Risk, Return and Performance of Funds

Risk, Return and Performance of Funds (Part 1)

Definition: This chapter covers the risks involved in investing with mutual funds, categorizing them into standard/general risks and those specific to individual asset categories.
Details: The chapter aims to educate on the various risk factors, measures of returns, and SEBI norms regarding return representation of returns by mutual funds in India.

Key Concepts

General Risk Factors: These are risks that all mutual fund investments are exposed to, including:
- Liquidity Risk: The risk that investments may be restricted by trading volumes, settlement periods, and transfer procedures.
- Interest Rate Risk: The risk that fixed income securities may fall in price when interest rates rise.
- Re-investment Risk: The risk that the rate at which interim cash flows can be reinvested may be lower than that originally assumed.
- Political Risk: The risk that investments may be impacted by Indian politics and changes in the political scenario.
- Economic Risk: The risk that a slowdown in economic growth or macro-economic imbalances may adversely affect investments.
- Foreign Currency Risk: The risk that the INR value of investments may be lower due to currency movements.
- Settlement Risk (Counterparty Risk): The risk that the counterparty may default in a swap transaction.
Specific Risk Factors: These are risks specific to individual asset categories, including:
- Risk related to equity and equity related securities: The risk that equity and equity related securities are volatile and prone to price fluctuations.
- Risk associated with short selling and Stock Lending: The risk of failure of the other party in securities lending, and the risk of counterparty risk and liquidity risk in short selling.
- Risks associated with mid-cap and small-cap companies: The risk that investment in mid-cap and small-cap companies may be based on the premise that these companies have growth potential, but may also be more volatile.

Risk, Return and Performance of Funds (Part 2)

Introduction to Risk: Companies with higher growth potential, such as mid-cap and small-cap companies, also come with higher risks in terms of volatility and market liquidity.
Risk Associated with Dividend: There is no assurance that a company will continue paying dividends in the future, making schemes vulnerable to instances where investments may not earn dividend or where lesser dividend is declared.
Risk Associated with Derivatives: Derivative products are highly leveraged instruments that require specialized investment techniques and risk analysis, carrying a high degree of risk due to their leveraged nature.
Types of Risks Associated with Derivatives:
- Counterparty Risk: The risk that a counterparty fails to abide by its contractual obligations.
- Market Liquidity Risk: The risk that derivatives cannot be transacted due to limited trading volumes.
- Model Risk: The risk of mis-pricing or improper valuation of derivatives.
- Basis Risk: The risk due to a difference in the price movement of the derivative vis-à-vis the security being hedged.
Risks Related to Debt Funds:
- Reinvestment Risk: The risk that interest rates prevailing on coupon payment or maturity dates may differ from the original coupon of the bond.
- Rating Migration Risk: The risk that a change in credit rating could impact the price of the security.
- Term Structure of Interest Rate Risk: The risk that changes in the general level of interest rates could affect the NAV of the scheme's units.
- Credit Risk: The risk that an issuer may be unable to meet interest and principal payments on its debt obligations.
Risk Associated with Floating Rate Securities:
- Spread Risk: The risk that the spread of a floating rate security over its benchmark may move adversely, leading to a loss in value.
- Basis Risk: The risk that the underlying benchmark of a floating rate security may become less active or cease to exist.
Risk Factors Associated with Repo Transactions in Corporate Bonds: The risk that the counterparty may fail to honour the repurchase agreement, although this risk is mitigated through over-collateralization.
Risks Associated with Creation of Segregated Portfolio: Investors holding units of a segregated portfolio may not be able to liquidate their holdings until the recovery of money from the issuer, and the security may not realize any value.
Risks Associated with Investments in Securitized Assets:
- Risks Associated with Asset Class: Credit risks relating to the underlying assets, such as commercial vehicles, auto finance, credit cards, and home loans.
- Risks Associated with Pool Characteristics: Factors such as the size of the loan, loan-to-value ratio, original maturity of loans, and average seasoning of the pool can affect the risk of the securitized asset.

