Introduction & Mutual Fund Products
Ø Mutual
fund is a pool of money collected from investors and invested according to
stated investment objectives
Ø Mutual
fund investors are like shareholders and they own the fund.
Ø Mutual
fund investors are not lenders or deposit holders in a mutual fund.
Ø Everybody
else associated with a mutual fund is a service provider, who earns a fee.
Ø The
money in the mutual fund belongs to the investors and nobody else.
Ø Mutual
funds invest in marketable securities according to the investment objective.
Ø The
value of the investments can go up or down, changing the value of the investors
holding.
Ø NAV of a mutual
fund fluctuates with market price movements.
Ø The market value of the investor’s funds is also called as
net assets.
Ø Investors
hold a proportionate share of the fund in the mutual fund. New investors come in and old investors can
exit, at prices related to net asset value per unit.
Ø Advantages
of mutual funds to investors are :
o Portfolio
diversification
o Professional
management
o Reduction
in risk
o Reduction
in transaction cost.
o Liquidity
o Convenience
and flexibility
Ø Disadvantages
of mutual funds to investors are:
o No
control over cost.
o No
tailor-made portfolios.
o Managing
a portfolio of funds.
Ø UTI
was the only mutual fund during the period 1963 – 1987
Ø UTI
was the only fund for a long period and enjoyed monopoly status.
Ø UTI
is governed by the UTI Act. 1963.
Ø In
1987 banks, financial institutions and insurance companies in the public sector
were permitted to set up mutual funds.
Ø SEBI
got regulatory powers in 1992
Ø SBI
was the first bank sponsored mutual fund to be set up.
Ø The
first mutual fund product was Master share in 1986.
Ø The
private sector players were allowed to set up
mutual funds in 1993
Ø In
1996 the mutual fund regulations were substantially revised and modified
Ø In
1999 dividends from mutual funds were made tax exempt in the hands of
investors.
Ø In
the recent years, the growth in private sector funds has been at a higher rate.
UTI holds about 50% of the total assets and the rest of players, the balance
50%.
Ø Mutual
funds can be open ended or close ended.
Ø In
an open-ended fund, sale and repurchase of units happen on a continuous basis
at NAV related price, from the fund itself.
Ø The
corpus of open-ended funds therefore changes everyday.
Ø A
close-ended fund offers units for sale only in the IPO. It is then listed in
the market. Investors wanting to buy or
sell units have to do so in the stock markets.
Usually close indeed funds sell at a discount on NAV.
Ø The corpus of a close-ended fund remains unchanged.
Ø Mutual
funds are also of Load and No Load fund.
Ø Schemes
initial expense or sales expense are taken form the investor in terms of load.
Entry load, Deferred load & Exit load.
Ø Mutual
fund products can be broadly classified as equity, debt and money market
products.
Ø Equity funds
have the following categories:
o Index
funds which indicate an index
o Sectorial
funds which focus on a sector.
o ELSS schemes,
that have the following features:
§ 3
year lock in
§ Minimum
investment of 90% in equity markets at all times
§ Open
or close ended.
§ Rebate
of 20% under section 88 for investments up to Rs. 10000.
o Diversified
funds that invest in the broad markets.
Ø Debt
funds are of the following types :
o Diversified
debt funds which invest in the broad debt market.
o Gilt
funds that invest only in Government securities.
o Money
market fund or liquid funds which invest only in short term securities.
o Short
term funds which invest in debt of tenor higher than the money market funds.
o Fixed
term plans thus invest in securities and hold them to maturity, for a fixed
period.
Ø Equity
funds are risky, liquid funds have the lowest risk.
Ø Equity
funds are for the long term, liquid funds are for the short term.
Ø Investors
choose funds on their objective, risk appetite, time horizon and return
expectations.
Sponsor, Trustee, AMC and Other Constituents
Ø Mutual
funds in INDIA
have a 3-tier structure of Sponsor – Trustee – AMC.
Ø Sponsor is the
promoter of the fund.
Ø Sponsor
creates the AMC and the trustee company and appoints the Boards of both these
companies, with SEBI approval.
Ø A
mutual fund is constituted as a Trust
Ø A
trust deed is signed by trustees and registered under the Indian Trust Act.
Ø The
mutual fund is formed as trust in INDIA, and supervised by the Board
of Trustees.
Ø The
trustees appoint the asset management company (AMC) to actually manage the
investor’s money.
Ø The
AMC’s capital is contributed by the sponsor. The AMC is the business face of the mutual
fund.
Ø Investor’s
money is held in the Trust (the mutual fund). The AMC gets a fee for managing
the funds, according to the mandate of the investors.
Ø The
trustees make sure that the funds are managed according to the investor’s
mandate.
Ø Sponsor should
have at-least 5-year track record in the financial services business and should
have made profit in at-least 3 out of the 5 years.
Ø Sponsor
should contribute at-least 40% of the capital of the AMC.
Ø Trustees
are appointed by the sponsor with SEBI approval.
Ø At-least
2/3 of trustees should be independent.
Ø At-least
½ of the AMC’s Board should be independent members.
Ø An
AMC of one fund cannot be Trustee of another fund.
Ø AMC should have
a net worth of at least Rs. 10 crore at all times.
Ø AMC
should be registered with SEBI.
Ø AMC
signs an investment management agreement with the trustees.
Ø Trustee
company and AMC are usually private limited companies.
Ø Trustees
oversee the AMC and seek regular reports and information from them.
Ø Trustees
are required to meet at least 4 times a year to review the AMC.
Ø The investor’s
funds and the investments are held by the custodian.
Ø Sponsor and the
custodian cannot be the same entity.
Ø R&T
agents manage the sale and repurchase of units and keep the unit holder
accounts.
