MMPF-004

Indira Gandhi
Security Analysis and
National Open University Portfolio Management
School of Management Studies

Block

4
UNIT 14 245
Mutual Funds

UNIT 15 263
Performance Evaluation of Managed Portfolio
 BLOCK 4

This block comprises of two units.

Unit 14: Mutual Funds highlights the purpose and concept of mutual funds,
their organizational structure; historical evaluation, types and investment
objectives. It also explains the process of creating, managing, and revising the
portfolios of securities by mutual funds in India.
Unit 15: Performance Evaluation of Managed Portfolio discusses various
concepts and methods of computing evaluation. This unit also highlights the
concepts of benchmark portfolio and return and distinguishes between performance
measurement and portfolio performance attribution for comparison and evaluation
of managed portfolio. The problems encountered in the process of performance
evaluation of managed are also highlighted in this unit.

244
 Mutual Funds
UNIT 14 MUTUAL FUNDS
Objectives
After going through this unit you should be able to:
x Highlight the purpose and the concept of Mutual Fund;
x Understand the organizational structure and the different activities
involved in floating a Mutual Fund;
x Explain the basic investment objectives of Mutual Funds.
x Explain the process of creating, managing and revising portfolios of
securities.
Structure
14.1 Introduction
14.2 Investment in mutual funds
14.3 Organization of mutual funds
14.4 Types of mutual funds
14.5 Evolution of mutual funds
14.6 Investment process in mutual funds
14.7 Portfolio revision
14.8 Systems and control
14.9 Summary
14.10 Key words
14.11 Self Assessment Questions
14.12 Further Readings

14.1 INTRODUCTION
In this unit, we will discuss another popular investment company namely
mutual funds. A Mutual Fund is a trust that pools the savings of a number of
investors, who share a common financial goal. Mutual funds make investments
in the stock and debt markets on behalf of investors joining the scheme and
thus offers two special services namely expertise in investments and
diversification. A small investor with a surplus fund of say 10,000 per year
may not be in a position to get such expert advice or diversification without
mutual funds. Investors thus not only share a common financial goal but also
share the cost associated with expert advice and diversification. Some of the
objectives that mutual funds pursue on behalf of their investors are attractive
yields, capital appreciation, holding the safety and liquidity as prime
parameters. The rest of the unit will introduce you with the concepts of mutual
funds, the advantages of investing in Mutual Funds, the history of mutual 245
 funds, the organisation of mutual funds and the mutual fund investment
process.

14.2 INVESTMENT IN MUTUAL FUNDS

As stated earlier mutual funds pool the funds from small investors and invest
in shares and bonds of companies. The income earned through these
investments and the capital appreciation realized are shared by its unit holders
in proportion to the number of units owned by them. Thus a Mutual Fund is
the most suitable investment for the common man as it offers an opportunity
to invest in a diversified, professionally managed basket of securities at a
relatively low cost. The flow chart in figure 14.1 describes broadly the working
of a mutual fund:

Figure 14.1: Mutual Fund Operation Flow Chart

By investing in various Mutual Fund Schemes, small investors or middle

income investors seek the following advantages compared to other types of
investments:
i) Professional Management: No impulsive decision making regarding
purchase or sale of share/securities, since the funds are managed by
expert, professional fund managers who have access to latest and detailed
information regarding the stock market and individual scrips.
ii) Diversification: Investment variety and spread in different industries
iii) Convenient Administration : Freedom from paper work
iv) Return Potential: Even the smallest dividend or capital gain gets
reinvested, thus enhancing the effective return.
v) Low Costs
vi) Liquidity: Liquidity through buy back arrangements of the mutual fund
or listing on some stock exchanges after a certain lock-in period.
vii) Transparency
viii) Flexibility
246
ix) Choice of schemes Mutual Funds

x) Tax benefits: Tax benefits on invested amounts/returns or dividends/

capital gains.
xi) Well regulated
xii) Capital appreciation: Without having to watch the upward or downward
performance curves of different scripts.

14.3 ORGANIZATION OF MUTUAL FUNDS

A Mutual fund can be constituted either as a corporate entity or as a trust. In
India, Unit Trust of India (UTI) was set up as a corporation under an Act of
Parliament in1964. SEBI regulation on Mutual Funds requires a mutual fund
be constituted in the form of a trust. The instrument of trust shall be in the
form of a deed, duly registered under the provisions of Mutual Funds the
Indian Registration Act, 1908 (16 of 1908) executed by the sponsor in favour
of the trustees named in such an instrument. While Mutual Funds registered
as trust floats schemes and collects money, the actual investment is made by
a different entity called Asset Management Company (AMC). AMC is typically
constituted as a company registered under Companies Act, 1956. The mutual
fund set up is slightly complex because of involvement of different entities
and the following diagram shows the relationship between the entities.

Figure 14.2: Organisation of a Mutual Fund

Mutual funds are to be sponsored by an individual or group of individuals or

companies. Sponsors also appoint Trustees who will manage the mutual funds.
Sponsors or Trustees also appoint AMC and enter into an agreement with
them for the management of funds. In practice, sponsors also promote an
AMC for the mutual funds. Transfer Agent maintains the records of unit holders
and make changes when investors buy or sell Units. Custodian keeps the
‘securities purchased by the fund. We will discuss each of the entities and the
role they played in mutual funds industry.
Asset Management Companies
As per guidelines, AMC shall be authorized for business by SEBI on the basis
of certain criteria and the Memorandum and Articles of Association of the
247
 AMC would have to be approved by SEBI. Accordingly, no company can
register as an AMC under the Companies Act 1956 without the Memorandum
and Articles of Association being approved by SEBI.
Transfer Agents
Their major responsibilities include:
i) Receiving and processing the application form of investors
ii) Issuing of Unit/Share Certificates on behalf of Mutual Fund
iii) Maintain detailed records of Unit holders transactions
iv) Purchasing, selling, transferring and redeeming the Unit/Share
Certificates
v) Issuing of income/dividend Warrants, Cheques etc.
vi) Creating security interest on Units/Certificates for allowing loans against
them
Advertiser
Major responsibilities of an advertiser include:
i) Helping mutual funds organizers to prepare a media plan for marketing
the fund
ii) Issuing/buying the space in the space in newspapers and other electronic
media for advertising the various features of a fund
iii) Arranging for hoardings at public places
Advisor/manager
It is generally a corporate entity who does the following jobs:
i) Professional advice on the Fund’s investments.
ii) Advice on Asset Management Services.
Trustees
Trustees provide the overall management services and charge management
fee.
Custodian
A custodian, which is again a corporate body does the following functions:
i) Holds securities
ii) Receives and delivers securities whenever investors sells and buys Units.
iii) Collects income/interest/dividends on the securities
iv) Holds and processes cash
Besides the above, other players who are involved in the Mutual Fund activities
248
are as under: Mutual Funds

i) Fund Administrator;
ii) Fund Accounting Services;
iii) Legal Advisors;
iv) Fund Officers;
v) Underwriters/Distributors;
vi) Legal Advisors
The basis of payment to various players for their services in organizing a
mutual fund is given in table 14.1. The SEBI regulation on mutual funds also
to an extent governs the service charges and management fee. Considering
the importance of mutual funds and large amount of public money being vested
with such funds, the SEBI has brought out a detailed guideline. These are
amended from time to time. You can visit www.sebi.gov.in for
ammendments.Since the mutual funds are typically promoted by an existing
financial service company or leading industrial group, the SEBI regulation
put various restrictions while investing the mutual funds money. It also
required a kind of arm-length relationship between the sponsors or their
companies and the management of the mutual funds.
Table 14.1: Basis for Service Charges to Intermediaries Associated with
Mutual Fund

