Performance of Mutual Funds — returns, risks, risk-adjusted measures and benchmarks

Where this chapter sits

Chapter 7 carries 12% of the paper — the joint-largest chapter. It contains almost all the arithmetic in the syllabus and the largest single block of definitions.

Three things dominate: the return formulas, the risk-adjusted ratios, and the PRI-versus-TRI benchmark rule.

7.1 Calculating returns

The returns from an investment is calculated by comparing the cost paid to acquire the asset (outflow) or the starting value of the investment to what is earned from it (inflows) and computing the rate of return.

What counts as a return: the inflows can be from periodic payouts such as interest from fixed income securities and dividends from equity investments and gains or losses from a change in the value of the investment.

And an important point about unrealised gains: the calculation of return for a period will take both the income earned and gains/loss into consideration, even if the gains/loss have not been realized.

Simple return

Simple return is simply the change in the value of an investment over a period of time.

The workbook's example: invested at a NAV of ₹12, which rose to ₹15. The return is (15 − 12) ÷ 12 = 25 percent.

Annualized return

Two investment options have indicated their returns since inception as 5 percent and 3 percent respectively. If the first investment was in existence for 6 months, and the second for 4 months, then the two returns are obviously not comparable.

Annualisation helps us compare the returns of two different time periods.

Investment 1: 5% over 6 months → 10 percent. Investment 2: 3% over 4 months → 9 percent.

Note the reversal. On the raw numbers the first looks better by 2 points; annualised, it is better by only 1 — and the ranking could easily have flipped.

Compounded return (CAGR)

Total return is a comprehensive measure of returns because it takes into account all the benefits earned from an investment. However, the time taken to generate returns should also be given due importance.

Hence: total return may not be an appropriate measure of return especially for investment period greater than a year.

Where 'n' is the period in years.

The workbook contrasts ₹1 lakh at 8% for 5 years:

Why the gap: when an investment generates simple interest, the return is earned only on the initial investment every single year. However, in case of CAGR method the interest/return earned during a period is added back to the principal amount. As a result, interest is reinvested in the asset so that interest is earned on interest. This is called the compounding effect.

And the workbook's warning about time horizons: the impact on returns due to compounding may be marginal in the initial years but for longer periods the positive difference in returns could be jaw dropping.

Total return

Mutual funds can offer returns in two forms; capital gains or losses and dividend. Total return can be positive or negative.

Ashish's case: ₹1 lakh at NAV ₹10 gives 10,000 units; a dividend of ₹2 is declared; NAV rises to ₹12.

Begin value = ₹1,00,000. End Value = ₹12 × 10,000 = ₹1,20,000. Dividend = ₹2 × 10,000 = ₹20,000.

Total Return = (1,20,000 − 1,00,000 + 20,000) ÷ 1,00,000 × 100 = 40%.

And a note on which method to use: the example above is non-annualized. To be noted, whenever a dividend is paid – and compounding is to be considered - the CAGR technique prescribed by SEBI is used to calculate the total return.

7.2 Loads

As per the current regulations, entry load is not allowed, however, exit load is permitted, and many schemes do carry some exit loads.

How exit load bites: if an exit load of 1 percent was applicable, then the investor will receive only 99 percent of Rs. 15 i.e. Rs. 14.85 on re-purchase. Thus, the investment return would be lower than the scheme returns.

Loads thus drag down the investor's return below the scheme return. Even taxes can pull down the investor's post-tax returns.

The rule for computing investor return: while calculating investor returns for a period, instead of the later value of NAV (which is used for calculating scheme returns), the amount actually received/receivable by the investor (i.e. NAV minus Exit Load, if any) would need to be used.

Scheme return uses NAV; investor return uses NAV minus exit load.

On promising returns

Mutual funds are not permitted to promise any returns, unless it is an assured returns scheme. Assured returns schemes call for a guarantor who is named in the SID. The guarantor will need to write out a cheque, if the scheme is otherwise not able to pay the assured return.

7.3 Risk in a mutual fund investment

Investing in mutual fund units carries risks such as trading volumes, settlement issues, liquidity risk, and default risk, including the potential loss of principal.

The value of investments in the scheme may rise or fall due to fluctuations in the price, value, or interest rates of the underlying securities. The scheme's NAV can be affected by broader market movements, influenced by factors like interest rates, currency changes, government policies, taxation, and political or economic developments.

And two cautions worth quoting to any client: past performance of the Sponsor, AMC, or Mutual Fund does not guarantee future results. The scheme's name does not reflect its quality or future returns.

