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Executive Summary

The report titled “Mutual Fund” has been prepared to give an in-depth analysis of mutual fund industry in India and also a brief study of Mutual fund structure outside India. The report starts with the introduction of Mutual Fund, giving details about what Mutual Fund is all about. This has been done so to make even a layman understand what a mutual fund is. After the introduction part, there is a mention of the parties involved in mutual fund business, namely the AMC, Fund Managers, Dealers of Mutual Fund, Distributors, Investors of Mutual Fund, and the Regulators and so on. Later on, in the report, the inclusion of types of Mutual fund, gives a good knowledge of different categories of mutual fund. The categorization has been made on different measures. Almost all the measures have been included in this report. This part of report has great details of the types of mutual funds.

Later part of the report contains the Mutual Fund history in India. The developments that have taken place since the start of Mutual Fund in India have been discussed in this part of the report. The history of Mutual Fund has been discussed in here under different phases. After the history part, the report discusses about the different fund performance.

One of the important parts of the part is the NAV part. In this section of report, a detailed study has been done on Net Asset Value (NAV) of Mutual Fund. How the NAV is calculated, its misconception in the minds of investors, how important it is for the parties of Mutual Fund has been explained in this section of the report. Just after this section, there is a mention of Taxation in Mutual Fund. How Mutual Funds are taxed and what are the tax-free Mutual Funds available in the market has been discussed. This part has been discussed with examples, so as to make the investors understand, how they can be benefited with the buying of Mutual Funds. The different terminologies in Mutual Fund namely, SIP, SWP, ARP, AWP, etc has been discussed in this report.

The last section of the report discussed about the risks involved in the mutual fund. The different methods through which the risks involved in mutual fund, has been discussed in this section. Also discussed are the advantages and disadvantages of buying a mutual fund. There has also been a comparison made between the returns that can be earned from mutual fund as compared with fixed deposit in banks, in post offices and investment in stock markets.


What is a Mutual Fund?

A mutual fund is a vehicle to pool money from investors with a promise that the money would be invested in a particular manner, by professional managers who are expected to owner the promise. In India mutual funds are governed by the regulations of the Securities and Exchange Board of India (SEBI).

The basic idea behind a mutual fund is that individual investors generally lack the time, the inclination or the skills to manage their own investments. Thus, mutual funds hire professional managers to manage the investment for the benefit of their investors in return for a management fee.

Then Mutual Funds came as a solution to benefit investors who had little or no idea about the working of stock market but were eager to create some money out of it.

It was created for the benefit of investors who were not able to understand the complicated functioning of the stock market but had money to invest in it. The basic purpose of any mutual fund is to put the money of the investors into various scrip in the stock market by creating a portfolio (a collection of various shares) and making investors understand the benefits and drawbacks of each and every scheme. The benefit to the customers is that they can invest in various stocks, can get help from professional people and that their money is being managed by professional who have clear understanding of the market.

The organization that manages the investment is the Asset Management Company (AMC). Employees of the AMC who perform this role of managing investments are the fund managers.

Professional Managements

Main idea behind mutual fund is that individual investors lack time and technical skills to research their choice of stock and invest in them so mutual fund hire skilled professional to manage investment of investors in return of management fee.

The organization which mange this mutual funds are called

Asset Management Company


And employees who perform this task are called

Fund Mangers



Portfolio Management Schemes

Investors have their own preference on how they want to invest their money and how much risk they want to take.

Personal treatment with which an individual investor manages their investment and how much risk they want to be decided is done by professional managers is referred as Portfolio Managements Schemes


This is normally done for investment under Rs 10 lakhs.

Money in trust

A mutual fund manages investment of the schemes for the benefits of the investors. Every schemes has an Investment Portfolio (portfolio statement)

Account of income and expenditure (revenue Account)

Account of asset and liabilities (Balance Sheet)

To insure fairness in investment, SEBI regulates the expenditure that can be charged to a scheme.

Who are the Parties Involved?


Every investor according to their financial position takes risk that is called

risk profile or risk appetite.

So hypothesis tells that by taking risk of loosing whole or partial money it is possible that investor would gain profit out of investment.


These are the people within the mutual fund organization who are responsible ensuring that investor's interest in a scheme is taken care properly.

Asset Management Company

AMC's manages the investment portfolio of schemes. An AMC's income come from the management fee it charges for the schemes it manages.

Every AMC asset under management because cost can not be reduced below some fixed level after that it becomes viable.


Distributors bring investors in mutual fund and it earns commission on each investors.

It is AMC decision whether to bear cost fully on distributors or partially.

On financial and physical resources distributors could be:

Tier 1 - who have their own franchised network reaching out to the investors all across the country.

Tier 2- who are generally regional players with some reach within their region.

Tier3 - who are small and marginal players with limited reach.


An investor's holding in mutual fund schemes is typically tracked by schemes Registrar and Transfer agent. Some manages it own house and some appoint it outside. Request to invest more money or to redeem money against existing investment is done by R&T.


The custodian maintain the securities in which the scheme invest - this ensure an outgoing independent record of the investment of the schemes

Schemes and units:-

Investment in company is normally represented by certain number of shares

People invest in a company by acquiring its share and disinvest by selling its shares.

The total outstanding shares of a company multiplied by the face value of each share,

Constitute the share capital of a company.

Shares are represented in a company and units are represented in a mutual fund scheme.

Types of schemes

Mutual fund schemes can be offered with any of a range of investment objectives each corresponding to a certain point in the risk return matrix. It can be categorized based on tenor, asset, class, position philosophy geography.

Open End Schemes

These are the schemes which do not have the fixed maturity. The mutual fund ensures the liquidity by announcing sale and repurchases prices for the units of an open end schemes on an ongoing basis.

Investors who wish to exit from an open end scheme can offer their unit to the mutual for redemption, generally called repurchase. Similarly mutual fund can sell new units to investors who want to participate in schemes generally called sale.

Additionally a mutual fund can choose to provide liquidity by listing in stock exchange, in that case investor can either trade schemes or opt for above mentioned route.

Closed End Schemes

These are schemes which have fixed maturity

Liquidity in such case is available through listing in stock market.

Trade alters change in ownership but don't change in schemes unit capital.

Occasionally closed end schemes provide a re purchase option to investors.

Either by a specified period or after a specified period normally up to a total limit for all investors together, or limit per investors.

Such repurchase would reduce the unit capital of the schemes.

Asset Class

Equity schemes invest in shares. Depending upon the schemes objective investment could be,

Growth stock where earning growth is expected to be attractive

Momentum stock that can go up and down with line market

Value stock where the fund manager is of the view that current valuation in the stock market does not reflect intrinsic value Income stock that can earn high returns through dividends.

Debt or income schemes

GILT schemes

These invest in government securities. Apart from being the most liquid schemes in the debt market, government securities are eligible for liquidity support.

Bond Schemes

These schemes invest in bond securities issued by the government or any other issuer.


can help people overcome some of the barriers to private renting posed by the requirement to pay a


to a landlord.


are usually set up by the local authority, a voluntary organization or by the Probation Service. All


have the same goal: to help people who could not otherwise do so to access private rented accommodation. In achieving this goal a successful scheme will be contributing to the confidence and efficiency of the private rented sector and helping to combat homelessness by assisting homeless and potentially homeless people.

Features of the 8% Savings (Taxable) Bond Scheme - 2003

Junk Bond Schemes

Junk bond schemes in securities that are below investment grade. High yield bonds are politically correct way of referring to junk bonds.

Junk bonds can be identified through the lower grades assigned by rating services (e.g., BBB instead of AAA for the highest quality bonds). Because the possibility of default is great, junk bonds are usually considered too risky for investment by the large institutional investors (mutual funds) that provide U.S. corporations with much of their investment capital. Junk bonds are often issued by smaller, newer companies.

Money Market and Liquid Schemes

These schemes invest in short term debt instrument.

Money Markets Instruments include:

1. Commercial papers

2. Commercial bills

3. Treasury bills

4. Government securities having an unexpired maturity up to one year

5. Call or notice money

6. Certificate of deposit

7. Usance bills

8. Permitted securities under a repo / reverse repo agreement

9. Any other like instruments as may be permitted by RBI / SEBI from time to time.

Liquid/Money market schemes:

These are designed for corporate and small businessmen to use for cash or treasury management. These schemes allow them to park short-term surplus funds in the money market, so that they earn some return before they find end uses. They invest in money market instruments like call money, inter-corporate deposits and commercial paper. Their returns range from 8 to 11 per cent, depending on money market conditions.

Even salaried individuals can use them in the short term, since they offer better returns than savings accounts. Some funds even offer cheque-writing facilities.

Risk comes from money market volatility - which also creates the possibility of gain due to a sudden increase in rates.

Balanced Schemes

Balanced schemes invest in both equity and debt. The debt investment ensures a basic interest income. Which fund managers hope to top up with capital gains on the investment portfolio. However loses can eat into the basic interest and the income.

Big advantage of these schemes is that market risk is more palatable

Capital Protected Schemes

It is a kind of balanced schemes, where a part of the initial issue proceeds is invested in gilts that would mature to a value equivalent to the unit capital of the schemes.

Thus the investor's capital is protected.

Physical Asset

Technically said that mutual fund can invest in any asset whether it can be real asset, precious metals, other metals (aluminium, steel) oil and commodities.

In India regulatory framework does permit investment in real asset.

Schemes by Position Philosophy.

Sector Funds

Regulator equity funds invest in a mix of equities that are spread across different sectors so they are called diversified equity funds.

Sectors funds on other hands invest in a particular sector,

Like energy funds.

Index Funds

These funds create and replicate according to the specified index such as BSE, NSE, etc. and such position can be created by two methods

It can be done by maintaining an investment portfolio that replicates the composition of a chosen index. Weight is same according to the index weight. This replicating style is called the passive investing. Investment fund are called passive funds. And funds that are not passive are called managed funds. Index schemes are also called as unmanaged schemes(since they are passive) or tracker schemes(since they track index)

Another is by doing research and identifying a basket of securities and derivatives whose movement is similar to that of index. Schemes that invest in such basket are called as active index funds.

Enhanced Index Funds

This is a managed index funds that can beat the performance of a bench mark index by at least 0.1 % but no more than the 2% if it crosses 2.5 it is called equity mutual fund.

