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Products & Services    >   Mutual Funds   >   Knowledge Center

 INTRODUCTION

 FORMATION OF A MUTUAL FUND
    The Sponsor
    The Trustees
    The AMC
    Other Supporting Entities

 PROS OF MUTUAL FUND INVESTING
    Professional Management and Informed Decision Making
    Investment Flexibility
    Portfolio diversity
    Transparency and Safety
    Tax Benefits

 CONS OF MUTUAL FUND INVESTING
    Impact Cost
    Lead Time
    Marketing and Fund management costs
    Cost of churn

 TAX BENEFITS AND IMPLICATIONS OF INVESTING IN MUTUAL FUNDS

 EXPENSES

 TYPES OF MUTUAL FUNDS
    Mutual funds based on structure
       Open ended and close-ended schemes
       Load and No Load Funds
       Cumulative or growth schemes, dividend reinvestment schemes and dividend payout schemes
    Mutual funds based on the Portfolio Allocation
       Equity Funds
         * Diversified funds
         * Sector funds
         * Theme based funds
         * Index funds
         * Exchange Traded Funds
         * Equity Linked Savings Schemes
         * Mid-cap, Large-cap, Small-cap, Multi-cap Funds
         * Dividend Yield Funds
         * Contra Funds
       Debt Funds
         * Short term debt funds
         * Medium term debt funds
         * Long term debt funds
         * Pension schemes
         * Floating Rate Funds
         * Gilt Funds
         * Fixed maturity Plans (FMPs)
       Balanced Funds
         * Monthly Income Plans (MIPs)
         * Dynamic Asset Allocation Funds
    Other Types of Funds
     * Fund of Funds
     * Evaluation and Monitoring of a Mutual Fund Scheme
     * Arbitrage funds
     * Hedge Funds
     * Gold Exchange Traded Funds (GETFs)
     * Realty Funds

 EVALUATION AND MONITORING OF A MUTUAL FUND SCHEME
    Net Asset Value (NAV) – A basic tool
    Quantitative measures using the NAV on a stand alone basis
      Appreciation/Depreciation of the NAV
      Total Return Method
      Return with Dividend Reinvestment Option
    Measuring Performance vis-à-vis Benchmark
    AMFI Indices

 MUTUAL FUND INVESTING STRATEGIES
    Systematic Investment Plans
    Systematic Withdrawal Plans
    Systematic Transfer Plans

 MUTUAL FUNDS v/s PORTFOLIO MANAGEMENT SERVICES

 CHECKLIST FOR MUTUAL FUND INVESTING

 MYTH BUSTERS

 JARGON BUSTER

 INTRODUCTION

To benefit from investing in the stock or the debt market, you must have a basic understanding of how these function and a good overview of what is on offer. Beyond that, it requires continuous tracking of various stocks and/or debt market products, in order to stay abreast with the trends in these markets. For example, if you buy shares of ten companies, it means that you will have to keep a close tab on these ten companies in terms of their performance, financial results, future plans and so on. In the case of debt, to invest gainfully, you must be aware of trends in inflation and interest rates, amongst other factors, not only in the domestic market but in international markets as well.

This may sound like a daunting task as it could take up a lot of your time and effort. It would also require access to a considerable amount of information, in addition to having suitable skills and expertise. The simple alternative would be to invest in debt and equity through mutual funds.

A mutual fund is a vehicle through which an investor can indirectly invest in equities or the debt instruments. It holds the contributions of a large number of investors and the common pool of funds so collected is invested by professional managers in equities and/or debt instruments in accordance with the predefined objectives of the mutual fund. Since the ownership of the corpus is joint, i.e., the fund belongs to all investors, and its investment purpose is “mutual”, i.e., common for all investors, it is called a mutual fund.

In proportion to their contributions, investors receive units of the mutual fund. At the outset, the units issued have a face value of Rs 10 each. Later, as the corpus is invested and the value of the investments change the value of each unit changes proportionately. The value of each unit is also impacted when management fees and other expenses are deducted from the overall pool of funds.

The value of each unit is called the Net Asset Value or NAV of the scheme. It changes on a daily basis. As per the definition, the net assets mean the current market price of all securities held plus cash and any accrued income, minus liabilities.

More specifically,
NAV = (Market value of the fund's investments + Current assets + Accrued income) - Current Liabilities - Accrued Expenses / (Total Number of units outstanding)

Investors who wish to purchase or sell units of a mutual fund after the scheme is fully functional must do so at a price that is linked to the NAV.

