CFP- Level-1-IP and Asset Management (Global) Chapter 1-6

Profitability Metric of MF investments • Interest Income • + Dividend Income • + Realized Capital Gain • +Valuation Gains • - Realized Capital Losses • - Valuation losses • -Scheme expenses Friday, 15 July 2022 Investment Planning & Asset Management

Why Mutual Funds? 1. Professional Management 2. Diversification 3. Convenient Administration 4. Return potential 5. Low cost 6. Liquidity 7. Transparency 8. Flexibility 9. Choice of schemes 10. Well regulated 11. Tax benefits International College of Financial Planning

Disadvantages of Mutual Funds Pricing Unlike stock prices that change with every trade and fluctuate throughout the day, mutual funds are priced only after the market is closed, and the closing price of each holding has been determined and aggregated. The effect is that unit holders do not know what price they are paying to buy units, or what price they will receive when selling units, until after that day’s market is closed. Mutual Fund Costs Investors incur various costs when purchasing and owning a fund. These costs can be divided into two categories: (1) transaction costs, which are the costs incurred in buying or redeeming units of the fund, which can include commissions paid to advisors (depending on applicable laws); and (2) operating expenses, which are the unitholder’s portion of the costs of operating the fund throughout the year. Friday, 15 July 2022 Investment Planning & Asset Management

Types of funds (Entry-Exit Point of view) • Open ended Funds Open for sale and repurchase throughout the year No time frame for schemes • Close ended funds Fixed maturity (Sale only during NFO) Listing on Stock Exchange if no repurchase option given • Interval Funds Combine features of both open ended and close ended. Become open ended at certain intervals (Both sale and repurchase) Minimum duration of an interval period is 15 days Friday, 15 July 2022 Investment Planning & Asset Management

Types of Funds as per churning of portfolio • Actively managed funds • Passive funds Index Funds Exchange Traded Funds Friday, 15 July 2022 Investment Planning & Asset Management

Why does tracking error occur in index funds? • Broadly, there are 3 reasons why tracking errors in index funds that cause the difference between the index performance and the actual fund performance.. • Firstly, the index is a dynamic combination and the index committee will keep changing the constituents regularly. For example, the Nifty recently added Grasim and Bajaj Finserv into the Nifty Index and removed two stocks from the index. Till the time the index fund manager also adjusts the fund holdings accordingly, there will be tracking error present in the fund. • Occasionally, funds face redemption pressure from investors. As long as the inflows into the fund are greater than the outflows there is no problem. However, when the outflows exceed the inflows it leads to shares being sold to cover these redemptions. This will lead to changes in the index fund and will ensure that they are not in sync with the index. • Finally, there is the issue of dividends. Normally, dividends are not adjusted for dividends but the fund that holds these shares will receive these dividends. This will again lead to differences between the fund values and the index value. The transaction costs and the expense ratio of the fund also play a part in determining the variance of the index fund performance from the actual index. The dividends act as a cushion against the negative impact of transaction costs and expense ratio. Friday, 15 July 2022

How should investors interpret Tracking Error?  Tracking error is the extent to which the portfolio of the index fund does not track the core index. Here are 5 ways to interpret the tracking error..  When you invest in an index fund it is essential to select the fund with the lowest tracking error. Normally, tracking error is evaluated based on the annualized number. While there is not official cut-off you must select the index fund that is lower than the benchmark average.  Apart from the annualized tracking error, it is essential to also look at the variance of the tracking error. A low tracking error that is stable is better than a tracking error that is low on an average but is showing high degree of variance.  Tracking error is required to be disclosed by index funds as part of their fact sheet. Apart from the absolute number of the tracking error also look at the trend in the tracking error. That is more instructive from an analytical perspective.  Tracking error is negatively impacted by the transaction costs and the expense ratio of the fund. But the fund manager has the cushion of the dividends, which are not included in the calculation of the index value. However, this could change if the Total Returns Index is considered instead of the Absolute Returns Index. To that extent the index funds may underperform as they will lose the cushion of dividends.  What fund managers actually do is to create a portfolio the mirrors the index performance as close as possible. Tracking error works both ways; i.e. outperforming the index and underperforming the index. Substantial returns over the index are also not a great signal as it will mean that the fund manager may be taking unwarranted risk on the index portfolio. That again defeats the purpose of indexing. Friday, 15 July 2022

