Investment Planning

Risk Return Spectrum

Note:The above chart is for illustrative purpose only and is not marked to scale. The chart is based on our perception of the risk and return potential of various investment avenues

Savings Bank/ FD

Liquid Funds

PPF, NSC, KVP, PO Deposits, RBI Bonds

Debt Funds

Gold

Real EstateEquity

Risk

Retu

rn p

oten

tial

Low HighLow

High

Which Investment Option Generated Maximum Return During Last 10 Years ?

Cash & Saving Management(Managing Monetary Assets)

Objective of Cash Management• Cash includes liquid assets• Cash/Savings management to meet the personal financial goals• Liquidity to meet requirement for transactions and contingencies• Saving programs to meet financial objectives• Investment in appropriate instruments to generate return• Cash Budget to estimate inflows, outflows and surplus/deficits

Cash Management Products• Saving Account• Fixed Deposits• Recurring Deposits• Smart Account – deposit linked saving account• Loan Against Shares• Mutual Funds (FMPs)• Money Market Instruments

What are Money Market Instruments ?

Money Market Instruments• Treasury Bills

– Issued by Government to meet short term needs– In the form of Promissory Notes– Highly liquid and credit risk free– RBI acts as an Issuing agent for the Govt.

• Minimum of Rs.25,000 and in multiple thereof• Issued at a discount/ redeemed at par• Duration – 91 days and 364 days

Treasury Bills• Yield

– (FV/Purchase Price - 1) *365/Days to maturity

• Traded on the Retail Debt Segment of NSE– Screen based– Order driven automated order matching system– Price-Time priority

Commercial Paper

• Used by corporate to raise short term finance – Minimum Net worth Rs.4 crores

• Unsecured promissory note issued at a discount• Maturity – 15 days to one year• Size – minimum Rs.5 lakhs and multiples thereof• Cheaper and less cumbersome for issuer• Liquid and high yield for the investor• Credit rating

Commercial Paper• Yield

(Par Value – Purchase Price) X 360

Par Value Days to Maturity

• Secondary market – endorsement and delivery

Certificate of Deposits• Issued by bank/FIs as promissory notes• Negotiable• Issued at a discount for up to one year• Registered or bearer or demat form• Size – Minimum Rs.5 lakh and thereafter in multiples of Rs. one lakh

National Saving CertificateFeature Description

Eligibility Any individual singly or jointly with other adult. applications for purchase of NSCs may be submitted on NC-71.A guardian on behalf of a minor.

Minimum amount Rs. 100/-Maximum amount No maximum limitMaturity period(VIII issue)

•Six years for NSCs purchased upto 30th November 2011.•Five years for NSCs purchased on or after 1st December 2011.

Maturity period(IX issue)

Ten years

Interest RatePeriod VIII Issue IX IssueUpto 30.11.2011 8.00% NA01.12.2011 to 31.03.1012 8.40% 8.70%01.04.2012 to 31.03.2013 8.60 8.90%01.04.2013 onwards 8.50 8.80%

Public Provident Fund (PPF)Type of Account Minimum limit Maximum limit

Public Provident Fund(Individual account on his behalf or on behalf of minor of whom he is the guardian)

INR. 500/- in a financial year

INR. 1,00,000/- in a financial year

Tax Free Bonds

What are Tax Free Bonds ? Central Government authorizes certain entities such as NHAI,

PFC, REC etc. to issue tax free, secured, redeemable, non convertible bonds

Do not form part of Total Income, interest Income is exempt from tax, no TDS is applicable

Benchmarked to the 10-year Government Security bonds

Good investment option now as 10 year gilt yields are high

They are usually issued for a period of 5-20 years.

Benefits of Tax Free Bonds

Tax-Free Income

Highly rated, which indicates low risk of default

Highly Liquid as it is listed on BSE & NSE.

Easy to track and monitor if the bonds are held in 'Demat Form'

Tax Implications Tax Free: The Interest earned is Tax free

TDS: No TDS is applicable, since the interest Income on these bonds is exempt.

Long Term Capital Gains: Bonds are treated as a long term capital asset if it is held for more than 12 Months.

Short Term Capital Gains: Bonds are held for a period of not more than 12 months would be taxed at the normal tax slab rates.

