Investment planning

performed by the analysts. Security dealers execute the actual buy and sell orders originated by the fund managers. They deal directly with the stockbrokers and internal operating staff. They do not decide on which shares to buy or sell. SEBI requires a dedicated fund manager for each scheme, so that the responsibility for the investment decisions is clearly allocated and identified. 4.1.8. Investment Style - Value vs. Growth Informed investors and investment practitioners generally employ this strategy for achieving superior returns than what normally market offers. This investment approach enables the investors to concentrate on carrying out an in-depth analysis of investment opportunities available in the specific areas chosen and specialise. There are various such investment concepts found in the literature. For instance, a specialised investment concept is ―value investing‖ which includes high dividend paying stocks in the portfolio. Commonly used other concepts are stock selection based on high growth rate, high book value etc., Growth Stocks Growth Stocks refer to shares in a company whose earnings are expected to grow at an above-average rate relative to the market. A growth stock usually does not pay a dividend, as the company would prefer to reinvest retained earnings in capital projects. Value Stocks A stock that tends to trade at a lower price relative to it's fundamentals (i.e. dividends, earnings, sales, etc.) and thus considered undervalued. Common characteristics include a high dividend yield, a low price-to-earnings ratio etc. 291

Sub-Section 4.2 Passive Investment Strategies Learning Outcome The objectives of the topic 4.2 – Passive Investment Strategies are as follows: 1. To understand the concept and effectiveness of the Buy & Hold investment strategy. 2. To comprehend the passive investment strategy – Index investing and its relative difference to active investment strategy. 3. To explain the concept & benefits of Systematic Investment Plan (SIP), Systematic Withdrawal Plan (SWP) and Systematic Transfer Plan (STP) methodology of investing. 4. To comprehend the investment strategy Value Averaging Investment Plan (VIP) and understand its effectiveness in generating returns. 292

4.2.1. Buy and Hold Strategy Buy and hold is an investment strategy where an investor buys stocks and holds them for a long time. This is based on the view that in the long run financial markets give a good rate of return even while taking into account a degree of volatility. It says that investors will never see such returns if they bail out after a decline. This viewpoint holds that market timing, i.e. the concept that one can enter the market on the lows and sell on the highs, does not work; attempting such timing gives negative results, at least for small or unsophisticated investors, so it is better for them to simply buy and hold. The antithesis of buy-and-hold is the concept of day trading, in which money can be made in the short term if an individual tries to short on the peaks, and buy on the lows with greater money coming with greater volatility. One argument for the strategy is the efficient-market hypothesis (EMH): If every security is fairly valued at all times, then there is really no point to trade. Some take the buy-and-hold strategy to an extreme, advocating that you should never sell a security unless you need the money. Others have advocated buy-and-hold on purely cost-based grounds, without resort to the EMH. Costs such as brokerage and bid/offer spread are incurred on all transactions, and buy-and-hold involves the fewest transactions for a given amount invested in the market, all other things being equal. Taxation law also has some effect; tax for long-term capital gains may be lower, and tax may be due only when the asset is sold (or never if the person dies). Warren Buffett is an example of a buy-and-hold advocate who has rejected the EMH in his writings, and has built his fortune by investing in companies at times when they were undervalued. 4.2.2. Index Investing Share Futures and Share Price Index Futures Share price index futures offers following advantages: 1. Short-term Trading Traders can frequently trade the share market by going long or short on the Index according to individual strategies. 2. Long-term Trend Following Index traders are able to roll over contracts when they expire, thereby continuing an open position to take advantage of long-term trends in the market. 3. Hedging Stock Portfolios Exchange-traded equity derivative products have become indispensable tools for institutional investors to manage the risks associated with volatile sharemarket returns. Mutual funds and FIIs can protect the value of their holdings by taking positions in the derivative markets either by shorting the index futures or by buying the puts on index derivatives. 293

4. Portfolio Substitution Index futures mean lower transaction costs, flexibility to modify stock market exposures quickly. 5. Cash flow Management Investors expecting to receive funds for share market investment some time in the future can protect against anticipated price movements prior to the receipt of the funds by using Index futures. In this situation, the Index can be purchased now, thereby locking in a price for the future share purchase. It the prices go up in the future at the time of the receipt of funds the Investor has alredy taken the position to take advantage of rise 6. Larger Volumes The lower transaction costs available to stock broking firms with trading departments mean that these firms can provide two-way prices on baskets of shares which reflect the index. Index futures help investors have an exposure of the whole of the market. 7. Exchange for Cash or Physical Markets Institutions wishing to switch exposures between the cash and futures markets can do so easily with Index futures. These trades can be executed in large volumes and at negotiable prices. 8. Arbitrage Trading Investors wishing to take advantage of changing price relationships between the broad market and specific shares, or industry sectors, can do so by implementing arbitage trades combining the Index and individual share futures. 9. International Trading The introduction of the futures & options in India has increased the depth of the market Index futures and options offer international investors a liquid and readily accessible means of gaining direct exposure to the Indian share market, at low transaction costs. This is the major contributor to the increased confidence of the FIIs in the Indian Stock Market The price of the Index contract at any particular time will reflect the underlying market plus the market‘s expectations of future movements in the Index, so it behaves investors to watch carefully for any factors that affect the underlying market. There are various investment approaches available. For estimating the stock price and therefore the overall market including approach and technical, or chartist fundamentalist Their description and evaluation is beyond the scope of this topic, but you should at least be aware of their existence. Derivatives on debt instruments also exist in India which would be covered in Topic on Fixed Income Instruments. Reasons for Popularity of Index Derivatives: Index-derivatives are more suited and cost-effective for portfolio-hedging facility. Stock index is difficult to manipulate as compared to individual stock prices. Stock index, being an 294

average, is much less volatile than individual stock prices. This implies much lower capital adequacy and margin requirements. Index Management  NSE – Managed by India Index Services and Products Ltd. (IISL), a joint venture between National Stock Exchange (NSE) and CRISIL Ltd.  BSE – Managed by its own Index Cell.  Index Construction:  Choosing index scripts based on certain eligibility criteria.  Index Maintenance  Adjusting for Corporate Actions  Index Revision  Change in Composition of Index Major Indices in India NSE The following are few popular indices in India: CNX Nifty CNX Nifty Junior BSE CNX Defty S&P BSE Sensex CNX Midcap S&P BSE Midcap CNX 500 S&P BSE-100 S&P BSE-200 S&P BSE-500 APPLICATION OF INDICES  Index Funds  Index Derivatives  Exchange Traded Funds (ETFs) Equity Index Fund This follows passive investment strategy of tracking a specific market index with an objective to match the market performance. Funds collected under these schemes are invested in the shares that are included in an index in the same proportion as that of an index. The fund will be a diversified one leaving only a systematic risk to the investor. 295

4.2.3. Systematic Investment Plan (SIP), Systematic Withdrawal Plan (SWP) and Systematic Transfer Plan (STP) Investment Plans The term ‗investment plans‘ generally refers to the services that the funds provide to investors offering different ways to invest or reinvest. The different investment plans are an important consideration in the investment decision, because they determine the level of flexibility available to the investor. Alternate investment plans offered by a fund allow the investors freedom with respect to investing one time or at regular intervals, making transfers to different schemes within the same fund family, or receiving income at specified intervals or accumulating distributions. Some of the investment plans offered by mutual funds in India are: Automatic Reinvestment Plans (ARP) Mutual funds generally offer two options under the same scheme - the Dividend Option and the Growth Option. The Growth Option or the Automatic Reinvestment Plan allows the investor to reinvest in additional units the amount of dividends or other distributions made by the fund, instead of receiving them in cash. Reinvestment takes place at the ex-dividend NAV. The ARP ensures that the investor reaps the benefit of compounding in his investments. Some funds allow reinvestment into other schemes in the fund family. Systematic Investment Plans (SIP) These require the investor to invest a fixed sum periodically, thereby letting the investor save in a disciplined and phased manner. The mode of investment could be through direct debit to the investor‘s salary or bank account. Such plans are also known as Systematic Investment Plans. Investors looking for ―rupee cost averaging‖ will generally opt for funds that offer this facility. A modified version of SIP is the Voluntary Accumulation Plan that allows the investor flexibility with respect to the amount and frequency of investment. Both SIP and VAP are only two optional ways of investing in a disciplined manner, in open-end funds. The difference is that in the SIP, the investor agrees as a contractual obligation to keep investing, whereas in case of the VAP, he is not obliged to keep investing but has to impose a certain voluntary self-discipline on himself. Example 1 An investor purchased 5000 units of an equity oriented MF scheme under dividend reinvestment scheme on 1st June 2012 at NAV of rs 18.46 along with systematic investment plan of rs 5000, each for 6 months. The SIP dates are 1st of every month beginning 1st July 2012. The NAV at which additional unit were bought through SIP were rs 19.06, rs 18.51, rs 17.23, rs 18.97, rs 16.75 and rs 17.95 on 15 October 2012. The scheme declared a dividend of 25% on face value of rs 10 per unit which record date being 21st October 2012. The NAV on 22nd October 2012 was rs 16.50. The investor redeemed all units on 28 January 2013 at a price of rs 19.10 . What holding period return was obtained by investor? 296

Sol. 18.46% Date Total No. of Units NAV 1-Jun-12 Amount 5000 18.46 1-Jul-12 Invested 19.06 1-Aug-12 92300 262.3294858 18.51 1-Sep-12 270.1242572 17.23 1-Oct-12 5000 290.1915264 18.97 5000 263.5740643 5000 5000 Total Units Invested till 1st 6086.219334 2.5 15215.54833 (6086.219334*2.5) Oct 2012 144881.766 (7585.432773*19.1) Dividend Re- 922.1544445 122300 (92300 + 5000*6) 144881.766 22-Oct-12 invested (15215.54833/16.5) 16.5 18.4642% {(144881.766 -122300)/ 1-Nov-12 5000 298.5074627 16.75 122300} 1-Dec-12 5000 278.551532 17.95 7585.432773 (6086.219334+ 922.1544445+ 298.5074627+ 28-Jan-13 278.551532) 19.1 Total Amount Invested Total Amount Accumulated Holding Period Return (End Value-Beg Value)/(Beg Value) Systematic Withdrawal Plans (SWP) Such plans allow the investor to make systematic withdrawals from his fund investment account on a periodic basis, thereby providing the same benefit as regular income. The investor must withdraw a specific minimum with the facility to have withdrawal amounts sent to him. The amount withdrawn is treated as redemption of units at the applicable NAV as specified in the offer document. For example, the withdrawal could be at the NAV on the first day of the month of payment. The investor is usually required to maintain a minimum balance in his fund account under this plan. Investors and agents should note that SWPs are different from Monthly Income Plans, as the former allow investors to get back the principal amounts invested while the latter only pay the income part on a regular basis. Systematic Transfer Plans (STP) These plans allow the investor to transfer on a periodic basis a specified amount from one scheme to another within the same fund family - meaning two schemes managed by the same AMC and belonging to the same fund. A transfer will be treated as redemption of units from the scheme from which the transfer is made, and as investment in units of the scheme into which the transfer is made. Such redemption or investment will be at the applicable NAV for the respective schemes as specified in the offer document. It is necessary for the investor to maintain a minimum balance in the scheme from which transfers are 297

