CHAPTER 10: RISK, RETURN AND PERFORMANCE OF

FUNDS

Learning Objectives:

After studying this chapter, you should know about:

 General and Specific risk factors

 Factors affecting mutual fund performance of different schemes
 Drivers of returns and risk in a scheme
 Measures of returns
 SEBI norms regarding return representation of returns by mutual funds
in India
 Risks in fund investing with a focus on investors
 Various risk measure
 Certain Provisions with respect to Credit risk

10.1 General and Specific Risk Factors

Chapter 1 covered various asset categories and the risks associated with those. This chapter
would go deeper in understanding the risks involved in investing with mutual funds. The risk
would be categorized between standard/general risks and those specific to individual asset
categories. Investment, per se, involves taking and managing various risks. In such a case, it
is important to understand which risks one is exposed to and how to manage those risks. It
is also important for one to decide which risks one needs to take and for what purpose.

When the investor chooses to invest through mutual funds, the fund manager manages
some part of the risks, whereas some of the others are controlled due to the structure of
mutual funds. And still, some risks remain to be managed by the investor separately.

The Scheme Information Document (SID) highlights two broad categories of risks, (1)
standard risk factors, and (2) specific risk factors. The standard risk factors are the risks that
all mutual fund investments are exposed to whereas there are certain risks specific to the
individual asset category. For example, credit risk or interest rate risk are associated with
debt securities, whereas currency risk would be associated with investments in foreign
securities, or even in shares of companies exposed to foreign currency.

The Scheme Information Document (SID) contains a list of all these risks. The SID also
contains a discussion on various risk mitigation strategies. A snapshot from a Scheme
Information Document is presented below:
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 10.1.1 General Risk Factors:

 Investment in mutual fund units involves investment risks such as trading volumes,
settlement risk, liquidity risk, default risk, including the possible loss of principal.

 As the price/value/interest rates of the securities in which the scheme invests fluctuates,
the value of an investment in the scheme may increase or decrease. In addition to the
factors that affect the value of individual investments in the Scheme, the NAV of the
Scheme can be expected to fluctuate with movements in the broader equity and bond
markets and may be influenced by factors affecting capital and money markets in general,
such as, but not limited to, changes in interest rates, currency exchange rates, changes in
governmental policies, taxation, political, economic or other developments and increased
volatility in the stock and bond markets.

 Past performance of the Sponsor/AMC/Mutual Fund does not guarantee the future
performance of the Scheme.

 The name of the Scheme does not in any manner indicate either the quality of the Scheme
or its future prospects and returns.

 The Sponsors are not responsible or liable for any loss resulting from the operation of the
Scheme beyond the initial contribution made by it towards setting up the Mutual Fund.

Some of the general risk factors are explained below:

Liquidity Risk

The liquidity of investments made in the Scheme may be restricted by trading volumes,
settlement periods and transfer procedures. Although the investment universe constitutes
securities that will have high market liquidity, there is a possibility that market liquidity
could get impacted on account of company/sector/general market-related events and there
could be a price impact on account of portfolio rebalancing and/or liquidity demands on
account of redemptions.

Different segments of the Indian financial markets have different settlement periods and
such periods may be extended significantly by unforeseen circumstances. There have been
times in the past, when settlements have been unable to keep pace with the volume of
securities transactions, making it difficult to conduct further transactions. Delays or other
problems in the settlement of transactions could result in temporary periods when the
assets of the Scheme are un-invested and no return is earned thereon. The inability of the
Scheme to make intended securities purchases, due to settlement problems, could cause
the Scheme to miss certain investment opportunities. By the same token, the inability to sell
securities held in the Scheme’ portfolios, due to the absence of a well-developed and liquid
secondary market for debt securities would result at times, in potential losses to the
Scheme, should there be a subsequent decline in the value of securities held in the Scheme’
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 portfolios.
Money market securities, while fairly liquid, lack a well-developed secondary market, which
may restrict the selling ability of the Scheme and may lead to the Scheme incurring losses till
the security is finally sold.

The liquidity of a bond may change, depending on market conditions leading to changes in
the liquidity premium attached to the price of the bond. At the time of selling the security,
the security can become illiquid, leading to a loss in the value of the portfolio.

Even though the Government securities market is more liquid compared to other debt
instruments, on occasions, there could be difficulties in transacting in the market due to
extreme volatility leading to constriction in market volumes. The liquidity of the Scheme
may suffer in case any relevant guideline issued by RBI undergoes any adverse changes.

Interest Rate Risk

Fixed income securities such as government bonds, corporate bonds, money market
instruments and derivatives run price-risk or interest-rate risk. Generally, when interest
rates rise, prices of existing fixed-income securities fall and when interest rates drop, such
prices increase. The extent of fall or rise in the prices depends upon the coupon and
maturity of the security. It also depends upon the yield level at which the security is being
traded.

Derivatives carry the risk of adverse changes in the price due to changes in interest rates.

Re-investment Risk

The investments made by the Scheme are subject to reinvestment risk. This risk refers to
the interest rate levels at which cash flows received from the securities in the Scheme are
reinvested. The additional income from reinvestment is the ‘interest on interest’
component. The risk is that the rate at which interim cash flows can be reinvested may be
lower than that originally assumed.

Political Risk

Investments in mutual fund Units in India may be materially adversely impacted by Indian
politics and changes in the political scenario in India either at the central, state or local level.
Actions of the central government or respective state governments in the future could have
a significant effect on the Indian economy, which could affect companies, general business
and market conditions, prices and yields of securities in which the Scheme invest.

The occurrence of selective unrest or external tensions could adversely affect the political
and economic stability of India and consequently have an impact on the securities in which
the Scheme invests. Delays or changes in the development of conducive policy frameworks
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could also have an impact on the securities in which the Scheme invests.

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Economic Risk

A slowdown in economic growth or macro-economic imbalances such as the increase in the

central and state level fiscal deficits may adversely affect investments in the country. The
underlying growth in the economy is expected to have a direct impact on the volume of new
investments in the country.

Foreign Currency Risk

The Scheme may be denominated in Indian Rupees (INR) which is different from the home
currency for Foreign Portfolio Investors in the mutual fund units. The INR value of
investments when translated into home currency by Foreign Portfolio Investors could be
lower because of the currency movements. The AMC does not manage currency risk for
Foreign Portfolio Investors and it is the sole responsibility of the Foreign Portfolio Investors
to manage or reduce currency risk on their own. The Sponsor/Fund/Trustees/ AMC are not
liable for any loss to Foreign Investors arising from such changes in exchange rates.

Settlement Risk (Counterparty Risk) - Specific floating rate assets may also be created by
swapping a fixed return into a floating rate return. In such a swap, there is the risk that the
counterparty (who will pay floating rate return and receive fixed rate return) may default.

Risks associated with transaction in Units through stock exchange(s)

In respect of a transaction in Units of the Scheme through stock exchanges, allotment and
redemption of Units on any Business Day will depend upon the order processing /settlement
by BSE/NSE and their respective clearing corporations on which the Fund has no control.

10.1.2 Specific Risk Factors

Risk related to equity and equity related securities

Equity and equity related securities are volatile and prone to price fluctuations on a daily
basis. The liquidity of investments made in the scheme can get restricted by trading volumes
and settlement periods. Settlement periods may be extended significantly by unforeseen
circumstances. The inability of the scheme to make intended securities purchases, due to
settlement problems, could cause the Scheme to miss certain investment opportunities.
Similarly, the inability to sell securities held in the scheme portfolio would result at times, in
potential losses to the scheme, if there is a subsequent decline in the value of securities held
in the scheme portfolio. Also, the value of the scheme investments may be affected by
interest rates, currency exchange rates, changes in law/policies of the government, taxation
laws and political, economic or other developments which may have an adverse bearing on
individual securities, a specific sector or all sectors.

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Risk associated with short selling and Stock Lending

Securities Lending is lending of securities through an approved intermediary to a borrower

under an agreement for a specified period with the condition that the borrower will return
equivalent securities of the same type or class at the end of the specified period along with
the corporate benefits accruing on the securities borrowed. There are risks inherent in
securities lending, including the risk of failure of the other party. Such failure can result in a
possible loss of rights to the collateral, the inability of the approved intermediary to return
the securities deposited by the lender and the possible loss of corporate benefits accruing
thereon. Short-selling is the sale of shares or securities that the seller does not own at the
time of trading. Instead, he borrows it from someone who already owns it. Later, the short
seller buys back the stock/security he shorted and returns the stock/security to the lender
to close out the loan. The inherent risks are Counterparty risk and liquidity risk of the
stock/security being borrowed. The security being short sold might be illiquid or become
illiquid and covering of the security might occur at a much higher price level than
anticipated, leading to losses.

Risks associated with mid-cap and small-cap companies

The market capitalization spectrum has been defined as follows:

• Large-Cap Stocks: 1st -100th company in terms of full market capitalization

• Mid-Cap Stocks: 101st -250th company in terms of full market capitalization
• Small-Cap Stocks: 251st company onwards in terms of full market capitalization
Investment in mid-cap and small-cap companies are based on the premise that these
companies have the ability to increase their earnings at a faster pace as compared to large-
cap companies and grow into larger, more valuable companies. However, as with all equity
investments, there is a risk that such companies may not achieve their expected earnings
results, or there could be an unexpected change in the market, both of which may adversely
affect investment results.

Historically, it has been observed that as you go down the capitalization spectrum i.e., from
large- cap stocks to mid-cap stocks and beyond, there are higher risks in terms of volatility
and market liquidity. Scheme also invests in mid-cap and small-cap companies and hence is
exposed to associated risks.

Risk associated with Dividend

Dividend is due only when declared and there is no assurance that a company (even though
it may have a track record of payment of dividend in the past) may continue paying dividend
in future. As such, the schemes are vulnerable to instances where investments in securities
may not earn dividend or where lesser dividend is declared by a company in subsequent
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 years in which investments are made by schemes. As the profitability of companies are likely
to vary and have a material bearing on their ability to declare and pay dividend, the
performance of the schemes may be adversely affected due to such factors.

Risk associated with Derivatives

The mutual fund schemes may invest in derivative products in accordance with and to the
extent permitted under the SEBI MF Regulations and by RBI. Derivative products are
specialized instruments that require investment techniques and risk analysis different from
those associated with stocks and bonds. The use of a derivative requires an understanding
not only of the underlying instrument but of the derivative itself. Trading in derivatives
carries a high degree of risk although they are traded at a relatively small amount of margin
which provides the possibility of great profit or loss in comparison with the principal
investment amount. Thus, derivatives are highly leveraged instruments. Even a small price
movement in the underlying security could have an impact on their value and consequently,
on the NAV of the Units of the Scheme. The risks associated with the use of derivatives are
different from or possibly greater than, the risks associated with investing directly in
securities and other traditional investments.

