• Managed Funds Research Methodology - Investor Desk

    Managed Funds Research Methodology

    1. Introduction

    1.1 Research Methodology

    This is a set of systematic technique used in research. This simply means a guide to research and how it is conducted.  It describes and analysis methods, throws

    more light on their limitations and resources, clarify their pre-suppositions and consequences, relating their potentialities to the twilight zone at the frontiers of knowledge. 

    Managed Fund is one of the financial instruments in capital market, here the study based on the empirical investigation on the performance of Fund schemes, main purpose of the study is to identify which of the month and year schemes provided highest return and minimize the risk.

    Research need because of the capital market is unexpected volatility and sometime reaction was positive and negative. Good and bad news affects price movement, that needs to identify how much market or bench mark provided return. Investors need to identify trade – off return and risk.

    Equity diversified fund directly affect the stock movements while index, income and balance fund are less affects.

    Assets Management Company design fund for particular investors and sectors like information technology, fast moving consumer goods, international financial instruments, So managed fund industry is high competitive and fund manager investment style and research team also affecting risk and return of the funds. An important practical motivation for managed fund performance evaluation is to help an investor decide in which funds to invest.

    1.2 Advantages

    The  following  are  the  advantages  of  research


    1. Advancement of wealth of human being

    2. Provision of tools for carrying out the research

    3. Develops a critical and scientific attitude, disciplined thinking to observations

    4. Enrichment of the research process and provision of chance for in-depth study and understanding of the subject. 

    5. Helps to inculcate the  ability  to evaluate  and use research results with reasonable confidence and in decision making.

    6. Inculcates the ability to learn to read and think critically.

    • Managed Funds
    • What are Managed Funds

    A managed fund pools multiple investors’ money into a fund which is professionally managed by specialist investment managers. Individual investors buy into the fund by purchasing units, or ‘shares. By pooling funds together, investors can gain access to a wide range of investment opportunities not normally available to an individual investor.

    • How do managed funds work

    Managed funds invest in a variety of asset classes including shares (Australian and international), fixed interest, property and cash. Each investor purchases units in the fund. The value of these units is calculated daily and changes as the market value of the assets in the fund rises and falls. Each managed fund has a specific investment objective which is usually based around different asset classes and investment management philosophy and is designed to deliver a desired risk/return outcome. For example, the investment objective of a fixed interest managed fund may be to provide income based returns which exceed the return available from cash (for example term deposits) over the medium term.

    • Types of Managed Funds

      Funds are generally defined by the asset classes and/or sectors that they invest in and the risk profile of these investments. Here are some common types of managed funds.
    • Multi-manager funds – These are sometimes referred to as a ‘fund of funds’. Rather than investing directly in assets, the fund invests in a selection of other managed funds. These funds are usually managed by a number of different fund managers
    • Income funds -These funds focus on generating an income stream with a low chance of losing capital i.e. the initial amount you invested. These are sometimes called ‘defensive’ funds and are usually heavily weighted in cash and fixed interest type investments.
    • Growth funds These funds focus on capital growth rather than income and are generally suited to investors who have longer investment horizons. They tend to be weighted towards property shares, Australian shares, international shares or a combination of these.
    • Advantages of Investing in Managed Funds

    Diversification: Diversification is spreading the money you wish to invest over a number of investments with different characteristics with the aim of reducing risk. Some investments perform better than others under different market conditions, and rarely do all asset classes, companies, sectors or countries reach their highs and lows simultaneously.

    There are a number of ways to achieve diversification, for example by:

    • Investing across different asset classes, such as cash, fixed interest and shares.

    • Diversifying within asset classes, such as by company size, sector and geography.

    • Investing with more than one fund manager.

    Under Equities, there are different sectors to diversify fund’s investment pool, to hedge against risk in being invested into one particular sector. Following are the few types of dominant sectors for investment;

    1. Consumer Discretionary: The consumer discretionary sector consists of retailers, media companies, consumer service providers, apparel companies and consumer durables.
    • Financials: The financial sector consists of banks, investment funds, insurance companies and real estate firms, among others. In general, the majority of the revenue generated by the sector comes from mortgages and loans that gain value as interest rates rise. The financial sector includes all companies involved in finance, investing, and the movement or storage of money.
    • Energy: The energy sector consists of oil and gas exploration and production companies, as well as integrated power firms, refineries and other operations. The energy sector consists of all companies that play a part in the oil, gas, and consumable fuels business. 
    • Healthcare: The energy sector consists of oil and gas exploration and production companies, as well as integrated power firms, refineries and other operations. In general, these companies generate revenue that’s tied to the price of crude oil, natural gas and other commodities.
    • Mining: The materials sector consists of mining, refining, chemical, forestry and related companies that are focused on discovering and developing raw materials. Companies within the materials sector provide the raw material needed for other sectors to function.
    • Technology: The technology sector consists of electronics manufacturers, software developers and information technology firms. In general, these businesses are driven by upgrade cycles and the general health of the economy, although growth has been robust over the years.

