India Mutual Fund

Persistance using
Sharpe and Treynor
ratios
MBA Finance disertation

Amey Kantak – 2007

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Overview
The paper attempts to measure the performance of mutual funds in Indian capital market by

applying Sharpe’s and Treynor’s ratios and analysis the Persistence of the returns over a period.

Performance analysis of this study includes a spread of funds in 2007 with low to high betas and

validate if the Beta value indicates equity funds return move along with NIFTY and SENSEX and

the probability of outperformance of the mutual funds.

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Preface
The mutual fund industry started in India with the UTI Act of 19641. Over a period of 25 years,

this small saving division grew fairly successfully giving investors a good return. In 1989, as the

next logical step, public sector banks and financial institutions such as LIC were allowed to float

mutual funds. Their success in turn led the government to open the doors to the private sector in

1993.

Since then the Indian mutual fund market has grown to over 32 asset management companies today

handling an ever increasing corpus of funds. However, with a plethora of schemes to choose from,

the retail investor faces problems in selecting funds. Factors such as investment strategy and

management style are qualitative, but the funds record is an important indicator too.

The world over performance measurement for mutual funds has been practiced since the 1960’s

on the basis of which rankings have been done. Past performance is what the ordinary investor

looks at to decide where to put his money. In most cases, he/she normally ends up investing in a

top ranking scheme. Lines such as “past performance is no guarantee of future performance…”

appearing in the offer document of the mutual fund scheme is hence forgotten for all practical

purposes. The main purpose of this paper is to see whether ranking are persistent in the Indian

context as well as to measure the performance of equity diversified mutual fund schemes in India.

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Data Description and

Methodology
Selection of funds

For the purpose of the study, a sample of 34 equity diversified mutual fund schemes has been taken

from moneycontrol.com2. Schemes in existence for at least five years up to December 2006 have

been considered.

Return

Some of the popular empirical studies on mutual fund performance have considered monthly

returns only, while Sharpe3 had considered annual returns. In the case of this paper, quarterly

returns have been used. For each mutual fund scheme in the sample, the returns have been

calculated taking start of month Net Asset Values (NAVs). Dividends4 and daily NAVs5 declared

by the mutual funds have been taken from the Association of Mutual Funds in India (AMFI)

website in the January 2002 – December 2006 time frame. From the daily NAV values, quarterly

returns have been computed as follows:

Where

- Rate of return

- Net asset value per share at the end of the quarter

- Net asset value per share at the start of the quarter

D - Dividend payments per share during the quarter
Average return on the portfolio of the mutual fund scheme has been arrived at by using the relation

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= /n

Where

- Average return on the mutual fund scheme

n - Number of quarters

Similarly the return on market index has also been calculated. S&P CNX NIFTY is assumed as

the benchmark. Historical Data for S&P CNX NIFTY was taken from NSE India website6. It is a

broad based index and hence represents the market portfolio. The market returns have been

computed as follows

Where

- Index value at end of quarter

- Index value at beginning of quarter

Average return on market index was found as follows:

= /n

Where

- Average return on S&P CNX NIFTY

Risk

Return alone cannot be considered as the basis of measurement of the performance of a mutual

fund scheme. Risk taken by the fund manager is also relevant because different funds will have

different levels of risk attached to them. The risk associated with a fund is a resultant of two forces.

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First, general market fluctuations, which affect all the securities, present in the market, called

market risk or systematic risk and second, fluctuations due to specific securities present in the

portfolio of the fund, called unsystematic risk.

Standard deviation of quarterly returns is taken as risk. Sharpe has termed this as variability and it

indicates the extent to which actual returns tend to diverge from the actual return during the period.

Where is the total risk of the scheme portfolio.

Similarly the total risk of the market portfolio is calculated as

Systematic Risk (Beta)

In order to obtain the systematic risk (Beta) of a mutual fund scheme, CAPM version of market

model has been applied. The estimable form of CAPM is;

=a+ +e

Where

a -Constant term

-Beta of mutual fund scheme

e -error term (approximation for unique risk of the portfolio)

Regression was run using the above model on and . For example the scheme return of

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Franklin India Prima Plus Fund (G) was regressed against NIFTY returns to obtain the following

output and give a Beta7 of 1.1998.

