CU-MBA-SEM-IV-Investment Management

bonds do not pay interest till maturity whereas interest may or may not be paid in case of deep discount bonds. 13.4 BOND VALUATION The valuation of a bond refers to the process used to determine the value of a bond. This value is used by the investor along with his personal estimates of what he is ready to pay and other options to determine the fair price. The valuation methods used help the investor to determine what he is ready to pay, what will be returns and what will be the worth of the investment portfolio at any given point in time. Bond valuation includes calculating the present value of future interest payments and the bond’s value on maturity also known as its face value. Since the interest payments and bond’s par value is fixed the investor uses bond valuation to determine the rate of return required for an investment in a bond to be worthwhile. Bond valuation helps the investor to decide whether to invest in the bond or not. Other things considered are credit worthiness of the issuer, the prospects of the market price to increase in future considering the growth potential of the company and probable market interest rates in future. The main principle behind bond valuation is that the bond’s value is equal to the present value of the expected future cash flows. The valuation process involves three steps a. Calculate the expected cash flows. b. Determine the appropriate interest rate that should be used to discount the cash flows. c. Calculate the present value of the expected cash flows using the interest rate determined in step 2. Illustration 1 Mr R is willing to purchase a five year ₹1000 par value bond having a coupon rate of 9% A’s required rate of return is 10%. How much A should pay to purchase the bond if it matures at par? Solution: Face Value of the bond = ₹ 1000 Coupon Rate = 9% Annual Interest = ₹ 90 Maturity Value = ₹ 1000 Required rate of return 151 CU IDOL SELF LEARNING MATERIAL (SLM)

Year Cash flows ₹ PVF @ 10% PV of cash flows ₹ 1 90 0.909 81.81 2 90 0.826 74.34 3 90 0.751 67.59 4 90 0.683 61.47 5 1090 0.621 676.89 Total 962.1 PVF = Present Value factor (for each year @ 10% is taken) The intrinsic value of the bond is ₹ 962.1 Illustration 2 A 6 years bond of ₹ 1000 has an annual rate of interest of 14%. The interest is payable half yearly. If the required rate of return is 16% what is the value of bond? Solution: Interest rate = 14% p.a. Interest amount = 1000 x14% x6/12 = ₹ 70 Required rate of return = 16% p.a. Time period = 12 periods (6 years x 2) Required rate of return for 6 months = 8% (16/2) Intrinsic Value of the bond = Present Value (PV) of Interest + Present Value of Maturity value = 70 x 7.5361 + 1000 x 0.3971 = ₹ 924.64 13.4.1 Yield Yield is the return the investor receives on a bond. Yield is calculated using the bond’s current market price and interest. Current Yield = Interest (in ₹) ÷ Market price x 100 152 CU IDOL SELF LEARNING MATERIAL (SLM)

Let’s understand the concept of yield with a simple example. Suppose a bond of face value 100 is purchased with an interest rate of 6%. So the yield in this case is 6% since it has been purchased at face value. If this bond is sold to another person at 110 yield would 6 ÷ 110 = 5.45%. If it was sold for ₹ 90 yield would be 6 ÷ 90 = 6.66%. Therefore yield is the return which the investor gets considering his purchase price i.e. market price. The above calculation does not consider time value of money. Complex calculations including time value of money include yield to maturity (YTM), bond equivalent yield (BEY) and effective annual yield (EAY) 13.4.2 Yield to Maturity: It is the total rate of return on the bond when all interest payments and original principal is received on maturity. It is the anticipated return on a bond if it is held till maturity. It is the bond’s internal rate of return (IRR) if held till maturity. It is the discounting rate at which PV of interest and maturity value equals the purchase price i.e. market price. It is assumed that all interest payments are re-invested at the same rate of return as the bond. Yield to Call (YTC): When the bond is repurchased by the issuer before maturity yield to call is to be calculated. The calculation is same as YTM but instead of maturity value it should be the call price Yield to Put (YTP): The bond holder has the option to redeem the bond from the issuer at a fixed price (normally face value) on specified date. The calculation is same as YTM except instead of maturity value it should be put price. There are two ways of calculating yield to maturity (YTM) 1. Simple formula for calculating YTM = Interest + (Maturity value – Purchase Price) ÷ No of years/ periods x100 Maturity Value + Purchase Price ÷ 2 2. Trial and Error method: Where the rate is found using interpolation Illustration 3 A 5 years bond with 8% coupon rate and maturity value of ₹ 1000 is currently selling at ₹ 925. What is yield to maturity? Calculate under both methods Solution: Method 1 153 CU IDOL SELF LEARNING MATERIAL (SLM)

Coupon rate = 8 %. 154 Face Value = ₹ 1000 (assumed to be same as maturity value) Annual interest = 1000 x8% = ₹ 80 Purchase price = ₹ 925 Time = 5 years Formula for YTM = Interest + (Maturity value – Purchase Price) ÷ No of years/ periods x 100 Maturity Value + Purchase Price ÷ 2 = 80 + (1000-925) ÷ 5 x 100 1000+925 ÷ 2 = (80+15) ÷ 962.5 X 100 =9.87 % Method 2: Using trial and error method If discounting rate is 9% then PV of Inflows = PV of Interest + PV of maturity value = 80 x 3.8897 +1000 x 0.6499 = 961.076 If discounting rate is 10% then PV of Inflows = PV of Interest + PV of maturity value = 80 x 3.7908 + 1000 x 0.6209 = 924.164 Using interpolation 961.07________________925___________________924.16 9% 10% CU IDOL SELF LEARNING MATERIAL (SLM)

