Q.1 Mr. Mahendra Kumar would like to invest in mutual funds.

He has been suggested by

his friend to choose a fund from any of the three mutual funds, as given in the table below.
Mr. Mahendra learns that he can use Sharpe’s ratio, Treynor’s ratio and Jensen’s Alpha to
measure the performance of a mutual fund. Help Mr. Mahendra to rank the three funds on
each of the measures.
Fund A Fund B Fund C
Portfolio Return 12% 15% 18%
Standard Deviation 0.15 0.25 0.4
Beta of the portfolio 0.6 0.8 1.4
Return from the market 12%
Risk free rate of return 6%

Answer: Mutual funds are a collection of stocks and bonds. It can be defined as the money that is
pooled together by many investors who give their money to a fund manager to invest in large
portfolio of stocks or bonds for a small fee. Mutual funds are advantageous because of its cost-
efficiency, risk-diversification and professional management nature. Since mutual funds involve
investment in different assets, a loss experienced in one asset investment can be recovered from
the gains obtained from the other asset investment. Investments through mutual funds are made in
equities, bonds, and debentures. They are set up with a specific strategy in mind and the focus is
on bonds from companies, bonds from government, large stocks, and small stocks.

Often the decision to buy and sell shares in mutual funds is “too easy” because investors assume
they do not need to evaluate these investments. The responsibility for choosing the right mutual
fund rests with you. You are the best judge of how much risk you are willing to undertake and how
a particular mutual fund can help you achieve your goals. Mutual funds are designed to meet just
about any conceivable investment objective. Most of mutual funds trade daily under the headings
of “aggressive growth”, “small cap”, and “growth income”. Fortunately, a lot of information is
available to help you evaluate a specific mutual fund.

It is very common to use Sharpe’s ratio, Treynor’s ratio and Jensen’s Alpha to measure the
performance of a mutual fund and these measures are very effective too.

Sharpe Ratio measures how well the fund has performed vis-a vis the risk taken by it. It is the
excess return over risk-free return (usually return from treasury bills or government securities)
divided by the standard deviation. The higher the Sharpe Ratio, the better the fund has performed
in proportion to the risk taken by it.

Sharpe’s Ratio = Total Return of the portfolio – Risk free rate

Standard deviation of the fund

FUND A FUND B FUND C

= 12 - 6 = 15 - 6 = 18 - 6
0.15 0.25 0.4
= 6/0.15 = 9/0.25 = 12/0.4
= 40 = 36 = 30
Sharpe ratio measures excess return over risk free rate. The greater a portfolio's Sharpe Ratio, the
better its risk-adjusted performance. A negative Sharpe Ratio indicates that a risk-less asset would
perform better than the security being analyzed.

Treynor suggested a similar looking formula as Sharpe ratio except that he defined the risk as not
the total risk, but the systematic risk. Treynor ratio is also known as reward-to-volatility ratio,
Treynor ratio is the excess return generated by a fund over and above the risk free return
(government bond yield). It is similar to Sharpe ratio though one difference is that it uses beta as
a measure of a measure of volatility.

Treynor ratio = Portfolio Return – Risk free rate

beta (β)

FUND A FUND B FUND C

= 12 - 6 = 15 - 6 = 18 - 6
0.6 0.8 1.4
= 6/0.6 = 9/0.8 = 12/1.4
= 10 = 11.25 = 8.57

A fund with a higher Treynor ratio implies that the fund has a better risk adjusted return than that
of another fund with a lower Treynor ratio.

Jensen’s alpha is the excess returns of the fund over the benchmark. Alpha is performance ratio to
measure risk-adjusted performance of a portfolio, intended to help investors determine the risk-
reward profile of a mutual fund. Alpha measures the difference between a fund's actual returns and
its expected performance, given its level of risk. A fund's alpha is often considered to represent the
value that a portfolio manager adds to or subtracts from a fund's return above and beyond a relevant
index's risk/reward profile.

Jensen’s Alpha = Portfolio return – Risk free rate - [Beta of the portfolio * (Expected
market return – Risk free rate)]

FUND A FUND B FUND C

= 12 – 6 – [0.6(12-6)] = 15 – 6 – [0.8(12-6)] = 18- 6- [1.4(12-6)]
= 6 – 3.6 = 9 – 4.8 = 4.2 = 12 – 8.4
= 2.4 = 4.2 = 3.6

A positive alpha means the fund has outperformed its benchmark index. Correspondingly, a
negative alpha would indicate an underperformance. As a fund's return and its risk both contribute
to its alpha, two funds with the same returns could have different alphas.

