Mutual Funds PDF

A Brief on Mutual Funds Concept of Mutual Fund Mutual fund is a vehicle to mobilize money from investors, to invest in different markets and securities, in line with the investment objectives agreed upon, between the mutual fund and the investors. In other words, through investment in a m...

A Brief on Mutual Funds Concept of Mutual Fund Mutual fund is a vehicle to mobilize money from investors, to invest in different markets and securities, in line with the investment objectives agreed upon, between the mutual fund and the investors. In other words, through investment in a mutual fund, an investor can get access to markets that may otherwise be unavailable to them and avail of the professional fund management services offered by an asset management company  Fund Structure Fund Sponsor Trustees Asset Management Company Depository Agent Custodian  Structure Of Mutual Funds In India Mutual Funds in India follow a 3-tier structure. The first tier is the sponsor who thinks of starting the fund. The second tier is the trustee. The Trustees role is not to manage the money. Their job is only to see, whether the money is being managed as per stated objectives. Trustees may be seen as the internal regulators of a mutual fund. Trustees appoint the Asset Management Company (AMC) who form the third tier, to manage investor’s money. The AMC in return charges a fee for the services provided and this fee is borne by the investors as it is deducted from the money collected from them Sponsor Any corporate body which initiates the launching of a mutual fund is referred to as “The sponsor”. The sponsor is expected to have a sound track record and experience in financial services for a minimum period of 5 years and should ensure various formalities required in establishing a mutual fund. According to SEBI, the sponsor should have professional competence, financial soundness and reputation for fairness and integrity. The sponsor contributes 40% of the net worth of the AMC. The sponsor appoints the trustee, The AMC and custodians in compliance with the regulations. Trustee Sponsor creates a public trust and appoints trustees. Trustees are the people authorized to act on behalf of the Trust. They hold the property of mutual fund. Once the Trust is created, it is registered with SEBI after which this trust is known as the mutual fund. The Trustees role is not to manage the money but their job is only to see, whether the money is being managed as per stated objectives. Trustees may be seen as the internal regulators of a mutual fund. A minimum of 75% of the trustees must be independent of the sponsor to ensure fair dealings. Trustees appoint the Asset Management Company (AMC), to manage investor’s money. Custodian A custodian’s role is keeping custody of the securities that are bought by the fund manager and also keeping a tab on the corporate actions like rights, bonus and dividends declared by the companies in which the fund has invested. The Custodian is appointed by the Board of Trustees. The custodian also participates in a clearing and settlement system through approved depository companies on behalf of mutual funds, in case of dematerialized securities. Only the physical securities are held by the Custodian. The deliveries and receipt of units of a mutual fund are done by the custodian or a depository participant at the instruction of the AMC and under the overall direction and responsibility of the Trustees. Regulations provide that the Sponsor and the Custodian must be separate entities. Asset Management Company (AMC) Trustees appoint the Asset Management Company (AMC), to manage investor’s money. The AMC in return charges a fee for the services provided and this fee is borne by the investors as it is deducted from the money collected from them. The AMC’s Board of Directors must have at least 50% of Directors who are independent directors. The AMC has to be approved by SEBI. The AMC functions under the supervision of it’s Board of Directors, and also under the direction of the Trustees and SEBI. It is the AMC, which in the name of the Trust, floats new schemes and manage these schemes by buying and selling securities. In order to do this the AMC needs to follow all rules and regulations prescribed by SEBI and as per the Investment Management Agreement it signs with the Trustees. AMC cont- The role of the AMC is to manage investor’s money on a day to day basis. Thus it is imperative