Debt Funds On the Basis of Issuer  Gilt Funds  Corporate Bond Funds On the Basis of Tenor  Overnight Fund  Liquid Schemes  Ultra Short Duration Fund  Low Duration Funds  Short Term Plans  Money market Fund  Short Duration Fund, Medium Duration Funds, Long Duration Funds  Diversified Debt funds  High yield bond schemes (Junk Bond schemes)  Fixed maturity plans  Floating rate funds Friday, 15 July 2022 Investment Planning & Asset Management

Equity Funds  Diversified equity funds  Market Segment Based Funds (Large, Mid and Small cap)  Multi Cap Funds vs Flexicap Fund (25% allocation minimum in all caps in Multi cap Funds)  Sector funds  Thematic funds  Value Funds  Growth Funds  Focused Funds  Equity Linked Saving Scheme Balanced/Hybrid Funds  Equity Oriented Balanced Funds  Debt Oriented Balanced Funds Friday, 15 July 2022 Investment Planning & Asset Management

Let us understand Loads • Entry Load (NAV+ Load %= Sale Price) • There is no entry load in any scheme now • Exit Load (NAV- Exit load%= Repurchase Price) • NAV of a scheme= Rs.20, Exit load is 1% if redemption done before 1 year • Repurchase price= 20(1-exit load) • =20(0.99) • =19.80 • Any person holding say 1000 units will get Rs.19800 Friday, 15 July 2022

Net Asset Value • Net Asset Value.. • Represents the value of each unit of the fund • Calculated as follows • NAV = Net assets of the scheme/ Number of outstanding units • Where net assets of the scheme are : on the valuation day Market value of investments + Receivables + Other accrued income + Other assets - Accrued expenses - Other payables - Other liabilities Friday, 15 July 2022

Net Asset Value • Daily by 9 pm on AMFI website for open ended schemes • Weekly for listed close ended schemes • Monthly / quarterly for unlisted close ended schemes • A Fund’s NAV is affected by • Purchase and sale of investment securities • Valuation of all investment securities held • Other assets and liabilities • Units sold or redeemed Friday, 15 July 2022

Net Asset Value • Market Value of investments= Rs.20 crore, Receivables Rs.50 Lakh, Accrued interest Rs.76 lakh, Accrued Expenses Rs.45 Lakhs, Liabilities Rs.50 Lakh, Number of units 2 crore • Compute NAV per unit • NAV = Net assets of the scheme/ Number of outstanding units • = 20 Crore+50 lakh+76 lakh-45 lakh-50 lakh/2 crore units • = 10.15 Friday, 15 July 2022

Types of returns While mutual funds have several different investment objectives, they can generally be said to fall into one of three categories: 1. Capital Appreciation/Growth: Seeking an increase in the value of the investment. 2. Income: Seeking regular, ongoing income from the investment. 3. Capital Preservation: Seeking maintenance of the investment’s value regardless of market conditions. Friday, 15 July 2022 Investment Planning & Asset Management

Exchange Traded Funds Exchange-traded funds are similar to index mutual funds, but trade like stocks throughout the course of a trading day. Like mutual funds, many ETFs are registered as open-end investment companies, but are structured differently than mutual funds. Each ETF is designed to track an index and replicate its returns. Friday, 15 July 2022 Investment Planning & Asset Management

Exchange Traded Funds A security market index is a group of securities representing a given security market, market segment, or asset class. The following are some well known indices, by country: United States: S&P 500 Index United Kingdom: FTSE 100 (practitioners commonly pronounce FTSE as “footsie”) France: CAC 40 South Korea: Korea Stock Price Index (KOSPI) India: SENSEX (BSE), NIFTY 50 (NSE), BSE 100, BSE 200 Friday, 15 July 2022 Investment Planning & Asset Management

Exchange Traded Funds ETFs are broadly diversified and highly transparent, with very low management and trading costs. Funds may invest in every security in the index, a strategy known as full replication. Funds may invest in only a representative sample of the index securities, a strategy called sampling replication. Friday, 15 July 2022 Investment Planning & Asset Management

