Introduction 33. Industry Profile 5

3.1Organization for Mutual Fund3.2Indian MF History

4. Company Profile 124.1Vision4.2Mission4.3Chairmans Profile4.4Awards and Achievements

5. Objectives of the Project 156. Mutual Fund Concepts 16

6.1NAV6.2Open Ended Fund6.3Closed Ended Fund6.4Equity Fund and Types6.5Debt Fund and Types6.6Liquid Fund

7. Regulations 328. Advantages of Mutual Fund 339. Tools of Evaluation 3510.Data Collection and Analysis 4911.Conclusion 5912.Annexure 6013.Bibliography 63


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1. Executive SummaryWith various investment avenues available today, the investor has to make a well informed

decision regarding the avenue to select and the amount to be put in it. The avenues include

various financial instruments with varying levels of risk and return. Higher the level of risk,

generally higher is the expected return. Mutual fund acts as one of the prominent player amongst

the investment choices.

The Mutual Fund industry grew at very rapid pace from its inception that is in last fifty years.

The reasons behind it are simple which includes professional management of funds,

diversification and thus risk reduction, etc. As every common investor may expect to get the

highest possible return with given risk, Mutual Funds exactly served this need over a period of

time. Over a period of time mutual funds came up with innovative ideas according to the

changing tastes of investors. Today there are around 38 major fund houses and over Rs.7600

billion managed by them. The fund provide various schemes and manages the portfolio of each

of them. There are 860 schemes available across asset classes including gold, equity, debt,

money market instruments, etc. These schemes are called as flavors, which caters the need of the

customers depending on their risk appetite. Depending on the need of investors Mutual fund

companies came up with variants, like Balanced Funds, Growth Funds etc. This study

particularly concentrates on the Equity Diversified Open-Ended Growth Schemes offered bydifferent fund houses. The evaluation of schemes cannot be done taking into consideration

returns solely. There are statistical tools like Alpha, Beta, Standard Deviation and certain ratios

which help to comment on the overall risk and return of a scheme. And thus will help an investor

to make an informed decision. The selected schemes are ranked so as to facilitate the decision

making for an investor. The ranking criteria for schemes involve much more than return of a

scheme, off course the major emphasis is on return but risk is also given proper weight.


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2. Introduction:There are a lot of investment avenues available today in the financial market for an investor with

an investable surplus. He can invest in Bank Deposits, Corporate Debentures, and Bonds where

there is low risk but low return. He may invest in Stock of companies where the risk is high and

the returns are also proportionately high. Retail investors generally opt for buying a share at low

price and selling it at the peak of the market. This involves considerable risk as research involved

is minimum and if overall sentiments of investors fall in the same line can cause serious capital

reduction for a company. People began opting for portfolio managers with expertise in stock

markets who would invest on their behalf. Thus we had wealth management services provided

by many institutions. However they proved too costly for a small investor. These investors have

found a good shelter with the mutual funds.

A mutual fund is a professionally managed type of collective investment scheme that pools

money from many investors and invests it in stocks, bonds, short-term money

market instruments, and/or other securities. The mutual fund will have a fund

manager that trades the pooled money on a regular basis. The net proceeds or losses are then

typically distributed to the investors annually.

Since 1940, there have been three basic types of investment companies in the United

States: open-end funds, also known in the U.S. as mutual funds; unit investment trusts (UITs);

and closed-end funds. Similar funds also operate in Canada. However, in the rest of the

world, mutual fund is used as a generic term for various types of collective investment vehicles,

such as unit trusts, open-ended investment companies (OEICs), unitized insurance funds, and

undertakings for collective investments in transferable securities (UCITS).

Mutual Fund concepts inception

Massachusetts Investors Trust (now MFS Investment Management) was founded on March 21,1924, and, after one year, it had 200 shareholders and $392,000 in assets. The entire industry,

which included a few closed-end funds, represented less than $10 million in 1924.

Congress passed the Securities Act of 1933 and the Securities Exchange Act of 1934. These laws

require that a fund be registered with the U.S. Securities and Exchange Commission (SEC) and


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provide prospective investors with a prospectus that contains required disclosures about the fund,

the securities themselves, and fund manager. The Investment Company Act of 1940 sets forth the

guidelines with which all SEC-registered funds today must comply.

By the end of the 1960s, there were approximately 270 funds with $48 billion in assets. John

Bogle conceptualized many of the key tenets of the industry in his 1951 senior thesis at Princeton

University.

Usage

Since the Investment Company Act of 1940, a mutual fund is one of three basic types

of investment companies available in the United States.

Mutual funds can invest in many kinds of securities. The most common are cash

instruments, stock, and bonds, but there are hundreds of sub-categories. Stock funds, for

instance, can invest primarily in the shares of a particular industry, such as technology or

utilities. These are known as sector funds. Bond funds can vary according to risk (e.g., high-

yield junk bonds or investment-grade corporate bonds), type of issuers (e.g., government

agencies, corporations, or municipalities), or maturity of the bonds (short- or long-term). Both

stock and bond funds can invest in primarily U.S. securities (domestic funds), both U.S. and

foreign securities (global funds), or primarily foreign securities (international funds).

Most mutual funds' investment portfolios are continually adjusted under the supervision of a

professional manager, who forecasts cash flows into and out of the fund by investors, as well as

the future performance of investments appropriate for the fund and chooses those which he or

she believes will most closely match the fund's stated investment objective. A mutual fund is

administered under an advisory contract with a management company, which may hire or fire

fund managers.

Mutual funds are subject to a special set of regulatory, accounting, and tax rules. Mutual fund

distributions of tax-free municipal bond income are tax-free to the shareholder. Taxable

distributions can be either ordinary income or capital gains, depending on how the fund earned

those distributions. Net losses are not distributed or passed through to fund investors.


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3. Industry Profile:

A Mutual Fund is a trust that pools the savings of a number of investors who share a common

financial goal. The money thus collected is then invested in capital market instruments such as

shares, debentures and other securities. The income earned through these investments and the

capital appreciation realized is shared by its unit holders in proportion to the number of units

owned by them. Thus a Mutual Fund is the most suitable investment for the common man as it

offers an opportunity to invest in a diversified, professionally managed basket of securities at a

relatively low cost. The flow chart below describes broadly the working of a mutual fund:

Fig. Mutual Fund Operation Flow Chart

3.1 ORGANISATION OF A MUTUAL FUND

There are many entities involved and the diagram below illustrates the organisational set up of a

mutual fund:


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Fig. Organisation of a Mutual Fund

Mutual fund industry has seen a lot of changes in past few years with multinational companies

coming into the country, bringing in their professional expertise in managing funds worldwide.

In the past few months there has been a consolidation phase going on in the mutual fund industry

in India. Now investors have a wide range of Schemes to choose from depending on their

individual profiles.

3.2 Indian Mutual Fund History:

The origin of mutual fund industry in India is with the introduction of the concept of mutual fund

by UTI in the year 1963. Though the growth was slow, but it accelerated from the year 1987

when on-UTI players entered the industry.

In the past decade, Indian mutual fund industry had seen dramatic improvements, both quality

wise as well as quantity wise. Before, the monopoly of the market had seen an ending phase; the

Assets Under Management (AUM) was Rs. 67bn. The private sector entry to the fund family

rose the AUM to Rs. 470 bn in March 1993 and till April 2004, it reached the height of 1,540bn.

Putting the AUM of the Indian Mutual Funds Industry into comparison, the total of it is less than


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the deposits of SBI alone, constitute less than 11% of the total deposits held by the Indian

banking industry.

The main reason of its poor growth is that the mutual fund industry in India is new in the

country. Large sections of Indian investors are yet to be intellectuated with the concept. Hence, it

is the prime responsibility of all mutual fundcompanies, to market the product correctly abreast

of selling.

The mutual fund industry can be broadly put into four phases according to the development of

the sector. Each phase is briefly described as under.

First Phase 1964-87

Unit Trust of India (UTI) was established on 1963 by an Act of Parliament. It was set up by the

Reserve Bank of India and functioned under the Regulatory and administrative control of the

Reserve Bank of India. In 1978 UTI was de-linked from the RBI and the Industrial Development

Bank of India (IDBI) took over the regulatory and administrative control in place of RBI. The first

scheme launched by UTI was Unit Scheme 1964. At the end of 1988 UTI had Rs.6,700 crores ofassets under management.