STT: Securities Transaction Tax (STT) is not applicable

Illustration on Effective Yield

Assuming the coupon rate of a ABC Tax Free Bond is 8%, an individual falling in a 10% Tax bracket will effectively earn a return of 8.89%

Tax bracket 10% 20% 30%Coupon Rate 8.00% 8.00% 8.00%Effective Pre-tax rate 8.89% 10.00% 11.43%

Higher the Tax bracket higher is the effective yield earned on Tax free Bonds.

Individuals falling in 30% tax slab will earn the highest return on Tax free Bonds

Inflation Indexed Bonds

Inflation Index Bonds

• IIBs will provide inflation protection to both principal and interest payments.

• RBI’s inflation index bonds better than bank FD for retirement savings

Year Inflation WPIIIB at 1.5% Coupon

Regular Bond at 7% Coupon

      Principal Interest Principal Interest

0  200 100  100 

1 10% 220 110 100 7

2 5% 231 115.50 1.7325 100 7

3 12% 259 129.36 1.9404 100 7

4 4% 269 134.53 2.01795 100 7

5 2% 274 137.23 2.05845 100 7

6 9% 299 149.58 2.2437 100 7

7 8% 323 161.54 2.4231 100 7

8 6% 342 171.23 2.56845 100 7

9 10% 377 188.36 2.8254 100 7

10 5% 396 197.78 2.9667 100 7

Regular Bond vs. IIB

Consider the following example, in which the initial investment (in 2004-05) is Rs 10,000, historic WPI data is from 2004-2005 (taken as 100) and the coupon rate is assumed at 3 per cent.

Year WPIAdjusted principal Coupon rate Interest paid

2005-06 104.47 10,447 3 per cent 313.41

2006-07 111.35 11,135 3 per cent 334.05

2007-08 116.63 11,663 3 per cent 349.89

2009-09 126.02 12,602 3 per cent 378.06

2009-10 130.81 13,081 3 per cent 392.43

2010-11 143.32 14,332 3 per cent 429.96

2011-12 156.13 15,613 3 per cent 468.39

Assuming a maturity period of 8 years; total interest payment = Rs 2,666.19; adjusted principal at maturity = Rs 15,613;total amount received on maturity = Rs 18,279.19

Disadvantages of inflation indexed bonds

• Inflation indexed bonds are currently linked to WPI and not CPI. The RBI has announced its plans to roll out inflation indexed bonds linked to CPI in the near future. The CPI linked bonds will have a better advantage over WPI linked bonds.

• Periods of deflation will often lead to less adjusted principal, which is less than the original principal. However, deflation in India's scenario is just a theoretical risk. As per the current state of economic affairs, deflation is not practically possible in India.

• The dynamics of the secondary market trading of the inflation indexed bonds are yet to be defined by the RBI. These factors will help investor's better gauge the performance of these bonds. It will also address the liquidity concerns of inflation indexed bonds.

Mutual Funds

Investment in Bonds through Mutual Funds

Mutual Fund• Liquidity, professional management with higher return• Structure

• Open ended • close ended

• Objective• Growth• Income• Growth plus Income• Liquidity• Tax Savings

• Load• Load Funds• No-Load Funds

Schemes of Mutual Funds

• Equity Funds– Diversified funds, Blue chip funds, Midcap funds,

small cap funds, indexed funds, sector funds

• Debt Funds• Gilt Funds• Balance Funds• Money Market Mutual Funds (Liquid Funds)• Global Funds

How to Invest and withdraw ?

• Lump Sump• Systematic Investment Plan (SIP)• Systematic Withdrawal Plan (SWP)• Systematic Transfer Plan (STP)

Asset Minimum holding period form LT gain TaxEquity 1 year Zero

Debt 3 year

Whichever benificial (10% without indexation, 20% with indexation)

Real Estate 3 year 20% with indexationGold 3 year physical gold, 20% with indexation

  3 year gold ETF/MF

Whichever benificial (10% without indexation, 20% with indexation)

Bonds/NCDS 3 year 10% without indexation

*3% education cess is applicable on all

Long Term Capital Gain Taxation

Short Term Capital Gain TaxationAsset

Minimum holding period form ST gain Tax

Equity Less than 1 year 15%

Debt Less than 3 year Added to incomeReal Estate less than 3 year Added to incomeGold below 3 year physical gold, Added to income

  below 3 year gold ETF/MF Added to incomeBonds/NCDS 3 year Added to income

*3% education cess is applicable on all

Identifying Goals and Risk Tolerance before Picking a Mutual Fund

• Before acquiring shares in any fund, you need to think about why you are investing. What is your goal? – Are long-term capital gains desired, or is a current

income preferred? – Will the money be used to pay for college expenses, or to

supplement a retirement that is decades away? – Identifying a goal is important because it will help you hone in

on the right fund for the task. 

