PORTFOLIO EVALUATION
MUTUAL FUND
Mutual fund is an investment vehicle that pools
together funds from investors to purchase
stocks, bonds or other securities. An investor
can participate in the mutual fund by buying the
units of fund. Each unit is backed by a diversified
pool of assets, where the funds have been
invested. A closed-end fund has a fixed number
of units outstanding. It is open for a specific
period. During that period investors can buy it.
The initial offer period is terminated at the end
of the pre-determined period. The closed- end
schemes are listed in the stock exchanges. The
investor can trade the units in the stock markets
just like other securities. The prices may be
either quoted at a premium or discount.
MUTUAL FUND
In the open-end schemes, units are sold and
bought continuously. The investors can
directly approach the fund managers to buy
or sell the units. The price of the unit is
based on the net asset value of the particular
scheme. The net asset value of the fund is
the underlying securities of the scheme. The
net asset value is calculated on a daily or
weekly basis.
ADVANTAGES OF MUTUAL FUNDS
The Association of Mutual Funds in India (AMFI), a
non-profit organization serving the cause of mutual
funds, has listed the following advantages to the
investors in mutual funds.
Professional Management- Experienced fund
managers supported by a research team, select
appropriate securities to the fund. The forecasting
of the market is done efficiently.
Diversification- Mutual funds invest in a diverse
range of securities and over many industries.
Hence, all the eggs are not placed in one basket.
Normally an investor has to have large sum of
money to achieve this objective, if he invests
directly in the stock market. Through mutual funds,
he can achieve diversification of portfolio at a
fraction of the cost.
ADVANTAGES OF MUTUAL FUNDS
Convenient administration- For the investors there is reduction in
paper work and saving in time. It is also very convenient. Mutual
finds help in overcoming the problems relating to bad deliveries,
delayed payments and the like.
Return potential- Medium and the long term mutual funds have the
potential to provide high returns.
Low cost- the funds handle the investments of a large number of
people, they are in a position to pass on relatively low brokerage and
other costs. This is because the funds can take advantage of the
economics of scale.
Liquidity- Mutual funds provide liquidity in two ways. In open-end
schemes, the investor can get back his money at any time by selling
back the units to the fund at NAV related prices. In closed-end fund,
he has the option to sell the units through the stock exchange.
Transparency- Mutual fund provide information on each scheme
about the specific investments made there under and so on.
ADVANTAGES OF MUTUAL FUNDS
Flexibility- Currently most funds have regular
investment plans, regular withdrawal plans
and dividend reinvestment schemes. A great
deal of flexibility is assured in the process.
Choices of scheme- Mutual funds offer a
variety of schemes to suit varying needs of
the investors.
Well- regulated- The funds are registered
with the Securities and Exchange Board of
India and their operations are continuously
monitored.
SHARPE’S PERFORMANCE INDEX
Sharpe’s performance index gives a single
value to be used for the performance ranking
of various funds or portfolios. Sharpe index
measures the risk premium of the portfolio
relative to the total amount of risk in the
portfolio. This risk premium is the difference
b/w the portfolio’s average rate of return and
the riskless rate of return. The standard
deviation of the portfolio indicates the risk. The
index assigns the highest values to assets that
have best risk-adjusted average rate of return
SHARPE’S PERFORMANCE INDEX
The details of two hypothetical funds A and B
are given below
Risk and Return for Funds A and B
Average Annual Riskless Rate of Standard
Fund St
Return Interest Deviation
A 0.0879 0.05 0.0829
= 0.457
B 0.1347 0.05 0.1982
= 0.427
The larger the St, better the fund has performed. Thus, A ranked
as better fund because its index .457> .427 even though the
portfolio B had a higher return of 13.47%.
TREYNOR’S PERFORMANCE INDEX
To understand the Treynor index, an investor
should know the concept of characteristic
line. The relationship b/w given market return
and the funds return is given by the
characteristic line. The fund’s performance is
measured in relation to the market
performance. The ideal funds return rises at
a faster rate than the general market
performance when the market is moving
upwards and its rate of return declines slowly
than the market return, in the decline. The
ideal fund may place its fund in the treasury
bills or short sell the stock during the decline
and earn positive return.
TREYNOR’S PERFORMANCE INDEX
With the help of the characteristic line Treynor measures the
performance of the fund. The slope of the line is estimated by
Rp = ⍺ + Rm + ep
Rp = portfolio return
Rm = the market return or index return
ep = the error term or the residual
⍺ + = Co-efficient to be estimated
Beta co-efficient is treated as a measure of un diversifiable or
systematic risk.
TREYNOR’S PERFORMANCE INDEX
Treynor’s risk premium of the portfolio is the
difference b/w the average returns and the
riskless rate of return. The risk premium depends
on the systematic risk assumed in a portfolio.