Conclusion: Comparison of all the funds

RATIOS FUND A FUND B FUND C
Sharpe’s Ratio 40 36 30
Treynor ratio 10 11.25 8.57
Jensen’s Alpha 2.4 4.2 3.6
Fund B has been performing good in terms of Treynor’s ratio and Jensen’s Alpha and it is ahead
of Fund C also when we calculate Sharpe’s ratio So, Fund B will be our first choice. Second rank
will be given to Fund A as it is good as compared to C in terms of Sharpe ratio and Treynor. Third
rank will be given to Fund C.

Q.2 Mr. Virendra Kumar invests Rs. 10,000 in a stock that gives him dividend of Rs. 100, Rs.
200 and Rs. 300 at the end of the first, second and third year respectively. He sells his holdings
at Rs. 13,500 at the end of the third year. How much returns did he earn, as per Money
weighted rate of return method? Further, instructions- students can directly calculate the
IRR either using in-built formula in MS Excel or create calculations of Present Values (PVs)
in MS Excel. Find sum of PVs and set the sum to zero by changing the value of the
discounting rate. (you may use Goal Seek function of MS Excel to accurately calculate the
IRR). The rate at which the sum is zero is IRR.

Answer: NPV: Net present value (NPV) method recognises the time value of money. It correctly
admits that cash flows occurring at different time periods differ in value. Therefore, there is the
need to find out the present values of all cash flows. NPV method is the most widely used technique
among the DCF methods.

IRR: Internal rate of return (IRR) is the rate (i.e. discount rate) which makes the NPV of any
project equal to zero. IRR is the rate of interest which equates the PV of cash inflows with the PV
of cash outflows. IRR is also called as yield on investment, managerial efficiency of capital,
marginal productivity of capital, rate of return and time adjusted rate of return. IRR is the rate of
return that a project earns.

GIVEN
Particulars Year 0 Year 1 Year 2 Year 3
Operating cash flow 100 200 300
Investing cash flow -10000 13500
Total cash flows -10000 100 200 13800

Calculation of NPV in EXCEL and set the sum to zero by changing the value of the
discounting rates as instructed in question:
NPV 1218.95
NPV 916.21
NPV 71.29
NPV -190.78
NPV -60.91
NPV -8.31
NPV 42.01
NPV 36.69
NPV 4.90
 NPV -1.71
NPV 0.14
NPV 0.00

Calculation of IRR in EXCEL to accurately calculate the IRR as instructed in question:

IRR 12.268540%

Therefore, IRR will be approx. 12.26854% or 12.27% at which NPV is 0.

Q.3 Mr. Dhirendra Kumar is a 24 years old professional, working as a programmer for the
largest software company in India. He has earned his bachelor degree of engineering in
Computer Science from IIT Mumbai and has been working for the company for last three
years. He belongs to Pathankot and his parents live there. For last three years, he has been
staying in Bengaluru along with his other colleagues in a rented accommodation. He plans
to get married not before the age of 28 and would like to have his own house before he gets
married. His father is working currently at Pathankot and is due to retire in another ten
years. He plans to convince to his parents to shift to Bengaluru from Pathankot to stay with
him post his father’s retirement. Mr. Dhirendra is the star performer of his company. He
currently enjoys a package of Rs. 18 lakhs per annum. After accounting for his expenditure,
he has been able to save close to Rs. 30 lakhs over the last three years. Till date he has been
putting his savings in either Fixed deposits (FDs) of his bank or some of the tax savings
instruments such as Public Provident Fund etc. However, now he would like to see his
investments grow much faster so that he can meet his marriage related expenditure four
years later and also make the down payment for his new house before marriage. He has been
getting various investment advices from different people telling him where to put his money.
His parents are advising him to buy some gold every year and put rest of the money in FD.
His boss tells him to buy the house right away, even though it could be smaller than he would
need later. According to his boss, value of his small house would appreciate in four years and
that the sale proceeds would partially fund the new purchase.
Some of his friends have told him that investing in high safety corporate bonds will give him
better returns than putting money in PPF. Amongst all this, he is getting the constant feed
through newspapers of Sensex and Nifty scaling new heights every other day and a few one-
off stories of rags to riches. Mr. Dhirendra is thoroughly confused between the choices and
he now approaches a professional (you) to advice him on the right investment strategy. Some
questions that you need to answer for Mr. Dhirendra:
a) Where should he put his money, in gold, in FD, in PPF, in real estate, in corporate bonds
or in stocks? Or do you have some other strategy in mind? Provide your answer with the
rationale.
b) Should he invest in any of these assets directly or should he choose the mutual fund route
or create a portfolio of mutual funds? How will choosing the mutual fund route (single
mutual fund or a portfolio of mutual funds) will prove beneficial to Mr. Dhirendra? Explain
your recommendation with reasons for the same.

