Foundation — General and specific risks, and what drives returns

10.1 Two lists, not one

"The Scheme Information Document (SID) highlights two broad categories of risks, (1) STANDARD RISK FACTORS, and (2) SPECIFIC RISK FACTORS. The standard risk factors are the risks that ALL mutual fund investments are exposed to, whereas there are certain risks SPECIFIC to the individual asset category. For example, credit risk or interest rate risk are associated with DEBT securities, whereas currency risk would be associated with investments in FOREIGN securities, or even in shares of companies exposed to foreign currency."

And the division of labour, which is the sentence a distributor should carry into every meeting: "When the investor chooses to invest through mutual funds, the FUND MANAGER manages SOME part of the risks, whereas some of the others are CONTROLLED DUE TO THE STRUCTURE of mutual funds. And STILL, SOME RISKS REMAIN TO BE MANAGED BY THE INVESTOR SEPARATELY."

10.1.1 The general risk factors

The SID's standard block reads:

• "Investment in mutual fund units involves investment risks such as trading volumes, settlement risk, liquidity risk, default risk, INCLUDING THE POSSIBLE LOSS OF PRINCIPAL."
• "As the price/value/interest rates of the securities... fluctuates, the value of an investment in the scheme may INCREASE OR DECREASE... the NAV... can be expected to fluctuate with movements in the broader equity and bond markets... such as changes in interest rates, currency exchange rates, changes in governmental policies, taxation, political, economic or other developments."
• "Past performance of the Sponsor/AMC/Mutual Fund DOES NOT GUARANTEE the future performance of the Scheme."
• "The NAME of the Scheme does NOT in any manner indicate either the QUALITY of the Scheme or its FUTURE PROSPECTS AND RETURNS."
• "The Sponsors are NOT responsible or liable for any loss resulting from the operation of the Scheme BEYOND THE INITIAL CONTRIBUTION made by it towards setting up the Mutual Fund."

The general risks, one by one

Liquidity risk. "may be restricted by trading volumes, settlement periods and transfer procedures... Money market securities, while fairly liquid, LACK A WELL-DEVELOPED SECONDARY MARKET." Two consequences: "Delays or other problems in the settlement... could result in temporary periods when the assets of the Scheme are UN-INVESTED and NO RETURN is earned", and "the inability to SELL securities held... due to the absence of a well-developed and liquid secondary market for debt securities would result at times, in potential losses." Even gilts are not immune — "on occasions, there could be difficulties in transacting in the market due to EXTREME VOLATILITY leading to constriction in market volumes."

Interest rate risk. "Generally, when interest rates RISE, prices of existing fixed-income securities FALL and when interest rates drop, such prices increase. 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. "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... 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 the central and state level FISCAL DEFICITS may adversely affect investments."

Foreign currency risk. "The INR value of investments when translated into home currency by Foreign Portfolio Investors could be LOWER because of the currency movements. 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."

Settlement (counterparty) risk. "Specific floating rate assets may also be created by swapping a fixed return into a floating rate return. In such a swap, there is the risk that the counterparty... may DEFAULT."

Exchange transaction risk. "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."

10.1.2 The specific risk factors

Equity. "volatile and prone to price fluctuations on a DAILY basis"; liquidity "can get restricted by trading volumes and settlement periods"; and value "may be affected by interest rates, currency exchange rates, changes in law/policies of the government, taxation laws and political, economic or other developments."

Short selling and stock lending. "Securities Lending is lending of securities THROUGH AN APPROVED INTERMEDIARY to a borrower... with the condition that the borrower will return EQUIVALENT securities of the same type or class at the end of the specified period ALONG WITH THE CORPORATE BENEFITS." The risks: "failure of the other party... possible loss of rights to the collateral, the inability of the approved intermediary to return the securities." Short selling is "the sale of shares or securities that the SELLER DOES NOT OWN at the time of trading", carrying "Counterparty risk and LIQUIDITY RISK of the stock/security being borrowed" — "covering of the security might occur at a MUCH HIGHER PRICE LEVEL than anticipated."

Mid-cap and small-cap. The definitions, which are examinable:

"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... However... there is a risk that such companies MAY NOT ACHIEVE their expected earnings results." And the general observation: "as you go DOWN the capitalization spectrum... there are HIGHER RISKS in terms of VOLATILITY AND MARKET LIQUIDITY."

Dividend. "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."