Difference between 961.07 and 924.16 is 36.91 Difference between 961.07 and 925 is 36.07 YTM = 9 + (36.07 x 1 ÷36.91) = 9.9772% 13.4.3 Bond Equivalent Yield (BEY): BEY enables investors to compare the yield of a short term security purchased at a discount with that of a bond with an annual yield. BEY helps investors to calculate annual yield of an investment that does not make annual payments. This analysis helps investors to compare fixed-income securities whose interest payments are not annual i.e. they are paid either quarterly or half-yearly or selling at a discount with securities with annual yields The formula for calculating BEY is BEY = Face Value –Purchase Price x 365 x 100 Purchase Price Days to maturity E g A bond of ₹ 1000 with 100 days to maturity is selling at ₹ 970). Calculate the BEY BEY = (1000-970 ÷970) * (365÷100) x 100 = 11.288% (https://xplaind.com/825622/effective-annual-yield, n.d.)13.4.4 Effective Annual Yield (EAY): EAY is a measure of annual return on investment that takes the compounding of interest into account. It is calculated by compounding and annualising the holding period return. The holding period return is not an annual rate so two investments can’t be compared directly using the holding period return. EAY makes holding period return comparable by standardizing it to annual basis and adjusting it for the effect of compound interest For example Mr A invested ₹ 10000 in stocks on 1st January 2019 which paid dividends of ₹ 400 till 20th May 2019. He sold the shares on 31st July 2019 for ₹ 10500. Calculate his return Ans: First step is to calculate holding period return 155 CU IDOL SELF LEARNING MATERIAL (SLM)

400 + (10500-10000) ÷ 10000 X 100 = 9% However time period of holding between 1st January 2019 to 20th May 2019 is 139 days Equivalent Annual Yield (EAY) = .0.09 x365/ 139 x 100 = 23.633% 13.5 DURATION OF BOND Duration of a bond is the sensitivity of price of a bond or other fixed income security to change in interest rates. Interest rates is one of the main factors to determine a bond’s value. Duration measures the sensitivity of value of bond to changes in interest rates. Macaulay’s duration is the weighted average of times it take for an investor to recover the bond’s price by its cash flows. Macaulay duration measures the weighted average of the time to receive cash flows from a bond so that present value of cash flows equals the bond price Modified duration measures the change in the price of a bond given a 1% change in interest rates. Modified Duration (Volatility) = Duration ÷ 1+YTM Duration of coupon bond is less than maturity period. Duration of a zero coupon bond is equal to maturity period. The longer the maturity the higher the duration and greater the interest rate changes. Bonds with longer maturities have higher volatility due to interest rate changes. (https://www.fidelity.com/learning-center/investment-products/fixed-income-bonds/duration, n.d.)Duration with long maturities and low coupons have the longest durations. These bonds are more sensitive to change in interest rates and thus volatile in a changing rate environment. Bonds with shorter maturities or higher coupons will have shorter durations. Bonds with a shorter duration are less sensitive to changing rates and less volatile in a changing rate environment. The formula for calculating duration is by dividing the sum product of discounted cash inflow of the bond and corresponding number of years by a sum of discounted future cash inflow. Macaulay duration = ∑������������=1 (������������)(������������������)×������ ������������������������������������ ������������������������������ ������������ ������������������������ 156 CU IDOL SELF LEARNING MATERIAL (SLM)

Where (PV) (CFt) = Present value of coupon (cash inflows) at period t t = time to each cash flow in years n = no of periods to maturity Example: Calculate duration of a 12% bond with a yield of 10% having 4 years to maturity.4 Year Cash flows Discounting factor Present Value of Product (a) @ 10% cash flows (b) axb 1 12 0.9091 10.9092 10.9092 2 12 0.8264 9.9168 19.8336 3 12 0.7513 9.0156 27.0468 4 12 0.6830 8.196 32.784 4 100 0.6830 68.3 273.20 Total 106.3376 363.7736 Duration = Total of products ÷ Price of bond = 363.7736 ÷ 106.3376 = 3.4209 years Modified duration measures the change in the value of a security in response to change in interest rates. The relationship between interest rates and price of the bond is inverse. A higher interest rate will lower the bond price and a lower interest rate will raise the bond prices Modified Duration = Duration ÷ 1+YTM 3.4209 ÷ 1.10 = 3.11 Modified duration in the above example is 3.11 which means that for every 1% change in interest price will change by 1% 157 CU IDOL SELF LEARNING MATERIAL (SLM)

Note: The relationship between maturity and duration is direct. The relationship between yield and duration is inverse. 13.6 CONCEPT & FEATURES OF PREFERENCE SHARES Preference Shares: They carry a preferential right over other classes of shares  A preferential right in respect of a fixed dividend. It may consist of a fixed amount or a fixed rate.  A preferential right as to repayment of capital in the case of winding up of a company in priority to other classes of shares. Thus preference shares carry preference over equity shares to receive dividend which is fixed. In the event of closure/winding up of the company they need to be paid before equity shareholders. Hence they are called preference shares. Preference Shares may be  Cumulative or Non-cumulative  Participating or Non-participating In the case of cumulative preference shares their dividend goes on accumulating unless paid. The accumulated arrears of dividend shall be paid before payment is made to equity shareholders. In the case of non-cumulative preference shares the right to claim dividend lapses if there are no profits in a particular year In the case of participating preference shares they get a share out of the surplus profits remaining after paying dividend to the equity shareholders at a fixed rate as determined by the company’s Articles apart from receiving dividend at a fixed rate. Non-participating preference shares do not have such rights. Preference shares are particularly useful to those investors who want comparatively higher rate of return with comparatively lower risk. Investors in preference shares have the following advantages 1. They get a regular fixed income as dividend even if the company has not earned any profits. 158 CU IDOL SELF LEARNING MATERIAL (SLM)