SERVICES COST BASIS

i) Registrar & Registrar & Transfer Number of Unit-holders/
Transfer Agents Agents fee Certificate holder accounts
Service fee; Number of
transactions; Standard
outputs and standing
charges for maintaining
records
ii) Advertiser Advertiser service Percentage of the total
fees budget of advertisement
iii) Custodian Custodian fee Number of transactions in
terms of amount
iv) Trustee Management fee Average net assets.
v) Advisor Advisory fee Average net assets.
vi) Underwriters Underwriters fee Total offering
vii) Legal Advisor Legal fees Actuals
viii) Auditors Audit fees Actuals
ix) Fund Officers Fund Officer’s fees Actuals
249
 14.4 TYPES OF MUTUAL FUNDS
Mutual funds could be classified in many ways based on structure, objectives
of investment, pattern ‘of investments and returns, etc.
Based on structure, mutual funds could be classified as:
1) Open - Ended Schemes
2) Close-Ended Schemes
3) Interval Schemes
Based on the investment objective, the classification could be:
a) Growth Funds
b) Income Funds
c) Balanced Schemes
d) Money Market Schemes
e) Other Special Schemes
Open-Ended Funds
Under open-ended scheme, the mutual fund will announce daily purchase
and sale, price of the Units of the scheme. If you want to buy the Units today,
you can buy the same at the sale price. May be, after six months, if you decide
to sell the units, you can sell at the purchase price announced by the mutual
fund on that date. Thus, the mutual fund offers instant liquidity for your
investment under open-ended scheme by taking responsibility of purchasing
back the Units. There is no limit to the size of the funds. Investors can invest
as and when they like. The purchase price is determined on the basis of Net
Asset Value (NAV). NAV is the market value of the fund’s assets divided by
the number of outstanding Shares/Units of the fund.
An open-ended fund is one that is available for subscription all through the
year. These do not have a fixed maturity. Investors can conveniently buy and
sell Units at Net Asset Value (“NAV”) related prices. The key feature of open-
ended schemes is liquidity.
Close-Ended Funds
Under close-ended schemes, there is no repurchase facility. However, the Units
are listed in the stock market and investors can sell and buy Units like any
other securities in the market. The scheme has a ‘specific life (say 10 years or
5 years) and at the end of the period, the mutual fund sells securities bought
under the scheme and disburses the proceeds to Unit holders. When the stock
market was doing well, many of the schemes have attracted investors and
there was also active secondary market. But they lost the fancy of the investors
after couple of stock market failures. Today, the close-ended scheme is virtually
dead and only a very few schemes of this nature floated during the last few
months. These funds are fixed in size as regards the crops of the fund and the
250
number of shares. In close-ended funds, no- fresh Units are created after the Mutual Funds
original offer of the scheme expires. The Shares/Units of these funds are not
redeemable at their NAV during their life as are in the case of open-ended
funds. The Shares of such funds are traded in the secondary. market on stock
exchanges at market prices that may be above or below their NAV.
Interval Funds
Interval funds combine the features of open-ended and close-ended schemes.
They are open for sale or redemption during pre-determined intervals at NAV
related prices.
The classification of Mutual Funds on the basis of investment objectives are:
Growth Funds
The aim of growth funds is to provide capital appreciation over the medium
to long-term. Such schemes normally invest a majority of their corpus in
equities. It has been proven that returns from stocks, have out performed most
other kind of investments held over the long term. Growth schemes are ideal
for investors having a long-term outlook seeking growth over a period of
time.
Income Funds
The aim of income funds is to provide regular and steady income to investo¹
Such schemes generally invest in fixed income securities such as bonds,
corporate debentures and Government securities. Income Funds are ideal for
capital stability and regular income.
Balanced Funds
The aim of balanced funds is to provide both growth and regular income.
Such schemes periodically distribute a part of their earning and invest both in
equities and fixed income securities in the proportion indicated in their offer
documents. In a rising stock market, the NAV of these schemes may not
normally keep pace, or fall equally when the market falls. These are ideal for
investors looking for a combination of income and moderate growth.
Money Market Funds
The aim of money market funds is to provide easy liquidity, preservation of
capital and moderate income. These schemes generally invest in safer short-
term instruments such as treasury bills, certificates of deposit, commercial
paper and inter-bank call money. Returns on these schemes may fluctuate
depending upon the interest rates prevailing in the market. These are ideal for
Corporate and individual investors as a means to park their surplus funds for
short periods.
Load Funds
A Load Fund is one that charges a commission for entry or exit. That is, each
time you buy or sell Units in the fund, a commission will be payable. Typically,
entry and exit loads range from 1% to 2%. It could be worth paying the load,
if the fund has a good performance history. 251
 No-Load Funds
A No-Load Fund is one that does not charge a commission for entry or exit.
That is, no commission is payable on purchase or sale of Units in the fund.
The advantage of a no load fund is that the entire corpus is put to work.
Tax Saving Schemes
These schemes offer tax rebates to the investors under specific provisions of
the Indian Income Tax laws as the Government offers tax incentives for
investment in specified avenues. Investments made in Equity Linked Savings
Schemes (ELSS) and Pension Schemes are allowed as deduction u/s 88 of the
Income Tax Act, 1961.
Special Schemes
Industry Specific Schemes
Industry Specific Schemes invest only in the industries specified in the offer
document. The investment of these funds is limited to specific industries like
InfoTech, FMCG, Pharmaceuticals, etc.
Index Schemes
Index Funds attempt to replicate the performance of a particular index such
as the BSE Sensex or the NSE 50.
Sectored Schemes
Sectoral Funds are those, which invest exclusively in a specified industry
(like Pharma fund or IT fund) or a group of industries or various segments
such as ‘A’ Group shares or initial public offerings.
Activity 1
The mutual fund industry in India has seen tremendous growth during the
last few years. The number of mutual funds and schemes offered by them
are very large. Visit a website of a mutual fund and go through the schemes
and their objectives. Based on the assessment, list down the schemes and
the broad head under which you would like to classify the schemes in the
following table format.
No. Scheme Name Classification Based Classification Based on
on Structure Investment Objective
1
2
.
.
.
.
N
252
 Mutual Funds
14.5 EVOLUTION OF MUTUAL FUNDS
Mutual Funds as a concept first originated in the Britain in the 19th century
but developed in the U.S. in the late 19th and early 20th century at the principal
money centres of North East. These funds were primarily close-ended and
used to finance growth in U.S.A. after the Civil War. However, the crash of
stock markets in 1929 led to the demise of these close-ended funds. In 1940,
U.S. had about 68 funds; currently there are several thousands of schemes.
More significantly, in the year 1965 there were only 2 to 3% of U.S. households
who owned fund shares. Nearly one- fourth of all U.S. households invests
today in Mutual Funds. The secret behind the U.S. success story is that their
fund managers have developed mutual funds for all economic conditions and
for every investment need. However, not only the U.S. but some other countries
of the world also saw the unprecedented growth in this industry. Italy’s Mutual
Fund Industry witnessed a growth of 2000%, Japan 600%, U.K. 350% and
Germany 330%. Countries like Canada, Australia, Mexico and many South
American countries too recorded enormous growth during the decade.
MUTUAL FUNDS IN INDIA
On the initiative of the Indian government and reserve bank, Unit Trust of
India was established in 1963, marking the beginning of the mutual fund sector
in India. Four main phases can be used to broadly categorise the development
of mutual funds in India.
Initial Phase: 1964–1987
In 1963, a parliamentary act created Unit Trust of India (UTI). It was
established by the Reserve Bank of India and operated under its regulatory
and managerial supervision. The Industrial Development Bank of India (IDBI)
replaced the RBI as the regulatory and administrative authority over UTI in
1978 after it was delinked from the RBI. Unit Scheme 1964 was UTI’s
inaugural initiative. At the end of 1988 UTI had ` 6,700 crores of assets under
management.
Second Phase - 1987-1993 (Entry of Public Sector Funds)
Public sector banks, Life Insurance Corporation of India (LIC), and General
Insurance Corporation of India (GIC) established non-UTI mutual funds in
1987. The first non-UTI mutual fund was formed by SBI in June 1987. This
was followed by Canbank in December 1987, Punjab National Bank in August
1989, Indian Bank in November 1989, Bank of India in June 1990, and Bank
of Baroda in October 1992. While GIC had formed its mutual fund in December
1990, LIC had done so in June 1989.The mutual fund sector managed assets
worth ¹ 47,004 crores by the end of 1993.
Third Phase - 1993-2003 (Entry of Private Sector Funds)
A new era in the Indian mutual fund market began with the arrival of private
sector funds in 1993, providing Indian investors a greater selection of fund
families. Additionally, the first Mutual Fund Regulations, which required all
mutual funds, with the exception of UTI, to be registered and supervised,
253
Institutional and were established in 1993. The first mutual fund in the private sector was
Managed Portfolios
registered in July 1993 under the name Kothari Pioneer, which has now merged
with Franklin Templeton.
In 1996, a revised and more thorough version of the Mutual Fund Regulations
replaced the 1993 SEBI (Mutual Fund) Regulations. The SEBI (Mutual Fund)
Regulations from 1996 govern how the sector currently operates.
As more overseas mutual funds established funds in the United States, the
number of mutual fund houses continued to rise.
Fourth Phase - since February 2003
After the Unit Trust of India Act of 1963 was repealed in February 2003, UTI
was divided into two distinct organizations. One is the Specified Undertaking
of the Unit Trust of India, which as of the end of January 2003 had assets
under management totalling ` 29,835 crores, about equivalent to the assets of
the US 64 plan, assured return, and a few other schemes. The Unit Trust of
India’s Specialised Undertaking, which is governed by an administrator and
by laws set forth by the Indian government, is exempt from the Mutual Fund
Regulations. The UTI Mutual Fund, sponsored by SBI, PNB, BOB, and LIC,
is the second. It operates in accordance with the Mutual Fund Regulations
and is registered with SEBI. The mutual fund industry has entered its current
phase of consolidation and growth with the bifurcation of the former UTI,
which had in March 2000 more than ` 76,000 crores of assets under
management and with the establishment of a UTI Mutual Fund, complying
with the SEBI Mutual Fund Regulations.

