1.

2 Mutual Funds

The History of Mutual Funds in India starts with the setting up of Unit Trust of India by the Gov of India in
1963 and the Unit Scheme 1964. Until 1987, UTI enjoyed a monopoly & in 1987, the Government of India
permitted public sector banks and the Life Insurance Corporation of India (LIC) and General Insurance
Corporation of India (GIC) to enter the mutual fund industry. The State Bank of India's SBI Mutual Fund was
the first such mutual fund to be established in 1987. Canara Bank set up Canbank Mutual Fund shortly after in
the same year, followed by funds from Punjab National Bank and Indian Bank in 1989, Bank of India in 1990
and Bank of Baroda in 1992. The LIC established its mutual fund in 1989 and the GIC in 1990.

Concept: A Mutual Fund is a trust that pools the savings of a number of investors with common financial
goals. The collected money is invested in various instruments like Shares, Debentures, Bonds, etc depending
upon the objectives of the scheme. The income generated and the capital appreciation is shared by investors in
proportion to their share of their investments, called ―units‖. Over the last three decades MFs have emerged
as major investment vehicle in view of the distinct advantages over the other forms of investments especially
for those with limited resources.

Advantages of MFs
 Safety: Being well regulated through SEBI which has instituted several rules for the distribution,
management and administration of mutual fund to ensure investor’s interest.
 Portfolio Diversification: In view of the quantum of funds available, the investments by the Mutual
Funds are diversified into various instruments or asset classes to minimize the risk.
 Convenience: Investments could be done in small monthly installments and could be done though a
number of offices/service centers or online directly which makes it very convenient.
 Flexibility: MFs offers a variety of schemes & plans such as growth, dividend payout/reinvestment to
meet the individual needs and preferences and the individual can choose the suitable scheme/plan.
 Liquidity: Mutual Funds except in the case of close ended schemes can be redeemed any time at the
prevalent market price ( NAV ) within 3 -4 days subject to payment of exit loads as applicable. This
option would not be available Individuals holding Shares and Bonds may not be able to sell quickly.
 Professional Management: Mutual funds are managed by experienced and highly qualified
Professional Manager who makes the investment decisions after considerable research and analysis, to
ensure fail-proof investment strategy.
 Risk Management: Thanks to the diversification, the investor’s reduces his risk.
 Lower Transaction Costs: In view of the high volume, the MF gets better deals with respect of
transaction costs which benefits the investors as against the high transaction fee for the individuals.
 Tax Benefits: Above all, the MFs offer a number of Tax Benefits –like Tax Free Dividends ( for
investment over 65% in equity), Exemption for Capital Gains ( over 12 months ) besides 80C benefits
for specified schemes.

Structure of Mutual Fund: A mutual fund is set up by a sponsor. But the sponsor cannot run the fund
directly. He has to set up a Trust and an Asset Management Company. While the trust expected to assure fair
business practice, the AMC manages the fund. A MF in India is constituted in the form of a Trust through a
Trust Deed under Indian Trusts Act,1882. The trustees hold the unit holders’ money in fiduciary capacity (ie)
the money belongs to the unit holder and is entrusted to the fund for the purpose of investment SEBI has
imposed conditions on to be fulfilled by the Individuals, being proposed as trustees.

AMFI: AMFI was incorporated in 1995 with the following objectives.

(1 )promote the interest of MF Industry & unit holders with RBI/SEBI/Govt
( 2 ) To set & maintain ethical & professional standards to promote best practices in the industry
( 3)Increase public awareness
( 4 ) Develop well trained distributors through training and providing certification for the same
Classification of Mutual Funds

Open ended, Close ended & Interval funds

Open Ended Funds open for the investors to enter or exit at any time even after the NFO. When existing
investor or new investors buy units of the Open ended scheme it is a sale, at NAV. When investor chooses to exit
it is repurchase or redemption which will be effected at the NAV with or without exit load. Investors come and go
but the scheme continues with remaining investors.

