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MF - Unit Iii
MF - Unit Iii
MF - Unit Iii
Unit – III
Mutual Funds Products – Concept and Salient Features;
Equity Schemes; Debt Schemes; Diversified Schemes; Balanced Schemes; Tax Funds; Liquid Funds; Index
Funds; Fixed Maturity Plans; Exchange Traded Funds (ETFs), Gold ETFs;
Risk Disclosures and Return Calculations by type of Mutual Fund;
Fact Sheet of Mutual Funds and their uses;
Identifying investor needs and choice of mutual fund products.
A. Introduction
i. What is investing?
An investment operation is one which, upon thorough analysis promises safety of principal and an adequate
return. Operations not meeting these requirements are Speculative.
- Benjamin Graham – The Intelligent Investor
Investing is the act of seeking value at least sufficient to justify the amount paid. Consciously paying more in the
hope that it can soon be sold for a still higher price should be labelled as speculation
- Warren Buffet – The Making of an American Capitalist
Investing is a method of purchasing assets to gain profit in the form of reasonably predictable income (dividend,
interest or rentals) and / or appreciation over the long term.
- Burton G Malkiel – A Random Walk Down Wall Street
Investing is an Act of faith, a willingness to postpone present consumption and save for the future. We entrust
our capital to corporate stewards in the faith –at least with the hope that their efforts will generate high rates of
return on our investments
- John C. Bogle – Common Sense on Mutual Funds
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iii. Debt Vs Equity Instruments
The debt market is the market where debt instruments are traded. Debt instruments are assets that require a
fixed payment to the holder, usually with interest. Examples of debt instruments include bonds (government or
corporate) and mortgages.
The equity market (often referred to as the stock market) is the market for trading equity instruments. Stocks
are securities that are a claim on the earnings and assets of a corporation (Mishkin 1998). An example of an
equity instrument would be common stock shares, such as those traded on the New York Stock Exchange.
i. Introduction
Mutual funds are a synonym for an investment company in USA and an investment trust in UK and other
European countries. It is a financial intermediary, which pools the savings of several individuals and invests the
money thus raised in equity shares, debentures, bonds, government securities and other such instruments. An
investor can invest either directly in securities or can invest through mutual funds. By investing through a mutual
funds having professional expertise, the risk is reduced. Several authors have defined mutual funds in different
words but meaning the same i.e. it is a non-banking financial intermediary who acts as ―important vehicle for
bringing wealth holders and deficit units tighter indirectly (Pierce, 1984).
A Mutual Fund is a trust that collects money from investors who share a common financial goal, and invest the
proceeds in different asset classes, as defined by the investment objective.
Simply put, mutual fund is a financial intermediary, set up with an objective to professionally manage the money
pooled from the investors at large.
An investor in a mutual fund scheme receives units which are in accordance with the quantum of money invested
by him. These units represent an investor’s proportionate ownership into the assets of a scheme and his liability
in case of loss to the fund is limited to the extent of amount invested by him. The pooling of resources is the
biggest strength for mutual funds. The relatively lower amounts required for investing into a mutual fund scheme
enables small retail investors to enjoy the benefits of professional money management and lends access to
different markets, which they otherwise may not be able to access. The investment experts who invest the pooled
money on behalf of investors of the scheme are known as 'Fund Managers'. These fund managers take the
investment decisions pertaining to the selection of securities and the proportion of investments to be made into
them. However, these decisions are governed by certain guidelines which are decided by the investment
objective(s), investment pattern of the scheme and are subject to regulatory restrictions. It is this investment
objective and investment pattern which also guides the investor in choosing the right fund for his investment
purpose.
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ii. How is a mutual fund set up?
A mutual fund is set up in the form of a trust, which has sponsor, trustees, asset management company (AMC) and
custodian. The trust is established by a sponsor or more than one sponsor who is like promoter of a company.
The trustees of the mutual fund hold its property for the benefit of the unitholders. Asset Management Company
(AMC) approved by SEBI manages the funds by making investments in various types of securities. Custodian,
who is registered with SEBI, holds the securities of various schemes of the fund in its custody. The trustees are
vested with the general power of superintendence and direction over AMC. They monitor the performance and
compliance of SEBI Regulations by the mutual fund.
SEBI Regulations require that at least two thirds of the directors of trustee company or board of trustees must be
independent i.e. they should not be associated with the sponsors. Also, 50% of the directors of AMC must be
independent. All mutual funds are required to be registered with SEBI before they launch any scheme.
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High Management Fee: The Management Fees charged by the fund reduces the return available to the
investors.
