Understanding Mutual Funds: Entities, Schemes, and Regulations

1. Chapter 3 MUTUAL FUNDS Indirect Investing

2. OUTLINE • Entities in a Mutual Fund Operation • Equity Schemes • Hybrid Schemes • Debt Schemes • Open-ended Schemes versus Closed-ended Schemes • Regulation of the Investments of a Mutual Fund • Key Financial Numbers • Rating of Mutual Fund Schemes • Costs of Investing in a Mutual Fund • Options and Value-added Services • Pros, Cons, and the Choice

3. ENTITIES IN A MUTUAL FUND OPERATION A mutual fund represents a vehicle for collective investment. In India, the following entities are involved in a mutual fund operation. Sponsor The sponsor of a mutual fund is like the promoter of a company. Mutual Fund The mutual fund is typically constituted as a trust under the Indian Trust Act. Trustees Trustees are the internal regulators of the mutual fund entrusted with the job of protecting the interest of unitholders. Appointed by the sponsor, the trustees are typically a corporate body (a trustee company)

4. ENTITIES IN A MUTUAL FUND OPERATION Asset Management Company (AMC) The AMC, referred to also as the Investment Manager, is a separate company appointed by the trustees to run the mutual fund. The AMC is compensated in the form of investment management and advisory fees. Custodian The custodian handles the investment back office operation of a mutual fund. Registrars and Transfer Agents The registrars and transfer agents handle investor-related services.

5. INVESTMENT-ORIENTATION OF MUTUAL FUND SCHEMES Mutual funds invest in three broad categories of financial assets: Stocks : Equity and equity-related schemes Bonds : Debt instruments that have a maturity of more than one year Cash : Debt-instruments that have a maturity of less than one year and bank deposits

6. EQUITY SCHEMES • Equity schemes (all called growth schemes) invest the bulk of their corpus (85–95 percent) in equity shares or equity-related instruments and the balance in cash: Equity schemes may be classified into the following sub-types: • Diversified Equity Schemes • Index Schemes • Sectoral Schemes • Mid-cap Schemes • Tax Planning Schemes

7. HYBRID SCHEMES • Hybrid schemes, also referred to as balanced schemes, invest in a mix of equity and debt instruments. Hybrid schemes may be classified into the following sub-types • Equity-oriented Schemes • Debt-oriented Schemes • Variable Asset Allocation Schemes

8. DEBT SCHEMES • Debt schemes also called income schemes invest in debt instruments viz., bonds and cash. They may be divided into the following sub-categories. • Gilt Schemes • Mixed Debt Schemes • Floating Rate Debt Schemes • Cash Schemes

9. OPEN-ENDED SCHEMES VS. CLOSED-ENDED SCHEMES • The subscription to a closed-ended scheme is kept open only for a limited period whereas an open-ended scheme accepts offers units on a continuing basis. • A closed-ended scheme does not allow investors to withdraw funds as and when they like, whereas an open-ended schemes permits withdrawal on a continuing basis. • A closed-ended scheme has a fixed maturity period whereas an open-ended scheme has no maturity period. • Closed-ended schemes are listed on the secondary market whereas open-ended schemes are ordinarily not listed.

10. REGULATION OF THE INVESTMENTS OF A MUTUAL FUND • The investments of a mutual fund are subject to a set of regulations prescribed by SEBI. The important ones are • A mutual fund, under all its schemes taken together, will not own more than 10 percent of any company’s paid up capital carrying voting rights. • A scheme shall not invest more than 15 percent of its NAV in debt instruments issued by a single issuer which are rated not below investment grade by an authorised credit rating agency. • Barring certain exceptions, a scheme shall not invest more than 10 percent of its NAV in the equity shares or equity related instruments of any one company. • A scheme shall not invest more than 5 percent of its NAV in unlisted equity shares or equity related instruments in case of an open ended scheme and 10 percent of its NAV in case of a close ended scheme. • Mutual funds shall mark all investments to market.