that people with the highest integrity are involved with this activity. The AMC cannot deal with a single broker beyond a certain limit of transactions. The AMC cannot act as a Trustee for some other Mutual Fund. The responsibility of preparing the OD(offer documents) lies with the AMC. Appointments of intermediaries like independent financial advisors (IFAs), national and regional distributors, banks, etc. is also done by the AMC. Finally, it is the AMC which is responsible for the acts of its employees and service providers. Registrar and Transfer Agents The registrar and transfer agents are appointed by the AMC. AMC pay compensation to these agents for their services. They carry out the following functions Receiving and processing the application forms of investors Issuing unit certificates Sending refund orders Giving approval for all transfers of units and maintaining records Repurchasing the units and redemption of units Issuing dividend or income warrents Fund Accountants Fund accountants are appointed by the AMC. The are in charge of maintaining proper books of accounts relating to the fund transactions and management. The perform the following functions Computing the net asset value per unit of the scheme on a daily basis Maintaining its books and records Monitoring compliance with the schemes, investment limitations as well as SEBI regulations Preparing and distributing reports of the schemes for the unit holders and SEBI and monitoring the performance of mutual funds custodians and other service providers. Lead Manager Lead manager carry out the following functions: Selecting and coordinating the activities of intermediaries such as advertising agency, printers, collection centers. Carrying out extensive campaign about the scheme and acting as marketing associates to attract investors. Assisting the AMC to approach potential investors through meetings, exhibitions, contacts, advertising, publicity and sales promotion. Investment Advisors Investment advisors carry out market and security analysis. Advising the AMC to design its investment strategies on a continuous basis. They are paid for their professional advice regarding fund investment on the average weekly value of the fund’s net assets. Legal Advisors Legal advisors are appointed to offer legal guidance about planning and execution of different schemes. A group of advocates and solicitors may be appointed as legal advisors. Their fee is not associated with net assets of the fund. Auditors and Underwriters An auditor is appointed by the AMC and must undertake independent inspection and verification of its accounting activities. Mutual funds also undertake the activities of underwriting issues. Such activities generate an additional source of income for mutual funds. Prior approval from SEBI is necessary for undertaking such activity Income and Expenses – Mutual Funds - NAV (A) +Interest income (B) + Dividend income (C) + Realized capital gains (D) + Valuation gains (E) – Realized capital losses (F) – Valuation losses (G) – Scheme expenses Types of Funds Open-Ended Funds, Close-Ended Funds and Interval Funds Open Funded Funds Open-ended funds are open for investors to enter or exit at any time, even after the NFO. (New Fund Offer) When existing investors acquire additional units or new investors acquire units from the open-ended scheme, it is called a sale transaction. It happens at a sale price, which is linked to the NAV. When investors choose to return any of their units to the scheme and get back their equivalent value (in terms of units), it is called a re-purchase transaction. This happens at a re-purchase price that is linked to the NAV. The on-going entry and exit of investors implies that the unit capital in an open-ended fund would keep changing on a regular basis Examples of Open-Ended Mutual Funds in India 1.HDFC Equity Fund Type: Equity Fund Objective: To provide long-term capital appreciation by investing predominantly in equity and equity-related instruments. Features: This fund has a diversified portfolio with a focus on large-cap stocks. 2/ SBI Bluechip Fund Type: Large-Cap Equity Fund Objective: To generate capital appreciation by primarily investing in large-cap companies. Features: Known for its stable performance, this fund invests in well-established companies with a strong market presence. 