Specialization report Module-3

Risk Return Analysis of Equity Mutual Funds

By,

ANAND MISHRA (2008-45 -135)

MUTUAL FUNDS A mutual fund is a managed group of owned securities of several corporations. These corporations receive dividends on the shares that they hold and realize capital gains or losses on their securities traded. Investors purchase shares in the mutual as if it was an individual security. After paying operating costs, the earnings (dividends, capital gains or losses) of the mutual fund are distributed to the investors, in proportion to the amount of money invested. Investors hope that a loss on one holding will be made up by a gain on another. Heeding the adage "Don't put all your eggs in one basket" the holders of mutual fund shares are able collectively to gain the advantage by diversifying their investments, which might be beyond their financial means individually.

TYPES OF MUTUAL FUNDS

According to structure a mutual fund may be either an open-end or a closed-end fund. An openend mutual fund does not have a set number of shares; it may be considered as a fluid capital stock. The number of shares changes as investors buys or sell their shares. Investors are able to buy and sell their shares of the company at any time for a market price. However the open-end market price is influenced greatly by the fund managers. On the other hand, closed-end mutual fund has a fixed number of shares and the value of the shares fluctuates with the market. But with close-end funds, the fund manager has less influence because the price of the underlining owned securities has greater influence.

Common types of mutual funds are as following:

Value stocks Stocks from firms with relative low Price to Earning (P/E) Ratio usually pay good dividends. The investor is looking for income rather than capital gains. Growth stock Stocks from firms with higher low Price to Earning (P/E) Ratio usually pay small dividends. The investor is looking for capital gains rather than income. Based on company size, large, mid, and small cap Stocks from firms with various asset levels such as over $2 Billion for large; in between $2 and $1 Billion for mid and below $1 Billion for small. Income stock The investor is looking for income which usually comes from dividends or interest. These stocks are from firms which pay relative high dividends. This fund may include bonds which pay high dividends. This fund is much like the value stock fund, but accepts a little more risk and is not limited to stocks. Index funds The securities in this fund are the same as in an Index fund such as the Dow Jones Average or Standard and Poor's. The number and ratios or securities are maintained by the fund manager to mimic the Index fund it is following. Enhanced index This is an index fund which has been modified by either adding value or reducing volatility through selective stock-picking.

Stock market sector The securities in this fund are chosen from a particular marked sector such as Aerospace, retail, utilities, etc. Defensive stock The securities in this fund are chosen from a stock which usually is not impacted by economic down turns. International Stocks from international firms. Real estate Stocks from firms involved in real estate such as builder, supplier, architects and engineers, financial lenders, etc. Socially responsible This fund would invest according to non-economic guidelines. Funds may make investments based on such issues as environmental responsibility, human rights, or religious views. For example, socially responsible funds may take a proactive stance by selectively investing in environmentally-friendly companies or firms with good employee relations. Therefore the fund would avoid securities from firms who profit from alcohol, tobacco, gambling, pornography etc.

Balanced funds The investor may wish to balance his risk between various sectors such as asset size, income or growth. Therefore the fund is a balance between various attributes desired.

Tax efficient Aims to minimize tax bills, such as keeping turnover levels low or shying away from companies that provide dividends, which are regular payouts in cash or stock that are taxable in the year that they are received. These funds still shoot for solid returns; they just want less of them showing up on the tax returns. Convertible Bonds or Preferred stock which may be converted into common stock. Junk bond Bonds which pay higher that market interest, but carry higher risk for failure and are rated below AAA. Mutual funds of mutual funds This fund specializes in buying shares in other mutual funds rather than individual securities. Exchange traded funds (ETFs) Baskets of securities (stocks or bonds) that track highly recognized indexes. Similar to mutual funds, except that they trade the same way that a stock trades, on a stock exchange.

Mutual funds vs. other investments From investors viewpoint mutual funds have several advantages such as:

Professional management and research to select quality securities Spreading risk over a larger quantity of stock whereas the investor has limited to buy only a hand full of stocks. The investor is not putting all his eggs in one basket

Ability to add funds at set amounts and smaller quantities such as $100 per month Ability to take advantage of the stock market which has generally out performed other investment in the long run

Fund manager are able to buy securities in large quantities thus reducing brokerage fees

Risk involved in mutual funds

Risk in mutual fund means volatility is nothing but the fluctuation of the Net Asset Value (price of a unit of a fund). The higher the volatility the greater the fluctuation of the NAV. Generally, past volatility is taken as an indicator of future risk and for the task of evaluating a mutual fund this is an adequate (even if not ideal approximation). Investors talk much about the returns their funds generated than the risk they took to achieve those returns or the losses theyve incurred. When investing in non-index mutual funds, investors make two critical assumptions a) That skillful managers exist. b) That they have the ability to recognize them. If an investor is not willing to make these two assumptions, they should invest in non active funds like index funds or exchange treaded funds (ETFs). Mutual fund analysis both qualitative and quantitative, attempts to identify skillful active managers qualitative analysis looks at factors such as the background and experience of the manager and the mutual fund company. Here we look only at the quantitative factors specifically risk and risk adjusted performance.

