Equity benchmark selection and its effects on Fund Performance

Measurement

Case of Sector focussed Equity Mutual Funds in India

Master’s Thesis

MSc Finance 2008-09

ADITYA BADAMI
Candidate Number: 23289

Supervisor: Dr. Devraj Basu, PhD

EDHEC Business School

393-400, Promenade des Anglais, 06202, Nice-France

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Abstract

The growth of the Indian economy has shown a rise in the number of sector focussed mutual

funds, with the choice of diversified indices as benchmarks over sector focussed indices,

many funds have not been able to outperform the sector under focus. Fund performance

measurement is widely measured by a comparison with a benchmark index; this benchmark

index is selected by the fund manager to reflect the objectives of the fund, however the vague

nature in the choice of choosing indices as benchmarks has effects on the performance

measurement of sector focused funds in India. The emphasis of this thesis is to show a

comparative study on performance measures that can arise by choosing incorrect and correct

benchmarks. The resultant analysis illustrates the fact that choosing the right index is not

alone crucial in determining fund performance but also shows whether fund managers are in

cohesion with the investment objectives of the fund.

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Acknowledgements

The implementation of a project is never an individual task, though the thesis is finally a

work by an individual, the credit of its success also lies with the people and institutions that

support the individual during the implementation.

The first and foremost acknowledgement goes to my parents; Mrs. & Mr. Badami and my

sister Radhika Badami, the constant intercontinental support that I have received can never be

replicated by any other individual or body and I am grateful to them for their unconditional

support and guidance. I would also like to acknowledge the guidance of my thesis supervisor

Dr. Devraj Basu, the meetings with him helped carve a thought process that led from a broad

notion to a specific purpose that has broader implications. I would also like to thank the

EDHEC Library team for their support in seeking academic documents for the purpose of the

thesis. I would also like to appreciate the support and best wishes received from my friends

during this thesis, a special mention to Alex Chan, Deviana Octavira and Kan Honore Kple.

A special mention towards the members of the EDHEC EcoFinance Club, whose belief in the

theme of “responsible investments” inspired me during the initial period of the thesis idea

generation.

I finally would like to acknowledge the support of Mr Vaidyanathan, the Cuissot family in

Nice, France and the Rao & Badami family in Mumbai, India for their constant best wishes.
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Table of Contents

1. Introduction...................................................................................................5

2. Overview.........................................................................................................7

2.1 Infrastructure Scenario in India......................................................................7

2.2 The viability of investments into the infrastructure asset class.......................9

3. Research Outline.......................................................................................11

3.1 Indian Exchanges and Indices........................................................................11

3.2 Infrastructure and other theme based funds in India......................................16

3.3 Motivation for research on sector focussed funds..........................................22

4. Literature Review.....................................................................................24

4.1 The Basic tenets of Portfolio theory...............................................................24

4.2 Portfolio Performance Measures.....................................................................29

4.3 Benchmark Error Problem..............................................................................33

4.4 The Ambiguity in Performance measurement due to benchmark selection...36

4.5 Literature review on Indices and Benchmarks................................................38

5. Data....................................................................................................................40

5.1 Indices.............................................................................................................40

5.2 Mutual Fund Data...........................................................................................40

5.3 Risk Free Rate.................................................................................................41

5.4 Benchmark information and Fund objective details.......................................41

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6. Analysis Formulation and Research Methodology..............42

6.1 Analysis Formulation......................................................................................42

6.1.1 The Scope of Analysis and Methodology.............................................44

6.2 Research Methodology...................................................................................48

6.2.1 Calculation of Basic Measures...............................................................48

6.2.2 Methodology of Analysis.......................................................................49

6.2.2 Execution of Four Stage Analysis..........................................................50

7. Results and Analysis................................................................................53

7.1 Comparison of Jensen’s Alpha Measure.........................................................53

7.2 Application of the Information Ratio as a motivation factor..........................56

7.3 Application of the M-Squared Measure..........................................................62

7.4 Sector Returns based Style analysis................................................................64

8. Conclusion and Scope for further Research............................70

9. References......................................................................................................72
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1. Introduction

The mutual fund industry in India serves as the bridge between the capital markets and the

masses of people who seek to invest on to it. The Indian mutual fund market has grown leaps

and bounds from the initial highly regulated market. The trust the retail investors have in the

fund industry is very apparent with the growth in assets under management especially in the

recent years. Though it seems that investing in a mutual fund is the safest and relatively an

easier method to traverse the market, it does have its downsides, the downsides range from

operational issues to macroeconomic issues, however the issue of performance measurement

has long been a matter of debate, with the numerous performance measures available, the

question is have these measures been truly appreciated by funds and thereby helped to

improve the returns of the corpus invested into the markets?. The answer is ambiguous, there

have been funds that have outperformed the market and there have been funds that have not.

Among the more recent flurry of schemes that have bloomed in recent times are sector

focussed funds, these funds cater exclusively to a particular sector and whose investors

appreciate the fact that the risk level is higher than diversified funds, among the largest group

of sector focussed funds that have been started are funds catering to the Infrastructure and

Energy sector, with the Indian economy expected to grow at about 8-9% (GDP) over the next

5 to 7 years, the Infrastructure and energy sector has been labelled as the next big

“revolution” in India and the capital markets has taken this “revolution” to investors who

seek to invest into this growth. However the mutual funds catering to this sector have not

been able to leverage the growth of this sector, returns from infrastructure and energy sector

indices have shown high returns but this has not been shown in their respective sector

focussed funds.
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This thesis looks into aspects on how a particular decisive factor can guide the fund industry

into improving its performance measurement as against the respective sector. This decisive

factor is the role of the “benchmark”. Since most widely used investment performance

measures have been derived from the comparison of the fund and the benchmark, the choice

of an effective equity index as a benchmark is crucial. The thesis uses the Infrastructure and

Energy sector growth as the motivational factor to explain the importance of the choice of the

benchmark. Other sector focussed funds are also studied and a contrast is shown in various

performance measures.

The thesis proceeds in the following manner, Chapter 2 gives an overview of the

Infrastructure and Energy scene in India, and this seeks to show the robust past growth and

the strong expectations of future growth. Chapter 3 seeks to bridge the practical aspects of the

viability of the Infrastructure/Energy sector and lists the research outline and motivation for

conducting the thesis. Chapter 4 is a presentation of the literature review that has been carried

out, the aim of this being to look into theoretical aspects of fund performance measurement,

choices of benchmarks and possible benchmarking error issues. Chapter 5 is a presentation of

the sources of data used to carry out the study. Chapter 6 presents the analysis formulation

and research methodology, the aim of this chapter being to present the motivational factors

and tools used to analyse the crux of the thesis. Chapter 7 lists out the analysed data with the

analysis of the results and the opinions that can be formed based on the analysis. Chapter 8

concludes the thesis and gives aspects of further academic research.

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2. Overview

2.1 Infrastructure Scenario in India

The Indian infrastructure sector is being viewed as the next big investment opportunity for

the Indian economy and capital markets, Until recent years the infrastructure sector in India

had been dominated by Government bodies and their close group of contractors and sub-

contractors, with the economic liberalisation of the 1990s and the robust GDP growth in the

2000s, the Indian infrastructure sector is now the most followed sectors in the Indian

economy, this has opened the sector to greater corporate bodies investing into it coupled with

existing government run enterprises. The Indian Central Planning Commission1 defines

infrastructure as all those activities involved in the following sectors:

 Power (includes generation, transmission and distribution)

 Non-conventional energy (includes solar, hydro and wind energy sectors)

 Telecommunications

 Roads, Bridges, Sea Ports, and Waterways

 Airports and Railways

 Irrigation and Agricultural storage facilities

 Oil and Gas transmission networks

Why is the Indian Infrastructure sector being viewed as the next big investment opportunity

for the Indian Economy?

__________________________________
1
Central Planning Commission’s Empowered Sub-Committee on Infrastructure following consensus on the
Rangarajan Committee recommendations on infrastructure (2008)
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The Planning Commission in a comment stated that the lack of adequate infrastructure in

India was holding back economic growth by about 1.5% to 2% per year. Following a near

7%+ growth in GDP over the last decade, there is a greater initiative by the Government to

improve the nation’s backbone, namely the infrastructure space. The state of the Indian

infrastructure has never quite lived up to the expectations of the nation’s growing population

and also by the international investment community. A study from Goldman Sachs Asset

Management2 estimates that the Indian economy is to grow at about 8% until 2020 and with

such a bullish sentiment to India there is a need for the infrastructure problem to be

addressed. To value the opportunity facing the investor community to the Indian

infrastructure sector, it is estimated to be worth US $ 492 billion with a major thrust

weightage towards the Power, Ports and Roadways subsectors. Within the Power sector an

amount of US $ 200 billion is estimated to be invested over the next 7 years to fuel a massive

100,000 megawatt capacity creation. However there are certain non financial roadblocks

namely being political risks, Supply side constraints to do business and possible environment

issues.

The Goldman Sachs report states however that the Indian economy is on the rise and that the

investment community can expect favourable returns.

Another crucial area to the Indian economy is the Oil and Gas sector. The Oil and Gas sector

amounts to about 15% of the GDP. According to a Confederation of Indian Industry and

KPMG report, the energy sector will need about US $ 120 to 150 billion in investments over

the next 5 years. Similar to the infrastructure space, the Oil and Gas space in India is too in

dire need of investments and that the issue of demand must be met with supply. India today is

the fifth largest consumer of energy.

__________________________________
2
Goldman Sachs Global Economics Paper No: 152; India’s rising potential.
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With imports amounting to 70% of total demand, India’s imports of oil and gas is about US $

90 billion in 2008-09, this causing a significant amount of burden to the exchequer. A

significant opportunity lies in the domestic reserves for Oil and Gas, estimated at around 60%

of the Oil reserves in India have yet to be discovered or explored, The Oil and Gas sector to

provide a massive opportunity for investors to seek profitable returns.

2.2 The viability of investments into the Infrastructure asset class

A recent study conducted by JP Morgan Asset Management on Infrastructure3 attempts to

classify infrastructure as a separate asset class and uses historic cash flows of US

infrastructure companies from 1986 to 2006 to assess infrastructure’s performance. The key

findings of this study are:

 Volatility of infrastructure cash flows is materially lower than those of equities and

real estate.

 Infrastructure cash flows are not highly correlated to equities and real estate.

 Diversification within the infrastructure space is possible with relatively low

correlations between sub sectors.

An interesting finding from the JP Morgan study is that infrastructure flows are generally

protected against inflation; this is due to various pricing mechanisms that infrastructure

providers enter into with the Government. Of late the infrastructure space is also being

looked up as a defensive asset class and that is due to a consistent user demand and a

relatively long term predictable income position of companies involved in infrastructure

activities.

__________________________________
3
JP Morgan Asset Management Insights: Infrastructure investing, a portfolio diversifier with stable cash yields.
 10

The study further adds that merchant power generation and communications networks

services provide the highest capital appreciation with an average cash yield of 4% to 12%.

This is followed with development of toll roads and seaports and airports. The risk factors are

generally medium to low. One factor that must be considered is the issue of liquidity; this

sector is generally less liquid but is suitable for long term investment holdings. Another key

issue is the disinvestment of government control can sometimes lead to delays in the

implementation of projects. The last point is a major factor that India has faced over the

decades however due to a robust capital market and inflows of foreign investments into the

capital market and through direct investments, the infrastructure sector can now be viewed

truly as the next big investment opportunity in India.

The following section gives an overview of the infrastructure sector in the Indian capital

markets, also discussed is the presence of mutual funds catering towards investments in

infrastructure and energy companies. A comparison with other sector based mutual funds is

also discussed. The following section concludes with the motivation on why this particular

topic was chosen for the master’s thesis.

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3. Research Outline

3.1 Indian exchanges and indices

The Indian capital markets have been in existence for over 100 years and dates back to

India’s colonial past, however it is in the recent years that the capital markets have received

the due attention needed and has begun to serves as an investment gateway to millions of

Indians and Indian enterprises seeking to invest in the growing Indian economy. The major

exchanges in India are the Bombay stock exchange and the National stock exchange, both of

which are located in India’s commercial capital Mumbai (Bombay).

The major stock indices of the Bombay Stock Exchange are described below:

 The Bombay Stock Exchange Sensitive Index (BSE SENSEX): This index tracks the

top 30 listed companies of the Indian economy and is the most widely tracked and

quoted index in India and the globe. The method of computation of this index is based

on the free float market capital methodology. The index represents about 45% of the

total market capital in the Bombay Stock Exchange.

 The Bombay Stock Exchange 100 Index (BSE 100): This index includes components

of the BSE SENSEX and the next top 70 listed companies in the Indian economy. The

method of computation is based too on the free float market capital methodology.

The index represents about 75% of the total market capital in the Bombay Stock

Exchange.

 The Bombay Stock Exchange 200 and 500 Index’s (BSE 200 & BSE 500): These two

indices track the broader market and include a number of medium and small capital

listed companies, the method of computation is also based on the free float market
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capital methodology. The BSE 200 represents about 85% of the total market capital

and the BSE 500 represents about 94% of the total market capitalisation of the

Bombay Stock Exchange.

In addition to the above mentioned indices, sector tracking indices for Banking, Power,

Oil & Gas, Metals, Technology and Consumer goods, etc. exist. Other indices include the

BSE Mid Cap and BSE Small Cap indices which track mid cap and small cap listed

companies exclusively.

From the National Stock exchange the following indices are widely tracked, these indices

are managed and owned by the India Index Services and Products Limited (a joint venture

between National Stock Exchange and CRISIL). The marketing of these indices are

executed by Standard and Poor’s. A brief description of the major indices is described

below:

 National Stock Exchange S&P CNX NIFTY: This is the premier index from the

National Stock exchange and tracks the top 50 listed companies of the economy. It

represents about 65% of the total market capitalization in the market and caters to

a broad diversification of sectors. The S&P CNX Nifty has an active index based

derivatives market attached to it, apart from being followed in India, the S&P

CNX Nifty’s futures positions are tracked on the Singapore Stock Exchange

through the SGX Nifty Futures. The method of computation of this index is based

on the free float market capitalisation methodology.

 National Stock Exchange CNX 100: This index includes components of the S&P

CNX Nifty and the next 50 listed companies on the National Stock Exchange. The

method of computation of this index is based on the total market capitalisation

methodology and represents about 75% of the total market capitalisation.

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 National Stock Exchange S&P CNX 500: This index is India’s largest broad based

index and captures about 95% of the total market capitalisation across 72 industry

specifications. The index is often referred to as the market portfolio in the Indian

capital markets because of the size and the volumes traded on it.

Similar to the Bombay Stock Exchange, the National Stock Exchange has the CNX Midcap

Index that tracks a large number of mid cap listed companies in India.

The Bombay Stock Exchange has a large number of sector tracking indices, these indices

represent some of the largest and reputed companies of India, sector indices worldwide have

been used as benchmarks to sector based mutual funds and in India too, a sizeable number of

funds use these indices as benchmarks. A brief description of these indices is given below.

(All indices are computed on the free float market capitalisation methodology.)

 BSE Oil and Gas index: This index tracks the top Oil and Gas companies of India,

which includes upstream, middle and downstream companies in addition to ancillary

companies. The index represents about 16% of the total market capital of the Bombay

Stock Exchange.

 BSE Power index: This index tracks the top Power companies of India, which

includes power generating, transmission and other power distribution companies, this

in addition to other ancillary companies. The index represents about 10% of the total

market capital of the Bombay Stock Exchange.

 BSE Metals index: This index tracks the top Metals and Mining companies of India,

The index represents about 9% of the total market capital of the Bombay Stock

Exchange.
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 BSE Capital Goods index: This index tracks the top Infrastructure and capital goods

producing companies of India, the companies provide a combination of companies

that supply capital goods to the infrastructure, power, and other energy sectors. The

index represents about 6% of the total market capital of the Bombay Stock Exchange.

 BSE TECk index: This index tracks the top Technology companies of India; the index

represents about 13% of the total market capital of the Bombay Stock Exchange.

 BSE IT index: This index tracks the top Information Technology companies of India;

the index represents about 7% of the total market capital of the Bombay Stock

Exchange.

 BSE FMCG index: This index tracks the top consumer goods companies of India; the

index represents about 4% of the total market capital of the Bombay Stock Exchange.

 BSE Healthcare index: This index tracks the top healthcare and pharmaceutical

companies of India; the index represents about 3% of the total market capital of the

Bombay Stock Exchange.

 BSE Bankex: This index tracks the top banking companies of India; the index

includes both government controlled and private controlled banks, the index

represents about 8% of the total market capital of the Bombay Stock Exchange.

Other indices include indices tracking the Automobile and Real Estate sector. Among other

sector indices that exist is the FTSE-IDFC Infrastructure 30 Index, this index jointly owned

by the FTSE and the Infrastructure Development Finance Corporation of India track the top

infrastructure companies in India, the term infrastructure refers to the Government of India’s

definition of infrastructure.
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Chart 2.1- Sector index weightings on the Bombay Stock Exchange

Other indices that track the Indian capital market include indices from the MSCI (MSCI India

Index comprising of 60 companies) and the FTSE (FTSE India Index comprising of about 50-

60 companies).

Returns from these indices along with have been relatively strong over the past four years4

and the table shows a comparative list of widely referred indices in India.

