8.3 What causes risks in a Mutual Fund Scheme?

8.3.1 Risks in Mutual Fund Scheme

Portfolio Risk
Returns from mutual fund schemes can fluctuate. The KIM of a mutual fund mentions –

  • Investment in mutual fund involves investment risk
  • Even principal can be lost
  • The investors should read SID
  • KIM then summarizes specific risk factors

SID mentions that the past performance of the mutual fund does not guarantee future performance. However, investment in mutual funds is not a gamble.

Portfolio Liquidity
If the scheme has invested in assets which are liquid then the Fund Manager can easily encash them whenever he needs the funds. The scheme can sell the liquid investments easily if they are likely to perform poorly or if the Fund Manager needs to generate liquidity.
SEBI has set a ceiling for illiquid assets. Open-ended mutual fund schemes require more liquidity. Hence the ceiling of illiquid assets that the open-ended scheme can hold is lower.

During the 2008 global economic slowdown, liquidity of the investments reduced drastically and RBI had to help the mutual funds with liquidity. Now, most of the open-ended schemes reserve the right to limit or even stop re-purchase (redemption) if ever a need for this arose in extreme circumstance. This is mentioned in the Offer Document. Schemes keep certain portion of their portfolio in liquid form for two reasons –

  • The fund manager thinks the market is over heated and he is looking for an entry point. This strategy may backfire if the markets continue to rise.
  • The scheme is providing for contingencies like upcoming dividend payment or possibility of heavy re-purchase (redemption).

Liquid assets generally give lower return so they lower the returns of the scheme, but they provide safety of liquidity.

Exposure of Mutual Fund schemes in Corporate Debt:
SEBI norms regarding exposure of Mutual Fund schemes in corporate debt are as under:
  • Maximum Exposure to a single issuer10% of NAV (can be increased to 12% with prior approval of trustees)
  • Maximum Exposure to a single Corporate Group25% of NAV
  • Maximum Exposure to a single sector25% of NAV


Scheme Liabilities
Scheme’s Net Assets = Total Assets – Outside Liabilities (liabilities other than to Unit Holders)
A scheme needs to pay outside liabilities irrespective of the performance of the scheme. Even if the scheme is performing poorly, it has to pay outside liabilities. Hence, they increase the risk of a scheme.

A scheme has to incur certain outside liabilities as routine business. Example, when a scheme purchases securities, a liability arises to pay for the securities. Sometimes, schemes take liabilities which are not routine business. This is called leveraging. SEBI has formed certain regulations regarding scheme’s liabilities towards leveraging –

  • Scheme cannot borrow more than 20 percent of its net assets.
  • Scheme cannot borrow for more than 6 months.
  • Scheme can borrow only to meet cash flow needs – dividend payment or re-purchase payment

Use of Derivatives by Mutual Funds Derivatives are instruments whose value depends upon underlying assets. It is a contract between two parties. Its price depends upon fluctuation in the price of the underlying asset. The asset can be shares, exchange rate, interest rate, precious metals, commodities, etc.   Types of derivatives – Forwards, Options, Futures, Swaps.   Uses of derivatives –

  1. Hedging against risk

Some derivatives earn money for the investor when market goes down. Hence, they can be used to hedge against the risk of portfolio’s value going down.

  1. Re-balancing the portfolio

If the fund manager wants to change the weightage of a sector in his portfolio, he can do so using derivatives. This will save him from having to sell the shares of other sectors and buying the shares of his preferred sector.

  1. Leveraging
  • Derivatives can be used to take large exposure in an asset by using only a small amount of funds.
  • In India, mutual funds can use derivatives for hedging or re-balancing but not leveraging.
  • To reduce risk in debt mutual fund scheme, fund manager may invest in Interest Rate Futures.
  • Mutual funds in India are not allowed to “write options” or buy instruments with “embedded written options”.
  • If a scheme wants to invest in derivatives, it should have included this clause in the Offer Document.
  • If the derivative clause was not included in the Offer Document, then the mutual fund must explain to all its unit holders, how much the mutual fund is going to invest in derivatives and the manner in which it will invest. Further, the existing unit holders will be given a time of at least 30 days to exit at existing NAV and without exit load.