Second Phase 1987-1993 (Entry of Public Sector Funds)

1987 marked the entry of non- UTI, public sector mutual funds set up by public sector banks and

Life Insurance Corporation of India (LIC) and General Insurance Corporation of India (GIC). SBI

Mutual Fund was the first non- UTI Mutual Fund established in June 1987 followed by Canbank

Mutual Fund (Dec 87), Punjab National Bank Mutual Fund (Aug 89), Indian Bank Mutual Fund

(Nov 89), Bank of India (Jun 90), Bank of Baroda Mutual Fund (Oct 92). LIC established its

mutual fund in June 1989 while GIC had set up its mutual fund in December 1990.

At the end of 1993, the mutual fund industry had assets under management of Rs.47,004 crores.


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Third Phase 1993-2003 (Entry of Private Sector Funds)

With the entry of private sector funds in 1993, a new era started in the Indian mutual fund

industry, giving the Indian investors a wider choice of fund families. Also, 1993 was the year in

which the first Mutual Fund Regulations came into being, under which all mutual funds, except

UTI were to be registered and governed. The erstwhile Kothari Pioneer (now merged with

Franklin Templeton) was the first private sector mutual fund registered in July 1993.

The 1993 SEBI (Mutual Fund) Regulations were substituted by a more comprehensive and

revised Mutual Fund Regulations in 1996. The industry now functions under the SEBI (Mutual

Fund) Regulations 1996.

The number of mutual fund houses went on increasing, with many foreign mutual funds setting up

funds in India and also the industry has witnessed several mergers and acquisitions. As at the end

of January 2003, there were 33 mutual funds with total assets of Rs. 1,21,805 crores. The Unit

Trust of India with Rs.44,541 crores of assets under management was way ahead of other mutual

funds.

Fourth Phase since February 2003

In February 2003, following the repeal of the Unit Trust of India Act 1963 UTI was bifurcated

into two separate entities. One is the Specified Undertaking of the Unit Trust of India with assets

under management of Rs.29,835 crores as at the end of January 2003, representing broadly, the

assets of US 64 scheme, assured return and certain other schemes. The Specified Undertaking of

Unit Trust of India, functioning under an administrator and under the rules framed by Government

of India and does not come under the purview of the Mutual Fund Regulations.

The second is the UTI Mutual Fund, sponsored by SBI, PNB, BOB and LIC. It is registered with

SEBI and functions under the Mutual Fund Regulations. With the bifurcation of the erstwhile UTI

which had in March 2000 more than Rs.76,000 crores of assets under management and with the

setting up of a UTI Mutual Fund, conforming to the SEBI Mutual Fund Regulations, and with

recent mergers taking place among different private sector funds, the mutual fund industry has


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entered its current phase of consolidation and growth.

Recent Developments in Mutual fund Industry

The Indian asset management industry , measured in terms of assets under management, has fared

well, compared to its global peers, growing at a compounded growth rate of 41% for seven years

ended March 2010. Today there are around 38 players and over Rs. 7600 bn worth of assets under

management, invested over 860 schemes across asset classes including gold, equity, debt, money

market instruments etc.

However the industry has been through volatile times due to the global financial crisis as well as

the changes made by pro-investor regulator, affecting the profitability of asset management

companies. The industry was recovering from the global crisis, the regulator clamped down entryload being charged, which forms an important part of selling and distribution expenses posed I big

problem to the AMCs. The companies used to pay the distributors through the same. There are

other amendments by the regulator so as to make MFs more investor friendly like ASBA. The

asset under management for equity schemes have shown declining trend over period of time and

there is moderate increase in the AUM of debt schemes.

The graph indicates the growth of assets over the years.


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Note:

Erstwhile UTI was bifurcated into UTI Mutual Fund and the Specified Undertaking of the Unit

Trust of India effective from February 2003. The Assets under management of the Specified

Undertaking of the Unit Trust of India has therefore been excluded from the total assets of the

industry as a whole from February 2003 onwards.

Major Players in Indian Mutual Fund Industry


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Here are Top10 Asset Management Companies as on March 31st 2010

Asset Management Company Assets Under Management(in Crores)

Reliance MF 110413

HDFC MF 88780

ICICI Pru 80989

UTI MF 80218

Birla Sun Life 62343

Kotak Mahindra 34681

Franklin Templeton 33290

IDFC 25386

TATA MF 23935DSP BlackRock MF 21491


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4. Company ProfileReliance Money

Reliance Money is the one of the Indias leading retail broking houses and distributor of

financial products. Reliance Money is a comprehensive financial services and solutions provider,

providing customers with access to equities, mutual funds, IPOs, insurance products, wealth

management, investment banking, gold coins, money changing and money transfer

Reliance Money has five million customers through its pan India presence with over 5,000

outlets.

Reliance Securities Limited is a Reliance Capital company and part of the Reliance Anil

Dhirubhai Ambani Group. Reliance Securities is a permitted user of the brand "Reliance Money"

for promoting its various products and services.

4.1 Vision Statement

To be a globally respected wealth creator with an emphasis on customer care and a culture of

good corporate governance.

4.2 Mission Statement

To create and nurture a world-class, high performance environment aimed at delighting our

customers.

4.3 Chairmans Profile

Regarded as one of the foremost corporate leaders of contemporary India, Shri Anil D Ambani,

50, is the chairman of all listed companies of the Reliance ADA Group, namely, RelianceCommunications, Reliance Capital, Reliance Infrastructure, Reliance Natural Resources,

Reliance Power and Reliance Big Entertainment. He is also Chairman of the Board of Governors

of Dhirubhai Ambani Institute of Information and Communication Technology, Gandhi Nagar,

Gujarat. Shri Ambani is credited with pioneering several financial innovations in the Indian

capital markets. He spearheaded the country's first forays into overseas capital markets with


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international public offerings of global depositary receipts, convertibles and bonds. Under his

chairmanship, the constituent companies of the Reliance ADA group have raised nearly US$ 3

billion from global financial markets in a period of less than 15 months.

Reliance Securities endeavors to change the way investors transact in equities markets and avails

services. It provides customers with access to Equity, Derivatives, Portfolio Management

Services, Investment Banking, Mutual Funds & IPOs. It also offers secured online share trading

platform and investment activities in secure, cost effective and convienent manner. To enable

wider participation, it also provides the convenience of trading offline through variety of means,

including Call & Trade,Branch dealing Desk and its network of affiliates.

Reliance Money through its pan India presence with 6,233 outlets, has more than 3.5 million

customers.

Reliance Capital is one of India's leading and fastest growing private sector financial services

companies, and ranks among the top 3 private sector financial services and banking groups, in

terms of net worth.

4.4 Awards and Achievements

y India's largest e-broking house and Best Equity House 2009 - Awarded by Dun andBradstreet 2009

y Reliance Money is rated no. 1 by Starcom Worldwide for online security and costeffectiveness

y Reliance Money has been awarded Debutant Franchisor of the Year 2007 by FranchiseIndia Holdings Ltd.

y The Companies offerings includey Facilities like Mobile trading, Online trading, Call & trade

Reliance Securities Limited is a SEBI Registered Portfolio Manager. Reliance Securities

endeavours that every portfolio created is reflective of the values on which Reliance Securities

has been built - a commitment towards transparency and a strong research - driven investment

process.

Apart from Internet trading and Call & Trade, our customers are also provided with the option of

trading through our SEBI registered Sub brokers. However, before the customers trading


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account is enabled for trading through a particular Sub broker, he needs to sign a Tripartite

agreement with the Sub broker as well as with us.ie. Reliance Securities Limited.

Non Resident Indian (NRI) clients can place orders using any of our online trading platforms -

Easy Trade, Insta trade & Fast Trade.

The customers can also place After Market Orders (AMO) on NSE & BSE from 7:30 PM

onwards on a Trading till 8:00 AM on the next Trading day

Reliance Capital has a net worth of Rs. 7,803 crore (US$ 2 billion) and total assets of Rs. 27,234

crore (US$ 6 billion) as on June 30, 2010.

