UNIT V PORTFOLIO

MANAGEMENT

Portfolio analysis –Portfolio Selection –Capital Asset Pricing model – Portfolio Revision –
Portfolio Evaluation – Mutual Funds.

Table of the Content

5.1 Portfolio Analysis……………………………...…………………………….... 1
5.2 Portfolio Selection……………………………………………………………... 3
5.3 Capital Asset Pricing Model………………..….………………………........... 9
5.4 Portfolio Revision………………………………………...…………………... 11
5.5 Portfolio Evaluation…………………………………………………………... 13
5.6 Mutual Funds………………………………………………………………….. 19
5.6.1 Types of Mutual Funds…………………………………………........... 20

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5.1 PORTFOLIO ANALYSIS

Security analysis related to the analysis of individual securities within the framework
of return and risk. Whereas, Portfolio analysis makes an analysis of securities in the
combined form. The portfolio analysis considers the determination of future risk and return
in holding various blends of individual securities. Portfolio expected return is a weighted
average of the expected return of individual securities but portfolio variance can be
something less than a weighted average of security variances.

Returns
The expected return of a portfolio depends on the expected return of each of the
security contained in the portfolio. It also seems logical that the amounts invested in each
security should be important. Indeed, this is the case. The example of a portfolio with three
securities shown in Table-1A illustrates this point. The expected holding period value-
relative for the portfolio is clearly:
Rs.23, 100
------------ = 1.155
Rs.20, 000
giving an expected holding period return of 15.50%.

Risk

The probability of loss is the essence of risk. A useful measure of risk takes into
account both the probability of various possible bad outcomes and their associated
magnitudes. Instead of measuring the probability of a number of different possible
outcomes, the measure of risk should somehow estimate the extent to which the actual
outcome is likely to diverge from the expected. Two measures used for this purpose are the
mean absolute deviation and the standard deviation.

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5.2 PORTFOLIO SELECTION:

The objective of every rational investor is to maximise his returns and minimise the
risk. Diversification is the method adopted for reducing risk. It essentially results in the
construction of portfolios. The proper goal of portfolio construction would be to generate a
portfolio that provides the highest return and the lowest risk. Such a portfolio would be
known as the optimal portfolio. The process of finding the optimal portfolio is described as
portfolio selection. The conceptual framework and analytical tools for determining the
optimal portfolio in disciplined and objective manner have been provided by Harry
Markowitz in his pioneering work on portfolio analysis described in 1952 Journal of Finance
article and subsequent book in 1959. His method of portfolio selection has come to be
known as the Markowitz model. In fact, Markowitz‘s work marks the beginning of what is
known today as modern portfolio theory.

Feasible set of portfolios:

With a limited number of securities an investor can create a very large number of
portfolios by combining these securities in different proportions. These constitute the
feasible set of portfolios in which the investor can possibly invest.

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 This is also known as the portfolio opportunity set.

Each portfolio in the opportunity set is characterised by an expected return and a

measure of risk, viz., variance or standard deviation of returns. Not every portfolio in the
portfolio opportunity set is of interest to an investor. In the opportunity set some portfolios
will obviously be dominated by others. A portfolio will dominate another if it has either a
lower standard deviation and the same expected return as the other, or a higher expected
return and the same standard deviation as the other. Portfolios that are dominated by other
portfolios are known as inefficient portfolios. An investor would not be interested in all the
portfolios in the opportunity set. He would be interested only in the efficient portfolios.

Efficient set of portfolios:

Let us consider various combinations of securities and designate them as
portfolios 1 to n. The expected returns of these portfolios may be worked out. The
Portfolio Selection 171 risk of these portfolios may be estimated by measuring the
standard deviation of portfolio returns. The table below shows illustrative figures for
the expected returns and standard deviations of some portfolios.

If we compute portfolio nos. 4 and 5, for the same standard deviation of 8.1
portfolio no. 5 gives a higher expected return of 11.7, making it more efficient than
portfolio no. 4. Again, if we compare portfolio nos. 7 and 8, for the same expected
return of 13.5 per cent, the standard deviation is lower for portfolio no. 7, making it
more efficient than portfolio no. 8. Thus, the selection of portfolio by the investor will
be guided by two criteria:
1. Given two portfolios with the same expected return, the investor would
prefer the one with the lower risk.
2. Given two portfolios with the same risk, the investor would prefer the one
with the higher expected return.

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 These criteria are based on the assumption that investors are rational and also
risk-averse. As they are rational they would prefer more return to less return. As they
are risk-averse, they would prefer less risk to more risk. The concept of efficient sets
can be illustrated with the help of a graph. The expected return and standard deviation
of portfolios can be depicted on an XY graph, measuring the expected return on the Y
axis and the standard deviation on the X axis. Following figure depicts such a graph.

As each possible portfolio in the opportunity set or feasible set of portfolios has
an expected return and standard deviation associated with it, each portfolio would be
represented by a single point in the risk-return space enclosed within the two axes of
the graph. The shaded area in the graph represents the set of all possible portfolios
that can be constructed from a given set of securities. This opportunity set of
portfolios takes a concave shape because it consists of portfolios containing securities
that are less than perfectly correlated with each other.

