MODULE-V

Capital Asset Pricing Model - CAPM

The capital asset pricing model (CAPM) is a model that describes the relationship between systematic risk
and expected return for assets, particularly stocks. CAPM is widely used throughout finance for the pricing of
risky securities, generating expected returns for assets given the risk of those assets and calculating costs of
capital.

The formula for calculating the expected return of an asset given its risk is as follows:

The general idea behind CAPM is that investors need to be compensated in two ways:  time value of money and
risk. The time value of money is represented by the risk-free (rf) rate in the formula and compensates the
investors for placing money in any investment over a period of time. The risk-free rate is customarily the yield
on government bonds like U.S. Treasuries.

The other half of the CAPM formula represents risk and calculates the amount of compensation the investor
needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns
of the asset to the market over a period of time and to the market premium (Rm-rf): the return of the market in
excess of the risk-free rate. Beta reflects how risky an asset is compared to overall market risk and is a function
of the volatility of the asset and the market as well as the correlation between the two. For stocks, the market is
usually represented as the S&P 500 but can be represented by more robust indexes as well.

The CAPM model says that the expected return of a security or a portfolio equals the rate on a risk-free security
plus a risk premium. If this expected return does not meet or beat the required return, then the investment should
not be undertaken. The security market line plots the results of the CAPM for all different risks (betas).

Example of CAPM

Using the CAPM model and the following assumptions, we can compute the expected return for a stock:

The risk-free rate is 2% and the beta (risk measure) of a stock is 2. The expected market return over the period is
10%, so that means that the market risk premium is 8% (10% - 2%) after subtracting the risk-free rate from the
expected market return. Plugging in the preceding values into the CAPM formula above, we get an expected
return of 18% for the stock:

18% = 2% + 2 x (10%-2%)

WHAT IT IS:

The capital asset pricing model (CAPM) is used to calculate the required rate of return for any risky asset.
Your required rate of return is the increase in value you should expect to see based on the inherent risk level of
the asset.

HOW IT WORKS (EXAMPLE):

As an analyst, you could use CAPM to decide what price you should pay for a particular stock. If Stock A is
riskier than Stock B, the price of Stock A should be lower to compensate investors for taking on the increased
risk.

The CAPM formula is:

ra = rrf + Ba (rm-rrf)

where:

rrf = the rate of return for a risk-free security 

rm = the broad market's expected rate of return 

Ba = beta of the asset

CAPM can be best explained by looking at an example.

Assume the following for Asset XYZ:

rrf = 3%
rm = 10%
Ba = 0.75

By using CAPM, we calculate that you should demand the following rate of return to invest in Asset XYZ:    
ra = 0.03 + [0.75 * (0.10 - 0.03)] = 0.0825 = 8.25%

The inputs for rrf , rm and Ba are determined by the analyst and are open to interpretation.

Beta (Ba) -- Most investors use a beta calculated by a third party, whether it's an analyst, broker or Yahoo!
Finance.

You can calculate beta yourself by running a straight-line statistical regression on data points showing price
changes of a broad market index versus price changes in your risky asset.  Note that beta can be different
depending on what time frame you pull your data from. Beta calculated with 10 years of data is different from
beta calculated with 10 months of data. Neither is right or wrong – it depends totally on the rationale of the
analyst.

Market return (rm) – Your input of market rate of return, r m, can be based on past returns or projected future
returns. Economist Peter Bernstein famously calculated that over the last 200 years, the stock market has
returned an average of 9.6% per year. Whether or not you want to use this as your projection of future stock
market returns is up to you as an analyst.

Risk-free return (rrf): U.S. Treasury bills and bonds are most often used as the proxy for the risk-free rate.
Most analysts try to match the duration of the bond with the projection horizon of the investment. For example,
if you're using CAPM to estimate Stock XYZ's required rate of return over a 10 year time horizon, you'll want to
use the 10-year U.S. Treasury bond rate as your measure of rrf.

IMPORTANCE OF CAPM:

CAPM is most often used to determine what the fair price of an investment should be. When you calculate the
risky asset's rate of return using CAPM, that rate can then be used to discount the investment's future  cash flows
to their present value and thus arrive at the investment's fair value.
By extension, once you've calculated the investment's fair value, you can then compare it to its market price. If
your price estimate is higher than the market's, you could consider the stock a bargain. If your price estimate is
lower, you could consider the stock to be overvalued.

Security market line

The SML essentially graphs the results from the capital asset pricing model (CAPM) formula. The x-axis
represents the risk (beta), and the y-axis represents the expected return. The market risk premium is determined
from the slope of the SML.
The relationship between β and required return is plotted on the securities market line (SML), which shows
expected return as a function of β. The intercept is the nominal risk-free rate available for the market, while the
slope is the market premium, E(Rm)− Rf. The securities market line can be regarded as representing a single-
factor model of the asset price, where Beta is exposure to changes in value of the Market. The equation of the
SML is thus:

It is a useful tool in determining if an asset being considered for a portfolio offers a reasonable expected
return for risk. Individual securities are plotted on the SML graph. If the security's expected return versus
risk is plotted above the SML, it is undervalued since the investor can expect a greater return for the
inherent risk. And a security plotted below the SML is overvalued since the investor would be accepting
less return for the amount of risk assumed.

Asset pricing

Once the expected/required rate of return   is calculated using CAPM, we can compare this
required rate of return to the asset's estimated rate of return over a specific investment horizon to determine
whether it would be an appropriate investment. To make this comparison, you need an independent
estimate of the return outlook for the security based on either fundamental or technical analysis
techniques, including P/E, M/B etc.
Assuming that the CAPM is correct, an asset is correctly priced when its estimated price is the same as the
present value of future cash flows of the asset, discounted at the rate suggested by CAPM. If the estimated
price is higher than the CAPM valuation, then the asset is undervalued (and overvalued when the estimated
price is below the CAPM valuation).[5] When the asset does not lie on the SML, this could also suggest mis-

pricing. Since the expected return of the asset at time   is  , a higher expected return than

what CAPM suggests indicates that   is too low (the asset is currently undervalued), assuming that

at time   the asset returns to the CAPM suggested price.

The asset price   using CAPM, sometimes called the certainty equivalent pricing formula, is a
linear relationship given by

where   is the payoff of the asset or portfolio.

Asset-specific required return

The CAPM returns the asset-appropriate required return or discount rate—i.e. the rate at which future
cash flows produced by the asset should be discounted given that asset's relative riskiness. Betas
exceeding one signify more than average "riskiness"; betas below one indicate lower than average.
Thus, a more risky stock will have a higher beta and will be discounted at a higher rate; less sensitive
 stocks will have lower betas and be discounted at a lower rate. Given the accepted concave utility
function, the CAPM is consistent with intuition—investors (should) require a higher return for holding
a more risky asset.
Since beta reflects asset-specific sensitivity to non-diversifiable, i.e. market risk, the market as a
whole, by definition, has a beta of one. Stock market indices are frequently used as local proxies for
the market—and in that case (by definition) have a beta of one. An investor in a large, diversified
portfolio (such as a mutual fund), therefore, expects performance in line with the market.

