PROJECT GUIDE: PROFESSOR P. C.

BASU

PREPARED BY: TARUNA MENGHANI

Roll No. 102
MFM III B (Year 2001 2002)

TABLE OF CONTENTS
Contents

Page no.

Section I
1.
2.
3.
4.

Introduction
The History of Mutual Funds
The Concept of a Mutual Fund
The Regulatory Framework of Mutual Funds
in India
5. Valuation and Taxation
6. Investment Management

4
7
13
20
25
28

Section II
1.
2.
3.
4.
5.

Investment Products
Financial Planning
Investing in a Mutual Fund Scheme Part 1
Investing in a Mutual Fund Scheme Part 2
Understanding and Managing risks of Mutual
Fund Investing
6. Conclusion

39
48
51
58
70
79

SECTION I

Introduction
The mutual fund (MF) industry has been one of the fastest growing financial sectors; it has been
growing at a CAGR of 20- 25 per cent in the last ten years. As per AMFI chairman, Mr. A. P.
Kurian, the asset base is expected to grow at an annual rate of about 30 to 35 percent over the
next few years as investors shift their assets from banks and other traditional avenues.
The mutual fund industry came into existence with the setting up of UTI in 1964. UTI continues
to dominate the mutual fund industry with a corpus of 700bn (54% of the industry assets), but the
investor confidence is shaken by the recent crisis.
The mutual fund industry in India has completed 36 yrs and the ride through these yrs. has not
been a smooth. Investors have still to overcome their experience with mutual funds like Morgan
Stanley, Mastergain, Monthly Equity plans of SBI, UTI and Canara Bank.
The nationalized banks entered the mutual fund business in the early nineties and got off to a
good start because of the stock market boom. But these banks did not understand the mutual fund
business nor did they have the required skill, experience or the technology. As a result they failed
miserably.
Investors experience with Morgan Stanley, the first foreign mutual fund was also not too good.
The Morgan Stanley fund in its initial public offer (IPO) raised 10bn. The entire fund raising
exercise was centered on the hype that the fund was first of its kind, promoted by an
internationally acclaimed asset management company. It was marketed like any other public
issue. Investors rushed in hoping for superior returns without realizing that the functioning of a
mutual fund is different from investing in an equity fund IPO. Nor did they realize that the
scheme was a closed-ended scheme with lock in of 15 years. The equity market also did not favor
Morgan Stanley and investors lost heavily.
As a result of all this, investors confidence in mutual funds was shaken up.
Though the experience of mutual fund investors in the past has not been good it does not mean
that all funds have performed badly. In fact, if one looks at income funds and recent performance
of equity funds, they have done quite well. Due to which investors are relooking at mutual funds
as a tool for investments. Most traditional avenues have become unattractive. Investors are
realizing the benefits of investing in the capital markets through mutual funds rather than
investing directly. The awareness about mutual funds is slowly but steadily growing.
Investors are realizing that they need to look no further than mutual funds for their complete set
of investment needs. However like any other investment a disciplined approach is required for
investing in mutual funds.
A mutual fund is the ideal investment vehicle for todays complex and modern financial scenario.
Markets for equity shares, bonds and other fixed income instruments, real estate, derivatives and
other assets have become mature and information driven. Price changes in these assets are driven

by global events occurring in faraway places. A typical individual is unlikely to have the
knowledge, skills, inclination and time to keep track of events, understand their implications and
act speedily.
The industry is also having a profound impact on financial markets. Fund managers, by their
selection criteria for stocks have forced corporate governance on the industry. By rewarding
honest and transparent management with higher valuations, a system of risk-reward has been
created where the corporate sector is more transparent then before.
One thing is certain - that the mutual fund industry is here to stay.
The study has been divided into two sections: Section I, talks about the genesis of mutual fund,
the evolution of mutual funds in India and the mutual funds registered in India. It also explains
the concept of a mutual fund, the benefits of investing in a mutual fund, the types of mutual fund
schemes. It talks about the regulatory framework within which mutual funds in India operate. The
concept of NAV and the tax benefits have also been explained in detail.
The last chapter in this section covers the most important aspect of mutual fund, Investment
Management. This chapter covers the different styles of debt and equity management, the
securities in which debt and equity funds invest and the risks associated with these investments.
Section II. describes the different avenues available to the retail investor. There was a time when
Indian investors did not have many investment schemes to choose from. It was easy then for the
agents to simply point out the benefits of any currently available scheme to a prospective
investor. The investor then decided whether the schemes suited to his needs or not. Now, the
Indian mutual funds industry offers a wide choice of investment schemes, unlike ever before.
Different schemes are suited to different investor needs. In this scenario, an investor not only has
to choose from this variety of investment options available, but also design a proper investment
strategy that is suitable to his situation and needs. In this scenario an investor should develop the
right approach to investing, and avoid ad-hoc investment decisions. All this has been covered in
section II.
It explains in detail the concept of financial planning, the benefits and the steps in financial
planning. Asset Allocation, which is an important aspect of financial planning, has also been
explained in detail.
The final chapter talks about choosing a mutual fund scheme and investing in it, keeping in mind
the costs involved and the risks associated with it.
To summarize, as Jacobs puts it, mutual fund investing is not a get-rich-quick scheme.
Investors should have an Investment Program and ought to set their sights on long term goals, in
other words, investment decisions to be taken in terms of clear, long-term goals, not on an ad-hoc
basis.
Each investor should expect only realistic wealth accumulation goals, no dramatic result
overnight. For example, in the current Indian market conditions, investors can expect 20% plus
returns in equity investments, 11 or 12% returns in debt investments and 8 to 9% in money
market investment. These expectations can change over time. Specific investments or funds can
give greater return or less return, but higher returns will be in most cases achieved by investors or
their fund managers taking greater risks.

The History of Mutual Funds

Mutual funds came into existence for the 1 st time when three Boston securities executives pooled
their money together in 1924 to create the first mutual fund; they had no idea how popular mutual
funds would become.
The idea of pooling money together for investing purpose started in Europe in the mid-1800. The
first pooled fund in the U.S. was created in 1893 for the faculty and staff of Harvard University.
On March 21st, 1924 the first official mutual fund was born. It was called the Massachusetts
Investors Trust.
After one year, the Massachusetts Investors Trust grew from $50,000 in assets in 1924 to
$392,000 in assets (with around 200 shareholders). In contrast, there are over 10,000 mutual
funds in the U.S. today totaling around $7 trillion (with approximately 83 million individual
investors) according to the Investment Company Institute.
The stock market crash of 1929 slowed the growth of mutual funds. In response to the stock
market crash, Congress passed the Securities Act of 1933 and the Securities Exchange Act of
1934. These laws require that a fund be registered with the SEC and provide prospective
investors with a prospectus.
The SEC (U.S. Securities and Exchange Commission) helped create the Investment Company Act
of 1940 which provides the guidelines that all funds must comply with today.
With renewed confidence in the stock market, mutual funds began to blossom. By the end of the
1960's there were around 270 funds with $48 billion in assets.
In 1976, John C. Bogle opened the first retail index fund called the First Index Investment Trust.
It is now called the Vanguard 500 Index fund and is the largest mutual fund with over $100
billion in assets.
One of the largest contributors of mutual fund growth was the birth of the Individual Retirement
Account (IRA) in 1981. Mutual funds are now popular in employer-sponsored defined
contribution retirement plans (401k's for example), IRA's and Roth IRA's.
Mutual funds are very popular today, known for ease-of-use, liquidity, and unique diversification
capabilities.

Structure of the Indian mutual fund industry

The Indian mutual fund industry is dominated by the Unit Trust of India which has a total corpus
of Rs700bn collected from more than 20 million investors. The UTI has many schemes in all
categories i.e. equity, balanced, income etc with some being open-ended and some being closedended. The Unit Scheme 1964 commonly referred to as US 64, which is a balanced fund, is the

biggest scheme with a corpus of about Rs200bn. UTI was floated by financial institutions and is
governed by a special act of Parliament. Most of its investors believe that the UTI is government
owned and controlled, which, while legally incorrect, is true for all practical purposes.
The second largest category of mutual funds is the ones floated by the private sector and by
foreign asset management companies. The largest of these are Prudential ICICI AMC and
Birla Sun Life AMC. The aggregate corpus of assets managed by this category of AMCs is in
excess of Rs250bn
The third largest category of mutual funds is the ones floated by nationalized banks. Canbank
Asset Management floated by Canara Bank and SBI Funds Management floated by the State
Bank of India are the largest of these. GIC AMC floated by General Insurance Corporation and
Jeevan Bima Sahayog AMC floated by the LIC are some of the other prominent ones. The
aggregate corpus of funds managed by this category of AMCs is about Rs150bn.

The Changing Face of Indian Mutual Fund Industry

Pvt. Se ctor
28%

Pvt. Sector
38%

UTI
65%

Institutions
& Bank
Sponsore d
7%

UTI
54%
Institutions
& Bank
Sponsored
8%

Total Assets 99,000 crs as on Dec 31, 2000

Total Assets 92,000 crs as on September 30,2001

Recent trends in mutual fund industry

The most important trend in the mutual fund industry has been the aggressive expansion of the
foreign owned mutual fund companies and the decline of the companies floated by nationalized
banks and smaller private sector players.
Many nationalized banks got into the mutual fund business in the early nineties and got off to a
good start due to the stock market boom prevailing then. These banks did not really understand
the mutual fund business and they just viewed it as another kind of banking activity. Few hired
specialized staff and generally chose to transfer staff from the parent organizations. The
performance of most of the schemes floated by these funds was not good. Some schemes had
offered guaranteed returns and their parent organizations had to bail out these AMCs by paying
large amounts of money as the difference between the guaranteed and actual returns. The service

levels were also very bad. Most of these AMCs have not been able to retain staff, float new
schemes etc. and it is doubtful whether, barring a few exceptions; they have serious plans of
continuing the activity in a major way.
The experience of some of the AMCs floated by private sector Indian companies was also very
similar. They quickly realized that the AMC business is a business, which makes money in the
long term and requires deep-pocketed support in the intermediate years. Some have sold out to
foreign owned companies; some have merged with others and their general restructuring going
on.
The foreign owned companies have deep pockets and have come in here with the expectation of a
long haul. They can be credited with introducing many new practices such as new product
innovation, sharp improvement in service standards and disclosure, usage of technology, broker
education and support etc. In fact, they have forced the industry to upgrade itself and service
levels of organizations like UTI have improved dramatically in the last few years in response to
the competition provided by these.
Mutual Funds in India (1964-2000)
The end of millennium marks 36 years of existence of mutual funds in this country. The ride
through these 36 years is not been smooth. Investor opinion is still divided, while some are for
mutual funds others are against it.
UTI commenced its operations from July 1964 .The impetus for establishing a formal institution
came from the desire to increase the propensity of the middle and lower groups to save and to
invest. UTI came into existence during a period marked by great political and economic
uncertainty in India. With war on the borders and economic turmoil that depressed the financial
market, entrepreneurs were hesitant to enter capital market. The already existing companies found
it difficult to raise fresh capital, as investors did not respond adequately to new issues. Earnest
efforts were required to canalize savings of the community into productive uses in order to speed
up the process of industrial growth.
The then Finance Minister, T.T. Krishnamachari set up the idea of a unit trust that would be
"open to any person or institution to purchase the units offered by the trust. However, this
institution, is intended to cater to the needs of individual investors, and even among them as far as
possible, to those whose means are small."
Mr. T.T. Krishnamachari ideas took the form of the Unit Trust of India, an intermediary that
would help fulfill the twin objectives of mobilizing retail savings and investing those savings in
the capital market and passing on the benefits so accrued to the small investors.
UTI commenced its operations from July 1964 "with a view to encouraging savings and
investment and participation in the income, profits and gains accruing to the Corporation from the
acquisition, holding, management and disposal of securities." Different provisions of the UTI Act
laid down the structure of management, scope of business, powers and functions of the Trust as
well as accounting, disclosures and regulatory requirements for the Trust.
One thing is certain the fund industry is here to stay. The industry was one-entity show till 1986
when the UTI monopoly was broken when SBI and Canbank mutual fund entered the arena. This
was followed by the entry of others like BOI, LIC, GIC, etc. sponsored by public sector banks.

10

Starting with an asset base of Rs0.25bn in 1964 the industry has grown at a compounded average
growth rate of 26.34% to its current size of Rs1130bn.
The period 1986-1993 can be termed as the period of public sector mutual funds. From one player
in 1985 the number increased to 8 in 1993. The party did not last long. When the private sector
made its debut in 1993-94, the stock market was booming.
The opening up of the asset management business to private sector in 1993 saw international
players like Morgan Stanley, Jardine Fleming, JP Morgan, George Soros and Capital
International along with the host of domestic players join the party. But for the equity funds, the
period of 1994-96 was one of the worst in the history of Indian Mutual Funds.
1999-2000 Year of the funds
Mutual funds have been around for a long period of time to be precise for 36 yrs. but the year
1999 saw immense future potential and developments in this sector. This year signaled the year
of resurgence of mutual funds and the regaining of investor confidence in these mutual funds.
This time around all the participants are involved in the revival of the funds ----- the AMCs, the
unit holders, the other related parties. However the sole factor that gave lift to the revival of the
funds was the Union Budget. The budget brought about a large number of changes in one stroke.
It provided center stage to the mutual funds, made them more attractive and provides
acceptability among the investors. The Union Budget exempted mutual fund dividend given out
by equity-oriented schemes from tax, both at the hands of the investor as well as the mutual fund.
No longer were the mutual funds interested in selling the concept of mutual funds they wanted to
talk business which would mean to increase asset base, and to get asset base and investor base
they had to be fully armed with a whole lot of schemes for every investor. So new schemes for
new IPOs were inevitable. The quest to attract investors extended beyond just new schemes. The
funds started to regulate themselves and were all out on winning the trust and confidence of the
investors under the aegis of the Association of Mutual Funds of India (AMFI)
One can say that the industry is moving from infancy to adolescence, the industry is maturing and
the investors and funds are frankly and openly discussing difficulties, opportunities and
compulsions.
Future Scenario
The mutual fund (MF) industry has been one of the fastest growing financial sector, it has been
growing at a CAGR of 20- 25 per cent in the last ten years. As per AMFI chairman, Mr. A. P.
Kurian, the asset base is expected to grow at an annual rate of about 30 to 35 % over the next
few years as investors shift their assets from banks and other traditional avenues. The market is
expected to witness a flurry of new players entering the arena. Some big names like Fidelity,
Principal, Old Mutual etc. are looking at Indian market seriously. One important reason for it is
that most major players already have presence here and hence these big names would hardly like
to get left behind.
The industry is also having a profound impact on financial markets. The new generation of
private funds which have gained substantial mass are now seen flexing their muscles. Fund
managers, by their selection criteria for stocks have forced corporate governance on the industry.
By rewarding honest and transparent management with higher valuations, a system of risk-reward
has been created where the corporate sector is more transparent then before.

11

Mutual funds are now also competing with commercial banks in the race for retail investors
savings and corporate float money. The power shift towards mutual funds has become obvious.
The coming few years will show that the traditional saving avenues are losing out in the current
scenario. Many investors are realizing that investments in savings accounts are as good as locking
up their deposits in a closet.
India is at the first stage of a revolution that has already peaked in the U.S. The U.S. boasts of an
asset base of mutual funds that is much higher than its bank deposits. In India, mutual fund assets
are not even 10% of the bank deposits, but this trend is beginning to change. Mutual Funds are
going to change the way banks do business in the future.
The first phase - 1964 and 1987, when the only player was the Unit Trust of India, had a total
asset of Rs. 6,700/- crores at the end of 1988.
The second phase - 1987 and 1993, during this period 8 funds were established (6 by banks and
one each by LIC and GIC). At the end of 1994, the total assets under management had grown to
Rs. 61,028/- crores and numbers of schemes were 167.
Currently there are 34 Mutual Fund organisations in India managing over Rs. 92,000/- crores.
The mutual funds registered in India are
A) Unit Trust of India
B) Bank sponsored
a. BOB Asset Management Co. Ltd.
b. BOI Asset Management Co. Ltd.
c. Canbank Investment Management Services Ltd.
d. PNB Asset Management Co. Ltd.
e. SBI Funds Management Ltd.
f. Indfund Management Ltd.
C) Institutions
a. GIC Asset Management Co. Ltd.
b. IDBI Principal Asset Management Co. Ltd.
c. IL & FS Asset Management Co. Ltd.
d. Jeevan Bima Sahayog Asset Management Co. Ltd.
D) Private Sector
1. Indian
a. BenchMark Asset Management Co. Ltd.
b. Kotak Mahindra Asset Management Co. Ltd.
c. Shriram Asset Management Co. Ltd.
d. Reliance Capital Asset Management Ltd.
e. J.M. Capital Management Ltd.
f. Escorts Asset Management Ltd.
2. Joint Ventures - Predominantly Indian
a. Birla Sun Life Asset Management Pvt. Co. Ltd.

12

b.
c.
d.
e.
f.
g.
h.
i.

Cholamandalam Cazenove Asset Management Co. Ltd.

DSP Merrill Lynch Investment Managers (India) Ltd.
First India Asset Management Private Ltd.
HDFC Asset Management Company Ltd.
Sundaram Newton Asset Management Company
Pioneer ITI AMC Ltd.
Tata TD Waterhouse Asset Management Private Ltd.
Credit Capital Asset Management Co. Ltd.

3. Joint Ventures - Predominantly Foreign

a. Alliance Capital Asset Management (India) Pvt. Ltd.
b. Standard Chartered Asset Mgmt Co. Pvt. Ltd.
c. Dundee Investment Management & Research (Pvt.) Ltd.
d. ING Investment Management (India) Pvt. Ltd.
e. JF Asset Management (India) Pvt. Ltd.
f. Morgan Stanley Investment Management Pvt. Ltd.
g. Prudential ICICI Management Co. Ltd.
h. Sun F & C Asset Management (I) Pvt. Ltd.
i. Templeton Asset Management (India) Pvt. Ltd.
j. Zurich Asset Mgmt. Company(I) Pvt. Ltd.

13

Concept of a Mutual Fund

A Mutual Fund is a trust that pools the savings of a number of investors who share a common
financial goal. The money thus collected is invested by the fund manager in different types of
securities depending upon the objective of the scheme. These could range from shares to
debentures to money market instruments. The income earned through these investments and the
capital appreciation realized by the scheme are shared by its unit holders in proportion to the
number of units owned by them (pro rata). Thus a Mutual Fund is the most suitable investment
for the common man as it offers an opportunity to invest in a diversified, professionally managed
portfolio at a relatively low cost. Anybody with an investible surplus of as little as a few thousand
rupees can invest in Mutual Funds. Each Mutual Fund scheme has a defined investment objective
and strategy.
A mutual fund is the ideal investment vehicle for todays complex and modern financial scenario.
Markets for equity shares, bonds and other fixed income instruments, real estate, derivatives and
other assets have become mature and information driven. Price changes in these assets are driven
by global events occurring in faraway places. A typical individual is unlikely to have the
knowledge, skills, inclination and time to keep track of events, understand their implications and
act speedily. An individual also finds it difficult to keep track of ownership of his assets,
investments, brokerage dues and bank transactions etc.
A mutual fund is the answer to all these situations. It appoints professionally qualified and
experienced staff that manages each of these functions on a full time basis. The large pool of
money collected in the fund allows it to hire such staff at a very low cost to each investor. In
effect, the mutual fund vehicle exploits economies of scale in all three areas - research,
investments and transaction processing. While the concept of individuals coming together to
invest money collectively is not new, the mutual fund in its present form is a 20th century
phenomenon. In fact, mutual funds gained popularity only after the Second World War. Globally,
there are thousands of firms offering tens of thousands of mutual funds with different investment
objectives. Today, mutual funds collectively manage almost as much as or more money as
compared to banks.