    Factors, such as how long you want to invest, how comfortable you are with risk and how much money you have to invest. Managed funds allow you to access a diversified investment portfolio at a fraction of the usual cost. This is because members’ investments are pooled together and then invested by the fund manager, so benefitting from the economies of scale.

    For example, $1,000 can provide you with exposure to around 50 company shares in an Australian equities managed fund, which would not be viable to achieve directly. This is because you would be limited to companies whose share price was (on average) under $20, and it may cost around $2,500 in brokerage fees alone to buy and sell 50 different company shares.

    Varied Investment Opportunities because a managed fund is made up of pooled money from lots of investors, the fund has the buying power to access assets not usually available to individuals such as private equity, large infrastructure projects and other major property assets.

    • How are returns earned

    Returns from managed funds come from two forms – income and capital growth

    1. Income is based on the earnings from the funds assets over the period and may include income from share dividends, rent from property and interest from cash investments less any costs.
    2. Capital growth comes from the revaluation of hard assets such as property or increases in the market value of liquid assets such as shares.
    • Rating Parameters
    • Quantitative Parameters
    • Beta

    Beta is a measure of mutual fund schemes volatility compared to its benchmark. This ratio would help us to judge how much a fund’s performance can move upside/downside compared to its benchmark.


    Beta = (Standard deviation of mutual fund scheme/ Standard Deviation of Benchmark)*R-Square


    A fund with beta value more than 1 would move more volatile than the market. i.e. if market moves up 100% a fund with beta value of 1.5 would move up by 150% and if market comes down by 20% the fund will come down by 30%.

    If beta value is less than 1 it means fund will be less volatile than the benchmark. i.e. if market moves up 100% a fund with beta value of 0.75 would move up by 75% and if market comes down by 20% the fund will come down by 15%.

    • Alpha

    Alpha is a measure of mutual funds’ performance after adjusting the risk. This ratio helps to measure the fund manager performance


    Alpha = Mutual fund scheme return – (Risk free rate of return+ (beta*(Benchmark return – Risk free rate of return)

    *Risk free return is the return that would be obtained if invested in a govt bond for the same duration as mutual fund.


    Higher the alpha, it’s better for investor. Positive alpha numbers indicate positive returns compared to benchmark and negative alpha value indicates negative returns to benchmark.

    For example if alpha is 8 it means scheme would outperform benchmark by 8% and if alpha -8 the scheme will underperform by 8% compared to benchmark.

    • Standard Deviation

    Standard deviation (SD) measures the volatility the fund’s returns in relation to its average returns. It tells you how much the fund’s return can deviate from the historical mean return of the scheme. If a fund has a 10% average rate of return and a standard deviation of 4%, its return will range from 6%-14%.


    When you take more than 3 years data

    Variance = (Sum of squared difference between each monthly return and its mean / number of monthly return data)


    When you take less than 3 years data

    Variance = (Sum of squared difference between each monthly return and its mean / number of monthly return data – 1)

    Standard deviation = square root of variance;


    The higher the standard deviation, the more volatile is the fund’s returns. Prefer funds with lower volatility.

    • Sharpe Ratio

    The Sharpe ratio can be used to evaluate the total performance of an aggregate investment portfolio or the performance of an individual stock and also the risk adjusted return of a portfolio.

    The ratio measures the return on the funds n excess of a proxy for a risk-free guaranteed investment relative to the standard deviation. The 90 days treasury bill rate is the proxy for risk free rate.

    To calculate the Sharpe ratio, you first calculate the expected return on an investment portfolio or individual stock and then subtract the risk-free rate of return. Then, you divide that figure by the standard deviation of the portfolio or investment.

    The Sharpe ratio can be recalculated at the end of the year to examine the actual return rather than the expected return.

