Drivers of Returns and Performance in Mutual Fund Schemes (Part 3)

The performance of a mutual fund is not accidental; it is driven by a combination of market forces, economic factors, and the specific strategies employed by fund managers. Understanding these drivers is essential for evaluating whether a fund's success is sustainable or merely a result of broader market movements.

1. Systematic vs. Unsystematic Risks

Every investment is exposed to two primary types of risk that influence its total return profile:

• Systematic Risk (Market Risk): These are risks that impact the entire economy or market. They cannot be avoided through diversification. Examples include changes in government policy, inflation, or global economic shifts.
• Unsystematic Risk (Company-Specific Risk): These risks are unique to a specific company or industry. They involve factors like a company's business performance, management changes, or sector-specific challenges. Diversifying a portfolio across different companies and sectors can effectively mitigate these risks.

Key Concept: Mutual funds are "pass-through" vehicles, meaning all investment risks are passed directly to the investor. While professional management aims to reduce unsystematic risk, the investor still carries the market risk inherent in the underlying securities.

2. Fundamental and Technical Analysis in Equity Schemes

Fund managers use two main disciplines to identify securities that will generate high returns while keeping risks low:

Fundamental Analysis

This involves a deep study of a firm’s business health and its financial statements. The goal is to identify securities that align with the scheme's strategy and offer high potential for investment returns at a low risk. Managers look at earnings, competitive advantages, and industry health to determine the "intrinsic value" of a stock.

Technical Analysis

This approach focuses entirely on price behaviour and market trends. Technical analysts believe that past price movements and trading volumes indicate future price directions and reflect overall investor sentiment. This is often used for shorter-term tactical moves within a portfolio.

3. Key Valuation Ratios for Equity Analysis

To determine if a stock is undervalued or overvalued, analysts use several critical ratios. These are vital for understanding the "price" one pays for a company's earnings:

• Price to Earnings (P/E) Ratio: Calculated as Market Price per share / Earnings Per Share (EPS). It indicates how much investors are willing to pay for every rupee of a company's earnings.
• Price Earnings to Growth (PEG) Ratio: This relates the P/E ratio to the company’s expected earnings growth. A ratio of 1 suggests fair valuation; less than 1 suggests the stock is undervalued, while greater than 1 suggests it may be overvalued.
• Book Value per Share: Calculated as Net Worth / Number of equity shares outstanding. It represents the historical value of each share according to the company’s books.
• Price to Book Value (P/B) Ratio: Calculated as Market Price per share / Book Value per share. It shows how much the market pays compared to the accounting value of the company’s assets.
• Dividend Yield: Calculated as Dividend per share / Market price per share. This is a measure of the cash payout received relative to the investment. Conservative investors often use this to identify steady, lower-risk equity options.

4. Investment Styles and Portfolio Building

Fund managers typically adopt specific styles and approaches to construct their portfolios:

Growth vs. Value Styles

• Growth Style: Focuses on high-growth stocks of companies expected to grow much faster than the average market rate.
• Value Style: Focuses on "picking up" stocks priced lower than their intrinsic value. The belief is that the market has not yet appreciated certain aspects of the company’s value.

Top-Down vs. Bottom-Up Approaches

• Top-Down Approach: The manager first evaluates broad economic factors, then narrows down to suitable industries, and finally selects individual companies.
• Bottom-Up Approach: The manager starts by analysing company-specific factors first, then evaluates the industry, and finally considers the macro-economic impact.

Key Takeaways

Important Terms

• Systematic Risk: Risks impacting the entire market that cannot be diversified away.
• Unsystematic Risk: Company or industry-specific risks that can be reduced through diversification.
• Fundamental Analysis: Evaluating a company's financial health to determine its true value.
• Intrinsic Value: The actual value of a company based on its assets and earnings potential, regardless of its current market price.
• Dividend Yield: The percentage return an investor receives from a company's dividend payments.