Ø If
the schemes of one fund are taken over by another fund, it is called as scheme
take over. This requires SEBI and trustee approval.
Ø If
two AMCs merge, the stakes of sponsor’s changes and the schemes of both funds
come together. High court, SEBI and Trustee approval needed.
Ø If
one AMC or sponsor buys out the entire stake of another sponsor in an AMC,
there is a take over of AMC. The sponsor, who has sold out, exits the AMC. This
needs high court approval as well as SEBI and Trustee approval.
Ø Investors
can choose to exit at NAV if they do not approve of the transfer. They have a
right to be informed. No approval is
required, in the case of open ended funds.
Ø For close ended
funds investor approvals is required for all cases of merger and take over.
Legal and Regulatory Framework
Ø Mutual
funds are regulated by the SEBI (Mutual Fund) Regulations, 1996.
Ø SEBI is the regulator of all funds, except offshore funds.
Ø Bank
sponsored mutual funds are jointly regulated by SEBI and RBI permission.
Ø If
there is a bank sponsored fund, it cannot provide a guarantee without RBI
permission.
Ø RBI
regulates money and government securities markets, in which mutual funds
invest.
Ø Listed
mutual funds are subject to the listing regulations of stock exchanges.
Ø Since the AMC and
Trustee company are companies, they are regulated by the Department of
company affairs. They have to send
periodic reports to the ROC (Registrar of Companies) and the CLB (Company Law Board) is the appellate authority.
Ø Bank
sponsored mutual funds are jointly regulated by SEBI and RBI.
Ø Investors cannot sue the trust, as they
are the same as the trust and can’t sue themselves.
Ø UTI does not
have a separate sponsor and AMC.
Ø UTI
is governed by the UTI Act, 1963 and is voluntarily under SEBI Regulations.
Ø UTI
can borrow as well as lend and also engage in other financial services
activities.
Ø SROs
are the second tier in the regulatory structure.
Ø SROs
get their powers from the apex regulating agency and act on their instructions.
Ø SROs
cannot do any legislation on their own.
Ø All
stock exchanges are SROs
Ø AMFI is an industry association of mutual funds.
Ø AMFI
is not yet a SEBI registered SRO.
Ø AMFI
has created code of conduct for mutual funds.
Ø AMFI
aims at increasing investor awareness about mutual funds, encouraging best
practices and bringing about high standards of professional behaviour in the
industry.
Offer Document and Key Information Memorandum
Ø Offer
Document (OD) is the most important source of information for investors.
Ø Abridged version
is called as Key Information Memorandum (KIM).
Ø Investors
are required to read and understand the offer document.
Ø No
recourse is available to investors for not reading the OD or KIM.
Ø A
glossary of important terms is included in the offer document.
Ø The
cover page contains the details of the scheme being offered and the names of
sponsor, trustee and AMC.
Ø Mandatory
disclaimer clause of SEBI should also be on the cover page.
Ø OD
is issued by the AMC on behalf of the trustees.
Ø KIM
has to be compulsorily made available along with the application from.
Ø Close
ended funds issue an offer document at the time of the IPO.
Ø Open
ended funds have to update OD at least once in 2 years.
Ø Any
change in scheme attributes calls for updating the OD.
Ø Addendums
for financial data should be submitted to SEBI and made available to investors.
Ø Trustees
approve the contents of the OD and KIM.
Ø The
format and content of the OD has to be as per SEBI Guidelines.
Ø The
AMC prepares the OD and is responsible for the information contained in the OD.
Ø Compliance
Officer has to sign the due diligence certificate. He is usually an AMC
employee.
Ø The
due diligence certificate states that
o Information
in the OD is according to SEBI formats.
o Information
is verified and is true and fair representation of facts.
o All
constituents of the fund are SEBI registered.
Ø SEBI
does not approve or certify the contents of the OD.
Ø OD
has to be submitted to SEBI prior to the launch of the scheme.
Ø The
OD contains
o Preliminary
information on the fund and scheme.
o Information
on fund structure and constitution.
o Fundamental
attributes of the scheme.
o Details
of the offer.
o Fee
structure and expenses.
o Investor
rights.
o Information
on income and expenses of existing schemes.
Ø Risk
factors, both standard and scheme – specific, have to be disclosed.
Ø Factors common to all funds are called as
standard risk factors. These include
market risk, no assurance of return, etc.,
Ø Factors
specific to a scheme are scheme-specific, risk factors in the OD. These include
restrictions on liquidity such as lock-in-period, risks of investing in the
first scheme of a fund, etc.,
Ø Fundamental
attributes of a scheme include:
o Scheme
type
o Objectives
o Investment
pattern
o Fees
and expenses
o Liquidity
conditions
o Accounting
and valuation
o Investment
restrictions, if any.
Ø For
any change in fundamental attributes, investor approval is not needed. Trustees and SEBI should approve the change
and investors should be informed.
Ø A
scheme cannot make any guarantee of return, without stating the name of the
guarantor, and disclosing the net worth of the guarantor.
Ø Information
on existing schemes and financial summary of existing schemes to be given for 3
years
Ø Information
on transaction with associate companies to be provided for the past 3 years.
Ø If
any expense incurred is higher than what was stated in the OD, for past
schemes, explanations should be given.
Ø There
is no information on other mutual funds, their product or performance in the
OD.
Ø Investor’s
rights are stated in the OD.
Ø The
borrowing restrictions on the mutual fund should be disclosed. This includes
the purposes and the limits on borrowing.
Ø Investors
have the right to inspect a number of documents. These are:
o Trust
deed.
o Investment
management agreement.
o SEBI
(MF) Regulations.
o AMC
Annual Reports.
o Unabridged
Offer Document.
o Annual
reports of existing schemes.
Ø 3
years track record of investor’s complaints and redressal should be disclosed
in the OD.
