Wealth management for HNIs: Products and processes by leading Public and Private sector banks in India The

Functioning of Investment Advisory Units (IAU)

Contents Introduction Asset Classes Asset classes in the Indian wealth management divisions: Mutual funds

Ranking of Mutual Funds: Process and parameters used Investment Advisory Units: Ranking of Mutual Funds, Review and Monitoring

Introduction

The Investment Advisory Units is the second vertical of the wealth management division, functioning as the backbone of the division. It performs the crucial function of determining the asset classes to be considered for making the clients portfolio by the wealth management division. While there are several asset classes that can be used to design the clients portfolio like equity, debt instruments, precious mental, real estate and art, in the Indian scenario the most popular asset class considered by the Wealth management Division are Mutual Funds. Mutual funds may be defined as a way of mobilizing savings of many investors by pooling together their resources and using this to for investing in resources in accordance to the objectives of the scheme. In India, the regulator, Securities & Exchange Board of India (SEBI) has mandated strict checks and balances in the structure of mutual funds and their activities, which are detailed in the subsequent units. Mutual fund investors benefit from such protection.

Asset Classes

A number of asset classes are available to the portfolio manager today to design his clients portfolio. However, a brief which some like fixed income securities, equity and commodities have traditionally been very popular for investors, new asset classes like mutual funs, real estate, structures products and art are now among the asset classes they fall into two broad categories, Assets are categorized into two types: financial assets and real assets. Financial assets are intangible or non-physical assets deriving value from underlying contractual obligations like equities, fixed income securities or bonds (corporate bonds and government securities). Real assets are represented by physical or tangible assets such as residential property, semi urban lands, commercial property, agricultural farms, precious objects, art pieces etc.

The major investment classes in India are1:

1.

Debt as an asset class: Debt instruments includes Fixed deposits, Fixed-income

securities issued by Governments, Government agencies, State governments, Corporates, Financial institutions, Municipalities etc., Debt funds like Gilt funds (funds which invest in government securities), Short-term debt funds, Liquid funds, Floating rate funds, Small saving schemes like National savings certificates, Recurring deposit accounts, Postal savings schemes, Kisan vikas Patra and Provident funds. Fixed income instruments contractually include predetermined payment schedules that usually include interest and principal payments. The payment amounts may be prespecified or they may vary according to a fixed formula that depends on the future values of an interest rate or a commodity price. Cash can be invested over a given period to generate interest income in a range of highly liquid or easily redeemable instruments, from bank deposits, negotiable certificates of deposits, commercial paper (short term corporate debt) and Treasury bills (short term government debt) to money market funds which manage cash resources across a range of domestic and foreign markets. Returns on cash are driven by general demand for funds in an economy, interest rates, and the expected rate of inflation. Investors can keep their money in the form of fixed deposits with banks, which time deposits offer a fixed rate of interest for a definite time period. Fixed deposits are safe instruments assuring modest returns. Fixed-income securities are financial claims issued by governments, government agencies, state governments, corporations, municipalities, banks, and other financial intermediaries. The cash flows promised to the buyers of fixed-income securities represent contractual obligations of the respective issuers. Debt securities offer a predictable stream of payments by way of interest and repayment of principal at the maturity of the instrument, with most debt securities carrying a fixed charge on the assets of the entity and generally enjoying a reasonable degree of safety by way of the security of the fixed and/or movable assets of the company. Debt funds are mutual funds that invest in debt instruments. There can be a variety of debt funds depending upon the instruments they primarily invest in. So there are short-term funds, long-term funds, gilt funds, etc.
The following discussion on asset classes is based on McMillan, M.G.; Pinto, Jerald, E.; Wendy, L.P. & Gerhard, V. V. et al. (2011). Investments: Principles of portfolio and equity analysis. USA: John Wiley & Sons, Inc.; Dun & Bradstrret (2009). Wealth management. New Delhi: Tata Mc Graw Hill; www.sebi.gov.in
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Small saving schemes help to promote savings among masses. Such schemes are usually floated by government or government agencies. The rate of interest is less, but then there are tax exemptions on interest earned.
2. Equity as an asset class: Equity represents an important asset class in most portfolios

and is often referred to as the default asset class. This implies that while constructing portfolios, this is the asset class which cannot be just ignored. Equities consists of shares in a company representing the capital originally provided by the shareholders. An ordinary shareholder owns a proportional share of the company and an ordinary share carries the residual risk and rewards after all the liabilities and costs have been paid. Ordinary share have the right to receive income in the form of dividends (once they are declared) and any residual claim on the companys assets once its liabilities have been paid in full. Another type of share capital is preference shares. They differ from ordinary shares in that the dividend on a preference share is usually fixed at some amount and does not change. Preference shares also do not carry voting rights and in the case the firm fails, preference shareholders are paid before ordinary shareholders. The return comes in the form of dividends and through appreciation in the price of the shares. However, this is also the most risky asset class as equity capital is permanent/non-redeemable capital and the payment of dividends is also discretionary, to be paid only when the company earns profits. However, even then the director have the discretion to decide whether dividend is to be paid and by how much. Even if the dividend yield is low, the shareholders may earn enough return through capital appreciation. Like any other investment, equity investment too has both positive and negative sides. The positive side includes attractive characteristics that are so unique to this asset class alone like the phenomenal capital appreciation in short period, possibility of obtaining bonus shares, high dividend-paying companies, rights issue, voting rights for all the stockholders, and high degree of marketability and loan ability of the stock across the country. However, there are many shortcomings of investments in equity, including a tremendous element of uncertainty and daily fluctuation of the stock prices. There are also other difficulties associated with equity markets including the lack of certainty to get allotted the shares of a sound company, as its initial public offering (IPO) may get oversubscribed several times more than the size of the offer.

Again, equity is residual capital, meaning that claims of equity holders can be satisfied after claims of all others, such as government, employees, lenders, creditors, etc., are satisfied. Hence, equity holders take maximum amount of risk. However, an important point in this case is that differentiation between the liability of shareholders and that of owners of partnership etc. is that shareholders have a limited liability. This means that the owner of a stock is not personally liable if the company is not able to pay its debts. In case of partnerships, on the other hand, if the partnership goes bankrupt, the creditors can hold the partners (shareholders) personally liable and sell off their houses, car, furniture, etc., to realize their dues. Owning stock means that no matter what, the maximum value a shareholder can lose is the value of his investment. Even if company goes bankrupt, the shareholder can never lose his personal assets. It must also be noted that share prices are highly volatile and keep changing as per markets perception about a particular company. Just as there is not upward limit to which share prices can go, there is no downside limit as well. Hence, shareholders may loose substantial or entire part of their part of their investments if share prices go down. Stocks are typically grouped into four categories based on the risk profile of the investors. There are: Defensive stocks (low risk-low return), Blue chips (average risk-average return), Growth stocks (above average in risk and returns), Turnaround stocks (high risk-high return) It is beneficial for low risk takers to invest in blue chips and follow a buy-and-hold policy for some time. Medium risk takers tend to select the growth stocks and wait for the medium term of 1-3 years. A reasonably aggressive strategy is suggested for them. High risk takers need to aim at a span of about a year or less and to take very bold decisions. The main purpose of analyzing a stock is to predict the future stock or business performance.The investment decision-making process is carried out while investing in the stocks in three major ways: Fundamental analysis (what to buy); Technical analysis (when to buy); Quantitative analysis (tools to be used). Fundamental analysis focuses on analyzing the economy, industry and the company. In this analysis, we proceed from the aggregate economic analysis (macroeconomic analysis) to the industry analysis, and further to the disaggregate level of company analysis. It may be done either through a top-down approach or bottom-up approach. A top - down analysis begins with consideration of macroeconomic conditions. Based on the current and forecasted economic environment, analysts evaluate markets and industries with the purpose of investing in those that are expected to perform well. Finally, specific companies

