Mutual Funds

Definition
A trust that pools the savings of investors who share a common
financial goal is known as mutual fund. The money collected is
then invested in financial instruments such as shares, debentures
and other securities the income and capital appreciation realized
are shared by its unit holders in proportion to the number of units
owned by them.
Investment in securities are spread over a wide cross section of
industries and sectors reducing the risk of the portfolio.
Mutual funds are mobilizers of saving of the small investors in
instruments like stock and money market instruments.
Mutual funds are corporation that accept money from investors
and use this money to buy stocks, long term bonds, short term
debt instruments issued by businesses or Govt.

Features
Mobilizing small savings: mutual funds mobilize funds by selling
their own shares known as units. This gives the benefit of
convenience and satisfaction of owning shares in many industries.
Mutual fund invest in various securities and pass on the returns to
the investors.
Investment Avenue: the basic characteristic of a mutual fund is that
it provides an ideal avenue for investment for investors and enables
them to earn a reasonable return with better liquidity. It offers
investors a proportionate claim on the portfolio of assets that
fluctuate in value.
Professional management: mutual fund provides investors with the
benefit of professional and expert management of their funds.
Mutual fund employees professionals/experts who manage the
investment portfolios efficiently and profitably. Investors are
relieved from the responsibility of following the markets on a
regular basis.

 Diversified investment: mutual fund have the advantage of

diversified investment of funds in various industries and
sectors. This is beneficial to small investors who cannot afford
to buy shares of established companies at high prices. Mutual
fund allow millions of investors who have investments in
variety of securities of different companies.
Better liquidity: mutual fund have the distinct advantage of
better liquidity of investment. There is always a market
available for mutual funds. In case of mutual funds it is
obligatory that units are listed and traded thus offering our
secondary markets for the funds. A high level of liquidity is
possible for the fund holders because of more liquid securities
in the mutual fund portfolio.
Reduced risks: the risk on mutual fund is minimum. This is
because of expert management diversification , liquidity and
economies of scale in transaction cost.

 Investment protection: mutual funds are regulated by guidelines

and legislative provisions put in place by regulatory agencies
such as SEBI in order protect the investor interest the mutual
funds are obligated to follow the provisions laid down by the
regulators.
Switching facility: mutual funds provide investors with the
flexibility to switch from one scheme to another, this flexibility
enables investors to switch from income scheme to growth
scheme and from close ended scheme to open ended scheme.
Tax benefits: mutual funds offer tax shelter to the investors by
investing in various tax saving schemes under the provisions
provided by the income tax act.
Low transaction cost: the cost of purchase and sale of MFs is
relatively lower.

 Economic development: MFs contribute to economic

development by mobilizing savings and channelizing them to
more productive sectors of the economy.
Convenience: MF units can be traded easily with little or no
transaction cost.

Products and Schemes

Investors have the option of choosing from a wide variety of
schemes in a mutual fund depending upon their requirements.
MFs are classified as follows:
Operational classification:
Open ended scheme: when a fund is accepted and liquidated on a
continuous basis by a MF manager, it is called as open ended
scheme. The fund manager buys and sells units constantly as
demanded by the investors. The capitalization of the funds changes
constantly as it is always open for the investors to buy or sell their
units. The scheme provides excellent liquidity facility to the
investors. The buying and selling of units takes place at a declared
NAV(Net Asset Value)

 Close ended scheme: when a units of a scheme liquidated only after the
expiry of a specified period it is known as close ended fund. Such funds have
fixed capitalization and remain with the mutual fund manager, units of close
ended schemes are traded on stock exchange in the secondary market. The
price is determined on the basis of supply and demand. There are 2 prices for
such funds, one that is market determined and the other is NAV based the
market price may be above or below NAV. Managing a close ended scheme is
comparatively easy for the fund Manager. The fund can be liquidated after a
specified period.
Interval scheme: it is kind of close ended scheme with a feature that it
remains open during a particular part of the year for the benefit of investors,
to either off load or to undertake purchase of units at a NAV.

Return based classification

Income fund scheme: this scheme is customised to suit the
needs of investors who are particular about regular returns. The
scheme offers maximum current income where by the income
earned by the units is distributed periodically there are 2 types of
such schemes, one that earns a target constant income at
relatively low risk while the other offers maximum possible
income.
Growth scheme: it is a MF scheme that offers the advantage of
capital appreciation of the underlying investment such funds
invest in growth oriented securities that are capable of
appreciating in the long run. The risk attached with such funds is
relatively higher.

