STUDY NOTES FOR NISM SERIES XIX-B: ALTERNATIVE INVESTMENT FUNDS (CATEGORY III) DISTRIBUTORS

Chapter 6: Fees Structure, Fund Performance and Benchmarking (Part 5 of 5)

1. Risk-Adjusted Return Metrics and Performance Measures

Raw returns do not provide a complete picture of an Alternative Investment Fund's (AIF's) performance. Because Category III AIFs employ leverage, short selling, and complex derivative strategies, it is essential to evaluate their returns relative to the level of risk taken. Risk-adjusted performance measures allow investors to compare the returns of a Category III AIF with its peers and benchmarks by standardising the risk element.

1.1 The Sharpe Ratio

The Sharpe ratio calculates how a Category III AIF compensates an investor for the total risk taken by investing in the fund. It computes the excess return earned by the fund over the risk-free rate, per unit of the portfolio's total volatility (measured by its standard deviation).

The Sharpe Ratio Formula:

Sharpe Ratio = (Rp - Rf) / sigma_p

Where:

• Rp = Expected Portfolio Return
• Rf = Risk-free Return (such as T-bills or Government Securities)
• sigma_p = Portfolio Standard Deviation (representing total risk)

Operational Interpretation:

• ** Sharpe ratios greater than 1 are preferable**.
• A higher Sharpe ratio indicates that the fund provides a better risk-adjusted return, meaning the manager is generating superior returns per unit of total volatility.
• When comparing two funds against the same benchmark, the one with the higher Sharpe ratio provides a higher return for the same amount of risk, or the same return for a lower level of risk.

1.2 The Treynor Ratio

The Treynor ratio computes the excess return earned by the fund over the risk-free rate, per unit of systematic risk (non-diversifiable market risk) taken by the fund, as defined by its portfolio Beta (beta).

The Treynor Ratio Formula:

Treynor Ratio = (Rp - Rf) / beta

Where:

• Rp = Expected Portfolio Return
• Rf = Risk-free Return
• beta = Portfolio Beta (measuring systematic sensitivity to the market)

Operational Interpretation:

• The Treynor ratio is based on the premise that the risk premium generated by an investment manager of a Category III AIF should not be compared with the total risk (which includes diversifiable unsystematic risk), but rather with the risk that cannot be diversified away.
• A high Treynor ratio value indicates that the investment offers a relatively high return for the market risks it carries.
• Comparison Note: For a well-diversified portfolio, the Sharpe Ratio and Treynor Ratio results may provide highly similar or identical relative rankings because the portfolio's total risk is dominated by systematic market risk. However, for undiversified portfolios, the results are likely to differ.

1.3 Practical Numerical Illustration (Sharpe vs. Treynor)

Consider the performance data for three funds managed by Investment Manager PQC:

• Risk-free rate (364-day T-bill rate): 5.60%

1. Growth Fund:

• Expected Return (Rp) = 24.50%
• Standard Deviation (sigma_p) = 3.35%
• Beta (beta) = 3.50

Calculations:

• Sharpe Ratio = (24.50% - 5.60%) / 3.35% = 18.90% / 3.35% = 5.64
• Treynor Ratio = (24.50% - 5.60%) / 3.50 = 18.90% / 3.50 = 5.40

2. Diversified Fund:

• Expected Return (Rp) = 13.25%
• Standard Deviation (sigma_p) = 1.05%
• Beta (beta) = 1.01

Calculations:

• Sharpe Ratio = (13.25% - 5.60%) / 1.05% = 7.65% / 1.05% = 7.29
• Treynor Ratio = (13.25% - 5.60%) / 1.01 = 7.65% / 1.01 = 7.57

3. Long-Short Fund:

• Expected Return (Rp) = 19.30%
• Standard Deviation (sigma_p) = 2.26%
• Beta (beta) = 1.95

Calculations:

• Sharpe Ratio = (19.30% - 5.60%) / 2.26% = 13.70% / 2.26% = 6.06
• Treynor Ratio = (19.30% - 5.60%) / 1.95 = 13.70% / 1.95 = 7.03

Comparative Strategic Analysis:

• Diversified Portfolio Symmetries: For the Diversified Fund, the Sharpe and Treynor ratios are nearly identical (7.29 vs. 7.57) because its Beta (1.01) is extremely close to its total risk standard deviation (1.05%).
• Risk-Adjusted Outperformance: Comparing the Growth Fund and the Long-Short Fund, the Growth Fund has a higher absolute expected return (24.50% vs. 19.30%). However, the Long-Short Fund is a superior risk-adjusted investment because it achieves a higher Sharpe Ratio (6.06 vs. 5.64) and a higher Treynor Ratio (7.03 vs. 5.40) due to its significantly lower risk profile.

2. Downside Risk Metrics

Standard deviation treats all deviations from the mean—both positive and negative—identically. However, investors are primarily concerned with negative deviations (losses). Therefore, managers utilize specific downside risk metrics to isolate loss potential.

2.1 Maximum Drawdown (MDD)

Maximum Drawdown is the peak-to-trough decline in the Assets under Management (AUM) of a Category III AIF during a specific reporting period. It is quoted as a percentage of the peak value (highest AUM) achieved during that period.

Maximum Drawdown Formula:

MDD = (Trough Value - Peak Value) / Peak Value

Operational Characteristics:

• Loss Isolation: MDD measures the extent of the greatest peak-to-trough loss in a portfolio before a new peak value is successfully created.
• Key Limitations: MDD does not take into consideration the frequency of large losses, nor does it indicate the length of time it will take for an investor to recover the loss.
• Perspective and Benchmarking: While a zero drawdown is ideal, MDD must be evaluated in the context of the time period selected and the drawdown of a suitable market benchmark over the exact same period.

