8.1 Factors that affect the Returns and Risks of a Scheme (Or, Drivers of Risk and Return)

The returns and risks in a mutual fund scheme are affected by –
  1. Asset Class – The asset class (equity, debt, etc.) in which the mutual fund scheme has invested.
  2. Market Sector – The market sector (pharma, banking, etc.) in which the scheme invests.
  3. Selection Style – The style adopted by the fund manager to select securities.
  4. Portfolio Management Strategy – The strategy adopted to manage the scheme’s portfolio.

8.1.1 Equity Schemes

1) How does an equity scheme earn returnsEquity mutual fund schemes invest in equity shares of the company. When the market price of shares increases, it in turn leads to an increase in Net Asset Value (NAV) of the scheme. The market price of shares is affected by earnings of the business.2) What are the risks in an equity schemeEquity schemes do not give fixed returns. Plus, the returns are volatile.

8.1.1.1 Security Analysis

How should equity securities be analysedTo analyse an equity security, the business must be analysed.When?  -1. Before making an investment, and2. Even after the investment has been made to check if the business continues to remain profitable.There are two main approaches of security analysis –A. Fundamental Analysis, andB. Technical Analysis.A. Fundamental Analysis – The analyst analyses fundamentals of the company viz –
  1. Financial Statements (Balance Sheet, Profit & Loss Statement)
  2. Quality of Management (how well the company is being managed by its top & middle management)
  3. Competitive Position in Market (how well does its products and services compete in the market)
The analyst also analyses financial parameters like Earnings Per Share (EPS), Price to Earning Ratio (P/E), etc. and is thus able to reach price target (i.e. the price at which the shares should be trading). Various financial parameters that are analysed –
  1. Earnings per Share (EPS)
  • EPS = Net profit after tax ÷ No. of Equity Shares Outstanding
  • This ratio tells how much profit is earned per equity share.
  1. Price to Earnings Ratio (P/E)
  • PE Ratio = Market Price per Share ÷ Earnings per share
  • This ratio tells how much the investors are prepared to pay, to buy a share, for earnings per share (EPS).
  • Another similar parameter is Forward P/E. In the place of current earnings per share analysts try to project the future earnings per share (EPS) and use that to calculate P/E.
  • To see if the shares of a company are expensive or not, its P/E ratio is compared with the P/E ratio of its peers and the market. However, it would be wrong to say that a share should be bought if it has a low P/E and sold if it has a high P/E. The P/E might be low because the prospects of the company might not be promising and vice versa.
  1. Price Earnings to Growth Ratio (PEG)
  • This is P/E Ratio divided by the estimated Growth in company’s earnings.
  • PEG ratio of 1 means shares are fairly valued, less than 1 means undervalued, more than 1 means overvalued
  1. Book Value per Share
  • Book Value per Share = Net Worth ÷ No. of Equity Shares Outstanding
  • This ratio tells how much each share is worth as per the company’s books of account.
  1. Price to Book Value
  • Price to Book Value = Market Price per share ÷ Book Value per share
  • Drawback of this indicator is that Book value is calculated as per the accounting policies of the company and may not show the correct value of the assets.
  1. Dividend Yield
  • Dividend Yield = Dividend per Share ÷ Market Price per Share
  • This ratio tells what percentage of market price of share is the company paying in the form of dividend.
  • Dividends are neither guaranteed nor fixed, hence, the way to study this ratio is look at the dividend yields of a particular company over a period of time.
  • High dividend yield means either high dividend payout or lower market price of share or both.
  • Another reason for high dividend yield could be that the company does not have significant investment opportunities, hence it is passing the profit to the investor instead of re-investing in the company.
B. Technical Analysis – Technical analysis is different from fundamental analysis. Under this approach, the analyst checks two things –
  1. Past Price Behaviour of the share over a period of time – Using this the analyst tries to determine the future share price.
  2. Volume of Shares Traded – This tells the analyst about the investor sentiment, which will influence the share price.
Hence, technical analysts study price-volume charts. The price-volume charts are used to find out – 1. Support levels, 2. Resistance levels, 3. Breakouts, 4. Other triggers. These are used in deciding buy/ sell/ hold recommendations. The best approach is that long term investment decisions should be taken through fundamental analysis and short term decisions (like intra-day trading, speculative investment decisions) should be taken through technical analysis. Even when fundamental analysis is being used, technical analysis will help in the timing of the investment.