within these industries are considered for investment. On the other hand, rather than emphasizing economic cycles or industry analysis, a bottom-up analysis focused on company-specific circumstances, such as management quality and business prospects. It is less concerned with broad economic trends than is the case for top down analysis, but instead focuses on company specifics. Thus, the top-down approach studies the economic factors like consumer demand (consumer expenditure, consumer sentiment), percentage change in business investments, percentage change in government expenditure, changes in net exports, change in inventories, rte of unemployment, inflation, and fiscal (government receipts and expenditure) and monetary policies (interest rates). Based on this analysis, projections for the next few years are made and accordingly the securities to be chosen are determined. The top down view can be combined with the bottom up insights of security analysts who are responsible for identifying attractive investments in particular market sectors. They will use their detailed knowledge of the companies and industries they cover to assess the expected level and risk of the cash flows that each security will produce. This knowledge allows the analysts to assign a valuation to the security and identify preferred investments Security analysts usually classify the state of economy into four phases, namely the Over heat (high growth, high inflation), Sort landing (low growth, low inflation), Hard landing (low growth, high inflation), and Recovery (high growth, low inflation). This is used for determining the stock market outlook. For example, during soft landing, the stock market outlook would be positives with low interest rate and rising earnings. The outlook is said to be negatives when the uncertainty is high. The goal of stock analysis is to find the outliers. Stocks within industries and industries within sectors tend to move together. Buy/sell stocks that will rise/fall more than the industry and sector. Growth and value stocks are analyzed differently using business, financial and valuation factors. Stocks are identified more or less based on type of stock, underweight and overweight. Right timing for entry and exist is something that an investor comes to know generally from experience and intuition. A small lapse in the entry/exist timing itself could prove to be a very costly mistake. Technical analysis helps in identifying the right entry/exist points. Quantitative analysis determines the best asst, style and sector to buy is based on a combination of top-down, bottom-up, fundamental, technical and quantitative analysis are used. Top-down

and bottom-up analyses are used for stock picking, while for timing of entry and exist technical analysis is used. By narrowing the universe, a small set of securities depending on their riskreturn attributes is finally chosen. Quantitative analysis tries to use econometric and time series models to study the historical behavior of security prices and use models to generate forecast of security prices. 3. Real Estate as an Asset Class Another important asset class, which has recently become an important part of High Net Worth Individuals portfolio, is real estate. One of the prime assets for individual investor is generally a residential house. In addition to this, the more affluent investors are likely to be interested in other types of real estate like commercial property, semi-urban land, agricultural land, and timeshare in a holiday resort. While real estate is an important asst class, it is generally not available to investors in India, except through direct ownership of properties. Investment in real estate provides opportunity for capital gains as well as periodic incomes. Over a longer term, real estate provides returns that are comparable with returns on equities. The volatility in prices of real estate is lower than equities leading to a better risk-return trade off for the investment. Real estate investments made over long periods of time provide an inflation hedge and yield real returns. However, real estate is distinct form other assets. The real estate investments are lumpy in nature and unaffordable to many. The specific risk is high and personal diversification is very difficult. The legal issues and lack of transparency make the probability of a mistake high. The illiquid nature of the markets makes the undoing of a wrong real estate investment a tedious and painful process. Distress sales generate much lower returns than the fair value of the property. Professional management attempts to limit the risks in real estate investment and, at the same time, bring in such advantages as legal expertise, information on prices and regular maintenance and repairs. Real estate investment schemes provide affordability to small investors enabling their participation in the property market. They help investors to diversify their investment portfolio across various asset classes and reduce the property specific risk. The benefits include professional management and liquidity for the investment. Real Estate Investment Trusts (REITs) have been in existence in the United States of America since 1960. In the beginning, REITs were constrained because of the limited permission to own real estate and no operate or manage it. The provision of the tax code which made real estate

investment tax shelter-oriented also hindered the growth of REITs. The Tax Reform Act of 1986 reduced the potential for real estate investment to generate tax shelter opportunities and permitted the REITs to also operate and manage most type of income producing commercial properties. REITs became a popular way of accessing the capital markets during the early 1990s when property value dropped between 30-50%. While the sector experienced credit crunch, REITs became the source of capital to many private real estate companies and a convenient mode for investors to gain exposure to the sector. There are about 190 publicly traded REITs in the US and registered with the SEC, with assets totaling over $ 500 billion. In the United Kingdom, real estate investments are done through pooled managed vehicles (PMVs), which are in the form of trusts, having a variable capital and are similar to open-ended funds, PMVs may get tax benefits based on the investor profile. REITs are a relatively new entrant in the Asia Pacific region in Singapore, Malaysia, Hong Kong, Taiwan, Korea and Thailand. In India, the Association for Mutual Funds of India (AMFI) formed a Sub-Committee to formulate a working plan for launching Real Estate Investment Schemes based on the recommendations of the Satwalekar Committee on Real Estate Funds. The Satwalekar Committee conducted a detailed study and prepared an exhaustive report on the above subject. The SEBI Advisory Committee on Mutual Funds also discussed the issues and concerns pertaining to real estate funds. Later on, the matter was placed before the board of SEBI also. Considering the procedural and regulatory convenience, it was felt that real estate mutual fund scheme (REMFS) should be launched first. Accordingly, in 2008 SEBI has amended SEBI (Mutual Funds) Regulations, 1996 to permit mutual fund to launch REMFS. A real estate mutual fund scheme can invest in real estate assets in the cities mentioned in (i) List of Million Plus Urban Agglomerations/Cities; or (ii) List of Million Plus Cities which appear in Census Statistics of India (2001)2.
4. Mutual Funds as an Asset Class

