CHAPTER 10

Risk, Return and Performance of Funds

Simple & Easy-to-Understand Revision Notes

Learning Objectives
• General and Specific risk factors in mutual funds
• Factors affecting mutual fund performance for different scheme types
• Drivers of returns and risk in a scheme
• Measures of returns (Simple, Annualized, Compounded, CAGR)
• SEBI norms regarding representation of returns by mutual funds
• Risks in fund investing from an investor's perspective
• Various risk measures (Variance, Standard Deviation, Beta, Duration, Credit Rating)
• Certain provisions with respect to Credit Risk — Gating and Segregated Portfolios

10.1 General and Specific Risk Factors

• Every investment involves taking and managing various risks. It is important to understand which risks you
are exposed to and how to manage them.
• When you invest through a mutual fund, the fund manager manages SOME of the risks. The structure of
mutual funds controls some others. But certain risks still remain with the investor directly.
• The Scheme Information Document (SID) of any mutual fund lists all risks clearly under two broad
categories: (1) Standard/General Risk Factors, and (2) Specific Risk Factors.
• Standard risks apply to ALL mutual fund investments. Specific risks are unique to individual asset
categories (e.g., credit risk for debt, currency risk for foreign investments).
• The SID also discusses risk mitigation strategies for each type of risk.

10.1.1 General Risk Factors (Applicable to All Mutual Fund Schemes)

• Investing in mutual fund units involves risks such as trading volumes, settlement risk, liquidity risk, default
risk, and the possible loss of the original principal amount.
• The value of your investment in a scheme may increase OR decrease, because the prices of the securities
it holds keep changing.
• Apart from the performance of individual securities, the NAV of a scheme can also be influenced by broader
market factors such as: changes in interest rates, changes in currency exchange rates, changes in
government policies, taxation changes, political or economic developments, and increased volatility in stock
and bond markets.
• Past performance of the sponsor, AMC, or mutual fund does NOT guarantee future performance.
• The name of a scheme does NOT indicate the quality of the scheme or its future returns.
• The Sponsor is NOT responsible or liable for any losses from the operation of the scheme beyond the initial
capital contribution made by the Sponsor to set up the mutual fund.

Liquidity Risk:
• Liquidity means how easily you can buy or sell an investment without affecting its price significantly.
• The liquidity of investments in a scheme can be restricted by: trading volumes, settlement periods, and
transfer procedures.
• Although the scheme typically holds securities expected to have high market liquidity, company-specific
events, sector-specific events, or general market events can impact liquidity.
 • Portfolio rebalancing or heavy redemption demands from investors can also cause a price impact.
• Different segments of the Indian financial markets have different settlement periods, which can be extended
significantly in unforeseen circumstances (e.g., if the volume of securities transactions exceeds settlement
capacity).
• If settlement is delayed, the scheme's assets may remain uninvested temporarily — earning no returns
during that period.
• Settlement problems may also cause the scheme to miss investment opportunities (cannot buy) or incur
losses (cannot sell before a price decline).
• Money market securities are fairly liquid but lack a well-developed secondary market, which may restrict
selling ability and cause losses.
• The liquidity of a bond can change based on market conditions, and a security that was liquid can become
illiquid at the time you want to sell it — causing a loss in the portfolio value.
• Even government securities (G-Sec) — which are generally more liquid than other debt instruments — can
face transaction difficulties during extreme market volatility that constricts trading volumes.
• Any adverse change in relevant RBI guidelines could also reduce the scheme's liquidity.

Interest Rate Risk:

• Fixed income securities (government bonds, corporate bonds, money market instruments, and derivatives)
face interest rate risk — also called price risk.
• The basic rule: When interest rates RISE, prices of existing fixed-income securities FALL. When interest
rates DROP, prices of existing fixed-income securities RISE.
• The extent of price change depends on: the coupon rate of the security, the maturity of the security, and the
yield level at which it is currently traded.
• Derivatives also carry the risk of price changes due to movements in interest rates.

Re-investment Risk:
• This is the risk that when cash flows (interest payments) from securities are received, they may have to be
re-invested at a lower interest rate than originally assumed.
• The additional income expected from reinvesting these cash flows (called 'interest on interest') may be
lower if market rates have fallen by then.

Political Risk:
• Investments in India may be materially and negatively affected by political developments — whether at the
central, state, or local government level.
• Actions by the central or state governments could significantly affect the Indian economy, companies,
general business conditions, and the prices and yields of securities held by the scheme.
• Selective unrest or external tensions could destabilise India's political and economic environment,
negatively impacting the securities in the scheme.
• Delays or changes in developing favourable policy frameworks could also negatively impact the securities
held.

Economic Risk:
• A slowdown in economic growth, or macro-economic imbalances (such as rising fiscal deficits at the central
or state level), can adversely affect investments in the country.
• The underlying growth of the economy is expected to directly impact the volume of new investments and
the performance of securities.

Foreign Currency Risk:

• Mutual fund schemes are typically denominated in Indian Rupees (INR), which may differ from the home
currency of Foreign Portfolio Investors (FPIs).
 • When an FPI converts the rupee value of their investment back to their home currency, exchange rate
movements may result in a lower value.
• The AMC does NOT manage currency risk for FPIs. FPIs are solely responsible for managing or reducing
their own currency risk.
• The Sponsor, Fund, Trustees, and AMC are not liable for any losses to foreign investors arising from
exchange rate changes.

Settlement Risk / Counterparty Risk:

• Floating rate assets can be created by swapping a fixed return into a floating rate return. In such a swap,
the counterparty (who pays floating rate and receives fixed rate) may default — this is the counterparty risk.

Risk of Transacting Units on Stock Exchanges:

• For transactions in units of a scheme through stock exchanges, allotment and redemption of units depends
on order processing and settlement by BSE or NSE and their clearing corporations.
• The mutual fund has no control over the stock exchange or its clearing corporation — any delays or failures
on their end will affect the investor.

10.1.2 Specific Risk Factors

Risk Related to Equity and Equity-Related Securities:
• Equity and equity-related securities are volatile — their prices can fluctuate significantly on a daily basis.
• Liquidity can be restricted by trading volumes and settlement periods (which can be extended
unexpectedly).
• Settlement problems can make the scheme miss investment opportunities or incur losses due to inability to
sell before a price decline.
• Value of equity investments can also be affected by: interest rate changes, currency exchange rate
changes, changes in government laws/policies, taxation changes, and political, economic, or other
developments — both at the individual security level and at the broader sector/market level.

Risk Associated with Short-Selling and Stock Lending:

• Securities Lending means lending your securities to a borrower through an approved intermediary for a
specified period. The borrower agrees to return equivalent securities (same type/class) at the end of the
period, along with any corporate benefits (like dividends) that accrued during the period.
• Risks in securities lending: risk of failure of the borrower, loss of rights to the collateral, inability of the
approved intermediary to return your securities, and possible loss of corporate benefits.
• Short-selling means selling shares or securities that the seller does NOT own at the time of the trade. The
short-seller borrows the security from someone who already owns it. Later, the short-seller buys back the
security and returns it to the lender to close the loan.
• Risks in short-selling: Counterparty risk (lender or intermediary fails), and liquidity risk — the security being
short-sold might be illiquid or become illiquid. Covering the position (buying back) might happen at a much
higher price than expected, leading to losses.

Risks Associated with Mid-Cap and Small-Cap Companies:

• SEBI defines the market capitalization spectrum as:
◦ Large-Cap Stocks: The top 100 companies by full market capitalization
◦ Mid-Cap Stocks: 101st to 250th company by full market capitalization
◦ Small-Cap Stocks: 251st company onwards by full market capitalization
• Mid-cap and small-cap investments are based on the belief that these companies can grow faster than
large-cap companies and become more valuable over time.
 • However, there is no guarantee: these companies may not achieve their expected earnings, or unexpected
market changes may adversely affect their performance.
• Historically, as you move down the market cap spectrum (from large to mid to small cap), risk in terms of
price volatility and market liquidity increases.