Sponsor: Reliance Capital Limited

Trustee: Reliance Capital Trustee Co. Limited

Investment Manager: Reliance Capital Asset Management Limited


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5. Objective of the Study1. Study of Mutual Fund industry as a whole2. Study of various types of types of Mutual Fund offerings3. Studying the Equity-Diversified schemes of various fund houses4. Study of various statistical tools to compare performance of selected schemes5. Comparing the selected schemes with a benchmark index and studying the results thereof6. Deciding the criteria of Rating schemes and rank them accordingly7. Determining the possible causes of fluctuation and under performance of the schemes8. Offering a general idea of performance of a scheme to interested investor


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6. Mutual Fund ConceptsA mutual fund is a professionally managed type of collective investment scheme that pools

money from many investors and invests it in stocks, bonds, short-term money

market instruments, and/or other securities. The mutual fund will have a fund

manager that trades the pooled money on a regular basis. The net proceeds or losses are then

typically distributed to the investors annually.

MUTUAL FUNDS : STRUCTURE IN INDIA

Mutual Funds in India follow a 3-tier structure. There is a Sponsor (the First tier), who thinks of

starting a mutual fund. The Sponsor approaches the Securities & Exchange Board of India

(SEBI), which is the market regulator and also the regulator for mutual funds. Not everyone can

start a mutual fund. SEBI checks whether the person is of integrity, whether he has enough

experience in the financial sector, his networth etc. Once SEBI is convinced, the sponsor creates

a Public Trust (the Second tier) as per the Indian Trusts Act, 1882. Trusts have no legal identity

in India and cannot enter into contracts, hence the Trustees are the people authorized to act on

behalf of the Trust. Contracts are entered into in the name of the Trustees. Once the Trust is

created, it is registered with SEBI after which this trust is known as the mutual fund. It is

important to understand the difference between the Sponsor and the Trust. They are two separate

entities. Sponsor is not the Trust; i.e. Sponsor is not the Mutual Fund. It is the Trust which is the

Mutual Fund. The Trustees role is not to manage the money. Their job is only to see, whether the

money is being managed as per stated objectives. Trustees may be seen as the internal regulators

of a mutual fund. Asset Management Company (the Third tier) manages the money of investors.

Trustees appoint the Asset Management Company (AMC), to manage investors money. The

AMC in return charges a fee for the services provided and this fee is borne by the investors as it

is deducted from the money collected from them. The AMCs Board of Directors must have at

least 50% of Directors who are independent directors. The AMC has to be approved by SEBI.The AMC functions under the supervision of its Board of Directors, and also under the direction

of the Trustees and SEBI. It is the AMC, which in the name of the Trust, floats new schemes and

manage these schemes by buying and selling securities. In order to do this the AMC needs to

follow all rules and regulations prescribed by SEBI and as per the Investment Management

Agreement it signs with the Trustees. If any fund manager, analyst intends to buy/ sell some


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securities, the permission of the Compliance Officer is a must. A compliance Officer is one of

the most important persons in the AMC. Whenever the fund intends to launch a new scheme, the

AMC has to submit a Draft Offer Document to SEBI. This draft offer document, after getting

SEBI approval becomes the offer document of the scheme. The Offer Document (OD) is a legal

document and investors rely upon the information provided in the OD for investing in the mutual

fund scheme. The Compliance Offic er has to sign the Due Diligence Certificate in the OD. This

certificate says that all the information provided inside the OD is true and correct. This ensures

that there is accountability and somebody is responsible for the OD. In case there is no

compliance officer then senior executives like CEO, Chairman of the AMC has to sign the due

diligence certificate. The certificate ensures that the AMC takes responsibility of the OD and its

contents.

A custodians role is safe keeping of physical securities and also keeping a tab on the corporate

actions like rights, bonus and dividends declared by the companies in which the fund has

invested. The Custodian is appointed by the Board of Trustees. The custodian also participates in

a clearing and settlement system through approved depository companies on behalf of mutual

funds, in case of dematerialized securities. In India today, securities (and units of mutual funds)

are no longer held in physical form but mostly in dematerialized form with the Depositories. The

holdings are held in the Depository through Depository Participants (DPs). Only the physical

securities are held by the Custodian. The deliveries and receipt of units of a mutual fund are done

by the custodian or a depository participant at the instruction of the AMC and under the overall

direction and responsibility of the Trustees. Regulations provide that the Sponsor and the

Custodian must be separate entities.


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The role of the AMC is to manage investors money on a day to day basis. Thus it is imperative

that people with the highest integrity are involved with this activity. The AMC cannot deal with

a single broker beyond a certain limit of transactions. The AMC cannot act as a Trustee for some

other Mutual Fund. The responsibility of preparing the OD lies with the AMC. Appointments of

intermediaries like independent financial advisors (IFAs), national and regional distributors,

banks, etc. is also done by the AMC. Finally, it is the AMC which is responsible for the acts of


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its employees and service providers. As can be seen, it is the AMC that does all the operations.

All activities by the AMC are done under the name of the Trust, i.e. the mutual fund. The AMC

charges a fee for providing its services. SEBI has prescribed limits for this. This fee is borne by

the investor as the fee is charged to the scheme, in fact, the fee is charged as a percentage of the

schemes net assets. An important point to note here is that this fee is included in the overall

expenses permitted by SEBI. There is a maximum limit to the amount that can be charged as

expense to the scheme, and this fee has to be within that limit. Thus regulations ensure that

beyond a certain limit, investors money is not used for meeting expenses.

Once the 3 tier structure is in place, the AMC launches new schemes, under the name of the

Trust, after getting approval from the Trustees and SEBI. The launch of a new scheme is known

as a New Fund Offer (NFO). We see NFOs hitting markets regularly. It is like an invitation to

the investors to put their money into the mutual fund scheme by subscribing to its units. When a

scheme is launched, the distributors talk to potential investors and collect money from them by

way of cheques or demand drafts. Mutual funds cannot accept cash. (Mutual funds units can also

be purchased on-line through a number of intermediaries who offer on-line purchase /

redemption facilities). Before investing, it is expected that the investor reads the Offer Document

(OD) carefully to understand the risks associated with the scheme. Registrars and Transfer

Agents (RTAs) perform the important role of maintaining investor records. All the New Fund

Offer (NFO) forms, redemption forms (i.e. when an investor wants to exit from a scheme, it

requests for redemption) go to the RTAs office where the information is converted from

physical to electronic form. How many units will the investor get, at what price, what is the

applicable NAV, what is the entry load, how much money will he get in case of redemption, exit

loads, folio number, etc. is all taken care of by the RTA. The investor has to fill a form, which is

available with the distributor. The investor must read the Offer Document (OD) before investing

in a mutual fund scheme. In case the investor does not read the OD, he must read the Key

Information Memorandum (KIM), which is available with the application form. Investors havethe right to ask for the KIM/ OD from the distributor. Once the form is filled and the cheque is

given to the distributor, he forwards both these documents to the RTA. The RTA after capturing

all the information from the application form into the system, sends the form to a location where

all the forms are stored and the cheque is sent to the bank where the mutual fund has an account.

After the cheque is cleared, the RTA then creates units for the investor. The same process is


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followed in case an investor intends to invest in a scheme, whose units are available for

subscription on an on-going basis, even after the NFO period is over.

6.1 Net Asset Value

The net asset value, or NAV, is the current market value of a fund's holdings, less the fund's

liabilities, usually expressed as a per-share amount. For most funds, the NAV is determined

daily, after the close of trading on some specified financial exchange, but some funds update

their NAV multiple times during the trading day. The public offering price, or POP, is the NAV

plus a sales charge. Open-end funds sell shares at the POP and redeem shares at the NAV, and soprocess orders only after the NAV is determined. Closed-end funds (the shares of which are

traded by investors) may trade at a higher or lower price than their NAV; this is known as

a premium or discount, respectively. If a fund is divided into multiple classes of shares, each

class will typically have its own NAV, reflecting differences in fees and expenses paid by the

different classes.


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Some mutual funds own securities which are not regularly traded on any formal exchange. These

may be shares in very small or bankrupt companies; they may be derivatives; or they may be

private investments in unregistered financial instruments (such as stock in a non-public

company). In the absence of a public market for these securities, it is the responsibility of the

fund manager to form an estimate of their value when computing the NAV. How much of a

fund's assets may be invested in such securities is stated in the fund's prospectus.