2. They carry preferential right as regards payment of dividend and repayment of capital in case of winding up of the company. 3. Preference Shareholders are given voting rights in matters affecting their interests. Hence their interests are safeguarded. 4. Preference Shares are fair securities for the shareholders during depression periods when the profits of the company are going down. Following are the disadvantages of preference shares 1. They do not have voting rights except in matters which directly affects their interests.’ 2. They get fixed dividend and cannot earn a share when the company has more profits except in the case of preference shares. 3. They cannot claim any surplus. They can only ask for their capital investment in the company. 4. Preference shareholders do not get security in the form of assets of the company as debenture holders. Thus their interests are not protected. 13.7 CONCEPT OF EQUITY SHARES Equity Shares: Issue of shares is the most common method of raising long term funds. A share is defined as one of the units into which the share capital of a company has been divided. The person who holds the share is known as shareholder. He receives dividend from the company as a consideration for investing his money into the company. Equity shareholders do not carry any preferential right for the purposes of receiving dividend and repayment of capital in the event of winding up of the company. The rate of dividend on these shares is not fixed. It depends upon the availability of divisible profits and the intention of the directors. These shares have the chance of earning good dividends in times of prosperity but at the same time stand chance of earning nothing in times of adversity. The equity shareholders control the company by exercising the voting rights at the general meetings of the company. These shares are preferred by persons who are ready to take risks for better return and also have a say in the management of the company. 159 CU IDOL SELF LEARNING MATERIAL (SLM)

13.8 DIVIDEND VALUATION MODELS Intrinsic Value is the fundamental objective value contained of an object, asset or financial contract. The intrinsic value of a stock helps an investor to determine whether the stock is under priced or over priced and accordingly take investment decisions. We will be discussing the dividend valuation model to find out intrinsic value of a share. (https://studyfinance.com/gordon-growth-model/, n.d.)Gordon growth model: The Gordon growth model helps the investor to determine the intrinsic value of a share based on constant rate of growth of future dividends. The intrinsic value of a stock is found out using the company’s rate of return and dividend growth rate. A. Where the dividend grows at a constant growth rate P0 = D1 ÷ Ke –g Where P0 = Fair value of the stock D1 = Expected dividend Ke = Cost of equity or required rate of return g = growth rate in dividends g = growth rate in dividends can be found out by multiplying Return on Equity with the retention ratio. Retention ratio is the percentage of earning retained by the company that is ploughed back into business. Formula for growth rate g = b x r Where b = percentage of retained earnings r = return on equity % Expected dividend D1 = D0 (1 + g) Cost of equity can be found out as Ke = (D1 ÷ P0 ) + g Illustration 1: A company’s share is quoted in the market at ₹ 60 currently. A company pays a dividend of company pays a dividend of ₹ 5 per share and investors expect a growth rate of 12% per year. Compute a. The company’s cost of capital 160 CU IDOL SELF LEARNING MATERIAL (SLM)

b. If anticipated growth rate is 13% p.a. calculate the indicated market price per share. c. If the company’s cost of capital is 18% and anticipated growth rate is 15% p.a. calculate the market price per share, If dividend of ₹ 5 per share is to be maintained Solution: a. Cost of capital (Ke) = (D1 ÷ P0) + g = (5 ÷ 60) + 0.12 = 20.333% b. If g is 13% P0 = D1 ÷ Ke - g = 5 ÷ (20.333% -13%) = 5 ÷ 7.3333% = ₹ 68.18 c. If Ke = 18% g= 15% D1 = 5 = 5 ÷ (0.18-0.15) = ₹ 166.67 B. Two –stage growth model: Where there is an increase in growth rate for few years after which the growth rate is constant First stage: We have to incorporate the increase in growth rate in dividends while calculating D1 i.e. D1 = D0(1+g) and then find present value of expected dividend Second stage: a. We have to calculate the terminal value of dividend by using the formula Terminal value = Dn ÷ Ke – g b. Later we have to find present value of terminal value by using the present value factor of the year previous to the year from which there will be a constant growth rate. Illustration 2 P Ltd presently pays a dividend of ₹ 1 per share and has a share price of ₹ 20 i. If this dividend is expected to grow at a rate of 12% per annum forever what is the firm’s expected or required return on equity using dividend discount model approach? 161 CU IDOL SELF LEARNING MATERIAL (SLM)

ii. If the dividends are expected to grow at a rate of 20% p.a for 5 years and 10% per year thereafter find the intrinsic value of the share. Assume cost of equity is 19%. Solution: i. Current Dividend D0 = 1 Market price of share = ₹ 20 Ke = (D1 ÷ P0) + g D1 = 1+ 12% = 1.12 (1.12 ÷ 20) + 12% = 17.6% ii. If growth rate is 20% p.a. for 5 years and 10% thereafter Year Dividends Disc factor @ 19% Present Value 1 1.2 (1+20%) 0.8403 1.008 2 1.44 (1.2+20%) 0.7062 1.017 3 1.728 (1.44+20%) 0.5934 1.025 4 2.0736(1.728+20%) 0.4987 1.034 5 2.48832(2.0736+20%) 0.4190 1.042 6 2.7371 (2.48832+10%) * 0.4190 12.74 Total 17.866 * 2.7371 ÷ (0.19 – 0.10) = 30.4122 is the terminal value of dividend. This will be multiplied with the present value factor of the fifth year i.e. 0.4190 to get the present value of terminal value of dividend. 162 CU IDOL SELF LEARNING MATERIAL (SLM)