Figure 14.3: Growth in asset under management

Source: amfiindia (2023)

The Indian Mutual Funds Industry has recorded a tremendous growth in size
during the last 10 years with cumulative resources mobilized . Figure 14.3
presents the growth of assets under management.
The concept of Mutual Fund is gaining practical relevance in India, and a
large number of funds have been floated in the recent past. The impetus to
this growth has basically come from the following factors:
(i) banks were earlier unable to tap the capital market for funds, or to invest
254 their deposits in the market;
(ii) individual investors, lacking risk bearing capacity and unsure of the Mutual Funds
capital market behaviour, were not keen on investing any substantial
amount directly in the market instruments;
(iii) banks working under Reserve Bank of India (RBI) guidelines could not
provide growth with better yields to the investing public and were losing
out in the competition with innovative new market instruments which
had better yields compared with savings and fixed deposit interest rates.
Table 14.2 presents a profile and status of Mutual Funds in India as on
March 2023.
Table 14.2: Status of Mutual funds as on March 2023
Quarterly data for the quarter January - March 2023
Net Assets
Funds Repurchase/ Net Inflow Net Assets Average Net
No. of Under
No. of Mobilized Redemption (+ve)/Outflow (- Under Assets Under
No. of Folios as segregated Management in
Schemes as on during the during the ve) during the Management as Management
Sr Scheme Name on March 31, portfolios segregated
March 31, period Jan - Mar period Jan - Mar period Jan - Mar on March 31, for the month
2023 created as on portfolio as on
2023 2023 (INR in 2023 (INR in 2023 (INR in 2023 (INR in March 2023
March 31, 2023 March 31, 2023
crore) crore) crore) crore) (INR in crore)
(INR in crore)
A Open ended Schemes
I Income/Debt Oriented Schemes
i Overnight Fund 32 6,28,550 12,80,217.66 12,89,097.95 -8,880.29 95,625.58 1,23,909.32 - -
ii Liquid Fund 36 17,73,500 9,35,238.56 10,08,508.61 -73,270.06 3,32,498.15 4,09,884.68 - -
iii Ultra Short Duration Fund 25 6,33,103 40,708.12 51,653.71 -10,945.59 79,122.51 85,469.53 - -
iv Low Duration Fund 21 9,40,074 21,166.03 30,025.16 -8,859.14 86,692.53 89,490.96 1 -
v Money Market Fund 22 4,22,082 74,160.70 79,664.74 -5,504.04 1,08,468.12 1,13,374.54 - -
vi Short Duration Fund 25 5,07,214 12,765.94 16,532.08 -3,766.15 91,238.61 90,588.81 - -
vii Medium Duration Fund 15 2,56,052 2,854.18 2,255.92 598.27 27,090.56 25,912.64 3 -
viii Medium to Long Duration Fund 12 1,06,926 451.74 525.27 -73.54 8,894.71 8,704.95 - -
ix Long Duration Fund 7 45,546 5,361.79 103.07 5,258.72 8,797.88 4,647.66 - -
x Dynamic Bond Fund 22 2,29,940 7,721.85 1,506.27 6,215.57 29,286.89 24,019.39 - -
xi Corporate Bond Fund 21 6,17,379 26,385.32 12,430.79 13,954.53 1,30,766.62 1,16,845.19 - -
xii Credit Risk Fund 15 2,46,438 1,466.90 2,432.28 -965.38 24,776.35 24,364.04 3 -
xiii Banking and PSU Fund 23 2,97,318 11,426.02 6,362.80 5,063.22 80,517.19 73,613.89 - -
xiv Gilt Fund 22 1,76,253 5,859.57 1,035.10 4,824.48 21,458.10 17,472.81 - -
xv Gilt Fund with 10 year constant duration 5 42,565 2,272.00 136.80 2,135.20 3,759.84 2,034.20 - -
xvi Floater Fund 12 2,36,780 5,566.51 12,367.83 -6,801.32 52,988.71 55,216.51 - -
Sub Total - I
315 71,59,720 24,33,622.86 25,14,638.38 -81,015.51 11,81,982.36 12,65,549.15 7 -
(i+ii+iii+iv+v+vi+vii+viii+ix+x+xi+xii+xiii+xiv+xv+xvi)

II Growth/Equity Oriented Schemes

i Multi Cap Fund 19 41,42,895 7,598.05 3,130.70 4,467.35 67,337.88 67,168.32 - -
ii Large Cap Fund 31 1,29,73,512 10,029.33 8,048.19 1,981.14 2,35,760.10 2,34,482.18 - -
iii Large & Mid Cap Fund 26 78,09,179 9,413.03 4,241.18 5,171.85 1,27,841.82 1,26,809.63 - -
iv Mid Cap Fund 29 1,06,12,983 10,996.82 5,423.18 5,573.65 1,83,255.54 1,83,088.76 - -
v Small Cap Fund 24 1,08,99,311 10,692.28 3,760.09 6,932.19 1,33,383.69 1,32,944.50 - -
vi Dividend Yield Fund 9 7,21,832 4,089.32 323.47 3,765.85 13,994.08 12,320.89 - -
vii Value Fund/Contra Fund 22 46,66,901 4,714.78 2,194.35 2,520.43 90,583.60 89,947.66 - -
viii Focused Fund 26 53,15,932 4,969.76 4,298.94 670.82 98,672.57 98,654.80 - -
ix Sectoral/Thematic Funds 126 1,31,75,494 16,900.62 8,212.56 8,688.05 1,72,819.48 1,70,195.33 - -
x ELSS 43 1,52,72,141 9,231.57 4,150.85 5,080.72 1,51,751.21 1,49,876.91 - -
xi Flexi Cap Fund 35 1,27,01,619 11,914.02 7,999.79 3,914.23 2,41,682.54 2,40,773.82 - -
Sub Total - II (i+ii+iii+iv+v+vi+vii+viii+ix+x+xi) 390 9,82,91,799 1,00,549.58 51,783.30 48,766.29 15,17,082.50 15,06,262.81 - -

III Hybrid Schemes

i Conservative Hybrid Fund 20 5,19,049 1,673.38 1,372.68 300.70 23,170.18 22,786.74 1 -
ii Balanced Hybrid Fund/Aggressive Hybrid Fund 31 53,17,925 6,126.47 5,575.81 550.66 1,53,898.71 1,53,839.51 2 9.33
iii Dynamic Asset Allocation/Balanced Advantage Fund 28 44,47,644 8,950.74 9,555.12 -604.38 1,91,809.76 1,92,521.27 - -
iv Multi Asset Allocation Fund 11 10,53,181 4,158.65 993.23 3,165.42 26,590.89 27,672.54 - -
v Arbitrage Fund 26 4,45,949 17,714.46 27,752.79 -10,038.33 67,435.21 87,315.98 - -
vi Equity Savings Fund 22 3,61,815 1,128.00 1,921.84 -793.84 16,012.07 16,864.40 2 25.81
Sub Total - III (i+ii+iii+iv+v+vi) 138 1,21,45,563 39,751.70 47,171.46 -7,419.76 4,78,916.83 5,01,000.44 5 35.14

