MUTUAL FUNDS

Regulated by

• SEBI (mutual fund) Regulation,1996

SEBI Definition of Mutual fund?

• As per SEBI definition, ”A fund established in the form of a trust by a sponsor,

• to raise money by the trustees thru the sale of units to the public,

• under one or more schemes ,• for investing in securities in accordance with

the sebi regulations.”

SEBI Definition of Mutual fund?

• In simple words,”a mutual fund collects the savings from the small investors, – invest them in Govt or corporate securities and – earns income – And distributes earnings to the unit holders”

• A Mutual Fund is a trust – that pools – the savings of – a number of investors who share a – common financial goal.

Concept Concept

• The money thus collected is • then invested in capital market instruments • such as shares, debentures and other securities.

Concept Concept

• The income earned through these investments and the capital appreciation

• realized are shared by its unit holders • in proportion to the number of units owned by them.

Concept Concept

• Thus a Mutual Fund is the • most suitable investment for the common man as it • offers an opportunity to invest in a • diversified, professionally managed basket of securities at a

relatively low cost.

Concept Concept

What is the structural arrangement of an average mutual fund?

• The mutual fund industry and all participants involved in this business are governed by SEBI.

What is the structural arrangement of an average mutual fund?

• The promoters or sponsors • appoints trustees • and set up and AMC which in turn • appoints a custodian/depository, registrars,

transfer agents and auditors.

• The trustees play a critical role • as they hold in trust the investments of the

investors/unit holders of the mutual fund.

• The board of trustees does not manage the day to day activities of the mutual fund directly.

• Instead it appoints an Asset Management Company (AMC) to perform that task.

• Thus the AMC manages the mutual fund scheme, while the trustees manage them.

Custodian

• A custodian holds the securities of various schemes of the fund in their custody.

• However, following demat, the term custodian has given way to the ‘Depository’.

Registrar

• The registrar is appointed in order to • accept and process the shareholder’s applications

and • inform the AMC about the amount received for

subscription, redemption and so forth.

Transfer Agents

• Transfer agents are responsible for issuing and redeeming units of the scheme .

• They are the conduits through which • fresh units are issued to new buyers • or units sent back to the AMC for redemption.

• The trustees appoint the top management of the AMC such as Chief Investment Officer or Chief Executive Officer.

• The trust company also appoints an auditor to audit the books of accounts of all schemes.

SEBI (mutual fund) Regulation,1996Structure of MF in India

Organizational Structure of MF Organizational Structure of MF

How does the IPO of a mutual fund differ from the IPO of a company

• Until the middle of 2005, AMCs announced an IPO every time they launched a new scheme.

• AMFI and SEBI instructed the AMCs to use the term – NFO (New Fund offer) instead of IPO for their schemes.

Difference

• IPO - can be priced at a premium while an NFO is issued at par.

• In case of oversubscription, the AMC retains the entire amount, while in an IPO the amount needs to be returned unless there is a green shoe option.

• The fund starts trading at the NAV (Net Asset Value).

• The NAV is largely governed by the value of the underlying securities into which the fund has invested and is therefore far less volatile.

Annual Recurring Expenses

• The annual recurring expenses include – trustee fees, – custodian fees, – registrar fees – and other recurring operating expenses.

• These are normally expressed as a percentage of the net assets and is known as the expense ratio.

Annual Recurring Expenses

• The AMC passes these annual recurring expenses or fund management fees

• to the Investors as entry or exit loads.

Entry Load

• Entry Load or front end charge is applied when an investor buys units of a scheme.

• Thus if the entry load is 2%, • then the AMC deducts 2% of the total fund

mobilized straight away and • invests the balance 98% of the corpus to

create the investor portfolio.

Exit Load or Back end Load

• Exit Load or Back end Load is levied when an investor exits the scheme (i.e sells the Units).

• For example, if the exit load is 2% and the NAV of the scheme is Rs 20, the 40 paise will be deducted as exit load and Rs 19.60 will be received when the Units are sold.

Exit Load or Back end Load

• A scheme may also be a no load scheme, if the AMC chooses not to levy any load on the scheme.

• Incorporated on 22 August, 1995.• Apex body of all the registered AMCs.• All AMCs are its member.• Objective to maintain high ethical and professional

standard. • Provide certificate to Agents to sell MF• Best practice guidelines.• Code of ethics.