3/ ICICI Prudential Balanced Advantage Fund Type: Hybrid Fund Objective: To provide long-term capital appreciation through a mix of equity and debt investments. Features: This fund dynamically allocates between equity and debt based on market conditions, aiming to reduce risk Close-ended funds Close-ended funds have a fixed maturity. Investors can buy units of a close-ended scheme, from the fund, only during its NFO. The fund makes arrangements for the units to be traded, post-NFO in a stock exchange. This is done through listing of the scheme in a stock exchange. Such listing is compulsory for close-ended schemes. Closed-ended mutual funds Closed-ended mutual funds in India are a unique investment vehicle that allows investors to buy units only during a specific New Fund Offer (NFO) period. After this period, the fund is closed for additional subscriptions and units can only be traded on stock exchanges. Close-ended funds Therefore, after the NFO, investors who want to buy units will have to find a seller for those units in the stock exchange. Similarly, investors who want to sell units will have to find a buyer for those units in the stock exchange. Since post-NFO, sale and purchase of units happen to or from counter- party in the stock exchange – and not to or from the scheme – the unit capital of the scheme remains stable or fixed. Since the post-NFO sale and purchase transactions happen on the stock exchange between two different investors, and that the fund is not involved in the transaction, the transaction price is likely to be different from the NAV. Depending on the demand-supply situation for the units of the scheme on the stock exchange, the transaction price could be higher or lower than the prevailing NAV. Examples of Closed-Ended Mutual Funds in India 1.ICICI Prudential Growth Fund Type: Equity Fund Objective: To provide long-term capital appreciation by investing primarily in equity and equity-related instruments. Features: This fund focuses on growth-oriented stocks and has a fixed maturity period. 2/ SBI Tax Advantage FundType: Equity Linked Savings Scheme (ELSS) Objective: To provide tax benefits under Section 80C while aiming for capital appreciation. Features: It has a lock-in period of three years and invests predominantly in equities. 3/ Mirae Asset Emerging Blue chip FundType: Multi-Cap Equity Fund Objective: To invest in a mix of large-cap and mid-cap stocks for capital growth. Features: This fund targets emerging companies with high growth potential. Key Characteristics of Closed-Ended Funds Fixed Number of Units: Closed-ended funds issue a predetermined number of units during the NFO, and no new units are created thereafter. Trading on Stock Exchanges: After the NFO period, units can be bought or sold on stock exchanges, allowing for liquidity despite the initial lock-in. Investment Horizon: These funds typically have a fixed maturity date, making them suitable for investors with specific long-term financial goals. No SIPs Allowed: Investors can only make lump-sum investments during the NFO; systematic investment plans (SIPs) are not applicable. Closed-ended mutual funds Closed-ended mutual funds offer a structured investment approach with specific maturity timelines, making them suitable for investors who can commit their capital for longer periods. The examples provided illustrate the diversity available within this category, catering to different risk appetites and investment objectives. Interval funds Interval funds combine features of both open-ended and close-ended schemes. They are largely close-ended, but become open-ended at pre-specified intervals. For instance, an interval scheme might become open-ended between January 1 to 15, and July 1 to 15, each year. The benefit for investors is that, unlike in a purely close-ended scheme, they are not completely dependent on the stock exchange to be able to buy or sell units of the interval fund. However, between these intervals, the units have to be compulsorily listed on stock exchanges to allow investors an exit route. Interval funds Interval funds in India represent a unique category of mutual funds that combine features of both open-ended and closed-ended funds. They allow investors to buy and sell units only during specific time intervals declared by the fund house Key Features of Interval Funds Limited Liquidity: Investors can purchase or redeem units only during predetermined intervals, which can be monthly, quarterly, or annually. This structure provides less liquidity compared to open-ended funds but