IV Solution Oriented Schemes

i Retirement Fund 26 27,59,419 707.68 345.62 362.06 17,993.42 17,856.06 - -
ii Childrens Fund 10 29,27,533 351.07 130.31 220.76 14,340.11 14,229.81 - -
Sub Total - IV (i+ii) 36 56,86,952 1,058.75 475.93 582.82 32,333.53 32,085.87 - -

V Other Schemes
i Index Funds 177 38,53,245 50,535.65 11,249.89 39,285.76 1,67,517.17 1,44,601.76 - -
ii GOLD ETF 12 46,99,537 942.72 1,243.30 -300.58 22,736.99 21,942.13 - -
iii Other ETFs 160 1,20,64,198 45,907.29 47,917.92 -2,010.63 4,84,277.18 4,79,155.28 - -
iv Fund of funds investing overseas 50 13,02,024 1,801.34 1,529.03 272.32 22,991.15 21,868.53 - -
Sub Total - V (i+ii+iii+iv) 399 2,19,19,004 99,187.00 61,940.14 37,246.86 6,97,522.48 6,67,567.70 - -

Total A-Open ended Schemes 1,278 14,52,03,038 26,74,169.90 26,76,009.20 -1,839.30 39,07,837.70 39,72,465.97 12 35.14

B Close Ended Schemes

I Income/Debt Oriented Schemes
i Fixed Term Plan 122 1,54,962 5,683.63 1,669.71 4,013.92 24,372.45 22,366.76 - -
ii Capital Protection Oriented Schemes 7 12,655 - - - 639.56 637.81 - -
iii Infrastructure Debt Fund 7 52 - 170.58 -170.58 1,981.98 1,976.66 - -
iv Other Debt Scheme - - - - - - - - -
Sub Total (i+ii+iii+iv) 136 1,67,669 5,683.63 1,840.29 3,843.34 26,993.99 24,981.24 - -

II Growth/Equity Oriented Schemes

i ELSS 19 2,97,534 - 80.69 -80.69 3,395.01 3,400.88 - -
ii Other Equity Schemes 10 59,513 0.01 366.98 -366.97 2,804.69 2,881.58 - -
Sub Total (i+ii) 29 3,57,047 0.01 447.67 -447.66 6,199.70 6,282.46 - -

III Other Schemes - - - - - - - - -

Total B -Close ended Schemes 165 5,24,716 5,683.64 2,287.97 3,395.67 33,193.69 31,263.70 - -

C Interval Schemes
I Income/Debt Oriented Schemes 12 2,846 565.56 437.82 127.74 999.29 907.93 - -

II Growth/Equity Oriented Schemes - - - - - - - - -

III Other Schemes - - - - - - - - -

Total C Interval Schemes 12 2,846 565.56 437.82 127.74 999.29 907.93 - -

Grand Total 1,455 14,57,30,600 26,80,419.10 26,78,734.98 1,684.11 39,42,030.68 40,04,637.60 12 35.14

Fund of Funds Scheme (Domestic) 76 18,62,743 9,268.14 4,325.50 4,942.64 66,590.41 61,842.01 - -

255
Source: amfiindia (2023)
 14.6 MUTUAL FUND INVESTMENT PROCESS
Creation of a Portfolio
The portfolio of a mutual fund depends on the objectives of each scheme/
fund floated by a mutual fund. For example, the objective of an income-
oriented scheme is to provide regular monthly income to its shareholders.
The portfolio of such a fund should consist of fixed income bearing securities
so that the fund can achieve its objective. It has been learnt from Indian
experience that the portfolio of such a fund consists of mainly the following
securities:
Non Convertible Debentures (NCD’s) - 75 to 90% Call Money - 10 to 25%
A portfolio of income cum growth oriented fund consists of mainly NCD’s
upto 70% of the portfolio, approximately 25% of equities and 5% of money
market instruments. On the other hand, a pure growth or equity fund creates a
portfolio of share/stock of growth or blue-chip companies.
The fund manager of a mutual fund is the person responsible for buying these
securities in such a way that the fund is able to achieve its objectives. A fund
manager tries to create a well diversified portfolio of securities so that
unsystematic risk is reduced significantly and returns expected on individual
securities and on portfolio is directly related to ‘mark risk’ or systematic risk.
A fund manager has the following investment options in terms of buying
securities from the Indian market :

Depending on the objective of the scheme and target return, fund managers
form a portfolio based on the expected return of the above securities. While
buying these securities, the fund manager takes into consideration the
following norms for each kind of security.
Non-convertible Debentures
i) Asset Cover or Security Cover : A company must maintain a minimum
asset cover. This cover is calculated on the basis of secured borrowings
and debentures charged to fixed assets, whereby fixed assets should be
in general more than one time of the total such existing borrowings and
debentures secured by equitable mortgage on fixed assets. The movable
256 fixed assets are generally excluded from the calculations.
ii) Interest Cover : PBIDT (profit before interest, depreciation and taxes) Mutual Funds
should be around two times the existing interest liability plus the interest
liability on the proposed debentures so as to protect the payment of
interest on the debentures. This cover is to be calculated on the basis of
the average of the proceeding three years profit figures.
iii) Company must have paid dividend for the last three or minimum two
preceding years.
iv) Net worth of the company should be around ` One Crore.
Small variations in the above norms are accepted provided the company is
otherwise very sound and the rate of return is higher than normal.
Equity Shares (Common Norms for Primary as well as Secondary Market):
Management: First and foremost emphasis is placed on quality of management
because unless the management is efficient and professional even a good
project can fail.
Industry: The industry in general should be growth oriented, expanding and
modernising, etc. Mutual Funds avoid seasonal and declining industries.
Government Policy: A fund manager constantly studies the economic and
fiscal policies of the government and analyses their impact on the companies.
Analytical Studies: A fund manager studies the full details of the past performance
of companies including turnover, profitability, earnings, track record and financial
strength. S/he also compares it with the industry in which the company falls. S/he
works out projections based on news reports and discussions to assess the future
prospects. S/he studies the expansion, diversification and other plans of the
companies to assess their future outlook and potential.
Market Study: Fund managers also assess the standing of the company, its
general reputation, its market shares and the competition it is likely to face.
Besides, factors like the demand and supply of the product and import and
export policy which have a bearing on the growth prospects of the company
are also looked into.
Studies on Industries: A mutual fund undertakes the studies of the industries
to find out the outlook as well as the problems and faced by the industries and
in turn the units in the said industries.
Besides studying the above fundamental factors, for both primary and
secondary market operations, a fund manager uses the following additional
tools to decide the timing for entering into secondary market operations.
However, this is not a rigid formula.
a) ‘PE’ Ratio (Price Earnings Ratio)
i) Average ‘PE’ ratio for the industry.
ii) Average ‘PE’ ratio of the company based on the last three years.
iii) Earnings per share of last year x Average ‘PE’ ratio of the company.
257
 b) High and Low Price
A fund manager is also aware that the market fluctuates as a normal pattern
3 - 4 times in a year and these movements are watched for proper opportunities.
For this purpose, a chart showing the trends in price movements for the
previous year is prepared.
c) Book Value
A mutual fund calculates the book value (less revaluation reserves) and
compares it with the market price. If the market price is twice or thrice the
book value, the share is over priced and if the market price is less or equal,
the share is called under priced.
Regulatory Environment Relating to Creation of Portfolio of various
Securities
We have discussed that a Fund Manager creates a diversified portfolio of
securities whereby unsystematic risk is almost eliminated and systematic risk
is analysed to provide optimum return: However, to protect general investors’
interest the Securities and Exchange Board of India has placed certain
restrictions on the investment by mutual funds in India as follows:
1) No individual scheme of the Mutual Fund should invest more than 5 per
cent of its corpus in any one company’s shares.
2) No Mutual Fund under all its schemes should own more than 5 per cent
of any company’s paid up capital carrying voting rights.
3) No Mutual Fund under all its schemes taken together should invest more
than 10 per cent of its funds in the shares or debentures or other securities
of a single company.
4) No Mutual Fund under its schemes taken together should invest more
than 15 per cent of its funds in shares and debentures of any specific
industry (such as cotton textiles, tea, tyres etc.) except where a scheme
has been floated for investments in one or more specified industries.
5) Privately placed debentures, securitized debt and other unquoted debt
instruments holdings shall not exceed 10 per cent in case of growth funds
and 40 per cent in case of income funds.

