Session3 4-5-6 investment planning [autosaved]

Risk Return Spectrum
Note:The above chart is for illustrative purpose only and is not marked to scale. The chart is based on our
perception of the risk and return potential of various investment avenues
Savings Bank/ FD
Liquid Funds
PPF, NSC, KVP, PO Deposits, RBI Bonds
Debt Funds
Gold
Real Estate
Equity
Risk
Returnpotential
Low High
LowHigh

Which Investment Option Generated
Maximum Return During Last 10 Years ?

Cash & Saving Management
(Managing Monetary Assets)

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

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

What are Money Market Instruments ?

Money Market Instruments
• Treasury Bills
– Issued by Government to meet short term needs
– In the form of Promissory Notes
– Highly liquid and credit risk free
– RBI acts as an Issuing agent for the Govt.
• Minimum of Rs.25,000 and in multiple thereof
• Issued at a discount/ redeemed at par
• Duration – 91 days and 364 days

Treasury Bills
• Yield
– (FV/Purchase Price - 1) *365/Days to maturity
• Traded on the Retail Debt Segment of NSE
– Screen based
– Order driven automated order matching system
– Price-Time priority

Commercial Paper
• Used by corporate to raise short term finance
– Minimum Net worth Rs.4 crores
• Unsecured promissory note issued at a discount
• Maturity – 15 days to one year
• Size – minimum Rs.5 lakhs and multiples thereof
• Cheaper and less cumbersome for issuer
• Liquid and high yield for the investor
• Credit rating

Commercial Paper
• Yield
(Par Value – Purchase Price) X 360
Par Value Days to Maturity
• Secondary market – endorsement and delivery

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

National Saving Certificate
Feature Description
Eligibility Any individual singly or jointly with other adult.
applications for purchase of NSCs may be
submitted on NC-71.A guardian on behalf of a
minor.
Minimum amount Rs. 100/-
Maximum amount No maximum limit
Maturity period
(VIII issue)
•Six years for NSCs purchased upto 30th
November 2011.
•Five years for NSCs purchased on or after 1st
December 2011.
Maturity period
(IX issue)
Ten years
Interest Rate
Period VIII Issue IX Issue
Upto 30.11.2011 8.00% NA
01.12.2011 to 31.03.1012 8.40% 8.70%
01.04.2012 to 31.03.2013 8.60 8.90%
01.04.2013 onwards 8.50 8.80%

Public Provident Fund (PPF)
Type of Account Minimum limit Maximum limit
Public Provident
Fund(Individual account on
his behalf or on behalf of
minor of whom he is the
guardian)
INR. 500/- in a financial
year
INR. 1,00,000/- in a
financial year

What are Tax Free Bonds ?
 Central Government authorizes certain entities such as NHAI,
PFC, REC etc. to issue tax free, secured, redeemable, non
convertible bonds
 Do not form part of Total Income, interest Income is exempt
from tax, no TDS is applicable
 Benchmarked to the 10-year Government Security bonds
 Good investment option now as 10 year gilt yields are high
 They are usually issued for a period of 5-20 years.

Benefits of Tax Free Bonds
Tax-Free Income
Highly rated, which indicates low risk of default
Highly Liquid as it is listed on BSE & NSE.
Easy to track and monitor if the bonds are held in
'Demat Form'

Tax Implications
 Tax Free: The Interest earned is Tax free
 TDS: No TDS is applicable, since the interest Income on these
bonds is exempt.
 Long Term Capital Gains: Bonds are treated as a long term
capital asset if it is held for more than 12 Months.
 Short Term Capital Gains: Bonds are held for a period of not
more than 12 months would be taxed at the normal tax slab
rates.
 STT: Securities Transaction Tax (STT) is not applicable

Illustration on Effective Yield
Assuming the coupon rate of a ABC Tax Free Bond is 8%, an individual
falling in a 10% Tax bracket will effectively earn a return of 8.89%
Tax bracket 10% 20% 30%
Coupon Rate 8.00% 8.00% 8.00%
Effective Pre-tax rate 8.89% 10.00% 11.43%
Higher the Tax bracket higher is the
effective yield earned on Tax free Bonds.
Individuals falling in 30% tax slab will earn
the highest return on Tax free Bonds

