ARTICLE ON FINANCIAL

SECURITIES

NOVEMBER 26, 2019

It is very crucial and requires ample expertise in stock investments and therefore people want a secure and
safe solution by pooling their funds in different portfolio which is mutual funds which are also managed by
experienced fund managers. The quality of stock picking determines their analytical skill.

Ratio’ is a simple and basic mathematical tool used to understand relationship between two numbers. It is
important for financial advisors to understand the way in which ratios are used to evaluate the performance
of a Mutual Fund Portfolio.

You can analyze the performance of an investor's portfolio by analyzing the ratios and by computing
returns. You as advisors are expected to understand and interpret the ratios and help the clients take a
decision.

For years, investors, fund managers, and stock analysts have sought reliable indicators to project the future
return and risk of owning an individual stock, bond, or a portfolio of securities. The underlying assumptions
are as follows:

1. All investments have inherent risk which is assumed upon ownership.

These assumptions exemplify modern portfolio management and are the basis for the widely used capital
asset pricing model (CAPM) developed in the 1960s, which led to a Nobel Memorial Prize in Economics
for its creators. Enabled by technology, Wall Street wonks amass and analyze massive amounts of historical
data searching for hidden, often arcane relationships to identify undiscovered opportunities for gain without
risk. The results of their analysis are often publicly available for use by private investors.

1. Alpha
Alpha is the measure of a portfolio’s return versus a specific benchmark, adjusted for risk. The
most common benchmark in use – and the one you can assume is used unless otherwise noted – is
the S&P 500. An investment with an alpha greater than zero has provided more return for the given
amount of risk assumed. A negative alpha – less than zero – indicates a security which has
underperformed the benchmark; it has earned too little for the risk assumed. Investors typically
want investments with high alphas.

2. Beta
Beta is the measure of an investment’s volatility to another market index, such as the S&P 500.
 Volatility indicates how likely a security is to experience wide swings in value. If beta is 1.0, the
investment moves in sync with the S&P or experiences a measure of volatility similar to the S&P.
If beta is positive, the investment moves more than the index; if negative, the investment is less
volatile than the index. For example, a beta of 2.0 projects a movement two times that of the market.
Assuming a market price change of 15%, the investment could move 30% up or down.
Conservative investors typically prefer investments with low betas to reduce volatility in their
portfolios.

3. Standard Deviation
While beta typically measures an investment’s movement against an index such as the S&P 500,
standard deviation measures the volatility of an investment in a different way. Instead of
comparing the investment’s return to a benchmark, standard deviation compares an investment’s
individual returns (for example, the closing price each day) over a specific period relative to its
average return over the same period. The more individual returns deviate from the investment’s
average return, the higher the standard deviation. An investment with a standard deviation of 16.5
is more volatile than an investment with a standard deviation of 12.0. According to Morningstar
Ratings, the standard deviation for the S&P 500 has been 18.8 for the last five years.

4. R-Squared Value
The R-squared value is a measurement of how reliable the beta number is. It varies between zero
and 1.0, with zero being no reliability and 1.0 being perfect reliability.
 The two charts illustrate the variability of return for two funds compared to the volatility of the S&P
500 in the same period. Each y-value represents a fund’s returns plotted against the S&P 500 returns
(x-values) in the same period. The beta, or the line created by plotting these values, is the same in each
case. This suggests that the correlation between each fund and the S&P 500 is identical. However,
closer examination indicates that the beta in the second chart is far more reliable than the beta in the
first chart as the dispersion of the individual returns (x) is much tighter. Therefore, the R-squared value
is higher for the fund in second chart.

5. Sharpe Ratio

Sharpe ratio was developed by Nobel Prize winner on capital asset pricing model,Dr. William Sharpe,
professor at the Stanford Graduate School of Business,is a measure of a portfolio’s return versus a risk-
free return. The risk-free return most often used is the interest rate on a three-month U.S. Treasury bill.

Where

RI =Scaled holding period return of investment I. The return is scaled to one year. The
calculation methodology for scaled holding period return has been discussed in the following
post:

Market Risk Metrics – Holding Period Return

Rf = Annualized risk-free rate of return.