Reg
res
sion
Stat
istic
s

Mul 0.89
tiple 730
R 257
7

R 0.80
Squ 515
are 191
5

Adj 0.79
ust 432
ed 702
R 2
Squ
are

Sta 6.19
nda 229
rd 149
Err 1
or

Obs 20
erv
atio
ns

AN
OV
A

df SS MS F Sign
ifica
nce
F

Reg 1 285 285 74.3 8.27

res 2.04 2.04 796 E-
sion 9 9 6 08

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Res 18 690. 38.3

idu 200 444
al 5 7

Tot 19 354
al 2.25

Coe Stan t P- Low Upp L U

fficie dard Stat valu er er o p
nts Erro e 95% 95% w p
r e e
r r
9 9
5 5
. .
0 0
% %

Inte 5.77 1.47 3.92 0.00 2.68 8.86 2 8

rce 959 070 980 098 975 943 . .
pt 397 7 8 2 4 4 6 8
5 8 6
9 9
7 4
5 3
4 4

1.19 0.13 8.62 8.27 0.90 1.49 0 1

980 911 436 E-08 752 207 . .
007 8 4 5 5 9 4
3 0 9
7 2
5 0
2 7
5 5

The high Beta value indicates a high sensitivity of fund returns to market returns. The equation

also gives value for (80.5%). Diversification is a major benefit provided by a mutual fund to

an investor. The coefficient of regression indicates the degree of diversification.

Risk-adjusted returns
In order to determine the risk-adjusted returns of investment portfolios, several eminent authors

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have worked since 1960s to develop composite performance indices to evaluate a portfolio by

comparing alternative portfolios within a particular risk class. The most important and widely used

measures of performance are:

● The Treynor Measure

● The Sharpe Measure

Both the above models utilize the risk free rate ( ) which is normally taken as the rate offered

by government long term bonds. For the purpose of the study, the average risk free rate ( )

has been taken as 5%.

The Treynor Measure

Developed by Jack Treynor, this performance measure evaluates funds on the basis of Treynor's

Index. This Index is a ratio of return generated by the fund over and above risk free rate of return

during a given period and systematic risk associated with it (beta). Treynor’s index has been

calculated using the formula

=( - )/

Where is Treynor's Index

The Treynor ratios for all the thirty four schemes were calculated using the above formula (refer

appendix 1)

The Sharpe Measure

The Sharpe Ratio8 is a ratio of returns generated by the fund over and above risk free rate of return

and the total risk associated with it. The ratio has been calculated using:

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● = for the mutual fund scheme

● =( for the benchmark index

The Sharpe ratios for all the thirty four schemes were calculated using the above formula (refer

appendix 1)

Comparison of Sharpe and Treynor

Sharpe and Treynor measures are similar in a way, since they both divide the risk premium by a

numerical risk measure. In theory, for a well-diversified portfolio the total risk is equal to

systematic risk. Thus Rankings based on total risk (Sharpe measure) and systematic risk (Treynor

measure) should be identical for a well-diversified portfolio, as the total risk is reduced to

systematic risk. To prove the above point all the 34 schemes were ranked using the Sharpe and

Treynor ratios. The results of the same have been presented in appendix 1 which shows that the

above holds good for the basket of equity diversified mutual fund schemes considered here.

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Performance and ranking

Past studies

The early studies on performance persistence of mutual funds gave many contradictory opinions.

In 1965, Jack Treynor suggested a method of measuring a mutual funds performance. The same

has even been acknowledged by W. F. Sharpe as a “good predictor even though a better measure

for superior past performance is available9”.

Dr. William F. Sharpe (1966) proposed the “reward-to-variability” ratio10 as a tool for measuring

mutual fund performance. The idea was to measure the rate of return achieved by a fund relative

to the amount of risk taken en route. He took a sample of 34 mutual funds and compared their

performance via ranking to the Dow Jones portfolio of thirty securities. The figure below shows

the distribution of R/V ratios (Sharpe’s ratios) of the 34 mutual funds based on their performance

during the period 1954-1963.

Figure 1 Reward-to-Variability ratio, 1954-1963

He observed that only 11 funds did better than the Dow-Jones portfolio while the remaining 23

did worse. This led to him concluding that “while the average mutual fund may provide

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performance somewhat below that of the Dow-Jones Average, some funds may do better”. In other

words he concluded that differences in performance can be predicted although imperfectly.

Jensen (1968) used “Jensen Alpha” to examine mutual fund performance in 1945-64. Carlson

studied equity mutual funds during 1948-67 and found partial evidence of persistence with 5 years

and no persistence for the 10 year risk adjusted returns.

Ranking

For the purpose of ranking the mutual funds

Bibliography

“Basics of Mutual Funds”, < http://www.myiris.com/mySchool/mfBasics.php>

“Mutual fund”, http://en.wikipedia.org/wiki,

Dr. Uday Lal Pai, “Indian Mutual Funds - highest returns in world”, February 20, 2007,
InvestorIdeas.com

Top mutual funds in July '05, value Research, Aug 2005 ,<
http://www.rediff.com/getahead/money.htm >

Rex Mathew, “Mutual Funds 8 - MF houses (Part A)” , 6 Mar 2007,< http://www.prdomain.com
>

“Will the Indian mutual fund industry grow up?”,October 10, 2006,<
http://ia.rediff.com/money/biz.htm >

MutualfundsIndia.com

Kazemi et al, “Performance persistence for mutual funds: Academic evidences”, May 2003

Value Research, “How to compare mutual funds” , June 20, 2005

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Iluka Hedge Fund Consulting, “All Hail the Sharpe Ratio”, www.ilukacg.com

Analysis of results

The high risk shown by the standard deviation is a negative sign which shown that the
high returns above the benchmark are being produced by investing into high risk
securities

The Treynor Measure

All risk-averse investors would like to maximize this value. While a high and positive Treynor's
Index shows a superior risk-adjusted performance of a fund, a low and negative Treynor's Index
is an indication of unfavorable performance.