Let’s analyze two hypothetical funds
Funds A and B
Fund Average Return Beta Risk Premium Rf Tn
=.0879-.05/.499
A 0.0879 0.499 .0379 .05
= 0.076
=.1347-.05/1.2493
B 0.1347 1.2493 .0847 .05
= 0.0678
JENSEN’S PERFORMANCE INDEX
The absolute risk adjusted return measure was developed
by Michael Jensen and commonly known as Jensen’s
measure. It is mentioned as a measure of absolute
performance because a definite standard is set and against
that the performance is measured. The standard is based
on the manager’s predictive ability. Successful prediction of
security price would enable the manager to earn higher
returns than the ordinary investor expects to earn in a
given level of risk. The basic model of Jensen is given
below.
Rp = ⍺ + (Rm - Rf)
Rp = average portfolio return
Rf = riskless rate of interest
⍺ = the intercept
= a measure of systematic risk
Rm = average market return
JENSEN’S PERFORMANCE INDEX
The return of the portfolio varies in the same proportion of to
the difference between the market return and riskless rate of
interest. Beta is assumed to reflect the systematic risk. The
fund’s portfolio beta would be equal to one if it takes a
portfolio of all market securities. The would be greater than
one if the fund’s portfolio consists of securities that are riskier
than a portfolio of all market securities.
Any professional manager would be expected to earn average
portfolio return Rp = Rf + (Rm - Rf). If his predictive ability is
superior, he should earn more than other funds at each level
of risk. If the fund manager has consistently performed better
than average Rp, there would be some constant factor that
would make the actual return higher than average Rp. The
constant may be ⍺p that represents the forecasting ability of
the manager. Then the equation becomes
Rp – Rf = ⍺p + (Rm - Rf)
OR
Rp = ⍺p + Rf + (Rm - Rf)
REVIEW PROBLEM-1
Mr. X has been owned units from three different
mutual funds namely R, S and T. The following
particulars are available to him. He wants to dispose
any one of the mutual fund for his personal
expenditure. Which fund should he dispose?
Funds Excess Average Return Beta
R 7.7 1.02
S 11.3 .99
T 11.6 1.07
Market 7.8 1.00
SOLUTION
The performance can be evaluated by finding out the differential
return
Rp – Rf = ⍺p + (Rm - Rf) OR
Rp = ⍺p + Rf + (Rm - Rf)
Portfolio R
⍺p = (Rp - Rf )- p (Rm - Rf)
= 7.7-1.02 * 7.8
= -.256
Portfolio S
⍺p = 11.3- .99 * 7.8
= 3.578
Portfolio C
⍺p = 11.6- 1.07 * 7.8
= 3.254
Since the portfolio R has a negative alpha value Mr. X can sell the
portfolio R and keep the other two.
For ranking purpose, Jensen measure should be properly adjusted.
Each asset’s alpha value should be divided by its beta co-efficient.
REVIEW PROBLEM-2
The following information is provided regarding
the performance of the funds namely Birla
Advantage, Sundaram Growth and Sun F & C Value
for a period of six months ending Aug, 2019. The
risk free rate of interest is assumed to be 9. Rank
them with the help of Sharpe Index and discuss.
Rp σp
4
Birla Advantage
25.38 .23
9.01
Sundaram Growth
25.11 .56
3.55
Sun F & C Value
25.01 .59
SOLUTION
The Birla Advantage fund ranks top among three
funds because of the higher return and low
volatility in return. The Sundaram Growth fund’s
return is high compared to Sun’s but the high
volatility in return has made it to be ranked third.
REVIEW PROBLEM-3
Assuming the inputs given in Q.1, rank the
performance of the funds according to
Treynor Index.
SOLUTION
Birla Advantage fund’s high value is due to
the high risk premium i.e. 16.38 and the low
market related risk .23, whereas in the Sun
Fund, the premium is low and the market
related risk is high.
REVIEW PROBLEM-4
The following results were obtained from a
study for a period of 6 months in 2009.
Rp σp
Birla Advantage 25.38 4 .23
PI CI CI GP 36.28 6.86 .52
Alliance Equity 45.56 4.31 .63
S&P CNX 500 36.74 3.69 1
Rp 9 - -
Using the inputs, rank the funds according to the predictive
ability of the fund’s management.
SOLUTION
Jensen Index
Rp – Rf = ⍺p + (Rm - Rf)
The ⍺p indicates the management skills. To properly adjust the Jensen measure for ranking
purpose, each assets alpha should be divided by its beta.
Birla Advantage
25.38 – 9 = ⍺p + .23(36.74-9)
16.38 = ⍺p + 6.38
⍺p = 10
PI CI CI GP
36.28-9 = ⍺p + .52 (36.74-9)
27.28 = ⍺p + 14.42
⍺p = 12.86
Alliance Equity
45.56-9 = ⍺p+ .63 (36.74-9)
36.56 = ⍺p + 17.48
⍺p = 19.08
REVIEW PROBLEM-5
Widsom fund, T bills and BSE Sensex have had
the following returns over the past 5 years.
Period Wisdom fund return % [Link] return % BSE Sensex return%
2001 9 6 6
2002 -6 10 -5
2003 14 8 11
2004 12 7 10
2005 16 9 13
What is the predictive ability of the fund?