Churn of Unit Holders

SEBI has mandated that every mutual fund scheme should have at least 20 investors and no investor should represent more than 25 per cent of the net assets of the scheme. This is called 20:25 rule. This is to ensure a better distribution of the assets of a scheme. If large amount of assets is concentrated in only a few investors, it can create a problem for smaller, retail investors. Example, when market is not performing well, if institutional investors offer large amount of their units for re-purchase and the amount of money they have to be paid is more than the liquid assets of the scheme and net inflows from the sale of new units, the scheme might have to sell its assets below their intrinsic value. The retails investors will unnecessarily suffer erosion in the value of their investment. Hence, the above mentioned 20:25 rule has been mandated by SEBI.

8.3.2 Risk in Equity Funds

A. Generic Risks

  1. Equity markets reflect the economy of the country in the long run. However, in short run, sometimes, share markets get over-optimistic or over-pessimistic and may rise or fall even if economy presents a different picture.
  1. Further, economy itself moves in wave from boom to recession. Therefore, investing in equity may lead to loss as well if the economy goes into recession.
  1. Investment in equity requires the investor to evaluate stocks and sectors, choose from the evaluated options and then monitor his investments. Investing in equity with only half-baked knowledge more often than not leads to losses.

B. Portfolio Specific Risks

  1. Sector Funds
  • Concentration risk – Scheme invests in only one sector.
  • If the sector performs poorly, the scheme returns will also be poor.
  • Sector Funds carry the Highest Risk among the equity mutual funds.
  1. Diversified Equity Funds
  • Schemes invests across multiple sectors and in stocks of many companies, hence the risk is lowered.
  • Some funds which are launched as focussed funds invest in only a few companies. Risk increases in such funds.
  1. Thematic Funds
  • Invest in stocks of a particular theme. Their exposure is wider than sector funds but narrower than diversified funds. Hence the risk is also less than sector funds but more than diversified fund.
  • Example – An infrastructure theme fund can invest in stocks of transportation, steel, real estate, infrastructure companies and is not limited to companies falling only under infrastructure sector.
  1. Mid Cap Funds
  • Stocks of mid cap funds present a greater volatility than large cap stocks. During boom, often mid-caps give good returns but they also present higher risk. These are the stocks of those companies which might not have very stable earnings. Further, they might not be traded as much as large cap stocks so they also present a liquidity risk.
  1. Contra Funds
  • Contra funds are those which behave in a manner contrarian from rest of the market. E.g. they may buy stocks that others are selling and vice versa. This decision of the fund manager is usually backed by very deep research into the stock and the belief that the stock has value and will perform well in the long run.
  • Carries high risk of misjudgement on the part of the fund manager.
  1. Dividend Yield Funds
  • Such funds invest in those shares whose price fluctuate less but offer attractive dividends to the investors.
  1. Investment Style
  • Investment style can be either growth or value. Growth investment style picks up the stocks which offer higher growth than the economy, but the risk of loss is also higher in such stocks. Value style is a conservative style seeking to identify the stocks that are priced lower than their real value. Such stocks carry lower volatility.
  1. Portfolio Turnover
  • Portfolio Turnover = (Purchase Value of Securities + Sale Value of Securities) Average Size of Net Assets
  • High portfolio turnover means the fund manager is buying and selling stocks to book profits and time the markets. This is a risky strategy.

8.3.3 Risk in Debt Funds

A. Generic Risks

  1. The value of debt securities changes because of changes in yield in the market. The interest rates are affected by many factors including the policies of Government and RBI. These are not easy to predict. Wrong judgement about the movement of interest rate can affect the scheme’s returns.
  1. Credit Risk – Investment in non-Government securities creates a risk that the issuer might not be able to repay principal and interest.
  1. Credit rating of a debt security may get downgraded which can lead to fall in the value of a debt security.
  1. The debt market is not as vibrant as equity market. Hence, there is a possibility of not finding a buyer of the debt security.
  1. If the securities are not traded in the market, then their valuation becomes subjective and this will affect the NAV.