Risk and diversification

The risk of a portfolio comprises systematic risk, also known as undiversifiable risk, and unsystematic
risk which is also known as idiosyncratic risk or diversifiable risk. Systematic risk refers to the risk
common to all securities—i.e. market risk. Unsystematic risk is the risk associated with individual
assets. Unsystematic risk can be diversified away to smaller levels by including a greater number of
assets in the portfolio (specific risks "average out"). The same is not possible for systematic risk within
one market. Depending on the market, a portfolio of approximately 30–40 securities in developed
markets such as the UK or US will render the portfolio sufficiently diversified such that risk exposure
is limited to systematic risk only. In developing markets a larger number is required, due to the higher
asset volatilities.
A rational investor should not take on any diversifiable risk, as only non-diversifiable risks are
rewarded within the scope of this model. Therefore, the required return on an asset, that is, the return
that compensates for risk taken, must be linked to its riskiness in a portfolio context—i.e. its
contribution to overall portfolio riskiness—as opposed to its "stand alone risk." In the CAPM context,
portfolio risk is represented by higher variance i.e. less predictability. In other words, the beta of the
portfolio is the defining factor in rewarding the systematic exposure taken by an investor.

What is the 'Security Market Line - SML'

The security market line (SML) is a line drawn on a chart that serves as a graphical representation of the capital
asset pricing model (CAPM), which shows different levels of systematic, or market, risk of various marketable
securities plotted against the expected return of the entire market at a given point in time. Also known as the
"characteristic line," the SML is a visual of the capital asset pricing model (CAPM), where the x-axis of the
chart represents risk in terms of beta, and the y-axis of the chart represents expected return. The market risk
premium of a given security is determined by where it is plotted on the chart in relation to the SML.

BREAKING DOWN 'Security Market Line - SML'

The security market line is an investment evaluation tool derived from the capital asset pricing model, a model
that describes risk-return relationships for securities, and is based on the assumptions that investors have to be
compensated for both the time value of money and the corresponding level of risk associated with any
investment, referred to as the risk premium.

The concept of beta is central to the capital asset pricing model and the security market line. The beta of a
security is a measure of its systematic risk that cannot be eliminated by diversification. A beta value of one is
considered as the overall market average. A beta value higher than one represents a risk level greater than the
market average, while a beta value lower than one represents a level of risk below the market average.

The formula for plotting the security market line is as follows:

Required Return = Risk Free Rate of Return + Beta (Market Return - Risk Free Rate of Return)

Using the Security Market Line

The security market line is commonly used by investors in evaluating a security for inclusion in an
investment portfolio in terms of whether the security offers a favorable expected return against its level of risk.
When the security is plotted on the SML chart, if it appears above the SML, it is
considered undervalued because the position on the chart indicates that the security offers a greater return
against its inherent risk. Conversely, if the security plots below the SML, it is considered overvalued in price
because the expected return does not overcome the inherent risk.

The SML is frequently used in comparing two similar securities offering approximately the same return, in order
to determine which of the two securities involves the least amount of inherent market risk in relation to the
expected return. The SML can also be used to compare securities of equal risk to see which one offers the
highest expected return against that level of risk.

While the SML can be a valuable tool in equity evaluation and comparison, it should not be used in isolation, as
the expected return of an investment over the risk-free rate of return is not the sole consideration when making
investment choices.

Capital Market Line - CML

 

The capital market line (CML) appears in the capital asset pricing model to depict the rates of returnfor efficient
portfolios subject to the risk level (standard deviation) for a market portfolio and the risk-free rate of return.

The capital market line is created by sketching a tangent line from the intercept point on the efficient frontier to
the place where the expected return on a holding equals the risk-free rate of return. However, the CML is better
than the efficient frontier because it considers the infusion of a risk-free asset in the market portfolio.

BREAKING DOWN 'Capital Market Line - CML'

The capital asset pricing model (CAPM) proves that the market portfolio is the efficient frontier. It is the
intersection between returns from risk-free investments and returns from the total market. The security market
line (SML) represents this.

The capital asset pricing model determines the fair price of investments. Once the fair value is determined, it is
compared to the market price. A stock is a good buy if the estimated price is higher than the market price.
However, if the price is lower than the market price, the stock is not a good buy.

In the CAPM, the securities are priced, so the expected risks counterbalance the expected returns. There are two
components needed to generate a CAPM, CML and the SML. The capital market line conveys the return of an
investor for a portfolio. The capital market line assumes that all investors can own market portfolios.

Single assets and nonefficient portfolios are not depicted on the CML. Alternatively, the SML must be used.
The capital market line permits the investor to consider the risks of an additional asset in an existing portfolio.
The line graphically depicts the risk top investors earn for accepting added risk.
Separation Theorem

All investors have portfolios on the CML relying on the risk-return preferences. However, the
market portfolio and the CML are depicted without reference to the risk-return tradeoff curves of the investors.
This result is Tobin’s Separation Theorem. It states that the best blend of risky assets in the market portfolio is
determined without considering the risk-return preferences of the investors.

Locating the best portfolio for a specific risk tolerance level consists of two methods: finding the best blend of
market securities that does not fluctuate with risk tolerance and then joining it with a suitable amount of money.

Security Market Line

The linear relationship between expected asset returns and betas posited by capital asset pricing model .It is a
line on the chart representing the capital asset pricing model . It plots thre risk vs expected return of the market .
It helps to asses whether a given security is undervalued or outperforming the market .

The formula for plotting the security market line is as follows:

Required Return = Risk Free Rate of Return + Beta (Market Return – Risk Free Rate of Return)
CAPITAL MARKET LINE
It is a graph which originates from capital asset pricing model . It determines the rate of return from different
efficient portfolios .It takes into account the risk free rate of return and the risk involved in a particular
portfolio. All efficient portfolios lie on the efficient frontier. But when an efficient portfolio consisting of only
risky assets is combined with a risk-free asset, the efficient portfolios no longer lie on the curved efficient
frontier. Instead, by combining a risk-free asset with the risky-asset portfolio, an enhanced linear efficient
frontier is realized: it is called the capital market line (CML). Theoretically, there is only one CML.
The CML intercepts the vertical (expected return) axis at point Rf, i.e., the risk-free rate. Refer to the following
graph.
The CML extends linearly to a point where it is tangent to efficient frontier called the market portfolio.

CML vs SML

CML stands for Capital Market Line, and SML stands for Security Market Line.

The CML is a line that is used to show the rates of return, which depends on risk-free rates of return and levels
of risk for a specific portfolio. SML, which is also called a Characteristic Line, is a graphical representation of
the market’s risk and return at a given time.
One of the differences between CML and SML, is how the risk factors are measured. While standard deviation
is the measure of risk for CML, Beta coefficient determines the risk factors of the SML.
The CML measures the risk through standard deviation, or through a total risk factor. On the other hand, the
SML measures the risk through beta, which helps to find the security’s risk contribution for the portfolio.
While the Capital Market Line graphs define efficient portfolios, the Security Market Line graphs define both
efficient and non-efficient portfolios.

While calculating the returns, the expected return of the portfolio for CML is shown along the Y- axis. On the
contrary, for SML, the return of the securities is shown along the Y-axis. The standard deviation of the portfolio
is shown along the X-axis for CML, whereas, the Beta of security is shown along the X-axis for SML.

