THE CONCEPT AND ROLE OF MUTUAL FUNDS

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Concept of a Mutual Fund

A common pool of money into which investors place their contributions to be invested in accordance with a stated objective. The ownership of the fund is joint or mutual The fund belongs to all investors

Ownership is proportionate to contribution made by one

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Dilemma investor faces in Equity investments directly

Buying potential Stocks Market timing Discipline Expert recommendation

? ? ? ?

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Advantages of Investing through Mutual Funds over Direct Investments

Not as difficult as researching individual stocks Portfolio Diversification Professional Management Reduction / Diversification of Risk Liquidity Flexibility & Convenience

Reduction in Transaction cost

Safety of regulated environment
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Disadvantages of Investing through Mutual Funds over Direct Investments

No Control over Cost
No Tailor-made Portfolios Managing a Portfolio Funds

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History of Mutual Funds

Phase 1 (1964-87) : Growth of UTI Phase 2 (1987-93) : Entry of PSU Banks and Financial Institutions MFs Phase 3 (1993-96) : Emergence of Private Sector Mutual Funds Joint Ventures between Foreign Funds & Indian Promoters resulting in innovations in - Investment Management Techniques, - Investor Services Techniques
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History of Mutual Funds

Phase 4 (1996-99) : SEBI Regulations for Investors Protection UTI Act 1963 repealed in Feb UTI Mutual Fund becomes SEBI compliant Assured Return Schemes of UTI taken over by a special undertaking administered by GOI Emergence of large & uniform inds.

Phase 5 (1999-2004) : 2003

Phase 6 (2004 onwards):

Consolidation & Growth cfpmahesh@gmail.com 35 AMC in 2008

Growth of AUM
31 3 -1999 68,472 CRORES

31-03-2001

90587 CRORES

31-03-2004

139616 CRORES

30-11-2008

4,02,000 CRORES

31-12-2012

7,95,000 CRORES

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Top Mutual Fund Companies in In India in AUM

HDFC Mutual Fund 101,393 3.70

Reliance Mutual Fund

90,636

4.99

ICICI Prudential Mutual Fund

81,394

6.55

Birla Sun Life Mutual Fund

76,890

5.47

UTI Mutual Fund SBI Mutual Fund

70,638

-0.20

53,311

4.62

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Types of Mutual Fund

Mutual Funds can be classified as: Close ended / Open-ended Funds

Load Fund / No-Load Funds : entry / front & exit / back load
Tax-exempt / Non-Tax exempt Funds

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Example on Loads and Returns

Date 1/1/1999 31/12/1999 Action Entry Exit NAV (Rs) 11.00 12.00 Entry Load 2% Exit Load 1%

ROI with Loads Amount invested = 11 + 0.22 = 11.22 Rs. Amount received = 12 0.12 = 11.88 Rs. Gain = 0.66 Rs. ROI = (0.66 x 100) /11.22 = 5.88%

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Contingent Deferred Sales Charge (CDSC)

Charges varying with the holding period it is called Contingent Deferred Sales Charge (CDSC) and it may vary as shown under.

Redemption during the first five years from the date of purchase
First Year Second Year Third Year Fourth Year Fifth Year Maximum CDSC 4% Maximum CDSC 3% Maximum CDSC 2% Maximum CDSC 1% Nil

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Types of Funds
Money Market Funds Gilt Funds Debt Funds Equity Funds Hybrid Funds ETF Commodity Real estate

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Money Market Funds

Invest in securities of less than 1 year maturity
High liquidity & safety of principal

Low risk and low returns

Money Market Instruments : Treasury Bills (T-Bills By RBI for 3,6,12 Months at discount price) Commercial Papers (promissory notes that are unsecured and issued by companies for 1 to 270 days) Current Return in MMMF is 8.5 %
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Gilt Funds
Invest only in Government Securities of over 1 year maturity Risk and return low but higher than that of MMF No default risk but carry interest rate risk Fund values drop when interest rates go up & rise when interest rates go down Returns from 11 % to 14 %
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Debt Funds & Types

Invest in Corporate Bonds and Government Securities Risk higher than that of Gilt Funds Aims at regular income distribution and not at capital appreciation Types of Debt Funds:
- Diversified Debt Funds - Assured return Debt Funds - Fixed Term Plan Series