Benefits of Investing in Mutual Funds

If mutual funds are emerging as the favorite investment vehicle it is because of the many
advantages they have over other forms and avenues of investing. The following are the major
advantages offered by mutual funds to all investors.
Diversification
The first principle of mutual fund investing is broad diversification of securities. For nearly all
investors, cost alone generally recludes achieving adequate diversification without using
mutual funds.

14

For example, if an investor had Rs. 50,000 to invest and he was keen on acquiring stocks like
Bajaj Auto, Hindustan Lever or Infosys, he would be unable to purchase even 100 shares (the
market lot) of any of these companies. While investing through a mutual fund could make him a
part owner of all these stocks with an investment of as low as Rs 1,000.
Professional Management
A mutual fund is managed by skilled, experienced professionals who are judged by the total
returns they generate over time. As an individual investor, one may not be in a position to keep
track of the performance of various companies. A fund manager, on the other hand, has access to
extensive research inputs both from its own research analysts as well as reputed broking firms.
Liquidity
In many cases, mutual funds offer more liquidity than individual stocks or bonds. Large amounts
of money can be invested or redeemed at a price based on the funds net asset value
(NAV). Further, money can be efficiently switched between, say, a stock and a money
market fund at little or no cost.
Convenience
Mutual fund investment provides simplicity and convenience. On every purchase or redemption,
an investor receives an Account Statement similar to a bank statement. An investor avails of
features like reinvestment of dividends, tax reporting, switches, systematic investment and
withdrawal and cheque writing on money market funds. Moreover, an investor is not required to
physically take delivery of securities, so problems of bad delivery, theft or loss in transit are
minimised.
Tax Benefits
There are several tax benefits available for investors in a mutual fund. A detailed explanation is
provided in the ensuing report.

Constitution of a Mutual Fund

Mutual Funds have a unique structure not shared with other entities such as companies or firms.
The structure of the firm determines the rights and responsibilities of the fund constituents viz.
Sponsors, trustees, custodian, transfer agents and the asset management company. The legal
structure also drives the inter relationships between these constituents.
Mutual Fund Structure in USA & UK
In the USA, the mutual funds are set up as the fund sponsors. An investment company may be
a corporation, partnership or a unit investment trust. The Investment Company in turn appoints a
management company, which may be either closed end Management Company or open end
Management Company. Only open-end management companies are technically called mutual
funds in the USA.
The constituents of mutual funds in the USA are the Management Company, underwriter,
management group and custodian. The Management Company is the equivalent in India of an
Asset Management Companies. Underwriter of a fund is the distributor or the marketing
15

company that sells the shares to brokers or to the public. A management group is a family of
management companies owned by a group of people or a corporation. Custodian is the entity that
holds the funds assets on behalf of the Management Company.
In the UK, mutual funds have two alternative structures. Open-end funds are in the form of unit
trusts, while closed end funds are in the form of corporate entities although called investment
trusts. Separate regulatory mechanism exists for both types of entities. The Securities and
Investments Board regulate unit trusts. Also they must be authorized by the relevant Self
regulatory Organizations. Investment trusts are structured as companies and provisions of the
companies act are applicable to them.
Structure of Mutual Funds in India
Like other countries, India has a legal framework within which mutual funds must be constituted.
Unlike in the UK, where distinct trust and corporate/ approaches are followed with separate
regulation, in India, open and closed end funds operate under the same regulatory structure. There
is one unique structure as unit trusts. A mutual fund in India is allowed to issue open end and
closed end schemes under a common legal structure. The structure which is required to be
followed by mutual funds in India is laid down under SEBI (Mutual Fund) Regulations, 1996.
The structure of each of the fund constituents is explained below,
The Fund Sponsor
Sponsor is defined under SEBI regulation as nay person who, acting alone or in combination
with another body corporate, establishes a mutual fund. The sponsor of a fund is akin to the
promoter of a company as he gets the fund registered with SEBI. The sponsor will form a Trust
and appoint a Board of Trustees. The sponsor will also generally appoint an Asset Management
Company as fund managers. The sponsor, either directly ar acting through the Trustees, will also
appoint a Custodian to hold the fund assets. All these appointments are made in accordance with
SEBI Regulations.
Mutual Funds as Trusts
A mutual fund in India is constituted in the form of Public Trust created under the Indian Trusts
Act, 1882, The Fund Sponsor acts as the Settlor of the Trust, Contributing to its initial capital and
appoints a Trustee to hold the assets of the Trust for the benefit of the unit-holders, who are the
beneficiaries of the Trust. The fund then invites investors to contribute their money in the
common pool, by subscribing to units issued by various schemes established by the trust as
evidence of their beneficial interest in the fund.
It should be understood that a mutual fund is just a pass-through, rather it is the Trustee or
Trustees who have the legal capacity and therefore all acts in relation to the trust are taken on its
behalf by the Trustees. The trustees hold the unit-holders money in a fiduciary capacity.
Trustees
A mutual fund is governed by trustees. The trustees have oversight responsibility for the
management of the fund's business affairs and safeguarding the interest of the unitholders. The
trustees are expected to exercise sound business judgement and keep a watchful eye on the
functioning of the asset management company. As per the Securities and Exchange Board of
16

India (SEBI) regulations, at least half of the board of trustees shall consist of independent
persons, who are not affiliated with the asset management company or any of its affiliates.
The Asset Management Company
An AMC is involved in the daily administration of the mutual fund and also acts as investment
advisor for the fund. An Asset Management Company is promoted by a sponsor, which usually is
a, reputed corporate entity with sound track record of profitability.
An AMC typically has three departments:
A) Fund Management comprises of fund managers, research analysts and dealers
B) Sales & Marketing which is involved in generating sales through brokers, agents and financial
planners.
C) Operations & Accounting oversees back office and operational activities. It consists of fund
accountants and compliance officer.
The other fund constituents are
Custodians and Depositories
Mutual funds are required by law to protect their portfolio securities by placing them with a
independent third party as custodian, typically a bank or trust company. The custodian also
handles payments and receipts for the funds security transactions
Bankers
A funds activities involve dealing with money on a continuous basis primarily with respect to
buying and selling units, paying for investments made, receiving the proceed on sale of
investments and discharing its obligations towards operating expenses. A funds bankers
therefore play a crucial role with respect to its financial dealings by holding its bank accounts and
providing it with remittance services.
Transfer Agents
A share transfer agent is employed by the AMC on behalf of the mutual fund to conduct record
keeping and related functions. Share transfer agent maintains records of unitholder accounts,
prepares and mails account statements confirming transactions and account balances. It also
maintains customer service departments (termed as "Investor Service Centres" or ISCs) at main
cities and towns to facilitate daily purchases and redemptions by investors.
Distributors
Mutual fund operate as collective investment vehicles, on the principle of accumulating funds
from a large number of investors and then investing on a big scale. For a fund to sell units across
a wide retail base of individual investors, an established network of distribution agents is essential
AMC, usually appoint Distributors or Brokers, who sell units on behalf of the fund.

17

A draft offer document is to be prepared at the time of launching the fund. Typically, it pre
specifies the investment objectives of the fund, the risk associated, the costs involved in the
process and the broad rules for entry into and exit from the fund and other areas of operation. In
India, as in most countries, these sponsors need approval from a regulator, SEBI (Securities
exchange Board of India) in our case. SEBI looks at track records of the sponsor and its financial
strength in granting approval to the fund for commencing operations.
A sponsor then hires an asset management company to invest the funds according to the
investment objective. It also hires another entity to be the custodian of the assets of the fund and
perhaps a third one to handle the registrars work for the unit holders (subscribers) of the fund.
In the Indian context, the sponsors promote the Asset Management Company also, in which it
holds a majority stake. In many cases a sponsor can hold a 100% stake in the Asset Management
Company (AMC). E.g. Birla Global Finance is the sponsor of the Birla Sun Life Asset
Management Company Ltd., which has floated different mutual funds schemes and also acts as
an asset manager for the funds collected under the schemes.

Types of Mutual Funds

Mutual fund schemes may be classified on the basis of its structure and its investment objective.
On the basis of its structure they are classified as open ended, close ended and interval
schemes. Most schemes floated by AMCs are open-ended schemes as investors need liquidity
and these schemes allow investors to enter or exit any time.
Open-ended Funds
An open-end fund is one that is available for subscription all through the year. These do not have
a fixed maturity. Investors can conveniently buy and sell units at Net Asset Value ("NAV")
related prices. The key feature of open-end schemes is liquidity. In open-ended schemes investors
can enter and exit on any business day hence the corpus of the schemes is not fixed and keeps
fluctuating.
Closed-ended Funds
A closed-end fund has a stipulated maturity period which generally ranging from 3 to 15 years.
The fund is open for subscription only during a specified period. The corpus of the scheme is
fixed. Investors can invest in the scheme only at the time of the initial public issue and thereafter
they can buy or sell the units of the scheme on the stock exchanges where they are listed. In order
to provide an exit route to the investors, some close-ended funds give an option of selling back
the units to the Mutual Fund through periodic repurchase at NAV related prices. SEBI
Regulations stipulate that at least one of the two exit routes is provided to the investor. A closedended fund has two prices; the NAV and the exchange price.
Interval Funds
Interval funds combine the features of open-ended and close-ended schemes. They are open for
sale or redemption during pre-determined intervals at NAV related prices. However interval
funds are not very popular.

18

On the basis of investment objective they are classified as growth, income or balanced schemes
Growth Funds
The aim of growth funds is to provide capital appreciation over the medium to long- term. Such
schemes normally invest majority of their corpus in equities. It has been proven that returns from
stocks, have outperformed most other kind of investments held over the long term. Growth
schemes are ideal for investors having a long-term outlook seeking growth over a period of time.
Income Fund
The aim of income funds is to provide regular and steady income to investors. Such schemes
generally invest in fixed income securities such as bonds, corporate debentures and Government
securities. Income Funds are ideal for capital stability and regular income.
Balanced Funds
The aim of balanced funds is to provide both growth and regular income. Such schemes
periodically distribute a part of their earning and invest both in equities and fixed income
securities in the proportion indicated in their offer documents. These are ideal for investors
looking for a combination of income and moderate growth. The advantage of investing in these
schemes that when equities are performing well the fund manager can increase his exposure in
equities and in a falling market he can increase his exposure in debt. Such a fund is ideal for
investors who do not desire high volatility.
Money Market Funds
The aim of money market funds is to provide easy liquidity, preservation of capital and moderate
income. These schemes generally invest in safer short-term instruments such as treasury bills,
certificates of deposit, commercial paper and inter-bank call money. Returns on these schemes
may fluctuate depending upon the interest rates prevailing in the market. These are ideal for
corporate and individual investors as a means to park their surplus funds for short periods.
Apart from the types of schemes mentioned above mutual fund schemes can be further classified
as follows,
Load Funds & No load Funds
Load Funds
Marketing of a mutual fund scheme involves initial expenses. These expenses may be recovered
from investors by the mutual fund in the form of load. The load is used to cover expenses
incurred on distribution, sales and marketing. Three ways in which load is charged is
Entry Load: This is charged at the time the investor enters into the fund by deducting a specified
amount from his initial contribution.
Exit Load: This is charged at the time the investor redeems from the fund by deducting a
specified amount from his redemption proceeds.

19

Deferred sales load: This amount is charged by the scheme over a period of time.
It could be worth paying the load, if the fund has a good performance history.
No-Load Funds
A No-Load Fund is one that does not charge a commission for entry or exit. That is, no charge is
payable on purchase or sale of units in the fund. The advantage of a no load fund is that the entire
corpus is put to work.
Tax Saving Schemes
These schemes offer tax rebates to the investors under specific provisions of the Indian Income
Tax laws as the Government offers tax incentives for investment in specified avenues.
Investments made in Equity Linked Savings Schemes (ELSS) and Pension Schemes are allowed
as deduction u/s 88 of the Income Tax Act, 1961. The Act also provided opportunities to
investors to save capital gains u/s 54EA and 54EB by investing in Mutual Funds, provided the
capital asset had been sold prior to April 1, 2000 and the amount was invested before September
30, 2000.
Special Schemes
Industry Specific Schemes
Industry Specific Schemes invest only in the industries specified in the offer document. The
investment of these funds is limited to specific industries like InfoTech, FMCG, Pharmaceuticals
etc.
Index Schemes
Index Funds attempt to replicate the performance of a particular index such as the BSE Sensex or
the NSE 50
Sectoral Schemes
Sectoral Funds are those, which invest exclusively in a specified industry or a group of industries
or various segments such as 'A' Group shares or initial public offerings.
Assets Under Managment Under Different Types
OF Schemes As On September 30, 2001

Money
Market
10%

Gilt
4%

Balanced
17%

ELSS
2%
Income
56%

Equity
11%

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The Regulatory framework of Mutual Funds in India

SEBI The Capital Markets Regulator
The Government of India constituted Securities and Exchange Board of India, by an act of
Parliament in 1992, as the apex regulator of all entities that either raise funds in the capital
markets or invest in capital market securities such as shares and debentures listed on stock
exchanges. It was formed to protect the interests of investors in securities and to promote the
development of, and to regulate the securities market and for matters connected therewith or
incidental thereto.
Mutual funds have emerged as an important institutional investor in capital markets securities.
Hence they come under the purview of SEBI. SEBI requires all mutual funds to be registered
with them. It issues guidelines for all mutual fund operations, including where they can invest,
what investment limits and restrictions must be complied with, how they should account for
income and expenses, how they should make disclosures of information to the investors and
generally acts in the interest of investor protection.
SEBI (MUTUAL FUNDS) REGULATIONS, 1996
A comprehensive set of regulations for all mutual funds has been accomplished with SEBI
(Mutual Fund) regulations 1996. These regulations set uniform standards for all funds and will
eventually be applied in full to Unit Trust of India as well, even though UTI is governed by its
own UTI Act. The regulation governing Mutual funds are as follows,
Registration of the Fund
The regulations lay down the procedure of registration for the Fund with the SEBI board. For the
purpose of grant of a certificate of registration, the applicant has to fulfil the following, namely:

the sponsor should have a sound track record and general reputation of fairness and integrity
in all his business transactions;
in the case of an existing mutual fund, such fund is in the form of as trust and the trust deed
has been approved by the Board;
the sponsor has contributed or contributes atleast 40% to the networth of the asset
management company.
the sponsor or any of its directors or the principle officer to be employed by the mutual fund
should not have been guilty of fraud or has not been convicted of an offence involving moral
turpitude or has not been found guilty of any economic offence:
appointment of trustees to act as trustees for the mutual fund in accordance with the
provisions of the regulations;

21

appointment of asset management company to manage the mutual fund and operate the
scheme of such funds in accordance with the provisions of these regulations;
appointment of a custodian in order to keep custody of the securities and carry out the
custodian activities as may be authorised by the trustees.

Constitution and Management of Mutual Fund and Operation of Trustees

A mutual fund is constituted in the form of a trust and the instrument of trust is a deed, the same
has to be registered under the provision of the Indian Registration Act. It lays down the contents
of the trust deed. The trust deed shall contain such clauses as are necessary for safeguarding the
interests of the unit holders. A mutual fund shall appoint trustees in accordance with these
regulations. The mutual fund will ensure that only people of ability, integrity and standing; and
who has not been found guilty of moral turpitude; and has not been convicted of any economic
offence or violation of any securities laws. An asset management company or any of its officers
or employees shall not be eligible to act as a trustee of any mutual fund.
Rights & Obligations of Trustees

The trustees and the asset management company shall with the prior approval of the Board
enter into an investment management agreement.
The trustees shall have a right to obtain from the asset management company such
information as is considered necessary by the trustee.
The trustees shall ensure before the launch of any scheme that the asset management
company has;- (a) systems in place for its back office, dealing room and accounting;
(b) appointed all key personnel including fund manager (s) for the scheme(s) and submitted
their bio-data which shall contain the educational qualifications, past experience in the
securities market with the trustee, 15 days of their appointment;
(c) appointed auditors to audit its accounts;
(d) appointed compliance officer to comply with regulatory requirement and to redress
investor grievances;
(e) appointed registrars and laid down parameters for their supervision;
(f) prepared compliance manual and designed internal control mechanisms including internal
audit systems;
(g) specified norms for empanelment of brokers and marketing agents.
The trustee shall ensure that the asset management company has not given any undue or
unfair advantage to any associates or dealt with any of the associates of the asset management
company in any manner detrimental to interest of the unitholders.
The trustee shall ensure that the transactions entered into by the asset management company
are in accordance with these regulations and the scheme.
The trustees shall ensure that all the activities of the asset management company are in
accordance with the provision of these regulations.
The trustees shall be accountable for, and be the custodian of, the funds and property of the
respective scheme and shall hold the same in trust for the benefit of the unit holders in
accordance with these regulations and the provisions of trust deed.
The trustees shall periodically review the investor complaints received and the redressal of
the same by the asset management company.

Constitution and Management of Asset Management Company and Custodian

22

The sponsor or, if so authorised by the trust deed, the trustee shall, appoint an asset
management company.
Majority of the trustees or seventy five per cent of the unitholders of the scheme can
terminate the appointment of an asset management company.
Any change in the appointment of the asset management company shall be subject to prior
approval of the Board and the unitholders.

Eligibility criteria for appointment of asset management company: For grant of approval of the
asset management company the applicant has to fulfil the following: in case the asset management company is an existing asset management company it has a
sound track record, general reputation and fairness in transactions
the directors of the asset management company are persons having adequate professional
experience in finance and financial services related field and not found guilty of moral
turpitude or convicted of any economic offence or violation of any securities laws;
the asset management company has a networth of not less than rupees ten crores:
Restriction on business activities of the management company: The asset management company
shall
not act as a trustee of any mutual fund;
not undertake any other business activities except activities in the nature of management and
advisory services to offshore funds, pension funds, provident funds, venture capital funds,
management of insurance funds, financial consultancy and exchange of research on
commercial basis if any of such activities are not in conflict with the activities of the mutual
fund;
the asset management company shall not invest in any of its scheme unless full disclosure of
its intention to invest has been made in the offer documents.
Asset Management Company and its obligations:

The asset management company shall take all reasonable steps and exercise due diligence to
ensure that the investment of funds pertaining of these regulations and the trust deed.
The asset management company shall exercise due diligence and care in all its investment
decision as would be exercised by other persons engaged in the same business.
The asset management company shall submit to the trustees quarterly reports of each year on
its activities and the compliance with these regulations.
In case the asset management company enters into any securities transactions with any of its
associates a report to that effect shall immediately be sent to the trustees.
The asset management company shall not appoint any person as key personnel who has been
found guilty of any economic offence or involved in violation of securities laws.
The asset management company shall appoint registrars and share transfer agents who are
registered with the Board.
The asset management company shall abide by the Code of Conduct as specified in the Fifth
Schedule.
Schemes of Mutual Fund

23

Procedure for launching of schemes: the asset management company shall launch no scheme
unless the trustees approve such scheme and a copy of the offer document has been filed with the
Board.
Disclosures in the offer document: The offer document shall contain disclosures, which are
adequate in order to enable the investors to make informed investment decision.
Advertisement material: Advertisements in respect of every scheme shall be in conformity with
the Advertisement Code: The offer document and advertisement materials shall not be misleading
or contain any statement or opinion, which are incorrect or false.
Investment Objectives and Valuation Policies
Investment objective:
The moneys collected under any scheme of a mutual fund shall be invested only in
transferable securities in the money market or in the capital market or in privately placed
debentures or securities debts.
The mutual fund shall not borrow except to meet temporary liquidity needs of the mutual
funds for the purpose of repurchase or redemption of units or payment of interest or dividend
to the unit holders.
The mutual fund shall not advance any loans for any purpose or for options trading.
Method of valuation of investments:

Every mutual fund shall compute and carry out valuation of its investments in its portfolio
and published the same in accordance with the valuation norms.

