Critical Study of Mutual Funds 1.

Introduction to Mutual Funds

1.1 Origin 1.2 Concept of a Mutual Fund 1.3 Advantages of Mutual Funds 2. Organisation of a Mutual Fund

2.1 Key Players 2.2 Key terms used in Mutual Fund industry 3. 4. 5. Types of Mutual Fund Schemes Growth of Mutual Funds in India Unitholders Protection 5.1Role of SEBI 5.2Role of AMFI 6. Conclusion

1. Introduction to Mutual Funds

1.1 Origin In India, the setting up of Unit Trust of India (UTI) in 1964 marked the advent of mutual fund industry. Unit Trust of India was set up by an act of Parliament. UTI was regulated since its inception by the UTI Act, 1963 and regulations framed there under. UTI was established as a corporate body. The purpose of establishing the Unit Trust of India was to give a fillip to equity market. The association of Mutual Funds in India (AMFI) has officially classified the four decades of mutual funds in India into four phases. The first phase during the years 1963-1987 saw UTI consolidating its position by offering a variety of products and extending its reach throughout the country. The next phase (198793) marked the arrival of mutual funds sponsored by public sector banks and financial institutions. The third phase began in 1993 with the arrival of private sector players, both Indian and foreign. The fourth phase started with SEBI (Mutual Funds) Regulation, 1996.

1.2 Concept of Mutual Fund

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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 then invested in capital market instruments such as shares, debentures and other securities. The income earned through these investments and the capital appreciation realised are shared by its unit holders in proportion to the number of units owned by them. 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 basket of securities at a relatively low cost. The flow chart below describes broadly the working of a mutual fund

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1.3 Advantages of Mutual Funds2 Since their creation, mutual funds have been a popular investment vehicle for investors. Their simplicity along with other attributes provides great benefit to investors with limited knowledge, time or money. These are some of the reason why one might consider investing in mutual funds Diversification One rule of investing, for both large and small investors, is asset diversification. Diversification involves the mixing of investments within a portfolio and is used to manage risk. For example, by choosing to buy stocks in the retail sector and offsetting them with stocks in the industrial sector, we can reduce the impact of the performance of any one security on our entire portfolio. By purchasing mutual funds, we are provided with the immediate benefit of instant diversification and asset allocation without the large amounts of cash needed to create individual portfolios. Economies of Scale Mutual funds are able to take advantage of their buying and selling size and thereby reduce transaction costs for investors. When we buy a mutual fund, we are able to diversify without the numerous commission charges.

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Liquidity Another advantage of mutual funds is the ability to get in and out with relative ease. In general, we are able to sell your mutual funds in a short period of time without there being much difference between the sale price and the most current market value. However, it is important to watch out for any fees associated with selling, including backend load fees. Professional Management When we buy a mutual fund, we are also choosing a professional money manager. This manager will use the money that we invest to buy and sell stocks that he or she has carefully researched. Therefore, rather than having to thoroughly research every investment before we decide to buy or sell, we have a mutual fund's money manager to handle it for us.

2. Organisation of a Mutual Fund

There are many entities involved and the diagram below illustrates the organisational set up of a mutual fund

2.1 Key Players Fund Sponsors They are akin to promoters of a company. They establish the fund and get it registered with SEBI. They also form a trust and appoint board of trustees. Trustees They hold assets on behalf of the unit holders in the trust. They appoint Asset Management Company and ensure that all the activities of the AMC are in accordance with the SEBI regulations. They also appoint the custodian of the fund. The trustees enter into investment management agreement with the asset management company. The trustees shall have a right to obtain from the asset management company such information as considered necessary by the trustees. Asset Management Company (AMC) The main objective of the AMC is to float schemes and manage them in accordance with the SEBI regulations.