6.2 Open-Ended mutual fund

Open ended MFs are more common compared to close ended MFs. In open ended MFs, the fund

house continuously buys and sells units from investors. New units are created and issued if there

is demand, and old units are eliminated if there is redemption pressure. There is no fixed date on

which the units would be permanently redeemed or terminated.

If you want to invest in an open ended fund, you buy units from the fund house. Similarly, when

you redeem your units, the fund house directly pays you the value of the units.

6.2.1 Advantages of an open endedmutual fund

y Larger Participation

There is no limit on the number of units that can be issued new units can easily be created andissued. Therefore, a large number of investors can participate in a MF scheme that is performing

well.

y More choicesSince open ended MFs are more prevalent compared to close ended MFs, there are

many MF schemes to choose from in case you want to invest in an open ended mutual fund.

y No issue expenses(This used to be an advantage due to an anomaly with close ended schemes, but SEBI took

corrective action in January 2008, and this is no more an advantage for open ended schemes).


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Fund houses can charge upto 6% of the amount raised as initial issue expense (more details later)

for close ended MFs.

Open ended schemes do not have any such issue expenses they only have an entry load, which

is much lesser (around 2.25%) in most cases. Thus, more of your money is actually invested.

y Large cash positions and Impact on returnsThe fund managers have to be prepared for redemptions at all times. At any time, investor can

surrender the units and redeem them.

Selling well-performing shares to meet redemptions is not a good strategy. Therefore, most open

ended MFs keep a large balance of cash to meet any redemption pressure.

Since this cash is not invested in equities, and is kept either as cash or is invested in very liquid

money market funds, it earns very low returns. Therefore, the overall return for the MF scheme

suffers.

y Large corpusLarger participation brings along its own problems. When a scheme is successful, it attracts more

people. So, new units are created and distributed, thus increasing the corpus under management.

As the amount managed by a fund manager increases, it becomes difficult to find good

investment opportunities for that fund.

This is especially true for mid-cap and small-cap funds, where investment avenues are very

limited, and any large-sized investment can swing a stocks price.

Thus, if the growth in corpus is not managed well, the schemes performance can deteriorate.

6.3 Close Ended mutual fund

The units of a close-ended mutual fund are very similar to individual shares.

The units of a close ended scheme are issued only at the time of the New Fund Offer (NFO).

These units are issued with a fixed tenure or duration, for example, 5 years. New units are not


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issued on an ongoing basis, and existing units are not eliminated before the term of the fund

ends.

At the time of an NFO, you can buy the units from the fund house, and at the time of the closure

of the scheme (and at some other pre-defined intervals, like once every six months), you canredeem the units with the fund house.

But if you want to buy or sell the units of a close ended scheme during the lifetime of the units,

you have to do that on a stock exchange. The units of such schemes are listed on the stock

exchanges just like ordinary shares, and can be bought and sold through a broker.

6.4 Equity Mutual fund

Equity Funds are defined as those funds which have at least 65% of their Average Weekly Net

Assets invested in Indian Equities. This is important from taxation point of view, as funds

investing 100% in international equities are also equity funds from the investors asset allocation

point of view, but the tax laws do not recognise these funds as Equity Funds and hence investors

have to pay tax on the Long Term Capital Gains made from such investments (which they do not

have to in case of equity funds which have at least 65% of their Average Weekly Net Assets

invested in Indian Equities). Equity Funds come in various flavours and the industry keeps

innovating to make products available for all types of investors. Relatively safer types of Equity

Funds include Index Funds and diversified Large Cap Funds, while the riskier varieties are the

Sector Funds. However, since equities as an asset class are risky, there is no guaranteeing returns

for any type of fund. International Funds, Gold Funds (not to be confused with Gold ETF) and

Fund of Funds are some of the different types of funds, which are designed for different types of

investor preferences. Equity Funds can be classified on the basis of market capitalisation of the

stocks they invest in namely Large Cap Funds, Mid Cap Funds or Small Cap Funds or on thebasis of investment strategy the scheme intends to have like Index Funds, Infrastructure Fund,

Power Sector Fund, Quant Fund, Arbitrage Fund, Natural Resources Fund, etc. These funds are

explained later.


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6.4.1 Index Funds

Index Funds invest in stocks comprising indices, such as the Nifty 50, which is a broad based

index comprising 50 stocks. There can be funds on other indices which have a large number of

stocks such as the CNX Midcap 100 or S&P CNX 500. Here the investment is spread across a

large number of stocks. In India today we find many index funds based on the Nifty 50 index,

which comprises large, liquid and blue chip 50 stocks. The objective of a typical Index Fund

states This Fund will invest in stocks comprising the Nifty and in the same proportion as in the

index. The fund manager will not indulge in research and stock selection, but passively invest in

the Nifty 50 scrips only, i.e. 50 stocks which form part of Nifty 50, in proportion to their market

capitalisation. Due to this, index funds are known as passively managed funds. Such passive

approach also translates into lower costs as well as returns which closely tracks the benchmark

index return (i.e. Nifty 50 for an index fund based on Nifty 50). Index funds never attempt to

beat the index returns, their objective is always to mirror the index returns as closely as possible.

The difference between the returns generated by the benchmark index and the Index Fund is

known as tracking error. By definition, Tracking Error is the variance between the daily returns

of the underlying index and the NAV of the scheme over any given period.

6.4.2 Diversified Large Cap Fund

Another category of equity funds is the diversified large cap funds. These are funds which

restrict their stock selection to the large cap stocks typically the top 100 or 200 stocks with

highest market capitalization and liquidity. It is generally perceived that large cap stocks are

those which have sound businesses, strong management, globally competitive products and are

quick to respond to market dynamics. Therefore, diversified large cap funds are considered as

stable and safe. However, since equities as an asset class are risky, there is no guaranteeing


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returns for any type of fund. These funds are actively managed funds unlike the index funds

which are passively managed, In an actively managed fund the fund manager pores over data and

information, researches the company, the economy, analyses market trends, there is one

emerging type of scheme, namely Exchange Traded Funds or ETFs.

6.4.3 OTHER EQUITY SCHEMES :

6.4.3.1 Arbitrage Funds

These invest simultaneously in the cash and the derivatives market and take advantage of the

price differential of a stock and derivatives by taking opposite positions in the two markets (for

e.g. stock and stock futures).

6.4.3.2 Multicap Funds

These funds can, theoretically, have a smallcap portfolio today and a largecap portfolio

tomorrow. The fund manager has total freedom to invest in any stock from any sector.

6.4.3.3 Quant Funds

A typical description of this type of scheme is that The system is the fund manager, i.e. there

are some predefined conditions based upon rigorous backtesting entered into the system and as

and when the system throws buy and sell calls, the scheme enters, and/ or exits those stocks.

6.4.3.4 P/ E Ratio Fund

A fund which invests in stocks based upon their P/E ratios. Thus when a stock is trading at a

historically low P/E multiple, the fund will buy the stock, and when the P/E ratio is at the upper

end of the band, the scheme will sell.

6.4.3.5 International Equities Fund

This is a type of fund which invests in stocks of companies outside India. This can be a Fund of

Fund, whereby, we invest in one fund, which acts as a feeder fund for some other fund(s), i.e

invests in other mutual funds, or it can be a fund which directly invests in overseas equities.


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These may be further designed as International Commodities Securities Fund or World Real

Estate and Bank Fund etc.

6.4.3.6 Growth Schemes

Growth schemes invest in those stocks of those companies whose profits are expected to grow at

a higher than average rate. For example, telecom sector is a growth sector because many people

in India still do not own a phone so as they buy more and more cell phones, the profits of

telecom companies will increase. Similarly, infrastructure; we do not have well connected roads

all over the country, neither do we have best of ports or airports. For our country to move

forward, this infrastructure has to be of world class. Hence companies in these sectors may

potentially grow at a relatively faster pace. Growth schemes will invest in stocks of such

companies.

6.4.3.7 ELSS

Equity Linked Savings Schemes (ELSS) are equity schemes, where investors get tax benefit upto

Rs. 1 Lakh under section 80C of the Income Tax Act. These are open ended schemes but have a

lock in period of 3 years. These schemes serve the dual purpose of equity investing as well as tax

planning for the investor; however it must be noted that investors cannot, under any

circumstances, get their money back before 3 years are over from the date of investment.