Diversification: Diversification minimizes risk but does not guarantee higher return.
Diversion of Funds: There may be unethical practices e.g. diversion of Mutual Fund amounts by Mutual
Fund/s to their sister concerns for making gains for them.
Lock-In Period: Many MF schemes are subject to lock in period and therefore, deny the investors market
drawn benefits
Accordingly, there is a wide range of Mutual fund schemes/products to choose from which is such devised
to meet the varied need of the investor. Thus, Mutual funds can be classified in accordance with its
structure, type of investment and/or the objective with which the mutual fund is set up. A pictorial
representation of the types of mutual funds products in the Indian Mutual Fund Industry is provided in
Figure 2;
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Figure 2: Classification of Mutual Funds
[source: https://arthikdisha.com/7-top-best-types-of-mutual-funds-in-india/]
Table 1
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Load Funds and NO load funds
Marketing of a new mutual funds scheme involves initial expenses. These expenses may be recovered from the
investors in different ways at different times. Three usual ways in which funds marketing expenses may be
recovered from the investors are:
At the time of investor’s entry into the fund/scheme, by deducting a specific amount from his
contribution
By charging the fund/scheme with a fixed amount each year, during a specified number of years
At the time of investors’ exit from the fund/scheme, by deducting a specified amount from the
redemption proceeds payable to the investors.
These charges imposed on the investors to cover distribution/sales/marketing expenses are often called loads.
The load charged to the investor at the time of his entry into a scheme is called ―front-end load or entry load. The
load amount charged to the scheme over a period of time is called a ―deferred load. The load that the investor
pays at the time of his exit is called a ―back end load or exit load. Some funds may also charge different amount
of loads to the investors, depending upon how many years the investor has stayed with fund, the long the investor
stays with the fund, less the amount of exit load he is charged. This is called ―contingent deferred sales charge.
Funds that charge a front end load would be load funds as per SEBI definition. This is in line with the
internationally used definition. However, SEBI would consider a fund to be a no-load fund, if an AMC absorbs these
initial marketing expenses and does not charge the fund – a situation that is somewhat special to India and not
widely prevalent elsewhere. Internationally, a fund even when it does not make a front end load would still be
considered a load fund, if it charges an exit load or a deferred sales load.
From the investor’s perspective, it is important to note that loads are not charged only by open end funds; even
a close end fund can charge a load to cover the initial issue expenses. It is also important to note that there are
other expenses such as the fund manager’s fees, which are charged to the investors on an ongoing basis. Such
expenses reduce the NAV of the fund. If the investor’s objective is to get the benefit of compounding his initial
investment by reinvesting and holding his investment for a very long term, then a no-front load is preferable. The
number of units allotted to an investor is based on the purchase price offered to him. In a no front end load fund,
the NAV based purchase price offered to the investor is same as the fund NAV per unit, there being no deduction
from the amount paid by him.
Load Funds: MF can recover the initial marketing expenses (loads) in any of the following ways —
• Entry Load: Deducting these expenses at the joining time (suitably adding to the existing NAV, thus allotting less units).
• Deferred Load: By deducting deferred load, where the expenses are charged over a specified period.
• Exit Load: By deducting these expense when investors exit the scheme (suitable reducing from the existing NAV while
making payment)
No Load Funds: Investor in a No-Load fund enters and exits the fund at the NAV, i.e. they do not bear the initial marketing
expenses.
Note: Load / No—Load Funds are differentiated on the basis of initial marketing expenses and not on the basis of other running/
management expenses. [special case in case of the India MF Market]
Interval Funds: Interval funds combine the features of open-ended and close ended schemes. They are open for
sale or redemption during pre-determined intervals at NAV related prices.
By Investment Objectives:
1. Growth Funds:
(a) Object: To provide capital appreciation over the medium to long term.
(b) Investment Pattern: Such schemes invest a majority of their corpus in equities. It has been proved
that returns from stocks, have outperformed most other kind of investments held over the long term.
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(c) For Whom? Growth Schemes are meant for investors who have a long-term outlook, and seek growth
over a period.
2. Income Funds:
(a) Object: To provide regular and steady income to investors.
(b) Investment Pattern: Fixed income securities such as Bond, Corporate Debentures and Government
Securities.
(c) For Whom? Income Funds are ideal for capital stability and regular income.
(d) Variants:
• Gilt Fund: Fund that invests its proceeds only in Government Securities and Treasury Bills.
• Bond Fund: Fund that invests its proceeds only in Bonds and Corporate Debt Instruments.