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 FORMATION OF A MUTUAL FUND

The domestic mutual fund industry is governed by the Securities and Exchange Board of India, Mutual Fund regulations and the Indian Trusts Act, 1882.

A mutual fund is constituted as a public trust created under the Indian Trusts Act, 1882 and has a three tier structure, in order to prevent potential conflicts of interest. The three main entities are the Sponsor, the Board of Trustees and the Asset Management Company (AMC).

The Sponsor

The sponsor of a mutual fund is the promoter who establishes a mutual fund and gets it registered with SEBI. The sponsor also forms a ‘trust’ and appoints a Board of Trustees to ensure that the mutual fund adheres to all the rules and regulation framed by the regulator.

The Trustees

The Board of Trustees is responsible for protecting investors’ interests and ensuring that the fund operates within the regulatory framework. The trustees appoint bankers, custodians and depositories, transfer agents and lastly, and most importantly, the AMC (if authorized by the Trust Deed) that plays a very critical role when it comes to achieving the objectives of the mutual fund. The trustees are responsible for ensuirng that the AMC has proper systems and procedures in place and has appointed key personnel including Fund Managers and Compliance Officer.

The AMC

Under the broad supervision and direction of the trustees the Asset Management Company (AMC) acts as the investment manager of the trust. The AMC charges a fee for the services that it renders. The trustees delegate the task of floating schemes and managing corpuses to AMCs, who are investment experts.

Other Supporting Entities Custodians and Depositories

The custodian is an independent entity which is entrusted with the physical possession of all securities purchased by the mutual fund. This entity undertakes the responsibility for handling and safekeeping of the securities, collection of benefits, etc. Bankers

The bankers play a crucial role with respect to the financial dealings of a mutual fund by holding its bank accounts and providing it with remittance services.

Transfer Agents

Transfer Agents are responsible for issuing and redeeming units of the mutual fund and provide other related services, such as preparation of transfer documents and updating investors’ records.

Mutual Fund Distributors

The distributors sell mutual funds to investors. They leverage their well spread out network to market and sell schemes and charge commissions for their services. They also facilitate redemptions, solve investor grievances, advise clients on asset allocation, etc. The distributors are paid commissions for the services rendered in facilitating subscriptions by the fund houses. The commission paid is upfront and can also be on a trailing basis.

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 PROS OF MUTUAL FUND INVESTING

1) Professional Management and Informed Decision Making

The biggest advantage that mutual funds offer is greater expertise on the markets, be it the stock market or debt market. The AMC, with its well organized and structured pool of talent, tracks the economy, companies and stock market happenings on a day-to-day basis, and investment decisions are made on the basis of this research. It would be far more difficult for a retail investor to undertake research of the same magnitude. They have better access to information than individual investors.

2) Investment Flexibility

Mutual fund houses offer various categories of schemes (equity, debt, hybrid etc) with a good number of options such as growth, regular income and so on. You can pick and choose as per your risk appetite, return expectations and overall investment objective.

3) Portfolio diversity

With a comparatively small capital investment in a mutual fund scheme, you can gain exposure to a large variety of instruments. In fact, some instruments which form part of a mutual fund’s portfolio, especially in the debt segment, are totally out of the reach of a retail investor due to the high threshold investment limits.

4) Transparency and Safety

No mutual fund guarantees returns but they are transparent in their operations, since they are subject to stringent disclosure norms. SEBI regulates all mutual funds operating in India, setting uniform standards for all funds. In addition, thanks to its three tier structure – clear cut demarcation between sponsors, trustees and AMCs, conflict of interests can be promptly checked. Lastly, the Association of Mutual Funds in India works towards promoting the interests of mutual funds and unit holders. It also launches Investor Awareness Programs aimed at educating investors about investing in mutual funds.

5) Tax Benefits

Generally, income earned by any mutual fund registered with SEBI is exempt from tax. However, income distributed to unit holders by a closed end or debt fund is liable to a dividend distribution tax. Capital gains tax is also applicable in the hands of the investor, depending on the type of scheme and the period of holding (See section Tax Benefits and implications of investing in mutual funds).

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  CONS OF MUTUAL FUND INVESTING

Impact Cost

Operationally, mutual funds buy and sell in large volumes and voluminous buying or selling of shares often results in adverse price movements. Funds which buy in large volumes end up inflating the prices and when funds sell in large quantities, they tend to depress prices. This could result in high prices while buying and low prices while selling is called ‘impact cost’

Lead Time

The mutual funds cannot remain fully invested all times due to various reasons. Firstly, they must maintain some part of their corpus in cash, in order to meet redemption pressures. Then there could be a time lag between identification of investment opportunities and actual investment. And finally, it is not possible for a fund house to deploy money in the market immediately after receiving it from investors. This lead time when cash is lying idle with mutual funds results in lower overall returns on the corpus.

