Topic X Mutual Fund

Investment
and
Performance
Measurement

LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Explain the process of managing funds in a portfolio;
2. Differentiate between open-end fund and closed-end fund; and
3. Evaluate the performance of investments, based on Sharps measure,
Treynors measure and Jensens measure.

X INTRODUCTION
This topic discusses another alternative approach to investment. In this topic we
will mainly discuss investment in mutual funds. These mutual funds are
basically portfolios that are managed by professional financial service
organisations. There are various kinds of funds available in the market. To
manage the portfolio, they will need to go through a process. Finally, we will
discuss performance evaluation of investments.

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9.1

PROCESS OF PORTFOLIO MANAGEMENT

In Topic 3, we saw how an investor could invest in more than one asset. By
investing in a portfolio, we could manage our return requirement to suit our
tolerance of risk. In practice, we find that there are some commercial
organisations that manage large amount of funds and invest them in portfolios.
The process of managing funds in a portfolio involves four main steps:

(a)

Step 1: Setting Objectives

The first step in building a portfolio is to set the investment objectives. In
general the objective will include the amount of return required, the level of
risk and the time horizon of the investment. There are many investors with
different risk tolerance and therefore the portfolio manager needs to cater to
different needs.
As an example, below is the objective of ASB taken from PNB website.
To generate long-term, consistent and competitive returns to the unit
holders whilst ensuring the preservation of capital at minimal risk tolerance
level.

(b)

Step 2: Determining Asset Class

Asset class is classification of assets into different types. A general
classification is between equities, debts and money market instruments. In
each class, we can further classify them into smaller categories.

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An example is as follows:
Table 9.1: Asset Classification
Asset Class

Smaller Classification

Equities

Domestic and Foreign

Bonds

Domestic and Foreign

Money Market
Properties

Further Classification
Government, Corporate

Cash, Short term instrument

Commercial, Industrial

Venture Capital
Arts

(c)

Step 3: Asset Allocation

After determining the asset class, the asset manager needs to divide his
funds into the selected asset class. This is similar to determining the
weights or proportion of funds that we saw in Topic 3. Recall that we have
to determine the return, risk and the covariance between assets. For
example, the asset mix can be 60:30:10, where 60% of funds are invested in
equity, 30% in bonds and 10% in cash and money market.
The decision on the right mix will depend on the managers forecast. The
60:30:10 mix may be due to the increase in confidence in the stock market as
a high proportion of funds are invested in equities. A 20:50:30 mix is a
portfolio that is heavy on bonds. This may be due to unfavourable share
market conditions.

(d)

Step 4: Monitoring and Rebalancing

Once the portfolios have been formed, their performance needs to be
monitored. There are various performance measures that can be used. Some
of it is discussed later in this topic. If the performance is not achieved or
if there is some new information that was acquired, the manager may
need to rebalance the portfolio. This may involve performing a new asset
allocation and the transfer of funds from one asset class to another.
However, there must be a policy on rebalancing. This is because frequent
rebalancing can increase transaction costs. Too little rebalancing may affect
returns when managers do not react to market conditions.

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SELF-CHECK 9.1
Recall the concept and examples of portfolio management in Topic 3.
What are the processes involved in managing a portfolio?

ACTIVITY 9.1
We have discussed portfolio management processes which involve four
sequential steps. What will happen to an investor if the steps were not
followed in sequence or if one of the steps was not done?

9.2

INVESTORS OBJECTIVES

As we mentioned earlier, investors have different risk tolerance. Therefore, each

major group of investors will have different portfolios that suit their needs. The
easiest way to determine an investors profile is by age.
Table 9.1 shows a broad description of investors needs categorised according to
age.
Table 9.1: Investors Needs Categorised According to Age
Age

Income
Generating
Potential

Return
Requirement

Risk Tolerance

Recommended
Assets

25 to 35

High

High

High

Equities with high

growth and price
appreciation.

35 to 45

High

Require to
strengthen
position

Normal

Mixture of growth
and income. Still
heavy on equities.

45-60

Moderate

Normal

Moderate and
will not be able
to tolerate high
risk

Focus
more
on
income generating
portfolios.

65 and above

Low

Normal

Low

Stable
or
fixed
income portfolios.

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SELF-CHECK 9.2
You have RM40,000 and wish to invest in bonds. But first, you
should set your objective. What would it be? Compare your objective
with that of your peers. What can you conclude?

9.3

MUTUAL FUNDS: PROFESSIONALLY

MANAGED INVESTMENT PORTFOLIOS

A mutual fund is a pool of money that is managed by an investment

company which invests shareholders money in a diversified portfolio of
securities and/or derivatives with the goal of producing a certain return for
the investors.

A potential shareholder will need to see an agent of the fund to buy the shares. A
share scrip is then normally issued. However, in Malaysia most transactions are
done without any scrips and recorded electronically.

9.3.1

Characteristics of a Fund

An open-end fund is a type of fund where investors can buy shares from the
fund.

The fund is obliged to buy back the shares. The size of the fund is limited by
the number of shares it can issue. Once it reaches its limit, no new share
can be sold unless there are investors who sell back their shares. The
organisation that created the fund can form another fund if there is a high
demand for its services. Examples of this fund are ASN, ASB, and RHB Dynamic
Fund.
A closed-end fund is a fund where the number of shares is fixed. Investors
can buy these shares initially from the fund, but they cannot sell them back
to the fund.

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The shares can only be sold to another investor in the stock exchange. Therefore,
when the shares cannot be bought initially, it can be purchased in the open
market. It is similar to ordinary shares in the share market. Currently in Malaysia
there is only one closed-end fund that is listed in the Bursa Malaysia. This is the
Amanah Small Cap Fund Berhad (ASFB).