The named risks

Liquidity Risk. A scheme's liquidity can be affected by factors like trading volumes, settlement periods, and transfer procedures. Illiquid markets, especially in the secondary debt and money markets, can prevent timely selling of securities, potentially leading to losses if market conditions deteriorate. Although government securities are more liquid, extreme market volatility or RBI regulatory changes may still challenge liquidity.

Interest Rate Risk. Fixed income securities such as government bonds, corporate bonds, money market instruments and derivatives run price-risk or interest-rate risk. Generally, when interest rates rise, prices of existing fixed income securities fall and when interest rates drop, such prices increase.

And what determines the magnitude: the extent of fall or rise in the prices depends upon the coupon and maturity of the security. It also depends upon the yield level at which the security is being traded.

Re-investment Risk. This risk refers to the interest rate levels at which cash flows received from the securities in the Scheme are reinvested. The additional income from reinvestment is the 'interest on interest' component. The risk is that the rate at which interim cash flows can be reinvested may be lower than that originally assumed.

Political Risk. Actions of the central government or respective state governments in the future could have a significant effect on the Indian economy. The occurrence of selective unrest or external tensions could adversely affect the political and economic stability of India.

Economic Risk. A slowdown in economic growth or macro-economic imbalances such as the increase in central and state level fiscal deficits may adversely affect investments in the country.

Foreign Currency Risk. The Scheme may be denominated in Indian Rupees (INR) which is different from the home currency for Foreign Portfolio Investors. The AMC does not manage currency risk for Foreign Portfolio Investors and it is the sole responsibility of the Foreign Portfolio Investors to manage or reduce currency risk on their own.

Note the workbook's own clarification: this is from the perspective of FPIs, not resident Indians.

Settlement Risk (Counterparty Risk). In a swap, there is the risk that the counterparty (who will pay floating rate return and receive fixed rate return) may default.

Risks of transacting through exchanges. Allotment and redemption of Units on any Business Day will depend upon the order processing/settlement by BSE/NSE and their respective clearing corporations on which the Fund has no control.

Equity risk. Equity and equity-related securities are volatile and subject to daily price fluctuations. If the scheme faces settlement issues, it may miss investment opportunities.

Short selling and stock lending. Securities lending involves lending securities through an approved intermediary to a borrower for a specified period, with the condition that equivalent securities will be returned, along with any corporate benefits. Risks include the possibility of counterparty failure, leading to loss of collateral, inability to return the securities, and loss of corporate benefits.

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, as the borrowed security may become illiquid, forcing the seller to repurchase at a higher price.

Mid-cap and small-cap risk. Investment in mid-cap and small-cap companies are based on the premise that these companies have the ability to increase their earnings at a faster pace as compared to large-cap companies. But historically, it has been observed that as you go down the capitalization spectrum i.e. from large-cap stocks to mid-cap stocks and beyond, there are higher risks in terms of volatility and market liquidity.

Dividend risk. Dividend is due only when declared and there is no assurance that a company (even though it may have a track record of payment of dividend in the past) may continue paying dividend in future.

Risks specific to debt funds

Reinvestment Risk — 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. For example: One notch downgrade of a AAA rated issuer to AA+ will have an adverse impact on the price of the security and vice-versa for an upgrade of a AA+ issuer.

Term Structure of Interest Rates Risk — when interest rates fall, the value of fixed income securities rises, and when rates rise, the value declines. This risk is minimal in liquid and money market funds. However, for Fixed Maturity Funds, the risk does not impact returns for investors who remain invested until maturity.

Credit Risk — the risk of an issuer's inability to meet interest and principal payments on its debt obligations. And the hierarchy: corporate bonds carry a higher amount of risk than Government securities. Further, even among corporate bonds, bonds which are rated AAA are comparatively less risky than bonds which are AA rated.

Segregated portfolio risk — investor holding units of segregated portfolio may not be able to liquidate their holding till the time recovery of money from the issuer. Security comprises of segregated portfolio may not realise any value. And listing of units of segregated portfolio on recognised stock exchange does not necessarily guarantee their liquidity.

REITs and InvITs — exposed to price risk, interest rate risk, credit risk, liquidity risk, reinvestment risk, and the risk of lower-than-expected distributions.

How these risks are managed

Market liquidity risk: the Investment Manager selects fixed income securities, which have or are expected to have high secondary market liquidity. There is good secondary market liquidity in government securities. The first access to liquidity is through cash and fixed income securities.

Credit risk: managed by investing in securities from issuers with strong credit profiles. The credit research process involves detailed in-house analysis and due diligence. Limits are set for each issuer (excluding the Government of India) regarding the amount and maximum allowable tenor.

Reinvestment risk: as the fixed income investments of the Scheme are generally short duration in nature, the impact can be expected to be small.

