Nitin Palan Financial Advisor

5 Ways To Measure Mutual Fund Risk

There are five main indicators of investment risk that apply to the analysis of stocks, bonds and mutual fund portfolios. They are alpha, beta, r-squared, standard deviation and the Sharpe ratio. These statistical measures are historical predictors of investment

5 Ways To Measure Mutual Fund Risk

There are five main indicators of investment risk that apply to the analysis of stocks, bonds and mutual fund portfolios. They are alpha, beta, r-squared, standard deviation and the Sharpe ratio. These statistical measures are historical predictors of investment risk/volatility and are all major components of modern portfolio theory (MPT). The MPT is a standard financial and academic methodology used for assessing the performance of equity, fixed-income and mutual fund investments by comparing them to market benchmarks.
All of these risk measurements are intended to help investors determine the risk-reward parameters of their investments. In this article, we'll give a brief explanation of each of these commonly used indicators.

Alpha

Alpha is a measure of an investment's performance on a risk-adjusted basis. It takes the volatility (price risk) of a security or fund portfolio and compares its risk-adjusted performance to a benchmark index. The excess return of the investment relative to the return of the benchmark index is its "alpha."
Simply stated, alpha is often considered to represent the value that a portfolio manager adds or subtracts from a fund portfolio's return. A positive alpha of 1.0 means the fund has outperformed its benchmark index by 1%. Correspondingly, a similar negative alpha would indicate an underperformance of 1%. For investors, the more positive an alpha is, the better it is.

Beta

Beta, also known as the "beta coefficient," is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is calculated using regression analysis, and you can think of it as the tendency of an investment's return to respond to swings in the market. By definition, the market has a beta of 1.0. Individual security and portfolio values are measured according to how they deviate from the market.
A beta of 1.0 indicates that the investment's price will move in lock-step with the market. A beta of less than 1.0 indicates that the investment will be less volatile than the market, and, correspondingly, a beta of more than 1.0 indicates that the investment's price will be more volatile than the market. For example, if a fund portfolio's beta is 1.2, it's theoretically 20% more volatile than the market.
Conservative investors looking to preserve capital should focus on securities and fund portfolios with low betas, whereas those investors willing to take on more risk in search of higher returns should look for high beta investments.

R-Squared

R-Squared is a statistical measure that represents the percentage of a fund portfolio's or security's movements that can be explained by movements in a benchmark index. For fixed-income securities and their corresponding mutual funds, the benchmark is the U.S. Treasury Bill, and, likewise with equities and equity funds, the benchmark is the S&P 500 Index.
R-squared values range from 0 to 100. According to Morningstar, a mutual fund with an R-squared value between 85 and 100 has a performance record that is closely correlated to the index. A fund rated 70 or less would not perform like the index.
Mutual fund investors should avoid actively managed funds with high R-squared ratios, which are generally criticized by analysts as being "closet" index funds. In these cases, why pay the higher fees for so-called professional management when you can get the same or better results from an index fund?

Standard Deviation

Standard deviation measures the dispersion of data from its mean. In plain English, the more that data is spread apart, the higher the difference is from the norm. In finance, standard deviation is applied to the annual rate of return of an investment to measure its volatility (risk). A volatile stock would have a high standard deviation. With mutual funds, the standard deviation tells us how much the return on a fund is deviating from the expected returns based on its historical performance.

Sharpe Ratio

Developed by Nobel laureate economist William Sharpe, this ratio measures risk-adjusted performance. It is calculated by subtracting the risk-free rate of return (U.S. Treasury Bond) from the rate of return for an investment and dividing the result by the investment's standard deviation of its return.
The Sharpe ratio tells investors whether an investment's returns are due to smart investment decisions or the result of excess risk. This measurement is very useful because although one portfolio or security can reap higher returns than its peers, it is only a good investment if those higher returns do not come with too much additional risk. The greater an investment's Sharpe ratio, the better its risk-adjusted performance.

Who is a Non-Resident Indian (NRI)?
A non-resident Indian (NRI) is an Indian citizen or a person of Indian origin who stays abroad for employment, business or vocation outside India, or stays abroad under circumstances indicating an uncertain duration.

Who is a Person of Indian Origin (PIO)?
A Person of Indian Origin means a citizen of any country (other than Bangladesh or Pakistan), if the person: (a) at any time held an Indian passport; or (b) or the person's parents or grandparents were citizens of India; or (c) is a spouse of an Indian citizen, or of a person referred to in (a) or (b) above.

Who is a Foreign Institutional Investor (FII)?
An FII is an institution established or incorporated outside India which proposes to invest in Indian securities and is registered with SEBI.

Who is an Overseas Corporate Body (OCB) ?
An OCB includes overseas companies, partnership firms, societies and other corporate bodies owned predominantly by non-resident persons of Indian nationality or origin outside India.

Can an NRI maintain a bank account in India?
Yes. NRIs can maintain accounts in rupees as well as in foreign currency.