Some of the risks associated with derivatives are discussed below:

 Counterparty Risk occurs when a counterparty fails to abide by its contractual

obligations and therefore, the scheme is compelled to negotiate with another counter
party, at the then prevailing (possibly unfavorable) market price. For exchange traded
derivatives, the risk is mitigated as the exchange provides the guaranteed settlement but
one takes the performance risk on the exchange.

 Market Liquidity Risk occurs where the derivatives cannot be transacted due to limited
trading volumes and/or the transaction is completed with a severe price impact.

 Model Risk is the risk of mis-pricing or improper valuation of derivatives.

 Basis Risk arises due to a difference in the price movement of the derivative vis-à-vis
that of the security being hedged.

 The Scheme may find it difficult or impossible to execute derivative transactions in

certain circumstances. For example, when there are in sufficient bids or suspension of
trading due to price limit or circuit breakers, the Scheme may face a liquidity issue.

 Investments in index futures face the same risk as the investments in a portfolio of shares
representing an index. The extent of loss is the same as in the underlying stocks.

 Derivative products are leveraged instruments and can provide disproportionate gains as
well as disproportionate losses to the investor / unitholder. Execution of investment
strategies depends upon the ability of the fund manager(s) to identify such opportunities
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 which may not be available at all times. Identification and execution of the strategies to
be pursued by the fund manager(s) involve uncertainty and decision of fund manager(s)
may not always be profitable. No assurance can be given that the fund manager(s) will
be able to identify or execute such strategies.

 There are certain additional risks involved with use of fixed income derivatives such as
interest rate risk, and liquidity risk.

Risks related to debt funds

Reinvestment Risk: Investments in fixed income securities carry re-investment risk as

interest rates prevailing on the coupon payment or maturity dates may differ from the
original coupon of the bond.

Rating Migration Risk: Fixed income securities are exposed to rating migration risk,
which could impact the price on account of change in the credit rating. For example: One
notch downgrade of a AAA rated issuer to AA+ will have an adverse impact on the price
of the security and vice-versa for an upgrade of an AA+ issuer.

Term Structure of Interest Rate Risk: The NAV of the Scheme’ Units, to the extent that
the Scheme are invested in fixed income securities, will be affected by changes in the
general level of interest rates. When interest rates decline, the value of a portfolio of
fixed income securities can be expected to rise. Conversely, when interest rates rise, the
value of a portfolio of fixed income securities can be expected to decline.

Credit Risk: Fixed income securities (debt and money market securities 1) are subject to
the risk of an issuer’s inability to meet interest and principal payments on its debt
obligations. The Investment Manager will endeavour to manage credit risk through in-
house credit analysis.

Different types of securities in which the Scheme would invest as given in the SID carry
different levels of credit risk. Accordingly, the Scheme’ risk may increase or decrease
depending upon their investment patterns. E.g., corporate bonds carry a higher amount
of risk than Government securities. Further, even among corporate bonds, bonds which
are rated AAA are comparatively less risky than bonds which are AA rated.

The credit risk is the risk that the counter party will default in its obligations and is
generally small as in a Derivative transaction there is generally no exchange of the
principal amount.

1
Sebi has introduced credit risk-based single issuer limits for investment in money market and debt instruments for
Actively-managed mutual fund (MF) schemes. For details read:
[Link]
[Link]
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Risk associated with floating rate securities

Spread Risk: In a floating rate security the coupon is expressed in terms of a spread or mark
up over the benchmark rate. In the life of the security this spread may move adversely
leading to loss in value of the portfolio. The yield of the underlying benchmark might not
change, but the spread of the security over the underlying benchmark might increase
leading to loss in value of the security.

Basis Risk: The underlying benchmark of a floating rate security or a swap might become
less active or may cease to exist and thus may not be able to capture the exact interest rate
movements, leading to loss of value of the portfolio.

Risk factors associated with repo transactions in Corporate Bonds

The Scheme may be exposed to counter party risk in case of repo lending transactions in the
event of the counterparty failing to honour the repurchase agreement. However, in repo
transactions, the collateral may be sold and a loss is realized only if the sale price is less than
the repo amount. The risk is further mitigated through over-collateralization (the value of
the collateral being more than the repo amount).

Risks associated with Creation of Segregated portfolio

Investor holding units of segregated portfolio may not able to liquidate their holding till the
time recovery of money from the issuer. Security comprises of segregated portfolio may not
realise any value. Listing of units of segregated portfolio on recognised stock exchange does
not necessarily guarantee their liquidity. There may not be active trading of units in the
stock market. Further trading price of units on the stock market may be significantly lower
than the prevailing NAV.

Risks associated with investments in Securitized Assets:

A securitization transaction involves sale of receivables by the originator (a bank, non-

banking finance company, housing finance company, or a manufacturing/service company)
to a Special Purpose Vehicle (SPV), typically set up in the form of a trust. Investors are issued
rated Pass-Through Certificates (PTCs), the proceeds of which are paid as consideration to
the originator. In this manner, the originator, by selling his loan receivables to an SPV,
receives consideration from investors much before the maturity of the underlying loans.
Investors are paid from the collections of the underlying loans from borrowers. Typically,
the transaction is provided with a limited amount of credit enhancement as stipulated by
the rating agency for a target (rating), which provides protection to investors against
defaults by the underlying borrowers.

Some of the risk factors typically analysed for any securitization transaction are as follows:

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Risks associated with asset class:

Underlying assets in securitised debt may assume different forms and the general types of
receivables include commercial vehicles, auto finance, credit cards, home loans or any such
receipts. Credit risks relating to these types of receivables depend upon various factors
including macro-economic factors of these industries and economies. Specific factors like
nature and adequacy of collateral securing these receivables, adequacy of documentation in
case of auto finance and home loans and intentions and credit profile of the borrower
influence the risks relating to the asset borrowings underlying the securitised debt.

Risks associated with pool characteristics:

Size of the loan: This generally indicates the kind of assets financed with loans. While a pool
of loan assets comprising of smaller individual loans provides diversification, if there is
excessive reliance on very small ticket size, it may result in difficult and costly recoveries.

Loan to Value Ratio: This indicates how much percentage value of the asset is financed by
borrower’s own equity. The lower LTV, the better it is. This ratio stems from the principle that
where the borrowers own contribution of the asset cost is high, the chances of default are
lower. To illustrate for a Truck costing Rs. 20 lakhs, if the borrower has himself contributed
Rs.10 lakh and has taken only Rs. 10 lakhs as a loan, he is going to have lesser propensity to
default as he would lose an asset worth Rs. 20 lakhs if he defaults in repaying an installment.
This is as against a borrower who may meet only Rs. 2 lakhs out of his own equity for a truck
costing Rs. 20 lakhs. Between the two scenarios given above, the latter would have higher risk
of default than the former.

Original maturity of loans and average seasoning of the pool: Original maturity indicates
the original repayment period and whether the loan tenors are in line with industry averages
and borrower’s repayment capacity. Average seasoning indicates whether borrowers have
already displayed repayment discipline. To illustrate, in the case of personal loans, if a pool
of assets consists of those who have already repaid 80 percent of the installments without
default, this certainly is a superior asset pool than one where only 10 percent of installments
have been paid. In the former case, the portfolio has already demonstrated that the repayment
discipline is far higher.

Default rate distribution: This indicates how much percent of the pool and overall portfolio
of the originator is current, how much is in 0-30 DPD (days past due), 30-60 DPD, 60-90 DPD
and so on.2 The rationale here is very obvious, as against 0-30 DPD, the 60-90 DPD is
certainly a higher risk category.

Credit Rating and Adequacy of Credit Enhancement

Unlike in plain vanilla instruments, in securitisation transactions, it is possible to work

towards a target credit rating, which could be much higher than the originator’s own credit
2
Days Past due or DPD means, that for any given month, how many months’ worth of payment is unpaid.
10
rating. This is possible through a mechanism called “Credit enhancement”. The process of
“Credit enhancement” is fulfilled by filtering the underlying asset classes and applying
selection criteria, which further diminishes the risks inherent for a particular asset class.
The purpose of credit enhancement is to ensure timely payment to the investors, if the
actual collection from the pool of receivables for a given period is short of the contractual
pay-out on securitisation. Securitisation is normally non- recourse instruments and
therefore, the repayment on securitisation would have to come from the underlying assets
and the credit enhancement. Therefore, the rating criteria centrally focus on the quality of
the underlying assets.

The Schemes predominantly invest in those securitisation issuances which have AA and
above rating indicating high level of safety from credit risk point of view at the time of
making an investment. However, there is no assurance by the rating agency either that the
rating will remain at the same level for any given period of time or that the rating will not
be lowered or withdrawn entirely by the rating agency.

• Limited Liquidity & Price Risk: The secondary market for securitised papers is not
very liquid. There is no assurance that a deep secondary market will develop for such
securities. This could limit the ability of the investor to resell them. Even if a secondary
market develops and sales were to take place, these secondary transactions may be at a
discount to the initial issue price due to changes in the interest rate structure.
• Limited Recourse to Originator & Delinquency: Securitised transactions are normally
backed by pool of receivables and credit enhancement as stipulated by the rating agency,
which differ from issue to issue. The Credit Enhancement stipulated represents a limited
loss cover to the Investors. These Certificates represent an undivided beneficial interest
in the underlying receivables and there is no obligation of either the Issuer or the seller
or the originator, or the parent or any affiliate of the seller, issuer and originator. No
financial recourse is available to the Certificate Holders against the Investors
Representative. Delinquencies and credit losses may cause depletion of the amount
available under the credit enhancement and thereby the investor pay-outs may get
affected if the amount available in the credit enhancement facility is not enough to cover
the shortfall. On persistent default of an obligor to repay his obligation, the servicer
may repossess and sell the underlying Asset. However, many factors may affect, delay
or prevent the repossession of such asset or the length of time required to realize the sale
proceeds on such sales. In addition, the price at which such asset may be sold may be
lower than the amount due from that Obligor.

• Risks due to possible prepayments: Asset securitisation is a process whereby

commercial or consumer credits are packaged and sold in the form of financial
instruments. Full prepayment of underlying loan contract may arise under any of the
following circumstances:
o Obligor pays the receivable due from him at any time prior to the scheduled maturity
date of that receivable; or
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 o Receivable is required to be repurchased by the seller consequent to its inability to
rectify a material misrepresentation with respect to that Receivable; or
o The servicer recognizing a contract as a defaulted contract and hence repossessing
the underlying asset and selling the same.
o In the event of prepayments, investors may be exposed to changes in tenor and yield.