6.4.3.8Fund of FundsThese are funds which do not directly invest in stocks and shares but invest in units of other

mutual funds which they feel will perform well and give high returns. In fact such funds are

relying on the judgment of other fund managers.

Let us now look at the internal workings of an equity fund and what must an investor know to

make an informed decision.


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ENTRY LOAD

Investors have to bear expenses for availing of the services (professional management) of the

mutual fund. The first expense that an investor has to incur is by way of Entry Load. This is

charged to meet the selling and distribution expenses of the scheme. A major portion of the Entry

Load is used for paying commissions to the distributor. The distributor (also called a mutual fund

advisor) could be an Independent Financial Advisor, a bank or a large national distributor or a

regional distributor etc. They are the intermediaries who help an investor with choosing the right

scheme, financial planning and investing in scheme s from time to time to meet ones

requirements. Investors must ensure that his Advisor has passed the AMFI Mutual Fund

(Advisors) module certification. Entry Load is applied as a percent of the Net Asset Value

NAV). Net Assets of a scheme is that figure which is arrived at after deducting all scheme

liabilities from its asset. NAV is calculated by dividing the value of Net Assets by the

outstanding number of Units.

Apart from Entry Load, there are other expenses which the investor has to bear. Whether an

investor chooses to invest directly or through an intermediary, he must be aware of these finer

points, which may materially affect investment decisions. We will now look at the other

important points which should be considered before making an investment in an Equity Fund.

All these are easily available in the Fund Fact Sheets.

EXPENSE RATIO

Among other things that an investor must look at before finalising a scheme, is that he must

check out the Expense Ratio.

PORTFOLIO TURNOVER

Fund managers keep churning their portfolio depending upon their outlook for the market, sector

or company. This churning can be done very frequently or may be done after sufficient time

gaps. There is no rule which governs this and it is the mandate of the scheme and the fund

managers outlook and style that determine the churning. However, what is important to

understand is that a very high churning frequency will lead to higher trading and transaction


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costs, which may eat into investor returns. Portfolio Turnover is the ratio which helps us to find

how aggressively the portfolio is being churned. While churning increases the costs, it does not

have any impact on the Expense Ratio, as transaction costs are not considered while calculating

expense ratio. Transaction costs are included in the buying & selling price of the scrip by way of

brokerage, STT, cess, etc. Thus the portfolio value is computed net of these expenses and hence

considering them while calculating Expense Ratio as well would mean recording them twice

which would be incorrect.

EXIT LOADS

As there are Entry Loads, there exist Exit Loads as well. As Entry Loads increase the cost of

buying, similarly Exit Loads reduce the amount received by the investor. Not all schemes have

an Exit Load, and not all schemes have similar exit loads as well. Some schemes have

Contingent Deferred Sales Charge (CDSC). This is nothing but a modified form of Exit Load,

wherein the investor has to pay different Exit Loads depending upon his investment period. If the

investor exits early, he will have to bear more Exit Load and if here mains invested for a longer

period of time, his Exit Load will reduce. Thus the longer the investor remains invested, lesser is

the Exit Load. After some time the Exit Load reduces to nil; i.e. if the investor exits after a

specified time period, he will not have to bear any Exit Load.

6.4.4 Exchange Traded Funds

Exchange Traded Funds (ETFs) are mutual fund units which investors buy/ sell from the stock

exchange, as against a normal mutual fund unit, where the investor buys / sells through a

distributor or directly from the AMC. ETF as a concept is relatively new in India. It was only in

early nineties that the concept gained in popularity in the USA. ETFs have relatively lesser costs

as compared to a mutual fund scheme. This is largely due to the structure of ETFs. Due to these

lower expenses, the Tracking Error for an ETF is usually low. Tracking Error is the acid test for

an index fund/ ETF. By design an index fund/ index ETF should only replicate the index return.


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The difference between the returns generated by the scheme/ ETF and those generated by the

index is the tracking error.

Index ETF

An index ETF is one where the underlying is an index, say Nifty. The APs deliver the shares

comprising the Nifty, in the same proportion as they are in the Nifty, to the AMC and create ETF

units in bulk (These are known as Creation Units). Once the APs get these units, they provide

liquidity to these units by offering to buy and sell through the stock exchange. They give two

way quotes, buy and sell quote for investors to buy and sell the ETFs. ETFs therefore have to be

listed on stock exchanges. There are many ETFs presently listed on the NSE.

6.5 DEBT FUNDS

Debt funds are funds which invest money in debt instruments such as short and long term bonds,

government securities, t-bills, corporate paper, commercial paper, call money etc. The fees in

debt funds are lower, on average, than equity funds because the overall management costs are

lower. The main investing objective of a debt fund is usually preservation of capital and

generation of income. Performance against a benchmark is considered to be a secondary

consideration. Investments in the equity markets are considered to be fraught with uncertainties

and volatility. These factors may have an impact on constant flow of returns. This is why debt

schemes, which are considered to be safer and less volatile, have attracted investors.

Debt markets in India are wholesale in nature and hence retail investors generally find it difficult

to directly participate in the debt markets.

DEBT MUTUAL FUND SCHEMES

6.5.1 Fixed Maturity Plans

FMPs have become very popular in the past few years. FMPs are essentially close ended debt

schemes. The money received by the scheme is used by the fund managers to buy debt securities

with maturities coinciding with the maturity of the scheme. There is no rule which stops the fund


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manager from selling these securities earlier, but typically fund managers avoid it and hold on to

the debt papers till maturity. Investors must look at the portfolio of FMPs before investing. If an

FMP is giving a relatively higher indicative yield, it may be investing in slightly riskier

securities. Thus investors must assess the risk level of the portfolio by looking at the credit

ratings of the securities. Indicative yield is the return which investors can expect from the FMP.

Regulations do not allow mutual funds to guarantee returns, hence mutual funds give investors

an idea of what returns can they expect from the fund. An important point to note here is that

indicative yields are pre-tax. Investors will get lesser returns after they include the tax liability.

6.5.2 Capital Protection Funds

These are close ended funds which invest in debt as well as equity or derivatives. The scheme

invests some portion of investors money in debt instruments, with the objective of capital

protection. The remaining portion gets invested in equities or derivatives instruments like

options. This component of investment provides the higher return potential. It is important to

note here that although the name suggests Capital Protection, there is no guarantee that at all

times the investors capital will be fully protected.

6.5.3 Gilt Funds

These are those funds which invest only in securities issued by the Government. This can be the

Central Govt. or even State Govts. Gilt funds are safe to the extent that they do not carry any

Credit Risk. However, it must be noted that even if one invests in Government Securities,

interest rate risk always remains.

6.5.4 Balanced Funds

These are funds which invest in debt as well as equity instruments. These are also known as

hybrid funds. Balanced does not necessarily mean 50:50 ratio between debt and equity. There

can be schemes like MIPs or Children benefit plans which are predominantly debt oriented but

have some equity exposure as well. From taxation point of view, it is important to note how

much portion of money is invested in equities and how much in debt. This point is dealt with in

greater detail in the chapter on Taxation.


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6.6 Liquid Funds

By far the biggest contributor to the MF industry, Liquid Funds attract a lot of institutional and

High Networth Individuals (HNI) money. It accounts for approximately 40% of industry AUM.

Less risky and better returns than a bank current account, are the two plus points of Liquid

Funds. Money Market instruments have maturities not exceeding 1 year. Hence Liquid Funds

(also known as Money Market Mutual Funds) have portfolios having average maturities of less

than or equal to 1 year. Thus such schemes normally do not carry any interest rate risk. Liquid

Funds do not carry Entry/ Exit Loads. Other recurring expenses associated with Liquid Schemes

are also kept to a bare minimum.

FLOATING RATE SCHEME

These are schemes where the debt paper has a Coupon which keeps changing as per the changes

in the interest rates. Thus there is no price risk involved in such paper. We know when rates go

up, bond prices go down. However, if the rates increase and so also the coupon changes and

increases to the level of the interest rates, there is no reason for the price of the paper to fall, as

the investor is compensated by getting higher coupon, in line with the on going market interest

rates. Investors prefer Floating Rate funds in a rising interest rate scenario.


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7. REGULATIONSRegulations ensure that schemes do not invest beyond a certain percent of their NAVs in a single

security. Some of the guidelines regarding these are given below:

No scheme can invest more than 15% of its NAV in rated debt instruments of a single issuer.

