Concept of Mutual Fund:

Mutual fund is a vehicle to mobilize moneys from investors, to invest in different markets and securities, in line with the investment objectives agreed upon, between the mutual fund and the investors. In other words, through investment in a mutual fund, a small investor can avail of professional fund managem ent services offered by an asset management company.

Role of Mutual Fund:

Mutual funds perform different roles for different constituencies.

 

Their primary role is to assist investors in earning an income or building their wealth, by participating in the opportunities available in various securities and markets. It is possible for mutual funds to structure a scheme for any kind of investment objective. Thus, the mutual fund structure, through its various schemes, makes it possible to tap a large corpus of money from diverse investors.

Therefore, the mutual fund offers schemes. In the industry, the words ‘fund’ and ‘scheme’ are used inter-changeably. Various categories of schemes are called “funds”.

The money that is raised from investors, ultimately benefits governments, companies or other entities, directly or indirectly, to raise moneys to invest in various projects or pay for various expenses.

As a large investor, the mutual funds can keep a check on the operations of the investee company, and their corporate governance and ethical standards.

The projects that are facilitated through such financing, offer employment to people; the income they earn helps the employees buy goods and services offered by other companies, thus supporting projects of these goods and services companies. Thus, overall economic development is promoted.

The mutual fund industry itself, offers livelihood to a large number of employees of mutual funds, distributors, registrars and various other service providers.

Higher employment, income and output in the economy boost the revenue collection of the government through taxes and other means. When these are spent prudently, it promotes further economic development and nation building.

Mutual funds can also act as a market stabilizer, in countering large inflows or outflows from foreign investors. Mutual funds are therefore viewed as a key participant in the capital market of any economy.

 

Why Mutual Fund Schemes:

Mutual funds seek to mobilize money from all possible investors. Various investors have different investment preferences. In order to accommodate these preferences, mutual funds mobilize different pools of money. Each such pool of money is called a mutual fund scheme.

Every scheme has a pre-announced investment objective. When investors invest in a mutual fund scheme, they are effectively buying into its investment objective.

 

How do Mutual Fund Schemes operate:

Mutual fund schemes announce their investment objective and seek investments from the public. Depending on how the scheme is structured, it may be open to accept money from investors, either during a limited period only, or at any time.

The investment that an investor makes in a scheme is translated into a certain number of ‘Units’ in the scheme. Thus, an investor in a scheme is issued units of the scheme.

Under the law, every unit has a face value of Rs. 10. (However, older schemes in the market may have a different face value). The face value is relevant from an accounting perspective. The number of units multiplied by its face value (Rs. 10) is the capital of the scheme – its Unit Capital.

The scheme earns interest income or dividend income on the investments it holds. Further, when it purchases and sells investments, it earns capital gains or incurs capital losses. These are called realized capital gains or realized capital losses as the case may be.

Investments owned by the scheme may be quoted in the market at higher than the cost paid. Such gains in values on securities held are called valuation gains.

valuation losses when securities are quoted in the market at a price below the cost at which the scheme acquired them.

Running the scheme leads to its share of operating expenses .

Investments can be said to have been handled profitably, if the following profitability metric is positive:

(A) +Interest income

(B) + Dividend income

(C) + Realized capital gains

(D) + Valuation gains

(E) – Realized capital losses

(F) – Valuation losses

(G) – Scheme expenses

When the investment activity is profitable, the true worth of a unit goes up; when there are losses, the true worth of a unit goes down. The true worth of a unit of the scheme is otherwise called Net Asset Value (NAV) of the scheme.

When a scheme is first made available for investment, it is called a ‘New Fund Offer’ (NFO). During the NFO, investors may have the chance of buying the units at their face value. Post-NFO, when they buy into a scheme, they need to pay a price that is linked to its NAV.

The money mobilized from investors is invested by the scheme as per the investment objective committed. Profits or losses, as the case might be, belong to the investors. The investor does not however bear a loss higher than the amount invested by him.

Various investors subscribing to an investment objective might have different expectations on how the profits are to be handled. Some may like it to be paid off regularly as dividends. Others might like the money to grow in the scheme. Mutual funds address such differential expectations between investors within a scheme, by offering various options, such as dividend payout option, dividend re-investment option and growth option. An investor buying into a scheme gets to select the preferred option also.

The relative size of mutual fund companies is assessed by their assets under management (AUM). When a scheme is first launched, assets under management would be the amount mobilized from investors. Thereafter, if the scheme has a positive profitability metric, its AUM goes up; a negative profitability metric will pull it down.