Mutual fund is a mechanism for pooling resources by issuing units to investors and investing funds in securities in accordance with objectives as disclosed in offer document. Simply put, a mutual fund is nothing more than coming together of a group of investors who contribute different sums of money to make up a large lump sum. Mutual Funds are thus vehicles to
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notification dated April 16, 2008, has stated that May 2, 2008 it was futher clarified that

mobilise money from investors, to invest in different avenues, in line with the investment objectives of the scheme. The money collected is invested by the fund manager in stocks, bonds, and other securities across companies, industries, and sectors and in some cases, across countries as well. Mutual fund issues units to the investors in accordance with quantum of money invested by them. Investors of mutual fund are known as unit holders. The unit holders receive interest/dividends and capital appreciation. Mutual funds are constituted as public trusts in India. These are set up for the benefit of the unit holders, who are the owners of the fund. Unlike other investments, mutual fund is not an investment in itself but just a vehicle to help an investor access various investment options discussed earlier. Investors pull their money and invest in a mutual fund. The money in the fund is managed by an entity called Asset Management Company (AMC). The AMC invests the funds money in line with the schemes objectives. The AMC is promoted by sponsors. Since the mutual fund is a trust, there are trustees who oversee the management of the fund. Their job is to ensure the funds money is managed in the best interest of the investors and as mandated by the scheme objectives. Majority of trustees are independent of the sponsors of the AMC. The scheme earns returns through investment in various avenues. These returns are passed on to the investors in form of either distribution of dividends or growth of capital. The AMC collects its professional fees for managing the funds money. SEBI, the securities market regulator, has issued detailed guidelines and regulations for protection of investor interests and regulated and orderly growth of mutual fund industry. Professional expertise along with diversification becomes available to an investor through Mutual Fund route of investment. Through mutual funds one can invest almost in all categories of assets. Diversification reduces the risk because not all stocks may move in the same direction ion the same proportion at the same time. The investors in proportion to their investments share the profits or losses. The mutual funds normally come out with a number of schemes with different investment objectives, which are launched form time to time. A mutual fund is required to be registered with the regulator, which regulates security markets, before it can collect funds from the public. A key advantage of mutual funds is the diversification it allows. A single mutual funds can hold securities from hundreds or even thousands of issuers, far more than most investors could afford on their own. This diversification sharply reduces the risk of serious loss due to problems in a

particular company or industry. Moreover, it also allows the investors to take advantage of professional management of funds. Only few investors have the time or expertise to manage their personal investments every day to efficiently reinvest interest or dividend income, or to investigate the thousand of securities available in the financial markets for which they prefer to rely on a mutual funds investment adviser. the fund. Another key advantage of mutual funds is the liquidity it offers. Shares in a mutual fund can be bought and sold on any business day. Therefore, investors have easy access to their money. While many individual securities can also be bought and sold readily, others are not widely traded. In those situations, it could take several days or even longer to build or sell a position. Mutual funds also offer services that make investing easier. Fund shares can be bought or sold by mail, telephone, or the Internet, and therefore you can easily move your money from one fund to another, as financial needs change. Most major fund companies offer extensive record-keeping services to help you track your transactions, complete your tax returns, and your funds performance. Given that mutual funds are able to take advantage of their buying and selling size and thereby reducing the transaction cost for investors. When you buy unit of a mutual fund, you are able to diversify without the numerous commission charges. A possible disadvantage of mutual funds is dilution. Because funds have small holdings in so many different companies, high returns from a few investments often do not make much difference on the overall return. Dilution is also the result of a successful fund getting too big. When money pours into funds that have had strong success, the manager often has trouble finding a good investment for all the new money. Again, mutual funds are like many other investments without a guaranteed return. There is always a possibility that the value of your mutual fund will depreciate. Unlike fixed-income products, such as bonds and treasury bills, mutual funds experience price fluctuations along with the stock that make up the fund. Another disadvantage of mutual funds is the difficulty they pose for investors interested in researching and evaluating the different funds. Unlike stocks, mutual funds do not offer investors the opportunity to compare the P/E ratio, sales growth, earnings per share, etc. A mutual funds net asset value gives investors the total value of the funds portfolio excluding liabilities. There are professional independent companies who track the mutual fund With access to extensive research, market information and skilled security traders, the adviser decides which securities to buy and sell for

NAV data and provide ranking on the performance of different fund houses and schemes. Their reports are based on analysis of the returns based on certain criteria and methodology. Also, Mutual funds provide investors with professional management; however, it comes at a cost. Funds will typically have a range of different fees that reduce the overall payout. is structured, it may be open to accept money from investors, either during a limited period only, or at any time. The investment that an investor makes in a scheme is translated into a certain number of Units in the scheme. Thus, an investor in a scheme is issued units of the scheme. Under the law, every unit has a face value of Rs10. (However, older schemes in the market may have a different face value). The face value is relevant from an accounting perspective. The number of units multiplied by its face value (Rs10) is the capital of the scheme its Unit Capital. The scheme earns interest income or dividend income on the investments it holds. Further, when it purchases and sells investments, it earns capital gains or incurs capital losses. These are called realized capital gains or realized capital losses as the case may be. Investments owned by the scheme may be quoted in the market at higher than the cost paid. Such gains in values on securities held are called valuation gains. Similarly, there can be valuation losses when securities are quoted in the market at a price below the cost at which the scheme acquired them. Types of Mutual Funds Each of the Mutual Funds has an objective and terms of scheme stated in their Offer Document/ Key Information Memorandum, which every investor must go through, in order to check if his own needs and objectives match with the funds objectives. Mutual funds could invest in equity, bonds, short term income instruments, Gold or other precious metals, or Real Estate. Mutual funds could choose to invest in a mixture of above assets in any combination or could invest in any particular type of sector in that asset and have accordingly been named in accordance with the investment guidelines. A mutual fund scheme can be classified into open-ended scheme or close-ended scheme depending on its maturity period. In an open-end fund, investors continually buy and redeem shares when they add o withdraw their money from the fund. Open-end funds are required to establish a daily price for shares, called the net asset value (or NAV). Mutual fund companies are obligated to buy and sell shares at the current NAV daily. The reason why these funds are called open-end is because there is no limit to the number of new shares that they can issue.

New and existing shareholders may add as much money to the fund as they want and the fund will simply issue new shares to them. Open-end funds also redeem, or buy back, shares from shareholdes. A closed-end-fund issues a fixed number of shares to raise capital, similar to selling stock in IPOs. After the initial offering, the closed-end funds shares trade on the Stock exchange or over the counter. Unlike open-end funds, closed-end funds are not obligated to issue new shares or redeem outstanding shares. The price of a share in a closed-end fund is determined entirely by market demand, and therefore shares can either trade below their NAV (at a discount) or above it (at a premium). Because of the volatility of prices, timing is more important for purchasing a closed-end fund than it is for purchasing an open-end fund. Since you must take into A per consideration not only the funds NAV but also the discount or premium at which the fund is trading, closed-end fund are considered more suitable for experienced investors. regulations, at least one of the two exist routes is provided to the investor, i.e., repurchase facility or through listing on stock exchanges. These mutual fund schemes disclose NAV generally on weekly basis. There are advantages and disadvantages to each type of fund. The open-end fund structure makes it easy to grow in size but creates pressure on the portfolio manager to manage the cash inflows and outflows. One consequence of this structure is the need to liquidate assets that the portfolio manager might not want to sell at the time to meet redemptions. Conversely, the inflows require finding new assets in which to invest. As such, open-end funds tend not to be fully invested but rather keep some cash for redemptions not covered by new investments. Closed-end funds do not have these problems, but they do have a limited ability to grow. A scheme can also be classified as growth scheme, income scheme, or balanced scheme considering its investment objective. Such schemes may be open-or-close-ended schemes as described earlier. Such schemes may be classified mainly in the following manner:
I.

