Determinants of mutual funds’ performance in India

INTRODUCTION
India is emerging as one of the topmost markets among the global players for investment purposes
and it is being called as the fundamentally strong emerging market. The resultant of the government
policy of liberalization in industrial and financial sector has been the development of new financial
instruments. These new instruments prove to be catalytic instrument to impart greater competitiveness
and efficiency to the financial sector. The development of these mutual fund products helps in
generating momentous investment growth in the capital market. Mutual fund is a special type of
institutional device or an investment vehicle through which the investors pool their savings. Savings
are then invested by financial experts in wide variety of portfolios of corporate securities in such a
way, so that the risks are minimized and there is steady return on investment.

Mutual fund is an investment company that pools money from shareholders and invests in a variety
of securities, such as stocks, bonds and money market instruments. Most open-end Mutual funds (also
known as an open-end investment company, to differentiate it from a closed end investment company)
continuously offer new shares to investors. Mutual funds invest pooled cash of many investors to
meet the fund's stated investment objective. Mutual funds stand ready to sell and redeem their shares
at any time at the fund's current net asset value i.e. total fund assets divided by shares outstanding.

Mutual fund is the pool of the money, based on the trusts who invest the savings of several investors
who shares a common financial goal. The money which is collected is then invested in capital market
instruments such as shares, debenture, and foreign market. Investors invest money and get the units
as per the unit value which we called as NAV (Net Assets Value). Mutual fund is the most suitable
investment for the common man as it offers an opportunity to invest in diversified portfolio
management. The main aim of the fund manager is to be taking the scrip that is under value and in
future will rising, then fund manager sells out the stock. Fund manager concentrates on risk – return
trade off, where risk is minimized, and the return are maximized through diversification of the
portfolio.

In other words, Mutual Funds coalesces different resources through the issuance of units to investors
and enables investment of pooled funds in varied securities in lieu of disclosed objectives of offer
documents. Security investments are spread across a wide cross-section of industries and sectors and
thus the risk is reduced. Diversification reduces the risk because all stocks may not move in the same
direction in the same proportion at the same time. Different units are issued to the investors (who are
also called as unit holders) by the Mutual Funds as per the money invested by them and hence as per
the investment, profits as well as losses are shared amongst them. Now-adays Mutual Funds offer
different schemes with diverse objectives. Before moving towards the market, the Mutual Fund has
to be registered with SEBI which scrutinizes it across different facets. Hence, Mutual Fund is an
optimum alternative where investors with comparable investment objectives could pool in the money,
Investment Manager therefore would invest money in accordance with the scheme objectives.

A Mutual Fund is a body corporate registered with the securities and exchange board of India (SEBI)
that pools up the money from individual / corporate investors and invests the same on behalf of the
investors/ unit holders, in equity shares, Government securities, Bonds, call money market etc., and
distributes the profits. In the other words, a Mutual Fund allows investors to indirectly take a position
in a basket of assets.

Mutual Fund is a mechanism for pooling the resources by issuing units to the investors and investing
funds in securities in accordance with objectives as disclosed in offer document. Investments in
securities are spread among a wide cross – section of industries and sectors thus the risk is reduced.
Diversification reduces the risk because all stocks may not move in the same direction, in the
proportion at same time. Investors of mutual funds are known as Unit Holders.

The investors in proportion to their investments share the profit of losses. The Mutual Funds normally
come out with several schemes with different investments objectives which are launched from time
to time.

STRUCTURE OF MUTUAL FUND

A Mutual Fund is a trust that pools the savings of several investors who share a common financial
goal. The money thus collected is then invested in the capital market by a professionally qualified
staff known as fund manager. Fund Manager invests in capital market instrument such as shares,
debentures and other securities. The income earned through these investments and the capital
appreciations generated are shared by its unit holders in proportion to the number of units owned by
them. Thus, Mutual Funds are the most suitable investment for a common man as it offers an
opportunity to invest in a diversified, professionally managed basket of securities at relatively low
cost. The small savings of all the investors are put together to increase the buying power and hire a
professional manager to invest and monitor the money. Anybody with an investible surplus of as little
as few thousand rupees can invest in Mutual Funds. Each Mutual Fund scheme has a defined
investment objective and strategy.