The intrinsic value of the share is ₹ 17.866 which is less than the market price which is ₹ 20 13.9 SUMMARY  Bonds are high security debt instruments which enables the issuer to raise funds for their capital requirements. There are three types of bonds based on the time period for which they are issued short term, medium term and long term. Bondholders are paid interest at a fixed rate predetermined by the issuer at the time of issue. Face value is the price of a unit of bond. Bonds trade in the market at discount or premium depending upon credit worthiness of the issuer and other parameters of the market. There are different types of bonds such as fixed rate, floating rate, inflation linked, perpetual, convertible, zero coupon, deep discount and convertible bonds  Investors are interested in knowing what should be the real value or intrinsic value of the bond. The intrinsic value of the bond is the present value of inflows i.e. interest and present value of maturity value.  Intrinsic Value of the bond = Present Value (PV) of Interest + Present Value of Maturity value.  Yield is the return the investor receives on a bond.  Current Yield = Interest (in ₹) ÷ Market price x 100  Yield to Maturity (YTM): YTM is the anticipated return on the bond if it is held till maturity. It is the discounting rate at which PV of interest and maturity value equals the market price. There are two ways of calculating yield to maturity (YTM) 1. Simple formula for calculating YTM = Interest + (Maturity value – Purchase Price) ÷ No of years/ periods x100 Maturity Value + Purchase Price ÷ 2 2. Trial and Error method: Where the rate is found using interpolation The relationship between interest rates and price of the bond is inverse. . Bonds with longer maturities have higher volatility due to interest rate changes. Macaulay duration = ∑������������=1 (������������)(������������������)×������ ������������������������������������ ������������������������������ ������������ ������������������������ 163 CU IDOL SELF LEARNING MATERIAL (SLM)

Modified duration is change in the price of a bond given a 1% change in interest rate Modified Duration (Volatility) = Duration ÷ 1+YTM The intrinsic value of a stock can be found out by using dividend discount model of Gordon growth model. A. Where the dividend grows at a constant growth rate P0 = D1 ÷ Ke –g Where P0 = Fair value of the stock D1 = Expected dividend Ke = Cost of equity or required rate of return g = growth rate in dividends B, Two –stage growth model: Where there is an increase in growth rate for few years after which the growth rate is constant First stage: We have to incorporate the increase in growth rate in dividends while calculating D1 i.e. D1 = D0(1+g). and then find present value of expected dividend. Second stage: a. We have to calculate the terminal value of dividend by using the formula Terminal value = Dn ÷ Ke – g b. Later we have to find present value of terminal value by using the present value factor of the year previous to the year from which there will be a constant growth rate. 13.10 KEYWORDS  Intrinsic Value: inherent value of an asset. Also called theoretical value  Coupon Rate: Interest rate paid by the issuer to the bond holder  Face Value: Nominal value of par value of a share or bond  Yield: The return the investor gets on the bond. It is the ratio of coupon amount received to the market price or purchase price for the investor.  Bond Equivalent Yield (BEY): It is the annual yield for fixed income security that does not make annual payments 164 CU IDOL SELF LEARNING MATERIAL (SLM)

 Effective Annual Yield: It is the annual return on investment by taking compounding of interest and annualising the holding period return. 13.11 LEARNING ACTIVITY 1. What are zero coupon bonds and deep discount bonds? ___________________________________________________________________________ ___________________________________________________ 2. What do you understand by the term duration? ___________________________________________________________________________ ___________________________________________________ 13.12 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Describe bond and the features of a bond 2. What is yield and yield to maturity? 3. Explain the different types of bonds 4. Why is it necessary to find out intrinsic value of a share? 5. Differentiate between convertible debentures and perpetual debentures (vturesource.com, n.d.) Long Questions 1. How do you compare returns on two bonds where the frequency of interest payments differ? Explain in detail 2. Explain the relationship between term to maturity, duration and interest rates 3. Explain the types of risks associated with bonds 4. Target Ltd paid a dividend of ₹ 2.75 during the current year. Forecasts suggest that earnings and dividends of the company are likely to grow at the rate of 8% over the next 5 years and at the rate of 5% thereafter. Investors have traditionally required rate of return of 20% on these shares. What is the present value of stock? 165 CU IDOL SELF LEARNING MATERIAL (SLM)

5. Mr Kishore purchased a bond with the face value of ₹ 1000. The bond has five years to maturity and a 10% coupon rate. The bond was called two years later for a price of ₹ 1200 after making second annual interest payment. Mr Kishore reinvested the proceeds in a bond selling at its face value of ₹ 1000 with three years to maturity and a 7% coupon rate. What is Karan’s actual YTM over the five year period? B. Multiple Choice Questions 1. Yield to maturity is the _____________ rate at which PV of interest and maturity value equals the market price. a. coupon b. market c. discounting d. changing 2. Preference shareholders get a ____________ amount of dividend. a. high b. fixed c. normal d. low 3. Under _____________ the issuer has the right to repay the bond. a. Puttable bond b. callable bond c. Zero coupon bond d. Convertible bond 4. The _____________ takes into account compounding of interest and annualised holding period returns. 166 CU IDOL SELF LEARNING MATERIAL (SLM)