Case Study Analysis (Fund PQR vs. NIFTY50):

During the market dislocation of Q1 2020 (quarter ending March 31, 2020), the following data was recorded:

• Fund PQR (AUM): Peak Value = Rs. 632.33 crore; Trough Value = Rs. 545.61 crore
• NIFTY50 (Index Value): Peak Value = 12430.50; Trough Value = 7610.25

Calculations:

• Fund PQR MDD = (545.61 - 632.33) / 632.33 = -13.71%
• NIFTY50 MDD = (7610.25 - 12430.50) / 12430.50 = -38.78%

Interpretation:

Although Fund PQR suffered a substantial drawdown of -13.71%, it significantly outperformed its benchmark, NIFTY50, which crashed by -38.78%. This demonstrates that the fund successfully managed its downside risk, experiencing less than half the decline of the overall market during a major systemic downturn.

2.2 Value at Risk (VaR)

Value at Risk (VaR) is a statistical measure used to quantify the maximum expected loss of a Category III AIF over a specified time frame and at a pre-defined confidence level.

Real-World Example:

If a Category III AIF has a 95% one-month VaR of Rs. 1 crore, this mathematically means:

• There is a 95% probability that the fund's losses over the next month will not exceed Rs. 1 crore.
• Conversely, there is only a 5% probability (100% - 95%) that the fund's losses over the next month will exceed Rs. 1 crore.

Operational Meaning:

VaR modeling assists managers in identifying the potential scale of losses and their probability of occurrence. While investors prefer a VaR close to zero, they should evaluate the metric across competing funds to select the one with the lowest VaR over a defined time period, commensurate with their risk appetite.

3. SEBI Performance Benchmarking Policies

To ensure transparency, standardization, and fair performance presentation, SEBI has implemented a comprehensive performance benchmarking framework for the AIF industry.

3.1 Operational Guidelines for Performance Benchmarking (SEBI Framework)

• Frequency: Performance Benchmarking must be conducted on a half-yearly basis based on data as of September 30 and March 31 of each financial year.
• Eligibility and Exclusion: AIFs or schemes that have completed at least one year from the date of First Close are mandatorily required to provide their historical cash flow and scheme-wise valuation data to the registered Benchmarking Agencies.
• Auditing Status: The data provided for March 31 must be audited, whereas the data provided for September 30 may be unaudited.
• Base of Reporting: The performance reporting and benchmarking of AIFs must be carried out on the pre-tax Net Asset Value (NAV) of the scheme.
• Currency Standardization: The performance data and benchmarks must be reported in both INR and USD terms.
• Reporting Output: Benchmarking Agencies are required to provide a Performance Benchmark Report to individual AIFs or schemes, comparing them directly against the relevant industry benchmarks.
• Customization: Benchmarking Agencies can create customized Performance Reports at the specific request of an AIF or scheme, provided they outline the calculation basis clearly.

3.2 Selecting the Appropriate Benchmark

Under SEBI guidelines, benchmarks must be selected based on objectively verifiable parameters such as the instrument of investment, target market capitalization, and sector focus.

4. Key Terms for Exam Reference

• Sharpe Ratio: A risk-adjusted return metric that measures excess return earned per unit of total risk (standard deviation).
• Treynor Ratio: A risk-adjusted return metric that measures excess return earned per unit of systematic, non-diversifiable risk (Beta).
• Maximum Drawdown (MDD): The largest peak-to-trough drop in a fund's AUM within a specified timeframe, indicating maximum downside risk.
• Value at Risk (VaR): A statistical measure quantifying the maximum expected loss over a specific period at a defined confidence level (e.g., 95% or 99%).
• Performance Benchmarking Agencies: Independent third-party entities appointed to compile AIF cash flows and valuation data to generate industry benchmarks.
• Pre-tax Net Asset Value: The base valuation used for benchmarking purposes under SEBI guidelines, before deducting investor-level taxes.

5. Self-Assessment Practice Questions

Question 1

A Category III AIF reports an Expected Return of 18%. The portfolio's Standard Deviation is 3.00% and its Beta is 1.50. Assuming a risk-free rate of 6%, what are the Sharpe and Treynor ratios for the fund?

A) Sharpe Ratio = 4.00; Treynor Ratio = 8.00
B) Sharpe Ratio = 6.00; Treynor Ratio = 12.00
C) Sharpe Ratio = 4.00; Treynor Ratio = 12.00
D) Sharpe Ratio = 6.00; Treynor Ratio = 8.00

Answer: A
Explanation:
Excess Return = 18% - 6% = 12%.
Sharpe Ratio = 12% / 3.00% = 4.00.
Treynor Ratio = 12% / 1.50 = 8.00.

Question 2

Under SEBI's performance benchmarking guidelines, which of the following datasets must be audited when submitted by an eligible AIF to a Benchmarking Agency?

A) Data as of September 30
B) Data as of March 31
C) Both September 30 and March 31 data must be audited
D) Auditing is voluntary for all reporting periods

Answer: B
Explanation: SEBI guidelines state that data provided for March 31 of every year shall be audited, whereas data for September 30 may be unaudited.

Question 3

If a Category III AIF has a 99% one-month Value at Risk (VaR) of Rs. 2 crore, what does this indicate to an investor?

A) There is a 99% probability that the fund will lose exactly Rs. 2 crore next month
B) There is a 1% probability that the fund will lose more than Rs. 2 crore over the next month
C) The fund is guaranteed to limit its absolute lifetime losses to Rs. 2 crore
D) The fund has a 99% probability of losing more than Rs. 2 crore next month

Answer: B
Explanation: A 99% confidence level VaR of Rs. 2 crore means there is a 99% probability that losses will not exceed Rs. 2 crore, leaving a 1% probability (100% - 99%) of losses exceeding that threshold.