 Conservative fund Scheme: a scheme that aims at providing a

reasonable rate of return, protecting the value of investment and
achieving capital appreciation is called a conservative fund
scheme. It is also known as middle of road funds as it offers a
blend of the above features. Such funds divide their portfolio in
stocks and bonds in such a way that it achieves the desired
objective.

Investment based classification

Equity fund: such fund invest in equity shares they carry a
high degree of risk such fund do well in favorable market
conditions. Investments are made in equity shares in diverse
industries and sectors.
Debt funds: Such fund invest in debt instruments like bonds
and debentures. These funds carry the advantage of secure and
steady income there is little chance of capital appreciation.
Such funds carry no risk. A variant of this type of fund is called
liquid fund which specializes in investing in short term money
market instruments.
Balanced funds: such scheme have a mix of debt and equity in
their portfolio of investments. The portfolio is often shifted
between debt and equity depending upon the prevailing market
conditions.

 Sectoral fund: Such fund invest in specific sectors of the

economy. The specialized sectors may include real estate
infrastructure, oil and gas etc, offshore investments,
commodities like gold and silver.
Fund of Funds: such funds invest in units of other mutual
funds there are a number of funds that direct investments into
specified sectors of economy. This makes diversified and
intensive investments possible.
Leverage funds: the funds that are created out of investments
with not only the amount mobilized from investors but also
from borrowed money from the capital markets are known as
leveraged funds. Fund managers pass on the benefit of leverage
to the mutual fund investors. Additional provisions must be
made for such funds to operate. Leveraged funds use short sale
to take advantage of declining markets in order to realize gains.
Derivative instruments like options are used by such funds.

 Gilt fund: These funds seek to generate returns through investment

in govt. securities. Such funds invest only in central and state govt.
securities and REPO/ reverse REPO securities. A portion of the
corpus may be invested in call money markets to meet liquidity
requirements. Such funds carry very less risk. Their prices are
influenced only by moment in interest rates.
Tax saving schemes: certain MF schemes offer tax rebate on
investments made in equity shares under section 88 of income tax
act. Income may be periodically distributed depending on surplus.
Subscriptions made Upto Rs.10000 are eligible for tax rebate under
section 88 for such scheme. The investment of the scheme includes
investment in equity, preference shares and convertible debentures
and bonds to the extent 80-100% and rest in money market
instruments.

 Indexed funds: these funds are linked to specific index. Funds

mobilized under such schemes are invested in securities of
companies included in the index of any exchange. The fund
performance is linked to the growth in concerned index.

Structure Of Mutual Funds In India

Mutual Funds in India follow a 3-tier structure.
The first tier is the sponsor who thinks of starting the fund.
The second tier is the trustee. The Trustees role is not to
manage the money. Their job is only to see, whether the
money is being managed as per stated objectives. Trustees
may be seen as the internal regulators of a mutual fund.
Trustees appoint the Asset Management Company (AMC)
who form the third tier, to manage investors money. The
AMC in return charges a fee for the services provided and this
fee is borne by the investors as it is deducted from the money
collected from them

Sponsor
Any corporate body which initiates the launching of a mutual
fund is referred to as The sponsor.
The sponsor is expected to have a sound track record and
experience in financial services for a minimum period of 5
years and should ensure various formalities required in
establishing a mutual fund.
According to SEBI, the sponsor should have professional
competence, financial soundness and reputation for fairness
and integrity. The sponsor contributes 40% of the net worth of
the AMC. The sponsor appoints the trustee, The AMC and
custodians in compliance with the regulations.

Trustee
Sponsor creates a public trust and appoints trustees. Trustees
are the people authorized to act on behalf of the Trust. They
hold the property of mutual fund.

Once the Trust is created, it is registered with SEBI after

which this trust is known as the mutual fund. The Trustees role
is not to manage the money but their job is only to see,
whether the money is being managed as per stated objectives.
Trustees may be seen as the internal regulators of a mutual
fund.

A minimum of 75% of the trustees must be independent of the

sponsor to ensure fair dealings.

Trustees appoint the Asset Management Company (AMC), to

manage investors money.

