Mutual Funds

Mutual Funds
There are small investors who invest in public issues. At a time when the stock markets crumbles, investors were looking for other avenues of investment when the concept of Mutual funds came to their rescue. The concept of mutual funds was conceived to mobilize savings from people and invest them in a mix or corporate and government securities and earn income through dividends, interest and capital gains which is eventually passed to mutual funds shareholders. We can thus say that Mutual funds are a non depository or non banking financial intermediary which acts as an important vehicle for brining wealth holders and deficit units together indirectly. We can understand the concept through a diagram.

Mutual Funds
Mutual funds are financial intermediaries

Financial market
Investments Earning and Appreciation

Professional and fund Management fee

Mutual funds

Pooling

Savings

Small Investors

Returns

Mutual Funds
SEBI defines mutual funds as Mutual funds means a fund established in the form of a trust by a sponsor to raise money by the Trustee through the sale of units to the public under one or more schemes for investing in securities in accordance with these regulations. There are 3 entities operating in a mutual fund . They are : 1) An agency which mobilizes savings and gets a commission 2) An investment agency which gets a prescribed rate of commission 3) A trustee institution, which is normally a Bank which holds the stock of securities of the Mutual fund. In India the Investment trusts are established under the Companies Act.

Mutual Funds
There are difference between Mutual funds and investment companies which can be as follows In terms of objective : In case of mutual funds the mobilization of savings is from the investors, mostly household whereas in case of investment companies it is savings of household , corporate sector. Highest investments belongs to the promoters of the company. In terms of organisation : In case of Mutual funds it is as per SEBI regulations 1993 and in case of UTI as per UTI Act 1963 whereas in case of investment companies it is as per Companies Act 1956 In terms of Capital structure : For Mutual funds initial capital would be provided by the sponsor. Scheme wise capital is decided based on the nature of scheme . Units are offered out of the scheme capital . No debt capital. Whereas, investment companies, on par with industrial companies . No scheme wise capital out of the equity capital. Capital may be debt capital also and has the advantage of gearing.

Mutual Funds
In terms of Liquidity : In Mutual funds it is close ended scheme units are traded on the organized stock exchange . Open ended schemes offer repurchase of facility and some ended schemes may also offer repurchase or premature encashment. Whereas, in case of investment companies. The company share is traded on stock exchange. No repurchase of shares. In terms of Name of the schemes Mutual funds Either open ended or close ended with a wide variety of investment objectives whereas in case investment companies it is neither open ended or close ended. Thus we have seen the difference between the mutual funds and the investment companies. Let us now understand the superiority of mutual funds over the other investment options.

Mutual Funds
Mutual funds with the expertise and experienced management cadre can be able to secure large varieties of high yielding Blue chip securities and show better results to the investing public. Thus Mutual funds are gaining popularity due to the following reasons: The basic purpose of reforms in financial sector was to enhance the generation of domestic resources by reducing dependence on outside funds. This calls for a market based institution. . Mutual funds are best suited for this purpose. Ordinarily investor in the market is not sure of getting share in the normal procedure. Investing in MF by MF companies get firm allotment. And later selling at a higher price. So investing in MF yields higher returns to the investors. Better knowledge of market behavior maximise gains by proper selection and timing of investments. Dividends and capital gains are reinvested automatically in MF and are not frittered away. MF operation provide reasonable protection to investors

Mutual Funds
They create awareness about benefits of investment in capital market and thus able to mop up large amounts Foreign capital inflows are attracted and secures profitable investment avenues abroad for domestic savings through the opening up of off shore funds in various foreign countries. Disbursing funds in various industrial sectors in view of booming trend has led the popularity of MF Risk of loss due to ill informed and misinformed purchase / sale is reduced. Risks are reduced due to diversification of portfolios in terms of companies and industries. They are controlled and regulated by SEBI and considered safe. Thus MF have many advantages even for an individual who wants to put his savings in various places and not only earn high yields but also safe landing later when he wants to acquire the money back.