B. Portfolio Specific Risks

  1. Short Maturity Securities –
  • Short maturity securities have less fluctuation in their value.
  • Short maturity securities have lower risk than long maturity securities.
  • Short maturity securities earn returns from interest on securities. They do not aim to earn returns from change in value. Hence, their returns are more stable.
  • Example
  • Liquid schemes – invest in securities of up to 91 days maturity. They have the lowest risk among all kinds of schemes.
  • Short term funds – invest in securities of less than one year
  1. Gilt Schemes –
  • Gilt schemes invest in Government securities.
  • Gilt schemes have carry price risk.
  • [Credit risk – Risk that the lender will not be able to pay interest or repay the principal when the security matures.
  • Price risk – Risk that value of the debt security will fall because of rise in interest rate in the market.]
  • The credit risk of Gilt schemes is lowest because it is highly unlikely that Government will be unable to pay interest or the principal of the debt security.
  • The price risk of Gilt schemes is high because they are sensitive to change in yield in the market. The NAV of long maturity securities fluctuates more.
  1. Bond Funds –
  • Sometimes, these take high credit risk by buying low rated securities to earn higher interest income or to take benefit from the increase in value if credit rating of that debt security improves. However, this strategy has high risk of fluctuation in value of debt securities or even default in payment of interest or repayment of principal.
  1. Fixed Maturity Plans (FMPs)
  • FMPs align the maturity of the security in their portfolio with the maturity of the scheme. This makes the yield more predictable. However, it is only on the maturity that the yield becomes predictable. During most of its tenor, however, the NAV of the FMPs will also fluctuate in line with the market.
  • If the FMPs have invested in non-Government securities, they also carry credit risk.
  1. Junk Bond Schemes
  • These schemes invest in securities which have poor credit quality with the aim of earning higher interest and appreciation of value if their credit rating improves. However, these schemes are extremely risky.
  • SEBI has set limit on the exposure that mutual funds can take on unrated debt securities and securities rated below investment grade.
  1. Capital Guaranteed Schemes
  • These schemes are those where guarantee comes because the investment has been made in the government securities. If the investment has been made in non-Government securities, then even if the scheme is named capital guarantee, it actually is a capital protection-oriented scheme, unless such return is guaranteed by Asset management Company or the Sponsor.

8.3.4 Risk in Hybrid Funds

Hybrid schemes invest in a mix of debt and equity to reduce risk.

  1. Monthly Income Plans – MIP schemes invest larger portion of their funds in debt securities (to lower the risk) and smaller portion in equity securities (to earn good returns). However, it is also possible that the equity component may incur loss and which might be more than the profit earned by the debt component. If the scheme does not earn any profit, it is possible that MIP might not pay any monthly income to the investor.
  1. Arbitrage Funds
  • Arbitrage funds buy and sell the same security at the same time in different markets and take advantage of price difference by buying low and selling high.
  • The risks are low as they get cancelled out between Cash and F&O market. However, some risk still remains which is that the position in Cash and F&O cannot be reversed at the same time and during the time gap, the price of the security can change in the market, adversely affecting the returns of the schemes.

8.3.5 Risk in Gold Funds

  1. Gold as an investment option gives two benefits
  • As an international commodity, gold’s pricing is very transparent.
  • Gold performs well when there is financial or political turmoil.
  1. There are two types of gold fundsGold Sector Fund and Gold ETF.

8.3.6 Risk in Real Estate Funds

  1. Valuation of real estate is highly subjective.
  2. Real estate is much less liquid than equity or debt.
  3. The real estate intermediaries are unorganised.
  4. Transaction cost (e.g. stamp duty) is high.
  5. Risk of litigation is high.
  6. Many real estate companies are family owned companies. Corporate governance and transparency are low.

8.4 Measures of Risk

Volatility in returns leads to risk. Hence, volatility is a measure of risk. To measure risk, first returns are recorded and then volatility is measured.   Volatility can be measured in relation to itself or in relation to some other index.

8.4.1 Variance

  • If two schemes have the same average return over long duration, say during last one year or two years or three years, etc. But if the monthly returns of one scheme fluctuates more than the other scheme, then the scheme whose returns fluctuate more is riskier and will have a higher variance.

8.4.2 Standard Deviation

  • Mathematically, standard deviation is equal to the square root of variance.
  • Like variance, Standard Deviation measures fluctuation in returns in relation to its own average return.
  • It is a measure of total risk of an investment.
  • Relevant for both debt and equity.
  • High Standard Deviation means higher volatility and higher risk.
  • Standard Deviation of a scheme should be compared with that of its peers and its benchmark.

8.4.3 Beta

  •  Capital Asset Pricing Model (CAPM) states that there are two types of riskssystematic risk (which applies to all entities in the market, cannot be avoided. E.g. risk arising out of inflation, political turmoil) and non-systematic risk (which is unique to a company, can be reduced using diversification across companies, e.g. risk arising out of change in management, product a company becoming obsolete).
  • Systematic Risk is measured by Beta. This is done by comparing fluctuations in periodic returns of the scheme with the fluctuations in periodic returns of a diversified stock index.
  • The diversified stock index has beta of 1. Companies or schemes whose beta is more than 1 are considered riskier than the market and whose beta is less than 1 are considered less risky.
  • Beta is relevant only for equity schemes.