• Bankruptcy of the Originator or Seller: If originator becomes subject to bankruptcy

proceedings and the court in the bankruptcy proceedings concludes that the sale from
originator to trust was not a sale then an Investor could experience losses or delays in the
payments due. All possible care is generally taken in structuring the transaction so as to
minimize the risk of the sale to Trust not being construed as a ‘True Sale’. Legal opinion
is normally obtained to the effect that the assignment of Receivables to Trust in trust for
and for the benefit of the Investors, as envisaged herein, would constitute a true sale.

• Bankruptcy of the Investor’s Agent: If Investor’s agent becomes subject to bankruptcy

proceedings and the court in the bankruptcy proceedings concludes that the recourse of
Investor’s Agent to the assets/receivables is not in its capacity as agent/Trustee but in its
personal capacity, then an Investor could experience losses or delays in the payments
due under the agreement. All possible care is normally taken in structuring the
transaction and drafting the underlying documents so as to provide that the
assets/receivables if and when held by Investor’s Agent is held as agent and in Trust for
the Investors and shall not form part of the personal assets of Investor’s Agent. Legal
opinion is normally obtained to the effect that the Investors Agent’s recourse to assets/
receivables is restricted in its capacity as agent and trustee and not in its personal
capacity.

• Risk of co-mingling: The servicers normally deposit all payments received from the
obligors into the collection account. However, there could be a time gap between
collection by a servicer and depositing the same into the collection account especially
considering that some of the collections may be in the form of cash. In this interim
period, collections from the loan agreements may not be segregated from other funds of
the servicer. If the servicer fails to remit such funds due to Investors, the Investors may
be exposed to a potential loss. Due care is normally taken to ensure that the Servicer
enjoys highest credit rating on standalone basis to minimize co-mingling risk.

Risk Factors Associated with Investments in REITs and InvITs:

ReITs and InvITs are exposed to price-risk, interest rate risk, credit risk, liquidity or
marketability risk, reinvestment risk. Also, there is a risk of lower-than-expected distributions.
The distributions by the REIT or InvIT will be based on the net cash flows available for
distribution. The amount of cash available for distribution principally depends upon the
amount of cash that the REIT/InvITs receives as dividends or the interest and principal
payments from portfolio assets.

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 However, various risk management strategies are employed to manage the different types
of risks. These are mentioned below:

Managing Market Liquidity Risk

The liquidity risk is managed by creating a portfolio which has adequate access to liquidity.
The Investment Manager selects fixed income securities, which have or are expected to
have high secondary market liquidity. There is good secondary market liquidity in
government securities. As far as other long dated fixed income securities are concerned, the
endeavour is to invest in high quality securities, for example bonds issued by public sector
entities. Market Liquidity Risk will be managed actively within the portfolio liquidity limits.
The first access to liquidity is through cash and fixed income securities.

Managing Credit Risk

Credit Risk associated with fixed income securities is managed by making investments in
securities issued by borrowers, which have a good credit profile. The credit research process
includes a detailed in-house analysis and due diligence. Limits are assigned for each of the
issuer (other than government of India); these limits are for the amount as well as maximum
permissible tenor for each issuer. The credit process ensures that issuer level review is done
at inception as well as periodically by taking into consideration the balance sheet and
operating strength of the issuer.

Managing Term Structure of Interest Rates Risk

The Investment Manager actively manages the duration based on the ensuing market
conditions. As the fixed income investments of the Scheme are generally short duration in
nature, the risk is expected to be small.

Managing Rating Migration Risk

The endeavour is to invest in high grade/quality securities. The due diligence performed by
the fixed income team before assigning credit limits and the periodic credit review and
monitoring should address company-specific issues.

Re-investment Risk

Re-investment Risk is prevalent for fixed income securities, but as the fixed income
investments of the Scheme are generally short duration in nature, the impact can be
expected to be small.

Market Risk related to equity and equity related securities

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 The Investment Manager endeavours to invest in companies, where adequate due diligence
and research has been performed by the Investment Manager. As not all, third-party
research companies very well research these companies, the Investment Manager also
relies on its own research. This involves one-to-one meetings with the management of
companies, attending conferences and analyst meets and tele-conferences. The company–
wise analysis will focus, amongst others, on the historical and current financial condition of
the company, potential value creation/unlocking of value and its impact on earnings growth,
capital structure, business prospects, policy environment, strength of management,
responsiveness to business conditions, product profile, brand equity, market share,
competitive edge, research, technological know- how and transparency in corporate
governance.

Risk associated with floating rate securities

There is very low liquidity in floating rate securities, resulting in lack of price discovery.
Hence, incremental investments in floating rate securities are going to be very limited.

Managing Risk associated with favourable taxation of equity-oriented Scheme

This risk is mitigated, as there is a regular monitoring of equity exposure of each of the
equity- oriented Scheme of the Fund.

10.2 Factors that affect mutual fund performance

Different asset classes have different characteristics. At the same time, different fund
managers may adopt different approaches and strategies, which may also impact the
performance of the schemes. Having said that, fund managers take certain risks in order to
outperform the respective benchmark’s performance. This means that the schemes may be
subject to the risks that an asset class is exposed to, as well as the risks that the fund
manager may choose or avoid. The various risks as applicable to the various scheme
categories have been discussed earlier in this chapter.

10.2.1 Difference between market/systematic risk and company specific risk

Various investments are exposed to a number of risk factors. For example, stock prices
move up or down based on various factors that impact the business performance of the
company, or the whole economy. Out of these, the risks that impact the specific company
are called company specific or firm specific risks. The risks that impact the entire economy
are known as systematic risks. The company specific risks are also known as unsystematic
risks. For example, a labour strike in a manufacturing plant is a company specific risk,
whereas rise in inflation in the economy is a systematic risk that impacts all the businesses
within the country. Hence, the systematic risk is also called the market risk.

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 The company specific risks can be reduced through diversification across diverse set of
companies. However, the systematic risks cannot be reduced through such diversification.
Since the unsystematic risk can be reduced through diversification, it is also called the
diversifiable risk. On the other hand, the systematic risk is known as non-diversifiable risk.

Fund managers cannot reduce the systematic risk except by staying out of the market. Thus,
some fund managers may tactically move between equity and cash depending on their view
on the broader market. However, SEBI regulations impose certain limits on the permissible
cash allocation in various scheme categories. The fund manager would need to operate
within that and to that extent, the scheme may not be able to control the systematic risk
beyond a certain level. At the same time, certain fund managers do not take such cash calls
and stay fully invested at all times. They do not try to reduce the systematic risk, as they
believe that the investor would have chosen the scheme after understanding the risks
involved in the scheme. On the other hand, the unsystematic risk is reduced through
diversification.

Finance theory states that one is rewarded for taking the non-diversifiable risk only, and not
for taking the diversifiable risk.

The fund managers adopt active management strategy in order to outperform the scheme’s
benchmark index. For that purpose, the manager would have no choice but to take certain
unsystematic risks by taking a view on the individual securities.

Mutual fund investments are subject to market risks

“Mutual fund investments are subject to market risks. Please read the scheme related
documents carefully before investing.” – These lines are part of any marketing
communication by mutual fund companies. This is a regulatory requirement. It is important
to understand the meaning of this line, to be able to take the advantages of the mutual
funds.

Let us understand this. Unlike most other products, mutual fund is a pass-through vehicle, in
which all the investment risks are passed onto the investor since the investor/unit-holder is
the owner of the fund. This is not the case when one invests in say a fixed deposit. Let us
take the case of a company fixed deposit. An investor is promised a certain return on
investment in such fixed deposits. What the company does with the money collected
determines the
return the company earns – in most cases, the company raise money through this route for
their investment in the business or their working capital requirements. The company is
supposed to pay the investor only the promised return – nothing more, nothing less. If the
company is unable to earn more than what it has promised the depositors, there is a risk that
the promise may not be honoured. This is known as credit risk for the depositors. In case of
a mutual fund, the ownership of the fund is with the fund’s investors. The fund may be
subject to this risk as the investments made by the fund may default on their commitments.
15
Is it possible to manage some of the risks? Is it possible to avoid some? Well, diversification
is a proven strategy that can be used as protection against credit risk. A diversified mutual
fund, as the name suggests, automatically offers diversification.

However, the one risk that a mutual fund portfolio cannot do anything about is the risk of
market-wide price fluctuations. If the fund invests in a market where prices fluctuate a lot,
the NAV of the fund is likely to witness huge fluctuations (e.g., growth funds investing in
equity market); however, if it invests in a market where prices do not fluctuate, the NAV of
the fund would be quite stable (e.g., overnight funds. This shall be discussed later.

When we talk about price fluctuations, it is important to separate the market price
fluctuation from fluctuation in the price of the individual securities. There are certain factors
that influence the broader market and prices of most securities fluctuate at the same time –
this is called market price fluctuation; whereas some factors only affect individual securities,
resulting into fluctuation in the price of an individual security. Diversification can help
reduce the latter, but cannot reduce the former.

As can be seen from the above discussion, it is not the mutual fund that carries the risk, but
the underlying investments where the mutual fund has invested. Mutual funds simply pass
on some of the risks and reduce some others. As discussed above, the market risk cannot be
reduced through diversification.

10.3 Drivers of Returns and Risk in a Scheme

The portfolio is the main driver of returns in a mutual fund scheme. The asset class in which
the fund invests, the segment or sectors of the market in which the fund will focus on, the
styles adopted to select securities for the portfolio and the strategies adopted to manage
the portfolio determines the risk and return in a mutual fund scheme. The underlying factors
are different for each asset class.

10.3.1 Factors Affecting Performance of Equity Schemes

Equity as an asset class represents growth investment. The returns to an investor are
primarily from appreciation in the value of the asset. The risk to the investor arises from
the absence of defined and fixed returns from these investments that can be volatile from
period to period. The returns from equity are linked to the earnings of the business. Not all
businesses are successful and manage to earn return for its equity investors. It is therefore
important to analyse the business and its prospects before investing in its equity. Moreover,
investors have to continue to evaluate the business to ensure that it remains profitable and
worthy of investment.

In order to generate returns superior to the benchmark, the fund manager must construct a

16
 portfolio that is different from the benchmark – either entire portfolio or a part of it, and
either always or at least some times. Two primary strategies adopted by the portfolio
managers are security selection and market timing.

Security selection is an attempt to select good quality securities that are likely to perform
well in the future, as well as avoid those securities where the future may be bleak. Market
timing, on the other hand, is an attempt to time the entry and exit into a market or timing
the purchase and sale of a security in order to capture the upside in prices and to avoid the
downside.

