Question Paper
Portfolio Management & Mutual Funds – II (252) : October 2003

Part D : Case Study (50 Points)

Case Study

Read the case carefully and answer the following questions:

1.      Identify and describe an appropriate set of investment objectives and investment constraints for Mr. Gupta. Also write an investment policy statement based on these objectives and constraints.

(10 points) < Answer >

2.      The allocation changes in the PE ratio fund are effected at the end of every month. Relevant data of NSE Nifty is given in the Appendix I. Ignoring cost of rebalancing and with the help of Investment pattern of the PE ratio fund you are required to

a.       Calculate the yield on an Index fund based on Nifty during last one-year period (August 2002-July 2003).

b.      Calculate the yield of the PE Ratio fund assuming it is under operation from 1.08. 2002.

(3 + 9 = 12 points) < Answer >

3.      Calculate downside volatility (–ve semi deviation) of an Index fund return based on Nifty during August 2002-July 2003? Explain the significance of this value in assessing the risk attached to the investment in Index fund.

(5 + 3 = 8 points) < Answer >

4.      Mr. Singh has transferred Rs.10, 000 every month from Templeton India Income Fund (TIIF) to Franklin India Bluechip fund (FIBCF) from October 2002 to January 2003 and after that he has withdrawn Rs.10, 000 per month from FIBCF during February 2003 to July 2003. Calculate the closing balance of number of units present in both the scheme for Mr. Singh. The amount of exit load and reinvestment load charged by mutual funds is 0.74% and 0.65% respectively (Ignore dividend on both the funds)

(8 points) < Answer >

5.      Briefly describe the merits and demerits of

a.       A PE Ratio fund

b.      A Fund of Funds.

(5 + 7 = 12 points) < Answer >

Mr. Srinivas Gupta is an engineer and runs his own consultancy firm. He is 40 years old. His wife Madhavi is doctor. Mr. Gupta has only one son, Ankit, and his age is 10 years. Mr. Gupta’s Parents are also staying with them. His father is suffering from diseases like diabetes, high blood pressure and therefore, needs regular medical treatment. Mr. Gupta is planning to send his son to a boarding school after one year. Presently, Mr. Gupta along with his family members is staying in a rented house. Mr. Gupta has a total cash surplus of Rs. 12 lakhs. Mr. Prashant Singh, a close friend of Mr. Gupta has already invested in FIBCF and TIIF and therefore, suggested him to invest in Franklin Templeton India Low Volatility Equity Fund. He has invested Rs. 100,000 each   in FIBCF and TIIF in the month of August 2002.  He has also advised him to consider the benefits SWP (Systematic Withdrawal Plan) and STP (Systematic Transfer Plan). Mr. Gupta is also considering to invest in index funds and therefore wants to assess the volatility attached to the Market index (S&P CNX Nifty index).

Franklin Templeton India Low Volatility Equity Fund
(Open – end Fund Of Funds)

HIGHLIGHTS

§         An open-ended Fund-of-Funds scheme sponsored by the Franklin Templeton Group, one of the world’s largest investment management companies, which has over 50 years of experience in international investment management and managed US$281.90 billion in assets (approximately Rs.13,25,776 crores) as on 31^st May 2003. 

§         The primary objective of the scheme is to provide long-term capital appreciation with relatively lower volatility through a dynamically balanced portfolio of equity and income funds. The equity allocation (i.e. the allocation to the diversified equity fund) will be determined based on the month-end weighted average PE ratio of the S&P CNX Nifty index (NSE Nifty).

§         The Scheme has an in-built buy / sell mechanism based on stock market valuations. As the stock markets get over valued (as represented by high PE Ratio of the NSE Nifty index), the scheme reduces its equity allocation and vice versa.

§         The scheme offers Dividend and Growth Options

§         The NAV of the Scheme will be calculated for all business days and the full portfolio of investments will be disclosed half-yearly.

SCHEME SPECIFIC RISK FACTORS AND SPECIAL CONSIDERATION

§         The scheme will invest primarily in a combination of Franklin Templeton India’s equity and income fund: 

         Equity Fund      :         Franklin India Bluechip fund (FIBCF/Bluechip Fund)

         Income Fund     :         Templeton India Income Fund (TIIF)

         Hence, movements in the Net Asset Value (NAV) of the above mentioned schemes will impact the performance of Franklin Templeton India Low Volatility Equity Fund.   