    The Formula for the Sharpe Ratio Is –

    Sharpe Ratio =

    Rp​=the expected return on the asset or portfolio

    Rf​=the risk-free rate of return

    σp=the standard deviation of returns (the risk) of the asset or portfolio​

    Sharpe ratio greater than 1.0 is considered acceptable to good by investors. A ratio higher than 2.0 is rated as very good. A ratio of 3.0 or higher is considered excellent.

    • Treynor Ratio

    Treynor ratio is a measure of the returns earned more than the risk-free return at a given level of market risk. It highlights the risk-adjusted profits generated by a mutual fund scheme.

    The Treynor ratio is a risk/return measure that allows investors to adjust a portfolio’s returns for systematic risk. A higher Treynor ratio result means a portfolio is a more suitable investment.

    A Treynor Ratio of 0.5 is better than one of 0.25, but not necessarily twice as good. The numerator is the excess return to the risk-free rate. The denominator is the Beta of the portfolio, or, in other words, a measure of its systematic risk.

    The Formula for the Treynor Ratio is:

    Treynor Ratio=


    rp​=Portfolio return

    rf​=Risk-free rate

    βp​=Beta of the portfolio​

    • Upside Capture Ratio

    Upside capture ratio is a measure of funds’ performance to its benchmark index during bull market (where the market is rising up)


    Upside capture ratio = (Mutual fund returns in bull market/ benchmark index returns in bull market)* 100 


    If the value is more than 100 it means the fund has performed better than benchmark during bull market (up market).

    • Downside Capture Ratio

    Downside capture ratio is a measure of funds’ performance to its benchmark index during bear market (where market is falling down)


    Downside capture ratio = (Mutual fund returns in bear market/ benchmark index returns in bear market)* 100


    If the value is less than 100 it means the fund has performed better than benchmark during bear market (bear market).

    • Jensen Ratio

    The Jensen’s measure is the difference in how much a person returns vs. the overall market.

    Jensen’s measure is commonly referred to as alpha. When a manager outperforms the market concurrent to risk, they have “delivered alpha” to their clients.

    The measure accounts for the risk-free rate of return for the time period.

    If the daily return based on CAPM is 0.15% and the actual stock return is 0.20%, then Jensen’s alpha is 0.05%, which is a good indicator.

    The formula for Jensen’s alpha is:

    Alpha = R(i) – (R(f) + B x (R(m) – R(f)))


    R(i) = the realized return of the portfolio or investment

    R(m) = the realized return of the appropriate market index

    R(f) = the risk-free rate of return for the time period

    B = the beta of the portfolio of investment with respect to the chosen market index

    • Information Ratio

    The information ratio (IR) is a measurement of portfolio returns above the returns of a benchmark, usually an index such as the S&P 500, to the volatility of those returns

    The information ratio is used to evaluate the skill of a portfolio manager at generating returns in excess of a given benchmark.

    A higher IR result implies a better portfolio manager who’s achieving a higher return in excess of the benchmark given the risk taken.

    An information ratio in the 0.40-0.60 range is considered quite good. Information ratios of 1.00 for long periods of time are rare. Typical values for information ratios vary by asset class.

    IR Formula

    IR = Information ratio

    Portfolio Return = Portfolio return for period

    Benchmark Return = Return on fund used as benchmark

    Tracking Error = Standard deviation of difference between portfolio and benchmark returns.

    • R-Squared

    It’s a measure of co-relation between mutual fund schemes performance and its benchmark. It ranges between 1 and 100.


    R – Squared = (covariance between benchmark and mutual fund scheme/ (Standard deviation of mutual fund scheme* standard deviation of benchmark)


    A high R-squared, between 85% and 100%, indicates the fund’s performance patterns have been in line with the index. A fund with a low R-squared, at 70% or less, indicates the security does not act much like the index.

    • Qualitative Parameters

    Whilst the first stage of the investment process tends to focus on the manager’s risk adjusted and absolute performance, the second stage incorporates an important qualitative overlay. The initial quantitative filter may identify a strongly performing manager who subsequently fails the qualitative filter given Laverne’s view on the team, organisation or process.

    Conversely, the quantitative filter may look less attractive if the current market conditions do not suit the manager’s investment style. For example, a growth manager will typically underperform in falling markets. However. Laverne may highly rate the team, organisation or process. Under this scenario, the manager may be added to the contender’s list despite its short term performance.