Mutual Funds in India follow a 3-tier structure. There is a Sponsor (the First tier), who starts a mutual
fund. The Sponsor approaches the Securities & Exchange Board of India (SEBI), which are the market
regulator and the regulator for mutual funds. Once SEBI is convinced, the sponsor creates a Public
Trust (the Second tier) as per the Indian Trusts Act, 1882. Trusts have no legal identity in India and
cannot enter into contracts, hence the Trustees are the people authorized to act on behalf of the Trust.
Contracts are entered into in the name of the Trustees. Once the Trust is created, it is registered with
SEBI after which this trust is known as the mutual fund. The Sponsor and the Trust are two separate
entities. Sponsor is not the Trust, i.e. Sponsor is not the Mutual Fund. It is the Trust, which is the
Mutual Fund.

Trustees appoint the Asset Management Company (AMC) (the Third tier), to manage investor’s
money on a day-to-day basis. The AMC in return charges a fee for the services provided and this fee
are borne by the investors as it is deducted from the money collected from them. Whenever the fund
intends to launch a new scheme, the AMC must submit a Draft Offer Document to SEBI. This draft
offer document, after getting SEBI approval becomes the offer document of the scheme. The Offer
Document (OD) is a legal document and investors rely upon the information provided in the OD for
investing in the mutual fund scheme. The Compliance Officer has to sign the Due Diligence
Certificate in the OD.
Custodian

A trust company, bank or similar financial institution responsible for holding and safeguarding the
securities owned within a mutual fund. A mutual fund's custodian may also act as the mutual funds
transfer agent, maintaining records of shareholder transactions and balances. Since a mutual fund is
essentially a large pool of funds from many different investors, it requires a third-party custodian to
hold and safeguard the securities that are mutually owned by all the fund's investors. This structure
mitigates the risk of dishonest activity by separating the fund managers from the physical securities
and investor records. Only the physical securities are held by the Custodian. The deliveries and receipt
of units of a mutual fund are done by the custodian or a depository participant at the instruction of the
AMC and under the overall direction and responsibility of the Trustees. Regulations provide that the
Sponsor and the Custodian must be separate entities.

Role of a Registrar and Transfer Agents

Registrars and Transfer Agents (RTAs) perform the important role of maintaining investor records.
All the New Fund Offer (NFO) forms, redemption forms (i.e. when an investor wants to exit from a
scheme, it requests for redemption) go to the RTA’s office where the information is converted from
physical to electronic form. It acts as single-window system for investors. How many units will the
investor get, at what price, what is the applicable NAV, how much money will he get in case of
redemption, exit loads, folio number, etc. is all taken care of by the RTA. An RTA also helps investors
with information and details on new fund offers, dividend distributions or even maturity dates in case
of FMPs (fixed maturity plans). While such details are also available from fund houses, an RTA is a
one-stop shop for all the information. Investors can get information about various investments in
different schemes of different fund houses at a single place.

REGULATORY AUTHORITIES

To protect the interest of the investors, SEBI formulates policies and regulates the mutual funds. It
notified regulations in 1993 (fully revised in 1996) and issues guidelines from time to time. MF either
promoted by public or by private sector entities including one promoted by foreign entities is governed
by these Regulations. SEBI approved Asset Management Company (AMC) manages the funds by
making investments in various types of securities. Custodian, registered with SEBI, holds the
securities of various schemes of the fund in its custody.

According to SEBI Regulations, two thirds of the directors of Trustee Company or board of trustees
must be independent. The Association of Mutual Funds in India (AMFI) reassures the investors in
units of mutual funds that the mutual funds function within the strict regulatory framework. Its
objective is to increase public awareness of the mutual fund industry. AMFI is also engaged in
upgrading professional standards and in promoting best industry practices in diverse areas such as
valuation, disclosure, transparency etc
LITERATURE REVIEW

Jensen (1968) developed a composite portfolio evaluation technique concerning risk-adjusted returns. He
evaluated the ability of 115 fund managers in selecting securities during the period 1945-66. Analysis of net
returns indicated that, 39 funds had above average returns, while 76 funds yielded abnormally poor returns.
Using gross returns, 48 funds showed above average results and 67 funds below average results. Jensen
concluded that, there was very little evidence that funds were able to perform significantly better than expected
as fund managers were not able to forecast securities price movements.