Risk, Return and Performance of Funds (Part 3)

Default Rate Distribution: Indicates the percentage of the pool and overall portfolio of the originator that is current, and the percentage that is in different stages of delinquency (e.g., 0-30 DPD, 30-60 DPD, 60-90 DPD).
Credit Rating and Adequacy of Credit Enhancement: Securitisation transactions can achieve a target credit rating higher than the originator's own credit rating through Credit Enhancement, which involves filtering underlying asset classes and applying selection criteria to diminish risks.
Risks Associated with Securitised Transactions: Include:
- Limited Liquidity & Price Risk: Secondary market for securitised papers may not be very liquid, and sales may be at a discount to the initial issue price.
- Limited Recourse to Originator & Delinquency: Securitised transactions are normally backed by a pool of receivables and credit enhancement, with limited loss cover to investors.
- Risks due to Possible Prepayments: Full prepayment of underlying loan contracts may arise under various circumstances, exposing investors to changes in tenor and yield.
- Bankruptcy of the Originator or Seller: May result in losses or delays in payments due to investors.
- Bankruptcy of the Investor's Agent: May result in losses or delays in payments due to investors if the agent's recourse to assets/receivables is not restricted to its capacity as agent/trustee.
- Risk of Co-mingling: Servicers may fail to remit collections to investors due to co-mingling of funds.
Risk Factors Associated with Investments in REITs and InvITs: Include price-risk, interest rate risk, credit risk, liquidity or marketability risk, reinvestment risk, and risk of lower-than-expected distributions.
Risk Management Strategies: Include:
- Managing Market Liquidity Risk: Creating a portfolio with adequate access to liquidity.
- Managing Credit Risk: Investing in securities issued by borrowers with good credit profiles.
- Managing Term Structure of Interest Rates Risk: Actively managing duration based on market conditions.
- Managing Rating Migration Risk: Investing in high-grade/quality securities.
- Re-investment Risk: Prevalent for fixed income securities, but impact expected to be small due to short duration investments.
- Market Risk related to Equity and Equity-related Securities: Investing in companies with adequate due diligence and research.
- Risk associated with Floating Rate Securities: Very low liquidity, resulting in lack of price discovery.
- Managing Risk associated with Favourable Taxation of Equity-oriented Scheme: Regular monitoring of equity exposure.

Risk, Return and Performance of Funds (Part 4)

Risk Types: There are two types of risks: systematic risk (also known as market risk) and unsystematic risk (also known as company-specific or diversifiable risk).
Systematic Risk: This type of risk affects all businesses within a country and cannot be reduced through diversification. Examples include rise in inflation, natural disasters, and economic downturns.
Unsystematic Risk: This type of risk is specific to a particular company and can be reduced through diversification. Examples include labor strikes, management changes, and product recalls.
Diversification: This is a strategy used to reduce unsystematic risk by investing in a diverse set of companies. However, it cannot reduce systematic risk.
Fund Manager's Role: Fund managers can adopt active management strategies to outperform the scheme's benchmark index, but they cannot reduce systematic risk except by staying out of the market.

Key Concepts

Market Risk: This is the risk that a mutual fund portfolio cannot avoid, which is the risk of market-wide price fluctuations.
Credit Risk: This is the risk that the investments made by the fund may default on their commitments.
Diversification: This is a proven strategy that can be used as protection against credit risk.
Fundamental Analysis: This is a study of the business and financial statements of a firm to identify securities suitable for investment.
Technical Analysis: This is a study of price-volume charts to identify trends and make buy/sell/hold recommendations.

Drivers of Returns and Risk

Portfolio: The portfolio is the main driver of returns in a mutual fund scheme.
Asset Class: The asset class in which the fund invests determines the risk and return in a mutual fund scheme.
Security Selection: This is an attempt to select good quality securities that are likely to perform well in the future.
Market Timing: This is an attempt to time the entry and exit into a market or timing the purchase and sale of a security to capture the upside in prices and avoid the downside.

Fundamental Analysis

Financial Parameters: These include Earnings Per Share (EPS), Price to Earnings Ratio (P/E Ratio), Price Earnings to Growth (PEG) ratio, Book Value per Share, and Dividend Yield.
Company Analysis: Fundamental analysts review a company's financial statements, quality of management, competitive position, and other factors to make investment decisions.
Financial Indicators: These need to be viewed in the context of unique factors underlying each company and cannot be viewed as stand-alone numbers.

Risk, Return and Performance of Funds (Part 5)

Steady and Lower Risk Equity Investments: Investors who prefer steady and lower risk equity investments often look for high dividend yield stocks. A high dividend yield can result from higher payout and/or lower market prices, making them attractive to conservative investors.
Dividend Yields: Dividend yields tend to decrease across stocks in a bull market and increase in a bear market.
Investment Styles:
- Growth Investment Style: Involves investing in high-growth stocks with higher valuations, typically featuring high P/E and PEG ratios and lower dividend yield ratios.
- Value Investment Style: Involves picking stocks priced lower than their intrinsic value based on fundamental analysis, with the expectation that the market will eventually recognize their true value.