• For really short-term goals, money market funds may be the right choice, For goals that are few years in the future, bond funds may be appropriate. For long-term goals, stocks funds may be the way to go.

Risk Tolerance and Mutual Funds

• One must also consider the issue of risk tolerance.

• Can you afford and accept dramatic swings in portfolio value?

• If so, you may prefer stock funds over bond funds.

• Or is a more conservative investment warranted? In that case, bond funds may be the way to go.

Debt Funds

Capital gain tax & DDT for debt MFs for FY 13-14

Tax Tax rate for Individuals/HUF

LT Capital gain 10% without indexation/ 20% WITH INDEXATION

ST Capital gain Added to income

Dividend Income Nil

DDT 25% (Effective 28.325%)

Taxation on debt mutual funds

• Debt MFs have a differential tax treatment compared to equity.

• While dividends are tax free for equity schemes, they are taxed in debt funds through dividend distribution tax.

• DDT has now been increased for all debt funds from 12.5% to 25%. The effective rate will now be 28.325% on account of a 10% surcharge and 3% education cess

• Similarly, there is no tax on long term capital gains in equity while same is taxed in debt

How should I Invest ?

• Growth Schemes• Dividend Reinvestment schemes• Dividend Schemes

Growth or Dividend Scheme• Dividends from debt funds are subject to a dividend distribution tax (DDT) of

28.325%, including surcharge and cess. Every time your MF scheme distributes dividends, it first deducts DDT out of the distributable dividend and pays you the rest. You don’t pay directly; it goes out of the dividend due to you.

• If you are in the 10% and 20% tax brackets and invest in debt funds for less than a 3 years, choose the growth plan. The reason: the tax outgo in the growth plan is less than that in the dividend reinvestment plan. The DDT rate is higher than the short-term capital gains tax rate for the 10% and 20% tax brackets

• In the same example if you are in the 30% tax bracket, choose the dividend reinvestment plan (less than 3 year).

• For more than 3 years of investments growth plans are better as they give you indexation benefits

What is FMP ?• Closed-ended debt scheme of mutual funds

• No equity component

• Tenures varying from 30 days to five years.

• Minimize the interest rate or reinvestment risk through synchronised maturity

• Invest largely in  money market instruments

• Tax efficient returns through indexation benefits

• Example ( Pre Budget 2014)• Example (Post Budget 2014)

FMP VS FD Comparison  FMP FD

Interest Rate Debt Market Rate. Not announced at the beginning

Debt Market Rate. Announced upfront

Risk Riskier, Invests in safe debt securities, but no guarantee

Safer, insurance cover up to one lakh rupees

Expense Fund management charge – less than 0.5%

No charge

EaseInvest directly in MF office, portal or through distributors

Open FD account at your bank, offline or online

Redemption

You can withdraw money before maturity. You can sell FMP in exchange, but finding the buyer is almost impossible

You can withdraw amount any time by paying penalty

Liquids Funds A supplement to your savings bank account

How Much Return You Can On Your Savings Accounts ?

What are Liquid Funds?

• Do not invest any part of assets in securities with a residual maturity of more than 91 days

• Invest in short-term debt instruments with maturities of less than one year

• Investments are mostly in money market instruments and short-term corporate deposits

• Historical Performance of Liquid Funds

Debt Funds

• http://www.moneycontrol.com/mutual-funds/nav/hdfc-high-interest-fund-dynamic-plan/MZU008

• http://www.mutualfundindia.com/MF/Portfolio/Details?id=29347

Equity Investments

Equity vs. FD

Direct Equity Investment vs. Indirect Equity Investment

?