Where the market portfolio and risk free assets are determined by the CML, all security factors are determined
by the SML.
Unlike the Capital Market Line, the Security Market Line shows the expected returns of individual assets. The
CML determines the risk or return for efficient portfolios, and the SML demonstrates the risk or return for
individual stocks.

Well, the Capital Market Line is considered to be superior when measuring the risk factors.

Summary:

1. The CML is a line that is used to show the rates of return, which depends on risk-free rates of return and
levels of risk for a specific portfolio. SML, which is also called a Characteristic Line, is a graphical
representation of the market’s risk and return at a given time.

2. While standard deviation is the measure of risk in CML, Beta coefficient determines the risk factors of the
SML.

3. While the Capital Market Line graphs define efficient portfolios, the Security Market Line graphs define both
efficient and non-efficient portfolios.

4. The Capital Market Line is considered to be superior when measuring the risk factors.

5. Where the market portfolio and risk free assets are determined by the CML, all security factors are
determined by the SML.

Markowitz Portfolio Theory

Harry Markowitz put forward this model in 1952. It assists in the selection of the most efficient by analyzing
various possible portfolios of the given securities. By choosing securities that do not 'move' exactly together, the
HM model shows investors how to reduce their risk. The HM model is also called mean-variance model due to
the fact that it is based on expected returns (mean) and the standard deviation (variance) of the various
portfolios. Harry Markowitz made the following assumptions while developing the HM model:
1. Risk of a portfolio is based on the variability of returns from the said portfolio.
2. An investor is risk averse.
3. An investor prefers to increase consumption.
4. The investor's utility function is convex and increasing, due to his risk aversion and consumption preference.
5. Analysis is based on single period model of investment.
6. An investor either maximizes his portfolio return for a given level of risk or maximizes his return for
the minimum risk.
7. An investor is rational in nature.
To choose the best portfolio from a number of possible portfolios, each with different return and risk, two
separate decisions are to be made:
1. Determination of a set of efficient portfolios.
2. Selection of the best portfolio out of the efficient set.
Determining the efficient set
A portfolio that gives maximum return for a given risk, or minimum risk for given return is an efficient
portfolio. Thus, portfolios are selected as follows:
(a) From the portfolios that have the same return, the investor will prefer the portfolio with lower risk, and [7]
(b) From the portfolios that have the same risk level, an investor will prefer the portfolio with higher rate of
return.
Figure 1: Risk-return of possible portfolios

As the investor is rational, they would like to have higher return. And as he is risk averse, he wants to have
lower risk.In Figure 1, the shaded area PVWP includes all the possible securities an investor can invest in. The
efficient portfolios are the ones that lie on the boundary of PQVW. For example, at risk level x2, there are three
portfolios S, T, U. But portfolio S is called the efficient portfolio as it has the highest return, y 2, compared to T
and U. All the portfolios that lie on the boundary of PQVW are efficient portfolios for a given risk level.
The boundary PQVW is called the Efficient Frontier. All portfolios that lie below the Efficient Frontier are not
good enough because the return would be lower for the given risk. Portfolios that lie to the right of the Efficient
Frontier would not be good enough, as there is higher risk for a given rate of return. All portfolios lying on the
boundary of PQVW are called Efficient Portfolios. The Efficient Frontier is the same for all investors, as all
investors want maximum return with the lowest possible risk and they are risk averse.
Choosing the best portfolio
For selection of the optimal portfolio or the best portfolio, the risk-return preferences are analyzed. An investor
who is highly risk averse will hold a portfolio on the lower left hand of the frontier, and an investor who isn’t
too risk averse will choose a portfolio on the upper portion of the frontier.
Figure 2: Risk-return indifference curves

Figure 2 shows the risk-return indifference curve for the investors. Indifference curves C1, C2 and C3 are shown.
Each of the different points on a particular indifference curve shows a different combination of risk and return,
which provide the same satisfaction to the investors. Each curve to the left represents higher utility or
satisfaction. The goal of the investor would be to maximize his satisfaction by moving to a curve that is higher.
An investor might have satisfaction represented by C2, but if his satisfaction/utility increases, he/she then moves
to curve C3 Thus, at any point of time, an investor will be indifferent between combinations S1 and S2, or S5 and
S6.

Figure 3: The Efficient Portfolio

The investor's optimal portfolio is found at the point of tangency of the efficient frontier with the indifference
curve. This point marks the highest level of satisfaction the investor can obtain. This is shown in Figure 3. R is
the point where the efficient frontier is tangent to indifference curve C3, and is also an efficient portfolio. With
this portfolio, the investor will get highest satisfaction as well as best risk-return combination (a portfolio that
provides the highest possible return for a given amount of risk). Any other portfolio, say X, isn't the optimal
portfolio even though it lies on the same indifference curve as it is outside the feasible portfolio available in the
market. Portfolio Y is also not optimal as it does not lie on the best feasible indifference curve, even though it is
a feasible market portfolio. Another investor having other sets of indifference curves might have some different
portfolio as his best/optimal portfolio.
All portfolios so far have been evaluated in terms of risky securities only, and it is possible to include risk-free
securities in a portfolio as well. A portfolio with risk-free securities will enable an investor to achieve a higher
level of satisfaction. This has been explained in Figure 4.
Figure 4: The Combination of Risk-Free Securities with the Efficient Frontier and CML

R1 is the risk-free return, or the return from government securities, as those securities are considered to have no
risk for modeling purposes. R1PX is drawn so that it is tangent to the efficient frontier. Any point on the line
R1PX shows a combination of different proportions of risk-free securities and efficient portfolios. The
satisfaction an investor obtains from portfolios on the line R1PX is more than the satisfaction obtained from the
portfolio P. All portfolio combinations to the left of P show combinations of risky and risk-free assets, and all
those to the right of P represent purchases of risky assets made with funds borrowed at the risk-free rate.
In the case that an investor has invested all his funds, additional funds can be borrowed at risk-free rate and a
portfolio combination that lies on R1PX can be obtained. R1PX is known as the Capital Market Line (CML). this
line represents the risk-return trade off in the capital market. The CML is an upward sloping curve, which means
that the investor will take higher risk if the return of the portfolio is also higher. The portfolio P is the most
efficient portfolio, as it lies on both the CML and Efficient Frontier, and every investor would prefer to attain
this portfolio, P. The P portfolio is known as the Market Portfolio and is also the most diversified portfolio. It
consists of all shares and other securities in the capital market.
In the market for portfolios that consists of risky and risk-free securities, the CML represents the equilibrium
condition. The Capital Market Line says that the return from a portfolio is the risk-free rate plus risk premium.
Risk premium is the product of the market price of risk and the quantity of risk, and the risk is the standard
deviation of the portfolio.
The CML equation is :
RP = IRF + (RM – IRF)σP/σM
where,
RP = expected return of portfolio
RM = return on the market portfolio
IRF = risk-free rate of interest
σM = standard deviation of the market portfolio
σP = standard deviation of portfolio
(RM – IRF)/σM is the slope of CML. (RM – IRF) is a measure of the risk premium, or the
reward for holding risky portfolio instead of risk-free portfolio. σM is the risk of the
market portfolio. Therefore, the slope measures the reward per unit of market risk.
The characteristic features of CML are:
1. At the tangent point, i.e. Portfolio P, is the optimum combination of risky investments
and the market portfolio.
2. Only efficient portfolios that consist of risk free investments and the market portfolio
P lie on the CML.
3. CML is always upward sloping as the price of risk has to be positive. A rational
investor will not invest unless he knows he will be compensated for that risk.