Close Ended Funds have fixed maturity say between 3-15 years. Investors can buy at the time of NFO only. The
fund is listed in the stock exchange providing a window for the investors to exit. Here only the investors may
change but the total capital amount of the scheme remains the same. Usually the Close ended MF traded at a
discount to their underlying asset value. In some cases the close ended Mutual funds are converted to opne ended
scheme at a later date
Eg.Kothari/Templeton Bluchip – originally close ended – now open ended.
Sundaram Equity Multiplier Fund – Originally a close ended scheme has been converted to open ended w e f
10.02.2010

Interval Funds combine the features of both open ended and close ended funds. They are mostly close ended
schemes, but become open ended during certain predetermined intervals or dates say between 1st July & 15th July.
Minimum period of interval is 15 days. Redemption/Repurchase is done only during the interval.

Money Market Mutual Fund: A Money Market Mutual fund invests solely in Money Market Instruments,
which are essentially debt instruments of maturity less than one year. The other instruments are Commercial
Papers, Certificate of Deposits, Interbank call money deposits, etc. Treasury bills constitute the major portion of
Money Market Instruments and are relatively risk free. MMMF ensures that the capital is protected along with
liquidity with modest returns. They are similar to high yielding bank account with but not entirely risk-free.
These are ideal for corporates and individuals to park their idle funds for a temporary periods with better interest
option.

Liquid Fund Schemes: Liquid Funds are open ended schemes which invest in money market instruments, but
with a very short maturity of 91 days. They offer very high liquidity as the funds can be parked for a few days or
a few months. Most liquid funds have a lock in period of maximum of 3 days mainly to protect against the
banking procedural requirements. The minimum deposit varies from Rs.25000 to Rs.1.00 Lakh. Liquid funds are
comparatively better than Bank Fixed Deposits since there will be no penalty for premature withdrawal. The
capital gains get added to the individual’s income if they are redeemed within 3 years. These funds have been
giving a return of 7%-8% over the past few years. Even at 7%, the post- tax return comes to 6.3% & 5.6% for
those in 10% & 20% tax bracket whereas the bank SB accounts give only 4%

Debt Funds: Debt Funds invest their funds predominantly in debt instruments both short term and long term,
government securities, Treasury Bills, Commercial Papers, Call Money etc. The objective of the fund is to protect
the investment besides providing a steady income. Debt funds are considered safer compared to equity fund
which are fraught with uncertainties and volatility. The fees and charges in Debt Funds are lower compared to the
equity funds. Since individuals may not be able to understand the relationship between interest rates and bond
prices, they can invest in debt funds to get regular return with least amount of risk.
Gilt Funds belong to the family of debt funds, but they invest only in Government Securities. While they are free
from default risk, the interest rate risk cannot be eliminated.

Fixed Maturity Plans: Fixed Maturity Plans are essentially Close ended debt schemes which invest their funds
in debt securities with maturities that coinciding with the maturity of the scheme. For example if the FMP is 370
days, the fund manager would invest in debt securities with maturity period of 12 months, so that the same can be
redeemed on maturity to pay the investor on due date since there can be no redemption before the due date. They
are offered with fixed maturity period ranging from 30 days to 5 years. The most common ones are 370 days, 395
days and 1100 days, etc. According to the regulations, the funds are not supposed to guarantee returns or provide
any indicative return.

Equity Funds

Equity Funds are the most popular category of funds although in actual fact they invest at least 65% of their
funds in equities and the balance in Debt funds. The fund managers identify companies with good prospects and
invest for high returns, which would correspond to investor’s risk appetite. These funds are considered to be
having the highest level of risk but reward the investors with higher return over long term. Some of these funds
have given a return of over 20% in the long term, thanks to the meteoritic rise in the equity market over the last 3
decades.

