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CHAPTER – III

AN OVERVIEW OF MUTUAL FUNDS

3.1 INTRODUCTION

Mutual Funds are investment institutions in the capital market of the

country. For the lay investors, the Mutual Funds have emerged as another

investments vehicle. The concept had originated in the US financial market

in 1930s itself and it is now one of the oldest industry in the US having more

than 4000 Funds and dealing with 6000 and odd scrips. In India, the UTI

pioneered the concept of Mutual Funds way back in 1963. Though the UTI

was a Mutual fund, yet the usage of the term „Mutual fund‟ was not so

familiar until the arrival of public sector and private sector Mutual Funds in

the Indian financial market. Starting from 1 in 1963, at present 40 registered

Mutual Funds are operating in India.

The range of Mutual fund products being offered to the investors

currently is wider and there is stiff competition among the Funds to garner

the savings of the individual investors. The investing public now is aware of

Mutual fund schemes as an asset class that can be considered for inclusion in

their portfolios. The Mutual fund industry has adopted aggressive marketing

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strategies to promote their investment products and established countrywide

distribution network for efficient servicing of investors.

3.2 MUTUAL FUND: CONCEPT AND RATIONALE

A Mutual fund is an institution that pools the savings of small

investors for investment in capital market and money market securities. The

Mutual fund invests in diversified securities so as to reduce the investment

risks. The portfolio is managed by the Mutual Funds and the returns from

the investments are distributed to the Mutual fund investors as dividends.

Even a small amount can be invested in the units of Mutual fund schemes.

This enables the investors to derive the benefits of diversification which

otherwise would not have been possible with smaller investments.

Mutual fund concept has emerged basically to address tow issues.

First, the investors may not be in a position to choose the securities for their

portfolio from among the multitude of securities available in the market. It is

better to leave the job of selection to experts. Second, because of the limited

Funds available with an investor, he may not be able to have a diversified

portfolio and thus drive the benefits with smaller amounts of investors.

The SEBI (Mutual Funds) regulations 1996 define a Mutual fund as „a

fund established in the form of a trust by a sponsor to raise monies by the

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trustee through sale of units to the public under one or more schemes for

investing in securities in accordance with the regulations‟.

The Association of Mutual Funds in India (AMFI) defines a Mutual

fund as „a trust that pools the savings of a number of investors who share a

common financial goal‟. Financial market offers a number of opportunities

to earn returns. Mutual Funds are one of such opportunities to the investors.

The rationale for investing in Mutual Funds lies in the fact that investment in

securities requires research and full-time professional attention. These are

critical to management of risks and to ensure a portfolio of quality shares

and securities. Mutual Funds are a low-cost avenue to avail the services of

investment experts while providing the benefits of risk diversification and

administrative convenience.

3.3 HISTORY OF MUTUAL FUNDS

In 1924 three Boston Securities executives pooled their money

together to create the first Mutual fund. The idea of pooling of money

together for investing purpose started in Europe in the mid 1800‟s. The first

pooled fund in the US was created in 1893 for the faculty and staff of

Harvard University on March 21st 1924 the first official fund was born. It

was called the Massachusetts Investors Trust.

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In India, the Mutual funds concept took root only in the sixties, after a

century-old history elsewhere in the world. Reacting to the needs for a more

active mobilization of household savings to provide investible resource to

industry, the idea of the first Mutual fund in India was born out of the far-

sighted vision of Shri. T. Krishnamachari, the then Finance Minister. He

wrote to the then Prime Minister Pandit Jawaharlal Nehru outlining the need

for an institution which could serve as the conduit for these resources to the

Indian Capital Market. The RBI was entrusted to create this special

institution. The idea of Mutual Funds took shape in India in 1963 with the

setting up and enactment of the Unit Trust of India (UTI) by framing an Act

titled the UTI Act, 1963 to operate both as a financial institution and an

investment trust.

3.3.1 First Phase (1964-1987)

The UTI was established in 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 took over

the Regulatory and Administrative Control in place of RBI. At the end of

1988, UTI had 6,700 crores of assets under management. The first scheme

launched by the UTI was US64.