Custodian The main function of the custodian is to hold the funds securities in safekeeping, settle securities transactions for the fund, collect interests and dividends paid on securities, and record information on stock splits and other corporate actions. Registrar and Transfer Agents They maintain records of unit holders accounts and transactions, disburse and receive funds from unit holder transactions, prepare and distribute account statements and tax information, handle unit holder communications and provide unit holder with transaction services. Distributors/agents To send their products across the length and breadth of the country, mutual funds take the services of distributors/agents. Distributors comprise of banks, non-banking financial companies and other distribution companies. Individuals constitute the agency force. 2.2 Key terms used in Mutual Fund Industry Net Asset Value (NAV) Net Asset Value is the market value of the assets of the scheme minus its liabilities. The per unit NAV is the net asset value of the scheme divided by the number of units outstanding on the Valuation Date. Sale Price It is the price you pay when you invest in a scheme. It is also called Offer Price. It may include a sales load. Repurchase Price It is the price at which units under open-ended schemes are repurchased by the Mutual Fund. Such prices are NAV related.

Redemption Price It is the price at which close-ended schemes redeem their units on maturity. Such prices are NAV related. Sales Load It is a charge collected by a scheme when it sells the units. It is also called, Front-end load. Schemes that do not charge a load are called No Load schemes. Repurchase or Back-end Load It is a charge collected by a scheme when it buys back the units from the unit holders.

3. Types of Mutual Fund Schemes

Mutual fund schemes may be classified on the basis of their structure and investment objectives. 3.1 Equity funds

These funds invest a maximum part of their corpus into equities holdings. The structure of the fund may vary different for different schemes and the fund managers outlook on different stocks. The Equity Funds are sub-classified depending upon their investment objective, as follows
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Diversified Equity Funds Mid-Cap Funds Sector Specific Funds Tax Savings Funds (ELSS)

Equity investments are meant for a longer time horizon, thus Equity funds rank high on the riskreturn matrix. 3.2 Debt funds The objective of these Funds is to invest in debt papers. Government authorities, private companies, banks and financial institutions are some of the major issuers of debt papers. By investing in debt instruments, these funds ensure low risk and provide stable income to the investors. Debt funds are further classified as:
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Gilt Funds Invest their corpus in securities issued by Government, popularly known as Government of India debt papers. These Funds carry zero Default risk but are associated with Interest Rate risk. These schemes are safer as they invest in papers backed by Government.

Income Funds Invest a major portion into various debt instruments such as bonds, corporate debentures and Government securities.

MIPs Invests maximum of their total corpus in debt instruments while they take minimum exposure in equities. It gets benefit of both equity and debt market. These scheme ranks slightly high on the risk-return matrix when compared with other debt schemes.

Short Term Plans (STPs) Meant for investment horizon for three to six months. These funds primarily invest in short term papers like Certificate of Deposits (CDs) and Commercial Papers (CPs). Some portion of the corpus is also invested in corporate debentures.

Liquid Funds Also known as Money Market Schemes, These funds provides easy liquidity and preservation of capital. These schemes invest in short-term instruments like Treasury Bills, inter-bank call money market, CPs and CDs. These funds are meant for short-term cash management of corporate houses and are meant for an investment horizon of 1day to 3 months. These schemes rank low on risk-return matrix and are considered to be the safest amongst all categories of mutual funds.

3.3 Balanced funds As the name suggest they, are a mix of both equity and debt funds. They invest in both equities and fixed income securities, which are in line with pre-defined investment objective of the scheme. These schemes aim to provide investors with the best of both the worlds. Equity part provides growth and the debt part provides stability in returns.

Further the mutual funds can be broadly classified on the basis of investment parameters Each category of funds is backed by an investment philosophy, which is pre-defined in the objectives of the fund. The investor can align his own investment needs with the funds objective and invest accordingly. By investment objective:
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Growth Schemes Growth Schemes are also known as equity schemes. The aim of these schemes is to provide capital appreciation over medium to long term. These schemes normally invest a major part of their fund in equities and are willing to bear short-term decline in value for possible future appreciation.

Income Schemes Income Schemes are also known as debt schemes. The aim of these schemes is to provide regular and steady income to investors. These schemes generally invest in fixed income securities such as bonds and corporate debentures. Capital appreciation in such schemes may be limited.