Exchange Traded Funds (ETF)

These are open end funds that trade on the exchange.

ETF different from index funds in following respect

A single NAV in case of open end and in case of ETF is traded in the market place. so its price keeps changing during day

The AMC of an ETF does not offer sale and re purchase price of the units.

Unique feature is that beside secondary market it also has primary market.

Fixed Maturity Plans

This eliminates the risk of capital loss by investing in a pre specified debt securities.

When a series of FMP are issued for different maturities they are called serial funds.

These funds can chose exclusively to invest in government securities and called Serial gilts, alternatively they can invest in non government securities in which case they become Serial Bond Schemes.

Non government securities have risk of default (credit risk) which does not exist in case government securities.

Schemes by Geography

Country or region funds

These invest in securities from a specified country or region.

This is based on the fact that a particular country or region will show a higher growth or returns on the equity market.

Offshore funds- these mobilize the money from investors for investment outside their country.

The principle of time diversification has given rise to the concept of

Systematic Investment Plan


Systematic Withdrawal Plan


Systematic Transfer Plan


Systematic Investment Plan (SIP)

It refers of investing constant fund regularly generally every month. When market goes up then the money invested in that period gets translated into fewer numbers units for investors and vise versa.

Thus it is clear that SIP tempers with the gain or loss from the investment SIP does not offer protection from losses. If the market turns adverse then you can lose money even in SIP.

SIP ensures that your acquisition cost approximate the average NAV. Therefore this investment style is also called rupee cost averaging.

Value averaging ensures that investors book profit in rising market and invest in loosing market.

For e.g.

- for ICICI bank (Open ended equity fund), monthly: Minimum Rs. 1000 + 5 post-dated cheques for a minimum of Rs. 1000 each.

Systematic Withdrawal Plan (SWP)

It is mirror image of SIP, under SWP investor would withdrawal constant amount periodically. The benefits are the same namely that through SWP the investor can temper gains though it does not prevent losses.

For e.g

. - in case of ICICI bank (Open ended equity fund) SWP is a Minimum of Rs.500/- and Multiples thereof.

Systematic Transfer Plan (STP)

Investors exposure to different type of securities whether debt or equity should flow from their risk profile or appetite which the function of their financial position and personal disposition.

It occurs in two situations

On investment or disinvestment (here SIP and SWP is useful)

On change in value of securities in market.

In case of mutual funds such rebalancing can be achieved by systematically moving money between schemes.

Mid-Cap Fund

Mid cap funds are those mutual funds, which invest in small / medium sized companies. As there is no standard definition classifying companies as small or medium, each mutual fund has its own classification for small and medium sized companies. Generally, companies with a market capitalization of up to Rs 500 crore are classified as small. Those companies that have a market capitalization between Rs 500 crore and Rs 1,000 crore are classified as medium sized.

Big investors like mutual funds and Foreign Institutional Investors are increasingly investing in mid caps now a day because the price of large caps has increased substantially. Small / mid sized companies tend to be under researched thus they present an opportunity to invest in a company that is yet to be identified by the market. Such companies offer higher growth potential going forward and therefore an opportunity to benefit from higher than average valuations.

But mid cap funds are very volatile and tend to fall like a pack of cards in bad times. So, caution should be exercised while investing in mid cap mutual funds.

Growth Option

The Scheme will not declare any dividends under this option. The income earned by the scheme will remain invested in the scheme and will be reflected in the NAV. This option is suitable for investors who are not looking for current income (but who have invested with the intention of capital appreciation). Moreover, if units under this option are held as capital asset for a period of at least one year, from the date of acquisition, unit holders should get the benefit of long term capital gains tax.

Dividend Option

This option is suited for investors seeking income through dividend declared by the scheme. Only unit holders opting for the dividend option will receive dividends. An investor on record for the purpose of dividend distributions is an investor who is an unit holder, as of the record date. In order to be a unit holder, an investor has to be allocated units representing receipt of clear funds by the scheme.

The scheme may be at the discretion of the trustee, declare annual dividends in its dividend plan subject to availability of distributable profits. Dividends will be declared on the last business day of March. If March 31st is a non business day, the previous business day will serve as the record date. Interim dividends may be declared at the discretion of the trustee. Unit holders also have the option to reinvest their dividend at the ex-dividend NAV. The trustee, in its sole discretion, may also declare interim dividends. It should be noted that actual distribution of dividends and the frequency of distribution indicated above, are provisional and will be entirely at the discretion of the trustee and depend, inter alia on the availability of distributable surplus to the extent the entire net income and realized gains are not distributed, the same will remain invested in the scheme and be reflected in the NAV.

Payout Dividend

As per the regulations, the fund shall dispatch to the unit holders, the dividend proceeds within 30 days of declaration of the dividend. Dividends will be payable to those unit holders whose names appear in the register of the unit holders on the date (record date). Dividends will be paid by cheque; net of taxes may be applicable. Unit holders will also have the option of direct payment of dividend to the bank account. The cheques will be drawn in the name of the sole/first holder and will be posted to the registered address of the sole/first holder as indicated in the original application form. The fund will endeavor to dispatch the dividend cheques within 30 days of the record date. To safeguard the interest of the unit holders from loss or theft of dividend cheques, investor should provide the name of their bank, branch and account number in the application form. Dividend cheques will be sent to the unit holder after incorporating such information.

Reinvest Dividend

Under this sub-option, unit holders may chose to reinvest all of their dividends by way of additional units of the scheme instead of receiving dividends in cash. Such additional units by way of reinvestment of dividends will be at the applicable NAV on the next day (excluding Saturday) after the record date. The dividend so reinvested shall be constructive payment of dividend to unit holders and constructive receipt of the same amount from each unit holder for reinvestment in units. Any such investment will be made by indicating in the investor's original application or by providing the fund with written notice signed by all the registered holder(s) of the units and also sent to the registrar.

Revocation of any such decision also must be made in writing and signed by all the registered holder(s) of the units and also sent to the registrar.

The additional units issued under the sub-option “Reinvest Dividend” under option B and held as capital asset would get benefit of long-term capital gains tax if sold after being held for one year. For this purpose one year will be computed from the date when such additional units are issued.

Effect of Dividend: The NAV of the unit holders in dividend option will stand reduced by the amount of dividend declared. The NAV of the growth option will remain unaffected.

Mutual fund industry in India

The origin of mutual fund industry in India is with the introduction of the concept of mutual fund by UTI in the year 1963. Though the growth was slow, but it accelerated from the year 1987 when non-UTI players entered the industry.

In the past decade, Indian mutual fund industry had seen a dramatic improvement, both qualities wise as well as quantity wise. Before, the monopoly of the market had seen an ending phase; the Assets under Management (AUM) were Rs. 67bn. The private sector entry to the fund family raised the AUM to Rs. 470 bn in March 1993 and till April 2004; it reached the height of 1,540 bn.

Putting the AUM of the Indian Mutual Funds Industry into comparison, the total of it is less than the deposits of SBI alone, constitute less than 11% of the total deposits held by the Indian banking industry.

The main reason of its poor growth is that the mutual fund industry in India is new in the country. Large sections of Indian investors are yet to be intellectuated with the concept. Hence, it is the prime responsibility of all mutual fund companies, to market the product correctly abreast of selling.

The mutual fund industry can be broadly put into four phases according to the development of the sector. Each phase is briefly described as under.

First Phase -1964-87

Unit Trust of India (UTI) was established on 1963 by an Act of Parliament. It was set up by the Reserve Bank of India and functioned under the Regulatory and administrative control of the Reserve Bank of India. In 1978 UTI was de-linked from the RBI and the Industrial Development Bank of India (IDBI) took over the regulatory and administrative control in place of RBI. The first scheme launched by UTI was Unit Scheme 1964.

Second phase1987_1993 (Entry of Public Sector Funds)

Entry of non-UTI mutual funds. SBI Mutual Fund was the first followed by Canara bank Mutual Fund (Dec 87), Punjab National Bank Mutual Fund (Aug 89), Indian Bank Mutual Fund (Nov 89), Bank of India (Jun 90), Bank of Baroda Mutual Fund (Oct 92). LIC in 1989 and GIC in 1990. The end of 1993 marked Rs.47, 004 as assets under management.

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

With the entry of private sector funds in 1993, a new era started in the Indian mutual fund industry, giving the Indian investors a wider choice of fund families. Also, 1993 was the year in which the first Mutual Fund Regulations came into being, under which all mutual funds, except UTI were to be registered and governed. The erstwhile Kothari Pioneer (now merged with Franklin Templeton) was the first private sector mutual fund registered in July 1993.

The 1993 SEBI (Mutual Fund) Regulations were substituted by a more comprehensive and revised Mutual Fund Regulations in 1996. The industry now functions under the SEBI (Mutual Fund) Regulations 1996.

The number of mutual fund houses went on increasing, with many foreign mutual funds setting up funds in India and also the industry has witnessed several mergers and acquisitions. As at the end of January 2003, there were 33 mutual funds with total assets of Rs. 1, 21,805 crores. The Unit Trust of India with Rs.44,541 crores of assets under management was way ahead of other mutual funds.

Fourth Phase- since February 2003

This phase had bitter experience for UTI. It was bifurcated into two separate entities. One is the Specified Undertaking of the Unit Trust of India with AUM of Rs.29, 835 crores (as on January 2003). The Specified Undertaking of Unit Trust of India, functioning under an administrator and under the rules framed by Government of India and does not come under the purview of the Mutual Fund Regulations.

The second is the UTI Mutual Fund 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 AUM 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. As at the end of September, 2004, there were 29 funds, which manage assets of Rs.153108 crores under 421 schemes.

Performance of Mutual Funds in India

Let us start the discussion of the performance of mutual funds in India from the day the concept of mutual fund took birth in India. The year was 1963. Unit Trust of India invited investors or rather to those who believed in savings, to park their money in UTI Mutual Fund.
For 30 years it goaled without a single second player. Though the 1988 year saw some new mutual fund companies, but UTI remained in a monopoly position.