Figure 5: CML and Risk-Free Lending and Borrowing

Figure 5 shows that an investor will choose a portfolio on the efficient frontier, in the
absence of risk-free investments. But when risk-free investments are introduced, the
investor can choose the portfolio on the CML (which represents the combination of
risky and risk-free investments). This can be done with borrowing or lending at the risk-
free rate of interest (IRF) and the purchase of efficient portfolio P. The portfolio an
investor will choose depends on his preference of risk. The portion from IRF to P, is
investment in risk-free assets and is called Lending Portfolio. In this portion, the
investor will lend a portion at risk-free rate. The portion beyond P is called Borrowing
Portfolio, where the investor borrows some funds at risk-free rate to buy more of
portfolio P.
Demerits of the HM model
1. Unless positivity constraints are assigned, the Markowitz solution can easily find
highly leveraged portfolios (large long positions in a subset of investable assets financed
by large short positions in another subset of assets), but given their leveraged nature the
returns from such a portfolio are extremely sensitive to small changes in the returns of
the constituent assets and can therefore be extremely 'dangerous'. Positivity constraints
are easy to enforce and fix this problem, but if the user wants to 'believe' in the
robustness of the Markowitz approach, it would be nice if better-behaved solutions (at
the very least, positive weights) were obtained in an unconstrained manner when the set
of investment assets is close to the available investment opportunities (the market
portfolio) – but this is often not the case.
2. Practically more vexing, small changes in inputs can give rise to large changes in the
portfolio. Mean-variance optimization has been dubbed an 'error maximization' device
(Scherer 2002): 'an algorithm that takes point estimates (of returns and covariances) as
inputs and treats them as if they were known with certainty will react to tiny return
differences that are well within measurement error'. In the real world, this degree of
instability will lead, to begin with, to large transaction costs, but it is also likely to shake
the confidence of the portfolio manager in the model.
3. The amount of information (the covariance matrix, specifically, or a complete joint
probability distribution among assets in the market portfolio) needed to compute a
 mean-variance optimal portfolio is often intractable and certainly has no room for
subjective measurements ('views' about the returns of portfolios of subsets of investable
assets).
Portfolio Analysis: Risk and Return

Expected return on a single stock. The expected return of a portfolio provides an estimate of how much return one can get from their portfolio.
And variance gives the estimate of the risk that an investor is taking while holding that portfolio.

Most investors do not hold stocks in isolation. Instead, they choose to hold a portfolio of several stocks. When
this is the case, a portion of an individual stock's risk can be eliminated, i.e.,diversified away. This principle is
presented on the Diversification page. First, the computation of the expected return, variance, and standard
deviation of a portfolio must be illustrated.

Once again, we will be using the probability distribution for the returns on stocks A and B.

Return on Return on
State Probability Stock A Stock B

1 20% 5% 50%

2 30% 10% 30%

3 30% 15% 10%

3 20% 20% -10%

From the Expected Return and Measures of Risk pages we know that the expected return on Stock A is 12.5%,
the expected return on Stock B is 20%, the variance on Stock A is .00263, the variance on Stock B is .04200, the
standard deviation on Stock S is 5.12%, and the standard deviation on Stock B is 20.49%.

Portfolio Expected Return

The Expected Return on a Portfolio is computed as the weighted average of the expected returns on the stocks
which comprise the portfolio. The weights reflect the proportion of the portfolio invested in the stocks. This can
be expressed as follows:

where

 E[Rp] = the expected return on the portfolio,

 N = the number of stocks in the portfolio,
 wi = the proportion of the portfolio invested in stock i, and
 E[Ri] = the expected return on stock i.

For a portfolio consisting of two assets, the above equation can be expressed as

Expected Return on a Portfolio of Stocks A and B

 Note: E[RA] = 12.5% and E[RB] = 20%

Portfolio consisting of 50% Stock A and 50% Stock B

Portfolio consisting of 75% Stock A and 25% Stock B

Portfolio Variance and Standard Deviation

The variance/standard deviation of a portfolio reflects not only the variance/standard deviation of the stocks that
make up the portfolio but also how the returns on the stocks which comprise the portfolio vary together. Two
measures of how the returns on a pair of stocks vary together are the covariance and the correlation coefficient.

The Covariance between the returns on two stocks can be calculated using the following equation:

where

 s12 = the covariance between the returns on stocks 1 and 2,

 N = the number of states,
 pi = the probability of state i,
 R1i = the return on stock 1 in state i,
 E[R1] = the expected return on stock 1,
 R2i = the return on stock 2 in state i, and
 E[R2] = the expected return on stock 2.

The Correlation Coefficient between the returns on two stocks can be calculated using the following equation:

where

 r12 = the correlation coefficient between the returns on stocks 1 and 2,

 s12 = the covariance between the returns on stocks 1 and 2,
 s1 = the standard deviation on stock 1, and
 s2 = the standard deviation on stock 2.

Covariance and Correlation Coefficent between the Returns on Stocks A and B

Note: E[RA] = 12.5%, E[RB] = 20%, sA = 5.12%, and sB = 20.49%.

Using either the correlation coefficient or the covariance, the Variance on a Two-Asset Portfolio can be
calculated as follows:

The standard deviation on the porfolio equals the positive square root of the the variance.

Variance and Standard Deviation on a Portfolio of Stocks A and B

Note: E[RA] = 12.5%, E[RB] = 20%, sA = 5.12%, sB = 20.49%, and rAB = -1.

Portfolio consisting of 50% Stock A and 50% Stock B

Portfolio consisting of 75% Stock A and 25% Stock B

Notice that the portfolio formed by investing 75% in Stock A and 25% in Stock B has a lower variance and
standard deviation than either Stocks A or B and the portfolio has a higher expected return than Stock A. This is
the essence of Diversification, by forming portfolios some of the risk inherent in the individual stocks can be
eliminated.

Portfolio Management Theories

Risk Aversion 
Risk aversion is an investor's general desire to avoid participation in "risky" behavior or, in this case, risky
investments. Investors typically wish to maximize their return with the least amount of risk possible. When
faced with two investment opportunities with similar returns, good investor will always choose the investment
with the least risk as there is no benefit to choosing a higher level of risk unless there is also an increased level
of return. 

Insurance is a great example of investors' risk aversion. Given the potential for a car accident, an investor would
rather pay for insurance and minimize the risk of a huge outlay in the event of an accident.

Markowitz Portfolio Theory

Harry Markowitz developed the portfolio model. This model includes not only expected return, but also includes
the level of risk for a particular return. Markowitz assumed the following about an individual's investment
behavior: 

 Given the same level of expected return, an investor will choose the investment with the lowest amount
of risk.
 Investors measure risk in terms of an investment's variance or standard deviation.
 For each investment, the investor can quantify the investment's expected return and the probability of
those returns over a specified time horizon.
 Investors seek to maximize their utility.
 Investors make decision based on an investment's risk and return, therefore, an investor's utility curve
is based on risk and return.