Marketing and Fund management costs

In the case of most mutual funds, there is an entry and/or exit load (fee) applicable while buying and/or selling mutual fund units, respectively. These loads, which are a certain percentage of the value of units held, are applied to cover marketing and other costs. In addition to this, the AMC charges annual asset management fees and expenses, which are captured in the expense ratio.

Cost of churn

Some schemes tend to churn their portfolio very often, in keeping with the investment philosophy of the fund manager, i.e., whether he/she believes in long term or short term returns. This means higher transaction costs (brokerage, custody fees etc) and consequently, lower returns.

 TAX BENEFITS AND IMPLICATIONS OF INVESTING IN MUTUAL FUNDS

The dividend distributed by both debt funds and equity funds is tax-free in your hands. In case of equity funds, no dividend distribution tax is payable by the mutual fund. However, in the case of debt funds, the mutual fund has to pay a Dividend Distribution Tax (DDT) of 14.025 per cent (12.5 per cent tax + 2 per cent education cess + 10 per cent surcharge) on the amount of dividend distributed to individuals.

In the case of short term capital gains (profits that accrue from the sale of units within one year from the date of purchase) earned on the sale of equity mutual funds, tax is applicable at the rate of 11.22 per cent, if your net taxable income is above 10 lakh per annum or 10.2 per cent if your net taxable income is below Rs 10 lakh per annum. Short term capital gains on debt mutual funds attract tax at the personal income tax rate applicable to you.

Long term capital gains (profits that accrue from the sale of units after one year from the date of purchase) earned on the sale of equity mutual funds are tax free in your hands. In case of debt funds, long term capital gains computed without indexation (indexation involves increasing the cost of your investment to account for inflation based on the cost inflation index table published by the government), the tax payable on long term capital gains from debt funds is 22.44 per cent if your income is above Rs 10 lakh per annum or 20.4 per cent if your income is below Rs 10 lakh per annum. You can choose to calculate your long term capital gains with or without indexation, depending on which one results in lower tax payable.

 EXPENSES

The Asset Management Company charges an annual fee, or expense ratio that covers administrative expenses, advertising expenses, custodian fees, etc. An expense ratio of 1.80 per cent means the AMC has charged Rs 1.80 for every Rs. 100 in assets under management.

A fund's expense ratio is typically linked to the size of the funds under management and not to the returns earned. Normally, the costs of running a fund increase at a slower rate than the growth in the fund size - so, the more assets in the fund, the lower should be its expense ratio. SEBI has prescribed limits for the maximum expense that can be charged to the scheme.

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 TYPES OF MUTUAL FUNDS

1) Mutual funds based on structure A. Open ended and close-ended schemes Based on maturity there are two types of mutual fund schemes - open-ended and close-ended schemes.

Open-ended schemes

These schemes do not have a defined or fixed maturity period. The investors can buy or sell units on any business day at NAV based prices from the fund house. Due to this flexibility offered to unit holders, the overall capital of open-ended schemes can fluctuate on a daily basis.

Close-ended schemes

These schemes have a stipulated maturity period and the fund remains open for subscription only during a specified period, at the time of launch of the scheme. Investors can invest in the scheme at the time of the initial public issue and thereafter, they can buy or sell the units of the scheme on the stock exchanges where the units are listed. To provide an exit route to the investors, a few close-ended funds give an option of selling back the units to the fund house through periodic (usually monthly or quarterly) repurchase at NAV related prices. SEBI regulations stipulate that at least one of the two exit routes is provided to the investor i.e., either repurchase facility or through listing on stock exchanges. B. Load and No Load Funds Some mutual funds charge entry or exit loads (fees) when an investor buys or sells units. These are called “Load funds”. The load is based on the NAV and is calculated as a certain percentage of the NAV. The load is applied to cover expenses incurred on the scheme’s marketing, distribution, advertisements, etc. Because of these charges, your purchase price is higher and your sale price is lower than the prevailing NAV of the scheme. For instance, if the NAV of a scheme is Rs 15, and the scheme levies an entry load of 2 per cent, then your purchase price is 15.30 (NAV + (entry load * NAV)). The number of units that you would hold is a function of your purchase price and not the NAV. Similarly, if the NAV of a scheme is Rs 15, and the scheme levies an exit load of 2 per cent, then your sale price is 14.70 (NAV - (exit load * NAV)). The sum of money that you receive on redemption is a function of your sale price and not the NAV. You should consider loads applicable to schemes while investing your money as it directly impacts your actual returns from the investment. A ‘no load’ fund does not charge any entry or exit fees. C. Cumulative or growth schemes, dividend reinvestment schemes and dividend payout schemes Mutual funds usually give investors a choice of three ways in which they can receive their profits from a scheme. These are called the dividend payout option, the growth option and the dividend reinvestment option.