3. Balance Funds:
(a) Object: Provide both growth and regular income. Such schemes periodically distribute a part of their
earning.
(b) Investment Pattern: Both in Equities and Fixed Income Securities, in the proportion indicated in their
offer documents.
(c) For Whom? For investors looking for a combination of income and moderate growth.
(d) Less Sensitive to Market Movements: In a rising stock market, the NAV of these schemes may not
normally keep pace, or fall equally when the market falls.
By Investment Types
(a) Industry Specific Schemes: Industry-Specific Schemes invest only in the industries specified in the
offer document. The investment of these fund is limited to specific industries like Infotech, FMCG,
Pharmaceuticals, etc.
(b) Index Schemes: Index Funds attempt to replicate the performance of a particular index such as the
BSE Sensex or the NSE 50
(c) Sectoral Schemes: Invest exclusively in a specified sector. This could be an industry or a group of
industries or various segments such as “A” Group shares or initial public offerings.
Some other Mutual fund schemes/products are also being prevalent in the Indian Mutual Fund Industry.
Exchange traded fund (ETF) and the Fund of Fund (FoF) are two very prevalent ones;
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(iii) Features:
Prices fluctuate from moment to moment. The difference in price is due to the forces of demand and
supply for ETF in the market at that point of time.
Investor needs a broker to purchase units of ETF.
They have very low operating and transaction costs, since there are no loads or investment minimums
required to purchase and ETF.
ETFs can be traded any time during the day, as against conventional index funds which can be traded
only at the end of the day.
ETF units can be traded at a premium or discount to the underlying Net Asset Value.
Fund of Funds:
(i) Nature: It is a Mutual Fund Scheme, where the subscription proceeds are invested in other Mutual
Funds, instead of investing in Equity or Debt Instruments.
(ii) Features:
These funds offer and achieve a greater diversification than traditional mutual funds.
Expense/Fees on such funds are higher than those on regular funds because they include part of the
expense fees charged by the underlying funds.
Indirectly, the proceeds of Fund of Funds may be invested in its own funds, and can be difficult to
keep track of overall holdings.
In addition to the above discussion on the classification of funds the following terminology is of prime
importance as the issues provide some fine tuning to the mutual fund products and how the investors go about
in buying the mutual fund products;
Systematic Transfer Plan (STP): Investors can use Systematic Transfer Plan (STP) as a defence mechanism in
volatile market. This plan is used to transfer investment from one asset or asset type into another asset or
asset type. Before we understand STP, let's define SIP (Systematic Investment Plan) first. SIP is a
disciplined way of investing where investors invest a regular sum every month in mutual funds. SIP is also
known as rupee cost averaging and it is the best way to handle volatility in investment. For example, you
start to invest Rs 5,000 every month in a mutual fund. If you do it via SIP, this money will be taken from
your account every month and invested in the mutual fund that you have selected for SIP.
STP is a variant of SIP. STP is essentially transferring investment from one asset or asset type into another asset
or asset type. The transfer happens gradually over a period. Systematic Transfer Plan is of two types; fixed
STP, and capital appreciation STP. A fixed STP is where investors take out a fixed sum from one investment
to another. A capital appreciation STP is where investors take the profit part out of one investment and
invest in the other.
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D. IDENTIFYING INVESTOR NEEDS AND CHOICE OF MUTUAL FUND PRODUCTS
In identifying the investor needs financial planning is of the essence. The Investor has to not only clarify his
investment needs but also zero down on his risk tolerance. For this the risk questionnaire (discussed in
wealth management module) is of prime importance. On the basis of the risk preference of the investor and
the customization of the Mutual Fund products some strategies have evolved, a discussion of the strategies
follows;
3. Buy-and-Hold Strategy
This is by far the most widely preached investment strategy. This strategy means you'll buy your investments
and hold onto them for a long time regardless of whether the markets are going up or down. Conventional
wisdom says If you employ a buy-and-hold strategy and weather the ups and downs of the market, over time
your gains will outweigh your losses. Billionaire and legendary investor, Warren Buffett, is on record as
saying this strategy is ideal for the long-term investor.
The other reason this strategy is so popular is that it's easy to employ. This does not make it better or worse
than the other options; it's simply easy to buy and then to hold.
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E. RISK DISCLOSURES AND RETURN CALCULATIONS BY TYPE OF MUTUAL FUND
Investor Returns
If the investor invested at the NAV and redeemed his investments at the NAV, then the scheme returns for
any period will be equal to the investor’s returns for the same period.