Derivatives. "Derivative products are SPECIALIZED INSTRUMENTS... Trading in derivatives carries a HIGH DEGREE OF RISK although they are traded at a relatively SMALL AMOUNT OF MARGIN which provides the possibility of great profit or loss in comparison with the principal investment amount. Thus, derivatives are HIGHLY LEVERAGED INSTRUMENTS."

The named derivative risks:

• "Counterparty Risk occurs when a counterparty fails to abide by its contractual obligations... For EXCHANGE TRADED derivatives, the risk is MITIGATED as the exchange provides the GUARANTEED SETTLEMENT but one takes the PERFORMANCE RISK ON THE EXCHANGE."
• "Market Liquidity Risk occurs where the derivatives cannot be transacted due to limited trading volumes and/or the transaction is completed with a severe price impact."
• "Model Risk is the risk of MIS-PRICING OR IMPROPER VALUATION of derivatives."
• "Basis Risk arises due to a DIFFERENCE IN THE PRICE MOVEMENT OF THE DERIVATIVE VIS-À-VIS THAT OF THE SECURITY BEING HEDGED."
• "Investments in INDEX FUTURES face the SAME RISK as the investments in a portfolio of shares representing an index. The extent of loss is the same as in the underlying stocks."

Debt fund risks. Reinvestment risk — "interest rates prevailing on the coupon payment or maturity dates may differ from the original coupon." Rating migration risk — "One notch downgrade of a AAA rated issuer to AA+ will have an ADVERSE IMPACT on the price, and vice-versa for an upgrade." Term structure of interest rate risk — "when interest rates DECLINE, the value of a portfolio of fixed income securities can be expected to RISE. Conversely, when interest rates RISE, the value... can be expected to DECLINE." Credit risk — "the risk of an issuer's INABILITY TO MEET INTEREST AND PRINCIPAL payments... 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."

Floating rate securities. Spread risk — "the coupon is expressed in terms of a SPREAD or MARK UP over the benchmark rate... the yield of the underlying benchmark might NOT change, but the SPREAD of the security over the underlying benchmark might INCREASE leading to loss in value." Basis risk — "the underlying benchmark... might become LESS ACTIVE or may CEASE TO EXIST."

Corporate bond repo. "the collateral may be sold and a loss is realized ONLY IF the sale price is LESS THAN the repo amount. The risk is further mitigated through OVER-COLLATERALIZATION (the value of the collateral being more than the repo amount)."

Segregated portfolio. "Investor holding units of segregated portfolio may NOT be able to liquidate their holding TILL THE TIME OF RECOVERY of money from the issuer. Security comprising of segregated portfolio may NOT REALISE ANY VALUE. LISTING... DOES NOT NECESSARILY GUARANTEE THEIR LIQUIDITY... trading price may be significantly LOWER than the prevailing NAV."

Securitised assets. "A securitization transaction involves sale of receivables by the ORIGINATOR (a bank, NBFC, housing finance company, or a manufacturing/service company) to a SPECIAL PURPOSE VEHICLE (SPV), typically set up in the form of a TRUST. Investors are issued rated PASS-THROUGH CERTIFICATES (PTCs)... Investors are paid from the COLLECTIONS OF THE UNDERLYING LOANS from borrowers."

The pool characteristics analysed:

• "Size of the loan: ... a pool comprising of smaller individual loans provides DIVERSIFICATION, [but] if there is excessive reliance on very small ticket size, it may result in DIFFICULT AND COSTLY RECOVERIES."
• "Loan to Value Ratio: ... THE LOWER LTV, THE BETTER it is." The illustration: on a Rs 20 lakh truck, a borrower contributing Rs 10 lakh "is going to have lesser propensity to default as he would lose an asset worth Rs 20 lakhs", against one contributing only Rs 2 lakh, who "would have higher risk of default."
• "Original maturity of loans and average seasoning of the pool: ... if a pool consists of those who have already repaid 80 percent of the installments without default, this certainly is a SUPERIOR asset pool than one where only 10 percent have been paid."
• "Default rate distribution: ... how much is in 0-30 DPD (days past due), 30-60 DPD, 60-90 DPD... as against 0-30 DPD, the 60-90 DPD is certainly a HIGHER RISK category."