An SIP reduces the average cost of investment in fluctuating markets

Benefits of Cost Averaging

Dec 99 Dec 00 Dec 01 Dec 02 Dec 03 Dec 04 Dec 05 Dec 06 Dec 07 Dec 08 Dec 09 Dec 10 Dec 11 Dec 120

500000

1000000

1500000

2000000

2500000

3000000

3500000

4000000

4500000

5000000

5,00

0

56,4

24

111,

879

197,

490

515,

568

760,

337

1,29

0,33

8

1,97

7,23

6 2,93

6,59

1

1,58

9,29

0

3,45

0,73

8 4,42

6,81

8

3,64

1,39

4 4,46

6,64

0

5,00

0

65,0

00

125,

000

185,

000

245,

000

305,

000

365,

000

425,

000

485,

000

545,

000

605,

000

665,

000

725,

000

785,

000

HDFC Top 200 (G) No of Instalments - 157Total Investment (5k / month) - 785000Investment Value - 4466640SIP Investment Returns CAGR - 24.38

Dec 99 Dec 00 Dec 01 Dec 02 Dec 03 Dec 04 Dec 05 Dec 06 Dec 07 Dec 08 Dec 09 Dec 10 Dec 11 Dec 120

50000010000001500000200000025000003000000350000040000004500000

5000

6500

0

1250

00

1850

00

2450

00

3050

00

3650

00

4250

00

4850

00

5450

00

6050

00

6650

00

7250

00

7850

00

5,00

0

53,4

19

96,8

57

157,

033

431,

420

646,

312

1,13

8,88

2

1,80

1,17

9 2,90

9,80

7

1,54

4,97

1

3,13

7,65

2

3,90

8,06

3

3,31

3,57

8

4,08

0,69

8DSP BlackRock Equity Fund

No of Instalment - 157Total Investment (5k / month) - 785000Investment Value - 40,80,697.54SIP Investment Returns CAGR - 23.17%

An SIP reduces the average cost of investment in fluctuating markets

Benefits of Cost Averaging

0500000

1000000150000020000002500000300000035000004000000

5000 65000 125000 185000 245000 305000 365000 425000 485000 545000 605000 665000 725000 7850005,000 61,751109,449

188,892475,793

701,8881,108,121

1,725,780

2,537,190

1,306,871

2,644,367

3,329,3102,992,283

3,593,835

Franklin India Bluechip Fund (G)No of Instalments - 157Total Investment (5k / month) - 785000Investment Value -3593834SIP Investment Returns CAGR – 21.46%

Dec 99 Dec 00 Dec 01 Dec 02 Dec 03 Dec 04 Dec 05 Dec 06 Dec 07 Dec 08 Dec 09 Dec 10 Dec 11 Dec 120

1000000

2000000

3000000

4000000

5000000

6000000

5000

6500

0

1250

00

1850

00

2450

00

3050

00

3650

00

4250

00

4850

00

5450

00

6050

00

6650

00

7250

00

7850

00

5,00

0

53,2

18

103,

179

217,

638

607,

355

973,

152

1,81

2,70

7

2,75

6,90

0

4,59

9,60

2

2,15

5,02

2

4,58

3,00

2

5,68

5,81

3

4,46

2,40

7 5,75

3,26

0

Reliance Growth Fund (G)No of Instalments - 157Total Investment (5k / month) - 785000Investment Value - 5753260SIP Investment Returns CAGR – 27.78%

Equity Funds

• http://www.moneycontrol.com/mutual-funds/nav/birla-sun-life-top-100-fund/MBS089

• http://www.mutualfundindia.com/MF/Portfolio/Details?id=16354

Performance of Mutual Funds• Large Cap Funds• Small and Mid Cap Funds• Diversified Equity• Pharma Health Care• Banking and Finance• FMCG• Technology• INDEX Funds• Balance Funds

PPF vs. Mutual Funds

I have burnt my fingers…Equity Investment is like gambling

• Direct Equity Investment is a full time professional activity

• Don’t indulge in trading with futures/shares

Equity oriented MF schemes for FY13-14

Tax Tax Rate for Individuals/HUF

LT Capital gain Nil

Short term capital gain 15%

Dividend Income Nil

DDT Nil

How should I Invest ?