Table 2.1- Annualised performance measures of major indices

Index Mean Standard Deviation
BSE Cap Goods 32.95% 45.34%
BSE Oil & Gas 25.36% 36.69%
BSE Power 24.33% 40.89%
FTSE IDFC Infrastructure 23.43% 34.20%
BSE Bankex 18.23% 42.51%
BSE SENSEX 17.96% 31.61%
BSE 100 17.33% 33.82%
S&P CNX NIFTY 16.64% 32.27%
BSE 200 16.08% 34.28%
BSE FMCG 15.88% 24.02%
BSE 500 15.86% 35.01%
S&P CNX 500 15.26% 34.86%
BSE Metals 12.98% 54.91%
BSE TECK 9.60% 28.81%
BSE Healthcare 6.19% 28.33%
BSE IT 5.57% 31.02%

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4
BSE Power Index created on January 2005, therefore returns taken from January 2005.
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3.2 Infrastructure and other theme based funds in India

The performance of the capital market in recent years and in particular infrastructure related

indices has led to a wide scale introduction of Equity mutual fund schemes from investment

management companies catering exclusively to the infrastructure and energy space. As of

June 2009 the Assets under Management in this category amounted to Rs 33,25,6105 (in

hundred thousand) or US $ 69,284 (in hundred thousand). The chart below shows the major

fund houses and the share of total Assets under Management for these schemes.

Chart 2.2-Share of AUMs in infrastructure related funds

There also exists a sizeable number of other sector based funds, these funds also with the

investment objective of investing into sector growth areas of the Indian economy. Other

sector funds include funds in the Banking, Consumer Goods, Pharmaceutical & Healthcare

space and in the Technology space. The robust growth and the returns on sector indices have

not been reflected by the funds, clearly there has been no consistent performer among these

funds6.

__________________________________
5
Source: Association of Mutual Funds India (AMFI).
6
Funds featured are values from growth funds also similar include dividend funds, no distinction has been made
on open or close ended schemes; data for these funds are from the time period April 2006 to the most recent new
fund offering. Source of data: Association of Mutual Funds of India.
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Table 2.2- Monthly and annualised mean and standard deviations of Infrastructure/Energy Funds
Sl No Mutual Fund Name Sector Mean Annualised Mean Std Dev Annualised Std Dev
1 Reliance Power Fund (Retail) Power 1.85% 22.24% 11.02% 38.17%
2 ICICI Prudential Infrastructure Fund (Retail) Infrastructure 1.19% 14.29% 10.91% 37.80%
3 Sahara Infrastructure Fund Infrastructure 0.83% 10.00% 10.87% 37.67%
4 DSP Blackrock TIGER Fund (Retail) Infrastructure 0.77% 9.26% 11.12% 38.53%
5 Tata Infrastructure Fund Infrastructure 0.76% 9.12% 11.22% 38.88%
6 Canara Robeco Infrastructure Fund Infrastructure 0.65% 7.83% 12.31% 42.64%
7 Sundaram BNP Capex Fund Infrastructure 0.63% 7.61% 12.57% 43.56%
8 UTI Infrastructure Fund Infrastructure 0.62% 7.47% 10.52% 36.44%
9 Birla Sunlife Infrastructure Fund Infrastructure 0.54% 6.52% 11.62% 40.26%
10 ICICI Prudential Power Fund (Institutional) Power 0.41% 4.86% 9.73% 33.71%
11 ICICI Prudential Power Fund (Retail) Power 0.31% 3.76% 9.74% 33.72%
12 HSBC Progressive Themes Fund Infrastructure -0.05% -0.56% 9.81% 33.98%
13 JM Financial Basic Industries Fund Infrastructure -0.21% -2.54% 16.53% 57.25%
14 UTI Energy Fund Energy -2.71% -32.51% 16.11% 55.81%

Table 2.3- Monthly and annualised mean and standard deviations of other sector Funds
Sl No Mutual Fund Name Sector Mean Annualised Mean Std Dev Annualised Std Dev
1 Reliance Banking Fund-Growth Plan-Growth Option Banking 1.63% 19.53% 11.30% 39.14%
2 UTI Banking Sector Fund-Growth Option Banking 1.34% 16.12% 11.59% 40.14%
3 Reliance Pharma Fund-Growth Plan-Growth Healthcare 0.54% 6.43% 10.41% 36.05%
4 DSP BlackRock Technology.com Fund-Regular Plan-Growth Technology 0.29% 3.45% 10.25% 35.51%
5 Franklin FMCG Fund - Growth Consumer Goods 0.07% 0.81% 5.80% 20.08%
6 Franklin Pharma Fund - Growth Healthcare 0.00% 0.01% 8.02% 27.77%
7 SBI MSFU FMCG Consumer Goods -0.09% -1.12% 7.14% 24.74%
8 ICICI Prudential FMCG Plan-Growth Option Consumer Goods -0.17% -2.07% 7.43% 25.73%
9 Birla Sun Life New Millenium Fund-Plan B(Growth) Technology -0.38% -4.57% 9.57% 33.17%
10 Franklin Infotech Fund-Growth Technology -0.59% -7.03% 9.19% 31.83%
11 ICICI Prudential Technology Fund Technology -0.61% -7.33% 10.60% 36.73%
12 SBI MSFU PHARMA - GROWTH Healthcare -0.93% -11.14% 11.02% 38.16%
13 SBI MSFU IT Technology -1.14% -13.69% 11.27% 39.04%

The funds featured above have returns available from April 2006, the period of April 2007,

and onwards have been an equal number of new fund offerings; the table below shows the

return statistics on these funds6a.

__________________________________
6a
Funds featured include values from Equity growth funds; similar schemes exist in the dividend option. Do
note that these funds new fund offerings dates are inconsistent and when ever featured in the rest of the thesis
will have the “date from which returns available” column next to it.
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Table 2.3- Monthly and annualised mean and standard deviations of Infrastructure/Energy Funds
Sl No Mutual Fund Name Sector Mean Annualised Mean Std Dev Annualised Std Dev Date Returns available
1 Taurus Infrastructure Fund -Growth Option Infrastructure 0.38% 4.55% 15.49% 53.66% Mar-07
2 ICICI Prudential Infrastructure Fund - Institutional Option - I - Growth Infrastructure 0.96% 11.52% 12.10% 41.93% Apr-07
3 DSP BlackRock India T.I.G.E.R. Fund - Institutional Plan - Growth Infrastructure/Energy -0.01% -0.11% 12.91% 44.73% Jun-07
4 SBI Infrastructure Fund-Series I Growth Infrastructure -0.62% -7.38% 13.95% 48.34% Jul-07
5 DBS Chola Infrastructure Fund-Cumulative Option Infrastructure -2.62% -31.48% 16.66% 57.70% Oct-07
6 Escorts Infrastructure Fund - Growth Option Infrastructure -2.64% -31.69% 11.81% 40.93% Oct-07
7 Religare Infrastructure Fund - Growth Option Infrastructure -2.50% -29.97% 11.72% 40.61% Nov-07
8 Tata Indo-Global Infrastructure Fund - Growth Infrastructure -2.04% -24.52% 13.07% 45.29% Nov-07
9 Sundaram BNP Paribas Energy Opportunities Fund Growth Energy -1.19% -14.24% 13.64% 47.24% Jan-08
10 JM Agri & Infrastructure Fund- Growth option Infrastructure -6.42% -77.04% 18.08% 62.63% Jan-08
11 Kotak Indo World Infrastructure Fund - Growth Infrastructure -1.87% -22.45% 12.95% 44.86% Jan-08
12 AIG Infrastructure and Economic Reform Fund-Institutional Plan-Growth Infrastructure -2.24% -26.83% 14.14% 48.99% Feb-08
13 AIG Infrastructure and Economic Reform Fund-Regular Plan-Growth Infrastructure -2.29% -27.49% 14.14% 48.99% Feb-08
14 Reliance Natural Resources Fund-Growth Plan-Growth Option Natural Resources/Energy -0.99% -11.91% 11.79% 40.85% Feb-08
15 Reliance Diversified Power Sector Fund Institutional Plan Growth Plan Growth Option Power -0.78% -9.40% 13.07% 45.27% Feb-08
16 LICMF-Infrastructure Fund-Growth Option Infrastructure -0.63% -7.53% 13.62% 47.19% Mar-08
17 HDFC Infrastructure Fund-Growth Option Infrastructure -0.48% -5.79% 14.78% 51.18% Apr-08
18 DSP BlackRock Natural Resources And New Energy Fund-Institutional Plan-Growth Natural Resources/Energy -0.19% -2.26% 11.24% 38.94% Apr-08
19 DSP BlackRock Natural Resources And New Energy Fund-Regular Plan-Growth Natural Resources/Energy -0.27% -3.22% 11.25% 38.98% Apr-08
20 Sahara Power & Natural resources Fund- Growth Option Power/Natural Resources 1.31% 15.71% 15.25% 52.83% Jun-08

Clearly as mentioned earlier there has not been a consistent performance among sector

focussed funds when compared to sector focussed indices. The table in the following page

shows the list of 47 mutual funds6b in India that represent approximately 95% of the total

sector focussed funds6c in India. Of the 47 funds in this study 21 funds use a sector index as

their benchmark and 26 funds use a broader market index as their benchmark.

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6b
Funds featured are growth focussed funds; similar funds exist for the dividend option. There has been no
distinction made on open and close ended funds. Funds featured have Net Asset values from April 2006 sourced
from the Association of Mutual Funds of India (AMFI)
6c
The remaining 5% of funds include very recent fund offerings(less than a year), also featuring in the 5%
include hybrid funds that track sectors but across asset classes, for example equity and commodities.
 19

Table 2.4- Sector focussed funds with details of type of index used as benchmark
Stated Benchmark
Sl No Mutual Fund Name Sector Sector Benchmark Diversified Benchmark
1 Reliance Banking Fund-Growth Plan-Growth Option Banking 
2 UTI Banking Sector Fund-Growth Option Banking 
3 Franklin FMCG Fund - Growth Consumer Goods 
4 ICICI Prudential FMCG Plan-Growth Option Consumer Goods 
5 SBI MSFU FMCG Consumer Goods 
6 UTI Energy Fund Energy 
7 Sundaram BNP Paribas Energy Opportunities Fund Growth Energy 
8 Franklin Pharma Fund - Growth Healthcare 
9 Reliance Pharma Fund-Growth Plan-Growth Healthcare 
10 SBI MSFU PHARMA - GROWTH Healthcare 
11 Birla Sunlife Infrastructure Fund Infrastructure 
12 Canara Robeco Infrastructure Fund Infrastructure 
13 ICICI Prudential Infrastructure Fund (Retail) Infrastructure 
14 JM Financial Basic Industries Fund Infrastructure 
15 Sahara Infrastructure Fund Infrastructure 
16 Sundaram BNP Capex Fund Infrastructure 
17 Tata Infrastructure Fund Infrastructure 
18 UTI Infrastructure Fund Infrastructure 
19 AIG Infrastructure and Economic Reform Fund-Institutional Plan-Growth Infrastructure 
20 AIG Infrastructure and Economic Reform Fund-Regular Plan-Growth Infrastructure 
21 DBS Chola Infrastructure Fund-Cumulative Option Infrastructure 
22 Escorts Infrastructure Fund - Growth Option Infrastructure 
23 HDFC Infrastructure Fund-Growth Option Infrastructure 
24 ICICI Prudential Infrastructure Fund - Institutional Option - I - Growth Infrastructure 
25 JM Agri & Infrastructure Fund- Growth option Infrastructure 
26 Kotak Indo World Infrastructure Fund - Growth Infrastructure 
27 LICMF-Infrastructure Fund-Growth Option Infrastructure 
28 Religare Infrastructure Fund - Growth Option Infrastructure 
29 SBI Infrastructure Fund-Series I Growth Infrastructure 
30 Tata Indo-Global Infrastructure Fund - Growth Infrastructure 
31 Taurus Infrastructure Fund -Growth Option Infrastructure 
32 DSP Blackrock TIGER Fund (Retail) Infrastructure/Energy 
33 HSBC Progressive Themes Fund Infrastructure/Energy 
34 DSP BlackRock India T.I.G.E.R. Fund - Institutional Plan - Growth Infrastructure/Energy 
35 DSP BlackRock Natural Resources And New Energy Fund-Institutional Plan-Growth Natural Resources/Energy 
36 DSP BlackRock Natural Resources And New Energy Fund-Regular Plan-Growth Natural Resources/Energy 
37 Reliance Natural Resources Fund-Growth Plan-Growth Option Natural Resources/Energy 
38 ICICI Prudential Power Fund (Institutional) Power 
39 ICICI Prudential Power Fund (Retail) Power 
40 Reliance Power Fund (Retail) Power 
41 Reliance Diversified Power Sector Fund Institutional Plan Growth Plan Growth Option Power 
42 Sahara Power & Natural resources Fund- Growth Option Power/Natural Resources 
43 Birla Sun Life New Millenium Fund-Plan B(Growth) Technology 
44 DSP BlackRock Technology.com Fund - Regular Plan - Growth Technology 
45 Franklin Infotech Fund-Growth Technology 
46 ICICI Prudential Technology Fund Technology 
47 SBI MSFU IT Technology 
 20

The choice of using diversified indices as benchmarks for sector focussed funds is a matter of

interest, the correlation matrix of returns from February 2005 below shows how diversified

indices and sector indices are correlated, the correlations between infrastructure/energy

indices (BSE Power, BSE Capital Goods, BSE Oil & Gas and FTSE-IDFC Infrastructure)

and the broader market diversified indices are relatively very highly correlated. Among other

sector focussed indices, the correlations are relatively lower.

Table 2.5- Correlation matrix of major broad indices with sector focussed indices

Correlation Matrix BSE Sensex S&P CNX NIFTY BSE 100 BSE 200 BSE 500 S&P CNX 500 BSE Power BSE Oil & Gas BSE Cap Goods BSE Bankex BSE Metals BSE FMCG BSE TECK BSE IT BSE Healthcare FTSE IDFC
BSE Sensex 1.00 0.99 1.00 0.99 0.99 0.98 0.93 0.92 0.92 0.88 0.91 0.66 0.86 0.67 0.79 0.95
S&P CNX NIFTY 0.99 1.00 0.99 0.99 0.98 0.99 0.94 0.94 0.92 0.85 0.91 0.66 0.85 0.64 0.82 0.96
BSE 100 1.00 0.99 1.00 1.00 1.00 0.99 0.94 0.92 0.93 0.89 0.92 0.65 0.86 0.65 0.81 0.96
BSE 200 0.99 0.99 1.00 1.00 1.00 1.00 0.94 0.92 0.93 0.89 0.93 0.64 0.86 0.65 0.81 0.97
BSE 500 0.99 0.98 1.00 1.00 1.00 1.00 0.94 0.92 0.93 0.89 0.93 0.63 0.86 0.65 0.82 0.97
S&P CNX 500 0.98 0.99 0.99 1.00 1.00 1.00 0.94 0.93 0.93 0.88 0.92 0.63 0.85 0.63 0.82 0.97
BSE Power 0.93 0.94 0.94 0.94 0.94 0.94 1.00 0.86 0.95 0.83 0.85 0.62 0.73 0.48 0.73 0.98
BSE Oil & Gas 0.92 0.94 0.92 0.92 0.92 0.93 0.86 1.00 0.84 0.75 0.89 0.58 0.73 0.52 0.72 0.87
BSE Cap Goods 0.92 0.92 0.93 0.93 0.93 0.93 0.95 0.84 1.00 0.82 0.87 0.56 0.74 0.51 0.71 0.96
BSE Bankex 0.88 0.85 0.89 0.89 0.89 0.88 0.83 0.75 0.82 1.00 0.75 0.44 0.72 0.51 0.63 0.85
BSE Metals 0.91 0.91 0.92 0.93 0.93 0.92 0.85 0.89 0.87 0.75 1.00 0.55 0.79 0.62 0.77 0.88
BSE FMCG 0.66 0.66 0.65 0.64 0.63 0.63 0.62 0.58 0.56 0.44 0.55 1.00 0.53 0.41 0.70 0.63
BSE TECK 0.86 0.85 0.86 0.86 0.86 0.85 0.73 0.73 0.74 0.72 0.79 0.53 1.00 0.92 0.81 0.79
BSE IT 0.67 0.64 0.65 0.65 0.65 0.63 0.48 0.52 0.51 0.51 0.62 0.41 0.92 1.00 0.67 0.54
BSE Healthcare 0.79 0.82 0.81 0.81 0.82 0.82 0.73 0.72 0.71 0.63 0.77 0.70 0.81 0.67 1.00 0.77
FTSE IDFC 0.95 0.96 0.96 0.97 0.97 0.97 0.98 0.87 0.96 0.85 0.88 0.63 0.79 0.54 0.77 1.00

The choice of sector focussed indices as benchmarks are absolute for Banking,

Pharmaceutical, Consumer Goods and Technology focussed funds, however among the

infrastructure and energy related funds, the choice of benchmarks are inconsistent and within

the choice of diversified indices there is no consistency in the choice of the index. Among

these diversified indices the correlations between them is ranges from 0.98 to 1.00, therefore

it could be argued that there is no major question regarding the choice of a broad index.
 21

The table below shows sector focussed funds using a wide range of broad indices and sector

indices as their respective benchmarks.

