Mutual Fund (Definition) • A trust that pools the savings of investors who share a common financial goal is known as mutual fund. The money collected is then invested in financial instruments such as shares, debentures and other securities the income and capital appreciation realized are shared by its unit holders in proportion to the number of units owned by them. • Investment in securities are spread over a wide cross section of industries and sectors reducing the risk of the portfolio. • Mutual funds are mobilizers of saving of the small investors in instruments like stock and money market instruments. • Mutual funds are corporation that accept money from investors and use this money to buy stocks, long term bonds, short term debt instruments issued by businesses or Govt.
Features • Mobilizing small savings: mutual funds mobilize funds by selling their own shares known as units. This gives the benefit of convenience and satisfaction of owning shares in many industries. Mutual fund invest in various securities and pass on the returns to the investors. • Investment Avenue: the basic characteristic of a mutual fund is that it provides an ideal avenue for investment for investors and enables them to earn a reasonable return with better liquidity. It offers investors a proportionate claim on the portfolio of assets that fluctuate in value. • Professional management: mutual fund provides investors with the benefit of professional and expert management of their funds. Mutual fund employees professionals/experts who manage the investment portfolios efficiently and profitably. Investors are relieved from the responsibility of following the markets on a regular basis.
Diversified investment: mutual fund have the advantage of diversified investment of funds in various industries and sectors. This is beneficial to small investors who cannot afford to buy shares of established companies at high prices. Mutual fund allow millions of investors who have investments in variety of securities of different companies. • Better liquidity: mutual fund have the distinct advantage of better liquidity of investment. There is always a market available for mutual funds. In case of mutual funds it is obligatory that units are listed and traded thus offering our secondary markets for the funds. A high level of liquidity is possible for the fund holders because of more liquid securities in the mutual fund portfolio. • Reduced risks: the risk on mutual fund is minimum. This is because of expert management diversification , liquidity and economies of scale in transaction cost.
Investment protection: mutual funds are regulated by guidelines and legislative provisions put in place by regulatory agencies such as SEBI in order protect the investor interest the mutual funds are obligated to follow the provisions laid down by the regulators. • Switching facility: mutual funds provide investors with the flexibility to switch from one scheme to another, this flexibility enables investors to switch from income scheme to growth scheme and from close ended scheme to open ended scheme. • Tax benefits: mutual funds offer tax shelter to the investors by investing in various tax saving schemes under the provisions provided by the income tax act. • Low transaction cost: the cost of purchase and sale of MF’s is relatively lower.
Economic development: MF’s contribute to economic development by mobilizing savings and channelizing them to more productive sectors of the economy. • Convenience: MF units can be traded easily with little or no transaction cost.
Products and Schemes • Investors have the option of choosing from a wide variety of schemes in a mutual fund depending upon their requirements. MF’s are classified as follows: • Operational classification: • Open ended scheme: when a fund is accepted and liquidated on a continuous basis by a MF manager, it is called as open ended scheme. The fund manager buys and sells units constantly as demanded by the investors. The capitalization of the funds changes constantly as it is always open for the investors to buy or sell their units. The scheme provides excellent liquidity facility to the investors. The buying and selling of units takes place at a declared NAV(Net Asset Value)
Close ended scheme: when a units of a scheme liquidated only after the expiry of a specified period it is known as close ended fund. Such funds have fixed capitalization and remain with the mutual fund manager, units of close ended schemes are traded on stock exchange in the secondary market. The price is determined on the basis of supply and demand. There are 2 prices for such funds, one that is market determined and the other is NAV based the market price may be above or below NAV. Managing a close ended scheme is comparatively easy for the fund Manager. The fund can be liquidated after a specified period. • Interval scheme: it is kind of close ended scheme with a feature that it remains open during a particular part of the year for the benefit of investors, to either off load or to undertake purchase of units at a NAV.
Return based classification • Income fund scheme: this scheme is customised to suit the needs of investors who are particular about regular returns. The scheme offers maximum current income where by the income earned by the units is distributed periodically there are 2 types of such schemes, one that earns a target constant income at relatively low risk while the other offers maximum possible income. • Growth scheme: it is a MF scheme that offers the advantage of capital appreciation of the underlying investment such funds invest in growth oriented securities that are capable of appreciating in the long run. The risk attached with such funds is relatively higher.