    The use of a rolling 3 year timeframe as the benchmark review period aims to smooth out style biases which can often lead to distortions. Following are the key attributes of qualitative parameters in our research & rating of funds;

    • Focused Sector of the fund
    • Assets Under Management
    • Asset Allocation
    • Comparison with Peer Funds
    • Fund Manager Profile
    • Past/Other Performance of Fund Manager
    • Profile of the Asset Management Company
    • Asset Allocation & Its Performance

    Asset allocation refers to the strategy of dividing your investments among different asset categories, such as stocks, bonds, real estate, cash, and cash alternatives. Asset allocation aims to control risk by diversifying an investment portfolio.

    Asset allocation is crucial to achieve the desired investment return and objective. Asset allocation involves a review of the fundamental and technical drivers of each asset class and the development of expected risks and returns. This research is used together with the portfolio construction process to develop the asset allocation and ranges for each fund.

    It is important to understand that reward for risk varies through time and is closely related to valuation. It therefore adopts an approach to investment strategy that involves adjusting the asset allocation from time to time with the allowable asset allocation ranges. Asset allocation is adjusted to help preserve capital when the risk of loss is perceived to be high or to take advantage of an asset or assets offering an attractive risk and reward opportunity.

    • Rating Factors
    • Credit Quality Rating

    The Fund Credit Quality Rating assigned to a fund reflects S&P Global Ratings’ opinion on the level of protection that its portfolio holdings provide against losses from credit defaults. Fund Credit Quality Ratings are derived from our historical default and transition studies that go back more than 30 years.

    For Fixed Income Funds’ Rating: The credit ratings assigned by Australia Ratings on selected securities are their opinion of the creditworthiness of the issuer of the security and are based on publicly available information at a point in time. It follows an alphabetical indicator of ‘AAA’, ‘AA’, ‘A’, ‘BBB’ etc. For example, the Australian Government as Issuer of AGBs – Treasury Bonds and Treasury Index Bonds, is assigned a credit rating of “AAA” which is the highest credit rating that can be assigned. 

    A Product Complexity Indicator (PCI) is a colour coded indicator based on the complexity and terms and conditions of a security. Factors include the specific debt obligations of the issuer such as seniority of debt, likelihood of recovery on company’s assets and rights of the company to vary terms and conditions. For example, all Treasury Bonds issued by the Australian Government have a PCI of GREEN which implies the terms are simple and straightforward.

    The primary goal of the assessment is to evaluate the managers effectiveness in maintaining an investment policy that is consistent with the fund’s stated investment goals.

    • Investment Grade Rating

    A security has an investment grade rating if it has a rating that falls within the range of Aaa to Baa from Moody’s or AAA to BBB- for Standard & Poor’s. The company’s securities have investment grade ratings if it has a strong capacity to meet its financial commitments.

    The Investment Grade rating indicates that the financial product can generate risk adjusted returns in line with relevant objectives. However, if applicable, we believe the financial product has fewer competitive advantages than its peers.

    • Average Coupon

    The average coupon is a measurement of the rate of return on a pool of mortgages that is sold to investors as a mortgage-backed security (MBS). The underlying mortgages are repaid at different lengths of time, so the average coupon represents its return at the time it was issued and may differ from its WAC later.

    The weighted average coupon (WAC) is calculated by taking the gross of the interest rates owed on the underlying mortgages of the MBS and weighting them according to the percentage of the security that each mortgage represents.

    To calculate the WAC, the coupon rate of each mortgage or MBS is multiplied by its remaining principal balance. The results are added together, and the sum total is divided by the remaining balance.

    • Rating Based on Risk Adjusted Returns
    • Laverne Rating for Funds

    This describes the rationale for, and therefore the formulas and procedures utilized in, calculating the Ratings for funds (commonly called the “star rating”).  The Laverne Rating has the subsequent key characteristics: Ratings are supported funds’ risk-adjusted returns.

    • Risk Adjusted Returns

    The star rating relies on risk-adjusted performance. However, different aspects of portfolio theory suggest various interpretations of the phrase “risk-adjusted.” because the term is most ordinarily used, to “risk adjust” the returns of two funds means to equalize their risk levels before comparing them. The Sharpe ratio is per this interpretation of “risk-adjusted.”

    But the Sharpe ratio does not always produce intuitive results. If two funds have equal positive average excess returns, the one that has experienced lower return volatility receives a higher Sharpe ratio score.

    However, if the average excess returns are equal and negative, the fund with higher volatility receives the higher score because it experienced fewer losses per unit of risk. While this result is consistent with portfolio theory, many retail investors find it counterintuitive. Unless advised appropriately, they may be reluctant to accept a fund rating based on the Sharpe ratio, or similar measures, in periods when the majority of the funds have negative excess returns.