Advantages Exchange Traded Funds (ETFs) Cost Efficiency Passively managed index mutual funds normally have lower expenses than their actively managed counterparts. ETFs have significantly lower expenses than even passive mutual funds that track the same indexes. Tax Efficiency ETF owners control the timing of their purchases and sales Availability of Option Contracts Several ETFs have call and put options available on them. This gives the investor the ability to employ strategies not available with mutual funds, such as writing covered calls for income and using protective puts to hedge positions. Friday, 15 July 2022 Investment Planning & Asset Management

Disadvantages Exchange Traded Funds (ETFs) NAV and Tracking Error ETFs and Index Funds are designed to track the performance of various market indexes, but they do not always trade exactly at their net asset value, leading to performance that differs from the index. The primary cause of tracking error in an ETF relates to how it is constructed. Friday, 15 July 2022 Investment Planning & Asset Management

Exchange-Traded Notes (ETNs) Exchange-traded notes (ETNs) are senior unsecured debt securities that, similar to ETFs, track the performance of various market indexes and trade like a stock. ETNs are usually issued by large banking institutions and do not actually own any underlying securities. As debt issues, ETNs do not possess any voting rights, nor do they pay a fixed rate of interest ETNs are most commonly used to track commodity and currency exchange markets, where mutual funds and ETFs aren’t typically available. Friday, 15 July 2022 Investment Planning & Asset Management

Advantages of Exchange-Traded Notes (ETNs) Benchmarking: ETNs track, exactly, the performance of their underlying market benchmark Liquidity: ETNs are open-ended securities, and therefore are not limited to on-exchange volumes Accessibility: ETNs are traded and settled on a stock exchange, the same as any equity, and can be purchased and held in ordinary brokerage or custodial accounts Friday, 15 July 2022 Investment Planning & Asset Management

Advantages of Exchange-Traded Notes (ETNs) Ease of Ownership: ETNs do not involve any of the difficulties with buying and then managing a futures position (e.g., worrying about margin calls, contracts expiring and rolling positions) or in buying and storing physical assets. Transparency: ETN pricing is based on a transparent formula with the pricing updated daily by the issuer. ETNs are priced using published settlement prices Flexibility: Investors can long or short ETNs Friday, 15 July 2022 Investment Planning & Asset Management

Disadvantages of Exchange-Traded Notes (ETNs) ETNs are not rated, but are tied instead to the creditworthiness of the issuer. Thus, the issuer’s credit rating is an important consideration for ETN investors. Typically, ETNs have a repurchase feature, providing qualified investors, known as authorized participants, the election to redeem notes of at least a specified minimum denomination or value with the issuer on a daily or weekly basis at a predetermined price. Individual investors not qualified for redemption election can purchase or sell their ETNs in the secondary market, sell at a specified issuer call event, or allow them to mature. Friday, 15 July 2022 Investment Planning & Asset Management

Unit Investment Trusts (UITs) Like mutual funds and closed-end funds, unit investment trusts (UITs) are registered investment companies that pool investor money, but unlike the other two funds, UIT holdings do not change. For this reason, they are sometimes also referred to as fixed trusts or defined portfolios. UITs can contain different types of securities (e.g. stocks, preferred stocks, bonds, REITs, etc.) that are professionally selected but not subsequently traded. Like mutual funds, UITs are priced daily, after markets close. Friday, 15 July 2022 Investment Planning & Asset Management

Advantages of Unit Investment Trusts (UITs) A UIT typically issues redeemable securities (or “units”), like a mutual fund, which means that the UIT will buy back an investor’s “units,” at the investor’s request, at their approximate net asset value (NAV). Some ETFs are structured as UITs. Two of the appealing aspects to UITs are a fixed portfolio that may be subject to tax on income distributions but not subject to capital gains until the termination of the trust, and a known portfolio of holdings (depending on the territory). Friday, 15 July 2022 Investment Planning & Asset Management