Equity market risk: the manager relies on its own analysis... one-on-one meetings with company management, attending conferences, analyst meetings, and teleconferences, examining the company's financial condition..., potential value creation, earnings growth, capital structure, business prospects, policy environment, management strength, market share, brand equity, competitive edge, research capabilities, technological expertise, and corporate governance transparency.

Systematic versus unsystematic risk

Investments face two main types of risks: company-specific (unsystematic) risks and systematic risks.

Company-specific risks, like a labour strike, impact individual firms and can be reduced through diversification. Systematic risks, such as inflation, affect the entire economy and cannot be mitigated by diversification, making them non-diversifiable or market risks.

Two names for the same thing on each side — company-specific = unsystematic = diversifiable; systematic = market = non-diversifiable.

What a fund manager can and cannot do: fund managers can reduce unsystematic risk by diversifying across different companies but cannot avoid systematic risks except by staying out of the market. While some managers shift between equities and cash depending on market outlook, SEBI regulations limit the extent of cash allocation.

And here is the paradox that explains active management:

Finance theory suggests investors are rewarded only for taking non-diversifiable (systematic) risks. To outperform the benchmark, fund managers must take on some unsystematic risks by selecting specific securities.

The fund managers adopt active management strategy in order to outperform the scheme's benchmark index. For that purpose, the manager would have no choice but to take certain unsystematic risks by taking a view on the individual securities.

You are only paid for systematic risk — yet beating the index requires taking unsystematic risk. That tension is the whole case for and against active management.

The disclaimer

"Mutual fund investments are subject to market risks. Please read the scheme-related documents carefully before investing."

What it actually means: this regulatory disclaimer highlights the fact that mutual funds pass on investment risks to investors, unlike fixed deposits where returns are promised. In mutual funds, the investor owns the fund and is exposed to risks such as credit risk if investments default.

And the limits of diversification: while diversification helps mitigate certain risks like credit risk, it cannot protect against market-wide price fluctuations.

The closing thought is worth memorising: in essence, mutual funds don't carry risk themselves—it's the underlying investments that do. Diversification helps manage individual security risk but cannot eliminate broader market risk.

7.4 Risk-adjusted return

Investors primarily select mutual funds based on the returns generated. However, to make a more informed choice, it's essential to assess the consistency of these returns and how they compare to the fund's benchmark and peer group.

The ideal: an actively managed fund should ideally perform well in rising markets and decline less than its benchmark in falling markets.

Why returns alone are not enough: simply looking at return figures is not enough for investment decisions; the scheme's suitability to an investor's needs must also factor in associated risks, including the volatility of returns over time. Higher volatility indicates a riskier scheme.

The principle: a fund manager who takes on more risk should achieve higher returns to justify that risk, while a manager earning lower returns may be able to justify this by taking less risk.

Sharpe Ratio

An investor can invest with the government and earn a risk-free rate of return (Rf). T-Bill index is a good measure of this risk-free return.

Through investment in a scheme, a risk is taken, and a return is earned (Rs).

The difference between the two returns i.e. Rs − Rf is called risk premium. It is like a premium that the investor has earned for the risk taken, as compared to government's risk-free return.

The workbook's example: risk-free 5 percent, scheme return 7 percent, standard deviation 0.5 percent → (7 − 5) ÷ 0.5 = 4.

Sharpe Ratio is effectively the risk premium generated by assuming per unit of risk. Higher the Sharpe Ratio, better the scheme is considered to be.

And a limit on its use: Sharpe Ratio comparisons can be undertaken only for comparable schemes. For example, Sharpe Ratio of an equity scheme cannot be compared with the Sharpe Ratio of a debt scheme.

Treynor Ratio

Like Sharpe Ratio, Treynor Ratio too is a risk premium per unit of risk. Computation of risk premium is the same as was done for the Sharpe Ratio. However, for risk, Treynor Ratio uses Beta.

The example: risk-free 5 percent, return 8 percent, Beta 1.2 → (8 − 5) ÷ 1.2 = 2.5.

Higher the Treynor Ratio, better the scheme is considered to be. Since the concept of Beta is more relevant for diversified equity schemes, Treynor Ratio comparisons should ideally be restricted to such schemes.

Sharpe uses standard deviation; Treynor uses Beta. That is the single difference, and it is the most examinable contrast in the chapter.

Information Ratio

Information ratio is an established financial ratio to measure the risk-adjusted return of any scheme portfolio. It is often used as a measure of a portfolio manager's level of skill and ability to generate excess returns adjusted for risk, relative to a benchmark. It also attempts to identify the consistency of the performance by incorporating standard deviation (risk) into the calculation.