Conservative fund Scheme: a scheme that aims at providing a reasonable rate of return, protecting the value of investment and achieving capital appreciation is called a conservative fund scheme. It is also known as middle of road funds as it offers a blend of the above features. Such funds divide their portfolio in stocks and bonds in such a way that it achieves the desired objective.
Investment based classification • Equity fund: such fund invest in equity shares they carry a high degree of risk such fund do well in favorable market conditions. Investments are made in equity shares in diverse industries and sectors. • Debt funds: Such fund invest in debt instruments like bonds and debentures. These funds carry the advantage of secure and steady income there is little chance of capital appreciation. Such funds carry no risk. A variant of this type of fund is called liquid fund which specializes in investing in short term money market instruments. • Balanced funds: such scheme have a mix of debt and equity in their portfolio of investments. The portfolio is often shifted between debt and equity depending upon the prevailing market conditions.
Sectoral fund: Such fund invest in specific sectors of the economy. The specialized sectors may include real estate infrastructure, oil and gas etc, offshore investments, commodities like gold and silver. • Fund of Funds: such funds invest in units of other mutual funds there are a number of funds that direct investments into specified sectors of economy. This makes diversified and intensive investments possible. • Leverage funds: the funds that are created out of investments with not only the amount mobilized from investors but also from borrowed money from the capital markets are known as leveraged funds. Fund managers pass on the benefit of leverage to the mutual fund investors. Additional provisions must be made for such funds to operate. Leveraged funds use short sale to take advantage of declining markets in order to realize gains. Derivative instruments like options are used by such funds.
Gilt fund : These funds seek to generate returns through investment in govt. securities. Such funds invest only in central and state govt. securities and REPO/ reverse REPO securities. A portion of the corpus may be invested in call money markets to meet liquidity requirements. Such funds carry very less risk. Their prices are influenced only by moment in interest rates. • Indexed funds: these funds are linked to specific index. Funds mobilized under such schemes are invested in securities of companies included in the index of any exchange. The fund performance is linked to the growth in concerned index. • Tax saving schemes: certain MF schemes offer tax rebate on investments made in equity shares under section 88 of income tax act. Income may be periodically distributed depending on surplus. Subscriptions made Upto Rs.10000 are eligible for tax rebate under section 88 for such scheme. The investment of the scheme includes investment in equity, preference shares and convertible debentures and bonds to the extent 80-100% and rest in money market instruments.
Structure Of Mutual Funds In India • Mutual Funds in India follow a 3-tier structure. • The first tier is the sponsor who thinks of starting the fund. • The second tier is the trustee. The Trustees role is not to manage the money. Their job is only to see, whether the money is being managed as per stated objectives. Trustees may be seen as the internal regulators of a mutual fund. • Trustees appoint the Asset Management Company (AMC) who form the third tier, to manage investor’s money. The AMC in return charges a fee for the services provided and this fee is borne by the investors as it is deducted from the money collected from them
Sponsor • Any corporate body which initiates the launching of a mutual fund is referred to as “The sponsor”. • The sponsor is expected to have a sound track record and experience in financial services for a minimum period of 5 years and should ensure various formalities required in establishing a mutual fund. • According to SEBI, the sponsor should have professional competence, financial soundness and reputation for fairness and integrity. The sponsor contributes 40% of the net worth of the AMC. The sponsor appoints the trustee, The AMC and custodians in compliance with the regulations.
Trustee • Sponsor creates a public trust and appoints trustees. Trustees are the people authorized to act on behalf of the Trust. They hold the property of mutual fund. • Once the Trust is created, it is registered with SEBI after which this trust is known as the mutual fund. The Trustees role is not to manage the money but their job is only to see, whether the money is being managed as per stated objectives. Trustees may be seen as the internal regulators of a mutual fund. • A minimum of 75% of the trustees must be independent of the sponsor to ensure fair dealings. • Trustees appoint the Asset Management Company (AMC), to manage investor’s money.