Portfolio Building Approaches

Top-Down Approach: Evaluates economic factors first, then narrows down to suitable industries, and finally selects companies for investment.
Bottom-Up Approach: Analyzes company-specific factors first, then industry factors, and finally macro-economic scenarios to select stocks for investment.

Factors Affecting Performance of Debt Schemes

Risks Associated with Marketable Debt Securities: Primarily include interest rate risk and credit risk.
Debt Securities: Entail a return in the form of interest and repayment of the invested amount at the end of the pre-specified period (tenor).
Yield to Maturity (YTM): The return an investor gets if the security is held till maturity.
Holding Period Return (HPR): A combination of interest paid and capital gain/loss relative to the price paid.

Types of Debt Securities

Government Securities (G-Sec or Gilt): Issued by the government, considered safe with no credit risk.
Treasury Bills: Short-term debt instruments issued by the Reserve Bank of India on behalf of the Government of India.
Certificates of Deposit: Issued by banks or financial institutions for short-term periods.
Commercial Papers: Short-term securities issued by companies.
Bonds/Debentures: Generally issued for tenors beyond a year by governments and private sector companies.

Credit Risk and Credit Spreads

Credit Risk: The possibility of a non-government issuer defaulting on a debt security, measured by credit rating companies.
Credit Spread: The difference between the yield on a Gilt and the yield on a non-Government Debt security.
Credit Rating: Assigned by companies such as CRISIL, ICRA, CARE, and Fitch to indicate the credit risk in a debt security.

Interest Rates and Debt Securities

Fixed Rate and Floating Rate Securities: Fixed rate securities offer a fixed interest rate, while floating rate securities (floaters) have interest rates linked to market rates.
Modified Duration: A concept used to assess how much a debt security is likely to fluctuate in response to changes in interest rates.
Volatility in Debt Securities: Higher modified duration securities tend to be more volatile in response to interest rate changes.

Investment Objectives and Strategies

Accrual vs. Appreciation: Debt funds may focus on earning interest income (accrual) or on appreciation in the value of securities held.
Portfolio Management: Fund managers make calls on likely interest rate scenarios to determine the returns in a debt fund, unlike equity where sector and stock calls are key.

Risk, Return and Performance of Funds (Part 6)

Duration Management: A strategy adopted by fund managers to alter the duration of a portfolio in anticipation of changes in interest rates. The fund manager increases the duration by moving into long-term maturities if interest rates are expected to decrease and vice versa.
Credit Risk Management: Fund managers explore opportunities to earn gains by anticipating changes in credit quality and credit spreads between different market benchmarks. Including securities with expected credit rating upgrades can translate into gains when the security's value appreciates in response to re-rating.
Risk Management: Depending on the investment strategy, fund managers may take or avoid these risks. If asset allocation is tightly defined by SEBI or the scheme document, there is limited room for the fund manager to take risks.

Factors Affecting Performance of Gold Funds

Global Price of Gold: Gold is seen as a safe-haven asset class, and its price increases during political or economic turmoil. Large countries' purchases of gold tend to push up the price, while sales by institutions like the International Monetary Fund weaken gold prices.
Strength of the Rupee: A stronger rupee can lead to lower returns in gold funds, as the same foreign currency can be bought for fewer rupees, translating into a lower rupee value for the gold portfolio.
Passive Nature of Gold Funds: Gold funds are passive in nature, and the fund manager does not take a view on gold price movements, eliminating the risk related to fund management decisions.

Factors Affecting Performance of Real Estate Funds

Economic Scenario: Real estate prices weaken during economic uncertainty and strengthen as the economy improves.
Infrastructure Development: Improvements in infrastructure in an area increase real estate values.
Interest Rates: Cheap and easily available money leads to higher real estate prices, while rising interest rates soften the real estate market.
Nature of Real Estate: The behavior of real estate is a function of its type (residential, commercial, industrial, etc.) and can be structured in various ways to generate returns.