The performance of mutual funds in India in the initial phase was not even closer to satisfactory level. People rarely understood, and of course investing was out of question. But yes, some 24 million shareholders were accustomed with guaranteed high returns by the beginning of liberalization of the industry in 1992. This good record of UTI became marketing tool for new entrants. The expectations of investors touched the sky in profitability factor. However, people were miles away from the preparedness of risks factor after the liberalization.

The Assets under Management of UTI was Rs. 67bn. by the end of 1987. Let me concentrate about the performance of mutual funds in India through figures. From Rs. 67bn. the Assets Under Management rose to Rs. 470 bn. in March 1993 and the figure had a three times higher performance by April 2004. It rose as high as Rs. 1,540bn.

The net asset value (NAV) of mutual funds in India declined when stock prices started falling in the year 1992. Those days, the market regulations did not allow portfolio shifts into alternative investments. There were rather no choices apart from holding the cash or to further continue investing in shares. One more thing to be noted, since only closed-end funds were floated in the market, the investors disinvested by selling at a loss in the secondary market.

The performance of mutual funds in India suffered qualitatively. The 1992 stock market scandal, the losses by disinvestments and of course the lack of transparent rules in the whereabouts rocked confidence among the investors. Partly owing to a relatively weak stock market performance, mutual funds have not yet recovered, with funds trading at an average discount of 10­20 percent of their net asset value.

The supervisory authority adopted a set of measures to create a transparent and competitive environment in mutual funds. Some of them were like relaxing investment restrictions into the market, introduction of open-ended funds, and paving the gateway for mutual funds to launch pension schemes.

The measure was taken to make mutual funds the key instrument for long-term saving. The more the variety offered, the quantitative will be investors.

At last to mention, as long as mutual fund companies are performing with lower risks and higher profitability within a short span of time, more and more people will be inclined to invest until and unless they are fully educated with the dos and don'ts of mutual funds.

Drawbacks of Mutual Funds

Mutual funds have their drawbacks and may not be for everyone:

No Guarantees:

No investment is risk free. If the entire stock market declines in value, the value of mutual fund shares will go down as well, no matter how balanced the portfolio. Investors encounter fewer risks when they invest in mutual funds than when they buy and sell stocks on their own. However, anyone who invests through a mutual fund runs the risk of losing money.

Fees and commissions:

All funds charge administrative fees to cover their day-to-day expenses. Some funds also charge sales commissions or "loads" to compensate brokers, financial consultants, or financial planners. Even if you don't use a broker or other financial adviser, you will pay a sales commission if you buy shares in a Load Fund.


During a typical year, most actively managed mutual funds sell anywhere from 20 to 70 percent of the securities in their portfolios. If your fund makes a profit on its sales, you will pay taxes on the income you receive, even if you reinvest the money you made.

Management risk:

When you invest in a mutual fund, you depend on the fund's manager to make the right decisions regarding the fund's portfolio. If the manager does not perform as well as you had hoped, you might not make as much money on your investment as you expected. Of course, if you invest in Index Funds, you forego management risk, because these funds do not employ managers

The asset size of Indian mutual funds have

grown by about 20 per cent

from Rs 47,000 crore in March 1993 to Rs 1,40,000 crore in December 2003 due to shift in investor preference for MFs and growing presence of private sector fund companies, according to CRISIL sectoral study.

"The shift in preference towards MFs has been facilitated by fiscal incentives, increasing returns from debt mutual fund investments due to the decline in interest rates and the growing number of choices available to investors," CRISIL's director-Financial Sector Ratings Raman Uberoi said.

Excluding Unit Trust of India (UTI), however, the growth has been a staggering eight-fold in just under five years, from Rs 15,200 crore as at March 1999 to Rs 1, 20,300 crore at December 2003, CRISIL said.

The gradual change in the investors' risk profile and the Association of Mutual Funds of India's (AMFI) efforts for an appropriate regulatory environment have also contributed to growth of MF industry, the CRISIL study said.

There is a huge latent growth potential as industry size is only

four per cent of the country's gross domestic product (GDP)

, very low compared to developed markets like United States where the assets under the management were more than 60 per cent of the GDP, or developing countries like Brazil, where the AUM is over 20 per cent of the GDP, it added.

Commenting on the volatility of returns and risks, CRISIL said the equity funds' reduced risk behavior over the last two years while debt funds are exhibiting greater risks in their returns.

Types of mutual Funds

There are so many types of “Schemes” of mutual fund available on the market for investors .Mutual fund schemes may be classified on the basis of their structure and its investment objective.

(a) By structure

- Open ended scheme

- Close ended scheme

- Interval fund

(b) By investment objective

- Growth fund

- Income fund

- Balanced fund

- Money market fund

( c) Other schemes

- Tax-saving fund

- Sectoral scheme

- Index scheme

- Foreign securities fund

Open ended scheme -

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 Asset Value (NAV) related prices. When the investors redeems the units, the fund repurchases the units from the investor.

Close-ended Funds -

A Close-ended Fund has a stipulated maturity period, which generally ranges from 3 to 15 years. The fund is open for subscription only during a specified 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 scheme on the Stock Exchanges, if they are listed. The market price at the stock exchange could vary from the scheme's NAV on account of demand and supply situation, unit holders' expectations and other market factors.

By Investment Objective:

On the basis of when and where investment is made, MF's can be classified into following categories.

Growth Funds -

The aim of growth funds is to provide capital appreciation over the medium to long term. Such schemes normally invest a majority of their corpus in equities. Growth schemes are ideal for investors who have a long-term outlook and are seeking growth over a period of time. These funds are invested in companies whose earnings are expected to rise at an above average rate.

Income Funds -

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 and Government securities.

Income Funds are ideal for capital stability and regular income. Capital appreciation in such funds may be limited, though risks are typically lower than that in a growth fund.

Balanced Funds

The aim of Balanced Funds is to provide both growth and regular income. Such schemes periodically distribute a part of their earning and invest both in equities and fixed income securities in the proportion indicated in their offer documents. This proportion affects the risks and the returns associated with the balanced fund - in case equities are allocated a higher proportion, investors would be exposed to risks similar to that of the equity market.

Balanced funds with equal allocation to equities and fixed income securities are ideal for investors looking for a combination of income and moderate growth.

Money Market Funds -

The aim of Money Market Funds is to provide easy liquidity, preservation of capital and moderate income. These schemes generally invest in safer short-term instruments such as Treasury Bills, Certificates of Deposit, Commercial Paper and Inter-Bank Call Money. Returns on these schemes may fluctuate depending upon the interest rates prevailing in the market.

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

Other Equity Related Schemes:

Tax Saving Schemes -

These schemes offer tax rebates to the investors under specific provisions of the Indian Income Tax laws, as the Government offers tax incentives for investment in specified avenues.

Investments made in Equity Linked Savings Schemes (ELSS) and Pension Schemes are allowed as deduction under Section 80 CCC of the Indian Income Tax Act, 1961.

Index Schemes -

Index Funds attempt to replicate the performance of a particular index such as the BSE Sensex or the NSE S&P CNX 50.

Sectoral Schemes -

Sectoral Funds are those which invest exclusively in specified sector(s) such as FMCG, Information Technology, Pharmaceuticals, etc. These schemes carry higher risk as compared to general equity schemes as the portfolio is less diversified, i.e. restricted to sector(s) / industry (ies).

Foreign Securities Funds

These funds invest in equities in one or more foreign countries thereby achieving diversification across the country's borders. However they have additional risks such as the foreign exchange rate risk- and their performance depends on the economic conditions of the countries they invest in. FSE funds may invest in a single country (hence riskier) or many countries (hence more diversified).

Exchange Traded Fund's

An Exchange traded Fund (ETF) is a mutual Fund Scheme, which combines the best features of open and closed end structures. It tracks a market index and trades like a single stock on the stock Exchange. its pricings is linked to index and units can be bought /sold on the stock Exchange.

Fund structure and constituents

Legal structure of mutual Funds:-

Mutual funds have a unique structure that is distinct from the other entities such as companies or firm's .it is imp. for employees and distributors to be familiar with special features of the structure of mutual fund, because it determines the rights and responsibilities of the fund's constituents viz., Sponsor,trustee,custodian,transfer agents, and fund/assets management company(AMC).the legal structure also drives the inter- relationships between these constituents.


Mutual funds structure in the USA.

In the USA, mutual funds are set up as investment companies, which may be thought of as “the fund Sponsor”. An investment company may be a corporation, partnership or a unit investment trust. For our purpose, all these legal entities may be broadly understood as mutual funds .The Investment Company in turn appoints a management company, which may either be a closed end management company or an open end management company. Only Open-end management companies are technically called “mutual funds” in the USA.

The constituents of mutual funds in the USA are

- The management company -

Equivalent to AMC

- Underwriter - Distributor or the mktg. company that sells share to public

- Management group - Family of mgmt .cos owned by a group of people.

- Custodian - The Entity that holds the fund's assets on behalf of

All the MFs irrespective of their structure, including a of the constituents described above, are regulated by Securities Exchange Commission (SEC).


Mutual Funds structure in UK.

In the UK, MFs have 2 alternative structures .Open-end funds are in the form of unit trusts, while Closed-end funds are in the form of corporate entities although called investment trusts. Separate regulatory Mechanisms exist for both type of entities .Unit trusts are regulated by the securities and Investment board. The must also be authorized by the relevant ‘self regulatory- Organization'. Investment Trusts are structured as cos and provisions of cos. Act are applicable to them.


Structure of MFs in INDIA.

Like other countries, India has a legal framework within mutual funds must be constituted. Unlike UK, where 2 distinct structure - ‘Trust' and ‘corporate' are allowed with separate regulations, depending on their nature open end or closed end, in India ,Open-end & closed-end funds are constituted along one unique structure - as unit trusts. A MF in India is allowed to issue open-end & closed end schemes under a common legal structure .therefore MF may have several different schemes (open & closed -end) under it. SEBI governed the MF in India. the structure that is required to be followed by mutual funds in India is laid down under SEBI regulations , 1996.

-The fund sponsor

-MF as trusts.