And a unique regulatory status: it is mandatory for the AMCs to disclose the Information Ratio as a financial metric to measure the risk-adjusted return of a portfolio. This is the only measure of risk-adjusted returns that is mandatory to disclose.

Where and how often: the information ratio must be disclosed by the AMCs on their website on a daily basis. It would also be available on AMFI website in a comparable format.

Two computation rules: the benchmark must be the tier-I benchmark used for the scheme (as disclosed in the SID), and the standard deviation of excess returns shall be calculated on the basis of daily return values.

Tracking error

The Beta of the market, by definition is 1. An index fund mirrors the index. Therefore, the index fund too would have a Beta of 1, and it ought to earn the same return as the market. The difference between an index fund's return and the market return is the tracking error.

How its use has widened: earlier it was used as a measure of how closely an index fund tracked the returns from the benchmark to which it was indexed. The tracking error was expected to be zero. Now, the tracking error is used to measure how consistently a fund is able to out-perform its benchmark.

And the point that follows: it is not enough if the fund is able to generate a high excess return, it must do so consistently.

The definition: tracking error is defined as the annualised standard deviation of the difference in returns between the Index fund and its target Index.

Practical rules: an Index fund manager needs to calculate his tracking error on a daily basis especially if it is open-ended fund. Lower the tracking error, closer are the returns of the fund to that of the target Index.

And what it is measured against: Tracking Error is always calculated against the Total Returns Index which shows the returns on the Index portfolio, inclusive of dividend.

In case of an index fund, this measure assumes great importance. The measure of a good index fund is a very low tracking error.

7.5 Benchmarks

Mutual fund schemes invest in the market for the benefit of unit-holders. How well did a scheme perform? An approach to assess the performance is to pre-define a comparable – a benchmark – against which the scheme can be compared.

What makes a benchmark credible

A credible benchmark should meet the following requirements: It should be in sync with (a) the investment objective of the scheme...; (b) asset allocation pattern; and (c) investment strategy of the scheme.

And on its construction: the benchmark should be calculated by an independent agency in a transparent manner, and published regularly. Most benchmarks are constructed by stock exchanges, credit rating agencies, securities research houses or financial publications.

The easiest case: choice of benchmark is simplest for an index fund. The investment objective is clear on the index that the scheme would track. That index would then be the benchmark for the scheme.

Who decides: for mutual fund schemes, selecting a benchmark is subjective and decided by the Asset Management Company (AMC) in consultation with the trustees. The Scheme Information Document (SID) must mention the chosen benchmark, and the scheme's past performance must be compared with the benchmark's performance over the same period.

Changing it: the fund may change its benchmark later due to reasons like a change in the scheme's investment objective, index construction, or the availability of a more suitable index. Such changes require consultation with trustees, justification, and documentation.

The three bases for choosing, and note what is absent: scheme's investment objective · investment strategy of the scheme · the scheme's asset allocation pattern.

Past returns are not among them.

PRI versus TRI

Earlier, the Mutual Fund schemes were benchmarked to the Price Return variant of an Index (PRI). PRI only captures capital gains of the index constituents.

With effect from February 1, 2018, the mutual fund schemes are benchmarked to the Total Return variant of an Index (TRI). The Total Return variant of an index takes into account all dividends/interest payments that are generated from the basket of constituents that make up the index in addition to the capital gains.

Why the change: such a change was required to ensure that the performance comparison is fair. The scheme performance would be calculated after adding the dividends that the scheme has earned from the investments. Even in case of dividend option, the scheme performance is calculated using the Reinvestment of Income distribution cum capital withdrawal method. In such a case, if the scheme performance is compared with that of PRI, it would give a slight advantage to the scheme.

The scheme's return already included dividends; the PRI's did not. That was an unfair comparison.

The consequence: in other words, this would make it appear that fewer schemes are able to beat their benchmark indices. While the reality has not changed, the presentation of the same has changed. The gap between the returns between PRI and TRI is the amount of dividend.

And where TRI history is missing: mutual funds should use a composite CAGR figure of the performance of the PRI benchmark (till the date from which TRI is available) and the TRI (subsequently).

The two-tier structure

To standardize and bring-in uniformity in the benchmarks of mutual fund schemes... there will be a two-tiered structure for benchmarking of certain category of schemes. The first-tier benchmark will be reflective of the category of the scheme, and the second-tier benchmark will be demonstrative of the investment style/strategy of the Fund Manager within the category.

All the benchmarks followed will necessarily be Total Return Indices.

Only debt and equity schemes get two tiers. The other four categories have a single benchmark, each for its own reason.