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Equity Funds & Types

Invest in Equity and Equity related instruments High risk and aim at Capital appreciation Types of Equity Funds
Growth Funds Value Funds Specialty Funds: Sector Funds, Foreign Securities Funds, Mid-Cap or Small-Cap Equity Funds,

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Equity Funds & Types

Diversified Equity Funds ELSS Funds Equity Index Funds Equity Income or Dividend Yield Fund

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Types of Hybrid Funds

Balanced Funds: Seek to provide regular income & Capital appreciation in different proportion
Flexible asset allocation between Debt, Equity & MM

Asset Allocation Funds:

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Other Funds
Commodity Funds
Real Estate Funds

:
:

Exchange Traded Funds

Fund of Funds

Invest in commodity stocks Invest in stocks of real estate companies :Trade like a single stock on exchange Invest in other Mutual Fund Schemes

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Risk Return Hierarchy of Different Funds

Risk High Sector Funds Diversified Equity Funds Index Funds

Balanced Funds
Debt Funds Gilt Funds

Risk Low

MMMF

Low return
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High return

Investments plans
SIP SWP STP VIP

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FUND STRUCTURE AND CONSTITUTENTS

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Mutual Fund Structure

Mutual Funds in U.S are setup as investment companies Mutual Funds in U.K are either Unit Trusts (Trust) or Investment Trust (Companies)

Mutual Funds are Public Trusts under the Indian Trusts Act, 1882
Mutual Fund is a 3 tier structure:
Sponsor, Trustee and AMC
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Mutual Fund Structure

Mutual Funds invest
in Capital market instruments on behalf of investors

All gains and losses of funds are shared by the unit holders
MF is a pass-through structure and it has tax implications

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Constituents of a Mutual Fund

1. Sponsor

2.
3. 4. 5. 6.

Trustees
Asset Management Company Custodian / Depository Participant R & T Agent Distributors

7.

Banker

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Role of Sponsor
Sponsor is a person who sets up a Mutual Fund Sponsor settles the Trust and executes Trust Deed Sponsor contributes to the initial capital of the Trust Sponsor appoints the Board of Trustees Sponsor appoints Asset Management Company Sponsor contributes minimum 40% of net worth of AMC
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Who can be a Sponsor?

Criteria of a Sponsor are
Minimum 5 years track record History of positive After Tax Profit for 3 out of 5 years including fifth year Net Worth more than Contribution for AMC Fit and Proper person

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Board of Trustees & Role

Trustees appointed by the Sponsor with SEBI approval At least two third Trustees must be Independent The Trustees have a FIDUCIARY responsibility towards unit holders Trustees not liable for acts done in good faith and if they have exercised adequate due diligence Trustees oversee the functioning of AMC Trustees approve each MF scheme floated by AMC The investments in MFs are held by the Trustees Trustees receive fees for their services
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Who can be a Trustee

Eligibility Conditions :

Person of high repute and integrity

Not guilty of moral turpitude Not convicted for economic offence under securities laws Not a part of AMC eg. Director, Employee or Officer of AMC One can be Trustee of two MFs if approved by Board of Trustees of both the Mutual Funds.

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Asset Management Company

Constituted as a Company under the Indian Companies Act Minimum Net worth of Rs. 10 crores for AMC Minimum contribution of sponsor: 40% of share capital of AMC At least 50% of Directors of AMC to be independent
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Asset Management Company

AMC can do only the following businesses
Asset Management Services
Portfolio Management Services Portfolio Advisory Services

AMC can be terminated/changed with the consent of

Majority of Trustees or At least 75% majority of Unit holders

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Role of AMC
AMC is the Fund Manager for managing Mutual Fund Assets AMC floats different MF schemes

AMC accountable to the Trustees

AMC charges Asset Management Fees subject to ceiling prescribed by SEBI. Asset Management Agreement between AMC and Trustee
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Obligations of AMC
Limit of 5% of aggregate purchase and sales of Securities under all its scheme per broker per quarter As far as possible AMC to avoid services of its sponsor. All Security transactions with a Sponsor and his associates to be disclosed Disclosure of transactions with a company which has invested more than 5% of NAV in any scheme
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Custodian / Depository Participant

Custodian / DP:
Appointed by Board of Trustees Keep record & account of Securities / Investments Collects benefits under Securities Sponsor & Custodian / DP cannot be the same entity Registered with SEBI

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Registrar & Transfer Agent

Registrar & Transfer Agent:
Issues, redeems, transfers units of MF schemes
Keeps Unit Holders A/cs upto date Registered with SEBI