made. The service allows the investor to manage his investments actively to achieve his objectives. Many funds do not even charge any transaction fees for this service - an added advantage for the active investor. 4.2.4. Value Averaging Investment Plan (VIP) Value averaging is a technique of adding to an investment portfolio to provide greater return than similar methods such as dollar cost averaging and random investment. It was developed by former Harvard University professor Michael E. Edleson. Value averaging is a formula-based investment technique where a mathematical formula is used to guide the investment of money into a portfolio over time. With the method, investors contribute to their portfolios in such a way that the portfolio balance increases by a set amount, regardless of market fluctuations. As a result, in periods of market declines, the investor contributes more, while in periods of market climbs, the investor contributes less. In contrast to dollar cost averaging which mandates that a fixed amount of money be invested at each period, the value averaging investor may actually be required to withdraw from the portfolio in some periods. Value averaging incorporates one crucial piece of information that is missing in dollar cost averaging – the expected rate of return of your investment. The investor must provide this information for the value averaging formula. Having this data allows the value averaging formula to identify periods of investment over-performance and under-performance versus expectations. After the investment has over-performed, the investor will be required to buy less or sell (selling high). After the investment has under-performed, the investor will be required to buy more (buying low). Some research suggests that the method results in higher returns at a similar risk, especially for high market variability and long time horizons. Some research suggests otherwise. A Pre-requisite for Following these Models: An Open Mind The first step of any investment program is always the hardest, and individual investors taking their first steps in an investment program must also confront a sea of stock market uncertainty. Some plunge headlong into the market with all their savings. Others barely wet their feet before heading back to the safe shores of their fixed income deposits and money market funds. The problem, however, with these two approaches is one of timing — the risk of entering the market at a high point in the market cycle. The purpose of this section of the website is to outline a framework as to how an investment portfolio can be created and implemented based on the Value Averaging (VA) investment strategy. The model portfolios created here have been based on the portfolio construction methods outlined in The Perfect Portfolio by Leland Hevner and 7 Twelve: A Diversified Investment Portfolio with a Plan by Dr. Craig Israelson. Using the ideas put forth in these books we created our own models and then applied the Value Averaging investment methodology to the portfolios to enhance the returns and reduce the risk. The VA investment methodology is an event driven formula-based system that is mathematically calculated using computer software to determine the dollar amount to invest or sell periodically. 298

Discipline is the Key In the book, \"What Works on Wall Street\", author James O'Shaughnessy found that one of the reasons why academics adopted the flawed \"random walk\" hypothesis of stock movements is because of inconsistent methodologies used by fund managers themselves. Fund managers do not adopt a well-defined strategy and stick to it, they tend to go with flavor of the month stocks, to adopt new paradigms when they see fit, to rebalance portfolios constantly and generally move about in a random manner. By analyzing the returns of fund managers academics were unable to find any managers who had consistently been able to get far above average results in a statistically significant manner. They erroneously concluded that it is the market that is random. In reality the market does reward certain approaches over time, but none of the market professionals studied ever stuck to any of these approaches. Rather than random stocks, it is clear that it is the investors who are random. The one factor that unites all of the great investors is that they have a simple formula that is applied consistently over time and can be easily stated in a book. As complicated as Warren Buffett's methods are, you could write a book about him and state with great precision how he goes to work analyzing stocks, in fact many books about him have indeed been produced. Buffet states that, to be a successful investor does not require one to have a high IQ but rather it requires two things. 1. A strong intellectual framework on which to base your decisions and 2. Not letting your emotions corrode the framework. The 80% of managed funds that fail to beat the market do so because of complicated and ever changing strategies, or lack of strategies as may be the case. To paraphrase O'Shaughnessy, \"if you can't write down and explain your technique on a piece of paper, you don't have a technique\". There are Approaches that Consistently Beat the Market! It is important to adopt an approach that works, and stick to it. The reason why most investors fail is that they go chasing better results elsewhere and tend to move out of sectors just when they are about ready to start making big gains. Today's equities markets change fast. Factors are influencing stock and bond prices today that we could not even have conceived of just a few years ago. Yet investing concepts and resources that we have been taught to use for decades have not changed, and they no longer work. This leaves investors, stuck using increasingly obsolete methods and tools to cope with new market dynamics and challenges. This sad state of affairs was evident as tens of millions of investors lost nearly half of their life savings in late 2008 and early 2009 by heeding \"conventional investing wisdom\" or relying on advisers. A \"new\" approach to investing is long overdue. Small changes won't help. Nothing less than an entirely new, and radically updated approach to personal investing is required to enable people to regain control of their portfolios and thus their financial futures. This is exactly what these model portfolios provide. Here you will learn a greatly simplified portfolio design and management methodology that can give you outstanding returns in any market condition, whether it is trending up, down or sideways, and with minimal risk. 299

Sub-section 4.3 Investment Portfolio Management Learning Outcome The objectives of the topic 4.3 – Investment Portfolio Management are as follows: 1. To understand the relationship between Risk & Return. 2. To comprehend the returns of investment portfolio using risk adjusted return measures like Sharpe, Treynor and Jensen‘s Ratio. 3. To understand the concept of Capital Asset Pricing Module (CAPM) and comprehending the expected return of investment portfolios. 4. To understand the concept of Capital Asset Pricing Module (CAPM) and comprehending the expected return of investment portfolios. 5. To understand the concept of Capital Market Line (CML) and Security Market Line (SML) and comprehending the expected return of investment portfolios based on both above. 6. To comprehend the concept of Modern Portfolio Theory (MPT) and its relative difference to the previously discussed other theories of investment. 7. To learn to optimize the return of investment portfolios given the inherent risks using the technique of Monte Carlo Simulation for portfolio optimization. In this topic we discuss the basic characteristics of investment viz., return and risk, how to quantify them and the relationship between them and the role they play in building the portfolio of investments and measuring the performance of an investment portfolio. Readers having a finance background find this topic familiar but we advise them to go through the material, as the concepts used here are the essential material used in the subsequent topics as well. 300

4.3.1. Relationship Between Risk and Return Risk can be defined as the possibility that the actual return on an investment will be different from the expected return. Rational investors expect to receive a higher return for increased risk. Therefore, higher the expected return from an asset, generally speaking, the higher shall be the associated risk. Conversely, Thats why the slogon Risk and Return move hand-in hand. The lower the risk associated with an investment, lower shall be expected rate of return from that investment. Investment, which at times can produce extremely good results, can at other times produce extremely poor results. Responsible investment advisers and financial planners spend much of their time in evaluating the risk element associated with a particular investment. However, the question of risk is often not discussed or is quickly brushed aside in investment publications by most of the promoters of certain financial products. Often investors are persuaded to make an investment because they are told that it does not face the risks associated with other investments. Another very important factor to consider is the risk of not being in the market. This may be termed opportunity risk. By investing in one asset class that achieves poor returns you have passed up the opportunity of investing in another asset class that achieves very good returns. This is one of the major reasons for constructing diversified portfolios. Over the long term, not having some investments in the higher performing assets can significantly affect the investor‘s wealth creation, as the effect of compounding at a lower rate results in a lower total portfolio value. Market timing is also important when considering risk. What is the best time to buy or sell? Generally assets such as quality shares and property show sound, consistent performance over long periods of time. However, if investors expect strong growth in a short period then they may be disappointed. Where the client has available funds, the best strategy is probably to just purchase the appropriate investments. If the client does not have a sizeable amount of free cash, they can begin a savings program. Benefit of using a savings program is that over a period of time the volatility of prices will mean that the client will have purchased their portfolio at average prices (rupee cost averaging). To a considerable extent, the difference between the quality of financial planners is based on their ability to recognize the importance of risk. Good planners are aware that in every investment decision and in every review of investments that may be undertaken for clients, the question of risk has a great significance. Return Investment is a current commitment of rupees for a time period to derive benefits in future. The future benefits derived from investment are known as returns. There are many factors that determine the level of the returns. Generally, the investors who sacrifice their current income would like to get compensated for (1) loss of liquidity for the time period of sacrifice (2) the expected rate of inflation and (3) the uncertainty associated with the investment. Investment involves the purchase of financial assets that are expected to produce a return, or series of returns, over time. In the broader economic sense, funds invested in securities (a term encompassing shares, debentures, bonds and other financial instruments) are redeployed and put to productive use by issuer of these securities. 301

Return on investment is likely to be the investor‘s main concern. Return may be in the form of (regular) income alone or a combination of income and capital growth gain (increase in value). Investments may also be structured in such a way as to produce returns for the investor in the form of capital growth alone. Income returns are dividends in the case of shares, rent in the case of property, and interest in the case of loan debt securities such as bonds. Property and shares may increase (or decrease) in value over time, but the capital value of a loan will remain unchanged if there is no movement in the general level of interest rates. Bonds too can appreciation in value on account of general interest rate declines. Of late, we also come across some debt instruments paying a variable interest rate. In subsequent topics, we include a detailed discussion on various types of instruments. The choice of an investment instrument for an individual will depend on his or her need for capital growth and income. For this reason, an understanding of the meaning of rate of return and the measures of return is essential. Risk Risk may be defined as the deviation of actual return from expected return. Risk is a measure of uncertainty that is the basic reason that one investment will pay a greater return than another? Obviously, in a business, a greater return may arise from one factor or a combination of factors, such as good management, sensible borrowing, and careful assessment of market and economic conditions. Economic conditions, including supply and demand, affect return and increases or decreases in returns of various markets. For instance, interest rate variations affect return. Changes in demand patterns affect return, change in exchange rate affect the returns of exporters. There are two types of risk: The first is where there is some probability of a negative outcome that will have financial implications. This is usually a risk to property or person and can be covered to some extent by insurance. The second type of financial risk is associated with investment. This is where there is a risk of flat, low, no returns or a loss of capital. Managing insurable risk was covered in CFP2. We will now look at the types of investment risk and client‘s attitudes towards taking risks. Risk-return Trade-off In all respects, the days of earning innocent money in the financial market were over with our learning about the risk-return trade-off. It took the work of many explorers of the fiscal wilderness such as Harry Markowitz, William Sharpe, et al, spread over many decades, to finally convince us that taller trees fall first during storms. Now, it seems almost like repeating the obvious when we say that high returns come only with high risk. That‘s the only rule. Anybody discovering the exception—a chance of earning high returns with low risk—would surely deserve a hug from all angels in the sky. Before understanding the intricacies of risk-return trade-off, it would be better if you could understand what exactly risk is? 302