For these purposes, two types of analysis may be used–fundamental analysis and technical
analysis.

Fundamental and Technical analysis

Fundamental analysis is a study of the business and financial statements of a firm in order
to identify securities suitable for the strategy of the schemes as well as those with high
potential for investment returns and where the risks are low. Fundamental analysis normally
ties in well with the security selection strategy and mostly used for identifying long term
investment avenues.

The discipline of Technical Analysis has a completely different approach. Technical Analysts
believe that price behaviour of a share over a period throws up trends for the future
direction of the price. Along with past prices, the volumes traded indicate the underlying
strength of the trend and are a reflection of investor sentiment, which in turn will influence
future price of the share. Technical Analysts therefore study price-volume charts (a reason
for their frequently used description as “chartists”) of the company’s shares to decide
support levels, resistance levels, breakouts, and other triggers to base their buy/sell/hold
recommendations for a share.

Both types of analysts swear by their discipline. It is generally agreed that longer-term
investment decisions are best taken through a fundamental analysis approach, while
technical analysis comes in handy for shorter-term speculative decisions, including intra-day
trading. Even where a fundamental analysis-based decision has been taken on a stock,
technical analysis might help decide when to implement the decision i.e., the timing.

Fundamental Analysis entails review of the company’s fundamentals viz. financial

statements, quality of management, competitive position in its product / service market etc.
The analyst sets price targets, based on financial parameters. Some of these financial
parameters are listed below:

Earnings per Share (EPS): Net profit after tax ÷ No. of equity shares outstanding

This tells investors how much profit the company earned for each equity share that they own.

17
Price to Earnings Ratio (P/E Ratio): Market Price per share ÷ Earnings Per Share (EPS)

When investors buy shares of a company, they are essentially buying into its future
earnings. P/E ratio indicates how much investors in the share market are prepared to pay (to
become owners of the company), in relation to the company’s earnings. The forward P/E
ratio is normally calculated based on a projected EPS for a future period (also called forward
EPS)

A company’s shares are seen as expensive or otherwise by comparing its P/E ratio to the
market P/E and peer group P/E ratios. A simplistic (but faulty) view is that low P/E means
that a share is cheap, and therefore should be bought; the corollary being that high P/E
means that a share is expensive, and therefore should be sold. In reality, the P/E may be high
because the company’s prospects are indeed good, while another company’s P/E may be
low because it is unlikely to replicate its past performances. The validity of this parameter
will depend upon the robustness of the future estimates of the earnings of the company.
The P/E ratio needs to be recalculated every time there is a change in the earnings and its
estimates.

The Price Earnings to Growth (PEG) ratio relates the P/E ratio to the growth estimated in
the company’s earnings. A PEG ratio of one indicates that the market has fairly valued the
company’s shares, given its expected growth in earnings. A ratio less than one indicates the
equity shares of the company are undervalued, and a ratio greater than one indicates an
overvalued share.

Book Value per Share: Net Worth ÷ No. of equity shares outstanding

This is an indicator of how much each share is worth, as per the company’s own books of
accounts. The accounts represent a historical perspective, and are a function of various
accounting policies adopted by the company.

Price to Book Value: Market Price per share ÷ Book Value per share

An indicator of how much the share market is prepared to pay for each share of the
company, as compared to its book value. The drawback with this is that the book value is an
accounting measure and may not represent the true value of the assets of the company.

Such financial parameters are compared across companies, normally within a sector.
Accordingly, recommendations are made to buy/hold/sell the shares of the company.

As in the case of P/E ratio, most financial indicators cannot be viewed as stand-alone
numbers. They need to be viewed in the context of unique factors underlying each
company. The fundamental analyst keeps track of various companies in a sector, and the
uniqueness of each company, to ensure that various financial indicators are understood in
the right perspective.

Dividend Yield: Dividend per share ÷ Market price per share

18
 This is used as a measure of the payouts received from the company, in percentage, for each
rupee of investment in the share. Since dividends are not guaranteed or fixed, investors who
are particular about receiving payouts look at the trend in dividend yields over a period of
time. Dividend yield is considered as a parameter by conservative investors looking to
identify steady and lower risk equity investments. A high dividend yield is the result of
higher payout and/or lower market prices, both of which are preferred by such conservative
investors.

Another way of looking at a high Pay-out of Income Distribution cum capital withdrawal plan
is that the company may have lower investment prospects and therefore pays out the
profits instead of re-investing it into the company.

Dividend yields tend to go down across stocks in a bull market and rise in a bear market.

Investment Styles – Growth and Value

Growth investment style entails investing in high growth stocks i.e., stocks of companies
that are likely to grow much faster than the market. Many market players are interested in
accumulating such growth stocks. Therefore, valuation of these stocks tends to be on the
higher side. Further, in the event of a market correction, these stocks tend to decline more.
Such stocks typically feature high P/E and PEG ratios and lower dividend yield ratio.

Value investment style is an approach of picking up stocks, which are priced lower than
their intrinsic value, based on fundamental analysis. The belief is that the market has not
appreciated some aspect of the value in a company’s share – and hence it is cheap. When
the market recognizes the intrinsic value, then the price would shoot up. Such stocks are
also called value stocks. Investors need a longer investment horizon to benefit from the
price appreciation in such stocks.

Value investors maintain a portfolio of such value stocks. In the stocks where their decision
is proved right, they earn very high returns, which more than offset the losses on failed
decisions.

It is important to note that ‘high valuation’ is not the equivalent of ‘high share price’, just as
‘low valuation’ is not the same as ‘low share price’. Fundamental analysts look at value in
the context of some aspect of the company’s financials. For example, how much is the share
price as compared to its earnings per share (Price to Earnings Ratio); or how much is the
share price as compared to its book value (Price to Book Value Ratio).

Thus, a company’s share price may be high, say Rs. 100, but still reasonably valued given its
earnings; similarly, a company may be seen as over-valued, even when its share price is Rs.
5, if it is not matched by a reasonable level of earnings.

Investments of a scheme can thus be based on growth, value or a blend of the two styles. In
19
 the initial phases of a bull run, growth stocks deliver good returns. Subsequently, when the
market heats up and the growth stocks get highly valued or costly, value picks end up being
safer.

Portfolio building approach – Top down and Bottom up

In analysing the factors that affect the earnings of company, analysts consider the EIC
framework i.e., the economy, the industry and the company-specific factors. Economic
factors include inflation, interest rates, GDP growth rates, fiscal and monetary policies of the
government, balance of payment etc. Industry factors that are relevant include regulations
that affect investment and growth decisions of the companies, level of competition,
availability of raw materials and other inputs and cyclical nature of the industry. Company-
specific factors include management and ownership structure, financial parameters,
products and market shares and others.
In a top-down approach, the portfolio manager evaluates the impact of economic factors
first and narrows down on the industries that are suitable for investment. Thereafter, the
companies are analysed and the good stocks within the identified sectors are selected for
investment.

A bottom-up approach on the other hand analyses the company-specific factors first and
then evaluates the industry factors and finally the macro-economic scenario and its impact
on the companies that are being considered for investment. Stock selection is the key
decision in this approach; sector allocation is a result of the stock selection decisions.

Both the approaches have their merit. Top-down approach minimizes the chance of being
stuck with large exposure to a poor sector. Bottom-up approach ensures that a good stock is
picked, even if it belongs to a sector that is not so hot. What is important is that the
approach selected should be implemented professionally.

Therefore, it can be said that equity returns are a function of sector and stock selection.
Investors can also hope for a secular growth in a diversified mix of equity stocks when the
economy does well.

10.3.2 Factors affecting performance of Debt Schemes

Risks associated with marketable debt securities have been covered earlier. Primarily there
are two risks impacting the debt securities, viz., interest rate risk and credit risk. The yields
on debt securities tend to move up as the maturity rises (interest rate risk rises), or as the
credit risk is increased.

Investment in a debt security, entails a return in the form of interest (at a pre-specified
frequency for a pre-specified period), and repayment of the invested amount at the end of
the pre-specified period.

The pre-specified period is called tenor. At the end of the tenor, the securities are said to
20
mature. The process of repaying the amounts due on maturity is called redemption. An
investor may earn capital gains or incur capital losses by selling the debt security before its
maturity period.

Debt securities that are to mature within a year are called money market securities.

The total return that an investor earns or is likely to earn on a debt security is called its
yield.
Yield to maturity (YTM) is the return that the investor gets provided the security is held till
maturity.

The holding period return (HPR) is a combination of interest paid by the issuer and capital
gain (if the sale proceeds are higher than the amount invested) or capital loss (if the sale
proceeds are lower than the amount invested) relative to the price paid to buy the security.

Central Government, State Governments, Banks, Financial Institutions, Public Sector

Undertakings (PSU), Private Companies, Municipalities, etc. may issue debt securities.
 Securities issued by the Government are called Government Securities or G-Sec or Gilt.

 Treasury Bills are short term debt instruments issued by the Reserve Bank of India on
behalf of the Government of India.

 Certificates of Deposit are issued by Banks (for 7 days to 1 year) or Financial Institutions
(for 1 to 3 years)

 Commercial Papers are short term securities (up to 1 year) issued by companies.

 Bonds/Debentures are generally issued for tenors beyond a year. Governments and public
sector companies tend to issue bonds, while private sector companies issue debentures.

Since the government is unlikely to default on its obligations, Gilts are viewed as safe as
there is no credit risk associated with them. The yield on Gilt is generally the lowest in the
market for a given tenor. Since non-Government issuers can default, they tend to offer
higher yields for the same tenor. The difference between the yield on Gilt and the yield on a
non- Government Debt security is called its credit spread.

The possibility of a non-government issuer defaulting on a debt security i.e., its credit risk is
measured by Credit Rating companies such as CRISIL, ICRA, CARE and Fitch (now India
Ratings). They assign different symbols to indicate the credit risk in a debt security. For
instance, ‘AAA’ is rating agencies’ indicator of highest safety in a debenture. Higher the
credit risk, higher is likely to be the yield on the debt security.

The interest rate payable on a debt security may be specified as a fixed rate, say 6 percent.
Alternatively, it may be a floating rate i.e., a rate linked to some other rate that may be
prevailing in the market, say the rate that is applicable to Gilt. Interest rates on floating rate
securities (also called floaters) are specified as a “Base + Spread”. For example, 5-year G-Sec
21
+ 2 percent, this means that the interest rate that is payable on the debt security would be 2
percent above whatever is the rate prevailing in the market for Government Securities of 5-
year maturity.

The returns in a debt portfolio are largely driven by interest rates and credit spreads.