Custodian
A custodians role is keeping custody of the securities that are
bought by the fund manager and also keeping a tab on the
corporate actions like rights, bonus and dividends declared by
the companies in which the fund has invested.
The Custodian is appointed by the Board of Trustees. The
custodian also participates in a clearing and settlement system
through approved depository companies on behalf of mutual
funds, in case of dematerialized securities.
Only the physical securities are held by the Custodian. The
deliveries and receipt of units of a mutual fund are done by the
custodian or a depository participant at the instruction of the
AMC and under the overall direction and responsibility of the
Trustees. Regulations provide that the Sponsor and the
Custodian must be separate entities.

Asset Management Company (AMC)

Trustees appoint the Asset Management Company (AMC), to

manage investors money. The AMC in return charges a fee for the
services provided and this fee is borne by the investors as it is
deducted from the money collected from them.

The AMCs Board of Directors must have at least 50% of Directors

who are independent directors. The AMC has to be approved by
SEBI. The AMC functions under the supervision of its Board of
Directors, and also under the direction of the Trustees and SEBI.

It is the AMC, which in the name of the Trust, floats new schemes
and manage these schemes by buying and selling securities. In
order to do this the AMC needs to follow all rules and regulations
prescribed by SEBI and as per the Investment Management
Agreement it signs with the Trustees.

AMC cont

The role of the AMC is to manage investors money on a day to

day basis. Thus it is imperative that people with the highest
integrity are involved with this activity.

The AMC cannot deal with a single broker beyond a certain limit of
transactions.

The AMC cannot act as a Trustee for some other Mutual Fund.

The responsibility of preparing the OD lies with the AMC.

Appointments of intermediaries like independent financial

advisors (IFAs), national and regional distributors, banks, etc. is
also done by the AMC.

Finally, it is the AMC which is responsible for the acts of its

employees and service providers.

Registrar and Transfer Agents

The registrar and transfer agents are appointed by the AMC. AMC
pay compensation to these agents for their services. They carry
out the following functions

Receiving and processing the application forms of investors

Issuing unit certificates

Sending refund orders

Giving approval for all transfers of units and maintaining records

Repurchasing the units and redemption of units

Issuing dividend or income warrents

Fund Accountants

Fund accountants are appointed by the AMC. The are in charge of

maintaining proper books of accounts relating to the fund
transactions and management. The perform the following
functions

Computing the net asset value per unit of the scheme on a daily
basis

Maintaining its books and records

Monitoring compliance with the schemes, investment limitations

as well as SEBI regulations

Preparing and distributing reports of the schemes for the unit

holders and SEBI and monitoring the performance of mutual funds
custodians and other service providers.

Lead Manager

Lead manager carry out the following functions:

Selecting and coordinating the activities of intermediaries such as

advertising agency, printers, collection centers.

Carrying out extensive campaign about the scheme and acting as

marketing associates to attract investors.

Assisting the AMC to approach potential investors through meetings,

exhibitions, contacts, advertising, publicity and sales promotion.

Investment Advisors

Investment advisors carry out market and security

analysis.

Advising the AMC to design its investment strategies

on a continuous basis.

They are paid for their professional advice regarding

fund investment on the average weekly value of the
funds net assets.

Legal Advisors

Legal advisors are appointed to offer legal guidance

about planning and execution of different schemes.

A group of advocates and solicitors may be

appointed as legal advisors.

Their fee is not associated with net assets of the

fund.

Auditors and Underwriters

An auditor is appointed by the AMC and must

undertake independent inspection and verification
of its accounting activities.

Mutual funds also undertake the activities of

underwriting issues. Such activities generate an
additional source of income for mutual funds. Prior
approval from SEBI is necessary for undertaking
such activity

Working mechanism of
AMC

Creating fund manager: A fund manager is responsible for

managing the funds of the AMC. The fund manager should be
an independent agency but in India a single fund manager
handles many schemes simultaneously. The basic function of
fund managers is to decide the rate, time, kind and quantum
of securities to be brought and sold. The fund manager
ensures the success of the fund scheme.

Research and Planning: the research and planning cell of

AMC undertake research activities relating to securities as well
as prospective investors the results of the study are analyzed
to draft future policies governing investments.