Risk is a kind of a wild card that disturbs all our plans. All our senses may not be enough to discern what exactly risk looks like but our past experiences are littered with its footprints. In general, we can understand risk as the chance or probability, or whatever else you like to call it, when the actual result does not turn out as expected. You fire a rocket and instead of going up it goes straight into your house. In investment parlance, you buy shares expecting the prices to go up, and instead the prices come down. So, no matter how carefully you make your investments, there is always a possibility that the actual return from your investment would be lower than what you expected. Risk means that there is always a chance of our losing in the game of investment. But risk does not strike all kinds of investments with equal force. While some investments are inherently more risky, some are inherently less. If you understand the risk level of a particular investment, then you can very well make your own plan for surviving the odds. We can make risk assessments based on past experiences. Statistically, risk is measured by calculating the standard deviation or how many times the actual results have varied from the mean. You need past data for such calculations. A higher standard deviation for an investment means that the actual returns have shown greater propensity to vary from the expected returns. In other words, we can say that the actual returns for the investment showing higher standard deviation are more volatile. Interestingly, investments of different kinds show different levels of standard deviation and consequently, different levels of volatility. This is the reason why different kinds of investments offer different returns. If investments of all kinds were to offer the same return, then no one would like to invest in an asset giving a return that is highly uncertain. In order to sweeten the deal, the risky investments offer a higher rate of return so that investors are compensated suitably for making a risky choice. This compensation for riskier investment is called ―risk premium‖ in common investment parlance. In a nutshell, we can say that the greater the promised return, the greater the chance that the actual return may vary from the expected. But that does not mean that you can never earn high returns. You enjoy a good chance of earning the expected return but always keep in mind that there is also a good chance that some wild card may unexpectedly turn up and disturb your plan. To minimize the role of wild cards in disturbing our investment plans. You should make your plans only after understanding the risk-return trade-off of your investment. Always evaluate. How much more are you likely to earn by taking on more risk? If someone is paying you ₹100 for embracing a rabbit and ₹110 for embracing a gorilla, then is it really worth it? If yes, then go for it. But always avoid the temptation of putting all your money in one basket. Choose from a broader class of assets such as stocks, bonds, treasury bills, commodities that show different risk-return profiles. Diversification, more than any other formula, really helps in striking a balance between the risk and return from different assets. On average, a diversified portfolio gives lower return but the overall risk of your portfolio is also less. The real art of diversification lies in generating the highest possible return by undertaking the least possible risk. But of late, many sceptics have started casting doubts on the ability of diversification in really saving us from the onslaught of wild cards. Summary: Understanding the risk-return trade-off helps in making the right investment decisions. An investment carrying higher risk generally offers higher return to compensate investors for the risk undertaken. We can minimize risk by maintaining a well-diversified 303

portfolio. 4.3.2. Risk and Return on a Portfolio - Sharpe, Treynor and Jensen’s Ratio You may have come across the rankings of some of the mutual funds published in the magazines or papers on the basis of any of the return measures enumerated earlier. You have to be very careful in interpreting the rankings because they do not consider other factors like risks associated with the investments, skills of portfolio managers etc., Two funds having same rates of return does not necessarily mean they have same risk characteristics and they behave in a similar fashion when the market goes up / down. An useful comparison of two funds can be drawn only when both return and risk aspects of funds are considered. Developments in portfolio theory enabled risk measurement and widespread usage of composite portfolio measures in performance evaluation. For using a risk adjusted measure of performance, we have to decide on the suitable risk measure and quantify risk. In Topic 1, we have covered the techniques for the quantification of risk in detail. Two risk measures covered are Variance or standard deviation and beta. You may recall that excess return (return minus risk free rate) is divided by any of these risk measures in order to find out the risk adjusted performance of the portfolios. Sharpe‘s index uses standard deviation and Treynor’s ratio uses beta respectively as risk measures. Ranking on the basis of risk-adjusted measure is better indicator of performance than just returns. Financial magazines use these risk adjusted performance measures, besides size of assets, income growth, expense ratio etc., for ranking the schemes in the mutual fund industry Jensen Index is another risk adjusted performance measure. Recall that expected return on a portfolio is equal to risk free rate plus the risk premium. Risk premium is calculated as beta times excess return on a market portfolio. (Beta*(return on a market index – risk free rate)). Jensen index shows that return on a portfolio (in this case, a mutual fund) higher or lower than this expected return will indicate the contribution of the fund manager. This higher or lower performance is measured by alpha. Accordingly, if alpha is significantly positive, this is an evidence of superior performance and if it is negative this is an evidence for inferior performance. The underlying assumption of this measure is that the portfolios are well diversified. Which of these measures would be used? For a completely diversified portfolio, without any unsystematic risk, both Sharpe and Treynor measures would give identical rankings because the total variance of a diversified portfolio is just the systematic risk. Any difference in ranking would come only from a different degree of diversification. In case of mutual funds, it is expected that both measures should provide similar rankings of funds. Jensen measure will give an additional information about the ability of the fund manager to perform better than the market. We are all aware that return on securities differs. It is possible to show higher return on a portfolio by including high risk securities. As a financial planner, you may be expected to explain the difference in return between securities or portfolios with reference to the risk of the return. 304

Beating the market return should not be considered as the only criterion of performance comparison. Real picture would emerge only when you calculate return that is adjusted for risk. How to compute risk adjusted return? By investing in corporate debt or equity or in real estate, the investors have chosen to assume risk and have foregone risk free return on government security. He would naturally expect comparatively higher return on the risky investments. The return on a risky security over and above the return on risk free security (Rf ) is known as ‗risk premium‘. Risk adjusted return is simply the risk premium per unit of risk. We have earlier seen that standard deviation of returns is the total risk associated with the investment and it can be divided into systematic and unsystematic risks. If a client wants to compare return on individual securities, it is better to consider the total variance as a measure of risk and calculate risk adjusted return. However, performance of diversified portfolios (like investment in mutual funds) is better compared by taking systematic risk, as measured by beta. The formulae for the calculation of risk adjusted return are: 1) For individual security, Shape Ratio = Ri  Rf i Where Ri is return form security i, Rf is risk free rate of return, and σi is the risk of security. Assume that security A has an average rate of return of 12 % with a standard deviation of 2% and security B has an average return of 14% and standard deviation of 4%. Return on a government security during the period is 6%. Calculate the risk adjusted rate of return on securities A and B. Risk adjusted rate of return on security A = (12 – 6) / 2 = 3% Risk adjusted rate of return on security B = (14 – 6) / 4 = 2% Though security B had higher return of 14%, but since its risk is also higher i.e. Security A is preferable on the basis of Risk adjusted rate of return. 2) For portfolio of securities, Treyner Ratio = Rp  Ri p Where Rp is return of the portfolio, Rf is risk free Rate of return and βp is Beta of portfolio 3) For Jensen Ratio = Rp – [Rf + (Bp * (Rm –Rf)] Where Rp is return of the portfolio, Rf is risk free Rate of return and βp is Beta of portfolio, Rm is return of portfolio 305

Example 1 Pearl and Diamond are the two mutual funds . Pearl has a mean success of 0.15 and diamond has 0.22 . The diamond has the beta of pearl Fund ‗s 1.5 . The standard Deviations of pearl and Diamond Funds are 15% and 21.43 % . The mean return of market Index is 12% and the standard deviation is 7 . The risk free rate is 8 % . (A ) Compute the Jensen Index for each fund . (B ) Compute the Treynor and sharpe Indices for the funds . Interpret the Results SOLUTION : (A) JENSEN INDEX Jensen Measure formula = Return of Fund – Return as per CAPM Rp=αp +β(Rm-Rf ) Jensen’s Index for the pearl fund =8+1.5(12-8) =14 For Diamond fund =8+3(12-8) =20 The difference between the actual and estimated returns . Pearl Fund = 15-14=1 Diamond Fund =22-20 =2 ( B) Treynor Index Tn= Rp –Rf / βp Pearl Fund = 1-8/1.5 = 4.67 Diamond Fund 22-8/3=4.67 According to Treynor Index , both the funds have the same value (C )Sharpe Index S t = Rp- Rf /σp Pearl index= 15-8/15 =0.46 306

Diamond Fund = 22-8/21.43 =0.65 Market Performance = 12-8/7 =0.57 Treynor Index and The sharpe Index results differ . Sharpe Index Considers the total Risk but the Treynors Index considers only the market risk . Example 2 Consider the following information for three mutual funds A, B and C and the market. Mean Return Standard Beta (%) Deviation (%) A 12 18 1.1 B 10 15 0.9 C 13 20 1.2 Market Index 11 17 1.00 The mean risk-free rate was 6 per cent. Calculate the Treynor measure, Sharpe measure Jensen measure. Treynor Sharpe Measure Jensen Measure Measure Rp – Rf Rp – [Rf + Bp (Rm - Rf)] Rp – Rf σp 12 – [6 + 1.1 (5)] =0.5 Fund A Bp (12-6)/18 = 10 – [6 + 0.9 (5)] = - 0.333 = 0.5 Fund B (12-6)/1.1 = = 13 – [6 + 1.2 (5)] = - 5.45 (10-6)/15 = 0.5 Fund C 0.267 0 (by definition) (10-6)/0.9 = Market 4.44 (13-6)/20 Index 0.350 (13-6)/1.2 = 5.83 (11-6)/17 0.294 (11-6)/1.0 = 5.00 307

Example 3 You are evaluating the rankings based on Treynor Ratio of three funds A, B and C. The average returns obtained from funds A, B and C have been 16%, 19% and 14%, respectively against the market return of 13%. The standard deviations of fund returns 35 have been 17%, 22% and 16%, respectively versus the market return standard deviation of 15%. If the beta reported of these funds is 1.2, 1.4 and 1.1, respectively and the risk-free rate of return is 5.5%, what are your rankings in the order of best to worst? a) B,A,C b) A,B,C c) C,B,A d) A,C,B ANS –Use Treynor Ratio formula = (Return of Fund – Rf) / Beta. A: (16 – 5.5) / 1.2 = 8.75. B: (19 – 5.5) / 1.4 = 9.64. C: (14 – 5.5) / 1.1 = 7.73. Ranking should be BAC Example 4 Mr. Anand is having units in a mutual fund for the past three years. He wants to evaluate its performance by comparing it to the market. Find out Sharpe Ratio and Comment. FUND MARKET RETURN 70.6 41.4 41.31 19.44 STANDARD DEVIATION RISK FREE RATE 2% 2 BETA 1.12 ___ Ans – Sharpe Ratio St For Fund= Rp-Rf/ St dev of portfolio = 70.6-12/41.21=1.419 St For Market = Rp-Rf/ St dev of market = 41.4-12/19.44 = 1.512 Sharpe Index for the fund is lower than the market and its indicates that the fund has not performed well. 308