8.4.4 Modified Duration

  • Modified duration measures sensitivity of value of a debt security to change in interest rates.
  • Higher the modified duration, higher is the interest sensitive risk in a debt portfolio and chances of higher fluctuation in its value.

8.4.5 Weighted Average Maturity

  • It can be said that longer the maturity period of the security, higher would be its interest rate sensitivity. With the same logic, weighted average maturity of debt securities in a scheme is also indicative of interest rate sensitivity of a scheme.
  • Weighted average maturity is however only used by laymen and not professionals. Fund Managers and professionals still use modified duration as a measure of risk.

8.4.6 Credit Rating

  • Credit rating is done by Credit Rating agencies. Higher the credit rating, lower the default risk of the security.
  • Government securities, cash and cash equivalent do not have credit risk.

8.5 Benchmarks and Performance

8.5.1 Benchmarks

  1. Benchmarks are developed so that a scheme’s performance can be compared with it. This helps in assessing the performance of the scheme. A scheme aims to give better risk-adjusted return than its benchmark.
  1. A benchmark can be considered good if
  • Benchmark and the scheme are in sync about the following –

– Investment Objectives of the scheme

– Asset Allocation pattern
– Investment Strategy of the scheme
  • Benchmark has been developed by an independent agency, transparently and is published regularly.
  1. How is benchmark of a scheme chosen?
  • Choosing benchmark of an index scheme is the easiest as it will be the relevant index.
  • For schemes falling in every other category, the choice of benchmark is subjective. AMC decides by consulting its trustees.
  • The fund can also change its benchmark on a later date if a better benchmark becomes available or if scheme’s investment objective changes or construction of index changes.
  • The benchmark and its performance along with that of the scheme has to be mentioned in the Offer Document.
  • Earlier, mutual fund schemes were benchmarked to Price Return variant of Index (PRI). Since Feb 1, 2018 schemes are benchmarked to Total Return variant of Index (TRI).
  • PRI captured only capital gains of the constituents of index. TRI captures dividends and interest payments as well.

8.5.2 Benchmarks for Equity Schemes

Following factors decide which benchmark should be chosen for an equity scheme –

  1. Scheme Type
  • Diversified funds will have diversified benchmark index like – S&P BSE Sensex, Nifty 50, etc.
  • Sectoral/ thematic funds will have sectoral thematic benchmark index like – S&P BSE Bankex, S&P BSE FMCG Index, etc.
  1. Choice of Investment Universe
  • Diversified equity funds which invest in large cap stocks will have benchmark index like – S&P BSE Sensex (30 Large Companies), Nifty 50 (50 large companies), etc.
  • Diversified equity funds which invest in mid cap stocks will have benchmark index like – Nifty Midcap 50, S&P BSE Midcap, etc.
  1. Choice of Portfolio Concentration

Diversified equity funds which have fewer stocks will have benchmark index like – S&P BSE Sensex (30 Companies), Nifty 50 (50 companies), etc. Diversified equity funds which have more stocks will have benchmark index like – S&P BSE 100 (100 Companies), Nifty 100 (100 Companies), etc.

8.5.3 Benchmarks for Debt Schemes

  1. As per SEBI guidelines, benchmark for debt (and balanced schemes) should be developed by research and rating agencies recommended by AMFI.

These agencies are – CRISIL, ICICI Securities, NSE, BSE.

Indices by NSE
NSE’s MIBOR (Mumbai Inter-Bank Offered Rate) – for short term money market
Nifty Composite G-sec index – for Government securities
Nifty 4-8 Year G-sec index – for Government securities
Nifty 10 year benchmark G-sec index – for Government securities
Indices by BSE
S&P BSE India Sovereign Bond Index – for Government securities
S&P BSE India Government Bill Index – for Government securities
Indices by ICICI Securities
ICICI Securities’ Sovereign Bond Index – for Government securities. This index has three sub-indices –
Si-Bex (1- 3 years)
Mi-Bex (3 – 7 years)
Li-Bex (more than 7 years)
Indices by CRISIL
SEBI CategoryCRISIL Index
Overnight FundCRISIL CBLO Index
Liquid FundCRISIL Liquid Fund Index
Ultra-Short Term FundCRISIL Ultra Short Term Debt Index
Money Market FundCRISIL Money Market Index
Low Duration FundCRISIL Low Duration Debt Index
Short Duration FundCRISIL Short Term Bond Fund Index
Medium Duration FundCRISIL Medium Term Debt Index
Medium to Long Duration FundCRISIL Medium to Long Term Debt Index
Long Duration FundCRISIL Long Term Debt Index
Dynamic BondCRISIL Composite Bond Fund Index
Corporate Bond FundCRISIL Short Term Corporate Bond Index
CRISIL Medium Term Corporate Bond Index
CRISIL Long term Corporate Bond Index
CRISIL Corporate Bond Composite Index
Credit Risk FundCRISIL Credit Risk Index
  1. The following aspects of investment objective decide which benchmarks should be chosen for debt schemes
    • Scheme Type – Liquid schemes (which invest in securities of up to 91 days maturity) will use a benchmark like NSE’s MIBOR, CRISIL Liquid Fund Index, etc.
    • Choice of Investment Universe – Gilt funds (which invest in Government securities) will use a Government Security benchmark