Type of Equity Funds

Diversified Equity Funds or Multi Cap Funds invest their resources in diverse mix of securities across various
sectors to derive maximum advantage from every possible growth opportunity while effectively reducing the risk
associated with individual sectors.
Example: SBI Magnum Multi Cap Fund, BSL Equity Fund, Franklin India Prima Plus Fund

Large Cap funds invest their funds in companies with Market Capitalization of more than1000 Cr ( US $8
billion ). These are generally the top 100-200 stocks , and go by the name blue chips. Since most of these
companies are a part of the Index, their performance resembles the index such as Sensex/Nifty/S&P500 etc.
Eg : SBI Blue Chip Fund, BSL Front Line Equity Fund, UTI equity Fund

Mid Cap Funds are the most popular among the investors in view of their spectacular performance over the last
2 decades . They invest in small and medium companies with Market capitalization of 500 – 1000 Crores. (US$
1- 8 billion).These are also considered emerging blue chips. The fact that there is a CNX Mid Cap Index is an
indication of the popularity of these funds. However in view of the high prices these stocks could be riskier when
there is fall in the market and these stocks may also suffer from liquidity risk
Example : SBI Magnum Mid Cap Fund, IDFC Premier Equity Fund, HDFC Mid Cap Opportunity Fund.

Small Cap Funds: As the name suggests these funds invest small companied Market Capitalization of 500
Crores ( less than US$1 billion). These are companies in initial stage of business but have potential to grow in the
long run. They may not be financially strong as the large cap stocks and the stocks may not have high liquidity
like the blue chips. The prices of these stocks could fall considerably in the event of turmoil. Hence these are
considered very risky although some these funds have given extra ordinary returns.
Example: Franklin India Smaller Cap Fund, DSBR Microcap Fund, Kotak Emerging Equity Fund

Balanced Funds/Hybrid Funds: These are hybrid fund which combination of stocks and bonds, short term
bonds, balancing risk& return. In fact some of these funds have given good return of nearly 15% pa over long
term with lower risk. Balanced Funds does not mean that they investment in equity and debt are at 50:50.
Balanced Fund provides an opportunity for the investor in a single mutual fund that combines both the income
and growth objectives. From Taxation point of view they are considered equity funds when the equity investment
exceeds 65%.
Example: Tata Balanced Fund, SBI magnum Balanced Fund, ICICI Prudential Balanced Fund

Monthly Income Plans: These are again hybrid funds predominantly debt oriented with equity component being
just15-20%. With such high debt portfolio, the fund would be able to generate regular income to provide monthly
dividends which would be again supplemented by the equity dividends. Since the Dividend can be declared
against distributable surplus, chances are that the fund would be unable to pay the monthly income or dividend.
Hence investors depending upon monthly income to meet their regular expenses should rather rely on safer
investments like Post Office Monthly Income Scheme.

Capital Protection Plans: These are close ended schemes which assure that the investors get their principal back
irrespective of whatever happens to the market. This is done though clever combination of investment in zero
coupon bonds to coincide with the maturity and equity investments. Let us assume that the investment is Rs.1.00
Lakh under the Capital protection plan for 5 years. If the 5 year Government securities yield 7% p a, then a Zero
coupon Bond of Rs.1.00 Lakh would be available for RsRs.71299. After investing this amount in the Zero
Coupon Bonds, the fund would invest the balance Rs.28701 in equities At the end of 5 years, the fund would
generate Rs.1.00 Lakh to repay the investor even if the equities become worthless, which is unlikely. Hence the
investor would always get more than the capital invested.
Example: SBI Capital Protection Fund , Sundaram Capital Protection Fund, etc.

Exchange Traded Funds: As the name suggests, these funds are traded in the stock exchanges so as to provide
more flexibility than the conventional funds as they can buy and sell these ETFs at real time prices in the case of
open ended mutual funds. These funds offer the investor an opportunity to utilize the intra day swings in the
market prices. ETFs offer the advantages like convenience of transaction and lower costs, while providing the
same transparency.