-The asset management company(AMC)

>-Independent directors and trustees

-Custodian and depositories

-Banker -Registrars & transfer Agents -Distributors

Sponsor -Eligibility

  • Carries a business of financial services for a period of not less than five years.
  • Net worth is positive in all the immediate preceding five years.
  • Net worth in the immediate preceding year is more than the capital contribution of sponsor in the AMC.
  • Should have profit after providing for depreciation, interest and tax in three out of immediate preceding five years including the fifth year.
  • An applicant is a fit and proper person.
  • Sponsor or any of its directors or the principal officer to be employed by the mutual fund should not have been guilty of fraud or has not been convicted of an offense involving moral turpitude or has not been found guilty of any economic offence.

Trusty Eligibility

Mutual fund will appoint a trusty in accordance with mutual fund regulations. , No person shall be eligible to be appointed as trusty unless:

- He is a person of ability, integrity and standing;

- Has not been found guilty of moral turpitude;

- Has not been convicted of any economic offence or violation of any securities law;

- Have furnished particulars as prescribed in from C.

  • Two third trusties shall be independent persons and shall not be associated with the sponsors or be associated with them in any manner whatsoever.
  • In case a company is appointed as a trusty then its directors can act as trusty of any other trust provided that the object of the trust is not conflicting with the object of MF.

AMC appointment

  • An AMC is asset Management Company that manages the assets of MF.
  • An AMC is appointed as under:

- The sponsor or if so authorized by trust deed, the trustees shall appoint an AMC which has been approved by the board.

- An appointment of AMC can be terminated by majority of trustees or by seventy five percent of the unit-holders of the MF scheme.

Any change in the appointment of an AMC shall be subject to prior approval of the board and the unit- holders.

Role of Self-Regulatory Organizations

What are self- regulatory organizations?

Agencies like RBI or SEBI are regulators with legal powers to set rules and enforce them on market participants over whom they have jurisdiction. For exp- SEBI regulates the merchant bankers, stock brokers, and mutual funds. However, at times regulator grants power to market participants for self regulation. A Self Regulatory Organization (SRO) is an association representing groups of market participants, which is specially empowered by the apex regulatory body to exercise pre-defined authority over the regulation of their members. Stock Exchange in most countries is granted the status of SROs. Normally, the SROs facilitate decentralization in the regulatory structure, involve the market players in the regulatory process and ensure that the regulatory policies and procedures do not ignore market realities or become unmanageable for apex regulatory body.

It has to be noted that everybody representing a group of market participants does not automatically become a SROs; it has to be granted specific powers and approvals to become a SRO by the govt., appropriate laws and recognition of by regulatory authority. Hence ,a brokers' or banks' or ‘mutual funds' industry association may choose to remain just that - a trade body without any specific powers as SRO.

SROs in India

While stock Exchange have a definite role as SROs even in India, in other sectors of the capital markets, SROs have yet to emerge as a potent force.

Association of Mutual Funds in India (AMFI)

As in the USA, where the investment co. institute plays a role as an industry association for the mutual fund industry, the Association of Mutual funds in India (AMFI) plays similar role in India. AMFI is not a SRO, though it is conceivable that it may choose to apply for that status and become one in future.

AMFI was incorporated in 1995 with the objective of representing the MF industry collectively.

Its principal objectives are:

  • To promote the interests of MF and unit-holders, and interact with SEBI/RBI/Govt./regulators.
  • To set and maintain ethical, commercial and professional standards in the industry and to recommend and promote best business practices and conduct to be followed by members and others engaged in activities of mutual fund and asset management.
  • To increase public awareness and understanding of the concept and workings of MF in the country, to undertake investor's awareness programmers, and to disseminates information on mutual fund industry.
  • To develop a cadre of well trained distributors and to implement a programmed of training and certification for all intermediaries and other engaged in industry.


The offer document of a scheme lays down the investors' rights. Investors are the owners of the scheme's assets, and it is therefore, imperative that they are aware of their rights with respect to the scheme's assets, its management, and recourse to the trustees, the AMC and other constituents. The imp rights are-

(1)Rights to Proportionate”Beneficial ownership”

  • Unit-holders have the right to beneficial ownership of the scheme's assets, otherwise held in trust for them by the trustees of the funds. They also have the right to any dividend or declare under the scheme. The right to assets, income, etc. is in proportion that the units held by the unit holder bears to the total number of the units issued and outstanding.
  • Unit- holders have the option to nominate a person in whom all the beneficial ownership rights in the units will vest in the event of his or her death.

(2)Right to Timely Services

  • Unit-holders are entitled to receive dividend warrants within 30 days of the date of dividend declaration.
  • Unit-holders have the right to payment of interest at a rate specified by SEBI in the event of failure on the part of the mutual fund to dispatch the redemption or repurchase proceeds within 10 working days. Such interest must be borne by the AMC.
  • Where any investor has failed to claim redemption proceeds or dividends due to him/her, the investor has right to do so within a period of 3 yrs. Of due date at prevailing NAV. After 3 yrs, he will be paid at the NAV applicable at the end of the 3rd yrs.
  • Investors also have right to receive compensation from the AMC representing the differences in NAV amounts in case where there has been a variation in NAV calculations on account of non-recording of any transaction/s in the scheme accounts in certain cases.

(3)Right to Information

Unit-holders have the right to obtain from the trustees any information that may have adverse bearings on their investments.
  • Unit-holders have the right to inspect major documents of the fund.doc. like materials contracts, memorandum and articles of association of the AMC, the texts of SEBI(MF) regulations and the offer document of the scheme.
  • Each unit- holder has the right to receive a copy of the annual financial statements.

(4) Right to approve changes in fundamental attributes of the schemes.

(5) Right to wind up scheme

Investors can demand the trustees to wind up a scheme prior to its earlier fixed duration and repay the investors, if 75% of the investors pass a resolution to this effect. This right applies to both closed end funds, and open end fixed term plan series.

(6) Right to terminate the AMC.

The appointment of an AMC of a fund can be terminated by 75% of the unit holders of the scheme with the prior approval of SEBI.

Limitation to investors ‘Right'

  • Investors cant sue the trust i.e., they do not have legal recourse to the trust as ,under Indian law, the trust is not distinct or separate entity.

  • Fundamental concept of a mutual fund is the investor invests at their own risks and can't force AMC to assure a specified level of return. Only if the offer document has specifically provided such guarantee by a named sponsor, the investor will have the right to sue the sponsor to make good any shortfalls in promised returns.

Offer documents

When an asset management co. or a fund sponsor wishes to launch a new mutual fund scheme, they are required to formulate the details of the scheme and register it with SEBI before announcing the scheme and inviting the investors to subscribe to the fund. launch of new fund scheme is called new fund offer(NFO).the doc. Containing the details of new fund offer that the AMC or sponsor prepares and circulates to the prospective investor is called the offer document . In the USA, it is called the prospectus.

The offer documents issued by mutual funds serve the same purpose of inviting investor and giving them the information about the new fund offer.

The prospectus of a closed -end fund is issued only once at the time of issue, as the units are normally not repurchased from investors. Investment in a closed-end fund is like investing in a co issuer's new shares.

Open-ended fund MFs could issue and repurchase units on an ongoing basis. this means that the offer document of open-ended funds is valid for a the time, until amended, though it will be 1st issued at the time of launch of the scheme. SEBI requires the offer doc. of an open-end fund to be revised every two years.

Importance for the investor

  • The offer doc. is one the most imp. Sources of information from the perspective of prospective investor considering investment in a new mutual fund. Apart from the scheme details, the offer doc. also gives much valuable information that is relevant for investor's decision making on whether he should consider subscribing to the new scheme being proposed.
  • The investor must understand the fundamental attributes of the schemes before he makes his investment decision.
  • The offer doc. is the operating doc. and describes the product.


The offer doc.issued by mutual funds in India are required by SEBI to include the following information

  • Detail of sponsor and AMC.
  • Description of the schedule and investment objectives/strategy.
  • Terms of issue
  • Historical statistics
  • Investors's Rights and services.

The key information memorandum (KIM) is concise version of offer documents, and it would be easier for the investor to obtain a copy with the application form at various distribution points such as the banks, the distributors and brokers.


In a vast country like India ,taking the message of investing through MFs is big mktg.challenge.Investors need to be educated about the benefits and intricasis of mutual fund investing. This challenges can be solved by large no. of intermediaries ao distributors working throughout the country. This “fund distributors” are clearly the most important link between the fund management industry and the investors.


INDIA MFs in India are open to investment by-


Residents including-

Resident Indian indivisuals

Indian cos./Partnership firms

Indian trusts/Charitable Institutions

Banks/ Financial Institutions

Non-Banking Financial Cos.

Insurance Cos.

Provident funds

(b)Non- Residents including

  • Non-Resident Indians, and person of Indian Origin.
  • Overseas corporate Bodies (OCBs).

(c)Foreign Entities

  • Foreign Institution Investors (FIIs) registered with SEBI.

Foreign citizens /entities are not allowed to invest in mutual funds in India

Distribution channels

Mutual funds devise investment plans for the institutional and the individual investors. Some funds target and contact the institutional investors directly, without any external distribution channels. But it is imp. To note that MFs are primarily vehicles for large collective investments, working on the principle of pooling the funds of a no. of investors. That is why large no. of schemes is targeted at individual investors. A substantial portion of investment in MFs takes place at the retail level. Retail Distribution is therefore important for distribution of MFs. The distributors are a vital link between the MFs and investors.

Types of distribution Channels

  • Individual Agents as Distributors
  • Distribution Companies
  • Banks and NBFCs
  • Post offices
  • Direct marketing.

Definition of NAV

What is NAV? Simply put, NAV is the sum total of all the assets of the mutual fund (at market price) less the expenses (fund manager fees, audit fees, registration fees among others); divide this by the number of units and you arrive at the NAV per unit of the mutual fund. An illustration should help us better understand the same.

The value of a mutual fund share. Calculated by dividing the total net asset value of the fund bythe number ofshares outstanding.

Calculated as:

NAV calculation

Net Assets (Rs)


Expenses (Rs)


No. of Units


NAV (Rs)


So when you wish to invest in a mutual fund, you invest in it at its existing NAV (adjusted for the entry load), i.e. you buy the units at a price (i.e. NAV), the calculation of which is based on the current market price of all the assets that the mutual fund owns. In other words, the NAV represents the fund's intrinsic worth.

Misconception about NAV

The NAV of a mutual fund has notbeen correctly understood by a large section of the investing community.