Mutual Funds
Classification of Mutual Funds 1. Operational classification 2. Portfolio classification 3. Geographical classification 4. Structural classification

Operational classification 1) Open ended 2) Close ended 3) Interval funds Open ended A scheme which offers units for sale or has any outstanding redeemable units and one that does not specify any duration for redemption or repurchase of units SEBI definition. They are open throughout the year for investment and redemption. Units are directly bought and sold by the fund. There is thus more transparency and certainty Corpus gradually increases to allow investment and is redeemable at that days NAV with the money being returned immediately.

Mutual Funds
Each open ended scheme should raise at lease Rs. 50 crore as minimum corpus. At least 60 % of the targeted amount should be raised. The entire subscription has then to be refunded to the investors. The first 45 days of subscription period should be considered for determining the target figure or the minimum size of the scheme. When individual investors redeem , these open ended funds offer a fair price related to funds NAV or the true worth of the fund. This eliminates the speculative nature . They have been able to offer tailored solutions to meet the requirements of a wide cross section of investors. Close ended MF : They have a definite period after which their shares / units are redeemed. Units are offered through public issues and after the date of closure the entry of investors will be closed. They are generally traded among the investors in the secondary market since they are quoted in the stock exchanges.

Mutual Funds
Their price is determined on the basis of demand and supply in the market. Each scheme is required to raise at least Rs. 20 cores of corpus fund. If the minimum of Rs. 20 crores or 60 % of the targeted amount is not raised the entire subscription is refunded to the investors. The scheme is permitted to be kept open for subscription for more than 45 days. Generally redemption period would be 5 to 10 years. Fund may provide premature encashment by offering repurchase after 2 or 3 years. Interval funds These combine the features of open ended and close ended schemes. Thy are open for sale or redemption during pre determined intervals at NAV related prices.

Distinction between open ended and close ended funds

Read in Word format given separately

Mutual Funds
Portfolio classification : Differ in respect of their instruments Growth oriented funds or Equity oriented funds. The objective of such funds is to provide capital appreciation to their investors and accordingly a substantial portion of the corpus is invested in high growth equity shares and other equity related instruments. The scheme may or may not declare dividends. This is a high risk investment fun with high capital gain potential and low current income assurance. This fund is ideal for investors having a long term outlook seeking growth over a period of time. Income of Debt oriented funds Here regular income to investors is provided in the form of dividends. The dividend may be cumulative or non cumulative on a quarterly, half yearly or yearly basis

Mutual Funds
The corpus of this scheme is invested in fixed income securities like debentures , bonds money market instruments etc. and a relatively lower percentage in shares. Such funds are less risky compared to equity schemes. These funds are not affected by fluctuations in equity markets. However, opportunities of capital appreciation are also limited in such funds. The NAV of such funds are affected because of change in the interest rates in the country. If the interest rates fall, NAV of such funds are likely to increase in the short term and vice versa. However, long term investors may not bother about these fluctuations. These funds are ideal for capital stability and regular income.

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Balanced funds or Income and growth oriented funds. Aim at distributing both income and capital appreciation to their investors. Corpus is invested in high growth equity shares and in fixed income earning debentures. These funds are also affected because of fluctuations in share prices of the stock market. However, NAVS of such funds are likely to be less volatile compared to pure equity funds. Bond funds These are more liquid funds and diversified and conservative investment with modest capital gains. Very secure with steady income. Carry low risk and provide fixed return for those who desire saftey.

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Stock Funds These are established for those who are willing to accept significant risk in the hope of a very high return. Called common stock funds Assets held in the fund are entirely in the common stocks of diversified list of industrial corporations . Stock funds are best suited for risk takers who are interested in capital growth rather than regular income. Index funds These funds invest only in those shares, which are included in the market indices and in exactly the same proportion . Whenever the market index goes up, the value of such index funds also goes up. Conversely , when the market index comes down, the value of such index funds goes down. Necessary disclosures in this regard are made in the offer document and mutual fund scheme . These are also exchange traded index funds launched by MF which are traded on the stock exchanges.

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Industry funds The fund invests its resources particularly in industries with growth potential like cement, steel, jute, power, real estate etc. These funds carry high risk and gains as the performance of these funds is directly exposed to a specific sector. While these funds may deliver high returns, they are more risky compared to diversified funds. Investors need to keep a watch on the performance of these sectors/industries and must exit at an appropriate time. They may also seek the advice of an expert. Tax Relief funds Popularly known as Equity linked saving schemes. Essentially close ended schemes. Investment would be high in equity shares . Investors can claim deduction or rebate in the income tax to the extent of his investment in the fund These are listed in stock exchanges. Minimum lock in period of 3 years is there and scheme shall not provide any liquidity during this period.