• Growth Schemes• Dividend Reinvestment schemes• Dividend Schemes

Growth vs. Dividend Scheme

• For equity funds, we assume you would invest for the long term; in other words definitely more than a year

• In this case, it doesn’t matter whether you choose the growth plan or the dividend reinvestment plan because equity funds neither impose DDT nor do they attract long-term capital gains tax.

Investing through Children and Parents

What If ?• You swiped your credit card for your friend Rs. 20,000 purchase

and that your friend paid back to you by transferring it to your bank account

• You asked Rs. 50,000 from your friend as loan and paid him back after a month

• You got Rs. 50,000 cheque from your relative on your wedding• Your father transferred some money you in your bank account as

help for some purpose• Gift up to Rs. 50,000 is tax free. But If you receive a gift of Rs.

60,000 than entire 60,000 will be taxed not just 10,000• Although gift received from relatives are tax free but one should

document huge amounts• Any wedding gift is not taxable

Investing through Children and Parents

• Income tax act provisions allow you to save tax, if your invest through major daughter, son or senior/super senior citizen parents, provided they are in lower tax bracket

• There is no gift tax if you receive money from relatives (Father, mother, son, sister, brother, daughter)

• No tax on gifts received from relatives at the time of marriage

• Gift beyond Rs. 50,000 is taxable from others• Example

Critical Question : Which Mutual Fund is Good for Me ?

S Naren: An old hand at fund management, the CIO at ICICI Prudential AMC is known for his contrarian bets. His equity schemes performed very well last year.

Sunil Singhania: The CIO at Reliance MF focuses on high-growth business models. In 2012, several schemes bounced back as top performers.

Sukumar Rajah: MD and CIO of Franklin Templeton has led the fund house to deliver strong returns over the long term and even in the last one year.

Evaluating Performance of MFs

Investment in GOLD

What Have Been Return on Gold Investment ? GUESS

Gold ( 10 Grams )Price History: Indian Rs.

Year Price Year Price Year Price Year Price Year Price

1971 193 1981 1800 1991 3466 2001 4300 2011 26400

1972 202 1982 1645 1992 4334 2002 4990 2012 31799

1973 278.5 1983 1800 1993 4140 2003 5600 2013 29190

1974 506 1984 1970 1994 4598 2004 5850 2014 27000

1975 540 1985 2130 1995 4680 2005 7000   

1976 432 1986 2140 1996 5160 2006 8400   

1977 486 1987 2570 1997 4725 2007 10800   

1978 685 1988 3130 1998 4045 2008 12500   

1979 937 1989 3140 1999 4234 2009 14500   

1980 1330 1990 3200 2000 4400 2010 18500   

Return on Gold Investment

• Range is 8% to 15% in medium to long term with average return expectation ~ 12%

• Minimum 5 Years Investment

CAGR (1971-2014)

CAGR (1981-2014)

CAGR (1991-2014)

CAGR (2001-2014)

CAGR (2009-2014)

12.17% 8.55% 9.34% 15.18% 13.24%

How to Invest in GOLD

• Jewellery buying• Investment in Gold coins and bars• Gold ETF• Gold Fund of Funds

How much to invest in Gold?

• 5% to 10% of your over assets can be invested in gold.

• If you invest more in gold, remember in the long term return on gold investment is less than 10% p.a.

Is it right time to invest in gold?

• “When to invest in gold?” or “Should I invest in gold now?”

• There is no right or wrong time to invest in gold.

• You need to invest in gold for long term ( 5+yrs).

• It is better to stagger your investments over a period of time to average out the cost of purchase.

Investment in Real Estate

Facts About Real Estate..1

• Short term vs. Long term capital gain tax• Capital Gain Tax : Under Construction Property

– Date of booking vs. date of registration

• 80 C benefit of principal repayment• 24 B benefit of interest repayment up to Rs.

2,00,000 for self occupied house• Joint ownership by husband and wife and tax

benefit• Interest benefit of second and more house given

on rent/lease

Facts About Real Estate..2

• How Soon Does Money From Selling a House Have to Be Invested So No Capital Gain Tax Is Paid?

Exchange Traded Funds (ETFs)

• ETFs are essentially mutual fund schemes or index funds that are listed and traded on the exchange like stocks.