14.7 PORTFOLIO REVISION

There are two broad aspects of portfolio management, namely, effective
investment planning, and constant review and revision of Investment.
Constant review and revision of investment requires:
i) Continuous monitoring of the quality of management of the companies
in which investment has already been made.
ii) Continuous financial analysis and trend analysis of the companies’
balance sheets/ profit & loss accounts to choose sound companies and
258 off-load investment made in companies where the performance is lacking.
iii) Continuous analysis of the securities market trends. Mutual Funds

Whereas a Funds Manager takes into consideration all fundamental and

technical analyses while making initial purchases of securities, continuous
monitoring jobs are done generally by a research cell of the mutual funds in
India. The research cell undertakes on a continuous basis all kinds of analysis
of securities existing in the portfolio and does further analysis of newer
securities in all classes of securities and compares them with the existing
securities and suggests changes in the portfolio for maintaining good returns
or higher returns with the same risk as perceived in the existing portfolio.
Thus measurement of risk involved in the expected rate of return is very
essential before diversification of any portfolio can be undertaken by a mutual
fund. A research executive measures the risk by taking variance and standard
deviation of return. A large variation around the average would indicate great
uncertainty regarding the expected return.

14.8 SYSTEMS AND CONTROL

For managing a portfolio, it is not only the creation, re-creation and regrouping
of various securities which is important for achieving the desired rate of return,
but various kinds of systems and controls are needed. A Mutual Fund generally
provides the desired controls through its accounting and custodian system.
We shall discuss each of them and how these help to manage a portfolio.
Accounting System
As accounting. system must clearly disclose:
i) The policy in respect of recognition of revenue and income from
investment.
ii) The policies relating to valuation of investments.
iii) The aggregate carrying value and market value of non performing assets
under each type of investment.
iv) Provision to be made for depreciation/loss in the value of non performing
investment
v) Per unit Net Asset Value (NAV) at various intervals and at the end of the
accounting year.
All the above accounting policies if pursued consistently help to maintain a
clear picture about all investments in a portfolio and thus provide the true
picture of the portfolio.
Custodian System
A custodian system should provide/ensure:
i) Timely receipt and delivery of cash and securities;
ii) Delivery of securities only upon receipt of payment and payment only
upon receipt of securities;
259
 iii) Timely resolution of discrepancies and failures;
iv) Segregation of assets by the custodian and regular inventory verification;
v) Regular reconciliation of assets to accounting records;
vi) Securities are properly registered;
vii) Proper nomination and record of declared dividend and other corporate
actions.
All the above accounting policies and custodian system if pursued by Mutual
Funds help them to maintain a clear picture of all investment and their
performance in a portfolio.

14.9 SUMMARY
The history of Mutual Funds in India is not very old. It started with the
establishment of the Unit Trust of India in the year 1964. However, the real
take off started when public sector banks entered into this area in the year
1987. Experience of the other countries shows that with the development of
the capital market more and more household savings are expected to be
channeled into the secondary market through institutions like mutual funds.
This is quite visible from the growing popularity of mutual funds in India.
Mutual Funds have proved to be an attractive investment for many investors,
the world over, since they give them a mixture of liquidity, return and safety
in accordance with their performance. Further, the investor gets these benefits
without having to directly invest in a large number of scrips. Only by investing
in one fund s/he gets the benefits of a diversified portfolio which is handled
by specialists. With the kind of innovative schemes available-in the market
today, mutual funds serve the needs of various investors. An analysis of
performance of many private sector funds also shows that they have done
reasonably well compared to market performance.

14.10 KEY WORDS

Asked or Offering Price : The price at which a mutual fund's shares can
be purchased.
The asked or offering price means the current
net asset value (NAV) per share plus sales
charge, if any.
Asset Allocation Fund : A fund that spreads its portfolio among a wide
variety of investments, including domestic and
foreign stocks and bonds, government
securities, gold bullion and real estate stocks.
Balanced Fund : A mutual fund that maintains a balanced
portfolio, generally 60% bonds or preferred
stocks and 40% common stocks.

260
Bid or Sell Price : The price at which a mutual funds and shares Mutual Funds
are redeemed (bought back) by the fund.
Bond Fund : A mutual fund whose portfolio consists
primarily of corporate or Government bonds.
These funds generally emphasize income
rather than growth.
Bond Rating : System of evaluating the probability of
whether a bond issuer will default.
Capital Appreciation : A mutual fund that seeks maximum capital
Fund appreciation through the use of investment
techniques involving greater than ordinary
risk, such as borrowing money in order to
provide leverage, short-selling and high
portfolio turnover.
Capital Growth : A rise in market value of a mutual fund's
securities, reflected in its net asset value per
share.
Common Stock Fund : An open-end investment company whose
holdings consist mainly of common stocks and
usually emphasize growth.
Income Fund : A mutual fund that primarily seeks current
income rather than growth of capital.
Load Fund : A mutual fund that levies a sales charge up to
6%, which is included in the offering price of
its shares, and is sold by a broker or salesman.

14.11 SELF-ASSESSMENT QUESTIONS

1. Discuss briefly the concept of mutual fund and explain how far mutual
funds have been successful in India.
2. Describe various types of schemes issued by various Mutual Funds in
India.
3. Discuss the role of the Registrar, Transfer Agents, Custodian and the
Fund Manager in a Mutual Fund.
4. Why Indian Mutual Funds in general guarantee a minimum return to
investors whereas this is not the practice in US and other countries?
5. Systems and Controls are as important as creation of portfolio of securities
in managing a portfolio by a Mutual Fund. Discuss this statement and
bring out the role played by accounting and custodian system in portfolio
management by a mutual fund.

261
 14.12 FURTHER REDINGS
Anderson, Carle E. and James B. Ross. (1988). Modern Mutual Fund families
and variable life:
Chandra, P. (2018). Investment Analysis & Portfolio Management (5e). Tata
McGraw Hill.
Fischer, D. E., Jordan, R. J., & Pradhan, A. K. (2018). Security Analysis
Portfolio Management (7th ed.). Pearson Education.
Hirsch. D. Michael. (1987), Multi fund Investing: How to Build a High
Performance Portfolio of House, New York. https://www.amfiindia.com/
research-information/amfi-quarterlydata (2023)
IIT Kharagpur [nptelhrd]. (2012). Mod-01 Lec-06 Mutual Funds [Video].
YouTube. https://www.youtube.com/watch?v=Izzxjks9AO8
Lucile Tomlinson (ed).( 1971). Flow to Start, Operate and Manage Mutual
Funds. Presidents Pub. Mutual Funds. Dow Jones - Irwin.
Reilly, F. K., Brown, K. C., Gunasingham, B., Lamba, A., & Elston, F. (2019).
Investment Analysis & Portfolio Management. Cengage AU.
Richard C. Dorf, 1988, The Mutual Fund Portfolio Planner: A Guide for
Selecting the Best
Tools for investment growth and tax benefits. Dow Jones – Irwin

262
 Performance
UNIT 15 PERFORMANCE EVALUATION OF Evaluation of
MANAGED PORTFOLIO Managed Portfolio

Objectives
After reading this unit you should be able to:
• Discuss the various concepts and methods of computing portfolio return;
• Distinguish between Performance Measurement and Performance
Evaluation and the primary components of performance;
• Understand the concept of benchmark portfolio for comparison and
evaluation;
• Explain why a portfolio earned a certain return over a particular time
period, also known as performance attribution; and
• Discuss the problems encountered in performance evaluation.
Structure
15.1 Introduction
15.2 Methods of computing portfolio return
15.3 Components of investment performance-stock selection
15.4 Benchmark portfolios
15.5 Summary
15.6 Key words
15.7 Self Assessment Questions
15.8 Further Readings