Dividend payout option

- In the dividend payout option, the profits of the scheme are distributed to the investors in proportion to the number of units that they hold. This option is suitable for investors who would like to receive a regular income and for those who would like to use their profits elsewhere.

Growth option

- In the growth option, the profits are not distributed and accordingly, the value of each unit keeps appreciating as the profits increase. This option is suitable for investors who do not have any immediate need for cash and would prefer to reap better wealth in the long run.

Dividend reinvestment option

- Lastly, the dividend reinvestment option is similar to the growth option, in that the profits are not distributed. However, here the value of the units is not left to simply appreciate. Instead, each investor’s profits are converted into more units of the same scheme at the NAV of the scheme as on the day of conversion. This option is for those investors who have a medium risk profile and would prefer to see their capital base grow rather than allow their appreciation to be eroded by any fall in the value of the scheme’s portfolio.

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Mutual funds based on the Portfolio Allocation
Based on portfolio allocations, there are three broad categories of funds:
  • Equity Funds
  • Debt Funds
  • Balanced Funds


A. Equity Funds

Equity funds invest largely in the shares of companies which are listed on the stock exchange. Equity funds are basically high risk, high return schemes. Dividend and capital appreciation are the major revenue streams for equity funds. The schemes are suitable for investors who are ready to take on some amount of risk to receive good returns. All those risks which are associated with equities are associated with these funds. The NAV will generally move in tandem with the share prices of the stocks that make up the fund’s portfolio. If the prices of the stocks in its portfolio fall, the NAV of the schemes too will register a dip. There are various types of equity funds, key among them include:

Diversified funds

The objective of diversified equity funds is to provide the investor with capital appreciation over a medium to long term by investing in stocks from various sectors and segments of the equity market.

Risk and returns:

These funds balance their portfolios so as to prevent any adverse impact on returns due to a downturn in one or two sectors. Hence, the returns change more or less in tandem with the broad movement of the stock market.

Suitability:

These funds are ideal for investors who wish to invest in an instrument that delivers equity market linked returns, without having to build up a large portfolio and monitor it separately.

Sector funds

Sector funds invest only in companies belonging to specific sector mentioned in the offer document. Normally, sectors that are in the limelight or are witnessing robust growth are the ones targeted by the mutual fund industry in order to launch sector funds. The sectoral equity funds dedicated to industries like technology, bank, pharmaceuticals, infrastructure, etc are good examples of such funds.

Risk and return:

Investment in these funds come with a higher risk attached, since the investment is spread only across a single sector. As a result, any adverse policy or environmental change which affects this sector could result in a huge loss to investors. At the same time, the profits could be better than those of a diversified fund if the sector takes off since a bulk of the funds are invested in a winning sector. Suitability: This fund is suitable for investors who are convinced about the future prospects of a particular industry and wish to cash in on it. Such investor must also have the ability to cope with risk.

Theme based funds

Theme based funds are fairly similar to sector funds. The differentiating factor is the level of diversification that they offer. Instead of concentrating on stocks belonging to a single sector/industry, their focus lies on a specific theme and they invest in companies which conform to that theme. For instance, some theme based schemes invest in only globally competitive Indian companies or multinational corporations operating in India, others invest in only those companies which offer a dividend yield above a certain pre-determined level, and so on.

Risk and return:

If the markets favour the chosen theme, there is a possibility of making very good returns but if they do not, there are chances of facing losses. Suitability: These schemes are ideal for investors who also subscribe to the notion that investing in companies which conform to the selected ‘theme’ will yield profits.

Index funds

An index funds replicates a selected index, such as the Nifty 50 or the Sensex, etc., by investing in the same stocks that comprise the index. There are two types of index funds – Passive Index Funds and Active Index Funds. The former align their portfolios as accurately as possible to the index and try to hold index stocks in proportion to the weight-age they enjoy in the index. Active index funds, on the other hand, aim to give a better return by changing the weightages of individual stocks and even sectors, as per the fund manager’s discretion. Such funds may also allocate a certain portion of their portfolio to non-index stocks.