22
Interest Rates

Suppose an investor has invested in a debt security that yields a return of 8 percent.
Subsequently, yields in the market for similar securities rise to 9 percent. It stands to reason
that the security, which was bought at 8 percent yield, is no longer such an attractive
investment. It will therefore lose value. Conversely, if the yields in the market go down, the
debt security will gain value. Thus, there is an inverse relationship between yields and value
of such debt securities, which offer a fixed rate of interest.

Let us look at another example:

Suppose Company X issued a debenture for a period of 5 years carrying a coupon rate of 9.5
percent p.a. The debenture carried credit rating of AAA, which denotes highest safety.

Two years later, the debenture has residual maturity of 3 years, i.e., the debenture will
mature after 3 years. At this stage, the interest rate for AAA rated debentures having 3-year
maturity is 8.5 percent p.a. In such a case, the Company X debenture would fetch premium
in the secondary market over its face value.

A security of longer maturity would fluctuate a lot more, as compared to short tenor
securities. Debt analysts’ work with a related concept called modified duration to assess
how much a debt security is likely to fluctuate in response to changes in interest rates.
Higher the modified duration of a debt security, greater is the volatility in its prices in
response to changes in interest rates in the market.

In a floater, when yields in the market go up, the issuer pays higher interest; lower interest
is paid, when yields in the market go down. Since the interest rate itself keeps adjusting in
line with the market, these floating rate debt securities tend to hold their value, despite
changes in yield in the debt market.

If the portfolio manager expects interest rates to rise, then the portfolio is switched towards
a higher proportion of floating rate instruments; or fixed rate instruments of shorter tenor
(which have lower modified duration). On the other hand, if the expectation is that interest
rates would fall, then the manager increases the exposure to longer term fixed rate debt
securities (which have higher modified duration).

The calls that a fund manager takes on likely interest rate scenario are therefore a key
determinant of the returns in a debt fund – unlike equity, where the calls on sectors and
stocks are important.

Credit Spreads

Suppose an investor has invested in the debt security of a company. Subsequently, its credit
rating improves. The market will now be prepared to accept a lower credit spread.
Correspondingly, the value of the debt security will increase in the market.
23
The investment objective of a debt will define whether the focus of the fund manager will
be on earning interest income (Accrual) or on appreciation or gains in the value of the
securities held. A money market or liquid fund, an Ultra short-term debt fund or a Floating
rate fund will focus only on accrual or interest income. The portfolio will hold only securities
with short- term maturities which have low modified duration so that there is no risk of
volatility in the values of securities held. A fund that seeks to earn a combination of coupon
income and gains in the value of the securities will hold a portfolio of both short-term
maturities and long-term securities. Higher the proportion of long-term securities in the
portfolio, greater will be the volatility in the returns of the fund since the securities with
higher duration will see a greater volatility in their values in response to changes in interest
rates in the market.

Duration management is the strategy adopted by funds with the mandate to do so where
the fund manager alters the duration of the portfolio in anticipation of changes in interest
rate scenario. The fund manager will increase the duration of the portfolio by moving into
long term maturities if interest rates are expected to go down and vice versa. The risk in the
strategy arises from the possibility that the expectation on interest rate movements may not
materialize.

A debt portfolio manager also explores opportunities to earn gains by anticipating changes
in credit quality, and changes in credit spreads between different market benchmarks in the
market place. Including securities in portfolio whose credit rating is expected to go up will
translate into gains for the portfolio when the value appreciates in response to the re-rating
of the security. The risk is that the default risk in the portfolio will go up if the expected re-
rating does not materialize.

Depending on the investment strategy, the fund managers may take or avoid these risks. If
the asset allocation for the category is tightly defined by SEBI or through the scheme
document, there is not much room for the fund manager. For example, in case of overnight
funds, the fund manager must invest only in overnight securities. Hence, there is no
question of taking the interest rate risk. On the other hand, when the limits are not tightly
defined, the fund manager may assume an active role in managing the risk, e.g., an ultra-
short term debt fund may take credit risk, since the SEBI regulations only define the
permitted maturity profile, which indicates how much interest rate risk the scheme can
take.

Dynamic bond fund is a category where the fund manager may take a view on the interest
rate movements and positions the portfolio to benefit out of it. When the view is that the
rates are likely to move down, the manager may increase the maturity of the portfolio (or
buy long maturity securities and sell short maturity papers), and vice versa.

10.3.3 Factors Affecting Performance of Gold Funds

Gold, as an asset class does not generate any current income. This was discussed in Chapter
24
 1. In such a case, the only way an investor in gold makes money is when one is able to sell
the gold at prices higher than one’s cost of purchase. The gold prices move on account of
the demand-supply balance or imbalance as well as the general view on the price of the
asset.

Gold is a truly international asset, whose quality can be objectively measured. The value of
gold in India depends on the international price of gold (which is quoted in foreign
currency), the exchange rate for converting the currency into Indian rupees, and any duties
on the import of gold.

Therefore, returns in gold as an asset class depends on the following factors:

Global price of gold

Gold is seen as a safe haven asset class. Therefore, whenever there is political or economic
turmoil, gold prices shoot up.

Most countries hold a part of their foreign currency reserves in gold. Similarly, institutions
like the International Monetary Fund have large reserves of gold. When they come to the
market to sell, gold prices weaken. Purchases of gold by large countries tend to push up the
price of gold.

Strength of the Rupee

Economic research into inflation and foreign currency flows helps analysts anticipate the
likely trend of foreign currency rates.

When the rupee becomes stronger, the same foreign currency can be bought for fewer
rupees. Therefore, the same gold price (denominated in foreign currency), translates into a
lower rupee value for the gold portfolio. This pushes down the returns in the gold fund. A
weaker rupee, on the other hand, pushes up the rupee value of the gold portfolio, and
consequently the returns in gold would be higher.

Since the gold funds are passive in nature, the fund manager does not take a view on the
movement of gold prices. Such funds simply invest in gold and hence there is no risk related
to the decisions taken by the fund management team.

10.3.4 Factors affecting performance of Real Estate funds

Unlike gold, real estate is a local asset. It cannot be transported – and its value is driven by
local factors. Some of these factors are:

Economic scenario

At times of uncertainty about the economy (like recessionary situation), people prefer to
postpone real estate purchases and consequently, real estate prices weaken. As the
25
economy improves, real estate prices also tend to keep pace.

26
Infrastructure development

Whenever infrastructure in an area improves, real estate values increase.

Interest Rates

When money is cheap and easily available, more people buy real estate. This pushes up real
estate prices. Rise in interest rates therefore softens the real estate market.

The behaviour of real estate is also a function of the nature of real estate viz. residential or
commercial; industrial, infrastructural, warehouse, hotel or retail.
Similarly, a lot of innovation is possible in structuring the real estate exposure. Real estate
analysts are experts in assessing the future price direction of different kinds of real estate,
and structuring exposure to them.

The composition of the portfolio is the most important driver of returns in a scheme. The
factors that drive the return of some of the asset classes are discussed above. The factors
that cause fluctuation in the returns of these asset classes, and the schemes that invest in
them, are discussed in a later section on risk drivers.

Real estate investments can generate returns in two ways, viz. rental income and capital
appreciation. While the former could accrue regularly, the latter is difficult to determine as
the same may happen over a period of time and it is difficult to ascertain the same in the
short term.

SEBI has mandated that the mutual funds employ neutral valuation agencies to determine
the current valuation of the real estate investments. Currently, there are no mutual fund
schemes investing in real estate.

10.4 Measures of Returns

The returns from an investment are calculated by comparing the cost paid to acquire the
asset (outflow) or the starting value of the investment to what is earned from it (inflows)
and computing the rate of return. The inflows can be from periodic payouts such as interest
from fixed income securities and dividends from equity investments and gains or losses from
a change in the value of the investment. The calculation of return for a period will take both
the income earned and gains/loss into consideration, even if the gains/loss have not been
realized.

10.4.1 Simple Return

Suppose you invested in a scheme at a NAV of Rs. 12. Later, you found that the NAV has
grown to Rs. 15. How much is your return?

27
The Simple Return can be calculated with the following formula:

i.e., 25 percent

Thus, simple return is simply the change in the value of an investment over a period of time.

10.4.2 Annualized Return

Two investment options have indicated their returns since inception as 5 percent and 3
percent respectively. If the first investment was in existence for 6 months, and the second
for 4 months, then the two returns are obviously not comparable. Annualisation helps us
compare the returns of two different time periods.

The Annualized Return can be calculated as:

Investment Investment
1 2

i.e., 10 i.e., 9

10.4.3 Compounded Return

If the two investment options mentioned above were in existence for 6 years and 4 years
respectively, then it is not possible to calculate the annualised return using the above
formula as it does not consider the effect of compounding.

What is compounding? Suppose you deposited Rs. 10,000 in a cumulative bank deposit for 3
years at 10 percent interest, compounded annually.

The bank would calculate the interest in each of the 3 years as follows:

Year Opening Balance Interest Closing Balance

(Rs) (10 percent (Rs)
on opening
balance)
28
 1 10,000 1,000 11,000

2 11,000 1,100 12,100

3 12,100 1,210 13,310

Thus, at the end of the 3-year period, your principal of Rs. 10,000 would have grown to Rs.
13,310. If, on the other hand, the bank had calculated interest on simple basis, it would
have calculated interest at Rs. 1,000 for each of the 3 years, and given you Rs. 13,000.

The difference between Rs 13,310 and Rs 13,000 is the effect of compounding. Longer the
period of investment holding, higher would be the difference, if compounding is not
considered.

Compounded return can be calculated using a formula:

(Later Value / Initial Value) ^(1/n) - 1

Where: ‘n’ is the period in years.

Thus, if Rs. 1,000 grew to Rs. 4,000 in 2 years, Later Value= Rs 4,000; Initial Value = Rs 1,000;
n = 2 years, then the compounded return is given by the formula:

Thus, compounded return= ((4000/1000) ^ (1/2))-1

MS Excel will calculate the answer to be 1. This is equivalent to 1 X 100 i.e., 100 percent.
Thus, the investment yielded a 100 percent compounded return during the 2 years.

Logically, for a return of 100 percent, the initial value of Rs. 1,000 should have grown by 100
percent i.e., doubled to Rs. 2,000 in the first year; and further doubled to Rs. 4,000 in the
second year. Thus, LV had to reach a value of Rs. 4,000, which indeed was the case. It is
possible to do the above calculations, by using the concerned NAVs of a scheme. Thus, to
calculate the returns from a scheme over a specific period of time, then:

o NAV at the beginning of the period is Initial Value

o NAV at the end of the period is Later Value and

o Exact number of days during the period, divided by 365 is ‘n’

Conceptually, these calculations give you only the return in the form of change in NAV.
Another form of return for an investor in a mutual fund scheme is dividend. NAV goes down
after a dividend is paid. Therefore, in the above examples, if dividend was paid, then that
has not been captured in any of the three kinds of returns calculated viz. Simple, Annualised
and Compounded.