Table 2.6- Sector focussed funds with stated benchmark utilised

Sl No Mutual Fund Name Sector Benchmark
1 Reliance Banking Fund-Growth Plan-Growth Option Banking BSE Bankex
2 UTI Banking Sector Fund-Growth Option Banking BSE Bankex
3 Franklin FMCG Fund - Growth Consumer Goods BSE FMCG
4 ICICI Prudential FMCG Plan-Growth Option Consumer Goods BSE FMCG
5 SBI MSFU FMCG Consumer Goods BSE FMCG
6 Franklin Pharma Fund - Growth Healthcare BSE Healthcare
7 Reliance Pharma Fund-Growth Plan-Growth Healthcare BSE Healthcare
8 SBI MSFU PHARMA - GROWTH Healthcare BSE Healthcare
9 Birla Sun Life New Millenium Fund-Plan B(Growth) Technology BSE TECk
10 DSP BlackRock Technology.com Fund-Regular Plan-Growth Technology BSE TECk
11 Franklin Infotech Fund-Growth Technology BSE IT
12 ICICI Prudential Technology Fund Technology BSE IT
13 SBI MSFU IT Technology BSE IT
14 UTI Energy Fund Energy BSE Oil & Gas and BSE Power
15 Birla Sunlife Infrastructure Fund Infrastructure S&P CNX Nifty
16 Canara Robeco Infrastructure Fund Infrastructure BSE 100
17 ICICI Prudential Infrastructure Fund (Retail) Infrastructure S&P CNX Nifty
18 JM Financial Basic Industries Fund Infrastructure BSE Capital Goods
19 Sahara Infrastructure Fund Infrastructure S&P CNX Nifty
20 Sundaram BNP Capex Fund Infrastructure BSE Capital Goods
21 Tata Infrastructure Fund Infrastructure BSE Sensex
22 UTI Infrastructure Fund Infrastructure BSE 100
23 DSP Blackrock TIGER Fund (Retail) Infrastructure BSE 100
24 HSBC Progressive Themes Fund Infrastructure BSE 200
25 ICICI Prudential Power Fund (Institutional) Power S&P CNX Nifty
26 ICICI Prudential Power Fund (Retail) Power S&P CNX Nifty
27 Reliance Power Fund (Retail) Power BSE Power
28 Sundaram BNP Paribas Energy Opportunities Fund Growth Energy BSE Oil & Gas
29 AIG Infrastructure and Economic Reform Fund-Institutional Plan-Growth Infrastructure BSE 100
30 AIG Infrastructure and Economic Reform Fund-Regular Plan-Growth Infrastructure BSE 100
31 DBS Chola Infrastructure Fund-Cumulative Option Infrastructure S&P CNX Nifty
32 Escorts Infrastructure Fund - Growth Option Infrastructure S&P CNX Nifty
33 HDFC Infrastructure Fund-Growth Option Infrastructure S&P CNX 500
34 ICICI Prudential Infrastructure Fund - Institutional Option - I - Growth Infrastructure S&P CNX Nifty
35 JM Agri & Infrastructure Fund- Growth option Infrastructure BSE 500
36 Kotak Indo World Infrastructure Fund - Growth Infrastructure S&P CNX Nifty
37 LICMF-Infrastructure Fund-Growth Option Infrastructure BSE 100
38 Religare Infrastructure Fund - Growth Option Infrastructure S&P CNX Nifty
39 SBI Infrastructure Fund-Series I Growth Infrastructure BSE 100
40 Tata Indo-Global Infrastructure Fund - Growth Infrastructure BSE Sensex
41 Taurus Infrastructure Fund -Growth Option Infrastructure BSE 200
42 DSP BlackRock India T.I.G.E.R. Fund - Institutional Plan - Growth Infrastructure BSE 100
43 DSP BlackRock Natural Resources And New Energy Fund-Institutional Plan-Growth Natural Resources/Energy BSE Oil & Gas and BSE Metals
44 DSP BlackRock Natural Resources And New Energy Fund-Regular Plan-Growth Natural Resources/Energy BSE Oil & Gas and BSE Metals
45 Reliance Natural Resources Fund-Growth Plan-Growth Option Natural Resources/Energy BSE 200
46 Reliance Diversified Power Sector Fund Institutional Plan Growth Plan Growth Option Power BSE Power
47 Sahara Power & Natural resources Fund- Growth Option Power/Natural Resources S&P CNX Nifty
 22

3.3 Motivation for research on sector focussed funds

The previous sub section showed that there is inconsistency among sector focussed funds in

their choice of their respective benchmark; this is especially related towards

infrastructure/energy related funds. Therefore this subsection relates to certain questions that

are the rationale for the motivation of further research into how benchmarks affect fund

performance and the implications they have on the mutual fund. Using the Returns based

style analysis of Sharpe to determine which sector of the market determines returns on the

broad index, it’s observed that these broad indices do not provide any major sector based

return and the weightings of the returns are inconsistent between the diversified indices.

Chart 2.3- Returns based sector style analysis of various diversified indices (Feb-05 onwards)
 23

The charts show that among the broader diversified indices such as the BSE 100, 200, 500

and the S&P CNX 500, Banking and Technology are the key components that measure the

styled returns on the index, among the widely tracked indices such as the BSE Sensex and the

S&P CNX Nifty returns are dominated by the Technology sector followed by the Oil & Gas

sector for the BSE Sensex and the Power Sector for the S&P CNX Nifty. The point to be

noted however is that the weightings are relatively even based throughout which is consistent

with the theory that these are diversified indices, however the stylised returns also show

inconsistency among the indices.

Therefore the questions that are a matter of research are as follows:

 Does having a diversified benchmark for sector funds show better performance

measurement of the mutual fund?

 Does having a diversified index as a benchmark reduce the motivation of fund

managers to outperform their respective sector and be content with the fact that they

have performed relatively higher than the diversified index?

 Are sector funds truly tracking their respective sector and are they consistent with

their investment objective defined in their features of their fund?

 24

4. Literature Review

In this section of the thesis, financial literature on portfolio management and mutual fund

performance is discussed, the section begins with the basic tenets of portfolio theory

following which portfolio performance measures are discussed. Later the review on literature

which has been built around the portfolio theory is discussed and finally concludes with a

review on literature surrounding effective indices and benchmarks for funds.

4.1 The Basic tenets of Portfolio Theory

Portfolio Management makes a basic assumption about an investor’s risk-reward trade off,

this is that an investor’s needs are to maximise return from a set of investments at a given

level of risk. This indicates that investors are basically risk averse, namely that an investor

would invest in an instrument at the lowest possible risk level in that investment to seek the

maximum return.

Harry Markowitz (1952, 1959) theorised that a portfolio of assets is considered to be efficient

if no other asset or portfolio of assets offer a higher than expected return with the same or

lower risk. This was the basis of the mean-variance analysis which is a combination risky

asset to minimize the variance of risk. Credited also with the quantification of the measure of

portfolio risk, Markowitz (1959) developed a formula on standard deviation which is still

widely used today to measure portfolio risk7.

n n n
 port   w i2 i2   w i w jCovij
i 1 i 1 i 1
 25

where:
 port  the standard deviation of the portfolio
Wi  the weights of the individual assets in the portfolio, where
weights are determined by the proportion of value in the portfolio
 i2  the variance of rates of return for asset i
Covij  the covariance between the rates of return for assets i and j,
where Covij  rij i j

The covariance measure is the basic tool block from which diverse performance measures are

derived from and are used for comparisons between portfolios and benchmarks.

Widely considered as the father of modern portfolio theory it is Markowitz’s work that lays

the foundation of all portfolio theories and performance measurements. Another major

accomplishment in portfolio management was the work of Sharpe (1964) and Litnner (1965),

known as the Capital Market theory; it introduced the concept of a risk free asset and the

Capital Asset Pricing Model or the CAPM. The Capital Market theory developed the Capital

market line which meant that all portfolios that were on the line were positively correlated

and the line was known as the efficient frontier. A major finding from these initial studies

was that the risk and return increased or decreased in a linear manner. Significant in the study

was the presence of systematic and unsystematic risk, and according to the theory,

diversification of the portfolio led to the elimination of unsystematic risk. These early

concepts led to the formation of what was labelled as the market portfolio. The market

portfolio forms the crux of this thesis, since it includes the universe of risky assets which

means that the there is complete portfolio diversification which in turn allows for only

systematic risk. The market portfolio is the optimum point of tangency on the Capital market

line. Lorie (1975) mentions that a completely diversified portfolio would have a correlation

of +1.00 with the market portfolio. This is the key goal for most diversified funds which

invest within asset classes or across them.

 26

Therefore how is risk calculated on the Capital market line?, the Markowitz model measures

risk as the standard deviation of the portfolio with a factor of the equation linked to

covariance between the assets of the portfolio. In the capital market line risk is measured as

the covariance between the portfolio and the market portfolio. Mathematically it can be

described as a linear model as follows8.

R it  a i  bi R Mi  
Where:
Rit = return for asset i during period t
ai = constant term for asset i
bi = slope coefficient for asset i
RMt = return for the M portfolio during period t
 = random error term

Therefore the variance for a risky asset is described as below:

Var(R it )  Var (a i  bi R Mi   )

The Var (bi RMt) is the variance of return for an asset related to the variance of the market or

the systematic risk and Var () is the residual variance which measures the variance of the

asset not related to the market portfolio, which is also known as unsystematic risk. An

important derivation from the capital market line is the security market line which measures

the concept of Beta. The Beta is a standardised risk measure of systematic risk; it is a

standardised measure since it relates covariance (CoviM) to the variance of the market

portfolio. It also states that the Beta of a market portfolio is measured as 1.

Numerically: i  Cov i,M

M
2

Numerically the CAPM

E(R i )  RFR  i (R M - RFR)
 27

Where:
E(Ri) = Expected Return for asset i
RFR = Risk Free Rate
i  Cov i,M
M
2

RM = Return on the Market portfolio.

If the Beta of the portfolio or asset is greater than 1, it is assumed that the systematic risk is

greater than the market and the opposite if the Beta is less than 1.The Capital Asset Pricing

Model or CAPM, developed through the Capital Market Theory conceptualises on another

aspect namely the “Alpha” developed by Jensen (1968). Since the CAPM indicates the

expected or required rate of return on risky assets, the Alpha measures the estimated return

and the expected or required rate of return. In simple terms it is known as the excess return.

As these expected returns are plotted graphically and a trend line is fitted, the “Characteristic

line” is formed. This characteristic line is a regression model and shows the asset or the

portfolio’s relationship with the market portfolio.

Numerically:

R i,t   i  i R M, t  

Where:
Rit = return for asset i during period t
RMt = return for the M portfolio during period t
 i  R i - i R m
i  Cov i,M
M
2

Ross (1976) developed the Arbitrage Pricing theory as an alternative to the CAPM, the major

point which the APT differs to the CAPM is the measurement of risk, the latter measures risk

through the Beta, the Beta of the CAPM measures risk through the market portfolio.
 28

The assumptions that the APT state are that the markets are competitive, investors prefer

greater wealth to lower wealth and that there is a stochastic process that generates asset

returns that can be expressed as a linear function to a set of factors (or indexes).

Numerically the APT9 is:

Rt  Et  bi1 i  bi 2 i  ...  bik k   i

For i = 1 to N where:
Ri = return on asset i during a specified time period
Ei = expected return for asset i
bik = reaction in asset i’s returns to movements in a common factor
 k = a common factor with a zero mean that influences the returns on all assets
 i = a unique effect on asset i’s return that, by assumption, is completely diversifiable in large
portfolios and has a mean of zero.
N = Number of assets

The choices for the factors can vary accordingly to preferences, for example Macroeconomic-

based risk factor models developed by Chen, Roll and Ross(1986) and the most popular

Microeconomic-based risk factor models developed by Fama and French (1993), which is

also known as the characteristic based approach. Carhart (1997) developed the four factor

model which was an extension of the earlier Fama and French study.

Among the more alternative portfolio theories developed is the Returns-based style analysis

theory, developed by Sharpe (1992) it is an attempt to measure the style of returns that a

portfolio generates when compared to a set of factors or benchmarks, Sharpe uses twelve

assets classes to measure the returns based style analysis but there is no restriction to the

choice of factors or benchmarks.

__________________________________
7, 8 &9
Notation of the formulae based on Reilly and Brown: Investment Analysis and Portfolio Management.
 29

This concludes the basic tenets of portfolio theory, though there have been numerous

extensions and changes to these theories the basic elements of the theory remain unchanged

and are still widely referred to in most academic literature and in actual practice.

4.2 Portfolio Performance Measures

In the earlier section of the literature review, the basic tenets of portfolio management

described the basic components of performance measurement through the Beta and the

Alpha, however when comparing different portfolios performance measures are used to

measure how returns and risk can be brought to a comparable figure. These performance

measures help investors make effective choices on their future investment plans. There are

four widely used performance measures, namely the Treynor Measure, the Sharpe Ratio,

Jensen’s Alpha and the Information Ratio.

Treynor (1965) developed a performance measure which could be used by all investors

regardless of their risk preferences. The Treynor Performance Measure uses the excess return

that the portfolio generates over the risk free rate divided by the Beta of the portfolio. The

beta used by Treynor is from the CAPM.

Numerically

T
R i  RFR 
i

The numerator is the Risk Premium for the stated time period and the denominator is the beta

of the portfolio for the stated time period. Larger the value of T indicates a stronger

performing portfolio. The drawback to the Treynor Performance Measure is that it does not

indicate diversification of the portfolio.

 30

Sharpe (1966) developed the Sharpe Ratio which was used to measure performance of mutual

funds, similar to the Treynor Performance Measure it differs only at the denominator which

in the Sharpe Ratio is the standard deviation of the portfolio.

Numerically

S
R i  RFR 
i
Jensen (1968) developed the Jensen measure which is closely linked to the CAPM, also

known as the Jensen’s Alpha it measures whether the portfolio is proving superior returns or

inferior returns. The Jensen’s Alpha is the intercept measured from the characteristic based

line when plotted. When the Alpha is positive, it means that the portfolio is superior and the

opposite if the measure shows a negative value. The key benefit of this measure is that since

it is calculated based on a regression model, it is statistically significant.

Numerically:

Rit – Rf = αi + βi[RMt – Rf] + eit

Where:
Rit = return for asset i during period t
RMt = return for the M portfolio during period t
Rf = risk free rate during period t

αi = Rit – Rf - βi[RMt – Rf] + eit [Jensen’s Alpha Measure]

i  Cov i,M
M
2

The Alpha is basically shows how a portfolio manager can derive an above average return

which is adjusted for risk. Another positive aspect of the Jensen’s Alpha is that it can be used

in Multifactor models such as the Fama-French and Carhart models.

The Information Ratio is used to measure portfolio performance against its appropriate

benchmark. It measures the degree by which the portfolio has beaten the benchmark and it is
 31

a measure of consistency of the portfolio. Goodwin (1998) notes that the Information ratio as

a special case of the Sharpe Ratio.

Numerically

( R i  Rb ) ER i j
IR j    
 ER  ER U

The formula indicates the return in excess of the benchmark divided by the standard deviation

of this excess return. Noted works on the Information Ratio include Treynor and Black

(1973) and the Goodwin (1998).Grinold and Kahn (2001) state that the reasonable level of

the Information Ratio is from 0.50 to 1.00, where the value 1.00 is exceptional. However

there have been several doubts on whether a negative information ratio captures the true

purpose of the ratio. Israelsen (2005) developed a modified version of the ratio where in the

denominator is raised to the power of -1 signifying the division of the negative excess return

over the modulus of excess return.

The M-Squared Return developed by Dr. Franco Modigliani and Leah Modigliani (1997).

This measures returns which have been adjusted for risk, therefore the portfolio/fund and its

benchmark are levered on the same risk basis, and this is of interest to investors since the risk

levels are similar. The M-Squared measure is basically the Sharpe Ratio scaled by the

deviation of the benchmark return. This implies that if the portfolio or fund has a higher M-

Squared return than the portfolio, the fund is said to be performing in a superior manner.

Lastly another significant measure is the R-Squared; this measure also serves as a measure of

diversification and ability to explain movements of the portfolio to the benchmark index. The

closer the value of R-Squared is to 1.00, the more diversified the fund is with respect to the

index and hence the closer the movement of returns towards the index.
 32

These performance measures are widely used to this day, however there have been recent

literature which have built on these measures and also using measures that use holdings than

returns, the famous being the Grinblatt-Titman Performance Measure (1993).

A significant feature in most of these performance measures is the presence of the

benchmark; therefore the benchmark selection is the most crucial feature in fund or portfolio

measurement; these benchmarks are used as a reference point to rank or evaluate fund

performance. This implies that the role of the benchmark and its implications on fund

performance is critical.

The period of study in this thesis is from April 2006, for which the net asset values data are

available in this thesis marks a significant growth and decline for the Indian capital markets,

the highs of 2007 preceded the sharp falls of 2008 and the recovery in the first half of 2009.

Therefore the recent period can be considered as a dynamic economic period with markets

being bullish and bearish. In lieu of such volatility in the markets and the economy, the

mutual fund industry has been affected greatly. The Infrastructure and Energy sector have

been labelled as a stable sector as per the JP Morgan study mentioned in the overview section

also is a sector that is expecting huge growth potential; in India fund houses have tried to

capitalise this theme and infrastructure/energy funds have proven to be largest theme based

funds. With infrastructure emerging as an asset class, funds that cater to this sector have been

branded as lowly diversified, thereby increasing risk for investors.