a. Normal yield b. Current yield c. Effective annual yield d. Bond Equivalent yield 5. When interest rates rise prices of bond ____________ a. Changes proportionately b. increase c. does not change d. Decrease Answers 1–c, 2–b, 3–b, 4–c, 5-d 13.13 REFERENCES Reference book  Chandra Prasanna (2009) Investment Analysis and Portfolio Management Tata McGraw Hill Website  https://fidelity.com  https://studyfinance.com  https://corporatefinance.com  https://investopedia.com  https://vturesource.com  https://pdfcoffee.com  https://groww.in/p/bonds/. (n.d.). Retrieved from https://groww.in: https://groww.in  https://studyfinance.com/gordon-growth-model/. (n.d.). Retrieved from studyfinance.com: https://studyfinance.com 167 CU IDOL SELF LEARNING MATERIAL (SLM)

 https://www.fidelity.com/learning-center/investment-products/fixed-income- bonds/duration. (n.d.). Retrieved from https://www.fidelity.com: https://fidelity.com  https://xplaind.com/825622/effective-annual-yield. (n.d.). Retrieved from xplaind.com: https://xplaind.com  vturesource.com. (n.d.). Retrieved from vturesource.com: https://www.vturesource.com 168 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 14 MANAGING MUTUAL FUNDS STRUCTURE 14.0 Learning Objectives 14.1 Introduction 14.2 Mutual fund basics 14.3 Types of mutual funds 14.4 Concept of Net Asset Value 14.5 Performance evaluation of managed portfolios 14.5.1 Sharpe’s index 14.5.2 Treynor’s index 14.5.3 Jensen’s index 14.5.4 Practical sums 14.6 Summary 14.7 Keywords 14.8 Learning Activity 14.9 Unit End Questions 14.10 References 14.0 LEARNING OBJECTIVES After studying this chapter you will be able to  Describe the basics of mutual fund  Explain the types of mutual fund  Define Net Asset Value  Assess the performance of mutual fund portfolios using various tools 169 CU IDOL SELF LEARNING MATERIAL (SLM)

14.1 INTRODUCTION Mutual funds provide a very good way for investors to invest in stock markets without involving heavy investment. When an investor invests in a fund his funds are pooled together with funds collected from other investors. Such pooled funds are then invested in a variety of instruments like equity, debt, money market instruments e t c. Thus it provides the benefit for diversification for the investor. It is managed by fund managers who are supported by a team of analysts who study the markets, consider the micro and macroeconomic factors and advise the fund manager. The fund manager invests the pooled money from the investors depending upon the scheme objectives agreed with the investors. In this chapter we will understand certain basics of mutual fund. Investors have a wide range of choice among the different types of funds. They can choose from the funds depending upon the objective to be achieved. You will become familiar with the types of funds. The performance of a particular mutual fund is based on the Net Asset Value (NAV). From this chapter you will learn the concept of NAV. In this chapter how to evaluate the performance of a fund. We will discuss various ways in which we can assess the performance of a fund. This assessment will help in deciding which funds are better as compared to other funds. 14.2 MUTUAL FUND BASICS (https://www.principalindia.com/new-investor-basics, n.d.)A mutual fund is formed as a trust which consists – sponsor, trustees and an asset management company. The sponsor is the promoter who has to obtain permission from Securities and Exchange Board of India (SEBI) for setting up the mutual fund. A public trust is formed under the Indian Trust Act 1882 and registered with SEBI. After the trust is created trustees are appointed who have to get themselves registered with SEBI. Trustees protect the interests of unitholders and comply with mutual fund regulations of SEBI. Later an Asset Management Company (AMC) is created by the sponsor which is registered under the provisions of Companies Act 2013.They are regulated by the capital market regulator Securities and Exchange Board of India (SEBI) (https://cleartax.in/s/asset-management-company-amc, n.d.)Asset Management Companies (AMC): Asset Management Companies collects funds from various retail and institutional investors and invests in various securities, real estate, bonds, e t c. The AMC have professionals called fund managers and a research team to manage the investment portfolio. 170 CU IDOL SELF LEARNING MATERIAL (SLM)

The AMC is responsible for running the mutual fund and making decisions that benefit the investors. The AMC under the leadership of the fund manager makes investments in accordance with the investment objectives of the scheme. For e.g. most debt funds have maximum portion invested in bonds and fixed- income securities while balanced funds invest in a mix of stock and fixed-income securities. The portfolio is constructed by the fund manager based on detailed study and analysis of the research team of market and trends. The AMC is also required to provide information to the unit holders that has a direct impact on their holdings. The AMC has to regularly update the investors about the portfolio holdings, NAV, sales and purchases and so on. It has to address the grievances of the investors regarding their mutual fund schemes. The investor needs to take into account the reputation of the AMC, check the past performance and check the fund manager’s track record while choosing an AMC. 14.3 TYPES OF MUTUAL FUNDS Mutual funds can be classified into the following types a. According to the type of investment: Every mutual fund has to disclose in its prospectus the type of investments it will make from the funds collected at the time of its issue. The various types of mutual funds according to the type of investments are as follows:  Equity funds: They invest predominantly in equities. The primary objective is wealth creation. They have the potential to generate higher return and suitable for long-term investment  Debt funds: They invest in government securities, bonds, commercial papers, debentures. They are relatively safer investments and suitable for income generation.  Diversified/Balanced funds: They invest in both equity and fixed income securities thus offering growth potential as well as income generation 171 CU IDOL SELF LEARNING MATERIAL (SLM)

