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Analysis of India's Mutual Fund Industry

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Any opinions, findings, conclusions or recommendations expressed in this material are those of the authors and do not necessarily reflect the views of UK Essays.

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.

MUTUAL FUNDS

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

(AMC)

And employees who perform this task are called

Fund Mangers

SCHEMES

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

(PMS).

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?

Investors

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.

Trustees

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

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.

Registrar

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.

Custodian/Depository

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.

BondSchemes

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

bond

to a landlord.

Bondschemes

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

BondSchemes

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

(SIP)

Systematic Withdrawal Plan

(SWP)

Systematic Transfer Plan

(STP)

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.

Taxes:

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.

(a)

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 mgmt.co.

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

(b)

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.

(c)

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.

-Trustees

-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.

INVESTORS'S RIGHTS AND OBLIGATIONS

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 CONTENTS

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.

DISTRIBUTION AND SALES CHANNELS

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.

WHO CAN INVEST IN MFs IN

INDIA MFs in India are open to investment by-

(a) 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)

51,000

Expenses (Rs)

1,000

No. of Units

5,000

NAV (Rs)

10

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

/td>

NAV (Rs)

/td>

1-Yr (%)

/td>

Franklin Prima Plus (G)

146.17

43.57

Franklin Bluechip (G)

138.10

39.09

Pru ICICI Power (G)

84.51

38.67

HSBC Equity (G)

74.42

37.63

Kotak 30 (G)

72.06

36.54

HDFC Equity (G)

153.79

35.50

(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.

CUSTOMISATION OF MUTUAL FUND AS PER THE TYPE OF INVESTOR:

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 th


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