This limit may be increased to 20% with prior approval of Trustees. This restriction is not

applicable to Government securities.

No scheme can invest more than 10% of its NAV in unrated paper of a single issuer and total

investment by any scheme in unrated papers cannot exceed 25% of NAV No fund, under all its

schemes can hold more than 10% of companys paid up capital.

No scheme can invest more than 10% of its NAV in a single company. If a scheme invests in

another scheme of the same or different AMC, no fees will be charged. Aggregate inter scheme

investment cannot exceed 5% of net asset value of the mutual fund.

No scheme can invest in unlisted securities of its sponsor or its group entities.

Schemes can invest in unlisted securities issued by entities other than the sponsor or sponsors

group. Open ended schemes can invest maximum of 5% of net assets in such securities whereas

close ended schemes can invest upto 10% of net assets in such securities.

Schemes cannot invest in listed entities belonging to the sponsor group beyond 25% of its net

assets.


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8. ADVANTAGES OF MUTUAL FUNDSy Mutual Funds give investors best of both the worlds. Investors money is managed by

professional fund managers and the money is deployed in a diversified portfolio. Retail

investors cannot buy a diversified portfolio for say Rs. 5000, but if they invest in a

mutual fund, they can own such a portfolio. Mutual Funds help to reap the benefit of

returns by a portfolio spread across a wide spectrum of companies with small

investments. Investors may not have resources at their disposal to do detailed analysis of

companies. Time is a big constraint and they may not have the expertise to read and

analyze balance sheets, annual reports, research reports etc. A mutual fund does this for

investors as fund managers, assisted by a team of research analysts, scan this data

regularly.

y Investors can enter / exit schemes anytime they want (at least in open ended schemes).They can invest in an SIP, where every month, a stipulated amount automatically goes

out of their savings account into a scheme of their choice. Such hassle free arrangement is

not always easy in case of direct investing in shares.

y There may be a situation where an investor holds some shares, but cannot exit the sameas there are no buyers in the market. Such a problem of illiquidity generally does not

exist in case of mutual funds, as the investor can redeem his units by approaching the

mutual fund.y As more and more AMCs come in the market, investors will continue to get newer

products and competition will ensure that costs are kept at a minimum. Initially mutual

fund schemes could invest only in debt and equities. Then they were allowed to invest in

derivative instruments. Gold ETFs were introduced, investing in international securities

was allowed and recently real estate mutual funds where also in the process of being

cleared. We may one day have commodity mutual funds or other exotic asset classes

oriented funds. Thus it is in investors best interest if they are aware of the nitty gritties of

MFs.

y Investors can either invest with the objective of getting capital appreciation or regulardividends. Young investors who are having a steady regular monthly income would

prefer to invest for the long term to meet various goals and thus opt for capital

appreciation (growth or dividend reinvestment options), whereas retired individuals, who


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have with them a kitty and would need a monthly income would like to invest with the

objective of getting a regular income. This can be achieved by investing in debt oriented

schemes and opting for dividend payout option. Mutual funds are therefore for all kinds

of investors.

y An investor with limited funds might be able to invest in only one or two stocks / bonds,thus increasing his / her risk. However, a mutual fund will spread its risk by investing a

number of sound stocks or bonds. A fund normally invests in companies across a wide

range of industries, so the risk is diversified.

y Mutual Funds regularly provide investors with information on the value of theirinvestments. Mutual Funds also provide complete portfolio disclosure of the investments

made by various schemes and also the proportion invested in each asset type. The large

amount of Mutual Funds offer the investor a wide variety to choose from.

y An investor can pick up a scheme depending upon his risk/return profile. All the MutualFunds are registered with SEBI and they function within the provisions of strict

regulation designed to protect the interests of the investor.


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9. Tools for evaluation9.1 Standard Deviation

Standard deviation is a representation of the risk associated with a given security stocks, bonds,

property, etc.), or the risk of a portfolio of securities. Risk is an important factor in determining

how to efficiently manage a portfolio of investments because it determines the variation in

returns on the asset and/or portfolio and ives investors a mathematical basis for investment

decisions. The overall concept of risk is that as it increases, the expected return on the asset will

increase as a result of the risk premium earned higher return on an investment when said

investment carries a higher level of risk

where,

2 denoted standard deviation

N is number of period,

X

2

is average return of a security,

x is number actual return,

The larger the Standard Deviation in a period, the greater risk the security carries.

9.2 Sharpe Ratio

The Sharpe ratio or Sharpe index or Sharpe measure or reward-to-variability ratio is a measure of

the excess return (or Risk Premium) per unit of risk in an investment asset or a trading strategy,

named after William Forsyth Sharpe. Since its revision by the original author in 1994, it is

defined as:


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where R is the asset return, Rf is the return on a benchmark asset, such as the risk free rate of

return, E[R Rf] is the expected value of the excess of the asset return over the benchmark

return, and is the standard deviation of the asset.

Note, if Rf is a constant risk free return throughout the period,

The Sharpe ratio is used to characterize how well the return of an asset compensates the investor

for the risk taken, the higher the Sharpe ratio number the better. When comparing two assets

each with the expected return E[R] against the same benchmark with return Rf, the asset with the

higher Sharpe ratio gives more return for the same risk. Investors are often advised to pick

investments with high Sharpe ratios. However like any mathematical model it relies on the data

being correct. Pyramid schemes with a long duration of operation would typically provide a high

Sharpe ratio when derived from reported returns but the inputs are false. When examining the

investment performance of assets with smoothing of returns (such as With profits funds) the

Sharpe ratio should be derived from the performance of the underlying assets rather than the

fund returns.

9.3 Treynor Ratio

The Treynor ratio (sometimes called the reward-to-volatility ratio or Treynor measure[1]),

named after Jack L. Treynor,[2] is a measurement of the returns earned in excess of that which

could have been earned on an investment that has no diversifiable risk (e.g., Treasury Bills or a

completely diversified portfolio), per each unit of market risk assumed.

The Treynor ratio relates excess return over the risk-free rate to the additional risk taken;

however, systematic risk is used instead of total risk. The higher the Treynor ratio, the better the

performance of the portfolio under analysis.


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where

Treynor ratio,

portfolio i's return,

risk free rate

portfolio i's beta

Like the Sharpe ratio, the Treynor ratio (T) does not quantify the value added, if any, of

active portfolio management. It is a ranking criterion only. A ranking of portfolios based on the

Treynor Ratio is only useful if the portfolios under consideration are sub-portfolios of a broader,

fully diversified portfolio. If this is not the case, portfolios with identical systematic risk, but

different total risk, will be rated the same. But the portfolio with a higher total risk is less

diversified and therefore has a higher unsystematic risk which is not priced in the market.

An alternative method of ranking portfolio management is Jensen's alpha, which quantifies the

added return as the excess return above the security market line in the capital asset pricing

model. As they two both determine rankings based on systematic risk alone, they will rank

portfolios identically.

9.4 Alpha

Alpha is a risk-adjusted measure of the so-called active return on an investment. It is the return in

excess of the compensation for the risk borne, and thus commonly used to assess active

managers' performances. Often, the return of a benchmark is subtracted in order to consider

relative performance, which yields Jensen's alpha.

The alpha coefficient (i) is a parameter in the capital asset pricing model (CAPM). It is

the intercept of the security characteristic line (SCL), that is, the coefficient of the constant ina market model regression.


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It can be shown that in an efficient market, the expected value of the alpha coefficient is zero.

Therefore the alpha coefficient indicates how an investment has performed after accounting for

the risk it involved:

i < 0: the investment has earned too little for its risk (or, was too risky for the return)

i = 0: the investment has earned a return adequate for the risk taken

i > 0: the investment has a return in excess of the reward for the assumed risk

For instance, although a return of 20% may appear good, the investment can still have a negative

alpha if it's involved in an excessively risky position.

9.5 Beta

Beta () of a stock or portfolio is a number describing the relation of its returns with that of

the financial market as a whole.

An asset with a beta of 0 means that its price is not at all correlated with the market. A positive

beta means that the asset generally follows the market. A negative beta shows that the asset

inversely follows the market; the asset generally decreases in value if the market goes up and

vice versa.