Creating dealers: Dealers having a deep understanding of

stock market operations may be created by the AMC in order
to execute sales and purchase transactions in the capital and
money market. Dealers should comply with all formalities of
sale and purchases through brokers.

Portfolio Management Process In

Mutual Fund
Setting investment goals: The first task of managing the
portfolio of mutual fund is to identify and set the goals for
the proposed scheme the goal is set keeping in mind the
nature of the scheme, risk and return, market condition,
regulatory norms, size of the issue and investor protection.
Identifying specific securities: Efforts are made to
analyze and identify the right securities where the fund
should invest in. security analyses is carried out and risk
and return characteristics are evaluated.
Portfolio designing: it involves making an ideal mix of
debt and equity securities of corporate, govt. etc. It is
concerned with decisions regarding the type of securities to
be bought, the quantum and timing of issue. Portfolio
design is carried out on the basis of research and analyses
of stock market and devising investment strategies. The
portfolio should be well diversified so as to reduce the total
risk of the portfolio.
Portfolio revision: The portfolio must be reviewed
periodically keeping in mind the risk return characteristics,
the revision of the portfolio is done by keeping in mind the

Operational Efficiency of
Mutual funds
Net Returns: the operational of a mutual
fund is best judged by its ability to earn for
the investors better and safe returns in the
form of capital appreciation and the
dividends or income received on such
investment.
Returns are calculated keeping in mind
the expenses incurred while earning
such returns which include trusteeship
fee, management fee, administrative
fee, fund accounting fee, initial charges,
brokerage etc. SEBI has fixed an overall
limit on expenses as per the regulations.

 Net Asset Value: It is another parameter to measure

the operational efficiency of the fund. The intrinsic
value of a unit under a specific scheme is referred to as
the NAV of the scheme. The value gives an idea of the
amount that may be obtained by the unit holder on sale
of the unit to the mutual fund company
NAV (per unit) = Total Market Value Fund liabilities
No. of outstanding Units
Load : The initial expenses that are incurred by a
mutual fund in relation to the scheme operated by it is
referred to as the load of the scheme. According to SEBI
guidelines a certain percentage of load must be borne
by the expected scheme.
Disclosures: A highly transparent nature of mutual
fund is said to operate to benefit the investors and
service their needs. MFs are supposed to follow certain
norms and ample disclosures for their operation.
Disclosures are made through half yearly and annual
reports where all the information relating to the scheme
is disclosed.

 Investor protection: the fund manager is

supposed to follow certain safe guards to protect
the interest of the investors. Unit certificates are
to be issued within 6 weeks from the date of
closure of subscriptions. Units submitted for
transfer should be executed within 30 days. A
dividend warrants are to be dispatched within 42
days of declaration of dividend. Repurchase
proceeds should be dispatched within 10 working
days from the date of redemption. SEBI takes all
possible safeguards such as conducting
inspections of the mutual funds to ensure that
investors interests are protected. Defaulting AMC
are prohibited from issuing new schemes.

Evaluation of Mutual Funds

It is essential that the performance of Mutual fund is

evaluated and appraised. Such appraisal helps the
fund to compare itself with other funds besides
being a potential source of information to the
present and prospective investors.

Evaluation includes simple evaluation tools to

sophisticated models which take into consideration
the risk and uncertainty associated with the returns.
Some of the models used are Treynors Model and
Sharpes Model

Sharpes Performance Index: It offers a single value for

performance ranking of different funds or portfolio. It measures
the risk premium of the portfolio in terms of its total risk.

Sharpes Index

= Average portfolio return Risk free

rate of return
Standard Deviation of Portfolio
=

Rp Rf

Treynors Performance Index: Here the funds performance is

measured against the market performance. It is used to calculate
return per unit of market risk.

Treynors Index = Average portfolio return Risk free

rate of return
Market risk of Portfolio

Rp Rf
p

Advantages of Mutual Funds

Mutual Funds give investors best of both the worlds.
Investors money is managed by professional fund
managers and the money is deployed in a diversified
portfolio. Mutual Funds help to reap the benefit of
returns by a portfolio spread across a wide spectrum of
companies with small investments.
A mutual fund analyses the investments for investors as
fund managers assisted by a team of research analysts
analyze the market daily.
Investors can enter / exit schemes anytime they want
(at least in open ended schemes). They can invest in an
SIP, where every month, a stipulated amount
automatically goes out of their savings account into a
scheme of their choice.
There may be a situation where an investor holds some
shares, but cannot exit the same as there are no buyers
in the market. Such a problem of illiquidity generally
does not exist in case of mutual funds, as the investor
can redeem his units by approaching the mutual fund.