 Gilt funds: These funds invest in bonds and fixed-interest bearing securities issued by the Central and State Governments. The investments are made in securities with different maturities. These instruments carry minimal risk since the money is invested with the government.  (https://groww.in/p/equity-funds/sector-mutual-funds/, n.d.)  Money market funds: Money market funds are short term debt funds. They invest in various money market instruments. These funds provide good returns over a period of up to one year while at the same time maintaining liquidity. The average maturity of Money Market fund is one year  (https://www.indiainfoline.com/mutualfunds, n.d.)  Sector funds: They invest in specific sectors of the economy such as aviation, telecommunication, real estate, natural resources, technology e t c. The main aim to invest in such funds is to generate good returns while a boom is witnessed e g. Reliance Pharma Fund, ICICI Prudential Technology Fund, Invesco India Infrastructure fund to name a few  (https://www.indiainfoline.com/mutualfunds, n.d.)Index funds: Index funds are those funds that mimic the composition of stock indices. These funds invest in those stocks that are part of its benchmark index.  e. g. ICICI Prudential Nifty Index fund, SBI Nifty Index fund. These funds follow Nifty 50 and spread investment across the same 50 stocks that Nifty tracks b. According to time of closure of the scheme: These are of the following types  Open-Ended Schemes: These schemes are open for investment and redemption throughout the year. Hence the name open-ended. They offer high liquidity compared to close-ended schemes where liquidity is available only after the lock-in period.  Close-Ended Schemes: The investment is locked for a specific period of time. Investors can subscribe to these schemes only during the time of new fund offer (NFO) and redeem the units after the tenure of the scheme is over. c. According to tax incentive schemes Tax Savings funds 172 CU IDOL SELF LEARNING MATERIAL (SLM)

Non-tax savings funds d. According to the time of pay-out  Dividend Paying Schemes: Profits are distributed to the unit holders. Dividends that are paid are deducted from the NAV hence ex-dividend NAV is less. Total returns will be less compared to growth or re-investment option. Investor who require regular cash flows from the investment prefer dividend paying schemes. They are taxed in the hands of the investor depending on his income-tax slab rate.  Re-investment schemes: Dividends are re-invested in the scheme. The NAV is higher than since profits are re-invested to earn profits. Total returns are higher compared to dividend paying scheme due to the compounding effect and long investment horizon. Short-term and long-term capital gains tax are paid by the investor depending upon when he redeems. Thus mutual funds provide the following key benefits  Diversified portfolio  Professional management  Liquidity  Wide range of funds 14.4 CONCEPT OF NET ASSET VALUE (NAV) Net Asset Value is the value of a fund’s assets minus the value of its liabilities divided by the total number of units outstanding. Mutual funds are required to calculate the NAV of their funds after the end of the trading day and disclose to its investors. Since the market value of securities in which investments are made by mutual fund change daily the NAV also changes. The total assets comprises of all the securities in the portfolio and cash/bank balances. The value of liabilities include all outstanding expenses such as staff salaries, management expenses e t c The formula for finding out NAV is (Total Assets – Total Liabilities) ÷ Number of units outstanding 173 CU IDOL SELF LEARNING MATERIAL (SLM)

The NAV helps the investors to determine the fund’s per unit market value. The per unit value is the value at which investors can buy or sell fund units. If the value of the securities in the fund increases the NAV increases. If the value of the fund decreases the value of the fund decreases. If a fund has made a 100% gain in its NAV compared to its peers during the same time period we can say that the fund has performed better. However NAV cannot be used as the only tool for analysing the performance of a fund. We cannot analyse the performance of a fund by comparing its NAV to other funds. To find out which fund is performing better we need to look at the performance history of each mutual fund, the securities within each fund, the longevity and experience of the fund manager, the expense ratio and the performance of the fund relative to its benchmark. The NAV should be looked over a time frame to judge the fund performance. NAV cannot be used in isolation to compare two similar funds. 14.5 PERFORMANCE EVALUATION OF MANAGED PORTFOLIOS Certain other tools are used to analyse the performance of a fund which we will discuss in the next sub-section 14.5.1 Sharpe’s index: The Sharpe index or Sharpe ratio was developed by William F Sharpe which helps investors to understand return of an investment compared to its risk. The ratio is the average return earned in excess of the risk free rate per unit of volatility i.e. standard deviation. Standard deviation is the risk due to price fluctuations of an asset or portfolio. The Sharpe ratio is one of the widely used methods used for calculating risk-adjusted return. We had studied in our earlier chapters that as per the Modern Portfolio theory adding asset to a diversified portfolio that has low correlations can decrease portfolio risk without having to compromise in returns. The Sharpe ratio can be used to evaluate the portfolio’s past performance where actual returns are used in the formula. We can also calculate expected portfolio performance and expected risk free rate to find expected Sharpe ratio The formula for Sharpe ratio is Sharpe ratio =( Rp -Rf) ÷ σ Where Rp = Return of the portfolio Rf = Risk free rate of return 174 CU IDOL SELF LEARNING MATERIAL (SLM)