The beta coefficient is a key parameter in the capital asset pricing model (CAPM). It measures

the part of the asset's statistical variance that cannot be mitigated by the diversification provided

by the portfolio of many risky assets, because it is correlated with the return of the other assets

that are in the portfolio. Beta can be estimated for individual companies using regression

analysis against astock market index.

Definition

If beta = 1, it is neither more nor less volatile than the market index as a whole. The formula for

the beta of an asset within a portfolio is


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,

where ra measures the rate of return of the asset, rp measures the rate of return of the portfolio,

and cov(ra,rp) is the covariance between the rates of return. The portfolio of interest in the

CAPM formulation is the market portfolio that contains all risky assets, and so the rp terms in the

formula are replaced by rm, the rate of return of the market.

Beta is also referred to as financial elasticity or correlated relative volatility, and can be referred

to as a measure of the sensitivity of the asset's returns to market returns, its non-

diversifiable risk, itssystematic risk, or market risk. On an individual asset level, measuring beta

can give clues to volatility and liquidity in the marketplace. In fund management, measuring beta

is thought to separate a manager's skill from his or her willingness to take risk.

The beta coefficient was born out of linear regression analysis. It is linked to a regression

analysis of the returns of a portfolio (such as a stock index) (x-axis) in a specific period versus

the returns of an individual asset (y-axis) in a specific year. The regression line is then called

the Security characteristic Line (SCL).

a is called the asset's alpha and a is called the asset's beta coefficient. Both coefficients have an

important role in Modern portfolio theory.

Security market line


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The SML graphs the results from the capital asset

pricing model (CAPM) formula. The x-axis

represents the risk (beta), and the y-axis represents

the expected return. The market risk premium is

determined from the slope of the SML.

The relationship between and required return is plotted on the security market line (SML)

which shows expected return as a function of . The intercept is the nominal risk-free rate

available for the market, while the slope is E(Rm) Rf. The security market line can be regarded

as representing a single-factor model of the asset price, where Beta is exposure to changes in

value of the Market. The equation of the SML is thus:

It is a useful tool in determining if an asset being considered for a portfolio offers a reasonable

expected return for risk. Individual securities are plotted on the SML graph. If the security's risk

versus expected return is plotted above the SML, it is undervalued since the investor can expect a

greater return for the inherent risk. And a security plotted below the SML is overvalued since the

investor would be accepting less return for the amount of risk assumed.

Beta volatility and correlation

There is a simple formula between beta and volatility (sigma):

That is, beta is a combination of volatility and correlation. For example, if one stock has low

volatility and high correlation, and the other stock has low correlation and high volatility, beta

can decide which is more "risky".

This also leads to an inequality (since |r| is not greater than one):

In other words, beta sets a floor on volatility. For example, if market volatility is 10%, any stock

(or fund) with a beta of 1 must have volatility of at least 10%.

The Security Market Line


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Another way of distinguishing between beta and correlation is to think about direction and

magnitude. If the market is always up 10% and a stock is always up 20%, the correlation is one

(correlation measures direction, not magnitude). However, beta takes into account both direction

and magnitude, so in the same example the beta would be 2 (the stock is up twice as much as the

market).

By definition, the market itself has an underlying beta of 1.0, and individual stocks are ranked

according to how much they deviate from the macro market. A stock whose price moves more

than the market over time has a beta whose absolute value is greater than 1.0. A stock price that

moves less than the market has an absolute value of less than 1.0.

A stock with a beta of 2 moves by twice the magnitude of the overall market; when the market

falls or rises by 3%, the stock will fall or rise by 6%. Betas can also be negative, meaning the

stock moves in the opposite direction of the market.A stock with a beta of -3 would decline 9%

when the market goes up 3%, and would climb 9% if the market falls by 3%.

Higher-beta stocks are more volatile and therefore riskier but provide the potential for higher

returns. Lower-beta stocks pose less risk but offer lower returns. Some have challenged this idea,

claiming that the data show little relation between beta and potential reward, or even that lower-

beta stocks are both less risky and more profitable (contradicting CAPM). In the same way a

stock's beta shows its relation to market shifts, it is also an indicator for required returns on

investment (ROI). If the market with a beta of 1 has an expected return of 8%, a stock with a beta

of 1.5 should return 12%.

Estimation of beta

To estimate beta, one needs a list of returns for the asset and returns for the index; these returns

can be daily, weekly or any period. Then one uses standard formulas from linear regression. The

slope of the fitted line from the linear least-squares calculation is the estimated Beta. The y-intercept is the alpha.

Beta is commonly misexplained as asset volatility relative to market volatility. If that were the

case it should simply be the ratio of these volatilities. In fact, the standard estimation uses the

slope of the least squares regression linethis gives a slope which is less than the volatility ratio.


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Specifically it gives the volatility ratio multiplied by the correlation of the plotted data. To take

an extreme example, something may have a beta of zero even though it is highly volatile,

provided it is uncorrelated with the market. The relative volatility ratio described above is

actually known as Total Beta (at least by appraisers who practice business valuation). Total Beta

is equal to the identity: Beta/R or the standard deviation of the stock/standard deviation of the

market (note: the relative volatility). Total Beta captures the security's risk as a stand-alone asset

(since the correlation coefficient, R, has been removed from Beta), rather than part of a well-

diversified portfolio. Since appraisers frequently value closely-held companies as stand-alone

assets, Total Beta is gaining acceptance in the business valuation industry. Appraisers can now

use Total Beta in the following equation:

Total Cost of Equity (TCOE) = risk-free rate + Total Beta*Equity Risk Premium.

Once appraisers have a number of TCOE benchmarks, they can compare/contrast the risk factors

present in these publicly-traded benchmarks and the risks in their closely-held company to better

defend/support their valuations.

Beta has no upper or lower bound, and betas as large as 3 or 4 will occur with highly volatile

stocks.

Beta can be zero. Some zero-beta assets are risk-free, such as treasury bonds and cash. However,

simply because a beta is zero does not mean that it is risk-free. A beta can be zero simply

because the correlation between that item and the market is zero.

A negative beta simply means that the stock is inversely correlated with the market. Many

precious metals and precious-metal-related stocks are beta-negative as their value tends to

increase when the general market is down and vice versa.

A negative beta might occur even when both the benchmark index and the stock under

consideration have positive returns. It is possible that lower positive returns of the index coincide

with higher positive returns of the stock, or vice versa. The slope of the regression line, i.e. the

beta, in such a case will be negative.

If it were possible to invest in an asset with positive returns and beta 1 as well as in the market

portfolio (which by definition has beta 1), it would be possible to achieve a risk-free profit. With


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the use of leverage, this profit would be unlimited. Of course, in practice it is impossible to find

an asset with beta 1 that does not introduce additional costs or risks.

Using beta as a measure of relative risk has its own limitations. Most analysis consider only the

magnitude of beta. Beta is a statistical variable and should be considered with its statistical

significance (R square value of the regression line). Higher R square value implies

higher correlation and a stronger relationship between returns of the asset and benchmark index.

If beta is a result of regression of one stock against the market where it is quoted, betas from

different countries are not comparable.

Staple stocks are thought to be less affected by cycles and usually have lower beta. Procter &

Gamble, which makes soap, is a classic example. Other similar ones are Philip Morris (tobacco)

andJohnson & Johnson (Health & Consumer Goods). Utility stocks are thought to be less

cyclical and have lower beta as well, for similar reasons.

'Tech' stocks typically have higher beta. An example is the dot-com bubble. Although tech did

very well in the late 1990s, it also fell sharply in the early 2000s, much worse than the decline of

the overall market.

Foreign stocks may provide some diversification. World benchmarks such as S&P Global

100 have slightly lower betas than comparable US-only benchmarks such as S&P 100. However,

this effect is not as good as it used to be; the various markets are now fairly correlated, especially

the US and Western Europe.

Risk and diversification

The risk of a portfolio comprises systematic risk, also known as undiversifiable risk,

and unsystematic risk which is also known as idiosyncratic risk or diversifiable risk. Systematic

risk refers to the risk common to all securitiesi.e. market risk. Unsystematic risk is the risk

associated with individual assets. Unsystematic risk can be diversified away to smaller levels by

including a greater number of assets in the portfolio (specific risks "average out"). The same is

not possible for systematic risk within one market. Depending on the market, a portfolio of

approximately 30-40 securities in developed markets such as UK or US will render the portfolio


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sufficiently diversified such that risk exposure is limited to systematic risk only. In developing

markets a larger number is required, due to the higher asset volatilities.