In a study by Treynor and Mazuy (1966) in their paper researched 57 mutual funds to see if

they could predict whether these funds could outguess the market moves, however they found

no evidence to show that the fund managers could anticipate the market moves and take

corrective positions. They used their sample and tested whether fund manager’s returns could

produce a concave upward shaping characteristic line. These funds are diversified funds and
 33

thereby can move into low volatility assets such as fixed income assets during lower equity

periods. The findings from their tests is that only 1 out of the 57 funds could produce this

type of line, clearly showing that fund managers in general cannot outguess the market. As

outguessing the market is a difficult proposition for fund managers especially in dynamic

markets, most managers maintain positions relatively close to their benchmark (actively or

passively managed funds). Maintaining investments close to the benchmark or measuring

performance through the use of a benchmark have long proven to be a matter of debate in the

field of portfolio management.

4.3 The Benchmark Error problem

In a paper by Roll (1978), the ambiguity of measuring portfolio performance based on the

security market line is discussed; the security market line or the benchmark is often

determined by “judges”, these judges in Roll’s paper have varied views on the determination

of the benchmark and it varies from an equally weighted benchmark to a weighted

benchmark and finally to a benchmark that is mean-variance efficient (in line with

Markowitz’s theory). The study also shows that the correlations between the benchmarks are

relatively high with the lowest correlation being 0.88 and the highest being 0.98, the

interesting finding in this paper was that that the winners and losers varied among the judges,

Roll states that there is no uniform beta measure for the portfolio and that the beta is often

produced to reflect a desired magnitude. Therefore it is assumed that the security market line

cannot alone be used to differentiate superior to inferior portfolios. Use of the CAPM to

measure risk is still widespread among evaluators and this exposes performance measurement

to the benchmark error, Roll (1981)10 on a continuation of his earlier work in 1978 mentions

that there is source of an error in the ex ante CAPM benchmark and is an error that is of

greater importance than errors dues to unforeseen causes in the market.

 34

The study mentions that the benchmark error occurs when the benchmark is not on the ex

ante mean-variance efficient portfolio, simply stated is not an optimised portfolio, an accurate

definition of an optimised portfolio is that the slopes connecting the asset with the portfolio

are equal at the point where the optimised portfolio or benchmark is located on the SML.

This results in misspecification of the beta thereby resulting in erroneous performance

measures.

In a second finding that builds on the above scenario Roll lists that the benchmark or the

SML position is incorrect, this occurs due to the choice between a risk free asset and a

nominal risk free asset being employed on the SML. The measure of the extent in the errors

of the alphas which Roll generates is denoted as “π”, the study does however mention that

true performance that is measured is ex post and that causes of deviation are the ex ante SML,

thereby if evaluators can estimate deviations (between ex post and ex ante) independently the

CAPM could be corrected and hence the true performance measure could be measured. The

use of broader and diverse indices are generally used to evaluate performance measures, it is

assumed that greater the diversification the greater the optimised the index is, however in the

same study by Roll, it’s mentioned that that indices can produce similar or different errors,

and is not a full proof mechanism that will offer evaluations to be completely accurate. Roll

states that the correlations between the Dow Jones Industrial average and the S&P 500 are

high thereby altering the benchmark does not significantly reduce the benchmark error. The

major crux of Roll’s study is that the benchmark must be an optimised portfolio, which

means that it must be ex ante mean/variance efficient. In the second part of Roll’s (1981)

paper he establishes a clear understanding that using historical data to solve the benchmark

error is possible however it does mention that returns have been exceedingly “noisy”, the

significance this has to theme based funds is crucial, since theme based funds are based on

sector movements, there is a possibility wherein sector could prove “noisier” than diversified
 35

sectors, this assumption is made since in the study its noticed that the standard deviations of

the sample are not in complete cohesion with a broad based benchmark. Roll gives a 5 point

procedure which is used to measure benchmark errors and uses the S&P 500 index to test it.

The only drawback with this methodology of Roll is that the returns that are used are “noisy”

and non-stationary, thus the measurement of the benchmark error is difficult.

The main findings from the Roll’s study which is popularly known as the Rolls Critique is

that there is an existence of a benchmark error issue. Reilly and Akhtar (1995) revisited this

issue with a study on how broadly diversified indices can show different performance

measures. The study considered the CAPM used model to measure performance measures

such as the alpha and beta. The indices used are broadest market indices from the USA,

Japan, UK, Germany and the Morgan Stanley World Index, another index used is the Brinson

Partners Global Markets Security Index (GSMI). The unique feature of the GSMI is that it

uses optimization techniques to identify the portfolio mix across equity and fixed income

asset classes, therefore it is considered as the broadest market index as per their study. The

findings from this study are that the performance measures widely differ from the respective

domestic index to the international index and to the GSMI. An interesting finding was that

the beta of the asset in study is larger and this is due to the relatively small variance within

the GSMI. Reilly and Akhtar conclude that the betas are more consistent with larger

diversified benchmarks and believe that portfolios must employ benchmarking to such

indices since they measure systematic risk measures on a wider scale.

__________________________________
10
Roll (1981) published one paper in two parts, namely Performance evaluation and benchmark errors (I & II);
the review includes both parts of the paper.
 36

4.4 The Ambiguity in Performance Measurement due to Benchmark

selection

The previous section dealt with how a benchmark error can result in varied performance

measures for a portfolio or fund. In this section the choices of erroneous benchmark selection

are discussed. Sensoy (2008) states that the relationship between funds and investors is that

of a principal agent one and with a loophole in SEC regulations about the use of benchmark

indices, there is often a mismatched benchmark used and this is generally overlooked by the

investors (principals) due to their limited ability to judge useful to non useful benchmarks.

These mismatched benchmarks often show that funds either outperform them or could be

used as a method of influencing fund flows into the fund, his investigation led that the R-

Squared varies significantly from this mismatched benchmark (70%) to the corrected

benchmark (82%). The evidence of intentionally choosing mismatched benchmarks is proved

correct by Sensoy, and it is consistent with the fund’s strategy to attract greater fund inflows.

Daniel et al (2006) use the CAPM based asset pricing model in this paper and mentions that

benchmark misspecification causes biases(statistically significant) in the measures of

selectivity and timing ability of fund managers and states that investors generally infer that

these managers have a selectivity ability when in most situations there does not exist one. The

study finds that benchmark misspecification shows biased estimates of the Alpha measure,

these biases are economically significant if only there is a timing model misspecification.

Intuitively in portfolio management, an actively managed fund shows higher average returns

versus a passive benchmark at a given risk level, however according to Lehmann and Modest

(1987) there are two` limitations to this intuition namely a) there is a disagreement on the

appropriate measure of risk and b) errors in inferring when fund managers outperform the

market. The authors employ both the CAPM as well as the APT benchmarks to assess
 37

whether performance evaluation measures vary accordingly to the benchmark. The findings

of this study is that there is a significant difference in the performance measures when the

CAPM and APT benchmarks are used, the research shows that the Alpha measure from the

CAPM benchmark is similar to a “no risk adjustment” as when compared to an APT

benchmark, also within the APT benchmarks, there are differences in the Alpha and Treynor-

Black Ratios and this is due to the method used to construct the various APT benchmarks.

The ambiguity of the benchmark based performance measures led to a formulation of

Characteristic-Based benchmarks, Grinblatt et al (1997) introduced a performance measure

that formed benchmarks based on certain characteristics of the stocks that make up a

fund/portfolio. The main logic behind the characteristic-based benchmarks is that the

holdings of a fund can exhibit a better performance indicator as compared to merely studying

returns of a fund. According to Grinblatt et al, the advantage that characteristic-based

approach has is as follows:

 Empirical evidence shows that there is a superior ex ante forecast ability of future

returns

 The statistical significance of comparisons of performance is more robust and has the

power to detect abnormal performance

 Characteristic-based approach can be further broken down to sub components such as

timing and selectivity measures that allow determination on how returns are generated

 The calculation of performance measures is straightforward.

Gallagher et al (2007) modified the original theory on characteristic-based benchmarks and

discovered that the tracking error volatility halved, and was statistically more superior to

factor based models, for example the Carhart model. Overall the characteristic-based
 38

benchmark performance measures show a greater quantification of managerial ability and

stock selection skill, thereby highlighting an alternative performance measure and a

significant move from standard benchmark based performance measures.

4.5 Literature review on Indices and Benchmarks

In a study by the EDHEC Risk & Asset Management Research Centre11 in 2006, the quality

of stock market indices are discussed, the motivation behind this study was the inherent

defects in using capitalisation-weighted indices since these portfolios are not necessarily

optimal. The study shows that there are strong indications that existing stock market indices

are highly inefficient when compared to mean variance portfolios, this is crucial since a

majority of funds in the Indian mutual fund industry use market capitalisation indices from

the Bombay and National stock exchanges as their benchmarks. The study states that even for

the broadest indices, around 90% of the total capitalisation is generally made up by the top

20-30 companies and the remaining small-cap companies do not pose a major component.

This raises questions on whether the uses of broad based indices are relevant especially when

considering the high possibility of a benchmark error. The study discusses that the

benchmarks are often highly neglected and there are instances where fund managers choose

indices as their benchmarks that do not reflect their true investment style, therefore there is a

possibility that choosing a broad market index may not be the most optimal method to show

performance measurement. Another important factor is that index chosen as the benchmark

must reflect the risk level of the fund; therefore the benchmark must reflect the diversity of

the concerned fund and the investment style. The study also lists the rules or best practices of

how a benchmark should be, these best practices are from the Bailey et al (1990) and Bailey

(1992) papers. The benchmark must be unambiguous, investable, measurable, and

appropriate and reflect investor’s views on the investment strategy. Kuenzi (2003) suggests
 39

the use of “strategic” benchmarks to reflect the fund’s investment objectives; these are

customised benchmarks that reflect the true nature of the portfolio.

Broad based benchmarks should reflect the characteristics that was mentioned in the study by

Bailey et al, however this has not been the case, Cremers et al (2008) state that the broadest

based indices used by fund managers, namely the S&P 500 and the Russell 2000, when

regressed on the Carhart four factor model produce a positive and a negative alpha measure.

This finding contradicts the basic definition that broad based, passive and well diversified

indices should not possess an alpha. The paper uses the Fama-French methodology to seek to

find nonzero alpha measures. The analysis of the study results is that the Fama-French and

Carhart models mislead due to the presence of large alphas to the passive benchmark. The

rationale to these results is because of their construction methodology; Cremers et al state that

the SMB factor in the Fama-French model assigns disproportionate weights towards value

focussed stocks (more in Large Cap stocks), and this leads to the HML factor producing

higher returns, thus this creates a harder time for fund managers of small cap funds to beat the

benchmark and skews the results to funds that are invested in large cap companies. The study

modifies the Fama-French factors and highlights that alternative index based models explain

the returns in a better fashion which are closer to the original hypothesis that benchmarks

should exhibit nonzero alphas. Overall the authors stress that a seven factor model explains

fund returns more effectively and that a pure four factor index based model is far more

superior to the Carhart model. Overall the choice of effective and accurate benchmarks is an

ongoing matter of debate within the field of portfolio management but till there is a strong

alternative, the use of capital weighted indices continues to be utilised.

__________________________________
11
Assessing the Quality of Stock Market Indices: Requirements for Asset Allocation and Performance
Measurement (2006) by Amenc, Goltz and Le Sourd (2006)
 40

5. Data

5.1 Indices

The data used to calculate index returns for the indices that were mentioned earlier in the text

are the monthly adjusted closing values12, the data was retrieved from the DataStream

database from the EDHEC Business School, Nice. Market capitalisation data of the indices

were retrieved directly from the stock exchange websites. The period of returns were from a

range of the past 10 years to the time a particular index was created, however to maintain

uniformity in the analysis of index data, returns has been from February 2005 as this is the

date that the BSE Power index first started reporting. Data for the constituent list of the

FTSE-IDFC Infrastructure index were requested and subsequently provided by the FTSE

Group.

5.2 Mutual Fund Data

Mutual fund net asset values (NAVs) were downloaded from the Association of Mutual funds

of India (AMFI) website. AMFI is an independent body that represents the mutual fund

industry in India and serves as a link between the regulatory bodies in India (for example the

Security Exchange Board of India or SEBI). Due to constraints in the website mutual fund

data retrieved is available from March 2006 and about 27 of the 47 funds mentioned earlier

have returns available from March 2006, of the remaining 20 funds, data retrieved is from the

date the fund has started functioning and reporting its NAVs on the AMFI website. There is

no distinction made in the thesis on open and close ended funds.

__________________________________
12
Lo & MacKinlay (1988) suggest that monthly returns are superior to daily returns since they are free from
sampling biases due to bid ask spreads, trading volumes and other inherent issues, Source: Testing Random
walk hypothesis for Indian Stock Market indices; Pant & Bishnoi
 41

Due to the complex nature of seeking details of dividends declared by mutual funds, the

thesis uses NAVs from only growth option (income or fixed option) schemes of these funds.

The month end NAVs are used to calculate the monthly returns. Details of the mutual funds

under study have been covered earlier in the text. Other data with respect to Asset under

Management have also been retrieved from the AMFI Website. A note of caution with

respect to the values from AMFI website is that these values are directly uploaded by the

concerned mutual fund at the end of business day transactions.

5.3 Risk Free Rate

The 91 day Treasury bill yield has been used as the risk free rate. The 91 day Treasury bill is

directly issued by the Government of India and is completely free of any risk. The 91 day

Treasury bill is highly liquid and is actively traded on the secondary fixed income market.

The data of the month end yields have been retrieved from the DataStream database at the

EDHEC Business School, the rates retrieved were in annualised terms and we converted to

monthly rates.

5.4 Benchmark information and Fund objective details

Details of the benchmarks used by the mutual funds was obtained from the respective fund’s

website, this benchmark was cross verified with two independent mutual fund research

agencies namely Mutual Funds India Online and Value Research India. Fund objective

details were similarly obtained.

 42

6. Analysis Formulation and Research Methodology

6.1 Analysis formulation

The scheme of this thesis study is ex-post and the period of study in this thesis is from April

2006 to June 2009, the study of the funds makes no distinction between open and closed

ended schemes, however for reason of simplicity only growth option mutual fund schemes

were chosen, since the similar fund exists for the dividend option the broad emphasis of the

thesis remains unchanged. The time period marked major economic events in the Indian and

Global markets the notable being the credit crisis of 2008 and the recovery of capital markets

from March 2009, the section on research outline earlier in the text showed discrepancies in

the selection of benchmarks for sector focussed funds in India, in particular for

infrastructure/energy funds. This section seeks to address the analysis required to address

certain key points about the choice of benchmarks and its effects on performance measures.

Reilly and Akhtar (1995) showed that the betas of the companies under their study vary

significantly when the benchmark is changed. Comparing their study to the case of sector

focussed funds in this case; the resultant table shows some varied results in the differences of

betas, the betas of the stated benchmark are compared to the betas of the broader index in

India, namely the S&P CNX 500.

Table 6.1- Differences in Beta values between stated benchmarks and S&P CNX 500
Stated Benchmark S&P CNX 500
Sl No Mutual Fund Name Sector Beta Intercept R-Squared (Adj) Beta Intercept R-Squared (Adj)
1 Reliance Banking Fund-Growth Plan-Growth Option Banking 0.8151 0.70% 0.9330 0.8801 1.23% 0.7514
2 UTI Banking Sector Fund-Growth Option Banking 0.8569 0.37% 0.9817 0.9094 0.93% 0.7630
3 Franklin FMCG Fund - Growth Consumer Goods 0.7460 0.02% 0.7228 0.4518 -0.14% 0.7523
4 ICICI Prudential FMCG Plan-Growth Option Consumer Goods 0.8419 -0.22% 0.5547 0.5475 -0.42% 0.6700
5 SBI MSFU FMCG Consumer Goods 0.6144 -0.13% 0.3080 0.3592 -0.25% 0.2973
6 Franklin Pharma Fund - Growth Healthcare 0.8502 0.18% 0.8296 0.5803 -0.26% 0.6450
7 Reliance Pharma Fund-Growth Plan-Growth Healthcare 1.0730 0.76% 0.7826 0.7976 0.18% 0.7263
8 SBI MSFU PHARMA - GROWTH Healthcare 1.1536 -0.68% 0.8084 0.8655 -1.32% 0.7649
9 Birla Sun Life New Millenium Fund-Plan B(Growth) Technology 1.0179 -0.27% 0.8830 0.7810 -0.73% 0.8266
10 DSP BlackRock Technology.com Fund-Regular Plan-Growth Technology 1.0766 0.40% 0.8611 0.8205 -0.08% 0.7949
11 Franklin Infotech Fund-Growth Technology 0.9574 -0.09% 0.9695 0.5241 -0.82% 0.3902
12 ICICI Prudential Technology Fund Technology 0.8312 -0.18% 0.5371 0.7506 -0.95% 0.6156
13 SBI MSFU IT Technology 0.9202 -0.66% 0.5849 0.7769 -1.49% 0.5825
 43

The table shows that except for the two banking related funds, the other funds show higher

betas to their respective sector benchmark as compared to the broader benchmark.

The R-Squared measure also shows the level of diversification and explanatory factors that

affect the movement of the fund has as compared to the broader index. The next table shows

the similar analysis on infrastructure/energy funds.

