Performance of Mutual Funds

1Risk factors in scheme documents

Every Scheme Information Document lists risk factors. General risks apply to all schemes: liquidity, interest rate, reinvestment, political and economic risk, settlement and counterparty risk. The sponsor is not liable for losses beyond its initial contribution.

Specific risks depend on what the scheme holds:

• Equity: price volatility; mid and small caps can be hard to sell.
• Derivatives: they are leveraged: a small margin gives a large exposure, so small price moves can cause large gains or losses. Other risks include counterparty, liquidity and basis risk.
• Debt: interest rate, credit, reinvestment and rating migration (downgrade) risk.
• Securitised debt: depends on the loan pool. A low loan-to-value (LTV) ratio and good seasoning (many instalments already repaid) mean lower risk. Credit enhancement gives limited loss cover so investors are paid on time even if collections fall short.
• Repo (lending against corporate bonds): counterparty risk, reduced by over-collateralisation (the collateral is worth more than the loan).
• Segregated portfolios: investors may get value only if the issuer repays, and listed units may trade far below NAV.

Example A pool of home loans where borrowers paid 30% upfront (LTV 70%) and have paid 5 years of EMIs is safer than a pool with LTV 90% and only 6 months of EMIs paid.

Remember

• Derivatives = leverage. Securitised debt: low LTV + good seasoning = lower risk.
• Repo risk reduced by over-collateralisation.

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2Market risk vs company-specific risk

Systematic (market) risk affects all securities: recessions, interest rate changes, elections. It cannot be diversified away. Unsystematic (company-specific) risk affects one company or industry and can be reduced by diversification. An equity fund manager can reduce systematic risk only by moving out of the market, for example holding more cash, within the scheme's allowed asset allocation.

Exam trap Adding more stocks or choosing only large caps does not remove market risk.

Example A fund holds 60 stocks across 15 sectors. One company's fraud barely dents the NAV, but a nationwide market fall of 15% pulls almost every holding down.

Remember

• Diversification removes company-specific risk, not market risk.

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3What drives equity fund returns

Equity fund managers follow different styles:

• Growth: companies expected to grow earnings fast; high P/E and PEG, low dividend yield. Tends to do well in bull markets.
• Value: companies priced below their intrinsic value by fundamental analysis. Tends to do better in falling markets and over long periods.
• Top-down: economy → sector → company. Bottom-up: pick strong companies whatever their sector, so a good company can be chosen even if its sector is out of favour.

Common ratios: EPS = profit ÷ shares; P/E = price ÷ EPS; PEG = P/E ÷ earnings growth rate (below 1 looks cheap for its growth; above 1, expensive); P/B = price ÷ book value per share; dividend yield = dividend per share ÷ price.

Example A share has a P/E of 20 and expected earnings growth of 15%. PEG = 20 ÷ 15 = 1.33, so it looks relatively expensive for its growth.

Exam trap A value investor buys because the price is below intrinsic value, not because the share price is low in rupees.

Remember

• Growth: high P/E, fast earnings growth. Value: below intrinsic value.
• PEG = P/E ÷ growth.

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4What drives debt fund returns

Two things drive debt fund returns: interest rates and credit spreads. Bond prices move opposite to interest rates, and longer-duration bonds move more. If a bond's credit rating improves, the market accepts a lower spread, so its price rises.

Funds such as liquid, money market, ultra short and floater funds earn mainly from interest (accrual). Long-duration and gilt funds also gain or lose from price changes.

Example A fund manager expects interest rates to rise. She shifts the portfolio to floating-rate bonds and shorter-maturity bonds, which lose less when rates rise.

Remember

• Rates up → bond prices down; longer duration = bigger effect.
• Rating upgrade → spread narrows → price rises.

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5Gold and real estate funds

Gold funds depend on the international gold price and the rupee–dollar rate (a weaker rupee raises rupee gold prices). Gold is seen as a safe haven: its price tends to rise in political or economic turmoil. Real estate funds depend on local property markets, the economy, infrastructure and interest rates. They are riskier than most other fund types, but less risky than buying property directly.