General Obligations

To maintain proper books of accounts and records, etc.

Limitation on fees and expenses on issue of schemes and annual charges.

Advertisement Code

An advertisement shall be truthful, fair and clear and shall not contain a statement, promise or
forecast which is untrue or misleading.
The advertisement shall not be so designed in content and format or in print as to be likely to
be misunderstood, or likely to disguise the significance of any statement. Advertisements
shall not contain statements, which directly or by implication or by omission may mislead the
investor.
Advertisements shall not be so framed as to exploit the lack of experience or knowledge of
the investors. As the investors may not be sophisticated in legal or financial matters, care
should be taken that the advertisement is set forth in a clear, concise, and understandable
manner. Extensive use of technical or legal terminology or complex language and the
inclusion of excessive details, which may detract the investors, should be avoided.

Code of Conduct

Mutual fund schemes should not be organised, operated, managed or the portfolio of
securities selected, in the interest of sponsors, directors of asset management companies,

24

members of Board of trustees or directors of trustee company, associated person or in the

interest of special class of unitholders rather than in the interest of all classes of unitholders of
the scheme.
Trustees and asset management companies must ensure the dissemination to all unitholders of
adequate, accurate, explicit and timely information fairly presented in a simple language
about the investment policies, investment objectives, financial position and general affairs of
the scheme.
Trustees and asset management companies should excessive concentration of business with
broking firms, affiliates and also excessive holding of units in a scheme among a few
investors.
Trustees and asset management companies must avoid conflicts of interest in managing the
affairs of the scheme and keep the interest of all unitholders paramount in all matters.
Trustees and asset management companies must ensure schemewise segregation of cash and
securities accounts.
Trustees and asset management companies shall carry out the business and invest in
accordance with the investment objectives stated in the offer documents and take investment
decision solely in the interest of unitholders.
Trustees and asset management companies must not use any unethical means to sell, market
or induce any investor to buy their schemes.

Miscellaneous
Power of the Board to issue clarifications: In order to remove any difficulties in the application or
interpretation of these regulations, the Board shall have the power to issue clarifications and
guidelines in the form of notes or circulars which shall be binding on the sponsor, mutual funds,
trustees, asset management companies and custodians.
The SEBI (Mutual Funds) Regulations 1996 also lays down regulations pertaining to appointment
of custodian, listing of close ended schemes, repurchase of close ended schemes, allotment of
units, refunds of moneys, transfer of units, contents of trust deed and asset management
agreement, pricing of units, inspection and audit and winding up of the scheme.

25

Valuation and Taxation

Net Asset Value
Net Asset Value refers to the price at which a mutual fund investor purchases or redeems units of
a scheme.
Mutual Funds value their investments on a mark to mark basis with reference to the date on
which they are valued i.e. valuation date. For e.g. if the fund announces its NAV every day, it
will have to value its portfolio daily. The norms of valuation are laid down in SEBI (Mutual
Fund) Regulations 1996.
The most important part of the NAV calculation is the valuation of the assets owned by the fund.
Once it is calculated, the NAV is simply the net value of assets divided by the number of units
outstanding.
The detailed methodology for the calculation of the asset value is given below.
Asset value is equal to
Sum of market value of shares/debentures
+ Liquid assets/cash held, if any
+ Dividends/interest accrued
+ Amount due on unpaid assets
+ Expenses accrued but not paid
Valuation of Traded Securities
When a security is traded on a stock exchange, its valuation is done on the basis of the last quoted
closing price on the principal exchange where the security is traded.
If the security is not traded on the stock exchange on a particular day the value at which it was
last traded on the stock exchange on the earliest previous day may be used, provided such date
was not more than 60 days prior to valuation day.
Valuation of Non traded Securities
When a security is not traded on any stock exchange for 60 days prior to valuation day, it must be
treated as Non traded security.
Non traded Securities are valued in good faith by the AMC on the basis of appropriate
valuation methods.
The following principals may be applied for valuation of Non traded securities

26

Equity Instruments: On the basis of capitalization of earnings solely or in combination with its
balance sheets Net Asset Value.
Debt Instruments: On a yield to maturity basis, the capitalization factor being determined for
comparable traded securities with an n appropriate discount for lower liquidity.
Interest is payable on debentures/bonds on a periodic basis say every 6 months. But, with every
passing day, interest is said to be accrued, at the daily interest rate, which is calculated by
dividing the periodic interest payment with the number of days in each period. Thus, accrued
interest on a particular day is equal to the daily interest rate multiplied by the number of days
since the last interest payment date. As a result the interest is reflected in the Net Asset Value of
the fund on a daily basis.
The value of fixed interest bearing securities moves in a direction opposite to interest rate
changes. Valuation of debentures and bonds is a big problem since most of them are unlisted and
thinly traded. This gives considerable leeway to the Mutual Funds on valuation and some of the
Mutual Funds are believed to take advantage of this and adopt flexible valuation policies
depending on the situation.
Taxation
Mutual funds of all types serve as an important savings tool in two ways: directly, by investing
in them, and indirectly, by offering you various tax benefits.
These tax advantages provided by investing in a mutual fund also give it an edge over certain
comparable investments.
The following is a general description of the tax laws in effect as of the date. Tax laws may
change in the future and the applicability of these laws may vary from person to person,
depending on each particular circumstance.
Tax benefits to the Mutual Fund

Under Section 10(23D), Income including Capital Gains earned by Mutual Funds are exempt
from tax.

Tax benefits to the investors

Under Section 10(33), Dividends declared by Mutual Funds are tax-free in the hands of the
investor. Schemes investing 50% or more in equities are exempt from distribution tax. Other
schemes are liable to 20% dividend distribution tax plus surcharge.
Under Section 2(42A), A unit of a mutual fund is treated as a long term capital asset if held
for more than one year.
Under Section 112, capital gains chargable on transfer of long term capital assets are will be
taxed @ 20% after indexation or @ 10% of capital gains, whichever is lower.
Under Section 194K & 196A, No Tax is deducted at source for income distributed by mutual
funds.

27

Under Section 88, subscriptions upto Rs. 10,000/- made in an equity linked saving scheme of
a mutual fund will be eligible for 20% rebate.
Short term / Long term Capital Gains and losses can be offset against each other.

Example:
Assuming if Rs.1000 was invested in a mutual fund for at least one year, Rs.200 would be the
taxable capital gains before adjusting for indexation,
(a) Purchase price of a unit:

Rs.1000

(b) You sell it after one year at:

Rs.1200

(c) Capital gains before indexation:

(c ) - (a)
= Rs.1200 - Rs.1000
= Rs.200

(e) Indexation benefit for one year

(assuming indexation factor of the FY @ 8.5% of Rs.1000)= Rs.85

(f) Your capital gains after indexation reduce to:

(d) - (e)
= Rs.200 - Rs.85
= Rs.115

(g) And your capital gains tax is: 20% of Rs.115 = Rs.23
Without indexation, the capital gains tax would have been computed at 20% of Rs. 200, which is
Rs.40. After indexation, as shown in the example above, the effective tax rate is reduced to 11.5%
(23/200 X 100).
However this is still higher than 10%. Hence an investor may choose to pay 10% of 200 which is
20.
Indexation benefit helps an investor if the holding period is longer. As he gets indexation benefit
for all the years of his holding the investment.

28

Investment Management
One foundation on which a mutual fund is built is the portfolio management skills. The
performance of the fund, the returns produced for the investor are accounted for largely by
success in the portfolio management function.

Equity Portfolio Management

A Review of the Indian Equity Market
Mutual fund managers generally invest only in market-traded stocks. Even then, the Indian fund
manager has a vast universe of shares available to him for investment. As of 1999 year-end,
major Indian stock exchanges had over 6400 shares listed. The market capitalization of all listed
stocks now exceeds Rs. 700,000 crores and often approaches Rs. 10 lakh crores. There are a large
number of indices also available, from BSE 30-share index to S&P CNX 500 index. The number
of industries or sectors represented in various indices or in the listed category exceeds 50. Of
course, the number of actively traded stocks is smaller, but still exceeds 1500. BSE has 140 scrips
in its Specified Group A list, which are basically large-capitalization stocks. B 1 Group includes
over 1100 stocks, many of which are mid-cap companies. The rest of the B 2 Group includes over
4500 shares, largely low-capitalization. NSE has a special mid-cap index that includes selected 50
companies. A fund manger must review all these candidates to choose from.
Indian economy is going through a period of both rapid growth and rapid transformation. Thus,
the industries with growth prospects or the blue chip shares of yesterday are no longer certain to
continue to be in that category tomorrow. New sectors such as software or technology stocks
have emerged recently. In this process of rapid economic change, the stock selection task of an
active fund manager in India is by no means simple of limited.
An equity portfolio managers task consists of two major steps:
a) Constructing a portfolio of equity shares or equity linked instruments that is consistent with
the investment objective of the fund and
b) Managing or constantly rebalancing the portfolio to produce capital appreciation and earnings
that would reward the investors with superior returns.
Stock Selection
The equity portfolio manager has available to him a whole universe of equity shares and other
instruments such as preference shares warrants or convertible debentures issued by many
companies. Event within each category of equity instruments, shares of one company may be
very different in terms of their potential than shares of other companies. So, how does the fund
manager go about choosing from the different types of stocks, in order to construct his portfolio?
The general answer is that his choice of shares to be included in a funds portfolio must reflect
the investment objective of the fund. However, more specifically, the equity portfolio manager
will choose from a universe of investible shares in accordance with

29

a) The nature of the equity instrument, or a particular stocks unique characteristics, and
b) A Certain investment style or philosophy in the process of choosing.
Thus, you may see a mutual funds equity portfolio include shares of diverse companies.
However, in reality, the group of stocks selected will have certain unique characteristics, chosen
in accordance with the preferred investment style, such that the portfolio as a whole is consistent
with the schemes objectives. We will now, therefore, review how different stocks are classified
according to their characteristics. Later, we will explain two major investment styles. But first a
short review of the size of the Indian stock markets.
Types of Equity Instruments
Ordinary Shares
Ordinary shareholders are the owners of a company, and each share entitles the holder to
ownership privileges such as dividends declared by the company and voting rights at meetings.
Losses as well as profits are shared by the equity shareholders. Without any guaranteed income or
security, equity shares are as risk investment, bringing with them the potential for capital
appreciation in return for the additional risk that the investor undertakes in comparison to debt
instruments with guaranteed income.
Preference Shares
Unlike equity shares, preference shares entitle the holder to dividends at fixed rates subject to
availability of profits after tax. If preference shares are cumulative, unpaid dividends for years of
inadequate profits are paid in subsequent years. Preference shares do not entitle the holder to
ownership privileges such as voting rights at meetings.
Equity Warrants
These are long term rights that offer holders the right to purchase equity shares in a company at a
fixed price (usually higher that the current market price) within a specified period. Warrants are
in the nature of options on stocks.
Convertible Debentures
As the term suggests, these are fixed rate debt instruments that are converted into a specified
number of equity shares at the end of a specified period. For example, a company may issue 10%
convertible debentures for Rs. 100 each that would be converted into 5 equity shares after 2
years. i.e. a holder of one debenture at the time of issue would become a holder of 5 equity shares
in two years time. Some issuers retain the right to redeem convertible debentures prior to the
conversion date. Clearly, CDs are debt instruments until converted and become equity shares
later.
Equity Classes
Equity shares are generally classified on the basis of either the market capitalization or the
anticipated movement of company earnings. It is imperative for a fund manager to understand
these elements of stocks before he select them for inclusion in the portfolio.

30

Classification in terms of Market Capitalization

Market capitalization is equivalent to the current value of a company i.e. current market price
per share times the number of outstanding shares. There are Large Capitalization companies,
Mid-Cap companies and Small-Cap companies. Different schemes of a fund may define their
fund objective as a preference for Large or Mid or Small-Cap companies shares. Large Cap
shares are more liquid and hence easily tradable. Mid or Small Cap shares may be thought of as
having greater growth potential. The stock markets generally have different indices available to
track these different classes of shares.
Classification in terms of Anticipated Earnings
In terms of the anticipated earnings of companies, shares are generally classified on the basis of
their market price in relation to one of the following measures:

Price / Earnings Ratio is the price of a share divided by the earnings per share, and indicates
what the investors are willing to pay for the companys earning potential. Young and /or fast
growing companies usually have high P/E ratios. Established companies in mature industries
may have lower P/E ratios.
The P/E analysis is sometimes supplemented with ratios such as Market Price to Book Value
and Market Price to Cash Flow per share.

Dividend Yield for a stock is the ration of dividend paid per share to current market price.
Low P/E stocks usually have high dividend yields. In India, at least in the past, investors have
indicated a preference for the high dividend paying shares. What matters to fund managers is
the potential dividend yields based on earnings prospects.

Based on companies anticipated earnings and in the light of the investment management
experience the world over stocks are classified in the following groups:

Cyclical Stocks are shares of companies whose earnings are correlated with the sate of the
economy. Their earnings (and therefore, their share prices) tend to go up during upward
economic cycles and vice versa. Cement or Aluminum producers fall into this category, just
as an example. These companies may command relatively lower P/E ratios, and have higher
dividend payouts.

Growth Stocks are shares of companies whose earnings are expected to increase at rates that
exceed normal market levels. They tend to reinvest earnings and usually have high P/E ratios
and low dividend yields. Software or information technology company shares are an example
of this type. Fund managers try to identify the sectors or companies that have a high growth
potential.

Value Stocks are shares of companies in mature industries and are expected to yield low
growth in earnings. These companies may, however, have assets whose values have not been
recognized by investors in general. Fund mangers try to identify such currently under-valued
stocks that in their opinion can yield superior returns later. A cement company with a lot or
real estate and a company with good brand names are examples of potential value shares.

31

Approaches to Portfolio Management

Portfolio management styles may be passive or active. Under passive management, the fund
managers objective is to construct a portfolio that seeks to equal the return on a given equity
market index. An active manager seeks to give a better performance that the return on an index
(Please refer to the section on Benchmarking in Chapter 9 for a more detailed discussion of
passive and active portfolio management styles)
Passive Fund Management: Index Funds
There are mutual funds that offer Stock Index funds whose objective is to equal the return on a
selected market index. While the style of investment may be called passive, even in this case, the
fund manager has to make some decisions. For example, he can purchase all of the securities
forming part of the index in the same proportion as their share in the index. Alternatively, if the
index stocks are too many, he can purchase a statistically representative sample of stocks whose
combined total return will closely approximate that of the index. The choice of this sample is
important and can require some amount of research into the behavior of index stocks. Similarly,
the fund manager has to also rebalance the portfolio to remain in line with changes in the index
composition. Finally, the fund manager has to keep the fund expenses as low as possible, so that
investors get returns close to the index return. The investment style is passive only in the sense
that the fund manager does not have to go through the process of stock selection.
Active Fund Management
Two basic investment styles prevalent among mutual funds are Growth Investing and Value
Investing.
Growth vs. Value Investing: A Contrast in Styles
In the US equity market, style investing is used to provide insights into markets and the
performance of fund managers. In our equity market, we do not make such clean distinctions.
Most fund managers practice a combination of both a growth and a value style. However, an
investor should know about his fund manager and the style he employs as a means of
understanding performance.
Fund managers use different approaches in selecting stocks for their portfolios. These
approaches, also known as investment styles, play an important role in portfolio performance. By
knowing the management style of a particular fund, investors can have a good idea of how it will
perform under various market conditions.
Broadly speaking, there are two investment styles, growth and value. What distinguishes each
style is its emphasis. For growth managers, the key to identifying an attractive stock is earnings.
They look for companies that exhibit powerful earnings growth. For value managers, the key
factor is price. They look for stocks, which are cheap, or in other words trading below their
intrinsic value.

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Value Investing Bargain Hunters

A value-oriented style is akin to looking for a good bargain. Value investors buy stocks, which
are cheap relative to either, their industry or the overall market. Then, they wait for the market to
realize the stocks' full value.
A stock may be undervalued for a number of reasons. It may be in an out-of-favor sector, may
have disappointed investors by poor financial performance or just been overlooked. Value stocks
are recognized, among other things, by lower P/E multiples, low price-to-book ratios and higher
dividend yields. The success to value investing lies in the consensus view (i.e. the market) of the
stock improving and the stock being valued fully. The risk for value managers is the company
may continue to under perform and the price may not rise. The skill in value investing is timing
the change in the consensus. In other words, not buying the stock too early. Value investing can
also be thought of as a willingness to bet on a stock with business concerns while avoiding
market risks. Since, value investing focuses on stocks that are undervalued; there is limited
downside risk and unlimited upside potential. Value stocks are also generally considered to be
less volatile.
Growth Investing Concentrate on the product not the price
Growth investing is very different from the value-oriented investment style. Here, the emphasis is
on companies that have demonstrated substantial revenue or earnings growth. Growth investors
do not heed valuation measures.
Managers using the growth approach look for companies that have consistently increased their
earnings at above average rates. Since, earnings drive stock prices, growth investors invest in
stocks that are expected to have above average, sustainable growth in earnings. As a result,
growth stocks are recognized by higher P/E multiples. Since, growth investors invest with the
expectation of continued high or higher earnings growth, they are willing to tolerate the high P/Es
often arguing that earnings growth will continue to dilute the P/E ratio. Growth stocks with high
valuations, it is believed, could experience higher price fluctuations. However, a growth investor
protects himself against such a situation by holding companies that do not exhibit signs of
business erosion but instead demonstrate a positive business outlook. In other words, the key to
success for a growth manager is to identify a superior growth pattern and to recognize when it
begins to deteriorate.
Growth Stocks and Value Stocks
A stock does not have to remain in either category. Depending on market direction, the
company's strategies and investors' perceptions, a stock can quickly go from one category to
another.
For instance, an emerging growth company can stumble with a product rollout raising serious
concerns in the market. Investors could reevaluate the company, questioning the potential for
growth. If the expectations fall, causing the stock to be sold to a level well below its intrinsic
value, then a company that was perceived to be a growth company would now become a value
candidate. This is when value investors step in to assess the damage and decide whether the price
represents good value. Similarly, a beaten down value stock can launch a successful product and
become a high expectation candidate quickly, migrating from value to growth territory.

33

Different Styles for Different Seasons

An investor should know what investment style his fund manager uses. An important reason to
know this is because value and growth stocks perform differently depending on where we are in
the economic cycle. In a bull market, growth funds often do well as the economy is strengthening
and stock prices rise as the companies they favor are benefiting from the strong economy.
But, in a bear market value funds may benefit more. As they are often modestly priced in the first
place, value stocks may have more to gain and less to lose in a stagnant or declining market.
Many managers also prefer a value approach when they believe that the stock market is
overvalued and may be headed for a decline. At such times, the increased demand for value
stocks can help boost their prices.