Mutual Funds
Leveraged funds Also called borrowed funds are used in order to increase the size of the value of the portfolio and benefit the share holders through gains exceeding the cost of borrowed funds. Funds are generally unused in speculative and risky investments. Real Estate funds These are close end type. The fund is named so because the investments are primarily in real estate ventures. Such funds are of various types depending upon real estate transactions. Money market Mutual funds Funds here are usually invested in money market instruments such as T. Bills, CD, DP , Bill discounting. Regulated on the basis of RBI guidelines. Returns here fluctuate to a much lesser extent compared to other funds. Funds are appropriate for corporate and individuals to park their surplus funds for short periods.

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Asset Management Mutual funds Also called as Asset Management companies. These funds have special characteristics of dealing with Assets other than securities. These funds can acquire various assets and give them on lease basis to needy leasees. Liquid funds These funds invest in short term debt securities with high liquidity. Here profitability is secondary. Since liquidity assumes importance Gift funds These funds invest exclusively in govt. securities since there is no default risk. NAVs of these schemes also fluctuate due to change in interest rates and other economic factors as in the case of income or debt oriented schemes.

Mutual Funds
Load or No Load fund The load fund is one that charges a percentage of NAV for entry or exit. That is each time one buys or sells units of the funds, a charge is payable. This charge is used by the mutual fun for marketing and distribution expenses. The investors should take into consideration the loads while making investments as these may affect their yield . However, the investors should also consider the performance track record and service standards of the MF, which are more important. Efficient funds may yield higher returns inspite of loads. A non load fund is one that does not charge for entry and exit. If there was no load investors would be able to buy and sell at NAV. However, if entry load is there, new investors would price higher than NAV and similarly investor who exit will take away a sum that is lower than the NAV.

Mutual Funds Example: If entry load for a scheme is 1.5% and the NAV is Rs. 24.50 Investor who wants to buy will pay 24.50 + (24.5 x 1.5 /100) = 24.50 + 0.3675 = 24.8675 Similarly if there is an exit load of 1.25 % the investor would not be able to get Rs. 24.50 but will get 24.50 (24.50 x 1.25/100) = 24.50 0.30625 = 24.19375

Therefore , the fund that imposes an entry and / or exit load as above will quote its sales and repurchase price as Rs. 24.8675 and 24.1937 while the NAV will be 24.50

Mutual Funds
Systematic investment plan (SIP) Here an investor is given an option of preparing a predetermined number of post dated cheques in favour of the fund. He will receive units on the date of cheque at the existing NAV. Systematic Withdrawal Plan (SWP) Here the scheme allows facility to withdraw predetermined amount / units from his fund at pre determined intervals. The units will be redeemed at the existing NAV as on that day. Retirement Pension plans Some schemes are linked with retirement pension. Individuals participate in these plans for themselves while corporate entities do so for their employees. Insurance Plan Some schemes are launched by UTI and LIC offer insurance cover to investors.

Mutual Funds Geographical Classification Domestic Mutual funds Scheme which raises funds from internal sources. This includes investments from NRI and foreign investors . Off shore Mutual funds These funds enable NRIs and International investors to participate in Indian capital market. Department of Economic affairs, Ministry of Finance and RBI sets the directions. To attract resources from outside, the Govt. has reduced the tax rate on dividends payable to the off shore funds. Even Private sectors have been permitted to set up these mutual funds. Structural classification of Mutual funds There are two categories Capital Market Mutual funds and Money market Mutual funds.

Mutual Funds
Advantages of Investing in MF Professional Management- Experienced and Skilled professionals handle them who have the knowledge of security analysis and portfolio management. Diversification Invest in broad cross section of industries and sectors. This reduces the risk . Investors obtains a proportion of the average market Convenience Avoids paper work and bad delivery, delayed payments and follow up and thus convenient Return potential Medium to long term investments offer a variety of higher return due to the diversity. Low costs- Less expensive compared to investing in capital markets as they have the advantage of benefits of scale in brokerage, custodial and other fees. Liquidity Provide easy liquidity since easy to dispose off after a stipulated period of time. Open ended offer instantaneous liquidity through repurchase facility and close ended after specific period apart from listing in stock exchanges.