Ø Any
pending cases or penalties against sponsors or AMC should be disclosed in the
OD.
Processes, Rights and Obligations for investors.
Ø Categories
of investors eligible to apply are stated in the OD.
Ø Whether
a certain class of investor, such as a trust or a company can invest in a fund,
depends on the list of eligible investors in the OD.
Ø NRI’s and OCB’s
are eligible to invest in
mutual funds.
Ø Foreign nationals
and entities cannot invest in
mutual funds.
Ø Any investor who becomes a foreign
citizen after investing in a fund has to compulsorily redeem the units after
obtaining foreign citizenship.
Ø Prospective
investors have no legal remedies.
Ø Mutual
funds use multiple channels to distribute the units.
Ø Institutional
distributors have a dominant market share in the Indian industry.
Ø Agents
can sell products of multiple mutual funds.
Ø Banks
are large distributors in developed countries.
Ø Distribution
channels are appointed by the AMC.
Ø Fees
and commissions are decided by the AMC and not subject to any regulation.
Ø AMFI
has a recommended code of conduct and best practices for agents.
Ø Agents
are paid up front and trail commissions. Trail depends on holding period of
investors.
Ø A
transaction is complete only after a fund has confirmed it.
Ø Investor
rights are as listed in the offer document.
Ø Investors have the
right to receive redemption proceeds within 10 days.
Ø Investors
have the right to sue the AMC, Trustees or Sponsor.
Ø Investors
cannot sue the Trust as they are the trust and can’t sue themselves.
Ø An
open ended fund opens for sale and repurchase within 30 days from the date of
closure of the IPO.
Ø Investors
can redeem units at the prevailing NAV, up to 3 years from the due date.
Ø Investors
do not have any remedy for performance of the fund being below the investor’s
expectations.
Ø If
investors representing 75% of the unit capital approve, the AMC’s services can
be terminated, or the scheme can be wound up.
Ø The
first right of the investor is towards the trustees.
Ø AMFI
code of ethics provides guidelines for sales practices and is a set of
recommendations (SEBI has notified these are Regulations in June 2002, but the
exam is based on the position as of January 2002).
Ø SEBI code for
advertising is mandatory for mutual funds.
TAX Aspects
Ø The
tax provisions are as on the date of Curriculum, which is January 2002. The changes in the tax provisions made in the
budget of 2002-03 are not incorporated in the curriculum.
Ø Taxation
provisions applicable to investors are stated and explained in the offer
document and the KIM.
Ø Dividends
are exempt from tax in the hands of the investor.
Ø Mutual
funds pay a distribution tax of 10% + Surcharge (2%) effective 10.2 before
paying out the dividend.
Ø Open
ended equity funds with more than 50% invested in equity do not pay any
dividend distribution tax.
Ø Investments
in ELSS schemes of mutual funds, up to a maximum of Rs. 10,000/- provides the
investor a rebate under section 88 (up to a maximum of Rs. 2000).
Ø Mutual
funds themselves pay no tax on the incomes they earn. They are fully exempt
from tax.
Ø Capital
gains or losses arise when investors buy and sell units. The difference between
the sale and purchase price is the gain (sale price > purchase price) or
loss (sale price < purchase price).
Ø If
an investor holds units for 12 months or less, any gain from selling the units
is called as short term capital gain.
Ø Short
term capital gains are taxable at the marginal rate of taxation of the
investor.
Ø If
an investor’s holding period is more than 12 months, any gain or loss from sale
is called as long term capital gain.
Ø Long
term capital gain can be indexed from inflation.
Ø Indexing
refers to updating of the purchase price, based on the cost of inflation index
published by the CBDT.
Ø The
formula for indexation is purchase price X index in the year of sale/ index in
the year of purchase.
Ø Investors
can pay either 10% tax (plus surcharge) on the capital gain tax without
indexation or 20% (plus surcharge) on capital gains after indexation, which
ever is lower.
NAV and Load’s
Ø Load
is charged to the investor when the investor buys or redeems (repurchases
units)
Ø Load
is an adjustment to the NAV, to arrive at the price.
Ø Load that is
charged on sale of units is called as entry load.
Ø An
entry load will increase the price above the NAV, for the investor.
Ø Load
that is charged when the investor redeems his units is called as exit load.
Ø Exit
load reduces the redemption proceeds of the investor.
Ø Load
is primarily used to meet the expenses related to sale and distribution of
units.
Ø An exit load that varies with the holding period of an
investor is called as CDSC (Contingent Deferred Sales Charge).
Ø To
arrive at the sale price, given NAV and load (%). We have to calculate the
amount of load and add it to the NAV. The amount of load will be = NAV x entry
load/100.
Ø To
arrive at the sale price, given NAV and load (%), we have to calculate the
amount of load and reduce it from the NAV. The amount of load will be = NAV x
exit load/100.
Ø Load
is subject to SEBI regulations.
Ø SEBI has
stipulated that the maximum entry of exit load cannot be higher than 7%.
Ø SEBI also
stipulates that the repurchase price cannot be less than 93% of the sale price.
o Maximum
sale price given repurchase price is = NAV / (1 – Load)
o Minimum
repurchase price, given sale price is = NAV X (1 – Load)
Ø For closed end
funds, the maximum entry of exit load cannot be higher than 5%. The repurchase
price cannot be less than 95% of the sale price.
Investment Management, Equity Markets and Mutual Funds
Ø The
investment pattern of the fund is primarily dictated by the fund objectives.
Ø The
fund states in the offer document, the broad asset allocation. The fund manager has to adhere to this
allocation, except under extra ordinary circumstances.
Ø Investment style refers to the manner in
which a fund manager will choose securities in a given sector.
Ø A
fund manager whose style is value investing, will prefer to invest in
established profit making companies, and will buy only if the price is
right. He will look for undervalued
shares, which have a value proposition that is yet to be recognized by the
market.
