Mutual Fund

Alwyn Pinto
MBA Lecturer
Brief Class Outline
Topics to be covered
• Concept, Type of Mutual Funds
• Fund Structure and Constituents
• Legal and Regulatory Framework
• Accounting Valuation and Taxation
• Return, Risk, Performance and Fund Selection
• Life Cycles and Wealth Cycles
 Mutual Funds- Concept, History, Products
• Investors contribute their money to a common pool.
• This common pool is called the ‘Mutual Fund’.
• Ownership of the pool of money is mutual and joint.
• While investing an Investor buys a part of the assets in the
pool.
• Investor’ share in the assets of the pool is called ‘units’.
• Market value per unit is known as ‘Net Asset Value- NAV’.
 Advantages of Mutual Funds
• Portfolio Diversification
• Low Transaction Costs
• Professional Management
• Reduction in Risk
• Convenience to Operate
• Flexibility to Change Options
• Liquidity
 History of Mutual Funds
• UTI was the first mutual fund set up in India, in 1963.
• In 1987 public sector financial institutions were allowed to set up mutual
funds.
• SBI was the second mutual fund set up.
• In 1993, private participation was allowed,
• In 1996 saw the emergence of a new set of regulations, currently referred
as SEBI (Mutual Fund) Regulations, 1996.
• Dividends declared by mutual funds were made tax free in 1999.
• In Feb 2003, UTI Act was repealed and UTI Mutual Fund was formed.
• Period from 2004 is called the phase of consolidation and growth.
 Disadvantages of Mutual Funds

• Costs.

• Customized Portfolios not Possible.

• As more funds comes into the market, choice becomes

difficult
 Income or Debt Funds
• Funds can be classified based on the
»Investment objective
»Risk profile
»Asset class which they invest in.
• Debt funds aim to provide regular income and are relatively less
risky.
• Money market funds are for short term parking of funds.
• Gilt funds invest in govt. securities, have no default risk.
• Gilt funds however has high interest rate risk
• Fixed maturity plans are mutual fund’s alternative to bank fixed
deposits.
 Equity Funds and its Variants
• Equity funds invest in equities issued by companies.
• Growth funds invest in companies that grow at an above average rate.
• Sector funds in a particular sector or industry
• Foreign securities fund invest in shares of companies outside the
country.
• Small and mid cap funds invest in stocks with low market capitalization.
• Other equity fund variants are ELSS schemes, value funds, equity index
funds.
 Hybrid Funds
• Hybrid funds - different asset classes in the same fund.
• Monthly income plans - debt oriented hybrid funds.
• Balanced funds – equity oriented hybrid funds.
• Asset allocation funds - switch between equity and debt as per market
scenario.
• Real estate funds
• Commodity funds
• Fund of funds
• Exchange traded funds
 Fund Structure
Fund Sponsor

Trustees

Asset Management
Company

Depository Agent

Custodian
SimplyFinance
 Fund Structure and Its Constituents
• In India mutual fund is structured as trusts.
• In US mutual funds are set up investment companies.
• In India mutual funds follow a 3 tier structure – Sponsor, Trust,
AMC.
• Sponsor promotes the trust and sets up the AMC.
• Trust is run by trustees.
• Trustees appoint the AMC.
 Sponsors, Trust, AMC
• Sponsor
– 5 years experience in finance industry.
– Positive net worth for last 3 years.
– Contribute 40% to the AMC capital.
• Trustees
– Protectors of unit holders’ interests.
– SEBI regulates the function of trustees.
• AMC
– Investment manager to the mutual fund
– Registered as public or private limited company
– Capital is contributed by sponsor.
– Min net worth of Rs 10 crores always.
– 50% of the board should be independent.
 Mutual Fund Constituents
• Custodian – Settlement of security transactions

• Depository Participant – Holds security accounts

• Bankers – Collection and clearing services

• Registrars & transfer agents – Investor records and

transaction processing

• Distributors - Selling mutual fund products

 Legal and Regulatory Environment
• Mutual funds are regulates by SEBI (Mutual Fund) Regulations, 1996.
• RBI regulates
» Money market mutual funds
» Bank sponsored mutual funds
• SEBI and RBI are governed by SEBI Act,1992 and RBI Act,1949
respectively.
• Securities Appellate Tribunal hears appeals against SEBI
• Complaints against AMC and trust can be made with Company Law
Board.
 Self Regulatory Organizations
• A Self Regulatory Organization

– Is an industry body.
– Is registered with the regulatory body.
– Has limited powers to enforce rules, award penalties.
– All stock exchanges are SROs.
– AMFI is not an SRO.
 Investors Rights and Limitations

• Investors are entitled to timely service.