4.3.3. Capital Asset Pricing Module (CAPM) The asset return depends on the amount paid for the asset today. The price paid must ensure that the market portfolio's risk / return characteristics improve when the asset is added to it. The CAPM is a model that derives the theoretical required expected return (i.e., discount rate) for an asset in a market, given the risk-free rate available to investors and the risk of the market as a whole. The CAPM is usually expressed: E(Ri )  Rf  i (E(Rm )  Rf ) Beta, is the measure of asset sensitivity to a movement in the overall market; Beta is usually found via regression on historical data. Betas exceeding one signify more than average \"riskiness\" in the sense of the asset's contribution to overall portfolio risk; betas below one indicate a lower than average risk contribution. (E(Rm )  Rf ) is the market premium, the expected excess return of the market portfolio's expected return over the risk-free rate. Once an asset's expected return, E(Ri ) , is calculated using CAPM, the future cash flows of the asset can be discounted to their present value using this rate to establish the correct price for the asset. A riskier 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. In theory, an asset is correctly priced when its observed price is the same as its value calculated using the CAPM derived discount rate. If the observed price is higher than the valuation, then the asset is overvalued; it is undervalued for a too low price. Example 1 The risk free rate is 8 per cent and the expected return on the market portfolio is 14 per cent. The beta of stock ABC Ltd. is 1.25. Investors believe that the stock will provide an expected return of 17 per cent. Compute the required rate of return on the stock? Required rate of return = Rf + Bp (Rp - Rf)] = 8 + 1.25 (14 – 8) = 15.5% Example 2 The risk free return of Security A is 8%. In addition to it, you expect that the return on market would be 14%. The expected return of Security A with beta of 0.70 is ________. (2 marks) a) 12.2%. b) 5.4%. 309

c) 17.8%. d) 18.2%. Sol (A) E(R)= Rf + Bp (Rp - Rf)]= 8 + .70(14-8) = 12.2% Example 3 Mr. A‘s portfolio consists of two stocks A and B in which he has invested Rs. 75,000 and Rs. 67,000, respectively. Stock A has beta of 1.4 and stock B has beta of 0.80. The return expected from the market in current scenario is 12% while the return on Treasury bonds is 7%. What is the expected return from the portfolio? (A)11.17%. (b) 12.58%. (c) 14%. (d) 10.4%. ANSWER- (B) 12.58% SOLUTION :- Expected Rate of Return is 12.5846% Solution: Step-1: Find allocation of stock A and B in relation to the portfolio value Stock A : 75,000 / (142,000) = 52.82% Stock B : 67,000 /(142,000) = 47.18% Step-2: Find Beta of the portfolio using weighted average formula: (Weight of Stock A *Beta of Stock A) + (Weight of Stock B *Beta of Stock B) Therefore Beta of the portfolio = 1.11692 Step-3: Find the expected return of the portfolio using the below formula: Expected Return of the Portfolio: Rf + (Rm - Rf)* beta of portfolio = 7%+(12%-7%)*1.117 =12.5846% Example 4 Assume that the risk free rate of return is 7 %. The market portfolio has an expected return of 14% and a standard deviation of return of 25%. Under equilibrium condition as described by CAPM, what would be the expected return for a portfolio having no unsystematic risk and 20% standard deviation of return? Ri = Rf + Beta of share*(Rm-Rf) Beta of share = σ I /σ m = 0.2/0.25 =0.8 Ri = Rf + Beta of share*(Rm-Rf) 310

= 0.07+(0.14-0.07)(0.8) =0.126 The portfolio return is 12.6 % 4.3.4. Capital Market Line (CML) and Security Market Line (SML) The risk-free asset is the (hypothetical) asset that pays a risk-free rate. In practice, short-term government securities (such as treasury bills) are used as a risk-free asset, because they pay a fixed rate of interest and have exceptionally low default risk. The risk-free asset has zero variance in returns (hence is risk-free); it is also uncorrelated with any other asset (by definition, since its variance is zero). As a result, when it is combined with any other asset or portfolio of assets, the change in return is linearly related to the change in risk as the proportions in the combination vary. When a risk-free asset is introduced, the half-line shown in the figure is the new efficient frontier. It is tangent to the hyperbola at the pure risky portfolio with the highest Sharpe ratio. Its vertical intercept represents a portfolio with 100% of holdings in the risk-free asset; the tangency with the hyperbola represents a portfolio with no risk-free holdings and 100% of assets held in the portfolio occurring at the tangency point; points between those points are portfolios containing positive amounts of both the risky tangency portfolio and the risk- free asset; and points on the half-line beyond the tangency point are leveraged portfolios involving negative holdings of the risk-free asset (the latter has been sold short—in other words, the investor has borrowed at the risk-free rate) and an amount invested in the tangency portfolio equal to more than 100% of the investor's initial capital. This efficient half-line is called the capital allocation line (CAL), and its formula can be shown to be E(RC )  Rf  C (E(Rp )  Rf ) p In this formula P is the sub-portfolio of risky assets at the tangency with the Markowitz bullet, F is the risk-free asset, and C is a combination of portfolios P and F. Capital Market Line - CML The capital market line (CML) appears in the capital asset pricing model to depict the rates of return for efficient portfolios subject to the risk level (standard deviation) for a market portfolio and the risk-free rate of return. The capital market line is created by sketching a tangent line from the intercept point on the efficient frontier to the place where the expected return on a holding equals the risk-free rate of return. However, the CML is better than the efficient frontier because it considers the infusion of a risk-free asset in the market portfolio. 311

The capital asset pricing model (CAPM) proves that the market portfolio is the efficient frontier. It is the intersection between returns from risk-free investments and returns from the total market. The security market line (SML) represents this. The Security Market Line (SML) The security market line (SML) is the line that reflects an investment's risk versus its return, or the return on a given investment in relation to risk. The measure of risk used for the security market line is beta. The line begins with the risk-free rate (with zero risk) and moves upward and to the right. As the risk of an investment increases, it is expected that the return on an investment would increase. An investor with a low risk profile would choose an investment at the beginning of the security market line. An investor with a higher risk profile would thus choose an investment higher along the security market line. The security market line (SML) is a line drawn on a chart that serves as a graphical representation of the capital asset pricing model (CAPM), which shows different levels of systematic, or market, risk of various marketable securities plotted against the expected return of the entire market at a given point in time. Also known as the \"characteristic line,\" the SML is a visual of the Capital Asset Pricing Model (CAPM), where the x-axis of the chart represents risk in terms of beta, and the y-axis of the chart represents expected return. The market risk premium of a given security is determined by where it is plotted on the chart in relation to the SML. 312

The security market line is an investment evaluation tool derived from the capital asset pricing model, a model that describes risk-return relationships for securities, and is based on the assumptions that investors have to be compensated for both the time value of money and the corresponding level of risk associated with any investment, referred to as the risk premium. Given the SML reflects the return on a given investment in relation to risk, a change in the slope of the SML could be caused by the risk premium of the investments. Recall that the risk premium of an investment is the excess return required by an investor to help ensure a required rate of return is met. If the risk premium required by investors was to change, the slope of the SML would change as well. When a shift in the SML occurs, a change that affects all investments' risk versus return profile has occurred. A shift of the SML can occur with changes in the following: 1. Expected real growth in the economy. 2. Capital market conditions. 3. Expected inflation rate. The concept of beta is central to the capital asset pricing model and the security market line. The beta of a security is a measure of its systematic risk that cannot be eliminated by diversification. A beta value of one is considered as the overall market average. A beta value higher than one represents a risk level greater than the market average, while a beta value lower than one represents a level of risk below the market average. The formula for plotting the security market line is as follows: Required Return = Risk Free Rate of Return + Beta x (Market Return - Risk Free Rate of Return) 313

Example 1 Government bonds currently have a return of 5% pa. A stock has an expected return of 6% pa and the market return is 7% pa. What is the beta of the stock? Ri = Rf + Beta of share*(Rm-Rf) 6% = 5% + β (7%-5%) β = ½ = 0.5 Example 2 The following table given as analyst’s expected return on two stocks for particular market returns: MARKET RETURN AGGRESSIVE STOCK DEFENSIVE STOCK 6% 2% 8% 20% 30% 16% (A) What are the betas of the two stocks? (B) What₹ is the expected return on each stock if market return is equally likely to be 6% or 20%? (C) If the risk – free rate is 7% and the market return is equally likely to be 6% or 20% . What is the SML? (D) What are the alphas of the two stocks? Solution : (A) The beta of the two stocks are : Aggressive Stock = 30%-2%/20%-6% =2 Defensive stock = 16%-8%/20%-6% =0.551 (b) The expected return of the two stocks are : Aggressive stock : 0.5*2% + 0.5*30% = 16% Defensive Stock :0.5*8% + 0.5*16% =12% (c) The expected return on the market portfolio is: 0.5*6% + 0.5*20% =13% Since the risk free rate is 7%, the market risk premium is: 13%-7% = 6%, So, the SML is: 314

Required return = 7% + β* 6% (d)The alpha of the two stocks are calculated below: STOCK –A Expected Return = 16% Beta =2 Required return =7% +2*6%=19% Alpha =16%-19%=-3% STOCK –B Expected Return -12% Beta =0.571 Required return =7% +0.571*6%=10.426% Alpha =12%-10.426%=1.574% 4.3.5. Modern Portfolio Theory (MPT) Modern portfolio theory (MPT) is a theory of finance that attempts to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets. Although MPT is widely used in practice in the financial industry and several of its creators won a Nobel memorial prize for the theory in recent years the basic assumptions of MPT have been widely challenged by fields such as behavioral economics. MPT is a mathematical formulation of the concept of diversification in investing, with the aim of selecting a collection of investment assets that has collectively lower risk than any individual asset. This is possible, intuitively speaking, because different types of assets often change in value in opposite ways. For example, to the extent prices in the stock market move differently from prices in the bond market, a collection of both types of assets can in theory face lower overall risk than either individually. But diversification lowers risk even if assets' returns are not negatively correlated—indeed, even if they are positively correlated. More technically, MPT models an asset's return as a normally or elliptically distributed random variable, defines risk as the standard deviation of return, and models a portfolio as a weighted combination of assets, so that the return of a portfolio is the weighted combination of the assets' returns. By combining different assets whose returns are not perfectly positively correlated, MPT seeks to reduce the total variance of the portfolio return. MPT also assumes that investors are rational and markets are efficient. MPT was developed in the 1950s through the early 1970s and was considered an important advance in the mathematical modeling of finance. Since then, some theoretical and practical criticisms have been leveled against it. These include evidence that financial returns do not 315