         Any change in the investment policies or fundamental attributes of FIBCF and TIIF will affect the performance of the scheme.

§         At the peak of a bull market, a portfolio balanced on PE ratios may not outperform a fully invested portfolio.

§         Investments in Debt Schemes will have all the risks associated with the debt scheme including reinvestment risks as interest rates prevailing on interest or maturity due dates may differ from the original coupon of the bond, which might result in the proceeds being invested at a lower rate

§         Investments in Equity Schemes will have all the risks associated with the Equity Schemes.

§         To the extent the underlined Equity Scheme/Debt Scheme make investment in overseas financial assets, there may be risk associated with currency movements, restriction on repatriation and transaction procedures in overseas markets.

§         To the extent the underlined Equity Schemes/Debt Schemes engage in security lending, the Fund will be subject to risks related to fluctuations in collateral value/settlement/liquidity/counter party.

§         To the extent the underlined Equity Scheme/Debt Scheme are permitted to invest in derivative instruments the Fund is exposed to the high risk, high return derivative instruments.

The performance of the scheme may be affected by changes in Government policies, general levels of interest rates and risk associated with trading volumes, liquidity and settlement systems in equity and debt markets.

How does the scheme work?

The scheme will change its asset allocation based on the PE ratio band. At higher PE ratios, it will reduce allocation to equities in order to minimise downside risk. Similarly at lower PE ratios, it will increase allocation to equities to capitalize on their upside potential. Historically, such a strategy of varying the allocation of equity and debt/money market instruments based on the PE ratio level has delivered superior risk-adjusted returns over the long term as explained below, although there is no guarantee that this past performance will be repeated in the future.

The equity component of the scheme will be invested in Franklin India Bluechip Fund (FIBCF), an open end diversified equity scheme investing predominantly in large cap stocks and the debt/money market component will be invested in Templeton India Income Fund (TIIF), an open end income scheme investing in government securities, PSU bonds and corporate debt.

Information about the underlying funds

The current asset size of these schemes (as on May 31, 2003) is given below:

Franklin India Bluechip Fund     :  Rs.570.62 crs (US$121.33 million)

Templeton India Income Fund   :  Rs.2,003.15 crs (US$425.93 million)

US$ rate = 47.03

The scheme objectives and the asset allocation pattern of the underlying funds are as follows:

Franklin India Bluechip Fund:

Scheme Objective: The investment objective of Franklin India Bluechip Fund is primarily to provide medium to long term capital appreciation.

Asset Allocation Pattern:

Templeton India Income Fund:

Scheme Objective: The primary investment objective of Templeton India Income Fund is to provide a steady stream of income through investment in fixed income securities.

Asset Allocation Pattern:

INVESTMENT OBJECTIVES AND POLICIES

The investment objective of Franklin Templeton India Low Volatility Equity Fund is to provide long-term capital appreciation with relatively lower volatility through a dynamically balanced portfolio of equity and income funds. The equity funds allocation will be determined based on the month-end weighted average PE ratio of the S&P CNX Nifty Index (NSE Nifty).

Portfolio turnover

The portfolio turnover will be confined to rebalancing of portfolio on account of new subscriptions, redemptions, dividend payouts and change in the weighted average PE ratio of the S&P CNX Nifty Index. Due to the monthly rebalancing feature of the scheme, the portfolio turnover may be high in volatile market conditions.

Investment Pattern

The scheme will invest its equity allocation in units of Franklin India Bluechip Fund (FIBCF) an open end, diversified equity fund with a large cap focus, and the debt components in units of Templeton India Income Fund (TIIF), an open end income scheme investing in fixed income securities.

Based on the month-end weighted average PE ratio of the NSE Nifty index, the portfolio will be rebalanced in the first week of the following month. Under normal circumstances, the asset allocation range would be as follows:

Calculation of PE ratio

The Price to Earnings Ratio (PE ratio) will be obtained from a reputed agency such as IISL or an internationally recognized brokerage house.  It will be the weighted average PE ratio of the 50 stocks that constitute the NSE Nifty Index.

The Price will reflect the closing market price on the NSE for that day.  The undiluted Earnings Per Share will reflect the trailing earnings of the most recent four quarters of each of the companies, for which information is available.