Credit enhancement. "in securitisation transactions, it is possible to work towards a TARGET credit rating, which could be MUCH HIGHER THAN THE ORIGINATOR'S OWN credit rating... The purpose of credit enhancement is to ensure TIMELY PAYMENT to the investors, if the actual collection... is SHORT of the contractual pay-out. Securitisation is normally NON-RECOURSE." Further risks named: limited liquidity and price risk, limited recourse to originator and delinquency, prepayment risk ("investors may be exposed to changes in TENOR AND YIELD"), bankruptcy of the originator or seller (guarded against by a "TRUE SALE" legal opinion), bankruptcy of the investor's agent, and co-mingling risk — "there could be a TIME GAP between collection by a servicer and depositing the same into the collection account... In this interim period, collections... may NOT be segregated from other funds of the servicer."

REITs and InvITs. "exposed to price-risk, interest rate risk, credit risk, liquidity or marketability risk, reinvestment risk. Also, there is a risk of LOWER-THAN-EXPECTED DISTRIBUTIONS."

10.2.1 Systematic versus unsystematic risk

"the risks that impact the specific company are called COMPANY SPECIFIC or FIRM SPECIFIC risks. The risks that impact the entire economy are known as SYSTEMATIC risks. The company specific risks are also known as UNSYSTEMATIC risks. For example, a LABOUR STRIKE in a manufacturing plant is a COMPANY SPECIFIC risk, whereas RISE IN INFLATION in the economy is a SYSTEMATIC risk... Hence, the systematic risk is also called the MARKET RISK."

"The company specific risks CAN be reduced through DIVERSIFICATION... However, the systematic risks CANNOT be reduced through such diversification. Since the unsystematic risk can be reduced through diversification, it is also called the DIVERSIFIABLE RISK... the systematic risk is known as NON-DIVERSIFIABLE RISK."

"Fund managers CANNOT reduce the systematic risk EXCEPT BY STAYING OUT OF THE MARKET. Thus, some fund managers may tactically move between equity and cash... However, SEBI regulations impose certain LIMITS ON THE PERMISSIBLE CASH ALLOCATION... certain fund managers do not take such cash calls and stay FULLY INVESTED at all times."

And the single most quotable line in the chapter: "Finance theory states that one is REWARDED FOR TAKING THE NON-DIVERSIFIABLE RISK ONLY, AND NOT FOR TAKING THE DIVERSIFIABLE RISK."

"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."

"Mutual fund investments are subject to market risks"

"mutual fund is a PASS-THROUGH VEHICLE, in which ALL THE INVESTMENT RISKS ARE PASSED ONTO THE INVESTOR since the INVESTOR/UNIT-HOLDER IS THE OWNER of the fund." Contrast a company fixed deposit: "The company is supposed to pay the investor only the promised return – nothing more, nothing less... This is known as CREDIT RISK for the depositors."

"Diversification is a proven strategy that can be used as protection against CREDIT risk... However, the ONE risk that a mutual fund portfolio CANNOT DO ANYTHING ABOUT is the risk of MARKET-WIDE PRICE FLUCTUATIONS." And the conclusion: "it is NOT the mutual fund that carries the risk, but the UNDERLYING INVESTMENTS where the mutual fund has invested. Mutual funds simply PASS ON some of the risks and REDUCE some others."

10.3 What drives returns

"The PORTFOLIO is the main driver of returns in a mutual fund scheme. The ASSET CLASS in which the fund invests, the SEGMENT OR SECTORS of the market... the STYLES adopted to select securities... and the STRATEGIES adopted to manage the portfolio determines the risk and return."

10.3.1 Equity schemes

"In order to generate returns superior to the benchmark, the fund manager MUST construct a portfolio that is DIFFERENT FROM THE BENCHMARK – either entire portfolio or a part of it, and either always or at least some times. Two primary strategies... are SECURITY SELECTION and MARKET TIMING."

"Security selection is an attempt to select good quality securities that are likely to perform well in the future, as well as avoid those securities where the future may be bleak. Market timing... is an attempt to time the entry and exit into a market... to capture the upside in prices and to avoid the downside."

Fundamental versus technical analysis. "Fundamental analysis is a study of the BUSINESS AND FINANCIAL STATEMENTS of a firm... normally ties in well with the SECURITY SELECTION strategy and mostly used for identifying LONG TERM investment avenues." Technical analysts "believe that PRICE BEHAVIOUR of a share over a period throws up TRENDS for the future direction of the price. Along with past prices, the VOLUMES TRADED indicate the underlying STRENGTH of the trend and are a reflection of INVESTOR SENTIMENT... Technical Analysts therefore study PRICE-VOLUME CHARTS (a reason for their frequently used description as 'CHARTISTS') to decide support levels, resistance levels, breakouts."