29
The above three formulae are thus applicable only for growth schemes, or for Income
distribution cum capital withdrawal (dividend) scheme that have not paid a dividend during
the period for which return is being calculated.

Whenever a dividend is paid – and compounding is to be considered - the CAGR technique

(or the reinvestment method, as some call it) prescribed by SEBI is used.

10.4.4 Compounded Annual Growth Rate

The CAGR calculation is based on an assumption that the dividend would be re-invested in
the same scheme at the ex-dividend NAV. The following example will clarify the calculation.

You invested Rs. 10,000 in a scheme at Rs. 10 per unit on June 30, 2019

On January 1, 2020, the scheme paid out a dividend of Re. 1 per unit. The ex-dividend NAV
was Rs. 12.50.

On January 1, 2021, the scheme paid out another dividend of Re. 1 per unit. The ex-dividend
NAV was Rs. 15.

Let us calculate the CAGR, which we know captures the impact of both dividend payments
and compounding.

We know that the initial value of investment is Rs. 10,000.

If Rs. 10,000 was invested at Rs. 10 per unit, then you would have 1,000 units (i.e., Rs.
10000/Rs. 10).

The first dividend of Re. 1 per unit on 1,000 units would amount to Rs. 1,000. If this amount
was re-invested in the same scheme at the ex-dividend NAV, then you would have 80
additional units (i.e., Rs. 1000/Rs. 12.50, where the reinvestment happens at the ex-
dividend NAV of Rs. 12.50).

Thus, your unit-holding would have gone up from 1,000 to 1,080 units.

The second dividend of Re. 1 per unit, on the revised unit-holding of 1,080 units would
amount to Rs. 1,080. If this amount were re-invested in the same scheme at the ex-dividend
NAV, then you would have 72 additional units (Rs. 1,080/Rs. 15, reinvestment at the ex-
dividend NAV).

Thus, your unit-holding would have gone up from 1,080 to 1,152 units. At Rs. 15 per unit,
this would be valued at Rs. 17,280.

Therefore, the later value of units is Rs. 17,280.

The impact of dividend has been captured in the form of increase in the number of units.

You now need the time period in years, to compute the compounded returns. The period of
30
 June 30, 2019 to January 1, 2021 has 551 days. Dividing by 365, it translates to 1.51 years.

Thus, the investment period in years (n) is 1.51 years.

Now the compound interest formula can be applied. (Later Value/Initial Value) ^(1/n) - 1
Where ’n’ is the period in years.

Here, Rs. 10,000 grew to Rs. 17,280 in 1.51 years, LV = Rs. 17,280; IV = Rs. 10,000; n = 1.51
years.

= ((17280/10000) ^ (1/1.51))-1

MS Excel will calculate the answer to be 0.4365. This is equivalent to 0.4365 X 100 i.e., 43.65
percent. Thus, the investment yielded a 43.65 percent CAGR between June 30, 2019 and
January 1, 2021. To be noted, this calculation does not take taxation into account.

Scheme Returns and Investor Returns

The discussion so far focused on scheme returns. Investors might have a return profile that
is different, on account of the role of loads.

In the earlier example, the CAGR was calculated with the closing NAV as Rs. 15. However, if
an exit load of 1 percent was applicable, then the investor will receive only 99 percent of Rs.
15 i.e., Rs. 14.85 on re-purchase. Thus, your return as investor would be lower than the
scheme returns.

Similarly, if the original investment had suffered an entry load of 2 percent, you would have
bought the units at 102 percent of Rs. 10 i.e., Rs. 10.20. This would have brought down the
returns. (Note: Entry load is no longer permitted).

Loads thus drag down the investor’s return below the scheme return. Even taxes would pull
down the investor’s post-tax returns.

While calculating investor returns for a period, the same formulae can be used, with the
following changes:

 Instead of the initial value of NAV (which is used for calculating scheme returns), the
amount actually paid by the investor (i.e., NAV plus Entry Load, if any) would need
to be used.
 Instead of the later value of NAV (which is used for calculating scheme returns), the
amount actually received/receivable by the investor (i.e., NAV minus Exit Load, if
any) would need to be used.

Investor returns might vary from the scheme returns also on account of choices regarding
investment schedule, i.e., additional investment being made during the period or redeeming
a portion of the investment. In such a case, for the same period investor’s returns may be
different from the published returns of the scheme.

31
 The returns published in a mutual fund advertisement would be without factoring the entry
or exit load, as may be applicable.

Holding period returns is calculated for a fixed period such as one month, three months, one
year, three years or since inception. The return is calculated using CAGR if the holding
period is over one year and simple absolute returns for less than one year. Holding period
returns may not present an accurate picture of the returns from a fund if the initial value or
the end value used for calculation was too high or low. To eliminate this impact rolling
returns are calculated. Rolling returns is the average annualized return calculated for
multiple consecutive holding periods in an evaluation period. For example, all consecutive
one year returns in a three-year period with a daily/weekly/monthly rollover is calculated
and averaged.

Pros and Cons of Evaluating Funds only on the Basis of Return Performance

The primary factor that investors use for selecting a mutual fund for investment is the
return that it has generated. To make the selection more robust, it is important to consider
the consistency of the return performance and the performance relative to the benchmark
of the scheme and its peer group funds. It is important for an actively managed fund to
perform well in rising markets and fall less than the benchmark in a declining market.

However, the return number alone is not adequate to make a decision to invest in a scheme
or exit from a scheme. The suitability of the scheme to an investor’s needs must also
consider the risk associated with the scheme. This includes evaluating factors like the
volatility in returns over time. The extent of volatility indicates the riskiness of the scheme.

10.5 SEBI Norms regarding Representation of Returns by Mutual Funds in India

Mutual funds are not permitted to promise any returns, unless it is an assured returns
scheme. Assured returns schemes call for a guarantor who is named in the SID. The
guarantor will need to write out a cheque, if the scheme is otherwise not able to pay the
assured return.

Advertisement Code and guidelines for disclosing performance related information of mutual
fund schemes are prescribed by SEBI. The same has been discussed earlier.

10.6 Risks in fund investing with a focus on investors

Section 10.1 of this book covered the discussion on various general and specific risk factors
in mutual fund schemes. The same must be seen from the point of view of the investors. It is
understood that the investor is taking some risks while investing in mutual funds. However,
in order to sell schemes suitable for the investor’s situation, the distributor needs to
understand the impact of these risks. The risks discussed in section 10.1 must be seen in
32
 light of the objective for which an investor has invested the money.

Risks in Equity Funds

An investor would be exposed to the risk of price fluctuations in an equity fund. The risk is
likely to go up when one moves from large-cap to mid-cap to small-cap schemes. In the
same manner, the business risk or the risk of failure of a company’s business also tends to be
higher in case of small-cap companies in comparison to mid-caps, and higher in case of mid-
caps in comparison to large caps. The liquidity risk is another risk that an equity fund
investor must be careful of, although equity investments are suitable for long term. All these
risks increase in a focused fund due to portfolio concentration.

The result of these risks could be that the investor’s objective of long-term growth from the
equity fund may not materialize due to the possibility of lower-than-expected returns. At
the same time, the presence of these risks also increases the return potential.

An investor should invest in equity funds in line with one’s risk profile. It would also be
prudent to ensure adequate liquidity in the portfolio through liquid funds so that one does
not have to resort to selling equity funds, if one needs money when the stock markets are
down.

10.6.1 Risks in Debt Funds

Debt funds or income funds are often used for providing stability to the portfolio or for the
purpose of generating regular income. A large number of investors are not exposed to
fluctuations in prices of their debt instruments, especially majority of Indians who invest in
non-marketable debt instruments, such as fixed deposits or small savings schemes. On the
other hand, debt fund NAVs may fluctuate due to change in interest rates or due to credit
migration. That means the debt fund portfolio may not be as stable as one expected.

Some investors opt for the Income distribution cum capital withdrawal (dividend) option in
order to receive regular income. However, such income is not guaranteed and there have
been instances in the past where some schemes have skipped paying the dividends during
certain periods, due to non-availability of distributable surplus (See Section 7.3 in the book).

The liquid, ultra-short term, or low duration funds are often used for parking of money for
short term. If gating provisions are applied or segregated portfolio is created, only partial
liquidity may be available. Section 10.8 explains gating provisions and segregated portfolio
in details

In case the segregated portfolios are not created, and some other investors exit from the
scheme, the investors who stay invested would be exposed to even greater risks. This is
explained in the below example:
33
Assume that XYZ Debt Fund investment in debentures of ABC Ltd. is to the extent of
5percent of scheme’s NAV. Sometime later the said debenture defaulted on repayment. If
the segregated portfolio was not created, the debenture would continue to remain part of
the portfolio. If various investors due to this credit default withdraw 50 percent of the
money from the scheme, the scheme would be required to sell the debentures that some
buyers are ready to buy. That means the scheme would end up holding debenture of ABC
Ltd. and sell some other papers. In such a case, the exposure to ABC Ltd.’s debenture on the
remaining portfolio would be 10 percent. The investors, who continued to stay invested got
a bigger problem.

In the recent past, there have been a few credit events that hit even the liquid funds, ultra-
short-term debt funds, and low duration funds. This highlighted once again that while these
scheme categories may be safe in terms of interest rate risk, these are not absolutely safe
when it comes to credit risk. The critical point to understand is “low risk” does not mean
“zero risk”.

Currently according to the SEBI (Mutual Funds) Regulations, 1996 and SEBI circular dated
December 28, 2018, every close-ended scheme (other than ELSS) and units of segregated
portfolio are required to be listed on recognized stock exchanges. As per MF Regulations,
there are several steps envisaged with respect to winding up of Mutual Fund schemes
before the scheme ceases to exist. During this process, such units can be listed and traded
on a recognized stock exchange, which may provide an exit to investors. Accordingly, the
units of Mutual Fund schemes which are in the process of winding-up in terms of
Regulation 39(2)(a) of MF Regulations, shall be listed on recognized stock exchange, subject
to compliance with listing formalities as stipulated by the stock exchange.

10.6.2 Risks in Hybrid Funds

SEBI circular on mutual fund scheme categorization defined the asset allocation between
equity and debt in case of certain categories within the hybrid funds. The distributor must
be careful in evaluating and selecting the schemes.