A rational investor should not take on any diversifiable risk, as only non-diversifiable risks are

rewarded within the scope of this model. Therefore, the required return on an asset, that is, the

return that compensates for risk taken, must be linked to its riskiness in a portfolio context - i.e.

its contribution to overall portfolio riskiness - as opposed to its "stand alone riskiness." In the

CAPM context, portfolio risk is represented by higher variance i.e. less predictability. In other

words the beta of the portfolio is the defining factor in rewarding the systematic exposure taken

by an investor.

The efficient frontier

The (Markowitz) efficient frontier. CAL stands for the capital allocation line.

The CAPM assumes that the risk-return profile of a portfolio can be optimizedan optimal

portfolio displays the lowest possible level of risk for its level of return. Additionally, since each

additional asset introduced into a portfolio further diversifies the portfolio, the optimal portfolio

must comprise every asset, (assuming no trading costs) with each asset value-weighted to

achieve the above (assuming that any asset is infinitely divisible). All such optimal portfolios,

i.e., one for each level of return, comprise the efficient frontier.

Because the unsystematic risk is diversifiable, the total risk of a portfolio can be viewed as beta.

The market portfolio


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An investor might choose to invest a proportion of his or her wealth in a portfolio of risky assets

with the remainder in cashearning interest at the risk free rate (or indeed may borrow money to

fund his or her purchase of risky assets in which case there is a negative cash weighting). Here,

the ratio of risky assets to risk free asset does not determine overall returnthis relationship is

clearly linear. It is thus possible to achieve a particular return in one of two ways:

By investing all of one's wealth in a risky portfolio,

or by investing a proportion in a risky portfolio and the remainder in cash (either borrowed or

invested).

For a given level of return, however, only one of these portfolios will be optimal (in the sense of

lowest risk). Since the risk free asset is, by definition, uncorrelated with any other asset, option 2

will generally have the lower variance and hence be the more efficient of the two.

This relationship also holds for portfolios along the efficient frontier: a higher return portfolio

plus cash is more efficient than a lower return portfolio alone for that lower level of return. For a

given risk free rate, there is only one optimal portfolio which can be combined with cash to

achieve the lowest level of risk for any possible return. This is the market portfolio.

Assumptions of CAPM

All investors:

Aim to maximize economic utilities.

Are rational and risk-averse.

Are broadly diversified across a range of investments.

Are price takers, i.e., they cannot influence prices.

Can lend and borrow unlimited amounts under the risk free rate of interest.

Trade without transaction or taxation costs.

Deal with securities that are all highly divisible into small parcels.


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Assume all information is available at the same time to all investors.

Shortcomings of CAPM

The model assumes that either asset returns are (jointly) normally distributed random variables

or that investors employ a quadratic form of utility. It is however frequently observed that returns

in equity and other markets are not normally distributed. As a result, large swings (3 to 6

standard deviations from the mean) occur in the market more frequently than the normal

distribution assumption would expect.

The model assumes that the variance of returns is an adequate measurement of risk. This might

be justified under the assumption of normally distributed returns, but for general return

distributions other risk measures (like coherent risk measures) will likely reflect the investors'

preferences more adequately. Indeed risk in financial investments is not variance in itself, rather

it is the probability of losing: it is asymmetric in nature.

The model assumes that all investors have access to the same information and agree about the

risk and expected return of all assets (homogeneous expectations assumption).[citation needed]

The model assumes that the probability beliefs of investors match the true distribution of returns.

A different possibility is that investors' expectations are biased, causing market prices to be

informationally inefficient.

The model does not appear to adequately explain the variation in stock returns. Empirical studies

show that low beta stocks may offer higher returns than the model would predict. Some data to

this effect was presented as early as a 1969 conference in Buffalo, New York in a paper

by Fischer Black, Michael Jensen, and Myron Scholes. Either that fact is itself rational (which

saves the efficient-market hypothesis but makes CAPM wrong), or it is irrational (which saves

CAPM, but makes the EMH wrong indeed, this possibility makes volatility arbitrage a strategy

for reliably beating the market).

The model assumes that given a certain expected return investors will prefer lower risk (lower

variance) to higher risk and conversely given a certain level of risk will prefer higher returns to

lower ones. It does not allow for investors who will accept lower returns for higher risk. Casino

gamblers clearly pay for risk, and it is possible that some stock traders will pay for risk as well.


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The model assumes that there are no taxes or transaction costs, although this assumption may be

relaxed with more complicated versions of the model.

The market portfolio consists of all assets in all markets, where each asset is weighted by its

market capitalization. This assumes no preference between markets and assets for individual

investors, and that investors choose assets solely as a function of their risk-return profile. It also

assumes that all assets are infinitely divisible as to the amount which may be held or transacted.

The market portfolio should in theory include all types of assets that are held by anyone as an

investment (including works of art, real estate, human capital...) In practice, such a market

portfolio is unobservable and people usually substitute a stock index as a proxy for the true

market portfolio. Unfortunately, it has been shown that this substitution is not innocuous and can

lead to false inferences as to the validity of the CAPM, and it has been said that due to the

inobservability of the true market portfolio, the CAPM might not be empirically testable.

The model assumes just two dates, so that there is no opportunity to consume and rebalance

portfolios repeatedly over time. The basic insights of the model are extended and generalized in

the intertemporal CAPM (ICAPM) of Robert Merton, and the consumption CAPM (CCAPM) of

Douglas Breeden and Mark Rubinstein.

CAPM assumes that all investors will consider all of their assets and optimize one portfolio. This

is in sharp contradiction with portfolios that are held by individual investors: humans tend to

have fragmented portfolios or, rather, multiple portfolios: for each goal one portfolio

see behavioral portfolio theory and Maslowian Portfolio Theory.

9.6 Fama

A factor model that expands on the capital asset pricing model (CAPM) by adding size and value

factors in addition to the market risk factor in CAPM. This model considers the fact that value

and small cap stocks outperform markets on a regular basis. By including these two additionalfactors, the model adjusts for the outperformance tendency, which is thought to make it a better

tool for evaluating manager performance.

Here r is the portfolio's return rate, Rf is the risk-free return rate, and Km is the return of the

whole stock market. The "three factor" is analogous to the classical but not equal to it, since


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there are now two additional factors to do some of the work. SMB and HML stand for "small

[Market Capitalization] minus big" and "high [book-to-price ratio] minus low"; they measure the

historic excess returns of small caps over big caps and "value stocks" over "growth stocks".

Fama and French attempted to better measure market returns and, through research, found that

value stocks outperform growth stocks; similarly, small cap stocks tend to outperform large cap

stocks. As an evaluation tool, the performance of portfolios with a large number of small cap or

value stocks would be lower than the CAPM result, as the three factor model adjusts downward

for small cap and value outperformance.


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10.Data Collection and Analysis10.1 Selection of Benchmark Index

1. NiftyThe S&P CNX Nifty is the headline index on the National Stock Exchange of India Ltd. (NSE).

The Index tracks the behavior of a portfolio of blue chip companies, the largest and most liquid

Indian securities. It includes 50 of the approximately 1430 companies listed on the NSE, captures

approximately 65% of its float-adjusted market capitalization and is a true reflection of the

Indian stock market. The S&P CNX Nifty covers 21 sectors of the Indian economy and offers

investment managers exposure to the Indian market in one efficient portfolio. The Index has

been trading since April 1996 and is well suited for benchmarking, index funds and index based

derivatives. The S&P CNX Nifty is a 50 stock, float-adjusted market-capitalization weighted

index for India, accounting for 21 diversified sectors of the economy. It is used for a variety of

purposes, such as benchmarking fund portfolios, index based derivatives and index funds. The

S&P CNX Nifty is derived from economic research and is created for those interested in

investing and trading in Indian equities. Market Representation. The S&P CNX Nifty stocks

represent about 65% of the total float-adjusted market capitalization of the National Stock

Exchange (NSE). Diversification. The S&P CNX Nifty is a diversified index, accurately

reflecting the overall market. The reward-to-risk ratio of S&P CNX Nifty is higher than other

leading indices, offering similar returns but at l

Evaluation of Mutual Funds

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