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3.3.2 Second Phase (1987-1993)

The Second Phase witnessed the broadening of the base of the

industry on account of the entry of Mutual Funds sponsored by commercial

banks and public sector financial institutions. Followed by the Government

decision to permit nationalized banks to set up Mutual Funds, the State Bank

of India (1987), Life Insurance Corporation (1989), General Insurance

Corporation (1991), Canara Bank (1987), Indian Bank (1990), Bank of India

(1990) and Punjab National Bank (1990) setup Mutual Funds sponsored by

public sector banks. During this period, the total assets of the industry grew

to about 61,000 crores with the total number of schemes increasing to about

167 by the end of 1994.

3.3.3 Third Phase (1993-2003) (Entry of Private Sector Funds)

Entry of private sector Funds, a new era began in the Indian Mutual

Fund industry with the entry of private sector Funds in 1993, giving Indian

investors a wider choice of fund families. The phase also signaled the

intensification of competition. Kothari Pioneer Mutual fund was the first

private sector fund to be established in association with a foreign fund. The

opening up of market to private players saw international players like

Morgan Stanley, Jardine Fleming, JP Morgan, George Soros and Capital

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International entering the market. The assets under management by the end

of January 31, 2005 increased to $34,927 million from $23,260 million in

March 1995.

The number of Mutual fund houses went on increasing with many

foreign Mutual Funds setting up Funds in India. The industry has also

witnessed several mergers and acquisitions. As at the end of January 2003,

there were 33 Mutual Funds with total assets worth 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.

3.3.4 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 to the

tune of Rs.29, 835 crores as at the end of January 2003, representing broadly

the assets of US 64 scheme, assured returns and certain other schemes. The

specified undertaking of Unit Trust of India, functioning under an

administrator and under the rules framed by the Government of India and

doesn‟t come under the purview of the Mutual Fund regulations.

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The Second is the UTI Mutual Funds Ltd, 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.

Apparently Mutual Fund Industry in India has undergone significant

structural changes during the last four decades. After growing slowly for

most of the times since its inception, the industry has witnessed a significant

growth rate since 1993. The entry of private players has galvanized the

sector as increased competition has forced industry players to focus on

product innovation, market penetration, identifying new channels of

distribution and the last but not the least improving investor‟s service. The

entry of private players meant that not only the market share but also the

mind share of investors was captured. These players went on high

marketing pitch to create awareness among the investors about the

advantages of investing in Mutual Funds. All those measures helped the

industry grow significantly.

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3.4 FORMATION OF MUTUAL FUND

An Asset Management Company (AMC) establishes a Mutual Fund,

which is registered with Securities and Exchange Board of India (SEBI).

The Mutual Fund then floats various types of schemes and sells the units of

these schemes to the retail investors. The money collected from the

investors is invested in stock and money market instruments such as shares,

bonds, gilts etc. The proportion of investment in these instruments would

depend on the objective of the scheme. The fund manager of the Mutual

Fund decides the instruments in which the Funds are to be invested and in

what proportion, that is, he creates a portfolio by investing in various

instruments available in stock and money markets.

3.5 TYPES OF MUTUAL FUNDS

3.5.1 By Structure

Open-ended fund

An open-ended fund is one that is available for subscription all

through the year. These do not have a fixed maturity. Investors can

conveniently buy and sell units at Net Assets Value related prices. The key

feature of open ended scheme is liquidity.

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Close-ended fund

A close ended fund has a stipulated maturity period which generally

ranging from 3 to 15 years. The fund is open for subscription only during

specific period. Investors can invest in the scheme at the time of the initial

public issue and thereafter they can buy or sell the units of the schemes on

the stock exchanges where they are listed. In order to provide an exit route

to the investors, some close-ended Funds give an option of selling back the

units to the Mutual fund through periodic repurchases at NAV related prices.

SEBI regulations stipulate that at least one of the two exit routes is provided

to the investors.

Interval Funds

Interval Funds are the combination of the features of open-ended and

close-ended schemes. They are open for sale or redemption during

predetermined intervals at NAV related prices.

3.5.2 BY INVESTMENT OBJECTIVES

Growth Funds

The aim of growth fund is to provide capital appreciation over the

medium to long term. Such schemes normally invest a majority of their

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corpus in equity. It has been proven that returns from stock have

outperformed most other kind of investments held over the long term.