The Sharpe Measure

While a high and positive Sharpe Ratio shows a superior risk-adjusted performance of a fund, a
low and negative Sharpe Ratio is an indication of unfavorable performance.

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Appendix 1

Schemes Treyn Treynor Sharpes Sharpe

or ranking (R/V) ranking
ratio ratio

ING Vysya Equity Fund (G) 0.84 1 0.0711 1

LIC MF Equity Fund (G) 1.57 2 0.1376 2

ING Vysya Select Stocks Fund (G) 1.60 3 0.1408 3

UTI Master Plus 91 (G) 2.29 4 0.1969 4

UTI Equity Fund (G) 2.51 6 0.2143 5

Morgan Stanley Growth Fund 2.43 5 0.2175 6

Franklin India Opportunities Fund (G) 2.73 7 0.2413 7

Birla Advantage Fund (G) 2.84 9 0.2449 8

ICICI Pru Growth Plan (G) 2.78 8 0.2461 9

Templeton India Growth Fund (G) 3.05 10 0.2561 10

Tata Pure Equity Fund (G) 3.71 17 0.3011 11

Principal Growth Fund (G) 3.39 12 0.3014 12

Tata Select Equity Fund (G) 3.50 14 0.3017 13

JM Equity Fund (G) 3.46 13 0.3031 14

DBS Chola Growth Fund (G) 3.33 11 0.3059 15

Sundaram BNP Paribas Growth Fund (G) 3.59 15 0.3097 16

SBI Magnum Multiplier Plus (G) 3.94 21 0.3134 17

HDFC Growth Fund (G) 3.79 19 0.3218 18

Franklin India Growth Fund 3.65 16 0.3222 19

HDFC Capital Builder Fund (G) 4.26 24 0.3299 20

Principal Resurgent India Equity Fund (G) 4.37 27 0.3304 21

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Franklin India Bluechip Fund (G) 3.73 18 0.3314 22

DSP-ML Equity Fund - Regular Plan 3.91 20 0.3397 23

Kotak 30 (G) 4.11 22 0.3525 24

Taurus Star Share 5.07 31 0.3543 25

ICICI Pru Power (G) 4.35 26 0.3654 26

Birla Sun Life Equity Fund (G) 4.31 25 0.3673 27

Franklin India Prima Plus Fund (G) 4.21 23 0.3702 28

DSP-ML Opportunities Fund - Regular Plan (G) 4.46 28 0.3866 29

HDFC Top 200 Fund (G) 4.74 30 0.3913 30

HDFC Equity Fund (G) 4.64 29 0.3955 31

SBI Magnum Contra Fund (G) 6.19 32 0.4923 32

Reliance Vision Fund (G) 6.86 34 0.5013 33

Reliance Growth Fund (G) 6.83 33 0.5292 34

Limitations

● Only two performance measures namely the Sharpe Measure and Treynor Measure have
been used. Other measures such as the Differential Return Method proposed by Michael
Jenson and the Eugene Fama model can also be used in this context. The Treynor measure
and Jenson model use systematic risk based on the premise that the unsystematic risk is
diversifiable. These models are suitable for large investors like institutional investors and
AMC’s 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. The Sharpe measure and Fama model on the
other hand consider the entire risk associated with fund and are more suitable for small
investors.

1 “BSE annual market review 2003”, section 3 : market trends ,2003

2 http://www.moneycontrol.com/india/mutualfunds/gainerloser/15/04/snapshot/eqd/ab
3 W. F. Sharpe, “Mutual Fund performance: measurement and predication”, The RAND corporation, March 1965
4 http://www.amfiindia.com/schemedividends.asp
5 http://www.amfiindia.com/navhistoryreport.asp
6
http://www.nseindia.com/content/indices/histdata/S&P%20CNX%20NIFTY112000142007.csv
7 Since Beta will change with the change in the portfolio held by the AMC for the scheme, it is
assumed that Beta remains constant in this paper.

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8 Also called as reward-to-variability ratio

9 W. F. Sharpe, “Mutual Fund performance: measurement and predication”, The RAND corporation, March 1965
10 As defined by its creator, the Sharpe Ratio is simply the average of excess returns divided by the volatility of excess returns.
Thus the Sharpe ratio increases as excess return increases or as volatility decreases. In theory, the higher the Sharpe ratio, the
better the manager.

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