Table 6.2-Differences in Beta values within Infrastructure/energy funds

Stated Benchmark S&P CNX 500
Sl No Mutual Fund Name Sector Beta Intercept R-Squared (Adj) Beta Intercept R-Squared (Adj)
1 UTI Energy Fund Energy 0.6168 -3.10% 0.1476 0.6298 -2.99% 0.1690
2 Birla Sunlife Infrastructure Fund Infrastructure 1.1047 -0.11% 0.9295 1.0251 0.08% 0.9707
3 Canara Robeco Infrastructure Fund Infrastructure 1.1202 -0.06% 0.9603 1.0831 0.16% 0.9663
4 ICICI Prudential Infrastructure Fund (Retail) Infrastructure 1.0422 0.57% 0.9390 0.9522 0.76% 0.9497
5 JM Financial Basic Industries Fund Infrastructure 1.0803 -1.45% 0.8693 1.4237 -0.85% 0.9247
6 Sahara Infrastructure Fund Infrastructure 1.0299 0.22% 0.9227 0.9511 0.40% 0.9540
7 Sundaram BNP Capex Fund Infrastructure 0.8324 -0.32% 0.8925 1.0615 0.16% 0.8871
8 Tata Infrastructure Fund Infrastructure 1.0889 0.06% 0.9297 0.9832 0.32% 0.9574
9 UTI Infrastructure Fund Infrastructure 0.9360 0.03% 0.9168 0.9078 0.21% 0.9283
10 DSP Blackrock TIGER Fund (Retail) Infrastructure 1.0157 0.12% 0.9670 0.9843 0.33% 0.9774
11 HSBC Progressive Themes Fund Infrastructure 0.8697 -0.55% 0.9445 0.8518 -0.43% 0.9403
12 ICICI Prudential Power Fund (Institutional) Power 0.9316 -0.15% 0.9435 0.8573 0.02% 0.9687
13 ICICI Prudential Power Fund (Retail) Power 0.9320 -0.24% 0.9434 0.8577 -0.07% 0.9686
14 Reliance Power Fund (Retail) Power 0.8184 1.10% 0.9192 0.9336 1.43% 0.8938

Among the 14 funds in the table above, only three funds use a sector focussed index as their

benchmark (JM Financial Basic Fund, Sundaram BNP Capex Fund and the Reliance Power

Fund), the other funds use varied diversified indices and hence there is no trend in the

differences in beta values, however the 3 funds mentioned above show a higher beta toward

the S&P CNX 500 as compared to their sector benchmark. The analysis of Reilly and Akhtar

(1995) states that the choice of a correct benchmark must be broad based and an index that

measures all the risk available in the market shows true performance measures to the

portfolio.
 44

This however may not be completely accurate with respect to sector focussed funds; to

compare these funds with a diversified index/benchmark dilutes the ability of the investment

objective that the fund has set out at inception. On average the main focus of sector focussed

equity funds is to capitalise on the benefits that the sector provides. The scope of equity

focussed funds in India are gaining momentum in recent years, however the ability of these

funds to provide the results as defined in their investment objectives is questionable. The

earlier section on the Research outline showed basic returns data and there is a clear focus

that the indices have outperformed the funds. The main focus of the analysis in this thesis is

to show how sector focussed funds are performing as compared to their respective industry

segment; this industry segment is represented by the respective index.

6.1.1 The Scope of Analysis and Methodology

The questions raised earlier in the earlier section of the Research Outline were:

 Does having a diversified benchmark for sector funds show better performance

measurement of the mutual fund?

 Does having a diversified index as a benchmark reduce the motivation of fund

managers to outperform their respective sector and be content with the fact that they

have performed relatively higher than the diversified index?

 Are sector funds truly tracking their respective sector and are they consistent with

their investment objective defined in their features of their fund?

In order to effectively analyse whether sector focussed funds show superior or inferior

performance measures when compared to a diversified benchmark and to their respective

sector index/benchmark the following “four stage” analysis is carried out to seek to determine

this premise.
 45

 Comparison of the Jensen’s alpha measure of the funds versus its stated benchmark,

broader index and the sector focussed index and its statistical relevance: The use of

the Jensen’s alpha measure is one of the most used performance indicators to judge

the performance gain/loss that a portfolio/fund has generated. The aim of this analysis

is to measure whether the “alpha measure” varies significantly and if so in which

direction. The hypothesis is whether benchmarking a fund to a broad index shows

superior alpha performance as compared to benchmarking as against a sector focussed

index. The alpha measure is obtained for the fund’s respective stated benchmark, the

broader index namely the S&P CNX 500 and the sector index. The implication of the

analysis is to measure whether the fund manager has outperformed his/her particular

industry segment or has he/her merely positioned the fund along with the market and

produced an alpha that is positive over the broader market but not the specific sector.

The use of the t-statistic is to analyse the statistical relevance of the alpha that is

deduced. The relevance of the value of the alpha is measured as significant if the t-

statistic is above or below +/- 1.96 at a 95% confidence level for degrees of freedom

greater than 200. The null hypothesis in this case is that the alpha is not significantly

different from zero, hence the rationale that if the t-statistic is greater that +/- 1.96

there is a significance to it.

 The second focus area of the analysis is the measure of the Information Ratio as a

motivation factor: The information ratio is the single adequate statistic that is used to

capture ex post value addition that has been created16. The information ratio is a

measure of excess benchmark return over the standard deviation of the excess return

on the benchmark. It is a risk adjusted performance measure. The information ratio is

used to measure the fund manager’s skill as described by Grinold and Kahn (2001),

the reasonable level of the Information Ratio is from 0.50 to 1.00, where the value
 46

1.00 is exceptional. The t-statistic of the Information Ratio is approximately equal to

the square root of the number of years under observation multiplied by the

Information ratio13.

Numerically: T-statistic = Information ratio * √T (T = number of years)

The t-statistic is significant as the time period is longer but the value addition to a

fund manager serves the same purpose. The reason behind the use of this performance

measure is that it measures the fund’s excess returns over a benchmark; hence the

value addition that the fund manager shows is directly proportional to the ability of

beating the benchmark. Since the choices of benchmarks are ambiguous in this

scenario, an information ratio should be able to determine whether the respective fund

has truly been able to carry on up to its investment objective. Israelsen (2005)

proposed a minor change in the Information ratio, this largely due to the fact that

excess returns are also negative and therefore the current Information ratio captures

the true essence of its purpose incorrectly when excess returns are negative.

 The use of the M Squared Measure: The M Squared measure is among the recent

additions to portfolio performance measurement; the measure is related to the Sharpe

ratio and is expressed as a percentage based measure. The M Squared measure was

developed by Franco Modigliani and Leah Modigliani, the idea of this measure is to

adjust the risk of the investment to the equal level of risk that the benchmark

possesses, and hence the rationale to use this measure to determine whether

benchmark selection is an important criterion for sector focussed funds in India.

________________________________
13
Grinold and Kahn (1999) Active Portfolio Management: A Quantitative approach for providing superior
returns and controlling risk. (Page 327) The t-statistic is related to the t-statistic from the Jensen’s alpha
calculation.
 47

Numerically14

M2 = {(Ri – Rf)/σi }* (σm + Rf)

A leverage factor is calculated (Li = σm/ σi) that measures the benchmark standard

deviation over the fund’s standard deviation. A leverage factor that is greater than one

indicates that the fund should consider leveraging its corpus (at the risk free rate) to

increase the investment into the fund and hence expect to achieve a higher return. The

complete opposite is evident if the leverage factor is lesser than one. Also if the M

Squared measure is higher than the benchmark, it not only shows that the fund has

outperformed the benchmark but it has with risk adjusted to it. Higher the measure as

compared to the benchmark, the more effective the measure is to an investor and for

the fund.

 Use of the Sector Returns based style analysis and Efficient Frontier: The returns

based style analysis is a method created by William Sharpe and it determines how a

portfolio returns are styled as against the respective benchmarks. The rationale for the

use of this method is that since the funds under study have shown mixed returns as

compared to sector indices and also the broader indices (certain funds use these

diversified indices as their benchmarks), the question lies in whether these funds have

remained definite towards their investment objective of investing in a particular sector

or whether the funds have shown diversification along the period.

________________________________
14
Notation based from the paper “Investing with a conscience” An evaluation of the risk adjusted performance
measure of SRI mutual funds; Ed Edwards and Ajay Samant (Western Michigan University), Mid American
Journal of Business (2003)
 48

The returns based style analysis shows weightings based on the level a particular

sector influences the returns of the fund. In order to determine whether the sector style

weights reflect with certain consistency to the sector’s risk and return, a risk and

return chart is constructed with an efficient frontier of an optimised portfolio of sector

indices. The efficient frontier is an important determinant on how the funds relate to

their style, closer to the frontier either indicates a stronger diversification of the fund

or a greater selection of individual assets in the portfolio that reflect a stronger risk-

return profile as compared to the respective index. The efficient frontier is constructed

with the restriction of “short selling” hence the weights add up to 1 (or 100%). The

optimised portfolio is carried out by maximising the returns of the portfolio at a

relatively lower measure of risk or vice versa. This is solved as a quadratic program.

Numerically

n n
Min  p2   wi w j ij i j Subject to w1  w2  ...  wN  1
i 1 j 1

Where w1 + w2 +........+ wN = 1 are the weights of the optimised portfolios generated

through the quadratic program.

6.2 Research Methodology

6.2.1 Calculation of basic measures

The returns of the index and the respective NAVs of the mutual funds were calculated based

on the lognormal returns formula given below. The use of the lognormal function is because

they show a time additive measure of returns also it is assumed that these returns provide a

normal distribution. Calculation of this return is conducted through the Microsoft excel

spreadsheet.
 49

Ri  ln Valuet / Valuet 1 

Where:

Ri = Percentage Returns of index or mutual fund

Valuet = Value of the index or net asset value at the current time

Valuet-1 = Value of the index or net asset value at the preceding time period, in this case the
prior month’s value.

The calculation of the average return and standard deviation is through the built in function

on Microsoft excel. When the above mentioned statistics are annualised the average monthly

mean is multiplied by 12 (signifying the twelve months) and the standard deviation is

multiplied by the square root of 12.

The Risk free rate as mentioned earlier is the 91 day Treasury bill yield issued by the

Government of India, the rates quoted are converted into monthly rates through the formula

“Monthly rate = (1 + Annual rate)(1/12) – 1”.

6.2.2 Methodology of Analysis

Due to constraints on the historic availability of data collection of Net Asset values and the

limitations on the AMFI database, the period of study is restricted from April 2006 to June

2009. Of the 47 sector focussed mutual funds, 27 of them have NAVs from April 2006 and

the remaining have NAVs ranging from April 2007 to June 2008, in the study and in the data

analysis there is a distinction in the presentation of results. The distinctions are as follows:

 Sector focussed funds with sector benchmarks are shown separately and performance

measures have been computed with the stated benchmark as well as the S&P CNX

500.
 50

 Sector focussed funds that use broad diversified indices as benchmarks are shown

separately and performance measures have been computed with the stated benchmark

as well as the S&P CNX 500 and the “would have been best sector index”.

 Among the 20 newer funds that have NAVs from April 2007, there is a similar

method of data analysis as the two points mentioned above.

The phrase “would have been best sector index” is an ex post phrase that the index that best

describes the benchmark index that would have best suited a particular fund. Among the

infrastructure funds, the best sector index that best describes the objectives of these funds is

the FTSE-IDFC Infrastructure Index.

The execution of the four stages of analysis is carried out independently from each other and

the resultant data and analysis is mutually exclusive from each other. The rationale for this

method is that there are intricate decisions taken by fund managers that are not available,

hence the purpose is to show a comparative study. The final analysis uses findings from these

four methods and forms and opinion and the conclusion.

6.2.3 Execution of the four stage analysis

 The first stage of the analysis is the calculation of the Jensen’s alpha, the Jensen’s

alpha is determined through the OLS time series regression of the returns of the fund

against the stated benchmark, the S&P CNX 500 and if needed the sector focussed

index, the regressions are independent to each other. The model used in the regression

is based on the single index model of the CAPM where in the only factor that

determines risk is the index. The resultant alpha measures and corresponding t-

statistics and p values are interpreted to determine the premise. For funds that have

NAVs from April 2006, the degrees of freedom are 37, the rest are documented.
 51

 The second stage of calculation namely of the Information ratio was similarly

calculated independently with comparison to the index, the formula and background

to the ratio was mentioned earlier in the thesis document. An additional measure

namely the Israelsen’s Information Ratio was also calculated, the Israelsen’s measure

is a used when there is a possibility of a negative excess return. The ratio remains

consistent with the original ratio when the excess return is positive.

Numerically

The Israelsen’s measure on Information Ratio

( R i  Rb )
IR j  
 ER X

Where X = ∑ ( Ri - Ri) / ∑ (Absolute value of Ri - Ri) or “-1”

 The third stage of the analysis is the calculation of the M Squared measure, the M

Squared measure is a percentage value and is compared with the stated benchmark,

the S&P CNX 500 and the sector focussed benchmark. (The details of the M-Squared

measure have been covered earlier in the chapter).

 The final analysis is the sector returns based style analysis developed by Sharpe

(1992), as there are no fixed factors in the original work, hence the factors that have

been used is the various sector indices and the resultant values determine the sector

style of returns that the fund generates. It is assumed that the sector focussed fund’s

returns are styled on the sector they are focussed too. The style sector factors weights

are achieved through a quadratic programming method and are conducted through the

use of the Solver function of Microsoft excel. In addition to this analysis, as

mentioned in the analysis formulation section for this method, the risk-return chart

and the efficient frontier of the portfolio of indices chart has been constructed. The
 52

efficient frontier is executed on Microsoft Excel through the Solver function. The

minimising factor to determine the efficient portfolio weights is the portfolio variance

and the weights are generated through changes made in the expected or desired rate of

returns of the portfolio.

 53

7. Results and Analysis

This section lists the results of the ex post analysis conducted on 47 sector focussed mutual

funds in India. The section is divided into four parts with each part detailing the results and

follows the four stage analysis mentioned in the earlier chapter.

7.1 Comparison of the Jensen’s Alpha measure

Tables 7.1.1 and 7.1.2 below shows comparative alpha measures of mutual funds that use a

sector focussed index as their respective benchmark.

Table 7.1.1- Comparative Alpha measures across industrial sectors and the S&P CNX 500
Benchmark S&P CNX 500
Sl No Mutual Fund Name Sector Benchmark Alpha t Stat P-value Alpha t Stat P-value
1 Reliance Banking Fund-Growth Plan Banking BSE Bankex 0.60% 1.28 0.21 1.17% 1.29 0.20
2 UTI Banking Sector Fund-Growth Option Banking BSE Bankex 0.29% 1.16 0.26 0.88% 0.98 0.33
3 Franklin FMCG Fund - Growth Consumer Goods BSE FMCG -0.11% -0.22 0.82 -0.43% -0.93 0.36
4 ICICI Prudential FMCG Plan-Growth Option Consumer Goods BSE FMCG -0.30% -0.38 0.70 -0.66% -0.97 0.34
5 SBI MSFU FMCG Consumer Goods BSE FMCG -0.33% -0.35 0.73 -0.60% -0.62 0.54
6 UTI Energy Fund Energy BSE Oil & Gas;Power -3.98% -1.60 0.12 -3.19% -1.36 0.18
7 Franklin Pharma Fund - Growth Healthcare BSE Healthcare 0.10% 0.19 0.85 -0.48% -0.63 0.53
8 Reliance Pharma Fund-Growth Plan-Growth Healthcare BSE Healthcare 0.80% 1.03 0.31 0.07% 0.08 0.94
9 SBI MSFU PHARMA - GROWTH Healthcare BSE Healthcare -0.60% -0.78 0.44 -1.39% -1.62 0.11
10 JM Financial Basic Industries Fund Infrastructure BSE Capital Goods -1.41% -1.47 0.15 -0.63% -0.86 0.39
11 Sundaram BNP Capex Fund Infrastructure BSE Capital Goods -0.41% -0.63 0.54 0.19% 0.28 0.78
12 Reliance Power Fund (Retail) Power BSE Power 1.00% 2.00 0.05 1.40% 2.43 0.02
13 Birla Sun Life New Millenium Fund Technology BSE TECk -0.26% -0.50 0.62 -0.85% -1.33 0.19
14 DSP BlackRock Technology.com Fund-Reg Technology BSE TECk 0.44% 0.72 0.48 -0.18% -0.24 0.81
15 Franklin Infotech Fund-Growth Technology BSE IT -0.11% -0.42 0.68 -1.08% -0.93 0.36
16 ICICI Prudential Technology Fund Technology BSE IT -0.26% -0.23 0.82 -1.08% -1.03 0.31
17 SBI MSFU IT Technology BSE IT -0.70% -0.60 0.55 -1.61% -1.38 0.18
* Values marked in bold show statistical significance at a 95% confidence interval

Table 7.1.2-Comparative Alpha measures** across industrial sectors and the S&P CNX 500
Benchmark S&P CNX 500
Sl No Mutual Fund Name Sector Benchmark Alpha t Stat P-value Alpha t Stat P-value df
1 Sundaram BNP Paribas Energy Opp Fund Energy BSE Oil & Gas -0.56% -0.42 0.68 0.07% 0.10 0.92 15
2 DSP BlackRock Nat Res & New Energy Fund-Inst Nat Res/Energy BSE Oil & Gas;Metals 0.89% 2.09 0.06 0.68% 0.60 0.56 12
3 DSP BlackRock Nat Res & New Energy Fund-Reg Nat Res/Energy BSE Oil & Gas;Metals 0.81% 1.89 0.09 0.60% 0.53 0.61 12
4 Reliance Diversified Power Sector Fund Inst Power BSE Power 0.40% 0.46 0.65 0.46% 1.06 0.31 14
** Alpha measures from funds whose returns are available from April 2007
 54

Of the 21 funds only 1 fund has shown an alpha measure that is statistically significant

(statistically tending to favour the choice of the S&P CNX 500 as a better indicator of the

alpha measure). Analysing the economic value of the alphas; 7 funds have shown that the

alpha indicated by the choice of the S&P CNX 500 as the benchmark is higher than against

their sector benchmark.14 funds have generated a higher alpha on their respective benchmark

over the alpha generated by S&P CNX 500. This result can be inconclusive as it can be

argued that outperforming the sector is important and on the other hand out performing the

broader market is important. Since there is no significant statistical number to conclude

statistical relevance of the robustness of the alpha, we analyse the p values to judge the

number of funds that tend to statistically favour the S&P CNX 500 or the sector index as true

benchmark to measure the robustness of the alpha. Of the 21 funds, 9 funds tend to show that

the alpha measure calculated on the sector benchmark show a more robust value as compared

to the S&P CNX 500. 11 funds show that the alpha on the S&P CNX 500 shows a robust

measure of alpha. Therefore the analysis shows mixed conclusions on which index shows a

stronger statistically tending value.