This is quite evident from the fact that Mutual Fundshad beenrecently collecting huge corpus in their New Fund Offers or NFOs, whereas the collections in the existing schemes were negligible. In fact, investors sold their existing investments and invested inNFOs. This switch makes no sense, unless the new fund has something different and better to offer.

This situation arises from the perception that a fund at Rs 10 is cheaper than say Rs 15 or Rs 100. However, this perception is totally wrong and investors would be much better off once they appreciate this fact. Two funds with same portfolio are same, no matter what their NAV is. NAV is immaterial.

Why people carry this perception is because they assume that NAV of a MF is similar to the market price of an equity share. This, however, is not true.

NAV vs Price of an equity share

In case of companies, the price of its share is ‘as quoted on the stock exchange', which apart from the fundamentals, is also dependent on the perception of the company's future performanceand the demand-supply scenario. And hence the market price is generally different from it's' book value.

There is no concept as market value for the MF unit. Therefore, when we buy MF units at NAV, we are buying at book value. And since we are buying atbook value, we are paying the right price of the assets whether it be Rs 10 or Rs.100. There is no such thing as a higher or lower price.

NAV & it's impact on the returns

We feel that a MF with lower NAV will give better returns. This again is due to the wrong perception about NAV. An example will make it clear that returns are independent of the NAV.

Say you have Rs 10,000 to invest. You have two options, wherein the funds are same as far as the portfolio is concerned. But say one Fund X has an NAV of Rs 10 and another Fund Y has NAV of Rs 50. You will get 1000 units of Fund X or 200 units of Fund Y. After one year, both funds would have grown equally as their portfolio is same, say by 25%. Then NAV after one year would be Rs 12.50 for Fund X and Rs 62.50 for Fund Y. The value of your investment would be 1000*12.50 = Rs 12,500 for Fund X and 200*62.5 = Rs 12,500 for Fund Y. Thus your returns would be same irrespective of the NAV.

It is quality of fund, which would makea difference to your returns. In fact for equity shares also broadly this logic would apply. An IT company share at say Rs 1000 may give a better return than say a jute company share at Rs 50, since IT sector would show a much higher growth rate than jute industry (of course Rs 1000 may ‘fundamentally' be over or under priced, which will not be the case with MF NAV).

The following illustration will clearly establish the irrelevance of NAV while making an investment decision.

NAV: Does size matter?

Open-ended large cap equity funds


NAV (Rs)


1-Yr (%)


Franklin Prima Plus (G)



Franklin Bluechip (G)



Pru ICICI Power (G)



HSBC Equity (G)



Kotak 30 (G)



HDFC Equity (G)



(Data sourced from Credence Analytics. NAV as on February 09, 2007)

(To insure a fair comparison we have only considered open-ended equity funds from the predominantly large cap segment.)

Franklin Prima Plus with an NAV of Rs 146.17 (second highest NAV in our sample) clocked a growth of 43.57% over 1-Yr and is the top performer in the segment. Pru ICICI Power with a much lower NAV of Rs 84.51 has clocked a return of 38.67%.

Kotak 30 with a lowest NAV of Rs 72.06 has clocked a return of 36.54% and performed better then HDFC Equity which has the highest NAV of Rs 153.79 but recorded an NAV appreciation of 35.50%, which is the lowest in our sample. This table clearly indicates that there is no correlation between the NAV and the performance of the mutual fund.

It is evident that the fund's current NAV and its expected performance are unrelated and therefore making an investment decision based on the NAV would be misguided. As an investor you need to consider factors like your own risk profile, the fund's management style and performance.

Who calculates a mutual fund's NAV?

Who calculates the Net Asset Value of mutual funds and who certifies if it is done correctly?

How would we know if the mutual fund is giving an incorrect picture to delay dividend distribution?

NAVs are calculated by the mutual fund housesthemselves or through independent entities.

Reliance Mutual Fund and ABN Amro Mutual Fund, for instance, get the calculations done by Deutsche Bank.

The market watchdog and mutual fund regulator, the Securities and Exchange Board of India, has laid down the regulations and guidelines with regard to how the funds must value their investments.

The above valuations may also be subject to audit on an annual basis.

Moreover, there is no advantage that a mutual fund can derive by disclosing incorrect NAVs in relation to dividend distribution.

No mutual fund isobliged to make dividend distributions at specific intervals of time or at the attainment of a specific NAV. They do so purely at their own discretion.

Therefore, an investor should have no apprehension as to the calculation of NAVs.


There are three kinds of investors who have been witnessed, i.e.:

  1. High-risk takers - Invest in Equity funds.
  2. Moderate risk takers - Invest in Balanced funds.
  3. Risk Averse - Invest in Debt funds.

In the contemporary scenario (volatile market) the choice of the Balanced Mutual Funds is the best choice for an individual investor. Let us discuss the difference between the three types of funds, i.e.- Equity mutual fund, Debt mutual fund and Balanced Mutual Fund and then we will see why Balanced Mutual Fund is considered to be the best option for an individual investor in the market consists of high volatility.

Equity fund

An equity mutual fund would try to achieve a higher long-term appreciation or growth of your capital. But then you had better be prepared for a certain amount of volatility (fluctuation in value of investment).

An equity mutual fund identifies and invests in shares of high quality companies whose businesses are sound and have good, steady growth. The share price of such companies should show an increase over a period of time, although it can fluctuate substantially in the short term. Thus, one can achieve higher growth if one were to invest for a long term (usually 2-3 years at least). In the short term, the prices may come down, causing a temporary reduction in value of the investment.

Debt fund

This one would aim to achieve steady income at low risk to the invested principal. To achieve this the mutual fund would invest in what are called fixed-income instruments. These are similar to the fixed deposits of banks, but are usually issued by private and public sector companies as well as by the Indian government as a means to borrow money.

Some of the money with the fund may be lent to various banks and other institutions for a very short term (call money and money market instruments). The value of these securities increases steadily as the interest associated with them accrues to the fund. Further fluctuations may also come about due to a change in the government or RBI interest rates, which may affect the value of your investments, or if one of the debtors is faced with an inability to return the money borrowed.

Therefore, although the actual returns cannot be guaranteed due to such fluctuations, debt funds usually are a very safe way to invest money and achieve superior returns to conventional bank deposits.

Balanced fund

A fund that combines a stock component, a bond component and, sometimes, a money market component, in a single portfolio. Generally, these hybrid funds stick to a relatively fixed mix of stocks and bonds that reflects either a moderate (higher equity component) or conservative (higher fixed-income component) orientation.

A balanced fund is geared toward investors who arelooking for a mixture of safety, income and modest capital appreciation. The amounts that suchamutual fund invests into each asset class usually must remain within a set minimum and maximum.

Why you must invest in a balanced fund


By investing in both shares and fixed-return investments, balanced funds seekthe best of both worlds.

They includethe power of equities (shares) and the stability of debt market instruments (fixed return investments like bonds) and are most likely to take you to your goal safely.

They are the best hope for those who want to benefit from the stock market but don't have the stomach for volatility.

We believeall sorts of investors should have at least some portion of their investments in balanced funds.

What makes balanced funds such a power investment tool is their inherent design, which allows them to maintain an effective balance between debt and equity.


Balanced funds have concentrated more on equity in recent times and the reward has been substantial.

On an average, balanced funds have gained 43.58% in the last one year.

Among the top gainers, Magnum Balanced has given areturn 71.01% and hasoutperformed the average returns of a diversified equity fund (average of a diversified equity fund: 67.37%).

Kotak Balance (59.81%), HDFC Prudence (59.73%) and BoB Balanced (57.92%) too have done well.

The laggards have not done bad either, with the worst performing LICMF ULSI gaining 25.14%.

Know where yourmoney is going

If the fund manager plays his cards right, returns follow. However, getting the balance right is tricky.That is why your fund managers' ability becomes all the more crucial.

An average balanced fund maintains a 60:40 equity debt ratio. That means 60% of their total investment is in equity and the balance in debt.

But, in a booming market (like the current bull run we are facing now), funds cross this 60% limit in the search of higher returns. And, if the fund manager makes a few wrong investments, the fund's returns may go for a toss.

The debt market is not doing too well right now, so most funds have been making optimum use of their equity component to earn returns. In the past year, mostof the top performers in this category have kept their debt allocation below 30%.

Take BoB Balance, for instance. The fund has a one-year return of 57.92% but has got it by completely ignoring the debt market for the last four months. Of all the money the fund manages, 60.79% is in shares and 39.21% is in cash (as of investments declared on June 30, 2005).

Magnum Balanced has kept half of its equity investments in mid-cap and small-cap stocks in the last year.

HDFC Prudence, BoB Balance and Kotak Balance too have huge amounts invested in these kinds of stocks.

While large-caps, the returns they have provided are much higher. A majority of balanced fund performers have not done well simply because they have stuck to their large-cap holdings

A good investment to consider

Balanced funds have proved their worth time and again and rewarded investors with superlative returns and stability.

The returns may not be as flashy as diversified equity funds, but balanced funds are the ultimate vehicle for long-term growth for conservative investors.

They will save you from bumpy rides and ensure a soft landing.


Impact of tax on income from mutual funds

Income earned from mutual funds falls under two heads -

dividend and capital gain.

Given that the tax implications can have a significant impact on the return earned it is necessary to understand the tax implications for both these heads of income.

Let's take income earned under the head of dividends first.

As per existing tax provisions, income from dividends is tax free in the hands of the investor. However, this is not to say that there is no tax levied at all. To the contrary, there is a levy of 12.5% of the dividend declared as distribution tax. This tax is paid out of the profits/reserves of the mutual fund scheme declaring the dividend. Therefore, though you may not feel the impact of the tax, it is borne by you.

The application of the distribution tax in case of mutual funds is however not universal. The dividend distribution tax has to be paid only in case of debt schemes of mutual funds. Equity schemes are exempt from tax.

So, if you were to receive Rs 100 as dividend from a debt mutual fund, it is equivalent to Rs 112.5 being paid out, the incremental Rs 12.5 having been paid to the government as distribution tax. In case of equity funds however, as mentioned, there will be no such implication.

Investors who fall in the highest tax bracket should opt for the dividend option in mutual fund schemes. However, they should consider the fact that the tax on dividend paid to them has been paid by the mutual fund company itself in so far as debt schemes are concerned.