It is widely believed that the arbitrage funds are very safe since they employ arbitrage
strategies that nullify the exposure to any security or the stock markets. However, some
arbitrage funds have the provision to invest in debt securities, as well as to employ
strategies like “paired arbitrage”, or “alpha hedging”, or “merger arbitrage". In all these
cases, the fund manager is taking a view on the price movement and not employing pure
arbitrage. If the judgment turns out to be wrong, the investor could lose some money, or
earn low returns.

10.6.3 Risk in Gold Funds

As an international commodity, gold prices are difficult to manipulate. Therefore, there is

34
better pricing transparency.

Further, gold does well when the other financial markets are in turmoil. Similarly, when a
country goes into war, and its currency weakens, gold funds generate excellent returns.

These twin benefits make gold a very attractive risk proposition. An investor in a gold fund
needs to be sure what kind of gold fund it is – Gold Sector Fund or Gold ETF. Gold funds
have the risk that if the value or price of gold falls then the investor could end up making a
loss too.

10.6.4 Risk in Real Estate Funds

Investment in real estate is subject to various kind of risks. Every real estate asset is
different; therefore, its valuation is highly subjective. Real estate is a less liquid asset class.
The intermediation chain of real estate agents is largely unorganized in India. Transaction
costs, in the form of stamp duty, registration fees, etc. are high. Regulatory risk is high in real
estate, as is the risk of litigation and other encumbrances. The transparency level is low
even among the real estate development and construction companies.

Many real estate groups are family-owned and family-driven, therefore there is poor
corporate governance standards which also increases the risks of investing in their
securities. Thus, real estate funds are quite high in risk, relative to other scheme types. Yet,
they are less risky than direct investment in real estate.

10.7 Measures of Risk

Fluctuation in returns is used as a measure of risk. Therefore, to measure risk, generally the
periodic returns (daily/weekly/fortnightly/monthly) are first worked out, and then their
fluctuation is measured against the average return. The fluctuation or variation may be to
the higher or lower side. Both are taken as risky. The fluctuation in returns can be assessed
in relation to itself, or in relation to some other index. Accordingly, the following risk
measures are commonly used.

10.7.1 Variance

Suppose there are two schemes, with monthly returns as follows:

Month Returns (%)

Scheme 1 Scheme 2
1 5 5
2 4 -5
3 5 10

Month Returns (%)

Scheme 1 Scheme 2
35
 4 6 5
Average Return 5 3.75
Variance 0.67 39.58

Variance measures the fluctuation in periodic returns of a scheme, as compared to its own
average return.

This can be easily calculated in MS Excel using the following function:

= var (range of cells where the periodic returns are calculated)3
Variance as a measure of risk is relevant for both debt and equity schemes.

10.7.2 Standard Deviation

Like Variance, Standard Deviation too measures the fluctuation in periodic returns of a
scheme in relation to its own average return. Mathematically, standard deviation is equal to
the square root of variance.

Standard deviation is a measure of total risk in an investment. As a measure of risk, it is

relevant for both debt and equity schemes.

A high standard deviation indicates greater volatility in the returns and greater risk.
Comparing the standard deviation of a scheme with that of the benchmark and peer group
funds gives the investor a perspective of the risk in the scheme. Standard deviation along
with the average return can be used to estimate the range of returns that the investment
will take.

Since standard deviation is calculated using historic numbers it has limited use in predicting
future performance.

The NAV of any scheme would keep fluctuating in line with changes in the valuation of
securities in its portfolio. The change in NAV of the growth option of a scheme captures the
scheme’s return, as already discussed. The return can thus be calculated at different points
of time, keeping the time period constant.

The standard deviation of the periodic returns can be calculated, using the ‘=stdev’ function
in MS Excel, as=stdev (range of cells where the periodic returns are calculated). This is
exhibited below in illustration 10.1.

Illustration 10.1: Calculating standard deviation

3
At least 30 observations are required in the series in order to compute an accurate statistical value of standard deviation.
36
Standard deviation is a statistical measure of how much the scheme’s return varies as
compared to its own past standard. It is a measure of total risk in the scheme. Higher the
standard deviation, riskier the scheme is.

The standard deviation has been calculated above, based on weekly returns. 52 weeks
represent a year. Therefore, the standard deviation can be annualised by multiplying the
weekly number by the square root of 52 [written in excel as ‘sqrt (52)’].

The annualised standard deviation would therefore be 0.65 X sqrt (52) i.e., 4.70 percent
(rounded).

While working with monthly returns, the standard deviation would be multiplied by sqrt
(12); in the case of daily returns, it would be multiplied by sqrt (252), because there are 252
trading days in a year, after keeping out the non-trading days (Saturdays, Sundays, holidays).

10.7.3 Beta
Beta is based on the Capital Asset Pricing Model (CAPM), which states that there are two
kinds of risk in investing in equities – systematic risk and non-systematic risk. This has been
explained in the earlier section. Since non-systematic risk can be diversified away, investors
need to be compensated only for systematic risk, according to CAPM. This systematic risk is
measured by its Beta.

Beta measures the fluctuation in periodic returns in a scheme, as compared to fluctuation in

periodic returns of a diversified stock index (representing the market) over the same period.

The diversified stock index, by definition, has a Beta of 1. Companies or schemes, whose
beta is more than 1, are seen as riskier than the market. Beta less than 1 is indicative of a
company or scheme that is less risky than the market.

An investment with a beta of 0.8 will move 8 percent when markets move by 10 percent.
This applies to increase as well as fall in values. An investment with a beta of 1.2 will move
by 12 percent both on the upside and downside when markets move (up/down) by 10
percent.

Beta as a measure of risk is relevant only for equity schemes.

10.7.4 Modified Duration

Modified duration measures the sensitivity of value of a debt security to changes in interest
rates. Higher the modified duration, higher is the interest sensitive risk in a debt portfolio.

A professional investor would rely on modified duration as a better measure of sensitivity to

37
interest rate changes.

38
10.7.5 Weighted Average Maturity
Broadly, it can be said that the extent of fluctuation in value of the fixed rate debt security
is a function of its time to maturity (balance tenor). Longer the balance tenor, higher would
be the fluctuation in value of the fixed rate debt security arising out of the same change in
interest rates in the market.

This has led to the concept of weighted average maturity in debt schemes. If a scheme has
70 percent of its portfolio in a 4-year security, and balance 30 percent in a 1-year security,
the weighted average maturity can be calculated to be (70 percent X 4 years) + (30 percent
X 1 year) i.e., 3.1 years. The NAV of such a scheme can be expected to fluctuate more than
another debt scheme with a weighted average maturity closer to 1.5 years.

While modified duration captures interest sensitivity of a security better, it can be reasoned
that longer the maturity of a debt security, higher would be its interest rate sensitivity.
Extending the logic, weighted average maturity of debt securities in a scheme’s portfolio is
indicative of the interest rate sensitivity of a scheme.

Being simpler to comprehend, weighted average maturity is widely used, especially in

discussions with lay investors. However, a professional debt fund manager would rely on
modified duration as a better measure of interest rate sensitivity.

10.7.6 Credit Rating

The credit rating profile indicates the credit or default risk in a scheme. Government
securities do not have a credit risk. Similarly, cash and cash equivalents do not have a credit
risk. Investments in corporate issuances carry credit risk. Higher the credit rating, lower is
the default risk.

Better the credit rating of an issuer, lower is the spread. Issuers with a poor credit rating
need to offer higher yields to attract investors. Therefore, the spread on such securities is
higher.

Credit rating too changes over time. A security that was rated ‘AAA’, can get downgraded to
say, ‘AA’. In that case, the yield expectations from the security would go up, leading to a
decline in its market value. Thus, a shrewd investor who anticipates an improvement in credit
rating on an instrument can benefit from the increase in its value that would follow.

10.8 Certain Provisions with respect to Credit risk

In the debt markets, the credit risk arises on account of three things, viz., default, delay in
payments, or rating downgrade. Any of these may result in fall in prices of the concerned
debt securities. Such an event is also called a credit event. Whenever a credit event
happens, it may lead to reduction in the trading volume of the respective paper. In such a

39
case, mutual funds may come under stress, if a large part of the scheme is redeemed. Here
is an example to understand this:
Assume that a scheme worth Rs. 10,000 crores hold 8 percent exposure in a single debt
paper–debenture ‘M’. If this paper is downgraded, the investors in the scheme may get
concerned and would want to redeem their investments. Assume that roughly 20 percent of
the scheme’s size, i.e., Rs. 2,000 crores are redeemed. Since debenture ‘M’ has been
downgraded, there may be no takers for the same in the debt market. In such a case, the
fund manager of the scheme may be forced to sell other securities, which would mean that
while the corpus of the scheme drops to Rs. 8,000 crores. Thus, the exposure of the scheme
to debenture M increases to 10 percent.

Original corpus of the scheme = Rs. 10,000 crores

Exposure to debenture M = 8 percent of the portfolio = Rs. 800 crores Reduced corpus of

the scheme after 20 percent redemption = Rs. 8,000 crores Now the scheme’s exposure to

debenture M = Rs. 800 crores/Rs. 8,000 crores

= 10 percent

If some other investors panic after seeing a larger exposure to debenture M and they also
redeem their investments, and if the corpus size reduces by half, the exposure to debenture
M doubles from here, which means now the scheme holds debenture M worth 20 percent
of the scheme’s NAV. This can go on and on. The problem with this is that the scheme’s
exposure to the affected paper keeps going up and that exposes the scheme’s investors to a
greater risk of potential loss of capital. As per regulation, a scheme can hold maximum 10
percent in securities issued by a single issuer.
On the other hand, there could be situations when the market-wide liquidity dries up, such
that the scheme is unable to liquidate some of the positions it holds in certain securities.
This may also mean that while the scheme may continue to hold a well- diversified portfolio
across good quality securities, it is unable to liquidate the same and hence cannot fund the
redemptions.
In order to reduce the impact of such risks, SEBI has allowed two provisions:
1. Gating or restriction on redemption in mutual funds
2. Segregated portfolios or side-pocketing

10.8.1 Gating or restriction on redemption in mutual funds

As a philosophy, restriction on redemption should apply during excess redemption requests

that could arise in overall market crisis situations rather than exceptional circumstances of
entity specific situations. The circumstances calling for restriction on redemption should be
such that illiquidity is caused in almost all securities affecting the market at large, rather

40
than in any issuer specific securities.