Role of AMFI Role of AMFI

Facts about Mutual Funds1. The biggest advantage of Mutual Funds is their ability

to diversify the risk.2. Mutual Funds are their in India since 1964. Mutual

Funds market is very evolved in U.S.A and is there for the last 60 years.

3. Mutual Funds are the best solution for people who want to manage risks and get good returns.

Mutual Funds

An equity fund would buy equity assets – ordinary shares, preference shares, warrants etc. A bond fund would buy debt instruments such as debenture bonds, or government securities/money market securities. A balanced fund will have a mix of equity assets and debt instruments.Mutual Fund shareholder or a unit holder is a part owner of the fund’s asset.

Mutual FundsOperations Flow Chart

(Reference: amfiindia.com)

Advantages of Mutual Funds• Portfolio diversification: It enables him to hold a diversified investment portfolio even with a small amount of investment like Rs. 2000/-.

• Professional management: The investment management skills, along with the needed research into available investment options, ensure a much better return as compared to what an investor can manage on his own.

• Reduction/Diversification of Risks: The potential losses are also shared with other investors.

• Reduction of transaction costs: The investor has the benefit of economies of scale; the funds pay lesser costs because of larger volumes and it is passed on to the investors.

• Wide Choice to suit risk-return profile: Investors can chose the fund based on their risk tolerance and expected returns.

Advantages of Mutual Funds• Liquidity: Investors may be unable to sell shares directly, easily and quickly. When they invest in mutual funds, they can cash their investment any time by selling the units to the fund if it is open-ended and get the intrinsic value. Investors can sell the units in the market if it is closed-ended fund.

• Convenience and Flexibility: Investors can easily transfer their holdings from one scheme to other, get updated market information and so on. Funds also offer additional benefits like regular investment and regular withdrawal options.

•Transparency: Fund gives regular information to its investors on the value of the investments in addition to disclosure of portfolio held by their scheme, the proportion invested in each class of assets and the fund manager's investment strategy and outlook

Disadvantages of Mutual Funds• No control over costs: The investor pays investment management fees as long as he remains with the fund, even while the value of his investments are declining. He also pays for funds distribution charges which he would not incur in direct investments.

• No tailor-made portfolios: The very high net-worth individuals or large corporate investors may find this to be a constraint as they will not be able to build their own portfolio of shares, bonds and other securities.

• Managing a portfolio of funds: Availability of a large number of funds can actually mean too much choice for the investor. So, he may again need advice on how to select a fund to achieve his objectives.

• Delay in redemption: It takes 3-6 days for redemption of the units and the money to flow back into the investor’s account.

Broad Types of Mutual Funds

Schemes according to Maturity Period

• A mutual fund scheme can be classified into – open-ended scheme or – close-ended scheme

• depending on its maturity period.

Open-ended Fund/ Scheme

• available for subscription and repurchase on a continuous basis.

• does not have a fixed maturity period. • Investors can conveniently buy and sell units at Net

Asset Value (NAV) related prices which are declared on a daily basis.

• The key feature of open-end schemes is liquidity.

Close-ended Fund/ Scheme

• Stipulated maturity period e.g. 5-7 years. • Open for subscription only during a specified

period at the time of launch of the scheme. • 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 scheme on the stock exchanges where the units 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 repurchase at NAV related prices.

• SEBI Regulations stipulate that at least one of the two exit routes is provided to the investor i.e. either repurchase facility or through listing on stock exchanges.

• These mutual funds schemes disclose NAV generally on weekly basis.

Schemes according to Investment Objective:

• Growth scheme, income scheme, or balanced scheme considering its investment objective.

• Such schemes may be open-ended or close-ended schemes.

• May be classified mainly as follows:

Growth / Equity Oriented Scheme

• The aim of growth funds is to provide capital appreciation over the medium to long- term.

• Such schemes normally invest a major part of their corpus in equities.

• Such funds have comparatively high risks. • Growth schemes are good for investors having a long-term

outlook seeking appreciation over a period of time.

Income / Debt Oriented Scheme

• The aim of income funds is to provide regular and steady income to investors.

• Such schemes generally invest in fixed income securities such as bonds, corporate debentures, Government securities and money market instruments.

• Such funds are less risky compared to equity schemes.

• These funds are not affected because of fluctuations in equity markets.