Depending on the band in which the above computed monthly PE ratio falls, the asset allocation will be rebalanced as per the table above during the first week of the following month.

TEMPORARY INVESTMENTS:

When the Fund Managers believes market or economic conditions are unfavorable for investors, the scheme may invest up to 100% of the Fund’s assets in a temporary defensive manner by holding all or a substantial portion of its assets in cash, cash equivalents or other high quality short-term investments. Temporary defensive investments generally may include commercial paper, bank obligations, repurchase agreements and other approved money market instruments, including Mibor/call linked instruments, fixed deposits of banks etc. The manager also may invest in these types of securities or hold cash while looking for suitable investment opportunities or to maintain liquidity. In these circumstances, the Fund may be unable to achieve its investment goal.

Change in the Investment Pattern

Subject to the Regulations, the asset allocation pattern indicated above will not change except to protect the interests of the Unitholders. Such changes in the Investment pattern will be for short term and defensive considerations.

The Fund will seek consent of the Unit holders of the Scheme in accordance with the Regulations, if there is any change in the fundamental attributes pursuant to change in investment pattern.

SYSTEMATIC INVESTMENT PLAN (SIP)

Mutual Fund Investors can benefit by investing specified rupee amounts periodically for a continuous period. This concept is called Rupee Cost Averaging.

This savings program allows investors to save a fixed amount of rupees every month by purchasing additional units of the Fund. Therefore, the average unit cost will always be less than the average sale price per unit irrespective of the market being rising, falling or fluctuating.

SYSTEMATIC TRANSFER PLAN (STP)

A unitholder may establish a systematic transfer plan and choose to transfer on a monthly or quarterly basis from the Scheme to another Templeton scheme. The transfer will be effected by way of redemption of units (with appropriate exit load, if any) and a reinvestment (with appropriate entry load, if any) of the redemption proceeds in another Scheme(s).

SYSTEMATIC WITHDRAWAL PLAN (SWP)

A Unitholder may establish a Systematic Withdrawal Plan in any scheme and receive regular/ quarterly payments from the account. The Unitholder can opt to withdraw a fixed amount subject to a prescribed minimum amount per month or per quarter.

Appendix - I

Annualized dividend rate on FIBCF is 10% during August 2002 July 2003. TIIF pays quarterly dividend and the annualized rates of dividend are as follows:

Part E : Caselets (50 Points)

Caselet 1

Read the caselet carefully and answer the following questions:

6.      The caselet says that private-sector companies are increasingly abandoning traditional “defined-benefit” pension funds in favor of “defined-contribution” plans. Comment

(10 points) < Answer >

7.      According to the caselet, banks and insurers will have always an edge over mutual fund firms and this is reflected by the fact that among world’s ten biggest asset managers, eight of them are still banks and insurers. How do you think that banks or insurance companies can act as good asset managers? Discuss the factors to be considered by mutual fund firms for their long-term success in the fund-management business.

(5 + 5 = 10 points) < Answer >

By pooling the savings of many investors and channelling them directly into liquid assets, mutual funds can bundle an endless variety of investment options into tidy little packages, containing anything from Treasury bonds to technology stocks to an assortment of international equities. All an investor need do is pick a few off the list, and with less effort than it takes to buy his weekly groceries he can inject his money swiftly and cheaply into whichever sectors of the economy he has chosen. Capitalism cannot get any more basic.

Now compare that streamlined approach with more traditional methods of harnessing people’s savings. Banks allow customers to make many kinds of transactions easily, but putting money on deposit is about as financially rewarding as stuffing it under a mattress. Traditional life insurance policies also act as a savings vehicle, but the relationship between what goes in and what comes out is generally incomprehensible. And most company pension plans base employees’ benefits on the size of their salary and the number of years they have worked for the firm, usually combined in a complicated formula; the average employee has virtually no control over his nest egg.

It is no wonder, then, that investors are buying mutual funds in droves. In the United States, a country of reluctant savers, the retail fund-management industry has nevertheless piled up assets of over $4 trillion. America’s mutual funds are now worth more than either its pension funds or its insurers, and are poised to overtake banks as the biggest repository of the nation’s wealth.

The same sort of thing is beginning to happen in other countries. As people grow richer and live longer, they will set aside more of their money to supplement retirement income from other sources, mainly social-security and company pensions. Moreover, ageing populations and a changing workforce are putting pressure on those other two retirement pillars, so more of the pensions burden is being passed on to individual workers.