What types of rupee accounts may NRIs maintain?
There are 4 types: 1. Non-resident (External) Rupee Accounts (NRE) 2. Non-Resident (Special) Rupee (NRSR) Account 3. Ordinary Non-resident Rupee Accounts (NRO) 4. Non-resident (Non-repatriable) Rupee deposit accounts (NRNR)

What are NRE, NRO and FCNR accounts?
Non-Resident (External) Rupee (NRE).This is a Rupee account from which funds are freely repatriable. It can be opened with either funds remitted from abroad or local funds which can be remitted abroad.
Non-Resident Ordinary Rupee (NRO). This is a Rupee account and can be opened with funds either remitted from abroad or generated in India. These funds are non-repatriable. However, under certain circumstances, these are allowed to be repatriated.
Fully Convertible Non-Resident Rupee (FCNR). This account is similar to the NRE account except that the funds are held in foreign currencies and can be maintained in Pound Sterling,U.S. Dollar, Euro and Japanese Yen. FCNR accounts can be maintained only in the form of 'term deposits', i.e. a deposit kept for fixed periods ranging from 6 months to 3 years.

How do NRE, NRO and NRSR accounts differ?
Balances held in NRE accounts can be repatriated abroad freely, whereas funds in NRSR and NRO account cannot be normally remitted abroad but have to be used only for local payments in rupees. Consequently, funds remitted from abroad or local funds which can otherwise be remitted abroad to the accountholder can only be credited to NRE accounts.

Can an NRI, and FIIs invest in mutual funds in India?
Yes. The following summary outlines the various provisions related to investments by Non-Resident Indians ('NRIs'), Persons of Indian Origin ('PIOs') and Foreign Institutional Investors ('FIIs') in the Schemes of the Mutual Fund and is based on the relevant provisions of the Income-tax Act, 1961 ('the Act'), regulations issued under the Foreign Exchange Management Act, 1999 and the Wealth-tax Act, 1957 (collectively called 'the relevant provisions'). The following information is provided for general information only. However, in view of the individual nature of the implications, each investor is advised to consult with his or her own tax advisors / authorised dealers with respect to the specific tax and other implications arising out of his or her participation in the funds.

Does an NRI, FII require any approval from the RBI to invest in mutual funds?
No special approval is required. NRIs/PIOs/FIIs have been granted a general permission by RBI [Schedule 5 of the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2000] for investing in /redeeming units of the funds subject to conditions set out in the aforesaid regulations.

Can an NRI invest in foreign currency?
An NRI cannot make the investment in foreign currency. He needs to give a Rupee cheque from his NRE, NRO, NRSR bank account in India. He may also send a Rupee cheque from abroad payable in a bank in India. However, for an NRI to invest, it is mandatory that he maintains a bank account in India.

What is the mode of payment for Repatriation and Non-Repatriation Basis?
Repatriable Basis. Payments for the purchase of the units may be made by Indian Rupee drafts purchased abroad, or by cheques drawn on the NRE/FCNR Account of the investor, payable at the city where the application form is accepted by any Investor Service Centres.
Non-Repatriable Basis. Payments for the purchase of the units may be made by Indian Rupee drafts purchased abroad, or by cheques/demand drafts drawn on the NRE/FCNR/NRO/NRSR/NRNR account of the investor, payable at the city where the application form is accepted by any Investor Service Centres.
FII Investors. FIIs may pay for their subscription amounts by Indian Rupee drafts purchased abroad, or from funds held in a Foreign Currency account or Non-resident Rupee account maintained in a designated branch of an authorised dealer. The Indian Rupee drafts/cheques should be made payable at a city where the application is accepted by any Investor Service Centres.

When will my NRI purchase take effect?
If an application is received before the 3 p.m., Indian Standard Time on any business day, the allocation of units will be based on the NAV of that business day. All applications received after the prescribed time will be treated as having been received on the next business day and the units allotted accordingly.

How does an NRI redeem funds?
In the open-end schemes of mutual fund units can be purchased or redeemed at any point in time. To redeem funds, submit the redemption request to the nearest Investor Service Centre. Your form must contain the investor's folio number and the amount / units you would like to redeem. Redemption requests by telephone, telegram, fax or email that lack valid signatures will not be accepted.

How will the redemption proceeds be paid?
Redemption proceeds will be paid by cheque. The cheque will be payable to the first unitholder and will include the bank account number.
Redemption proceeds/repurchase price and/or dividend or income earned (if any) will be payable in Indian Rupees only.

How can the redemption proceeds be repatriated?
The investments shall carry the right of repatriation of capital invested and capital appreciation so long as the investor continues to be a resident outside India.

In the case of an FII, the designated branch of the authorised dealer may allow remittance of net sale/maturity proceeds (after payment of taxes) or credit the amount to the Foreign Currency account or Non-Resident Rupee account of the FII, maintained in accordance with the approval granted to it by the RBI.

