Chapter 7: Investment Evaluation

Framework
Contents
▪ Risk-Return Framework
▪ Risk
▪Standard Deviation
▪Beta
▪ Risk Adjusted Return
▪Sharpe Ratio
▪Treynor Ratio
▪Alpha
▪ SSELECTIVVELLY

3
Risk-Return Framework
• Return and risk are two
important characteristics of
any investment product.

• Generally return and risk go

hand in hand.

• A rational investor likes

return and dislike risk, so
most of the investment is a
tradeoff between risk and
return.

4
Risk-Return Framework
o A normal investor is expected to select more return to less return; and
less risk to more risk.

o Risk adjusted return matrix aid decision making in such situations.

o Suppose the investor were to choose between four portfolios, as

follows:

Any rational investor would

like to choose Portfolio C, as
it offers more return for
same or lower level of risk.

5
Measure of Risk - Standard Deviation & Beta
Two commonly used measure of risk in financial markets are Standard
Deviation and Beta.
Standard Deviation (S.D)

o It is the extent to which the scheme

returns deviate from its own past.
o A high standard deviation would mean
that the scheme deviates more from its
past standards i.e it is more risky.
o Standard deviation is used in the case
of debt and equity
investments.

6
How to calculate Standard Deviation

1. Find the mean of the data.

2. Subtract the mean from each value –
called the deviation from the mean.
3. Square each deviation of the mean.
4. Find the sum of the squares.
5. Divide the total by the number of items –
result is the variance.
6. Take the square root of the variance –
result is the standard deviation.

7
Measure of Risk - Beta
It is a measure of risk that can be used for equity investments.

Beta measures risk as compared to a diversified equity index.

A higher beta would mean that the investment deviates more as compared to the
diversified equity index i.e it is more risky.

If the beta is more than 1, it means that the investment is more risky than the market. A
value of beta that is less than 1 would mean that the beta is less risky than the market.

Since index funds / schemes mirror the portfolio of their benchmark index, their risks
are expected to be similar. Therefore, beta of an index scheme would be close to 1.

8
How is the Beta Coefficient Interpreted?
o The beta of the market portfolio is always = 1.0
o The beta of a security compares the volatility of its returns to the
volatility of the market returns:

βs = 1.0 - the security has the same volatility as the market

as a whole

βs > 1.0 - aggressive investment with volatility of returns

greater than the market

βs < 1.0 - defensive investment with volatility of returns

less than the market

βs < 0.0 - an investment with returns that are negatively

correlated with the returns of the market

9
Risk Adjusted Return – Sharpe Ratio
Risk-adjusted returns are a composite measure of performance. They
help investors assess how well the returns are covering for the risk taken
in investing. Sharpe ratio and Treynor ratio are two commonly used ratios
to measure the risk adjusted return in an investment.

Sharpe ratio
o It measures the extra return of a
investment generated over and above
the risk-free return as measured by
standard deviation.

o Sharpe Ratio is calculated as -

10
Risk Adjusted Return – Sharpe Ratio
Example:
• An investor earns 15% return from his portfolio
• Standard deviation of portfolio is 0.6
• Risk-free return is 6.50 % (government instrument )
• Now, Sharpe Ratio is = (15% - 6.50 %) / 0.6 = 14.17%

o This indicates that for every unit of risk taken (as measured by
standard deviation), the investor earned a return of 14.17%.

o When comparing two portfolios of the same type, the one with the
higher Sharpe Ratio is considered to have delivered superior risk-
adjusted returns.

o Sharpe Ratio can be used for assessing debt and equity investments.

11
Risk Adjusted Return – Treynor Ratio
o Treynor ratio uses beta, instead of standard
deviation, as a measure of risk. It is calculated as
(Portfolio Return minus Risk free Return) ÷ Beta
of the Investment.

o In the previous example, if the Beta of the

portfolio is 1.15 , then Treynor Ratio would be
8.50 % / 1.15 = 7.39%.

o This means that for every unit of risk taken (as

measured by beta), the investor earned a return
of 7.39 %.

12
Risk Adjusted Return – Treynor Ratio

o In a comparison of two diversified equity portfolios, the one with the

higher Treynor Ratio is considered to have delivered superior risk-
adjusted returns.
o Treynor Ratio is to be used only for evaluating diversified equity
portfolios.