Custodian • A custodian’s role is keeping custody of the securities that are bought by the fund manager and also keeping a tab on the corporate actions like rights, bonus and dividends declared by the companies in which the fund has invested. • The Custodian is appointed by the Board of Trustees. The custodian also participates in a clearing and settlement system through approved depository companies on behalf of mutual funds, in case of dematerialized securities. • Only the physical securities are held by the Custodian. The deliveries and receipt of units of a mutual fund are done by the custodian or a depository participant at the instruction of the AMC and under the overall direction and responsibility of the Trustees. Regulations provide that the Sponsor and the Custodian must be separate entities.
Asset Management Company (AMC) • Trustees appoint the Asset Management Company (AMC), to manage investor’s money. The AMC in return charges a fee for the services provided and this fee is borne by the investors as it is deducted from the money collected from them. • The AMC’s Board of Directors must have at least 50% of Directors who are independent directors. The AMC has to be approved by SEBI. The AMC functions under the supervision of it’s Board of Directors, and also under the direction of the Trustees and SEBI. • It is the AMC, which in the name of the Trust, floats new schemes and manage these schemes by buying and selling securities. In order to do this the AMC needs to follow all rules and regulations prescribed by SEBI and as per the Investment Management Agreement it signs with the Trustees.
AMC cont- • The role of the AMC is to manage investor’s money on a day to day basis. Thus it is imperative that people with the highest integrity are involved with this activity. • The AMC cannot deal with a single broker beyond a certain limit of transactions. • The AMC cannot act as a Trustee for some other Mutual Fund. • The responsibility of preparing the OD lies with the AMC. • Appointments of intermediaries like independent financial advisors (IFAs), national and regional distributors, banks, etc. is also done by the AMC. • Finally, it is the AMC which is responsible for the acts of its employees and service providers.
Registrar and Transfer Agents • The registrar and transfer agents are appointed by the AMC. AMC pay compensation to these agents for their services. They carry out the following functions • Receiving and processing the application forms of investors • Issuing unit certificates • Sending refund orders • Giving approval for all transfers of units and maintaining records • Repurchasing the units and redemption of units • Issuing dividend or income warrents
Fund Accountants • Fund accountants are appointed by the AMC. The are in charge of maintaining proper books of accounts relating to the fund transactions and management. The perform the following functions • Computing the net asset value per unit of the scheme on a daily basis • Maintaining its books and records • Monitoring compliance with the schemes, investment limitations as well as SEBI regulations • Preparing and distributing reports of the schemes for the unit holders and SEBI and monitoring the performance of mutual funds custodians and other service providers.
Lead Manager • Lead manager carry out the following functions: • Selecting and coordinating the activities of intermediaries such as advertising agency, printers, collection centers. • Carrying out extensive campaign about the scheme and acting as marketing associates to attract investors. • Assisting the AMC to approach potential investors through meetings, exhibitions, contacts, advertising, publicity and sales promotion.
Investment Advisors • Investment advisors carry out market and security analysis. • Advising the AMC to design its investment strategies on a continuous basis. • They are paid for their professional advice regarding fund investment on the average weekly value of the fund’s net assets.
Legal Advisors • Legal advisors are appointed to offer legal guidance about planning and execution of different schemes. • A group of advocates and solicitors may be appointed as legal advisors. • Their fee is not associated with net assets of the fund.
Auditors and Underwriters • An auditor is appointed by the AMC and must undertake independent inspection and verification of its accounting activities. • Mutual funds also undertake the activities of underwriting issues. Such activities generate an additional source of income for mutual funds. Prior approval from SEBI is necessary for undertaking such activity
Working mechanism of AMC • Creating fund manager: A fund manager is responsible for managing the funds of the AMC. The fund manager should be an independent agency but in India a single fund manager handles many schemes simultaneously. The basic function of fund managers is to decide the rate, time, kind and quantum of securities to be brought and sold. The fund manager ensures the success of the fund scheme. • Research and Planning: the research and planning cell of AMC undertake research activities relating to securities as well as prospective investors the results of the study are analyzed to draft future policies governing investments. • Creating dealers: Dealers having a deep understanding of stock market operations may be created by the AMC in order to execute sales and purchase transactions in the capital and money market. Dealers should comply with all formalities of sale and purchases through brokers.