Balanced Fund

• The aim of balanced funds is to provide both growth and regular income as such schemes invest both in equities and fixed income securities in the proportion indicated in their offer documents.

• These are appropriate for investors looking for moderate growth.

• They generally invest 40-60% in equity and debt instruments. • These funds are also affected because of fluctuations in share

prices in the stock markets. • However, NAVs of such funds are likely to be less volatile

compared to pure equity funds.

Money Market or Liquid Fund

• These funds are also income funds and their aim is to provide easy liquidity, preservation of capital and moderate income.

• These schemes invest exclusively in safer short-term instruments such as treasury bills, certificates of deposit, commercial paper and inter-bank call money, government securities, etc.

• Returns on these schemes fluctuate much less compared to other funds.

• These funds are appropriate for corporate and individual investors as a means to park their surplus funds for short periods.

Gilt Fund

• These funds invest exclusively in government securities.

• Government securities have no default risk. • NAVs of these schemes also fluctuate due to

change in interest rates and other economic factors as is the case with income or debt oriented schemes.

Index Funds

• Index Funds replicate the portfolio of a particular index such as the BSE Sensitive index, S&P NSE 50 index (Nifty), etc

• These schemes invest in the securities in the same weightage comprising of an index.

• NAVs of such schemes would rise or fall in accordance with the rise or fall in the index, though not exactly by the same percentage due to some factors known as "tracking error" in technical terms.

What is a Fund of Funds (FoF) scheme?

• A scheme that invests primarily in other schemes of the same mutual fund or other mutual funds is known as a FoF scheme.

• An FoF scheme enables the investors to achieve greater diversification through one scheme.

• It spreads risks across a greater universe.

What is a sales or repurchase/redemption price?

• The price or NAV a unitholder is charged while investing in an open-ended scheme is called sales price. It may include sales load, if applicable.

• Repurchase or redemption price is the price or NAV at which an open-ended scheme purchases or redeems its units from the unitholders. It may include exit load, if applicable.

How to invest in a scheme of a mutual fund?

• Mutual funds normally come out with an advertisement in newspapers publishing the date of launch of the new schemes.

• Investors can also contact the agents and distributors of mutual funds who are spread all over the country for necessary information and application forms.

• Forms can be deposited with mutual funds through the agents and distributors who provide such services.

• Now a days, the post offices and banks also distribute the units of mutual funds.

What is the procedure for registering a mutual fund with SEBI ?

• An applicant proposing to sponsor a mutual fund in India must submit an application in Form A along with a fee of Rs.25,000.

What is the procedure for registering a mutual fund with SEBI ?

• The application is examined and • once the sponsor satisfies certain conditions such as being in

the financial services business and possessing positive net worth for the last five years,

• having net profit in three out of the last five years • and possessing the general reputation of fairness and

integrity in all business transactions, • it is required to complete the remaining formalities for setting

up a mutual fund.

• These include inter alia, – executing the trust deed and investment management agreement, – setting up a trustee company/board of trustees comprising two- thirds

independent trustees, – incorporating the asset management company (AMC), – contributing to at least 40% of the net worth of the AMC and

appointing a custodian. – Upon satisfying these conditions, the registration certificate is issued

subject to the payment of registration fees of Rs.25.00 lacs

• Details are in the SEBI (Mutual Funds) Regulations, 1996.

Distribution Channels

Distribution ChannelsMutual Funds are primary vehicles for large collective investments, working on the principle of pooling funds.A substantial portion of the investments happen at the retail level.Agents and distributors are a vital link between the mutual funds and investors.

Distribution ChannelsAgents - Is a broker between the fund and the investor and acts on behalf of the principal.- He is not exclusive to the fund and also sells other financial services. This in a way helps him to act as a financial advisor.

Distribution Channels

Distribution Companies- Is a company which sells mutual funds on behalf of the fund.- It has several employees or sub-broker under it.- It manages distribution for several funds and receives commission for its services.

Distribution Channels

Banks and NBFCs- Several banks, particularly private and foreign banks are involved in a fund distribution by providing similar services like that of distribution companies.- They work on commission basis.

Distribution Channels

Direct Marketing- Mutual funds sell their own products through their sales officers and employees of the AMC.- This channel is normally used to mobilise funds from high net worth individuals and institutional investors.