Growth /equity-oriented scheme. The aim of growth funds is to provide capital

appreciation over the medium to long term. These funds invest in equities and depending on the type of equities these funds have been further classified as, a) Growth funds, b) Value funds, c) Dividend Yield funds, d) Large Cap funds, e) Mid Cap or Small Cap funds, f) Speciality funds or Sector funds, g) Diversified Equity funds and h) Equity Index funds. Certain equity funds have tax benefit under section 80C of the Income-tax Act, 1961 and have a lock in period of

three years. These are Equity Linked Savings Schemes popularly called as ELSS. These funds have higher risk, but potential for higher returns. These schemes provide different options to the investors like dividend option, capital appreciation etc. and the investors may choose an option depending on their preferences. The investors must indicate the option in the application form. The mutual funds also allow the investors to change the options at a later date. Growth schemes are good for investors having a long-term outlook seeking appreciation over period of time.
a) Growth funds: These funds invest in the growth stocks, which is stocks that exhibit and

promise above average earnings growth. Managers using the growth style select stocks which are normally quite high profile. Such stocks being high growth are more visible and also have high investor interest. Due to this, the stocks may appear to be costly on historical valuation parameters. However, the high valuation is justified by the expected high future growth.
b)

Value funds: Such stocks are generally out of favour with most investors in the market

and hence the market price is low as compared to the inherent value of the business. The value style managers generally hold the stocks for longer time horizon than their growth style counter parts.
c)

Dividend yield funds: One of the valuation parameters a value style fund manager looks

for is high dividend yield. However, there is a category of funds that consider this one parameter as the most important factor to select stocks. As compared to other parameters of considering value, dividend is believed to be more reliable as it involves cash movement from the company account to the share holder account and hence there is no room for any subjectivity.
d)

Large cap funds / Mid cap funds / Small cap funds: Equity mutual funds can be

classified based on the size of companies invested in. In capital market terms, the size of the companies is measured in terms of its market capitalisation, which is the product of number of outstanding shares and the market price. It also denotes the price the market is willing to pay to buy the entire company. Larger the market capitalisation, larger the company. In popular usage, the word market capitalisation is referred to as cap. Fund investing in stocks of large companies are called Large Cap Funds and those investing in stocks of midsized companies are called Small Cap Funds.
e)

Speciality / sector funds: Certain funds invest in a narrow segment of the overall

market. The belief here is that stocks in similar industry move together, as companies in such

sectors are similarly impacted due to some factors. There are funds that invest in stocks of only one industry, e.g. Pharma Funds, FMCG Funds or broader sectors, e.g. Services Sector Fund or Infrastructure Fund. Similarly, there could be thematic or speciality funds that invest based on some common theme, e.g. PSU Funds or MNC Funds. Most advisors recommend that an investor would be better off keeping the exposure to such funds limited. These funds are more suitable for aggressive and savvy investors.
f)

Diversified equity funds: These funds invest in stocks from across the market

irrespective of size, sector or style. The fund manager has a greater freedom to pick up stocks from a wider selection. Most advisors advise investors to have diversified funds as core part of their portfolio. These funds, being diversified in nature, are considered to be less risky than thematic or sector funds.
g)

Index funds. These are funds that replicate the portfolio of a particular index such as the

BSE Sensitive Index, S&P NSE 50 Index (Nifty), etc. These schemes invest in the securities in the same weightage as the securities have in the index. NAVs of such schemes would rise or fall in accordance with the rise or fall in the index, though there may be a small difference due to tracking error. Necessary disclosures in this regard are made in the offer document of the mutual fund scheme. There are also exchange-traded index funds launched by the mutual funds, which are traded on the stock exchanges. These are also called Exchange Traded Funds (ETFs).
2. Income/debt-oriented scheme. The aim of income funds is to provide regular and steady

income to investors. Such schemes generally invest in fixed-income securities such as bonds, corporate debentures, government securities, and money market instruments. Such funds are less risky compared to equity schemes. These funds are not affected by the fluctuations in equity markets. However, opportunities of capital appreciation are also limited in such funds. The NAVs of such funds are affected because of change in interest rates in the country. If the interest rates fall, NAVs of such funds are likely to increase in the short run and vice versa. However, long-term investors may not bother about these fluctuations. These funds can further be categorized as, a) Diversified Debt funds, b) Short Term Debt funds, c) High Yield Debt funds, d) Fixed Term Plans, e) Gilt Funds, f). Money Market or Liquid Funds
a. Diversified Debt Funds: These funds invest in a diversified basket of debt securities.

They can invest in debentures issued by Government, companies, banks, public sector

undertakings, etc. The objective of these schemes could be to provide safety of capital and regular income. At the same time, some funds may also have an objective of generating higher returns than traditional debt investments. This objective can be achieved by proper management of certain risks, viz. credit risk, interest rate risk or liquidity risk.
b.

Short Term Debt Funds In order to reduce interest rate risk, some funds are mandated

to invest in debt securities with short maturity, generally less than three years. Such funds earn large part of returns in form of interest accrual and are less sensitive to interest rate movements. These funds may or may not take liquidity and credit risks. These funds have the potential to earn higher than liquid funds but the NAVs of these funds also exhibit some degree of volatility. At the same time, the volatility is likely to be much lower than diversified debt funds.
c.

High Yield Debt Funds: High quality (those having high credit rating) debt securities

offer low interest rates and hence some investors are not happy with such low returns. They are willing to take some risk without getting exposed to the risk of equity. High yield debt funds are ideally suited for such investors. These funds invest in debt securities with lower credit rating. The lower rating ensures the securities offer higher interest rates compensating the investor for the extra risk taken.
d.

Fixed Term Plans: As seen earlier, debt funds are subject to interest rate risk and the

NAVs of these funds fluctuate if the interest rates change. Investors willing to hold the investments for a defined term face the risk when they need to take the money out of the scheme. If there was an option where the investors risk could be reduced as the withdrawal time approaches, it serves a major purpose for the investor. Fixed term plans, popularly known as FMPs (Fixed maturity plans), have a defined maturity period; say 3 months, 6 months, 1 year, 3 years, etc. The maturity of the debt securities in which the fund invests, and the maturity of the scheme are almost the same. Hence, when the scheme matures and money has to be returned to the investors, the fund does not have to sell the bonds in the market, but the bonds themselves mature and the fund gets maturity proceeds. Since the fund does not have to sell the bonds in the market, the fund is not exposed to interest rate risk. These are close-ended debt funds. The units of these funds have to be listed on a stock exchange to provide liquidity to the investors. These funds are ideally suitable for investors who know the time when they will need the money and also do not need money before the maturity of the FMP.

e.

Gilt Funds: These funds invest in government securities. Since the funds invest largely

in the securities issued by Government of India, the credit risk can be assumed to be nonexistent. However, these government securities, also called dated securities, may face interest rate risk, which means as the interest rates rise, the NAV of these funds fall (and vice versa). The NAVs of these funds could be highly volatile, if the maturity is long. These funds are also known as Government Securities Funds or G-Sec Funds.
f.

Money market or liquid fund. These funds are also income funds and their aim is to

provide easy liquidity, preservation of capital and moderate income. These schemes invest exclusively in safer short-term instruments such as treasury bills, certificates of deposit, commercial paper and inter-bank call money, government securities, etc. Returns on these schemes fluctuate much less compared to other funds. These funds are appropriate for corporate and individual investors as a means to park their surplus funds for short periods. These instruments in which Money Market Mutual Fund (MMMF) invests can be encashed at a short notice; capital is safe though returns are low. Post tax the returns from MMMF may be higher than keeping money in savings account in the bank. These are ideal for investors looking to park their short term surplus with an objective of high liquidity with high safety.
3.