The global shift towards mutual-fund investing is already under way. At present, the American industry still dwarfs all others, accounting for over half of the world’s mutual-fund assets. But retail funds are rapidly taking hold in other countries. In Britain, such funds, locally known as unit trusts, have become a booming industry, thanks to a deep stock market and a modest social-security system. With only $250 billion in unit-trust assets, the market is far smaller than America’s, but it is growing rapidly and reaching out to an ever-larger pool of customers. Elsewhere in Europe, investors who have historically shunned equities are at last taking their first bold steps towards retail equity funds.

In Japan, financial deregulation, if followed through, should at last enable the country’s inveterate savers to put their money into something remunerative. The rest of high-saving Asia will slowly begin to join them as global fund-management houses cobble together their sales networks. Latin America, too, is starting to stir. In Chile, a private-sector pension scheme, funded by mandatory contributions, now channels a tenth of most workers’ pay into the fund of their choosing. Mexico and Bolivia followed Chile’s example earlier this year.

This trend will continue to gather momentum during the next decade, as rich countries face pressures to reform their state pensions. Governments will have to find some way of supporting their ageing baby-boomers, who from early next century will begin retiring—and continue consuming—on contributions from a relatively smaller number of workers. This devastating arithmetic will eventually force governments to make their pension schemes less generous, perhaps even to privatize them altogether, thus sending individual workers into the waiting arms of mutual-fund providers.

Employers are unlikely to fill the gap. Confronted with a changing workforce, private-sector companies are increasingly abandoning traditional “defined-benefit” pension funds in favour  of “defined-contribution” plans. As labour markets grow more flexible, the demand for such plans is increasing.

Over the next decade or so, therefore, fundamental changes in the world economy will place individual investors in a pivotal role, both as consumers of retail mutual funds and as members of defined-contribution plans. The battle for control of the world’s financial assets will be won by whichever companies can meet those demands.

As a group, banks and insurers have been losing ground in that battle, but they are by no means out of it. For one thing, besides managing assets they serve other valuable functions that mutual funds cannot replicate. Among world’s ten biggest asset managers, eight of them are still banks and insurers. Only two stand-alone fund-management companies—Fidelity and Capital Group—have entered the ranks of the behemoths.

Caselet 2

Read the caselet carefully and answer the following questions:

8.      According to the caselet, despite volatility in the market during the 20 years before 1998, industry-specific betas—as opposed to the betas of individual companies—were remarkably stable. Comment.

(7 points) < Answer >

9.      How do you think that changes in the stocks prices of the TMT sector distort the real change in the relative risk borne by companies in other industries?

(6 points) < Answer >

10.    The caselet states that some industries in the telecom, media, and technology sectors might find themselves with a fortunate combination of lower betas and a lower equity risk premium. Discuss.

(5 points) < Answer >

The stock market bubble might have burst, but the memory lingers. One pernicious after effect of the rise and fall in the valuations of telecommunications, media, and technology shares is a continuing distortion of the risk metrics that companies use—for example, to estimate their cost of capital. Unless they correct for this bias, their executives could overvalue investment and acquisition opportunities and overestimate their companies’ historical financial performance.

Most companies estimate their cost of capital using the capital asset-pricing model, in which the non-diversifiable risk of a company is measured by calculating the way its stock price moves, both in speed and volatility, in relation to market indexes. The resulting measure is known as a beta, which is greater than 1.0 if a stock moves, over time, ahead of the market (and is therefore riskier) and less than 1.0 if it tends to move behind the market. A beta of 1.5 foretells a 1.5 percent change in an asset’s return for every 1 percent change in the market’s return. The higher the beta, it is argued, the higher the cost of capital.

 Despite volatility in the market during the 20 years before 1998, industry-specific betas—as opposed to the betas of individual companies—were remarkably stable. But during the bubble, betas for many industries appeared to decline significantly: the US utility sector’s beta fell to 0.1, from 0.6, for example, suggesting a 2 percent decline in the industry’s cost of equity.

Yet these apparent decreases actually reflect the influence of telecom, media, and technology share prices on the indexes during the 1998–2001 bubble and distort the real change in the relative risk borne by companies in other industries.