Disadvantages of Unit Investment Trusts (UITs) A UIT does not actively trade its investment portfolio; a UIT buys a relatively fixed portfolio of securities (e.g., five, 10, or 20 specific stocks or bonds), and holds them with little or no change for the life of the UIT. A UIT will have a termination date (a date when the UIT will terminate and dissolve) that is established when the UIT is created (although some may terminate more than fifty years after they are created). In the case of a UIT investing in bonds, for example, the termination date may be determined by the maturity date of the bond investments. When a UIT terminates, any remaining investment portfolio securities are sold and the proceeds are paid to the investors. Friday, 15 July 2022 Investment Planning & Asset Management

Managed Accounts Another approach to investing that has traditionally only been available to high net worth clients are managed accounts. Sometimes referred to as separately managed accounts (SMAs) or privately managed accounts (PMAs), these are individual (or joint) accounts that are managed by a professional investment manager (typically on a fee-based platform), directly for the account owner. Unlike a mutual fund where the fund owns the securities in the portfolio and individuals then own shares of the mutual fund, investors in managed accounts own the individual securities directly Friday, 15 July 2022 Investment Planning & Asset Management

Advantages of Managed Accounts Tax efficiency/Tax loss harvesting: Because each security is owned individually, the owner (and manager) controls what securities are sold, and when. This allows for much more strategic tax and investment planning, as shares with a loss can be sold before those with a gain, which helps minimize the impact of capital gains. Customized portfolios: Investors can specify individual securities or types of asset classes they do or do not want in their portfolios. Friday, 15 July 2022 Investment Planning & Asset Management

Disadvantages of Managed Accounts Generally, investors must have at least $100,000 to invest to participate in a separately managed account. Friday, 15 July 2022 Investment Planning & Asset Management

Considerations in Investment Product Analysis/Selection Fund Comparison Before comparing multiple funds, it is important that a like-for-like basis is found for the comparison, meaning the funds being compared should be of a similar type/have similar investment objectives. Manager Discretion While investment objectives guide which securities are included in a fund’s portfolio, managers may have some flexibility in what they invest in. It is important to know just how much flexibility a manager is allowed, as they may be permitted to purchase assets that may not match the stated investment objective, a client’s objectives, or the purpose for investing in the fund in the first place. Friday, 15 July 2022 Investment Planning & Asset Management

Considerations in Investment Product Analysis/Selection Total Costs In addition to a fund’s expense ratio, there are several other costs that can add as much or more, including: Brokerage commissions Bid-ask spread Taxes (as applicable) Fund Size: As with the style of management (active/passive), there is some debate as to whether the total assets of a fund can make it too big or too small. Friday, 15 July 2022 Investment Planning & Asset Management

Considerations in Investment Product Analysis/Selection Turnover The frequency that holdings are bought and sold impacts both the cost of a fund (transaction costs) and its tax efficiency (or inefficiency). The more frequent the portfolio is turned over (all holdings sold, and new holdings purchased) the greater the chance for short-term capital gains (or losses) to be generated. High turnover can also be an indicator of more active or short-term trading by a manager, which should be a red flag warranting further research. Friday, 15 July 2022 Investment Planning & Asset Management

End of Chapter-2 Thank you all Friday, 15 July 2022 Investment Planning & Asset Management

Chapter 3: Principles of Investment Risk Friday, 15 July 2022 Investment Planning & Asset Management

Total Risk There are two broad categories of investment-related risk: 1. systematic and 2. nonsystematic. Systematic risk is also sometimes called market risk, and it refers to factors that affect the overall economy or securities markets. Nonsystematic risk (or specific risk) is associated with a specific company, industry or investment product (FINRA, 2013). Total Risk = Systematic Risk + Nonsystematic Risk Friday, 15 July 2022 Investment Planning & Asset Management

Systematic Risk Types of systematic risk include: Market Interest-rate Inflation Currency Socio-political Endogenous  It is the risk that comes from shocks generated within the financial system. (2008 global economic crisis is an example of endogenous risk) Exogenous  The opposite of endogenous risk is exogenous risk, which represents risks from outside the financial system. (Unanticipated changes in economic fundamentals – the more vulnerable a security is to the negative news, the more exogenous risk it carries) Friday, 15 July 2022 Investment Planning & Asset Management