more than traditional closed-ended funds. Investment Strategy: Fund managers can invest in illiquid assets without the pressure of frequent redemption requests, allowing for potentially higher returns. Asset Allocation: Interval funds can invest in both equity and debt instruments, though many tend to focus on debt to provide lower-risk returns. Taxation: The tax treatment depends on the asset allocation. If at least 65% is invested in equity, it is treated as an equity fund for tax purposes; otherwise, it is considered a debt fund Examples of Interval Funds in India 1/ Aditya Birla Sun Life Interval Income Fund – Quarterly Plan – Series 11-Year Return: 7.31% 3-Year Return: 5.45% 5-Year Return: 5.28% 2/ Nippon India Interval Fund – Quarterly – Series 2 1-Year Return: 7.24% 3-Year Return: 5.31% 5-Year Return: 5.39% 3/ Nippon India Interval Fund – Annual – Series 1 1-Year Return: 7.09% 1. 3-Year Return: 5.24% 2. 5-Year Return: 5.62% 4/ UTI Quarterly Interval Fund – III 1-Year Return: 7.01% 1. 3-Year Return: 5.00% 2. 5-Year Return: 4.91% Who Should Invest in Interval Funds? Interval funds are suitable for investors who:Seek exposure to unconventional assets (like commercial properties or business loans). Have a low-to-moderate risk tolerance. Can align their investment horizon with the fund's intervals for buying and selling units. Actively Managed Funds and Passive Funds Actively managed funds are funds where the fund manager has the flexibility to choose the investment portfolio, within the broad parameters of the investment objective of the scheme. Since this increases the role of the fund manager, the expenses for running the fund turn out to be higher. Investors expect actively managed funds to perform better than the market Passive funds Passive funds invest on the basis of a specified index, whose performance it seeks to track. Thus, a passive fund tracking the S&P BSE Sensex would buy only the shares that are part of the composition of the S&P BSE Sensex. The proportion of each share in the scheme’s portfolio would also be the same as the weightage assigned to the share in the computation of the S&P BSE Sensex. Thus, the performance of these funds tends to mirror the concerned index. They are not designed to perform better than the market. Such schemes are also called index schemes. Exchange Traded Funds (ETFs) Exchange Traded Funds (ETFs) are also passive funds whose portfolio replicates an index or benchmark such as an equity market index or a commodity index. The units are issued to the investors in a new fund offer (NFO) after which they are available for sale and purchase on a stock exchange. Units are credited to the investor’s demat account and the transactions post-NFO is done through the trading and settlement platforms of the stock exchange. The units of the ETF are traded at real time prices that are linked to the changes in the underlying index. Exchange Traded funds Exchange Traded funds (ETF) are open-ended funds, whose units are traded in a stock exchange. Investors buy units directly from the mutual fund only during the NFO of the scheme. All further purchase and sale transactions in the units are conducted on the stock exchange where the units are listed. The mutual fund issues further units and redeems units directly only in large lots defined as creation units. Transactions in ETF units on the stock exchange happen at market- determined prices. In order to facilitate such transactions in the stock market, the mutual fund appoints intermediaries called authorized dealers as market makers, whose job is to offer a price quote for buying and selling units at all times. Examples of ETFs in India 1/ Kotak Nifty PSU Bank ETF Type: Equity ETF 3-Year Return: 207.20% Objective: Tracks the performance of publicly owned banks in India. 2/ Nippon India ETF PSU Bank BeES Type: Equity ETF 3-Year Return: 207.43% Objective: Focuses on the public sector banks, providing exposure to this specific sector. 