Sharp recent declines in telecom, media, and technology valuations suggest that the past three to five years were truly extraordinary. Since July 2002, these sectors’ share of the market’s total capitalization has returned to its average 20-year historical level. Moreover, an analysis carried out in August 2002 shows that as telecom, media, and technology valuations have declined, betas for many other sectors have risen. For a significant number of them, the recent beta estimates are also more closely in line with pre-1998 values.

With adjusted beta approach, the most recent 36 months’ returns (as of August 2002) data is used to estimate the betas of a broad cross section of sectors but then eliminated abnormal high price  months, from 1998 to 2001. In many cases this approach leads to significantly higher and, we believe, more accurate betas. Eliminating the impact of the boom implies a beta of 0.65 for the food, beverage, and tobacco sector, for example, a figure that is more consistent with its average historical beta from 1990 through 1997—0.85—and that contrasts sharply with the low 0.02 betas that an unadjusted approach produces. Obviously, in some sectors the bubble led first to a decline in betas and then, in recent months, to some degree of recovery.

Since the market has seldom if ever seen the kind of bubble that developed around the telecom, media, and technology sectors in the late 1990s, we are continuing to sort out the impact of that aberration on metrics and economic tools that rely on historical data. Indeed, while betas for other sectors are higher than previously thought, the effect on the cost of capital might have been mitigated by a lower equity risk premium, as earlier research suggests. Some industries in the telecom, media, and technology sectors, however, might find themselves with a fortunate combination of lower betas and a lower equity risk premium.

Caselet 3

Read the caselet carefully and answer the following questions:

11.    What is name of the strategy followed by hedge funds as described in the caselet? In what circumstances these funds can make money?

(3 + 2 = 5 points) < Answer >

12.    The caselet says that the main determinant of value of an option embedded in a convertible bond is volatility of the underlying asset over the life of the option. What are the other factors which affect the value of a convertible bond?

(7 points) < Answer >

How wonderfully flexible financial markets are? Unable to repair their debt-laden balance sheets by issuing more shares, companies in both Europe and America have been flocking to the convertible-bond market. Issuance of these bonds in June was the second-highest monthly total ever.

Convertibles are a hybrid of debt and equity. Investors receive a lower rate of interest than on conventional debt, in return for the right to convert the bonds into shares if the share price rises above a certain point. So companies end up either paying less interest (good) or issuing cheapish equity (better). Investors get some income, plus the chance of equity that rises in value.

That, at least, is the sales pitch. As it happens, most buyers in Europe and almost all in America have been hedge funds. Most have little or no interest in using convertibles as a low-risk way of getting into the stock market. On the contrary, as short-sellers—investors who sell stock that they do not own—many would be delighted if the share prices of the companies in which they invested dropped to nothing.

A convertible is, in effect, two financial instruments in one: a bond, plus a call option on the company's shares. Investors pay for the call option by forgoing some interest on the debt. However, companies issuing convertible debt have been selling the option too cheaply. The main determinant of the value of an option is the volatility of the underlying asset over the life of the option. In the case of convertibles, the more volatile the price of shares, the more the option is worth. And companies assumed that their shares would be less volatile than they actually were.

Hedge funds have latched on to the opportunity for arbitrage this has thrown up. A hedge fund buys the convertible and sells the debt component, keeping the call option. It then sells the company's shares short, giving it a hedge against movements in the share price.

In the past couple of years hedge funds specializing in such techniques have been among their industry's best performers. Lately, though, the strategy has become less profitable. For one thing, volatility has fallen by half: the VIX, the Chicago Board Options Exchange's volatility index on the S&P 100, has dropped from 40 in January to 22 now. For another, investment banks have been more aggressive in pitching for convertible business, and convertibles have become more expensive.

Moreover, the sharp reduction in the tax American companies pay on dividends has led to a marked increase in the number of companies raising payouts to shareholders and this has resulted lower demand for the convertible bonds by short sellers.

For all these reasons demand has fallen, and the investment banks that launched them have lots left on their books. Issuance will probably fall. This may be no bad thing. Companies have been issuing convertibles to make it look as though they were cleaning up their balance sheets.