Income Funds

The aim of income fund is to provide regular and steady income to

investors. Such schemes generally invested in fixed income securities such

as bonds, corporate debentures and government securities. Income Funds

are ideal for capacity stability and regular income.

Balanced Funds

These Funds provide both growth and regular income. Such schemes

periodically distribute a part of their earnings and invest both in equity and

fixed income securities in the proportion indicated in their offer documents.

In a rising stock market, the NAV of these schemes may not normally keep

pace of fall equally when the market falls. These are ideal for investors

looking for income and moderate growth.

Load Funds

A load fund is one that charges a commission for entry or exit. That is

each time you buy or sell units in the fund a commission will be payable.

Typically entry and exit loads range from 1% to 2%. It could worth payable

the load, if the fund has a good performance history.

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No Load Fund

A no load fund is one that doesn‟t charge a commission for entry to

exit. That is a commission payable on purchase or sale of units in the fund.

The advantage of a no load fund is that the entire corpus is put to work.

Money Market Fund

These Funds provide easy liquidity, preservation of capital and

moderate income. These schemes generally invest in safer short-term

instrument such as treasury bills, certificate of deposits, commercial papers

and interbank call money. Returns on these schemes may be fluctuating

depending on the interest prevailing in the market. These are ideal for

corporate and individual investors as a mean to park their surplus Funds for

short periods.

3.5.3 OTHER SCHEMES

Tax Saving Schemes

These schemes offer tax rebates to the investors under specific

provisions of the Indian income tax incentives for investments in specified

avenues. Investments made in Equity Linked Saving Schemes and Pension

Schemes are allowed as deduction Under Section 88 of the Income Tax Act

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1961. The Act also provides opportunity to investors to save capital gains

Under Section 54A, 54 EB by investing in Mutual Funds.

Specific Schemes

Industry specific schemes invest only in the industries specified in the

offer document. The investment of these Funds is limited to specific

industries like Info-Tech, Fast moving customer goods, Pharmaceutical etc.

Index Schemes

Index Funds attempt to replicate the performance of a particular index

such as the BSE senses or the NSE 50. Such schemes usually carry medium

level of risk and are suitable for investors with medium risk appetite.

Sectoral Schemes

Sectoral schemes are those which invest exclusively in a specified

industry or a group of industries or various segments such as „A‟ group

shares or initial public offerings.

Unit-linked insurance plan

These are strictly not Mutual fund schemes, but these are insurance

plans operating on the line of Mutual Funds. Investors get the dual

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advantage of insurance cover with growth prospects of equities, since the

Funds are invested in the securities market.

Systematic Investment Plan (SIP)

The investor in these schemes invests specified amount at a regular

interval for a specified period and the fund allots units on a predetermined

date at the applicable NAV.

3.5.6 FEATURES OF MUTUAL FUND

The MFs have become an attractive avenue for investment because of

the following features.

Safety

Mutual Funds are regulated by SEBI which has evolved specific

guidelines and regulations for their operations and management. The

monitoring of Mutual Funds by SEBI is comprehensive and regular. The

Mutual Funds have to maintain transparency in their working. The

investments (portfolio) of the MFs are disclosed regularly on a

monthly/quarterly basis and the NAV‟s are declared on daily basis.

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Liquidity

Investors many times find it difficult to deal in shares, bonds, Govt.

Securities and debentures of certain companies even at adverse prices. The

bulk of trading in such instruments is done by institutions and MFs.

Investors can now get the opportunity of investing in the instruments of their

choice through the schemes of MFs with assurance that they get immediate

liquidity at the net asset value (NAV) related price of the units on the date of

redemption request as MFs dispatch redemption proceeds to investors within

2/3 working days of request.

Returns

As dividend received by investors is tax free it enhances the yield

marginally as compared to income from other investment options.

Investment for more than a year helps investors to take advantage of the

benefits of indexation and lower capital gains tax. These options can be

used as an effective tax planning tool to provide better post tax returns to the

investors.

Professional and Expert Management

Mutual Funds are set up by established promoters with proven track

record and managed by professionals having vast experience and expertise

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in the field. These fund managers are backed by strong research teams

which keep a close eye over the market movements and opportunities.