    Standard deviation is another common measure of risk, but it is not always a good measure of fund volatility or consistent with investor preferences. First, any risk-adjusted return measure that is based on standard deviation assumes that the riskiness of a fund’s excess return captured by standard deviation, as would be the case if excess return were normally or lognormally distributed, which is not always the case. Also, standard deviation measures variation both above and below the mean equally.

    But investors are generally risk-averse and dislike downside variation more than upside variation. We at Laverne give more weight to downside variation when calculating Risk-Adjusted Return and does not make any assumptions about the distribution of excess returns.

    The other commonly accepted meaning of “risk-adjusted” is based on assumed investor preferences. Under this approach, higher return is “good” and higher risk is “bad” under all circumstances, without regard to how these two outcomes are combined. Hence, when grading funds, return should be rewarded and risk penalized in all cases.

    • LaVerne Categories
    • Peer Groups

    We use the Category as the primary peer group for a number of calculations, including percentile ranks, fund-versus-category-average comparisons, and the Star Rating. The  Rating compares funds’ risk-adjusted historical returns. Its usefulness depends, in part, on which funds are compared with others.

    It can be assumed that the returns of major asset classes (domestic equities, foreign equities, domestic bonds, and so on) will, over lengthy periods of time, be commensurate with their risk. However, asset class relative returns may not reflect relative risk over ordinary investor time horizons. For instance, in a declining interest-rate environment, investment-grade bond returns can exceed equity returns despite the higher long-term risk of equities; such a situation might continue for months or even years. Under these circumstances many bond funds outperform equity funds for reasons unrelated to the skills of the fund managers.

    A general principle that applies to the calculation of fund star ratings follows from this fact; that is, the relative star ratings of two funds should be affected more by manager skill than by market circumstances or events that lie beyond the fund managers’ control.

    Another general principle is that peer groups should reflect the investment opportunities for investors. So, categories are defined and funds are rated within each of the major markets around the world. Laverne supports different category schemes for different markets based on the investment needs and perspectives of local investors.

    • Style Profiles of the Funds

    A style profile may be considered a summary of a fund’s risk-factor exposures. Fund categories define groups of funds whose members are similar enough in their risk-factor exposures that return comparisons between them are useful.

    The risk factors on which fund categories are based can relate to value-growth orientation; capitalization; industry sector, geographic region, and country weights; duration and credit quality; historical return volatility; beta; and many other investment style factors. The specific factors used are considered to be a) important in explaining fund-return differences and b) actively controlled by the fund managers.

    Because the funds in a given category are similar in their risk-factor exposures, the observed return differences among them relate primarily to security selection (“stock-picking”) or to variation in the timing and amount of exposure to the risk factors that collectively define the category (“asset weighting”). Each of these, over time, may be presumed to have been a skill-related effect.

    Note that if all members of a fund category were uniform and consistent in their risk factor exposures, and the risk factors were comprehensive, there would be no need to risk-adjust returns when creating category-based star ratings. However, even within a tightly defined category, the risk exposures of individual funds vary over time. Also, no style profile or category definition is comprehensive enough to capture all risk factors that affect the returns of the funds within a category.

    In extreme cases where the funds in a category vary widely in their risk factor exposures, a star rating would have little value and is not assigned.

    • Defining Fund Categories

    The following considerations apply when Morningstar defines fund categories:

    1. Funds are grouped by the types of investment exposures that dominate their portfolios.
    2. In general, a single return benchmark should form a valid basis for evaluating the returns for all funds in a single category (that is, for performance attribution).
    3. In general, funds in the same category can be considered reasonable substitutes for the purposes of portfolio construction.
    4. Category membership is based on a fund’s long-term or “normal” style profile, based on minimum three years of portfolio statistics.
    • Conclusion

    Our Rating measures how funds have performed on a risk-adjusted basis against their category peers. It gives investors the ability to quickly and easily identify funds that are worthy of further research. The Rating is calculated for three years, five years, and 10 years, and the overall rating is a weighted average of the time-period ratings.

    The Risk-Adjusted Return is calculated based on expected utility theory, a framework that recognizes that investors are risk-averse and willing to give up some portion of expected return in exchange for greater certainty of return. We at Laverne calculate risk-adjusted return by adjusting total return for the risk-free rate and risk.

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