8.5.4 Benchmarks for Other Schemes

  1. Hybrid Funds

Benchmark – gold price Hybrid funds invest in both debt and equity; hence the benchmark should also be a mix of equity and debt benchmark index. Example – A hybrid scheme with 75% of its portfolio in diversified equity shares and 25% of its portfolio in debt securities of up to 1 year can have a benchmark that is 75% Nifty 50 and 25% CRISIL Ultra Short Term Bond Index.   CRISIL has also created some blended indices –

SEBI CategoryIndexDebt IndexEquity Index
Aggressive Hybrid FundCRISIL Hybrid 25+75 – AggressiveCRISIL Composite Bond Fund Index [25% allocation]S&P BSE 200 (TRI) [75% allocation]
Balanced Hybrid FundCRISIL Hybrid 50+50 – ModerateCRISIL Composite Bond Fund Index [50% allocation]S&P BSE 200 (TRI) [50% allocation]
Conservative Hybrid FundCRISIL Hybrid 75+25 – ConservativeCRISIL Composite Bond Fund Index [75% allocation]S&P BSE 200 (TRI) [25% allocation]
2. Gold ETF Benchmark – Gold Price

  1. Real Estate Funds

Real estate indices developed by some real estate companies. These have yet to gain wider acceptance.

  1. International Funds

The choice of benchmark would depend on where the investment is being made. If investment is made in China – Hang Seng US – S&P 500   The international funds have an additional requirement. Apart from the scheme benchmarks, they need to disclose the return in INR and in CAGR for the following benchmarks

Scheme TypeBenchmark
Equity SchemeSensex or Nifty
Long term debt scheme10 year dated GoI security
Short term debt fund1 year T-Bill

8.6 Quantitative Measure of Fund Manager Performance

8.6.1 Absolute & Relative Returns

When returns of a scheme are compared with its benchmark, the process is called relative return comparison.

8.6.2 Risk-Adjusted Returns

When two schemes are compared, comparing only their returns will not show a complete picture because the risk taken by the two schemes might be different. Technically, if a scheme takes higher risk then it should give higher returns to the investor.   Hence, instead of just comparing returns, a better approach is to compare risk-adjusted returns. Various measures of risk-adjusted returns are –

  1. Sharpe Ratio
  • Formula –
Sharpe Ratio = (? minus Rf) ÷ Standard Deviation

Rf = Risk Free Rate of Return e.g. T-Bill Index ? = Average Return earned

  • Sharpe ratio is the Risk Premium which means Average Return earned in excess of Risk Free Rate (? minus Rf) per unit of total risk (Standard Deviation).
  • Sharpe ratio of only similar schemes can be compared which means Sharpe of equity cannot be compared with Sharpe of debt.
  1. Treynor Ratio
  • Formula –
Treynor Ratio = (? minus Rf) ÷ Beta

Rf = Risk Free Rate of Return e.g. T-Bill Index ? = Average Return earned

  • Treynor ratio is risk premium per unit of risk. As a unit of risk, Treynor uses Beta.
  • Treynor is more relevant for diversified equity schemes.
  1. Alpha
  • Alpha is the difference between optimal return of a scheme and actual return of the scheme.
  • Positive alpha is out-performance by the fund manager and negative alpha is under-performance.
  • Alpha is relevant for diversified equity schemes.
  1. Tracking Error
  • An index fund mirrors the index hence its return should also be the same as the index. However, there are differences in the returns. The standard deviation of the difference between an index fund’s return and market return is called tracking error.
  • Earlier, tracking error was used to measure how closely did the index fund track the returns from benchmark, now it is used to measure how consistently is it able to out-perform the benchmark.
  • The tracking error should be low if the index fund is consistently beating the benchmark.

Quick Revision

[WATU 18]

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