• ETFs are priced continually and can be bought or sold through out the trading day.

• Buying or selling ETFs is as simple as buying or selling any other stock on the exchange allowing the investor to take advantage of intra day price movements.

Exchange Traded Fund

Types of ETF

• Index ETF

• Commodity ETFs

• Liquid ETFs

ETFs V/S Stocks and Mutual Fund

Functionality ETFs Stocks Mutual Funds Unit

Can be purchase through NSE broker or online trading account

Yes Yes No

Ability to put limit orders Yes Yes No

Real time trading and pricing throughout market hours

Yes Yes No

Returns at par with the market/index

Yes No No

Listed ETFs on NSE

Liquid & Gold ETFs

Performance of Gold ETFs

Mutual Funds Portfolio Performance Measures

MF Portfolio Performance Measures

What do we require of portfolio managers?

1. Earn a fair return for the level of risk in the portfolio

2. Ability to manage risk

3. Eliminate unnecessary risks

MF Portfolio Performance Measurement

• Benchmarking– Gives us a reference point for comparison– Comparison of return and risk

MF Portfolio Performance Measurement

• Choosing a benchmark– The most important consideration for portfolio

performance measurement is benchmark choice. All portfolio evaluation is dependent on benchmark choice

1. Make sure the benchmark is unambiguous

2. Make sure the benchmark is an investable index

3. Make sure the benchmark has a measurable value

MF Portfolio Performance Measurement

• Choosing a benchmark 4. Make sure that the benchmark is appropriate for the

style of portfolio that you are evaluating

5. Make sure the benchmark is specified in advance

6. Make sure the benchmark reflects current knowledge and opinion

7. Don’t change indices. Be consistent across portfolios

Portfolio Performance Measures• Treynor’s measure

i

fii

RRT

Portfolio Performance Measures• Treynor’s measure– Treynor’s measure basically gives us a measure of return per unit of market risk (or systematic risk) that our investment earns– Strictly speaking, the larger the Treynor measure the better. However, we would like to have some benchmark with which to compare our individual Treynor measures.

Portfolio Performance Measures

• Tryenor’s measure– Benchmark comparison

fmm

fmm RR

RRT

Portfolio Performance Measures• Treynor’s measure– If Ti > Tm, the portfolio would plot above the security market line, indicating superior performance by the portfolio manager.– If Ti < Tm, the portfolio would plot below the security market line, indicating poor performance by the portfolio manager.

Portfolio Performance Measures• Sharpe performance measure

i

fii

RRS

Portfolio Performance Measures

• Sharpe performance measure– Thus, the Sharpe measure gives us a measure of

return per unit of total risk. Again, the higher the Sharpe measure, the better the performance. We can also compare individual Sharpe measures to a benchmark:

m

fmm

RRS

Portfolio Performance Measures• Sharpe performance measure– Instead of plotting deviations from the security market line, like the Treynor measure, we are plotting deviations from the market determine price of risk as defined by the capital market line (CML).

Portfolio Performance Measures• Sharpe measure– If Si > Sm, the asset earn more than the risk premium required by the capital market line, indicating superior performance by the portfolio manager.– If Si < Sm the asset earn less than the risk premium required by the capital market line, indicating poor performance by the portfolio manager.

Portfolio Performance Measures

• Comparing the Treynor and Sharpe measures– For a completely diversified portfolio of assets, the

Sharpe and Treynor measures would be identical in what they are measuring

– Treynor measures performance relative to systematic risk

– Sharpe measure s performance relative to total risk

Portfolio Performance Measures• Comparing the Treynor and Sharpe measures– Sharpe measure gives some indication of how good the portfolio manager is at diversifying away unsystematic risk– A poorly diversified portfolio could have a high Treynor ranking

Portfolio Performance Measures

• Jensen’s Alpha– Jensen’s alpha is based on the ideas contained

in the CAPM. It, like the Treynor measure, measures how well a portfolio manager does at dealing with systematic risk

– To calculate Jensen’s alpha we need to estimate the following regression model:

)( ,,,, tftmiitfti RRRR

Portfolio Performance Measures• Jensen’s Alpha– measures the degree to which managers are earning significant returns after accounting for market risk, as measured by beta. If the manager is earning a fair return for the given portfolio’s systematic risk, then would be zero.