Risk Associated with Dividends:

• A company is only required to pay a dividend if and when it is declared — there is no guarantee of future
dividends, even if the company has a strong track record of dividend payments.
• Schemes investing in companies that fail to declare or pay dividends (or pay less than expected) may see
their performance affected.
• The profitability of companies varies, and this directly impacts their ability to declare and pay dividends.

Risk Associated with Derivatives:

• Derivatives are specialised instruments requiring different investment techniques and risk analysis
compared to stocks and bonds.
• You need to understand not just the underlying instrument, but also the derivative itself.
• Derivatives are HIGHLY LEVERAGED — they are traded with relatively small margins, but can cause
disproportionate profits OR losses compared to the principal amount.
• Even a small price movement in the underlying security can have a large impact on the value of the
derivative, and therefore on the scheme's NAV.
• The risks associated with derivatives can be GREATER than those of investing directly in securities.

Specific risks within derivatives:

◦ Counterparty Risk: A counterparty fails to honour its contractual obligations, forcing the scheme to deal
with another counterparty at a possibly unfavourable price. For exchange-traded derivatives, the risk is
reduced because the exchange guarantees settlement — but performance risk on the exchange still
remains.
◦ Market Liquidity Risk: The derivative cannot be traded due to limited trading volumes, or the transaction
is completed at a severe price impact.
◦ Model Risk: The risk of incorrect pricing or improper valuation of derivatives.
◦ Basis Risk: Arises from a difference in the price movement of the derivative versus the security being
hedged.
◦ Execution Risk: In some circumstances (insufficient bids, trading suspension due to circuit breakers),
the scheme may face difficulty executing derivative transactions.
◦ Index Futures Risk: Investing in index futures carries the same risks as investing in a portfolio of shares
making up that index. The extent of loss is the same as in the underlying stocks.
◦ Leverage Risk: Derivative products are leveraged — they can provide disproportionate gains as well as
disproportionate losses. The fund manager's ability to identify the right opportunity and execute the
strategy correctly is key; there is no assurance this will always work.
◦ Fixed Income Derivative Risk: Additional risks include interest rate risk and liquidity risk.

Risks Related to Debt Funds:

• Reinvestment Risk: When coupon payments or the principal maturity amount is received, the prevailing
interest rates may be different from the original coupon rate — reducing the total return.
• Rating Migration Risk: A fixed income security's credit rating can change (upgrade or downgrade). A
downgrade (e.g., from AAA to AA+) causes the price of the security to fall and negatively impacts the NAV.
An upgrade has the opposite (positive) effect.
• Term Structure of Interest Rate Risk: The NAV of the scheme (to the extent it is invested in fixed income
securities) will be affected by changes in the general level of interest rates. When interest rates decline,
fixed income portfolio values rise; when rates rise, values fall.
• Credit Risk: Fixed income securities carry the risk that the issuer may not be able to meet interest and/or
principal payments. The Investment Manager tries to manage this through in-house credit analysis.
 ◦ Different securities carry different levels of credit risk. Corporate bonds carry more credit risk than
Government securities. Among corporate bonds, AAA-rated bonds are less risky than AA-rated bonds.
◦ In derivatives, the credit risk (counterparty default risk) is generally small since there is typically no
exchange of the principal amount.

Risk Associated with Floating Rate Securities:

• Spread Risk: In a floating rate security, the coupon is set as a spread (mark-up) over a benchmark rate. If
this spread moves adversely (increases), the value of the security falls — even if the underlying benchmark
rate hasn't changed.
• Basis Risk: If the underlying benchmark of a floating rate security or swap becomes less active or ceases to
exist, it may not accurately capture actual interest rate movements, leading to portfolio losses.

Risk Factors Associated with Repo Transactions in Corporate Bonds:

• In a repo transaction, the scheme lends money against the security of corporate bonds as collateral.
• If the counterparty fails to honour the repurchase agreement (i.e., fails to buy back the bonds), the scheme
may need to sell the collateral. A loss is only realized if the sale price of the collateral is less than the repo
amount.
• This risk is partially reduced by over-collateralisation — the collateral value is kept higher than the repo
amount as a safety buffer.

Risks Associated with Creation of Segregated Portfolio:

• Investors holding units of a segregated portfolio may not be able to sell (liquidate) their holding until the
issuer repays the money.
• Securities in a segregated portfolio may never recover any value.
• Even if units of the segregated portfolio are listed on a stock exchange, this does NOT guarantee liquidity
— there may be very little or no active trading in those units.
• The trading price of segregated portfolio units on the stock exchange may be significantly LOWER than the
prevailing NAV.

Risks Associated with Investments in Securitised Assets:

• Securitisation is a process where a bank, NBFC, housing finance company, or any company sells its loan
receivables (like home loans, auto loans, credit card receivables) to a Special Purpose Vehicle (SPV),
typically set up as a trust.
• The SPV then issues rated instruments called Pass-Through Certificates (PTCs) to investors. The money
collected from investors is paid to the original company (originator).
• Investors in PTCs receive payments from the collections made on the underlying loans.
• The transaction typically includes credit enhancement — a limited buffer to protect investors against
defaults by the underlying borrowers.

Risks based on Asset Class:

• Underlying assets can be commercial vehicles, auto loans, credit cards, home loans, etc. Credit risk
depends on: macro-economic factors of the specific industry, nature and adequacy of collateral, adequacy
of documentation (for auto loans and home loans), and the borrower's credit profile and intentions.

Risks based on Pool Characteristics:

• Size of Loan: Smaller individual loans provide diversification, but very small ticket sizes may make recovery
difficult and costly.
• Loan to Value (LTV) Ratio: This shows how much of the asset's cost is financed by borrowed money. Lower
LTV = lower default risk, because the borrower has more of their own money at stake. Example: For a Rs.
20 lakh truck, a borrower who contributed Rs. 10 lakh (50% LTV) is much less likely to default than one who
contributed only Rs. 2 lakh (10% LTV) — the first borrower risks losing an asset worth Rs. 20 lakh.
 • Original Maturity and Average Seasoning: Original maturity tells you the repayment period. Seasoning tells
you how much of the loan has already been repaid. Higher seasoning = lower risk. Example: A pool where
borrowers have already repaid 80% of instalments without default is much safer than one where only 10%
has been repaid.
• Default Rate Distribution: This shows what percentage of the loan pool is current (up to date), in 0-30 DPD
(Days Past Due), 30-60 DPD, 60-90 DPD, etc. The 60-90 DPD category is clearly higher risk than the 0-30
DPD category.

Credit Rating and Credit Enhancement:

• In securitisation, it is possible to achieve a credit rating HIGHER than the originator's own rating, through a
mechanism called credit enhancement.
• Credit enhancement filters the underlying asset pool using selection criteria to reduce inherent risk,
ensuring investors receive timely payments even if actual collections are lower than expected.
• Since securitisation is generally non-recourse, repayment must come from the underlying assets and the
credit enhancement — not from the originator's other assets.
• Schemes invest mainly in securitisation issuances rated AA and above, indicating high safety from credit
risk at the time of investment.
• However, there is no assurance that the rating will remain the same or won't be downgraded or withdrawn
later.