Risk and return:

The performance and returns of such schemes usually move in sync with that of the index that they try to replicate. The risk that such funds cGreenArrowy is directly related to the volatility of the index that they follow.

Suitability:

Index funds are recommended for investors who are satisfied with a return that is approximately equal to that delivered by the index.

Exchange Traded Funds

Exchange Traded Funds (ETFs) are similar to index funds, in that they too invest in stocks comprising a particular stock index like the NSE Nifty or the BSE Sensex. The crucial difference is that an ETF is listed and traded on a stock exchange while an index fund is bought and sold by the fund and its distributors.

Risk and return:

Like index funds, these funds follow a passive investment strategy and their risk-return profile is similar too.

Suitability:

There is very little difference between these funds and index funds structurally, except for the fact that entry and exit in the case of ETF will attract brokerage while buying and selling index funds could attract entry and/or exit loads. Investors who wish to regularly enter and exit index funds may prefer ETFs if they work out more cost effective.

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Equity Linked Savings Schemes

The Equity Linked Savings Schemes are popularly known as ELSS. ELSS is a variant of diversified equity funds, however, these schemes come along with income tax benefits. Investment in ELSS is eligible for a tax deduction under section 80 (C) of the Income Tax Act. However the income tax deduction comes with a lock-in-period of 3 years. ELSS are governed by ELSS 2005 guidelines of Central Board for Direct Taxes, Ministry of Finance, Govt of India apart from the usual SEBI (Mutual Funds) Regulations, 1996.

Risk and return:

Such schemes cGreenArrowy the same risk as equity diversified schemes. Yet they could deliver better returns since the lock in period gives the scheme’s fund manager the freedom to invest without fear of redemption pressures.

Suitability:

These schemes are suitable for investors who are looking for a tax break from their mutual fund investment and can safely lock away their funds for a period of three years.

Mid-cap, Large-cap, Small-cap, Multi-cap Funds

Based on their market capitalisation, companies that are traded on the bourses can be classified as large caps, mid caps or small caps. Market capitalisation (also known as market cap) is equal to the total number of equity shares issued by a company multiplied by the company’s current market price. Market cap based equity funds invest in stocks that belong to either only one or two or all three of the stated segments. In other words, at the time of stock selection, the company's market capitalisation is the basic criteria for selection.

Risk and return:

Each market cap segment has a different risk-return profile. Investing in small and mid cap stocks could deliver phenomenal returns if the fund manager’s investment strategy pays off or they could lose tremendous value. Large caps on the other hand invest in stocks which are established and unlikely to suddenly lose value. However, having reached growth plateaus, such stocks are also unlikely to display spectacular take offs in price. Multi-cap funds, which invest in large cap, mid cap and small cap stocks, have a profile that is similar to vanilla diversified equity funds.

Suitability:

The level of risk that you are willing to accept and the returns that you expect will be the criteria for determining which category of funds you choose to invest in.

Dividend Yield Funds

Dividend yield mutual funds invest in share of companies which have a high dividend yield ratio. The dividend yield ratio is calculated as the dividend paid divided by the current market price of the share and represented as a percentage.

Risk and return:

Generally, high dividend yield stocks have a low beta value relative to benchmark (say the Sensex) and hence are stable. Besides, dividend yield stocks offer reasonably good returns over the medium to long term. However, the universe of high dividend yield stocks is limited.

Suitability:

Such schemes are suitable for those who can invest their capital for a fairly long period of time.

Contra Funds

Contra funds are equity diversified schemes which follow a ‘value investing’ strategy. The fund manager of such schemes looks for stocks of companies which are fundamentally sound but their values are currently not recognised and invests before this value is acknowledged by the market.

Risk and return:

This strategy could result in significant capital appreciation if the fund manager’s investment call proves correct. However, if the fund management team goes wrong in stock selection, you might not only face a loss but capital erosion too.

Suitability:

If you are ready to take on a fair amount of risk and are not necessarily keen on investing in stocks that are popular at present, you could consider such schemes.