The Efficient Frontier

Markowitz' work on an individual's investment behavior is important not only when looking at individual
investment, but also in the context of a portfolio. The risk of a portfolio takes into account each investment's risk
and return as well as the investment's correlation with the other investments in the portfolio.

A portfolio is considered efficient if it gives the investor a higher expected return with the same or lower level
of risk as compared to another investment. The efficient frontieris simply a plot of those efficient portfolios,

While an efficient frontier illustrates each of the efficient portfolios relative to risk and return levels, each of the
efficient portfolios may not be appropriate for every investor. Recall that when creating an investment policy,
return and risk were the key objectives. An investor's risk profile is illustrated with indifference curves. The
optimal portfolio, then, is the point on the efficient frontier that is tangential to the investor's highest
indifference curve.

Utility Indifference Curves for Risk-averse Investors

For each investor the degree of risk aversion translates into certain utility (read satisfaction) that he
gets from an investment. In our example of $100 for sure vs. a gamble where you get $200 or nothing, when a
risk averse chooses to go with $100 for sure, it means that the $100 with certainty provides him more utility
compared to the gamble. For another person, even $90 may be good enough for him to find more utility
compared to going for a gamble. However, if the certain amount is reduced more, say to just $20, then he might
as well try the gamble option.

The risk-return utility function of an investor can be exhibited using the following formula:

U = E(R) – ½ A * Variance

Where:

 U is a given level of happiness/utility

 A is the level of risk averseness

We can make some interesting observations from this function:

1. Utility increases as expected returns increase

2. Utility decreases when variance or risk increases
3. Utility reduces as risk-aversion (A) increases

As the risk aversion increases, an investor demands more return for every unit of increase in risk. When the risk
increases, the investor demands more return based on his utility function, thereby keeping the level of utility the
same. This concept can be explained with the help of indifference curve. An indifference curve presents the risk-
return requirements of an investor at a certain level of utility. The following graph shows three indifference
curves for the same investor.

Indifference Curves for an Investor

 

Note that each of the curves (C1, C2, and C3) represents different levels of utility for the investor. However, on
any one indifference curve, the utility is the same anywhere on the curve. For example, on indifference curve
C1, the investor gets same level of utility (satisfaction) at both points S1 and S2. Similarly, the utility is the
same at S3 and S4.

Note that each of the curves (C1, C2, and C3) represents different levels of utility for the investor. However, on
any one indifference curve, the utility is the same anywhere on the curve. For example, on indifference curve
C1, the investor gets same level of utility (satisfaction) at both points S1 and S2. Similarly, the utility is the
same at S3 and S4.

Now let’s compare points S4 on C2 and S6 on C3. On point S4, the investor faces a certain amount of risk for
certain return. On point S6, he gets the same return as on S4 but at lower risk. So, given a choice, he can
increase is utility by moving to the indifference curve C3.

In general, the utility of risk-averse investors increases as we move leftwards in the graph. Given a choice
between C1, C2, and C3, the investor would want to be on C3 to maximize this utility.

A portfolio consists of a number of different securities or other assets selected for investment gains. However, a
portfolio also has investment risks. The primary objective of portfolio theory or management is to maximize
gains while reducing diversifiable risk. Diversifiable risk is so named because the risk can be reduced by
diversifying assets. Systemic risk, on the other hand, cannot be reduced through diversification, since it is a risk
that affects the entire economy and most investments. So even the most optimized portfolio will still be subject
to systemic risk.

Traditional portfolio management is a nonquantitative approach to balancing a portfolio with different assets,
such as stocks and bonds, from different companies and different sectors as a way of reducing the overall risk of
the portfolio. The main objective is to select assets that have little or negative correlation with each other, so that
the overall diversifiable risk is reduced.

Modern portfolio theory (MPT) reduces portfolio risk by selecting and balancing assets based on statistical
techniques that quantify the amount of diversification by calculating expected returns, standard deviations of
individual securities to assess their risk, and by calculating the actual coefficients of correlation between assets,
or by using a good proxy, such as the single-index model, allowing a better choice of assets that have negative
or no correlation with other assets in the portfolio. Modern portfolio management differs from the traditional
approach by the use of quantitative methods to reduce risk. The main objective of modern portfolio theory is to
have an efficient portfolio, which is a portfolio that yields the highest return for a specific risk, or, stated in
another way, the lowest risk for a given return. Profits can be maximized by selecting an efficient portfolio that
is also an optimal portfolio, which is one that provides the most satisfaction — the greatest return — for an
investor based on his tolerance for risk.

Utility Values and Risk Aversion

Most investors will assume a greater risk for a greater return. However, investors differ in the amount of risk
they are willing to take for a given return. Investors who are risk averserequire a greater return for a given
amount of risk than a risk lover. A risk-neutral investor is only concerned with the magnitude of the return.
However, most investors are risk averse to varying degrees.

Although investors differ in their risk tolerance, they should be consistent in their selection of any portfolio in
terms of the risk-return trade-off. Because risk can be quantified as the sum of the variance of the returns over
 time, it is possible to assign a utility score (aka utility value, utility function) to any portfolio by subtracting its
variance from its expected return to yield a number that would be commensurate with an investor's tolerance for
risk, or a measure of their satisfaction with the investment. Because risk aversion is not an objectively
measurably quantity, there is no unique equation that would yield such a quantity, but an equation can be
selected, not for its absolute measure, but for its comparative measure of risk tolerance. One such equation is the
following utility formula:

Utility Score = Expected Return – 0.005σ2  × Risk Aversion Coefficient

The risk aversion coefficient is a number proportionate to the amount of risk aversion of the investor and is
usually set to integer values less than 6, and 0.005 is a normalizing factor to reduce the size of the variance, σ2,
which is the square of the standard deviation (σ), a measure of the volatility of the investment and therefore its
risk. This equation is normalized so that the result is a yield percentage that can be compared to investment
returns, which allows the utility score to be directly compared to other investment returns, such as the return of
risk-free T-bills. For example, if a risk-free T-bill pays 4%, and XYZ stock has a return of 12% and a standard
deviation of 25%, the utility score of XYZ stock is equal to

Utility Score = 12 – 0.005 × 252 × 2= 12 – 6.25 = 5.75%

In the above example, we let the risk aversion coefficient be equal to 2. If someone were more risk averse, we
might use 3 instead of 2 to indicate the investor's greater aversion to risk. In this case, the above equation yields:

Utility Score = 12 – 0.005 × 252 × 3 = 12 – 9.375 = 2.625%

Since 2.625% is less than the 4% yield of risk-free T-bills, this risk-averse investor will reject XYZ stock in
favor of T-bills while the other investor will invest in XYZ stock since he assigns a utility score of 5.75% to the
investment, which is higher than the T-bill yield.

Another way to measure the risk averseness of an investor is by comparing the desirability of a risky investment
to a risk-free investment. The certainty equivalent rate is the rate of return of a risk-free investment that would
be equally attractive as a risky investment. Since the utility score of a risk-free investment is simply its rate of
return
 However, there are many possible portfolios on many risk-indifference curves that do not yield the
highest return for a given risk. All of these portfolios lie below the efficient frontier. The optimal portfolio is a
portfolio on the efficient frontier that would yield the best combination of return and risk for a given investor,
which would give that investor the most satisfaction.