Further, if the scheme is open to receiving money from investors even post-NFO, then such contributions from investors boost the AUM. Conversely, if the scheme pays any money to the investors, either as dividend or as consideration for buying back the units of investors, the AUM falls.

The AUM thus captures the impact of the profitability metric and the flow of unit-holder money to or from the scheme.

 

Advantage of Mutual Funds for Investors:

Professional Management

Mutual funds offer investors the opportunity to earn an income or build their wealth through professional management of their investible funds. There are several aspects to such professional management viz. investing in line with the investment objective, investing based on adequate research, and ensuring that prudent investment processes are followed.

 

Affordable Portfolio Diversification

Units of a scheme give investors exposure to a range of securities held in the investment portfolio of the scheme. Thus, even a small investment of Rs. 500 in a mutual fund scheme can give investors a diversified investment portfolio.

 Consequently, the investor is less likely to lose money on all the investments at the same time. Thus, diversification helps reduce the risk in investment. In order to achieve the same diversification as a mutual fund scheme, investors will need to set apart several lakhs of rupees. Instead, they can achieve the diversification through an investment of less than thousand rupees in a mutual fund scheme.

 

Economies of Scale

The pooling of large sums of money from so many investors makes it possible for the mutual fund to engage professional managers to manage the investment. Individual investors with small amounts to invest cannot, by themselves, afford to engage such professional management.

Large investment corpus leads to various other economies of scale. For instance, costs related to investment research and office space get spread across investors. Further, the higher transaction volume makes it possible to negotiate better terms with brokers, bankers and other service providers.

Thus, investing through a mutual fund offers a distinct economic advantage to an investor as compared to direct investing in terms of cost saving.

 

At times, investors in financial markets are stuck with a security for which they can’t find a buyer – worse, at times they can’t find the company they invested in! Such investments, whose value the investor cannot easily realise in the market, are technically called illiquid investments and may result in losses for the investor.

Investors in a mutual fund scheme can recover the value of the moneys invested, from the mutual fund itself. Depending on the structure of the mutual fund scheme, this would be possible, either at any time, or during specific intervals, or only on closure of the scheme. Schemes, where the money can be recovered from the mutual fund only on closure of the scheme, are listed in a stock exchange. In such schemes, the investor can sell the units in the stock exchange to recover the prevailing value of the investment.

 

Tax benefits

 

Specific schemes of mutual funds (Equity Linked Savings Schemes) give investors the benefit of deduction of the amount subscribed (upto Rs. 150,000 in a financial year), from their income that is liable to tax. This reduces their taxable income, and therefore the tax liability.

The Rajiv Gandhi Equity Savings Scheme (RGESS) offers a rebate to first time retail investors (in equity or mutual funds) with annual income upto Rs. 12 lakhs. Mutual funds announce specific equity-oriented schemes that are eligible for the RGESS benefit.

The RGESS benefit is linked to amount invested (excluding brokerage, securities transaction tax, service tax, stamp duty and all taxes appearing in the contract note). Rebate of 50% of the amount invested upto Rs. 50,000, can be claimed as a deduction from taxable income. The investment limit of Rs. 50,000 is applicable for a block of three financial years, starting with the year of first investment.

Thus, if an investor invests Rs. 30,000 in RGESS schemes in a financial year, then he can reduce his taxable income for that previous year by 50% of Rs. 30,000 i.e. Rs. 15,000. In the following year, he still has an investment limit of Rs. 20,000 available. The maximum deduction that can be made from the taxable income over the period of three financial years is 50% of Rs. 50,000 i.e. Rs. 25,000

 

Dividends received from mutual fund schemes are tax-free in the hands of the investors.

Convenient Options

The options offered under a scheme allow investors to structure their investments in line with their liquidity preference and tax position.

There is also great transaction conveniences like the ability of withdraw only part of the money from the investment account, ability to invest additional amounts to the account, setting up systematic transactions, etc.

Investment Comfort

Once an investment is made with a mutual fund, they make it convenient for the investor to make further purchases with very little documentation. This simplifies subsequent investment activity.

Regulatory Comfort

The regulator, Securities & Exchange Board of India (SEBI), has mandated strict checks and balances in the structure of mutual funds and their activities. Mutual fund investors benefit from such protection.

Systematic Approach to Investments

Mutual funds also offer facilities that help investor invest amounts regularly through a Systematic Investment Plan (SIP); or withdraw amounts regularly through a Systematic Withdrawal Plan (SWP); or move moneys between different kinds of schemes through a Systematic Transfer Plan (STP). Such systematic approaches promote an investment discipline, which is useful in long-term wealth creation and protection. SWPs allow the investor to structure a regular cash flow from the investment account.