Investors always judge a fund by the return it gives, never by the risk it took. In any past analysis of a mutual fund the return is remembered but the risk is quickly forgotten. So a fund manager may have used very high risk strategies hoping that his wins will be remembered but the risk will be soon forgotten.

Methods to measure the risk:

There are many ways in which it can be determined how risky a fund is while no single risk measure can predict with 100% accuracy how volatile a fund will be in future, studies have shown that past risk is a pretty good indicator of future risk.

1) Sharpe Ratio:
The Sharpe ratio is a single number which represents both the risk and return inherent in a fund. As is widely accepted, high returns are generally associated with a high degree of volatility. It was developed by William F. Sharpe (1966). Here, additional portfolio return over risk free return is related with the total risk of the portfolio. = ( rp - rf ) SD The Sharpe ratio represents the tradeoff between risk and returns. At the same time, it also factors in the desire to generate returns, which are higher than risk free returns. Sharpe ration measure risk premium of port folio relative to the total amount of risk in the port folio. Sharpe ratio summarizes the risk and return of a portfolio in a single measure that categorize the performance of funds on the risk adjusted basis. The larger the Sharpe ratio, the portfolio is over performing the market and vice versa.

2) Standard Deviation: Standard deviation is probably used more often than any other measure to guage a funds risk. Standard deviation simply quantifies how much a series of numbers, such as fund returns, varies around its many or average. Investors like using standard deviation because it provides a precise measure of how varied a funds returns have been over a particular time frame- both on the upside and the down side. With this information, you can judge the range of returns your fund is likely to generate in the future. Morning star calculates standard deviations for the most recent 36 month of a funds life. The more a funds returns fluctuate from month to month, the greater its standard deviation. Standard deviation allows a funds performance swings to be captured into a single number. For most funds, future monthly return will fall within one standard deviation of its average return 68% of the time and within two standard deviations 95% of the time. 3) Beta Value: Beta meanwhile is a relative risk measurement, because it depicts a funds volatility against a benchmark. In other words, it is a statistical measure that shows how sensitive a fund is to benchmarks movement. If the sensex moves by 25 percent, a funds beta number will tell you whether the funds returns will be more than this or less. The beta value for an index itself is taken as one. Equity funds can have beta values, which can be above one, less than one or equal to one. By multiplying the beta value of a fund with the expected percentage movement of an index, the expected movement in the fund can be determined. Thus if a fund has a beta of 1.3 and the market is expected to move up by ten percent, the fund should move by 13 percent. Similarly if the market loses ten percent the fund should lose 13 percent. This shows that a fund with a beta of more than one will rise more than the market and also fall more than market.

4. Jenson Measure (Alpha value) According to Jenson (1968), equilibrium average return on a portfolio would be a bench mark. Equilibrium average return in the return of the portfolio by the market with respect to systemic risk of the portfolio. This is a return the portfolio should earn with the given systemic risk. EARp = rf +( rm + rf ) Where EARp = Equilibrium average return. Difference between equilibrium average return and return of portfolio indicates superior performance of the fund. This called alpha () = rp - EARp If the alpha is positive, the portfolio has performed better and if alpha is negative it has not shown performance up to the bench mark. i.e. the market Index 6. Treynors Ratio This is introduced by Treynor (1965). Here additional return of the portfolio over the risk free return is expressed in relation to portfolio risk. = ( rp - rf ) Greater value of the portfolio over the risk free indicates the superior performance of the fund. The Basic Concepts 1.Return of a portfolio

Rp = NAV end of the period NAV beginning of the period Then portfolio return was compounded for the purpose of calculations.

Rp = (R1 * R2*R3.R12)1/12 2. Market Return:-

To fund out the market return, the BSE 100 index was used. Market return is calculated by formula rm= Market index (t)- Market Index (t-1) Market Index (t-1) 3.Risk free return: For fund out the risk free return (rf) the return of 364 days T-bills rate was used.