Measures of Returns

Simple Return: Calculated by comparing the cost paid to acquire an asset to its current value, considering both income earned and gains/losses.
Annualized Return: Helps compare returns of two different time periods by annualizing the returns.
Compounded Return: Calculates the return on investment over a period, considering the effect of compounding, which can be significant over longer periods.
Compounded Annual Growth Rate (CAGR): Captures the impact of both dividend payments and compounding, assuming dividends are re-invested in the same scheme at the ex-dividend NAV.

Risk, Return and Performance of Funds (Part 7)

Compound Interest Formula: The formula to calculate compounded returns is ((Later Value/Initial Value) ^ (1/n)) - 1, where 'n' is the period in years.
Scheme Returns vs Investor Returns: Scheme returns are different from investor returns due to the impact of loads (entry and exit) and taxes.
Loads: Loads, such as entry and exit loads, can reduce an investor's return below the scheme return.
Taxation: Taxation can also reduce an investor's post-tax returns.
Investor Return Calculation: To calculate investor returns, use the amount actually paid by the investor (including entry load) as the initial value and the amount actually received (after exit load) as the later value.
Holding Period Returns: Holding period returns are calculated for a fixed period, such as one month, three months, one year, three years, or since inception.
Rolling Returns: Rolling returns are the average annualized return calculated for multiple consecutive holding periods in an evaluation period.
SEBI Norms: SEBI norms prohibit mutual funds from promising returns unless it's an assured returns scheme, and prescribe guidelines for representing returns in advertisements.

Risks in Fund Investing

Equity Funds: Equity funds carry risks such as price fluctuations, business risk, and liquidity risk, which increase with smaller-cap companies and focused funds.
Debt Funds: Debt funds carry risks such as interest rate risk, credit risk, and liquidity risk, which can result in fluctuating NAVs and potential losses.
Hybrid Funds: Hybrid funds carry risks based on their asset allocation, and distributors must carefully evaluate and select schemes.
Gold Funds: Gold funds carry the risk of falling gold prices, but offer benefits such as pricing transparency and performance during market turmoil.
Real Estate Funds: Real estate funds carry risks such as subjective valuation, illiquidity, and various other risks associated with real estate investments.

Key Considerations

Risk Profile: Investors should invest in funds that align with their risk profile.
Liquidity: Investors should ensure adequate liquidity in their portfolio to avoid selling funds at unfavorable times.
Diversification: Investors should diversify their portfolio to minimize risk.
Regulatory Framework: Investors should be aware of the regulatory framework governing mutual funds, including SEBI norms and guidelines.

Risk, Return and Performance of Funds (Part 8)

Introduction to Real Estate Funds: Real estate funds are considered high-risk investments due to the unorganized nature of the real estate market in India, high transaction costs, regulatory risks, and poor corporate governance standards among real estate groups.
Measures of Risk: Fluctuation in returns is used as a measure of risk, with various methods to calculate and assess this risk, including:
- Variance: Measures the fluctuation in periodic returns of a scheme compared to its own average return.
- Standard Deviation: Measures the fluctuation in periodic returns of a scheme in relation to its own average return, with higher standard deviation indicating greater volatility and risk.
- Beta: Measures the fluctuation in periodic returns of a scheme compared to a diversified stock index, with beta greater than 1 indicating higher risk and beta less than 1 indicating lower risk.
- Modified Duration: Measures the sensitivity of a debt security's value to changes in interest rates, with higher modified duration indicating higher interest rate risk.
- Weighted Average Maturity: Measures the average time to maturity of a debt scheme's portfolio, with longer maturity indicating higher interest rate sensitivity.
- Credit Rating: Indicates the credit or default risk of a scheme, with higher credit rating indicating lower default risk.

Key Concepts in Risk Measurement

Variance Calculation: Can be calculated using the =var function in MS Excel.
Standard Deviation Calculation: Can be calculated using the =stdev function in MS Excel, with at least 30 observations required for accurate calculation.
Annualized Standard Deviation: Can be calculated by multiplying the weekly or monthly standard deviation by the square root of the number of periods in a year.
Beta Interpretation: An investment with a beta of 0.8 will move 8% when the market moves 10%, and an investment with a beta of 1.2 will move 12% when the market moves 10%.