Example In a year when the international gold price is flat but the rupee weakens 5% against the dollar, a gold ETF in India still gains about 5%.

Remember

• Gold: global price × exchange rate; safe haven in turmoil.

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6Measuring returns

Formula Simple return = (Ending value − Starting value) ÷ Starting value

Formula Annualised return = Simple return × 12 ÷ months held

Formula CAGR = (Ending value ÷ Starting value)^(1 ÷ years) − 1

Simple and annualised returns ignore compounding. CAGR (compounded annual growth rate) is the steady yearly rate that would turn the starting value into the ending value. Returns based only on the change in NAV are wrong for schemes that paid IDCW, because the pay-out reduced the NAV; SEBI's method assumes IDCW is reinvested.

Example ₹1,00,000 grows to ₹1,61,051 in 5 years. CAGR = (1.61051)^(1/5) − 1 = 10% a year. The simple return is 61.05%.

Exam trap For an IDCW-paying scheme, a return calculated only from NAV change understates the true return.

Remember

• CAGR is the correct multi-year measure.
• Account for IDCW paid out.

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7How funds may show returns

Only an assured returns scheme with a guarantor named in the SID may promise a return. Otherwise, no scheme may promise or guarantee returns.

Example An advertisement says "12% assured every year" for an equity fund. That is not allowed; only an assured returns scheme with a guarantor named in the SID may promise a return.

Remember

• No promised returns, except assured return schemes with a named guarantor.

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8The investor's actual experience

An investor's own return is often lower than the scheme's published return, because of exit loads, taxes and the timing of the investor's own money going in and out. Rolling returns (the average of returns over many overlapping periods) give a fairer picture than a single start and end date.

Risks investors themselves face:

• Debt funds: low interest rate risk does not mean zero credit risk; the 2018–19 credit events hurt even some liquid and ultra-short funds. Matching the holding period with the fund's portfolio maturity reduces interest rate risk.
• Equity funds: a forced sale in a market fall locks in losses. Keeping near-term needs in liquid funds avoids this.
• Arbitrage funds: not completely risk-free; some strategies and their debt holdings involve views that can go wrong.

Example Suresh needs ₹3 lakh in six months for a wedding. Keeping it in a liquid fund avoids having to sell equity funds if the market happens to be down then.

Remember

• Investor return < scheme return (loads, tax, timing).
• Rolling returns reduce start/end date bias.

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9Measuring risk

• Variance and standard deviation: how widely returns swing around their average; a measure of total risk (volatility).
• Beta: how much a fund moves relative to the market. Beta 1.2 means it tends to move 20% more than the market. Used for equity funds.
• Modified duration: how sensitive a debt fund's NAV is to interest rate changes (the professional measure).
• Weighted average maturity: the average maturity of the bonds, weighted by holding (the simpler measure).
• Credit rating profile: shows a debt portfolio's credit risk.

Example A fund has beta 1.3. If the market falls 8%, the fund is expected to fall about 1.3 × 8% = 10.4%.

Example 60% of a debt fund is in 5-year bonds and 40% in 2-year bonds. Weighted average maturity = 0.6 × 5 + 0.4 × 2 = 3.8 years.

Remember

• Standard deviation = total risk. Beta = risk relative to the market.
• Modified duration = interest rate sensitivity.

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10Protecting investors when credit problems hit

When a debt fund holds a bond that runs into trouble, investors who redeem first could leave the bad bond to those who stay. Two tools deal with this:

• Gating (restricting redemptions): allowed only in exceptional situations such as market-wide illiquidity, for at most 10 working days in 90 days, with the AMC and trustee boards' approval. During a restriction, the first ₹2 lakh of each redemption request is paid normally.
• Segregated portfolio (side pocket): on a credit event, the bad bond is moved to a separate portfolio. Existing investors get the same number of units in it as they hold in the main portfolio. The main portfolio carries on normally; investors get money from the side pocket if and when the issuer pays.

Example During a restriction, an investor asks to redeem ₹5 lakh. ₹2 lakh is paid normally; the other ₹3 lakh is subject to the restriction.