RISK RETURN ANALYSIS OF EQUITY MUTUAL FUNDS The risk return trade-off indicates that if investor is willing to take higher risk then correspondingly he can expect higher returns and vise versa if he pertains to lower risk instruments, which would be satisfied by lower returns. The investors choose mutual funds as their primary means of investing, as Mutual funds provide professional management, diversification, convenience and liquidity. That doesnt mean mutual fund investments risk free. This is because the money that is pooled in are not invested only in debts funds which are less riskier but are also invested in the stock markets which involves a higher risk but can expect higher returns. Objective of the Study To undertake the risk return analysis of selected open ended equity mutual funds Methodology of the Study The present study is an attempt to analyze the performance of three sector specific growth oriented mutual funds. For the purpose of the study a single fund house (ICICI) is selected randomly and the three growth oriented schemes under the fund house are selected from www.mutualfundindia.com from three sectors such as Banking Sector, Infrastructure Sector, and FMCG sector. The study period was 12 months from May 2011 to April 2012. The schemes selected were 1. ICICI Banking & Financial Services Growth 2. ICICI Infrastructure- Growth 3. ICICI FMCG- Growth All of these mutual funds schemes belong to the best ten schemes in the corresponding sector according to www.valueresearchonline.com.

Analysis For calculating the market return, the index BSE 100 from May 2011 to May 2012 was used Months Opening Index Closing Index Market return

May2011 June 2011 July 2011 August 2011 September 2011 Oct 2011 Nov 2011 Dec 2011 Jan 2012 Feb2012 Mar 2012 April 2012

5817.32 5644.23 5717.27 5568.18 5132.47 4950.13 5295.02 4938.91 4616.42 5198.68 5393.04 5320.66

5638.16 5686.26 5531.7 5062.17 4995.67 5334.14 4831.73 4598.21 5202.65 5406.46 5315.15 5268.41

-0.0308 0.007447 -0.03246 -0.09088 -0.02665 0.077576 -0.0875 -0.06898 0.126988 0.039968 -0.01444 -0.00982

Market return hence found was compounded for the purpose of further calculations Compounded rm =(R1*R2*R12) 1/12 -1 = -0.9632

T BILL (Calculation of Risk Free Returns) Period May 2011 June 2011 July 2011 August 2011 September 2011 Oct 2011 Nov 2011 Dec 2011 Jan 2012 Feb2012 Mar 2012 April 2012 Rf 8.201 8.318 8.236 8.166 8.341 8.518 8.743 8.259 8.200 8.506 8.447 8.341

Risk free return (Rf)

0.696361

ICICI

PRUDENTIAL

BANKING

&

FINANCIAL

SERVICES

FUND-RETAIL-

GROWTH MONTHS NAV RETURN

April 2011 May 2011 June 2011 July 2011 August 2011 September 2011 Oct 2011 Nov 2011 Dec 2011 Jan 2012 Feb2012 Mar 2012 April 2012 Average Return Compounded Return

18.7800 18.20000 18.4300 18.2400 15.7800 15.7000 16.5100 14.4000 13.2400 16.3000 17.1300 17.1400 17.2900 0.969116 1.012637 0.989691 0.865132 0.99493 1.051592 0.872199 0.919444 1.231118 1.05092 1.000584 1.008751 0.997176 -0.00686

rp

= -0.00686

SD

= 0.095778

Beta () = 1.408844

rm

= -0.9632

Sharpes Ratio =

r p- r f
SD = -0.00686-0.696361 0,095778 = -7.342164728

Treynors Ratio

rp- rf

= -0.00686-0.696361
1.40884396 = -0.49915 Jensons alpha () = rp- { rf +

p (rm- rf}

= - 0.00686- {0.696361 +1.40884396 (-0.9632-0.696361)} = 1.63484

ICICI PRUDENTIAL FMCG (G) MONTHS April 2011 May 2011 June 2011 July 2011 August 2011 September 2011 Oct 2011 Nov 2011 Dec 2011 Jan 2012 Feb2012 Mar 2012 April 2012 Average Return Compounded Return NAV 68.4600 69.0100 74.1000 78.9300 77.0500 76.6900 79.3800 76.3300 75.5200 76.4300 78.9400 85.2400 91.1200 1.008033 1.073757 1.065182 0.976181 0.995328 1.035076 0.961577 0.989388 1.01205 1.032841 1.079807 1.068982 1.02485 0.024104 RETURN

rp
SD

= 0.024104

= 0.040567

Beta () = 0.23717243

rm

= -0.9632

Sharpes Ratio =

rp- rf
SD

0.024104- 0.696361 0.040567

= -16.57138706

Treynors Ratio

rp- rf

0.024104 -0.696361 0.23717243

= -2.834465204

Jensons alpha () = rp- { rf +

p (rm- rf}

= 0.024104 - {0.696361 +0.23717243(-0.9632-0.696361)} = -0.278654885

ICICI PRUDENTIAL INFRASTRUCTURE (GROWTH) MONTHS April 2011 May 2011 June 2011 July 2011 August 2011 September 2011 Oct 2011 Nov 2011 Dec 2011 Jan 2012 Feb2012 Mar 2012 April 2012 Average Return Compounded Return -0.01658 NAV 29.7700 28.5700 28.7800 28.3700 25.8400 25.1800 26.0700 23.7500 22.0400 25.2300 26.5000 25.1800 24.6900 0.959690 1.00735 0.985754 0.910821 0.974458 1.035346 0.911009 0.928 1.144737 1.050337 0.950189 0.98054 0.98652 RETURN