Other Securitisation Risks:

• Limited Liquidity and Price Risk: The secondary market for securitised papers is not very liquid. There is no
guarantee that a deep secondary market will develop. Even if a secondary market exists, transactions may
happen at a discount to the original issue price due to interest rate changes.
• Limited Recourse and Delinquency Risk: Securitised instruments represent an interest in the underlying
receivables pool. There is no obligation on the issuer, seller, originator, or their affiliates. If credit
enhancement is depleted by delinquencies, investor payouts may be affected. If a borrower persistently
defaults, the servicer may repossess and sell the underlying asset — but repossession may be delayed,
and the sale price may be lower than the amount owed.
• Risk of Prepayment: Full prepayment of an underlying loan can happen if: (a) the borrower pays early, (b)
the seller is required to repurchase the receivable due to a material misrepresentation, or (c) the servicer
classifies the contract as defaulted and sells the repossessed asset. Prepayments can expose investors to
changes in tenor and yield.
• Bankruptcy of Originator: If the originator goes bankrupt and the court finds that the sale of assets to the
trust was not a true sale, investors could face losses or payment delays. Transactions are carefully
structured to ensure the transfer qualifies as a true sale, and legal opinion is obtained on this.
• Bankruptcy of Investor's Agent: If the investor's agent (trustee) goes bankrupt and it is found that the agent
holds assets in its personal capacity (not as agent/trustee), investors could face losses or delays.
Documents are carefully drafted to prevent this, and legal opinions are obtained.
• Risk of Co-mingling: There is a time gap between when the servicer collects payments from borrowers and
when those payments are deposited into the collection account. During this gap, collections may be mixed
with the servicer's own funds. If the servicer fails to remit the collected amounts, investors could suffer
losses. To minimise this risk, the servicer should have the highest credit rating.

Risk Factors Associated with Investments in REITs and InvITs:

• REITs (Real Estate Investment Trusts) and InvITs (Infrastructure Investment Trusts) are exposed to: price
risk, interest rate risk, credit risk, liquidity/marketability risk, reinvestment risk, and risk of lower-than-
expected distributions.
• The distribution (income) paid to investors depends on the net cash flows available. Cash availability
depends on dividends, interest, and principal payments received from the underlying portfolio assets.

Risk Management Strategies (as described in SIDs):

Managing Market Liquidity Risk:
 • The Investment Manager builds a portfolio with adequate liquidity — investing in securities expected to
have high secondary market liquidity.
• Government securities provide good secondary market liquidity. For other long-dated fixed income
securities, focus is on high-quality issuers (e.g., public sector entities).
• Market Liquidity Risk is managed actively within defined portfolio liquidity limits. Primary sources of liquidity
are cash and fixed income securities.

Managing Credit Risk:

• Credit risk is managed by investing in securities issued by borrowers with a good credit profile.
• The credit research process involves detailed in-house analysis and due diligence.
• Exposure limits are set for each issuer (other than the Government of India) — both in terms of amount and
maximum permissible tenure.
• Issuer-level credit review is done both at the time of initial investment and periodically, considering balance
sheet strength and operating performance.

Managing Term Structure of Interest Rate Risk:

• The Investment Manager actively manages the portfolio's duration based on prevailing market conditions.
• Since fixed income investments of most schemes are generally short-duration, this risk is expected to be
small.

Managing Rating Migration Risk:

• Focus is on investing in high-grade and high-quality securities.
• Rigorous due diligence before assigning credit limits, and periodic credit review and monitoring, helps
address company-specific issues.

Managing Re-investment Risk:

• Since fixed income investments are generally short-duration, the impact of re-investment risk is expected to
be small.

Market Risk (Equity):

• The Investment Manager invests in companies after extensive due diligence and research, including: one-
to-one meetings with company management, attending conferences, analyst meets, and tele-conferences.
• Company analysis covers: historical and current financials, potential value creation, capital structure,
business prospects, policy environment, management quality, product profile, brand equity, market share,
competitive advantage, R&D/technology, and corporate governance transparency.

Risk Associated with Floating Rate Securities:

• Due to very low liquidity in floating rate securities and a lack of price discovery, incremental investments in
floating rate securities are kept very limited.

10.2 Factors That Affect Mutual Fund Performance

• Different asset classes have different characteristics. Fund managers adopt different approaches and
strategies, which also impact scheme performance.
• Fund managers take certain risks to try to outperform the scheme's benchmark. This means schemes are
exposed both to the risks of the asset class AND to risks the fund manager chooses to take or avoid.

10.2.1 Systematic Risk vs. Unsystematic Risk

Company-Specific (Unsystematic) Risk:
• Risks that impact a SPECIFIC company — not the broader market. Example: A labour strike in one factory
is a company-specific risk.
• Also called firm-specific risk or diversifiable risk.
 • CAN be reduced through diversification — spreading investments across many different companies.

Market (Systematic) Risk:

• Risks that impact the ENTIRE economy — affecting all businesses. Example: A rise in inflation is a
systematic risk.
• Also called market risk or non-diversifiable risk.
• CANNOT be reduced through diversification.
• Fund managers cannot reduce systematic risk except by moving out of the market. Some managers may
tactically move between equity and cash based on their market view.
• However, SEBI regulations impose limits on how much cash a scheme can hold — so there is a limit to how
much systematic risk can be reduced.
• Some fund managers choose to stay fully invested at all times and do not try to reduce systematic risk.
They believe the investor chose the scheme understanding its risks.
• Finance theory states: Investors are rewarded ONLY for taking non-diversifiable (systematic) risk, NOT for
taking diversifiable (unsystematic) risk.
• Fund managers adopt active management strategies to outperform the benchmark. To do this, they must
take views on individual securities — which necessarily involves unsystematic risk.

Understanding 'Mutual fund investments are subject to market risks':

• This regulatory disclaimer appears in all mutual fund marketing communications because mutual fund is a
pass-through vehicle — ALL investment risks are passed on to the investor.
• This is different from a bank fixed deposit, where the company promises a fixed return regardless of how it
uses the money. In an FD, if the company can't pay, that is the investor's credit risk. In a mutual fund, the
investor owns the fund and directly bears the risk of underlying investments.
• Diversification can protect against credit risk (individual company defaults). A diversified mutual fund offers
this protection automatically.
• However, MARKET-WIDE price fluctuations CANNOT be managed by diversification. If the entire market
falls, the fund's NAV will fall.
• Equity (growth) funds invest in volatile markets — so NAV will fluctuate significantly. Overnight funds invest
in stable instruments — so NAV is very stable.
• Key distinction: Market-wide price fluctuation (affects all securities at once) vs. individual security price
fluctuation (affects only specific securities). Diversification helps with the latter, NOT the former.
• It is NOT the mutual fund that carries the risk — it is the underlying investments. Mutual funds pass on
some risks and reduce others through diversification and management.

10.3 Drivers of Returns and Risk in a Scheme

• The portfolio is the main driver of returns in a mutual fund scheme.
• The following factors determine risk and return: asset class in which the fund invests, segment/sectors of
the market the fund focuses on, styles used to select securities, and strategies used to manage the
portfolio.

10.3.1 Factors Affecting Performance of Equity Schemes

• Equity represents a growth investment — returns come primarily from appreciation in the value of the asset.
• Risk arises because returns from equity are NOT fixed or defined — they can be volatile from period to
period.
• Returns from equity are linked to the earnings of businesses. Not all businesses succeed. Therefore,
careful analysis of a business and its prospects is essential before investing.
• Investors must also continually evaluate whether their holdings remain profitable and worthy of investment.
• To generate returns superior to the benchmark, the fund manager must construct a portfolio that is different
from the benchmark — either for the full portfolio or part of it, either always or at certain times.
Two Primary Strategies:
• Security Selection: Choosing high-quality securities likely to perform well in the future, while avoiding those
with poor prospects.
• Market Timing: Timing the entry and exit into a market or a specific security to capture price upsides and
avoid downsides.