Hybrid Funds: These are mixed equity and debt funds. Depending on the objective these

funds can be further classified as a) Balanced funds, b) Monthly Income Plans (MIP) and c) Asset allocation funds.
a.

Balanced funds: The most popular among the hybrid category, these funds were

supposed to be investing equally between equity and fixed income securities. However, in order to benefit from the provisions of the prevailing tax laws, these funds invest more than 65% of their assets into equity and remaining in fixed income securities. These funds are preferred by investors who seek the growth through investment in equity but are not very comfortable with the volatility associated with pure equity funds.
b.

Monthly Income Plans (MIPs): This category of funds invests predominantly in fixed

income securities with marginal exposure to equity. The fixed income component provides stability to the portfolio, whereas equity provides capital appreciation over long periods of time. Generally, 80% of the scheme corpus is invested in fixed income securities and the balance 20% in equity. However, the allocation could be different from the above. Recently, some fund houses have also launched schemes under this category that invest in equity, fixed income and

gold. These funds are ideally suitable for any investor who wishes to have steady growth of capital with the ability to beat inflation over long periods of time.
c.

Asset allocation funds: Asset allocation is a very important part of the investment plan.

Advisors have a choice of either constructing portfolios for their clients through careful selection of components. Alternately, they can also look at readymade solutions available in the form of Asset Allocation Funds launched by certain mutual fund companies. These funds are designed with certain investor profiles in mind and most of the fund houses also offer tools to match the investor profile with the various options under these funds.
4. Equity-linked Savings schemes. This category is well known. If features funds that have

to keep at least 80% of their funds invested in equity at all times. They also carry a threeyear lock-in-period. Every mutual fund has at least one open-ended equity-linked saving scheme (ELSS). Most of these schemes are diversified funds when it comes to where they invest, though there are a selected few which limit themselves to an index or adhere to some criteria. The lock-in-period is believed to lend stability to the fund as the asset manager gets more time to take long-term calls on his/her investment. The lock-in applies from the date of investment, for money invested in phases; the lock-in for units purchased each time applies from their respective date of purchase. Long-term capital gains on open-ended ELSS are nil. There is also no dividend distribution tax on open-ended ELSS.
5.

Loan fund vs. no-load fund. A load fund is one that charges a percentage of NAV for

entry or exit. That is, each time one buys or sells units in the fund, a charge will be payable. This charge is used by the mutual fund for marketing and distribution expense. Suppose the NAV per unit is Rs 10. If the entry as well as exist load charged is 1%, then the investors who buy would be required to pay Rs 10.10 and those who offer their units for repurchase to the mutual fund will get only Rs 9.90 per unit. The investors should consider the loads while making investment; as these affect their yields/returns. However, the investors should also consider the performance record of accomplishment and service standards of the mutual fund, which are more important. Efficient fund may give higher returns in spite of loads. 6. Exchange Traded Funds (ETFs): These funds combine the best features of open and closed mutual fund schemes, and trade like a single stock on stock exchange. Thus these funds can be purchased and sold at real time price rather than at NAV, which would be calculated at the end

of the day. These funds, available in India track indices (e.g. Nifty, Junior Nifty or Sensex) or commodities like Gold (Gold ETFs). Recently, active ETFs have also been introduced in Indian market. ETFs are very popular in other countries, especially USA. The biggest advantage offered by these funds is that they offer diversification at costs lower than other mutual fund schemes and trade at real time prices. Gold Funds are one of the most popular of exchange traded funds in India. These funds invest in gold and gold-related securities. The Gold Exchange Traded Fund, is like an index fund that invests in gold, the NAV of such funds moving in line with gold prices in the market. Gold Sector Funds i.e. the fund will invest in shares of companies engaged in gold mining and processing. Though gold prices influence these shares, the prices of these shares are more closely linked to the profitability and gold reserves of the companies. Therefore, NAV of these funds do not closely mirror gold prices 7. Fund of Funds (FOF): Mutual funds that do not invest in financial or physical assets, but invest in other mutual fund schemes, are known as Fund of Funds. Fund of Funds maintain a portfolio comprising of units of other mutual fund schemes, just like conventional mutual funds maintain a portfolio comprising of equity/ debt/money market instruments or non financial assets. There are different types of fund of funds, each investing in a different type of collective investment scheme. Fund of Funds provide investors with an added advantage of diversifying into different mutual fund schemes with even a small amount of investment, which further helps in diversification of risks.
5.

Strucutred Products as an Asset Class: Structured products are synthetic investment

instruments. They are created to meet specific needs that cannot be met from the standardized financial instruments available in the market. Structured products are used as an alternative to a direct investment. It is also used as a part of the asset allocation process to reduce risk exposure of the portfolio and used for current market trend analysis. Structured products typically result in a final product that is often nonstandard and structured to meet the specific financial objectives of a customer. There are usually two components for any structured products an at risk element, which is called an Alpha Generator, provides the high performance potential. This alpha generator can be a stock, an index, currencies, or commodities; an element of capital protection, usually a bond product. This bond element sets the time horizon and the level of capital protection offered

by the product. The alpha generator provides the enhanced performance potential. A lower risk, defensive structured product will allocate the majority of the investors capital to the bond element. A higher risk, aggressive product will use derivatives to increase the extent of alpha exposure. The endless combinations of fixed-income instruments and alpha generators mean that the structured product markets are highly diverse. There are otherleveraged-structures available for investors probing for higher returns (who are prepared to take on higher risk). These boost the potential returns of the basic zero structure by using derivatives. When a derivative product is used to leverage the amount of working capital available from the bond, increasing its risk/return profile, the combined product is usually called a synthetic bond. There are two main ways of increasing the amount of available working capital: Using notes and interest rate swaps: The fund issues a promissory note or letter of credit to receive capital and simultaneously enters into a zero-coupon swap. Capital received is then invested in the alpha generator, leveraging the investors total risk/return exposure. Using bond options: The small amount of working capital allowed by the zero-coupon bond is used to buy call or put options. Because an option contract allows you to gain exposure to the price behavior of an asset for a smaller sum (the premium) than the asset value you are exposed to, working capital can be leveraged several times. Options offer the benefit of using both long and short positions according to the market movements. This increases the attractiveness of using the options, as manager can generate more returns from the alpha generator irrespective of the market direction. The selection of instruments used to enhance returns is generally governed factors like interest rate, regulation environment, taxation issues, time horizon of the investor. The benefits of structured products can include principal protection, tax-efficient access to fully taxable investments, enhanced returns within an investments, reduced volatility (or risk) within an investment Structured products are classified as follows: Interest rate-linked notes. These are principal protected notes where the coupon and additional return are linked to performance of an underlying asset. The return is based upon the movement in a specific interest rate index such as LIBOR. These are particularly good for investors who seek the potential of increased yield with some credit protection.