Debt Portfolio Management

Debt portfolio management has to contend with the construction and management of portfolios of
debt instruments, with the primary objective of generating income.
Classification of Debt Securities
Many instruments give regular income. Debt Mutual funds can invest only in market traded
securities. Debt instruments may be secured by the assets of the borrowers as in case of Corporate
Debentures or may be unsecured, as is the case with Indian Financial Institutions.
A debt security is issued by a borrower and is often known by the issuer category. Thus you have
government securities and corporate securities or FI Bonds. Debt instruments are also known by
their maturity profile. Thus instruments issued with short-term maturities, typically under one
year, are classified as Money Market securities. Instruments carrying longer than one-year
maturities are generally called Debt Securities.
Most debt securities are interest bearing. However there are securities or zero coupon bonds that
do not pay regular interest at intervals but are bought at discount to their face value. A large part
of the interest bearing securities are generally fixed income paying, while there are also securities
that pay interest on a floating rate basis.
Size and Breakup of Indian Debt Market
The Indian debt market is the third largest in Asia. It is estimated to be of US $100 bn
(Rs.460000 crs).
Instruments in Indian debt market
1.
2.
3.
4.
5.
6.

Government Securities
Treasury Bills
PSU bonds
FI Bonds
Certificate of Deposits (CD)
Corporate Debentures and Commercial Paper (CP)

71%
5%
12%
5%
4%
3%

Government securities and T-bills account for Rs 3,50,000 crores and the remaining of the
above instruments account for Rs 1,10,000 crores.

34

The objective of a debt fund is to provide investors with a stable income stream. Hence a debt
fund invests mainly in instruments that yield a fixed rate of return where the principal is secure.
The debt markets in India offer the following instruments for investments to mutual funds.
1. Call Money Market
Mutual funds invest in call money to maintain liquidity in the portfolio. A large part of the
liquid/money market funds is invested in call money markets, as the need for liquidity in such
funds is very high.
The Call Money Market in India is the example of the sub market dealing with near cash or
overnight money. The demand comes from the banks that fall short of reserves, which has to be
maintained with the RBI for its CRR and the SLR requirements. This market in India is called the
Inter-Bank Call Market wherein the funds are borrowed overnight for book adjustments. The
market for short-term finance is Call Money Market. The Call Money Market is that part of the
national money market where days to day surplus funds mostly of the banks are traded in.
However as per the new regulations Mutual Funds access to call money market is going to phase
out in steps.
Treasury Bills
T-bills are short term, rupee denominated obligations issued by the RBI on behalf of the govt. Of
India, and are in the form of a discounted govt. Promissory note or by credit to the Securities
General Ledger (SGL) account. Unlike commercial bills they are not backed by commercial
transactions in goods. These bills are highly liquid and are virtually risk free as they are backed
by government guarantee. These bills are issued for 14 days, 91 days, 182 days and 364 days.
Commercial Paper (CP)
Corporate borrowers to meet their working capital finance requirement issue commercial papers.
To give a boost to the money market and to reduce the dependence on highly rated corporate
borrowers on bank finance for meeting their working capital requirements, corporate borrowers
were permitted to arrange short term borrowing by issue of commercial paper with effect from 1 st
Jan 1990. This has provided financial instrument for investors. The maturity period for CPs has
been reduced from 30 days to 15 days.
The major investors in the CP market are Mutual Funds, Commercial banks, and FIs.
Certificate of Deposit (CD)
Only banks can issue the CD. It is a document of title to a time deposit. It is a bearer certificate
and is negotiable in the market. They are bank deposits. Bank CDs have a maturity of 91 days to
one year, while those issued by FIs have maturities between one and years.
Government Securities

35

Government Securities are instruments issued by Central/State Government (Central Government

Guaranteed bodies like IDBI, ICICI, NABARD, etc. State Government Guaranteed bodies like
SFCs, SEBs, etc.)
Government securities are normally semi annual coupon, barring bullet redemption bonds (a bond
that pays maturity value in one lumpsum at maturity). Zero coupon bonds have also been issued
in the past.
These bodies borrow regularly from the capital markets to finance their projects by way of
medium to long term dated securities either on issue basis or by way of auction. There is no limit
to the bid size for auctions. Based on the bids received RBI determines maximum rate of yield
which will become the cut off rate and the coupon rate for that stock. The investors in the GOI
securities are the Mutual Funds, State Governments, RBI, banks, LIC, PFs, etc.
Public Sector Undertaking Bonds: (PSU)
PSU bonds are medium term obligations issued by the public sector companies such as the ones
in which the central or state govt. has more than 51% stake. The market for PSU bonds has grown
substantially over the past decade. All PSU bonds have bullet redemption and some of them are
embedded with call or put options.
Corporate Debentures (CPD)
CPD are short to medium term obligations issued by the private and public sector corporations.
Debentures are creditorship securities with fixed rate of return, fixed maturity period, high
certainty and low capital uncertainty. Debentures can be secured or unsecured.
Corporate debentures can be privately placed or publicly issued. Public issues of debentures are
mandatory rated by at least one of the three rating agencies in India. Typical maturity of corporate
debentures is between 3 and 12 years. However the majorities of them have a maturity period of
less than 18 months and are placed privately.
The types of debentures:

Non convertible debentures

Partly convertible debentures
Fully convertible debentures
Bearer debentures
Registered debentures
Redeemable & Irredeemable debentures
Secured & unsecured debentures

Floating rate notes (FRN)

These are the instruments of debt of short term duration say 5 to 6 months which is extendable to
5 years, carrying no fixed rate, but the rate is above 2% above the benchmark rate which is the
bank deposit rate of 2 years and above. The floor and the cap which are the minimum and the
maximum rate promised to the investors which protects both the investor and the issuer from the
interest rate fluctuations For e.g. if the deposit rate is 12% the floating rate of the bonds will be
14%. UTI and ICICI have issued this for institutions/ companies. Interest is payable half yearly at

36

the rates adjustable to bank deposit rates of 2 years and above and conversion to equity shares are
also offered in some cases.
Measures of bond (Debt Securities) yield
Current Yield: The most common way to calculate a bond fund's current yield is to multiply the
half yearly dividend by 2 and divide by the price per unit (the "net asset value" or NAV). For
example, if a bond fund is selling at Rs. 12 per unit and it pays a half yearly dividend of Rs. 0.70
per unit, or Rs. 1.40 a year, the current yield would be 11.67%. [(0.70 x 2) 12)].
Yield-to-Maturity: It is the rate of interest that an investor would have to earn if an investment
equal to the current price of the bond were capable of generating the coupon payments and the
maturity amount in exactly the same time pattern promised by the bond issuer. For example,
suppose a bond is selling at Rs. 961.60 and pays a semi annual coupon of Rs. 40 per year for the
next 20 years. The holder of such a bond would expect to receive Rs. 40 every six months for the
next 20 years and Rs. 1000 at the end of the 20th year. What rate of interest on an investment of
Rs. 961.60 would be able to produce these cash flows and leave nothing after the payment of Rs.
1000? The answer, an annual compounded rate of 8.58%, which is the yield-to-maturity (YTM)
of this bond.
Risks in Investing in bonds
Investments in bond or debt funds are also associated with risks. Some of the risks that debt fund
manager needs to manage are
Interest Rate Risk: Interest rates and bond prices have an inverse relationship, moving just like a
seesaw. A sound analysis of rate movements is therefore essential.
Credit Risk: A credit quality "upgrade" can increase a bond's value, and a "downgrade" can
cause a price decline.
Maturity Risk: The longer a bond's maturity, the further out it rests on the price side of the seesaw
and the more its price tends to fluctuate as interest rates change. For example, a rise in interest
rates will bring about a larger drop in price for a 20-year bond than for an otherwise equivalent
10-year bond.
Default Risk: A bond is subject to the risk that the issuer may default on its obligations to make
payments.
Call Risk: If a bond has been issued with a call provision, the issuer may call them back and
return the proceeds to the investors, whenever interest rates fall so that the borrowing can be
replaced with cheaper debt.
Reinvestment Risk: A bonds yield assumes reinvestment of interest received during the term as
constant. This may not be possible if interest changes and the risk of interim cash flows being
reinvested at lower rates.
Liquidity Risk: This refers to the ease with which the bond can be liquidated at a price near its
value. This element is important for a fund because its investments are made on behalf of unit
holders and market conditions may require the fund to liquidate part of its portfolio within a short
time.

37

Debt Investment Strategies

We can now look at some debt investment strategies adopted by portfolio managers.

Buy and Hold: Historically, in India, UTI and many of the other mutual funds tended to
invest in high yielding debt securities that give adequate returns on the overall portfolio. The
returns are considered sufficient to reward the investors. Therefore, the funds would just
encash the coupons and hold the bonds until maturity. These fund managers will tend to
avoid bonds with call provisions, to counter the prepayment risk.
It has to be understood that the strategy holds good as long as the general interest rate levels
are stable. If yields rise, the price of bonds will fall. Hence, while the fund may generate
sufficient current income according to original target, it will incur a capital loss on its
portfolio as and when re-valued to current market prices. Another risk on the portfolio,
particularly if its maturities are long, is the risk of default by the issuer.

Duration Management: If Buy & Hold is like Passive Fund Management, Duration
Management is like Active Fund Management. This strategy involves altering the average
duration of bonds in a portfolio depending on the fund managers expectations regarding the
direction of interest rates. If bond yields are expected to fall, the fund manager will buy bonds
with longer duration and sell bonds with shorter duration, until the funds average duration
becomes longer than the markets average duration. Based as the strategy is on interest rate
anticipations, it is akin to the Market Timing strategy for equity investments.
Note that the mere fact of active interest rate risk management does not mean the fund
manager will always get it right. Thus, Debt Funds that manage durations of their portfolios
are still subject to interest rate risk. And the credit risk of default by the borrower is present;
Prepayment risk on callable bonds will have to be managed, too.

Credit Selection: Some debt managers look to investing in a bond in anticipation of changes
in its credit rating. An upgrade of a bonds credit rating would lead to increase in its price,
thereby leading to a superior return. The fund would need to analyze the bonds credit quality
so as to implement this strategy. Usually, debt funds will specify the proportion of assets they
will hold in instruments of different credit quality/ ranges, and hold these proportions. Active
Credit Selection strategy would imply frequent trading of bonds in anticipation of changes in
ratings. While being an active risk management strategy, it does not take away the interest
rate, prepayment or credit risks that are faced by any debt fund.

Prepayment Prediction: As noted earlier, some bonds allow the issuers the option to call for
redemption before maturity. A fund which holds bonds with this provision is exposed to the
risk of high yielding bonds being called back before maturity when interest rates decline. The
fund manager would therefore strive to hold bonds with low prepayment risk relative to yield
spread. Or try to predict the course of the interest rates and decide what the prepayment risk
is likely to be, and then increase or decrease his exposure. In any case, the risks faced by such
fund managers are the same as any other. What matters at the end is the yield performance
obtained by the fund manager.

38

Section II

39

INVESTMENT PRODUCTS
Mutual Fund Investment viz. a viz. other products
Physical and Financial Assets
The ranges of investment options available in India cover both physical assets and financial assets
Real estate and Gold are examples of physical assets. Traditionally, gold has been a favorite asset
for many Indians.
In the financial assets category, Indian investors have generally had guaranteed or fixed return
products such as bank deposits, company deposits and Government Savings instruments such as
Public Provident Fund, Indira Vikas Patra and National Savings Certificates.
Financial assets also include capital market securities such as equity/preference shares, and
bonds/debentures issued by companies or financial institutions, money market instruments such
as commercial paper or certificates of deposit. Individual investors can buy capital market
instruments but do not have any direct access to money markets instruments.
Guaranteed and Non-Guaranteed Investments
Quite distinct from the above-described investment instruments are the mutual fund units. Unlike
capital market or money market instruments, where the investor lends directly to the borrower/
issuer of securities, mutual fund units represent indirect investments through an intermediary
the fund. However, unlike the bank deposits or government savings instruments, where the
intermediary or the borrower guarantees the capital protection and interest rates, investment in a
mutual fund is not guaranteed for returns or capital.
The salient features of the investment products available in India are given below.
Physical Assets: Gold and Real Estate
Indians are the largest investors in Gold in its various forms. Investment in Gold is not subject to
erosion on account of rupee depreciation, which is perhaps its biggest advantage. Historically,
Gold has been perceived as a hedge against inflation or as a means of security in bad times.
Hence, investors do not always look for returns while investing in gold. Recently, the government
has deregulated the import of Gold significantly. Nevertheless, it is the average Indians
obsession with Gold that has maintained its place as a key investment option.
An interesting development recently has been the permission by the government for banks to
issue Gold Bonds. These bonds represent securitisation of gold. Investors can hold these bonds
and earn some returns, instead of holding the metal and incur costs and risks associated with
storage. The instrument is till in its infancy.

40

Real estate the also been a preferred investment alternative with the Indian investor. However the
capital required is often beyond the means of the small individual investor. Also, the real estate
market has been in a recession for the past few years, and even during and upswing, it is not easy
to liquidate holdings quickly at an appropriate price. Even high net worth individuals have tended
to keep away from real estate purely as a form of investment.
Once again, for those investors who like investing in real estate, an attractive option may emerge
soon with some Mutual Funds planning to offer Real Estate Mutual Funds an indirect form of
investing that still offers to the investors the benefits of both real estate investing and mutual fund
investing.
Financial Assets
Products by Issuer
Issuer
Banks
Corporate

Government

FIs
Insurance Cos

Product
- Fixed Deposits
-

Shares
Bonds, Debentures
Fixed Deposits
Govt. Securities
PPF
Other
Personal
Investments
Bonds
Insurance Policies

Available To
- Investor
-

Investor, MFs
Investor, MFs
Investor, MFs
Investor, MFs
Investor
Investor

Investor, MFs
Investor

Banks
Bank deposits have been a favored investment option with the India investor, mainly because of
the liquidity and safety benefits they offer. Most Indian banks are promoted either by the
government or by leading financial institutions. The liquidity and safety offered by banks does
however come at a price. Yield on bank deposits is negligible after accounting for inflation and
tax. While the bank guarantees the return of the capital, deposit is not a secured investment, its
perceived safety coming from the soundness of the bank management or ownership. Investors
should be advised to park only a part of the savings in bank deposits
Corporate Papers
Securities available in the capital market include equity instruments, debt instruments and quasi
debt-quasi equity instruments issued by companies.
Equity instruments are in the form of shares in companies either issued privately and unlisted, or
issued publicly and listed on a stock exchange(s). The investor may acquire such shares, either at
the time of the initial public offering by the company or subsequently, though the stock
exchanges at which they are listed. The benefit of investing in equities is the high growth
potential that this avenue offers. Also, the listing at stock exchanges ensures a high degree of

41

liquidity. Historically, equities have yielded the highest return as compared to other investment
options. However, for the individual investor, it is challenge to identify shares which are likely to
appreciate in value, and even if the succeeds in doing so, he may be unable to raise capital that is
required to develop a diversified portfolio. Besides, a risk-averse investor should be advised to
refrain from investing heavily in the equity market.
The corporate borrowers- companies- also issue debentures paying fixed rates of interest. In
India, these debentures are generally secured by the assets of the borrower. However, credit
standing of the borrower has to be determined with the help of the credit rating that a particular
debentures issue is given by a rating agency. Companies pay different rates of interest depending
upon how strong their rating or their market acceptance is. Borrowers with lower rating need to
pay higher interest. Companies can also issue unsecured bonds, like Financial Institutions, though
the instrument will not be called a debenture.
Both bonds and debentures may be subscribed to either in a private placement or in a public
issue. Many companies privately issue debt securities with less than 18 months maturity, as such
issues are exempt from the requirement of credit rating. Investors need to be extremely careful
about such investment and need to be sure that the issuing company is really creditworthy. Public
issues and other private issues have to be rated, so some guidance is available to the investor to
judge the risk of default by the borrower.
Investing in company fixed deposits is yet another avenue available in the market. While
company fixed deposits may carry a higher rate of interest as compared to bank deposits, they are
also an unsecured investment. Each companys deposits must be evaluated with reference to the
risk rating assigned to them by credit rating agencies such as Crisil, ICRA and CARE. Also, the
tax effect could make the net returns on these instruments less attractive than other debt
instruments.
Financial Institutions
In recent times, financial institutions such as ICICI and IDBI have issued bonds on a regular
basis. Sometimes, these are general-purpose bonds issued to augment their resources. Sometimes,
they are issued with the intent of financing infrastructure development in the country. These
bonds are available for investment in the form of alternate options. One option allows the investor
to receive periodic interest payments (monthly, quarterly, and annually) over the term of the
instrument. The deep discount option does not pay interest on a periodic basis. Instead, it yields a
redemption value, which is higher than the issue price, the difference being chargeable to tax as
interest. Both options qualify for tax rebate under Section 88 of the Income Tax Act. Deduction
of interest income under Section 80L is not applicable. The Third option gives interest at periodic
interval and qualifies as investment specified under Section 54EA/EB of the Income Tax Act.
Institution bond schemes usually have 3, 5, 10 and 15- year maturities with annualized
compounded returns ranging between 11% and 12.5%. A savvy investment approach can make
these bonds a very attractive investment option. It must be noted that these bonds are unsecured.
Government
a) Public Provident Fund
Public Provident Fund is a government obligation, hence virtually risk-free. Besides, tax-free
interest of 12% p.a. and contributions up to Rs.60000/- eligible for tax rebate under Section 88,
make the Public Provident Fund (PPF) one of the best options available to the investor. An

42

individual is allowed only one account in his name. The scheme requires annual contributions
(between Rs.100 and Rs.60000) to be made over 16 years, with the option to withdraw 50% of
the 4th year balance in the 7th year. Assured tax-free interest, which can be compounded over 16
years, makes this scheme a truly attractive option. There are restrictions on withdrawals, which
does reduce liquidity for the investor.
b) Indira and Kisan Vikas Patra
These were originally introduced as post office schemes in order to tap savings in rural India, but
also became popular with urban investors. However, their current yield (12.25% over 6 years,
fully taxable) has made them unattractive. Nevertheless, Indira Vikas Patra continues to appeal
to investors with unaccounted income because the post office does not record the identity of the
investor. Consequently, they are easily transferable and liquid.
c) Other Scheme from National Savings Organization.
Besides PPF and Indira Vikas Patras, the NSO offers schemes such as post office accounts,
recurring deposits, relief bonds and the scheme for retiring government employees. However
these schemes have ceased to be attractive after the advent of PPF and institutional bonds.
d) Government Securities.
This is government paper normally issued on a long-term basis and defines the yield curve to a
great extent. Only primary dealers specially appointed for this purpose deal in government
securities. From the individual investors perspective, government securities are not a direct
investment and are accessible through mutual funds.
Life Insurance
Life insurance in India is the monopoly of the Life Insurance Corporation of India (LIC). LIC
offers two types of policies- without profits and with profits. A without profits policy
purchased by an individual promises to pay a certain sum of money (the sum assured) to his
survivor nominated by him in the event of his death within a specified period (the term of the
Policy). If the individual services the term of the policy, he does not receive anything. A with
profits policy not only pays the sum assured in the event of death during the policy term, but also
pays a bonus as declared by LIC from year to year. If the individual services the term of the
policy, he receives the sum assured plus bonus accrued. Most policies require the individual to
pay a fixed premium on a yearly basis. If the individual decides to discontinue the policy during
its tenure, he would be entitled to the policys surrender value, which is a percent of premium
paid till date.
In India, life insurance is viewed more as an investment option than as a vehicle for risk
protection. In fact, very few individuals evaluate the need for insurance. Instead, they tend to opt
for it on account of tax benefits. Premium paid on life insurance qualifies for tax rebate under
Section 88 and proceeds at the time of death or maturity are exempt from tax. Certain investors
prefer life insurance because it acts as a forced saving (the policy would lapse if annual premium
is not paid to LIC). However, a careful evaluation of life insurance reveals that the opportunity
cost is significant when compared to other secure investment such as PPF. It is important for an
individual to evaluate the need for insurance with respect to his earning potential and the financial
impact on his dependents in the event of his untimely death. Proceeds in the event of his