?I = Annualized volatility

The underlying premise is that an investor should receive a higher return if he assumes more volatility in
his portfolio. Theoretically, the higher the ratio, the stronger the portfolio’s return has been relative to the
risk taken. A ratio of 1.0 indicates that the return was what should be expected for the risk taken, a ratio
greater than 1.0 is an indication that the rate was better than expected, and less than 1.0 is an indication that
the return did not justify the risk taken. Refinements of return to volatility ratios include the Sortino ratio,
the Treynor ratio, and the Modigliani risk adjustment performance measure (RAP). However, in ETFs, the
ratio does not comply with exact risk measurement due to expense ratio. therefore, another ratio was
introduced with better measurement of risks associated with mutual funds that is The Sortino Ratio is the
return above a risk-free investment divided by the downside deviation (DSDEV). The Martin Ratio is the
return above a risk-free investment divided by the Ulcer Index, which measures the magnitude and duration
of drawdowns.

6. Maximum drawdown:

The assessment of risk for the investor is most crucial considering the losses. The most important factor an
investor must look into the maximum capacity of a mutual fund with maximum possible loss. It is calculated
through the highest hit price a mutual fund went with a lowest dropdown value. It measures the largest
peak-to-trough decline in the value of a portfolio (before a new peak is achieved). With passively managed
funds like ETFs (Exchange traded funds), the loss is minimum with lower expense ratio compared to
actively managed funds.

The ratio is most useful for the investor in assessing the relative riskiness of one fund versus another. as it
focuses on capital preservation, which is a key concern for most investors. However, it's important to
remember that it only measures the size of the largest loss but says nothing about the frequency of large
losses. For the avoidance of doubt, this relates to the performance of the basket as a whole, it may well be
the case that a given single stock within the basket experiences a much higher drawdown but has been
hedged by the rest of the basket. It's always important to consider other risk management elements, for
example the extent to which the portfolio is diversified.

For example, if a portfolio starts being worth £200,000, increases in value to £250,000, decreases to
£190,000, increases to £225,000, then decreases to £180,000, then increases to £325,000, the max
drawdown is (£250,000- £180,000) / £250,000 = 28%. The highest peak of £325,000 is not included in the
calculation because the drawdown began at a peak of £250,000. Likewise, the increase to £225,000 before
the drop to £180,000 is ignored, because £225,000 was not a new peak.

7. Information Ratios

This ratio measures the risk-adjusted returns of a mutual fund relative to certain industry benchmark such
as U.S treasury bill or S&P 500. It will reveal the excess returns for the risks associated with a portfolio. It
is primarily used as a performance measure by the fund managers for actively managed funds in a similar
portfolio with equal returns and risks as well. It will be then depending on the acumen of the managers with
certain information that determine which fund to choose. The ratio will tell the ability of fund manager to
generate excess returns that determines the fees structure of managers.
The sharpe ratio and information ratio differs in factor of comparison. Sharpe ratio used to compare with
the risk-free rate as a benchmark while the information sets U.S treasury bills or S&P 500 as benchmark.
Is measured as the difference between benchmark ratio and returns from a particular fund divided by the
standard deviation of benchmark ratio.

8. Treynor Ratio

It is the measurement of return with risk-adjustment based on systematic risk. It shows how much a mutual
fund or ETF earned compared to risk taken for the investment. It will probably reveal the benefits of a fund
to the investor so that for the amount of risk taken. If the benefits increase than the risk taken, then it is
likely that the investor should put more investment in that fund otherwise not. The negative Treynor ratio
indicate that the investment performed worst compared to risk-free instrument. Below is the formula for
the calculation

Where

RI =Scaled holding period return of investment I. The return is scaled to one year. The calculation
methodology for scaled holding period return has been discussed in the following post:

Market Risk Metrics – Holding Period Return

Rf = Annualized risk-free rate of return.

?I = Beta of the investment with respect to a well-diversified broad market index. The calculation
methodology for beta has been discussed in the following post:

Market Risk Metrics – Beta with respect to market indices.

9. Tracking error

The tracking error measures the consistency of a mutual fund or ETF relative to benchmark set by the fund
manager. It is very important for the investors to keep this ratio in mind when going for the fund in long
term or with large investment. Because the increased deviation from the benchmark would lessen returns
for the investor and main ingredient of the manager performance. It determines how the information ratio
measure is consistence over time. Determining the expert’s performance in mutual funds. A good ratio is
dependent on the type of investors in the portfolio.
Calculating tracking error is a three-step process. First, an excess return series is created by calculating the
periodic differences between the manager and the benchmark. Next, the mean of that excess return series
is calculated. Finally, the dispersion of individual observations from the mean excess return is calculated.