Tables 7.1.3 and 7.1.4 below shows comparative alpha measures of infrastructure/energy

sector funds that use a diversified index as their benchmark.

Table 7.1.3- Comparative alpha measures of funds with their benchmark, S&P CNX 500 and sector index
Stated Benchmark S&P CNX 500 Sector Index #
Sl No Mutual Fund Name Sector Benchmark Alpha t Stat P-value Alpha t Stat P-value Alpha t Stat P-value
1 Birla Sunlife Infrastructure Fund Infrastructure S&P CNX Nifty -0.06% -0.12 0.91 0.09% 0.30 0.77 -0.36% -0.80 0.43
2 Canara Robeco Infrastructure Fund Infrastructure BSE 100 0.00% 0.01 1.00 0.21% 0.58 0.57 -0.28% -0.82 0.41
3 ICICI Prudential Infrastructure Fund (Ret) Infrastructure S&P CNX Nifty 0.59% 1.37 0.18 0.74% 1.88 0.07 0.31% 0.72 0.48
4 Sahara Infrastructure Fund Infrastructure S&P CNX Nifty 0.24% 0.49 0.63 0.38% 1.01 0.32 -0.05% -0.13 0.90
5 Tata Infrastructure Fund Infrastructure BSE Sensex 0.11% 0.23 0.82 0.31% 0.83 0.41 -0.13% -0.34 0.73
6 UTI Infrastructure Fund Infrastructure BSE 100 -0.01% -0.02 0.99 0.16% 0.36 0.00 -0.25% -0.59 0.56
7 DSP Blackrock TIGER Fund (Retail) Infrastructure BSE 100 0.13% 0.41 0.68 0.32% 1.20 0.24 -0.12% -0.35 0.73
8 HSBC Progressive Themes Fund Infrastructure BSE 200 -0.62% -1.67 0.10 -0.51% -1.33 0.19 -0.89% -2.18 0.04
9 ICICI Prudential Power Fund (Institutional) Power S&P CNX Nifty -0.19% -0.50 0.62 -0.06% -0.21 0.84 -0.40% -0.74 0.46
10 ICICI Prudential Power Fund (Retail) Power S&P CNX Nifty -0.28% -0.75 0.46 -0.15% -0.54 0.59 -0.49% -0.91 0.37
* Values marked in bold show statistical significance at a 95% confidence interval
## Values marked in italic bold shows statistical significance at a 90% confidence interval
# Sector index for Infrastructure sector is the FTSE-IDFC Index and the BSE Power index for the Power Sector
 55

Table 7.1.4- Comparative alpha measure across the stated benchmark, S&P CNX 500 and Sector Index
Stated Benchmark S&P CNX 500 Sector Index #
Sl No Mutual Fund Name Sector Benchmark Alpha t Stat P-value Alpha t Stat P-value Alpha t Stat P-value df
1 AIG Infrastructure and Eco Reform Fund-Inst Infrastructure BSE 100 -0.90% -1.08 0.30 -0.89% -0.94 0.36 -1.16% -1.31 0.21 14
2 AIG Infrastructure and Eco Reform Fund-Reg Infrastructure BSE 100 -0.96% -1.15 0.27 -0.94% -0.99 0.34 -1.21% -1.38 0.19 14
3 DBS Chola Infrastructure Fund-Cumulative Option Infrastructure S&P CNX Nifty -0.40% -0.32 0.75 -0.68% -0.54 0.60 -0.63% -0.43 0.67 18
4 Escorts Infrastructure Fund - Growth Option Infrastructure S&P CNX Nifty -1.30% -1.09 0.29 -1.44% -1.43 0.17 -1.41% -1.24 0.23 18
5 HDFC Infrastructure Fund-Growth Option Infrastructure S&P CNX 500 0.17% 0.22 0.83 0.17% 0.22 0.83 0.02% 0.03 0.98 13
6 ICICI Prudential Infrastructure Fund - Inst Infrastructure S&P CNX Nifty 0.78% 1.65 0.11 0.83% 1.64 0.11 0.21% 0.40 0.69 24
7 JM Agri & Infrastructure Fund- Growth option Infrastructure BSE 500 -4.39% -3.21 0.01 -4.66% -3.20 0.01 -4.73% -2.71 0.02 15
8 Kotak Indo World Infrastructure Fund - Growth Infrastructure S&P CNX Nifty -0.79% -1.05 0.31 -0.69% -1.41 0.18 -0.72% -1.10 0.29 15
9 LICMF-Infrastructure Fund-Growth Option Infrastructure BSE 100 -0.12% -0.18 0.86 -0.06% -0.11 0.92 -0.19% -0.27 0.79 13
10 Religare Infrastructure Fund - Growth Option Infrastructure S&P CNX Nifty -1.14% -1.58 0.13 -1.14% -2.07 0.05 -1.10% -1.88 0.08 17
11 SBI Infrastructure Fund-Series I Growth Infrastructure BSE 100 -0.32% -0.80 0.43 -0.22% -0.48 0.64 -0.62% -1.10 0.28 21
12 Tata Indo-Global Infrastructure Fund - Growth Infrastructure BSE Sensex -0.56% -0.44 0.67 -0.60% -0.47 0.64 -0.57% -0.43 0.67 17
13 Taurus Infrastructure Fund -Growth Option Infrastructure BSE 200 -0.08% -0.09 0.93 0.05% 0.06 0.95 -0.77% -0.76 0.45 25
14 DSP BlackRock India T.I.G.E.R. Fund - Inst Infrastructure BSE 100 0.01% 0.03 0.98 0.15% 0.44 0.66 -0.32% -0.67 0.51 22
15 Reliance Natural Resources Fund-Growth Plan Nat Res/Energy BSE 200 0.02% 0.02 0.99 0.02% 0.02 0.98 0.00% 0.00 1.00 13
16 Sahara Power & Natural resources Fund Power/Nat Res S&P CNX Nifty 0.81% 0.81 0.44 0.64% 0.99 0.34 0.67% 0.77 0.46 8
* Values marked in bold show statistical significance at a 95% confidence interval
## Values marked in italic bold shows statistical significance at a 90% confidence interval
# Sector index for Infrastructure sector is the FTSE-IDFC Index, Power Sector is the BSE Power Index and for
the Natural resources sector it is the BSE Oil & Gas and BSE Metals indices.

From tables 7.1.3 and 7.1.4, the total number of funds that use a diversified index as a

benchmark is 26, out of which 4 funds have shown statistical significance (2 funds at 90%

confidence interval and 2 funds at 95% confidence interval). Of the 26 funds, 25 funds have

shown a higher alpha (economically significant) when compared between the existing

benchmark and the sector index and 22 funds have shown a higher alpha (economically

significant) when compared between the S&P CNX 500 and the sector index.

On the comparison on whether the alphas are tending to be statistically significant when

compared between the benchmark and the sector index, 17 funds show that the p value on the

sector index is lower than the benchmark, thus implying that the alpha measured through the

sector shows a more robust value as compared to the alpha calculated from the benchmark.

On comparison on whether the alphas are tending to be statistically significant when

compared between the S&P CNX 500 and the sector index, 11 funds show that the p value on
 56

the sector index is lower than the S&P CNX 500, thus implying that the alpha measured

through the sector index shows a more robust value as compared to the alpha calculated from

the S&P CNX 500.

In conclusion to this analysis it can be argued that the erratic choice of diversified

benchmarks (non S&P CNX 500) does not reflect a robust alpha measure, however the

robustness of the alpha is mixed when sector indices and the S&P CNX 500 are compared

with 20 funds favouring the use of sector indices as a stronger indicator of alpha and 26

favouring the use of the S&P CNX 500.

7.2 Application of the Information Ratio as a motivation factor

The Information ratio metric shows the excess returns that a fund generates over a benchmark

divided by the standard deviation of the excess return over the benchmark. As stated earlier, a

higher Information ratio shows that the fund has been able to outperform the benchmark and

shows value addition to the fund. However a lower Information ratio shows that the fund has

not performed to its benchmark and that there are questions on the active portfolio

management strategies of the fund.

 Funds that use sector indices as benchmarks

Table 7.2.1 and 7.2.3 show the Information ratio of funds that use a sector focussed indices as

their benchmarks and a comparative Information ratio if the S&P CNX 500 is chosen as the

benchmark. Table 7.2.2 and 7.2.4 show the Modified Information ratio based on the similar

parameters as the previous tables. The Modified Information ratio is based on the corrected

version of Information ratio of Israelsen (2005).

 57

Table 7.2.1- Information Ratio comparison between benchmark and S&P CNX 500
Information Ratio
Sl No Mutual Fund Name Sector Benchmark Benchmark S&P CNX 500 Sector outperformance
1 Reliance Banking Fund-Growth Plan Banking BSE Bankex 0.44 0.71 YES
2 UTI Banking Sector Fund-Growth Option Banking BSE Bankex 0.29 0.55 YES
3 Franklin FMCG Fund - Growth Consumer Goods BSE FMCG 0.01 -0.20 NO
4 ICICI Prudential FMCG Plan-Growth Option Consumer Goods BSE FMCG -0.16 -0.33 NO
5 SBI MSFU FMCG Consumer Goods BSE FMCG -0.08 -0.20 NO
6 UTI Energy Fund Energy BSE Oil & Gas;Power -0.83 -0.73 YES
7 Franklin Pharma Fund - Growth Healthcare BSE Healthcare 0.21 -0.23 NO
8 Reliance Pharma Fund-Growth Plan-Growth Healthcare BSE Healthcare 0.54 0.05 NO
9 SBI MSFU PHARMA - GROWTH Healthcare BSE Healthcare -0.50 -0.87 NO
10 JM Financial Basic Industries Fund Infrastructure BSE Capital Goods -0.79 -0.35 YES
11 Sundaram BNP Capex Fund Infrastructure BSE Capital Goods -0.38 0.15 YES
12 Reliance Power Fund (Retail) Power BSE Power 0.83 1.34 YES
13 Birla Sun Life New Millenium Fund Technology BSE TECk -0.29 -0.62 NO
14 DSP BlackRock Technology.com Fund-Reg Technology BSE TECk 0.36 -0.11 NO
15 Franklin Infotech Fund-Growth Technology BSE IT -0.13 -0.41 NO
16 ICICI Prudential Technology Fund Technology BSE IT -0.04 -0.52 NO
17 SBI MSFU IT Technology BSE IT -0.30 -0.73 NO

Table 7.2.2- Modified Information Ratio comparison between benchmark and S&P CNX 500
Modified Information Ratio
Sl No Mutual Fund Name Sector Benchmark Benchmark S&P CNX 500 Sector outperformance
1 Reliance Banking Fund-Growth Plan Banking BSE Bankex 0.44 0.71 YES
2 UTI Banking Sector Fund-Growth Option Banking BSE Bankex 0.29 0.55 YES
3 Franklin FMCG Fund - Growth Consumer Goods BSE FMCG 0.01 -0.01 NO
4 ICICI Prudential FMCG Plan-Growth Option Consumer Goods BSE FMCG 0.00 -0.02 NO
5 SBI MSFU FMCG Consumer Goods BSE FMCG 0.00 -0.02 NO
6 UTI Energy Fund Energy BSE Oil & Gas;Power -0.28 -0.20 YES
7 Franklin Pharma Fund - Growth Healthcare BSE Healthcare 0.21 -0.01 NO
8 Reliance Pharma Fund-Growth Plan-Growth Healthcare BSE Healthcare 0.54 0.05 NO
9 SBI MSFU PHARMA - GROWTH Healthcare BSE Healthcare -0.01 -0.03 NO
10 JM Financial Basic Industries Fund Infrastructure BSE Capital Goods -0.03 -0.02 YES
11 Sundaram BNP Capex Fund Infrastructure BSE Capital Goods -0.01 0.15 YES
12 Reliance Power Fund (Retail) Power BSE Power 0.83 1.34 YES
13 Birla Sun Life New Millenium Fund Technology BSE TECk 0.00 -0.02 NO
14 DSP BlackRock Technology.com Fund-Reg Technology BSE TECk 0.36 0.00 NO
15 Franklin Infotech Fund-Growth Technology BSE IT 0.00 -0.04 NO
16 ICICI Prudential Technology Fund Technology BSE IT 0.00 -0.03 NO
17 SBI MSFU IT Technology BSE IT -0.02 -0.05 NO

Table 7.2.3- Information Ratio comparison between benchmark and S&P CNX 500(recent funds)
Information Ratio
Sl No Mutual Fund Name Sector Date Benchmark Benchmark S&P CNX 500 Sector outperformance
1 Sundaram BNP Paribas Energy Opp Fund Growth Energy Jan-08 BSE Oil & Gas -0.26 0.18 YES
2 Reliance Diversified Power Sector Fund Inst Power Feb-08 BSE Power 0.61 1.02 YES
3 DSP BlackRock Nat Res & New Energy Fund-Inst Nat Res/Energy Apr-08 BSE Oil & Gas; Metals 0.81 0.71 YES
4 DSP BlackRock Nat Res & New Energy Fund-Reg Nat Res/Energy Apr-08 BSE Oil & Gas; Metals 0.77 0.67 YES
 58

Table 7.2.4- Modified Information Ratio comparison between benchmark and S&P CNX 500 (recent
funds)
Modified Information Ratio
Sl No Mutual Fund Name Sector Date Benchmark Benchmark S&P CNX 500 Sector outperformance
1 Sundaram BNP Paribas Energy Opp Fund Growth Energy Jan-08 BSE Oil & Gas -0.01 0.18 YES
2 Reliance Diversified Power Sector Fund Inst Power Feb-08 BSE Power 0.61 1.02 YES
3 DSP BlackRock Nat Res & New Energy Fund-Inst Nat Res/Energy Apr-08 BSE Oil & Gas; Metals 0.81 0.71 YES
4 DSP BlackRock Nat Res & New Energy Fund-Reg Nat Res/Energy Apr-08 BSE Oil & Gas; Metals 0.77 0.67 YES

In the analysis to show a comparative performance metric and the choice of benchmark

selection reflects investment performance, the following scenarios are analysed.

The Sector index has outperformed the S&P CNX 500: Among the sector indices that have

outperformed the S&P CNX 500 is the BSE Power, BSE Capital Goods, BSE Oil and Gas,

BSE Metals and the BSE Bankex, this therefore implies that an active sector focussed fund or

even a passive fund would have outperformed the S&P CNX 500 and the respective sector

index especially since the benchmark is the sector index, however of the 10 funds belonging

in this category, 8 of the funds have shown a lower Information ratio (including Modified

Information ratio) based on the sector index when compared to the Information ratio

(including Modified Information ratio) based on the S&P CNX 500. Only 2 funds (recent

fund category) have shown the opposite, where the Information ratio for the sector index as a

benchmark is higher than the S&P CNX 500. The Modified Information ratio reduces the

differences between the Information ratios and thus giving it a stronger indication. The

inference of this is that there is a valid opinion that favours the use of a sector index as a

benchmark.

The Sector Index has underperformed the S&P CNX 500: The Sector indices that have not

been able to outperform the S&P CNX 500 is the BSE TECk, BSE IT, BSE FMCG and the

BSE Healthcare, therefore the importance of the Information ratio plays the opposite role in

this case, if the fund can reduce the Information ratio when the sector index has

underperformed the market index, the possibility of the fund to reduce the downward returns

reduces.
 59

Overall the use of the Information ratio for sector funds that calculate it based on the sector

benchmark shows that it serves as a motivational factor to outperform not only the sector but

also the broader market, this results in an enhanced performance measure and shows the

significance of having a valid benchmark for the fund.

