11.3 Drivers of Returns and Risk in a Scheme

Why Drivers Matter

When an investor asks why a scheme fell, there are only a small number of true answers, and they differ by scheme type. A distributor who knows the drivers can answer accurately in one sentence; one who does not offers a market narrative that may be wrong.

Equity Scheme Return Drivers

An equity scheme's return decomposes into three sources:

Equity return  =  Earnings growth
               +  Dividend yield
               +  Change in the valuation multiple

Earnings growth is the fundamental engine. Over long periods, equity returns track the growth in the profits of the companies held.

Dividend yield is the income component, modest in India relative to many markets because companies retain more for growth.

Change in valuation multiple is what markets pay per rupee of earnings — the price-earnings ratio. This is the volatile component. A market can deliver 15% earnings growth and still fall if the multiple contracts, and can rise sharply on multiple expansion with no earnings improvement at all.

The practical implication is important and often unstated: short-term equity returns are dominated by multiple changes, long-term equity returns by earnings growth. That is precisely why equity requires a long horizon — time is what allows the fundamental driver to overwhelm the sentiment-driven one.

Risk drivers in equity schemes

• Market risk, which diversification cannot remove
• Sector concentration, where a mandate or a manager's positioning creates dependence on one industry cycle
• Market capitalisation, since small and mid caps carry higher volatility and lower liquidity
• Style, since value and growth approaches lead and lag at different points in a cycle
• Liquidity, which determines impact cost when the fund trades

Debt Scheme Return Drivers

A debt scheme's return has two components:

Debt return  =  Accrual (coupon income)
             +  Price change (from yield movements and spread changes)

Accrual is the interest earned on the holdings. It is steady, positive and predictable — the yield to maturity approximates it, less expenses.

Price change is where volatility comes from, and it has two sources:

1. Movement in the general level of interest rates. Yields rise, prices fall, and the magnitude depends on duration.
2. Movement in credit spreads. The extra yield demanded over government securities for taking credit risk. When spreads narrow, corporate bond prices rise relative to gilts; when spreads widen, they fall.

Duration is the amplifier

Approximate price change  ~  - Modified Duration x change in yield

Worked example. A gilt fund with modified duration 7.5 years, yields fall 0.60%:

Price gain  =  7.5 x 0.60%  =  approx 4.5%
Plus accrual over the period

The same fund loses roughly 4.5% from price if yields rise 0.60% instead. Duration works symmetrically, which investors in long-duration funds sometimes discover only in the second direction.

Risk drivers in debt schemes

• Interest-rate risk, scaled by duration
• Credit risk, from downgrades and defaults
• Liquidity risk, in lower-rated paper during stress
• Reinvestment risk, when maturing amounts must be redeployed at lower rates
• Concentration, bounded by the 20% sector cap and rating-linked issuer limits

Hybrid Schemes

Returns are a weighted blend of the equity and debt drivers, in proportions set by the mandate. An aggressive hybrid holding 70% equity behaves largely like an equity scheme; a conservative hybrid holding 20% equity behaves largely like a debt scheme with an equity tilt.

A dynamic asset allocation or balanced advantage scheme varies its equity exposure according to a model, so its driver mix itself changes over time — which is why its behaviour is harder to predict than either a pure equity or a fixed-allocation hybrid scheme.

Gold and International Schemes

Gold has a single return driver — the price change — since it produces no income. For an Indian investor the rupee price reflects both the international price and the rupee-dollar rate, so rupee depreciation supports rupee gold returns independently of the dollar price.

International schemes carry three drivers: the underlying market's return, the currency movement, and the valuation change in that market. An investor can be right about the foreign market and still lose in rupee terms if the rupee appreciates — an outcome that surprises investors who tracked only the overseas index.

Answering the Investor's Question