Ø A
fund manager, whose style is growth, is more aggressive and is willing to
invest in companies with future profit potential. He is willing to buy even if the stock looks
expensive. He focuses on sectors that are expected to do well in future, and
will be willing to buy them even at higher prices.
Ø Equity stocks can be classified as large cap
and small cap stocks.
Ø Large cap stocks are liquid and trade every day. They are established companies offering
normal profit potential.
Ø Small cap stocks provide higher return potential. But they are generally not very liquid.
Ø Cyclical stocks
are those whose performance is closely linked to macro economic factors.
Ø P/E
ratio is the ratio of Earnings per share to market price per share. Growth
shares sell at higher P/E ratios than value shares.
Ø Dividend
yield is the ratio between the dividend per share and market price per
share. Growth shares have lower dividend
yields than value shares.
Ø If
the market prices move down, P/E ratios are lower and dividend yields are
lower.
Ø If
the market prices move down, P/E ratios are lower and dividends yields are
higher.
Ø An
equity fund manager can invest in equity, equity warrants, and preference
shares and in convertible securities.
Ø An
equity warrant gives the investor the right to buy equity shares at specific
prices.
Ø An
active fund manager hope to do better than the market by selecting companies,
which he believes, will out perform the market.
Ø A
passive fund manager simply replicates the index, and hopes to do as well as
the index.
Ø A
passive fund manager tries to keep costs down and has to rebalance his
portfolio if the composition of the index changes.
Ø Beta is a measure of the sensitivity of
the portfolio to the market. A passive fund has a beta of 1. An active fund’s beta is higher or lower than
1.
Ø If
Beta is more than 1, the fund is called an aggressive fund.
Ø If
Beta is less than 1, the fund is called a defensive fund.
Ø Fundamental analysis is the analysis of the
profit potential of a company, based on the numbers relating to products,
sales, costs, profits etc., and the management of a company.
Ø Technical analysis is an analysis of market
price and volumes, to identify clues to the market assessment of a stock.
Ø Quantitative analysis is the analysis of
sectors and industries based on macro economic variables.
Ø A
fund manager focuses on asset allocation; a dealer buys and sells shares; and
an analyst researches companies and recommends them for buy and sell.
Ø Equity
derivatives refer to products whose prices depend on prices of equity shares.
Ø We
have index futures and index options as well as equity stock futures and
options in the Indian markets.
Ø In the derivative markets, the settlement
is in cash, and there is no delivery of underlying stocks.
Debt Markets and Mutual Funds
Ø Debt
instruments can be classified as follows:
o Instruments
issued by the government such as treasury bonds, and treasury bills, and
instruments issued by other agencies like the corporate sector and financial
institutions.
o Long
term instruments like bonds and debentures and short term instruments like
commercial paper, certificates of deposit etc., Instruments with less than 1
year’s term to maturity are also called as money market instruments.
o Instruments
that are secured, as in the case of secured corporate debentures and
instruments that are unsecured such as bonds of financial institutions or
company fixed deposits.
o Instruments
that pay a periodic interest (coupon) and instruments those are issued on
discounted basis, and mature at face value (zero coupon or deep discount
bonds).
o Instruments
that pay a fixed rate of interest; instruments that pay a floating rate of
interest.
Ø Debt
markets are wholesale markets in which large institutional investors
operate. Banks are the largest players
in debt markets.
Ø The wholesale debt market (WDM0 segment of
the NSE is a nationwide platform for trading in debt market securities.
Ø About
96% of secondary market trading happens in Government securities.
Ø CD’s are usually issued by banks
and have a maturity of 91 days to a year.
Ø CP’s are unsecured instruments issued by
corporate. Their maturity ranges
from 3 months to 1 year.
Ø Corporate
debentures are long term instruments issued by corporate. They are usually secured and listed on stock
exchanges.
Ø Government
securities are issued through an auction, by the RBI, on behalf of the
government of India.
Ø Government
securities are held in the form of book entries in the Securities General
Ledger (SGL), maintained by the Public Debt Office (PDO) of the RBI.
Ø Treasury bills are short term instruments with maturity
of 91 days or 364 days, issued by the RBI.
Ø Basic
characteristics of bonds are as follows:
o Principal
value, per value, or face value is the amount representing the principal
borrowed and the rate of interest is calculated on the sum. On redemption this amount is payable.
o Coupon
is the interest paid periodically to the investor.
o Maturity
date is the date on which a bond is redeemed.
Term to maturity or tenor is the period remaining for the bond to
mature.
o Put
option refers to the option to the investor to redeem the bond before
maturity. Call option is the option to
the borrower to redeem before maturity.
If interest rates go up, investors may exercise the put option. If interest rates fall, issuers may exercise
the call option.
Ø Current
yield is the ratio of coupon amount to market price of a bond. If a bond paying coupon at 8% is selling in
the market for Rs. 105, the current yield is 8/105 = 7.62%.
Ø Changes
in interest rates impacts bond values, in the opposite direction. An increase in interest rates leads to a fall
in bond values; a decrease in interest rates leads to an increase in bond
values.
Ø Interest
rates are affected by inflation rates, exchange rate situation, and the
policies of the RBI.
Ø Duration
of a bond helps measure the interest rate risk of a bond. If duration is 3, and interest rate changes
by 1%, the value of the bond will change by 3% (duration times the change in
interest rate) in the opposite direction.
Ø Credit
risk refers to the risk of default.
Ø Credit
ratings are important indicators of credit risk of a bond. Credit risk refers
to the risk of default in the payment of interest and/or principal amount.
Ø The
base rate or benchmark rate in the bond market is the rate at which the
government borrows in the market. All
other borrowers pay a rate that is higher, due to presence of credit risk.