follow a Gaussian distribution or indeed any symmetric distribution, and that correlations between asset classes are not fixed but can vary depending on external events (especially in crises). Further, there remains evidence that investors are not rational and markets may not be efficient. Finally, the low volatility anomaly conflicts with CAPM's trade-off assumption of higher risk for higher return. It states that a portfolio consisting of low volatility equities (like blue chip stocks) reaps higher risk-adjusted returns than a portfolio with high volatility equities (like illiquid penny stocks). A study conducted by Myron Scholes, Michael Jensen, and Fischer Black in 1972 suggests that the relationship between return and beta might be flat or even negatively correlated. The fundamental concept behind MPT is that the assets in an investment portfolio should not be selected individually, each on its own merits. Rather, it is important to consider how each asset changes in price relative to how every other asset in the portfolio changes in price. Investing is a tradeoff between risk and expected return. In general, assets with higher expected returns are riskier. The stocks in an efficient portfolio are chosen depending on the investor's risk tolerance, an efficient portfolio is said to be having a combination of at least two stocks above the minimum variance portfolio. For a given amount of risk, MPT describes how to select a portfolio with the highest possible expected return. Or, for a given expected return, MPT explains how to select a portfolio with the lowest possible risk (the targeted expected return cannot be more than the highest-returning available security, of course, unless negative holdings of assets are possible.) Therefore, MPT is a form of diversification. Under certain assumptions and for specific quantitative definitions of risk and return, MPT explains how to find the best possible diversification strategy. The Harry Markowitz Theory You may have heard about a statistician who had his head in an oven and his feet in a refrigerator but on average he felt just fine. That‘s right. Things on the average sometimes may look very comfortable. But what looks comfortable may actually be deceptive. Think of this. If two investments are giving an annual return of 10% on average, then what does that mean? Can you conclude that both investments are equally good? May or may not bet? As we have discussed how the risk-return trade-off works in general; now we can discuss about the theory of Harry Markowitz. Markowitz is a well-known name among portfolio managers, institutional investors or anybody even remotely interested in understanding how the risk-return trade-off works. Markowitz laid down the foundation of risk- return trade-off in his doctoral thesis Portfolio Selection, which was published in 1952 in The Journal of Finance. This important work hardly aroused any interest for many years after its publication, but with the passage of time, it became the raw material for what became popular as Modern Portfolio Theory. Markowitz believed that merely looking at the average return of an investment may not be enough. What we also need to look at is ―variance of return‖ for different investments, which tells us how much the actual return has fluctuated over the period. High variance of return or high volatility means the actual returns over the period may have fluctuated wildly. 316

Speculators no doubt like such opportunities where the upside is high, but for common investors such wild fluctuations or variance of return represents what we call risk. So, Markowitz was the one who suggested that it is possible to understand what exactly risk is. But more than this, it was Markowitz who showed how to think about risk in terms of numbers. By using past data, it is possible to know in terms of numbers how much the variance of return is for any particular investment. Quantifying risk by calculating ―standard deviation‖ or variance of return is just one step. Markowitz suggested that for actually choosing a diversified portfolio you also need to calculate the ―covariance of return‖ for different investments. Now you may be wondering what this covariance of return is. Covariance of return is also known as correlation of return for different assets. Those who are good at crunching numbers already know what correlation means. But for the benefit of many like you who believe that numbers are our worst enemies I will briefly explain what it is. Correlation of return for different assets is expressed as a number lying between +1 and -1. There could be three different scenarios: the correlation could be positive, negative or zero. If the correlation of return for two assets is positive, then the returns from the two assets are likely to move in tandem, that is, if the return from one asset is rising, the return from the other asset would also rise, and if the return from one asset is falling, the return from the other asset would also fall. Assets having a negative correlation show just the opposite relationship. When the return from one asset is rising, the return from the other asset falls. Assets having zero correlation do not show any relationship. The rise or fall of return from one asset has no effect on the rise or fall of return from the other asset. Well, once you know the correlation, you can use it for diversifying your portfolio. We can summarize the whole process suggested by Markowitz in three steps. First, you need to find out the expected return from different investments over a period. Second, you need to find out how much the return from each investment has varied from the average over the period. In other words, you need to find out the standard deviation of return from each investment. Third, you need to find out the correlation of return for different investments, that is, how returns from different assets have moved in comparison with each other. Once you are through with all these calculations, you can use Markowitz‘s prescription for selecting your portfolio—choose the investment that enjoys high expected return with low standard deviation and also low correlation with other assets in your portfolio. The basic idea is that, overall, a portfolio of uncorrelated assets faces less risk than a portfolio of correlated assets. I hope you now understand why it is so. Harry Markowitz laid the foundation of risk-return trade-off in his doctoral thesis Portfolio Selection. The process of portfolio selection suggested by Markowitz involved comparison of expected returns, standard deviation of returns, and correlation of returns from different assets. Choosing uncorrelated assets helps in diversifying the portfolio and hence minimizing risk. 317

Sharpe/Single Index Portfolio Selection Model The technique of portfolio selection proposed by Harry Markowitz provided a good recipe for minimizing risk. But good recipes are sometimes tougher to follow. The hardest part of Markowitz‘s formula involved putting all the basic ingredients together. Let‘s try to understand some of the basic difficulties associated with the Markowitz model and how the work of William Sharpe helped in improving it. The technique of portfolio selection proposed by Harry Markowitz in 1952 was based on a remarkable insight— for every level of return, there is one investment that is available at the lowest possible risk, and for every level of risk there is one investment that offers the highest return. The aim of portfolio selection is to minimize risk while maximizing return. But the real challenge was how this unique idea of portfolio selection could be put to actual use. The technique of portfolio selection as originally proposed by Markowitz remained ignored for many years both by professional fund managers and common investors, mainly because it was really hard to derive the main inputs of the model. We know how the three inputs of Markowitz‘s model—expected return, volatility of return and correlation of return between different assets—help us in portfolio selection. By doing some number crunching, you can find out the expected return and volatility of return for different securities, but Markowitz‘s model also expects you to calculate the correlation of return for different pairs of securities, which is a tough job. Even the fastest computer available during the 1960s required hours for the calculations necessary and the cost of using such a facility was really prohibitive. But the model started arousing some curiosity after another academician, William Sharpe, suggested some changes. Sharpe recognized that finding out how the return from asset A is correlated with that from 318

asset B, or return from asset C is correlated with that from asset B, is a tiring job. You must obtain estimates of return and variance of returns for all the 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, analyzing a set of 200 securities would require 200 returns estimates, 200 variance estimates and 19,900 covariance estimates, adding upto a total of 20,300 estimates. For a set of 500 securities, estimates required would be 1, 25,750. It may be noted that the number of estimates required becomes large because covariances between each pair of securities have to be estimated. You can go on counting the stars but will never be able to find their exact number. Sharpe suggested that instead of using the correlation of return of different pairs of individual assets, we can use the correlation of return of different assets with a common index for the whole market. So, if I is the index for the market, you need to find out how asset A is correlated with I or asset B is correlated with I and so on. In all cases, I remains common pillar. If A is positively correlated with I, then its return would rise or fall in tandem with the rise or fall of I, and if A is negatively correlated, then its return would move in the opposite direction of rise or fall of I. This greatly reduced the number of calculations required for Markowitz‘s original model and with the advent of faster computers; things became merrier for professional fund managers and institutional investors who relied on the application of this model for making allocations for different assets. But common investors, who are not very computer savvy, have to mainly rely on the services of investment advisers to utilize this model for selecting a well-diversified portfolio. Markowitz and Sharpe together received the Nobel Prize in 1990 for their work on portfolio selection. But even now the basic idea behind the Modern Portfolio Theory (MPT) receives brickbats from critics. Many critics believe this theory oversimplifies risk by assuming that risks can be quantified in terms of numbers by measuring the standard deviation or volatility of return. Critics argue that it is wrong to treat risk and volatility of return as synonymous. Critics believe that we still don‘t know what exactly risk is. Standard deviations or volatilities of return are just like the footprints of some dreaded beast which no one has seen. By no means can the footprints represent the whole picture. Further, critics believe that risks in the future may arise from totally unexpected events. No one knows where the unknown beast may leave his footprints tomorrow. So the use of past data for calculating future risk is like trying to make a new car by using old parts. No matter how much we may try, all our future risk assessments will remain imperfect. When forced with unknown situations, all measurements of risk may just wither. Critics believe that sometimes intuition can be a better guide for avoiding risk than our mathematical risk models. Summary: William Sharpe, an academician, suggested some changes to simplify the Markowitz‘s formula of portfolio selection. Changes were necessary because it was difficult ot calculate the inputs required for Markowitz‘s model. Sharpe suggested the use of correlation of individual assets with a common index. 319

Efficient Markets Hypothesis Do efficient stock markets make you feel small? A group of academicians as well as practitioners believe that stock markets have their own mind and know how to beat you, no matter what strategy you choose. But how could that be? We have come across many individuals who, like Warren Buffett, have made fortunes by constantly running ahead of the market. Let‘s understand the most debatable topic in capital market called the efficient market hypothesis (EMH). The Efficient market hypothesis which believes that an individual investor, no matter how smart he is, can‘t beat the market. But we have known countless number of individuals who have shown how to make fortunes by their sheer skill of thinking ahead of the market. The efficient market hypothesis evolved during the 1960s and 1970s through the work of many thinkers such as Eugene Fama, Burton G. Malkiel, et al. These thinkers believe that in efficient markets, large numbers of rational investors constantly compete with each other to find out the right price of securities on the basis of available information. This is the result of good communication system through which information can be spread almost anywhere in the world economies instantaneously. So, at any given point in time the prices of securities truly reflect all available information in the market. In other words, the market is so efficient that any information worth a penny is instantly absorbed by the collective mind of the market and helps in correctly pricing securities. No one can earn high returns only because he knows better. You can expect to get high returns only when you make riskier investments. A buyer of the security buys at a price that reflects the collective judgement of the market on available information. So you don‘t have any scope for picking any treasure lying unnoticed. Likewise, a seller sells at a price that truly incorporates the available information. So efficient markets would not let you sell your garbage at the price of gold. Everybody knows the true worth of what you are holding in your hands. Everybody knows the true worth of every security available in the market. That seems fantastic. But big question is where to find such a market? We may or may not be able to find perfectly efficient markets in reality. The efficient market theorists put markets into three categories on the basis of quality of information available in the market. In the weak form of efficient markets, the prices of securities reflect only past information. Finding such a market is not a tough job. Even the laziest markets know how to digest stale news. However, in the semi- strong markets, the prices reflect all public information. Markets, like a hungry shark, gulp whatever current news is floating around. Finally, in the strongest form of efficient markets, the prices fully reflect all public as well as private information. In other words, in strong efficient markets, there is no scope for insider trading. In efficient markets, prices of securities are not predictable but follow a random path. Why so? This is because the events that shape our lives seem to occur in a random manner. The fall of Bear Stearns Companies Inc., Lehman Brothers Holdings Inc. or Merrill Lynch and Co., for instance. Random news creates random movements in the stock market prices. Since you can‘t predict random news in advance, it is difficult to predict prices. So, what‘s the conclusion? The investor who outperforms the market does so by luck and not by skill. Efficient market theorists believe that neither technical analysis — which is basically an analysis of past trends of prices—nor fundamental analysis, which involves analysis of 320