Inflation Index Bonds
• IIBs will provide inflation protection to both
principal and interest payments.
• RBI’s inflation index bonds better than bank
FD for retirement savings

Year Inflation WPI
IIB at 1.5%
Coupon
Regular Bond at 7%
Coupon
Principal Interest Principal Interest
0 200 100 100
1 10% 220 110 100 7
2 5% 231 115.50 1.7325 100 7
3 12% 259 129.36 1.9404 100 7
4 4% 269 134.53 2.01795 100 7
5 2% 274 137.23 2.05845 100 7
6 9% 299 149.58 2.2437 100 7
7 8% 323 161.54 2.4231 100 7
8 6% 342 171.23 2.56845 100 7
9 10% 377 188.36 2.8254 100 7
10 5% 396 197.78 2.9667 100 7
Regular Bond vs. IIB

Consider the following example, in which the initial investment (in
2004-05) is Rs 10,000, historic WPI data is from 2004-2005 (taken as
100) and the coupon rate is assumed at 3 per cent.
Year WPI
Adjusted
principal
Coupon rate Interest paid
2005-06 104.47 10,447 3 per cent 313.41
2006-07 111.35 11,135 3 per cent 334.05
2007-08 116.63 11,663 3 per cent 349.89
2009-09 126.02 12,602 3 per cent 378.06
2009-10 130.81 13,081 3 per cent 392.43
2010-11 143.32 14,332 3 per cent 429.96
2011-12 156.13 15,613 3 per cent 468.39
Assuming a maturity period of 8 years; total interest payment = Rs 2,666.19; adjusted
principal at maturity = Rs 15,613;total amount received on maturity = Rs 18,279.19

Disadvantages of inflation indexed bonds
• Inflation indexed bonds are currently linked to WPI and not CPI.
The RBI has announced its plans to roll out inflation indexed bonds
linked to CPI in the near future. The CPI linked bonds will have a
better advantage over WPI linked bonds.
• Periods of deflation will often lead to less adjusted principal, which
is less than the original principal. However, deflation in India's
scenario is just a theoretical risk. As per the current state of
economic affairs, deflation is not practically possible in India.
• The dynamics of the secondary market trading of the inflation
indexed bonds are yet to be defined by the RBI. These factors will
help investor's better gauge the performance of these bonds. It will
also address the liquidity concerns of inflation indexed bonds.

Investment in Bonds through
Mutual Funds

Mutual Fund
• Liquidity, professional management with higher return
• Structure
• Open ended
• close ended
• Objective
• Growth
• Income
• Growth plus Income
• Liquidity
• Tax Savings
• Load
• Load Funds
• No-Load Funds

Schemes of Mutual Funds
• Equity Funds
– Diversified funds, Blue chip funds, Midcap funds,
small cap funds, indexed funds, sector funds
• Debt Funds
• Gilt Funds
• Balance Funds
• Money Market Mutual Funds (Liquid Funds)
• Global Funds

How to Invest and withdraw ?
• Lump Sump
• Systematic Investment Plan (SIP)
• Systematic Withdrawal Plan (SWP)
• Systematic Transfer Plan (STP)

Asset Minimum holding period form LT gain Tax
Equity 1 year Zero
Debt 3 year
Whichever benificial (10%
without indexation, 20%
with indexation)
Real Estate 3 year 20% with indexation
Gold 3 year physical gold, 20% with indexation
3 year gold ETF/MF
Whichever benificial (10%
without indexation, 20%
with indexation)
Bonds/NCDS 3 year 10% without indexation
*3% education cess is applicable on all
Long Term Capital Gain Taxation

Short Term Capital Gain Taxation
Asset
Minimum holding period form ST
gain Tax
Equity Less than 1 year 15%
Debt Less than 3 year Added to income
Real Estate less than 3 year Added to income
Gold below 3 year physical gold, Added to income
below 3 year gold ETF/MF Added to income
Bonds/NCDS 3 year Added to income
*3% education cess is applicable on
all

Identifying Goals and Risk Tolerance before
Picking a Mutual Fund
• Before acquiring shares in any fund, you need to think about why you
are investing. What is your goal?
– Are long-term capital gains desired, or is a current
income preferred?
– Will the money be used to pay for college expenses, or to
supplement a retirement that is decades away?
– Identifying a goal is important because it will help you hone in
on the right fund for the task.
• For really short-term goals, money market funds may be the right
choice, For goals that are few years in the future, bond funds may be
appropriate. For long-term goals, stocks funds may be the way to go.