"longer-term investment decisions are best taken through a fundamental analysis approach, while technical analysis comes in handy for SHORTER-TERM SPECULATIVE decisions, including INTRA-DAY trading. Even where a fundamental analysis-based decision has been taken... TECHNICAL ANALYSIS MIGHT HELP DECIDE WHEN TO IMPLEMENT the decision i.e., THE TIMING."

The financial parameters:

On P/E: "A SIMPLISTIC (BUT FAULTY) VIEW is that LOW P/E means that a share is CHEAP, and therefore should be bought... In reality, the P/E may be HIGH because the company's PROSPECTS ARE INDEED GOOD, while another company's P/E may be low because it is unlikely to replicate its past performances." The forward P/E "is normally calculated based on a projected EPS for a future period."

On PEG: "relates the P/E ratio to the GROWTH estimated in the company's earnings. A PEG ratio of ONE indicates that the market has FAIRLY VALUED the company's shares... A ratio LESS THAN ONE indicates the equity shares... are UNDERVALUED, and a ratio GREATER THAN ONE indicates an OVERVALUED share."

On dividend yield: "A HIGH dividend yield is the result of HIGHER PAYOUT and/or LOWER MARKET PRICES, both of which are preferred by conservative investors... Another way of looking at a high Pay-out... is that the company may have LOWER INVESTMENT PROSPECTS and therefore pays out the profits instead of re-investing... Dividend yields tend to go DOWN across stocks in a BULL market and RISE in a BEAR market."

Growth versus value. "Growth investment style entails investing in high growth stocks... valuation of these stocks tends to be on the HIGHER side... in the event of a market correction, these stocks tend to DECLINE MORE. Such stocks typically feature HIGH P/E AND PEG RATIOS AND LOWER DIVIDEND YIELD ratio."

"Value investment style is an approach of picking up stocks, which are PRICED LOWER THAN THEIR INTRINSIC VALUE, based on fundamental analysis... Investors need a LONGER investment horizon... In the stocks where their decision is proved right, they earn very high returns, which MORE THAN OFFSET THE LOSSES on failed decisions."

The crucial clarification: "'HIGH VALUATION' IS NOT THE EQUIVALENT OF 'HIGH SHARE PRICE', just as 'LOW VALUATION' IS NOT THE SAME AS 'LOW SHARE PRICE'... a company's share price may be high, say Rs 100, but still REASONABLY VALUED given its earnings; similarly, a company may be seen as over-valued, even when its share price is Rs 5, if it is not matched by a reasonable level of earnings."

And the cycle observation: "In the INITIAL PHASES of a bull run, GROWTH stocks deliver good returns. Subsequently, when the market heats up and the growth stocks get highly valued or costly, VALUE PICKS END UP BEING SAFER."

Top-down versus bottom-up. The framework is EIC — economy, industry, company. "In a TOP-DOWN approach, the portfolio manager evaluates the impact of ECONOMIC FACTORS FIRST and narrows down on the INDUSTRIES... Thereafter, the companies are analysed." "A BOTTOM-UP approach... analyses the COMPANY-SPECIFIC FACTORS FIRST and then evaluates the industry factors and finally the macro-economic scenario... STOCK SELECTION IS THE KEY DECISION in this approach; SECTOR ALLOCATION IS A RESULT of the stock selection decisions."

"Top-down approach MINIMIZES THE CHANCE OF BEING STUCK WITH LARGE EXPOSURE TO A POOR SECTOR. Bottom-up approach ENSURES THAT A GOOD STOCK IS PICKED, EVEN IF IT BELONGS TO A SECTOR THAT IS NOT SO HOT."

10.3.2 Debt schemes

"Primarily there are TWO risks impacting the debt securities, viz., INTEREST RATE RISK and CREDIT RISK. The yields on debt securities tend to move UP as the MATURITY rises... or as the CREDIT RISK is increased."

The vocabulary: the pre-specified period is the tenor; repayment on maturity is redemption; "Debt securities that are to mature WITHIN A YEAR are called MONEY MARKET securities"; "Yield to maturity (YTM) is the return that the investor gets PROVIDED THE SECURITY IS HELD TILL MATURITY"; and "The HOLDING PERIOD RETURN (HPR) is a combination of INTEREST paid by the issuer and CAPITAL GAIN or CAPITAL LOSS relative to the price paid."