Sectoral Funds: Sectoral funds invest in stocks from a single sector and related sector. There are several Funds
like Pharma Fund, Technology Fund, Service Sector Fund, Energy Fund, etc. While the regulations restrict the
investment in a single company to not more than 10% of the NAV, the sectoral funds are exempted from this
restriction. Sectoral Funds are exposed to concentration risk as the fund could suffer seriously, in case the sector
encounters volatility.

Gold and Silver Exchange Funds: Gold has remained as one of the most popular forms of investment for
generations. Historically gold prices have provided stability even during financial crisis. Hence financial experts
advice for asset allocation of 10-15% in gold. Gold Exchange Traded fund tracks the price of gold with an
objective to provide a return corresponding to the returns from the domestic physical gold price. Gold ETF offers
the return corresponding to the physical gold while relieving the investor from the possibilities of loss in sale of
physical gold besides offering liquidity. Further the Gold ETF does not attract Securities Transaction tax, making
it more attractive.

Commodity Funds: Commodities are another asset class where people with expertise deal with to take
advantage of changes in prices. Some of the commodities which are actively traded are Industrial Metals like
Iron, Copper, Aluminum, Cotton, Turmeric, Pepper, bullion items like gold and silver, etc. The investment
objective of the commodity Funds would be to invest in companies connected with these commodities since the
Mutual Funds in India is not permitted to invest in commodities directly.

International Funds: These are specialized funds to cater to select group of investors as these funds invest their
resources in companies across the world. These funds offer an opportunity for the investors to invest in
companies located outside the investors residence, as direct investment by individuals could be difficult and
exposed to high risks. These funds offer yet another diversification of investors’ portfolio.
Example : BSl International Fund, Franklin India US Opportunity Fund

Arbitrage Funds: These are typical equity funds that take contrary positions in different markets or securities to
take advantage of mis-pricing between the markets. These are useful for the risk averse investors to park their idle
funds when there is constant fluctuations in the market. For example shares of the company are bought in cash
market and same number of shares is sold in the derivatives market so that no position is created. The difference
in price between cash and derivatives market is the risk free earning. If the cash market position is over 65% they
are treated as equity fund and get the tax advantage.
Example: SBI Arbitrage Opportunities Fund, ICICI Arbitrage Fund.

Offer documents lists out the complete details of the scheme such as AMC, Objectives ,Terms of Issue,
Historical Statistics, Investor Right and services, Registrars, NAV valuation, Bench Mark, etc

SEBI Regulations
 All initial expenses including brokerage should not exceed 6% of the amount collected and cannot be
amortized. Open ended funds can charge entry exit loads to cover distribution expenses.
 The Dividend declared should be mentioned as Rupee per unit along with FV
 Only CAGR should be mentioned only if the fund is >1 year
 Returns should be based on NAV & Payout as though dividends have been reinvested
 Annualised yield for 1,3, 5 years & since launch should be shown. Also for SIP

Accounting Valuation & Taxation

NAV = Net Asset Value =
Net Asset of the Scheme = (Mkt Value of Investments + receivables + other accrued income-accrued exp-other
liabilities.
Example: A Funds’ investments at market value aggregates to Rs.700 crores. Total liabilities stand at Rs.50
Lakhs and the receivables and accrued income are at Rs.140 Lakhs. The number of units outstanding is 28 crores.
What will be the NAV?