Risk Tolerance and Mutual Funds
• One must also consider the issue of risk tolerance.
• Can you afford and accept dramatic swings in
portfolio value?
• If so, you may prefer stock funds over bond funds.
• Or is a more conservative investment warranted?
In that case, bond funds may be the way to go.

Capital gain tax & DDT for debt MFs for
FY 13-14
Tax Tax rate for Individuals/HUF
LT Capital gain 10% without indexation/ 20%
WITH INDEXATION
ST Capital gain Added to income
Dividend Income Nil
DDT 25% (Effective 28.325%)

Taxation on debt mutual funds
• Debt MFs have a differential tax treatment compared to
equity.
• While dividends are tax free for equity schemes, they
are taxed in debt funds through dividend distribution tax.
• DDT has now been increased for all debt funds from
12.5% to 25%. The effective rate will now be 28.325%
on account of a 10% surcharge and 3% education cess
• Similarly, there is no tax on long term capital gains in
equity while same is taxed in debt

How should I Invest ?
• Growth Schemes
• Dividend Reinvestment schemes
• Dividend Schemes

Growth or Dividend Scheme
• Dividends from debt funds are subject to a dividend distribution tax (DDT) of
28.325%, including surcharge and cess. Every time your MF scheme distributes
dividends, it first deducts DDT out of the distributable dividend and pays you the
rest. You don’t pay directly; it goes out of the dividend due to you.
• If you are in the 10% and 20% tax brackets and invest in debt funds for less
than a 3 years, choose the growth plan. The reason: the tax outgo in the
growth plan is less than that in the dividend reinvestment plan. The DDT rate is
higher than the short-term capital gains tax rate for the 10% and 20% tax
brackets
• In the same example if you are in the 30% tax bracket, choose the dividend
reinvestment plan (less than 3 year).
• For more than 3 years of investments growth plans are better as
they give you indexation benefits

What is FMP ?
• Closed-ended debt scheme of mutual funds
• No equity component
• Tenures varying from 30 days to five years.
• Minimize the interest rate or reinvestment risk through synchronised
maturity
• Invest largely in money market instruments
• Tax efficient returns through indexation benefits
• Example ( Pre Budget 2014)
• Example (Post Budget 2014)

FMP VS FD Comparison
FMP FD
Interest Rate
Debt Market Rate. Not
announced at the beginning
Debt Market Rate.
Announced upfront
Risk
Riskier, Invests in safe debt
securities, but no guarantee
Safer, insurance cover up to
one lakh rupees
Expense
Fund management charge –
less than 0.5%
No charge
Ease
Invest directly in MF office,
portal or through
distributors
Open FD account at your
bank, offline or online
Redemption
You can withdraw money
before maturity. You can sell
FMP in exchange, but
finding the buyer is almost
impossible
You can withdraw amount
any time by paying penalty

Liquids Funds
A supplement to your savings bank account

How Much Return You Can On Your
Savings Accounts ?

What are Liquid Funds?
• Do not invest any part of assets in securities with
a residual maturity of more than 91 days
• Invest in short-term debt instruments with
maturities of less than one year
• Investments are mostly in money market
instruments and short-term corporate deposits
• Historical Performance of Liquid Funds

Debt Funds
• http://www.moneycontrol.com/mutual-
funds/nav/hdfc-high-interest-fund-dynamic-
plan/MZU008
• http://www.mutualfundindia.com/MF/Portfoli
o/Details?id=29347

Equity Investments
Equity vs. FD

Direct Equity Investment vs.
Indirect Equity Investment
?

