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Risk management and the mutual funds

The basic objective of a mutual fund is to provide a diversified portfolio so as to reduce

the risk in investments at a lower cost. The mutual fund industry worldwide is based on
this premise. Investors who take up mutual fund route for investments believe that their
risk is minimized at lower costs, and they get an optimum portfolio of securities that
match their risk appetite. They are ignorant about the diverse techniques and hedging
products that can be used for minimizing the market volatility and hence take the help of
the fund managers. It is very daunting to note that the drop in the NAV of some of the
schemes is higher than the erosion of value in some of the ICE stocks. The recent survey
conducted by PricewaterhouseCoopers (PWC) on risk management by mutual funds has
posted interesting as well as worrying results. According to the survey, as many as 50
percent of the respondent mutual funds are not managing risk properly. If this is not all,
50 percent of the respondents did not even have documented risk procedures or dedicated
risk managers. The respondents included among others, some of the heavyweights of the
Indian MF industry viz. Templeton, Alliance, Prudential and IDBI Principal MF.

Worrisome news it is, for the investor who still believes MFs are a route to manage one’s
money in a better and safe manner. The recent wild movements in the NAVs of several
equity funds have belied all expectation of a diversified portfolio from the fund managers
when the basic tenet behind portfolio management is risk management. Mr. Shyam Bhat,
Fund Manager-Tata asset Management Ltd. said ‘Indian Mutual fund industry is not
using statistical techniques of risk management but is using diversification effectively
within the market limitations. As far as use of derivatives is concerned, they are not
presently used because of the low volumes, low liquidity and absence of sufficient
hedging products in the market ’.

Aggression has been the key word followed by the AMCs when it comes to taking
positions in stocks. With investment in volatile ICE sectors being the driver of growth
last season, almost everybody had taken big exposures to them. Birla MF maintained its
exposures in Infosys to almost 25 percent in all of its equity schemes throughout last
year. The same is true of ING Savings Trust that has Rs. 60 crores invested in Wipro and
Infosys out of the total fund size of 135 crores in its growth fund. The result of these
exposures is that the fund witnessed a movement of almost 9 percent in a single day on
budget when the market saw an appreciation of around 4.36 percent. In their quest for
growth, many funds have seen very volatile movements in NAVs. The investor
confidence may not be lost but such volatility sure dents it. The point is not whether
AMCs should be chastised or not but just to question the practices as the fate of many
investors is linked to it. An ordinary investor considers mutual funds as the experts in
investment decisions and so naturally expects the decision of investing in mutual funds to
bear fruit. However, AMCs often leave a lot to be desired as they falter on important
fronts like NAV and portfolio disclosure besides posting high fluctuations and poor
returns.
The Beta of some of the favorite stocks is shown below. The Table contains the Beta of
some of the ICE scrips that constitute the top 10 holdings across various equity funds.

DSQ Software Ltd. 2.09 Taurus Libra Leap (5.68%), DSP ML

Tech. (6.06%)
Satyam Computer Services Ltd. 2.00 ING Growth Port (11.2%), Alliance
Equity Fund (9.7%), Chola freedom
Tech (11.51%)
SSI Ltd. 1.98 IL&FS eCom (9.63%), LIC
Dhansamridhi (9.18%)
Wipro Ltd. 1.87 ING Growth (23.8%), Magnum
Sector Fund -Infotech (15%),
Alliance Alliance New Millennium
(10%)
Himachal Futuristic 1.82 UTI Sector- Services (9.48%), Taurus
Communications Ltd. Discovery Stock (10.45%)
Global Tele-Systems Ltd. 1.81 UTI US 92 (7.02%), ING Growth
Portfolio (3.8%)
Zee Telefilms Ltd. 1.70 UTI Sector- Services (7.21%), ING
Growth Portfolio (10.06%),
Infosys Technologies Ltd. 1.54 ING Growth Portfolio (20.5%),
Alliance New Millennium (11.5%)

As can be seen, some of the stocks are too volatile and can cause wild movements in the
NAVs of funds that have taken exposures in them. The standard deviation of the returns
in some of these funds points to it. While Alliance Equity Fund has a Standard Deviation
of 2.53, Birla Advantage has its Standard Deviation at 2.57. ING Growth has a standard
deviation of 3.3, which is relatively high due to its exposure to two volatile ICE scrips.
Birla Advantage has reduced its exposures to Infosys drastically in the last two months
and taken steps to contain volatility. Similar steps are being planned by SBI Mutual Fund
that is recasting its equity portfolio to reduce risks as they can scare investors.