rp
SD

= -0.01658

= 0.066743

Beta () = 0.98659093

rm

= -0.9632

Sharpes Ratio =

rp- rf
SD = -10.68181266

Treynors Ratio =

rp- rf

= -0.722630804

Jensons alpha () = rp- { rf +

p (rm- rf}

= 0.924366838

RISK MEASUREMENT IN MUTUAL FUNDS

Treynor's Ratio

ICICI Banking & financial services ICICI FMCG ICICI Infrastructure

0.09577 1.40884396 -0.00686

-0.9632 0.69636

-7.34216 -16.57138 -10.68181

-0.49913 -2.83446 -0.72264

Jenson'S Alpha 1.63484 -0.27865 0.92436

Risk free

0.04056 0.23717243 0.024104 -0.9632 0.69636 0.06674 0.98659093 -0.01658 -0.9632 0.69636

Return of various mutual funds All of the 3 mutual funds performs better than the market where as their return were lower than the risk free return. Among 3 mutual funds ICICI FMCG Fund has better return than Banking and Infrastructure funds. ICICI Banking Funds performance is inferior when compared in other funds.
Systematic Risk Beta () of Selected Mutual Funds Portfolio Beta value Market()

ICICI Banking & financial servicesGrowth ICICI FMCG-Growth ICICI Infrastructure-Growth

1.40884396 1 0.23717243 1 0.98659093 1

Sharpe Ratio

Beta Value

Scheme

SD

Rm

Rp

Rf

0 0 0

Systematic risk of market is always one, systematic risk of risk free investment is Zero. Here the value of banking mutual fund is greater than one, which means the risk of the portfolio is

greater than the market risk. The systematic risk of FMCG fund is lower than the banking and Infrastructure funds, means that it performs better than the other funds in the market.
Standard Deviation of Selected Mutual Funds

Sl No 1 2 3

Fund ICICI Banking & financial services-Growth ICICI FMCG-Growth ICICI Infrastructure-Growth

Standard Deviation 0.09577 0.04056 0.06674

It is clear from the table that ICICI Banking &financial services Growth (0.09577) has the highest Standard Deviation among the funds. It implies that deviation from mean return is more in case of this fund. It is followed by ICICI Infrastructure-Growth (0.06674) and ICICI FMCG Growth (0.04056). Sharpe Ratio of Selected Mutual Funds Sl No 1 2 3 Fund ICICI Banking & financial services-Growth ICICI FMCG-Growth ICICI Infrastructure-Growth Sharpe Ratio -7.34216 -16.57138 -10.68181

Sharpe ratio of the selected schemes shows a negative value for all the schemes implying that, return of the scheme was less than that of risk free return. This makes it clear that the return from each scheme was not sufficient to cover the total risk. Among these 3 funds, Banking Fund showed a better performance followed by infrastructure Fund. By considering Sharpe ratio worst performer is FMCG Fund.

Treynors Ratio of Selected Mutual Funds Sl No 1 2 3 Fund ICICI Banking & financial services-Growth ICICI FMCG-Growth ICICI Infrastructure-Growth Treynors Ratio -0.49913 -2.83446 -0.72264

All the schemes have negative value as per Treynors measure, which implies that the return from a scheme was less than the risk free return. Among the schemes selected, ICICI banking& financial service performs well followed by ICICI Infrastructure Fund. Jensons alpha () of Selected Mutual Funds Sl No 1 2 3 Fund ICICI Banking & financial services-Growth ICICI FMCG-Growth ICICI Infrastructure-Growth Jensons alpha 1.63484 -0.27865 0.92436

From the table it could be observed that all the funds posted positive alpha which implies that all those funds have outperformed the benchmark index (BSE 100), which means the funds have earned over and above what it was expected to earn incorporating the risk. The fund with highest alpha is ICICI Banking &Financial Services Fund Growth (1.63484) is better than other funds in the category.

Conclusion From the risk return analysis of 3 selected open ended sectoral equity mutual funds, it is found that the return from the schemes was less than the risk free rate of return as per Sharpe and Treynors ratios in all cases, as per Jensens measure all the three funds were outperforming the market Whereas all of the 3 mutual funds shows a positive alpha it indicates that all of the 3 funds performs better than the market index ie. BSE100. From the study it revealed that the ICICI Banking & Financial Services - Growth Fund performs better than the other 2 funds. Banking & Financial Servicec is followed by ICICI Infrastructure Growth. Among the 3 funds, ICICI FMCG Growth is the worst performer with low alpha, Sharpe & Treyners ratios.