Mutual Funds
Transparency Provide regular information on the value of their investment in addition to disclosure on specific investment made by the scheme, the proportion invested in each type of security and the funds manager investment strategy and outlook. Flexibility Through features such as regular investment plans , regular withdrawal plans and dividend reinvestment plans, investors can systematically invest or withdraw funds according to their needs and convenience. Choice of schemes Variety of schemes to take advantage of opportunities not only equity , debt and money markets but specific industries and sectors. Tax benefits Some schemes offer tax rebates Government regulations All MF are registered with SEBI and monitored by SEBI Shareholders services One of the important service is Automatic Reinvestment of distributions for those who want it. Obtain cash dividends for spending, withdrawal plans in others . Automatic investment, retirement and record keeping for tax purposes

Mutual Funds
Safety from loss due to unethical practices Probability of loss due to fraud, scandal or bankruptcy is small. By transferring investment risk to shareholders, MF side step the problems that have been especially painful for people dealing with certain thrifts, banks and insurance companies. Product structure They take their customer seriously. Products are designed to suit the needs of common investors. Eg. Tata childrens fund which helps plan the education expenses of a child. Mutual fund and Taxation According to section 10(23D) of Income Tax 1961, any income of a notified MF set up by a public sector Bank or a Public FI is fully exempt from Tax. According to Section 10(33) of IT act, tax exemption to income received on units of UTI and MF which will improve this sector. Whereas big investors who pay 30 % dividend tax will benefit , small investors will tend to loose Benefits under Wealth Tax Investment in MF treated at part with all types of investments within a overall limit of Rs. 5 laks as per wealth tax Act 1957.

Mutual Funds
Choosing a Mutual Fund Investment objective Choose the schemes offered by MF based on investment objectives viz A) Regular income B) Pure growth oriented C) Balanced Fund D) Tax Savings E) Period of scheme F) Liquidity / open ended schemes / listing Past performance Check the past performance of the Fund Manager- Capability gives the risk indicators to investors Equity Research Equity research capability and other fund management techniques will be of great importance Global linkages Must understand Indian market and global linkages . This will be critical to investment decision making process

Mutual Funds
Transparency in fund accounting Choose a fund with full transparency in the investment made and discloses NAV periodically to assist investor and understanding the value of investment and area where investments have been made / are to be made. Investor service This will help in sorting out procedural grievences. Efficiency of Mutual Funds The following factors may give an evaluation of MF. Stability Whether stable or not so far its schemes are concerned Liquidity Whether schemes offer liquidity byway of listing on SE Growth Offer increase in NAV, consistent growth in dividend and capital appreciation Credibility of issuer Previous track record of issuer Returns Assured or otherwise Management approach Risk taking, diversification, return maximisation, bonus etc.

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Risks involved in MF investing Market risk If an overall stock or bond market fall on account of macro economic factors, the value of stock or bond holdings in the funds portfolio can drop thereby impacting the NAV Non Marketing risk Bad news about individual company can pull down the stock prices , which can negatively affect , funds holding a large portfolio of that stock. This risk can be reduced by having a diversified portfolio that consists of a wide variety of stocks drawn from different industries. Interest Rate Risk Bond prices and interest rates move in opposite direction. When Interest rate rises, bond prices fall and this decline in underlying securities affects the NAV negatively. The extent of the negative impact is dependent on factors such as maturity profile , liquidity etc. Credit risk Bonds are debt obligations. So when funds invest in corporate bonds, they run the risk of the corporate defaulting on their interest payment and the principal as well and when that risk crystallizes, it leads to fall in value of bond causing the NAV of the fund to take a beating.