9.3.2

Types of Funds

A fund can be specialised. It can either focus on equities, bonds or a mixture of

both. Some funds are more specific like Islamic and non-Islamic. Below are some
general examples of funds.
A growth funds specific objective is price appreciation. It targets securities that
will have long-term growth and capital gains and focuses less on securities that
give dividends or income. Because of this, a growth fund is risky. This type of
fund is suitable for investors in the age group of 25 to 40 years. Their objective is
to accumulate capital.
Income funds emphasise on current income. They will invest in securities that
provide stable income. Shares that provide high dividends are normally the
favourite choice as well as established blue chip companies. They, however, do
hold a few growth shares. Apart from shares, these types of funds also invest in
bonds. The investment is less risky than growth shares.
Index fund is a portfolio that replicates the combination of shares in an index.
For example, the KLCI contain 100 shares, with predetermined weight for each
share. A portfolio can be built to replicate that index and use the same 100 shares
and weights.

ACTIVITY 9.2
Refer to the business section in one of the local newspapers and
list down the different types of funds available in the Malaysian
market. In which categories do the funds fall?

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9.4

PERFORMANCE EVALUATION

The final process of investment is to evaluate the performance. This process is

vital as it provides a feedback mechanism and control in our investment
management. The process that we describe here can be used to evaluate the
performance of individual stocks, portfolios as well as unit trusts.

SELF-CHECK 9.3
Why do you think we need to evaluate the performance of our
investment?

9.4.1

Sharpes Measure

Sharpes measure or index, as it is sometimes called, can be determined by using

the formula below.

Sp

RP  RF
VP

where, SP is the Sharpes index for the portfolio p, RP is the return of the
portfolio, RF is the risk free rate and P is the standard deviation or risk measure
for the portfolio.
Sharpes index measures the excess return (risk premium RP - RF) of a portfolio
relative to its risk measured by the standard deviation. The index uses the
Capital Market Line (CML) as a basis (see Topic 4). For example, if portfolio A
has a return of 10%, RF is 4%, and A is 13%. Then Sharpes index for the
portfolio is (10  4)/13 = 0.46. The higher the index, the better the investment
performance.

9.4.2

Sharpes Differential Return

As the index is based on the CML, we can also reinterpret the measure in
a form of differential return. As we know from Topic 4, the CML is based on the
following model:
R  Rf
Ri Rf  m
V i
Vm

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We will compare the return from a portfolio with the return that is being stated by
the model above. We therefore need the market return as well as its standard
deviation. Using the example above where the return of portfolio A = 10% and its
standard deviation = 13%. If the market return equals to 12%, and its standard
deviation, Vm = 15%, then based on the model, portfolio A should have a return of

RA

12  4
4
13 10.93%
15

The Differential Return is the actual return minus the above return from the
model, which is 10  10.93 =  0.93. The performance is well below the standard
of the CML. A positive difference would indicate a better performance, the
higher the better.

9.4.3

Treynors Measure

Treynor s measure is calculated using the formula below:

TP

RP  RF
EP

where TP is Treynors measure for portfolio P, P is the Beta of portfolio, while the
other variables are the same as above. The difference between Sharpes and Treynor
s measures is the risk measurement used. Treynor uses the Beta of the
portfolio.
The Beta of the portfolio is obtained by taking the weighted average of all asset
Betas in the portfolio, as shown below:

E P W1 E1  w 2 E 2 .........W n E n
where w1, w2.......wn are the percentage weights of funds in each asset 1 to n.
As an example, Portfolio C gives a return of 15%, RF is 4%, and EC is 2. The
Treynors measure is (15 4 )/2 = 5.5. A portfolio with the highest measure is the better
portfolio.

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9.4.4 Treynors Differential Return

Treynors Differential Return uses the Security Market Line (SML). Again you
can refer to Topic 4 for further details.
The expected return can be determined using the SML equation below:

RP

Rf   R m  Rf  E p

The actual return is then compared with the return calculated by the model.
For example, portfolio C gives a return of 15%, RF is 4%, C is 2 and Rm = 12%,
and the model will show that the expected return is:

RC

4   12  4  u 2 20%

The differential return is 15% - 20% = -5%. Portfolio Cs performance is below

the performance of the model. Differential return calculated using Beta is
sometimes known as the Jensen index.
Investors can choose any of the indices. However, if the portfolio is well
diversified, the Treynor measure is most appropriate, since unsystematic risks
have been reduced. Treynors measure is also used when a portfolio is part
of many portfolios. If the portfolio contains a small number of assets, or is
the investors only portfolio, then Sharpes measure is more appropriate.

EXERCISE 9.1
1. Explain the difference between open-end fund and closed-end
fund.
2. Look into a newspaper and list down the different types of funds
available in the Malaysian market.
3. If you were a 35-year-old person, what kind of investment would
be suitable for you? Lets say you are earning RM3,500 a month.

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4. Below are the data for the following portfolios

Portfolio SBS

Portfolio IMB

Returns

13.8

12.2

Standard Deviation

14.5

Beta

1.5

If the market return is 11.5% with standard deviation of 10%, and

the risk free rate is 5%, determine the Sharpe, Treynor and Jensen
measures for each portfolio. Explain the performance of the
portfolios.

The process of managing funds in a portfolio involves four main steps,

namely, setting objectives, determining asset class, asset allocation as well as
monitoring and rebalancing.

A mutual fund is a pool of money that is managed by an investment

company which invests shareholders money in a diversified portfolio of
securities and/or derivatives with the goal of producing a certain return for
the investors.

Investment funds can either focus on equities, bonds or a mixture of both.

General examples of funds can be classified into growth funds, income funds
and index funds.

Investment performance can be evaluated based on three measures  Sharps

measure, Treynors measure and Jensens measure.