15.1 INTRODUCTION
Quite frequently small investors feel insecure in managing their own
investment in securities because they consider themselves inadequate to
perform this delicate task successfully. Often, they feel that they lack
education, background, time, foresight, resources and the temperament to carry
out the proper handling of their portfolio. The logical step they then take is to
turn the job over to a professional portfolio manager. Most often, the portfolio
manager chosen takes the form of a mutual fund or investment company.
The main reasons for selecting a mutual fund or investment company involves
the management, diversification and liquidity aspects. Managers trained in
the techniques of security analysis devote their full time for meeting the funds’
investment objectives. This permits a constant monitoring of the securities
comprising the portfolio. Furthermore, large amounts of money entrusted to
the fund is invested in securities of different industries and thereby enabling
263
 diversification which otherwise is not possible for an average investor with
limited funds. This diversification evolves as a result of stated objectives of
the Fund. Further, these institutions are also able to obtain lower brokerage
commissions than that of an individual small investor. The small investors
opt for a fund whose objectives are mostly in line with his/her own. Since
many funds with various objectives are competing to acquire the funds of
investors, it is necessary to evaluate the performance of the fund managers
Institutional and historical performance is not an indicator for future
performance, it given a fair understanding on how the fund manager performs
in different market. For instance, some fund managers perform better than
others when the market was in uptrend whereas some others focus on reducing
volatility and they show better performance when the market was not doing
well.
This unit discusses various methods of computing portfolio returns and
components of investment performance. And pinpoint the difficulties in risk-
adjusted measures of portfolio performance. Further, we shall also explain
the concept and method of construction of benchmark portfolio for
performance evaluation of a managed portfolio. Let us begin by distinguishing
performance measurement and performance evaluation and explaining
methods of computing portfolio return.

15.2 METHODS OF COMPUTING PORTFOLIO

RETURN
Performance measurement is just an accounting function, which attempts to
reconcile the end of period with the beginning period values. Performance
evaluation on the other hand, addresses the issues of whether:
x The past performance was superior or inferior
x Such performance was due to skill or luck
x Future performance will be similar or not
Portfolio performance is generally evaluated over a time interval of at least
four years, with returns for a number of sub-periods within the interval-like
monthly or quarterly, so that there is a fairly adequate number of observations
for statistical evaluation. The calculation of portfolio return is fairly simple
when there are no deposits or withdrawals of money from a portfolio during
a time period. In that case, the market value of the portfolio in the beginning
and at the end of the period are determined for computing the portfolio return.
The three steps involved in the computation of the return are illustrated in
table 15.1.

264
 Table 15.1 Measuring Portfolio Return Performance
Evaluation of
Managed Portfolio

Performance measurement becomes difficult when a client adds or withdraws

money from the portfolio. The per cent change in the market value of the
portfolio as computed above may not be an accurate measurement of the
portfolio’s return in that case. For example, if the beginning value of the
portfolio is ` 50,000 and the value at the end of October is ` 70,000 and the
client deposits ` 30,000 in cash in early November, the value at the end of the
year would be ` 1,00,000. The portfolio return in this case will be
1,00,000-50,000/50,000 = 100%
However, the entire return was not due to the investment manager. A more
accurate measure would be
(1,00,000-30,000) - 50,000/50,000 = 40%
Dollar or Value-Weighted Rate of Return
It is also called as the internal rate of return. The interest rate that equates the
initial contribution and the cash flows that occur during the period with the
ending value of the fund is the dollar-weighted rate of return. Mathematically,
this measure of return is the dollar-weighted average of sub-period returns
with the dollar weights equal to the sum of the initial contribution and all the
cash flows upto the time of the sub-period return. Note, we don’t need to 265
 make any adjustment for Rupee investment since the dollar actually means
value.
For example, a portfolio has market value of ` 100 lakhs. In the middle of
the quarter, the client deposits ` 5 lakhs and at the end of the quarter the value
of the portfolio is ` 103 lakhs. The dollar-weighted return would be calculated
by solving the following equation for r.
-5 103
100 = +
(1 + r) (1 + r)2
r = - .98% which is a semi-quarterly rate of return.
This can be converted into quarterly return with the help of the following
equation.
[1 + (- 0.0098)]2 - 1 = - 1 . 95 % per quarter
Time-Weighted Rate of Return
The time-weighted rate of return is the weighted average of the internal rates
of return for the sub-periods between the cash flows and it is weighted by the
length of the sub-periods. In other words, the geometric (compounded) return
measured on the basis of periodic market valuations of assets is time-weighted
return. The equation for time-weighted rate of return for 4 sub-periods is
Annual Return = [(1 +r1)(1+r2)(1+r3)(1+r4)]1/ 4 -1
Let us now make a quick comparison of Dollar-Weighted and Time-Weighted
Returns. A portfolio of ` 50 lakhs declines to ` 25 lakhs in the middle of the
quarter at which point, the client deposits ` 25 lakhs with the portfolio
management firm. Note before the investment of additional investment, the
investor lost 50% of the return. At the end of the quarter, the portfolio has a
market value of ` 100 lakhs. Now the investor during the second period has
gained 100% return. The semi-quarterly dollar-weighted return for this port-
folio would be:
-25 100
50 = +
(1 + r) (1 + r)2
r = 18.6%
Quarterly dollar-weighted return = (1.186)2 - 1 = 40.66 %. However, its
quarterly time- weighted return would be [(1 - 0.5) (1 + 1)]1/2 - 1 = 0 per cent.
There is a lot of difference in returns. Each rupee lost half its value in the first
half and the remaining half doubled in value in the second half. Thus assuming
that a rupee at the beginning was worth a rupee at the end of the quarter, a
time-weighted return is a more accurate measure than the dollar-weighted
return. A dollar-weighted return is strongly influenced by the size and the
timing of the cash flows (that is deposits or withdrawals) over which the
investment manager has no control.
If the return in the first, second, third and fourth quarters are given by r1, r2 r3
266 and r4, annual return can be calculated by adding 1 to each quarterly return,
then multiplying the four figures, taking the nth route of the product and Performance
Evaluation of
finally subtracting 1 from the resulting product. Thus,
Managed Portfolio
Annual Return = [(1 + r1)(1 + r2 )(1 + r3)(1 + r4)]1/4 ? 1
This method assumes the reinvestment of both the capital and the earnings at
the end of each quarter.
The performance of a mutual fund can be evaluated by using the beginning
and the end period net asset values as follows:
Rp = (NAVt- NAVt-1 ) + Dt + Ct /NAVt-1
The one period rate of return for a mutual fund (Rp) is defined as the change
in net asset value (NAV) plus its cash disbursement (D) and capital gains
disbursements (C). Net asset values of the fund are adjusted for bonus and
rights. The funds are ranked in the order of performance. The differential
return earned could have been due to differential risk exposures of the funds.
Hence, the returns have to be adjusted for risk before making any comparison.
Risk-adjusted return gives an idea of whether the return earned is
commensurate with the risk incurred.
Activity 1
1. Between performance measurement and performance evaluation, which
one is just an accounting function?
.............................................................................................................
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.............................................................................................................
2. Between Dollar-Weighted Return and Time-Weighted Return, which
method considers the market value of the portfolio just before each cash
flow occurs?
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3. In order to evaluate the performance of a mutual fund besides the
beginning ,the end periods, net asset values, which other financial
variables are relevant?
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 Risk Adjusted Rate of Returns
It is a measure of how much risk a fund or portfolio assumed to earn its returns.
This is usually expressed as a number or a rating. The performance of a fund
should be assessed in terms of return per unit of risk. The more return per unit
of risk, the better. The funds that provide the highest return per unit of risk
would be considered the best performer. For well-diversified portfolios in all
asset categories, the standard deviation is the relevant measure of risk. When
evaluating individual stocks and not so well diversified portfolios, the relevant
measure of risk is the systematic or market risk, which can be assessed using
the beta co-efficient (E). Beta signifies the relationship between covariance
(stock, market) and variance of market. Two well-known measures of risk
adjusted return are used for the purpose, one is the Sharpe ratio and the other
is the Treynor ratio.
Sharpe Ratio
Sharpe ratio is the ratio developed by Bill Sharpe and is calculated by
subtracting the risk free rate from the rate of return for a portfolio and dividing
it by the standard deviation of the portfolio returns. It tells us whether the
returns of the portfolio were because of smart investment decisions or by
excess risk.
Sharpe ratio = (Portfolio return - risk free return) / Portfolio Standard Deviation
Or
[rp - rf ] / p
i.e., realized return on the portfolio (rp ) in excess of risk- free rate (rf) divided
by the standard deviation of the portfolio ( p ).
For example, let’s assume that we look at a one-year period of time where an
index fund returned 11% and Treasury bills earned 6%. If the standard
deviation of the index fund was 20%, then the Sharpe Ratio is computed as
follows:
Sharpe ratio = [11- 6] / 0.20 = 25
The Sharpe ratio is an appropriate measure of performance for an overall
portfolio . particularly when it is compared to another portfolio or another
index such as BSE Sensex, BSE 100, NSE-50, etc.
Treynor Ratio (Reward to Variability ratio)
Treynor Ratio measures the returns earned in excess of those that could have
been earned on a riskless investment, per unit of market risk assumed. This
ratio is similar to Sharpe Ratio except it uses beta instead of standard deviation.
It is the ratio of a fund’s average excess return to the fund’s beta.
T = Return of Portfolio - Return of Risk Free Investment / Beta of Portfolio
Or
[rp- rf ] / E p
268
i.e. realized portfolio return (rp ) in excess of risk-free rate (rf) divided by the Performance
Evaluation of
beta of the portfolio (E p ).
Managed Portfolio
The absolute risk adjusted return is the Treynor ratio + the risk free rate.
For instance, assume two portfolios A and B. The respective returns are 12%
and 14% with a beta of 0.7 and 1.2 respectively. If the Risk Free Rate = 9%,
then the Treynor’s ratio is computed as follows:
T(A)=[12-9] / 0.7 = 4.25
Risk adjusted rate of return of Portfolio A = 4.25 + 9 = 13.25% T( B) = [14 -
9 ]/ 1.2=4.17
Risk adjusted rate of return of Portfolio B =4.17 + 9 = 13.17%
Without any analysis of risk, if you ask any investor what is the better number
(12% or 14%) almost universally they might say 14%. However, when you
point out the risk-adjusted rate of return, many adjust their thinking.
Both these measures provide a way of ranking the relative performance of
various portfolios on a risk-adjusted basis. For investors whose portfolio is a
predominant representation in a particular asset class, the total variability of
return as measured by standard deviation is the relevant risk measure.
The calculation of Sharpe and Treynor ratios for two hypothetical Funds are
given below:
Fund Return Risk- Excess SD Beta Sharpe Treynor
Return Return Ratio Ratio
1 20 10 10 8 0.80 L25 12.50
2 30 10 20 15 1.10 1.33 18.18