Equity-linked notes. These instruments combine the characteristics of a zero-or-low coupon bond with that of equity. The return component consists of very low or nil interest payments plus equity returns based on performance of a single equity security, basket or equity securities, or an equity index. FX and commodity-linked notes. These are mainly structured as fixed-income products whose coupon or maturity payment is linked to performance of an underlying which may be a single foreign currency, a basket of foreign currencies, a single commodity, or a basket of commodities. They may provide principal protection if held to maturity or call. The maturity ranges from one to three years. Coupons are paid monthly, quarterly, semiannually, or only upon maturity.
6. Art as an Asset Class: Art includes works of creative imagination/ artifacts having

visible beauty. Objects that possess aesthetic appeal because their production requires skill, taste, talent, creativity, or imagination may be termed as art objects. Therefore, art objects mainly include paintings, sculptures, antiques, etc. The value of these art objects is a function of its aesthetic appeal, rarity, and reputation of the creator, fashion, or physical condition. Art objects are economic gods as they can be priced and become a public good when it becomes a part of a museum. Though unlike other financial assets it does not provide periodic cash flows, it definitely offers a capital appreciation over a period of time. While an active market in art is now fast emerging, art is a scarce product not easily and others. Markets for art objects may not be an efficient market. As the traded products are differentiated, art markets are often very thin with very few works of art of a specific artist traded each year. Market transparency is low with large differences in expertise between buyers and sellers, so that there is little liquidity and high transaction costs. The financial objective obviously is to earn returns above the rate of inflation in an asset class which is minimally correlated to the equity and debt market. In 2008, a time when the art funds first became visible in India, markets remained bullish for a time, fuelled by wealthy collectors and a steady supply of top-quality pieces by star artists. Edelweiss Securities launched the first art fund in the country in 2005. Christened the Yatra Fund, it is structured as a closed-end fund with a four-year maturity. However, a few years later, particularly in view of the collapse and failure of some of the world's blue chip art funds like Osian's Art Fund and Fernwood Art Investments, and the art market suffered a setback.

In 2008, when art funds entered the Indian market scenario, Securities and Exchange Board of India (SEBI) issued a public notice to warn the investors against putting their money into art funds or schemes of entities not registered with SEBI. Art Funds are Collective Investment Schemes as defined under the SEBI Act. Only a company which has been granted certificate of registration by the Board in accordance with the Regulations can launch or sponsor a collective investment scheme. In other words, for a collective investment scheme to raise money from the public it is prerequisite that the entity must (a) be a company and (b) registered with SEBI as a Collective Investment Management Company. At that time, no entity had registered with SEBI, under the SEBI (Collective Investment Schemes) Regulations implying that the schemes/funds have been launched / floated by these entities without obtaining a certificate of registration in accordance with the SEBI (Collective Investment Schemes) Regulations, 1999 (the Regulations). SEBI also warned that since launching / floating of Art Funds or Schemes without obtaining registration from SEBI amounted to violation of SEBI Act and Regulations, appropriate actions, civil and criminal, under the SEBI Act may be taken by SEBI against such funds / companies. Further, SEBI is planning a consultation process with various stakeholders, including the central government and RBI, with an aim to frame the specific regulations for these alternative investment vehicles this fiscal. 7. Commodities as An Asset Class A commodity includes all kinds of goods. The various types of commodities can be categorized as follows: The commodities under this category can be classified broadly into following categories: Primary commodities: like energy sources like crude oil, coal, natural gas, and nuclear fuel. Secondary energy sources: like electricity, refined oil products, diesel and gasoline (US), petrol (UK), liquefied petroleum gas (LPG) Half-products: such as petrochemicals, ethylene, and naphtha which may also be included as commodities in a broader sense. Mineral ores: Ferrous metals like iron, cast iron, steel, and steel products, nonferrous metals like aluminum, copper, lead, nickel, tin, zinc, precious metals like gold, silver, platinum.

Agricultural food products: Most commonly traded agricultural products are cereals, wheat, and corn, beverages like tea, coffee, and cocoa; fruits like apple, dates, grapes, bananas, oranges; cotton, jute and wool; rubber and timber; seafood products like fish, shrimps and crabmeat. Exposure in the commodity markets can be taken in one of the following ways: Direct investment in commodities (spot market) Indirect investment through equity/debt of companies using commodities Indirect investment through commodity features Indirect investment through exchange traded funds As against this, indirect investments in equities, or debt, or ownership of firms

Historically, direct commodity investments have been a minor part of investors asset allocation decision. specializing in direct commodity market production, were the principal means of obtaining claims on commodity investments. Forward contracts in the OTC commodity markets have a long history of trading. However, futures contracts on commodity exchanges have also become popular. Futures trading is organized in such goods or commodities as are permitted by the government. At present, all goods and products of agricultural (including plantation), mineral, and fossil origin are allowed for futures trading under the auspices of the commodity exchanges. The national commodity exchanges have been recognized for orderly trading in all permissible commodities which include precious (gold and silver) and nonferrous metals; cereals and pulses; ginned and unginned cotton; oilseeds, oils, and oilcakes; raw jute and jute goods; sugar and gur; potatoes and onions; coffee and tea; rubber and spices, etc. A commodity futures contract (like a financial futures contract) is a tradable standardized contract, the terms of which are set in advance by the commodity exchange organization trading in it. The futures contract is for a specified variety of a commodity, known as the basis, through quite a few other similar varieties, both inferior and superior, are allowed to be deliverable or tenderable for delivery against the specified futures contract. The quality parameter of the basis and the permissible tenderable varieties; the delivery months and schedules; the places of delivery; the on and off allowance for the quality difference and the transport costs; the tradable lots; the modes of price quotes; the procedures for regular periodical (most daily) clearings; the payment of prescribed clearing and margin monies; the transaction,

clearing, and other fees; the arbitration, survey, and other dispute redressing methods; the manner of settlement of outstanding transactions after the last trading day, the penalties for non-issuance or non-acceptance of deliveries, etc. are all pre-determined by the rules and regulations of the commodity exchange. Consequently, the parties to the contract are required to negotiate only the quantity to be bought and sold, and the price. The exchange prescribes everything else. Because of the standardized nature of the future contract, it can be traded with ease at a moments notice. The increased use of commodity trading in wealth management has led wealth managers to create investable opportunities in commodity indices and products that offer unique performance opportunities for investors in physical commodities. The investors benefits from commodity or commodity-based products lie primarily in their ability to offer risk and return trade-offs that cannot be easily replicated through other investment alternatives. Trading volumes in the commodities market are picking up in India as the volatility and attractiveness of returns draws more and more investors. Investment in commodities can be done by day traders as well as medium- to long-term position investors. Commodities are being used by global investors for hedging and hence are a good investment option for position investors. Trading in commodities is especially attractive due to the higher risk/return ratio. Commodities trades are highly leveraged, which means that the margin requirement for trading in commodities futures is quite low in comparison to overall position holding. Therefore, it magnifies the gains and losses of an investor. Commodities prices are seeing a lot of volatility in the recent times. Price fluctuation is due to turbulence in global markets, monsoon, Trading in commodities has some tangible advantages over investing in shares. For one thing, price volatility is much less than in the case of shares, bonds, and other financial instruments. The factors that influence commodity prices are also fewer in number and easier to understand and interpret. In case of agricultural good, these relate primarily to weather, the demand and supply scenario, government actions by way of subsidies and taxation, and international trading norms that are now guided by the World Trade Organization. However, commodity investment is a fraught with the risks as well. The return in commodities is good, but it is a roller coater ride all along. Success in commodity investment primarily depends on selecting the right commodity along with the appropriate strategy. Commodities react to a variety of supply and demand factors and some are inflation sensitive. Gauging the price