• 75% of unit holders can wind up a scheme or terminate an
AMC.
• A unit holder cannot sue the mutual fund.
• A prospective investor has no rights.
• Investors cannot claim any shortfall from the fund in case
assured return is not met.
 Offer Document
• Offer document
» Is the most authentic communication on a scheme.
» Is a legal document between the investor and the fund
• Offer document to follow SEBI format
• Condensed version of OD is KIM
• Offer Document
» for open ended funds to be revised every 2years
» For closed ended funds it is issued during NFO only
• Addendums notify changes in OD
 Contents of OD
• Details of the sponsor and the AMC
• Description of the scheme and the investment objective
• Terms of issue
• Historical statistics
• Investor’s rights and services
• Fee structure and expenses
• Information on income and expenses of existing schemes
 Investor Services
• Investors to submit completed application form.
• Documents like PAN, to be submitted
• Payment to be made in cheque or DD.
• Account statement is the proof of investment.
• Redemption proceeds to be paid in 10 working days.
• Penal interest of 15% for delay.

SimplyFinance
 Investment Pattern
• Equity
• Debt & Money Market Instruments
 Accounting, Valuation and Taxation
• Assets Under Management – market value of portfolio
• Fund Running Expense – charged to the fund every day
• Net Asset Value – value of investor’ unit
• NAV= (AUM- expenses)/no of units
• Applicable NAV
» Non liquid schemes 3 pm
» Liquid schemes 12 noon
• NAV rounded off
» 2 decimals all schemes except liquid
» 4 decimals for liquid schemes
 NAV and Load
• Two types of load
» Entry load, exit load
• SEBI regulates max load funds can charge.
• Open ended funds max entry/exit load 7%.
• A fund cannot charge both.
• Close ended funds max is 5%.
 Mutual Fund Expenses
• Expenses to be charged with SEBI specified limits
»2.5% for first 100 crores
»2.25% for next 300 crores
»2% on next 300 crores
»1.75% for balance assets
»Debt funds charge 0.25% less across
• Investment management expenses
»1.25% on the first 100 crores
»1% on the remaining assets
»I% extra in case of no load funds
 Initial Issue Expenses & Accounting Policies

• Initial issue expenses

» Max of 6% for close ended funds
» Open ended funds cannot charge
• Open ended funds can charge load.
• Closed ended funds amortize the initial issue expenses.
• Dividends declared from realized gains.
• Average cost method determines holding cost.
• An asset is an NPA
» If interest is not paid within 3 months from due date
 Tax Aspects
• Mutual fund exempted from tax under section 10(23D)

• Dividends from mutual funds are exempt under section 10(35)

• Funds with more than 65% equity do not pay DDT

• DDT
» 12.5% for individuals and HUFs
» 20% for institutional investors
 Tax Aspects
• Equity funds
» STCG @15% plus Surcharge
» LTCG Nil
• Debt funds
» STCG marginal rate of tax
» LTCG 10 % without indexation
» 20% with indexation
• STT payable @0.25% while equity is redeemed
• ELSS schemes eligible for deduction upto 1 lakh
• ELSS under section 80©
 Risk, Return and Performance
• Return to the investor is in the form of
– Dividends
– Capital appreciation
• Returns are calculated using
– Change in NAV method
• {(NAV at the end –NAV at the beginning)/NAV at beginning }*100
Total return method
• {(Dividend+ Change in NAV)/NAV at beginning }*100

SimplyFinance
 Return Methods
• Return on Investment method
– {(value of holdings at end- value at beginning)/value at beginning
}*100
• Compounded Annualized Growth Rate
R = (V1/V0)^1/n -1
• V1= Value at the end
• V0= Value at the beginning
• n = holding period in years
• R = is the rate of interest

SimplyFinance
 Expense Ratio and Income Ratio
• Expense ratio
– (Total expenses incurred/ average net assets)*100
– Very important information for liquid & debt funds
• Income ratio
– Net income earned/average net assets
– Not calculated as funds have unrealized income also

SimplyFinance
 Portfolio Turnover
• Portfolio turnover measures the extent to which securities are
bought and sold
• Portfolio turnover % = (value of assets purchased or
sold)/net assets *100
• High portfolio turnover indicates high costs
• An important criteria for equity funds

SimplyFinance
 Portfolio Features
• Small funds
– More agile
• Large funds
– Less agile
– Enjoys economies of scale

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 Benchmarks
• Benchmarks are independent portfolios not managed by any
fund manager
• Equity funds are benchmarked against equity index
• Debt funds benchmarked with debt indices
• Relative benchmarks
– Funds must invest in same asset class
– Funds should have same investment pattern and objectives
– Size and quality of assets should be comparable