An SIP reduces the average cost of investment in fluctuating markets
Benefits of Cost Averaging
5,000
56,424
111,879
197,490
515,568
760,337
1,290,338
1,977,236
2,936,591
1,589,290
3,450,738
4,426,818
3,641,394
4,466,640
5,000
65,000
125,000
185,000
245,000
305,000
365,000
425,000
485,000
545,000
605,000
665,000
725,000
785,000
0
500000
1000000
1500000
2000000
2500000
3000000
3500000
4000000
4500000
5000000
Dec 99 Dec 00 Dec 01 Dec 02 Dec 03 Dec 04 Dec 05 Dec 06 Dec 07 Dec 08 Dec 09 Dec 10 Dec 11 Dec 12
HDFC Top 200 (G)
No of Instalments - 157
Total Investment (5k / month) - 785000
Investment Value - 4466640
SIP Investment Returns CAGR - 24.38
0
500000
1000000
1500000
2000000
2500000
3000000
3500000
4000000
4500000
5000
65000
125000
185000
245000
305000
365000
425000
485000
545000
605000
665000
725000
785000
5,000
53,419
96,857
157,033
431,420
646,312
1,138,882
1,801,179
2,909,807
1,544,971
3,137,652
3,908,063
3,313,578
4,080,698
DSP BlackRock Equity Fund
No of Instalment - 157
Investment Value - 40,80,697.54
SIP Investment Returns CAGR - 23.17%

An SIP reduces the average cost of investment in fluctuating markets
Benefits of Cost Averaging
5000 65000 125000 185000 245000 305000 365000 425000 485000 545000 605000 665000 725000 7850005,000 61,751
109,449
188,892
475,793
701,888
1,108,121
1,725,780
2,537,190
1,306,871
2,644,367
3,329,310
2,992,283
3,593,835
0
500000
1000000
1500000
2000000
2500000
3000000
3500000
4000000
Franklin India Bluechip Fund (G)
Investment Value -3593834
SIP Investment Returns CAGR – 21.46%
0
1000000
2000000
3000000
4000000
5000000
6000000
5000
65000
125000
185000
245000
305000
365000
425000
485000
545000
605000
665000
725000
785000
5,000
53,218
103,179
217,638
607,355
973,152
1,812,707
2,756,900
4,599,602
2,155,022
4,583,002
5,685,813
4,462,407
5,753,260
Reliance Growth Fund (G)
Investment Value - 5753260
SIP Investment Returns CAGR – 27.78%

Equity Funds
• http://www.moneycontrol.com/mutual-
funds/nav/birla-sun-life-top-100-
fund/MBS089
• http://www.mutualfundindia.com/MF/Portfoli
o/Details?id=16354

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

I have burnt my fingers…Equity
Investment is like gambling
• Direct Equity Investment is a full time
professional activity
• Don’t indulge in trading with futures/shares

Equity oriented MF schemes for FY13-14
Tax Tax Rate for
Individuals/HUF
LT Capital gain Nil
Short term capital gain 15%
Dividend Income Nil
DDT Nil

Growth vs. Dividend Scheme
• For equity funds, we assume you would invest
for the long term; in other words definitely
more than a year
• In this case, it doesn’t matter whether you
choose the growth plan or the dividend
reinvestment plan because equity funds
neither impose DDT nor do they attract long-
term capital gains tax.

Investing through Children and Parents

What If ?
• You swiped your credit card for your friend Rs. 20,000 purchase
and that your friend paid back to you by transferring it to your
bank account
• You asked Rs. 50,000 from your friend as loan and paid him
back after a month
• You got Rs. 50,000 cheque from your relative on your wedding
• Your father transferred some money you in your bank account as
help for some purpose
• Gift up to Rs. 50,000 is tax free. But If you receive a gift of Rs.
60,000 than entire 60,000 will be taxed not just 10,000
• Although gift received from relatives are tax free but one should
document huge amounts
• Any wedding gift is not taxable

Investing through Children and Parents
• Income tax act provisions allow you to save tax, if
your invest through major daughter, son or
senior/super senior citizen parents, provided they
are in lower tax bracket
• There is no gift tax if you receive money from
relatives (Father, mother, son, sister, brother,
daughter)
• No tax on gifts received from relatives at the time
of marriage
• Gift beyond Rs. 50,000 is taxable from others
• Example

Critical Question :
Which Mutual Fund is Good for Me ?