The ranking on both these measures will be identical when both the funds are
well diversified. A poorly diversified fund will rank lower according to the
Sharpe measure than the Treynor ratio. The less diversified fund will have
greater risk when using standard deviation is used.
Differential Return (Jensen Measure)
Jensen’s measure is an absolute measure of performance, adjusted for risk.
This measure assesses the portfolio manager’s predictive ability. The objective
is to calculate the return that should be expected for the fund, given the risk
level and comparing it with the actual return realised over the period.
The model used is;
R jt - R ft = ai +? E j (Rmt - Rft ) + e
The variables are expressed in terms of return and risk.
Rjt = Average return on portfolio for period t
Rft = Risk-free rate of interest for period t
269
 ai = Intercept that measures the forecasting ability of the portfolio manager
E j = A measure of systematic risk
Rmt = Average return on the market portfolio
e = Error term
In both Sharpe and Treynor models, it is assumed that the intercept is at the
origin. In the Jensen model, the intercept can be at any point, including the
origin.
If the intercept is ai and has a positive value, it indicates that the superior
return has been earned due to superior management skills. On the other hand
if the intercept is zero, it indicates neutral performance. This manager has
done as well as an unmanaged randomly selected portfolio with a buy-and-
hold strategy. If the intercept is negative, then the managed portfolio did not
do as well as an unmanaged portfolio of equal systematic risk.
Jensen’s measure is illustrated below:
Actual Returns and Risk
R ft Rjt R mt Beta

Fund A 5 12 15 0.50

Fund B 5 20 15 1.50

Fund C 5. 14 15 1.10
From Jensen’s equation, the return on the portfolio (assuming c = 0 and the
intercept (ai) is at the origin) is :
R jt = Rft + âj (Rmt - Rft )
Fund A
Rjt = 5 + 0.5 (15 - 5) = 10
a = 12 - 10 = 2% (Excess Positive Return)
Fund B
= 5 + 1.5 ( 1 5 - 5 ) = 20
a = 20 - 20 = 0% (Neutral Performance).
Fund C
= 5 + 1.10 ( 15 - 5 ) = 16
a = 14 - 16 = - 2% (Negative Return)
Jensen measure not only calculates the differential between actual and expected
earnings, but also enables an analyst to determine whether the differential
return could have occurred by chance or whether it is significantly different
from zero in a statistical sense. The (alpha value) value of the equation can be
270 tested to see if it is significantly different from zero by using a ‘t statistic’.
When the (alpha value) value is high and the error in the regression is low, Performance
Evaluation of
the statistic will be high.
Managed Portfolio
A low (alpha value) value and high regression error results in low t-statistic.
At- statistic of 2 is significant in a statistical sense. It implies that the
probability of the performance due to chance is very low. A t-statistic of - 1
indicates that the performance occurred due to chance.
The R2 for regression of the fund returns with the market returns indicates the
degree of diversification of the fund. Higher the R2, the more the fund is
correlated with the market index; and less the unsystematic risk, the better
diversified is the fund.
Activity 2
Fund January 2019 July 2022
Return Beta SD R2
Scheme X 39.90 0.81 7.30 96%
Scheme Y 32.70 0.91 930 78%
Between Scheme X and Scheme Y, which one is more diversified? Which
one is having greater unsystematic risk in the portfolio?
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LIMITATIONS OF RISK ADJUSTED METHODS

Problems with risk-adjusted measures
In 1997, Modigliani and Modigliani developed the risk-adjusted performance
measure (RAP) often called M-squared, which is by now widely accepted in
theory and practice. Two-years later Lobosco showed that Modigliani’s
measure can be combined with Sharpe style analysis to take investment style
into consideration. Both the measures have increased the investor awareness
of risk adjusted performance measures. However, these measures use the
standard deviation as the measure of risk and hence it is relevant only for
investors who invest the whole of their savings into the fund. It is pertinent to
note here the other problems of using the risk-adjusted performance measures.
• Use of Market Surrogate: All measures other than reward to variability
ratio (Treynor ratio) requires the identification of a market portfolio.
Whatever Surrogate is used for market portfolio (say a market index like
the ET Index) it can be criticised as being inadequate. By making slight
changes in the surrogate, performance ranking can vary.
• Choice of Risk-Free Rate: The choice of a risk-free rate has to be
appropriate. If the risk-free rate is too low, then the benchmark portfolio
based on it may give too high a return, making it difficult for the portfolio
to show superior performance against the benchmark. 271
 • Validity of CAPM: reward to volatility measure and differential return
measure involves beta, using the Capital Asset Pricing Model. But CAPM
may not be the correct asset-pricing model in all circumstances. Other
asset pricing models are being developed where the risk would incorporate
many other factors apart from market related risk.
COMPONENTS OF INVESTMENT PERFORMANCE
Portfolio Managers need a clear and relevant method of attributing returns to
various activities that comprises the investment management process viz.
investment policy or risk taking, market timing and stock selection.
Stock Selection
The most important decision as part of investment strategy is asset allocation.
This involves deciding about what percentage of the portfolio should be in
stocks, bonds, cash, etc., based on the goals and funds available with the
portfolio manager, and also taking in view the current and anticipated market
conditions. Once s/he makes that decision, he has to select suitable investments
within the selected asset classes.
For that portion of the portfolio that the portfolio manager allocates to equities
(or if the fund is equity based fund), s/he should strive to buy shares in excellent
businesses at prices that make business sense. Search for opportunities that
offer the highest predictable annual compounding rate of return possible, where
the risk is reasonable in light of the potential reward.
Further, s/he should make long-term investments in the common stock of
great businesses at prices that make economic sense given the business’s
intrinsic value. The intrinsic value of an investment is the projected annual
compounding rate of return the investment will produce. Focus on the
predictability of future earnings of a business in order to project future value,
and make long-term investments in businesses whose future earnings are
predictable to a satisfactory degree of certainty. Moreover he should make
only those investments where s/he is able to do so at fair or bargain prices.
The price he pays determines the rate of return.
Various methods have been developed to decompose total portfolio returns
and attribute it to each component. Eugene Fama has provided a framework
for performance attribution. We will use one example to show how this
decomposition is feasible.
Example:
A mutual fund scheme has offered a return of 15% during a period when the
market index (like Sensex or Nifty) reported a return of 8%. The risk-free
rate during the period was 6%. The standard deviation of returns of the market
index and the portfolio are 12% and 10% respectively. The beta of the portfolio
is 0.75. The scheme has reported an excess return of 9% (15% - 6%) over and
above the risk-free return and we need to find out the sources of such excess
returns with the help of the information given.
Since the beta of the stock is 0.75, the expected return of the fund as per
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CAPM is E(R) = Rf+ beta (Rm-Rf) = 6% + 0.75 (8% - 6%) = 7.5% Performance
Evaluation of
Against this expected return 7.5%, the fund has offered a return of 15%. The Managed Portfolio