Total Asset Value A = 700+1.40- 0.50 = 700.90 crores

No of Units B = 28 crores
NAV = A/B = 700.90/28 = 25.03

Example: Mr Gupta purchased MF units worth Rs.10000 @NAV of Rs.10 on 1st Feb 2016. On 15th September
2016, he sold the units at NAV of Rs.20. The exit load was 0.05%. Calculate return
1. Applicable NAV on Purchase = 10 (No Entry Load ) =10 No of Units = 10000/10=1000
2. Applicable NAV on Sale = 20-0.05% ( Exit Load ) =19.90
Growth or return = (19.90-10)/10 =99%

Taxation: Mutual fund is a pass-through structure and is exempted from Income Tax. The fund does not pay any
Income Tax on its income

Equity Mutual Funds

See the chart attached for Taxation from 2016/17

In the hands of investors: - ( 1 )Dividends are exempted from Tax ( 2 ) Capital Gains are taxed as shown below

Dividend Distribution Tax (DDT) is payable before the distribution of Dividend

 Equity Schemes (at least 65% assets In Equity) are exempt from DDT & applies to others only
 Liquid Funds – 25% for individuals/HUF & 30% for others
 Non-equity oriented, non liquid funds – same as above
 Sur charge and Cess as applicable

Capital Gains Tax

Short-Term Capital Gain/Loss(STCG/STCL) -Capital Gain or Loss realized by sale of units within 12 months
Long Term Capital Gain/Loss(LTCG/LTCL)- Gain or loss on sale after 12 months. Indexation benefit available
and double indexation benefits can be availed by timing the purchase and sale

The securities transaction tax (STT) was introduced in 2004-05 to stop tax avoidance of capital gains tax.
Earlier, many people usually didn’t declare their profits on the sale of stocks and avoided paying capital gains tax.
The government could tax only those profits, which have been declared by people. To stop this situation, the then
Finance Minister P Chidambaram in the Union Budget 2004-05—introduced STT. Transactions in stock, index
options and futures would also be subject to transaction tax. This tax is payable whether you buy or sell a share
and gets added to the price of the stock at the time the transaction is made. Since brokers have to automatically
add this tax to the transaction price, there is no way to avoid it.. The applicable Rates are:

Sale of Equity oriented MF in an Exchange on delivery basis 0.001%

Sale of Shares/ Mutual Funds ( non-delivery Basis) 0.025%
Redemption of Equity Based MF unit 0.001%

Taxation Matrix on Mutual Funds

Fund Type DDT STCG LTCG STT
Equity Oriented NA 15% Exempt 0.001% on redemn
Liquid Funds 25%- Individual/HUF* Marginal rate of 10% w/o Indexation Not Applicable
30% - Others Taxation 20% with indexation
Other Non Equity 25%- Individual/HUF* Marginal rate of 10% w/o Indexation Not Applicable
Oriented Schemes 30% - Others Taxation 20% with indexation
** To the above rates surcharge and cess will be added.

Securities Transaction Tax (STT) on the securities market transactions as revised w.e.f 01/06/2016 is as under:
1. STT @ 0.1% on all delivery (purchase and sale) trades in cash market
2. STT @ 0.025% on sell leg of all non-delivery trades in the cash market (Equity Shares and units of Equity
Oriented Funds) market
3. STT @ 0.001% on sell leg of delivery trades in Equity Oriented Mutual Funds. - SELLER
4. STT @ 0.01% on sell trades in the futures contracts - SELLER
5. STT @ 0.05% on sell trades in the options contracts - SELLER
6. STT @ 0.125% on buy trades in the options contracts when the option is exercised - PURCHASER

Distribution and Marketing Practices of Mutual Funds:

Mutual Funds are distributed through direct marketing as well as through intermediaries. From the time of UTI,
distribution through intermediaries was very popular as these agents would be selling a number of other products
– like insurance, Post office schemes etc which in turn would help them to tap the clients easily. There are nearly
50000 IFAs (individual financial advisors) involved in the marketing the mutual funds. With the accessibility of
internet across the country many of the mutual funds have started marketing their products and the investments
could be done online. Many fund houses have offered the facility of online transaction including additional
purchase, redemption, change of bank/ other details which has made the direct investment very popular.
Apart from the individual agents, there are corporate agents like banks, brokerage houses have also been in the
field of marketing mutual funds. In fact, the close ended mutual funds are listed in the stock exchanges and these
could be bought and sold online like stocks.