Ø The difference
between the benchmark rate and the rate that is paid by other borrowers is
called the credit spread. (Called as yield spread in the AMFI book).
Ø Interest
rate swap is an interest rate derivative product, used in the debt markets to
hedge interest rate risk.
Restrictions and Investment
Ø Investment
pattern of a scheme is driven by the objectives, as stated in the offer
document.
Ø SEBI
(MF) Regulations place a number of restrictions on the investments of a mutual
fund.
Ø Mutual
fund can invest only in marketable securities.
Ø All
investments by the mutual fund have to be on delivery basis, that is, a mutual
fund has to pay for each buy transaction, and deliver securities for every sell
transaction. A mutual fund cannot enter
into trades with the view to squaring off the positions.
Ø A mutual fund
under all its schemes cannot hold more than 10% of the paid up capital of a
company.
Ø Except in the case of sectorial funds and index funds, a
mutual fund scheme cannot invest more than 10% of its NAV in a single company.
Ø Investments in
rated investment grade issues of a single issuer cannot and can be extended to
20% with the approval of the trustees. exceed 15% of the net assets
Ø Investment in unrated securities cannot exceed 10% of the net
assets for one issue and 25% of net assets for all such issues.
Ø Investment in unlisted shares cannot exceed 5% of net
assets for an open ended scheme, and 10% of net assets for a closed end scheme.
Ø Mutual funds can invest in ADRs/GDRs up to a maximum limit
or 10% of net assets or $50 million, whichever is lower. The limit for the
mutual fund industry as a whole is $500 million.
Ø Inter
scheme transfers are allowed by the SEBI regulations, provided:
o Such
transfers happen on a delivery basis, at market prices.
o Such
transfers do not result in significantly altering the investment objectives of
the schemes involved.
o Such
transfer is not of illiquid securities, as defined in the valuation norms.
Ø The
funds of one mutual fund scheme can be invested in another mutual fund scheme
of the same mutual fund, or any other mutual fund.
Ø Such investment cannot exceed 5% of the net
assets of the scheme that invests its funds in another scheme. Investment management fees are not paid on
such investments.
Ø A
mutual fund can borrow a sum not exceeding 20% of its net assets for a period
not exceeding 6 months. This facility is
clearly designed as a stopgap arrangement, and is not a permanent source of
funds for the scheme.
Ø A
fund can borrow only to meet liquidity requirements for paying dividend or
meeting redemptions.
Ø All
investment made in the marketable securities of the sponsor and its associated
companies must be disclosed by the mutual fund in its annual report and offer
document, along with the amount invested and the share of such investment in
the total portfolio of the mutual fund.
Ø A
mutual fund scheme cannot invest in unlisted securities of the sponsor or an
associate or group company of the sponsor.
Ø A
mutual fund scheme cannot invest in privately placed securities of the sponsor
or its associates:
Ø Investment
by a scheme in listed securities of the sponsor or associate companies cannot
exceed 25% of the net assets of the scheme.
Accounting and Valuation
Ø Accounting
policies to be followed by mutual funds are laid down in the SEBI (Mutual Fund)
regulations, 1996.
Ø Mutual
funds are pools of investments held by investors with common investment
objective. Therefore there is a separate
account for every mutual fund scheme.
Ø Investor’s
subscriptions to the mutual fund are accounted as unit
capital, and not as liabilities or deposits.
Ø Assets
of a mutual fund are investments made by the fund.
Ø Liabilities
of a mutual fund are strictly short term in nature.
Ø The
unit capital account is maintained at face value.
Ø Other
short term assets in the fund balance sheet are called as current assets.
Ø Net
assets, in simple terms, refer to market value of investments less current
liabilities.
Ø Net
assets are computed as:
o Market
value of investments
o Plus
other assets
o Plus
accrued income
o Less
current liabilities
o Less
accrued expenses
Ø Accrued
income refers to income that is due and not yet received such as interest
payments that are accrued on everyday basis, but paid only at the end of 6
months.
Ø Accrued
expenses refer to expenses due but not paid, such as investment management
fees, which are accrued everyday, but paid at the end of the year.
Ø NAV
is the net assets per unit, computed as Net asset dividend by number of units
outstanding.
Ø Given
number of units and NAV, net assets can be computed. Similarly, given net
assets and number of units NAV can be computed.
Ø The
day on which NAV is calculated is called as the valuation date.
Ø The
major factors affecting the NAV of a fund are:
o Sale and purchase of
securities.
o Sale and repurchase of
units
o Valuation
of assets
o Accrual
of income and expenses.
Ø All
mutual funds have to disclose there NAV everyday, by posting it on the AMFI web
site by 8:00 p.m.
Ø Open
ended funds have to compute and disclose NAV’s everyday.
Ø Closed
end funds can compute NAV’s every week, but disclosures have to be made
everyday.
Ø Closed
end schemes not mandatorily listed on stock exchanges can publish NAV according
to the periodicity of 1 month, as permitted by SEBI. UTI’s monthly income
schemes fall under this category.
Ø Changes
in NAV due to the assumptions about accruals should not impact NAV by more than
1%.
Ø Changes
in NAV attributable to non recording of sale and repurchase of units or
securities cannot be more than 2% and that these transactions should be
recorded within 7 days.
Ø Initial issue expenses of a
scheme cannot exceed 6% of funds
mobilized. Any amounts above
this have to be borne by sponsors or AMC.
Ø A
fund that does not charge any of the initial issue expenses is called a no load
fund. AMC’s can charge 1% higher
investment management fee in this case.
Ø For
a closed end fund, initial issue expenses are charged over the life of the
scheme, on a weekly basis.
Ø For
an open ended scheme, the initial issue expenses are carried in the balance
sheet of the fund as “deferred revenue expenses”. They are written off over a period not exceeding
5 years.