Mutual Funds
SWOT analysis of MF Strengths Large number of potential customer base Govt. support by way of tax concessions for MF investors Sophisticated capital market Volatility of Bank interest rate Vital source of capital formation Better scope for accessing market information Offer liquidity to the investors at any time Offer variety of products such as equity, debt and balanced schemes to investors to suit their risk appetite and time horizons The size of the market is very large Weaknesses Poor participation of retail investors There is very high degree of discomfort along with uncertinity Lack of focus

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Leadership vacuum Under performance Inability to scale up Unclear value proposition Over emphasis on funds under management Strategic vacuum Poor service conditions Distribution network is confined to only to metro cities Increasing NPAs in the portfolio Opportunities Huge untapped market in semi urban and rural areas High level of saving habit among people Liberalized business enviorenment

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Increasing number investors have begun turning towards money market instruments of MF Using on line system of trading Linkage of ATM for cash withdrawal is ongoing Consolidation in the industry Investment opportunities abound in international market Failures of Non Bank Financial company operations Threats Increasing competition among the players High level volatility in the stock market NAVs are highly sensitive to internal and market factors Possibility of more stringent regulations by SEBI , RBI, AMFI etc in future

Mutual Funds
Mutual Fund Evaluation The following parameters are taken into for evaluation Net Asset Value (NAV) SEBI has given a standard format for Balance sheet and minimum disclosure requirements MF do not have a standard accounting policy and hence there must be evaluated after reducing the performance to a common denominator Return per unit of risk or ability to earn superior returns for a given class of risk is one evaluation. NAV is the method of evaluation. It is the market value of the securities held by the scheme. NAV per unit is the market value of the scheme on a particular day. MF sell their shares and redeem them at current NAV which is calculated by a formula as given below

Mutual Funds
The formula is : NAV of MF = (Total market value of MF holding all MF liabilities ) /No of MF units or share Example: Scheme name XYZ Scheme size Rs. 50 crore Face value of unit Rs.10 No of units 5 core Investment in shares Market value of shares Rs. 75 cores NAV =Rs. 75 crore / 50 crore i.e. Market value of investments / No of units Rs. 15 Thus each unit of Rs. 10 is now worth Rs. 15 NAV also includes Dividends, interest accruals and reductions of liabilities and expenses, besides the market value of investments.

Mutual Funds
Total Return The return of the fund includes the impact of appreciation of its value and dividends . The following formula is useful for calcuation Distributors + Change in NAV TR = ----------------------------------------------NAV at the beginning of the period The Expense Ratio The expense ratio is the total recurring expenses to average net sales. Depending upon the portfolio , expense ratio vary from 0.5% to over 3 % . Small funds tend to have higher expense ratio. Similarly stock funds have higher expense ratio than fixed income portfolio . Funds which invest globally tend to have higher expense ratio due to higher cost on research and foreign investing. Portfolio Turnover Ratio Turnover varies by the type of fund and the investment philosophy of the manger. The funds that are more depending on short selling strategies could be expect to have higher turnover and transaction costs. But it depends on the performance of the companies

Mutual Funds
Good performers The market return of the fund is very often used as an important tool to find the performance of the fund . Sometimes the performance is not repeated in the subsequent years Size of the fund Size of the fund is another important factor which affects performance for certain types of funds. In general, MF schemes can be classified into the following categories Tiny under Rs. 10 crore Small Rs. 10 core to Rs. 100 crore Medium Rs. 100 crore to Rs. 500 crore Large- Rs. 500 crore to Rs. 1000 crore Giant Over Rs. 1000 crore Analyzing fund management Expertise available with the Management is another parameter. The role of Fund manager becomes crucial as return depends upon the investments strategies.

Mutual Funds
Organisation of Mutual funds There are 3 parties to a MF Sponsors, Asset Management company and the trustees.

Sponsors (Promoters) Trustees Ownership Of Trust Fund

MF ( A trust)

AMC Fund Manager

Custodians (Safe custody of the fund)

Mutual Funds
Sponsors Any person while acting alone or in combination with another body corporate who establishes a Mutual fund. He should have a sound track record . Sound track record means - carrying business in financial services for a period not less than 5 years - NW is positive in all the immediate preceding 5 years -NW in the preceding year is more than the capital contribution of the sponsor in the AMC - Sponsor has PAT (not losses) in 3 out of 5 years including 5th year Trustees MF shall be constituted in the form of Trust with a trust deed and registered under Indian registration Act 1908 Trustees will act as the Managers and Management which defines their functions

Mutual Funds
Fund Manager of AMC The sponsor or the trustee shall appoint an AMC to mange the affairs of the MF and operate the Schemes of such fund. AMC can be terminated by majority of 75 % of unit holders of the scheme. SEBI shall authorise the AMC to conduct business. Functions of AMC Take investment decisions Realize fund position by taking account of receivables Maintain proper accounting and information for pricing of units and arriving at NAV Give feed back to trustees about operations etc.