financial information such as earnings, asset value and so on — can help in discovering undervalued companies. Malkiel once famously said that a blindfolded chimpanzee throwing darts at The Wall Street Journal could select a portfolio that would do as well as any financial analyst‘s. However Critics use different logic. First of all, information on which the markets move is not freely available. Market sharks have to work hard to obtain the information. The person obtaining the information is the first to benefit from it. Ironically, if everybody believed that the market is efficient and would take care of the flow of information, then the market would not remain efficient because nobody would bother to find new information. In other words, we require people who do not believe in the efficiency of markets to make the market efficient. Summary: The efficient market hypothesis believes that the prices of securities truly reflect all available information in the market. Investors constantly compete with each other to find out the right price of securities on the basis of available information. In efficient markets, the prices of securities move randomly because of random market events. 4.3.6. Monte Carlo Simulation for Portfolio Optimization Portfolio optimization is the process of choosing the proportions of various assets to be held in a portfolio, in such a way as to make the portfolio better than any other according to some criterion. The criterion will combine, directly or indirectly, considerations of the expected value of the portfolio's rate of return as well as of the return's dispersion and possibly other measures of financial risk. Modern portfolio theory, fathered by Harry Markowitz in the 1950s, assumes that an investor wants to maximize a portfolio's expected return contingent on any given amount of risk, with risk measured by the standard deviation of the portfolio's rate of return. For portfolios that meet this criterion, known as efficient portfolios, achieving a higher expected return requires taking on more risk, so investors are faced with a trade-off between risk and expected return. This risk-expected return relationship of efficient portfolios is graphically represented by a curve known as the efficient frontier. All efficient portfolios, each represented by a point on the efficient frontier, are well-diversified. For the specific formulas for efficient portfolios, see Portfolio separation in mean-variance analysis. 321

As shown in this graph, every possible combination of the risky assets, without including any holdings of the risk-free asset, can be plotted in risk-expected return space, and the collection of all such possible portfolios defines a region in this space. The left boundary of this region is a hyperbola, and the upper edge of this region is the efficient frontier in the absence of a risk-free asset (sometimes called \"the Markowitz bullet\"). Combinations along this upper edge represent portfolios (including no holdings of the risk-free asset) for which there is lowest risk for a given level of expected return. Equivalently, a portfolio lying on the efficient frontier represents the combination offering the best possible expected return for given risk level. 322

Sub-Section 4.4 Revision of Portfolio Learning Outcome The objectives of the topic 4.4 – Revision of Portfolio are as follows: 1. To understand the importance and benefits of portfolio revision. 2. To get acquainted with the concept of periodic review and revision of portfolio. 3. To understand the concept and application of portfolio rebalancing vis-à-vis different personal & economic scenarios. 4. To get acquainted with different asset allocation strategies like Buy and Hold policy, Constant Mix policy and Portfolio Insurance policy and their relevance to changing market circumstances. 5. To look for opportunities for Portfolio upgradation with changing market circumstances. 323

4.4.1. Benefits of Revision 1. Helps against Adjustment to Changing Lifestyle Over a period of time an individual faces a lot of changes in his financial life. For instance, a salaried employee would experience annual bonus, hike and promotions which would change the surplus levels. Inflation also impacts expenses and reduce the investable surplus which could be considered during the review. Instances when there is an addition to a family - child birth, the financial plan needs to be revisited as there would be an additional goal to plan for the child‘s future. 2. Helps to Change the Investment Strategy for Remaining Goals if Any Goal Gets Achieved Goals can be tracked better if do a periodic review and rebalancing. It really helps to know how far we have headed in terms of achievement of a particular goal. During the review, additional goals or any modification towards existing goals can be done if found feasible. In case where post implementation of the plan, some of the short term goals would be achieved, a review of goals would ensure that the surplus released from the first goal can be used for remaining goals. For example if the goals for car or home is achieved, the surplus released post achievement of the goal could be used to enhance the investments towards retirement or child‘s education goal. 3. Helps the Portfolio to Remains on Track and Reduce Market Risk through Asset Allocation Equity debt balance in the portfolio would change after a period of 12-18 months depending on the market conditions. As the investment portfolio is designed keeping in mind the macro economic conditions, rebalancing would make sure such allocation would be maintained throughout. Asset allocation revision may also be needed once there is a major change in fiscal policies (for example, interest rate changes). For example, when there is an interest rate cut, the exposure towards equity based asset class can be enhanced to earn better returns. 4. Helps in Securing Benefits of Equity Markets Over Time In case of a bullish market, equity part of the portfolio would grow higher than the debt portion. Rebalancing would shift the gains from the equity to debts so that the profits are secured. If the original allocation for investment of ₹1 lac between debts and equity was 50:50 and during the investment tenure of one year equity grew by 20% and debts by 10%, then there would be a gap in the allocation of asset classes. The value of equity would be ₹60000, whereas debts would become ₹55000. In order to maintain the original allocation ₹2500 should be moved to debt funds. Thus, by rebalancing gains from equity can be secured and invested towards debt funds. 5. Helps in Eliminating bad Investments or Replacing Them During the recommendation of investment portfolio, the investment avenues are expected to perform well to get high inflation adjusted returns. But, this may not happen due to various reasons. 324

4.4.2. Periodic Review and Revision of Portfolio This is clearly an important aspect of the investment process. While establishing an appropriate investment portfolio in the first instance is a critical issue, the ongoing management and review of the portfolio is just as important in ensuring that the investor‘s long-term objectives can be achieved. A key approach to adopt at this stage is a formalised re-balancing strategy within the ongoing review of the portfolio. While re-balancing back to the SAA can often result in the reallocation of funds away from high- performing managers to low performing managers, it is never-the-less an important exercise to ensure that the overall ‗balance‘ of the portfolio is maintained, and that it remains consistent with the client‘s objectives and risk/ return profile. Another important part of this process is to review the underlying performance of each manager, and whether they are performing in line with their stated portfolio objectives. When blending different managers the adviser does not want to include managers who change their investment style (style drift) in an attempt to protect portfolio returns. This issue is often the most critical aspect of reviewing a manager and not the underlying investment performance. Managers will inevitably go through periods of lacklustre investment performance, but having adopted a blended mix of managers and investment styles this issue is mitigated if the managers remain ‗true to label‘. It is really in circumstances where a client‘s objectives have changed or the manager has gone through a period of upheaval (i.e. loss of personnel, changing ownership structure, long-term systemic investment underperformance, substantial increase in FUM and so on) that an adviser should consider changing those managers in a portfolio. Given that most investors do have a medium-term investment horizon, switching managers over the short-term can lead to continual investment underperformance and also an increase in costs to the investor. 4.4.3. Portfolio Rebalancing Once the portfolio is constructed after deciding the asset mix and investment strategy, it is equally important to periodically monitor and make necessary changes in the portfolio. This exercise of portfolio revision would enable investors to take into consideration the developments in the capital market and incorporate necessary changes required in risk – return profile. Portfolio revision normally involves a) Rebalancing and b) Upgrading. Rebalancing a portfolio is the process of periodically reviewing and revising the portfolio composition. Mutual funds, in their offer document, state the overall investment objective of the fund and resort to periodic rebalancing when the actual portfolio composition differs from the stated objective. The same is true even in case of an individual investor. We give below examples of constant proportion and constant beta portfolios of rebalancing. 325

4.4.4. Buy and Hold Policy, Constant Mix Policy and Portfolio Insurance Policy Buy-and-Hold Strategy In a buy-and-hold strategy an investor buys stocks and basically holds them until some future time in order to meet some objective until portfolio is left undisturbed. The emphasis is on avoiding transaction costs, additional search costs, etc., Under buy and hold approach, no portfolio rebalancing takes place. The underlying belief is that such a strategy will, over some period of time, produce results as good as alternatives that require active management whereby some securities deemed not satisfactory, are sold and replaced with other securities. This strategy is applicable to the investor‘s portfolio, whatever its composition - be large or small and of stocks and / or bonds. The investor must decide to build a portfolio initially to implement this strategy. To illustrate, consider a billionaire making an investment of ₹1 million in the equity segment. Assume that he had chosen 5 stocks, viz., A, B, C, D and E and bought these stocks at the rates shown in the table below. Also assume that no dividend has been received by him during the holding period. Share No. of shares Price per share Value A 1000 200 200000 B 500 300 150000 C 800 150 90000 D 1200 250 300000 E 2000 115 230000 Total 1000000 Since the investor will simply hold the portfolio he would be interested in assessing the performance at the end of his holding period. The following table shows market value and portfolio return for different holding periods, say 1year, 2 years and 3 years. Holding period (years) Market value of Portfolio Return (million ₹) (%) 1 1.2 20 2 0.9 -10 3 1.3 30 However, the investor will have to undertake certain functions when he adopts‗ buy-and- hold‘ strategy. For example, any income generated by the portfolio may be reinvested in other securities or used for consumption. Another issue may be the source of funding additional investment if there is rights or preferential issue. By and large, this strategy involves minimum time and expertise of the investors. A point in favour of adopting this naïve strategy is that managed portfolios, on a risk adjusted basis, generally underperform buy and hold strategy 326

Constant Proportion Rebalancing In a constant proportion portfolio, adjustments are made so as to maintain the relative weighting of the portfolio components as their prices change. A balanced asset allocation policy is a periodical rebalancing of the portfolio which ensure that asset mix is in line with long term ‗normal‘ mix. An equally weighted portfolio is a special case of a constant proportion portfolio. Assume a portfolio that contains four stocks and an approximate investment of 25% percent in each of the four securities as given in the table below: Initial portfolio for an investment of ₹1 lakh Investment Price (₹) Shares Value (₹) % of total portfolio A 20 1250 25000 25 B 250 100 25000 25 C 125 200 25000 25 D 25 1000 25000 25 Note that it is an ideal situation where the investor is in a position to exactly invest money in the desired proportion. In reality, the percentages may be slightly more or less the desired percentage. Suppose that after a period of time, say 3 months, the value of the portfolio has appreciated from ₹1,00,000 to ₹1,05,000; the first two securities have appreciated in value and the other two declined. Under constant rebalancing, in order to maintain equal weighting, the investor will have to sell some of the shares that performed the best and buy more of the securities that had done poorly. This is just one of the methods of rebalancing but not necessarily the best one. Adopting this strategy, the investor would be selling some shares of A & B and utilise the proceeds to add shares of C & D in the portfolio. Following table gives a glimpse of action taken by the investor and the weights of portfolio before and after revision. Revision of Constant Proportion Portfolio Investment Before Revision Price (₹) Value (₹) % of total Action Value portfolio A 32 40000 36.36 Sell 400 shares 27200 B 300 30000 27.27 Sell 10 shares 27000 C 100 20000 18.18 Buy 75 shares 27500 D 20 20000 18.18 Buy 400 shares 28000 Cash 300 Total 110000 110000 Under this strategy, the investor had booked profits on A& B and reinvested the money in C & D. 327