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B. Debt Funds

Debt oriented schemes cater to more conservative investors as they invest all or a significant portion of their corpus in various debt instruments, such as company bonds and debentures, treasury bills, government securities, etc. The income of such funds comes from the interest that the debt instruments held in the portfolio deliver. In the case of debt instruments that are traded, income could be accrued in the form of capital appreciation on traded debt paper. Interest rate movements are the biggest risk factor for debt funds. This is because the prices of debt instruments and therefore their value share an inverse relationship with interest rates. The longer the duration of the paper held by the fund, the higher this risk. Other risk factor is the intrinsic risk attached to the paper held in the portfolio; for instance government bonds are risk free but corporate bonds have some risk attached. There are various types of debt funds, key among them include:

Short term debt funds

- Cash funds, liquid funds and money market funds can be classified as short-term funds as their portfolios contain instruments that have a maturity of up to one year such as treasury bills, certificates of deposit, commercial paper, reverse repo, etc.. The main objective of these funds is to offer investors a liquid investment avenue that also offers scope for good returns, unlike a bank fixed deposit which offers low fixed returns.

Risk and returns:

The returns from these funds are not subject to any great risk as the instruments in the corpus can be held to maturity, unless there are better prospects.

Suitability:

These schemes are designed to provide easy liquidity, preservation of capital and moderate income. Accordingly, they are ideal for corporates and individual investors who want to park their surplus funds in a safe but lucrative investment for short periods or until a more favourable investment alternative emerges.

Medium term debt funds

- Income funds fall into the category of medium term debt funds. These funds have a time frame of 1-3 years. Income funds have the liberty to invest in longer maturity instruments, like commercial papers, treasury bills, repos, medium term bonds, debentures and government securities. These funds also have some of their corpus invested in short term avenues like the money market and treasury bills. In addition, if an income fund spots good opportunities in the long-term maturity segment, it may even invest a small proportion of its funds in fixed income instruments that have a maturity period of well over 5 years, which usually offer better returns.

Risk and return:

Since redemption pressures on such funds are less than those on cash/liquid funds, the fund managers can plan their investment strategies better. However, while income funds offer scope for better returns, they come tied with greater risks. A rise in interest rates could impact income funds more severely than it affects shorter-term funds.

Suitability:

Investors with short to medium term horizons who are comfortable with low to medium risk could choose to invest in income funds.

Long term debt funds

- Bond funds and balanced funds have an investment horizon of three to five years and therefore fall into the category of long term debt funds. These funds invest in long term debt instruments which typically offer the highest returns since the durations are long and there is a direct relationship between the duration of a bond and its returns.

Risk and returns:

Although these funds could offer greater returns than any other debt fund on the maturity spectrum, they are open to both credit risks (the risk that the market value of the bond will fall below the price at which it was purchased, which in turn will cause the NAV of such funds to fall) and interest rate risks (if interest rates rise, the prices of bonds fall, as these two factors are inversely related).

Suitability:

These funds are suitable for people who wish to allocate some part of their assets to a variety of long term debt but may not have enough capital to get such an exposure without the help of a mutual fund.

Pension schemes

– are also allowed the same tax break that is applicable to ELSS, i.e., an investor can claim a deduction from taxable income for payments made to specified pension plans, up to a limit of Rs 1 lakh under Section 80C of the Income Tax Act. These funds aim to build up a corpus for investors that can be converted into an annuity on retirement. This annuity will ensure that the investor receives a regular stream of income post retirement.

Risk and return:

These schemes invest most of their funds in conservative instruments since capital preservation is their prime objective. Accordingly, the risk exposure of such funds is minimal.

Suitability:

Such schemes are ideal for individuals who are currently in a high tax bracket due to the magnitude of their current income but expect to witness a drastic fall in income post retirement. Such individuals can avail of the dual benefit of a tax break at present along with the comfort that they are saving for their post-retirement years.

Floating Rate Funds

– Some debt instruments are characterised by a floating rate of interest. This means that the return on such instruments is derived from a particular market determined interest rate that changes periodically. Debt funds that invest all or a substantial part of their corpus in such funds are called floating rate funds. Since the interest rates of the securities held in the portfolios change, the return on floating rate funds also changes accordingly. Floating rate funds offer investors the opportunity to receive market related returns.

Risk and return:

When interest rates move upwards, the return of these funds improves but at times when rates are falling, investors could receive lower returns.

Suitability:

Investors who believe that interest rates will head upwards in the future could go in for floating rate funds.

Gilt Funds

The Gilt Funds invest most of their corpus in sovereign securities, i.e. central and state government securities. Such schemes can further be further categorized into short term and long term gilt funds depending on the types of instruments that they invest in.

Risk and return:

Although these funds are almost risk free, they are subject to interest rate volatility. Whenever the interest rates are showing a declining trend, they will fetch higher returns due to appreciation in value of the Gilt portfolio. But in case of an increasing trend in interest rates, Gilt funds can give low or negative returns.