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OFFER DOCUMENT

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Offer Document & KIM

Offer Document
A Legal document Issued by AMC on behalf of Trustees Offer Document describes the Product/Scheme Very important document for prospective investor First time investors must read OD before deciding to invest For Close Ended Fund issued at the time of launching a scheme For Open Ended Fund revised every 2 years

KIM
A abridged version of Offer Document A part of the Application Form To be in the format as prescribed by SEBI

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Offer Document
Offer Document prepared and issued by AMC Offer Document to be approved by Trustees Offer Document filed with SEBI with fees of Rs. 25000/ Modifications if any advised by SEBI within 21 days of its filing SEBI neither approves nor disapproves an OD Offer Document valid for 6 months for launching of scheme from the date of receipt of by AMC of SEBI letter containing observations. Thereafter fresh OD to be filled with SEBI
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Contents of Offer Document

Summary information on Cover page:
Names of Trustees, AMC, Scheme, Period of Opening / Closing, Face value of unit , SEBI Disclaimer

Risk factors: Standard & Scheme Specific Legal & Regulatory Compliance Certificate Financial information on Schemes & Expenses for last 3 years Constitution of MF its Sponsors, Trustees, AMC & their functions Investment objectives & policies Management of Funds: Names of Fund Manager Offer related information: Minimum Subscription amount
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Pricing of a Fund Unit

SEBI Regulations on pricing of Mutual Fund units
For Open Ended Funds
Repurchase price not lower than 93% of NAV Sale price cannot be more than 107% of NAV

Difference between the repurchase and sale price of a

Unit cannot be more than 7%

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Charges in a MF
Mutual Funds can recover two types of Expenses a. Initial issue expenses b. Recurring Expenses Initial Issue Expenses

effective April 04 2006 allowed up to 6% for Close Ended Funds only Close Ended Funds cannot charge Entry Loads Open Ended Funds can recover initial expenses through Entry Load

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Recurring Expenses cannot exceed the following regulatory limits

Average Weekly Assets For first Rs.100 crs For next Rs.300 crs For next Rs.300 crs On the Balance Average Weekly Assets For Equity Funds 2.50% 2.25% 2.0% 1.75% For Bond Funds 2.25% 2.00% 1.75% 1.50%

Maximum Recurring Expenses

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Asset Management Fees

AMC charges Asset Management Fees
Limits on AMC Fees as per SEBI Regulations: 1.25% of the 1st Rs. 100 crs of weekly Average Net Assets 1.00% of the weekly Average Net Assets in excess of Rs. 100 crs AMC may charge additional 1% of weekly Average Net Assets for No Load Funds

Asset Management Fees are not in addition to but a part of Recurring Expenses Asset Management fees are usually lower for Debt Funds as compared to Equity Funds and are disclosed in OD

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Amortization of Initial Expenses

Close Ended Funds do not charge initial expenses of fund but amortize the same over a period of years Initial Expenses amortized on a weekly basis over the period of the scheme. e.g for a 5 yr scheme, amortized over 260 weeks

Investor existing before expiry of period of scheme will be charged unrecovered initial issue expenses
Conversion of close ended funds into open ended funds allowed only after recovery of unrecovered initial expenses Un-amortized portion added for NAV calculation as Other Asset but no AMC fee on this amount
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 Investment in unlisted shares of companies

Regulatory Restrictions on Investments by Funds

Close Ended Fund : Not more than 10% of Net Assets Open Ended Fund: Not more than 5% of Net Assets

Investments in Equity shares under all schemes of a MF

Not more than 10% of Paid up capital of a company

Investment by a Mutual Fund in ADRs / GDRs allowed Investment by a M.F. in Equities of listed overseas companies having share holding of at least 10% allowed Overall limit of U.S. $ 5 Billion for such overseas investment for entire M.F. industry Overall limit per M.F.
Not exceeding 10% of Net Assets subject to maximum USD 300 Million
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Regulatory Restrictions on Investments by Funds

A Mutual fund can invest
maximum 5% of Net Assets under all its schemes into different fund schemes of the same AMC or of any other AMC except Fund of Funds Scheme

The above limit does not apply to Fund of Funds Securities are to be bought or sold only on delivery basis No short selling allowed Securities to be bought and sold for a relevant scheme. Purchases/Sales cannot be aggregated and allocated later
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Regulatory Restrictions on Investments by Funds