Suggested Answers
Portfolio Management & Mutual Funds - II : October 2003

Part D : Case Study

1.      Investment Objectives

         Mr. Gupta  is 40 years old and is quite rich.  His liquidity requirements are high because he has to cater to  the needs of his ill father and child’s education.  He would like to invest in safer securities and his risk taking capacity would not be very high. Mr. Gupta has a sizeable working life left for him. An ideal investment policy statement for Mr. Gupta should be a blend of safety of capital and capital appreciation. He will be interested in parking his funds in avenues that would generate above average returns.

         Investment Constraints

         Liquidity

         The liquidity requirements of Mr. Gupta are quite high.

         Time Horizon

         The time horizon of investment for Mr. Gupta is medium to long term because his major monetary requirements like child’s education, constructing a house etc. are medium to long-term needs.

         Tax considerations

         Tax considerations are very important for Mr. Gupta is falling in the highest tax bracket.  Therefore, proper care should be taken while making investment decisions for him.  His investment avenues should be such that the more and more long-term capital gains are realized from his portfolio.

         Risk Consideration

         The risk tolerance level of Mr. Gupta is moderate.  Although he has got a sufficient working life left but liabilities of his father and child will prevent him to invest in risky assets. But, as both Mr. and Mrs. Mathur earning nicely they can devote a part of their income or savings in risky assets to gain extra returns.

         Investment Policy Statement

         An ideal investment policy statement will call for growth of wealth as well as regular income in the context of medium to long-term time horizon.  There should be more emphasis on growth of capital with a special attention towards regular income.

< TOP >

2.      a.       Return on Index fund following Nifty

                   =      

                   Dividend received during the one-year period

                   =       1010.6 ´0.0105 + 963.15 ´0.0065  + 951.4 ´0.0085  + 1050.15´0.0089  + 1093.5´0.0115  + 1041.85´0.013  + 1063.4´0.0155 + 978.2 ´0.0152  + 934.05 ´0.0145  + 1006.8 ´ 0.0152  + 1134.15 ´0.0165+ 1185.85 ´0.0142

                   =       156.18

                   Price change during the one-year period

                   =       1185.85 – 958.9  =  226.95

                   Therefore, return on Index fund     =             

                                                                                =              4%

         b.     

                   From above it is clear that portfolio is changing four times during the given time period