In order to protect the interest of the investors, the following requirement shall be observed
before imposing restriction on redemptions:
Such restrictions may be imposed only when there are circumstances leading to a systemic
crisis or event that severely constricts market liquidity or the efficient functioning of markets
such as:

a. Liquidity issues – when the market at large faces illiquidity affecting almost all securities.
This means that such a measure cannot be employed during illiquidity in case of any
particular security. AMCs should have sound internal liquidity management systems and
tools in place for the mutual fund schemes. The restriction cannot be used as a tool to
manage the liquidity of a scheme. Similarly, such restriction is not allowed in case of
illiquidity of a specific security in the portfolio due to poor investment decision.
b. Market failure or exchange closure–when markets are affected by unexpected events
which impact the functioning of exchanges or the regular course of transactions. Such
unexpected events could also be related to political, economic, military, monetary or other
emergencies.
c. Operational issues–when exceptional circumstances are caused by force majeure,
unpredictable operational problems and technical failures (e.g., a black out). Such cases
can only be considered if they are reasonably unpredictable and occur in spite of
appropriate diligence of third parties, adequate and effective disaster recovery procedures
and systems.

According to SEBI regulations, such restrictions may be imposed only for a specified period
not exceeding 10 working days in any 90-day period. Any imposition of restriction would
require specific approval of Board of AMCs and Trustees and the same is required to be
informed to SEBI immediately. When restriction on redemption is imposed, the following
procedure shall be applied:

 No redemption requests up to Rs. 2 lakhs shall be subject to such restriction;

 When redemption requests are above Rs. 2 lakhs, AMCs shall redeem the first Rs. 2 lakhs
without such restriction and remaining part, i.e., amounts over and above Rs. 2 lakhs shall
be subject to the restriction.
The above information to investors shall be disclosed prominently and extensively in the
scheme related documents regarding the possibility that their right to redeem may be
restricted in such exceptional circumstances and the time limit for which it can be
restricted.

10.8.2 Segregated portfolio or side pocketing

To ensure fair treatment to all investors in case of a credit event and to deal with the
liquidity risk, in December 2018, SEBI permitted creation of segregated portfolio of debt and

41
money market instruments by mutual funds schemes. “Segregated portfolio” means a
portfolio, comprising of debt or money market instrument affected by a credit event, that
has been segregated in a mutual fund scheme. “Main portfolio” means the scheme portfolio
excluding the segregated portfolio. Asset Management Company (AMC) were allowed to
create segregated portfolio in a mutual fund scheme in case of a credit event at issuer level
i.e., downgrade in credit rating by a SEBI registered Credit Rating Agency (CRA). Vide the
December 28, 2018 circular, creation of segregated portfolio was made optional and at the
discretion of the AMC.

In partial modification to SEBI circular issued in December 2018, SEBI permitted to create
segregated portfolio of unrated debt or money market instruments by mutual fund schemes
of an issuer that does not have any outstanding rated debt or money market instruments
subject to the following:

 Segregated portfolio of such unrated debt or money market instruments may be created
only in case of actual default of either the interest or principal amount. As per SEBI
circular dated December 28, 2018, credit event is considered for creation of segregated
portfolio, however vide SEBI circular dated November 7, 2019, ‘actual default’ by the
issuer of such instruments was considered for creation of segregated portfolio.
 The respective AMC is required to inform AMFI immediately about the actual default by
the issuer. Upon receiving such information, AMFI is required to immediately inform the
same to all AMCs. Pursuant to dissemination of information by AMFI about actual
default by the issuer, AMCs may segregate the portfolio of debt and money market
instruments of the said issuer in terms of SEBI circular dated December 28, 2018.
 SEBI has mandated that all new schemes launched after November 7, 2019 shall have
the enabling provisions included in the SID for creation of segregated portfolio.
 AMCs shall have a detailed written down policy on creation of segregated portfolio and
the same shall be approved by the trustees.

Once trustee’s approval is received by the AMC:

 Segregated portfolio shall be effective from the day of credit event.

 AMC shall issue a press release immediately regarding details about segregated portfolio.
 NAV of both segregated and main portfolio shall be disclosed from the day of the credit
event.
 All existing investors shall be allotted equal number of units in the segregated portfolio
as held in the main portfolio as on the day of the credit event.
 No redemption or subscription is allowed in the segregated portfolio. However, in order
to facilitate exit to unitholders in segregated portfolio, AMC shall enable listing of units
of segregated portfolio on the recognized stock exchange within 10 working days of
creation of segregated portfolio and also enable transfer of such units on receipt of
transfer requests.

Upon trustee’s approval to create a segregated portfolio, the investors redeeming proceeds

42
 based on the NAV of main portfolio will continue to hold the units of segregated portfolio.
However, investors subscribing to the scheme, will be allotted units only in the main
portfolio based on its NAV. In case trustees do not approve the proposal of segregated
portfolio, subscription and redemption application will be processed based on the NAV of
the total portfolio.

TER for Segregated Portfolio

1) AMC will not charge investment and advisory fees on the segregated portfolio. However,
TER (excluding the investment and advisory fees) can be charged, on a pro-rata basis only
upon recovery of the investments in segregated portfolio.

2) The TER so levied shall not exceed the simple average of such expenses (excluding the
investment and advisory fees) charged on daily basis on the main portfolio (in percent
terms) during the period for which the segregated portfolio was in existence.

3) The legal charges related to recovery of the investments of the segregated portfolio may be
charged to the segregated portfolio in proportion to the amount of recovery. However, the
same shall be within the maximum TER limit as applicable to the main portfolio. The legal
charges in excess of the TER limits, if any, shall be borne by the AMC.

4) The costs related to segregated portfolio shall in no case be charged to the main portfolio.

Net Asset Value of Segregated Portfolio

The Net Asset Value (NAV) of the segregated portfolio is required to be declared on a daily
basis. Adequate disclosure of the segregated portfolio shall appear in all scheme related
documents, in monthly and half-yearly portfolio disclosures and in the annual report of the
mutual fund and the scheme.

Risks Associated with Segregated Portfolio

1) Investor holding units of segregated portfolio may not able to liquidate their holding till
the time of recovery of money from the issuer.
2) Securities comprising segregated portfolio may not realize any value.
3) Listing of units of segregated portfolio in recognized stock exchange does not necessarily
guarantee their liquidity. There may not be active trading of units in the stock market.
Further trading price of units on the stock market may be significantly lower than the
prevailing NAV.

The following case illustrates the concept of segregated portfolios.

Illustration of Segregated Portfolio:

Portfolio Date: 30 September 2019

Portfolio on the date of credit event

43
 Price Per
Unit Market
Security Rating Type of security Qty (INR) Value
(INR)
8.00 % XYZ Ltd.* (A) CRISIL A- Non-Convertible Debenture 25000 49.552 12,38,800
7.80% AVC Ltd. (B) CRISIL AAA Non-Convertible Debenture 25000 101.021 25,25,525
7.65% UYV Ltd. (C) CRISIL AAA Non-Convertible Debenture 21000 100.022 21,00,462
8.10% MNO Ltd. (D) CRISL A- Non-Convertible Debenture 30000 99.548 29,86,440
Cash and Cash Equivalent (E) 11,50,000
Net Assets (A+B+C+D+E) 1,00,01,227
Unit Capital (no. of units) 10,000
NAV per unit (INR) 1000.1227

*Downgraded security

Downgrade event date: 30 September 2019

Downgrade Security: 8 percent XYZ ltd. from A- to C

Valuation marked down: 50 percent

Before marked down, the security was valued at Rs.99.105/- per unit. On the date of credit
event i.e., on 30 September 2019, NCD of 8 percent XYZ Ltd will be moved to a segregated
portfolio.

Main portfolio as on 30th September

2019
Price Per Unit
(INR) Market
Security Rating Type of security Qty Value (INR)
7.80% AVC Ltd. (B) CRISIL AAA Non-Convertible Debenture 25,000 101.021 25,25,525
7.65% UYV Ltd. (C) CRISIL AAA Non-Convertible Debenture 21,000 100.022 21,00,462
8.10% MNO Ltd. (D) CRISL A- Non-Convertible Debenture 30,000 99.548 29,86,440
Cash and Cash Equivalent (E) 11,50,000
Net Assets (B+C+D+E) 87,62,427
Unit Capital (no. of units) 10,000
NAV per unit (INR) 876.2427

Segregated Portfolio as on 30th September 2019

Non-Convertible
8.00 % XYZ Ltd.# (A) CRISIL C 25,000 49.552 12,38,800
Debenture
Net Assets (A only since this
comprises of only this security) 12,38,800
Unit Capital (no. of units) 10,000
NAV per unit (INR) 123.88

This security was marked down by 50 percent on the date of credit event.

44
 Total Portfolio value after creation of segregated portfolio
Total Value
Particular Main Portfolio Segregated Portfolio (INR lakhs)
Number of Units 10,000 10,000
Total Value 87,62,427 1,238,800 1,00,01,227
NAV per unit (INR) 876.2427 123.88 1000.1227

Risk mitigation

We have discussed the various aspects of risks in MF investments. However, there are
mitigants as well.

Equity: Adequately long holding period is a great leveller. While price fluctuations in the
market do happen, history shows that the longer your holding period, the lower is the
volatility in your returns. As an example, if your holding period is one year in an equity fund,
you stand to earn highly positive, moderate or deeply negative returns, depending on
market movement. If your holding period is five years, the extremes i.e., highly positive or
highly negative would be more in a range. You are likely to earn positive or moderate
returns. If your investment horizon is ten years, then, as per history, the probability of
earning negative returns is next to nil. Higher probability is, you will earn decent positive
returns.

The rationale is, market cycles do happen, prices move up and down. Over a long horizon,
cycles take care of themselves i.e., It settles down in a range. Over a short holding period,
you risk facing the “waves” in the market.

Debt: Credit risk can be gauged from the credit rating of the securities in the portfolio.
Certain portfolios e.g., Government Securities Funds, Target Maturity Funds or Corporate
Bond Funds run better quality portfolios. For the interest rate risk, it is again your holding
period. As a ballpark guidance, if you match your holding period with the portfolio maturity
of the fund, you are reasonably protected from market fluctuations.

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Chapter 10: Sample Questions

1. Unsystematic risk can be reduced through diversification. State whether True or

False.

a. True
b. False

2. Which of the following type of analysis tracks the price and volume data related to
trading in the security?

a. Quantitative analysis
b. Fundamental analysis
c. Technical analysis
d. Situation analysis

3. An investor invested in scheme A when the scheme’s NAV was Rs. 120 per unit. The
investor redeemed the investments at the NAV of Rs. 135. Calculate the simple return.

a. 10.00 percent
b. 11.11 percent
c. 12.50 percent
d. 15.00 percent

4. Which of the following is a measure of fluctuation in periodic returns in an equity

mutual fund scheme?

a. Variance
b. Sharpe ratio
c. Modified duration
d. Jensen’s Alpha

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