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Types of Funds:

1.1.  Open-Ended Funds, Close-Ended Funds and Interval Funds

Open-ended funds are open for investors to enter or exit at any time, even after the NFO.

When existing investors acquire additional units or new investors acquire units from the open-ended scheme, it is called a sale transaction. It happens at a sale price, which is equal to the NAV.

When investors choose to return any of their units to the scheme and get back their equivalent value, it is called a re-purchase transaction. This happens at a re-purchase price that is linked to the NAV

 

Although some unit-holders may exit from the scheme, wholly or partly, the scheme continues operations with the remaining investors. The scheme does not have any kind of time frame in which it is to be closed. The on-going entry and exit of investors implies that the unit capital in an open-ended fund would keep changing on a regular basis.

Close-ended funds have a fixed maturity. Investors can buy units of a close-ended scheme, from the fund, only during its NFO. The fund makes arrangements for the units to be traded, post-NFO in a stock exchange. This is done through a listing of the scheme in a stock exchange. Such listing is compulsory for close-ended schemes. Therefore, after the NFO, investors who want to buy Units will have to find a seller for those units in the stock exchange. Similarly, investors who want to sell Units will have to find a buyer for those units in the stock exchange. Since post-NFO, sale and purchase of units happen to or from counter-party in the stock exchange – and not to or from the scheme – the unit capital of the scheme remains stable or fixed.

Since the post-NFO sale and purchase transactions happen on the stock exchange between two different investors, and that the fund is not involved in the transaction, the transaction price is likely to be different from the NAV. Depending on the demand-supply situation for the units of the scheme on the stock exchange, the transaction price could be higher or lower than the prevailing NAV.

 

Interval funds combine features of both open-ended and close-ended schemes. They are largely close-ended, but become open-ended at pre-specified intervals. For instance, an interval scheme might become open-ended between January 1 to 15, and July 1 to 15, each year. The benefit for investors is that, unlike in a purely close-ended scheme, they are not completely dependent on the stock exchange to be able to buy or sell units of the interval fund. However, between these intervals, the Units have to be compulsorily listed on stock exchanges to allow investors an exit route.

The periods when an interval scheme becomes open-ended, are called ‘transaction periods’; the period between the close of a transaction period, and the opening of the next transaction period is called ‘interval period’. Minimum duration of transaction period is 2 days, and minimum duration of interval period is 15 days. No redemption/repurchase of units is allowed except during the specified transaction period (during which both subscription and redemption may be made to and from the scheme).

 

1.2.  Actively Managed Funds and Passive Funds

Actively managed funds are funds where the fund manager has the flexibility to choose the investment portfolio, within the broad parameters of the investment objective of the scheme. Since this increases the role of the fund manager, the expenses for running the fund turn out to be higher. Investors expect actively managed funds to perform better than the market

 

Passive funds invest on the basis of a specified index, whose performance it seeks to track. Thus, a passive fund tracking the BSE Sensex would buy only the shares that are part of the composition of the BSE Sensex. The proportion of each share in the scheme’s portfolio would also be the same as the weightage assigned to the share in the computation of the BSE Sensex. Thus, the performance of these funds tends to mirror the concerned index. They are not designed to perform better than the market. Such schemes are also called index schemes. Since the portfolio is determined by the index itself, the fund manager has no role in deciding on investments. Therefore, these schemes have low running costs.

1.3.  Debt, Equity and Hybrid Funds

A scheme might have an investment objective to invest largely in equity shares and equity-related investments like convertible debentures. The investment objective of such funds is to seek capital appreciation through investment in this growth asset. Such schemes are called equity schemes.

Schemes with an investment objective that limits them to investments in debt securities like Treasury Bills, Government Securities, Bonds and Debentures are called debt funds. Hybrid funds have an investment charter that provides for investment in both debt and equity. Some of them invest in gold along with either debt or equity or both.

Types of Debt Funds

Gilt funds invest in only treasury bills and government securities, which do not have a credit risk (i.e. the risk that the issuer of the security defaults).

Diversified debt funds on the other hand, invest in a mix of government and non-government debt securities such as corporate bonds, debentures and commercial paper. These schemes are also known as Income Funds.

Junk bond schemes or high yield bond schemes invest in companies that are of poor credit quality. Such schemes operate on the premise that the attractive returns offered by the investee companies makes up for the losses arising out of a few companies defaulting.