However, if the investor believes that A&B would continue to do well, he may decide to allocate more money for investment in these shares. Constant Beta Rebalancing Suppose a portfolio manager has the objective of maintaining a low beta strategy and has constructed a portfolio accordingly. As time passes, the values of the portfolio components as well as the betas of the components may change. In order to maintain the constant beta, portfolio manager has following alternatives:  shift money into the equity portfolio and hold cash  shift money into the equity portfolio and buy low beta stocks  sell high beta stocks and buy low beta stocks.  Sell high beta stocks and hold cash The first two alternatives involve introduction of fresh funds in to the portfolio. The alternatives involving cash holding (alternatives 1 & 4) may attract criticism of keeping idle funds. Third alternative involves portfolio revision, by making some additions and deletions. Let us consider the same constant proportion portfolio discussed above to illustrate this aspect. Assume initial betas of stocks A, B, C and D are 1.15, 0.95, 1.00, .90 respectively. The portfolio beta is 1 which is the target beta of the portfolio manager. After 6 months, when the manager reviewed the portfolio, he found that the values have changed and also beta of the portfolio. Investment Price (₹) Before Revision Beta 32 Value (₹) 1.20 A 300 40000 1.40 B 100 30000 0.8 C 20 20000 1.1 D 20000 Cash Total 110000 Portfolio beta is 1.125 which is higher than target beta of 1. The task before the portfolio manger is to bring down the portfolio beta to the target level. One way of achieving the target is to sell high beta shares and add low beta ones to the portfolio. 328

Investment Action After Revision Value (₹) A Sell 650 shares Price (₹) 19200 Weights B Sell 50 shares 32 15000 0.175 C Buy 400 shares 300 60000 0.136 D Buy 500 shares 100 15800 0.516 Cash 20 0.143 Total 110000 After revision, the portfolio beta is 0.995, which is closer to the target beta. This portfolio revision resulted in a composition of asset mix wherein more than 50% of the funds are invested in the share having the lowest beta. If the manager is to adhere to some exposure norms, say not more than 30% of funds in any one security he may be adopting a different rebalancing strategy to arrive at a target beta of 1. Rebalancing through Maturity Selection Let us now consider another example of rebalancing which used in case of debt portfolio. The ultimate motive of the investors is to match the time of cash outflow with inflows. It is the general practice to estimate the time of liability outgo and select a bond portfolio with a matching maturity so that the required cash flow is generated. Maturity Selection is the basic approach that bond investors use in managing their bond portfolios or the bond portion of their overall portfolio. This approach differs among investors - depending on their risk preferences, knowledge of bond market and investment objectives. This approach requires understanding the basic nature of the bond market and the relationship between yield and maturity and the liquidity. The level of inflation in the economy has a direct bearing on the level of interest rates. Changes in interest rates are the main factor affecting bond prices. There is an inverse relationship between changes in bond prices and changes in interest rates. It is important for an investor to have a view on the likely inflation level and have a forecast of interest rates. Following are the tradeoffs involving maturity selection.  Short maturities do not offer price appreciation opportunities and usually give lower interest income but will protect investors when interest rates are expected to rise  Longer maturities offer chance for capital gains (losses also) What an investor has to do? A defensive investor would try to build a bond portfolio having a maturity closer to his liability term. An aggressive investor would lengthen the maturity of a bond portfolio when interest rates are expected to decline and vice versa. By closely studying the shape of the yield curve at any point in time, the investor has to decide as to the segments of the bond market to invest in. For instance, if an aggressive investor has a forecast of fall in long term interest rates, he would buy a bond having a maturity more than his liability term. That is, to meet a 5 year liability, he would buy bonds having maturity more than 5 years, of say 7 years. What happens if his forecast becomes a reality? We have already seen that there exists an inverse relationship between interest rates and bond prices. With the fall in interest rate, there 329

would be an increase in the value of his investments which will provide him an opportunity of booking capital gains. What is the risk involved in this strategy? If the interest rate does not fall as expected by the investor, he would face the risk of realizing the capital gains. Let us now consider another investor who expects a rise in interest rates. His investment strategy would be to select a bond having lower maturity than his liability, so that he would be in a position to maximize the interest receipts. How does it happen? In order to meet a liability after 5 years, the investor may purchase a 2 year bond. After 2 years, as per his forecast, if the interest rates go up, he would then be buying a bond bearing higher coupon, thereby earning higher returns. The inherent risk in this is the reinvestment risk that he would be facing when bonds with shorter tenure matures Constant Proportion Portfolio Insurance (CPPI)  Portfolio insurance strategy takes the following general form:  CPPI is the dynamic asset allocation policy which involves shifting the asset mix in response to the changing market conditions. Exposure to shares = m (Total Portfolio Value – Floor value) For implementing this strategy, the investor has to determine a minimum / floor value for the portfolio. The difference between the total portfolio value and the floor value represents the margin that effectively provides a cushion/protection for the floor value. Once the floor value and the multiplier (m) is determined by the investor. M is always greater than 1, ‗m‘ respresents the risk appetite of an investor. To illustrate, assume a portfolio having a value of ₹100,000 and the fund manager desires to have a floor value of ₹75000. Thus, the cushion available initially is 100000 –75000 = 25000. If the fund manager decided on a multiplier of 2, the exposure to shares will be, 25000 * 2 = 50000 With 50% of investible funds in equities, the balance 50% is invested in short term government and other liquid securities. Suppose, after a month, there is a 20% decline in the market value of equities, i.e., from ₹50000 to ₹40000, the portfolio value will now be ₹90000. The cushion available is, 90000 – 75000 = 15000 The exposure to equity shares would be 15000 * 2 = 30000 To attain this target of equity exposure, the investor needs to sell ₹10000 worth of shares and invest the proceeds in short term liquid instruments. Conversely, if the market rises, the exposure to equity would increase and investments in liquid investments would decline. For example, assume that the market value of equity had gone up from ₹50000 to ₹60000, the amount of equity exposure would be, 2*(110000-75000) = 70000 330

In this case, the investor will be selling ₹ 10000 worth of liquid investments and investing the proceeds in equity segment, so as to attain the target. As explained above, this strategy puts more and more money in liquid instruments as stocks decline. In essence, the CPPI policy calls for ―felling stocks as they fall and buying stocks as they rise‖. The exposure to stocks will be zero when the portfolio value equals the floor value. The underlying assumption is that the investor will be in opposition to rebalance the portfolio during market decline. Precipitous declines in the market or lack of liquidity may render this insurance strategy ineffective. When the market crashed in October 1987, this insurance strategy could not offer effective protection to the investors. In short, Portfolio rebalancing involves revision of portfolios within the scope of asset mix decided by the in- vestor. With the exception of ‗buy and hold strategy, where no changes effected, other strategies like constant proportion, fixed beta portfolio insurance etc., would call for rebalancing. Example: Let us take an example to understand the concepts. Consider the following portfolio under 3 different situations when the market is currently at 100 points. Buy and hold Stocks Bonds Total Constant Mix Policy 50,000 50,000 1,00,000 Constant Proportion 50,000 50,000 1,00,000 Portfolio Insurance Policy (PPI) 50,000 50,000 1,00,000 Market Falls to 80 Buy and hold Before Rebalancing After Rebalancing Stock Bonds Total Stock Bonds Total Constant Mix Policy 40,000 50,000 90,000 30,000 50,000 90,000 40,000 50,000 90,000 30,000 50,000 90,000 Constant Proportion 40,000 50,000 90,000 30,000 50,000 90,000 Portfolio Insurance Policy (PPI) Buy and Hold In buy and hold, one need not rebalance the composition of the portfolio. Constant Mix Policy In the above table, initial portfolio is ₹1,00,000. After the market falls by 20%, the value of stocks comes down to ₹ 40,000 and bond remain at ₹50,000, thereby making a total portfolio value of ₹ 90,000. According to this policy, stock should be 45,000 (50% of 90,000) and bonds should be 45,000. Hence he will sell ₹5000 woth bond and invests the proceeds to buy the stock to arrive at the 331

initial targetted ratio of 50:50. Constant Proportion Portfolio Insurance Policy When the market falls by 20%, the value of portfolio comes down to ₹ 90,000. According to this policy, investment in stock should be 2 (PV - Floor) = 2 (90,000 - 75,000) = 30,000. (Assume floor value as 75,000 and multiplies as ‗2‘) and rest ₹60,000 should be invested in bonds. Hence, we will sell stocks worth ₹10,000 and invest the proceeds in bonds. 4.4.5. Portfolio Upgrading Portfolio upgrading involves making changes that are necessary to enhance the performance of the portfolio. This may include identification of mispriced securities so as to include in / exclude from portfolio, reassessing the risk – return characteristics of asset classes considered in the asset mix etc., Let us take an example. When the growth prospects of a company/industry sector deteriorates, it would be advisable to disinvest as it no longer merits a place in the portfolio. Consider the example under constant proportion rebalancing. If the investor has reasons to believe that the stocks C&D will not be profitable, he may upgrade his portfolio by selling these shares and real locate the funds in only in profitable shares viz., A and B. Another way of upgrading his portfolio would be to utilise the funds from disinvestment to include some additional shares from a sector having good prospects. Note that portfolio revision decision involves costs – data collection and research cost, transaction costs and professional fee like charges payable to portfolio manager or financial planner for undertaking this activity. Another important aspect borne in mind is the taxation aspect. Mutual funds are exempt from tax payment, but not individuals and corporates. The financial planner/portfolio manager should consider the tax implications and address this aspect specifically at the time of portfolio management. 332

SECTION–V REGULATORY ASPECTS -INVESTMENT PRODUCTS and INVESTMENT ADVISORY SUB-SECTIONS 5.1 Regulatory Oversight of Financial Products and Services 5.2 Other Entities Facilitating Market Play and Intermediation Testing Objective Theoretical testing knowledge: ―Grade 1” Theoretical testing clarity of concepts: ―Grade 2” Total weight to Exam 3 Nature of Test Items 8% 8 items: 1 mark each 2 items: 2 marks each 333

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Sub-Section 5.1 Regulatory Oversight of Financial Products and Services Learning Outcome The objectives of the topic 5.1 – Regulatory Oversight of Financial Products and Services are as follows: 1. To understand the regulatory oversights on various financial products and services under the different regulatory Acts such as: a) Reserve Bank of India (RBI) Act-1934 b) Securities and Exchange Board of India (SEBI) Act-1992 c) Securities Contract Regulation (SCR) Act-1956 d) Foreign Exchange Management Act-1999 e) Disclosure and Investor Protection Guideline issued by SEBI f) Grievance Mechanisms, SEBI Ombudsman Regulations-2003 g) Right to Information (RTI) Act-2005 h) Forward Contacts (Regulation) Act-1952 i) SEBI Investment Advisers Regulations, 2013 importance and benefits of portfolio revision. 335

