Mutual Fund Scheme Selection: formula sheet

Key formulas

Risk-return trade-off

Higher expected return ↔ higher risk (generally)

A principle about expected return. It does not guarantee that a riskier scheme will earn more.

Risk tolerance

Willingness to take risk (psychological)

Depends on temperament, experience and attitude to loss.

Risk capacity

Ability to take risk (financial)

Depends on income, age, horizon, dependants, liabilities and assets.

Risk need

Risk required to reach the goal

Depends on goal amount, time available and return required.

Suitable risk level

Risk taken ≤ lower of (tolerance, capacity)

If need is higher, adjust the goal, horizon or savings, not the risk.

Horizon-to-category guide

Very short (days to 3 months) → liquid/overnight/money market; Short (up to about 3 years) → short-duration debt; Medium (3-5 years) → hybrid/conservative mix; Long (5+ years) → equity

A general guide, not a regulatory rule. The exam tests the direction: longer horizon, more equity.

Suitability test

Suitable scheme = fits goal AND horizon AND risk appetite AND risk capacity

If appetite and capacity differ, the lower of the two usually limits the risk taken.

Life stage pattern

Young: higher equity → Mid-career: balanced → Retired: higher debt, income focus

Patterns only. Investor-specific facts override them.

ELSS lock-in

ELSS lock-in = 3 years

Suits tax saving under Section 80C with a long horizon, as it is equity-oriented.

Strategic allocation

Long-term target weights set from goals, horizon and risk profile

Stable policy mix. Changed only when the investor's circumstances change, not on market views.

Tactical allocation

Strategic weights ± short-term deviation based on market view

Temporary and active. The portfolio is expected to return to the strategic mix.

Portfolio weights

Weight of asset = Value of asset ÷ Total portfolio value × 100

Weights must add up to 100%.

Rebalancing

Current weights → sell the overweight, buy the underweight → target weights

Done periodically or when weights drift beyond a set band.

Diversification

Spread across assets with low correlation

Reduces unsystematic (specific) risk. Does not remove systematic (market) risk.

Absolute return

(Ending NAV − Beginning NAV) ÷ Beginning NAV × 100

Add dividends or income distributed if any. Used for periods up to one year.

Relative return (excess return)

Scheme return − Benchmark return

Positive means the scheme outperformed. Use the same period and the TRI.

Sharpe ratio

(Rp − Rf) ÷ σp

Rp is scheme return, Rf is risk-free rate, σp is standard deviation. Higher is better. Uses total risk.

Treynor ratio

(Rp − Rf) ÷ βp

Uses beta, so only market (systematic) risk. Higher is better.

Alpha (Jensen's)

Rp − [Rf + β × (Rm − Rf)]

Rm is market or benchmark return. Positive alpha means return above what risk justified.

Beta reading

β = 1 moves with market; β > 1 more volatile; β < 1 less volatile

Beta measures sensitivity to market movement, not total risk.

Net return after costs

Net return ≈ Gross portfolio return − TER

Reported NAV returns are already net of TER. Do not deduct it again.

Exit load amount

Exit load = Redemption value at NAV × Load %

Applies only if units are redeemed within the load period. Payout = value − load.

Entry load

Entry load = 0

Entry load is not permitted. Distributor fees are not charged as an entry load.

IDCW effect on NAV

NAV after payout = NAV before payout − IDCW per unit

The payout comes out of the investor's own money. Total value is unchanged before tax.

Direct vs regular

TER (regular) = TER (direct) + distribution cost

Same portfolio and same manager. Only costs differ, so direct NAV is higher.

Units allotted

Units = Amount invested ÷ NAV on the applicable date

Same amount at a lower NAV gives more units.

Average cost per unit (SIP)

Average cost = Total amount invested ÷ Total units bought

This is a harmonic-type average. It is never above the simple average of the NAVs when the amount is fixed.

Simple average NAV

Simple average = Sum of NAVs ÷ Number of instalments

Compare it with the average cost to see the rupee cost averaging gain.

SIP

Money flows: bank account → scheme

Accumulation. For regular earners.

SWP

Money flows: scheme → bank account

Regular income. For investors with a corpus.

STP

Money flows: scheme A → scheme B (same fund house)

Used to phase entry into equity or to shift out gradually.

Quick revision

• Higher expected return generally comes with higher risk; the trade-off is a tendency, not a guarantee.
• Risk profiling looks at both the ability to take risk (capacity) and the willingness to take it (tolerance).
• Match the scheme's risk to the investor's profile and horizon, not to past returns alone.
• Longer horizons can generally support more equity; short horizons call for lower-risk debt or liquid options.
• Life stage shapes needs: early earners can often take more risk, while retirees usually need income and capital safety.
• Asset allocation is the split across asset classes and is a major driver of portfolio outcomes.
• Compare a scheme with a benchmark of the same category and style, not with an unrelated index.
• Past performance does not guarantee future returns; check consistency over several periods.
• Costs such as the expense ratio reduce the return the investor actually receives; compare costs within the same category.
• Check the latest workbook for taxation rules, as tax treatment depends on scheme type and holding period.
• SIP spreads investment over time, SWP gives regular withdrawals, and STP moves money from one scheme to another.

Common mistakes

• Treating risk tolerance and risk capacity as the same thing Fix: Tolerance is willingness (psychological). Capacity is ability (financial). Link the words willing and able to them.
• Recommending based on the higher of tolerance and capacity Fix: Use the lower of the two. A bold client with weak finances still needs a conservative approach.
• Choosing equity only because the investor is young. Fix: Check the horizon and capacity too. A young person needing money in one year should not hold equity.
• Ignoring risk capacity and using only risk appetite. Fix: Look at income stability, dependants and liabilities. If capacity is lower than appetite, advise on the lower.
• Treating tactical allocation as the main long-term plan. Fix: Remember that strategic is the base policy and tactical is a temporary tilt around it.
• Saying diversification eliminates all risk. Fix: Diversification reduces specific risk only. Market-wide risk remains.
• Dividing the scheme return by standard deviation without subtracting the risk-free rate. Fix: Write (Rp − Rf) first every time, then divide.
• Mixing up Sharpe and Treynor risk measures. Fix: Sharpe uses standard deviation (total risk). Treynor uses beta (market risk only).
• Thinking a direct plan has a different portfolio from the regular plan. Fix: Remember both plans hold the same portfolio under the same manager. Only the expenses and so the NAV differ.
• Treating IDCW as extra income or a bonus. Fix: The NAV drops by the payout. It is a return of the investor's own money or gains, not an addition, and it is not assured.

Exam tips

• Expect scenario questions where you must label facts as tolerance or capacity. Practise the W and A labels.
• Watch for absolute words such as always, guaranteed and ensures. They usually mark wrong options.
• Remember that when tolerance and capacity differ, the lower one governs the recommendation.
• Link profiling to suitability and mis-selling. Selling a scheme unsuited to the profile is a conduct issue.
• V-A has no negative marking, so attempt every question. Eliminate the extreme options first and then guess.
• Most questions are short cases. Find the horizon and risk words before reading the options.
• Watch for traps that use age alone. The correct answer usually uses horizon and risk capacity too.
• Expect questions linking liquid funds to surplus cash parked for short periods and ELSS to Section 80C.