It is unfortunate that the fund managers are not taking due care for minimizing the risk
and are in a race to post higher and higher returns during the phase of bull-run. They
should understand that the investors forget the high returns posted in any specific period
very soon but they take hell lot of time to forget the burns they get during periods of
losses. Hence for maintaining the confidence of the retail investors it is very important to
control wild fluctuations in the NAVs. The basic technique of portfolio management
thrusts on diversification, which preaches inclusion of negative beta, stocks in the
portfolio so as to minimize the impact of fluctuation in the market. Diversification always
has a cost and investors are willing to pay for it if it is properly done. The fund manager
should disclose what they are doing at the hedging front. They should come up and tell
their investors as to what they do at times of high fluctuations. Normally it has been seen
that they outperform the broad market indices during the bull-runs and under-perform the
indices during the bear-phases. The industry needs to revise their attitude and try to
streamline their actions with their objectives. Some mutual fund houses are quite
disciplined but every body should embrace the same spirit. There are some infrastructural
problems but fund managers need to be more vigilant on the market movements. Mr.
Bhupinder Sethi, Fund Manager - Dundee Mutual Fund said ‘We are actively monitoring
the market movements and taking calls accordingly. Though we are presently not using
derivatives for hedging of risk because of lack of depth in the market for the product, but
we go into cash when we see the expectations of huge corrections coming in.’

Poor performance, poor servicing to clients and failure of third party service providers,
are the three major risk factors identified in the survey by PWC. These are also going to
be crucial in a rapidly growing competitive scenario. Under this setting, it is not just
growth that should be the focus area but also better management of all risks and hence,
AMCs would do well to keep the investor and his interest in mind before taking any
decision.

Source : Mutualfundsindia Research Team,

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There are a number of attractive mutual funds and fund managers that have performed
very well over both long-term and short-term horizons. Sometimes, performance can be
attributable to a mutual fund manager's superior stock-picking abilities and/or asset
allocation decisions. In this article, we'll summarize how to analyze a mutual fund's
portfolio and determine whether there are specific performance drivers.

Portfolio Analysis
All mutual funds have a stated investment mandate that specifies whether the fund will
invest in large companies or small companies, and whether those companies exhibit
growth or value characteristics. It is assumed that the mutual fund manager will adhere to
the stated investment objective. It's a good start to understand the fund's specific
investment mandate, but there is more to fund performance that can only be revealed by
digging a bit deeper into the fund's portfolio over time.

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1. Sector Weights
Sometimes fund managers will gravitate toward certain sectors either because they
have deeper experience within those sectors, or the characteristics they look for in
companies force them into certain industries. A reliance on a particular sector may leave
a manager with limited possibilities if they have not broadened their investment net.(To
learn more, read Words From The Wise On Active Management.)

To determine a fund's sector weight, we must either use analytical software or sources
like Yahoo! or MSN. Regardless of how the information is obtained, the investor must
compare the fund to its relevant indexes to determine where the fund manager increased
or decreased his allocation to specific sectors relative to the index. This analysis will shed
light on the manager's over/underexposure to specific indexes (relative to the index) in
order to gain additional insight on the fund manager's tendencies or performance drivers.

The analysis can be as simple as listing the fund and relevant indexes side by side with a
breakdown by sector. For example, for a large cap manager, the simplest way to
determine sector reliance is to place the fund's sector breakdown next to both the S&P
500 Growth Index and the S&P 500 Value Index. Both of these indexes exhibit unique
sector breakdowns because certain sectors routinely fall into the value category, while
others fall into the growth category. Technology, known more as a growth sector, will
have a higher weight in the S&P Growth Index than in the S&P 500 Value Index.
Industrials, on the other hand, known as a value sector, will have a higher weight in the
S&P 500 Value Index than in the S&P 500 Growth Index. A comparison of the fund
relative to the sector breakdown of these two indexes will indicate whether the fund is in
line with its stated mandate and reveal any over/under allocations to a specific
sector. (For more insight, read Benchmark Your Returns With Indexes.)

The key to this analysis is to perform it on both current as well as historical data in order
to identify any tendencies the fund manager may have. (To learn more, read Shifting
Focus To Sector Allocation.)

2. Attribution Analysis
There are fund managers who claim to have a top-down approach and others that claim to
have a bottom-up approach to stock-picking. Top-down indicates that a fund manager
evaluates the economic environment to identify global trends and then determines which
regions or sectors will benefit from these trends. The fund manager will then look for
specific companies within those regions or sectors that are attractive. (To learn more,
read Build A Model Portfolio With Style Investing.)

A bottom-up approach, on the other hand, ignores, for the most part, macroeconomic
factors when searching for companies to invest in. A manager that employs a bottom-up
methodology will filter the entire universe of companies based on certain criteria, such as
valuation, earnings, size, growth, or a variety of combinations of these types of factors.
They then perform rigorous due diligence on the companies that pass through each phase
of the filtering process.