Portfolio Management Process In Mutual Fund • Setting investment goals: The first task of managing the portfolio of mutual fund is to identify and set the goals for the proposed scheme the goal is set keeping in mind the nature of the scheme, risk and return, market condition, regulatory norms, size of the issue and investor protection. • Identifying specific securities: Efforts are made to analyze and identify the right securities where the fund should invest in. security analyses is carried out and risk and return characteristics are evaluated. • Portfolio designing: it involves making an ideal mix of debt and equity securities of corporate, govt. etc. It is concerned with decisions regarding the type of securities to be bought, the quantum and timing of issue. Portfolio design is carried out on the basis of research and analyses of stock market and devising investment strategies. The portfolio should be well diversified so as to reduce the total risk of the portfolio. • Portfolio revision: The portfolio must be reviewed periodically keeping in mind the risk return characteristics, the revision of the portfolio is done by keeping in mind the dynamic investment climate
Operational Efficiency of Mutual funds • Net Returns: the operational of a mutual fund is best judged by its ability to earn for the investors better and safe returns in the form of capital appreciation and the dividends or income received on such investment. • Returns are calculated keeping in mind the expenses incurred while earning such returns which include trusteeship fee, management fee, administrative fee, fund accounting fee, initial charges, brokerage etc. SEBI has fixed an overall limit on expenses as per the regulations.
Net Asset Value: It is another parameter to measure the operational efficiency of the fund. The intrinsic value of a unit under a specific scheme is referred to as the NAV of the scheme. The value gives an idea of the amount that may be obtained by the unit holder on sale of the unit to the mutual fund company NAV (per unit) = Total Market Value – Fund liabilities No. of outstanding Units • Load : The initial expenses that are incurred by a mutual fund in relation to the scheme operated by it is referred to as the load of the scheme. According to SEBI guidelines a certain percentage of load must be borne by the expected scheme. • Disclosures: A highly transparent nature of mutual fund is said to operate to benefit the investors and service their needs. MFs are supposed to follow certain norms and ample disclosures for their operation. Disclosures are made through half yearly and annual reports where all the information relating to the scheme is disclosed.
Investor protection: the fund manager is supposed to follow certain safe guards to protect the interest of the investors. Unit certificates are to be issued within 6 weeks from the date of closure of subscriptions. Units submitted for transfer should be executed within 30 days. A dividend warrants are to be dispatched within 42 days of declaration of dividend. Repurchase proceeds should be dispatched within 10 working days from the date of redemption. SEBI takes all possible safeguards such as conducting inspections of the mutual funds to ensure that investors interests are protected. Defaulting AMC are prohibited from issuing new schemes.
Evaluation of Mutual Funds • It is essential that the performance of Mutual fund is evaluated and appraised. Such appraisal helps the fund to compare itself with other funds besides being a potential source of information to the present and prospective investors. • Evaluation includes simple evaluation tools to sophisticated models which take into consideration the risk and uncertainty associated with the returns. Some of the models used are Treynor’s Model and Sharpe’s Model
Sharpe’s Performance Index: It offers a single value for performance ranking of different funds or portfolio. It measures the risk premium of the portfolio in terms of its total risk. • Sharpe’s Index = Average portfolio return – Risk free rate of return Standard Deviation of Portfolio = Rp – Rf σp
Treynor’s Performance Index: Here the fund’s performance is measured against the market performance. It is used to calculate return per unit of market risk. • Treynor’s Index = Average portfolio return – Risk free rate of return Market risk of Portfolio = Rp – Rf βp
Advantages of Mutual Funds • Mutual Funds give investors best of both the worlds. Investor’s money is managed by professional fund managers and the money is deployed in a diversified portfolio. Mutual Funds help to reap the benefit of returns by a portfolio spread across a wide spectrum of companies with small investments. • A mutual fund analyses the investments for investors as fund managers assisted by a team of research analysts analyze the market daily. • Investors can enter / exit schemes anytime they want (at least in open ended schemes). They can invest in an SIP, where every month, a stipulated amount automatically goes out of their savings account into a scheme of their choice. • There may be a situation where an investor holds some shares, but cannot exit the same as there are no buyers in the market. Such a problem of illiquidity generally does not exist in case of mutual funds, as the investor can redeem his units by approaching the mutual fund.