                   Return up to December, 2002

                   i.       On investment in FIBCF

                            Dividend received     = 0.10 x 10x (5/12) = Rs.5/12 = Rs.0.416

                            Price change               = 22.13- 22.15      = -0.02

                            Hence yield on FIBCF for 5 months period

                                                         =          = 1.79%

                           Yield on TIIF

                            Dividend  received = 10 X (0.0225) X (2/12) + 10 X (0.045) X (3/12) =0.15

                            Price change = 10.75-10.05 = 0.70

                            Yield = (0.70 + 0.15) / 10.05= 8.46%

                            Therefore, return on PE Ratio fund for 5-months period

                            =       0.7 ´ 1.79+ 0.3 ´8.46  =3.791 %

                   ii.      Return for the period January 2003 to February 2003

                            On investment FIBCF

                            Dividend received

                            =       0.10 X 10 X (2/12) = Rs.0.167

                            Price change      =       23.59  – 22.13=1.46

                            Hence, yield on FIBCF for two months

                            =       = 7.35%

                            Yield On TIIF

                            Dividend received =    10 X 0.02 X (2/12) = 0.0334

                            Price change = 11.05 – 10.75 =0.30

                         = (0.30 + 0.0334) / 10.75 = 3.10%

                            Therefore, return on PE Ratio fund for 2 – month period

                            =       0.50 ´ 0.0735 + 0.031´ 0.50 = 5.23%

                   iii.     Return for the period March, 2003 to April 2003

         .                  On investment in FIBCF

                     Dividend received     =       0.10 X 10 X (2/12) = 0.167

                            Price change               =       23.15 –23.59 = –0.44 

                            Yield on FIBCF = (0.167–0.44) / 23.59= - 1.157%

                            Yield on TIIF

                            Price change  = 11.50 – 11.05 = 0.45

                            Dividend received = 0.02 X 10 X (1/12) + 0.0177 X 10 X (1/12) = 0.0314

                            Yield = (0.45 + 0.0314) / 11.05  = 4.36% 

                            Return on PE ratio fund for a period of March 2003 to April 2003

                            –1.157X0.70 + 4.36X0.30 = 0.4981 %

                   iv. Return for the period May 2003 to June 2003

                            Investment in FIBCF = 23.05 – 23.15 = –0.10

                            Dividend received = 0.10 X 10 X (2/12) = 0.167

                            Yield on FIBCF = (–0.10 + 0.167) / 23.15 = 0.289%

                            Yield on TIIF

                            Price change = 11.35 –11.50 = – 0.15

                            Dividend  = 10 X 0.0177 X 2/12  = 0.0295

                            Yield = (–0.15 + 0.295) / 11.50 = –1.047%

                            Return on PE ratio fund for a period of May 2003 to June2003

                            0.50 X 0.289 + 0.50 X –1.047 = –(0.668) %

                   v.      Return on P/E ratio fund during July 2003

                            On investment in FIBCF

                            Dividend received = 0.10 x 10 x (1/12) = 0.0833

                            Price change = 23.26 – 23.05 = 0.21

                            Yield =

                            Yield on TIIF

                            Price change 11.50 – 11.35 = 0.15

                            Dividend = 10 x 0.0175 x 1/12 = 0.0146

                            (0.15 + 0.0146) / 11.35 = 1.45%

                            Return = 1.27 x 0.70 + 1.45 x 0.30

                                      = 1.324%

                            Overall return on PE ratio fund for 12-month period

                            (1 + r)         =       (1+0.0379)(1+0.0523) (1+0.004)( 1–0.00668)(1+0.01324)

                                               =       1.1047       

                                         r     =       10.47%

< TOP >

3.     

          = 23.8 / 12 = 1.9833%

(–ve) Semi variance = 241.96 / 11 = 21.99

         Semi deviation  = (21.99)^1/2  = 4.69%

         Most widely used measure of risk is standard deviation, which considers both positive and negative deviation of returns. However any return above the expected return should be considered as reward and not risk, considering only negative deviation from mean return (downside semi-deviation) gives an idea about the index funds variability which is below the mean from the index. This measure could be considered as a more meaningful measure of risk.

< TOP >

4.      Number of Units in both the Plans as on August 2002

         FIBCF =  = 4498 units

         TIIF  = = 9901 units

< TOP >

5.      a.       Merits and Demerits of PE ratio fund are as follows:

                   Merits of PE ratio fund

·           Less volatility of the fund NAV.

·           Superior risk-adjusted returns through a dynamically balanced portfolio.

·           The strategy does not require extensive research.

                   Demerits of PE Ratio fund

·           It is a not an active investment  strategy and expected to give less return in continuously rising index.

·           The asset allocation is based on certain historical value of underlying Index and P/E. The future relationship may be different altogether.

·           The rigid asset allocation framework undermines the stock selection and timing skills of fund manager.

         b.      Merits of Fund of Funds  

                   Reduction in risk – Fund of funds provide double diversification benefit by assembling a portfolio of different mutual funds .A fund of funds manager can achieve a broadly diversified   spread of investments and minimise the consequences of choosing a wrong mutual fund.

                   Expertise – Fund of Funds can utilize expertise and knowledge of various fund managers about   mutual fund schemes in the same way that other fund managers know about shares. This benefit helps in understanding the mutual fund schemes.

                   Institutional Investment - Fund of funds are capable of investing in desirable institutional funds which are not available to retail investors. Sometimes these funds can invest in some funds which charges load without paying the load.

                   Cheap for Beginning Investors  -It is tough to diversify when starting out because of account minimums.  A fund of funds allows for an investor to diversify amongst hundreds or thousands of stocks in one small account.

                   Reduced paperwork – A fund of funds gives a uniques advantages in the form of reduced paperwork. Instead of investing in many different funds to achieve the same result, you can just invest in one fund.  This allows for much less paperwork. Suppose an investor invests separately in 20 funds, the paperwork involved would be exactly 20 times as much as for a fund of funds, which has invested, in the same 20 mutual funds.

                   Demerits of Fund of Funds

                   Extra Fees  -Some fund of funds charge extra fees at the parent level which can compel investors to create the same portfolio by buying different mutual funds themselves.

                   Expense Ratios  - Most of the fund of funds carry a high expense ratios, which can curtail the effective return form these funds.