5.1.1. Reserve Bank of India (RBI) Act-1934 Reserve Bank of India Act, 1934 is the legislative act under which the Reserve Bank of India was formed. This act along with the Companies Act, which was amended in 1936, were meant to provide a framework for the supervision of banking firms in India. The Act contains the definition of the so-called scheduled banks, as they are mentioned in the 2nd Schedule of the Act. These are banks which were have paid up capital and reserves above 500,000. The Section 17 of the Act defines manner in which the RBI can conduct business. The RBI can accept deposits from the central and state governments without interest. It can purchase and discount bills of exchange from commercial banks. It can purchase foreign exchange from banks and sell it to them. It can provide loans to banks and state financial corporations. It can provide advances to the central government and state governments. It can buy or sell government securities. It can deal in derivative, repo and reverse repo. The Section 18 deals with emergency loans to banks. The Section 21 states the RBI must conduct the banking affairs for the central government and manage public debt. The Section 22 says that only RBI has the exclusive rights to issue currency notes in India. The Section 24 states that the maximum denomination a note can be 10,000. The Section 28 allows the RBI to form rules regarding the exchange of damaged and imperfect notes. The Section 31 says that in India only the RBI or the central government can issue and accept promissory notes that are payable on demand. However, cheque, that are payable on demand, can be issued by anyone. The Section 42(1) says that every scheduled bank must have a average daily balance with the RBI. The amount of the deposit shall be more that a certain percentage of its net time and demand liabilities in India. The Reserve Bank of India (RBI) is the apex financial institution of the country‘s financial system entrusted with the task of control, supervision, promotion, development and planning. RBI is the queen bee of the Indian financial system which influences the commercial banks‘ management in more than one way. The RBI influences the management of commercial banks through its various policies, directions and regulations. Its role in bank management is quite unique. In fact, the RBI performs the four basic functions of management, viz., planning, organising, directing and controlling in laying a strong foundation for the functioning of commercial banks. The Preamble to the Reserve Bank of India Act, 1934 spells out the objectives of the Reserve Bank as: ―to regulate the issue of Bank notes and the keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage.‖ Prior to the establishment of the Reserve Bank, the Indian financial system was totally inadequate on account of the inherent weakness of the dual control of currency by the Central Government and of credit by the Imperial Bank of India. The Hilton-Young Commission, therefore, recommended that the dichotomy of functions and division of responsibility for control of currency and credit and the divergent policies in 336

this respect must be ended by setting-up of a central bank – called the Reserve Bank of India – which would regulate the financial policy and develop banking facilities throughout the country. Hence, the Bank was established with this primary object in view. Another objective of the Reserve Bank has been to remain free from political influence and be in successful operation for maintaining financial stability and credit. The fundamental object of the Reserve Bank of India is to discharge purely central banking functions in the Indian money market, i.e., to act as the note- issuing authority, bankers‘ bank and banker to government, and to promote the growth of the economy within the framework of the general economic policy of the Government, consistent with the need of maintenance of price stability. A significant object of the Reserve -Bank of India has also been to assist the planned process of development of the Indian economy. Besides the traditional central banking functions, with the launching of the five-year plans in the country, the Reserve Bank of India has been moving ahead in performing a host of developmental and promotional functions, which are normally beyond the purview of a traditional Central Bank. The Reserve Bank of India performs all the typical functions of a good Central Bank. In addition, it carries out a variety of developmental and promotional functions attuned to the course of economic planning in the country:  Issuing currency notes, i.e., to act as a currency authority.  Serving as banker to the Government.  Acting as bankers‘ bank and supervisor.  Monetary regulation and management.  Exchange management and control.  Collection of data and their publication.  Miscellaneous developmental and promotional functions and activities.  Agricultural Finance.  Industrial Finance  Export Finance.  Institutional promotion. Under Section 22 of the Reserve Bank of India Act, the bank has the sole sight to issue bank notes of all denominations. The notice issued by the Reserve bank has the following advantages:  It brings uniformity to note issue.  It is easier to control credit when there is a single agency of note issue.  It keeps the public faith in the paper currency alive.  It helps in the stabilization of the internal and external value of the currency and  Credit can be regulated according to the needs of the business. The system of note issue as it exists today is known as the minimum reserve system. The currency notes issued by the Bank aid legal tender everywhere in India without any limit. At 337

present, the Bank issues notes in the following denominations: ₹2, 5, 10, 20, 50, 100, and 500. The responsibility of the Bank is not only to put currency into, or withdraw it from, the circulation but also to exchange notes and coins of one denomination into those of other denominations as demanded by the public. All affairs of the Bank relating to note issue are conducted through its Issue Department. As a banker agent and financial advisor to the State, the Reserve Bank performs the following functions:  It keeps the banking accounts of the government.  It advances short-term loans to the government and raises loans from the public.  It purchases and sells through bills and currencies on behalf to the government.  It receives and makes payment on behalf of the government.  It manages public debt and  It advises the government on economic matters like deficit financing price stability, management of public debts. Etc. It acts as a guardian for the commercial banks. Commercial banks are required to keep a certain proportion of cash reserves with the Reserve bank. In lieu of this, the Reserve bank provides them various facilities like advancing loans, underwriting securities etc. The RBI controls the volume of reserves of commercial banks and thereby determines the deposits/credit creating ability of the banks. The banks hold a part or all of their reserves with the RBI. Similarly, in times of their needs, the banks borrow funds from the RBI. It is, therefore, called the bank of last resort or the lender of last resort. It is the responsibility of the Reserve bank to stabilize the external value of the national currency. The Reserve Bank keeps golds and foreign currencies as reserves against note issue and also meets adverse balance of payments with other counties. It also manages foreign currency in accordance with the controls imposed by the government. As far as the external sector is concerned, the task of the RBI has the following dimensions:  To administer the foreign Exchange Control;  To choose ,the exchange rate system and fix or manages the exchange rate between the rupee and other currencies;  To manage exchange reserves;  To interact or negotiate with the monetary authorities of the Sterling Area, Asian Clearing Union, and other countries, and with International financial institutions such as the IMF, World Bank, and Asian Development Bank. The RBI is the custodian of the country‘s foreign exchange reserves, id it is vested with the responsibility of managing the investment and utilization of the reserves in the most advantageous manner. The RBI achieves this through buying and selling of foreign exchange market, from and to schedule banks, which, are the authorized dealers in the Indian, foreign exchange market. The Bank manages the investment of reserves in gold counts abroad‘ and the shares and securities issued by foreign governments and international banks or financial institutions. 338

At one time, it was supposed to be the most important function of the Reserve Bank. When Commercial banks fail to meet obligations of their depositors the Reserve Bank comes to their rescue as the lender of the last resort, the Reserve Bank assumes the responsibility of meeting directly or indirectly all legitimate demands for accommodation by the Commercial Banks under emergency conditions. The commercial banks are not required to settle the payments of their mutual transactions in cash, It is easier to effect clearance and settlement of claims among them by making entries in their accounts maintained with the Reserve Bank, The Reserve Bank also provides the facility for transfer to money free of charge to member banks. In modern times credit control is considered as the most crucial and important functional of a Reserve Bank. The Reserve Bank regulates and controls the volume and direction of credit by using quantitative and qualitative controls. Quantitative controls include the bank rate policy, the open market operations, and the variable reserve ratio. Qualitative or selective credit control, on the other hand includes rationing of credit, margin requirements, direct action, moral suasion publicity, etc. Besides the above mentioned traditional functions, the Reserve Bank also performs some promotional and supervisory functions. The Reserve Bank promotes the development of agriculture and industry promotes rural credit, etc. The Reserve Bank also acts as an agent for the international institutions as I.M.F., I.B.R.D., etc. In addition to its traditional central banking functions, the Reserve Bank has certain non- monetary functions of the nature of supervision of banks and promotion of sound banking in India. The supervisory functions of the RBI have helped a great deal in improving the methods of their operation. The Reserve Bank Act, 1934, and Banking Regulation Act, 1949 have given the RBI wide powers of:  Supervision and control over commercial and cooperative banks, relating to licensing and establishments.  Branch expansion.  Liquidity of their assets.  Management and methods of working, amalgamation reconstruction and liquidations.  The RBI is authorized to carry out periodical inspections off the banks and to call for returns and necessary information from them. A striking feature of the Reserve Bank of India Act was that it made agricultural credit the Bank‘s special responsibility. This reflected the realisation that the country‘s central bank should make special efforts to develop, under its direction and guidance, a system of institutional credit for a major sector of the economy, namely, agriculture, which then accounted for more than 50 per cent of the national income. However, major advances in agricultural finance materialised only after India‘s independence. Over the years, the Reserve Bank has helped to evolve a suitable institutional infrastructure for providing credit in rural areas. Another important function of the Bank is the regulation of banking. All the scheduled banks are required to keep with the Reserve Bank a consolidated 3 per cent of their total deposits, and the Reserve Bank has power to increase this percentage up to 15. These banks must have capital and reserves of not less than ₹5 lakhs. The accumulation of these balances with the Reserve Bank places it in a position to 339

use them freely in emergencies to support the scheduled banks themselves in times of need as the lender of last resort. To a certain extent, it is also possible for the Reserve Bank to influence the credit policy of scheduled banks by means of an open market operations policy, that is, by the purchase and sale of securities or bills in the market. The Reserve bank has another instrument of control in the form of the bank rate, which it publishes from time to time. Further, the Bank has been given the following special powers to control banking companies under the Banking Companies Act, 1949:  The power to issue licenses to banks operating in India.  The power to have supervision and inspection of banks.  The power to control the opening of new branches.  The power to examine and sanction schemes of arrangement and amalgamation.  The power to recommend the liquidation of weak banking companies.  The power to receive and scrutinize prescribed returns, and to call for any other information relating to the banking business.  The power to caution or prohibit banking companies generally or any banking company in particular from entering into any particular transaction or transactions.  The power to control the lending policy of, and advances by banking companies or any particular bank in the public interest and to give directions as to the purpose for which advances mayor may not be made, the margins to be maintained in respect of secured advances and the interest to be charged on advances. 5.1.2. Securities and Exchange Board of India (SEBI) Act-1992 It was officially established by The Government of India in the year 1988 and given statutory powers in 1992 with SEBI Act 1992 being passed by the Indian Parliament. SEBI has its Headquarters at the business district of Bandra Kurla Complex in Mumbai, and has Northern, Eastern, Southern and Western Regional Offices in New Delhi, Kolkata, Chennai and Ahmedabad respectively. Initially SEBI was a non-statutory body without any statutory power. However in the year of 1995, the SEBI was given additional statutory power by the Government of India through an amendment to the Securities and Exchange Board of India Act, 1992. In April, 1988 the SEBI was constituted as the regulator of capital markets in India under a resolution of the Government of India. The SEBI is managed by its members, which consists of following: a) The chairman who is nominated by Union Government of India. b) Two members, i.e. Officers from Union Finance Ministry. c) One member from The Reserve Bank of India. d) The remaining 5 members are nominated by Union Government of India, out of them at least 3 shall be whole-time members. 340