3/ BHARAT 22 ETF Type: Equity ETF 3-Year Return: 189.75% Objective: Invests in a diversified portfolio of stocks from various sectors, including government-owned companies example of the constitution of SBI Mutual Fund – Structure of Mutual Funds Mutual Fund Trust SBI Mutual Fund Sponsor State Bank of India Trustee SBI Mutual Fund Trustee Company Private Limited AMC SBI Funds Management Private Limited Custodian HDFC Bank Limited SBI-SG Global Securities Services Private Limited Bank of Nova Scotia (custodian for Gold) RTA Computer Age Management Services Pvt. Ltd *Registrar and Transfer Agent NAV Calculation example Calculate the NAV given the following information: Value of stocks: Rs. 150 cr, Value of bonds: Rs. 67 cr Value of money market instruments: Rs. 2.36 cr, Dividend accrued but not received: Rs. 1.09 cr, Interest accrued but not received: Rs. 2.68 cr Fees payable: Rs. 0.36 cr, No. of outstanding units: 1.90 cr Solution NAV NAV = (Value of stocks + Value of bonds + Value of money market instruments + Dividend accrued but not received + Interest accrued but not received – Fees payable) / No. of outstanding units NAV = (150 + 67 + 2.36 + 1.09 + 2.68 – 0.36) / 1.90 = 222.77 / 1.90 = Rs. 117.25 Problem no 2 Calculate the NAV given the following information: Value of stocks: Rs. 230 cr, Value of money market instruments: Rs. 5 cr, Dividend accrued but not received: Rs. 2.39 cr, Amount payable on purchase of shares: Rs. 7.5 cr Amount receivable on sale of shares: Rs. 2.34 cr Fees payable: Rs. 0.41 cr, No. of outstanding units: 2.65 cr Solution to NAV NAV = (Current value of investments held + Income accrued + Current assets – Current liabilities – Accrued expenses / No. of outstanding units Income accrued is the dividend declared but not received. Expenses accrued include fees payable. The NAV is calculated as: NAV = (230 + 5 + 2.39 + 2.34 – 7.5 – 0.41) / 2.65 = 231.82 / 2.65 = Rs. 87.48 Sale Price, Re-purchase Price and Loads A distinctive feature of open-ended schemes is the ongoing facility to acquire new units from the scheme (“sale” transaction) or sell units back to the scheme (“re-purchase transaction”). In the past, schemes were permitted to keep the Sale Price higher than the NAV. The difference between the Sale Price and NAV was called the “entry load”. If the NAV of a scheme was Rs11.00 per unit, and it were to charge entry load of 1 percent, the Sale Price would be Rs11 + 1 percent on Rs11 i.e. Rs11.11. Entry load is no longer permitted. So Sale Price is the same as NAV. Exit Load Schemes are permitted to keep the Re-purchase Price lower than the NAV. The difference between the NAV and Re-purchase Price is called the “exit load”. If the NAV of a scheme is Rs. 11.00 per unit, and it were to charge exit load of 1 , the Re-purchase Price would be Rs. 11 – 1 percent on Rs. 11 i.e. Rs. 10.89 current position However, the current position is that: SEBI has banned entry loads. So, the Sale Price needs to be the same as NAV (subject to deduction of applicable transaction charges, if any, as discussed in the next section). While charging exit loads, no distinction will be made among unitholders on the basis of the amount of subscription. While complying with the same, any imposition or enhancement in the load shall be applicable only on prospective investments. The parity among unitholders on exit load shall be made applicable at portfolio level. No exit load will be charged on bonus units and units allotted on reinvestment of dividend. Expenses Initial Issue expenses are incurred at the time of launching a scheme in an NFO. It is a one- time expense. Schemes launched before the commencement of the Securities and Exchange Board of India (Mutual Funds) (Amendment) Regulations, 2008 had to bear the initial issue expenses up to 6 percent of the amount mobilized. This has been discontinued and the initial issue expenses are now borne by the AMC. Recurring Expenses are the fund running expenses incurred to manage the money raised from the investors. These can be charged to the scheme. Since the recurring expenses drag down the NAV, SEBI has laid down the types of expenses, which can be charged to the scheme and the limits to such expenses. Measures of Returns – Simple Return 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. Annualization helps us compare the returns of two different time periods. Annualized Return Compounded Annual Growth Rate (CAGR) You invested Rs10,000 in a scheme at Rs10 per unit on June 30, 2013 On January 1, 2014, the scheme paid out a dividend of Rs1 per unit. The ex-dividend NAV was Rs12.50. On January 1, 2015, the scheme paid out another dividend of Rs1 per unit. The ex-dividend NAV was Rs15.00. Let us calculate the CAGR, which we know captures the impact of both dividend payments and compounding. Solution We know that ‘IV’, the initial value of investment is Rs10,000. If Rs10,000 was invested at Rs10 per unit, then you would have 