Fixed maturity plans are a kind of debt fund where the investment portfolio is closely aligned to the maturity of the scheme. AMCs tend to structure the scheme around pre-identified investments. Further, being close-ended schemes, they do not accept moneys post-NFO. Thanks to these characteristics, the fund manager has little ongoing role in deciding on the investment options.This helps them compare the returns with alternative investments like bank deposits.

Floating rate funds invest largely in floating rate debt securities i.e. debt securities where the interest rate payable by the issuer changes in line with the market. For example, a debt security where interest payable is described as‘5-year Government Security yield plus 1%’, will pay interest rate of 7%, when the 5-year Government Security yield is 6%; if 5-year Government Security yield goes down to 3%, then only 4% interest will be payable on that debt security. The NAVs of such schemes fluctuate lesser than other debt funds that invest more in debt securities offering a fixed rate of interest.

Liquid schemes or money market schemes are a variant of debt schemes that invest only in short term debt securities. They can invest in debt securities of upto 91 days maturity. However, securities in the portfolio having maturity more than 60-days need to be valued at market prices [“marked to market” (MTM)]. Since MTM contributes to volatility of NAV, fund managers of liquid schemes prefer to keep most of their portfolio in debt securities of less than 60-day maturity. As will be seen later in this Work Book, this helps in positioning liquid schemes as the lowest in price risk among all kinds of mutual fund schemes. Therefore, these schemes are ideal for investors seeking high liquidity with safety of capital.

1. Types of Equity Funds

Diversified equity fund is a category of funds that invest in a diverse mix of securities that cut across sectors.

Sector funds however invest in only a specific sector. For example, a banking sector fund will invest in only shares of banking companies. Gold sector fund will invest in only shares of gold-related companies.

Thematic funds invest in line with an investment theme. For example, an infrastructure thematic fund might invest in shares of companies that are into infrastructure construction, infrastructure toll-collection, cement, steel, telecom, power etc. The investment is thus more broad-based than a sector fund; but narrower than a diversified equity fund.

Equity Linked Savings Schemes (ELSS), as seen earlier, offer tax benefits to investors. However, the investment is subject to lock-in for a period of 3 years.

Rajiv Gandhi Equity Savings Schemes (RGESS) too, as seen earlier, offer tax benefits to first-time investors. Investments are subject to a fixed lock-in period of 1 year, and flexible lock-in period of 2 years.

Equity Income / Dividend Yield Schemes invest in securities whose shares fluctuate less, and the dividend represents a larger proportion of the returns on those shares. The NAV of such equity schemes are expected to fluctuate lesser than other categories of equity schemes

 

Arbitrage Funds take opposite positions in different markets / securities, such that the risk is neutralized, but a return is earned. For instance, by buying a share in BSE, and simultaneously selling the same share in the NSE at a higher price. Most arbitrage funds take contrary positions between the equity market and the futures and options market. (‘Futures’ and ‘Options’ are commonly referred to as derivatives. These are designed to help investors to take positions or protect their risk in some other security, such as an equity share. They are traded in exchanges like the NSE and the BSE

Although these schemes invest in equity markets, the expected returns are in line with liquid funds.

2. Gold Funds

These funds invest in gold and gold-related securities. They can be structured in either of the following formats:

Gold Exchange Traded Fund, which is like an index fund that invests in gold, gold-related securities or gold deposit schemes of banks. The NAV of such funds moves in line with gold prices in the market.

Gold Sector Fund i.e. the fund will invest in shares of companies engaged in gold mining and processing. Though gold prices influence these shares, the prices of these shares are more closely linked to the profitability and gold reserves of the companies. Therefore, NAV of these funds do not closely mirror gold prices.

(Gold Sector Fund is like any equity sector fund, which was discussed under ‘Types of Equity Funds’. It is discussed here to highlight the difference from a Gold ETF. It is important to understand that unlike Gold sector fund, Gold ETF does not invest in equity shares of companies involved in Gold related businesses including gold mining.)

3.  Types of Hybrid Funds

Monthly Income Plan seeks to declare a dividend every month. It therefore invests largely in debt securities. However, a small percentage is invested in equity shares to improve the scheme’s yield.

As will be discussed in Unit8, the term ‘Monthly Income’ is a bit of a misnomer and investor needs to study the scheme properly, before presuming that an income will be received every month.