Fama (1972) developed methods to distinguish observed return due to the ability to pick up the best securities
at a given level of risk from that of predictions of price movements in the market. He introduced a multi-
period model allowing evaluation on a period-by-period and on a cumulative basis. He concluded that, return
on a portfolio constitutes of return for security selection and return for bearing risk. His contributions
combined the concepts from modern theories of portfolio selection and capital market equilibrium with more
traditional concepts of good portfolio management

Ramesh Chander (2000) examined 34 mutual fund schemes with reference to the three fund characteristics
with 91-days treasury bills rated as risk-free investment from January 1994 to December 1997. Returns based
on NAV of many sample schemes were superior and highly volatile when compared to BSE SENSEX. Opened
schemes outperformed close-end schemes in term of return. Income funds outsmarted growth and balanced
funds. Banks and UTI sponsored schemes performed fairly well in relation to sponsorship. Average annual
return of sample schemes was 7.34 percent due to diversification and 4.1 percent due to stock selectivity. The
study revealed the poor market timing ability of mutual fund investment. The researcher also identified that
12 factors explained majority of total variance in portfolio management practices.

Singh and Meera (2001) in their book presented a framework for conducting critical appraisal of mutual fund
performance in the Indian context reviewed the performance of Unit Trust of India (UTI), private and money
market mutual funds.

Otten and Schweitzer (2002) compare the characteristics and the performance of US versus European equity
mutual funds for a sample from 1991 till 1997, consisting of 506 open-ended European and 2096 American
open-ended funds. The authors find that Europe is still lagging the American mutual fund industry with respect
to asset size.

Sadhak (2003) in his book suggested several improvements in the strategic and operational practices of mutual
funds keeping in mind the mechanisms used by fund managers in developed economies. Saha, Tapas Rajan
(2003) identified that Prudential ICICI Balanced Fund, Zurich Equity Fund were the best among the equity
funds while Pioneer ITI Treasury scheme was the best among debt schemes. He concluded that, the efficiency
of the fund managers was the key in the success of mutual funds.
Sondhi (2004) studied the financial performance evaluation of equity oriented mutual funds on the basis of
type size and ownership of mutual funds using the measure of absolute rate of return, comparison with
benchmark (BSE 100) , the return on 364 days T-Bills and risk adjusted performance measure (Sharpe,
Treynor, Jensen's Alpha and Fama)

Muthappan and Damodharan (2006) provided empirical evidence of "Risk adjusted performance evaluation
of Indian Mutual fund schemes”. They evaluated 40 schemes for the period April 1995 to March 2000. The
study identified that majority of the schemes earned returns higher than the market but lower than 91 days
Treasury bill rate. The average risk of the schemes was higher than the market. 15 schemes had an above
average monthly return. Growth schemes earned average monthly return. The risk and return of the schemes
were not always in conformity with their stated investment objectives. The sample schemes were not
adequately diversified, as the average unique risk was 7.45 percent with an average diversification of 35.01
percent. 23 schemes outperformed both in terms of total risk and systematic risk.

Anand, S. and Murugaiah, V. (2006) in his paper, has made an attempt to examine the components and sources
of investment performance in order to attribute it to specific activities of Indian fund managers. It also attempts
to identify a part of observed return which is due to the ability to pick up the best securities at given level of
risk. For this purpose, Fama's methodology is adopted here. The study covers the period between April 1999
and March 2003 and evaluated the performance of mutual funds based on 113 selected schemes having
exposure more than 90% of corpus to equity stocks of 25 fund houses. The empirical results reported here
reveal the fact that the mutual funds were not able to compensate the investors for the additional risk that they
have taken by investing in the mutual funds. The study concludes that the influence of market factor was more
severe during negative performance of the funds while the impact selectivity skills of fund managers was more
than the other factors on the fund performance in times of generating positive return by the funds. It can also
be observed from the study that selectivity, expected market risk and market return factors have shown closer
correlation with the fund return.