In order to determine whether a fund manager is actually adding any value to

performance based on asset allocation or stock picking, an investor needs to complete an
attribution analysis that determines a fund's performance driven by asset allocation versus
performance driven by stock selection. Attribution analysis, for example, can reveal that
a manager has placed incorrect bets on sectors but has picked the best stocks within each
sector. Using this example, this manager should have a bottom-up approach. If the
manager's mandate describes a top-down methodology, this might be a cause for concern
because we've discovered that the fund manager has done a poor job of asset allocation
(top-down).

Let's look at a five-sector portfolio as an example:

In the tables below, we compare a mutual fund portfolio with its relevant benchmark and
identify how much of the portfolio's performance was attributable to asset allocation
(sector weights) versus how much was attributable to superior stock picking.
 Portfolio
-- Weight Return Contribution
Sector 1 0.30 4.2 1.26
Sector 2 0.20 3.7 0.74
Sector 3 0.30 6.2 1.86
Sector 4 0.10 3.0 0.3
Sector 5 0.10 2.2 0.22
Total: 4.38

Benchmark
Overweigh
-- Weight Return Contribution Performance
t
Sector
0.20 6.2 1.240 0.10 -2.0
1
Sector
0.30 3.5 1.050 -0.10 0.2
2
Sector
0.20 3.7 0.740 0.10 2.5
3
Sector
0.15 1.5 0.225 -0.05 1.5
4
Sector
0.15 2.0 0.300 -0.05 0.2
5
Total: 3.550 Total: 0.83

Attribution
-- Selection Allocation Interaction
Sector 1 -0.400 0.620 -0.200
Sector 2 0.060 -0.350 -0.020
Sector 3 0.500 0.370 0.250
Sector 4 0.225 -0.075 0.075
Sector 5 0.030 -0.100 0.010
Total: 0.415 0.465 --

Active Management Effect 0.880

Error -0.055
 Overperformance 0.825

In the first chart, we see the sector weights for the fund's portfolio for each of five
sectors. The second column in that chart shows the return of each sector within that
portfolio, and the third column calculates the contribution of each sector to the fund's
total return (weight x return).

• Step 1: Determine the sector weights for both the fund and the index.
• Step 2: Calculate the contribution of each sector for the fund by multiplying the
sector weight by the sector return. Repeat for the index.
• Step 3: Calculate the rate of return for the fund by adding the contribution of each
sector together. Repeat for the index. In this case, the fund had a return for the
period of 4.38%. The second chart shows the same calculations for the relevant
benchmark. We could see that the total return for the benchmark was 3.55% and
that the fund outperformed the benchmark by 0.83%. (To learn more, read
Benchmark Your Returns With Indexes.)
• Step 4: Calculate the overweight amount by subtracting the index weight for each
sector from the fund weight for each sector.
• Step 5: Calculate performance by subtracting the index return for each sector from
the fund return for each sector. Notice that the fund had a 30% weight to Sector 1
while the benchmark only had a 20% weight. As such, the fund manager over
allocated to this sector assuming it would outperform. We can see from the return
of 4.2% for Sector 1 within the fund was 2% less than the return for the same
sector within the benchmark. Now this might get a bit tricky: The fund manager
made the correct choice of allocating to Sector 1 as the sector for the benchmark
had a return of 6.2%, the highest of all five sectors; however, the security
selection within the sector was not very good and therefore the fund only had a
4.2% return.
• Step 6: Calculate the selection attribution by multiplying the benchmark weight
with the difference in performance.
• Step 7: Calculate the allocation attribution by multiplying the index return for
each sector by the overweight amount.
• Step 8: Calculate the interaction by multiplying the overweight column by the
performance column.

The third chart shows the calculation of both allocation and security selection
contribution. In this example, the manager contribution to performance for overweighting
Sector 1 was 0.62% but the manager did a poor job of security selection, which resulted
in a contribution of -0.4%.

The last chart shows the active management effect of positive 0.88% minus the
unexplained portion of -0.055, resulting in active management contribution of 0.825%.

As you can see, this information is very useful to determine whether a manager is driving
performance through asset allocation (top-down) or security selection (bottom-up)
analysis. The results of this analysis should be compared to the fund's stated mandate and
the fund manager's process.

Conclusion
There are many other factors to consider when analyzing a mutual fund's portfolio. By
analyzing the sector weights of a fund and the fund manager's attributions to
performance, an investor can better understand the historical performance of the fund and
how it should be used within a diversified portfolio of other funds. An investor can also
break down the portfolio into market cap groupings and determine whether the fund
manager is particularly skilled at picking companies with certain size characteristics.

Whichever factor or characteristic an investor wants to analyze, the results can provide
valuable insight into a manager's skill and further enhance the investor's portfolio
construction process. Ideally, an investor would want a mix of good allocators and good
stock pickers, as well as fund managers with different levels of expertise in certain
sectors. This type of analysis, although time consuming, can provide the information
required to properly construct a portfolio.

Source: Investopedia.com, by Arturo Neto,CFA (Contact Author | Biography)

Arturo Neto Jr., CFA, is president of Neto Financial Group.