1,000 units. The first dividend of Rs1 per unit on 1,000 units would amount to Rs1,000. If this amount were re-invested in the same scheme at the ex- dividend NAV, then you would have Rs1,000 ÷ Rs12.50 i.e. 80 additional units. Solution Thus, your unit-holding would have gone up from 1,000 to 1,080 units. The second dividend of Rs1 per unit, on the revised unit-holding of 1,080 units would amount to Rs1,080. If this amount were re-invested in the same scheme at the ex-dividend NAV, then you would have Rs1,080 ÷ Rs15.00 i.e. 72 additional units. Thus, your unit-holding would have gone up from 1,080 to 1,152 units. At Rs15 per unit, this would be valued at Rs17,280. ‘LV’, the later value of units is thus Rs17,280. 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 June 30, 2013 to January 1, 2015 has 550 days. Dividing by 365, it translates to 1.51 years. Drivers of Risk in a Scheme Portfolio Risk Portfolio Liquidity Measures of Risk 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. This can be easily calculated in MS Excel using the following function: =stdev(range of cells where the periodic returns are calculated)  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  TOTAL RISK =SYSTEMTATIC RISK + UNSYSTEMATIC RISK SIGMA = STANDARD DEVIATION SYSTEMATIC RISK➔ MARKET RISK RISK THAT IS EXTERNAL TO AN ORGANIZTION UNSYSTEMATIC RISK ➔ FIRM SPECIFIC RISK UNSYSTEMATIC RISK: Management strategies, Capital Structure, Technology ,human relation management, business product development etc  Diversificaiton ➔ investing diverse securities ,where correlation coefficient is not positive Invest in a basket of securities , may belong different asset class, In a diversified portfolio, unsystematic risk-firm specific risk comes to zero In a diversified portfolio , total risk =systematic risk You can systematic risk through beta Beta = Covariance(Security, Market)/ Var. market =Slope function 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. Systematic risk is integral to investing in the market; it cannot be avoided. For example, risks arising out of inflation, interest rates, political risks etc. This arises primarily from macro-economic and political factors. This risk cannot be diversified away. Non-systematic risk is unique to a company; the non-systematic risk in an equity portfolio can be minimized by diversification across companies. For example, risk arising out of change in management, product obsolescence etc. Beta and Systematic Risk 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 over the same period Beta and Systematic Risk 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 over the same period Benchmarks and Performance Sharpe Ratio An investor can invest with the government and earn a risk-free rate of return (Rf). T-Bill index is a good measure of this risk-free return. Through investment in a scheme, a risk is taken, and a return earned (Rs). The difference between the two returns i.e. Rs– Rf is called risk premium. It is like a premium that the investor has earned for the risk taken, as compared to government’s risk-free return. Sharpe Ratio This risk premium is to be compared with the risk taken. Sharpe Ratio uses Standard Deviation as a measure of risk. It is calculated as (Rs-Rf) ÷ Standard Deviation Thus, if risk free return is 5 percent, and a scheme with standard deviation of 0.5 earned a return of 7 percent, its Sharpe Ratio would be (7 percent - 5 percent) ÷ 0.5 i.e. 4 percent. Sharpe Ratio Sharpe Ratio is effectively the risk premium per unit of risk. Higher the Sharpe Ratio, better the scheme is considered to be. Care should be taken to do Sharpe Ratio comparisons between comparable schemes. For example, Sharpe Ratio of an equity scheme is not to be compared with the Sharpe Ratio of a debt scheme. Sharpe ratio is very commonly used measure of risk-adjusted returns.  