Two Types of Analysis:

Fundamental Analysis:
• A study of a company's business and financial statements to identify securities suitable for the scheme's
strategy — those with high return potential and low risk.
• Best suited for security selection and long-term investment decisions.
• Involves reviewing: financial statements, management quality, competitive position in its product/service
market, etc.
• Analysts set price targets based on financial parameters such as:
◦ Earnings Per Share (EPS) = Net Profit After Tax ÷ Number of Equity Shares Outstanding. Tells
investors how much profit the company earned for each share.
◦ Price to Earnings Ratio (P/E Ratio) = Market Price Per Share ÷ EPS. Shows how much investors are
willing to pay for each rupee of the company's earnings. Forward P/E is calculated using projected
(future) EPS. A simplistic but faulty view: low P/E = cheap (buy), high P/E = expensive (sell). In reality,
high P/E may reflect good growth prospects; low P/E may reflect poor future performance. P/E ratios
must be recalculated whenever earnings estimates change.
◦ Price Earnings to Growth (PEG) Ratio = P/E Ratio ÷ Earnings Growth Rate. PEG = 1: Fairly valued.
PEG < 1: Undervalued. PEG > 1: Overvalued.
◦ Book Value Per Share = Net Worth ÷ Number of Equity Shares Outstanding. Shows what each share is
worth as per the company's accounting records (historical perspective).
◦ Price to Book Value = Market Price Per Share ÷ Book Value Per Share. Shows how much the market is
prepared to pay relative to the accounting value. Drawback: Book value is an accounting measure and
may not reflect true asset value.
◦ Dividend Yield = Dividend Per Share ÷ Market Price Per Share. Measures the payout received from the
company as a percentage of the share price. Preferred by conservative investors looking for steady
income. High dividend yield results from higher payouts and/or lower market prices. High dividend
payout might also suggest the company has limited reinvestment opportunities. Dividend yields tend to
fall during bull markets and rise during bear markets.

Important Note on Financial Ratios:

• Most financial indicators cannot be viewed as standalone numbers — they must be seen in the context of
each company's unique factors.
• Financial parameters are compared across companies in the same sector to make buy/hold/sell
recommendations.

Technical Analysis:
• Technical analysts believe that a share's past price behaviour throws up trends that indicate its future price
direction.
• Along with past prices, trading volumes indicate the strength of the price trend and reflect investor
sentiment.
• Technical analysts study price-volume charts (hence called 'chartists') to identify: support levels, resistance
levels, breakouts, and other buy/sell/hold triggers.
• Best suited for shorter-term and speculative decisions, including intra-day trading.
• Even when a fundamental analysis decision has been made about a stock, technical analysis can help
decide WHEN to execute that decision.
• General consensus: Long-term investment decisions → Fundamental analysis. Short-term speculative
decisions → Technical analysis.

Investment Styles — Growth vs. Value:

 • Growth Style: Investing in stocks of companies expected to grow much faster than the market. These
stocks are in high demand, so valuations tend to be higher. In a market correction, growth stocks tend to fall
more. Typical characteristics: high P/E, high PEG ratios, lower dividend yield.
• Value Style: Picking stocks priced BELOW their intrinsic value (real worth), based on fundamental analysis.
The belief is that the market has not recognised some aspect of the company's value. When the market
recognises the intrinsic value, the price will rise. These are called 'value stocks.' Investors need a longer
investment horizon for price appreciation.
• Value investors hold a portfolio of value stocks. Stocks where the decision is right can earn very high
returns, more than offsetting losses on wrong decisions.
• Important clarification: 'High valuation' does NOT equal 'high share price'; 'low valuation' does NOT equal
'low share price.' A Rs. 100 share can be reasonably valued; a Rs. 5 share can be overvalued if not
supported by earnings.
• A scheme can be based on growth, value, or a blend of both styles. In the early phase of a bull run, growth
stocks deliver good returns. Later, when growth stocks become costly, value stocks tend to be safer.

Portfolio Building Approach — EIC Framework:

• Analysts consider three levels of factors: Economy (E), Industry (I), and Company (C) — the EIC
framework.
◦ Economic factors: Inflation, interest rates, GDP growth, fiscal and monetary policy, balance of
payments.
◦ Industry factors: Regulations affecting investment/growth, competition, availability of raw materials,
cyclical nature of the industry.
◦ Company-specific factors: Management and ownership structure, financial parameters, products,
market shares.

Top-Down Approach:
• The portfolio manager first evaluates the impact of economic factors, then narrows down to suitable
industries, then selects the best stocks within those industries.
• Minimises the chance of having large exposure to a poor sector.

Bottom-Up Approach:
• The portfolio manager first analyses company-specific factors, then industry factors, then macro-economic
factors.
• Stock selection is the key decision; sector allocation is a result of stock selection.
• Ensures a good stock is picked even if it belongs to a sector that isn't performing well overall.
• Both approaches have merit. What matters is that the chosen approach is implemented professionally.
• Equity returns are therefore a function of: sector selection + stock selection. Investors can also benefit from
secular growth in a diversified equity mix when the economy does well.

10.3.2 Factors Affecting Performance of Debt Schemes

• Two primary risks in debt: (1) Interest Rate Risk, and (2) Credit Risk.
• Yields on debt securities tend to rise as maturity increases (more interest rate risk) or as credit risk
increases.
• A debt investment gives you: regular interest income at a pre-specified frequency, and repayment of the
principal at the end of the pre-specified period (tenor).
• At the end of the tenor, the security matures — this process is called redemption.
• If you sell a debt security BEFORE maturity, you may earn a capital gain (if sold at higher price) or incur a
capital loss (if sold at lower price).
• Debt securities maturing within 1 year are called money market securities.
• Yield to Maturity (YTM): The total return the investor gets if the security is held till maturity.
• Holding Period Return (HPR): A combination of interest received AND capital gain or loss from selling
before maturity.
Types of Debt Issuers:
• Government Securities (G-Sec or Gilt): Issued by the Central/State Government. No credit risk. Lowest
yield in the market for a given tenor.
• Treasury Bills: Short-term debt issued by the Reserve Bank of India (RBI) on behalf of the Government.
• Certificates of Deposit (CDs): Issued by Banks (7 days to 1 year) or Financial Institutions (1 to 3 years).
• Commercial Papers (CPs): Short-term securities (up to 1 year) issued by companies.
• Bonds/Debentures: Generally issued for tenors beyond 1 year. Governments and PSUs issue bonds;
private sector companies issue debentures.
• Credit Spread: The difference between the yield on Gilt and the yield on a non-government debt security of
the same tenor. Non-government issuers offer higher yields because they can default; the government
cannot.
• Credit ratings are assigned by agencies like CRISIL, ICRA, CARE, and Fitch (India Ratings). 'AAA' =
Highest safety. Higher the credit risk, higher the yield.
• Fixed rate securities: Interest is at a pre-specified fixed rate (e.g., 6%).
• Floating rate securities (floaters): Interest rate is linked to a market rate and expressed as 'Base + Spread.'
Example: 5-year G-Sec + 2% means the interest rate will always be 2% above the prevailing 5-year
government securities rate.
• Returns in a debt portfolio are largely driven by: interest rates and credit spreads.