8.1.1.2 Investment Styles

A. Growth Investment Style
  1. Investment is made in high growth stocks. These stocks grow much faster than market. However, if the market falls, their price falls more sharply than the market.
  2. These stocks have high PE Ratio and PEG Ratio, but low Dividend Yield.
B. Value Investment Style
  1. Under this approach investment is made in those stocks which analysts believe are priced lower than their intrinsic value which is calculated through fundamental analysis.
  2. The reason that their market price is cheap is because the market has not recognized their value. When it does, the market price of these stocks would increase.
  3. This style requires long investment horizon.
Investment style can be either growth or value or a mix of two. In the initial phases of the bull run i.e. when the stock market is increasing, the growth stocks give good returns. Once that initial phase is over and the stock market has become costly, growth stocks become too costly to buy. At that point investment in value stocks becomes a good strategy.

8.1.1.3 Portfolio Building Approach

There are two approaches to portfolio building – 1. Top down approach 2. Bottom up approach. To analyse the factors that affect earnings of a company, analysts use EIC Framework. EIC stands for economy, industry and company specific factors. These are –
  1. Economic factors – Inflation, interest rates, GDP growth rate, fiscal policy of Govt, monetary policy of Govt, balance of payments
  2. Industry factors – Regulations, Competition, Availability of raw material, Cyclical nature of industry, etc.
  3. Company specific factors – Management, Ownership Structure, Financial condition, Product, Market Share, etc.
A. Top Down Approach
  1. The analyst first analyses the economic factors.
  2. Then he shortlists the industries that are suitable for investment by checking the industry-based factors.
  3. Finally, within the shortlisted industry, attempt is made to find the companies most suitable for investment.
B. Bottom Up Approach – In the approach, the reverse path is followed –First, the companies are analysed,then industry, andthen the macro-economic factors.Both approaches have merits. Top down approach reduces the chance that a large portion of investment will be made in a poor performing sector. Bottom up approach helps in finding out a company which is good even if it belongs to a sector that is not very good in itself.

8.1.2 Debt Schemes

  1. How do debt securities provide returns to an investor?

The debt securities provide returns in the forms of –

  • Interest
  • Capital gains in value of security
  1. What is tenor of a debt security?

The interest is paid at a pre-specified frequency for a pre-specified period. The invested amount is repaid at the end of a pre-specified period. This pre-specified period is called tenor. When the amount is paid on maturity of the security, it is called redemption.

  1. Money Market Securities – Debt securities that mature within one year.
  1. Yield – Yield equals to interest plus capital gain (if sale proceeds are higher than the invested amount) or less capital loss (if sale proceeds are lower than the invested amount). It is the total returns earned by an investor on debt security.
  1. Who can issue debt security?
Following can issue debt security –
  • Central Government
  • State Government
  • Banks
  • Financial Institutions
  • Public Sector Undertakings
  • Private Companies
  • Municipalities
  1. What are the various types of debt securities?
  • Gilt or G-Sec or Government Security – issued by the Government.
  • Treasury Bill – short term security – issued by Reserve Bank of India (RBI) on behalf of the Government.
  • Certificate of Deposit – issued by Banks (7 days to 1 year) or Financial Institutions (1 to 3 years).
  • Commercial Paper – short term security (upto 1 year) – issued by Companies.
  • Bond – for a tenor of more than 1 year – issued by Government and Public Sector Companies.
  • Debenture – for a tenor of more than 1 year – issued by Private Sector Companies.
  1. What is credit spread?
  • Gilt is considered a safe security, because Government is not likely to default on its obligation. Since there is no credit risk, its yield is lowest. Non-Government debt securities can default, so they have a higher risk and that’s why they offer higher yield.
  • The difference between the yield of Gilt and any other non-Government security for the same tenor is termed as the credit spread.
  1. What is credit risk?
  • The possibility of a non-Government issuer of a security failing to repay its obligation (defaulting on debt security) is called credit risk.
  • This credit risk is measured by companies called Credit Rating Agencies. Some of the credit rating agencies are – CRISIL, ICRA, CARE, Fitch.
  • Each agency has its own rating system and the rating is awarded to a security in the form of symbols E.g. when CRISIL gives “AAA” to a security, it means the security falls in the safest bracket possible. If “AA” is given then it means that this security is less safe than “AAA” securities.
  • Higher the credit risk, higher the yield.
  1. What is the difference between fixed rate security and floating rate security?