The Sharpe Ratio is calculated by taking the return of the portfolio and subtracting the risk-free return, then dividing the result (the excess return) by standard deviation of the portfolio returns. Basically, it is measuring excess return (over risk-free rate) per unit of risk. If Sharpe ratio is 1.25 p.a., then it implies 1.25%p.a. excess return for 1% annual volatility. Sharpe Ratio Example Your investor gets 7 per cent return on her investment in a scheme with a standard deviation/volatility of 0.5. We assume risk free rate is 5 per cent. Sharpe Ratio is 7-5/0.5 = 4 in this case Significance of Sharpe Ration The greater a portfolio's Sharpe Ratio, the better its risk-adjusted performance. A negative Sharpe Ratio indicates that a risk-less asset would perform better than the security being analyzed. This measurement is very useful to compare funds with similar returns or high returns, by analyzing the same in line with the risk taken. Risk-adjusted financial performance of investment portfolios or mutual funds is typically measured by Sharpe's ratio. Significance of Sharpe Ration From an investor's point of view, the ratio describes how well the return of an investment compensates the investor for the risk he takes. Investors are often advised to pick investments with high Sharpe ratios. Sharpe ratios, along with Treynor ratios and Jensen's alphas, are often used to rank the performance of portfolio or mutual fund managers. Weaknesses –Sharpe Ratio To an investor looking for a potentially rewarding investment, sharp volatility to the upside is not necessarily a bad thing, yet the Sharpe ratio does not differentiate them, and thus the volatility would be penalized in the formula. Because the ratio sees negative and positive volatility in the same light, some believe that the ratio is not as rigorous or as fine-tuned as it could be. Treynor Ratio Like Sharpe Ratio, Treynor Ratio too is a risk premium per unit of market or systematic risk. Computation of risk premium is the same as was done for the Sharpe Ratio. However, for risk, Treynor Ratio uses Beta. Treynor Ratio is thus calculated as: (Rs minus Rf) ÷ Beta Thus, if risk free return is 5 percent, and a scheme with Beta of 1.2 earned a return of 8 percent, its Treynor Ratio would be (8 percent - 5 percent) ÷ 1.2 i.e. 2.5 percent. Higher the Treynor Ratio, better the scheme is considered to be. Since the concept of Beta is more relevant for diversified equity schemes, Treynor Ratio comparisons should ideally be restricted to such schemes.  For example: Your investor gets 7 per cent return on her investment in a scheme with a beta of 1.0. We assume risk free rate is 5 per cent. Treynor Ratio is 7-5/1.0 = 2 in this case. Significance of Treynor Ratio A fund with a higher Treynor ratio implies that the fund has a better risk adjusted return than that of another fund with a lower Treynor ratio. Treynor measure and Jenson model use systematic risk based on the premise that the unsystematic risk is diversifiable. Significance of Treynor Ratio These models are suitable for large investors like institutional investors with high risk taking capacities as they do not face paucity of funds and can invest in a number of options to dilute some risks. Sharpe measure considers the entire risks associated with fund are suitable for small investors, as the ordinary investor lacks the necessary skill and resources to diversify. Moreover, the selection of the fund on the basis of superior stock selection ability of the fund manager will also help in safeguarding the money invested to a great extent. Weaknesses Like the Sharpe ratio, the Treynor ratio does not quantify the value added, if any, of active portfolio management. It is a ranking criterion only. A lot of investors evaluate funds based on Jensen Alpha, which is the value added by the fund manager. Jensen Alpha Non-index schemes too would have a level of return, which is in line with its higher or lower beta as compared to the market. Let us call this the optimal return. The difference between a scheme’s actual return and its optimal return is its Alpha – a measure of the fund manager’s performance. Positive alpha is indicative of out-performance by the fund manager; negative alpha might indicate under-performance. Since the concept of Beta is more relevant for diversified equity schemes, Alpha should ideally be evaluated only for such schemes. These quantitative measures are based on historical performance, which may or may not be replicated. Alpha Such quantitative measures are useful pointers. However, blind belief in these measures, without an understanding of the underlying factors, is dangerous. While the calculations are arithmetic – they can be done by a novice; scheme evaluation is an art - the job of an expert Alpha Computation: Alpha = R(i) - (R(f) + B x (R(m) - R(f))) Example: Fund return 10% Risk free return 8% Benchmark return 5% Beta of Fund 0.8 By computing with above formula we will get alpha as 4.4 for this fund Example Alpha Ratio Assume a mutual fund