43

surviving the term of the policy do not make insurance a worthwhile investment. Surrender
values paid by LIC are not attractive leading to lengthy lock-in period. LICs plans also offer very
little flexibility and are not attractive due to a lengthy lock-in period. LICs plans also offer very
little flexibility. Therefore, an investor would be well advised to buy insurance, not just as an
investment, but mainly to provide for his dependants in case of his untimely death.
The table below compares the investment options discussed above under the broad heads viz.
return, safety, volatility, liquidity and convenience.
Return

Safety

Volatility

Liquidity

Convenience

Equity

High

Low

High

FI Bonds

Moderate

High

Moderate

High
or Moderate
Low
Moderate
High

Corporate Debenture
Company
Fixed
Deposits
Bank Deposits
PPF
Life Insurance
Gold
Real Estate
Mutual Funds

Moderate
Moderate

Moderate
Low

Moderate
Low

Low
Low

Low
Moderate

Low
Moderate
Low
Moderate
High
High

High
High
High
High
Moderate
High

Low
Low
Low
Moderate
High
Moderate

High
Moderate
Low
Moderate
Low
High

High
High
Moderate
Low
Low
High

Although the table provides a qualitative evaluation of various financial products, the comparison
serves as a useful guide towards determining the best option.
It is clear from the above that equity investing in general has good potential in terms of return,
liquidity and convenience. However, individual stocks can give varied performance, one stock
being more liquid than another or one stock giving lower return than another. For this reason,
equity investing is fraught with risk and is not ideal for every individual investor. It is
recommended only for investors who are willing to invest the time required for research in stock
selection (or have access to sound financial advice) and possess the capacity to bear the inherent
risk.
Bonds issued by institutions are an attractive option, particularly now with the liquidity that
accompanies their listing on stock exchanges. Bonds are a stable option in terms of fixed returns,
and are recommended for the risk-averse investor. However, bonds can lose value when general
interest rates go up. Bonds are also subject to credit risk or risk of default by the borrower. In
case of corporate bonds, the risk must be assessed in terms of the strength of the borrower as
indicated by the credit rating assigned to the bonds. In the absence of credit rating, it is extremely
difficult for the investor to decide on the quality of the bonds or debentures. The secondary
market in corporate bonds in India is also very thin, leading to lack of liquidity for the investors
who wish to sell.
Company fixed deposits fall short on several counts and are recommended only if the issuing
company and the deposits on offer are rated highly by credit rating agencies.

44

The major advantage of bank deposits relative to other products is the liquidity they offer. Banks
are usually willing to give loans against fixed deposits at a nominal charge over the interest rate
applicable to the deposits. Deposits rates offered by banks vary as per RBI directives and the
interest rate scenario in the economy. Bank deposits score high on safety, as the return of capital
is guaranteed to the depositor by the bank. However, the financial soundness of the bank is
important to look at.
PPF combines stability with a respectable return. Its tax-exempt status makes it an attractive
mechanism for the small investor to build his savings portfolio. However the lock in period
involved in PPF means that the investor loses out in terms of liquidity, particularly during the
early years of the scheme. Being a government supported investment, PPF scores very high on
safety, compared even to bank deposits.
Insurance could become a serious investment vehicle once the insurance market in India is
opened to private players. In todays scenario the opportunity cost in terms of return is too high
for insurance to be compared on even terms with the other option. Its liquidity is also extremely
low, though safety is considered high at present for the government-owned LIC as the only
insurer.
Direct Equity Investment versus Mutual Fund Investing.
As mentioned earlier, investors have the option to invest directly in equities through the stock
market instead of investing through mutual funds. However, a practical evaluation reveals that
mutual funds are indeed a more recommended option for the individual investor. A comparison
between the two options is given below:

Identifying stocks that have growth potential is a difficult process involving detailed research
and monitoring of the market. Mutual Funds specialize in this area and possess the requisite
resources to carry out research and continuous market monitoring. This is clearly beyond the
capability of most individual investors.

Another critical element towards successful equity investing is diversification. A diversified

portfolio serves to minimize risk by ensuring that a downtrend in some securities/sectors is
offset by an upswing in the others. Clearly, diversification requires substantial investment
that may be beyond the means of most individual investors. Mutual funds pool the resources
of many investors and thus have the funds necessary to build a diversified portfolio, and by
investing even a small amount in a mutual fund, an investor can, through his proportionate
share, reap the benefit of diversification.

Mutual funds specialize in the business of investment management, and therefore employ
professional management for carrying out their activities. Professional management ensures
that the best investment avenues are tapped with the aid of comprehensive information and
detailed research. It also ensures that expenses are kept under tight control and market
opportunities are fully utilized. An investor who opts for direct equity investing loses out on
these benefits.

Mutual funds focus their investment activities based on investment objectives such as
income, growth or tax savings. An investor can choose a fund that has investment objectives
in line with his objectives. Therefore, funds provide the investor with a vehicle to attain his
objectives in a planned manner.

45

Mutual funds offer liquidity through listing on stock exchange (for closed-end funds) and
repurchase options (for open-end funds). This is in contrast to direct equity investing where
several stocks are often not traded for long periods

Direct equity investing involves a high level of transaction costs per rupee invested in the
form of brokerage, commissions, stamp duty, etc. While mutual funds charge a management
fee, they succeed in keeping transaction costs under control because of the economies of scale
they enjoy.

In terms of convenience, mutual funds score over direct equity investing. Funds serve
investors not only through their investor services networks, but also through associates such
as banks and other distributors. Many funds allow investors the flexibility to switch between
schemes within a family of funds. They also offer facilities such as check writing and
accumulation plans. These benefits are not matched by direct equity investing.

It is clear that investing through mutual funds is far superior to direct investing except perhaps for
the investor who has truly large portfolio and the time, knowledge and resources required for
direct investing.
Bank Deposits versus Debt Funds
It needs to be understood that bank deposits cater to a segment of the investor class that looks for
safety and accepts a relatively lower return. Equity Funds cannot clearly be compared with the
bank deposits, as investors can expect higher returns from equity funds only at the risk of losing
part of the capital also. Given the risks, Indian investors are currently investing heavily in debt
funds. However, before a bank depositor considers shifting his funds to debt funds, he should
compare the two in a meaningful manner.
A bank deposit is guaranteed by the bank for repayment of principal and interest. Any risks
associated with investment of the investors funds have to be borne by the bank. The depositor
has a contractual commitment from the bank to pay. A mutual fund, on the other hand, invests at
the risk of the investor. Hence, there is no contractual guarantee for repayment of principal or
interest to the investor.
The bank depositor does not directly hold the bank portfolio of investment, as he does in case of a
fund. The investor needs to assess the risk in terms of the credit rating of the bank, which
provides an indication of the financial soundness of the bank. However, a debt fund is not rated
by any agency. The investor has to assess the risk on the portfolio held by the fund. The investor
needs to know whether the fund invests in high quality assets or lower rated debt. Unlike in case
of bank deposits, therefore, the investor needs to know his own investment objective and risk
appetite before investing in a debt fund. The expected returns will be commensurate with the
level of risk assumed by the fund.
It can been seen that the bank deposits are not totally free from risk, while generally giving lower
returns. A conservative debt fund can give higher returns than a bank deposit, even if there is no
contractual guarantee as in a deposit. Investors seeking higher returns form the capital market
securities, a diversified debt portfolio while still investing small amounts and a portfolio that
matches his objective and risk appetite is well advised to consider part of his investment in debt
funds.

46

The Investor Perspective: Funds vs. Other Products

Equity
FI Bonds

Investment
Objective
Capital Appreciation
Income

Risk
Tolerance
High
Low

Corporate Debentures
Company Fixed Deposits
Bank Deposits

Income
Income
Income

H-M-Low
The Same
Generally Low

PPF
Life Insurance

Income
Risk Cover

Low
Low

Gold
Real Estate
Mutual Funds

Inflation Hedge
Inflation Hedge
Capital Growth,
Income

Low
Low
H-M- Low

Investment
Horizon
Long Term
Medium to
Long Term
The Same
Medium
Flexible
All Terms
Long Term
Long Term
Long Term
Long Term
Flexible
All Terms

The comparison above highlights the flexibility offered by mutual funds from the investors
perspective. An investor can choose form a wide variety of funds to suit his risk tolerance,
investment horizon and investment objective. Bank deposits offer similar flexibility in investment
horizon and risk level, but only a fixed income. An investor looking for capital growth has to
potential, but a high risk and without the benefit of diversification and professional management
offered by mutual funds. Gold and real estate are attractive only in high inflation economies.
Other options are largely for the risk-averse, income-oriented investor. Mutual funds present the
widest choice to the investors.
Mutual Funds the best Investment Option
From the comparative analysis provided above, it emerges that each investment alternative has its
strengths and weakness. Some options seek to achieve superior returns (e.g. equity), but with
correspondingly higher risk. Others provide safety (such as PPF), but at the expense of liquidity
and growth. Options such as bank deposits offer safety and liquidity, but at the cost of return.
Mutual funds seek to combine the advantages of investing, in each of these alternatives, while
dispensing with the shortcomings. Clearly, it is in the investors interest to focus his investment
on mutual funds.
However, a note of caution is in order. While the mutual funds are one of the best options for the
individual small investor, there are many mutual funds already available for the investor to
choose from. It must be realized that the performance of different funds varies form time to time.
Also, the Indian mutual fund sector has been in an evolving phase over the past five years during
which time several investors have encountered some poorly performing funds, while others have
been fortunate to be with good performers. Besides, evaluation of fund performance is
meaningful when a fund has access to an array of investment products in the market. Currently in
India, there are limited investment opportunities available to mutual funds, and their track record
must be studied in this context. Therefore, the Indian investors have moved over to mutual funds

47

in a gradual process. But, there is little doubt that mutual funds will increasingly attract the small
investors as compared to other intermediaries such as banks and insurance companies.

48

Financial Planning
Each of us needs finance at various stages of our life and we need to ensure that we have the
money available at the right time, when we need it. The money may be required at the time of
marriage of a daughter or son, at the time of a medical emergency or at the time of retirement. In
other words finance is required at different times for different goals. Buying a home, providing
for childs education and marriage or for retirement. Personal financial needs are of two types
protection and investment.
Financial Planning is an exercise aimed at identifying all the financial needs of an individual,
translating the needs into monetarily measurable goals at different times in the future, and
planning the financial investments that will allow the individual to provide for and satisfy his
future financial needs and achieve his lifes goals.
The objective of financial planning is to ensure that the right amount of money is available in the
right hands at the right point in the future to achieve an individuals financial goal. Successful
financial planning makes a considerable contribution to the sum total of human happiness.
Financial planning is a process that helps a person work out where he or she is now, what he/she
may need in the future and what he/she must do to reach the defined goals. The process involves
gathering relevant financial information, setting life goals, examining the current financial status
and coming up with a strategy or plan for how the person can meet his/her goals given the
persons current situation and future plans.
The benefits of financial planning
It is important that financial plans are tax efficient. The simplest financial plan may mean little
more than making contributions into a suitable financial product. The most complex plans will
involve detailed knowledge of law, taxation and investment principles. Amidst this complex
environment for an investor, financial planning provides direction and meaning to financial
decisions. It allows one to understand how each financial decision one makes affects other areas
of ones finances. By viewing each financial decision as a part of the whole, one may consider its
short and long-term effects on ones life goals.
Mutual funds form the core foundation and building block for any type of financial plan long
term or short term, high or low risk and for any type of client retail, affluent or institutional.
There is a great variety in mutual fund offerings including diversified equity funds, sector funds,
gilt funds, and money market funds and these individually or in combination can tailor for every
investor the exact mix of return potential, risk diversification, Liquidity and tax efficiency that
they need. Financial planners and their clients therefore need top look no further than mutual
funds for their complete set of investment needs. Barring life and individual property insurance,
which provides protection against unexpected and unforeseeable events mutual funs provide easy
access to each financial asset class and are suitable for all types of investors young or old,
accumulating or retiring, aggressive or conservative.

49

Steps In Financial Planning

Investing is never an easy process however experts suggest that, with a sound understanding of
some basic concepts, one can really make sound investment decisions. The following steps would
enable an individual to get on to the path of successful investments.
Step 1 Defining the investment goals:
As a starting step the investor needs to lay down his investment goals. In other words he needs to
explicitly state or write down what does he wants to achieve by saving i.e. is he saving to buy a
house, for his childs education or for retirement. He should find out the amount that would be
required for meeting each of these goals.
The investor needs to ask himself questions like, Why am I saving and investing my money? The
question may seem obvious but thinking about and defining his goals helps him understand what
he needs his investment to do.
Step 2. Gather and Analyze Data, Assess the Current resources and future Income
potential:
The investor should access his financial situation. He should define his personal and financial
goals, understand the time frame for results and judge his risk tolerance. He can construct a
balance sheet of all his assets and liabilities. As a next step, he should prepare his income
statement with projections of I) cash inflows from salary, professional fees and receipts from
investment s and other sources. II) Outflows or expenses including regular monthly as well as
non-recurring expenses. From this the ongoing investment surpluses or deficit is arrived, this
inturn will determine the investment strategy that should be adopted. The investor to meet his
goals must also take into account his current insurance coverage, investments and tax strategy.
Step 3. Determine and shape the risk tolerance level:
Risk and return are directly related. Higher the risk higher the return. An investor needs to
determine the level of risk that he would be comfortable with. If an investor has a higher
tolerance for risk, he may want a larger allocation in growth investments in his portfolio for
though they are riskier they generally offer a greater potential for higher returns. The common
perception among investors is that all investments are risky. Hence an understanding and
managing of risk is required. The same has been explained in detailed later.
Step 4. Ascertain the tax situation:
Ultimately what matters are the post tax returns? The investor should analyze the tax bracket that
he falls into and his tax situation as some investments may offer him tax advantage over other
investments. A detailed study of his tax-paying pattern is required to ensure that correct
investments are made.
Step 5. Appropriate asset allocation and specific investments:
Asset Allocation is the critical decision and the essence of what all financial planning comes
down to. The purpose of ascertaining your goals, your resources, risk tolerance and tax situation
is simply to decide the most appropriate asset allocation and investment strategy

50

The client must evaluate all his existing assets both fixed and financial and decide in what asset
classes and in what proportion he should distribute his investments. After the asset allocation has
been decided upon the investor should identify the mutual fund schemes which confirm to his
asset allocation and whose risk and return profiles are appropriate to his requirement.
Many Mutual Funds and Financial Planners have designed asset allocation calculators, which ask
investors basic questions in order to understand the investors profile and recommend the right
asset allocation. These questions are based to get an insight on the investors,
1.
2.
3.
4.

Investment goals
Time horizon of investment
Risk tolerance and
Investors personal circumstances

One such Asset Allocation calculator is attached in the end for reference.
Step 6. Executing the plan and making the client invest:
After the asset allocation and specific investments have been decided upon, the plan should be
executed. If the plan requires reallocation of some existing investments the existing investments
should be liquidated and new investments should be added.
Step 7. Reviewing progress and portfolio rebalancing:
Once every 3 to 6 months the investor should review the progress of his investments and perform
an active evaluation of results. During the reviewing of portfolio the investor should evaluate
whether the investment strategy needs to be redefined, this should be done in case if,
His future needs or current resources have changed.
The investment climate and financial markets have experienced a dramatic change.
His personal situation has changed in a significant way on account of a personal or financial
event.

51

Investing in Mutual Funds Part I

There was a time when Indian investors did not have many investment schemes to choose from.
It was easy then for the agents to simply point out the benefits of any currently available scheme
to a prospective investor. The investor then decided whether the schemes suited to his needs or
not. Now, the Indian mutual funds industry offers a wide choice of investment schemes, unlike
ever before. Different schemes are suited to different investor needs. In this scenario, an investor
not only has to choose from this variety of investment options available, but also design a proper
investment strategy that is suitable to his situation and needs. In this scenario an investor should
develop the right approach to investing, and avoid ad-hoc investment decisions.
However as Jacobs puts it, mutual fund investing is not a get-rich-quick scheme. Investors must
have an Investment Program and ought to set their sights on long term goals, in other words,
investment decisions to be taken in terms of clear, long-term goals, not on an ad-hoc basis.
Each investor should expect only realistic wealth accumulation goals, no dramatic result
overnight. For example, in the current Indian market conditions, investors can expect 20% plus
returns in equity investments, 11 or 12% returns in debt investments and 8 to 9% in money
market investment. These expectations can change over time. Specific investments or funds can
give greater return or less return, but higher returns will be in most cases achieved by investors or
their fund managers taking greater risks.
It is extremely important for investors to know how to choose a particular scheme or set of
schemes from all of the options available.

Asset Allocation Determining of the Portfolio Mix

The principles of financial planning are also applicable to investment in mutual Funds. The 1 st
step to selecting a mutual fund is asset allocation.
It is a very important aspect of financial planning. Asset Allocation is the critical decision and the
essence of what all financial planning comes down to. It has been observed that over 94% of
returns on a managed portfolio come form the right levels of asset allocation between stocks and
bonds/cash. So any financial planning for an investor must determine a suitable asset allocation
plan.
The purpose of ascertaining your goals, your resources, risk tolerance and tax situation is simply
to decide the most appropriate asset allocation and investment strategy. This is because every
asset class (i.e. stocks, bonds, cash etc.) has different characteristics. Stocks, for example, have
the potential to provide high total returns, while bonds provide lower risk along with regular
income. Every investor may also have distinct goals. These goals should determine an investor's
investment strategy. Since each investor's goals may differ there should be a different investment
mix, or asset allocation, that satisfies their goals.
What is Asset Allocation?
52

Asset allocation can be defined in a number of ways. However, most simply, asset allocation is
the process of diversifying your investments among different types of asset classes. The purpose
of doing this is manifold. Primarily, the goal of asset allocation is to help the investor meet his or
her investment goal. But asset allocation provides many other salutary effects. Diversification
across asset classes balances investments with higher levels of safety with those that have higher
levels of growth. Diversification also offers the additional benefit of countering the negative
effects of various economic or market conditions, by combining investments which behave
differently when exposed to those conditions.
Since different asset classes do not move in tandem, when one asset is down, the other may be up.
This may help in lowering the investment risk across the portfolio. The goal of asset allocation is
to achieve the highest return at a particular level of risk.
A suitable asset allocation may differ from investor to investor. It will be based on his individual
investment goals, his risk tolerance, his time horizon and his personal circumstances.
Investment goals
The asset class that an investor should choose will depend on his investment objective. There are
four basic investment objectives associated with any investment: safety, income, growth or tax
benefits. For example, if an investor were investing for retirement, his main investment goal
would be to amass sufficient funds to maintain his standard of living during his retirement years,
i.e. a growth objective.
Risk Tolerance
An investors risk tolerance depends on his attitude towards investment risk and may be unique to
you. Individuals having same income, same investment horizon and same investment objective
may still opt for different asset allocations. An investor having a higher tolerance for risk may
want a larger allocation in growth investments in his portfolio for though they are riskier they
generally offer a greater potential for higher returns.
Investment Horizon
Knowing the investment time horizon is critical and will help an investor decide on a proper asset
allocation. If an investor has 10 years to save, his investment strategy will be significantly
different from say a 3 year time horizon. Over a longer period of time he can take advantage of
growth opportunities, whereas over a shorter period of 3 years, he may be more concerned about
safety. If he is investing for retirement and starts saving at the age of 30-40 yrs, he can then
assume an investment span of 20 to 30 years assuming the traditional retirement age of 60 years.
As he grows older, his investment horizon obviously diminishes.
Personal Circumstances
An investors level of savings and his financial responsibilities play a role in influencing his asset
allocation decision. An investor needs to evaluate his financial situation and his income sources
through his investment time span. How much discretionary income does he have available every
month? What is his cash flow situation? If his current and future income is expected to be stable
he can consider equity investments.