Diagram:

Consider portfolios F and E. Both the portfolios have the same expected return
but portfolio E has less risk. Hence, portfolio E would be preferred to portfolio F.
Now consider portfolios C and E. Both have the same risk, but portfolio E offers more
return for the same risk. Hence, portfolio E would be preferred to portfolio C. Thus,
for any point of risk-return space, an investor would like to move as far as possible in
the direction of increasing returns and also as far as possible in the direction of
decreasing risk. Effectively, he would be moving towards the left in search of
decreasing risk and upwards in search of increasing returns.

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 Let us consider portfolios C and A. Portfolio C would be preferred to portfolio
A because it offers less risk for the same level of return. In the opportunity set of
portfolios represented in the diagram, portfolio C has the lowest risk compared to all
other portfolios. Here portfolio C in this diagram represents the global minimum
variance portfolio.
Comparing portfolios A and B, we find that portfolio B is preferable to
portfolio A because it offers higher return for the same level of risk. In this diagram,
point B represents the portfolio with the highest expected return among all the
portfolios in the feasible set.

Thus, we find that portfolios lying in the north-west bound ary of the shaded
area are more efficient than all the portfolios in the interior of the shaded area. This
boundary of the shaded area is called the efficient frontier because it contains all the
efficient portfolios in the opportunity set. The set of portfolios lying between the
global minimum variance portfolio and the maximum return portfolio on the efficient
frontier represents the efficient set of portfolios. The efficient frontier is shown
separately in the following figure:

The efficient frontier is a concave curve in the risk-return space that extends
from the minimum variance portfolio to the maximum return portfolio.

Selection of optimal portfolio: The portfolio selection problem is really the

process of delineating the efficient portfolios and then selecting the best portfolio
from the set.
Rational investors will obviously prefer to invest in the efficient portfolios. The
particular portfolio that an individual investor will select from the efficient frontier
will depend on that investor‘s degree of aversion to risk.

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 A highly risk averse investor will hold a portfolio on the lower left hand
segment of the efficient frontier, while an investor who is not too risk averse will hold
one on the upper portion of the efficient frontier.

The selection of the optimal portfolio thus depends on the investor‘s risk
aversion, or conversely on his risk tolerance. This can be graphically represented
through a series of risk return utility curves or indifference curves. The indifference
curves of an investor are shown in the figure below. Each curve represents different
combinations of risk and return all of which are equally satisfactory to the concerned
investor. The investor is indifferent between the successive points in the curve. Each
successive curve moving upwards to the left represents a higher level of satisfaction
or utility. The investor‘s goal would be to maximise his utility by moving upto the
higher utility curve. The optimal portfolio for an investor would be the one at the
point of tangency between the efficient frontier and the risk-return utility or
indifference curve.

This is shown in the following figure. The point O‘ represents the optimal
portfolio.

Markowitz used the technique of quadratic programming to identify the

efficient portfolios. Using the expected return and risk of each security under
consideration and the covariance estimates for each pair of securities, he calculated
risk and return for all possible portfolios. Then, for any specific value of expected
portfolio return, he determined the least risk portfolio using quadratic programming.
With another value of expected portfolio return, a similar procedure again gives the
minimum risk portfolio. The process is repeated with different values of expected
return, the resulting minimum risk portfolios constitute the set of efficient portfolios.

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Limitations of Markowitz model:
1. Large number of input data required for calculations: An investor must
obtain estimates of return and variance of returns for all securities as also covariances
of returns for each pair of securities included in the portfolio. If there are N securities
in the portfolio, he would need N return estimates, N variance estimates and N (N-1) /
2 covariance estimates, resulting in a total of 2N + [N (N-1) / 2] estimates. For
example, analysing a set of 200 securities would require 200 return estimates, 200
variance estimates and Portfolio Selection 176 19,900 covariance estimates, adding
upto a total of 20,300 estimates. For a set of 500 securities, the estimates would be
1,25,750. Thus, the number of estimates required becomes large because covariances
between each pair of securities have to be estimated.
3. Complexity of computations required: The computations required are
numerous and complex in nature. With a given set of securities infinite number of
portfolios can be constructed. The expected returns and variances of returns for each
possible portfolio have to be computed. The identification of efficient portfolios
requires the use of quadratic programming which is a complex procedure.

Although betas help in selecting stock, care should be taken to select the stock with
the beta approach because selection of portfolio with beta is followed only when the
following assumptions are considered:
a) The market movement in positives and negatives directions haves to be carefully
analyzed and
b) The past historical considerations of beta must be analyzed
for future prediction of beta.
c) The sensitivity of the security to inflation;
d) Economics events as Market Index causes systematic change and
e) Risk and return with portfolio.

The fundamental factors are the following:

a) The earning of a firm;
b) The movements of the market;
c) Continuous valuation of stock;
d) Survey of stock, whether it represents large or small
firms, old and established and new firms;
e) Growth of firms historically and
f) The capital structure of the firm.