realized a return of 15% last year. The appropriate market index for this fund returned 12%. The beta of the fund versus that same index is 1.2 and the risk-free rate is 3%. The fund's alpha is calculated as: Alpha = R(i) - (R(f) + B x (R(m) - R(f))) Alpha = 15% - (3% + 1.2 x (12% - 3%)) = 15% - 13.8% = 1.2%. Tracking Error The Beta of the market, by definition is 1. An index scheme mirrors the index. Therefore, the index scheme too would have a Beta of 1, and it ought to earn the same return as the market. The difference between an index fund’s return and the market return, as seen earlier, is the tracking error. Tracking Error Tracking error is a measure of the consistency of the out-performance of the fund manager relative to the benchmark. Earlier it was used as a measure of how closely an index fund tracked the returns from the benchmark to which it was indexed. The tracking error was expected to be zero. Now, the tracking error is used to measure how consistently a fund is able to out-perform its benchmark. It is not enough if the fund is able to generate a high excess return, it must do so consistently. Tracking error is calculated as the standard deviation of the excess returns generated by the fund. The tracking error has to be low for a consistently out-performing fund. WHAT IS TRACKING ERROR? Tracking error is the difference between a portfolio's returns and the benchmark or index it was meant to mimic or beat. Tracking error is sometimes called active risk. There are two ways to measure tracking error. The first is to subtract the benchmark's cumulative returns from the portfolio's returns, as follows: Returnp - Returni = Tracking Error Where: p = portfolio i = index or benchmark  WHAT IS TRACKING ERROR? However, the second way is more common, which is to calculate the standard deviation of the difference in the the portfolio and benchmark returns over time. The formula is as follows: HOW IT WORKS (EXAMPLE): Let's assume you invest in the XYZ Company mutual fund, which exists to replicate the Russell 2000 index, both in composition and in returns. If the XYZ Company mutual fund returns 5.5% in a year but the Russell 2000 (the benchmark) returns 5.0%, then using the first formula above, we would say that the XYZ Company mutual fund had a 0.5% tracking error. HOW IT WORKS (EXAMPLE): As time goes by, there will be more periods during which we can compare returns. This is where the second formula becomes more useful. The consistency (or inconsistency) of the "spreads" between the portfolio's returns and the benchmark's returns is what allows analysts to try to predict the portfolio's future performance. If, for example, we knew that the portfolio's annual returns were 0.4% higher than the benchmark 67% of the time during the last five years, we would know that this would probably be the case going forward (assuming the portfolio manager made no major changes). The predictive value of these calculations gets even better when there are more data points and when the analyst accounts for how the portfolio's securities move relative to one another (this is called co-variance). Several factors generally determine a portfolio's tracking error: 1. The degree to which the portfolio and the benchmark have securities in common 2. Differences in market capitalization, timing, investment style, and other fundamental characteristics of the portfolio and the benchmark 3. Differences in the weighting of assets between the portfolio and the benchmark 4. The management fees, custodial fees, brokerage costs and other expenses affecting the portfolio that don't affect the benchmark 5. The volatility of the benchmark 6. The portfolio's beta Tracking Error Example Let's assume the following returns for XYZ Fund and the Big Stock Index: Big Stock Index {10%, 5%, 7%, 2%, 8%} XYZ Fund {9.7%, 4.6%, 7.2%, 2.2%, 7.8%} How do we find the tracking error, given this knowledge? Solution – Tracking Error To begin, we calculate the simple tracking error of each period by subtracting the Big Stock Index's performance from XYZ Fund's performance. Big Stock Index {10%, 5%, 7%, 2%, 8%} XYZ Fund {9.7%, 4.6%, 7.2%, 2.2%, 7.8%} Doing so gives the following five values: { -0.3%, -0.4%, 0.2%, 0.2%, -0.2% } Square each value: { 0.09%, 0.16%, 0.04%, 0.04%, 0.04% } Then, sum these five values to find: 0.37%. Divide the sum by N - 1, or (5 - 1): 0.0925% Lastly, take the square root of 0.0925% to find the tracking error: 0.304%