σ = Standard deviation of the portfolio The greater the Sharpe ratio the more attractive is the risk adjusted return. A high Sharpe ratio is good compared to other similar funds with lower returns. The Sharpe ratio helps to determine the profits earned due to risk taking activities since it removes the risk free rate. The Sharpe ratio helps to decide whether the portfolio’s excess returns are due to smart decisions or due to assuming too much risk. When a portfolio is diversified it has a higher Sharpe ratio compared to other portfolios with lower diversification. If the addition of a new investment would lower the Sharpe ratio it should not be added. 14.5.2 Treynor’s index: Treynor ratio is a measure of returns earned over the risk free rate at a given level of market risk. This ratio was given by Jack Treynor expanding the contribution by William Sharpe towards the modern portfolio theory. The Sharpe ratio helps us to determine how well the fund has performed against the overall risk. Treynor ratio finds out the performance of the portfolio in the backdrop of risks prevailing in the economy. We had already studied in our earlier chapters that market rewards the investor only for systematic risk. Unsystematic risk can be avoided through portfolio diversification. Hence systematic risk is the market risk and other macroeconomic factors which increase the risk of the portfolio. Beta is a measure of systematic risk. It measures the sensitivity or volatility of the price of a stock relative to the market. Treynor’s ratio explains the excess returns gained by the investor due to the systematic risk i.e. beta Formula for calculating Treynor’s ratio is Treynor ratio = (Rp - Rf) ÷ β Where Rp = Return of the portfolio Rf = Risk free rate of return β =Beta of the portfolio The beta of the fund which invest in volatile stocks will be higher than the fund which invests in low volatile stocks. The higher the beta the higher is the sensitivity of the fund returns and riskier is the investment. 175 CU IDOL SELF LEARNING MATERIAL (SLM)

A fund with a higher Treynor ratio is better as compared to a fund with a lower Treynor ratio. It means it gives more returns for every additional unit of market risk. In the case of a well- diversified portfolio company risk is low hence the total risk is due to market risk. In such a case both Sharpe ratio and Treynor ratio yield similar results. However in the case of non- diversified portfolio Treynor ratio will be a better measure. Where addition of a new fund lowers the Treynor ratio it means riskiness has increased without contributing to the portfolio return. 14.5.4 Jensen’s index: Jensen’s index or Jensen’s alpha is the risk adjusted performance measure that shows the average return on the portfolio or investment over or below the expected returns predicted as per Capital Asset Pricing Model (CAPM). When the value of alpha is positive it means the fund manager has generated higher returns by outperforming the market while a negative alpha would mean the fund manager has not earned enough returns for the risks assumed The formula for calculating Jensen’s alpha is Alpha = Rp - Expected returns as per CAPM Alpha = Rp - Rf + (Rm –Rf) xβ Where Rp = Return of the portfolio Rf = Risk free rate Rm =Return of the market index β = Beta of the portfolio of investment 14.5.4 Practical sums (https://www.icai.org/post/bos-knowledge-portal, n.d.) Illustration 1 Five portfolios experience the following results during a 7 year period. Following data is provided. Calculate Sharpe ratio and Treynor ratio and give rankings Portfolio Average Annual Standard deviation Correlation with Return Rp σ market returns A 19 2.5 0.840 176 CU IDOL SELF LEARNING MATERIAL (SLM)

B 15 2 0.540 C 15 0.8 0.975 D 17.5 2 0.750 E 17.1 1.8 0.600 Market risk is 1.2, Market rate of return is 14% Risk free rate is 9% Solution Sharpe Ratio = Rp – Rf ÷ σ Portfolio Calculation as per formula Rank IV A (19-9) / 2.5 =4 V I B (15-9) /2 = 3 III II C (15-9) /0.8 =7.5 D (17.5-9) /2= 4.25 E (17.1-9) /1.8 =4.5 Treynor ratio = Rp – Rf ÷ β 177 Beta of each portfolio is not given Beta of portfolio βp = Correlation of the portfolio with market x Standard deviation of portfolio Standard deviation of market Βp = ρpm x σp ÷ σm For portfolio A beta will be 0.840 x 2.5/1.2 = 1.75 Similarly beta of other portfolios are calculated CU IDOL SELF LEARNING MATERIAL (SLM)

Portfolio Beta Calculation Ranking A 1.75 B 0.90 (19-9) /1.75 = 5.71 V C 0.65 D 1.25 (15-9) /0.90 = 6.67 IV E` 0.90 (15-9) /0.65 = 9.23 I (17.5-9)/1.25 = 6.80 III (17.1-9) /0.90 = 9 II Illustration 2 Using the data in the above illustration calculate Jensen’s alpha for each portfolio Formula for Jensen’s alpha = Return of the portfolio – Returns as per CAPM Alpha = Rp - Rf + (Rm –Rf) xβ Return as per CAPM for portfolio A is = 9 + (14-9)1.75 = 17.75% Portfolio Return of Return as per Alpha (a-b) Ranking portfolio (a) CAPM (b) A 19 17.75 1.25 V B 15 13.50 1.50 IV C 15 12.25 2.75 II D 17.5 15.25 2.25 III E 17.1 13.50 3.60 I 178 CU IDOL SELF LEARNING MATERIAL (SLM)