53

Asset Allocation Determining the right mix.

After taking into consideration the above the investor should determine the investment mix. As
with many decisions the choices are numerous.
An investor may choose investment products between different asset classes or he may choose
mutual fund schemes that suit his requirement.

Different Asset Allocation Models

Benjamin Grahams 50/50 Balance
The fundamental asset allocation advice given by one of the stalwarts of investment planning,
Benjamin Graham, who advocates 50/50 split between equities and bonds, the common sense
approach to start with. When value of equities goes up, balance can be restored by liquidating
part of the equity portfolio, and vice versa. This is the basic defensive or conservative investment
approach. Benefits include not being drawn into investing more and more into equities in rising
markets. Both the gains and losses will be limited. But it is good to get about half the returns of a
rising market and to avoid the full losses of a falling market.
50/50 Portfolio of Mutual Funds
Grahams approach can be translated into reality by holding different kinds of portfolios of funds.
Bogle suggests the following combinations:
1.

A Basic Managed Portfolio

2.
3.
4.

5.

A Basic Indexed Portfolio

A Simple Managed Portfolio A

Complex
Managed Portfolio
A readymade Portfolio
-

50% in diversified Equity Value

Funds
25% in Government Securities Fund
25% in High Grade Corporate Bond
Funds
50% in Total Stock Market/Index Fund
50% in Total Bond Market Portfolio
85% in a Balanced 60/40 Fund
15% in a medium term Bond Fund
20% in diversified equity fund
20% in aggressive growth funds
10% in specialty funds
30% in long-term bond funds
20% in short-term bond fund
Single Index Fund with 60/40
equity/bond holdings

Strategic Asset Allocation

Bogle recommends adjusting the percentage for each group of investors after taking account of
their age, financial circumstances and objectives. He classifies investors in terms of their lifecycle
phases. During the Accumulation Phase, an investor would be building assets by periodic
investments of capital and reinvestment of all dividends received. During the Distribution Phase,

54

he will stop adding assets and start receiving dividends as income. Considered in conjunction
with the investors age, he recommends the following strategic allocations:
Older Investors in Distribution Phase :
Younger Investors in Distribution Phase :
Older Investors in Accumulation Phase :
Younger Investors in Accumulation Phase

50/50(equity/debt)
60/40
70/30
80/20

In other words, younger investors can be more aggressive and let the magic of compounding
work for them, while older investors take a more conservative approach. Similarly, investors in
the Accumulation Phase can take greater risk than those who need income and are in their
Distribution Phase.
Bogle gives a nice rule of thumb for asset allocation: debt portion of an investors portfolio
should be equal to his age. So let a 30- year old investor make 70/30- asset allocation, and at age
50 let him balance it out. And so on.
This can be further explained with the help of life cycle stage and welath stage.
The Life Cycle Stage
This model recommends allocation based on the age of the investor.
The early working years - 25-40 years
During the early part of an investors career his primary objective may be to accumulate wealth
for his retirement years. Keeping in mind his investment time horizon, which may be 20-30 years,
stocks should comprise a major part of his asset allocation.
The later working years - 40- 50 years
In the later part of his career, while capital appreciation remains an important objective he would
also want to take care that his capital is preserved. Therefore, a more conservative asset mix may
be called for.
The Pre and Post Retirement years - 50 -70 years
As an investor approaches retirement, and even after retirement, he will probably be concerned
more with steady income at low risk. So most of his investment should be in bonds. However, for
purposes of diversification and to protect you from inflation, stocks should still form a part of his
portfolio.
The Wealth Cycle guide
While the life cycle stage is a useful approach to asset allocation, another supplementary
approach that many experts recommend is that of The Wealth Cycle. The life cycle approach
groups all investors in age groups, irrespective of their financial planning condition. In fact each
investor is so unique with a unique combination of circumstances, resources, attitudes and needs
that any attempt at grouping them by age has its drawbacks, especially if the attempt is to identify
the one investment strategy that works best for the entire group. However it has been observed
that certain investment strategies work well to meet specific type of investor needs.

55

In this regard, the Wealth Cycle grouping seems to work best and is more comprehensive and
relevant than grouping investors merely by age or life stage.
The Accumulation Stage: During this phase, investors are looking to build wealth because their
financial goals are quite some time away and investments can be made for the long term. Typical
investor needs such as saving for retirement acquiring assets are distant and the investors
primary aim is long term wealth accumulation. Such investors should consider a higher allocation
of their investment in equity, as statistics show that in the long-term equities outperform all other
forms of investment. In fact a study shows that no investor who has invested for a 9-year period
in the BSE Sensex has lost his capital. Though equity is volatile in the short term, over longer
term the volatility is reduced. However this should be after taking into account his risk tolerance
and his personal circumstances.
The Transition Stage: During this stage, one or more of the investors goals are approaching and
clearly in sight. For e.g. A salaried executive in late fifties who is planning to retire at 60 years of
age needs to start preparing in advance by adjusting his investments. Like wise, couples in there
40s who have children approaching the age of higher education or marriage are in transition
stage. Such investors need to have higher allocations in debt instruments or debt mutual funds as
equity investments are volatile in short term. Debt funds can provide them adequate returns
coupled with safety and liquidity.
Reaping Stage: This is the cashing out stage, because the goal and the purpose towards which
the investor has been investing have arrived. In essence this is the time to reap the harvest that
they have sown. An investor who is about to retire or has retired is an example. Such investors
should have a conservative portfolio and may consider the money market funds offered by mutual
funds. These money markets are a very safe investment as they invest in short term investments
viz., call money, commercial papers and Floaters. Such schemes offer investors high degree of
safety and liquidity.
The Intergenerational Transfer Stage: Investors upto their early 50s may not yet feel the need
to take care of the next generation in the event of their own death. However many older investors
need to start thinking about how to share their wealth either during their own lifetime or by
bequeathing through their will after their lifetime. Such transfer of wealth may have to be done in
favor of different categories of beneficiaries such as investors children or grandchildren or to
family or charitable trusts or causes.
The Sudden Wealth Stage: Sometimes significant events such as sale of shares or business,
inheritances or winnings from lotteries may give investors bonanza in the form of one time
receipt which multiplies their networth, making them suddenly wealthy. Till September 2000
investors who had made capital gains could save capital gains tax by investing in mutual funds
and availing of section 54EA and 54EB benefits.
Fixed vs. Flexible Asset Allocation
The allocation made by the investor can be fixed or flexible allocation.
Once a strategic asset allocation has been decided, should it be re-balanced periodically to benefit
from market movements and as investors circumstances, returns obtained or time horizon
change?

56

Fixed Allocation
A Fixed ration of asset allocation means that balance is maintained by liquidating a part of the
position in the asset class with higher return and reinvesting in the other asset with lower return.
This is not what investors normally do. They tend to increase their equity position when equity
prices tend to climb up and vice versa. But, this approach is more disciplined and lets him book
profits in rising markets and increasing holdings in falling markets.
Flexible Allocation
A flexible ration of asset allocation means not doing any re-balancing and letting the profits run.
As stocks and bonds will give different returns over time, the initial asset allocation will change,
generally in favor of equity portion, as its returns would be higher than bond portion. The
distribution- oriented investor will find his initial ratio change in favor of equities much more
than the accumulation oriented investor. As an example:
Rs. 200 invested equally in Stock and Bonds, with returns being 10% & 7%
At the end of 10 years, for accumulating investor, will result in 57/43 ratio
At the end of 20 years
63/37 ratio
But for the distribution-receiving investor, 10 years will see
66/34 ratio
And 20 years will see
79/21 ratio
The investor, who takes out the income from debt fund without reinvesting, stands to
automatically increase his equity part of the portfolio much more significantly than the
accumulating investor does, since his debt capital remains fixed.
Which option will likely give better returns? If stocks continue to return more than bonds, then a
fixed ration is better than variable ratio. If bond returns are close to equity market returns, then
the variable ratio may work better. The answer depends upon whether one can really forecast the
future. It is logical to assume that stocks will give higher returns than bonds, so fixed ration
approach to asset allocation is better at least in bull markets.
Asset allocation is not a one-time exercise. Over time an individuals lifestyle will change due to
economic changes. An individual should therefore review his asset allocation decision, and
possibly make changes to it at least once a year. He may need to rebalance his portfolio to the
original asset allocation to maintain diversification within his risk tolerance profile.
It is important to understand the risk and return relationship of the assets that are being
considered. Studying the historical returns of the different asset classes can provide an insight
into demonstrated risk.
Asset allocation may be one of the most important decisions an investor has to make. While
arriving at an asset allocation, an investor needs to carefully evaluate the parameters listed above.
The process of asset allocation takes a simplified view of how to go about investing ones savings.
Model Portfolios
Jacobs gives four different portfolios, summarized below. However it should be kept in mind that
the exact percentage allocations have been recommended for the investors in the U.S.A. Besides,
the percentage allocations can change depending upon the specific facts about an investor, or also
in the light of his changing conditions. However, the following four portfolios are still of general

57

applicability and investors in India may consider them as the basis to develop similar model
portfolios.
Investor

Recommended Model Portfolio

Young, Unmarried Professional

50% in Aggressive Equity Funds

25% in High Yield Bond Funds, and
Growth and Income Funds
25% in Conservative Money Market Funds

Young Couple with Two Incomes

and two Children

10% in Money Market

30% in Aggressive Equity Funds
25% in High Yield Bond Funds, and
Long Term Growth Funds
35% in Municipal Bond Funds

Older Couple, Single Income

30% in short-term Municipal Funds

35% in long-term Municipal Funds
25% in moderately Aggressive Equity
10% in Emerging Growth Equity

Recently Retired Couple

35% in conservative Equity Funds for

capital preservation/income
25% in moderately Aggressive Equity
for modest capital growth
40% in Money Market Funds

A good exercise will be to find the Indian mutual fund equivalent recommendations for Indian
investors, using the above guide.

ASSET ALLOCATION
STOCKS/BONDS
Older

70/30

50/50

80/20

60/40

Age

Younger
Accumulation

Distribution
Investment Goal

Source: Bogle On Mutual Funds

58

Investing in Mutual Funds - Part II

From Asset Allocation to Fund Category Selection
Once an investor has worked out an asset allocation plan, he would have allocated funds to the
two basic categories of Equity and Debt funds. However, building the risk factor into an
investors portfolio requires two steps:
1. Sub-allocating equity and debt percentage investments to sub-categories of equity and debt
Funds, consistent with the risk appetite of each investor, and
2. Evaluating the risk of specific funds/schemes for the purpose of deciding the schemes own
risk level and whether the fund fits into the investors portfolio in view of its actual
performance and risk level.
At a practical lever, it is best to classify various mutual funds and arrange them in order of their
generally expected risk level, in the same way that the investors are classified into three risk
levels Jacobs recommends the following classification:
Low Risk Funds (for investors with low risk appetite)
1. Money Market Funds
2. Government Securities Funds
Moderate Risk Funds (for investors with moderate risk appetite)
1.
2.
3.
4.
5.
6.
7.

Income funds
Balanced funds
Growth and income funds
Growth Funds
Short-term bond funds
Intermediate bond funds
Index funds

High Risk Funds (for investors with high-risk appetite)

1.
2.
3.
4.
5.
6.
7.

Aggressive growth funds

International funds
Sector funds
Specialised funds
Precious metal funds
High-yield bond funds
Commodity funds

59

Based on risk level of different fund categories, Jacobs recommends the following portfolio suballocations within each category:
1. Low Risk (Conservative ) Portfolio:
50% Government Securities Funds + 50% Money Market Funds
2. Moderate Risk (Cautiously Aggressive ) Portfolio:
40% Growth & Income Funds + 30% Govt. Bond Funds + 20% Growth Funds + 10% Index
Funds
3. High Risk (Aggressive) Portfolio:
25% Aggressive Growth Funds + 25% International Funds + 25% Sector Funds + 15% High
Yield Bond Funds + 10% Gold Funds

Selecting Specific Fund Managers and their Schemes

This step is required to translate the amounts to be invested in each MF sector into actual
decisions on which scheme of which fund manager to select for investments, as the investor
would have a choice of many Debt Funds or MMMFs or even Balanced Funds.

Selecting the Right Mutual Fund: The Bogle Approach

After an investor chooses a model portfolio that suits him, he will arrive at the decision on the
amounts to be invested in the basic categories of Equity, Debt, Balanced and Money Market
Funds. The next step is to decide which specific funds/schemes should be selected for inclusion
in the mode1 portfolio. One practical and sound approach to fund selection has been worked out
from experience by John C. Bogle, the ex- Chairman of the Vanguard Group of Funds in the
U.S.A.
Selecting the Equity Funds
Step One: Classify the available equity schemes in Growth, Value, Equity Income, Broadbased Specialty and Concentrated Specialty funds.
The purpose of classification is to decide whether the investment objective of the fund suits the
investor needs as translated in the model portfolio. It is easy to make the mistake of looking only
at the past performance of a fund and ignoring its suitability for the investor. For example, no
matter how good the performance of as specialty offshore or industry fund, it would not be
advisable for the conservative equity portfolio of a retiree.
Step Two: Choose one of two strategies either 1. Select mainstream growth or value funds,
providing broad diversification, or 2. Select either a differentiated growth or value fund or a
specialty fund whose risks and returns will vary from the overall market. In the first choice,
further selection of growth or value fund should depend upon their relative returns, which have
been similar in the U.S. (not yet known in India). This choice should be dictated by the investor
profile. For a young investor, a growth fund will be preferable to an equity income fund, more
suited to an older investor.
Step Three: Evaluate past returns of available funds in each category mainstream equity
income or even index fund, or high risk/reward specialty fund.

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Step Four: Review the salient features of a scheme. SEBI in India requires the Offer
Documents of new schemes to highlight the risk factor that a funds past performance is no guide
to the future. This is important to remember. That is why Bogle cautions against relying only on
past performance to select a fund. Bogle recommends looking at past returns only after reviewing
a funds structural characteristics like,
a) Fund Size - smaller funds mean higher expenses or possibility of it not surviving, so
avoid such funds unless it is part of a big family, or unless you seek exceptional
return and so do not want a very large fund.
b) Fund Age look at funds performance over five to ten years, except that you may
consider a new scheme or a new Balanced Fund from a fund manager who has
offered successful equity or debt funds or even a new index fund.
c) Portfolio Managers Experience: It is good to know who manages your portfolio,
how long he has managed it, and what his performance track record is. In some large
mainstream funds, there are tams and advisors who mange the investments.
Remember that a fund manager is supported by research, and sometimes his
performance may be simply due to favorable market conditions or good luck.
d) Costs of Investing: Less important than in bond/govt. securities/balanced find,
overall costs of front-end and redemption loads and the funds expense rations are
important to consider while choosing an equity fund. Adjust the past or expected
returns for costs to get net returns.
e) Portfolio Characteristics:
e) i. Cash Position: Equity funds would normally hold little cash, say 5%. Too
much cash means you are paying somewhat excessive management fees to the
fund manager. However, look at whether the manager has successfully predicted
up market moves by holding cash before such bull market phases. In India, this
may be difficult to track for older schemes, but funds now disclose their
portfolios more frequently for you to look at the cash position and analyze its
impact on performance.
e) ii. Portfolio Concentration: Check the funds largest ten holdings their
proportion in the funds net assets. Is the concentration in line with the stated
objective of the fund? Ten largest holdings accounting for over 50% of the net
assets means the fund is concentrated, not diversified. Concentration helps
achieve differentiated performance, but has it meant superior performance?
e) iii. Market Capitalization of the Fund: Judge the funds strategy by the size
of the market cap of its equity holdings does it have large-cap, blue chip shares
or emerging small-cap shares? The market cap also indicated the level of risks
assumed. Relate this information to the fund objectives and consistency of its
performance.
f) iv. Portfolio Turnover: A Steady holding of investments indicates a longterm orientation. Larger turnover purchases and sales could generate

61

higher capital gains but also higher transaction costs for the fund and so for
the investor. See what strategy fits the investment objective of the fund, and
has given better returns.
g) v. Portfolio Statistics: While selecting a fund, an investor needs to compare
its performance with others. To ensure a proper comparison, look at three
measures:
ExMark: A term coined by Bogle, it explains a funds performance in relation to
a benchmark like a market index. Simply put, a high proportion of an equity
funds Total Return is generally explained by the return on the index or the
performance of the overall market. Only 10 to 20% of a funds return may come
from the funds strategy. If ExMark is lower is lower than 80%, the funds
performance relative to the market is less predictable. An Index Fund would
carry a nearly 100% relationship with the market index.
Beta: ExMark measures performance. Beta measures risk. A funds risk is
measured by the volatility of its past price relative to a market index. A beta of 1
means the fund value will fluctuate exactly with the index value. A portfolio with
less than 1 beta is obviously less risky (with less return in a rising market but
less loss in a falling market). What is your target funds beta? Diversified equity
funds will have a beta nearer 1, small company funds higher than 1.
Gross Dividend Yield: Find out if the funds reported yield is net after fund
expenses or gross before expenses. Gross dividend yields tend to be higher for
value funds than for growth funds. Small company funds have lower gross
yields.
While evaluating a proposed fund, look at all three statistics together the
relative return, the risk and net returns to the investor. The best fund will have
higher ExMarks, lower beta and higher Gross Dividend Yield.
An investor should invest mainly in mainstream diversified funds. He should select funds by
comparing his target fund with other funds in the same category. He should look at the ExMarks,
Beta and Gross Yield, the age and size of the fund, its portfolio turnover. And avoid funds at the
top of the performance rankings, and those at the bottom, too. He should also avoid narrowly
focused funds (Sector or small company funds). There may, of course, be exceptions in India
such as Technology or Pharmaceuticals Sector Funds, because of the projected economic growth
in India. But he should be aware of the additional risks of such funds.
Selecting a Debt/bond/income Fund
In India, a large number of investors like fixed returns. Hence debt schemes are popular. Bogle
recommends the right process to select the right debt fund.
Step One: Narrow Down the Choice: Contrary to impressions, Debt funds have a larger variety
to choose from than equity funds. The debt funds may have short, intermediate and long-term
portfolios. They may invest in government securities, corporate debentures and bonds
investment grade or below, Financial Institution bonds, state or even municipal level bonds, or
global bonds. Combinations of maturities with the types if investment securities is what gives the
large variety. However, the good thing is Debt Funds portfolios can be easily recognized and

62

distinguished form each other than Equity Funds portfolios. So the fist step in selecting a Debt
Fund is to narrow down the universe.
Step Two: Know Your Investment Objective: For young investors doing retirement planning,
long-term bond funds are appropriate. But, for retired persons, monthly income schemes are more
appropriate. What are the other options open to the investor? That defines the return targets.
Step Three: Determine the Right Selection Criteria and select:
a) Fund Age and Size Due to explicit objectives of a debt fund, unlike equity funds,
there is no harm in investing in new funds, though the fund managers track record is
relevant to consider. An investor should be careful of funds that invest in as yet
unknown or new instruments. Similarly, the tenure of the portfolio manager is also
less important for bond funds than for equity funds.
b) Relative Yields If an investor needs income, he should select a fund with high
current yield (fund dividends as percentage of its market value). But, a debt fund also
has a yield to maturity. YTM is important, if the objective is total return, not just
current income. As the principal value will decline when interest rates rise, causing a
capital loss and a lower total return. That is why an investor must know the fund
portfolio composition.
c) Costs: More than in equity fund, a bond fund operates in narrow income margins.
For a bond fund therefore, expense ratio is much more important than for an equity
fund. A debt fund returning 10% with 1% expense ration means significant impact
for the investor, as compared to even 1.5% expense ration for an equity fund
returning 20%. For the same reason, any front-end, entry load for a bond fund also
reduces the return to the investor significantly. An investor should look at both these
elements of costs. Costs involve what is called yield sacrifice.
d) Portfolio Characteristics: An investor must know the portfolio quality in terms of
the Credit Ratings - how much percentage of the portfolio is held in highest credit
rated instruments and how much in lower rated or non-investment grade instruments.
This is a measure of portfolio risk risk of credit default by the funds borrowers.
High yield of a fund may be coming at high risk of loss from securities with low
credit ratings. Thus, a government securities fund is the highest quality debt fund,
follower by other portfolios of AAA credit-rated bonds, followed by lower- rated
bonds and so on.
e) Average Maturity of a debt portfolio will determine whether the portfolio is
sensitive to movements in interest rates. The longer the average duration of a
portfolio, the greater the sensitivity meaning higher interest rates will cause
portfolio value to decline and vice versa. High current yield of a fund may come at
the cost of higher risk of principal amount loss. Thus, long-term funds carry higher
risk of capital loss (or gain). Even government securities still carry this interest rate
risk. Money market funds carry smaller risk as they invest in short-term securities.
Some balance is necessary to be kept for most investors. In times of rising interest
rates, all funds with similar average maturity will lose value, better managed ones
may lose less, but the differences among most funds are not as high as in case of
equity funds. What makes the difference is the costs.