Interest Rates — Inverse Relationship with Bond Prices:

• If you bought a bond yielding 8%, and market yields rise to 9%, your bond becomes less attractive — its
price will FALL.
• If market yields fall, your bond becomes more attractive — its price will RISE.
• There is an INVERSE relationship between yields and the prices of fixed-rate debt securities.
• Example: Company X issued a 5-year debenture with a 9.5% coupon at AAA rating. Two years later, with 3
years remaining to maturity, the market rate for AAA 3-year bonds is 8.5%. Since 9.5% > 8.5%, this
debenture will trade at a PREMIUM (above face value) in the secondary market.
• Longer maturity securities fluctuate MORE than short tenor securities for the same change in interest rates.
• Modified Duration: A measure of how much a debt security's price will change in response to a change in
interest rates. Higher modified duration = greater price volatility = greater interest rate sensitivity.
• Floating rate securities hold their value better when interest rates change, because the coupon itself adjusts
with the market rate.

Portfolio Management Based on Interest Rate Expectations:

• If the fund manager expects interest rates to RISE: Switch to more floating rate securities OR shorter-tenor
fixed rate securities (lower modified duration).
• If the fund manager expects interest rates to FALL: Increase exposure to longer-term fixed rate securities
(higher modified duration).
• Interest rate calls by the fund manager are therefore a KEY driver of returns in a debt fund — unlike equity,
where sector and stock selection calls are key.

Credit Spreads:
• If a company's credit rating improves, the market will accept a lower credit spread. The value of that
company's debt security will increase.
• Accrual Funds (money market, liquid, ultra-short-term, floating rate funds): Focus only on earning interest
income. Hold only short maturity securities with low modified duration — no volatility in values.
• Combination Funds: Seek both coupon income and capital appreciation. Hold a mix of short and long-term
securities. Higher proportion of long-term securities = greater NAV volatility.
• Duration Management: Fund managers with this mandate actively alter the portfolio's duration anticipating
interest rate changes. Increase duration (buy long-term bonds) if rates are expected to fall; decrease
duration (move to short-term) if rates are expected to rise. Risk: the anticipated rate change may not
materialise.
 • Credit Quality Trading: A fund manager can also earn gains by anticipating credit rating upgrades. If an
upgrade happens, the security's value rises. Risk: If the expected upgrade doesn't happen, default risk
rises.
• SEBI regulations define what risks a fund manager may take for each scheme category. For example:
Overnight fund managers MUST invest only in overnight securities — no interest rate risk. Ultra-short-term
debt funds can take credit risk, since SEBI only specifies maturity limits.
• Dynamic Bond Fund: A category where the fund manager actively takes views on interest rate movements
and repositions the portfolio accordingly.

10.3.3 Factors Affecting Performance of Gold Funds

• Gold does NOT generate any income (no interest, no dividend). The only way to make money in gold is by
selling it at a higher price than you paid.
• Gold prices are driven by: the global demand-supply balance, and the general view on gold as an asset.
• Gold is an international commodity. Its value in India depends on: (1) International price of gold (quoted in
foreign currency), (2) Exchange rate (to convert foreign currency to INR), and (3) Import duties on gold.
• Returns in gold depend on:
◦ Global Price of Gold: Gold is considered a safe-haven asset. During political or economic turmoil, gold
prices rise. Central banks and institutions like the IMF hold large gold reserves. When large countries
buy gold, prices rise; when they sell, prices fall.
◦ Strength of the Rupee: Stronger rupee → same foreign currency costs fewer rupees → gold portfolio
value in INR falls → lower gold fund returns. Weaker rupee → gold portfolio value in INR rises → higher
gold fund returns.
• Since gold funds are passive (they simply buy and hold gold), the fund manager does NOT take a view on
gold prices. There is NO risk from fund management decisions.

10.3.4 Factors Affecting Performance of Real Estate Funds

• Real estate is a LOCAL asset — unlike gold, it cannot be transported. Its value is driven by local factors.

Key Factors:
• Economic Scenario: During economic uncertainty or recession, people postpone real estate purchases —
prices weaken. When the economy improves, real estate prices tend to recover.
• Infrastructure Development: Improved infrastructure in an area increases real estate values.
• Interest Rates: When money is cheap and easily available (low interest rates), more people buy real estate
— prices rise. When interest rates rise, the real estate market softens.
• Nature of Real Estate: Performance also depends on the type — residential, commercial, industrial,
infrastructure, warehouse, hotel, or retail.
• Real estate can generate returns in two ways: Rental income (can accrue regularly) and Capital
appreciation (difficult to determine in the short term; may happen over a long period).
• SEBI has mandated that mutual funds use neutral (independent) valuation agencies to determine the
current value of real estate investments.
• Note: Currently, there are NO mutual fund schemes investing directly in real estate in India.

10.4 Measures of Returns

• Returns are calculated by comparing the cost of acquiring an asset (outflow/starting value) to what you earn
(inflows) and computing the rate of return.
• Inflows can be from: periodic payouts (interest, dividends) and gains or losses from changes in value.
• Return calculations for a period consider BOTH income earned AND gains/losses — even if gains/losses
have not been realised yet.
10.4.1 Simple Return
• Formula: Simple Return = [(Later Value − Initial Value) ÷ Initial Value] × 100
• Example: Invested at NAV of Rs. 12; NAV later grew to Rs. 15.
• Simple Return = [(15 − 12) ÷ 12] × 100 = (3 ÷ 12) × 100 = 25%
• Simple return is just the percentage change in the value of an investment over a period of time.

10.4.2 Annualized Return

• Problem with simple return: If Investment 1 gave 5% in 6 months and Investment 2 gave 3% in 4 months,
you can't directly compare them.
• Annualisation converts returns of different durations into an annual equivalent so they can be compared.
• Formula: Annualized Return = (Simple Return × 12) ÷ Period in Months
• Investment 1: (5% × 12) ÷ 6 = 10% per annum
• Investment 2: (3% × 12) ÷ 4 = 9% per annum
• So Investment 1 is better on an annualised basis.
• Limitation: This formula does NOT account for compounding — so it should only be used for short periods
(not multi-year investments).

10.4.3 Compounded Return

• For longer periods (years), you must account for compounding — the effect of 'interest earning interest.'

What is Compounding?
• Example: Rs. 10,000 invested for 3 years at 10% interest compounded annually:
Year Opening Balance (Rs.) Interest (10% on Closing Balance (Rs.)
Opening)
1 10,000 1,000 11,000
2 11,000 1,100 12,100
3 12,100 1,210 13,310

• With compounding, Rs. 10,000 grows to Rs. 13,310 in 3 years.

• With simple interest, it would grow to only Rs. 13,000 (Rs. 1,000 × 3 years added on top of Rs. 10,000).
• The difference (Rs. 310) is the effect of compounding. The longer the period, the bigger this difference gets.
• Formula for Compounded Return: (Later Value ÷ Initial Value) ^ (1 ÷ n) − 1, where n = period in years.
• Example: Rs. 1,000 grew to Rs. 4,000 in 2 years. Compounded Return = (4000 ÷ 1000) ^ (1 ÷ 2) − 1 = 4 ^
0.5 − 1 = 2 − 1 = 1 = 100%. This means the investment doubled each year.

Using NAV for Return Calculation:

• NAV at the beginning of the period = Initial Value
• NAV at the end of the period = Later Value
• Exact number of days ÷ 365 = n (period in years)
• Important: These three formulas (Simple, Annualised, Compounded) only capture the return from NAV
change. They do NOT capture dividends paid during the period.
• If a dividend was paid and NAV dropped, the above formulas will understate the actual return.
• Therefore, these three formulas are only suitable for: Growth schemes (no dividends), or IDCW schemes
where NO dividend was paid during the calculation period.
• When dividends are involved AND compounding is to be considered → Use the CAGR method (prescribed
by SEBI).
10.4.4 Compounded Annual Growth Rate (CAGR)
• CAGR assumes that dividends are re-invested in the same scheme at the ex-dividend NAV.
• This captures both the dividend payment AND the effect of compounding.