14.6 SUMMARY  Mutual funds provide a very good avenue for investors to participate in stock market. Investors get benefit of portfolio diversification with limited fund requirement. Professional management, liquidity and wide range of funds are other benefits of mutual fund investments.  Asset Management Companies collect funds from institutional and retail investors and invest in a variety of securities such as equity, debt, money market instruments e t c. AMC’s are regulated by SEBI. AMC’s are also regulated by the Association of Mutual Fund of India (AMFI) in order to protect the interests of investors.  Investors have a wide range of funds from which they can choose depending upon their investment objectives and risk appetite. Some type of mutual funds are equity funds, debt funds, balanced funds, index funds, money market funds, sector specific funds to name a few.  Mutual funds are managed by professionals such as fund manager who is assisted by a research team of analysts who study the market and other trends in the economy. They advise the fund manager based on their analysis and the fund manager invests the funds.  Net Asset Value (NAV) is the market value per unit of the fund. Investors buy and sell units based on the NAV declared by the mutual fund every business day. The formula for calculating NAV is Total Assets – Total Liabilities / Total number of units outstanding.  The performance of a mutual fund cannot be assessed only by comparing NAV of fund with another similar fund. Various tools are available to study the performance of mutual funds.  Sharpe ratio, Treynor ratio and Jensen’s alpha are some measures which we can use  Sharpe ratio = Rp –Rf ÷ σ  It measures the returns earned in excess of risk free rate per unit of standard deviation  Treynor ratio = Rp - Rf ÷ β  Higher the Sharpe and Treynor ratio better is the performance of the fund  It measures the excess returns earned for a given level of market risk i.e. beta  Jensen’s Alpha is the excess return of the portfolio over the returns calculated as per CAPM 179 CU IDOL SELF LEARNING MATERIAL (SLM)

Alpha = Rp - Rf + (Rm –Rf) xβ  A higher alpha means the fund manager has generated extra returns for the risk assumed. 14.7 KEYWORDS  Asset Management Company (AMC): AMC is a company registered under the Companies Act and regulated by SEBI. AMC collects funds from retail and institutional investors and invests in various securities.  Net Asset Value (NAV): NAV is the market price per unit of the fund. The formula for calculating NAV is Total Assets – Total Liabilities / Total number of units outstanding.  Standard deviation: It is the measure of the total risk of the stock or portfolio. It is the square root of variance.  Beta: Beta is a measure of systematic risk. It is a measure of stock’s volatility in relation to the market  Alpha: Alpha is the excess return earned on a portfolio over the returns calculated as per CAPM.  CAPM: It is a model to determine a theoretically appropriate required rate of return on an asset. 14.8 LEARNING ACTIVITY 1. Why are mutual funds preferred by investors compared to stocks for investment? ___________________________________________________________________________ _____________________________________________ 2. Define Jensen’s alpha ___________________________________________________________________________ _____________________________________________ 14.9 UNIT END QUESTIONS 180 A. Descriptive Questions CU IDOL SELF LEARNING MATERIAL (SLM)

Short Questions 1. Explain how mutual funds are formed 2. Define AMC. Explain its functions 3. Differentiate between equity fund and balanced fund 4. What do you understand by Net Asset Value? 5. Define beta Long Questions 1. State the benefits of investing in mutual funds 2. List the different types of funds available for investor while investing in mutual fund. Explain any 3 3. Which tool will you use to measure performance of the portfolio with reference to market risk? Explain 4. Do you think NAV’s are the best way to assess the performance of the portfolio? Why? 5. (vturesource.com, n.d.)The following portfolios have given the following results during a five year period Portfolio Average Annual Standard deviation Correlation with the Return market A 15.60 27.00 0.81 B 11.80 18.00 0.55 C 8.30 15.20 0.38 D 19.00 21.20 0.75 E -6.00 4.00 0.45 F 23.50 19.30 0.63 181 CU IDOL SELF LEARNING MATERIAL (SLM)

G 12.10 8.20 0.98 Market 13.00 12.00 i. Rank these portfolios using Sharpe and Treynor methods. The risk free rate is 6% ii. Did any portfolio outperform the market? Why or why not B. Multiple Choice Questions 1. _____________ funds provide fixed income for investors a. Balanced b. Debt c. Equity d. Sector 2. When investments are made in two assets ____________ correlation helps to mitigate risk in the portfolio. a. zero b. positive c. negative d. greater than zero 3. A fund manager’s performance is assessed with a __________ alpha a.maximum b. negative c. minimum d. positive 182 CU IDOL SELF LEARNING MATERIAL (SLM)

4. Systematic risk ____________be diversified a. rarely b. can c. cannot d. sometimes 5. _____________ funds have maturity of up to 1 year a. Tax savings b. balanced c. Index d. Money market Answers 1–b, 2–c, 3–d, 4–c, 5-d 14.10 REFERENCES Reference book  Chandra Prasanna (2009) Investment Analysis and Portfolio Management Tata McGraw Hill Website  https://www,principalindia.com  https://cleartax.in  https://groww.in  https://indiainfoline.com  https://corporatefinanceinstitute.com  https://www.icai.org  https://www.vturesource.com  https://www.investopedia.com 183 CU IDOL SELF LEARNING MATERIAL (SLM)

 https://cleartax.in/s/asset-management-company-amc. (n.d.). Retrieved from cleartax.in: https://cleartax.in  https://groww.in/p/equity-funds/sector-mutual-funds/. (n.d.). Retrieved from groww.in: https://groww.in  https://www.icai.org/post/bos-knowledge-portal. (n.d.). Retrieved from icai.org: https://www.icai.org  https://www.indiainfoline.com/mutualfunds. (n.d.). Retrieved from indiainfoline.com: https://www.indiainfoline.com  https://www.indiainfoline.com/mutualfunds. (n.d.). Retrieved from indiainfoline: https://www.indiainfoline.com  https://www.principalindia.com/new-investor-basics. (n.d.). Retrieved from principalindia.com: https://www.principalindia.com  vturesource.com. (n.d.). Retrieved from vturesource.com: https://www.vturesource.com/ 184 CU IDOL SELF LEARNING MATERIAL (SLM)