S Naren: An old hand at fund
management, the CIO at ICICI
Prudential AMC is known for
his contrarian bets. His equity
schemes performed very well
last year.
Sunil Singhania: The CIO
at Reliance MF focuses on
high-growth business
models. In 2012, several
schemes bounced back as
top performers.
Sukumar Rajah: MD and
CIO of Franklin Templeton
has led the fund house to
deliver strong returns over
the long term and even in
the last one year.

What Have Been Return on Gold Investment
? GUESS

Gold ( 10 Grams )Price History: Indian Rs.
Year Price Year Price Year Price Year Price Year Price
1971 193 1981 1800 1991 3466 2001 4300 2011 26400
1972 202 1982 1645 1992 4334 2002 4990 2012 31799
1973 278.5 1983 1800 1993 4140 2003 5600 2013 29190
1974 506 1984 1970 1994 4598 2004 5850 2014 27000
1975 540 1985 2130 1995 4680 2005 7000
1976 432 1986 2140 1996 5160 2006 8400
1977 486 1987 2570 1997 4725 2007 10800
1978 685 1988 3130 1998 4045 2008 12500
1979 937 1989 3140 1999 4234 2009 14500
1980 1330 1990 3200 2000 4400 2010 18500

Return on Gold Investment
• Range is 8% to 15% in medium to long term
with average return expectation ~ 12%
• Minimum 5 Years Investment
CAGR
(1971-2014)
CAGR
(1981-2014)
CAGR
(1991-2014)
CAGR
(2001-2014)
CAGR
(2009-2014)
12.17% 8.55% 9.34% 15.18% 13.24%

How to Invest in GOLD
• Jewellery buying
• Investment in Gold coins and bars
• Gold ETF
• Gold Fund of Funds

How much to invest in Gold?
• 5% to 10% of your over assets can be invested
in gold.
• If you invest more in gold, remember in the
long term return on gold investment is less
than 10% p.a.

Is it right time to invest in gold?
• “When to invest in gold?” or “Should I invest
in gold now?”
• There is no right or wrong time to invest in
gold.
• You need to invest in gold for long term (
5+yrs).
• It is better to stagger your investments over a
period of time to average out the cost of
purchase.

Facts About Real Estate..1
• Short term vs. Long term capital gain tax
• Capital Gain Tax : Under Construction Property
– Date of booking vs. date of registration
• 80 C benefit of principal repayment
• 24 B benefit of interest repayment up to Rs.
2,00,000 for self occupied house
• Joint ownership by husband and wife and tax
benefit
• Interest benefit of second and more house given
on rent/lease

Facts About Real Estate..2
• How Soon Does Money From Selling a
House Have to Be Invested So No Capital
Gain Tax Is Paid?

• ETFs are essentially mutual fund schemes or index funds
that are listed and traded on the exchange like stocks.
• ETFs are priced continually and can be bought or sold
through out the trading day.
• Buying or selling ETFs is as simple as buying or selling any
other stock on the exchange allowing the investor to take
advantage of intra day price movements.
Exchange Traded Fund

Types of ETF
• Index ETF
• Commodity ETFs
• Liquid ETFs

ETFs V/S Stocks and Mutual Fund
Functionality ETFs Stocks Mutual Funds Unit
Can be purchase through NSE
broker or online trading account
Yes Yes No
Ability to put limit orders Yes Yes No
Real time trading and pricing
throughout market hours
Yes Yes No
Returns at par with the
market/index
Yes No No

Mutual Funds Portfolio
Performance Measures

MF Portfolio Performance Measures
What do we require of portfolio managers?

1. Earn a fair return for the level of risk in the portfolio
2. Ability to manage risk
3. Eliminate unnecessary risks

MF Portfolio Performance
Measurement
• Benchmarking
– Gives us a reference point for comparison
– Comparison of return and risk

MF Portfolio Performance Measurement
• Choosing a benchmark
– The most important consideration for portfolio
performance measurement is benchmark
choice. All portfolio evaluation is dependent on
benchmark choice
1. Make sure the benchmark is unambiguous
2. Make sure the benchmark is an investable index
3. Make sure the benchmark has a measurable value

MF Portfolio Performance
Measurement
• Choosing a benchmark
4. Make sure that the benchmark is appropriate for the
style of portfolio that you are evaluating
5. Make sure the benchmark is specified in advance
6. Make sure the benchmark reflects current knowledge
and opinion
7. Don’t change indices. Be consistent across portfolios

Portfolio Performance Measures
• Treynor’s measure
i
fi
i
RR
T




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

• Tryenor’s measure
– Benchmark comparison
fm
m
fm
m RR
RR
T 




– If Ti > Tm, the portfolio would plot above the
security market line, indicating superior
performance by the portfolio manager.
– If Ti < Tm, the portfolio would plot below the
security market line, indicating poor performance
by the portfolio manager.