These risk-indifference curves, calculated with the utility formula with the risk aversion coefficient equal to 2,
but with higher utility values resulting from setting the risk-free rate to successively higher values. Of course,
any investor, regardless of risk aversion, would like to receive a higher return for the same risk. The utility of
these risk-indifference curves is that they allow the selection of the optimum portfolio out of all those that are
attainable by combining these curves with the efficient frontier. Where 1 of the curves intersects the efficient
frontier at a single point is the portfolio that will yield the best risk-return trade-off for the risk that the investor
is willing to accept.

In the graph below, risk-indifference curves are plotted along with the investment opportunity set of
attainable portfolios. Data points outside of the investment opportunity set designate portfolios that are not
attainable, while those portfolios that lie along the northwest boundary of the investment opportunity set is the
efficient frontier. All portfolios that lie below the efficient frontier have a risk-return trade-off that is inferior to
those that lie on the efficient frontier. If a utility curve intersects the efficient frontier at 2 points, there are a
number of portfolios on the same curve that lie below the efficient frontier; hence they are not optimal.
Remember that all points on a risk-indifference curve are equally attractive to the investor; therefore, if any
points on the indifference curve lie below the efficient frontier, then no point on that curve can be an optimum
portfolio for the investor. If a utility curve lies wholly above the efficient frontier, then there is no attainable
portfolio on that utility curve.

However, there is a utility curve such that it intersects the efficient frontier at a single point—this is
the optimum portfolio. The only attainable portfolio is on the efficient frontier, and thus, provides the greatest
satisfaction to the investor. The optimum portfolio will yield the highest return for the amount of risk that the
investor is willing to take
These risk-indifference curves were calculated with the utility formula, setting the risk aversion coefficient to 2.
Note that there is a point where 1 utility curve intersects the efficient frontier at a single point—this is the
optimum portfolio for someone with a moderate amount of risk aversion. Portfolios on higher utility curves are
not attainable and those on lower utility curves have risk-return trade-offs that are worse than the optimum
portfolio. For instance, on the red curve representing a utility of 6, there is a point on that curve that offers a
slightly higher return than the optimum portfolio, but at a much greater risk, so it is not as satisfying as the
optimum portfolio. A risk-lover might accept that small return for the much greater risk, which is why the risk-
indifference curves of risk-lovers are relatively flat while risk-averse investors have curves that are much
steeper.

'Sharpe Ratio'

The Sharpe Ratio is a measure for calculating risk-adjusted return, and this ratio has become the industry
standard for such calculations. It was developed by Nobel laureate William F. Sharpe. The Sharpe ratio is
the average return earned in excess of the risk-free rate per unit of volatility or total risk. Subtracting the risk-
free rate from the mean return, the performance associated with risk-taking activities can be isolated. One
intuition of this calculation is that a portfolio engaging in “zero risk” investment, such as the purchase of
U.S. Treasury bills (for which the expected return is the risk-free rate), has a Sharpe ratio of exactly zero.
Generally, the greater the value of the Sharpe ratio, the more attractive the risk-adjusted return.

The Sharpe ratio has become the most widely used method for calculating risk-adjusted return; however, it can
be inaccurate when applied to portfolios or assets that do not have a normal distribution of expected returns.
Many assets have a high degree of kurtosis ('fat tails') or negative skewness. The Sharp ratio also tends to fail
when analyzing portfolios with significant non-linear risks, such as options or warrants. Alternative risk-
adjusted return methodologies have emerged over the years, including the Sortino Ratio, Return Over Maximum
Drawdown (RoMaD), and the Treynor Ratio.

Modern Portfolio Theory states that adding assets to a diversified portfolio that have correlations of less than
one with each other can decrease portfolio risk without sacrificing return. Such diversification will serve to
increase the Sharpe ratio of a portfolio.

Sharpe ratio = (Mean portfolio return − Risk-free rate)/Standard deviation of portfolio return

The ex-ante Sharpe ratio formula uses expected returns while the ex-post Sharpe ratio uses realized returns.

Applications of the Sharpe Ratio

The Sharpe ratio is often used to compare the change in a portfolio's overall risk-return characteristics when a
new asset or asset class is added to it. For example, a portfolio manager is considering adding a hedge fund
allocation to his existing 50/50 investment portfolio of stocks which has a Sharpe ratio of 0.67. If the new
portfolio's allocation is 40/40/20 stocks, bonds and a diversified hedge fund allocation (perhaps a fund of funds),
the Sharpe ratio increases to 0.87. This indicates that although the hedge fund investment is risky as a
standalone exposure, it actually improves the risk-return characteristic of the combined portfolio, and thus adds
a diversification benefit. If the addition of the new investment lowered the Sharpe ratio, it should not be added
to the portfolio.

The Sharpe ratio can also help explain whether a portfolio's excess returns are due to smart investment decisions
or a result of too much risk. Although one portfolio or fund can enjoy higher returns than its peers, it is only a
good investment if those higher returns do not come with an excess of additional risk. The greater a portfolio's
Sharpe ratio, the better its risk-adjusted performance has been. A negative Sharpe ratio indicates that a risk-less
asset would perform better than the security being analyzed.

'Treynor Ratio'

The Treynor ratio, also known as the reward-to-volatility ratio, is a metric for returns that exceed those that
might have been gained on a risk-less investment, per each unit of market risk. The Treynor ratio, developed by
Jack Treynor, is calculated as follows:

(Average Return of a Portfolio – Average Return of the Risk-Free Rate)/Beta of the Portfolio

In essence, the Treynor ratio is a risk-adjusted measurement of a return, based on systematic risk. It is a metric
of efficiency that makes use of the relationship that exists between risk and annualized risk-adjusted return.

Sharpe Ratio

The Treynor ratio shares similarities with the Sharpe ratio. The difference between the two metrics is that the
Treynor ratio utilizes beta, or market risk, to measure volatility instead of using total risk (standard deviation).

How the Treynor Ratio Works

Ultimately, the ratio attempts to measure how successful an investment is in providing investors compensation,
with consideration for the investment’s inherent level of risk. The Treynor ratio is reliant upon beta – that is, the
sensitivity of an investment to movements in the market – to judge risk. The Treynor ratio is based on the
premise that risk inherent to the entire market (as represented by beta) must be penalized,
because diversification will not remove it.

When the value of the Treynor ratio is high, it is an indication that an investor has generated high returns on
each of the market risks he has taken. The Treynor ratio allows for an understanding of how each investment
within a portfolio is performing. It also gives the investor an idea of how efficiently capital is being used.

Limitations

The Treynor ratio does not include any added value gained from active portfolio management. It is simply a
ranking criterion. A list of portfolios ranked based on the Treynor ratio is useful only when considered
portfolios are actually sub-portfolios of a larger, fully diversified portfolio. Otherwise, portfolios with varying
total risk, but identical systematic risk, will be ranked or rated exactly the same.

Another weakness of the Treynor ratio is its backward-looking nature. Investments will almost inevitably
perform differently in the future than they did in the past. For example, a stock carrying a beta of 2 will not
typically be twice as volatile as the market indefinitely. By the same token, a portfolio can’t be expected to
generate 12% returns over the next decade all because it generated 12% returns over the last 10 years.