Let's now consider the second head of income from mutual funds - capital gain.

Capital gains from mutual funds are of two types - short term and long term. This classification is based upon the period of holding. If the investment is sold within 365 days from the date of purchase, any capital gain made would be treated as a short term nature. Such a capital gain will be treated as a part of the total income and chargeable to tax at the normal rate of tax. If the mutual fund investment is sold after 365 days from the date of purchase, any capital gain made during that period will be treated as a long-term capital gain. Tax on long term capital gains is computed as follows:

Step I: Compute Capital gains with indexation

Sale Proceeds xxx

Less: Indexed Cost of Acquisition xxx


Long term Capital Gains xxx


Tax payable will be 20% of capital gains as compute above

Formula for calculation of indexed cost of acquisition

Cost of acquisition

------------------------------------------------------- x Cost inflation index for the year in

Cost inflation index for the year in which asset is transferred

which asset is acquired

Step II: Compute Capital Gains without indexation

Sale Proceeds xxx

Less: Cost of Acquisition xxx


Long term Capital Gains xxx


Tax payable will be 10% of Capital Gains as compute above

Compare the tax payable under both the options. Lower of the two will be tax payable.


: Mr. A purchased 5,000 units of a mutual fund on 20-6-1999 .The price per unit is Rs 10. He sells all the 5,000 units on 15-9-2000 for Rs 12 per unit.

Since the investment is held for more than 365 days the capital gain will be long term capital gain

The capital gains will be calculated as follows

Step I: Compute Capital gains with indexation

Sale Proceeds (5,000 units x Rs 12 ) 60,000

Less: Indexed Cost of Acquisition** 52,185


Long term Capital Gains 7,815


Tax payable will be 20% of Rs 7,815 i.e. Rs 1,563.

** Indexed cost of acquisition: 50,000 x 406 / 389 = Rs 52,185

Step II: Compute Capital Gains without indexation

Sale Proceeds (5,000 units x Rs 12) 60,000

Less: Cost of Acquisition (5,000 units x Rs 10) 50,000


Long term Capital Gains 10,000


Tax payable will be 10% of Rs 10,000 i.e. Rs 1,000

Compare the tax payable under both the steps. Lower of the two will be tax payable. Therefore the tax payable will be Rs 1,000

Tax liability on mutual fund investment can be reduced either by choosing the dividend option or by holding the investment for more than 365 days.

Set off and carry forward of capital gains.

Long term capital loss can be set off only against long term capital gains. Short term capital loss can be set off against any capital gains, whether short term or long term

Long term capital loss can be carried forward for 8 years to be set off only against long term gains. However, a short term capital loss can be set off against any income under the head, capital gains (whether short term or long term) and such carry forward is permitted for 8 years.

If indexation benefit is opted, then the rate of tax is 20%, if indexation benefit is not opted, then the rate of tax is 10%. The assessee can calculate the tax under both these methods and can adopt any method which is more beneficial. In other words, the assessee can choose the method in which the tax burden will be lesser than the other method. However this option of opting for the indexation or not opting for the indexation is available only in cases where the securities are listed in a recognized stock exchange in India. If such securities are not listed then the assessee will have to necessarily opt for the method using indexation benefit.

Note: In all the cases, surcharge and education cess will be charged additionally over and above the given tax rate.

E.g.: LTCG on Listed securities (STT not suffered): Sale consideration is Rs.5,00,000/-, cost of acquisition is Rs.25,000/-. The shares were purchased in 1994-95 and their sale took place in 2005-06. The cost inflation index for the both years is 259 and 497 respectively.

Option 1 (With indexation): Indexed cost is Rs.25000 * 497/259 = Rs.47,973/-. Capital gains = Rs.4,52,507/-. Capital gains tax = Rs.4, 52,507*20% = Rs.90,501/-

Option 2 (Without indexation): In the above case the capital gains will be Rs.5,00,000 minus Rs.25,000 = Rs.4,75,000/-. Capital gains tax = Rs.4,75,000 * 10% = Rs.47,500/-.

The assessee can opt for Option 2 because the tax payable is lesser than that in Option 1.

What is Cost Inflation Index (CII)?

It is a measure of inflation that finds application in tax law, when computing long-term capital gains on sale of assets. Section 48 of the Income-Tax Act defines the index as what is notified by the Central Government every year, having regard to 75 per cent of average rise in the consumer price index (CPI) for urban non-manual employees for the immediately preceding previous year.

This is a five-fold growth in about quarter of a century. The base year for the index is 1981-82.

In the first few years, CII grew only by single digits. The latest jump is of 22 points, from 497 in 2005-06. The biggest increase thus far was in 1999-2000, when CII vaulted by 38 points to reach 389.

How does CII help in capital gains computation? Capital gain, as you know, arises when the net sale consideration of a capital asset is more than the cost. Since `cost of acquisition' is historical, the concept of indexed cost allows the taxpayer to factor in the impact of inflation on cost. Consequently, a lower amount of capital gains gets to be taxed than if historical cost had been considered in the computations.

An explanation in Section 48 defines `indexed cost of acquisition' as an amount which bears to the cost of acquisition the same proportion as CII for the year in which the asset is transferred bears to the CII for the first year in which the asset was held by the assessee or for the year beginning on April 1, 1981, whichever is later.

For instance, an asset of value Rs 1 lakh on April 1, 1981 can be reckoned to cost Rs 5.19 lakh, were it to be sold now. If the assets sold had been acquired before April 1, 1981, the taxpayer has the choice of substituting the actual cost with market value as on April 1, 1981.

Formula for computing indexed cost is (Index for the year of sale/ Index in the year of acquisition) x cost.

For example, if a property purchased in 1991-92 for Rs 10 lakh were to be sold now for Rs 40 lakh, indexed cost = (519/199) x 10 = Rs 26.08 lakh. And the long-term capital gains would be Rs 13.92, that is Rs 40 lakh minus Rs 26.08 lakh.

Mutual funds and tax benefits

What are the tax benefits available to those who invest in mutual funds? What are the tax liabilities, if any?

Since, April 1, 2003, all dividends, declared by debt-oriented mutual funds (i.e. mutual funds with less than 50% of assets in equities), are tax-free in the hands of the investor.

A dividend distribution tax of 12.5% (including surcharge) is to be paid by the mutual fund on the dividends declared by the fund. Long-term debt funds, government securities funds (G-sec/gilt funds), monthtly income plans (MIPs) are examples of debt-oriented funds.

Dividends declared by equity-oriented funds (i.e. mutual funds with more than 50% of assets in equities) are tax-free in the hands of investor. There is also no dividend distribution tax applicable on these funds under section 115R. Diversified equity funds, sector funds, balanced funds are examples of equity-oriented funds.

Amount invested in tax-saving funds (ELSS) would be eligible for deduction under Section 80C, however the aggregate amount deductible under the said section cannot exceed Rs 100,000.

Is a capital gain on sale/transfer of units of mutual fund liable to tax? If yes, at what rate?

Section 2(42A):

Under Section 2(42A) of the Act, a unit of a mutual fund is treated as short-term capital asset if the same is held for less than 12 months. The units held for more than twelve months are treated as long-term capital asset.

Section 10(38):

Under Section 10(38) of the Act, long term capital gains arising from transfer of a unit of mutual fund is exempt from tax if the said transaction is undertaken after October 1, 2004 and the securities transaction tax is paid to the appropriate authority. This makes long-term capital gains on equity-oriented funds exempt from tax from assessment year 2005-06.

Short-term capital gains on equity-oriented funds is chargeable to tax @10% (plus education cess, applicable surcharge). However, such securities transaction tax will be allowed as rebate under Section 88E of the Act, if the transaction constitutes business income.

Long-term capital gains on debt-oriented funds are subject to tax @20% of capital gain after allowing indexation benefit or at 10% flat without indexation benefit, whichever is less.

Short-term capital gains on debt-oriented funds are subject to tax at the tax bracket applicable (marginal tax rate) to the investor.

Section 112:

Under Section 112 of the Act, capital gains, not covered by the exemption under Section 10(38), chargeable on transfer of long-term capital assets are subject to following rates of tax:

  • Resident Individual & HUF -- 20% plus surcharge, education cess.
  • Partnership firms & Indian companies -- 20% plus surcharge.
  • Foreign companies -- 20% (no surcharge).

Capital gains will be computed after taking into account the cost of acquisition as adjusted by Cost Inflation Index, notified by the central government.

'Units' are included in the proviso to the sub-section (1) to Section 112 of the Act and hence, unit holders can opt for being taxed at 10% (plus applicable surcharge, education cess) without the cost inflation index benefit or 20% (plus applicable surcharge) with the cost inflation index benefit, whichever is beneficial.

Under Section 115AB of the Income Tax Act, 1961, long term capital gains in respect of units, purchased in foreign currency by an overseas financial, held for a period of more than 12 months, will be chargeable at the rate of 10%. Such gains will be calculated without indexation of cost of acquisition. No surcharge is applicable for taxes under section 115AB, in respect of corporate bodies.

Is it possible to offset the capital loss on a mutual fund investment after a dividend declaration?

This is a practice that is popularly referred to as 'dividend stripping.' The capital loss from a dividend declaration can be offset if you have remained invested in the mutual fund 3 months before and 9 months after the dividend declaration.

If you haven't adhered to this guideline then you cannot offset the capital loss arising from a dividend declaration.

How can I avoid payment of capital gains on mutual fund investments?

The capital gain, which is not exempt from tax as explained above, can be invested in the specified asset, and mentioned below, within 6 months of the sale.

Specified asset means any bond redeemable after 3 years:

  • Issued on or after April 1, 2000 by NABARD (National Bank for Agriculture and Rural Development or NHA (National Highways Authority of India
  • Issued on or after April 1, 2001 by the Rural Electrification Corporation Ltd.
  • Issued on or after April 1, 2002 by the National Housing Bank or by the Small Industries Development Bank of India.

Such capital gains can also be invested in any residential house property in accordance with Section 54F of the Act and one can claim exemption from capital gains.