In any other case, where the investment is made out of inward remittance or from funds held in the NRE/FCNR account of the investor, the maturity proceeds/repurchase price of units (after payment of taxes) may be credited to the NRE/FCNR/NRO/NRSR account of the non-resident investor maintained with an authorised dealer in India

What about redemption proceeds where investments were made on a non-repatriable basis?
Where the purchase of units is made on a non-repatriable basis, the maturity proceeds/repurchase price of units (after payment of taxes) will not qualify for repatriation and may be credited to the NRO/NRSR account of the non-resident investor.

Where the investment is made out of funds held in a NRSR account, the maturity proceeds/ repurchase price of units (after payment of taxes) may be credited to the NRSR account maintained by the investor with an authorised dealer in India.

Similarly, investments in units purchased in Rupees, where the investor was a resident of India and subsequently becomes a non-resident, will not qualify for repatriation of repurchase proceeds of units.

The entire income distribution on the investment will, however, qualify for full repatriation. Investors are advised to contact their banks/tax consultants if they desire remittance of the income distribution on units abroad.

Is the income/dividend on mutual fund units repatriable?
The investments shall carry the right of repatriation of capital invested and capital appreciation so long as the investor continues to be a resident outside India. In the case of an FII, the designated branch of the authorised dealer may allow remittance of net sale/maturity proceeds (after payment of taxes) or credit the amount to the Foreign Currency account or Non-resident Rupee account of the FII maintained in accordance with the approval granted to it by the RBI. In any other case, where the investment is made out of inward remittance or from funds held in NRE/FCNR account of the investor, the maturity proceeds/repurchase price of units (after payment of taxes) may be credited to NRE/FCNR/NRO/NRSR account of the non-resident investor maintained with an authorised dealer in India.

What is the tax liability on redemptions?
Under Section 2(42A) of the Income Tax Act, units of the fund held as a capital asset for a period of more than 12 months immediately preceding the date of transfer, will be treated as a long-term capital asset for the computation of capital gains, thus qualifying for the long-term capital gains tax rate. In all other cases, it would be treated as a short-term capital asset and would be taxed at the short-term capital gains tax rate.

What is the tax liability for income received from your mutual funds?
As per Section 10(35) of the Income Tax Act, 1961, income received from mutual fund units specified under Section 10(23D) is exempt from income tax in India and the mutual funds are subject to pay distribution tax in debt oriented schemes. Hence all dividends are tax-free in the hands of non-resident investors and no TDS is applicable on the same.

Is it mandatory to have a Permanent Account Number (PAN)?
Yes. Submission of PAN card copy (irrespective of the amount of investment) is mandatory for all existing as well as prospective investors including joint applicants / holders, guardians and NRIs for investing with Mutual Funds from January 1, 2008.

How does one apply for a PAN?
An application is required to be made in Form 49A (download form).

What is the proof of the Tax Deduction at Source?
A TDS certificate is issued in the name of the investor mentioning the details of the transaction and the tax deducted. The TDS certificate is commonly known as Form16 A.

When will the TDS certificate be issued?
A TDS certificate (Form 16A) will be despatched to the investor at his or her registered address along with the redemption warrant.

Can an NRI have a joint account in a mutual fund with a resident Indian?
Yes. An NRI investor can jointly own a fund account with a resident Indian or a Non-resident Indian.

Is the indexation benefit available to NRIs?
Yes, if units are held for more than 12 months i.e. on long-term capital gains.

Are fund units liable to the wealth tax?
No. Units issued to overseas investors will not be treated as assets as defined under section 2(ea) of the Wealth-Tax Act, 1957 and hence will not be liable to wealth tax.

Can dividend received from a mutual fund in an NRO account be repatriated?
Yes. Income generated from investments (dividend, in this case) done on a non-repatriable basis qualify for full repatriation.

Can an NRI fax a request followed by the original documents?
No. Units cannot be redeemed or allotted on the basis of fax applications. A request that lacks a valid signature cannot be processed due to legal restrictions.

Can a Power of Attorney (POA) invest on behalf of the NRI investor?
Yes. unlike banks where a POA holder cannot open an account on behalf of the NRI, in a mutual fund the POA has the authority to invest on behalf of the investor and sign documents for initial and additional purchases as well as redemptions.

While applying for purchase of units the POA holder needs to submit the original POA or a copy duly notarised should be submitted. The Power of attorney should contain the signature of both the first holder and the POA holder. Only when the POA is registered does the POA holder have the right to transact on behalf of the NRI investor. His signature will be verified for processing any transaction/request.

Is nomination by NRIs allowed in Mutual Funds?
Yes. It is allowed only for Individuals/HUFs.

Can a resident Indian have an NRI as nominee?
Yes. The same rules apply for nominees to resident Indian accounts. An NRI can be a nominee to an account which is in the name of a resident Indian.

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