Ø The
mutual fund can charge the following expenses:’
o Investment
management fees to the AMC.
o Custodian’s
fees.
o Trustee
fees.
o Registrar
and transfer agent fees.
o Marketing
and distribution expenses.
o Operating
expenses.
o Audit
fees.
o Legal
expenses.
o Costs
of mandatory advertisements and communications to investors.
Ø The
maximum limit on the expenses that can be charged to a mutual fund are :
o For
net assets up to Rs. 100 crore : 2.5%
o For
the next Rs. 300 crore of net assets: 2.25%
o For
the next Rs. 300 crore of net assets: 2%
o For
the remaining net assets: 1.75%
Ø These
regulatory ceilings are applied on the weekly average net assets of the mutual
fund scheme.
Ø On
debt funds the limits on expenses are lower by 0.25%.
Ø The
investment management fees are regulated by SEBI as follows:
o For
the first Rs. 100 crore of net assets : 1.25%
o For
net assets exceeding Rs. 100 crore: 1.00%.
Ø An
asset shall be classified as an NPA, if the interest and/or principal amount
have not been received or have remaining outstanding for one quarter; from the
day such income / installment has fallen due.
Ø Valuation
of equity shares is done on the basis of traded price; provide the price is not
more than 30 days old.
Ø If
a share is not traded for 30 days of is thinly traded (less than 50,000 shares
and Rs. 5 lakh volume in a month). SEBI approved valuation norms have to be
applied.
Ø Debt
securities with less than 182 days to maturity are valued on accrual basis.
Ø Debt
securities which have more than 182 days tenor :
o Debt
with investment grade rating, are valued using YTM derived from the CRISIL
valuation matrix.
o Debt
with speculative grade (non investment grade rating less than BBB) rating, but
are not NPA’s are valued at 25% discount to face value.
o Debt
classified as NPA are written down as per valuation norms for NPA’s.
Ø Illiquid
securities cannot be more than 15% of the portfolio’s net assets. Any illiquid assets above this limit have to
be valued at Zero.
Risk, Return and Performance
Ø The
major sources of return to an investor are dividend and capital gain.
Ø Holding
period is the period for which an investor stays invested in a fund.
Ø Rate
of return is computed as: (income earned / Amount invested0 * 100.
Ø This
number can be annualized by multiplying the result by the factor 12/n, where n is
the number of months in the holding period.
If the holding period is in days, the above factor will be 365/n is the
number of days in the holding period.
Ø Change
in NAV method of calculating return is applicable to growth funds and funds
with no income distribution.
Ø Change
in NAV method computed return as follows:
o (NAV
at the end of the holding period – NAV at the beginning of the holding period)
/ NAV at the beginning of the period.
Ø Return
is then multiplied by 100 and annualized.
Ø Simple
total return method includes the dividends paid to the investor.
Ø Simple
total return method computes return as follows :
o (NAV
at the end of the holding period – NAV at the beginning of the holding period)
* dividends paid / NAV at the beginning of the period.
Ø Return
is then multiplied by 100 and annualized.
Ø The
total return with re-investment method or the ROI method is superior to all
these methods. It considers dividend and assumes that dividend is re-invested
at the exe dividend NAV.
o (Value
of holdings at the end of the period – value of holdings at the beginning of
the period) / value of holdings at the beginning of the period x 100.
o Value
of holdings at the beginning of the period = number of units at the beginning x
begin NAV.
o Value
of holdings end of the period = (number of units held at the beginning + number
of units re-invested) X end NAV.
o Number
of units re-invested = dividends / ex-dividend NAV.
Ø If
an investment has doubled over a period of time, we can use the rule of 72 to
find the approximate rate of return.
Ø Rule of 72 is
a thumb rule used in finding our doubling rate or doubling
period. If Rs. 100 grows to Rs. 200 in 7
years, the rate of return is 72/7 – 10.28 years. Similarly, if Rs. 100 grows to Rs. 200 at 8%,
the number of years in which this will happen is 72/8 = 9 years.
Ø If
there is an entry load, the investors return will be lower as amount actually
invested is less by the amount of load.
Ø SEBI
regulations on returns are as follows:
o Standard
measurements to be used for computation of return.
o Compounded
annual growth rate to be used for funds over 1 year old.
o Return
for 1, 3 and 5 years, or since inception, which ever is later is to be
provided.
o No
annualisation for periods less than a year.
Ø Expense
ratio is the ratio of total expenses to average net assets of the fund.
Ø Expense
ratio is an indicator of efficiency and very crucial in a bond fund.
Ø Expenses
do not include brokerage paid (this amount is capitalized) and therefore may be
understand.
Ø Income
ratio is the ratio of net investment income by net assets. This ratio is
important for fund earning regular income, such as bond funds, and not for
funds with growth objective, investing for capital appreciation.
Ø Portfolio
turnover rate refers to the ratio of amount of sales or purchase (which ever is
lesser) to the net assets of the fund.
Higher the turnover ratio greater is the amount of churning of assets
done by the fund manager.
Ø High
turnover ratio can also mean higher transaction cost. This ratio is relevant
for actively managed equity portfolios.
Ø Risk
arises when actual returns are different from expected returns.
Ø Historical
average is a good proxy for expected return.
Ø Standard
deviation is an important measure of total risk.
Ø Beta
co-efficient is a measure of market risk.
Ø Ex-marks
are an indication of extent of correlation with market index. Index funds have
ex-marks of 100%.
Ø Relative
returns are important than absolute returns for mutual funds.
Ø Comparable
passive portfolio is used as benchmark.
Ø Compare
both risk and return, over the same period for the fund and the benchmark.
Ø Risk
adjusted return is the return per unit of risk.
