Risk Return Analysis of 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 u nderlining 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

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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 they’ve 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 fund’s 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 fund’s 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 fu nd’s returns fluctuate from month to month, the greater its standard deviation. Standard deviation allows a fund’s 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 fund’s

volatility against a benchmark. In other words, it is a statistical measure that shows how sensitive a fund is to  benchmark’s movement. If the sensex moves by 25 percent, a fund’s beta number  will tell you whether the fund’s 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 )β Where EARp = Equilibrium average return. Difference between equilibrium average return and return of portfolio indicates superior  performance of the fund. This called alpha (α) α= r p - 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. Treynor’s 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 ) β

Greater value of the portfolio over the risk free ind icates 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………………….R 12)1/12

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1

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 (r f ) 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 doesn’t 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

5817.32

5638.16

-0.0308

June 2011

5644.23

5686.26

0.007447

July 2011

5717.27

5531.7

-0.03246

August 2011

5568.18

5062.17

-0.09088

September 2011

5132.47

4995.67

-0.02665

Oct 2011

4950.13

5334.14

0.077576

Nov 2011

5295.02

4831.73

-0.0875

Dec 2011

4938.91

4598.21

-0.06898

Jan 2012

4616.42

5202.65

0.126988

Feb2012

5198.68

5406.46

0.039968

Mar 2012

5393.04

5315.15

-0.01444

April 2012

5320.66

5268.41

-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

Rf 

May 2011

8.201

June 2011

8.318

July 2011

8.236

August 2011

8.166

September 2011

8.341

Oct 2011

8.518

Nov 2011

8.743

Dec 2011

8.259

Jan 2012

8.200

Feb2012

8.506

Mar 2012

8.447

April 2012

8.341

Risk free return (Rf )

=

0.696361

ICICI

PRUDENTIAL

BANKING

&

FINANCIAL

GROWTH

MONTHS

NAV

RETURN

April 2011

18.7800

May 2011

18.20000

0.969116

June 2011

18.4300

1.012637

July 2011

18.2400

0.989691

August 2011

15.7800

0.865132

September 2011

15.7000

0.99493

Oct 2011

16.5100

1.051592

Nov 2011

14.4000

0.872199

Dec 2011

13.2400

0.919444

Jan 2012

16.3000

1.231118

Feb2012

17.1300

1.05092

Mar 2012

17.1400

1.000584

April 2012

17.2900

1.008751

Average Return

0.997176

Compounded

-0.00686

Return

rp

= -0.00686

SERVICES

FUND-RETAIL-

SD

= 0.095778

Beta (β) = 1.408844

rm

= -0.9632

rp- rf 

Sharpe’s Ratio =

SD =

-0.00686-0.696361 0,095778

=

Treynor’s Ratio

-7.342164728

=

rp- rf  β

= -0.00686-0.696361 1.40884396 = -0.49915 Jenson’s alpha (α) = rp- { rf +

βp (rm- rf }

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

ICICI PRUDENTIAL FMCG (G)

MONTHS

NAV

RETURN

April 2011

68.4600

May 2011

69.0100

1.008033

June 2011

74.1000

1.073757

July 2011

78.9300

1.065182

August 2011

77.0500

0.976181

September 2011

76.6900

0.995328

Oct 2011

79.3800

1.035076

Nov 2011

76.3300

0.961577

Dec 2011

75.5200

0.989388

Jan 2012

76.4300

1.01205

Feb2012

78.9400

1.032841

Mar 2012

85.2400

1.079807

April 2012

91.1200

1.068982

Average Return

1.02485

Compounded Return

0.024104

rp

= 0.024104

SD

= 0.040567

Beta (β) = 0.23717243

rm

= -0.9632

rp- rf 

Sharpe’s Ratio =

SD

=

0.024104- 0.696361 0.040567

= -16.57138706

Treynor’s Ratio

rp- rf 

=

β

=

0.024104 -0.696361 0.23717243

=

-2.834465204

Jenson’s alpha (α) = rp- { rf +

βp (rm- rf }

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

ICICI PRUDENTIAL INFRASTRUCTURE (GROWTH)

MONTHS

NAV

April 2011

29.7700

May 2011

28.5700

0.959690

June 2011

28.7800

1.00735

July 2011

28.3700

0.985754

August 2011

25.8400

0.910821

September 2011

25.1800

0.974458

Oct 2011

26.0700

1.035346

Nov 2011

23.7500

0.911009

Dec 2011

22.0400

0.928

Jan 2012

25.2300

1.144737

Feb2012

26.5000

1.050337

Mar 2012

25.1800

0.950189

April 2012

24.6900

0.98054

Average Return

RETURN

0.98652

Compounded Return

-0.01658

rp SD

= -0.01658

= 0.066743

Beta (β) = 0.98659093

rm

= -0.9632

rp- rf 

Sharpe’s Ratio =

SD =

Treynor’s Ratio =

-10.68181266

rp- rf  β

= -0.722630804

Jenson’s alpha (α) = rp- { rf +

βp (rm- rf }

= 0.924366838

RISK MEASUREMENT IN MUTUAL FUNDS

  e   m   e    h   c    S

   D    S

ICICI Banking & financial services ICICI FMCG ICICI Infrastructure

  e   u    l   a    V   a    t   e    B

  p

   R

  m

   f

  o    i    t   a    R   e   p   r   a    h    S

  a    h   p    l    A    S    '   n   o   s   n   e    J

  o    i    t   a    R   s    '   r   o   n   y   e   r    T

   R

   R

-0.9632

0.69636

-7.34216

-0.49913

1.63484

0.04056 0.23717243 0.024104 -0.9632

0.69636

-16.57138

-2.83446

-0.27865

0.06674 0.98659093

0.69636

-10.68181

-0.72264

0.92436

0.09577 1.40884396 -0.00686

-0.01658 -0.9632

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 Fund’s performance is inferior when compared in othe r  funds. Systematic Risk – Beta (β) of Selected Mutual Funds Portfolio

Beta value

Market(β)

Risk free

ICICI Banking & financial servicesGrowth

1.40884396 1

0

ICICI FMCG-Growth

0.23717243 1

0

ICICI Infrastructure-Growth

0.98659093 1

0

Systematic risk of market is always one, systematic risk of risk free investment is Zero. Here the β 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.

Treynor’s Ratio of Selected Mutual Funds Sl No

Fund

Treynor’s Ratio

1

ICICI Banking & financial services-Growth

-0.49913

2

ICICI FMCG-Growth

-2.83446

3

ICICI Infrastructure-Growth

-0.72264

All the schemes have negative value as per Treynor’s 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. Jenson’s alpha (α) of Selected Mutual Funds Sl No

Fund

Jenson’s alpha

1

ICICI Banking & financial services-Growth

1.63484

2

ICICI FMCG-Growth

-0.27865

3

ICICI Infrastructure-Growth

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 Treynor’s ratios in all cases, as per Jensen’s 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 al pha, Sharpe & Treyner’s ratios.