The issuers: "Securities issued by the Government are called Government Securities or G-Sec or Gilt"; "Treasury Bills are short term debt instruments issued by the Reserve Bank of India ON BEHALF OF the Government of India"; "Certificates of Deposit are issued by Banks (for 7 days to 1 year) or Financial Institutions (for 1 to 3 years)"; "Commercial Papers are short term securities (up to 1 year) issued by companies"; "Bonds/Debentures are generally issued for tenors beyond a year. GOVERNMENTS AND PUBLIC SECTOR COMPANIES tend to issue BONDS, while PRIVATE SECTOR companies issue DEBENTURES."

"Gilts are viewed as safe as there is NO CREDIT RISK... The yield on Gilt is generally the LOWEST in the market for a given tenor... The difference between the yield on Gilt and the yield on a non-Government Debt security is called its CREDIT SPREAD."

Rating agencies named: "CRISIL, ICRA, CARE and Fitch (now India Ratings)", and "'AAA' is rating agencies' indicator of HIGHEST SAFETY. Higher the credit risk, higher is likely to be the yield."

Floaters: "specified as a 'Base + Spread'. For example, 5-year G-Sec + 2 percent."

The two drivers: "The returns in a debt portfolio are LARGELY DRIVEN BY INTEREST RATES AND CREDIT SPREADS."

The workbook's example: "Company X issued a debenture for 5 years carrying a coupon rate of 9.5 percent p.a.... rated AAA. Two years later, the debenture has residual maturity of 3 years... the interest rate for AAA rated debentures having 3-year maturity is 8.5 percent p.a. In such a case, the Company X debenture would fetch PREMIUM in the secondary market over its face value."

"If the portfolio manager expects interest rates to RISE, then the portfolio is switched towards a higher proportion of FLOATING RATE instruments; or FIXED RATE instruments of SHORTER TENOR (which have LOWER modified duration). On the other hand, if the expectation is that interest rates would FALL, then the manager increases the exposure to LONGER TERM fixed rate debt securities (which have HIGHER modified duration)."

"The calls that a fund manager takes on likely INTEREST RATE SCENARIO are therefore a KEY DETERMINANT of the returns in a debt fund – UNLIKE EQUITY, where the calls on SECTORS AND STOCKS are important."

On mandates: "in case of OVERNIGHT funds, the fund manager must invest only in overnight securities. Hence, there is NO QUESTION OF TAKING THE INTEREST RATE RISK. On the other hand... an ULTRA-SHORT TERM debt fund MAY TAKE CREDIT RISK, since the SEBI regulations only define the PERMITTED MATURITY PROFILE." And: "DYNAMIC BOND FUND is a category where the fund manager MAY TAKE A VIEW on the interest rate movements."

10.3.3 Gold funds

"Gold, as an asset class does NOT generate any CURRENT INCOME... the only way an investor in gold makes money is when one is able to SELL the gold at prices HIGHER than one's cost."

"The value of gold in India depends on (1) the INTERNATIONAL PRICE OF GOLD (which is quoted in foreign currency), (2) the EXCHANGE RATE for converting the currency into Indian rupees, and (3) any DUTIES ON THE IMPORT of gold."

"Gold is seen as a SAFE HAVEN asset class. Therefore, whenever there is POLITICAL OR ECONOMIC TURMOIL, gold prices SHOOT UP." And on official holdings: "When they come to the market to SELL, gold prices WEAKEN. PURCHASES of gold by large countries tend to PUSH UP the price."

On the rupee: "When the rupee becomes STRONGER... the same gold price (denominated in foreign currency), translates into a LOWER rupee value... This pushes DOWN the returns in the gold fund. A WEAKER rupee, on the other hand, PUSHES UP the rupee value."

"Since the gold funds are PASSIVE in nature, the fund manager DOES NOT TAKE A VIEW on the movement of gold prices... hence there is NO RISK RELATED TO THE DECISIONS TAKEN BY THE FUND MANAGEMENT TEAM."

10.3.4 Real estate funds

"Unlike gold, real estate is a LOCAL asset. It CANNOT BE TRANSPORTED – and its value is driven by LOCAL factors." The three named: economic scenario ("At times of uncertainty... people prefer to POSTPONE real estate purchases"); infrastructure development ("Whenever infrastructure in an area improves, real estate values increase"); and interest rates ("When money is CHEAP AND EASILY AVAILABLE, more people buy real estate... Rise in interest rates therefore SOFTENS the real estate market").

"Real estate investments can generate returns in two ways, viz. RENTAL INCOME and CAPITAL APPRECIATION." And: "SEBI has mandated that the mutual funds employ NEUTRAL VALUATION AGENCIES... Currently, there are NO MUTUAL FUND SCHEMES INVESTING IN REAL ESTATE."