Suitability:

These funds are suitable for those who wish to play on the interest rate risk.

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The Fixed mMaturity Plans (FMPs) are close-ended income schemes with a fixed maturity. This fixed period of time could range from fifteen days to as long as two years or more. Moreover similar to an income scheme, FMPs invest in fixed income instruments like bonds, government securities, money market instruments and so on.

Risk and return:

The returns on such schemes are fairly predictable since the scheme invests in instruments whose maturity date coincides with the duration of the plan and the fund manager does not change the composition of the portfolio unless there is a better opportunity available.

Suitability:

These schemes are somewhat comparable to fixed deposits and are ideal for investors who are looking for a fixed return but other benefits of a mutual fund scheme.

C. Balanced Funds / Schemes

The Balanced Schemes invest in equities as well debt instruments. The key objective here is to blend advantages of equity and debt mutual funds – steady returns with moderate capital appreciation. Accordingly, the risk and return profile is somewhere between debt and equity funds.

Monthly Income Plans (MIPs)

The Monthly Income Plans (MIPs) are basically debt schemes that invest small portion of the portfolio (about10-25% in equities) to boost the scheme’s returns. There is, however, no assured return in such schemes, unlike the Post Office Monthly Income Scheme or a Company Deposit.

Risk and return:

These funds could offer slightly better returns than pure long-term debt schemes at marginally higher risk.

Suitability:

MIP schemes are ideal for investors who require a regular income and have a limited appetite for equity investment risk

Dynamic Asset Allocation Funds

Dynamic asset allocation funds have the flexibility to invest partly/wholly in equity and/or debt, in line with the limits/parameters that are pre-determined by the fund house. The main objective of these schemes is to take advantage of the equity market by entering at lower levels, cashing out at high levels, then investing the funds in debt/money market instruments and later re-entering equities when the markets undergo a correction.

Risk and return:

Such schemes focus on preservation of capital but in case the fund management team gets their market timing wrong, it could lead to erosion of capital. The returns generated by dynamic funds can be lower than those of diversified equity funds. This is because they may follow a defensive investment strategy, wherein safety of capital is given preference over earning higher returns.

Suitability: Since dynamic asset allocation funds regularly reallocate their portfolio based on market conditions in order to prevent capital erosion, they are suitable for investors who would like an exposure to equity markets along with capital stability.

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Other Types of Funds
Fund of Funds

The Funds of Funds invest in other mutual funds. The significant benefit of this scheme is diversification, not only across investments, but also across Fund Managers.

Evaluation and Monitoring of a Mutual Fund Scheme

Global funds Invest in the International equity markets. These types of funds allow the investors to diversify their portfolio across countries thus reducing country-specific risk.

Arbitrage funds

An Arbitrage Opportunities Fund, is an open-ended equity scheme that aims to provide capital appreciation and regular income to unit holders by identifying profitable arbitrage opportunities between the spot and derivative market segments as also through investment of surplus cash in debt and money market instruments.

Hedge Funds

A Hedge Funds deploys highly speculative trading strategies in order to protect its portfolio and gain from short term speculation in the market. These funds invest in all kinds of instruments including derivatives and their main objective is to cash in on the arbitrage opportunities using advanced investment strategies.

Gold Exchange Traded Funds (GETFs)

GETFs are like other Exchange Traded Funds, i.e., units of these funds can be bought and sold on the exchange on which they are listed in the same manner as units of equity ETFs. The difference is that the underlying investments in this case are in gold and gold related instruments. .

Realty Funds

This concept is new to the Indian markets and has recently been approved by SEBI. These funds can invest in real estate properties and instruments related to real estate. The core attraction of this product is that even individuals with relatively small investment amounts have access to real estate investment, which has been the privilege of big investors over the years.

 EVALUATION AND MONITORING OF A MUTUAL FUND SCHEME

Before you evaluate mutual funds on the basis of a comparison between schemes, you must keep in mind that there are numerous types of mutual fund schemes in the market. Besides, there are different ways in which the returns can be disbursed to unit holders, such as regular dividend payouts, dividend reinvestment and so on. So, you must be careful that you are not comparing apples with oranges. Further, if you are trying to measure the performance of a scheme in comparison to a benchmark, you must ensure that the benchmark is in fact representative of the index or it could give you an inaccurate picture of your fund’s performance.