SimplyFinance
 SEBI Regulations on Returns
• Return is calculated using growth option NAV
• Return is calculated using NAV without considering load
• Returns to be calculated for 1,3,5 and 10 years and since
inception
• Returns for less than one year is not annualized except in case
of liquid funds
• Returns for more than one year is CAGR

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 Risk in Mutual Funds
• Measures of risk is as follows
– Standard deviation
• Measures the funds fluctuation around the mean level
• Higher volatility gives high SD
– Beta Coefficient
• Measures the sensitivity of the fund to market movements
• Index funds with a beta of 1
• Higher the variance from the index , higher is the beta
– Exmarks
• Measures the correlation of a fund with the market
• Exmarks of 100% indicates perfect correlation with market

SimplyFinance
 Risk-adjusted Return
• Risk premium
– Fund return- risk free rate of return
• Sharpe ratio
– Risk premium/std deviation of return
• Treynor ratio
– Risk premium/beta of the fund
• P/E ratio
– Price of the stock/earnings per share
– Higher the P/E higher the risk
SimplyFinance
 Selecting an Equity Fund
• Funds to be categorized according to objectives
• Diversified funds offer growth
• Sector funds come with higher risk
• Dividend yield funds are income generating
• A good equity fund will have
– High gross div yield
– Low beta
– High ex marks
• Never select funds based only on past record
 Classification Based on Valuation
• Growth Stocks, Value stocks ,Cyclical stocks
• Passive fund management
» Aims at delivering market returns
• Active fund management
» Aims at delivering better returns than market
• Growth Style
» Aims for capital appreciation by investing in growth
stocks
• Value Style
» Invests in undervalued stocks and expects price to go up
in future
 Equity Stock Selection Tools & Structure
• Fundamental Analysis
» Involves studying the finance and operations of a company
• Technical Analysis
» Studying the price movements of a stock and predicting
future price
• Quantitative Analysis
» Using mathematical tools for equity valuation
• Fund Managers
» Take overall decision about the fund
• Security Analysts
» Tracks companies/ industry
• Security Dealers
» Executes buy and sell orders
 Comparing Investment Options
• Investment Options to be compared with respect to
– liquidity
– returns
– flexibility
– risk
– convenience
– stability

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 Life Cycles and Wealth Cycles

Life cycle stages

• Childhood - dependant on parents, income in the form of gifts- Invest for long term
• Young unmarried – short term needs are high
• Young married – protection over investment
• Married with young children- protection and starts planning investments
• Married with older children – Investment needs are higher
• Pre retirement age – 2/3rd of last income needed for retirement
• Retirement age- protection of capital is important
 Wealth Cycle stages
• Accumulation
» investors are young
» invest for long term
» not dependant on income from investments
• Transition
» starts drawing from the invested pool
» education needs and retirement needs are high
• Distribution
» also called reaping stage
» investors depend on investment income
» sell some of the accumulated investment
 Planning for Wealthy Investors
• High net worth investors do not need goal based planning
• HNIs can be classified as
– Wealth creating investors
• willing to take risks
• invest in equity and allied asset classes
– Wealth preserving investors
• not willing to take risks
• preserving wealth is important
• will choose debt and govt securities
 Model Portfolios
• Graham’ 50:50
– 50% allocation in equity and 50% in debt
• Portfolio linked to wealth cycle
– Accumulation phase
• 60-85% equity and balanced funds
• 15-35% income funds
• 5% liquid funds
– Distribution phase
• 15-25% equity
• 60-85% income funds
• 5% liquid funds
 Model Portfolio
• Bogle’s portfolio
– Young investor’ in accumulation phase
• 80% equity 20% debt
– Older investors in accumulation phase
• 40% equity 30% debt
– Young investors in distribution phase
• 60% equity 40% debt
– Older investors in distribution phase
• 50% equity 50% debt
 Jacob’ Model Portfolio
• Young Unmarried
– 50% aggressive equity
– 25% growth and income funds
– 25% money market funds
• Young Couple
– 30% aggressive equity
– 25% income and growth funds
– 35% municipal bond funds
– 10% money market
• Retired Couple
– 35% conservative equity
– 25% moderate equity
– 40% money market funds
• Older couple
– 25% moderate equity
– 35% long term bond funds
– 30% short term funds
– 10% emerging equity
 Investment Strategies
• Strategic asset allocation
– allocation between debt and equity that match
• life cycle and wealth cycle
– tactical allocation
• altering debt and equity to suit market conditions
– fixed allocation
• investor decides an allocation and rebalances it as portfolio value
changes
– flexible asset allocation
• investor does not change the asset allocation
• it changes with changes in market conditions
 Investment Strategies
• Power of compounding
– encourage long term investing
– higher the compounding frequency better the return
– growth option suggested if regular income is not needed
• Buy and Hold
– common mistake made by investors
– portfolio needs to be reviewed