Accounting and Taxation

AccountingCalculating Net Asset Value

NAV = (Market value of investments + Receivables + Other Accrued Income + Other assets – Accrued Expenses – Other Payables – Other liabilities) / ( No. of Units Outstanding as at the NAV date)

Accounting

SEBI regulations for NAV• The day on which NAV is calculated by a fund is

called valuation date.• NAV of all schemes must be calculated and

published at least weekly.• This is applicable to both open-end and closed-

end fund.

Accounting

Since investments held by a mutual fund in its portfolio are to be marked to the market, the NAV includes two components:

a) Realized gains or losses.b) Unrealized gains or losses.

As per SEBI guidelines, unrealized appreciation cannot be distributed by a fund, whereas the realized gain can be distributed.

Taxation

Taxation in the Hands of the Fund Income earned by any mutual fund registered with SEBI or set up by a public sector bank/Financial Institution or authorized by RBI is exempt from tax. Income distributed to unit holders by a closed-end or debt fund has to pay a distribution tax of 10% plus surcharge of 1% I.e. a tax of 11%. This tax is also applicable to distributions made by open-end funds which have less than 50% allocation to equity.

Taxation

The Impact on the Fund and the Investor Due to the tax payment by the fund, the NAV and the value of the investor’s investment will come down. The tax bears no relationship to the investor’s tax bracket. This tax makes the income schemes less attractive than growth schemes. The fund cannot avoid tax even if the investor chooses to reinvest the distribution back into the fund.

What tax benefits are available to those who invest in mutual funds?

• Dividends declared by debt-oriented mutual funds (i.e. mutual funds with less than 65% of assets in equities), are tax-free in the hands of the investor.

• However, a dividend distribution tax (which varies for individual and corporate investors) is to be paid by the mutual fund on the dividends declared.

• Dividends declared by equity-oriented funds (i.e. mutual funds with more than 65% of assets in equities) are tax-free in the hands of investor.

• There is also no dividend distribution tax applicable on these funds.

• Diversified equity funds, sector funds, balanced funds (with more than 65% of net assets in equities) are examples of equity-oriented funds.

Taxation

Taxation in the Hands of the InvestorDividend Tax : The tax paid by the investor on receiving dividends from a mutual fund. There is no dividend tax to be paid at the investor’s end. There is no dividend distribution tax deduction from NAV in all funds which are open-end and with over 50% allocation of investment to equities.

Tax of 10.2% is deducted from the NAV by the fund in the following cases: - All closed end funds including equity. - All open end funds with less than 50% allocation in equity.

TaxationTaxation in the Hands of the InvestorCapital Gains on Sale of Units: Capital Gains tax is charged when something is sold at profit. If the investor sells his units and earns “Capital Gains”, the investor is subject to the Capital Gains Tax.If the units are held for less than 12 months, they will be treated as short term capital gain. Otherwise they are called long term capital gains.

For short term, capital gains = Sale consideration – (Cost of Acquisition + Cost of Improvements + Cost of Transfer)The tax charged depends on the income bracket of the investor.

For long term capital gains, the investor gets the benefit of ‘Indexation’ by which his purchase price is marked up by an inflation index.Cost of acquisition or improvement = actual cost of acquisition or improvement * cost of inflation index for year of transfer/cost of inflation index for year of acquisition or improvement.

Long Term Capital Gains

• As per section 10(38), Long-term capital gains arising on transfer of equity sharesor

• units of equity oriented mutual fund is not chargeable to tax from theassessment year 2005-06 if such a transaction is covered by securities transactiontax.

Long Term Capital Gains

• In case of other shares and securities, person has an option to either index costs to inflation and pay 20% of indexed gains, or pay 10% of non indexed gains.

• The indexation rates are released by the I-T department each year.

• In case of all other long term capital gains, indexation benefit is available and tax rate is 20%.

Short term capital gains

• Under section 111A, for shares or mutual funds where STT is paid, For Asst Yr 2009-10 the tax rate is 15%.

• In all other cases, it is part of gross total income and normal tax rate is applicable.

Measuring and Evaluating Mutual Fund Performance

Why Measure Fund Performance

The Investor Perspective-To make intelligent decisions on whether he should continue with the investment or not.- He needs the basic knowledge of fund evaluation to judge the performance of the fund.

Why Measure Fund Performance

The Advisor’s Perspective-The potential investors would expect the advisor to give them a proper advise on which funds have good performance.- In order to compare different funds, the advisor must have the correct knowledge and appropriate measures of evaluating the fund performance.