CAGR Example — Step by Step:

• Initial investment: Rs. 10,000 at Rs. 10/unit on June 30, 2019 → 1,000 units.
• First dividend (Jan 1, 2020): Re. 1 per unit on 1,000 units = Rs. 1,000. Ex-dividend NAV = Rs. 12.50. Re-
invest: Rs. 1,000 ÷ Rs. 12.50 = 80 additional units. Units now: 1,000 + 80 = 1,080 units.
• Second dividend (Jan 1, 2021): Re. 1 per unit on 1,080 units = Rs. 1,080. Ex-dividend NAV = Rs. 15. Re-
invest: Rs. 1,080 ÷ Rs. 15 = 72 additional units. Units now: 1,080 + 72 = 1,152 units.
• Later value: 1,152 units × Rs. 15 = Rs. 17,280.
• Period: June 30, 2019 to January 1, 2021 = 551 days ÷ 365 = 1.51 years.
• CAGR = (17,280 ÷ 10,000) ^ (1 ÷ 1.51) − 1 = approximately 0.4365 = 43.65% per annum.
• Note: This calculation does NOT account for taxes.

Scheme Returns vs. Investor Returns:

• The above CAGR is the SCHEME return. An investor's actual return may differ because of loads.
• If exit load of 1% applies: Investor receives 99% of Rs. 15 = Rs. 14.85 instead of Rs. 15. This lowers the
investor's CAGR.
• If entry load of 2% applied: Investor bought at Rs. 10.20 (102% of Rs. 10) instead of Rs. 10. This also
lowers returns. (Note: Entry load is no longer permitted.)
• Loads drag investor returns BELOW scheme returns. Taxes further pull down post-tax returns.
• For calculating investor returns (instead of scheme returns): Replace Initial NAV with actual amount paid by
investor (NAV + Entry Load, if any). Replace Later NAV with actual amount received by investor (NAV −
Exit Load, if any).
• Investor returns may also differ from scheme returns if the investor makes additional purchases or partial
redemptions during the period.
• Returns published in mutual fund advertisements do NOT factor in entry or exit loads.

Holding Period Returns and Rolling Returns:

• Holding period returns are calculated for a fixed period: 1 month, 3 months, 1 year, 3 years, or since
inception.
• If the holding period is over 1 year → Use CAGR. If under 1 year → Use simple absolute returns.
• Limitation of holding period returns: If the initial or ending NAV was unusually high or low, the return figure
may be misleading.
• Rolling Returns: The average annualised return calculated for MULTIPLE consecutive holding periods
within an evaluation period. Example: Calculate all consecutive 1-year returns in a 3-year period (rolling
daily, weekly, or monthly), then average them. This gives a more accurate picture of typical performance
and removes the distortion of a single starting/ending point.

Pros and Cons of Evaluating Funds Only on Return Performance:

• Primary selection criterion for most investors: Past returns.
• To make selection more robust, also consider: Consistency of return performance over time, performance
relative to the scheme's benchmark, and performance relative to peer group funds.
• An actively managed fund should: Perform well in rising markets AND fall LESS than the benchmark in
declining markets.
• Return alone is NOT enough for an investment decision. You must also consider: The suitability of the
scheme to the investor's needs, and the risk associated with the scheme.
• Volatility in returns over time indicates the riskiness of the scheme.
10.5 SEBI Norms Regarding Representation of Returns by Mutual Funds
• Mutual funds are NOT permitted to promise or guarantee any returns — UNLESS it is specifically an
'assured returns scheme.'
• Assured returns schemes require a guarantor, who must be named in the SID. If the scheme cannot pay
the assured return, the guarantor is required to make up the difference.
• SEBI has prescribed an Advertisement Code and guidelines for disclosing performance-related information
of mutual fund schemes.

10.6 Risks in Fund Investing — An Investor's Perspective

• The risks discussed in Section 10.1 must be understood from the investor's point of view.
• The distributor must understand the IMPACT of these risks on investors and recommend schemes suitable
to the investor's objectives and situation.

Risks in Equity Funds:

• Investors in equity funds face the risk of price fluctuations.
• As you move from large-cap to mid-cap to small-cap funds, risk INCREASES — in terms of price volatility,
business risk (risk of company failure), and liquidity risk.
• Risks are even higher in focused funds (concentrated portfolios with fewer stocks).
• Result of these risks: The investor's goal of long-term growth may not materialise if returns are lower than
expected.
• However, the presence of risk also increases the return POTENTIAL.
• Investor advice: Invest in equity funds in line with your risk profile. Maintain adequate liquidity through liquid
funds so you don't need to sell equity funds at a bad time (e.g., when markets are down).

10.6.1 Risks in Debt Funds:

• Debt/income funds are often used for portfolio stability or regular income generation.
• Many investors (especially those used to FDs and small savings schemes) are NOT accustomed to price
fluctuations in their debt instruments. However, debt fund NAVs DO fluctuate — due to interest rate
changes or credit rating migrations.
• This means debt funds may not be as stable as some investors expect.
• IDCW (dividend) investors: Dividend is NOT guaranteed. Some schemes have skipped dividends in the
past when distributable surplus was unavailable.
• Liquid, ultra-short-term, and low-duration funds are often used for short-term parking of money. If gating
provisions are applied or a segregated portfolio is created, only partial liquidity may be available.

Risk of Concentration in Debt Funds — Example:

• XYZ Debt Fund holds 5% of NAV in debentures of ABC Ltd. ABC Ltd. defaults.
• If a segregated portfolio is NOT created, and 50% of scheme investors redeem: The fund must sell liquid
securities to fund redemptions. The defaulted ABC Ltd. debenture remains in the portfolio.
• After 50% redemption, the remaining portfolio is smaller. Now ABC Ltd.'s debenture represents 10% of the
smaller portfolio — double the original exposure.
• If more investors panic and redeem, the exposure keeps rising (can reach 20%, 40%, etc.). The remaining
investors face ever-increasing risk from the bad debt.
• This is the key risk that segregated portfolios are designed to prevent.
• Important: In the recent past, even liquid funds, ultra-short-term debt funds, and low-duration funds have
been affected by credit events. This proves that 'LOW risk' does NOT mean 'ZERO risk.'
• As per SEBI (Mutual Funds) Regulations, 1996 and SEBI circular dated December 28, 2018: Every close-
ended scheme (other than ELSS) and units of segregated portfolio must be listed on recognised stock
 exchanges. Schemes that are in the process of winding up can also be listed and traded on the exchange
to provide an exit to investors.

10.6.2 Risks in Hybrid Funds:

• SEBI's scheme categorisation circular defines the asset allocation between equity and debt for various
categories of hybrid funds. Distributors must carefully evaluate schemes before recommending.
• Arbitrage funds are widely believed to be very safe since they use arbitrage strategies that neutralise
exposure to any single security or market direction.
• However, some arbitrage funds have the option to invest in debt securities AND employ strategies like:
paired arbitrage, alpha hedging, or merger arbitrage. In these strategies, the fund manager is taking a
directional VIEW (not pure arbitrage). If the view is wrong, the investor can lose money or earn low returns.

10.6.3 Risk in Gold Funds:

• As an international commodity, gold prices are difficult to manipulate — providing better pricing
transparency.
• Gold performs well when other financial markets are in turmoil — providing a safe-haven benefit.
• When a country goes to war and its currency weakens, gold funds tend to generate excellent returns.
• These two benefits make gold an attractive risk-return proposition.
• Investors in a gold fund must clarify what type of gold fund it is: Gold Sector Fund or Gold ETF.
• Key risk: If gold prices fall, the investor will make a loss.