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f) Tax Implications In many countries some debt securities pay taxable income and
others tax-free income. In India, currently all income in the hands of the mutual funds
is tax-free. Hence, all funds that invest in debt with the same coupon will have the
same yield. However, debt funds are required to pay a Dividend Distribution Tax.
That means, cumulative or growth option of debt fund has advantage over a fund that
pays out dividends to investors. Distribution tax is therefore the third element of
costs besides management expenses and entry/exit loads to be considered by an
investor in computing the net relative returns of a debt fund.
g) Bonds versus Bond Funds: Investors ought to remember that all debt funds will
have an average maturity of their portfolio, exposing them to risk of principal loss.
Hence, anyone who wants to lock in returns is better off buying a bond and holding it
on till maturity, which is not possible with holding a bond fund. However, direct
interest income from bonds is taxable, while the same bond income received through
a fund is not taxable, making the debt funds more attractive at present.
h) Past Returns: Once again, do not be guided by past returns obtained by funds.
Future returns will depend upon future level of interest rates not easily predictable.
All the same, while computing returns, an investor should use average annual rates of
return, not cumulative return numbers. However, while comparing different funds to
select one among them, an investor should remember expenses is what will make the
most difference between them. So he should look at expense performance which is
somewhat predictable for a given fund manager.
Currently in India, we do not have high-yield or junk bond funds. But, still investors should make
sure he compares the credit quality of portfolios of different mutual funds. Higher yield per se is
not an indication of better performance if achieved with much higher risk. Once again, an
investor should avoid a debt fund with a lower-rated portfolio and a higher expense ratio than
others, if a better quality and less expensive fund is available.
Selecting a Money Market Fund.
Selecting a money market mutual fund is a somewhat easier exercise than selecting a bond or
equity fund. The elements to consider in selection are:
a) Costs: If expenses are important in case of debt funds, they are crucial in case of
money market funds, since they generally offer lower returns and expenses can take
away a significant part of returns. An investor should look for funds with lower
expense ratios.
b) Quality: Portfolio quality is the other factor that affects yield. Higher yield with
lower rated portfolio comes at higher risk. Lower quality may have some justification
in long-term funds, but such risk in case of short-term money market funds is
unacceptable.
c) Yields: Higher yielding money market funds are not necessarily of lower quality, or
vice versa. That is why yield quotations of different funds have to be investigated. In
general, unlike debt funds, MMMFs have the lowest principal risk but highest
income variability as short-term interest rates fluctuate. So virtually no capital gains
possibility either. Yields of portfolios that are of the same quality are likely to be near

64

identical. In any case, investor should compare net yields after fund expenses and
loads.
Management quality does make some difference, not so much in achieving vastly superior
performance, but because running an MMMF portfolio takes a lot of trading skills.
Selecting a Balanced Mutual Fund:
In India we now have an increasing number of Balanced Funds available. Hence selecting the
right fund is important.
First point to note is that a Balance Fund is rarely exactly 50% equity/50% debt, no exact golden
mean. So there are two basic types: equity oriented balanced funds that invest upto 60% in an
equity portfolio and income oriented balanced funds that hold upto 60% of their funds in debt
instruments. For this reason, it seems logical that investor should use the selection criteria for
equity funds for the equity portion of the balanced funds, and those for the debt funds for their
debt portion. However, these funds follow clearly defined guidelines. Hence, the fund size and
age, or the tenure of the portfolio manager is less important. Even portfolio characteristics
(turnover, concentration, market capitalization, and the credit quality and average maturity of the
bond portfolio) tend to be similar in each of the two types of balanced funds.
The special selection criteria for balance funds include:
a) Portfolio Balance: Proportion of portfolio in stocks, bonds and money market
securities is one factor. Weight given to current income versus total return is another
factor. Both must be in line with the investors objectives.
b) Debt Portfolio Character: In general, balanced funds are for the slightly
conservative investor. So its bond portfolio ought to be of investment grade quality,
with long average maturities. A deviation may prove to be too aggressive.
c) Costs: More important than in an equity fund. For the income oriented balanced
fund, costs are even more important than the equity- oriented type.
d) Portfolio Statistics: Equity- oriented funds would have lower ExMarks than the
index, since the conservative character of balanced funds usually means investment
in value stocks versus growth stocks. Conversely, income-oriented funds have
lowest ExMarks as they would invest in equity-income type stocks. Lower stock
market risk is reflected in lower Betas of balanced funds. Gross yields of balanced
funds ought to be much higher than the equity funds, given their debt component.
e) Returns: The same principles of comparing and selecting from different funds will
also apply to balanced funds.
To summarize, investors will do well to invest in mainstream balanced funds, emphasizing
current income. An investor should make proper distinction between income-oriented and equityoriented balanced funds. He should see the funds portfolio character in the light of the
investment objectives. Apply statistical tools Ex-Marks, Beta Gross Yield to the equity part of
the fund, and focus on quality in case of the debt part of the fund. Finally, the costs should be
considered and the net yield should be calculated.

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How to Measure A Fund's Performance

An investor should avoid the classic mistake that of automatically selecting a fund with
excellent past returns. Past returns are an important factor, but no guide to and no assurance for
the future. An investor needs to take into account the investment objective and characteristics of
the fund. For past returns, consistency in performance over a ten-year period is essential. Or in
case of a new scheme, the track record of the fund manager is important.
How's the fund doing? This perhaps is the most common query among investors before investing
in a fund. If it is an existing investor, this question is important to keep a track of his investment.
Though rate of return, may be critical for assessing the performance of a fund, by itself it may not
be good enough to evaluate it's performance. Instead long-term performance and comparison with
its peers and relevant benchmarks are required to understand the performance better.
It is important, however, to remember that much of the information available about a fund may be
historical in nature. While past performance does not guarantee future performance of the fund, it
can allow an investor to understand the fund's risk and return characteristics better.
Some key issues that can help an investor determine a fund's performance.
Total Return - A Good Starting Point
Long-term Performance - Is More Reliable
Volatility - Is an Important Consideration
Compare - Apples with Apples
Benchmarks - The Proper Measuring Stick
Total Return A Good Starting Point
Studying total return can be a good start to understand a fund's performance. Expressed as a
percentage, total return is a change in the value of the fund's unit price during the period and
assumes reinvestment of dividends - after the ongoing expenses are paid.
Total return can be reported as an absolute return or an annualized return. For example, if a fund's
net asset value has grown from Rs.10 to Rs. 25 over three years, the absolute total return would
be 150%. Whereas an annualized compounded return, that is, an average annual return across the
three years, would be 35.7%. However, for accurate portrayal of a fund's performance, total
returns should only be reported as annualized returns if returns are for a period of one year or
more.
Long-term Performance - Is More Reliable
Steady performance over the long-term is a good indicator of a fund manager's consistency in
varying market conditions. Moreover, the longer the period covered by performance data, more
reliable would be conclusions about the fund's record. Comparing returns over just one year may
be of little value in assessing the relative merits of two or more funds, whereas a comparison of
year-by-year returns can be revealing. Checking long-term performance of most funds in India
may not be possible yet as most are only a few years old, however, a meaningful period to
measure a fund's performance should at least be over three to five years.

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Use the Same Time Period: It is essential while comparing two or more funds in a similar
category the investor should use the same time period. It is possible that market conditions may
vary significantly from one to another.
Volatility - Is an Important Consideration
A fundamental principle in investing is the risk-return relationship: usually, the higher the return,
the higher the risk. This explains why performance in certain categories of funds may fluctuate
more than in others. Two technical measures that may be used for measuring volatility are
standard deviation and beta. Standard deviation reflects the degree to which a fund's returns
fluctuate around its average in a given period. The higher the standard deviation, greater the
volatility and therefore greater the risk. A fund investing in stocks may have a higher standard
deviation for it may probably have more ups and down than a fund investing in bonds.
Market risk is usually measured by what's known as the "Beta Coefficient". Beta relates the
return on an equity fund to a market index, for example the BSE 200. It reflects the sensitivity of
the fund's return to fluctuations in the market index. The market index is assumed to have a beta
of 1.0. So, a fund with a beta of less than 1.0 is considered to have below-average volatility, while
betas greater than 1.0 indicate above average volatility- the higher the beta, the greater the
volatility.
A simpler method of knowing the volatility would be to look at a fund's year-to-year
performance. Reviewing the fund's year-by-year returns may give you an idea on how the fund's
performance has fluctuated in the past.
While two funds can have identical annualized returns for a specified period, year-by-year returns
can show that Fund X exhibits higher volatility than Fund Y. Therefore, Fund X appears to be a
riskier investment.
Compare - Apples with Apples
As the characteristics of each asset class like cash, bonds and equity vary considerably, the
relative performance of a fund may be better known when compared with similar funds. Funds
with similar investment objectives presumably invest in a similar pool of securities, so an equity
fund should be compared with an equity fund, a debt fund with a fund, a sector fund with a sector
fund and so on.
Similarly, comparison of a fund should be with a relevant benchmark (refer next section on
Benchmarks- The Proper Measuring Stick). The best-known benchmarks quoted for the stock
market are the BSE 30 Sensex and the BSE 200, so an equity fund's performance may be better
understood in comparison with these benchmarks, over the same time period of course.
However, it is important to recognize funds in the same category may differ in the way they are
managed. One fund manager may adhere to value investing, while another may be a growth
investor which should affect the fund's performance at a given point in time.
Benchmarks - The Proper Measuring Stick
Another way to gauge the performance of a fund is to compare it with a relevant benchmark. An
equity fund may have given 20% annualized return over a three-year period, which may seem
rewarding to investors. But if its benchmark has returned, say 25% in the same period, then the

67

fund has under performed. A benchmark is an unmanaged group of securities whose overall
performance is used as a standard to measure investment performance. Used as a measuring stick,
a benchmark is usually a major index that tracks the total returns of all the returns in the market
or a segment.
By measuring it against appropriate benchmark an investor can assess his fund's performance. An
investor should keep in mind that a fund may fare better or worse than its benchmark because of
concentration of investments. For a fund may hold a higher percentage of its assets in an industry
while the same industry's representation in the benchmark may be lower. It is important to note
that returns may vary by the type of asset class that your fund invests in.
Characteristically, cash, bonds and stocks differ in their ability to generate total return. An equity
fund may have the potential to provide higher returns than a bond fund over a period of time.
Besides, while measuring returns and comparison with peers and benchmarks is useful, it is
equally important to look at the investors financial goals, tolerance for risk and investment
horizon before investing money in any fund.

The Impact of Mutual Fund Costs

Increased Return without Increased Risk?
We have seen that one cannot expect increased returns without increased risks. But, Bogle points
out at least one important way in which mutual fund investing can offer higher returns, which
come without higher risk level. This is the issue of costs of investing. A fund that earns a higher
return than another can still give lower net returns, if its expense ratio or loads are higher. If the
first funds higher return is on a riskier portfolio, the investor gets a higher risk and a lower overall
return. An investor should choose a fund that holds a lesser-risk portfolio and has lower expenseimpact on amounts distributed to investors. A fund that holds higher risk assets will have a risk
premium built into its return. But, its costs can act as a penalty for investors. While doing the
investment planning, an investor should remember to either hold the similar funds in terms of
both risk level of the portfolio and the fund costs, or choose the right risk level for the investor
and then the fund with less cost penalty.
Mutual fund costs can be classified into two broad categories: operation expenses, which are paid
out of the fund's earnings, and sales charges, that are directly deducted from your investment. Not
all mutual funds levy sales charges, but all have operation expenses, and both impact the returns
on your investment in a fund.
Mutual Fund Costs
|
______________________________________
Operating Expense
Sales Charges
Operating Expenses
These refer to costs incurred in operating a mutual fund. Advisory fees paid to investment
managers, audit fees, custodial fees, transfer agent fees, trustee fees and agent's commission
(upfront or trailer) are included in these. Also known as expense ratio, this is an annual expense
expressed a percentage of the fund's average daily net assets. The break-up of these expenses is
required to be reported in the scheme's offer document.

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The expense ratio is calculated by dividing the operating expenses by the average net assets. For
instance, a fund with Rs. 100 crores in assets and expenses of Rs. 20 lakhs would have an
expense ratio of 2%. Expense ratio is available from the offer document and from historical per
unit statistics included in the financial results of the fund, which are published bi-annually,
unaudited for September 30 and audited for March 31.
Depending on the type of scheme and the net assets, operating expenses are determined by limits
mandated by the Securities and Exchange Board of India (SEBI) MF Regulations (see table
below). Any excess over the specified limits has to be borne by the asset management company,
the trustees or the sponsor.

Expenses Charged By Mutual Funds

Scheme Assets Under
Management
First Rs. 100 Crores

Equity / Balanced Schemes

Debt Schemes

2.50%

2.25%

Next Rs. 300 Crores

2.25%

2.00%

Next Rs. 300 Crores

2.00%

1.75%

On the balance of assets

1.75%

1.50%

How do expenses affect your earnings? If a debt scheme earns 13% and the operating expenses
are 2.25% - assuming the scheme's net assets are under Rs. 100 crores -, you will see a return of
10.75%, i.e. 13% minus 2.25%. The expenses are subtracted before you see your earnings.
Operating expenses are calculated on an annualized basis and are normally accrued on a daily
basis. Therefore, an investor pays expenses pro-rated for the time he is invested in the fund.
Sales Charges
Commonly known as sales loads, these are charged directly to the investor. Sales loads are used
by the mutual fund for payment of agent's commission, distribution and marketing expenses.
Usually expressed in percentages sales loads are mainly of two types: front-end and back-end.
Front-end load is a one-time fixed fee paid by an investor when buying into a scheme. This load
has no affect on performance of the scheme but may well affect your own investment
performance as you start with lower capital.
Front-end load determines the purchase offer price (POP) which in turn decides how much of an
investors initial investment actually gets invested. The standard practice of arriving at the POP in
the United States, is as follows:
Purchase Offer Price = Net Asset Value/ (1- Front-end Load).
Let's assume an investor invests Rs. 10,000 in a scheme that charges a 2% front-end load at an
NAV per unit of Rs. 10. Using the formula, POP = 10/(1-2%) = Rs. 10.20
So only 980 units are allotted to the investor (Amount Invested/POP or 10,000/10.20)

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At an NAV of Rs. 10, this means units worth Rs. 9,800 are allotted to him on an initial
investment of Rs. 10,000.
Normally, front-end loads tend to decrease as the initial investment amounts increase.
Back-end load may be a fixed fee redemption load or a CDSC as explained below. A redemption
load is charged in perpetuity and is paid only at the time of redeeming (or selling) the units of a
fund.
In the event a back-end load is applied, the redemption price is arrived at using the following
formula:
Redemption Price = Net Asset Value/ (1+ Back-end Load).
Let's assume, an investor redeems units valued at Rs. 10,000 in a scheme that charges a 2% frontend load at an NAV per unit of Rs. 10. Using the formula, POP = 10/ (1+2%) = Rs. 9.80
So what he gets in hand is (POP) 9.80 x 1000 (Units you own) = Rs. 9,800
Contingent Deferred Sales Charge (CDSC) is a structured back-end load. It is paid when the units
are redeemed during the initial years of ownership. It is for a pre-defined period only and reduces
over the time the investor has remained in a fund. The longer the investor remains invested in the
fund the lower the CDSL. The SEBI (MF) Regulations 1996 stipulate that a CDSC may be
charged only for first four years after purchase of units.
The limit to sales charges is mandated by the Securities And Exchange Board of India (MF)
Regulations which do not allow either front-end load or back-end load in any combination to be
higher than 7%. In case of CDSC, SEBI regulations stipulate the maximum amount that can be
charged every year.
Transaction Costs: Some funds may also impose a Switchover Fee which is a charge on transfer
of investment from one scheme to another within the same mutual fund and also to switch from
one plan to another within the same scheme.
A cost-conscious investor will need to consider two things. First, he needs to compare a fund's
expense ratio with similar funds in the industry. If it's higher, he needs to check to see if it's
justified by performance. Second, he needs to compare the load, if any, to other similar funds. As
a load will reduce his investment by the amount of load. These should give a fair idea about the
costs involved.
However, an investor needs to keep all this in perspective. While he considers costs in choosing
funds, his investment decisions should not be based on this alone. His goals, risk tolerance and
investment horizon is more important. He should remember this is only a part of the overall
equation.