Exam trap New investors do not get units of the segregated portfolio; only those holding units when it is created do.

Remember

• Gating: up to 10 working days in 90; first ₹2 lakh not restricted.
• Side pocket: same number of units to existing holders.

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11What a benchmark is and who picks it

A benchmark is an index that represents what a scheme invests in. It must match the scheme's objective, asset allocation and strategy, and it must be calculated and published independently. The AMC chooses it in consultation with the trustees and discloses it in the SID; any change must be justified and documented.

Example A large-cap fund that returned 14% looks good, but if its benchmark, the Nifty 50 TRI, returned 16%, it actually underperformed.

Remember

• Benchmark chosen by the AMC with the trustees; changes justified and documented.

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12Price Return Index vs Total Return Index

A Price Return Index (PRI) tracks only price changes. A Total Return Index (TRI) also includes dividends, as if they were reinvested. Since February 2018, schemes are benchmarked against TRI, because scheme returns include dividends too. This made comparisons fairer, and fewer schemes appeared to beat their benchmarks. If TRI data is not available for part of the period, a composite is used: PRI until TRI starts, TRI thereafter.

Exam trap TRI does not exclude dividends and is not easier to beat; it is harder, because it is higher than the PRI.

Example In a year the Nifty 50 price index rose 10% and companies paid about 1.5% in dividends. The TRI rose about 11.5%, so a fund that returned 11% beat the PRI but lagged the TRI.

Remember

• TRI includes dividends; used since February 2018.

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13Choosing the right benchmark

Under SEBI's two-tier framework, the Tier-1 benchmark reflects the category and an optional Tier-2 benchmark reflects the fund manager's style or strategy within the category.

Example A banking sector fund compared with the Nifty 500 would look wrong in years when banks and the broad market move differently. Nifty Bank is the right yardstick.

Remember

• The benchmark must match what the scheme actually holds.
• Tier-1 = category; Tier-2 = style.

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14Risk-adjusted performance

Comparing returns alone ignores risk: a manager may have earned more simply by taking more risk. Risk-adjusted measures fix this:

Example A scheme returned 11% with a standard deviation of 12.5%, and the risk-free rate is 6%. Sharpe = (11 − 6) ÷ 12.5 = 0.40.

Example Risk-free 6%, market 11%, beta 1.1, scheme return 12%. Expected return = 6 + 1.1 × (11 − 6) = 11.5%. Alpha = 12 − 11.5 = 0.5%.

Exam trap Sharpe ratios should be compared only among similar schemes; an equity fund's Sharpe cannot be meaningfully compared with a debt fund's.

Remember

• Sharpe: total risk; Treynor: beta; Alpha: excess over expected.
• Compare like with like.

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15Tracking error

Tracking error is the standard deviation of the difference between a scheme's returns and its benchmark's returns. For an index fund it should be close to zero, because the fund is meant to copy the index. For an active fund, a low tracking error means its performance stays close to the benchmark.

Exam trap Tracking error is a standard deviation of excess returns, not the expense ratio or the beta.

Example Two Nifty index funds both returned close to the index. Fund A's daily returns stray little from the index (tracking error 0.05%); Fund B's stray more (0.30%). Fund A is copying the index more closely.

Remember

• Index funds: tracking error should be near zero.

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16Reading performance disclosures

The product label tells a distributor whether a scheme suits an investor: its objective, asset class, suggested holding period and risk level (risk-o-meter). Discrete annual returns (year by year) show how consistent the performance has been across different market conditions; a strong 5-year CAGR can hide one exceptional year.

Factsheets also link scheme performance to the economy. For example, a persistently high fiscal deficit means more government borrowing, which tends to push interest rates up; and low interest rates abroad tend to bring foreign money into emerging markets like India.

Example Two funds both have a 5-year CAGR of 12%. Fund A returned 10–14% every year; Fund B returned 40% once and was flat in other years. The discrete annual returns reveal that Fund A was far more consistent.

Remember

• Product label = suitability at a glance.
• Discrete annual returns show consistency.

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