An individual has to pass the NSE’s Capital Market certification Module and get the certification from AMFI
which would be valid for 3 years. AMFI certification is compulsory for the distribution of Mutual Funds and the
agents are given AMFI Registration Number ( ARN). According to the latest developments, SEBI has ruled that
IFAs will have to be registered with SEBI to become SEBI registered investment advisors and for getting the
same, one should have either CFP or should pass the examination under NISM-Series-X-A: Investment Adviser
(Level 1) Certification Examination is the level 1 examination
Fees & Expenses: An AMC may incur expenses specifically attributable to the scheme and other expenses that
are not specific to any one scheme but to several schemes (allocation on reasonable basis) These are paid out of
fees charged to the unit holders. The AMC may charge the scheme with investment management fees that are
fully declared in the offer document subject to the following.
 1.25% for the first 100 Cr weekly average net assets & @ 1 % of the weekly average assets >100 Cr
 For no load schemes AMC may charge upto 1% of the average weekly assets
Expense ratio is the cost of running and managing a mutual fund which is charged to the investor. It
includes fund management fees, marketing or selling expenses, transaction costs, investor communication
costs, custodian fees, and registrar fees

Total Expense Ratio

The Total expenses charged by the AMC ( TER) to the scheme including investment Management & advisory
fees excluding issue or redemption expenses are subject to the following
On the first Rs.100 Crores of daily or weekly average assets – 2.50%
On the Next Rs.300 Crores of daily or weekly average assets – 2.25%
On the Next Rs.300 Crores of daily or weekly average assets – 2.00%
On the balance of daily or weekly average assets - 1.75%
For Debt Funds the above are reduced by 0.25%
Index Funds -1.50%
For Fund of Funds, the total expenses cannot exceed 0.75% of average assets.

Total Expense Ratio (TER) is calculated as follows - TER = (Total expenses during an
accounting period) * 100 / Total net assets of the fund.

SEBI has recently come out with a circular that AMCs would be allowed to charge an additional 30
bps of TER on the condition that the new inflows from beyond top 15 cities are at least 30% of
gross new inflows in the scheme or 15% of the scheme's AUM (year-to-date), whichever is higher.
In other words, TER may go up to 2.8% instead of 2.5% for equity schemes. However, the
additional TER will be clawed back if inflows from beyond top 15 cities are redeemed within a
period of one year from the date of investment. The circular also stated that mutual funds shall
annually set apart at least 2 bps on daily net assets within maximum limit of TER for investor
education / awareness initiatives

Measures of Return & Risk: The return on a MF is the percentage of growth between purchase and sale price
with reference to the Purchase price. This could be either HPR, Annual Return or CAGR ( generally used )
Fluctuations in the returns is used as measures of risk – Variance, Standard Deviation & Beta ( CAPM)
To compare the risk v/s return in respect of several funds/portfolios or shares and to make investment decisions,
the above measures alone may not be adequate. To evaluate the performance of the funds the measures – R-
Squared, Sharp, Treynor and Jenson Alpha are used. These measures are considered very important with specific
reference to the examinations.

Risk Adjusted Performance Measurement

R-Squared ( Coefficient of Determination): The R-Squared of a fund or security is an indicator
as to how well the fund/security is correlated with the appropriate benchmark. R-squared measures
the relationship between a portfolio and its benchmark. It can be thought of as a percentage from 0 to 100,
where 0 represents least correlation and 100 represents full correlation.
R-squared is not a measure of the performance of a portfolio. A great portfolio can have a very low R-
squared. It is simply a measure of the correlation of the portfolio's returns to the benchmark's returns.

∑ ∑ ∑
R=
∑ ∑ ∑ ∑

Whrere x represents benchmark and y represents the stock/mutual fund.

If you want a portfolio that moves like the benchmark, you'd want a portfolio with a high R-squared. If you
want a portfolio that doesn't move at all like the benchmark, you'd want a low R-squared.