Mutual Funds
Sponsors ( Examples) Banks sponsored SBI, BOB, Can Investment , UTI AMC Institutions GICAMC, Jeevan Bima Sahayog AMC Private sector Benchmark AMC, Tata AMC Cholamandalam, Sundaram AMC Credit Capital. Sahara AMC Escorts. Reliance Capital JM Financial MF, Kotal Mahindra Indian Joint Ventures Birla sun life , DSP Merril Lynch, HDFC AMCs Foreign Joint ventures ABNAMRO, Allianz capital, DeutscheAMC, Fidelity Franklin templeton, HSBC, ING , Morgan stanley Prudential ICICI, Standard Chartered , Principal AMC

Mutual Funds
Investors right as a MF unit holder Receive unit certificates within 30 days of closure of subscription Receive information about investment policies , objectives and financial position and general affairs of the scheme Receive dividend with 30 days of the declaration and receive the redemption or repurchase proceeds within 10 days from date of redemption/ repurchase. Vote in accordance with regulation Inspect the documents of MF specified in the scheme offer document. They also expect - to get the NAV published in accordance with regulations - disclose the entire portfolio of investors twice a year - to adhere to the code of ethics

Mutual Funds
Facilities Available to Investors Repurchase facilities Close ended schemes are required to be listed in stock exchanges. These schemes are bought and sold at market prices. But listing is not mandatory for open ended schemes. So they have to be bought only from the funds. The fund reserves the right to buy back the units from its members. This process of buying back the units from the investors by the fund is called repurchase facility Reissue facilities The units / schemes / funds purchased from the investors are again reissued to the interested investors. The price for this purpose is called re issue price. Roll over facilities At the time of redemption, investors are given an option to reinvest this entire amount once again for another term. An investor can overcome the adverse market conditions at the time of redemption by resorting to roll over facility. This is cited in close ended scheme. Lateral shifting facilities Shifting from one fund to another on basis of NAV. This shifting is called lateral shifting .

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Non performing asset for a mutual fund SEBI definition An asset can be classified as NPA if the interest and / or principle amount have not been received or have remained outstanding for one quarter from the day they have fallen due. After an asset has been classified as an NPA: A) No income shall be accrued on the assets after its classification as an NPA B) All accruals of income made on the asset prior to its classification as an NPA should be fully provided for. The asset is fully provided for 18 months from the date on which interest was due, but unpaid, or 15 months from the date of it being classified as an NPA.. Book value is the value assigned to the security as per the prevailing valuation norms. Let us now see the provisions against the book value has to be done in the following graded manner even if the principle amount is not yet due:

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% of BV of the NPA to be provided for Distance of the date of provisioning from date of interest was due, but unpaid Distance of the date of provisioning from date the asset was classified as NPA

10% 20% 20% 25% 25%

6 months 9 months 12 months 15 months 18 months

3 months 6 months 9 months 12 months 15 months

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Restrictions on Borrowings Mutual funds are not permitted to borrow except to meet temporary liquidity needs for the purpose of repurchase, redemption of units or payment of interest or dividend to the unit holders. In any case, they cannot borrow more than 20 per cent of the net assets of the scheme for a period exceeding six months. Mutual funds can borrow only to meet temporary liquidity needs for repurchase/ redemption/payment of dividend and so on, upto a maximum of 20 per cent of their net assets, for upto 6 months. They cannot advance any loans but they can lend securities under the stock lending scheme. They cannot enter into option trading/short selling/carry forward transactions. But they can enter into derivative trading for hedging and portfolio balancing. They can also carry on underwriting business. The investment valuation norms for mutual funds relate to traded securities, non-traded securities and rights shares.