Kavitha. R. (2007) analysed the fund selection behaviour of individual investors towards Mutual Funds in
Mumbai city during the period July 2004 – December 2004. She reported that there is a fair opportunity for
mutual fund investments in future.

Acharya and Sidana (2007) attempted to classify hundred mutual funds employing cluster analysis and using
a host of criteria like the 1 year total return, 2 year annualized return, 3 year annualized return, 5 year
annualized return, alpha, beta, R-squared, Sharpe’s ratio, mean and standard deviation etc. The data is obtained
from Value research online. They do find evidence of inconsistencies between the investment style/objective
classification and the return obtained by the fund.
Agrawal, D. (2007) has conducted a research, since the development of the Indian capital Market and
deregulations of the economy in 1992 it has come a long way with lots of ups and downs. There have been
structural changes in both primary and secondary markets since 1992 scandal. Mutual funds are key
contributors to the globalization of financial markets and one of the main sources of capital flows to emerging
economies. Despite their importance in emerging markets, little is known about their investment allocation
and strategies. This article provides an overview of mutual fund activity in emerging markets. It describes
their size, asset allocation. This paper is a process to analyse the Indian Mutual Fund Industry pricing
mechanism with empirical studies on its valuation. It also analyses data at both the fund-manager and fund-
investor levels. The study revealed that the performance has affected the saving and investment habits of the
people and at the second side the confidence and loyalty of the fund manager and rewards affect the
performance of the mutual fund industry in India

Agarwal, R K. and Mukhtar, W. (2010) conducted a study; today mutual funds represent the most appropriate
opportunity for most small investors. As financial markets become more sophisticated and complex, investors
need a financial intermediary who provides the required knowledge and professional expertise on successful
investing. It is no wonder then that in the birthplace of mutual funds- the USA - the fund industry has already
overtaken the banking industry, with more money under mutual fund management than deposited with banks.
This project covers a broad range of equity growth funds. The objectives of the paper are as (a) Twenty four
Equity growth funds have been studied for the application of composite portfolio performance measures like
Treynor ratio, Sharpe ratio, Jenson ratio, Information ratio, M square, Specific ratio etc., and (b) Evaluate the
asset allocation policy for Kotak 30 Growth Mutual fund using Sharpe optimization technique

Research Methodology

Research methodology is a symmetric approach in management to get the pre-defined objective. It is a method
to define the problem collecting data and analysing them, reaching to conclusion. It helps the researcher during
research work like a guide. The scope of research methodology is greater than research.

OBJECTIVES OF STUDY

The thesis deals with the structure of Indian Mutual Fund Industry and in-depth analysis of UTI mutual fund.
The main objective is to analyse the position of UTI in Indian markets and outline the factors which make
UTI still the leading player in Mutual fund Industry. To achieve said objective following sub objectives are
as follows:

 To examine the position of UTI Mutual Fund in the industry after US64 crises.
 To examine comparative performance of equity schemes of UTI with the equity scheme of other
mutual fund in terms of risk and return along with reward to variability and volatility.
  To examine comparative performance of debt schemes of UTI with the debt scheme of other mutual
fund in terms of risk and return along with reward to variability and volatility.
 To examine comparative performance of hybrid schemes of UTI with the hybrid scheme of other
mutual fund in terms of risk and return along with reward to variability and volatility.
 Comparison of periodic performance of schemes of UTI with its respective benchmark

RESEARCH DESIGN

The present research study is a study of examining and analysing the performance of UTI Mutual fund
schemes by using different financial and statistical tool. The study compares performance of different type of
UTI mutual fund scheme with other fund houses scheme with same investment objective. Also, the periodic
return of schemes of UTI has been compared with their respective benchmarks and schemes of other mutual
funds.

TOOLS OF ANALYSIS

SHARPE RATIO

William Sharpe devised the Sharpe ratio in 1966 to measure this risk/return relationship, and it has been one
of the most-used investment ratios ever since. The Sharpe Ratio is a commonly used benchmark that describes
how well an investment uses risk to get return. Given several investment choices, the Sharpe Ratio can be
used to quickly decide which one is a better use of your money. It’s equal to the effective return of an
investment divided by its standard deviation (the latter quantity being a way to measure risk). The Sharpe ratio
is a way to compare the return of portfolios on a risk-adjusted basis rather than a less informative, pure return
basis. From a risk-to-reward perspective when analysing an investment, the higher the Sharpe ratio, the more
desirable will be the investment.