11. KEY FINANCIAL NUMBERS Asset Mix Allocation of the corpus of a scheme across three broad asset categories viz., stocks, bonds, and cash. Example : 60 : 30 : 10 Net Asset Value (NAV) The actual value of a share / unit on any business day. Market value of the fund’s investments + Receivables + Accrued income – Liabilities – Accrued expenses NAV = Number of shares or units outstanding Repurchase and Reissue Price The repurchase and reissue price of an open-ended scheme are closely linked to its NAV Discount Closed-ended schemes typically trade at a discount over their NAV

12. KEY FINANCIAL NUMBERS Rate of Return The periodic rate of return on a mutual fund scheme is: NAV at the end NAV at the beginning Dividend paid during of the period of the period the period NAV at the beginning of the period Ex-Mark The extent to which the return of a mutual fund is Explained by a particular financial Market. Beta Beta of a fund measures its price volatility relative to a particular Stock market index. Portfolio Turnover Ratio The churn in the portfolio: Lower of purchase or sales during a given period Portfolio turnover ratio = Average daily net assets Expense Ratio The annual recurring costs as a percentage of the net assets of the scheme – +

13. COSTS OF INVESTING • There are four costs associated with mutual fund investing: • Initial Issue Expenses • Entry Load • Exit Load • Annual Recurring Expenses

14. RATING OF MUTUAL FUND SCHEMES CRISIL CRISIL ranks schemes in five categories, viz., Equity Schemes, Debt Schemes, Gilt Schemes, Balanced Schemes, and Liquid Schemes. The ranking is based on four criteria, viz., risk-adjusted return of the scheme’s NAV, diversification of the portfolio, liquidity, and asset size. Value Research India Value Research India rates schemes in different categories. Each scheme is assigned a risk grade and a return grade and a composite measure of performance is calculated by subtracting the risk grade from the return grade. Economic Times Lipper The Economic Times, powered by Lipper, evaluates mutual fund schemes using a return-risk ratio defined as average return divided by standard deviation of return.

15. OPTIONS • With respect to a number of schemes, mutual funds offer the following: • Dividend and Growth Options • Systematic Investment Plan • Systematic Withdrawal Plan VALUE-ADDED SERVICES • Redemption Over Phone • Triggers and Alerts • Cheque Book Facility • New Points of Purchase

16. PROS & CONS • Pros • Diversification • Professional Management • Liquidity • Assured Allotment • Small Investment • Tax Advantages • Transparency Cons • Cost • Lack of Thrill

17. CHOICE • Invest on your own if you: • Have fairly strong speculative instincts • Find the game of investing enjoyable • Have the time to manage your investments • Can earn superior returns Invest through a mutual fund if you: • Have a small amount to invest • Hold fewer than five stocks • Think that you need better advice on investing • Have difficulty in deciding when to sell • Find the paperwork relating to investments cumbersome.

18. SUMMING UP • A mutual fund represents a vehicle for collective investment. • In India, the following entities are involved in a mutual fund operation the sponsor, the mutual fund, the trustees, the AMC, the custodian, and the registrars and transfer agents. • A mutual fund scheme may be a close-ended or an open-ended scheme. • Mutual funds invest in three broad categories of financial assets: stocks, bonds, and cash. • Depending on the asset mix, mutual fund schemes are classified into three broad categories : equity schemes, hybrid schemes, and debt schemes. • The investments of a mutual fund are subject to certain regulations.

19. The key financial numbers of mutual fund scheme are : asset mix, net asset value, repurchase price, reissue price, rate of return, standard deviation, Ex-Mark, beta, gross yield, portfolio turnover ratio, and expense ratio. • Mutual fund schemes are periodically evaluated by independent institutions. • There are visible and invisible costs associated with mutual fund investing. • Mutual funds offer various options and value-added services to attract and retain customers. • Mutual funds offer the advantages of diversification, professional management, liquidity, assured allotment, tax savings, and transparency.