movement as accurately as possible is the challenge for the wealth manager. In India, mutual fund schemes are not permitted to invest in commodities. Therefore, the commodity funds in the market are in the nature of Commodity Sector Funds, i.e. funds that invest in shares of companies that are into commodities. Like Gold Sector Funds, Commodity Sector Funds too are a kind of equity fund. Steps in the Portfolio Management Process In the previous section we discussed the different types of investment management clients and the distinctive characteristics and needs of each. The following steps in the investment process are critical in the establishment and management of a clientss investment portfolio. The Planning Step: The first step in the investment process is to understand the clients needs (objectives and constraints) and develop an investment policy statement (IPS). A portfolio manager is unlikely to achieve appropriate results for a client without a prior understanding of the clients needs. The IPS is a written planning document that describes the clients investment objectives and the constrains that apply to the clients portfolio. The IPS may state a benchmark such as a particular rate of return or the performance of a particular market index that can be used in the feed back stage to assess the performance of the investments and whether objectives have been met. The IPS should be reviewed and updated regularly (for example, either every three years or when a major chage in a client (objectives, constraints, or circumstances occurs). The Execution Step: The next step is for the portfolio manager to construct a suitable portfolio based on the IPS of the client. The portfolio execution step consists of first deciding on a target asset allocation, which determines the weighting of asset classes to be included in the portfolio. This step is followed by the analysis, selection, and purchase of individual investment securities. Asset Allocation: The next step in the process is to assess the risk and return characteristics of the available investments. The analyst forms economic and capital market expectations that can be used to form a proposed allocation of asset classes suitable for the client. Decision that need to be made in the asset allocation of the portfolio include the distribution between equities, fixedincome securities, and cash; subasset classes, such as corporate and government bonds; and geographical weightings within asset classes. Alternative assets such as real estate, commodities, hedge funds, and private equity may also be included. Economists and market strategists may set the top down view on economic conditions and broad market trends. The returns on various asset classes are likely to be affected by economic

conditions; for example, equities may do well when economic growth has been unexpectedly strong whereas bonds may do poorly if inflation increases. The economists and strategists will attempt to forecast these conditions. Security Analysis: The top down view can be combined with the bottom up insights of security analysts who are responsible for identifying attractive investments in particular market sectors. They will use their detailed knowledge of the companies and industries they cover to assess the expected level and risk of the cash flows that each security will produce. This knowledge allows the analysts to assign a valuation to the security and identify preferred investments. Protfolio Construction: The portfolio manager will then construct the portfolio, taking account of the target asset allocation, security analysis, and the clients requirements as set out in the IPS. A key objective will be to achieve the benefits of diversification (i.e. to avoid putting all the eggs in one basket). Decisions need to be taken on asset class weightings, sector weightings within an asset class, and the selection and weighting of individual securities or assets. The relative importance of these decisions on portfolio performance depends at least in part on the investment strategy selected; for example, consider an investor that actively adjusts asset sector weights in relation to forecasts of sector performance and one who does not. Although all decisions have an effect on portfolio performance, the asset allocation decision is commonly viewed as having the greatest impact. Risk management is an important part of the portfolio construction process. The clients risk tolerance will be set out in the IPS, and the portfolio manager must make sure the portfolio is consistent with it. As noted previously, the manager will take a diversified portfolio perspective: What is important is not the risk of any single investment, but rather how all the investments perform as a portfolio. The portfolio construction phase also involves trading. Once the portfolio manager has decided which securities to buy and in what amount, the securities must be purchased. In many investment firms, the portfolio manager will pass the trades to a buy side trader a colleague who specializes in securities trading who will contact as stockbroker or dealer to have the trades executed. The Feedback Step: Finally, the feedback step assists the portfolio manager in rebalancing the portfolio due to a change in, for example, market conditions or the circumstances of the client.

Once the portfolio has been constructed, it needs to be monitored and reviewed and the composition revised as the security analysis changes because of changes in security prices and changes in fundamental factors. When security and asset weightings have drifted from the intended levels as a result of marker movements, some rebalancing may be required . The profolio may also need to be revised if it becomes apparent that the clients needs or circumstances have changed. Performance Measurement and Reporting: Finally, the performance of the portfolio must be measured, which will include assessing whether the clients objectives need to be reviewed and perhaps changes made to the IPS. As we will discuss in the next section, there are numerous investment products that clients can use to meet their investment needs. Many of these products are diversified portfolios that an investor can purchase.

Ranking of Mutual Funds: Process and parameters used

For the Investment Advisory Units the ranking of mutual funds is the key activity deciding the final white list of asset classes. Given the dominance of mutual fund products among Indian banks wealth management divisions the ranking of mutual funds holds key importance for wealth management divisions. While wealth management divisions in banks can outsource the rating of mutual funds to rating agencies like CRISIL or ICRA, most banks lay emphasis on developing an in-house team with expertise in ranking of mutual funds. The methodology used by the in-house team will be specific to the bank but broadly pertain to the basic parameters for ranking of mutual funds. We initially give an overview of the basic parameters for ranking of mutual funds before focusing in the next section on the particular methodologies used by the wealth management divisions of Indian banks and rating agencies in India. Ranking of mutual funds: Parameters Both qualitative and quantitative parameters are taken into account for ranking of mutual funds by Investment Advisory Units. The basic eligibility criteria for inclusion in the ranking universe is different for different ranking houses and banks. The usual criterion include two or three years

NAV history, assets under management in excess of cut-off limits, complete portfolio disclosure and a minimum number of schemes per category. For example, the CRISIL Mutual Fund Ranking, which is the relative performance ranking of mutual fund schemes within peer group considers NAV history (one-year for Liquid, Ultra Short Term Debt, Index and Debt-Short funds and five-year inclusion for the Consistent Performers), assets under management in excess of category cut-off limits and complete portfolio disclosure. Again, ICICI Bank Mutual Fund Analysis and Performance Rating (IMAP), which is also a relative ranking of mutual fund schemes as compared to their respective peer group in each scheme category, considers for open-ended mutual fund schemes two years daily Net Asset Value (NAV) details, full monthly portfolio disclosure, an overall cut-off for AMC of INR twenty billion, a minimum cut-off size for each category and a minimum five schemes per category

Quantitative parameters:
The first major quantitative parameter commonly considered by investment advisory units is a relative measure of the return and the risk for the schemes compared to their peer group. The simplest measure of return is the return or yield, which can be expressed as Wealth Relative minus one. Wealth Relative is defined as the ratio of Current value of Investment to original value of investment. The simple wealth relative can be converted to an annual basis by applying the formula Annualised WR = (WR)1/n, where n = number of years the investment is held. The Annualised Return = Annualised WR-1. For measuring mean return for a single investment over successive time periods, the mean return can be calculated by multiplying the WRs from the successive periods and taking the nth root of the product, where n equals the number of periods (geometric mean). Again, when managing a group of investments, it is often important to know what the mean return was across the whole set of investments. In this case, there are two cases to consider. First, there could be an equal investment in all of the different assets. Second, there might be different amounts invested in the various assets. The calculation of the mean return for both cases is done by the formula
N