 Funds that use diversified indices as benchmarks

Tables 7.2.5 and 7.2.7 show the Information ratios of infrastructure/energy focussed funds

that use a diversified index as their benchmark and the Information ratios if the S&P CNX

500 or the sector index had been chosen as the benchmark. Table 7.2.6 and 7.2.8 show the

Modified Information ratio based on the similar parameters as the previous tables. Notably

the sector indices in the first two tables have outperformed the diversified benchmark indices.

Table 7.2.5-Information ratio measures with benchmark, S&P CNX 500 & Sector index
Information Ratio
Sl No Mutual Fund Name Sector Stated Benchmark Sector Index Benchmark S&P CNX 500 Sector Index
1 Birla Sunlife Infrastructure Fund Infrastructure S&P CNX Nifty FTSE-IDFC -0.06 0.16 -0.46
2 Canara Robeco Infrastructure Fund Infrastructure BSE 100 FTSE-IDFC 0.02 0.29 -0.48
3 DSP Blackrock TIGER Fund (Retail) Infrastructure BSE 100 FTSE-IDFC 0.23 0.67 -0.22
4 HSBC Progressive Themes Fund Infrastructure BSE 200 FTSE-IDFC -0.80 -0.60 -0.86
5 ICICI Prudential Infrastructure Fund (Retail) Infrastructure S&P CNX Nifty FTSE-IDFC 0.77 1.04 0.25
6 Sahara Infrastructure Fund Infrastructure S&P CNX Nifty FTSE-IDFC 0.28 0.56 -0.13
7 Tata Infrastructure Fund Infrastructure BSE Sensex FTSE-IDFC 0.13 0.47 -0.22
8 UTI Infrastructure Fund Infrastructure BSE 100 FTSE-IDFC -0.02 0.20 -0.32
9 ICICI Prudential Power Fund (Institutional) Power S&P CNX Nifty BSE Power -0.28 -0.07 -0.35
10 ICICI Prudential Power Fund (Retail) Power S&P CNX Nifty BSE Power -0.41 -0.20 -0.42

Table 7.2.6-Modified Information ratio measures with benchmark, S&P CNX 500 & Sector Index
Modified Information Ratio
Sl No Mutual Fund Name Sector Stated Benchmark Sector Index Benchmark S&P CNX 500 Sector Index
1 Birla Sunlife Infrastructure Fund Infrastructure S&P CNX Nifty FTSE-IDFC 0.00 0.16 -0.01
2 Canara Robeco Infrastructure Fund Infrastructure BSE 100 FTSE-IDFC 0.02 0.29 0.00
3 DSP Blackrock TIGER Fund (Retail) Infrastructure BSE 100 FTSE-IDFC 0.23 0.67 0.00
4 HSBC Progressive Themes Fund Infrastructure BSE 200 FTSE-IDFC -0.02 -0.01 -0.01
5 ICICI Prudential Infrastructure Fund (Retail) Infrastructure S&P CNX Nifty FTSE-IDFC 0.77 1.04 0.25
6 Sahara Infrastructure Fund Infrastructure S&P CNX Nifty FTSE-IDFC 0.28 0.56 0.00
7 Tata Infrastructure Fund Infrastructure BSE Sensex FTSE-IDFC 0.13 0.47 0.00
8 UTI Infrastructure Fund Infrastructure BSE 100 FTSE-IDFC 0.00 0.20 0.00
9 ICICI Prudential Power Fund (Institutional) Power S&P CNX Nifty BSE Power 0.00 0.00 -0.01
10 ICICI Prudential Power Fund (Retail) Power S&P CNX Nifty BSE Power 0.00 0.00 -0.01
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Table 7.2.7-Information Ratio measures with benchmark, S&P CNX 500 & Sector Index (recent funds)
Information Ratio
Sl No Mutual Fund Name Sector Date Benchmark Sector Index Benchmark S&P CNX 500 Sector Index Sector Outperformance
1 Taurus Infrastructure Fund -Growth Option Infrastructure Mar-07 BSE 200 FTSE-IDFC -0.06 0.01 -0.50 Yes
2 ICICI Prudential Infrastructure Fund - Inst Infrastructure Apr-07 S&P CNX Nifty FTSE-IDFC 1.12 1.10 0.16 Yes
3 DSP BlackRock India T.I.G.E.R. Fund-Inst Infrastructure Jun-07 BSE 100 FTSE-IDFC 0.02 0.36 -0.32 Yes
4 SBI Infrastructure Fund-Series I Growth Infrastructure Jul-07 BSE 100 FTSE-IDFC -0.62 -0.38 -0.68 Yes
5 DBS Chola Infrastructure Fund-Cumulative Infrastructure Oct-07 S&P CNX Nifty FTSE-IDFC -0.55 -0.59 -0.42 No
6 Escorts Infrastructure Fund - Growth Option Infrastructure Oct-07 S&P CNX Nifty FTSE-IDFC -0.68 -0.68 -0.42 No
7 Religare Infrastructure Fund - Growth Option Infrastructure Nov-07 S&P CNX Nifty FTSE-IDFC -1.01 -0.69 -0.38 No
8 Tata Indo-Global Infrastructure Fund - Growth Infrastructure Nov-07 BSE Sensex FTSE-IDFC -0.33 -0.16 -0.02 No
9 JM Agri & Infrastructure Fund- Growth option Infrastructure Jan-08 BSE 500 FTSE-IDFC -2.66 -2.65 -2.41 No
10 Kotak Indo World Infrastructure Fund - Growth Infrastructure Jan-08 S&P CNX Nifty FTSE-IDFC -0.94 -0.83 -0.39 No
11 AIG Infrastructure & Eco Reform Fund-Inst Infrastructure Feb-08 BSE 100 FTSE-IDFC -0.95 -0.93 -0.85 No
12 AIG Infrastructure and Eco Reform Fund-Reg Infrastructure Feb-08 BSE 100 FTSE-IDFC -1.01 -0.984 -0.90 No
13 Reliance Natural Resources Fund-Growth Plan Nat Res/Energy Feb-08 BSE 200 BSE Metals;Oil & Gas 0.30 0.32 0.41 No
14 LICMF-Infrastructure Fund-Growth Option Infrastructure Mar-08 BSE 100 FTSE-IDFC -0.09 0.04 -0.02 Yes
15 HDFC Infrastructure Fund-Growth Option Infrastructure Apr-08 S&P CNX 500 FTSE-IDFC 0.21 0.21 0.12 Yes
16 Sahara Power & Natural resources Fund Power/Nat Res Jun-08 S&P CNX Nifty BSE Metals; Power;Oil & Gas 0.75 1.02 0.92 No

Table 7.2.8-Modified Information Ratio measures with benchmark, S&P CNX 500 & Sector Index
(recent funds)
Modified Information Ratio
Sl No Mutual Fund Name Sector Date Benchmark Sector Index Benchmark S&P CNX 500 Sector Index Sector Outperformance
1 Taurus Infrastructure Fund -Growth Option Infrastructure Mar-07 BSE 200 FTSE-IDFC 0.00 0.01 -0.02 Yes
2 ICICI Prudential Infrastructure Fund - Inst Infrastructure Apr-07 S&P CNX Nifty FTSE-IDFC 1.12 1.10 0.16 Yes
3 DSP BlackRock India T.I.G.E.R. Fund-Inst Infrastructure Jun-07 BSE 100 FTSE-IDFC 0.02 0.36 0.00 Yes
4 SBI Infrastructure Fund-Series I Growth Infrastructure Jul-07 BSE 100 FTSE-IDFC 0.00 0.00 -0.01 Yes
5 DBS Chola Infrastructure Fund-Cumulative Infrastructure Oct-07 S&P CNX Nifty FTSE-IDFC -0.03 -0.02 -0.02 No
6 Escorts Infrastructure Fund - Growth Option Infrastructure Oct-07 S&P CNX Nifty FTSE-IDFC -0.02 -0.02 -0.02 No
7 Religare Infrastructure Fund - Growth Option Infrastructure Nov-07 S&P CNX Nifty FTSE-IDFC -0.01 -0.01 -0.01 No
8 Tata Indo-Global Infrastructure Fund - Growth Infrastructure Nov-07 BSE Sensex FTSE-IDFC -0.01 -0.01 0.00 No
9 JM Agri & Infrastructure Fund- Growth option Infrastructure Jan-08 BSE 500 FTSE-IDFC -0.13 -0.14 -0.15 No
10 Kotak Indo World Infrastructure Fund - Growth Infrastructure Jan-08 S&P CNX Nifty FTSE-IDFC -0.01 -0.01 -0.01 No
11 AIG Infrastructure & Eco Reform Fund-Inst Infrastructure Feb-08 BSE 100 FTSE-IDFC -0.01 -0.02 -0.02 No
12 AIG Infrastructure and Eco Reform Fund-Reg Infrastructure Feb-08 BSE 100 FTSE-IDFC -0.01 -0.017 -0.02 No
13 Reliance Natural Resources Fund-Growth Plan Nat Res/Energy Feb-08 BSE 200 BSE Metals;Oil & Gas 0.30 0.32 0.41 No
14 LICMF-Infrastructure Fund-Growth Option Infrastructure Mar-08 BSE 100 FTSE-IDFC 0.00 0.04 0.00 Yes
15 HDFC Infrastructure Fund-Growth Option Infrastructure Apr-08 S&P CNX 500 FTSE-IDFC 0.21 0.21 0.12 Yes
16 Sahara Power & Natural resources Fund Power/Nat Res Jun-08 S&P CNX Nifty BSE Metals; Power;Oil & Gas 0.75 1.02 0.92 No

From the previous analysis wherein the choice of the sector index as a benchmark was

addressed, the notable inference was that fund manager’s attempt to maximise the

Information ratio (calculated on the sector benchmark) when then sector has outperformed

the market and minimise the risk adopted when the sector performs worse than the market.

The rationale behind this is to maintain the risk and return parity that investors seek to

achieve. However the 26 funds (16 funds are categorised as recent since NAVs on them are

available after March 2007) in the tables above are largely from the Infrastructure sector with

few being directly classified as Power sector or Energy sector funds. The funds above use a

diversified index as their respective benchmark, the sector index is mentioned in the table and
 61

shows the best optional sector index that would have been applicable if the fund had chosen.

On analysis of the funds that have NAVs from April 2006 namely the 10 funds from Table

7.2.5 the respective sector indices in this case has outperformed the broader market indices,

applying the thumb rule for active and even passive management, a fund should be able to

match or even show signs of outperformance over the respective benchmark, indeed the

benchmark being various diversified indices the use of the Information ratio plays a critical

role as a performance measure. Grinold and Kahn (1999) state that an Information ratio of

0.50 indicates a strong performance and a value of 1.00 shows exceptional performance, in

this scenario the Information ratio for the funds when measured on the sector indices, 9 out

10 show a negative value, however the reported value is based on the diversified benchmark

and 4 funds show a positive value and the remaining show a low negative value as compared

to the sector index Information ratio. Clearly the fund has not tried to capitalise on the sector

gains. The Modified Information ratio shows the similar analysis.

The funds from Table 7.2.7 show the funds that have sectors that have beaten the broader

market to some sectors that have underperformed due to the recent economic turmoil, using

the similar logic for over performance (6 funds) from the previous paragraph, 5 funds fall into

the same category wherein the Information ratio from the diversified index is the

performance measure that measures the active value addition. Among the funds that have had

their sectors underperform the broader market, the higher the negative Information ratio on

the sector index the Information ratio plays the opposite role in this case, if the fund can

reduce the Information ratio when the sector index has underperformed the market index, the

possibility of the fund to reduce the downward returns reduces. To conclude, the choice of

choosing a sector index as a benchmark for sector funds has the advantage of serving as a

motivating factor when the sector outperforms the market and as a risk measuring factor to

reduce the fall in returns when there is trough in the market.

 62

7.3 Application of the M-Squared (M2 Squared) measure.

The M-Squared measure developed by Modigliani and Modigliani (1997) determines the risk

adjusted return of an asset over its benchmark, in this analysis we first contrast the risk

adjusted returns of funds that use a sector index as their benchmark and secondly funds that

use a diversified index as their benchmark.

Risk Adjusted Returns when sector index is the benchmark

Table 7.3.1- Risk Adjusted Returns with sector index as benchmark

Sl No Mutual Fund Name Sector Stated Benchmark Fund Return Sector Return M-Squared Return
1 Reliance Banking Fund-Growth Plan Banking BSE Bankex 19.53% 13.67% 21.97%
2 UTI Banking Sector Fund-Growth Option Banking BSE Bankex 16.12% 13.67% 17.64%
3 Franklin FMCG Fund - Growth Consumer Goods BSE FMCG 0.81% 0.70% 0.00%
4 SBI MSFU FMCG Consumer Goods BSE FMCG -1.12% 0.70% -0.59%
5 ICICI Prudential FMCG Plan-Growth Option Consumer Goods BSE FMCG -2.07% 0.70% -1.17%
6 UTI Energy Fund Energy BSE Oil & Gas; Power -32.51% 15.47% -23.54%
7 Reliance Pharma Fund-Growth Plan-Growth Healthcare BSE Healthcare 6.43% -2.54% 6.43%
8 Franklin Pharma Fund - Growth Healthcare BSE Healthcare 0.01% -2.54% -0.46%
9 SBI MSFU PHARMA - GROWTH Healthcare BSE Healthcare -11.14% -2.54% -7.31%
10 JM Financial Basic Industries Fund Infrastructure BSE Capital Goods -2.54% 13.81% -1.33%
11 Sundaram BNP Capex Fund Infrastructure BSE Capital Goods 7.61% 13.81% 7.77%
12 Reliance Power Fund (Retail) Power BSE Power 22.24% 11.04% 24.98%
13 DSP BlackRock Technology.com Fund-Reg Technology BSE TECk 3.45% -1.27% 3.85%
14 Birla Sun Life New Millenium Fund Technology BSE TECk -4.57% -1.27% -3.74%
15 Franklin Infotech Fund-Growth Technology BSE IT -7.03% -6.27% -7.42%
16 ICICI Prudential Technology Fund Technology BSE IT -7.33% -6.27% -5.84%
17 SBI MSFU IT Technology BSE IT -13.69% -6.27% -10.45%

Table 7.3.2-Risk Adjusted Returns with sector index as benchmark (recent funds)
Sl No Mutual Fund Name Date Sector Stated Benchmark Fund Return Sector Return M-Squared Return
1 Sundaram BNP Paribas Energy Opp Fund Growth Jan-08 Energy BSE Oil & Gas -14.24% -9.25% -15.14%
2 Reliance Diversified Power Sector Fund Inst Feb-08 Power BSE Power -9.40% -19.19% -12.72%
3 DSP BlackRock Nat Res & New Energy Fund-Inst Apr-08 Nat Res/Energy BSE Oil & Gas; Metals -2.26% -25.74% -7.95%
4 DSP BlackRock Nat Res & New Energy Fund-Reg Apr-08 Nat Res/Energy BSE Oil & Gas; Metals -3.22% -25.74% -9.54%

From the two tables above it can be observed that 3 of the 17 funds (older funds) and all 4

funds of the recent funds category have shown that the risk adjusted returns have been lower

than the fund’s original return (marked in bold), however the remaining majority shows that

when the fund has taken on the similar risk of the sector index the returns have in fact been

stronger. This indicates that choosing a sector’s risk level can help a fund achieve greater

return on their strategy.

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Risk Adjusted Returns when diversified index is the benchmark

This part shows the fund’s actual returns versus the fund’s M-squared return (based on

diversified benchmark) versus the fund’s M-squared return (based on the sector index). Of

the 10 funds that have NAVs from April 2006(table 7.3.3), 7 funds have shown a higher M-

squared return when the risk is adjusted to the sector index versus 1 fund that has shown a

higher M-squared return when the risk is adjusted to the diversified benchmark.

Table 7.3.3-Risk adjusted returns for diversified benchmark and sector index
Benchmark M- Sector M-Squared
Sl No Mutual Fund Name Sector Stated Benchmark Fund Return Sector Return
Squared Return Return
1 ICICI Prudential Infrastructure Fund (Retail) Infrastructure S&P CNX Nifty 14.29% 11.39% 13.74% 15.53%
2 Sahara Infrastructure Fund Infrastructure S&P CNX Nifty 10.00% 11.39% 9.76% 10.58%
3 DSP Blackrock TIGER Fund (Retail) Infrastructure BSE 100 9.26% 11.39% 9.17% 9.65%
4 Tata Infrastructure Fund Infrastructure BSE Sensex 9.12% 11.39% 8.81% 9.46%
5 Canara Robeco Infrastructure Fund Infrastructure BSE 100 7.83% 11.39% 7.65% 7.86%
6 UTI Infrastructure Fund Infrastructure BSE 100 7.47% 11.39% 7.49% 7.68%
7 Birla Sunlife Infrastructure Fund Infrastructure S&P CNX Nifty 6.52% 11.39% 6.51% 6.53%
8 HSBC Progressive Themes Fund Infrastructure BSE 200 -0.56% 11.39% -1.39% -2.57%
9 ICICI Prudential Power Fund (Institutional) Power S&P CNX Nifty 4.86% 11.04% 4.79% 4.35%
10 ICICI Prudential Power Fund (Retail) Power S&P CNX Nifty 3.76% 11.04% 3.65% 2.89%

Among the 16 recent funds for which NAV start dates are varied(table 7.3.4), 6 funds show

that the risk adjusted returns when measured against the sector index is higher than the actual

returns versus 10 funds that show that the diversified index has shown a higher risk adjusted

return than the actual return.