Answer: a) Financial planning is a process of assessing the goals of an investor. It is a type of

planning that includes estimation of the wealth of an investor. For example, the wealth of the
investor includes the annual income, the assets owned, and the investments made. Financial
planning guarantees that the right quantity of money is available to the investor at the right time to
meet the financial goals. The financial goals can be long-term, short-term or intermediate.

Some of the long-term financial goals are:

 Investing in education of children.
 Planning for retirement.

Some of the short-term financial goals are:

 Investing in funds, stocks, real estate, and savings to minimise tax.
 Planning for vacation.

Some of the intermediate financial goals are:

 Purchasing a house or a flat worth INR 20, 00,000 after three years.
 Planning to buy a bike or a car after two years.

Before jump to the investment decision directly, we need to assess some points which will
help us to make better investments like:
 Future Financial Goals: First, you should be very clear about your future goals like what
you want to achieve after say 5 years or 10 years. If you know your goals very well, you
can start the investment using appropriate investment tools for you.
 Asset allocation: Whether it is short-term goal or long-term goal, the proper asset
allocation between debt and equity is a must. I personally prefer the below asset allocation.
Remember that it may differ from individual to individual. However, the basic idea of asset
allocation is to protect your money and smoothly sail to reach the financial goals.
 If the goal is below 5 years-Use debt products mainly and make investments in
equity wisely and better through mutual funds
 If the goal is 5 years to 10 years-Allocate debt: equity in the ratio of 40:60.
 If the goal is more than 10 years-Allocate debt: equity in the ratio of 30:70.
 Expected return: You should be very realistic when it comes to expected return. When
your expectations are defined, it is less probability of deviations.

Investment in gold and bonds are not much rewarding and these options are not attractive now a-
days. He should continue investing some part of income in PPF. Real estate investment needs time
and that is not suitable for Dhirendra.

Dhirendra is 24 years old only so he has plenty of time to get best returns from his investments.
He has already invested in some fixed deposits and public provident fund, but both these
investments are debt investments which will not give him good returns and he may not fulfill his
dreams of own house and other major expenditure soon. Now he can look to invest in equity
portion, as I have mentioned about asset allocation above. He should invest some part of his
earnings in stock market preferably through the mutual funds route as they are considered to be
safer, properly managed and give better returns than directly invest in share market.

b) As gold, corporate bonds or real estate will not fetch him good returns, he should think to invest
in share market but only through mutual fund route as he does not have much knowledge about
financial planning and professional help will make his task easier. As a finance professional, I
would advise Dhirendra to have portfolio of mutual funds as single type of fund will not help him.

To build the best portfolio of mutual funds you must go beyond the sage advice, "Don’t put all
your eggs in one basket:" A structure that can stand the test of time requires a smart design, a solid
foundation and a simple combination of mutual funds that work well for your needs.

Portfolio of mutual funds will have all type of funds like:

 Large cap: These stocks are issued by large companies that have a large amount of stock
outstanding and a large amount of capitalization. Many investors find large cap stocks more
appealing than small cap stocks since the latter is more secure. Some of the examples are
SBI blue-chip fund, Kotak select focus fund etc. Both these funds have given more than
20% return in last 3 years.
 Mid cap: These funds invest in companies whose stocks offer more security than small-
cap funds and more growth potential than funds that invest in large corporations. Some of
the MID cap funds are HDFC mid cap fund and HSBC mid cap fund.
 Small cap: small-cap stock is defined as a stock that has a less capitulation value. These
stocks are issued by smaller companies and tend to be more speculative. These stocks are
often purchased by investors who hope to make quicker profit. Some of the small cap funds
are L&T emerging business fund, SBI small cap fund etc. Both these funds provided
tremendous returns in last three years.
 Balanced funds: These funds invest in stocks that provide both a predictable source of
dividend income and the potential for currency appreciation. These funds are generally
more conservative than aggressive growth funds and growth funds because they invest in
larger and more established companies. They are also called as balanced funds. HDFC
balanced fund and ICICI prudential balanced fund are doing well in this category.
 Tax saver funds: These are also known as Equity Linked Saving Scheme (ELSS). These
were introduced in the financial market in 1990 under Section 80 CCB of the Indian Income
Tax Act. The extent of this kind of scheme is 10 years. Profits made under this scheme will
be considered as long-term capital gains. These funds are tax savings and good for the
investors who want to save tax as well as have the mutual fund’s benefit. Birla sun life tax
relief 96 and Tata tax savings fund are good in this category.

On the basis of above information which has been mentioned in first and second part, portfolio of
mutual funds will be the best and most rewarding option for Mr. Dhirendra and will help him to
fulfill his desired goals.