Following are the different investment plans available in Mutual Fund:

  1. Systematic Investment Plan
  2. Systematic Withdrawal Plan (SWP)
  3. Systematic Transfer Plan (STP)
  4. Dividend Transfer Plan (DTP)
  5. ARP
  6. Systematic Investment Plan

Systematic Investment Plan (SIP) is a simple, time-honored strategy designed to help investors accumulate wealth in a disciplined manner over the long-term and plan a better future for them.

How does a SIP works

An SIP allows you to take part in the stock market without trying to second guess its movements. It meansyou commit yourself to investing a fixed amount every month. Let's say it is Rs 1,000.

When the NAV is high, you will get fewer units. When it drops, you will get more units.





Approx number of units you will get at Rs 1,000


Jan 1



Feb 1



Mar 1



Apr 1



May 1



Jun 1



Within six months, you would have 5,894 units by investing just Rs 1,000 every month.

This disciplined approach to investing will provide you with the following benefits:

  1. Power of Compounding
  2. Rupee Cost Averaging
  3. Convenience

Power of Compounding - The benefit of investing NOW

Most of usdelay investments until the last moment. Needless to say, the longer you delay, the greater will be the financial burden on you to meet your goals. On the other hand, you would be surprised what you could achieve by saving a small sum of money regularly at an early age. Moreover, the earlier you invest, the longer your money works for you and greater will be the power of compounding.
The power of compounding underlines the importance of making your money work for you at an early age. For instance, Sameer starts saving Rs 5000 every year from the age of 20 and continues to do so till he reaches 35, after which he stops making any further investment. Sanjay starts saving Rs 12,000 every year from the age of 35 and continues to do so till he reaches 65 years of age. If both earn, say, 12% per annum on their investments, which of them would be wealthier when they retire at 65? Sameer. Surprising, isn't it? At 65, Sameer would have accumulated Rs 36.43 lakhs whereas Sanjay's wealth would have been lower at Rs 32.44 lakhs.

Clearly, the power of compounding can have a significant impact on your wealth accumulation, especially if you remain invested over a long period of time.

Rupee Cost Averaging - The power of disciplined investment . Investing would be simple if you could always pick the best time to buy and sell. However, timing the market consistently can be a difficult task and you could be hit with a loss sooner or later. What you need is an automatic market-timing mechanism like Rupee Cost Averaging (RCA) that eliminates the need to time your investments.

In other words, with RCA, you don't have to worry about where share prices or interest rates are headed. You simply invest a fixed amount at regular intervals, regardless of the NAV. The idea is that you buy fewer units when the NAV is high and more when it is low - automatically. This is in line with our natural desire to buy low and sell high.

For instance, you could opt for a Systematic Investment Plan (SIP) by investing Rs 1000 every month into an open-ended equity scheme with an NAV of Rs 10.
RCA, however, does not guarantee a profit. But with a sensible and long-term investment approach, it can smoothen out the market ups and downs and reduce the risk of investing in volatile markets. In a nutshell, RCA is an efficient and convenient vehicle to accumulate wealth in a time-bound and disciplined manner.

So when is the best time to invest? This month, next month…every month, starts right now!!


Save yourself the trouble of doing the same thing.

You do not have to take time out from your busy schedule to make your investments. Enroll for the SIP by starting an account and providing post-dated cheques of periodic investments (monthly, quarterly) based on your convenience. You can relax once you have sent in your cheques with the completed Enrolment Form. We shall bank your cheques on the requested date and credit the units to your account. The SIP facility is available in the Principal Income Fund, Monthly Income Plan, Child Benefit Fund (Career Builder Plan only), Balanced Fund, Index Fund, Growth Fund, Equity Fund and Tax Savings Fund.

Systematic Withdrawal Plans

Systematic Withdrawal Plans (SWPs) allow the investor to withdraw money from a debt or an equity fund in equal instalments at periodic intervals. Just like a systematic investment, a systematic withdrawal plan reduces the impact of timing when you liquidate your investments in a fund. Each instalment is generated by redeeming the necessary number of units from the investment. An SWP allows you to choose the quantum and periodicity of withdrawals from the fund. You will need to leave instructions with the fund on the periodicity of withdrawal, a date for each withdrawal and the delivery instructions for the money.

You can use SWPs to set up a stream of monthly or quarterly incomes to see you through monthly expenses. Or you can use them to book profits periodically on investment to lock into a period of high returns from the equity or debt markets. The SWP could be a good alternative to the dividend option of a mutual fund, because payouts can be timed to your convenience, instead of having to wait for the fund to declare dividends.


SWPs are offered both on debt and equity products by most fund houses. Monthly and quarterly withdrawals are usually permitted.

Fund houses such as Franklin Templeton, HDFC Mutual, Birla Sun Life and Kotak Mahindra Mutual offer two sub-options within the SWP — Fixed and Appreciation.

Under the Fixed SWP, the investor can choose to receive a fixed sum, say, Rs 1000 a month, over a specified number of months by way of systematic withdrawals. Under the Appreciation option, you can leave instructions with the fund to redeem units only to the extent of the capital appreciation, if any, earned on the units.

Fund houses have some limitations on how and when you can avail yourself of the SWP facility. Franklin Templeton requires a minimum balance of Rs 25,000 in a fund. Funds may also specify the minimum size of the monthly instalment under the SWP. Templeton sets a minimum instalment of Rs 1,000 for the Fixed SWP, while in Birla Sun Life it is Rs 500.

The rules for the Appreciation option differ from fund to fund. For instance, Birla Sun Life allows withdrawals up to 90 per cent of the appreciation in a particular month or a quarter.

Others allow you to specify a particular amount; withdrawals will be made only if the fund earns capital appreciation over the specified limit.

Trigger options

A few fund houses such as PruICICI Mutual Fund and UTI Mutual Fund offer a Trigger facility that is a variant of the Appreciation SWP. The Trigger facility saves you the bother of having to keep track of your investment; you can leave instructions on booking profits on fund holdings when a specified `trigger' is reached.

For instance, with PruICICI you can choose among four Trigger options.

`Appreciation' Trigger allows you to book profits when a certain NAV level is reached. You can have a `Stop-loss Trigger', by specifying certain lower NAV level at which the fund is to redeem units on your behalf.

You can also specify a Trigger that will be activated after certain tenure or on a particular date.

PruICICI also allows use of the option with a switch facility that enables the investor to switch investments from, say, equity to a debt fund, when a certain target return is reached.

Systematic Transfer Plans

Suppose you have made big money on equity fund investments over the past year and want to plough the capital gains into safe investment avenues. A Systematic Transfer Plan (STP) could be the answer.

A STP allows you to make periodic transfers from one fund into another managed by the same fund house. As with an SWP, you have to specify the instalment and the periodicity of the transfer.

Fund houses usually offer monthly and quarterly STPs. But a few funds, such as PruICICI, allow systematic transfers even at weekly intervals. The STP can be a useful facility to re-balance your portfolio or to phase out investments in a fund over a period. You can invest a lump sum in a liquid or floating rate fund and leave instructions to transfer Rs 1000 every month into an equity fund.

Or you can transfer a fixed sum every month from a debt to an equity fund. While many fund houses permit STPs from debt to equity funds, only a few allow the reverse.

Franklin Templeton, PruICICI and Birla Sun Life allow systematic transfers out of their debt schemes and into their equity funds, but not the reverse. Kotak Mutual Fund permits two-way STP. Therefore, if you own Kotak products, you can make regular transfers from equity to debt funds, or vice versa. This can be useful for an investor who would like to re-balance his equity investments, and contain them within a desirable limit. STPs, too, offer a choice between a Fixed and an Appreciation option.

A Fixed option STP allows you to sweep a fixed sum at periodic intervals into another fund. The Appreciation STP is activated only when the capital appreciation on your investment crosses a limit you have set.

Dividend Transfer Plan

Offered by Franklin Templeton, the Dividend Transfer Plan allows the investor to sweep all the dividends declared by a debt scheme into the equity or hybrid products it manages.

A useful feature for investors looking to acquire a marginal equity exposure or benefit from an `equity kicker' to their debt returns.


Useful as many of these facilities are, the value-adds are not without limitations:

These facilities are useful only when you own two or more products from the same fund house, not when your investments are diversified across fund houses.

Fund houses have a shortlist of specific funds that are eligible for SWPs, STPs and DTPs. You will have to run a check on whether the fund in your investment shortlist offers each facility.

Fund houses may have limitations on the simultaneous use of two add-on features.

For instance, Franklin Templeton disallows the use of SIPs and SWPs at the same time, from a single fund. PruICICI stipulates that the Trigger facility is not available on investments made through the SIP or STP route.

Fund houses usually have specific days in a month, when all STP and SWP requests will be given effect. This is inconvenient if you like to time each transaction.

Types of risks

All investments involve some form of risk. Even an insured bank account is subject to the possibility that inflation will rise faster than your earnings, leaving you with less real purchasing power than when you started (Rs. 1000 gets you less than it got your father when he was your age). Consider these common types

of risk and evaluate them against potential rewards when you select an investment.

Market Risk

At times the prices or yields of all the securities in a particular market rise or fall due to broad outside influences. When this happens, the stock prices of both an outstanding, highly profitable company and a fledgling corporation may be affected. This change in price is due to "market risk".


Sometimes referred to as "loss of purchasing power." Whenever inflation sprints forward faster than the earnings on your investment, you run the risk that you'll actually be able to buy less, not more. Inflation risk also occurs when prices rise faster than your returns.

In short, how stable is the company or entity to which you lend your money when

You invest? How certain are you that it will be able to pay the interest you are promised, or repay your principal when the investment matures?

Changing interest rates affect both equities and bonds in many ways. Investors

are reminded that "predicting" which way rates will go is rarely successful. A

Diversified portfolio can help in offsetting these changes.

An industries' key asset is often the personnel who run the business i.e.

Intellectual properties of the key employees of the respective companies. Given the ever-changing complexion of few industries and the high obsolescence levels, availability of qualified, trained and motivated personnel is very critical for the success of industries in few sectors. It is, therefore, necessary to attract key personnel and also to retain them to meet the changing environment and challenges the sector offers.

Failure or inability to attract/retain such qualified key personnel may impact the prospects of the companies in the particular sector in which the fund invests.

A number of companies generate revenues in foreign currencies and may have investments or expenses also denominated in foreign currencies. Changes in exchange rates may, therefore, have a positive or negative impact on companies which in turn would have an effect on the investment of the fund.