General Range for R-Squared:

 70-100% = good correlation between the portfolio's returns and the benchmark's returns
 40-70% = average correlation between the portfolio's returns and the benchmark's returns
 0-40% = low correlation between the portfolio's returns and the benchmark's returns

An R-squared of 100 indicates that all movements of a portfolio can be explained by movements in the
benchmark. Thus, index funds that invest only in S&P 500 stocks will have an R-squared very close to 100.
Conversely, a low R-squared indicates that very few of the portfolio's movements can be explained by
movements in its benchmark index. An R-squared measure of 35, for example, means that only 35% of the
portfolio's movements can be explained by movements in the benchmark index.

R-squared can be used to ascertain the significance of a particular beta or alpha. Generally, a higher R-
squared will indicate a more useful beta figure. If the R-squared is lower, then the beta is less relevant to the
fund's performance

The Sharpe measure

In 1966, William Forsyth Sharpe developed what is now known as the Sharpe ratio. Sharpe
originally called it the "reward-to-variability" ratio before it began being called the Sharpe ratio by
later academics and financial operators.

This ratio measures the excess return, or risk premium, of a portfolio compared with the risk-free
rate, compared, this time, with the total risk of the portfolio, measured by its standard deviation.
If the portfolio is well diversified, then its Sharpe ratio will be close to that of the market. With this
ratio the manager can check whether the expected return on the portfolio is sufficient to compensate
for the additional share of total risk that he is taking. Since this measure is based on the total risk, it
enables the relative performance of portfolios that are not very diversified to be evaluated, because
the unsystematic risk taken by the manager is included in this measure.

The Treynor measure

The Treynor Ratio also called ―Reward to Volatility introduced by Jack L Treynor in 1965, is
defined by
The term on the left is the Treynor ratio for the portfolio, and the term on the right can be seen as
the Treynor ratio for the market portfolio, since the beta of the market portfolio is 1 by definition.
Comparing the Treynor ratio for the portfolio with the Treynor ratio for the market portfolio
enables us to check whether the portfolio risk is sufficiently rewarded.
The Treynor ratio is particularly appropriate for appreciating the performance of a well diversified
portfolio, since it only takes the systematic risk of the portfolio into account.

The Jensen measure

Jensen's alpha was first used as a measure in the evaluation of mutual fund managers by Michael
Jensen in 1968. The CAPM return is supposed to be 'risk adjusted', which means it takes account of
the relative riskiness of the asset. Jensen’s alpha (Jensen, 1968) is defined as the differential
between the return on the portfolio in excess of the risk-free rate and the return explained by the
market model, or

Illustration:
The particulars in respect of Three MFs P, Q, R are furnished below. Risk free Return =10%
Funds/Stocks Mean Return Std Deviation Beta
P 15% 20% 0.09
Q 17% 24% 1.1
R 19% 27% 1,2
Market Index 16% 20% 1.0
P Q R
Sharpe = (Rp-Rf)/ϭ =(15-10)/20 = 0.25 =(17-10)/24 =0.29 =(19-10)/27 =0.33
Treynor= (Rp-Rf)/β =(15-10)/0.9=5.55 =(17-10)/1.1= 6.33 = (19-10)/1.20 =7.5

Jensons Alpha = Rp –Rf - β(Rm-Rf)

β(Rm-Rf) =0.9(16-10)=5.4 =1.11(16-10)=6.66 =1.2 (16-10)
Jensons Alpha =(15-10)-5.4 =-0.4 =(17-10)-6.6 =0.4 =(19-10)-7.2 =1.8

Higher the Sharpe Ratio, better is the fund on a risk adjusted return metric
A better fund would have a higher Treynor ratio.
Jensen’s alpha can be positive, negative, or zero. Note that, by definition, Jensen’s alpha of
the market is zero. If the alpha is negative, then the portfolio is underperforming the market;
thus, higher alphas are more desirable.

Inflation Int Rate Price Yield Duration

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