difference of 7.50% can be attributed to selectivity or ability of the fund

managers in selecting the stocks. The balance 1.5% represents the premium
for risk.
Risk Taking
To earn excess return, portfolio managers bear additional risk. By using the
Capital Market Line (CML) we can determine the return commensurate with
risk as measured by the standard deviation of return. The normal return for
Fund A, using total risk would be:
Rf + [(Rm - Rrf ) ( p / m )]
i.e. 6% + [ (8% - 6%) (10% / 12%)] = 7.67%
The difference between this normal return of 7.67% and the expected normal
return computed earlier (7.50%) is 0.17. This additional expected return is on
account of diversification risk.
The fund offered a return of 15% against the expected return of 7.50% and
the excess return is attributed to selectivity. However, selectivity increases
diversification risk, which was quantified as 0.17%. If we remove the
compensation required for bearing diversification risk, the net return attributed
to selectivity is 7.33%
The overall performance of a Fund can be thus decomposed into (i) due to
selectivity and (ii) due to risk taking.
Market Timing
Portfolio Managers can also achieve superior performance by picking up high
beta s tocks during a market upswing and moving out of equities and into
cash in declining markets. To study market timing ability, one could calculate
the quarterly returns for a Fund and for the market index like Bombay Stock
Exchange’s National Index of a 5 year period and plot them on a scatter
diagram.

15.4 BENCHMARK PORTFOLIOS FOR

PERFORMANCE EVALUATION
Benchmark portfolio is a tool for the meaningful evaluation of the performance
of a portfolio manager. The more the benchmark reflects the manager’s stated
style, the more accurately the performance of the manager’s skill can be
assessed. Specialized benchmarks are called ‘normal portfolios’. They are
especially constructed by mutual consent of the client and the manager to
reflect the client’s needs and the manager’s style. Some management firms
develop a normal portfolio, which they can use for all clients, and some develop
it separately for each type of client.
When benchmarks are designed in advance, the portfolio managers know what 273
 the specific objectives are and tailor the portfolio accordingly. The benchmark
should reflect the appropriate investment universe in which the manager works.
Without a yardstick for proper comparison, it becomes difficult to distinguish
between active management skills and random results.
Rather than using a market index like the Bombay Stock Exchange’s Sensitive
Index or the Economic Times Index, a benchmark portfolio would use a
portfolio with predominantly value-oriented shares for a value manager,
growth-oriented shares for a growth manager and small capitalization shares
for a small-cap (size) manager. It is quite possible for an investment manager
to perform better than the benchmark, though the benchmark may itself under-
perform in relation to a market index.
The process of constructing a benchmark portfolio involves:
a) Defining the universe of stock to be used for the benchmark portfolio,
and
b) Defining the weightage of the stocks in the universe.
An investment manager’s month-end portfolio can be examined for the last
five years to get an idea of the average exposure of the manager to various
factors (industry, capitalization, P/E etc.). For example, if an investment
manager tends to invest in securities in high capitalization, low PE, low growth
stocks, higher weights can be assigned to these in the benchmark. The more
stable the exposure and the investment style, the easier it should be to build
benchmarks with appropriate weights.
Performance attribution analysis, as mentioned earlier, is a means of evaluating
an investment manager’s performance, the return and the sources of return
relative to a benchmark portfolio. This analysis looks to an investment
manager’s total ‘excess’ return, or ‘Active Management Return’ (AMR)
relative to its benchmark over the given period. It also looks at the components
of AMR stock selection, industry selection and market timing.
The benchmark portfolio return is a ‘buy-and-hold’ return on a predetermined
portfolio tailored to a manager’s style. The cumulative excess return or
cumulative AMR is the difference between actual portfolio return and the
benchmark return over the evaluation period.

15.5 SUMMARY
In this unit we have discussed various concepts and methods of computing
portfolio return viz. Dollar-Weighted Return, Value-Weighted Return, and
Risk-adjusted Rate of Return. We have also distinguished between
performance measurement and performance evaluation and highlighted the
primary components of performance namely stock selection and market timing
and also the concept and method of construction of a benchmark portfolio for
comparison and evaluation with a managed portfolio. The problems faced in
using risk-adjusted measures for portfolio evaluation have also been briefly
discussed in this unit. In the following two units, we shall learn about portfolio
management practices in investment companies and mutual funds in India.
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 Performance
15.6 KEY WORDS Evaluation of
Managed Portfolio
Sharpe Ratio : It tells us whether the returns of the portfolio
were because of smart investment decisions or
by excess risk.
Treynor Ratio : measures the returns earned in excess of those
that could have been earned on a riskless
investment, per unit of market risk assumed.
Jensen measure : is an absolute measure of performance, adjusted
for risk.
Dollar-Weighted Return : The interest rate that equates the initial
contribution and the cash flows that occur during
the period with the ending value of the fund.
Time-Weighted Return : is the weighted average of the internal rates of
return for the sub-periods between the cash flows
and it is weighted by the length of the sub-
periods.

15.7 SELF-ASSESSMENT QUESTIONS/EXERCISES

1. Distinguish between performance measurement and performance
evaluation of an investment portfolio.
2. Distinguish between Dollar-Weighted and Time-Weighted Return.
3. Describe the Sharpe, Treynor and the Jensen measures of portfolio returns.
4. How are the returns on managed portfolio attributed to stock selection
and market timing? Discuss and illustrate.
5. What are benchmark portfolios? How are they used to evaluate the
performance of a portfolio manager? Discuss with suitable examples.

15.8 FURTHER READINGS

Chandra, P. (2018). Investment Analysis & Portfolio Management (5e). Tata
McGraw Hill.
Fischer, D. E., Jordan, R. J., & Pradhan, A. K. (2018). Security Analysis
Portfolio Management (7th ed.). Pearson Education.
IIT Kharagpur [nptelhrd]. (2012). Mod-01 Lec-39 Portfolio Performance
Evaluation - I [Video]. YouTube. https://www.youtube.com/watch?v=pJOeL-
wR5zE
IIT Kharagpur [nptelhrd]. (2012). Mod-01 Lec-40 Portfolio Performance
Evaluation - II [Video]. YouTube. https://www.youtube.com/
watch?v=YAqgtB9hu8Y

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 Reilly, F. K., Brown, K. C., Gunasingham, B., Lamba, A., & Elston, F. (2019).
Investment Analysis & Portfolio Management. Cengage AU.
Rustagi, R. (2021). Investment Analysis & Portfolio Management. Sultan
Chand & Sons.
Singh, J. P., [IIT Roorkee]. Lecture 56: Arbitrage Pricing Model III, Portfolio
Performance Evaluation [Video]. YouTube. https://www.youtube.com/
watch?v=q_dsbXukVFs
Tripathi, V. (2023). Taxmann’s Fundamentals of Investments. Taxmann
Publications Private Limited.

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