At the NFO stage, investors invest at the face value of Rs10, in the case of both open-end and closed-end
schemes.
They invest in the post-NFO stage in closed-end schemes at the prevailing price in the stock exchange.
Investors can sell their units held in closed-end schemes, at the prevailing market price.
They can redeem their units held in open-end schemes, at the Re-purchase Price, which can be lower
than NAV. The difference is called exit load. For example, if NAV is Rs 15 and the scheme declares Re-
purchase Price of Rs. 14.75, the differential of Rs 0.25 is exit load. SEBI regulations permit exit load
upto 7% of NAV.
Offer Document
1. AMC prepares the Offer Document for the NFO. This needs to be approved by the trustees and the Board
of Directors of the AMC.
2. The observations that SEBI makes on the Offer Document need to be incorporated. After approval by
the trustees, the Offer Document can be issued in the market.
3. Three dates are relevant for the NFO of an open-ended scheme:
i. NFO Open Date - This is the date from which investors can invest in the NFO
ii. NFO Close Date - This is the date upto which investors can invest in the NFO
iii. Scheme Re-Opening Date - This is the date from which the investors can offer their units for re-
purchase to the scheme (at the re-purchase price); or buy new units of the scheme (at the sale
price).
4. Information like the nature of the scheme, its investment objectives and term, are the core of the
scheme. Such vital aspects of the scheme are referred to as its fundamental attributes.
5. Investment in mutual funds is governed by the principle of caveat emptor i.e. let the buyer beware.
6. Mutual Fund Offer Documents have two parts:
i. Scheme Information Document (SID), which has details of the scheme, like.
a. Investment Objective defines the broad investment charter.
b. The investment policy gets into details of how the portfolio is proposed to be distributed
between different types of assets (also called asset allocation).
c. Investment strategy is decided regularly by the top management of the AMC based on
developments in the economy and market
ii. Statement of Additional Information (SAI), which has statutory information about the mutual
fund that is offering the scheme.
[In practice, SID and SAI are two separate documents, though the legal technicality is that SAI is part of
the SID].
A single SAI is relevant for all the schemes offered by a mutual fund
A single SAI is relevant for all the schemes offered by a mutual fund
7. Key Information Memorandum (KIM) is essentially a summary of the SID and SAI. It is more easily and
widely distributed in the market,
8. The Offer Documents in the market are “vetted” by SEBI, though SEBI does not formally “approve” them
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Problems on return computation
Calculation of NAV
Quantitative Indicators
Sharpe Ratio:
The Sharpe Ratio is a measure for calculating risk-adjusted return, Itis the average return earned in excess of
the risk-free rate per unit of volatility or total risk.
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Beta Ratio (Portfolio Beta):
Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as
a whole.
Macaulay Duration:
The Macaulay duration is the weighted average term to maturity of the cash flows from a bond. The weight of
each cash flow is determined by dividing the present value of the cash flow by the price.
Modified Duration:
Modified Duration is the price sensitivity and the percentage change in price for a unit change in yield.
Standard Deviation:
Standard deviation is a measure of the dispersion of a set of data from its mean. The more spread apart the
data, the higher the deviation. It is applied to the annual rate of return of an investment to measure the
investment's volatility.
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Multiple Choice Questions
1. NAV of growth option of a scheme went up from Rs 10 to Rs 12. Simple return on the scheme is
a. 2%
b. 20%
c. 1.2%
d. 12%
10. A greater portion of returns from equity asset class is generally through
a. Capital gain
b. Interest income
c. Dividend income
d. Inflation
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11. A greater portion of returns from conventional debt investments is generally through
a. Capital gain
b. Interest income
c. Dividend income
d. Inflation
14. Gilt funds invest in only treasury bills and government securities, which do not have a _______________
a. Credit risk
b. Market risk
c. Interest risk
d. Purchase power risk
18. A scheme has 50 cr units issued with a face value of Rs. 10. Its NAV is Rs. 12.36. Its AUM in Rs. Cr is _______________. Given
that the Entry Load is 2%
a. 500
b. 618
c. 630.36
d. Insufficient Information
19. A group of securities, usually a market index, whose performance is used as a standard is called as a ____
a. Benchmark
b. Beta
c. Standard deviation
d. None of the above
20. A debt fund that aims to generate ___________________ by investing in a range of debt and money market instruments of
various maturities
a. Dividend
b. Income
c. Capital appreciation
d. None of the above
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ANSWER KEY
1 2 3 4 5 6 7 8 9 10
b c a d a a c d b a
11 12 13 14 15 16 17 18 19 20
b c b a c c a a a b
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