Because ETF investors have become more cost conscious, a fund’s expense ratio and trading costs are
always top of mind. Given the focus on due diligence, tracking error—which in some circumstances may
increase costs—is becoming more heavily scrutinized. A large tracking error between a passively managed
ETF and the index it tracks may be a red flag. It could signal excessive trading costs or issues relating to
fund management.

tracking error is an inherent feature of investing. To begin with, a passively managed strategy will likely
lag behind its benchmark because of fees associated with the fund. Another culprit? Cash drag. If a fund
has a cash position of 1% and the market rises 10%, that cash will not benefit from the market jump—
resulting in tracking error. While passively managed ETF cash levels tend to be low, they can fluctuate as
a result of dividend payments. In these days of record-setting markets, even a low cash position can have
an impact on tracking error.

10. Tracking difference

The vast majority of ETFs aim to track an index—which means that ETFs try to deliver the same returns
as a particular index. Tracking difference is the discrepancy between ETF performance and index
performance.

Tracking difference is rarely nil: The ETF usually trails its index.
That’s because a number of factors prevent the ETF from perfectly mimicking its index. ETF returns don’t
always trail their index though; tracking difference can be small or large, positive or negative.

Tracking error is a related but distinct metric. Tracking error is about variability rather than performance.
Math geeks measure variability through standard deviation. Tracking error is the annualized standard
deviation of daily return differences between the total return performance of the fund and the total return
performance of its underlying index.

In laymen’s terms, tracking error basically looks at the volatility in the difference of performance between
the fund and its index.

The following indicators are used for the tracking difference to properly understands it.

a. Total Expense Ratio

11. Active share

Active share is the percentage of a fund's holdings that are different from its benchmark index. The lower
the active share percentage, the more closely the fund resembles its benchmark. A fund that has no holdings
in common with the benchmark will have an active share of 100%, and a fund that has exactly the same
holdings as the benchmark will have an active share of 0%.

This ratio is useful in determining the how much you are paying for the fund’s active management. The
funds low performance or underperformance is attributed to less active shares in a portfolio. Which means
the funds are no more different from the benchmark that equals the trends of the benchmark. It has also fee
for the managers. Therefore, it is very important for the investor to invest in the portfolio with suitable share
of active share. With almost 80% and keeping the cost at check.

For example, Putnam Investors Fund, a $2 billion large company blend fund, had a 45% active share in
2016, according to activeshare.info. It also had an expense ratio of about 1%. The fund lagged the Standard
& Poor's 500 stock index by 8.27 percentage points in 2017.
Benefits of higher active share

• High active share strategies, on average, delivered stronger excess returns when compared to low
active share strategies.
• The stronger performance delivered by high active share funds cannot necessarily be associated
with higher levels of risk (absolute or relative).
• Within lower active share funds, those that are systematic equity strategies delivered
meaningfully better outcomes than nonsystematic strategies (as measured by excess returns and
information ratio).

12. Jensen’s Alpha

This measure is used to determine the abnormal return of the mutual funds over the expected return. In
terms of EFTs, the benchmark set to determine whether the securities have performed well or not compared
to benchmark. Jensen’s Alpha, also known as the Jensen’s Performance Index, is a measure of the excess
returns earned by the portfolio compared to returns suggested by the CAPM model. It represents by the
symbol α.

The value of the excess return may be positive, negative, or zero. The CAPM model itself provides risk-
adjusted returns, i.e., it takes into account the risk of the security. So, if the security is fairly priced, its
actual returns will be same as CAPM. The Alpha in this case will be 0. If, however, the security earns even
more than the risk-adjusted returns, it will have a positive Alpha. Negative alpha indicates that the portfolio
has not earned its required return. A higher Alpha is always desirable by portfolio managers.

Conclusively, in perspective of actively managed funds the crucial ratios are information ratios, sharpe
ratios, tracking error and active share. These are very useful for the investors investing in actively managed
fund because it involves managers fees and trading cost. While passively managed funds have beta, alpha,
standard deviation, and maximum drawdown. Although all the ratios are equally important for measuring
the stock performance.