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Understanding and Managing Risks of Mutual Fund

Investments
A very common perception among investors is that Mutual Fund investments are risky. This is
definitely not true. As we have seen Mutual Funds have different types of schemes. And these
schemes have different types and different degree of risk associated with them. Proper financial
planning helps investors in understanding these risks and managing them.
What is risk?
A dictionary defines risk as the possibility of loss or injury. But, like many things in life, risk is in
the eye of the beholder. When it comes to investing, people tend to have different points of view
about risk.
Many investors see risk as the possibility of losing investment principal. Investment managers,
like the professionals who manage mutual funds, know that only those people who sell their
investments when prices have dropped lose money. They view risk as a combination of technical
measurements, such as standard deviation, beta, and alpha. They use these measurements as tools
in their ongoing assessment and management of the risk in portfolios. In other words, mutual
fund managers see risk not as loss but as fluctuation in the value of investments.
Professional financial advisors, on the other hand, generally relate risk to the risk/reward tradeoff
discussed later in this section. The risk that is often forgotten is inflation risk - the risk of price
fluctuation - the possibility that higher prices will rob a nest egg of its future value. Risk is part of
life. Everything we do - or don't do - entails risk. While some of life's risks are large, even life
threatening, others are hardly noticeable.
We first learned about risk from our parents. They taught us, for example, about the dangers of
sharp objects, hot things and electrical sockets. Some of us listened; others learned the hard way.
As we grew older, we learned from others and from our experience to manage some risks, and
over time those risk management skills became second nature - like looking both ways before
crossing the street. We take risks because the rewards justify them. Driving on the highway is a
risk, but most of us consider that the paycheck, or people or some other rewarding experience at
the end of the ride is worth the chance.
By the time most people reach early adulthood, they have highly developed skills to identify,
understand and successfully manage risk in their lives. But when it comes to investments, many
people feel their risk management skills do not apply. In reality, they do! In dealing with
investment risk, investors can use the same process that they have used successfully to understand
and manage the wide range of risks in life.
The human risk management process: Understanding and managing risk
Step 1 Identifying risks

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Relying on ones well-honed skills - and working with a professional advisor for knowledgeable
assistance - one can apply this process successfully to investment risks. Every individual investor
has his or her own comfort level, and there are as many ways to learn about investment risks and
how to manage them as there are people.
The first step is to identify actions, inactions and behavior that can lead to negative results or
shortfalls. This is the most critical step, because it's difficult to control or manage any risk on
which you have not focused.
Here are a few risks commonly associated with investors:
Buying when prices are high
Selling when prices are low
Failing to set goals
Failing to plan to achieve
Harboring unrealistic expectations
Allowing emotions to drive decisions
Not diversifying assets
Confusing fluctuation with loss
Starting too late in life
Investments themselves present a variety of risks. All of them, for example, are subject to market
risk. That's because the prices of securities go up and down.
Those involving stocks are subject to company risks (negative developments affecting a
company's financial status). There's also economic risk (the impact of an overall economic
slowdown on company profits).
Those involving bonds are subject to credit risk, also known as default risk (potential inability of
the issuer to pay interest and repay principal). There's also interest rate risk (rising rates pushing
security prices lower).
Evaluating the Risks of a Mutual Fund
In the overall process of fund selection, risk is one important consideration.
Measurement of a specific funds risks is by now a highly evolved though somewhat technical
and quantitative exercise. The principal risk measures used by the funds themselves and by the
fund performance-tracking agencies are given below. The following summary is based largely on
the approach suggested by Fredman and Wiles (part of the recommended reading)
Equity Funds: Volatility of an Equity mutual fund portfolio comes from
a) the kinds of stocks in the portfolio (growth or value, small or big).
b) the number of stocks in, or degree of diversification of, the portfolio
(smaller portfolios may be more volatile than large, diversified ones)
c) fund managers success at market timing (adjusting the asset allocation in
in response to asset class price movements).
A) Equity Price Risks are a) Company Specific, b) Sector Specific and c) Market

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Level. Company specific risks have to be researched and assessed by the funds analysts and
portfolio managers.
Holding a large, say 15/20 share portfolio, generally balances out and diversifies the company
risks. Sectors or industries have risks, too. Funds research and track the sectors with good
potential. Again, the more the number of sectors in a portfolio, the less is the portfolios sector
risk. Specific Sector funds clearly have more risks. Then comes the Market Risk, which is not
diversifiable, as it arises from broad economic and other factors. Managers try to anticipate
bear or bull phases and try to adjust their portfolio asset allocation. If equity index futures and
options are available, managers try to hedge their portfolios with these instruments.
B) Market Cycles are extensively researched and analyzed in the U.S. by agencies such as
Lipper. In India, independent agencies, brokers and newspapers are doing some of this analysis.
It is important to see how a portfolio or a share performs over a well-defined cycle than over
some arbitrary, calendar period. It is also important to understand that equity investment is
basically more rewarding in the long-term. Any equity fund can be more risky as a short-term
investment. Sticking to a good fund helps.
C) Risk Measures: Risk, defined as volatility, is measurable by the statistical concept of

Standard Deviation. SD measures the fluctuations of a funds returns around a mean level. Use
monthly results of an equity fund. Tabulate returns. Calculate mean (average) returns. Calculate
variances of each months return from the mean. Square these numbers. Sum up. Divide by the
number of periods of observations.
Compute the overall variance or the Standard Deviation. SD basically gives you an idea of how
volatile the earnings are. SD can be computed for both equity and debt funds. SDs of different
funds can be compared with each other, or with SD of a market index or even that of another
category.
Another measure of a funds risk is its Beta Coefficient. Beta relates a funds return with a
market index and measures the sensitivity of the funds returns to changes in the market index. A
beta of I means the fund moves with the market. A beta of less than one means the fund will be
less volatile than the market, typically in case of conservative portfolios. Higher beta portfolios
give greater returns in rising markets and are riskier in falling markets. Beta is a good measure of
fund risk level. But, it should be remembered that beta is based on past performance, so it does
not necessarily indicate future performance. Funds with specialized portfolios have higher beta
and such portfolios give greater returns in rising markets and are riskier in falling markets. Funds
with specialized portfolios cannot be assessed by betas based on overall market index.
Bogles ExMarks or a number known as R-Squared is used to help spot questionable betas. Rsquared measures how much of a funds fluctuations are attributable to movements in the overall
market, from 0 to 100 percent. Clearly, an Index Fund will have ExMarks of nearly 100%. Nondiversified funds will have lower ExMarks. To be meaningful, the fund being evaluated should
have some correlation with the market. For example, you might think that a low-beta fund with
very low R-squared/ExMarks is least risky; but not so if the fund in question is a Gold Fund, with
little relation to stock markets.
Overall, Standard Deviation is the best measure of risk, even though it is also based on past
returns. It is a broader concept than beta that measures total risk, not just market risk. It is an
independent number. Risks of both specialized and diversified funds, and both equity and debt
funds are measurable with SD.

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We know that risk and returns are inextricably related. So it makes sense to measure what is
called Risk Adjusted Performance. Sharpe and Treynor Ratios do that, both of which compute
the risk premium of a fund as difference between the funds average return and the return of a
risk-less government security or Treasury Bill over a given period. Sharpe Ratio divides the risk
premium by the funds standard deviation. Treynor divides it by beta. One step further in similar
risk adjusted performance calculation is what is called Alpha. Alpha of fund compares the funds
actual results with what would have been expected given the funds beta and the market index
performance.
A simple way of gauging a funds risk level is to see its Price/Earnings Multiple, which is simply
the weighted average of the P/E ratios of all the stocks held in its portfolio. Higher the fund P/E
as compared to the market or other funds, the higher the probability of its fall in the future. It is a
simple risk measure.
Increasingly, an investor can see these numbers being presented in the published analyses of fund
performance and their risk levels. In India, three sources of such information are the fund
tracking agencies, research reports from brokers and others, and the funds own reports (Offer
Document, its annual and quarterly reports and its newsletters).
Debt Funds: Many of the risk measures outlined above are also useful to evaluate the risks of
debt funds, except the obviously not so relevant measures such as a beta or a P/E ratio. Debt
funds are exposed to credit risk risk of loss through borrower defaults, and interest rate risk that
comes from the average maturity of the funds portfolio. An investor should look at two simple
measures of risk. First, what has been the Default Experience of the Fund in the past and Its NonPerforming-Assets at present? Second, the average maturity or duration of a portfolio, to ensure
that it matches with the risk appetite of your investor. The longer the maturity of a portfolio, the
greater the risk it has from interest rate fluctuations.
Once an investor has decided on the asset allocation, and devised a mutual fund action plan by
choosing the funds that suit his risk level, he is ready to go on to the practical tasks of selecting
specific funds/schemes that are to be included in his portfolio.
Step 2 Understanding risks
Some risks are likely to happen but have low potential impact (such as cutting oneself while
shaving). Others happen only very rarely but carry severe consequences (such as being struck by
lightning). In addition, there are risks with a high probability of occurring and severe
consequences (lighting a match near gasoline), as well as risks with little chance to occur and low
impact (being rained on in the Sahara desert).
Let's look at market risk. What's the likelihood that the value of an investment in a bond or stock
mutual fund will fluctuate? The answer is that it's certain. How much impact might market risk
have? Some investments tend to fluctuate in value a great deal, others less so. In general, over
long periods of time (10 years or more), investment types with the largest fluctuations tend to
show the greatest growth - but, as with every aspect of investing, there are no sure things. An
investment with wide price fluctuations can often make sense for a long-term investor but be
inappropriate for someone with less time. There are other factors to consider, too, such as how
much fluctuation risk an investor is personally comfortable taking and the percentage of his assets
involved.

74

Step 3 Reviewing strategies to control risks

In our everyday lives we act to control our exposure to risk by doing things such as checking the
weather forecast before leaving the house. The investment world has risk-reducing strategies, too.
These range from highly sophisticated mathematical strategies to classic, proven methods
available to every investor.
Here are five broad and proven strategies for controlling investment risks:
Diversification
This strategy - built right into all mutual funds, which usually are diversified portfolios - spreads
an investors risks and opportunities. The result is a combination of less loss and less gain. It's
simply the investment version of not putting all your eggs in one basket.
Investing systematically, following a disciplined investment approach
An investor can put price fluctuations to work for you and may actually reduce the average price
he pays for shares in a mutual fund by investing identical amounts on a regular basis. The secret
is, he is buying more shares when the price is low and fewer when prices are high. Of course
rupee cost averaging does not guarantee a profit or protect against a loss in a constantly declining
market. Also, an investor should consider his financial ability to continue purchases through
periods of low price levels or changing economic conditions.
Rupee Cost Averaging
An investor would want to take advantage of the markets when share prices are low, and you also
want to avoid paying inflated prices when markets are high. Yet even the most experienced
investors find it almost impossible to time the markets.
That's why many financial planners agree that investing at regular intervals may be one of the
best ways to take advantage of market downturns and benefit from stock and bond market rallies.
This investment technique is called Rupee Cost Averaging.
Simply put Rupee Cost Averaging is a disciplined investment practice that takes the guesswork
out of "timing" the markets. While no investment technique can assure a profit or protect against
loss in declining markets, Rupee Cost Averaging provides an investor with a simple investment
strategy that can help him make the most of his investment. What's more, he doesn't have to think
about timing the markets just right.
With Rupee Cost Averaging, an investor can invest a fixed rupee amount on a scheduled basis,
regardless of market directions. The essence of this strategy is that more units are purchased
automatically when prices are low and fewer units when prices rise. Over time, this results in the
average cost per unit - the money you pay - being lower than the average price per unit.
This disciplined approach to investing can help long-term investors improve their chances for
strong returns and build significant assets over time.
How It Works

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Let's take an example using The Alliance '95 Fund (A balanced fund from Alliance Capital
Mutual Fund). Suppose an investor had invested a fixed amount of Rs.10000 in the scheme on the
first business day of each month beginning from April 1995 to October 2001. The total
investment would be Rs.7,90,000 and by October 2001 he would own 46,567.729 units of the
scheme. This makes your average cost per unit Rs.16.96, which is lower than the average unit
price of Rs. xx. The value, of Rs.7,90,000. invested in the Alliance 95 Fund would have been
Rs.17,65,848. as on October 2001.
Although Rupee Cost Averaging eliminates the guesswork involved in market timing, it does not
guarantee a profit or guarantee against loss in a declining market. However, with Rupee Cost
Averaging an investor can avoid investing too much when the market is high and too little when
the market is low. It is a good habit where an investor pays himself first in a disciplined manner
without pinching his pocket.
Ignoring short-term fluctuations in value (not being overly enthusiastic or overly concerned) and
focusing on the long term is a proven risk control strategy. In fact, history shows that the longer
you stay invested, the less likely it is that you'll experience a negative return.
A study of the sensex for the period April 1979 to June 1999 shows that, for ever one year period
of investment, the investor could have made a gain of 112% in the best year or lost 30.6% in the
worst year. However if the investor would have invested for atleast 7 yrs. Then he would have
made a compounded annualized return of 38% and in the worst 7 yr. period he would have still
made 5.7% return. For any 7-yr. period of investment, the investor would have made positive
returns.
The study, which compared equity investments v/s other products viz. Gold, Company deposits
and bank deposits also showed that the best performing asset class during the period was equities.
How To Make It Work?
Most Mutual Funds offer the Systematic Investment plan to investors to take the benefit of Rupee
Cost Averaging. AIP is flexible and convenient. An investor can decide on an amount that he is
comfortable investing regularly over a period of time. He may choose to invest say, monthly or
quarterly. And he can invest as low as Rs.500.
A Variant of this disciplined strategy is Value Averaging. The investor keeps the target value
of his investment constant by investing the amount by which the investment value has come
down, or by cashing the increased value of his investment, or by doing nothing if the value is
unchanged.
Jacobs Recommendation of a Combined Approach: You can of course combine the rupeecost and value averaging strategies. To accomplish this, Jacobs recommends using an aggressive
growth fund and a money market fund of the same family. Invest Rs. 100 in an MMMF ever
month. Set a target value for the aggressive equity fund. Later, if the value of the equity fund has
declined, transfer 100 form the MMMF to the equity fund. If the equity fund value has increased
by 100, do nothing. If the value has risen by 200, transfer 100 from the equity fund to the MMMF
book the profit.
Power of Compounding

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Why should one invest for the long-term? Quite simply, to benefit from the power of
compounding the returns on the investment to accumulate a large capital at the end of the longterm. If you invest a hundred rupees in a bank deposit that pays interest at 12% per year which
you simply keep withdrawing, you will still have your hundred rupees deposit and keep
reinvesting the 12% interest each year, your capital would have grown more than threefold to Rs.
311 at the end of ten years. Or to Rs. 965 at the end of twenty years!
Examples: For the past few years, financial institutions such as the ICICI and IDBI have been
offering both Regular Income Bonds and Deep Discount Bonds. Rs. 5300 invested in one DDB
grows to Rs. 2 lakhs in twenty-five years. Deep Discount Bonds show the power of compounding
the investment.
The more frequent the compounding, the greater the growth in capital. Six-monthly compounding
of the same 100 rupees after ten years will result in capital of Rs.321, instead of Rs. 311 with
annual compounding.
In the mutual fund industry, most funds offer what is called the growth option, meaning
reinvestment of dividends. They have the same power of compounding as a compound interest
deposit, unlike the other option whereby the investor receives the dividends. Let the investors
know the effect of compounding. This does not mean that all investors must buy only the growth
option of investment plans. All of us need fixed income at some stage in our lives, to a smaller or
greater extent. But, what an investor earns over his immediate needs, he ought to invest and
compound. With open-end schemes, even in the debt category, it is now possible to benefit from
compounding by choosing the growth option, and withdrawing the capital in parts as required.
Lets take the instance of two investors Jyoti and Sanjay.
Jyoti started investing Rs. 5,000 from the age of 25. She invested for 10 yrs. and her total
investment was 6 lakhs.
Sanjay started investing Rs. 5,000 from the age of 35. He invested for 25 yrs and his total
investment was 15 lakhs.
At the age of 60, when they both retired Jyotis investment had grown to Rs. 4.6 crs whereas
Sanjays investment was worth only Rs. 1.5 crs. This is the power of compounding. Both these
investors have been assumed to be investing in an instrument, which gave a return of 12%,
compounded annually.
The impact of Taxes and Inflation
Very often investors ignore the impact of taxes and inflation. When comparing returns of scheme
investors should compare the post tax returns. As some investments provide a tax advantage over
other investments.
Inflation is a silent killer. Its not visible and hence we ignore its importance when making
investments.
Taxes & Inflation
Stocks

Nominal Returns
20.90%

After Taxes
13.90%

After Taxes & Inflation

4.90%
77

Company Deposits
Bank Deposits

15.60%
9.70%

10.60%
6.60%

1.90%
-1.85%

Cost of Living
Items

1987

1997

2017

Colgate Toothpaste
Hamam Soap
Masala Dosa
Petrol
LPG Cylinder
Zodiac Men's shirt

8.05
3.05
3.50
7.99
56.15
225.00

18.90
7.85
14.00
25.48
137.85
510.00

104.00
52.00
224.00
259.12
830.85
2620.27

Employing professional management

A seasoned, full-time investment manager - another benefit built into mutual funds - may help an
investor reduce his risk while increasing your return. Consulting with his financial advisor can
lead to selecting professional managers most suitable for him and his goals.
Step 4: Evaluate the risk/reward tradeoff
Higher return means higher risks. However higher risks may not always mean higher return, as
there is a fear that a wrong investment may wipe of your entire principal. Different asset classes
involve different degrees of risk. An investor should gather information and study the investment
features and the risks associated with these investments.
An inherent advantage of mutual funds is of diversification and due to diversification the risks
gets diluted. For e.g. the risk of an investor who chooses to invest in an individual stock is
directly associated with the performance of that stock. If the stock performs he benefits, if it fails
his investment fails. Whereas in case of the investor who invests in diversified equity fund the
risk gets spread across the entire portfolio, which may constitute of 20 stocks. Hence even if one
stock fails he does not lose his entire principal. His risk gets diluted.
Questions to ask:
What's my potential return?
What's a reasonable holding period?
What's my own time horizon?
What's the likely fluctuation range?
How will this investment help me achieve my goals?
What are the chances I'll need this money during the preferred holding period?
Are there other/better alternatives?
What's the realistic risk that I could lose principal?
How much fluctuation is acceptable to me?
How vulnerable is this investment to interest rate changes?
How stable is the industry?
What risk control strategies are available to me?

78

Which risk control strategies have I used?

What are my risks if I don't act?

79

Conclusion
It clearly emerges from the above study that mutual funds are one of the best options for the
individual small investor.
However, a note of caution is in order, while it might be one of the best options, there are many
mutual funds already available for the investor to choose from. It must be realized that the
performance of different funds varies form time to time.
Also, the Indian mutual fund sector has been in an evolving phase over the past five years during
which time several investors have encountered some poorly performing funds, while others have
been fortunate to be with good performers. Besides, evaluation of fund performance is
meaningful when a fund has access to an array of investment products in the market. Currently in
India, there are limited investment opportunities available to mutual funds, and their track record
must be studied in this context. Therefore, the Indian investors have moved over to mutual funds
in a gradual process.
But, there is little doubt that mutual funds will increasingly attract the small investors as
compared to other intermediaries such as banks and insurance companies.

80

Glossary
CLB

Company Law Board

DCA

Department of Company Affairs

FII

Financial Institution

FIPB

Foreign Investment Promotion Board

M&A

Mergers & Acquisitions

MOF

Ministry of Finance

NBFC

Non-Banking Finance Company

NPA

Non-Performing Asset

NRI

Non-Resident Indian

NSE

Notional Stock Exchange

ROC

Registrar of Companies

WDM

Wholesale Debt Market

SD

Standard Deviation

CAGR

Compounded Annual Growth Rate

81

Bibliography
Annual Investment Planner

A.N. Shanbhag

All About Mutual Funds

Bruce Jacobs

Bogle on Mutual Funds

John C Bogle

AMFI Mutual Fund Testing Programme-

AMFI

Investing in Mutual Funds

India Infoline

SEBI (Mutual fund) Regulations, 1996

Economic Times
Websites

Fidelity
MyIris
India Infoline

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