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5.3. CAPITAL ASSET PRICING MODEL (CAPM)

The capital asset pricing model (CAPM) is used in finance to determine a

theoretically appropriate rate of return of an asset, if that asset is to be added to an already
well-diversified portfolio, given that asset's non-diversifiable risk. The CAPM formula
takes into account the asset's sensitivity to non-diversifiable risk (also known as systematic
risk or market risk), referred to as beta (â) in the financial industry, as well as the expected
return of the market and the expected return of a theoretical risk-free asset. The model was
introduced by Jack Treynor, William Sharpe, John Lintner and Jan Mossin independently,
building on the earlier work of Harry Markowitz on diversification and modern portfolio
theory.

Capital asset pricing model (CAPM) is a model which establishes a relationship

between the required return and the systematic risk of an investment. It estimates the
required return as the sum of risk free rate and product of the security’s beta coefficient and
equity risk premium.

Investors face two kinds of risks: systematic risk and unsystematic risk.

Systematic risk is the risk of the whole economy or financial system going down and
causing low or negative returns. For example, the risk of recession, enactment of
unfavorable regulation, etc. Systematic risk can’t be avoided by adding more investments to
the portfolio (i.e. diversification) because a downturn in the whole economy affects all
investments.

Unsystematic risk on the other hand is the risk specific to a particular investment. For
example, unfavorable court ruling affecting the company, major disruption in the
company’s supply chain, etc. Such risks can be mitigated by adding additional investments
to a portfolio. For example, a portfolio of 100-stocks is less prone to a negative
performance of one company due to any specific event affecting it.

Since unsystematic risk can be eliminated through diversification, the capital asset
pricing model doesn’t provide any reward for taking such a risk. It measures the required
return based on the level of systematic risk inherent in a particular investment.
Formula
Required return = risk free rate + beta coefficient × equity risk premium

Risk free rate is the rate of return on an investment which has zero risk. It is normally
estimated as equal to the yield on a 10-year government bond.

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 Beta coefficient is a statistic which measures the systematic risk of a particular
investment relative to the broad market. A beta efficient of more than 1 means that the
investment carries more systematic risk than the market and that of less than 1 means less
systematic risk than the broad market.

Equity risk premium equals the rate of return on the broad market such as S&P 500
minus the risk free rate. It is an estimate of the reward the equity investors require to take
the systematic risk inherent in a portfolio of securities representative of the equity market.

Capital asset pricing model effectively notches the equity risk premium up or down
based on the beta coefficient of the relevant stock which is reflected in the higher or lower
required return.

Example

ExxonMobil Corporation (NYSE: XOM) has a beta coefficient of 0.88. Estimate its cost of
equity if the risk free rate is 4% and return on the broad market index is 8%.

Solution

Under capital asset pricing model,

Cost of equity = risk free rate + beta coefficient × equity risk premium

Equity risk premium = broad market return – risk free rate

Cost of equity = risk free rate + beta coefficient × (broad market return – risk free rate)

Cost of equity (XOM) = 4% + 0.88 × (8% – 4%) = 4% + 0.88 × 4% = 7.52%

The required return (cost of equity) estimated based on CAPM should be compared
with the investor expectation of return on the stock keeping in view the company’s
operations and future growth potential. If the expected return is higher than the required
return, the stock is a good investment (on standalone basis) and vice versa.

Asset-specific required return

The CAPM returns the asset-appropriate required return or discount rate - i.e. the
rate at which future cash flows produced by the asset should be discounted given that
asset's relative risk. Betas exceeding one signify more than average "risk"; betas below one
indicate lower than average. Thus a more risky stock will have a higher beta and will be
discounted at a higher rate; less sensitive stocks will have lower betas and be discounted at
a lower rate.

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5.4 Portfolio Revision

Meaning, its Need and Strategies

A combination of various investment products like bonds, shares, securities, mutual
funds and so on is called a portfolio.
In the current scenario, individuals hire well trained and experienced portfolio
managers who as per the client’s risk taking capability combine various investment products
and create a customized portfolio for guaranteed returns in the long run.
It is essential for every individual to save some part of his/her income and put into
something which would benefit him in the future. A combination of various financial
products where an individual invests his money is called a portfolio.

Portfolio Revision
The art of changing the mix of securities in a portfolio is called as portfolio revision.
The process of addition of more assets in an existing portfolio or changing the ratio of
funds invested is called as portfolio revision.
The sale and purchase of assets in an existing portfolio over a certain period of time to
maximize returns and minimize risk is called as Portfolio revision.

Need for Portfolio Revision

An individual at certain point of time might feel the need to invest more. The need for
portfolio revision arises when an individual has some additional money to invest.

Change in investment goal also gives rise to revision in portfolio. Depending on the
cash flow, an individual can modify his financial goal, eventually giving rise to changes in
the portfolio i.e. portfolio revision.
Financial market is subject to risks and uncertainty. An individual might sell off some
of his assets owing to fluctuations in the financial market.

Portfolio Revision Strategies

There are two types of Portfolio Revision Strategies.
1. Active Revision Strategy
Active Revision Strategy involves frequent changes in an existing portfolio over a
certain period of time for maximum returns and minimum risks. Active Revision Strategy
helps a portfolio manager to sell and purchase securities on a regular basis for portfolio
revision.