Diversified and Large Portfolio

The Mutual Funds create a portfolio which is a combination of varied

instruments, keeping in view the liquidity and return, which cater the need of

each class of investor (those who have invested for short term and also for

long term). The risk bearing capacity of MFs is enhanced because of the

large and diversified portfolio which dilutes risk.

Dividend Stripping

As dividend distributed by a MFs is exempt from tax in the hands of

the recipient, if an investor is having capital gain and wants to save capital

gain tax he can enter the scheme at the time of declaration of dividend and

move out after receipt of dividend. When he moves out, he incurs short term

capital loss as the NAV will come down an account of dividend distribution

with this the investor can convert his capital into tax free income and any

incur notional loss. This is being used as an effective tool for tax planning

where by tax free income can be generated and also short term capital losses

are adjusted against capital gains.

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Cash Management

Many corporate and MNCs have surplus funds for a very short span,

say 3-15 days for which they find no gainful investment avenues. MFs

operate cash schemes where these surplus funds can be parked. The returns

relate to the call money market rates and the money can be redeemed within

a short span of 24 hours.

Transparency

As per SEBI guidelines MFs have to disclose their NAV on daily

basis and portfolios and past return of their schemes on regular interval, it is

very much in the interest of investor as the investor can take an informed

decision while investing and switching to the scheme.

Low Cost

AMC, charge a very nominal cost as its management fee which varies

in the range of 0.75percent to 2.0 percent of the annual assets managed by it

depending on the nature of scheme.

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3.5.7 VARIOUS OTHER SCHEMES

The investor can choose scheme according to its risk profile and

return expectations.

If the person want to go for approx nil risk and with relatively better

return then there are dept, gift and cash schemes.

If they want to go for moderate risk and return then they may go for

balanced schemes.

Keeping in view this market perception he can go for a sector specific

scheme as there are scheme which exclusively invest in IT, FMCG,

Parma sector etc or they may go for diversified schemes which invest

in most of the sector where there are more chances of appreciation.

3.6 MUTUAL FUND REGULATIONS

The SEBI (Mutual Fund) Regulations 1996 provides a clear frame

work for regulating the Mutual fund industry. The rights and obligations of

trustees, AMCs, Mutual fund scheme and disclosure requirements are stated

in the SEBI‟s regulations. The schedules to the regulations prescribe the

code of conduct, advertisement code, investment valuation norms, and

accounting policies and standards.

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A brief summary of the salient provisions of the Regulations is given

below.

Sponsor

The sponsor should have a sound track record and general reputation

of fairness and integrity in all its business transactions. It should have been

carrying on financial services business for a period of not less than 5 years

and has positive net worth. The sponsor should not have been found guilty

of an economic offence. Further, a sponsor appoints the trustees, AMC and

the custodian.

Constitution

As per the Regulations, a Mutual fund has to be constituted in the

form of a trust and the trust deed has to be registered under the Indian

Registration Act. Various clauses of the trust deed are furnished in the Third

Schedule to the Regulations. A trust deed is executed by the sponsor in

favour of the trustees.

Rights and obligations of the trustees

These include the right to enter into investment agreement with the

AMC. The trustee has to ensure that the AMC possesses the systems, back

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office, dealing room accounting services before the launch of a scheme.

Trustees should also ensure that the AMC has appointed the key persons

such as the fund manager, auditor, registrars and transfer agents, and

compliance officer.

Accountability

Trustees are accountable for and be the custodian of the funds and

property of the respective schemes. Trustees hold the property for the benefit

of the unit holders or investors. They have to abide by the code of conduct

started in the Fifth Schedule to the Regulations. Trustees and AMCs have to

invest the moneys in accordance with the investment objectives stated in the

offer documents and take investment decisions solely in the interest of the

unit holders.

Identity maintainer

Trustees ensure that the AMC has been managing the Mutual fund

schemes independently of the other activities. The AMC should have taken

adequate steps to ensure that the interests of investors of the one scheme are

not compromised with those of any other scheme or other activities of AMC

on a half-yearly basis.