Different Performance MeasuresChange in NAV -most commonly used by investors to evaluate fund performance and most commonly published by fund managers. -NAV Change in absolute terms:(NAV at the end of period) – (NAV at the beginning of period)

NAV Change in percentage terms:(Absolute change in NAV/NAV at the beginning of period) * 100

Annualised NAV Change:{[(Absolute Change in NAV/NAV at the beginning)/months covered]*12}*100

Different Performance Measures

No, percentage NAV change cannot give a correct picture as it does not take into account the interim dividends paid. The correct measure here is Total Return Method.Total Return Method- It takes into account the dividends paid in the interim period and is suitable for all types of funds.- It must be interpreted in the light of market conditions and investment objective of the fund.- Its limitation is that it ignores the fact that distributed dividends also get reinvested if received during the year.

Total Return is:[(Distributions + Change in NAV)/NAV at the beginning of the period]* 100

Expense RatioThe Expense Ratio- Indicator of fund’s efficiency and cost effectiveness.- It is defined as the ratio of total expenses to average net assets of the fund.-If a fund’s income levels or returns are small say a debt fund with 10% return, expense ratio becomes important and difference of even 0.5% between two funds can make lot of difference.

Income Ratio

The Income Ratio- Defined as its net investment income divided by its net assets for the period.- - Cannot be used in isolation, but only with expense ratio and total return.

BenchmarkingImportance of Benchmarking- A funds performance can be judged in relation to investor’s expectations.- However, it is important for the investor to define his expectations in relation to certain “guideposts”.- These guideposts or indicators of performance can be thought of as benchmarks against which a fund’s performance ought to be measured.- For instance, BSE-30 will be a benchmark for diversified equity fund and BSE IT index for tech funds.

While an advisor needs to look at the absolute measures of performance, he needs to select the right benchmark to evaluate a fund’s performance, so that he can compare the measured performance figures against the selected benchmark.

BenchmarkingBasis for choosing an Appropriate Performance BenchmarkThe appropriate benchmark has to be selected by reference to:1. The Asset Class it invests in. Thus, an equity fund has to be judged by from

an appropriate benchmark from the equity market and so on.2. The fund’s stated Investment Objective.

There are three types of benchmarks that can be used to evaluate a fund’s performance:

1. Relative to the market as a whole.2. Relative to other mutual funds.3. Relative to other comparable financial products or investments options

open to the investor.

Benchmarking relative to other Financial Products

An investor will compare the mutual fund performance with other -investment products like bank deposits, NSC’s Indira Vikas Patra etc. Only instruments of similar investment characteristics and with returns and calculated over the same periods should be used for meaningful comparisons.

Why Invest in Mutual Funds?

• Liquidity

• Minimal transaction costs

• Convenience

• Instant diversification

• Level the playing field between professional and individual investors

• Share administrative expenses

Disadvantages of Mutual Fund Investing

• Lower-than-market performance

• Costs

The Costs of Mutual Funds• Load funds -- sales commissions charged to the investor

when purchasing fund shares

• Management fees and expenses -- fees associated with the operation of the company

• fees -- fees charged to cover the fund’s cost of advertisement and marketing

Stock Mutual Funds

• Aggressive growth funds• Small-company growth funds• Growth funds• Growth-and-income funds• Sector funds• Index funds• International funds• Emerging markets funds

Buying a Mutual Fund• Step 1: Determine your risk

preferences

• Step 2: Determine your asset allocation

• Step 3: Identify family of funds that meet your objectives

• Step 4: Evaluate the funds.

Steps 1 & 2: Determine Your Risk Preferences and Asset Allocation

• Determine your time horizon and risk tolerance

• Determine your asset allocation preferences

Step 3: Identify Funds That Meet Your Objectives

• Look to third-party publications– Look for no-load, open-end, low-fee funds– Find a family of funds to manage your asset

allocation

Step 4: Evaluate the Fund

• Read the prospectus!!!

• Compare returns, risk, turnover, and costs of funds with the same objective

• Evaluate the fund’s long-term performance

• Look at returns in both up and down markets

Questions for Revision

• What is a Mutual Fund? Describe the organizational structure of a mutual fund?

• Write short Notes on the following:– Entry Load– Exit Load– Closed Ended Fund– Open Ended Funded

• What are the advantages of investing in Mutual Funds

Thank You!