Ø Comparisons
are usually done.
o With
a market index.
o With
funds from the same peer group.
o With
other similar products in which investors invest their funds.
Ø SEBI
Guidelines on risk and return.
o Benchmark
should be reflecting the asset allocation.
o Bench
mark should be the same as stated in the offer document.
o Growth
fund with more than 60% in equity should use a broad based equity index.
o Bond
fund with more than 60% in bonds should use a bond market index.
o Balanced
funds should use tailor made index.
o Liquid
funds should use money market instruments.
Ø Other
measures of performance.
o Tracking
error should be predictable.
o Tracking
error for index funds should be very small.
o Rating
profile of portfolio should be studied.
o Higher
expense ratios hurt long term investors for debt funds expense ratio should be
under control.
o Portfolio
turnover should be higher for short term funds and lower for longer term funds.
Ø When
comparing fund performance with peer group funds _______ and composition of the
portfolios should be comparable.
Financial Planning Process
Ø Financial
planning comprises :
o Defining
a client’s profile and goals.
o Recommending
appropriate asset allocation.
o Monitoring
financial planning recommendations.
Ø The
objective of financial planning is to ensure that the right amount of money is
available at the right time to the investor to be able to meet his financial
goals.
Ø Tax
implications on investment income can affect the choice of products and the
financial plan.
Ø Financial
planning is more than mere tax planning.
Ø Financial
planning helps a mutual fund distributor to establish long term relationships
and build a profitable business.
Ø Steps
in financial planning are :
o Asset
Allocation.
o Selection
of fund.
o Studying
the features of a scheme.
Ø Financial
planning is concerned only with broad asset allocation, leaving the actual
selection of securities and their management to fund managers.
Ø A
fund manager has to closely follow the objectives stated in the offer document,
because financial plans of investors are chosen using these objectives.
Ø The
financial planner can only work with defined goals and cannot take up larger
objectives that are not well defined.
Ø The
client is responsible ultimately for realizing the goals of the financial plan.
Ø The
basis of genuine investment advice should be financial planning to suit the
investor’s situation.
Ø Risk
tolerance of an investor is not dependent on the market, but his own
situations.
Life Cycle and Wealth Cycle Stages
Ø The
life cycle stages of an investor can be classified as follows :
o Childhood
stage
o Young
unmarried stage
o Young
married with children stage
o Married
with older children stage
o Pre-retirement
stage
o Retirement
stage
Ø The
income level of investors, the saving potential, the time horizon and the risk
appetite of the investor depend on his life cycle.
Ø Younger
investors have higher income and saving potential, take longer term view and
may be willing to take risks.
Ø Older
investors may have limited income and saving, shorter time horizon, and
unwilling to risk their savings.
Ø There
are 3 wealth cycle stages for investors :
o Accumulation stage is when
investors are earnings and have limited need for investment income. They focus on saving and accumulating wealth
for the long term. Equity investments
are preferred in this stage.
o Transition stage is when
financial goals are approaching.
Investors still earn incomes, but have also draw on their earnings. Investors choose balanced portfolios that
have both debt and equity.
o Reaping stage or distribution stage
in when investors need the income from their investment, and cannot save
further. They reap the benefits of their
savings. They prefer debt investments
and preserving of capital at this stage.
Ø Inter
generational fund transfer refers to transfer of wealth to an investor. The preferred investment avenue will depend
on the life cycle and wealth cycle stage of the beneficiaries.
Ø Sudden
wealth surge refers to winnings in games and lotteries. Investors should be advised to temporarily
park their funds in money market investments and create a long term plan after
thinking through the plan.
Ø Affluent
investors are of two types :
o Wealth
preserving investors who are risk averse and like to invest in debt.
o Wealth
creating investors who prefer growth and are willing to take the risk of equity
investments.
Investment Products
Ø Key
features of all investment options should be remembered. Please note that the questions are based on
the date of the curriculum, which is December 2001. any changes in rates and other features after
that date are not included in the examination.
For example, rate on the RBI relief bond, for the exam, is 8.5% and not
8%.
Ø Physical
assets like gold & real estate are preferred by investors who like physical
ownership. These investments are not
liquid.
Ø Physical
assets are perceived to be a hedge against inflation.
Ø Real
estate investment requires high initial investments.
Ø Bank
deposits are preferred by large number of investors due to the perception of
bank deposits being safe and free of default.
Ø Features
of PPF
o 15
years deposit product made available through banks.
o 9%
p.a. interest payable on monthly balances.
o Minimum
Rs. 100 & maximum Rs. 60,000 p.a. investment allowed.
o Tax
benefits u/s 88 under IT Act.
o Interest
receipt and withdrawal of principal exempt for tax.
o Limited
liquidity available.
Ø Features
of RBI Relief Bonds.
o Issued
by banks on behalf of the RBI.
o Tenure
of five years.
o 8.5%
p.a. interest payable semi annually.
o Option
to receive or reinvest interest.
o Interest
income exempt from tax.
Ø Features
of other government schemes.
o Indira
Vikas Patra & KVP issued by central government & sold by post offices.
o Current
yield on IVP is 10.5% (according to the curriculum).
o Interest
is taxable.
o Investor
identity is protected and investment in cash is possible.
o Post
office savings and RD – gives fixed rate of interest but are not liquid.
§ These
are government guaranteed deposits.
§ Attractive
for their safety and cash investment options.
Ø Features
of instruments issued by companies.
o Commercial
Paper: Short Term (90days) unsecured instrument. Credit rated.
o Debentures:
secured fixed income instruments with credit rating.
o Equity
shares – liquidity through listing.
o Preference
shares – Fixed rate of dividend.
o Fixed
Deposits – Unsecured deposits with credit risk.
o Bonds
of FI – Unsecured fixed income securities issued by public financial
institutions.