Balanced Schemes Balanced Schemes aim to provide both growth and income by periodically distributing a part of the income and capital gains they earn. These schemes invest in both shares and fixed income securities, in the proportion indicated in their offer documents (normally 50:50).

Money Market Schemes Money Market Schemes aim 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.

Other schemes
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Tax Saving Schemes: Tax-saving schemes offer tax rebates to the investors under tax laws prescribed from time to time. Under Sec.88 of the Income Tax Act, contributions made to any Equity Linked Savings Scheme (ELSS) are eligible for rebate.

Index Schemes: Index schemes attempt to replicate the performance of a particular index such as the BSE Sensex or the NSE 50. The portfolio of these schemes will consist of only those stocks that constitute the index. The percentage of each stock to the total holding will be identical to the stocks index weightage. And hence, the returns from such schemes would be more or less equivalent to those of the Index.

Sector Specific Schemes: These are the funds/schemes which invest in the securities of only those sectors or industries as specified in the offer documents. e.g. Pharmaceuticals, Software, Fast Moving Consumer Goods (FMCG), Petroleum stocks, etc. The returns in these funds are dependent on the performance of the respective sectors/industries. While these funds may give higher returns, they are more risky compared to diversified funds. Investors need to keep a watch on the performance of those sectors/industries and must exit at an appropriate time.

4. Growth of Mutual Funds in India

The mutual fund industry in India started in 1963 with the formation of Unit Trust of India, at

the initiative of the Government of India and Reserve Bank of India. The history of mutual funds in India can be broadly divided into four distinct phases First Phase 1964-87 Unit Trust of India (UTI) was established on 1963 by an Act of Parliament. It was set up by the Reserve Bank of India and functioned under the Regulatory and administrative control of the Reserve Bank of India. In 1978 UTI was de-linked from the RBI and the Industrial Development Bank of India (IDBI) took over the regulatory and administrative control in place of RBI. The first scheme launched by UTI was Unit Scheme 1964. At the end of 1988 UTI had Rs.6,700 crores of assets under management. Second Phase 1987-1993 (Entry of Public Sector Funds) 1987 marked the entry of non- UTI, public sector mutual funds set up by public sector banks and Life Insurance Corporation of India (LIC) and General Insurance Corporation of India (GIC). SBI Mutual Fund was the first non- UTI Mutual Fund established in June 1987 followed by Canbank Mutual Fund (Dec 87), Punjab National Bank Mutual Fund (Aug 89), Indian Bank Mutual Fund (Nov 89), Bank of India (Jun 90), Bank of Baroda Mutual Fund (Oct 92). LIC established its mutual fund in June 1989 while GIC had set up its mutual fund in December 1990. At the end of 1993, the mutual fund industry had assets under management of Rs.47,004 crores. Third Phase 1993-2003 (Entry of Private Sector Funds) With the entry of private sector funds in 1993, a new era started in the Indian mutual fund industry, giving the Indian investors a wider choice of fund families. Also, 1993 was the year in which the first Mutual Fund Regulations came into being, under which all mutual funds, except UTI were to be registered and governed. The erstwhile Kothari Pioneer (now merged with
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Franklin Templeton) was the first private sector mutual fund registered in July 1993. The 1993 SEBI (Mutual Fund) Regulations were substituted by a more comprehensive and revised Mutual Fund Regulations in 1996. The industry now functions under the SEBI (Mutual Fund) Regulations 1996. The number of mutual fund houses went on increasing, with many foreign mutual funds setting up funds in India and also the industry has witnessed several mergers and acquisitions. As at the end of January 2003, there were 33 mutual funds with total assets of Rs. 1,21,805 crores. The Unit Trust of India with Rs.44,541 crores of assets under management was way ahead of other mutual funds. Fourth Phase since February 2003 In February 2003, following the repeal of the Unit Trust of India Act 1963 UTI was bifurcated into two separate entities. One is the Specified Undertaking of the Unit Trust of India with assets under management of Rs.29,835 crores as at the end of January 2003, representing broadly, the assets of US 64 scheme, assured return and certain other schemes. The Specified Undertaking of Unit Trust of India, functioning under an administrator and under the rules framed by Government of India and does not come under the purview of the Mutual Fund Regulations. The second is the UTI Mutual Fund, sponsored by SBI, PNB, BOB and LIC. It is registered with SEBI and functions under the Mutual Fund Regulations. With the bifurcation of the erstwhile UTI which had in March 2000 more than Rs.76,000 crores of assets under management and with the setting up of a UTI Mutual Fund, conforming to the SEBI Mutual Fund Regulations, and with recent mergers taking place among different private sector funds, the mutual fund industry has entered its current phase of consolidation and growth.