Fixed Rate Security – The interest rate on a fixed rate security is fixed e.g. 6%. The security will continue to pay the same interest (i.e. @ 6% in our example) throughout its tenor.

Floating Rate Security

  • Floating rate is linked to the interest rate of some other security in the market e.g. Gilt. So, a floating rate security (floater) will specify its interest rate as follows – Example – 5-year Gilt + 3 percent. This security will pay the interest equal to whatever the interest rate of the Gilt is at that time plus 3 percent.
  • The interest rate of floating rate security will be specified as – Base + Spread. The base in this example is the interest rate of Gilt and the spread is the extra interest which is 3 percent in this example.
  1. Why is value of a debt security inversely related to the yield?
If a security was issued at the yield of 8 percent. Later, securities carrying similar risk are issued with a yield of 9 percent, then the value of older security will fall. This is because they will no longer be attractive, as securities with higher returns are available. The reverse will be true if the yield falls. Longer the tenor of the security, higher will be the volatility in the market price / valuation of the security.
  1. What is modified duration?
  • The value of a debt security increases or decreases in response to the change in interest rates. Debt securities which have a longer tenor carry a higher possibility that interest rate will change before they mature. Interest rate might change multiple times during the tenor of a debt security.
  • Modified duration is used to measure how much will the value of a debt security fluctuate in response to change in interest rate. Higher the modified duration of a security, greater the possibility of fluctuation in its value.
  1. Why does the value of a floating rate debt security remain steady?
When the yields in the market go up, the issuer of floating rate debt security pays higher interest rate, when yields go down, lower interest is paid. Hence, the value of a security remains nearly stable, despite changes in yield.
  1. What should a portfolio manager do when he expects interest rates will rise or fall?
If fund manager thinks that the interest rates will rise, he should move higher proportion of portfolio of the scheme to –
  • floating rate debt securities, or
  • fixed rate debt securities of short tenor
If fund manager thinks that the interest rates will fall, his portfolio should include higher proportion of –
  • fixed rate debt securities of long tenor
  1. What is the key factor that determines returns in debt mutual fund schemes?
  • In debt mutual fund schemes, fund manager’s decision on the likely interest rate scenario will determine the returns of the scheme. If the fund manager is correctly able to forecast whether interest rates will increase or decrease, then the scheme will earn good returns.
  • This is unlike the factors that affect the returns in an equity schemes i.e. stock selection and sector selection.
  1. How will investment objective affect returns and risks in a debt mutual fund scheme?
The investment objective of a fund manager can be to earn either-
  • interest income only, or
  • combination of interest income and capital gain in value of security
  1. Interest Income only
  • Money Market Schemes/ Liquid Fund Schemes, Ultra-Short Term Debt Fund schemes, Floating Rate Fund Schemes will focus only on interest income.
  • These will carry a relatively lower risk and will give lower returns.
  1. Interest Income plus Capital Gain in Value –
  • This portfolio will have both short-term tenor securities as well as long-term tenor
  • Higher the proportion of long-term tenor securities, greater will be the modified duration and greater will be the chances of capital gain or capital loss.
  1. What is duration management of a debt security?
Duration management is a strategy of debt fund manager where he alters the duration of the portfolio in the anticipation of change in interest rate. Risk – if the fund manager’s forecast on the likely interest rate scenario proves to be incorrect, then there will be a fall in the value of his portfolio.
  1. How can fund manager of a debt security earn returns by anticipating change in credit quality? What are the risks?
If the fund manager anticipates that credit rating of a debt security will improve, he will increase his exposure in that security. Once the credit rating improves, the value of the security will increase. Risk – If the credit rating of the security does not improve, there will be no increase in value and the portfolio will continue to have a lower rated security prone to default risk.