2. Passive Revision Strategy

Passive Revision Strategy involves rare changes in portfolio only under certain
predetermined rules. These predefined rules are known as formula plans. According to
passive revision strategy a portfolio manager can bring changes in the portfolio as per the
formula plans only.

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Formula Plans
Formula Plans are certain predefined rules and regulations deciding when and how
much assets an individual can purchase or sell for portfolio revision. Securities can be
purchased and sold only when there are changes or fluctuations in the financial market.
Formula plans help an investor to make the best possible use of fluctuations in the financial
market. One can purchase shares when the prices are less and sell off when market prices are
higher.
With the help of Formula plans an investor can divide his funds into aggressive and
defensive portfolio and easily transfer funds from one portfolio to other.

Aggressive Portfolio
Aggressive Portfolio consists of funds that appreciate quickly and guarantee
maximum returns to the investor.

Defensive Portfolio
Defensive portfolio consists of securities that do not fluctuate much and remain
constant over a period of time.
Formula plans facilitate an investor to transfer funds from aggressive to defensive
portfolio and vice a versa.

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5.5 PORTFOLIO PERFORMANCE EVALUATION

The portfolio performance evaluation involves the determination of how a managed

portfolio has performed relative to some comparison benchmark. Performance evaluation
methods generally fall into two categories, namely conventional and risk-adjusted methods.
The most widely used conventional methods include benchmark comparison and style
comparison. The risk-adjusted methods adjust returns in order to take account of differences
in risk levels between the managed portfolio and the benchmark portfolio. The major
methods are
• Sharpe ratio,
• Treynor ratio,
• Jensen’s alpha,
• Modigliani and Modigliani, and
• Treynor Squared.

The risk-adjusted methods are preferred to the conventional methods.

The portfolio performance evaluation primarily refers to the determination of how a

particular investment portfolio has performed relative to some comparison benchmark. The
evaluation can indicate the extent to which the portfolio has outperformed or under-
performed, or whether it has performed at par with the benchmark.

The evaluation of portfolio performance is important for several reasons. First, the
investor, whose funds have been invested in the portfolio, needs to know the relative
performance of the portfolio. The performance review must generate and provide information
that will help the investor to assess any need for rebalancing of his investments. Second, the
management of the portfolio needs this information to evaluate the performance of the
manager of the portfolio and to determine the manager’s compensation, if that is tied to the
portfolio performance. The performance evaluation methods generally fall into two
categories, namely conventional and risk-adjusted methods.

Benchmark Comparison

The most straightforward conventional method involves comparison of the

performance of an investment portfolio against a broader market index. The most widely
used market index in the United States is the S&P 500 index, which measures the price
movements of 500 U.S. stocks compiled by the Standard & Poor’s Corporation. If the
return on the portfolio exceeds that of the benchmark index, measured during identical
time periods, then the portfolio is said to have beaten the benchmark index. While this
type of comparison with a passive index is very common in the investment world, it
creates a particular problem. The level of risk of the investment portfolio may not be the

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 same as that of the benchmark index portfolio. Higher risk should lead to commensurately
higher returns in the long term. This means if the investment portfolio has performed
better than the benchmark portfolio, it may be due to the investment portfolio being more
risky than the benchmark portfolio. Therefore, a simple comparison of the return on an
investment portfolio with that of a benchmark portfolio may not produce valid results.

Style Comparison

A second conventional method of performance evaluation called ”style-

comparison” involves comparison of return of a portfolio with that having a similar
investment style. While there are many investment styles, one commonly used approach
classifies investment styles as value versus growth. The ”value style” portfolios invest in
companies that are considered undervalued on the basis of yardsticks such as price-to-
earnings and price-to-topic value multiples. The ”growth style” portfolios invest in
companies whose revenue and earnings are expected to grow faster than those of the
average company.

In order to evaluate the performance of a value-oriented portfolio, one would

compare the return on such a portfolio with that of a benchmark portfolio that has value-
style. Similarly, a growth-style portfolio is compared with a growth-style benchmark
index. This method also suffers from the fact that while the style of the two portfolios that
are compared may look similar, the risks of the two portfolios may be different. Also, the
benchmarks chosen may not be truly comparable in terms of the style since there can be
many important ways in which two similar style-oriented funds vary.

Reilly and Norton (2003) provide an excellent disposition of the use of benchmark
portfolios and portfolios style and the issues associated with their selection. Sharpe
(1992), and Christopherson (1995) have developed methods for determining this style.

Risk-adjusted Methods

The risk-adjusted methods make adjustments to returns in order to take account

of the differences in risk levels between the managed portfolio and the benchmark
portfolio. While there are many such methods, the most notables are the Sharpe ratio (S),
Treynor ratio (T), Jensen’s alpha (a), Modigliani and Modigliani (M2), and Treynor
Squared (T2). These measures, along with their applications, are discussed below.