 As more and more AMCs come in the market, investors

will continue to get newer products and competition
will ensure that costs are kept at a minimum.
Investors can either invest with the objective of
getting capital appreciation or regular dividends i.e.,
mutual fund are structured to suit the needs of all
investors.
An investor with limited funds might be able to invest
in only one or two stocks / bonds, thus increasing his /
her risk. However, a mutual fund will spread its risk by
investing a number of sound stocks or bonds. A fund
normally invests in companies across a wide range of
industries, so the risk is diversified.
Mutual Funds regularly provide investors with
information on the value of their investments. Mutual
Funds also provide complete portfolio disclosure of the
investments made by various schemes and also the
proportion invested in each asset type.

 The large amount of Mutual Funds offer

the investor a wide variety to choose from.
An investor can pick up a scheme
depending upon his risk/ return profile
All the Mutual Funds are registered with
SEBI and they function within the
provisions of strict regulation designed to
protect the interests of the investor

Regulations

Regulations ensure that schemes do not invest beyond a certain

percent of their NAVs in a single security. Some of the guidelines
regarding these are given below

No scheme can invest more than 15% of its NAV in rated debt
instruments of a single issuer. This limit may be increased to 20%
with prior approval of Trustees. This restriction is not applicable to
Government securities.

No scheme can invest more than 10% of its NAV in unrated paper
of a single issuer and total investment by any scheme in unrated
papers cannot exceed 25% of NAV.

No fund, under all its schemes can hold more than 10% of
companys paid up capital

No scheme can invest more than 10% of its NAV in a single

company.

If a scheme invests in another scheme of the same or different

AMC, no fees will be charged. Aggregate inter scheme investment
cannot exceed 5% of net asset value of the mutual fund

 No scheme can invest in unlisted

securities of its sponsor or its group
entities.
Schemes can invest in unlisted securities
issued by entities other than the sponsor
or sponsors group. Open ended schemes
can invest maximum of 5% of net assets in
such securities whereas close ended
schemes can invest upto 10% of net
assets in such securities
Schemes cannot invest in listed entities
belonging to the sponsor group beyond
25% of its net assets

SEBI Mutual Fund

Regulations
The regulations governing the functioning
of mutual funds in India were introduced
by SEBI in Dec 1996. The objectives of
these regulations was to bring in existence
the regulatory norms for the formation,
operation and management of mutual
funds in India. The regulations also laid
down the broad guidelines on investment
valuation, investment restriction,
advertising code and code of conduct for
mutual funds and AMCs.

Registration of mutual
funds
Every mutual fund shall be registered with
SEBI through an application to be made by the
sponsor in a prescribed format accompanied
by an application fee of Rs.25000.
Every mutual fund shall pay Rs.25lakhs
towards registration fee and Rs:2.5lakhs per
annum as service fees.
Registration shall be granted by the board on
fulfillment of conditions such as sponsors,
sound track record of 5yrs integrity, net worth
etc.

Regulations for the trust

Mutual fund shall be constituted in the form of a trust under the

provisions of Indian Registrations Act and provisions laid down by
SEBI.

A trustee should be person of integrity, ability, and should not have

been found guilty or being convicted of any economic offence or
violation of securities law.

At least 50% of the trustees shall be independent trustees.

The trustees and the AMC with SEBIs prior approval shall enter into
an investment management agreement.

The trustees shall ensure the AMC has the necessary infrastructure
and personnel.

The trustees shall ensure that AMC is monitoring security transaction

with brokers.

The trustees shall ensure that the EMC has been managing the
scheme independently.

The trustees should fulfill all its duties in order to protect the interest
of the investors.

Regulations for AMC

It should have a sound track record, reputation and fairness in

transaction.

The sponsor or trustee shall appoint an AMC with SEBIs approval.

The appointment of the AMC can be terminated by majority of

trustees or by 75% of unit holders.

The directors of AMCs should have adequate professional

experience.

At least 50% of the directors of the AMC should not be associated

with the sponsors or its subsidiaries or the trustees.