Mutual Funds- Derivatives

In a stock market the stocks are stocks are bought and sold in cash and why they are called spot markets. Thus in derivatives they are the market where derivatives are bought and sold. Derivatives are financial instruments which derive their value from the underlying asset which can be equities, commodities, currency, bonds etc. Derivatives may be used to hedge against some form of risk and as a means of making an indirect investment in a security or an index. Most commonly known derivative products are futures and options. Derivatives in Mutual funds were introduced by SEBI in December 1999. Previously MF could use derivatives only for hedging purposes; also they could deploy no more than 50 % of their assets towards hedging.

Mutual Funds- Derivatives

Sec 45 of MF was amended in 1999 stating The MF shall enter into derivatives transactions in a recognized stock exchange for purpose of hedging and portfolio balancing, in accordance with the guidelines issued by the board. On Sep 14,2005 SEBI allowed MF to participate in the derivatives market, bringing them at part with FII. According to this MF will be considered as trading members like FII in respect of position limits in index futures, index option, stock options and stock futures contracts. The MF schemes will be treated as clinets. The position limit for MF in index options and Index futures on a particular index shall be Rs. 250 cr or 15 % of the total open interest of the market in index options, whichever is higher per stock exchange. The MF may take exposure in equity index derivatives if the nominal value of short positions in index derivatives ( short futures, short calls and long puts) does not exceed the MF holding of stocks

Mutual Funds- Derivatives

Similarly long value of long positions in index derivatives ( long futures, long calls and short puts) does not exceed the MF holding of cash, Govt. sec and T Bills The MF position limit for stocks is 20 % of the MV position in case of stocks in which the market wide position is < 250 cr and 50crore if the market wide position limit is > Rs 250 cr. MF can increase their net assets exposures upto 80% in futures and option segment. Regulations strictly limit the extent to which MF may use derivatives for ex. No more than 10 % of the Net asset of a fund taken at market value at the time of purchase may be invested in derivative instruments. Thus Fund managers may use derivatives in 2 ways. 1. As a hedge against some form of risk- ex. Expected fluctuations in currency values and interest rates 2. Making an indirect in security or index.

Mutual Funds- Derivatives

Hedging is by no means simple. Hedge funds and MF are alike in some aspects. Both of them are pooled investment vechicles. In such a scenario, the most likely alternative for MF are : 1. Sell stocks immediately (i.e. distress selling). If the stocks have been purchased at higher prices, such an action could prove to be detrimental for the funds and its investors. 2. Remain invested and continue to bear the brunt of volatility. This could lead to interim losses ( although notional) till the stock market recovers. But with derivatives , there is a third and smarter alternative. 3. Over shorter time frames, index futures can be used to reduce or eliminate stock market fluctuations. Every portfolio has a market linked associated with it. As a result the portfolio reacts to market volatility. To insulate Fund manager can hedge his portfolio by taking contrary position in futures market.

Mutual Funds- Derivatives

Speculation involves buying, holding, selling and short selling of stocks, bonds , commodities, currencies etc to profit from fluctuations in its price . Speculation in derivatives is a double edged sword- i.e. make profit or incur loss Arbitrage-involves simultaneous purchase and sale of identical or equivalent instruments in two or more markets in order to benefit from a discrepancy in pricing. This normally acts as a shield against market volatility as the buying and selling transaction offset each other. The returns from arbitrage funds would be typically be much lower than those of equity funds. That is why they are benchmarked against indices like CRISIL, Liquid fund index for want of more appropriate index.

Mutual Funds
Risk Management The risk management framework covers all aspects of a mutual funds operations. The risks have been broadly categorised into five areas: (i) fund management, (ii) operations, (iii) customer service, (iv) sales and marketing, (v) other business risks. The risk management measures have been described foreach of these areas across three dimensions: policies and procedures, systems and organisations. The risk involved include: Fund Management: volatility in performance, style drift and portfolio concentration, interest rate movements, liquidity issues, credit risk; Operations: deal errors, settlement problems, NAV and fund pricing errors, inaccurate financial reporting, fraud, failure of mission critical systems and infrastructure, obsolete systems; Customer Service: errors in deal processing other investor services, fraud; Marketing and Distribution: new product development, selling and distribution; Other Business Risk: critical knowledge loss, skills shortage, noncompliance, third party risks.