10.6.4 Risk in Real Estate Funds:

• Every real estate asset is unique — so its valuation is highly subjective.
• Real estate is a less liquid asset class — hard to buy/sell quickly.
• The real estate agent intermediation chain is largely unorganized in India.
• Transaction costs are high — stamp duty, registration fees, etc.
• Regulatory risk is high in real estate, as are the risks of litigation and encumbrances.
• Transparency is low, even among real estate development and construction companies.
• Many real estate groups are family-owned and family-run — poor corporate governance standards increase
investment risk.
• Overall: Real estate funds are quite HIGH risk compared to other scheme types. However, they are still less
risky than DIRECT investment in real estate.

10.7 Measures of Risk

• Risk is measured by fluctuation in returns — the more a scheme's returns vary, the riskier it is.
• To measure risk: First calculate periodic returns (daily, weekly, fortnightly, monthly). Then measure how
much these returns fluctuate around the average return.
• Fluctuation can be on either side (higher or lower than average) — BOTH are considered risky.
• Fluctuation can be measured against itself (absolute) or against a benchmark (relative).

10.7.1 Variance
• Variance measures the fluctuation in periodic returns of a scheme compared to its OWN average return.
• MS Excel formula: =VAR(range of cells with periodic returns)
• Relevant for BOTH debt and equity schemes.
• Example:
 Month Scheme 1 Returns (%) Scheme 2 Returns (%)
1 5 5
2 4 -5
3 5 10
4 6 5
Average Return 5 3.75
Variance 0.67 39.58

• Scheme 2 has much higher variance (39.58 vs. 0.67) — meaning it is much riskier (more volatile) than
Scheme 1, even though its returns may be similar or higher.

10.7.2 Standard Deviation

• Like Variance, Standard Deviation measures fluctuation in periodic returns compared to the scheme's OWN
average return.
• Standard Deviation = Square Root of Variance. It is expressed in the same units as the returns (%).
• Standard Deviation is a measure of TOTAL risk in the scheme.
• Relevant for BOTH debt and equity schemes.
• Higher standard deviation = greater volatility = greater risk.
• You can compare the standard deviation of a scheme against its benchmark and peer group funds to
understand the scheme's relative risk.
• Standard deviation combined with average return can help estimate the RANGE of returns the investment is
likely to give.
• Limitation: Since it is calculated from historical data, it has limited use in predicting FUTURE performance.
• MS Excel formula: =STDEV(range of cells with periodic returns)
• At least 30 observations are needed for a statistically accurate standard deviation calculation.
• Annualising Standard Deviation:
◦ Weekly standard deviation × √52 = Annualised standard deviation
◦ Monthly standard deviation × √12 = Annualised standard deviation
◦ Daily standard deviation × √252 = Annualised standard deviation (252 trading days in a year)
• Example from the book: Weekly standard deviation = 0.65%. Annualised = 0.65 × √52 = 4.70% (rounded).

10.7.3 Beta
• Beta is based on the Capital Asset Pricing Model (CAPM).
• CAPM states: There are two kinds of risk in equity investing — systematic (market) risk and non-systematic
(company-specific) risk. Since non-systematic risk can be diversified away, investors should only be
compensated for systematic risk. Beta measures this systematic risk.
• Beta measures fluctuation in a scheme's periodic returns compared to fluctuation in a diversified stock
index (the market) over the same period.
• A diversified stock index (by definition) has Beta = 1.
◦ Beta > 1: The scheme is RISKIER than the market (moves more than the market).
◦ Beta < 1: The scheme is LESS RISKY than the market (moves less than the market).
• Example: Beta = 0.8 → If the market moves 10%, the scheme moves 8% (both up and down).
• Example: Beta = 1.2 → If the market moves 10%, the scheme moves 12% (both up and down).
• Beta is relevant ONLY for equity schemes (not debt).
10.7.4 Modified Duration
• Modified Duration measures the sensitivity of a debt security's VALUE to changes in INTEREST RATES.
• Higher modified duration = higher interest rate sensitivity = greater risk in a debt portfolio.
• Professional investors use modified duration as the primary measure of interest rate sensitivity.

10.7.5 Weighted Average Maturity

• Broadly: The longer the remaining maturity (balance tenor) of a fixed-rate debt security, the more its value
will fluctuate when interest rates change.
• Weighted Average Maturity (WAM) calculates the average maturity of all securities in the portfolio, weighted
by their proportion in the portfolio.
• Example: Portfolio has 70% in a 4-year security and 30% in a 1-year security. WAM = (70% × 4) + (30% ×
1) = 2.8 + 0.3 = 3.1 years.
• A scheme with WAM of 3.1 years will fluctuate MORE in NAV than a scheme with WAM of 1.5 years — for
the same change in interest rates.
• While modified duration is a better and more precise measure of interest rate sensitivity, WAM is simpler to
understand.
• WAM is widely used in discussions with regular (retail) investors. Professional debt fund managers prefer
modified duration.

10.7.6 Credit Rating

• The credit rating profile of a scheme's portfolio indicates the credit/default risk in the scheme.
• Government securities: No credit risk.
• Cash and cash equivalents: No credit risk.
• Corporate bonds: Carry credit risk. Higher the credit rating, LOWER the default risk and LOWER the spread
(premium over Gilt yield). Lower the credit rating, higher the required yield (higher spread).
• Credit ratings change over time. A downgrade (e.g., AAA to AA) causes the yield expectation to rise →
market price falls → NAV declines. An upgrade has the opposite effect.
• A shrewd investor who anticipates a rating upgrade can benefit from the subsequent rise in the security's
market value.

10.8 Certain Provisions with Respect to Credit Risk

What is a Credit Event?
• In debt markets, a credit event arises from: (1) Default on payment, (2) Delay in payment, or (3) Credit
rating downgrade.
• Any credit event can cause the price of the affected debt security to fall and reduce its trading volume.
• If a large proportion of a scheme is redeemed following a credit event, the scheme comes under stress.

Illustration of the Problem:

• Scheme worth Rs. 10,000 crore holds 8% exposure (Rs. 800 crore) in Debenture 'M'. Debenture M gets
downgraded — no buyers in the market for it.
• 20% of investors redeem → Rs. 2,000 crore redeems. Fund sells OTHER securities (not Debenture M).
Remaining corpus = Rs. 8,000 crore.
• Now Debenture M = Rs. 800 crore ÷ Rs. 8,000 crore = 10% of the portfolio (up from 8%).
• More investors panic and redeem, corpus halves again → Debenture M exposure doubles to 20%.
• This can spiral upward — remaining investors face ever-increasing exposure to the bad security.
• SEBI regulations allow a maximum 10% exposure to any single issuer.
• A further risk: Market-wide liquidity may dry up so that the scheme cannot sell even good securities —
making it impossible to fund redemptions.
 • To reduce these risks, SEBI has introduced two provisions: (1) Gating (Restriction on Redemption), and (2)
Segregated Portfolio (Side-Pocketing).

10.8.1 Gating (Restriction on Redemption)

• Philosophy: Gating should be applied during EXCESS REDEMPTIONS arising from MARKET-WIDE crisis
situations — NOT for entity-specific problems.
• Gating is appropriate when illiquidity affects almost all securities in the market, not just specific ones.

When Can Gating Be Applied?

• Only in cases of a SYSTEMIC crisis or event that severely restricts market liquidity or the functioning of
markets. Three permitted circumstances:
◦ (a) Liquidity Issues: When the market as a whole faces illiquidity affecting almost all securities. Gating
CANNOT be used for illiquidity in a specific security. AMCs must have their own internal liquidity
management systems. Gating cannot be a tool to manage the scheme's own liquidity. Gating is not
permitted due to illiquidity of a specific security caused by poor investment decisions.
◦ (b) Market Failure or Exchange Closure: When unexpected events impact the functioning of exchanges
or normal transactions — including political, economic, military, monetary, or other emergencies.
◦ (c) Operational Issues: When exceptional circumstances are caused by force majeure, unpredictable
operational problems, or technical failures (e.g., a total system blackout). These must be reasonably
unpredictable events that occurred despite adequate diligence, disaster recovery procedures, and
systems.