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Sharpe Ratio

The Sharpe ratio (Sharpe, 1966) computes the risk premium of the investment
portfolio per unit of total risk of the portfolio. The risk premium, also known as
excess return, is the return of the portfolio less the risk-free rate of interest as
measured by the yield of a Treasury security. The total risk is the standard deviation
of returns of the portfolio. The numerator captures the reward for investing in a risky
portfolio of assets in excess of the risk-free rate of interest while the denominator is
the variability of returns of the portfolio. In this sense, the Sharpe measure is also
called the ”reward-to-variability” ratio. Equation gives the Sharpe ratio:

where S is the Sharpe ratio, rp the return of the portfolio, rf the risk-free rate, and sp
the standard deviation of returns of the portfolio.

The Sharpe ratio for an investment portfolio can be compared with the same
for a benchmark portfolio such as the overall market portfolio. Suppose that a
managed portfolio earned a return of 20 percent over a certain time period with a
standard deviation of 32 percent. Also assume that during the same period the
Treasury bill rate was 4 percent, and the overall stock market earned a return of 13
percent with a standard deviation of 20 percent. The managed portfolio’s risk
premium is (20 percent — 4 percent) = 16 percent, while its Sharpe ratio, S, is equal
to 16 percent/32 percent = 0.50. The market portfolio’s excess return is (13 percent —
4 percent) = 9 percent, while its S equals 9 percent/20 percent = 0.45. Accordingly,
for each unit of standard deviation, the managed portfolio earned a risk premium of
0.50 percent, which is greater than that of the market portfolio of 0.45 percent,
suggesting that the managed portfolio outperformed the market after adjusting for
total risk.

Treynor Ratio

The Treynor ratio (Treynor, 1965) computes the risk premium per unit of
systematic risk. The risk premium is defined as in the Sharpe measure. The difference
in this method is in that it uses the systematic risk of the portfolio as the risk
parameter. The systematic risk is that part of the total risk of an asset which cannot be
eliminated through diversification.
Page 15
 It is measured by the parameter known as ‘beta’ that represents the slope of
the regression of the returns of the managed portfolio on the returns to the market
portfolio. The Treynor ratio is given by the following equation:

where T is the Treynor ratio, rp the return of the portfolio, rf the risk-free rate,
and bp the beta of the portfolio.

Suppose that the beta of the managed portfolio in the previous example is 1.5.
By definition, the beta of the market portfolio is equal to 1.0. This means the managed
portfolio has one-and-half times more systematic risk than the market portfolio. We
would expect the managed portfolio to earn more than the market because of its
higher risk. In fact, in the above example, the portfolio earned an excess return of 16
percent whereas the market earned only 9 percent. These two numbers alone do not
tell anything about the relative performance of the portfolio since the portfolio and the
market have different levels of market risk. In this instance, the Treynor ratio for the
managed portfolio equals (20 percent — 4 percent)/1.5 = 10.67, while that for the
market equals (13 percent — 4 percent)/1.00 = 9.00. Thus, after adjusting for
systematic risk, the managed portfolio earned an excess return of 10.67 percent for
each unit of beta while the market portfolio earned an excess return of 9.00 percent
for each unit of beta. Thus, the managed portfolio outperformed the market portfolio
after adjusting for systematic risk.

Jensen’s Alpha

Jensen’s alpha (Jensen, 1968) is based on the Capital Asset Pricing Model
(CAPM) of Sharpe (1964), Lintner (1965), and Mossin (1966). The alpha represents
the amount by which the average return of the portfolio deviates from the expected
return given by the CAPM. The CAPM specifies the expected return in terms of the
risk-free rate, systematic risk, and the market risk premium. The alpha can be greater
than, less than, or equal to zero. An alpha greater than zero suggests that the portfolio
earned a rate of return in excess of the expected return of the portfolio. Jensen’s alpha
is given by.

where a is the Jensen’s alpha, rp the return of the portfolio, rm the return of the
market portfolio, rf the risk-free rate, and bp the beta of the portfolio.

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 Using the same set of numbers from the previous example, the alpha of the
managed portfolio and the market portfolio can be computed as follows. The expected
return of the managed portfolio is 4 percent + 1.5 (13 percent — 4 percent) = 17.5
percent. Therefore, the alpha of the managed portfolio is equal to the actual return less
the expected return, which is 20 percent — 17.5 percent = 2.5 percent. Since we are
measuring the expected return as a function of the beta and the market risk premium,
the alpha for the market is always zero. Thus, the managed portfolio has earned a 2.5
percent return above that must be earned given its market risk. In short, the portfolio
has a positive alpha, suggesting superior performance.

When the portfolio is well diversified all three methods - Sharpe, Treynor, and
Jensen – will give the same ranking of performance. In the example, the managed
portfolio outperformed the market on the basis of all three ratios. When the portfolio
is not well diversified or when it represents the total wealth of the investor, the
appropriate measure of risk is the standard deviation of returns of the portfolio, and
hence the Sharpe ratio is the most suitable. When the portfolio is well diversified,
however, a part of the total risk has been diversified away and the systematic risk is
the most appropriate risk metric. Both Treynor ratio and Jensen’s alpha can be used to
assess the performance of well-diversified portfolios of securities. These two ratios
are also appropriate when the portfolio represents a sub-portfolio or only a part of the
client’s portfolio. Chen (1981, 1986) examined the statistical distribution of Sharpe,
Treynor, and Jensen measures and show that the empirical relationship between these
measures and their risk proxies is dependent on the sample size, the investment
horizon and market conditions. Cumby and Glen (1990), Grinblatt and Titman (1994),
Kallaberg et al. (2000), and Sharpe (1998) have provided evidence of the application
of performance evaluation techniques.

