Comprehensive Guide to the Performance of Mutual Funds (Chapter 7)

Understanding the performance of mutual fund schemes is vital for investors to make informed decisions and for distributors to provide suitable recommendations. This chapter explores the methodologies for calculating returns, the impact of costs like exit loads, and the various risks associated with mutual fund investments. Furthermore, it details how risk-adjusted returns and benchmarks are used to evaluate fund manager efficacy.

7.1 Calculation of Returns of Mutual Fund Schemes

The return on a mutual fund investment is determined by comparing the initial cost or starting value (outflow) with the earnings (inflows) over a specific period. These inflows encompass periodic payouts like dividends and interest, as well as capital gains or losses from changes in the security's value, even if they remain unrealised.

7.1.1 Simple Return

Simple return represents the basic percentage change in an investment's value over time.

• Formula: [(Later Value - Initial Value) / Initial Value] x 100.
• Example: If an investor enters at a Net Asset Value (NAV) of Rs. 12 and it later rises to Rs. 15, the simple return is 25%.

7.1.2 Annualized Return

Annualization is necessary to compare the performance of different investment options that have existed for varying time periods.

• Formula: (Simple Return x 12) / Period of Simple Return (in months).
• Example: A 5% return earned over 6 months equates to a 10% annualized return, whereas a 3% return earned over 4 months equates to a 9% annualized return.

7.1.3 Compounded Annualized Growth Rate (CAGR)

For investment periods exceeding one year, total return can be misleading, making Compounded Annualized Growth Rate (CAGR) the preferred measure. CAGR accounts for the "compounding effect," where returns earned during a period are reinvested to earn further returns.

• Significance: While the difference between simple and compound interest may be marginal initially, it becomes substantial over longer durations.

7.1.4 Total Return

Total return provides a comprehensive view of performance by including both capital appreciation (or losses) and dividends received.

• Calculation: [(End Value - Begin Value) + Dividend] / Begin Value x 100.
• Regulatory Standard: SEBI prescribes using the CAGR technique for total return calculations when dividends are paid and compounding must be considered.

7.2 Concept of Loads and Their Impact on Transactions

While SEBI has banned entry loads, exit loads remain permitted and are applied by many schemes. These loads act as a "drag" on the investor's actual returns.

• Exit Load Application: If an investor redeems units worth a NAV of Rs. 15 but an exit load of 1% applies, they receive only Rs. 14.85.
• Transaction Price: For calculating investor returns, the transaction price used is the NAV minus Exit Load.
• Regulation on Promises: Mutual funds cannot promise specific returns unless the scheme is an "assured returns scheme" with a named guarantor in the Scheme Information Document (SID).

7.3 Risk in Mutual Fund Investments

Investing in mutual funds carries inherent risks, including the potential loss of principal. The NAV of a scheme can fluctuate due to broader market movements, changes in government policy, or specific security performance.

Key Types of Investment Risk

• Liquidity Risk: The difficulty of selling securities at a fair price due to low trading volumes or settlement delays.
• Interest Rate Risk: Fixed-income security prices generally fall when interest rates rise and vice versa.
• Re-investment Risk: The risk that cash flows from an investment may be reinvested at lower interest rates than originally assumed.
• Credit Risk: The possibility that an issuer of a debt instrument will default on interest or principal payments.
• Equity Risk: Volatility in share prices driven by company-specific or sector-wide developments.
• Political and Economic Risk: Adverse impacts from changes in the political climate, fiscal deficits, or a slowdown in national economic growth.
• Currency Risk: For foreign investors, the risk that fluctuations in exchange rates will reduce the value of their Rupee-denominated investments.

Systematic vs. Unsystematic Risk

1. Systematic Risk (Market Risk): Economy-wide factors like inflation that affect the entire market and cannot be mitigated through diversification.
2. Unsystematic Risk (Company-Specific Risk): Factors like labor strikes that affect specific firms; this risk can be reduced through portfolio diversification.

Risk Disclosure: All mutual fund communications must include the standard warning: "Mutual fund investments are subject to market risks, read all scheme related documents carefully".

7.4 Risk-Adjusted Returns

Evaluating returns in isolation is insufficient; they must be measured against the risk taken to achieve them. Consistently performing actively managed funds should outperform their benchmark in rising markets and decline less in falling markets.

Common Risk-Adjusted Measures

• Sharpe Ratio: Measures the "risk premium" (Return of scheme - Risk-free return) per unit of total risk (Standard Deviation). A higher Sharpe Ratio indicates a better performing scheme for the risk taken.
• Treynor Ratio: Similar to Sharpe, but uses Beta (market risk) as the measure of risk. This is primarily used for comparing diversified equity schemes.
• Tracking Error: Specifically relevant for index funds, it measures the consistency of the fund's performance relative to its benchmark. A good index fund aims for a very low tracking error.

7.5 Scheme Benchmarks

A benchmark is a pre-defined comparable used to assess a scheme's performance. A credible benchmark must align with the scheme's investment objective, asset allocation, and investment strategy.

Benchmarking Regulations

• TRI vs. PRI: Since February 2018, all mutual fund schemes must be benchmarked against the Total Return variant of an Index (TRI), which includes dividends and interest, rather than the Price Return variant (PRI). This ensures a fairer comparison as schemes themselves earn dividends from their holdings.
• Two-Tier Structure: SEBI notified a two-tiered structure for benchmarking in 2021.
  • Tier-1 Benchmark: Reflective of the broad scheme category (e.g., NIFTY 100 for Large Cap Funds).
  • Tier-2 Benchmark: Demonstrative of the specific investment style or strategy of the fund manager (e.g., Nifty 50 Index).

Benchmark Types by Scheme

Key Terms to Remember

• NAV (Net Asset Value): The true worth of a unit of a scheme.
• Standard Deviation: A measure of total risk/volatility in the Sharpe Ratio.
• Beta: A measure of systematic risk used in the Treynor Ratio.
• Risk-Free Rate (Rf): Usually measured by the T-Bill index.
• Mark to Market (MTM): Valuing portfolio securities at current market prices daily.

Key Takeaways for the Exam

1. CAGR is the standard for long-term return representation.
2. Exit loads reduce the final return for the investor compared to the stated scheme return.
3. TRI is mandatory for benchmarking to account for dividend reinvestment.
4. Investors are only rewarded for taking systematic (non-diversifiable) risk according to finance theory.
5. Sharpe Ratio allows for comparison of risk-adjusted performance across similar scheme types.