Table 7.3.4- Risk adjusted returns for diversified benchmark and sector index (recent funds)
Benchmark M-Squared Sector M-Squared
Sl No Mutual Fund Name Date Sector Stated Benchmark Fund Return Sector Return
Return Return
1 Taurus Infrastructure Fund -Growth Option Mar-07 Infrastructure BSE 200 4.55% 13.51% 4.93% 4.71%
2 ICICI Prudential Infrastructure Fund - Inst Apr-07 Infrastructure S&P CNX Nifty 11.52% 9.54% 11.28% 12.44%
3 DSP BlackRock India T.I.G.E.R. Fund-Inst Jun-07 Infrastructure BSE 100 -0.11% 3.31% -0.02% -1.03%
4 SBI Infrastructure Fund-Series I Growth Jul-07 Infrastructure BSE 100 -7.38% -0.56% -6.42% -8.40%
5 DBS Chola Infrastructure Fund-Cumulative Oct-07 Infrastructure S&P CNX Nifty -31.48% -22.40% -21.31% -27.13%
6 Escorts Infrastructure Fund - Growth Option Oct-07 Infrastructure S&P CNX Nifty -31.69% -22.40% -32.88% -41.12%
7 Religare Infrastructure Fund - Growth Option Nov-07 Infrastructure S&P CNX Nifty -29.97% -24.04% -32.37% -40.47%
8 Tata Indo-Global Infrastructure Fund - Growth Nov-07 Infrastructure BSE Sensex -24.52% -24.04% -22.60% -29.33%
9 JM Agri & Infrastructure Fund- Growth option Jan-08 Infrastructure BSE 500 -77.04% -17.59% -58.77% -63.40%
10 Kotak Indo World Infrastructure Fund - Growth Jan-08 Infrastructure S&P CNX Nifty -22.45% -17.59% -21.35% -27.26%
11 AIG Infrastructure & Eco Reform Fund-Inst Feb-08 Infrastructure BSE 100 -26.83% -15.43% -26.41% -30.17%
12 AIG Infrastructure and Eco Reform Fund-Reg Feb-08 Infrastructure BSE 100 -27.49% -15.43% -27.07% -30.89%
13 Reliance Natural Resources Fund-Growth Plan Feb-08 Nat Res/Energy BSE 200 -11.91% -22.37% -15.66% -21.91%
14 LICMF-Infrastructure Fund-Growth Option Mar-08 Infrastructure BSE 100 -7.53% -7.31% -7.98% -9.78%
15 HDFC Infrastructure Fund-Growth Option Mar-08 Infrastructure S&P CNX 500 -5.79% -7.31% -5.57% -6.66%
16 Sahara Power & Natural resources Fund Jun-08 Power/Nat Res S&P CNX Nifty 15.71% 0.52% 14.41% 17.51%
 64

Though the results for the above analysis is varied, clearly calculating the M-squared risk

adjusted returns with the sector as the benchmark is the better way to measure the

performance of the fund if the fund adopted the same risk level as the sector.

7.4 Sector Returns based Style analysis and Efficient Frontier

In the final analysis of determining the choice of equity indices as benchmarks, the style of

returns of the funds is determined. Using the conceptual framework of Sharpe (1992), we

determine the sector returns based style analysis. The basic premise is to determine how a

fund’s returns relate to its respective sector. Table 7.4 below shows the sector and non sector

style weights that relate to the fund’s returns. From the table it can be observed that the

Banking sector funds show the highest sector returns based style weights followed by the

Healthcare sector funds. On an overall basis only 1 fund out of 47 funds have shown that its

returns are completely styled as against the sector it represents. Among the

Infrastructure/Energy funds, the results are varied, none of the Energy, Power and Natural

Resources funds shows a major weighting towards the sector it is supposed to cater. The

Infrastructure funds show a range of about 50% in the differences of weights of returns with

the highest being about 75% of the sector returns style weight being related to sector under

focus. The significance of this analysis is to show whether sector focussed funds are truly

related to the investment objective that they seek to offer toward investors. It is evident that

the sector focussed funds in India have not shown a focus related asset allocation strategy and

have relatively been diverse. The rationale for this could be to reduce the risk or there could

be other technical reasons. Though the asset allocation is beyond the scope of this study, the

Sector Returns Style analysis shows that fund managers continue to follow diversified

holdings patterns in sharp contrast with the investment objectives of the fund. This leads to a
 65

dilution of the purpose of the fund catering to a sector and the investors that seek to invest in

a sector.

Table 7.4- Sector Returns Style Analysis weights across sectors

Sl No Mutual Fund Name Sector Sector Returns Style Non Sector Returns Style Returns Sector Returns
1 UTI Banking Sector Fund-Growth Option Banking 85.55% 14.45% 16.12% 13.67%
2 Reliance Banking Fund-Growth Plan-Growth Option Banking 77.48% 22.52% 19.53% 13.67%

1 Sundaram BNP Paribas Energy Opp Fund Growth Energy 59.44% 40.56% -14.24% -9.25%
2 UTI Energy Fund Energy 0.00% 100.00% -32.51% 15.47%

1 Sahara Power & Nat resources Fund Nat Res/Power 42.09% 57.91% 15.71% 0.52%
2 DSP BlackRock Nat Res & New Energy Fund-Inst Nat Res/Energy 37.56% 62.44% -2.26% -25.74%
3 DSP BlackRock Nat Res & New Energy Fund-Reg Nat Res/Energy 37.49% 62.51% -3.22% -25.74%
4 Reliance Nat Resources Fund-Growth Plan Nat Res/Energy 0.00% 100.00% -11.91% -22.37%

1 Reliance Power Fund (Retail) Power 58.45% 41.55% 22.24% 11.04%

2 Reliance Diversified Power Sector Fund Inst Power 39.32% 60.68% 0.85% -19.19%
3 ICICI Prudential Power Fund (Retail) Power 22.58% 77.42% 3.76% 11.04%
4 ICICI Prudential Power Fund (Institutional) Power 22.55% 77.45% 4.86% 11.04%

1 Franklin FMCG Fund - Growth Consumer Goods 64.68% 35.32% 0.81% 0.70%
2 SBI MSFU FMCG Consumer Goods 48.63% 51.37% -1.12% 0.70%
3 ICICI Prudential FMCG Plan-Growth Option Consumer Goods 43.81% 56.19% -2.07% 0.70%

1 Franklin Pharma Fund - Growth Healthcare 77.09% 22.91% 0.01% -2.54%

2 Reliance Pharma Fund-Growth Plan-Growth Healthcare 75.71% 24.29% 6.43% -2.54%
3 SBI MSFU PHARMA - GROWTH Healthcare 66.11% 33.89% -11.14% -2.54%

1 JM Agri & Infrastructure Fund- Growth option Infrastructure 75.74% 24.26% -77.04% -17.59%
2 JM Financial Basic Industries Fund Infrastructure 74.68% 25.32% -2.54% 13.81%
3 Canara Robeco Infrastructure Fund Infrastructure 70.12% 29.88% 7.83% 11.39%
4 ICICI Prudential Infrastructure Fund - Inst Option Infrastructure 69.87% 30.13% 11.52% 9.54%
5 DBS Chola Infrastructure Fund-Cumulative Option Infrastructure 64.52% 35.48% -31.48% -22.40%
6 SBI Infrastructure Fund-Series I Growth Infrastructure 60.60% 39.40% -7.38% -0.56%
7 ICICI Prudential Infrastructure Fund (Retail) Infrastructure 60.41% 39.59% 14.29% 11.39%
8 UTI Infrastructure Fund Infrastructure 59.72% 40.28% 7.47% 11.39%
9 Tata Infrastructure Fund Infrastructure 59.52% 40.48% 9.12% 11.39%
10 Sundaram BNP Capex Fund Infrastructure 57.91% 42.09% 7.61% 13.81%
11 Taurus Infrastructure Fund -Growth Option Infrastructure 57.56% 42.44% 4.55% 13.51%
12 DSP BlackRock India T.I.G.E.R. Fund - Inst Plan Infrastructure 55.98% 44.02% -0.22% 3.31%
13 Tata Indo-Global Infrastructure Fund - Growth Infrastructure 53.96% 46.04% -24.52% -24.04%
14 DSP Blackrock TIGER Fund (Retail) Infrastructure 53.90% 46.10% 9.26% 11.39%
15 Sahara Infrastructure Fund Infrastructure 53.49% 46.51% 10.00% 11.39%
16 AIG Infrastructure and Eco Reform Fund-Reg Plan Infrastructure 53.27% 46.73% -27.49% -15.43%
17 AIG Infrastructure & Eco Reform Fund-Inst Plan Infrastructure 53.13% 46.87% -26.83% -15.43%
18 LICMF-Infrastructure Fund-Growth Option Infrastructure 51.28% 48.72% -7.53% -7.31%
19 Kotak Indo World Infrastructure Fund - Growth Infrastructure 51.07% 48.93% -22.45% -17.59%
20 Birla Sunlife Infrastructure Fund Infrastructure 49.62% 50.38% 6.52% 11.39%
21 HDFC Infrastructure Fund-Growth Option Infrastructure 48.15% 51.85% -5.79% -7.31%
22 HSBC Progressive Themes Fund Infrastructure 44.28% 55.72% -0.56% 11.39%
23 Religare Infrastructure Fund - Growth Option Infrastructure 40.58% 59.42% -29.97% -24.04%
24 Escorts Infrastructure Fund - Growth Option Infrastructure 27.89% 72.11% -31.69% -22.40%

1 Franklin Infotech Fund-Growth Technology 100.00% 0.00% -7.03% -6.27%

2 SBI MSFU IT Technology 68.54% 31.46% -13.69% -6.27%
3 Birla Sun Life New Millenium Fund-Plan B(Growth) Technology 60.98% 39.02% -4.57% -1.27%
4 DSP BlackRock Technology.com Fund-Regular Plan Technology 53.44% 46.56% 3.45% -1.27%
5 ICICI Prudential Technology Fund Technology 49.29% 50.71% -7.33% -6.27%
 66

In trying to understand the possible rationale for sector focussed funds not to commit the

entire corpus into the particular sector, an efficient frontier of a portfolio of the sector

focussed indices (BSE Oil & Gas, Power, Capital Goods, FMCG, Bankex, TECk, Healthcare

and FTSE-IDFC) is constructed. The time period under consideration is from April 2006 to

June 2009 and the 27 older funds are chosen. Chart 7.4.1 shows the efficient frontier of the

portfolio of indices, also marked in the chart is the risk and returns comparisons of the

respective indices.

Chart 7.4.1-Efficient Frontier of Portfolio of Sector Indices

From the chart it can be observed that the BSE Oil and Gas and BSE FMCG Indices lie

closest to the efficient frontier. The farthest index being the BSE Metals and among the

indices that feature in the negative quadrant are the BSE TECk and the BSE Healthcare

indices. Among the rest of the indices, none of them lie close to the efficient frontier; there

could be a possibility that the funds have chosen to stay closer to the frontier (signifying a

diversified holding) to avoid the riskiness of staying committed to a sector. The limitation to

this result can differ, since the sector indices are mostly composed of large cap-weighted

companies and the funds can be invested in mid to small cap companies and hence the risk-

return trade-off may differ from the sector index.

 67

Case 1: Banking and Healthcare Funds: The first analysis of this possibility that funds are

staying close to the efficient frontier to manage a lower risk profile of the fund is conducted

on the Banking and Healthcare funds. On average these funds secure sector style returns of

82% for Banking Funds (2 Funds), and 73% for Healthcare Funds (3 Funds). Chart 7.4.2

illustrates this possibility.

Chart 7.4.2-Efficient Frontier of Portfolio of Sector Indices and Banking and Healthcare funds

From the Chart above it shows that the 2 Banking funds are closer to the efficient frontier as

compared to the Healthcare funds and show stronger risk and returns trade-off as compared to

the sector index. Therefore on the Banking funds show a high sector style based return and

are providing risk and returns trade-off close to the efficient frontier, thereby adhering to

investor objectives. The 3 Healthcare funds show a mixed feature with the Reliance Pharma

(75% sector style based return) fund providing the highest return but at a higher risk.

Case 2: Consumer Goods and Technology Funds: Among the Consumer Goods (3funds) and

Technology (5 funds) funds the average sector style based returns are 52% and 66%

respectively, however on the risk-return chart in combination with the efficient frontier there

appears to be stark difference between these two categories, the Consumer Goods fund have

in fact matched the benchmark index risk-return trade-off but the Technology funds have

underperformed the benchmark index (exception being DSP Blackrock Tech Fund). The

sector style based return was on average higher for Technology funds over Consumer goods
 68

funds they have stayed close to the benchmark indicating greater allocation towards the

sector.

Chart 7.4.3-Efficient Frontier of Portfolio of Sector Indices and Consumer Goods and Technology funds

Case 3: Power and Capital Goods Funds: Chart 7.4.4 shows the risk-return chart for the

Power and Capital Goods Funds (Capital Goods related closely to Infrastructure sector, sector

index however is the BSE Cap Goods). The chart also shows the BSE Metals, BSE Power,

BSE Oil & Gas and BSE Capital Goods indices since they the funds are interconnected with

these funds. On average the Power Funds (3) have an average sector style based return of

35% and the Capital Goods Funds (2) have an average sector style based return of 66%.

Graphically it can be observed that with the exception of the Reliance Power Fund, the other

funds have been relatively less volatile as the sector indices and this could be attributed to a

sizeable percentage of its sector style returns not related to the concerned sector. Reliance

Power Fund on the other hand must be mentioned specifically, with about 58% of its returns

based on the Power index and a position to the left of the efficient frontier shows that the

diversified component of the fund has clearly levered the fund to an improved risk-return

trade off.
 69

Chart 7.4.4-Efficient Frontier of Portfolio of Sector Indices and Capital Goods and Power funds

Case 4: Infrastructure Funds: The 8 Infrastructure focussed funds have an average sector

style based return of about 55%, this indicates that a wide margin of the corpus is invested

into other sectors, the risk-return chart shows that all the funds have a lower risk profile than

the two sector indices in this context (FTSE-IDFC and BSE Power), however only 1 fund

(ICICI Infrastructure) has been able to outperform the sector indices, the possibility of the

funds allocating a proportion of the corpus into other sectors is prominently evident.

Chart 7.4.5-Efficient Frontier of Portfolio of Sector Indices and Infrastructure funds

 70

8. Conclusion and Scope for further Research

The thesis showed how the importance of a sector specific equity index can influence

performance measurement of sector focussed funds; it described contrasts over funds that use

a sector focussed index as the benchmark to funds that use a diversified index as a

benchmark. The study by Roll, popularly known as Roll’s critique formed the basis of the

academic motivation into exploring the rationale on how a benchmark can serve as a true

guidance mechanism for improved performance measurement. The use of the Information

ratio and the M-Squared performance measure is used to show the contrast between active

component and risk adjusted returns in difference scenarios when a sector index is chosen as

a benchmark and when a diversified index is chosen as a benchmark. The use of Sharpe’s

returns based style analysis using sector indices as style factors describes how the returns of

funds can be weighted according to the fund’s sector allocation processes.

The key finding in the thesis is the differences in the Jensen’s alpha when sector indices and

diversified indices are used as the benchmark for the fund. Few of the funds have shown

statistically significant differences, however the economic and statistically tending

significance throws into perspective the importance of favouring the use of sector indices as

benchmarks. The important factor that can be attributed through this study is that though

there have been large-scale improvements in asset theories the fundamental issue on whether

the portfolio outperforms a benchmark still remains and will persist, the investor community

will continue to seek comparisons and asset managers will have to show improved

performance over benchmarks. The choice of benchmarks is crucial and the error in

performance measurement if a mismatched benchmark is chosen is still valid point today as it

was when Roll wrote his seminal works, to Reilly and Akhtar’s analysis in 1995. The work of

Sensoy (2008) made valid inferences on how mismatched benchmarks influence fund flows,
 71

though the issue of fund flows is a separate issue, the choice of benchmarks is crucial in

determining the motivation of the fund manager. It can be attributed from the thesis through a

large number of funds using diversified indices as their respective benchmarks that “beating

the broader market” is the key factor, however the thesis shows that though the market index

may have been beaten, on a sector level the sector growth has not been able to be matched

(reference to infrastructure and energy sector). Also there seems to be no clear pattern on the

choice of indices as benchmarks. The reasons for having such varied indices shows the point

that there could be certain regulatory processes in place to streamline the methodology on

choosing the index as the benchmark.

The issues for further research is mainly on the viability of using capital weighted indices as

benchmarks, the study of the EDHEC Risk and Asset Management Centre shows how

capital-weighted indices can show an erroneous method of index construction can influence

the issue of benchmarking, however with no publicly available characteristic based index

fund managers of sector focussed continue to use changeable indices as benchmarks. On a

survey of the broader market there are approximately 120 plus companies within the Energy

and Infrastructure space in India, though capital-weighted indices may not give a major

weight to a small cap company, the possibility of creating mid and small cap sector focussed

indices is a possibility.

To conclude, a sector focussed fund takes on risk that is higher than the market, this is

evident to a fund investor, in order to beat the market, the sector must be outperformed first,

since the basic purpose is to show cohesion and positive correlation between the investment

objective of the fund and the performance measurement of the fund.

 72

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