The sectoral fund schemes, investments will be predominantly in equities of select companies in the particular sectors. Accordingly, the NAV of the schemes are linked to the equity performance of such companies and may be more volatile than a more diversified portfolio of equities.

Changes in Government policy especially in regard to the tax benefits may impact the business prospects of the companies leading to an impact on the investments made by the fund.

Need for measuring mutual fund performance:

The investors would naturally be interested in tracking the value of his investment, whether he invests directly in the market or indirectly in mutual funds. He would have to make intelligent decisions on whether he gets an accepted return on his investment in the funds selected by him, or if he needs to switch to another fund. He, therefore, needs to understand the basis of appropriate performance measurement for the fund, and acquire the basic knowledge of the different measures of evaluating the performance of the fund. Only then he would be in a position to judge correctly whether his fund is performing well or not, and make the right decisions.

Understanding Volatility Measurements

When considering a fund's volatility, an investor may find it difficult to decide which fund will provide the optimal risk-reward combination. Many websites provide various volatility measures for mutual funds free of charge; however, it can be hard to know not only what the figures mean but also how to analyze them. Furthermore, the relationship between these figures is not always obvious. Read on to learn about the four most common volatility measures and how they're applied in the type of risk analysis that is based on modern portfolio theory.

Optimal PortfolioTheory and Mutual Funds

One examination of the relationship between portfolio returns and risk is the efficient frontier, a curve that is a part of the modern portfolio theory. The curve forms from a graph plotting return and risk indicated by volatility, which is represented by standard deviation. According to the modern portfolio theory, funds lying on the curve are yielding the maximum return possible given the amount of volatility.

Notice that as standard deviation increases, so does the return. In the above chart, once expected returns of a portfolio reach a certain level, an investor must take on a large amount of volatility for a small increase in return. Obviously portfolios that have a risk/return relationship plotted far below the curve are not optimal as the investor is taking on a large amount of instability for a small return. To determine if the proposed fund has an optimal return for the amount of volatility acquired, an investor needs to do an analysis of the fund's standard deviation.

Note that the modern portfolio theory and volatility are not the only means investors use to determine and analyze risk, which may be caused by many different factors in the market (see the tutorial R

#1: Standard Deviation

As with many statistical measures, the calculation for standard deviation can be intimidating, but, as the number is extremely useful for those who know how to use it, there are many free mutual fund screening services that provide the standard deviations of funds.

The standard deviation essentially reports a fund's volatility, which indicates the tendency of the returns to rise or fall drastically in a short period of time. A security that is volatile is also considered higher risk because its performance may change quickly in either direction at any moment. The standard deviation of a fund measures this risk by measuring the degree to which the fund fluctuates in relation to its mean return, the average return of a fund over a period of time.

A fund that has a consistent four-year return of 3%, for example, would have a mean, or average, of 3%. The standard deviation for this fund would then be zero because the fund's return in any given year does not differ from its four- year mean of 3%. On the other hand, a fund that in each of the last four years returned -5%, 17%, 2% and 30% will have a mean return of 11%. The fund will also exhibit a high standard deviation because each year the return of the fund differs from the mean return. This fund is therefore more risky because it fluctuates widely between negative and positive returns within a short period.

A note to remember is that, because volatility is only one indicator of the risk affecting a security, a stable past performance of a fund is not necessarily a

guarantee of future stability. Since unforeseen market factors can influence volatility, a fund that this year has a standard deviation close or equal to zero may behave differently in the following year.

To determine how well a fund is maximizing the return received for its volatility, you can compare the fund to another with a similar investment strategy and similar returns. The fund with the lower standard deviation would be more optimal because it is maximizing the return received for the amount of risk acquired. Consider the following graph:

With the S&P 500 Fund B, the investor would be acquiring a larger amount of volatility risk than necessary to achieve the same returns as Fund A. Fund A would provide the investor with the optimal risk/return relationship.

#2: Beta

While standard deviation determines the volatility of a fund according to the disparity of its returns over a period of time, beta, another useful statistical measure, determines the volatility, or risk, of a fund in comparison to that of its index or benchmark. A fund with a beta very close to 1 means the fund's performance closely matches the index or benchmark. A beta greater than 1 indicates greater volatility than the overall market, and a beta less than 1 indicates less volatility than the benchmark.

If, for example, a fund has a beta of 1.05 in relation to the S&P 500, the fund has been moving 5% more than the index. Therefore, if the S&P 500 increased 15%, the fund would be expected to increase 15.75%. On the other hand, a fund with a beta of 2.4 would be expected to move 2.4 times more than its corresponding index. So if the S&P 500 moved 10%, the fund would be expected to rise 24%, and, if the S&P 500 declined 10%, the fund would be

expected to lose 24%. Investors expecting the market to be bullish may choose funds exhibiting high betas, which increase investors' chances of beating the market.

If an investor expects the market to be bearish in the near future, the funds that have

betas less than 1 are a good choice

because they would be expected to decline less in value than the index. For example, if a fund had a beta of 0.5 and the S&P 500 declined 6%, the fund would be expected to decline only 3%.

Beta is calculated using regression analysis, and you can think of beta as the tendency of a security's returns to respond to swings in the market. A beta of

1 indicates that the security's price will move with the market. A beta less than 1

means that the security will be less volatile than the market. A beta greater than

1 indicates that the security's price will be more volatile than the market. For example, if a stock's beta is 1.2 it's theoretically 20% more volatile than the market.

Many utilities stocks have a beta of less than 1. Conversely most high-tech Nasdaq-based stocks have a beta greater than 1, offering the possibility of a higher rate of return but also posing more risk.

Be aware of the fact that beta by itself is limited and can be skewed due to factors other than the market risk affecting the fund's volatility.

#3: R-S quared

The R-squared of a fund advises investors if the beta of a mutual fund is measured against an appropriate benchmark. Measuring the correlation of a fund's movements to that of an index, R-squared describes the level of association between the fund's volatility and market risk, or more specifically, the degree to which a fund's volatility is a result of the day-to-day fluctuations experienced by the overall market.

R-squared values range between 0 and 100, where 0 represents the least correlation and 100 represents full correlation. If a fund's beta has an R-squared value that is close to 100, the beta of the fund should be trusted. On the other hand, an R-squared value that is close to 0 indicates that the beta is not particularly useful because the fund is being compared against an inappropriate benchmark.

If, for example, a bond fund was judged against the S&P 500, the R- squared value would be very low. A bond index such as the Lehman Brothers Aggregate Bond Index would be a much more appropriate benchmark for a bond fund, so the resulting R-squared value would be higher. Obviously the risks apparent in the stock market are different than the risks associated with the bond market. Therefore, if the beta for a bond were calculated using a stock index, the beta would not be trustworthy.

An inappropriate benchmark will skew more than just beta. Alpha is calculated using beta, so if the R-squared value of a fund is low, it is also wise not to trust the figure given for alpha. We'll go through an example in the next section.

#4: Alpha

Up to this point, we have learned how to examine figures that measure risk posed by volatility, but how do we measure the extra return rewarded to you for taking on risk posed by factors other than market volatility? Enter alpha, which measures how much if any of this extra risk helped the fund outperform its corresponding benchmark. Using beta, alpha's computation compares the fund's performance to that of the benchmark's risk-adjusted returns and establishes if the fund's returns outperformed the market's, given the same amount of risk.

A measure of a mutual fund's risk relative to the market. The formula for alpha is the following:

[ (sum of y) - ((b)(sum of x)) ] / n


n = number of observations (36 mos.)

b = beta of the fund

x = rate of return for the market y = rate of return for the fund


2. If a CAPM analysis estimates that a portfolio should earn 10% based on the risk of the portfolio but the portfolio actually earns 15%, then the alpha of the portfolio would be 5%. This 5% is the excess return over what was predicted in the CAPM model.

For example, if a fund has an alpha of 1, it means that the fund outperformed the benchmark by 1%. Negative alphas are bad in that they indicate that the fund underperformed for the amount of extra, fund-specific risk that the fund's investors undertook.

#5: Sharpe Ratio

The Sharpe ratio measures the return of a mutual fund compared to the risk-free rate of return, which is the 91-day T-bill rate. This should be similar to money market returns. Often this ratio is used to determine if a mutual fund is able to beat the money market.

Say a growth fund has a Sharpe ratio over the last five years of 0.57 and the recent range of Sharpe ratios for global equity funds went from as low a -1.11 to a high of 0.94. A positive Sharpe ratio means the fund did better on a risk- adjusted basis than the 91-day T-bill rate. In other words, the higher the Sharpe ratio, the better.

The Sharpe ratio tells you about history but it does not tell you anything about the future. Just because a fund has a positive Sharpe ratio for the last five years does not mean it will outperform money market instruments for the next five years. A ratio developed by Bill Sharpe to measure risk-adjusted performance. It is calculated by subtracting the risk free rate from the rate of return for a portfolio and dividing the result by the standard deviation of the portfolio returns.

Rp-Ri = -------- S.D.p


Rp= Expected Portfolio Return

Ri= Risk Free Rate

S.D.p= Portfolio Standard Deviation

The Sharpe ratio tells us whether the returns of a portfolio are because of smart investment decisions or a result of excess risk.


Mutual Fund is a trust that pools the savings, which are then invested in capital market instruments such as shares, debentures and other securities. It works in a different manner as compared to other savings organizations such as banks, national savings, post offices, non-banking financial companies etc. As most, if not all capital market instruments, have an element of risk, it is very essential that the investors have a clear understanding of how a mutual fund operates and what are its advantages and limitations. This understanding has to be created in the investors by the distributors engaged in the marketing of mutual fund products. The distributors should also be knowledgeable enough to answer fundamental and basic questions that will be raised by the investors. It is thus essential that those engaged in marketing of mutual funds - such as individual agents, distribution companies, and bank executives and others have a comprehensive, clear and correct understanding of the concept and working of Mutual Funds as essential operational and technical details.

Keeping in mind, the above points, this report was prepared to educate all the parties involved in the mutual fund. Hopefully, our aim of preparing this report has been met after going through this report. All possible details about the mutual fund have been discussed here. The language that has been used here is also very simple to be understood even to a layman.