Ø Features
of insurance policies.
o Investors
buy due to tax concessions, while they should buy for the insurance cover.
o With profit policy provides bonus along
with sum assured.
o Without profit policy only provides
insurance cover.
Ø Why
MF is the best option.
o Mutual
funds combine the advantages of each of the investment products.
o Dispense
the short comings of the other options.
o Returns
get adjusted for the market movements.
Investment Strategies.
Ø Investors
should choose to allow their investment to compound over the long run.
Ø This
can be achieved by choosing the growth or re-investment option of mutual
funds. Automatic reinvestment plans can
also be used.
Ø Buy
and hold strategy which is preferred by many investors, may not be beneficial
because investors may not weed out poor performing companies and invest in
better performing companies.
Ø Rupee
cost averaging (RCA) involves the following.
o A
fixed amount is invested at regular intervals.
o More
units are bought when price is low and fewer units are bought when price is
high.
o Over
a period of time, the average purchase price of the investor’s holdings will be
lower than if one tries to guess the market highs and lows.
Ø RCA
does not tell indicate when to sell or switch from one scheme to another. This is a disadvantage.
Ø Investors
use the systematic investment plan to implement RCA.
Ø Value
averaging involves the following:
o A
fixed amount is targeted as the desired value of the portfolio at regular
intervals.
o If
markets have moved up, the units are sold and the target value is restored.
o If
markets move down, additional units are bought at the lower prices.
o Over
a period of time, the average purchase price of the investor’s holdings will be
lower than if one tries to guess the market highs and lows.
Ø Value
averaging is superior to RCA, because it enables the investor to book profits
and rebalances the portfolio.
Ø Investors
can use the systematic withdrawal and automatic withdrawal plans to implement
value investing.
Ø Investors
can also use a money market fund and an equity fund to implement value
averaging.
Asset Allocation and Model Portfolios
Ø Asset
allocation is about allocating money between equity, debt and money market
segments.
Ø Asset
allocation varies from investor to another depending on their situation,
financial goals and risk appetite.
Ø A
model portfolio creates an ideal approach for the investor’s situation and is a
sensible way to invest.
Ø The
asset allocation for an investor will depend on his life cycle and wealth
cycle.
Ø Investors
can have two strategies :
o Fixed
asset allocation.
o Flexible
asset allocation.
Ø Fixed
asset allocation means.
o Maintaining
the same ratio between various components of the portfolio.
o Re-balancing
the portfolio in a disciplined manner.
Ø Fixed
allocation means periodical review and returning to the original
allocation. If equity is going up, such
investors would book profits. They are
disciplined.
Ø Flexible
allocation means allowing the portfolios profits to run, without blocking them.
Ø If
equity market appreciates, flexible asset allocation will result in hither
percentage in equity than in debt.
Ø Bogle
recommends that age, risk profile and preferences have to be combined in asset
allocation.
o Older
investors in distribution phase – 50% equity; 50% debt.
o Younger
investors in distribution phase – 60% equity; 40% debt.
o Older
investors in accumulation phase – 70% equity; 30% debt.
o Younger
investors in accumulation phase – 80% equity; 20% debt.
Ø Steps
in developing a model portfolio for the investors:
o Develop
long term goals.
o Determine
asset allocation
o Determine
sector distribution.
o Select
specific fund schemes for investment.
Ø Jacob’s
Model Portfolios.
o Accumulation
phase.
§ Diversified
equity: 65 – 80%
§ Income
and gilt funds: 15 – 30%
§ Liquid
funds: 5%
o Distribution
phase
§ Diversified
equity: 15 – 30%
§ Income
and gilt funds: 65 – 80%
§ Liquid
funds: 5%
Fund Selection
Ø Fund
selection refers to the actual choice of funds according to the chosen model
portfolio for the investor.
Ø Equity
funds : Characteristics:
o Fund
category – The fund chosen should be suitable to investor objective.
o Investment
style – Choose between growth and value depending on investor’s risk
perception.
o Age
of the fund – Experienced funds are preferred to new funds.
o Fund
management experience – Track record of the fund managers is important.
o Sizes
of the fund – Larger funds have lower costs.
o Performance
and risk – Risk adjusted performance matters.
Ø Equity
funds: Selection Criteria :
o Percentage
holding in cash should be low – Funds can always sell liquid stocks for
liquidity requirements.
o Concentration
in portfolio should be low – An equity fund should be well diversified.
o Market
capitalization of the fund – High capitalization means better liquidity.
o Portfolio
turnover – Higher turnover means more transactions and costs, but exploitation
of opportunities. Low turnover
represents patience and stable investments.
Ø Risk
Statistics.
o Beta
– Represents market risk, higher the beta higher the risk.
o Ex-Marks
– Represents correlation with markets – Higher the ex-marks, lower the
risk. A fund with higher ex-marks is
better diversified than a fund with lower ex-marks.
o Gross
dividend yield represents return. Funds
with higher gross dividend yield should be preferred.
o Funds
with low beta, high ex-marks and high gross dividend yield are preferable.
Ø Debt
Funds: Selection Criteria:
o A
smaller or new debt fund may not necessarily be risky.
o Total
return rather than yield to maturity (YTM) is important.
o Expenses
are very important, because high expense ratios lead to yield sacrifice.
o Credit
quality – Better the rating of the holdings, safer the funds.
o Average
maturity – Higher average maturity means higher duration and interest rate
risk. Funds with higher average maturity
are more risky than funds with lower average maturity.
Ø Money
Market Funds.
o Liquidity
and high turnover rate is high.
o Shorter
term instruments are turned over more frequently.
o Protection
of principal invested is important.
o NAV
fluctuation limited due to low duration and lack of interest rate risk.
o Credit
quality of portfolio should be high.
o Low
expense ratio is important.