13
Risk Adjusted Return – Alpha

14
Risk Adjusted Return – Alpha
o Alpha is a measure of the portfolio manager’s performance.
o This absolute risk adjusted return measure was developed by Michael
Jensen.
o It can be interpreted as a measure of how much the portfolio “beat the
market.”
o It is computed as the actual portfolio return less the expected portfolio
return as predicted by the Capital Asset Pricing Model (CAPM).

15
Risk Adjusted Return – Alpha
In the process of managing a non-index scheme, the portfolio manager may
take a risk (as measured by beta) that is different from the market risk; the
portfolio returns too are likely to be different from the market.

Logically, if the portfolio manager took a higher risk than the market, he
ought to deliver a return that is higher than the market.
Alpha compares the return which ought to have been generated (for the risk
taken) by the scheme with the return that was actually generated. The
difference between the two is out-performance (if actual return is higher) or
underperformance (if actual return is lower).
Between two managers of competing diversified equity portfolios, the one
with higher alpha is considered to have delivered better risk adjusted
returns. The concept of alpha is technically correct, only for diversified equity
schemes.

16
 Risk Return Analysis - Example
1 Year 3 Year 5 Year
Mutual Funds S.D. Beta Sharpe Alpha Return Return Return
(%) (%) (%)
DSP BR Micro-Cap
16.27 0.90 1.16 15.49 22.01 23.33 30.33
(DSPMC)

Reliance Small Cap (RSC) 18.33 1.01 1.01 14.74 38.66 23.20 32.21

HDFC Mid-Cap Opp Fund

14.62 0.89 1.00 11.32 25.49 19.34 26.43
(HDFCMC)
Franklin Prima (Franklin) 13.76 0.87 0.98 10.20 22.71 18.00 25.66
ABSL Frontline Equity
13.08 0.94 0.63 5.82 20.67 12.24 18.41
(ABSL)
DSP BR Top 100 Fund
15.08 1.05 0.36 1.53 13.49 8.62 13.51
(DSP100)

Data as on 31 Dec 2017

5/17/2018
Risk Return Analysis - Example
RSC has highest SD, which means high risk involved. From the table it is
shown that RSC has generated highest return for the highest risk taken
both in long term (5years) as well as short term (1year).

Beta higher than 1, indicates aggressive investment with higher volatility in

returns. Both DSP100 and RSC has beta greater than 1. However, with
regards to returns, RSC has outperformed while DSP100 posted lowest
returns among all both in short term as well as long term.

The higher Alpha returns in RSC shows that the Fund manager has taken
higher risk by investing in non-index schemes, which is different from the
market risk.

Similarly, Alpha is highest in DSPMC and thereby highest sharpe ratio i.e
risk adjusted return.

5/17/2018
SSELECTIVVELLY
Invest Classification Scheme that helps the investor to get a
comprehensive understanding of any investment product. The following
drivers of risk and return are the attributes of SSELECTIVVELLY:-

Sector — for Liquidity

Source non- Exposure (offered by
End (Maturity)
(Issuer) government (Asset Class) Issuer / Issuer’s
exposures agent / Market)

Insurance
Cost Tax Exemption Vehicle Valuation
level

Leverage
Exchange Leverage
(Foreign Yield
Rate (Asset Class)
Currency)

19
Thank You

20
DISCLAIMER
The following presentation is for educational purpose only. All symbols and investment/ trading ideas
discussed by instructors are for demonstration purposes only and are not recommendations to buy or sell into
any asset class.

This information may demonstrate certain hypothetical trading strategies with the use of software(s). Please
note, hypothetical or simulated performance results have certain inherent limitations and do not represent
actual trading. Simulated trading are generally designed with the benefit of hindsight. No presentation is being
made herein, that any account will or is likely to achieve profits or losses similar to those shown here. This
demonstration is not a recommendation to buy or sell financial instruments, but rather guidelines to interpret
and use specific indicators and features within the software.

We strongly suggest that information and techniques presented should only be used by investors who are
aware of the risk inherent in trading. www.elearnmarkets.com will have no liability for any investment
decisions based on the use of information and/ or techniques shown in this presentation.

21