The graph indicates the growth of assets over the years.

5. Unit holders Protection 5.1 Role of SEBI

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During 1995-96, SEBI had prepared and widely circulated a paper titled "Mutual Funds 2000"

which identified ways to improve the working and regulation of the mutual fund industry, so that mutual funds could provide a better performance and service to all categories of investors and offer a range of innovative products in a competitive manner to match investor needs and preferences across various investor segments. Based on the comments received on the recommendations made in the paper by market participants and investors and on discussions held with the Association of Mutual Funds of India (AMFI), the SEBI (Mutual Funds) Regulations, 1993 were revised and the new regulations notified in December 1996.The revised regulations embodied far reaching changes in the regulation and functioning of mutual funds. The revised regulations provide for
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enhanced level of investor protection empowerment of investors stringent disclosure norms in the offer documents, so that investors are better informed, better advised, better aware of risks and rewards

standardisation of norms for valuation of assets, computation of Net Asset Values (NAVs) of schemes of mutual funds and accounting standards and policies

complete freedom to asset management companies to structure schemes in accordance with investor preferences

removal of quantitative restrictions on investment by mutual funds and replacement by prudential supervision

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replacement of vetting of offer documents by filing guaranteed return schemes by mutual funds permitted provided returns including capital were guaranteed

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indication of expected returns based on hypothetical portfolio permitted better governance of mutual funds through higher responsibilities and empowerment of trustees as front-line regulators of mutual funds

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closer scrutiny through off site and onsite inspections code of ethics for asset management companies

The impact of the new regulations was immediately felt. Asset management companies framed several schemes which made use of the freedom provided to them by the new regulations. Not only did the number of schemes filed with SEBI increase significantly in a short period of time, but also there was greater variety in the investment products offered. There was also a significant improvement in disclosures in the offer documents. The new regulations have brought into greater focus the responsibilities of trustees of mutual funds who are uniquely positioned to promote the interests of the unitholders and to ensure that mutual funds are managed responsibly and ethically. The trustees act independently to uphold the public trust. In this process, trustees act as the first level regulators and are critical in helping to ensure the profitability and progress of the mutual funds. To assist trustees in their new role, and to set out the manner in which they could best perform this role, SEBI appointed a committee under the chairmanship of Shri P K Kaul, former Cabinet Secretary and Ambassador to the United States. SEBI is using its interface with AMFI to assess the impact of the new regulations on the working of mutual funds and to examine further ways of improving the performance of mutual funds so as to restore investor confidence in them. SEBI also continued working with AMFI so that it becomes a more effective body representing the mutual fund industry and embarks on a campaign to sharpen the industry's focus on the consumer. 5.2 Role of AMFI AMFI, the apex body of all the registered asset management companies was incorporated on August 22, 1995 as a non-profit organization. All the asset management companies that have launched mutual fund schemes are its members. One of the objectives of AMFI is to promote investors interest by defining and maintaining high ethical and professional standards in the mutual fund industry. The AMFI code of ethics set out the standards of good practices to be followed by the asset management companies in their operations and in their dealing with investors, intermediaries and public. AMFI code has been drawn up to encourage adherence to

standards higher than prescribed by the regulations for the benefits of the investors in the mutual fund industry .