As more and more AMCs come in the market, investors will continue to get newer products and competition will ensure that costs are kept at a minimum. • Investors can either invest with the objective of getting capital appreciation or regular dividends i.e., mutual fund are structured to suit the needs of all investors. • An investor with limited funds might be able to invest in only one or two stocks / bonds, thus increasing his / her risk. However, a mutual fund will spread its risk by investing a number of sound stocks or bonds. A fund normally invests in companies across a wide range of industries, so the risk is diversified. • Mutual Funds regularly provide investors with information on the value of their investments. Mutual Funds also provide complete portfolio disclosure of the investments made by various schemes and also the proportion invested in each asset type.
The large amount of Mutual Funds offer the investor a wide variety to choose from. An investor can pick up a scheme depending upon his risk/ return profile • All the Mutual Funds are registered with SEBI and they function within the provisions of strict regulation designed to protect the interests of the investor
Regulations • Regulations ensure that schemes do not invest beyond a certain percent of their NAVs in a single security. Some of the guidelines regarding these are given below • No scheme can invest more than 15% of its NAV in rated debt instruments of a single issuer. This limit may be increased to 20% with prior approval of Trustees. This restriction is not applicable to Government securities. • No scheme can invest more than 10% of its NAV in unrated paper of a single issuer and total investment by any scheme in unrated papers cannot exceed 25% of NAV. • No fund, under all its schemes can hold more than 10% of company’s paid up capital • No scheme can invest more than 10% of its NAV in a single company. • If a scheme invests in another scheme of the same or different AMC, no fees will be charged. Aggregate inter scheme investment cannot exceed 5% of net asset value of the mutual fund
No scheme can invest in unlisted securities of its sponsor or its group entities. • Schemes can invest in unlisted securities issued by entities other than the sponsor or sponsor’s group. Open ended schemes can invest maximum of 5% of net assets in such securities whereas close ended schemes can invest upto 10% of net assets in such securities • Schemes cannot invest in listed entities belonging to the sponsor group beyond 25% of its net assets
SEBI Mutual Fund Regulations • The regulations governing the functioning of mutual funds in India were introduced by SEBI in Dec 1996. The objectives of these regulations was to bring in existence the regulatory norms for the formation, operation and management of mutual funds in India. The regulations also laid down the broad guidelines on investment valuation, investment restriction, advertising code and code of conduct for mutual funds and AMCs.
Registration of mutual funds • Every mutual fund shall be registered with SEBI through an application to be made by the sponsor in a prescribed format accompanied by an application fee of Rs.25000. • Every mutual fund shall pay Rs.25lakhs towards registration fee and Rs:2.5lakhs per annum as service fees. • Registration shall be granted by the board on fulfillment of conditions such as sponsor’s, sound track record of 5yrs integrity, net worth etc.
Regulations for the trust • Mutual fund shall be constituted in the form of a trust under the provisions of Indian Registrations Act and provisions laid down by SEBI. • A trustee should be person of integrity, ability, and should not have been found guilty or being convicted of any economic offence or violation of securities law. • At least 50% of the trustees shall be independent trustees. • The trustees and the AMC with SEBI’s prior approval shall enter into an investment management agreement. • The trustees shall ensure the AMC has the necessary infrastructure and personnel. • The trustees shall ensure that AMC is monitoring security transaction with brokers. • The trustees shall ensure that the EMC has been managing the scheme independently. • The trustees should fulfill all its duties in order to protect the interest of the investors.
Regulations for AMC • It should have a sound track record, reputation and fairness in transaction. • The sponsor or trustee shall appoint an AMC with SEBI’s approval. • The appointment of the AMC can be terminated by majority of trustees or by 75% of unit holders. • The directors of AMCs should have adequate professional experience. • At least 50% of the director’s of the AMC should not be associated with the sponsors or it’s subsidiaries or the trustees. • The chairman of the AMC should not be trustee of any other mutual fund. • The AMC shall have a minimum net worth of Rs.10 crores. • The AMC shall not act as an AMC for any other mutual funds.