Modigliani and Modigliani Measure

The Sharpe ratio is not easy to interpret. In the example, the Sharpe ratio for
the managed portfolio is 0.50, while that for the market is 0.45. We concluded that the
managed portfolio outperformed the market. The difficulty, however, is that the
differential performance of 0.05 is not an excess return. Modigliani and Modigliani
(1997) measure, which is referred to as M2, provides a risk-adjusted measure of
performance that has an economically meaningful interpretation. The M2 is given by

where M2 is the Modigliani-Modigliani measure, rp* the return on the

adjusted portfolio, rm the return on the market portfolio.

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 The adjusted portfolio is the managed portfolio adjusted in such a way that it
has the same total risk as the market portfolio. The adjusted portfolio is constructed as
a combination of the managed portfolio and risk-free asset, where weights are
specified as in Equations (34.5) and (34.6).

where wrp represents the weight given to the managed portfolio, which is
equal to the standard deviation of the market portfolio (sm) divided by the standard
deviation of the managed portfolio (sp). wrf is the weight on the risk-free asset and is
equal to one minus the weight on the managed portfolio. The risk of the adjusted
portfolio (sp*) is the weight on the managed portfolio times the standard deviation of
the managed portfolio as given in Equation (34.7). By construction, this will be equal
to the risk of the market portfolio.

The return of the adjusted portfolio (rp*) is computed as the weighted average
of the returns of the managed portfolio and the risk-free rate, where the weights are as
in Equations (34.5) and (34.6) above:

The return on the adjusted portfolio can be readily compared with the return
on the market portfolio since both have the same degree of risk. The differential
return, M2, indicates the excess return of the managed portfolio in comparison to the
benchmark portfolio after adjusting for differences in the total risk. Thus, M2 is more
meaningful than the Sharpe ratio.

In the example, the standard deviation of the managed portfolio is 32 percent

and the standard deviation of the market portfolio is 20 percent. Hence, the wrp =
20/32 = 0.625, and wrf = 1 — 0.625 = 0.375. The adjusted portfolio would be 62.5
percent invested in the managed portfolio and 37.5 percent invested in Treasury bills.
Now the risk of the adjusted portfolio, sp* = 0.625 x 32 percent = 20 percent, is the
same as the risk of the market portfolio. The return on the adjusted portfolio would be
rp* = 0.375 x 4 percent + 0.625 x 20 percent = 14 percent. The M2 = 14 percent — 13
percent = 1 percent. Thus, on a risk-adjusted basis, the managed portfolio has
performed better than the benchmark by 1 percent.

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Treynor Squared

Another performance measure, called T2 analogous to M2, can be constructed.

This is a deviant of the Treynor measure, and the rationale is the same as that of M2.
T2 is defined as

where T2 is the Treynor-squared measure, rp* the return on the adjusted portfolio, and rm the
return on the market portfolio.

The adjusted portfolio is the managed portfolio adjusted such that it has the same degree of
systematic or market risk as the market portfolio. Since the market risk or beta of the market
portfolio is equal to one, the adjusted portfolio is constructed as a combination of the
managed portfolio and risk-free asset such that the adjusted portfolio has a beta equal to one.

5.6 MUTUAL FUNDS:

A mutual fund is a professionally managed type of collective investment that pools

money from many investors to buy stocks, bonds, short-term money market instruments,
and/or other securities.

Definition: A mutual fund is a professionally-managed investment scheme, usually run by

an asset management company that brings together a group of people and invests their
money in stocks, bonds and other securities.

Description: As an investor, you can buy mutual fund 'units', which basically represent
your share of holdings in a particular scheme. These units can be purchased or redeemed
as needed at the fund's current net asset value (NAV). These NAVs keep fluctuating,
according to the fund's holdings. So, each investor participates proportionally in the gain
or loss of the fund.

All the mutual funds are registered with SEBI. They function within the provisions
of strict regulation created to protect the interests of the investor.

The biggest advantage of investing through a mutual fund is that it gives small
investors access to professionally-managed, diversified portfolios of equities, bonds and
other securities, which would be quite difficult to create with a small amount of capital.

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5.6.1 Types of mutual funds

I. Types of Mutual Funds based on structure

1. Open-Ended Funds: These are funds in which units are open for purchase or redemption
through the year. All purchases/redemption of these fund units are done at prevailing
NAVs. Basically these funds will allow investors to keep invest as long as they want.
There are no limits on how much can be invested in the fund. They also tend to be
actively managed which means that there is a fund manager who picks the places where
investments will be made. These funds also charge a fee which can be higher than
passively managed funds because of the active management. They are an ideal investment
for those who want investment along with liquidity because they are not bound to any
specific maturity periods. Which means that investors can withdraw their funds at any
time they want thus giving them the liquidity they need.

