Performance indicators – Sharpe, Jensen and Treynor, SIP – Taxation on Mutual Fund

Performance Indicators – Sharpe, Jensen, and Treynor Ratios

Portfolio Performance Measures:

• Key Factor in Investment Decisions: Portfolio performance measures are key factors in the investment decision process.
• Popular Performance Measurement Tools:
  • Sharpe Ratio
  • Treynor Ratio
  • Jensen's Alpha
• Risk-Adjusted Returns: Without evaluating risk-adjusted returns, an investor cannot possibly see the whole investment picture.

1) Sharpe Ratio (SR):

• Definition: It is a financial metric used to measure the risk-adjusted return of an investment portfolio.

• Purpose: Helps investors determine whether the returns of an investment are due to smart investment decisions or excessive risk-taking.

• Formula:

  Sharpe Ratio (SR) = (Rp - Rf) / σp
  

  Where:

  • Rp: Portfolio Return (Average return of the portfolio over a period)
  • Rf: Risk-Free Rate (Return from a risk-free investment, e.g., return from government bonds or treasury bills)
  • σp: Standard Deviation of Portfolio Return (Measures the total risk or volatility of the portfolio) (Represents Total Risk / Volatility)

• Interpreting Sharpe Ratio:

  • Higher Sharpe Ratio (>1): Good risk-adjusted return. Indicates better return per unit of total risk.

  • Sharpe Ratio (= 1): Acceptable risk-adjusted return.

  • Sharpe Ratio (< 1): Poor risk-adjusted return.

  • Negative Sharpe Ratio: Portfolio is performing worse than the risk-free rate.

    Higher is Better: Generally, a higher Sharpe Ratio is considered better.`

• Key Points:

  • Excess Return per unit of Total Risk: Sharpe Ratio measures excess return per unit of total risk (both systematic and unsystematic).
  • Not Very Useful on Standalone Basis: Best used for comparing portfolios or funds rather than in isolation.

2) Treynor Ratio (TR) (Reward-to-Volatility Ratio):

• Definition: Measures the risk-adjusted return of an investment by considering only systematic risk (market risk), rather than total risk.

• Purpose: Helps investors assess how well a portfolio compensates for the systematic risk taken relative to market movements.

• Formula:

  Treynor Ratio (TR) = (Rp - Rf) / βp
  

  Where:

  • Rp: Portfolio Return
  • Rf: Risk-Free Rate
  • βp: Beta of Portfolio (Measures systematic risk or market sensitivity of the portfolio) (Represents Systematic Risk / Beta)

• Interpreting Treynor Ratio:

  • Higher Treynor Ratio: Better risk-adjusted performance relative to market risk.
  • Lower Treynor Ratio: Poor compensation for risk taken.
  • Negative Treynor Ratio: Portfolio underperforms the risk-free rate.

• Key Points:

  • Excess Return on Systematic Risk: Treynor Ratio focuses on excess return per unit of systematic risk only.
  • Useful for Diversified Portfolios: More appropriate for well-diversified portfolios where unsystematic risk is minimized.

3) Jensen's Alpha (αp):

• Definition: Jensen's Alpha measures a portfolio's excess return over the return predicted by the Capital Asset Pricing Model (CAPM).

• Purpose: Helps determine whether a fund manager has added value through active management.

• Formula:

  Jensen's Alpha (αp) = Rp - [Rf + βp * (Rm - Rf)]
  

  Where:

  • Rp: Portfolio Return
  • Rf: Risk-Free Rate
  • βp: Beta of Portfolio
  • Rm: Market Return (Return of the market index or benchmark)

• Interpreting Jensen's Alpha:

  • Positive Alpha (αp > 0): The portfolio has outperformed the market on a risk-adjusted basis ("seeking alpha"). Fund manager has added value.
  • Negative Alpha (αp < 0): The portfolio has underperformed the market on a risk-adjusted basis.
  • Zero Alpha (αp = 0): Portfolio performance is in line with what CAPM predicts based on its risk.

• Value of Alpha: The value of Alpha can be used to rank portfolios or assess the managers of those portfolios.

• Alpha as Representation: The alpha is a representation of the maximum an investor should pay for the active management of a portfolio.

Capital Asset Pricing Model (CAPM):

• Definition: CAPM is a financial model used to determine the expected return of an asset based on its risk.

• Purpose: Helps investors evaluate whether an asset provides adequate return for its risk level.

• Formula for Expected Rate of Return (using CAPM):

  E(Ri) = Rf + βi * (Rm - Rf)
  

  Where:

  • E(Ri): Expected Rate of Return of Investment 'i'
  • Rf: Risk-Free Rate
  • βi: Beta of Investment 'i'
  • Rm: Market Return

SIP (Systematic Investment Plan)

SIP (Systematic Investment Plan):

• Definition: SIP is a method of investing a fixed sum of money in a mutual fund scheme at regular intervals (e.g., monthly, quarterly).
• Rupee Cost Averaging: SIPs utilize the principle of rupee cost averaging. You buy more units when the market is down (NAV is lower) and fewer units when the market is up (NAV is higher). This averages out your purchase cost over time and can potentially lead to better returns in volatile markets compared to lump-sum investments.
• Disciplined Investing: SIPs promote disciplined investing habits by automating regular investments.
• Power of Compounding: By investing regularly over the long term, SIPs benefit from the power of compounding, where returns generate further returns.
• Accessibility: SIPs make mutual fund investing accessible to investors with smaller amounts to invest regularly.
• Flexibility: SIPs offer flexibility to start, stop, or modify investments as per investor needs.

Taxation on Mutual Funds

Taxation on Mutual Funds in India (General Overview):

• Taxation depends on:
  • Type of Mutual Fund Scheme: Equity, Debt, Hybrid
  • Holding Period: Short-term (less than 36 months for debt funds, less than 12 months for equity funds) or Long-term.
• Capital Gains Tax: Profits from selling mutual fund units are taxed as capital gains.
  • Equity Funds (and Equity-Oriented Hybrid Funds - >65% equity):
    • Short-Term Capital Gains (STCG): If units are held for less than 12 months, STCG is taxed at 15% + applicable surcharge and cess.
    • Long-Term Capital Gains (LTCG): If units are held for 12 months or more, LTCG exceeding ₹1 lakh in a financial year is taxed at 10% + applicable surcharge and cess (without indexation benefit).
  • Debt Funds (and Debt-Oriented Hybrid Funds - <65% equity):
    • Short-Term Capital Gains (STCG): If units are held for less than 36 months, STCG is taxed at your income tax slab rate.
    • Long-Term Capital Gains (LTCG): If units are held for 36 months or more, LTCG is taxed at 20% + applicable surcharge and cess, with indexation benefit (which adjusts purchase cost for inflation).
• Dividend Taxation: Dividend income from mutual funds is taxable in the hands of the investor and is taxed at their income tax slab rate. However, mutual funds are required to deduct TDS (Tax Deducted at Source) on dividend payouts exceeding a certain threshold.
• Securities Transaction Tax (STT): STT is applicable on the sale of equity mutual fund units, similar to stocks, and is a small percentage levied on the transaction value.
• No Wealth Tax on Mutual Funds: Mutual fund investments are not subject to wealth tax in India.
• Taxation Rules are Subject to Change: Tax laws are subject to amendments by the government. It's crucial to stay updated on the latest tax regulations.