The chairman of the AMC should not be trustee of any other

mutual fund.

The AMC shall have a minimum net worth of Rs.10 crores.

The AMC shall not act as an AMC for any other mutual funds.

Regulations for custodians

The mutual fund shall appoint a custodian to carry

out the custodian services for the schemes of the
fund.

The agreement with the custodian shall be entered

into with prior approval of trustees.

Regulations for Schemes of mutual

funds

All the schemes to be launched by the AMC should be approved by the trustees
and are to be filed with SEBI.

The offer document should contain adequate disclosures to enable the investors
to make informed decisions.

Advertisement of schemes should be in conformance with SEBIs code.

The listing of closed ended schemes is mandatory and it should be listed on a

recognized stock exchange within 6 months of its subscriptions.

Units of close ended schemes can be opened for redemption at a fixed interval.

The AMC shall specify in the offer document the minimum subscription to be
raised under the scheme.

The AMC may repurchase, reissue the units of close ended schemes.

The units of close ended schemes can be converted into open ended schemes.

Any scheme on mutual fund shall not be opened for subscription after 45 days.

The mutual fund and AMC shall be liable to refund the application money to the
applicants if minimum subscription is not received.

Exchange Traded Fund (ETF)

Exchange Traded Funds (ETFs) are mutual fund units which

investors buy or sell from the stock exchange, as against a normal
mutual fund unit, where the investor buys / sells through a
distributor or directly from the AMC.

ETFs have relatively lesser costs as compared to a mutual fund

scheme

The ETF structure is such that the AMC does not have to deal
directly with investors or distributors. It instead issues units to a
few designated large participants, who are also called as
Authorized Participants (APs), who in turn act as market makers
for the ETFs.

The Authorized Participants provide two way quotes for the ETFs
on the stock exchange, which enables investors to buy and sell the
ETFs at any given point of time when the stock markets are open
for trading

Prices are available on real time and the ETFs can be purchased
through a stock exchange broker just like one would buy / sell
shares. There are huge reductions in marketing expenses and
commissions in case of ETFs.

Assets in ETFs: Practically any asset class can be used to create

ETFs. Globally there are ETFs on Silver, Gold, Indices etc. In India,
we have ETFs on Gold, Indices such as Nifty, Bank Nifty etc.

Characteristics of ETFs

An Exchange Traded Fund (ETF) is essentially a scheme where the

investor has to buy/ sell units from the market through a broker
(just as he would by a share).

An investor must have a demat account for buying and selling

ETFs.

An important feature of ETFs is the huge reduction in costs. While

a typical Index fund would have expenses in the range of 1.5% of
Net Assets, an ETF might have expenses around 0.75%

Hedge Funds

Hedge funds are aggressively managed portfolio of investments

that uses advanced investment strategies such as leveraged, long,
short and derivative positions in both domestic and international
markets with the goal of generating high returns,

Hedge funds are most often set up as private investment

partnerships that are open to a limited number of investors and
require a very large initial minimum investment

Hedge funds are a more risky variant of mutual funds. Hedge

funds are aimed at high net worth investors. They operate with
high fee structures and are less closely monitored by the
regulatory authorities.

The risk in hedge funds is higher on account of the following

features

Risky investment styles

Hedge funds take extreme positions in the market, including shortselling of investments.

Ex. In a normal long position, the investor buys a share at say, Rs.
15. The worst case is that the investor loses the entire amount
invested. The maximum loss is Rs. 15 per share.

Suppose that the investor has short-sold a share at Rs. 15. There
is a profit if the share price goes down. However, if the share price
goes up, to say, Rs. 20, the loss would be Rs. 5 per share. A higher
share price of say, Rs. 50 would entail a higher loss of Rs. 35 per
share. Thus, higher the share price more would be the loss. Since
there is no limit to how high a share price can go, the losses in a
short selling transaction are unlimited.

Borrowings: Normal mutual funds accept money from unitholders to fund their investments. Hedge funds invest a mix of
unit-holders funds (which are in the nature of capital) and
borrowed funds (loans). Unlike capital, borrowed funds have a
fixed capital servicing requirement. Even if the investments are at
a loss, loan has to be serviced. However, if investments earn a
return better than the cost of borrowed funds, the excess helps in
boosting the returns for the unit-holders