'Jensen's Measure'

The Jensen's measure is a risk-adjusted performance measure that represents the average return on a portfolio or
investment above or below that predicted by the capital asset pricing model (CAPM) given the portfolio's or
investment's beta and the average market return. This metric is also commonly referred to as Jensen's alpha, or
simply alpha.

To accurately analyze the performance of an investment manager, an investor must look not only at the
overall return of a portfolio, but also at the risk of that portfolio to see if the investment's return compensates for
the risk it takes. For example, if two mutual funds both have a 12% return, a rational investor should prefer the
fund that is less risky. Jensen's measure is one of the ways to determine if a portfolio is earning the proper return
for its level of risk. If the value is positive, then the portfolio is earning excess returns. In other words, a positive
value for Jensen's alpha means a fund manager has "beat the market" with his stock picking skills.

Given a beta of 1.2, the mutual fund is expected to be riskier than the index, and thus earn more. A positive
alpha in this example shows that the mutual fund manager earned more than enough return to be compensated
for the risk he took over the course of the year. If the mutual fund only returned 13%, the calculated alpha would
be -0.8%. With a negative alpha, the mutual fund manager would not have earned enough return given the
amount of risk he was taking.

Difference between Sharpe and Treynor

The Sharpe ratio aims to reveal how well an equity investment portfolio performs as compared to a risk-free
investment. The common benchmark used to represent a risk-free investment is U.S. Treasury bills or bonds.
The Sharpe ratio calculates either the expected or the actual return on investment for an investment portfolio (or
even an individual equity investment), subtracts the risk-free investment's return on investment, and then divides
that number by the standard deviation for the investment portfolio. The primary purpose of the Sharpe ratio is to
determine whether you are making a significantly greater return on your investment in exchange for accepting
the additional risk inherent in equity investing as compared to investing in risk-free instruments.

The Treynor ratio also seeks to evaluate the risk-adjusted return of an investment portfolio, but it measures the
portfolio's performance against a different benchmark. Rather than measuring a portfolio's return only against
the rate of return for a risk-free investment, the Treynor ratio looks to examine how well a
portfolio outperforms the equity marketas a whole. It does this by substituting beta for standard deviation in the
Sharpe ratio equation, with beta defined as the rate of return that is due to overall market performance. For
example, if a standard stock market index shows a 10% rate of return, that constitutes beta; an investment
portfolio showing a 13% rate of return is then, by the Treynor ratio, only given credit for the extra 3% return
that it generated over and above the market's overall performance. The Treynor ratio can be viewed as
determining whether your investment portfolio is significantly outperforming the market's average gains.

Definition of 'Mutual Fund'

Definition: A mutual fund is a professionally-managed investment scheme, usually run by an asset management
company that brings together a group of people and invests their money in stocks, bonds and other securities.

Types of mutual funds

Categorisation by maturity period

Open-ended fund/scheme

An open-ended fund or scheme is one that is available for subscription and repurchase on a continuous basis.
These schemes do not have a fixed maturity period. Investors can conveniently buy and sell units at Net Asset
Value (NAV) related prices which are declared on a daily basis. The key feature of open-end schemes is
liquidity.

Close-ended fund/scheme

A close-ended fund or scheme has a stipulated maturity period eg five and seven years. The fund is open for
subscription only during a specified period at the time of launch of the scheme. Investors can invest in the
scheme at the time of the initial public issue and thereafter they can buy or sell the units of the scheme on the
stock exchanges where the units are listed. In order to provide an exit route to the investors, some close-ended
funds give an option of selling back the units to the mutual fund through periodic repurchase at NAV related
prices. SEBI Regulations stipulate that at least one of the two exit routes is provided to the investor ie either
repurchase facility or through listing on stock exchanges. These mutual funds schemes disclose NAV generally
on weekly basis.

Categorisation by investment objective

A scheme can also be classified as growth scheme, income scheme, or balanced scheme considering its
investment objective. Such schemes may be open-ended or close-ended schemes as described earlier. Such
schemes may be classified mainly as follows:

Growth/Equity oriented schemes

The aim of growth funds is to provide capital appreciation over the medium to long- term. Such schemes
normally invest a major part of their corpus in equities. Such funds have comparatively high risks. These
schemes provide different options to the investors like dividend option, capital appreciation, etc and the
investors may choose an option depending on their preferences. The investors must indicate the option in the
application form. The mutual funds also allow the investors to change the options at a later date. Growth
schemes are good for investors having a long-term outlook seeking appreciation over a period of time.
Income/Debt oriented scheme

The aim of income funds is to provide regular and steady income to investors. Such schemes generally invest in
fixed income securities such as bonds, corporate debentures, Government securities and money market
instruments. Such funds are less risky compared to equity schemes. These funds are not affected because of
fluctuations in equity markets. However, opportunities of capital appreciation are also limited in such funds. The
NAVs of such funds are affected because of change in interest rates in the country. If the interest rates fall,
NAVs of such funds are likely to increase in the short run and vice versa. However, long term investors may not
bother about these fluctuations.

Balanced fund

The aim of balanced funds is to provide both growth and regular income as such schemes invest both in equities
and fixed income securities in the proportion indicated in their offer documents. These are appropriate for
investors looking for moderate growth. They generally invest 40-60 per cent in equity and debt instruments.
These funds are also affected because of fluctuations in share prices in the stock markets. However, NAVs of
such funds are likely to be less volatile compared to pure equity funds.

Money Market or Liquid fund

These funds are also income funds and their aim is to provide easy liquidity, preservation of capital and
moderate income. These schemes invest exclusively in safer short-term instruments such as treasury bills,
certificates of deposit, commercial paper and inter-bank call money, government securities, etc Returns on these
schemes fluctuate much less compared to other funds. These funds are appropriate for corporate and individual
investors as a means to park their surplus funds for short periods.

Gilt fund

These funds invest exclusively in government securities. Government securities have no default risk. NAVs of
these schemes also fluctuate due to change in interest rates and other economic factors as is the case with
income or debt oriented schemes.

Index funds

Index funds replicate the portfolio of a particular index such as the BSE Sensitive index, S&P NSE 50 index
(Nifty), etc These schemes invest in the securities in the same weightage comprising of an index. NAVs of such
schemes would rise or fall in accordance with the rise or fall in the index, though not exactly by the same
percentage due to some factors known as "tracking error" in technical terms. Necessary disclosures in this
regard are made in the offer document of the mutual fund scheme.

There are also exchange traded index funds launched by the mutual funds which are traded on the stock
exchanges.

Sector specific funds/schemes

These are the funds/schemes which invest in the securities of only those sectors or industries as specified in the
offer documents. Eg Pharmaceuticals, Software, Fast Moving Consumer Goods (FMCG), Petroleum stocks, etc
The returns in these funds are dependent on the performance of the respective sectors/industries. While these
funds may give higher returns, they are more risky compared to diversified funds. Investors need to keep a
watch on the performance of those sectors/industries and must exit at an appropriate time. They may also seek
advice of an expert.

Tax saving schemes

These schemes offer tax rebates to the investors under specific provisions of the Income Tax Act, 1961 as the
Government offers tax incentives for investment in specified avenues. Eg Equity Linked Savings Schemes
(ELSS). Pension schemes launched by the mutual funds also offer tax benefits. These schemes are growth
oriented and invest pre-dominantly in equities. Their growth opportunities and risks associated are like any
equity-oriented scheme.