2. Close-Ended Funds: These are funds in which units can be purchased only during the
initial offer period. Units can be redeemed at a specified maturity date. To provide for
liquidity, these schemes are often listed for trade on a stock exchange. Unlike open ended
mutual funds, once the units or stocks are bought, they cannot be sold back to the mutual
fund, instead they need to be sold through the stock market at the prevailing price of the
shares.

3. Interval Funds: These are funds that have the features of open-ended and close-ended
funds in that they are opened for repurchase of shares at different intervals during the
fund tenure. The fund management company offers to repurchase units from existing unit
holders during these intervals. If unit holders wish to they can offload shares in favour of
the fund.

II. Types of Mutual Funds based on asset class

1. Equity Funds: These are funds that invest in equity stocks/shares of companies.
These are considered high-risk funds but also tend to provide high returns. Equity
funds can include specialty funds like infrastructure, fast moving consumer goods and
banking to name a few. THey are linked to the markets and tend to
2. Debt Funds: These are funds that invest in debt instruments e.g. company debentures,
government bonds and other fixed income assets. They are considered safe
investments and provide fixed returns. These funds do not deduct tax at source so if
the earning from the investment is more than Rs. 10,000 then the investor is liable to
pay the tax on it himself.

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 3. Money Market Funds: These are funds that invest in liquid instruments e.g. T-Bills,
CPs etc. They are considered safe investments for those looking to park surplus funds
for immediate but moderate returns. Money markets are also referred to as cash
markets and come with risks in terms of interest risk, reinvestment risk and credit
risks.
4. Balanced or Hybrid Funds: These are funds that invest in a mix of asset classes. In
some cases, the proportion of equity is higher than debt while in others it is the other
way round. Risk and returns are balanced out this way. An example of a hybrid fund
would be Franklin India Balanced Fund-DP (G) because in this fund, 65% to 80% of
the investment is made in equities and the remaining 20% to 35% is invested in the
debt market. This is so because the debt markets offer a lower risk than the equity
market.

III. Types of Mutual Funds based on investment objective

1. Growth funds: Under these schemes, money is invested primarily in equity stocks
with the purpose of providing capital appreciation. They are considered to be risky
funds ideal for investors with a long-term investment timeline. Since they are risky
funds they are also ideal for those who are looking for higher returns on their
investments.
2. Income funds: Under these schemes, money is invested primarily in fixed-income
instruments e.g. bonds, debentures etc. with the purpose of providing capital
protection and regular income to investors.
3. Liquid funds: Under these schemes, money is invested primarily in short-term or
very short-term instruments e.g. T-Bills, CPs etc. with the purpose of providing
liquidity. They are considered to be low on risk with moderate returns and are ideal
for investors with short-term investment timelines.
4. Tax-Saving Funds (ELSS): These are funds that invest primarily in equity shares.
Investments made in these funds qualify for deductions under the Income Tax Act.
They are considered high on risk but also offer high returns if the fund performs
well.
5. Capital Protection Funds: These are funds where funds are are split between
investment in fixed income instruments and equity markets. This is done to ensure
protection of the principal that has been invested.
6. Fixed Maturity Funds: Fixed maturity funds are those in which the assets are
invested in debt and money market instruments where the maturity date is either the
same as that of the fund or earlier than it.
7. Pension Funds: Pension funds are mutual funds that are invested in with a really
long term goal in mind. They are primarily meant to provide regular returns around
the time that the investor is ready to retire. The investments in such a fund may be
split between equities and debt markets where equities act as the risky part of the
investment providing higher return and debt markets balance the risk and provide
lower but steady returns.

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IV. Types of Mutual Funds based on specialty
1. Sector Funds: These are funds that invest in a particular sector of the market e.g.
Infrastructure funds invest only in those instruments or companies that relate to the
infrastructure sector. Returns are tied to the performance of the chosen sector. The
risk involved in these schemes depends on the nature of the sector.
2. Index Funds: These are funds that invest in instruments that represent a particular
index on an exchange so as to mirror the movement and returns of the index e.g.
buying shares representative of the BSE Sensex.
3. Fund of funds: These are funds that invest in other mutual funds and returns depend
on the performance of the target fund. These funds can also be referred to as multi
manager funds. These investments can be considered relatively safe because the funds
that investors invest in actually hold other funds under them thereby adjusting for risk
from any one fund.
4. Emerging market funds: These are funds where investments are made in developing
countries that show good prospects for the future. They do come with higher risks as a
result of the dynamic political and economic situations prevailing in the country.
5. International funds: These are also known as foreign funds and offer investments in
companies located in other parts of the world. These companies could also be located
in emerging economies. The only companies that won’t be invested in will be those
located in the investor’s own country.
6. Global funds: These are funds where the investment made by the fund can be in a
company in any part of the world. They are different from international/foreign funds
because in global funds, investments can be made even the investor's own country.
7. Real estate funds: These are the funds that invest in companies that operate in the real
estate sectors. These funds can invest in realtors, builders, property management
companies and even in companies providing loans. The investment in the real estate
can be made at any stage, including projects that are in the planning phase, partially
completed and are actually completed.
8. Commodity focused stock funds: These funds don’t invest directly in the
commodities. They invest in companies that are working in the commodities market,
such as mining companies or producers of commodities. These funds can, at times,
perform the same way the commodity is as a result of their association with their
production.
9. Market neutral funds: The reason that these funds are called market neutral is that
they don’t invest in the markets directly. They invest in treasury bills, ETFs and
securities and try to target a fixed and steady growth.
10. Inverse/leveraged funds: These are funds that operate unlike traditional mutual funds.
The earnings from these funds happen when the markets fall and when markets do
well these funds tend to go into loss. These are generally meant only for those who
are willing to incur massive losses but at the same time can provide huge returns as
well, as a result of the higher risk they carry.