< TOP >

Part E: Caselets

Caselet 1

6.       Defined-contribution schemes let workers tailor their retirement plans to their personal circumstances, and make it easy to change those plans as required. They are also completely portable, breaking the restrictive link between retirement goals and career decisions. In America, which glories in the rich world’s most flexible labour markets, most companies now enroll their new workers in such schemes. Employers in other rich countries are beginning to follow. To cash in on this market, the providers of such plans will continue to expand the range of investment options available to firms’ employees, and make it even simpler for them to invest and keep tabs on their money. However, Traditional defined-benefit plans still have a role to play in many large firms: for example, they reward people for staying on, encouraging them to make a long-term commitment to the company. But fewer companies are now keen to secure their workers’ services for life; conversely, few workers these days expect to spend their entire careers with a single employer. Many will be self-employed at times, or work for a small firm without a formal pension scheme; many more will drop in and out of the labour force.

< TOP >

7.      Banks will continue to occupy this territory no matter how far mutual funds expand. This is because banks and insurers have extensive distribution links with retail customers, as well as strong business ties with many companies. This gives them an edge in the competition for both mutual-fund and institutional customers (ie, pension funds, foundations and endowments, all of which usually have their money managed separately rather than mixed in with the mutual-fund rabble). And if a bank or insurer lacks expertise in managing money, it can always acquire a firm that has it. Many banks, for example, are already providing wealthy individuals with a tailor-made asset-management service, bundled up with other services such as tax advice and administration of trusts. Such private-client services are considered part of the institutional segment, but they serve individual investors nonetheless and they are delivered almost exclusively by banks.The factors that make for long-term success in the fund-management business are not much different from those that determine winners in other industries. Fund providers that can find ways to cut costs, improve service and deliver their products in a convenient form will continue to do well. Those that cannot will see their margins erode, and will either be bought up or drop out altogether. The key to counter the competition with the bank  is  to improve distribution, which in turn is being shaped by two powerful trends: the spread of information technology, and the growing sophistication of investors

< TOP >

Caselet 2

8.      Individual betas are directly affected by the stocks prices of a particular stock. Any fluctuation in the stock market price will affect the beta of individual stock .As some of the stock which are highly traded will experience the most frequent change in the prices, their beta will be very volatile however, all stocks within the same industry may not experience the same kind of fluctuations. Again, changes in the prices of the stock in the same industry may not be similar i.e. all stocks may not rise or fall in the similar fashion. Some company specific factors may also come into the picture and therefore some stocks of a particular industry may show rise in beta while some may experience fall. As overall impact of all the stocks determine the beta of a particular industry   it is not incorrect to state that the beta of industries were fairly constant during the last 20 years.

< TOP >

9.       From December 1997 to August 2000, the three sectors (TMT) together accounted for about 68 percent of the change in the total S&P 500 index, for example. By 2000, the stocks of such companies represented 45 percent of its value and were responsible for as many as 21 percentage points of its 26 percent annual growth. As the three sectors expanded, their influence not only shaped the market as a whole but also skewed calculations of its returns and volatility. The betas of other sectors, such as automotive, chemicals, and utilities, were driven down as the overvalued telecom, media, and technology sectors increasingly dominated the S&P 500 .By the end of the bubble, these sectors had such a strong influence on market indexes that theirs were the only rising betas.  Hence strong influence of TMT sector distorted the real change in the relative risk borne by companies of other industries.

< TOP >

10.    Industries with lower beta and lower risk premium will have lower cost of capital based on Capital Asset Pricing Model (CAPM) and this will increase their value, as the cash flows attached with them will be discounted with lower rates. As their value will increase more and more people would like to invest in the stocks and even a big firm interested in acquiring this firm has to pay more to acquire or merge a firm with lower risk premium and lower cost of capital. Clearly, lower risk premium with lower beta is a favorable combination for a firm.

< TOP >

Caselet 3

11.    As the share price moves up and down, the fund adjusts its short position, a tactic known as delta hedging. The hedge fund makes money if the shares turn out more volatile than was assumed by the issuer of the convertible.

< TOP >

12.     The price of a convertible bond can be viewed as the price of a bond plus that of the equity option available on it.  Option theory can be used to value option.  Key factors

         Time to expiry

         Volatility of Stock

         How far in/out of the money the option is

         In addition to these factors, since the security is a bond, there is interest rate volatility that affects the price of the bond. Credit quality of the issuing firm is also important while valuing a convertible bond because it determines the interest paying capacity of the issuer.

< TOP >

< TOP OF THE DOCUMENT >