Rules for Implementing Gating:

• Maximum duration: Not exceeding 10 WORKING DAYS in any 90-day period.
• Requires specific approval from BOTH the AMC Board AND the Trustees.
• SEBI must be informed immediately once gating is imposed.
• Redemptions up to Rs. 2 lakh per investor: NOT subject to the restriction — must be processed normally.
• Redemptions above Rs. 2 lakh: The first Rs. 2 lakh is paid without restriction; the amount above Rs. 2 lakh
is subject to the restriction.
• Investors must be clearly and prominently informed in all scheme documents about: the possibility that their
redemption right may be restricted, and the maximum time period for which it can be restricted.

10.8.2 Segregated Portfolio (Side-Pocketing)

• In December 2018, SEBI permitted the creation of segregated portfolios of debt and money market
instruments in mutual fund schemes.
• Segregated Portfolio: The portion of the scheme's portfolio containing debt/money market instruments
affected by a credit event, which is separated from the rest of the scheme.
• Main Portfolio: The scheme portfolio EXCLUDING the segregated portfolio.
• Purpose: To ensure fair treatment to all investors during a credit event and to manage liquidity risk.

When Can a Segregated Portfolio Be Created?

• When there is a credit event at the issuer level — meaning a downgrade of the credit rating of the security
by a SEBI-registered Credit Rating Agency (CRA).
• Under the original December 2018 circular: Creation was OPTIONAL and at the AMC's discretion.
• Modified provision (November 2019): AMCs can ALSO create segregated portfolios for unrated debt/money
market instruments, but ONLY in case of an ACTUAL DEFAULT (on interest or principal) by an issuer that
has no outstanding rated instruments.
• When actual default occurs, the AMC must inform AMFI immediately. AMFI must then immediately inform
all AMCs. AMCs may then segregate the portfolio.
• SEBI has mandated: All new schemes launched after November 7, 2019 MUST have enabling provisions
for creating a segregated portfolio in their SID.
• AMCs must have a detailed written policy on creating segregated portfolios, approved by trustees.
Process Once Trustees Approve:
• Segregated portfolio is effective from the day of the credit event.
• AMC must immediately issue a press release about the segregated portfolio.
• NAV of BOTH the main portfolio and the segregated portfolio must be disclosed daily from the date of the
credit event.
• All existing investors are allotted an equal number of units in the segregated portfolio as they hold in the
main portfolio on the day of the credit event.
• NO redemption or subscription is allowed in the segregated portfolio.
• Within 10 working days, the AMC must enable listing of segregated portfolio units on a recognised stock
exchange, and enable transfer of units upon transfer requests.
• Investors who redeem from the MAIN portfolio will still continue to hold their units in the segregated
portfolio.
• New investors subscribing after the credit event will get units ONLY in the main portfolio.
• If trustees do NOT approve the segregated portfolio: All subscriptions and redemptions are processed
based on the total portfolio NAV.

TER for Segregated Portfolio:

• Investment and advisory fees CANNOT be charged on the segregated portfolio.
• Other TER expenses (excluding investment and advisory fees) CAN be charged on a pro-rata basis — but
ONLY after recovery of investments in the segregated portfolio.
• The TER charged must not exceed the simple average of such expenses charged daily on the main
portfolio (in % terms) during the period the segregated portfolio was in existence.
• Legal charges related to recovering investments from the segregated portfolio can be charged to the
segregated portfolio in proportion to the amount recovered. However, these must stay within the maximum
TER limits of the main portfolio. Any legal charges exceeding TER limits must be borne by the AMC.
• Costs related to the segregated portfolio CANNOT in any case be charged to the main portfolio.

NAV of Segregated Portfolio:

• NAV of the segregated portfolio must be declared on a DAILY basis.
• Adequate disclosures about the segregated portfolio must appear in: all scheme documents, monthly and
half-yearly portfolio disclosures, and the annual report of the mutual fund and the scheme.

Risks of Segregated Portfolios:

• Investors may not be able to liquidate their segregated portfolio holding until money is recovered from the
defaulting issuer.
• Securities in the segregated portfolio may never recover any value.
• Listing on a stock exchange does NOT guarantee liquidity — there may be little or no active trading.
• Trading price on the stock exchange may be significantly LOWER than the NAV.

Illustration of Segregated Portfolio:

• Portfolio Date: September 30, 2019. Credit event: 8% XYZ Ltd. bond downgraded from A- to C. Valuation
marked down by 50%.
• Before credit event: Bond value = Rs. 99.105/unit. After markdown (50%): Bond value = Rs. 49.552/unit.
• The XYZ Ltd. bond is moved to the segregated portfolio on the date of the credit event.
• Main portfolio NAV (after removing XYZ Ltd.) = Rs. 876.2427 per unit.
• Segregated portfolio NAV = Rs. 123.88 per unit.
• Total portfolio NAV (main + segregated) = Rs. 876.2427 + Rs. 123.88 = Rs. 1,000.1227 per unit.
• Each existing investor receives: 10,000 units in the main portfolio (NAV Rs. 876.2427) AND 10,000 units in
the segregated portfolio (NAV Rs. 123.88).
Risk Mitigation — Summary:
Equity:
• An adequately long holding period is the best risk mitigant for equity.
• While prices fluctuate in the short term, history shows: 1-year holding → highly variable returns (could be
very positive or very negative). 5-year holding → extremes reduce; likely to earn positive or moderate
returns. 10-year holding → probability of negative returns is near zero; decent positive returns are highly
probable.
• Rationale: Market cycles play out over time. Short-term holding exposes you to market 'waves'; long-term
holding lets cycles balance out.

Debt:
• Credit risk: Assess from the credit rating profile of the portfolio. Government Securities Funds, Target
Maturity Funds, and Corporate Bond Funds generally run better-quality portfolios.
• Interest rate risk: Match your investment holding period with the portfolio maturity (duration) of the fund.
This provides reasonable protection against market fluctuations in NAV.

Chapter 10 — Sample Questions with Answers

Q1. Unsystematic risk can be reduced through diversification. True or False?
• Answer: (a) True.
• Reason: Unsystematic (company-specific) risk is also called diversifiable risk because spreading
investments across many different companies reduces this risk. Systematic (market-wide) risk, on the other
hand, cannot be reduced through diversification.

Q2. Which type of analysis tracks price and volume data related to trading in a security?
• Answer: (c) Technical Analysis.
• Reason: Technical analysts (chartists) study price-volume charts of a security to identify trends, support
levels, resistance levels, and breakout points for buy/sell/hold decisions. Fundamental analysis studies
financial statements and business fundamentals — not price-volume charts.

Q3. An investor bought scheme units at NAV of Rs. 120 and redeemed at NAV of Rs. 135.
Calculate simple return.
• Simple Return = [(135 − 120) ÷ 120] × 100 = [15 ÷ 120] × 100 = 12.50%
• Answer: (c) 12.50 percent.

Q4. Which is a measure of fluctuation in periodic returns in an equity mutual fund scheme?
• Answer: (a) Variance.
• Reason: Variance measures the fluctuation (spread) in periodic returns compared to the scheme's own
average return. It is relevant for both debt and equity schemes. Beta measures equity risk relative to the
market (not fluctuation in periodic returns per se). Modified Duration is a debt risk measure. Jensen's Alpha
is a performance measure.