The formula is as follows:

Sharpe Ratio = (Rx – Rf) ÷ StdDev (Rx)

Where:

Rx = average rate of return from investment X

Rf = risk-free rate StdDev (Rx) = standard deviation of Rx

When analysing the Sharpe ratio, the higher the value, the more excess return investors can expect to receive
for the extra volatility they are exposed to by holding a riskier asset. Similarly, a risk-free asset or a portfolio
with no excess return would have a Sharpe ratio of zero.

It has three parts:

1. Average Return

The Sharpe ratio was originally developed as a forecasting tool, but it can also be used to calculate a
historical risk-adjusted return. Expected average returns are used to calculate the forward-looking ratio,
whereas actual returns are used in the historical ratio. The expected return is also known as the required
rate of return because it represents the minimum return investors require to compensate them for the added
risk, which includes both the riskiness of the investment and the time value of money.
 2. Risk-Free Rate

The risk-free rate is the return investors require to compensate for the time value of money alone.
Typically, investors use the return on U.S. Treasury bills for the risk-free rate because it is reasonable to
assume the U.S. government will not default on its debt obligations, and thus investors need only be
compensated for the time their capital is tied up in the security. The Sharpe ratio requires that Rf represents
the average return of the risk-free rate over the time period under evaluation. When analysing a three-year
period, investors must average the rate of return on T-bills over the same three-year period. Traditionally,
the shortest-dated bill is used since it is the least volatile. However, some argue the risk-free security
should match the duration of the investment. Since equities theoretically have an infinite duration, one
could argue that the longest-dated bill should be used.

3. Standard Deviation

The standard deviation of a security measures how far returns deviate on average from its mean (or
average) return. Standard deviation is a common indicator used to measure the volatility, and thus the
riskiness, of an investment. For instance, an investment that deviates only 3% from its mean on average is
judged as less risky than an investment with a 20% average deviation.

STANDARD DEVIATION

The standard deviation of an investment is the amount of dispersion that the results have in compared to the
mean. If a mutual fund has a high standard deviation, this means that it is very volatile. If the standard deviation
is low, this means that it is a safer form of investment that will not experience extreme highs and lows.

The formula is as follows:

Standard Deviation (SD) = Square root of Variance (V)

Variance = (Sum of squared difference between each monthly return and its mean / number of monthly return
data – 1).

The standard deviation for a fund should always be considered in relation to other funds. Investors should
compare it to other, similar types of funds to see if the deviation is particularly high or low for the fund’s type.
Because it is impossible to tell if a standard deviation value represents a gain or a loss, other factors must be
considered when choosing mutual fund investments. Indicators such as the dividend yield and the total return,
which show how a fund has performed in the past, are very useful when assessing a fund

R-SQUARED

R-Squared measures the relationship between a portfolio and its benchmark. It can be thought of as a
percentage from 1 to 100. 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. The formula is as follows:

R-Squared = Square of Correlation

Formula for Correlation:

Covariance between index and portfolio

Correlation = ---------------------------------------------------------

Standard deviation of portfolio * standard deviation of index

The higher the R-squared figure, the more closely the fund's performance can be explained by its index,
whereas a fund with a lower R-squared doesn't behave much like its index. And the higher the R-squared, the
more relevant the beta figure.

R-squared can range from zero, meaning there's no degree of performance correlation between a market
benchmark and a given investment, to 100, meaning that an investment is highly correlated with an index.

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

 1-40% = low correlation between the portfolio's returns and the benchmark's returns

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

ALPHA

Jensen's Alpha was first used as a measure in the evaluation of mutual fund managers by Michael Jensen in
1968. Alpha measures the difference between a fund's actual returns and its expected performance, given its
level of risk (as measured by beta). A positive alpha figure indicates the fund has performed better than its
beta would predict. In contrast, a negative alpha indicates a fund has underperformed, given the expectations
established by the fund's beta. Alpha gives an investor an expectation of how well a mutual fund may perform
in relation to its risk level. Some investors see alpha as a measurement of the value added or subtracted by a
fund's manager.