MFs can lend securities under the SEBI approved Stock Lending scheme A Mutual Fund can invest only in Marketable Securities A Mutual Fund cannot invest in unlisted securities of Sponsor or Sponsor Group Companies

A Mutual Fund can invest in listed securities of the sponsor / Sponsor Group Companies upto 25% of Net Assets of the Fund
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 A Mutual fund can transfer Securities from one scheme to another scheme at market prices and on spot delivery basis Inter-scheme transfers allowed if objectives of both the schemes are same A Mutual fund can park its money in deposits of Scheduled Commercial Banks pending deployment into regular investments Borrowing by MFs restricted upto 20% of Net Assets for maximum 6 months for paying dividend/redeeming units Record of investment decisions to be maintained. A FOF cant invest in other FOF scheme
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Regulatory Restrictions on Investments by Funds

Expense Ratio / Income Ratio Method of Fund Evaluation

Funds can be evaluated based on Expense ratio and Income ratio Expense Ratio: It is the ratio of total expenses to Average Net Assets of the fund.
This ratio is important for evaluating Bond Funds Expenses do not include brokerage paid since it is capitalized and therefore expenses may be understated

Income Ratio =

Net Investment Income Net Assets

Income ratio is important for evaluating Bond Funds

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Portfolio Turn Over Rate Method of Fund Evaluation

Another Measure of Fund Evaluation is Portfolio Turn Over Rate Portfolio Turnover Rate = Total Sales & Purchases Net Assets of the Fund.

Higher Turn Over Rate indicates

More churning of Portfolio More transaction costs

Portfolio turn over ratio relevant for actively managed funds

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LEGAL & REGULATORY FRAMEWORKS

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Regulators in India
SEBI is Capital Market Regulator with legal powers
SEBI regulates Mutual Funds. All Mutual Funds to be registered with SEBI

RBI is Money Market Regulator SEBI is regulator for Liquid Funds Investing in MM instruments

MOF supervisory body for RBI & SEBI

Security Appellate Tribunal setup in 2003 to hear appeal against SEBI decisions Registrar of Companies(ROC) ensures compliance by AMC & by Trustee Company with the Indian Companies Act 1956 ROC supervised by Department of Company Affairs (DCA)
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Regulators in India
DCA frames and modifies regulations relating to the companies DCA is a part of Company Law Board CLB is a part of Ministry of Law and Justice

Company Law Board carries out judicial proceedings for offences under Companies Act
Mutual Fund Trustees accountable to Public Trustees

Public Trustee reports to Charity Commissioner

UTI set up under UTI Act 1963
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Self Regulatory Organisations

SROs are second tier in the regulatory structure

SRO is an association of Market Participants Approval of SRO given by MOF All Stock Exchanges are SROs and are supervised by SEBI Close Ended Funds listed on SE observe listing Agreement Requirements of SEs
AMFI was incorporated in 1995 and is not an SRO Role of AMFI
To promote interest of MFs & Unit Holders To set ethical, commercial & professional standards To increase public awareness of MF industry
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Investors Rights & Obligations

Right of proportionate beneficial ownership

Right to timely service

Right to information eg. NAV Calculation, Unit Pricing Right to approve changes in fundamental attributes of the scheme Right to wind up a close ended scheme with 75% majority of unit holders

Right to terminate the AMC with 75% majority of unit holders

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Investor Rights to Services

Investor to be informed about change in fundamental attributes of the scheme eg. from No Load fund to Load fund or change in Pricing norms for purchase/sale of Units Open ended Fund must reopen within 30 days after the Offer period Nomination facility allowed Redemption proceeds to be sent to investor within 10 working days otherwise Penal interest at the rate specified by SEBI for the full period
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Investor Rights to Services

Annual Holding statements and Transaction statements to be sent to investors Dividend Warrants to be dispatched within 30 days of dividend declaration by MF Mandatory portfolio disclosure for half-yearly period to unit holders within 1 month

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Investor Rights to Services

Investors right to inspect documents such as
Trust deed,
AMC Agreement, Balance Sheets of MF Schemes and

Balance Sheet of AMC

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Legal limitation to Investor Rights

Investors cant sue the Trust Investor can sue the Trustee

Sponsor of fund not responsible for shortfall in non assured scheme

Prospective investors cant sue the trustees/AMC/ Custodians

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