8.1.3 Gold

Gold is an international asset. What affects the value of gold in India? The value of gold is affected by –
  1. International Price of gold
  2. Currency Exchange Rate – Weaker rupee will mean higher gold price in rupee terms and vice versa.
  3. Import Duty
Gold is considered a very safe asset. So, when there is political or economic uncertainty, demand for gold rises, and its price increases. Gold is held as part of foreign currency reserves by most countries. Institutions like International Monetary Fund also hold large reserves of gold.

8.1.4 Real Estate

What factors affect the returns from real estate?
  1. Economy – When the economy is uncertain, people do not prefer purchasing real estate, hence real estate prices weaken. When economy improves and stabilizes, real estate prices also increase.
  2. Infrastructure – Improvement in infrastructure leads to increase in real estate value.
  3. Interest Rate – When interest rates fall, real estate looks more favourable to people as their buying capacity increases. When interest rates rise, real estate prices fall.
  4. Nature of real estate – Whether the real estate is commercial, residential, industrial etc. also affects the real estate price and its behaviour.

8.2 Measures of Returns

8.2.1 Simple Return

Formula –
(Later Value – Initial Value) × 100 ÷ Initial Value

8.2.2 Annualized Return

Meaning – If one investment was made for 8 months @ 7.5% and another investment was made for 7 months @ 6.9%, their performance is not comparable as the time period of both is different. So, their performance will be annualized which means if the investment was made for one year in that investment, how much return would it have earned. Formula –
Simple Return × 12 ÷ Period of Simple Return (in months)

8.2.3 Compounded Return

  1. What is compounding?
An investment earns returns. When the returns are invested back, then it is not only the initial investment but also the re-invested returns that will earn returns. As the time period of the investment increases, the returns will keep being re-invested. This is compounding of returns.
  1. When are compounded returns calculated?
If an investment has been made for more than one year then the returns cannot be calculated using annualised return. In this case, compounded returns are calculated. Formula –
(LV 1÷n ÷ IV) – 1
LV – Later Value
IV – Initial Value
n – period (in years)

8.2.4 Compounded Annual Growth Rate (CAGR)

  • The above three formulas are relevant for calculating returns of only mutual fund schemes of GROWTH option or the schemes of Dividend option that have not paid dividend during the period of calculation.
  • SEBI prescribes CAGR as the technique to consider when – dividend is being paid and compounding is being taken into account.
  • CAGR assumes that the dividend would be re-invested in the same scheme at the ex-dividend NAV.
Formula –
(LV 1÷n ÷ IV) – 1
LV – Later Value of Units. The impact of dividend on returns is captured in the form of number of units.IV – Initial Valuen – period (in years)

Factors other than returns that should be evaluated by an investor

  1. Volatility in Returns – More volatile the returns, higher the risk.
  2. Asset Allocation of the scheme – Asset allocation should match investor’s need for growth and liquidity. E.g. for steady income, investor should invest in Monthly Income Plan (MIP). If higher growth is the objective, then he should invest in equity.
  3. How well does the scheme follow its stated asset allocation?
  4. Cash level of the scheme.
  5. Diversification across stocks and sectors.
  6. Credit Rating of debt
  7. Duration of debt
  8. Expense Ratio of the scheme.

8.2.5  What are SEBI’s Norms regarding Representation of Returns by Mutual Funds?

Mutual funds cannot guarantee returns. They can guarantee returns on only one condition – it is an assured returns scheme. This scheme requires a guarantor who will pay investors’ money, if the scheme does not earn assured returns.

8.2.6  Scheme Returns vs Investor Returns

  • Scheme returns can be different from investor returns
  • Exit load can decrease investor return. Exit load is levied if the client redeems his investment before the end of a pre-specified period.
  • To calculate return, instead of using Later Value (LV), the investor should use Later Value – Exit Load, if any.
  • Investor returns might also be different because of additional investment and redemption of a portion of the investment.
  • Holding period returns are calculated for a fixed period and may not present an accurate picture. Hence, rolling returns are calculated which are an average of annualized returns calculated for multiple consecutive period.

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[WATU 17]

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