Regulations for custodians • The mutual fund shall appoint a custodian to carry out the custodian services for the schemes of the fund. • The agreement with the custodian shall be entered into with prior approval of trustees.
Regulations for Schemes of mutual funds • All the schemes to be launched by the AMC should be approved by the trustees and are to be filed with SEBI. • The offer document should contain adequate disclosures to enable the investors to make informed decisions. • Advertisement of schemes should be in conformance with SEBI’s code. • The listing of closed ended schemes is mandatory and it should be listed on a recognized stock exchange within 6 months of its subscriptions. • Units of close ended schemes can be opened for redemption at a fixed interval. • The AMC shall specify in the offer document the minimum subscription to be raised under the scheme. • The AMC may repurchase, reissue the units of close ended schemes. • The units of close ended schemes can be converted into open ended schemes. • Any scheme on mutual fund shall not be opened for subscription after 45 days. • The mutual fund and AMC shall be liable to refund the application money to the applicants if minimum subscription is not received.
Exchange Traded Fund (ETF) • Exchange Traded Funds (ETFs) are mutual fund units which investors buy or sell from the stock exchange, as against a normal mutual fund unit, where the investor buys / sells through a distributor or directly from the AMC. • ETFs have relatively lesser costs as compared to a mutual fund scheme • The ETF structure is such that the AMC does not have to deal directly with investors or distributors. It instead issues units to a few designated large participants, who are also called as Authorized Participants (APs), who in turn act as market makers for the ETFs. • The Authorized Participants provide two way quotes for the ETFs on the stock exchange, which enables investors to buy and sell the ETFs at any given point of time when the stock markets are open for trading
Prices are available on real time and the ETFs can be purchased through a stock exchange broker just like one would buy / sell shares. There are huge reductions in marketing expenses and commissions in case of ETFs. • Assets in ETFs: Practically any asset class can be used to create ETFs. Globally there are ETFs on Silver, Gold, Indices etc. In India, we have ETFs on Gold, Indices such as Nifty, Bank Nifty etc.
Characteristics of ETFs • An Exchange Traded Fund (ETF) is essentially a scheme where the investor has to buy/ sell units from the market through a broker (just as he would by a share). • An investor must have a demat account for buying and selling ETFs. • An important feature of ETFs is the huge reduction in costs. While a typical Index fund would have expenses in the range of 1.5% of Net Assets, an ETF might have expenses around 0.75%
Hedge Funds • Hedge funds are aggressively managed portfolio of investments that uses advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns, • Hedge funds are most often set up as private investment partnerships that are open to a limited number of investors and require a very large initial minimum investment • Hedge funds are a more risky variant of mutual funds. Hedge funds are aimed at high net worth investors. They operate with high fee structures and are less closely monitored by the regulatory authorities.
The risk in hedge funds is higher on account of the following features • Risky investment styles • Hedge funds take extreme positions in the market, including short-selling of investments. • Ex. In a normal long position, the investor buys a share at say, Rs. 15. The worst case is that the investor loses the entire amount invested. The maximum loss is Rs. 15 per share. • Suppose that the investor has short-sold a share at Rs. 15. There is a profit if the share price goes down. However, if the share price goes up, to say, Rs. 20, the loss would be Rs. 5 per share. A higher share price of say, Rs. 50 would entail a higher loss of Rs. 35 per share. Thus, higher the share price more would be the loss. Since there is no limit to how high a share price can go, the losses in a short selling transaction are unlimited.
Borrowings: Normal mutual funds accept money from unit-holders to fund their investments. Hedge funds invest a mix of unit-holders’ funds (which are in the nature of capital) and borrowed funds (loans). Unlike capital, borrowed funds have a fixed capital servicing requirement. Even if the investments are at a loss, loan has to be serviced. However, if investments earn a return better than the cost of borrowed funds, the excess helps in boosting the returns for the unit-holders