The formula is as follows:

Alpha = {(Fund Return-Risk free return) – (Funds beta) *(Benchmark return risk free return)}.

BETA

Beta measures the responsiveness of a stock's price to changes in the overall stock market. Beta is a measure
of the volatility of a particular fund in comparison to the market as a whole, that is, the extent to which the
fund's return is impacted by market factors. Beta can be a useful tool when at least some of a fund's
performance history can be explained by the market. Beta is particularly appropriate when used to measure
the risk of a combined portfolio of mutual funds.

The formula is as follows:

Standard Deviation of Fund

Beta = ----------------------------------------x R-Square

Standard Deviation of Benchmark

If a fund has a beta of 1.5, it means that for every 10% upside or downside, the fund's NAV would be 15% in
the respective direction. Beta is an expression of how volatile an investment is compared to the overall market.
A Beta of 1 indicates that the investment will move with the market. A Beta of less than 1 means that
investment will be less volatile than market.
Beta = 1: This happens when the stock price movement is same as that of market

Beta > 1: Beta exceeds one when the stock price movement surpass market movement.

Beta < 1: This happens when the stock price moves less in comparison of market movement.

Beta allows the investor to understand if the price of that security has been more or less volatile than the
market itself, which is certainly a good variable to understand before adding any security to a portfolio.
However, it doesn't distinguish between large upswing or downswing movements. So, while beta can tell
something about the past risk of a security, it tells very little about the attractiveness or the value of the
investment today or in the future

TREYNOR RATIO

It is developed by Jack Treynor. Treynor Ratio attempts to measure how well an investment has compensated
its investors given its level of risk. The Treynor ratio relies on beta, which measures an investment's sensitivity
to market movements, to gauge risk.

Treynor Ratio Formula

Treynor Ratio = Total Portfolio Return – Risk-Free Rate

Portfolio Beta

The Treynor ratio is an assessment of the fund's historical risk/reward profile. The Treynor ratio is best used
to compare two investments within the same category or to compare an investment's Treynor ratio with that
of a market benchmark or category average. The higher the ratio, the greater the portfolio's returns relative to
its beta (level of sensitivity to its market index).Treynor ratio is higher with either higher portfolio returns or
lower portfolio betas, so it is a measure of the return per unit risk. The problem with the Treynor ratios is that
it treats upside price movements the same as downside price movements. Treynor ratio is a relative measure
of risk, so the number means nothing on its own.

SIGNIFICANCE OF THE STUDY

The thesis focuses on the growth and structure of Indian mutual funds industry and in-depth analysis of UTI
mutual funds. The study has been done to analyse the position of UTI mutual fund in Indian market and also
focus on those factors which make UTI Mutual Fund still the leading player. When the mutual funds industry
was liberalized in 1992, the UTI had held a monopoly in the market for almost 30 years. Indian retail investors
had been familiarized with guaranteed high returns on their UTI investments. This good record, combined
with aggressive marketing by new entrants, led to expectations of high profits by investors who began to invest
strongly in the new private mutual funds. Thus, from the monopoly of a single mutual fund like UTI, mutual
fund industry moved to public with a few public sector funds and has now with the entry of private and foreign
funds, it has moved to a competitive environment. This background motivated the need to explore more about
the Indian scenario of mutual funds particularly UTI and its competitiveness. It clearly shows that the structure
of mutual fund industry has changed after commencement of the financial sector reforms in various forms
including different types of funds and different schemes for mobilizing resources in the economy.
LIMITATION OF THE STUDY

The limitations of this study are as follows:

 Since the study is mostly based on the secondary data, the shortcomings of the use of secondary data are
inevitable.

 Performance evaluation of the scheme is based only on the NAV of the growth category schemes with
growth option alone.

 Brokerage commission, entry load, exit load and taxes were not considered.

 Only 14 schemes of UTI Mutual Fund have been considered for analysis which may not reflect the true
picture of the fund house as whole.

 The present study is confined to regulated environment of MF industry in India and that of UTI MF. During
the course of study, it was observed that technological and environmental changes have many social
implications. The research analyses were based on past performance of UTI scheme. The scheme had been
affected by markets overall performance.