Performance of Mutual Funds

Performance of Mutual Funds (Part 1)

• Calculation of Returns: The returns from an investment are calculated by comparing the cost paid to acquire the asset to what is earned from it, considering both income earned and gains/losses.
• Types of Returns:
  • Simple Return: The change in the value of an investment over a period of time, calculated as (End Value - Begin Value) / Begin Value.
  • Annualized Return: Helps compare returns of different time periods, calculated as (1 + Simple Return)^(1/n) - 1, where 'n' is the number of years.
  • Compounded Return: Takes into account the time taken to generate returns, calculated using the formula (Later Value/Initial Value)^(1/n) - 1, where 'n' is the period in years.
  • Total Return: A comprehensive measure of returns, considering both capital gains/losses and dividend, calculated as (End Value - Begin Value + Dividend) / Begin Value.
• Concept of Loads:
  • Exit Load: A fee charged when an investor redeems their units, which can drag down the investor's return below the scheme return.
  • Impact on Transaction Price: The amount actually received by the investor is the NAV minus the exit load, if any.
• Risk in Mutual Fund Investment:
  • Liquidity Risk: The risk that the scheme's liquidity can be affected by factors like trading volumes, settlement periods, and transfer procedures.
  • Interest Rate Risk: The risk that fixed income securities may face price-risk or interest-rate risk, with prices falling when interest rates rise and increasing when interest rates drop.
  • 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 adversely 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 for Foreign Portfolio Investors due to currency movements.
  • Settlement Risk (Counterparty Risk): The risk that the counterparty in a swap may default.

Performance of Mutual Funds (Part 2)

• Risk related to equity and equity-related securities: Equity and equity-related securities are volatile and subject to daily price fluctuations. Liquidity in the scheme can be restricted by trading volumes and extended settlement periods.
• Risk associated with short selling and Stock Lending: Short selling involves selling securities that the seller does not own, borrowing them, and later repurchasing them to return to the lender. Risks include counterparty risk and liquidity risk.
• Risks associated with mid-cap and small-cap companies: Investment in mid-cap and small-cap companies carries higher risks in terms of volatility and market liquidity.
• Risk associated with Dividend: Dividend is due only when declared, and there is no assurance that a company may continue paying dividend in the future.
• Sources of risks in debt funds:
  • Reinvestment Risk: Investments in fixed income securities carry re-investment risk as interest rates prevailing on the coupon payment or maturity dates may differ from the original coupon of the bond.
  • Rating Migration Risk: Fixed income securities are exposed to rating migration risk, which could impact the price on account of change in the credit rating.
  • Term Structure of Interest Rates Risk: The Term Structure of Interest Rates Risk affects the Net Asset Value (NAV) of a scheme invested in fixed income securities.
  • Credit Risk: Fixed income securities are subject to the risk of an issuer’s inability to meet interest and principal payments on its debt obligations.
• Risks associated with Creation of Segregated portfolio: Investor holding units of segregated portfolio may not be able to liquidate their holding till the time recovery of money from the issuer.
• Risk Factors Associated with Investments in REITs and InvITs: REITs and InvITs are exposed to risks such as price risk, interest rate risk, credit risk, liquidity risk, reinvestment risk, and the risk of lower-than-expected distributions.
• Managing Market Liquidity Risk: The liquidity risk is managed by creating a portfolio which has adequate access to liquidity.
• Managing Credit Risk: Credit risk in fixed income securities is managed by investing in securities from issuers with strong credit profiles.
• Re-investment Risk: Re-investment Risk is prevalent for fixed income securities, but as the fixed income investments of the Scheme are generally short duration in nature, the impact can be expected to be small.
• Market Risk related to equity and equity related securities: The Investment Manager aims to invest in companies after conducting thorough due diligence and research.
• Managing Risk associated with favourable taxation of equity-oriented Scheme: This risk is mitigated as there is a regular monitoring of equity exposure of each of the equity-oriented Scheme of the Fund.
• Difference between market / systematic risk and company specific risk: Investments face two main types of risks: company-specific (unsystematic) risks and systematic risks.
• Mutual fund investments are subject to market risks: Mutual fund investments are subject to market risks, and investors should read the scheme-related documents carefully before investing.
• Concept of risk-adjusted return: Investors should assess the consistency of returns and how they compare to the fund's benchmark and peer group, as well as the associated risks, including the volatility of returns over time.

Performance of Mutual Funds (Part 3)

• Risk-Adjusted Returns: Measures used to evaluate the performance of mutual funds by taking into account the risk taken to achieve the returns. These include:
  • Sharpe Ratio: A measure of risk-adjusted returns that uses Standard Deviation as a measure of risk. It is calculated as (Rs - Rf) ÷ Standard Deviation, where Rs is the return of the scheme and Rf is the risk-free rate of return.
  • Treynor Ratio: A measure of risk-adjusted returns that uses Beta as a measure of risk. It is calculated as (Rs - Rf) ÷ Beta.
  • Information Ratio: A measure of risk-adjusted returns that is mandatory for Asset Management Companies (AMCs) to disclose. It is calculated as (Portfolio Return - Benchmark return) / Standard deviation of Excess Return.
• Tracking Error: A measure of the consistency of a fund's out-performance relative to its benchmark. It is calculated as the standard deviation of the excess returns generated by the fund.
• Scheme Benchmarks: A benchmark is a standard against which the performance of a mutual fund scheme is measured. A credible benchmark should meet certain requirements, including being in sync with the scheme's investment objective, asset allocation pattern, and investment strategy.
• Types of Benchmarks: There are two types of benchmarks:
  • Price Return Index (PRI): Captures only the capital gains of the index constituents.
  • Total Return Index (TRI): Takes into account all dividends/interest payments generated by the index constituents, in addition to capital gains.
• Choosing a Benchmark: The scheme's benchmark should be chosen based on the scheme's investment objective, investment strategy, and asset allocation pattern. SEBI has notified a two-tiered structure for benchmarking certain categories of schemes, with the first tier being a broad market index and the second tier being a bespoke index according to the investment style/strategy of the fund manager.
• Disclosure of Benchmarks: AMCs are required to disclose the benchmark index used for performance comparison on their website on a daily basis, and the benchmark index should be a Total Return Index.

Performance of Mutual Funds (Part 4)

• Scheme’s asset allocation pattern: Refers to the distribution of investments within a mutual fund scheme across different asset classes, such as stocks, bonds, and cash.
• Scheme’s past returns: Involves analyzing the historical performance of a mutual fund scheme to understand its potential for future growth and risk.

Evaluating Mutual Fund Performance

• Total return index: Takes into account all dividends generated from the basket of constituents that make up the index in addition to the capital gains.
• Key considerations:
  • Liquidity risk: Involves the difficulty of redeeming mutual fund units due to lack of buyers or market disruptions.
  • Interest rate risk: Affects the price of existing fixed income securities in a mutual fund, which generally falls when interest rates rise.

Risk Management

• Risk types:
  • Credit risk: Related to the borrower's ability to repay debts.
  • Liquidity risk: The risk that mutual fund units cannot be traded or liquidated easily.
  • Interest rate risk: The risk that changes in interest rates will affect the value of fixed income securities.
  • Manager risk: The risk that the fund manager's decisions will negatively impact the fund's performance.
• Reinvestment risk and settlement risk are other types of risks that may affect mutual fund investments, but they are not directly related to the difficulty of redeeming units or the impact of interest rate changes.