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 11. Asset allocation funds: The asset allocation fund comes in two variants, the target
date fund and the target allocation funds. In these funds, the portfolio managers can
adjust the allocated assets to achieve results. These funds split the invested amounts
and invest it in various instruments like bonds and equity.
12. Gift Funds: Gift funds are mutual funds where the funds are invested in government
securities for a long term. Since they are invested in government securities, they are
virtually risk free and can be the ideal investment to those who don’t want to take
risks.
13. Exchange traded funds: These are funds that are a mix of both open and close ended
mutual funds and are traded on the stock markets. These funds are not actively
managed, they are managed passively and can offer a lot of liquidity.

V. Types of Mutual Funds based on risk

1. Low risk: These are the mutual funds where the investments made are by those who
do not want to take a risk with their money. The investment in such cases are made in
places like the debt market and tend to be long term investments. As a result of them
being low risk, the returns on these investments is also low. One example of a low
risk fund would be gift funds where investments are made in government securities.
2. Medium risk: These are the investments that come with a medium amount of risk to
the investor. They are ideal for those who are willing to take some risk with the
investment and tends to offer higher returns. These funds can be used as an
investment to build wealth over a longer period of time.
3. High risk: These are those mutual funds that are ideal for those who are willing to
take higher risks with their money and are looking to build their wealth. One example
of high risk funds would be inverse mutual funds. Even though the risks are high with
these funds, they also offer higher returns.

ADVANTAGES OF MUTUAL FUND

S.
Advantage Particulars
No.
Mutual Funds invest in a well-diversified portfolio of securities which
Portfolio
1. enables investor to hold a diversified investment portfolio (whether the
Diversification
amount of investment is big or small).
Fund manager undergoes through various research works and has better
Professional
2. investment management skills which ensure higher returns to the investor
Management
than what he can manage on his own.
Investors acquire a diversified portfolio of securities even with a small
3. Less Risk investment in a Mutual Fund. The risk in a diversified portfolio is lesser
than investing in merely 2 or 3 securities.

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 Low
Due to the economies of scale (benefits of larger volumes), mutual funds
4. Transaction
pay lesser transaction costs. These benefits are passed on to the investors.
Costs
An investor may not be able to sell some of the shares held by him very
5. Liquidity
easily and quickly, whereas units of a mutual fund are far more liquid.
>Mutual funds provide investors with various schemes with different
Choice of investment objectives. Investors have the option of investing in a scheme
6.
Schemes having a correlation between its investment objectives and their own
financial goals. These schemes further have different plans/options
Funds provide investors with updated information pertaining to the
7. Transparency markets and the schemes. All material facts are disclosed to investors as
required by the regulator.
Investors also benefit from the convenience and flexibility offered by
Mutual Funds. Investors can switch their holdings from a debt scheme to
8. Flexibility an equity scheme and vice-versa. Option of systematic (at regular
intervals) investment and withdrawal is also offered to the investors in
most open-end schemes.
Mutual Fund industry is part of a well-regulated investment environment
9. Safety where the interests of the investors are protected by the regulator. All
funds are registered with SEBI and complete transparency is forced.

DISADVANTAGES OF MUTUAL FUND

S.
Disadvantage Particulars
No.
Costs Control
Investor has to pay investment management fees and fund distribution
Not in the
1. costs as a percentage of the value of his investments (as long as he holds
Hands of an
the units), irrespective of the performance of the fund.
Investor
The portfolio of securities in which a fund invests is a decision taken by
No Customized the fund manager. Investors have no right to interfere in the decision
2.
Portfolios making process of a fund manager, which some investors find as a
constraint in achieving their financial objectives.
Difficulty in Many investors find it difficult to select one option from the plethora of
Selecting a funds/schemes/plans available. For this, they may have to take advice
3.
Suitable Fund from financial planners in order to invest in the right fund to achieve their
Scheme objectives.

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Top 10 Large Cap-oriented Equity Funds in India
Funds that invest a relatively large percentage of their corpus in companies that have
large market capitalization are known as Large Cap-oriented Equity Funds. Following are
the top 10 Large Cap-oriented Equity Funds:
1. Franklin India Opportunities Fund
2. Kotak Select Focus Fund

3. SBI Blue Chip Fund

4. Birla Sun Life Frontline Equity Fund

5. Birla Sun Life Top 100 Fund
6. BNP Paribas Equity Fund
7. Franklin India Bluechip Fund
8. IDBI India Top 100 Equity Fund

9. JP Morgan India Equity Fund

10. Religare Invesco Business Leaders Fund

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