Portfolio Performance Measures• Jensen’s Alpha– (+) indicates good performance– (-) indicates poor performance– Jensen’s alpha allows us to statistically test whether the return the manager earns is significantly more (or less) than what we would expect using the CAPM.– Jensen’s alpha allows us to get a performance measure that incorporates information from more than one time period.

Portfolio Performance Measures• Jensen’s Alpha– The validity of the Jensen performance measure is tied to the validity of the CAPM. Thus, some individuals will choose estimate Jensen's alpha performing the regression model without subtracting the risk-free rate. This gives us the alpha from the characteristic line. Its interpretation is the same as the interpretation of Jensen's alpha.

Sortino Ratio• The Sortino ratio measures the risk-adjusted return of an investment asset,

portfolio or strategy. It is a modification of the Sharpe ratio but penalizes only those returns falling below a user-specified target, or required rate of return, while the Sharpe ratio penalizes both upside and downside volatility equally. It is thus a measure of risk-adjusted returns that treats risk more realistically than the Sharpe ratio.

• A ratio developed by Frank A. Sortino to differentiate between good and bad volatility in the Sharpe ratio. This differentiation of upwards and downwards volatility allows the calculation to provide a risk-adjusted measure of a security or fund's performance without penalizing it for upward price changes. It is calculated as follows:

•

Portfolio Performance Measures

• Fama’s performance measure– Fama breaks performance by a portfolio manager into

two categories: selectivity and diversification. Fama’s measure incorporates measures for managing both systematic and unsystematic risk.

Portfolio Performance Measures• Fama’s performance measure– Selectivity: measures the ability of the portfolio manager to earn a return that is consistent with the portfolio’s market (systematic) risk. The selectivity measure is:

))((( fmifi RRRR

Portfolio Performance Measures• Fama’s performance measure

(+) selectivity indicates that the manager earned a higher return than the systematic risk of the portfolio would indicate. Basically, you are just comparing the return on the asset with the return earned by the CAPM.

Portfolio Performance Measures• Fama’s performance measure– Diversification: Diversification measures the extent to which the portfolio may not have been completely diversified. Diversification is measured as:

ifmfm

ifmf RRRRRR

)()(

Portfolio Performance Measures

• Fama’s performance measure– If the portfolio is completely diversified, contains no

unsystematic risk, then diversification measure would be zero. A positive diversification measure indicates that the portfolio is not completely diversified; it would contain unsystematic risk.

– If the diversification measure is positive, it represents the extra return that the portfolio should earn for not being completely diversified.

Portfolio Performance Measures

• Fama’s performance measure– Net selectivity = selectivity - diversification– Net selectivity measures how well the portfolio

manager did at earning a fair return for the portfolio’s systematic risk and how well the portfolio manager did at diversifying away unsystematic risk.

– Positive net selectivity indicates the portfolio manager did a good job. Negative net selectivity indicates that the portfolio manager did a poor job.

Exercise• Based on the information given below, identify the funds which have produced excess return as per Jensen model. Examine whether the excess return provided by the funds are due to superior stock selection skills or inadequate diversification. Illustrate using the Eugene Fama framework. Assume that risk free rate of return is 8%. Alliance Perpetual find is a market fund which mirrors the BSE SENSEX both in terms of returns and risk profile.

Data

Funds Return(%) Beta SD(%)

Birla Growth Fund 21 1.12 24.8

ICICI balanced fund 15 0.90 17.5

Sun F&C Debt fund 14 0.95 21.6

Alliance perpetual fund

13 1.00 14.5

Solution :Jensen Measure

Funds R(%) Required ReturnRf+β(Rm-Rf)

Jensen AlphaRi-Rr

Birla Growth Fund 21 13.60 7.40

ICICI balanced fund 15 12.50 2.50

Sun F&C Debt fund 14 12.75 1.25

Alliance perpetual fund

13 13.00 0

Fama Total SelectivityFunds Total

SelectivityNet Selectivity Return for Inadequate

DiversificationTS - NS

Birla Growth Fund 7.40 4.45 2.95

ICICI balanced fund 2.50 0.97 1.53

Sun F&C Debt fund 1.25 (1.45) 2.70

Alliance perpetual fund

0 0 0