Another very popular category among the hybrid funds is the Balanced Fund category. These schemes were historically launched for the purpose of giving an investor exposure to both equity and debt simultaneously in one portfolio

 

provide growth and stability (or regular income), where equity had the potential to meet the former objective and debt the latter. The balanced funds can have fixed or flexible allocation between equity and debt. One can get the information about the allocation and investment style from the Scheme Information Document.

Capital Protected Schemes are close-ended schemes, which are structured to ensure that investors get their principal back, irrespective of what happens to the market. This is ideally done by investing in Zero Coupon Government Securities whose maturity is aligned to the scheme’s maturity. (Zero coupon securities are securities that do not pay a regular interest, but accumulate the interest, and pay it along with the principal when the security matures).

As detailed in the following example, the investment is structured, such that the principal amount invested in the zero-coupon security, together with the interest that accumulates during the period of the scheme would grow to the amount that the investor invested at the start.

Suppose an investor invested Rs 10,000 in a capital protected scheme of 5 years. If 5-year government securities yield 7% at that time, then an amount of Rs 7,129.86 invested in 5-year zero-coupon government securities would mature to Rs 10,000 in 5 years. Thus, by investing Rs 7,129.86 in the 5-year zero-coupon government security, the scheme ensures that it will have Rs 10,000 to repay to the investor in 5 years.

After investing in the government security, Rs 2,870.14 is left over (Rs 10,000 invested by the investor, less Rs 7129.86 invested in government securities). This amount is invested in riskier securities like equities. Even if the risky investment becomes completely worthless (a rare possibility), the investor is assured of getting back the principal invested, out of the maturity moneys received on the government security.

Some of these schemes are structured with a minor difference – the investment is made in good quality debt securities issued by companies, rather than Central Government Securities. Since any borrower other than the government can default, it would be appropriate to view these alternate structures as Capital Protection Oriented Schemes rather than Capital Protected Schemes.

It may be noted that capital protection can also be offered through a guarantee from a guarantor, who has the financial strength to offer the guarantee. Such schemes are however not prevalent in the market.

Some of these funds are also launched as Asset Allocation Funds. These schemes are not different from those under the Hybrid category. One should go through the Scheme Information Document to understand the unique characteristics of the individual scheme.

 

 

4. International Funds

These are funds that invest outside the country. For instance, a mutual fund may offer a scheme to investors in India, with an investment objective to invest abroad.

One way for the fund to manage the investment is to hire the requisite people who will manage the fund. Since their salaries would add to the fixed costs of managing the fund, it can be justified only if a large corpus of funds is available for such investment.

An alternative route would be to tie up with a foreign fund (called the host fund). If an Indian mutual fund sees potential in China, it will tie up with a Chinese fund. In India, it will launch what is called a feeder fund. Investors in India will invest in the feeder fund. The moneys collected in the feeder fund would be invested in the Chinese host fund. Thus, when the Chinese market does well, the Chinese host fund would do well, and the feeder fund in India will follow suit

 

Such feeder funds can be used for any kind of international investment, subject to the scheme objective. The investment could be specific to a country (like the China fund) or diversified across countries. A feeder fund can be aligned to any host fund with any investment objective in any part of the world, subject to legal restrictions of India and the other country.

In such schemes, the local investors invest in rupees for buying the Units. The rupees are converted into foreign currency for investing abroad. They need to be re-converted into rupees when the moneys are to be paid back to the local investors. Since the future foreign currency rates cannot be predicted today, there is an element of foreign currency risk.

5. Fund of Funds

The feeder fund was an example of a fund that invests in another fund. Similarly, funds can be structured to invest in various other funds, whether in India or abroad. Such funds are called fund of funds. These ‘fund of funds’ pre-specify the mutual funds whose schemes they will buy and / or the kind of schemes they will invest in. They are designed to help investors get over the trouble of choosing between multiple schemes and their variants in the market.

Thus, an investor invests in a fund of funds, which in turn will manage the investments in various schemes and options in the market.

6.  Exchange Traded Funds

Exchange Traded funds (ETF) are open-ended funds, whose units are traded in a stock exchange.

A feature of open-ended funds, which allows investors to buy and sell units from the mutual fund, is made available only to very large investors in an ETF.

Other investors will have to buy and sell units of the ETF in the stock exchange. In order to facilitate such transactions in the stock market, the mutual fund appoints some intermediaries as market makers, whose job is to offer a price quote for buying and selling units at all times.

If more investors in the stock exchange want to buy units of the ETF, then their moneys would be due to the market maker. The market maker would use the moneys to buy a basket of securities that is in line with the investment objective of the scheme, and exchange the same for units of the scheme from the mutual fund. Thus, the market maker can offer the units to the investors