Credit Risk and Provisions

Credit Risk: Arises from default, delay in payments, or rating downgrade, which can lead to a fall in prices of debt securities.
Credit Event: An event that may lead to reduction in trading volume of a debt security, causing stress on mutual funds if a large part of the scheme is redeemed.
Provisions to Reduce Credit Risk: SEBI has allowed two provisions to reduce the impact of credit risk:
- Gating or Restriction on Redemption: Can be imposed during systemic crisis or events that severely constrict market liquidity, with certain requirements to be observed before imposing restrictions.
- Segregated Portfolios or Side-Pocketing: Allows mutual funds to separate distressed assets from the main portfolio to protect the interests of investors.

Risk, Return and Performance of Funds (Part 9)

Restrictions on Redemption: In exceptional circumstances, Asset Management Companies (AMCs) may impose restrictions on redemption, but such restrictions cannot be used to manage liquidity or as a result of poor investment decisions.
Exceptional Circumstances: These include:
- Illiquidity: Not applicable in case of illiquidity of a specific security due to poor investment decision.
- Market Failure or Exchange Closure: Unexpected events impacting exchange functioning or transactions.
- Operational Issues: Force majeure, unpredictable operational problems, and technical failures.
SEBI Regulations: Restrictions may be imposed for a specified period not exceeding 10 working days in any 90-day period, with specific approval from the Board of AMCs and Trustees, and informed to SEBI immediately.
Redemption Procedure:
- No redemption requests up to Rs. 2 lakhs shall be subject to restriction.
- For redemption requests above Rs. 2 lakhs, the first Rs. 2 lakhs shall be redeemed without restriction, and the remaining amount shall be subject to the restriction.

Segregated Portfolio or Side Pocketing

Definition: A segregated portfolio is a portfolio comprising debt or money market instruments affected by a credit event, segregated from the main portfolio.
Creation of Segregated Portfolio: Allowed by SEBI in case of a credit event, and is optional and at the discretion of the AMC.
Conditions for Creation:
- In case of actual default of either interest or principal amount.
- The AMC must inform AMFI immediately about the actual default.
- New schemes launched after November 7, 2019, must have enabling provisions for creation of segregated portfolios.
Procedure for Segregated Portfolio:
- Effective from the day of the credit event.
- AMC must issue a press release with details about the segregated portfolio.
- NAV of both segregated and main portfolios shall be disclosed from the day of the credit event.
- Existing investors shall be allotted equal number of units in the segregated portfolio as held in the main portfolio.
- No redemption or subscription is allowed in the segregated portfolio, but units can be listed on a recognized stock exchange.
TER for Segregated Portfolio:
- AMC will not charge investment and advisory fees on the segregated portfolio.
- TER (excluding investment and advisory fees) can be charged on a pro-rata basis upon recovery of investments.
- Legal charges related to recovery can be charged to the segregated portfolio, within the maximum TER limit.
Net Asset Value of Segregated Portfolio: NAV must be declared on a daily basis, with adequate disclosure in scheme-related documents.
Risks Associated with Segregated Portfolio:
- Investors may not be able to liquidate their holdings until recovery.
- Securities in the segregated portfolio may not realize any value.
- Listing on a recognized stock exchange does not guarantee liquidity, and trading prices may be lower than the NAV.

Risk, Return and Performance of Funds (Part 10)

NAV per unit (INR): 123.88, which was marked down by 50 percent on the date of credit event.
Total Portfolio value after creation of segregated portfolio:
- Main Portfolio: 10,000 units, Total Value - 87,62,427, NAV per unit (INR) - 876.2427
- Segregated Portfolio: 10,000 units, Total Value - 1,238,800, NAV per unit (INR) - 123.88
- Total Value (INR lakhs): 1,00,01,227, NAV per unit (INR) - 1000.1227

Risk Mitigation

Equity:
- Adequately long holding period is a great leveller, reducing volatility in returns.
- Holding period:
  - 1 year: highly positive, moderate, or deeply negative returns
  - 5 years: positive or moderate returns
  - 10 years: high probability of decent positive returns, low probability of negative returns
Debt:
- Credit risk: gauged from credit rating of securities in the portfolio.
- Interest rate risk: managed by matching holding period with portfolio maturity of the fund.

Sample Questions

Question 1: Unsystematic risk can be reduced through diversification. (Answer: a. True)
Question 2: Technical analysis tracks price and volume data related to trading in the security. (Answer: c. Technical analysis)
Question 3: Simple return calculation: (135 - 120) / 120 = 12.50 percent. (Answer: c. 12.50 percent)
Question 4: Variance is a measure of fluctuation in periodic returns in an equity mutual fund scheme. (Answer: a. Variance)