Mean WR= wi WRi

t=1

For measurement of risk, the most common measures are variance (2) and standard deviation (), measuring the risk of the WR of investments. The standard deviation ( ) is simply the square root of the variance (2). The measurement of risk by variance or standard deviation implies that the investor is interested in the dispersion of WRs or returns from their means. The decision to measure risk by the variance or standard deviation implies that the investor interested in the dispersion of WRs or returns from their means. The greater the chance of getting a result far away from the mean the greater the risk of a particular investment. The variance of the WR is defined by the following equation:
T

2WR =
t=1

(WRi Mean WR )2/ T

where T is the number of individual WRs being used to make the calculation. The variance and standard deviation can be compared to those of other assets to provide a comparison of the risk levels. The mutual fund ranking methodology of different ranking agencies or in-house IAU of banks employ different parameters based on return and risk to rank the mutual funds. For example, CRISIL Mutual Fund Ranking considers the parameter Superior Return Score (SRS), which is the relative measure of the return and the risk for the schemes compared to their peer group. It is computed for Equity Oriented Categories, Equity Linked Saving Schemes (ELSS), Debt, Balance, Monthly Income Plan (Aggressive & Conservative) and Gilt categories for a two-year period. The weightages for the four six monthly periods starting from the latest are 32.5%. 27.5%, 22.5% and 17.5% respectively. In case of the Consistent Mutual Fund Performers for Equity, Balanced and Debt categories, the SRS is calculated for a period of five years, with separate one year periods weighted differentially with the most recent period having the highest weight age. CRISIL Mutual Fund Ranking also considers a parameter called the Mean Return and Volatility which is computed separately in case of Liquid, Ultra Short Term Debt and Debt-Short term schemes for a one - year period. Mean return is average of daily return on fund NAV for the latest one-year period and the Volatility is the standard deviation of these returns. The weightages for the four quarterly periods starting from the latest are 32.5%. 27.5%, 22.5% and 17.5% respectively. In case of the Consistent Mutual Fund Performers for the Liquid category,

Mean Return and Volatility are calculated for a period of five years, with separate one year periods weighted differentially with the most recent period having the highest weightage. The second major parameter considered is the Portfolio Concentration Analysis. Portfolio Diversification for any fund mangaer is essential for reduction of volatilityin all portfolios. These allocations may represent, While allocation may represent the investment objectie or atyle, concentrated portfolios will generally be more volatile. Stout (1997) has shown that investors should concentrate with care in selecting mutual funds with concentrated portfolios. The range of fund returns increases as diversification decreases3.

A major reason that portfolios can effectively reduce risk is that combining securities whose returns do not move together provides diversification. Sometimes a subset of assets will go up in value at the same time that another will go down in value. The fact that these may offset each other creates the potential diversification benefit we attribute to portfolios. However, an important issue is that the co-movement or correlation pattern of the securities returns in the portfolio can change in a manner unfavorable to the investor. We use historical return data from a set of global indices to show the impact of changing co-movement patterns.

When we examine the returns of a set of global equity indices over the past 15 years, we observe a reduction in the diversification benefit due to a change in the pattern of co-movements of returns. Exhibits 4-6 and 4-7 show the cumulative returns for a set of five global indices4 for two different time periods. Comparing the first time period, from Q4 1993 through Q3 2000 (as shown in Exhibit 4-6), with the last time period, from Q1 2006 through Q1 2009 (as shown in

Mutual funds: risk and performance analysis for decision making

By John A. Haslem
4

The S&P 500, Hang Seng, and Nikkei 500 are broad-based composite equity indices designed to measure the performance of equities in the United States, Hong Kong, and Japan. MSCI stands for Morgan Stanley Capital International. EAFE refers to developed markets in Europe, Australasia, and the Far East. AC indicates all countries, and EM is emerging markets. All index returns are in US dollars.

Exhibit4-7), we show that the degree to which these global equity indices move together has increased over time. The latter part of the second time period, from Q4 2007 to Q1 2009, was a period of dramatic declines in global share prices. Exhibit 4-8 shows the mean annual returns and standard deviation of returns for this time period. During the period Q4 2007 through Q1 2009, the average return for the equally weighted portfolio, including dividends, was 48.5 percent. Other than reducing the risk of earning the return of the worst performing market, the diversification benefits were small. Exhibit 4-9 shows the cumulative quarterly returns of each of the five indices over this time period. All of the indices declined in unison. The lesson is that although portfolio diversification generally does reduce risk, it does not necessarily provide the same level of risk Returns to Global Equity Indices

Mean Global Index S&P 500 MSCI EAFE US$ Hang Seng Nikkei 500 MSCI AC E+EM US$ Randomly index selected 12.6% 20.5% 10.9 20.4 3.3 7.6

Standard Deviation 13.9% 14.2 35.0 18.0 13.2

Mean -6.3% -3.5 5.1 -13.8 -4.9

Standard Deviation 21.1% 29.4 34.2 27.6 30.9

Mean

Standard Deviation

-40.6% 23.6% -48.0 -53.8 -48.0 -52.0 35.9 34.0 30.0 37.5

18.9%

-4.7%

28.6%

-48.5% 32.2%

Equally portfolio

weighted 12.6%

14.2%

-4.7%

27.4%

-48.5% 32.0%

Diversification ratio Source for data: Datastream.

75.1%

95.8%

99.4%

Concentration measures the risk arising out of improper diversification. Diversity Score is used as the parameter to measure Industry concentration and Company concentration for equity securities. In case of Debt papers, the industry concentration is analyzed only for any / over exposure in sensitive sectors which is arrived at based on CRISILs assessment of the prospects for various sectors and Company concentration will have an individual issuer specific limit of 10.0% Liquidity Analysis It measures the ease with which the portfolio can be liquidated. In case of Equities, liquidity is computed by dividing the Average Turnover in term of value by the Average Market Capitalisation for the security during the preceding six months. Gilt liquidity is measured by analysing the market turnover, days traded and size of trade in any security for a three months period for that security. Corporate Debt Liquidity is computed by classifying each security into 3 categories - Liquid, Semi Liquid and Illiquid and then evaluating a funds exposure to each such category. Asset Quality

Asset Quality measures the probability of default by the issuer of a debt security to honour the debt obligation in time. CRISIL penalizes lower rated securities to a higher level in its analysis. Modified Maturity /Average Maturity Modified duration /Average Maturity are considered across all debt categories to capture the interest rate risk of the portfolio. Lower the value better it is. Downside Risk Probability (DRP) DRP measures the probability of the investment getting lower returns than short tenor risk free securities. It measured by assessing the number of times a funds return falls below the risk free return over the period of analysis. The risk free return is taken as the 91-day T-Bill yield over the period. Asset Size It is considered only for Ultra Short Term Debt and Liquid categories to take into account the effect of large fund flows on the funds performance and ability of the funds to manage such flows optimally. Higher the asset size better it is. Tracking Error This is used only for Index funds. The tracking error is an estimation of the variability in a funds performance vis--vis the index that it tracks. Lower the tracking error better it is. Historic CRISIL Mutual Fund Performance Historic CRISIL Mutual Fund performance is considered only for the Consistent category. Quarterly mutual fund ranks during the five year period of analysis are weighted with separate one year periods weighted differentially with the most recent period having the highest weightage.