SOLUTION
The solution value can be determined as follows
Rp – Rf = ⍺p + (Rm - Rf)
(Rp - Rf)= y; (Rm - Rf)= x
y x
Period Fund return Sensex return% Rf x2 xy
Rp -Rf Rm -Rf
2001 9 6 6 3 0 0 0
2002 -6 -5 10 -16 -15 225 240
2003 14 11 8 6 3 9 18
2004 12 10 7 5 3 9 15
2005 16 13 9 7 4 16 28
5 -5 259 301
= 1530/1270 = 1.2047
= 1-(1.2047*-1) = 2.2047
REVIEW PROBLEM-6
Alpha and beta co-efficient for five stocks are
given below.
Stocks Alpha Beta
Crafts High-Corp 1 .8
Crown Corp 1.35 1.15
Courtesy Corp 1.18 1.25
Cute Corp 1.25 .95
Cure Corp 1.5 1.4
Rank the five stocks using Jensen’s performance measure.
SOLUTION
Solution
Each stock’s alpha should be divided by its
beta as shown below
Craft’s value = 1.0/.8 = 1.25 II
Crowns value = 1.35/1.15 = 1.17
III
Courtesy’s value = 1.18/1.25 = .94
V
Cute’s value = 1.25/.95 = 1.32
I
Cure’s value = 1.5/1.4 = 1.07
IV
REVIEW PROBLEM-7
Mr. Anand is having units in a mutual fund for the
past 3 years. He wants to evaluate its
performance by comparing it to the market.
Fund Market
Return 70.60 41.40
Standard Deviation 41.31 19.44
Risk Free Rate 2% 2
1.12% -
Find out Sharpe and Treynor indices.
SOLUTION
Sharpe Index
Treynor Index
(Market index by definition would have equal to 1). According to Treynor
index, the portfolio has performed better than the market. The two measures
give different opinions. Reason is that the Sharpe’s measure uses the total
risk and the Treynors measures uses only the systematic risk. In a well-
diversified portfolio, the unsystematic risk would become zero and both the
measures would give the same result. But, here the portfolio seems to be
poorly diversified and so, the results differ.
REVIEW PROBLEM-8
Nithya firm is trying to decide two out of for investment funds.
From the past performance, they were able to calculate the
following average returns and standard deviations of these
funds. The current risk free rate of interest is 9%.
Alpha Fund Vinu Fund Meenu Fund Arvind Fund
Average Return 17 18 16 14
Standard Deviation
19 20 13 12
SOLUTION
Using Sharpe index:
Alpha Fund = 17-19/19 = .421
St for Vinu Fund = 18-19/20 = .45
St for Meenu Fund= 16-9/13 = .538
St for Arvind Fund = 14-9/12 = .417
Nithya firm is advised to choose the Meenu
Fund and the Vinu Fund because their
performances are better than the other two.
REVIEW PROBLEM-9
Pearl and Diamond are the two mutual funds. Pearl has a
mean success of .15 and Diamond has .22. The Diamond has
double the beta of Pearl fund’s 1.5. The standard deviations of
Pearl and Diamond funds are 15% and 21.43%. The mean
return of market index is 12% and its standard deviation is 7.
The risk free rate is 8%.
a) Compute the Jensen Index for each fund.
b) Compute the Treynor and Sharpe indices for the funds.
Interpret the results.
SOLUTION
(A) Jensen Index
Rp – Rf = ⍺p + (Rm - Rf)
Jensen’s Index for Pearl fund
= 8 + 1.5 (12-8) = 14
For Diamond fund
= 8 + 3 (12-8) = 20
The difference b/w the actual and estimated returns
Pearl fund = 15-14 = 1
Diamond fund = 22-20 = 2
(B) Treynor Index
Pearl fund = 15-18/1.5= 4.67
Diamond fund = 22-8/3 = 4.67
According to Treynor Index, both the funds have same value.
SOLUTION
(C) Sharpe Index
Pearl fund = 15-18/15 = 0.46
Diamond fund = 22-8/21.43 = 0.65
Market Performance = 12-8/7 = 0.57
Treynor index and the Sharpe index results
differ. Sharpe index considers the total risk
but the Treynors index considers only the
market risk.
REVIEW PROBLEM-10
The following three portfolio provide the particulars given
below
Portfolio Average Annual Return Standard Deviation Correlation Co-efficient
A 18 27 0.8
B 14 18 0.6
C 15 8 0.9
Market 13 12 -
Risk free rate of interest is 9
Rank these portfolios using Sharpe’s and Treynor’s
methods.
Compare both the indices.
SOLUTION
Sharpe Index
(a)
A = 18-9/27 = .333
B = 14-9/18 = .277
C = 15-9/8 = .75
Ranking order is C, A, P
Treynor Index
SOLUTION
Beta values are not given. Beta values can be
estimated by using the formula
SOLUTION
Tn for A = 18-19/1.8 = 5
Tn for B = 14-9/.9 = 5.56
Tn for C = 15-9/.6 = 10
The ranking is C, B, A
(b) The order of B and A get reversed in the
Treynor’s index. This may be due to their
relationship with the market i.e. the
systematic risk factor.