• Sharpe performance measure
i
fi
i
RR
S




– Thus, the Sharpe measure gives us a measure of
return per unit of total risk. Again, the higher
the Sharpe measure, the better the performance.
We can also compare individual Sharpe
measures to a benchmark:
m
fm
m
RR
S




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

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

• Comparing the Treynor and Sharpe measures
– For a completely diversified portfolio of assets, the
Sharpe and Treynor measures would be identical in
what they are measuring
– Treynor measures performance relative to systematic
risk
– Sharpe measure s performance relative to total risk

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

• Jensen’s Alpha
– Jensen’s alpha is based on the ideas contained
in the CAPM. It, like the Treynor measure,
measures how well a portfolio manager does at
dealing with systematic risk
– To calculate Jensen’s alpha we need to estimate
the following regression model:
)( ,,,, tftmiitfti RRRR  

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

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

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

Sortino Ratio
• The Sortino ratio measures the risk-adjusted return of an investment asset,
portfolio or strategy. It is a modification of the Sharpe ratio but penalizes
only those returns falling below a user-specified target, or required rate of
return, while the Sharpe ratio penalizes both upside and downside volatility
equally. It is thus a measure of risk-adjusted returns that treats risk more
realistically than the Sharpe ratio.
• A ratio developed by Frank A. Sortino to differentiate between good and
bad volatility in the Sharpe ratio. This differentiation of upwards and
downwards volatility allows the calculation to provide a risk-adjusted
measure of a security or fund's performance without penalizing it for
upward price changes. It is calculated as follows:
•

• Fama’s performance measure
– Fama breaks performance by a portfolio manager into
two categories: selectivity and diversification.
Fama’s measure incorporates measures for managing
both systematic and unsystematic risk.

– Selectivity: measures the ability of the portfolio
manager to earn a return that is consistent with the
portfolio’s market (systematic) risk. The
selectivity measure is:
))((( fmifi RRRR  

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

– Diversification: Diversification measures the
extent to which the portfolio may not have been
completely diversified. Diversification is measured
as:
 ifmf
m
i
fmf RRRRRR 


)()( 







– If the portfolio is completely diversified, contains no
unsystematic risk, then diversification measure would
be zero. A positive diversification measure indicates
that the portfolio is not completely diversified; it would
contain unsystematic risk.
– If the diversification measure is positive, it represents
the extra return that the portfolio should earn for not
being completely diversified.

– Net selectivity = selectivity - diversification
– Net selectivity measures how well the portfolio
manager did at earning a fair return for the
portfolio’s systematic risk and how well the
portfolio manager did at diversifying away
unsystematic risk.
– Positive net selectivity indicates the portfolio
manager did a good job. Negative net
selectivity indicates that the portfolio manager
did a poor job.

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

Data
Funds Return(%) Beta SD(%)
Birla Growth Fund 21 1.12 24.8
ICICI balanced fund 15 0.90 17.5
Sun F&C Debt fund 14 0.95 21.6
Alliance perpetual
fund
13 1.00 14.5

Solution :Jensen Measure
Funds R(%) Required Return
Rf+β(Rm-Rf)
Jensen Alpha
Ri-Rr
Birla Growth Fund 21 13.60 7.40
ICICI balanced fund 15 12.50 2.50
Sun F&C Debt fund 14 12.75 1.25
Alliance perpetual
fund
13 13.00 0

Fama Total Selectivity
Funds Total
Selectivity
Net Selectivity Return for Inadequate
Diversification
TS - NS
Birla Growth Fund 7.40 4.45 2.95
ICICI balanced fund 2.50 0.97 1.53
Sun F&C Debt fund 1.25 (1.45) 2.70
Alliance perpetual
fund
0 0 0

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