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Review of activities

The trustee has to review the transaction between the Mutual fund and

the AMC, the net worth of the AMC, on quarterly basis. Besides this, the

trustees shall periodically review the service contracts with custodians and

transfer agents as well as the investor complaints received and the redresses

of those compliant by the AMC. The trustees have to report to the SEBI on

the activities of AMC on half-yearly basis.

Due diligence

Trustees have to exercise certain general and specific due diligence

under the regulations. General due diligence relates to administration of trust

property, the care to be exercised in the appointment of the board of the

AMC and ensuring that the service providers are registered entities. Specific

due diligence relates to internal audit, compliance report, conducting regular

meetings of trustees etc.

Assets Management Company

Responsive or the trustee can appoint the AMC and it has to be

approved by the SEBI. The AMC must have the net worth of Rs. 10 crores

and the directors must have been professional experience in finance or

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financial service area. Again 50% of the directors should be independent

outside persons not connected with the sponsor or the trustees.

Activities of AMC

An AMC cannot function as trustees for another Mutual fund. There

are restrictions on the business activities of the AMC. The regulations

stipulate that an AMC shall not undertake any other business activities

except activities in the nature of portfolio management services,

management and advisory services to offshore funds, pension funds,

provident funds, venture capital funds, management of insurance funds and

financial consultancy. The AMC should have sufficient infrastructure to

carry out each of the activity and should also meet the capital adequacy

requirements.

AMC’s obligations

The AMC is supposed to take reasonable steps and exercise due

diligence and care in its investment decision. Further the investment

activities of AMC should not be contrary to the provisions of the regulations

and the trust deed. The Chief Executive Officer of the AMC has to ensure

that the Mutual fund complies with all the regulations, guidelines and

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circulars issued by the regulating authorities. He shall also be responsible for

the overall risk management of the Mutual fund.

Schemes

The procedure for launching of the schemes, the disclosures is to be

made in the offer documents, regulations regarding advertisement materials

and regulations for listing of closed-ended schemes or described in this

chapter of SEBI regulations. This part of the regulations speaks more about

the operation of schemes right from the start off a scheme up to winding up

of the scheme.

Investment Objectives

Moneys collected by the Mutual fund through the schemes have to be

invested in accordance with the investment objective of the relevant scheme.

A money market scheme, for example, has to invest only in money market

instruments; a gold exchange-traded fund scheme has to invest in gold or

gold-related instruments only. Regulations specified that investment can be

made in securities instruments such as mortgage -or asset-backed securities

in addition to the usual types of securities such as shares, bonds and

privately placed debentures.

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Investment Valuation

The regulations also speak about the computation of NAV of the

schemes. It also includes provisions regarding investment restrictions, short

selling of securities and underwriting of securities by Mutual fund.

Maintenance of Books of Account

It is the general obligation of the AMC to maintain proper books of

account, records and documents for each scheme separately to explain its

transactions and reveal the financial position. The AMC is supposed to

follow the accounting policies and standards as specified in the Ninth

Schedule so as to provide details of scheme wise disposal of assets. The

Mutual fund or the AMC has to prepare its annual report and annual

statement of accounts of the scheme and fund as per the format prescribed.

CONCLUSION

The present chapter highlights an overview of Mutual Fund schemes

from its evaluation at US financial market in 1930‟s, and the concept and

rational, by highlighting the role of SEBI (Mutual Funds) Regulations Act

1996, the association of Mutual Funds in India, operational definition. The

history of Mutual Funds was traced into four phases the first phase covered

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the period (1964 – 1987) highlights the regulatory administrative control in

the place of RBI, the second phase witnessed the broadening of the base of

the industry on account of the entry of Mutual Funds sponsored by

commercial banks and public sector financial institutions. In the third phase

allowed the private sector players particularly with the establishment in

association with foreign banks. The fourth phase, the role of UTI act and

UTI Mutual Funds Limited sponsored by SBI, PNB, BOB and LIC was

given in detail. The formation of Mutual Fund with the help of asset

management company is registered with SEBI then the Mutual Fund floats

various types of schemes by structure, by investment, and other schemes.

The special features of the schemes also explained in detail for easy

understanding of the concepts, rational, and the benefits of Mutual Funds

schemes.