Nonsystematic Risk Types of nonsystematic risk include: Company Liquidity Financial Credit or default Call Call risk is the risk that a callable security (e.g., callable bond) will be called back by the issuing company prior to its maturity date. Friday, 15 July 2022 Investment Planning & Asset Management

Principles of Investment Risk Investors are capable of avoiding nonsystematic risk through diversification by forming a portfolio of assets that are not highly correlated with one another. Investors do not receive any return for accepting nonsystematic or diversifiable risk. In an efficient market, no incremental reward can be earned for taking on diversifiable risk. Total Risk = Systematic Risk + Nonsystematic Risk Friday, 15 July 2022 Investment Planning & Asset Management

Principles of Investment Risk • Total Risk Risk Total Specific Risk Risk Risk of Market Portfolio Systematic Risk 1 5 10 Number of Stocks 20 30 Friday, 15 July 2022 Investment Planning & Asset Management

Standard Deviation Standard deviation (σ) is a measure of the degree to which an individual value in a probability distribution tends to vary from the distribution’s mean. More specifically for investments, it is the degree to which an investment’s return is expected to vary from its mean return. Standard deviation is a frequently used measure of an investment’s risk, and is calculated by taking the square root of the variance. Friday, 15 July 2022 Investment Planning & Asset Management

Standard Deviation Friday, 15 July 2022 Investment Planning & Asset Management

Principles of Investment Risk Step 1: Calculate or use the return given for each period and sum up the returns Step 2: Calculate the average return Step 3: Subtract the average return from each period return Step 4: Square the result Step 5: Add the sum of the squares Step 6: Divide by the number of periods minus one (sample); this gives us the variance Step 7: Take the square root of the variance and you have the standard deviation s  s2 Friday, 15 July 2022 Investment Planning & Asset Management

Standard Deviation • To illustrate the calculation of the standard deviation for an example of a three-year investment that returns 5% or 0.05 the first year, -2% or -0.02 the second year, and 6% or 0.06 the third year. The arithmetic mean return is 3% or 0.03. • Sample Variance and Sample Standard Deviation  T Xi  X 2 s2  i1 n 1 • ������ = (0.05 −0.03)2 +(−0.02 −0.03)2 +(0.06 −0.03)2 s  s2 • ������ = 3 −1 (0.0004) +(0.0025) + (0.0009) 2 • ������ = (0.0038) = 0.04359 = 4.359% is the Standard Deviation 2 Friday, 15 July 2022 Investment Planning & Asset Management

Practice question Return of Stock X (%) 0 Outcome -10 1 20 2 10 3 4 Friday, 15 July 2022 Investment Planning & Asset Management

Calculate Standard Deviation FC 200 V • Go to STAT, • 1-VAR (EXE) • Feed the Values (return) • AC SHIFT STAT •5 •4 • EXE • 12.909 Friday, 15 July 2022 Investment Planning & Asset Management

Practice question Return of Stock X (%) 10 Outcome 12 1 -5 2 10 3 4 Friday, 15 July 2022 Investment Planning & Asset Management

FC 200 V • Go to STAT, • 1-VAR (EXE) • Feed the Values (return) • AC SHIFT STAT •5 •4 • EXE • 7.889 Friday, 15 July 2022 Investment Planning & Asset Management

When probability of an outcome is given Outcome Probability Return(%) 1 0.10 12% 2 0.40 15% 3 0.30 -6% 4 0.20 9% Friday, 15 July 2022 Investment Planning & Asset Management

Standard Deviation FC 200 V • Go to STAT, • 1-VAR (EXE) • Feed the Values (return and probability (frequency) • AC SHIFT STAT •5 •3 • EXE • 8.9196 Friday, 15 July 2022 Investment Planning & Asset Management

Standard Deviation for a Two Asset Portfolio • ������������ = ������������2���������2��� + ������������2������������2 + 2������������������������������������������������������ • p = portfolio • σ = standard deviation • Wi =percentage weighting of asset I, Wj =percentage weighting of asset j • σi = standard deviation of asset I, σj = standard deviation of asset j • covi = covariance of asset I and j • The formula for correlation is ������������������ = ������������������ ������,������ ������������������������ • We can rearrange that formula so that ������������������������������ = ������������ ������������ ������������������ Friday, 15 July 2022 Investment Planning & Asset Management