Load or no-load fund

A load fund is one that charges a percentage of NAV for exit. That is, each time one sells units in the fund, a
charge will be payable. This charge is used by the mutual fund for marketing and distribution expenses. A no-
load fund is one that does not charge for exit. It means the investors can exit the fund/scheme at no additional
charges are payable on sale of units.

Assured return scheme

Assured return schemes are those schemes that assure a specific return to the unit holders irrespective of
performance of the scheme. A scheme cannot promise returns unless such returns are fully guaranteed by the
sponsor or AMC and this is required to be disclosed in the offer document. Investors should carefully read the
offer document whether return is assured for the entire period of the scheme or only for a certain period. Some
schemes assure returns one year at a time and they review and change it at the beginning of the next year.

Systematic Investment Plan (SIP)

It is an investmentvehicle offered by mutual funds to investors, allowing them to invest small amounts

periodically instead of lump sums. The frequency of investment is usually weekly, monthly or quarterly.

As the investor is getting more units when the price is low and less units when the price is high, in the long run,
the average cost per unit is supposed to be lower.
SIP claims to encourage disciplined investment. SIP's are flexible, the investors may stop investing a plan
anytime or may choose to increase or decrease the investment amount. SIP is usually recommended to retail
investors who do not have the resources to pursue active investment.
SIP investment is a good choice for those investors who do not possess enough understanding of financial
markets. The benefits of SIP is it reduces the average cost of units purchased, as well as consistent investment,
ensures that no opportunity is missed arising out of the market
SIP, for instance, allows you to invest with 10 periodic investments of ₹1,000 each, instead of investing
₹10,000 at one go in a mutual fund. You can invest the money monthly or quarterly without changing your
other financial liabilities. It’s important to understand the rupee-cost averaging concept and the power of
compounding for better appreciating how SIPs work. SIPs have brought mutual funds within the reach of
ordinary people because it enables those with a tight budget to invest ₹500 , or ₹1,000 per month or any amount
they are comfortable with.

SIPinELSSfund

ELSS is a type of diversified equity mutual fund qualified for tax exemption under Section 80C of the Income
Tax Act. Investors have an option to start SIPs of a specific amount in such funds for certain duration. Experts
advise investors to opt for monthly SIPs, which helps them participate in the stock market without trying to time
it, and also brings discipline to their investments. Investors can choose the growth. 

TimetakentostartanSIP

All open-ended ELSS schemes allow investors to make investments through SIPs. Some fund houses allow you
to choose any day of the month for the SIP. Investors just need to fill an application form along with SIP and
ECS mandates, and submit it to the fund house. It generally takes about 21 to 30 days for the bank to register
your ECS mandate. You can also set up an SIP online. 

TenureofSIP
Since investors are looking to stagger their investments over the entire financial year, the SIP should be for a
tenure of at least one year. Fund houses stipulate a minimum time frame of six months for an SIP. Investors can
do an SIP for a certain period or even opt for the perpetual option, which means the SIP will continue till the
investor gives an instruction to the fund house to stop it. 

ELSS

ELSS (Equity Linked Savings Scheme) is a type of diversified equity mutual fund which is qualified for tax
exemption under section 80C of the Indian Income Tax Act, and offers the twin-advantage of capital
appreciation and tax benefits. It comes with a lock-in period of three years.

RE-INVESTMENT PLAN

On declaration of dividend, mutual fund scheme under the dividend reinvestment plan re-invests the dividend
amount on an immediate basis into units of the same scheme at the net asset value (NAV) for a given day. So,
units held in the investor's mutual fund portfolio increase with every dividend. As in the dividend payout option,
declaration of the dividend results in the fall in the value of NAV and hence additional units are bought at ex-
dividend NAV by the fund.

TAX IMPLICATIONS

Long-term capital gains arising on the transfer of units of an 'equity oriented' mutual fund is exempt from
income tax, if the Securities Transaction Tax (STT) is paid on this transaction i.e., the transfer of such units
should be made through a recognized stock exchange in India (or such units should be repurchased by .

FACTORS INFLUENCING MUTUAL FUNDS

1. Risk Tolerance
There is an inverse relationship between risk and return. Risk is the probability of a negative outcome, while
return is compensation for taking on that risk.For example, a bond fund typically carries relatively lower risk
and therefore a lower rate of return. You can determine your risk tolerance by taking a risk profile test.

2. Fund Performance

Mutual funds are required to compare performance to a benchmark index. For example, a core stock fund would
most likely be compared to the S&P 500 Index.If your fund has a five-year average return of 12 percent, you
might consider that a good return on its own. However, if the S&P 500 has a five-year average return of 15
percent, your fund is actually underperforming. There are different benchmarks for different types of funds.

3. Fund Size
Usually the size of the fund doesn't affect returns, but there are instances where a fund can be either too small or
too large for its own good.For example, in 1999 Fidelity's Magellan Fund reached $100 billion in assets. The
fund was so large that whenever the fund bought or sold stocks, it automatically pushed the prices of those
stocks up or down.On the flip side, if a smaller fund has strong short-term performance, it can attract more
investors, potentially leaving the manager with more cash than it can find quality securities to invest in. The
more cash that isn't invested, the lower the return of the fund.

4. Fees
Mutual funds make their money by charging investors fees. Some funds charge a sales fee, called a load fee,
which can be assessed either when you buy or sell fund shares.Such fees are usually between 3 percent and 6
percent, with a cap at 8.5 percent. All funds typically charge an annual fee called an expense ratio, which is
made up of management fees, administration costs, and promotion and sales activity.The average expense
ratio is 1.25 percent. However there are brokers, such as Vanguard, who charge as little as 0.19 percent.

5. Turnover Rate
The turnover rate represents how often the fund manager keeps stocks in the fund's portfolio. A mutual fund
incurs costs every time it makes a transaction, which is passed on to the investors.This means that the more
often a manager buys and sells portfolio securities, the higher your expenses and capital gains taxes. If a fund
has a turnover of 100 percent, its manager essentially buys a whole set of new securities every year. Ideally, a
fund's turnover rate should be as close to 0 percent as possible.

6. Fund Type
Depending on your time horizon and objective, there are different types of mutual funds to consider. For
example, a long-term investor might be more interested in a growth fund that has a high risk, high reward
profile. This is because short-term losses will likely be made up for by long-term gains.If the investor is seeking
a long-term investment but is fairly risk-averse, he should choose a balanced fund with a healthy mix of high-
risk and low-risk securities. Finally, if the investor has a short-term income need, investing in a mutual fund that
consists of government and corporate debt can provide that at a low risk.

7. Timing

It's important to understand that timing mutual funds (not to be confused with market timing) is generally
frowned upon. The idea of making a quick profit by buying low and selling high in the short term is contrary to
the purpose of a mutual fund, which is typically used as a long-term investment.Mutual fund timing has a
negative effect on other investors in the fund in the form of higher fees due to the short-term trading transaction
costs. Therefore, many mutual funds impose what's called a redemption fee to discourage timing.This penalty
applies to sales of funds that are not held for a minimum amount of time specified by the fund, ranging from 90
days to a year. As a long-term investor, investing in a fund with a redemption fee can protect your returns from
mutual fund timers.