Net Asset Value (NAV) – A basic tool

The first and the most important measure used for evaluating the performance of a mutual fund scheme is its NAV. The NAV of a mutual fund scheme, which is determined by dividing the net assets of the scheme by the number of outstanding units as on particular date, fluctuates up or down depending on the market value of its investments. The NAVs of open ended schemes are published on a daily basis in newspapers and available on the web sites of mutual fund houses. You can also check NAVs on the web site of the Association of Mutual Funds in India (AMFI) www.amfiindia.com.

More detailed information about schemes is also available in the form of half-yearly results published by mutual funds. These results include the fund’s returns or yields over a period of time, i.e. the last six months, 1 year, 3 years, 5 years and since inception of schemes as well. The results also provide additional information such as annual expenses as percentage to total assets. It is mandatory for the mutual funds to dispatch annual reports or abridged annual reports to unit holders every year.

While the NAV is a primary parameter which helps to evaluate the performance of the scheme in question, it is not possible to draw any meaningful insights from merely being aware of the NAV itself. Instead, comparing the NAV of a scheme to its past levels or checking its performance vis-à-vis the performance of a benchmark will give you a better picture of the performance of the scheme. Here are some simple techniques which will help you to gauge the performance of your scheme using the NAV.

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I) Quantitative measures using the NAV on a stand alone basis

Appreciation/Depreciation of the NAV

The annualized appreciation of a scheme’s NAV, in percentage terms, over the period for which the performance is to be evaluated gives you a quick measure of how much your investment has grown (or shrunk).

Illustration of Appreciation / Depreciation in the NAV

You bought units of ABC mutual fund on 1 January 2005
Your purchase price per unit was Rs 14.00
You want to evaluate the performance of your investment on 1 June 2006
The NAV of each unit of this was on 1 June 2006 was Rs 21.00
Appreciation in the NAV (NAV on 1 June 2006 minus your purchase price on 1 January 2005) Rs 7.00 (Rs 21.00 minus Rs 14.00)
Number of days you have stayed invested in the scheme (Number of days from 1 January 2005 to 1 June 2006) 517 days
Percentage appreciation in investment (Appreciation in NAV/Purchase price x 100) 50% (Rs 7.00 / Rs 14.00 x 100)
Annualized percentage appreciation in NAV (Percentage appreciation in NAV x 365/Number of days you have stayed invested in the scheme) 35.30% (50% x 365/517)


Drawback:

Although this NAV-related performance evaluation is easily understood and universally applicable and accepted, it has the pitfall of not taking into consideration the dividends declared and paid out by the mutual fund leading to a technical drop in the NAV. A simple NAV comparison is suitable if the investor has selected the growth option, under which no dividends are declared.

Total Return Method

In case you have opted for a dividend payout, you should use the Total Return Method of evaluating your mutual fund’s performance.

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Illustration of Total Return Method

You bought units of ABC mutual fund on 1 January 2005
Your purchase price per unit was Rs 14.00
Number of units you purchased 1,000 units
Total cost of your investment (number of units purchased x cost per unit) Rs 14,000 (1,000 units x Rs.14 per unit)
On 30 September 2005, the mutual fund declared a dividend of 10% giving you dividends to the tune of Rs 1,000 (1,000 units x Rs.10 (Face value) x 10%)
You want to evaluate the performance of your investment as on 31 December 2005
The NAV of each unit of this was on 31 December 2005 was Rs 21.00
Appreciation in the NAV (NAV on 31 December 2005 minus your purchase price on 1 January 2005) Rs 7.00 (Rs.21.00 minus Rs 14.00)
Capital appreciation value is Rs 7,000 (1,000 units x Rs7 per unit)
Total appreciation to your credit (capital appreciation in NAV + dividends received) Rs 8,000 (Rs 7,000 + Rs 1,000)
Percentage appreciation (Total appreciation to your credit / Total cost x 100) 57.14%
Since the investment is held for one year, no need to annualize the return.


Return with Dividend Reinvestment Option

If you have opted for the dividend reinvestment plan you will get additional units to the extent of the dividend declared. Reinvestment of the dividend takes place at the NAV prevailing at the time of dividend declaration. This will change the cost of your investment. The returns, in this case, have to take into account both these aspects.

Illustration of Return with Dividend Reinvestment Option

You bought units of ABC mutual fund on 1 January 2005
Your purchase price per unit was Rs 14.00
Number of units you purchased 1,000 units
Total cost of your investment (number of units purchased x cost per unit) Rs 14,000 (1,000 units x Rs.14 per unit)
On 30 September 2005, the mutual fund declared a dividend of 10% giving you dividends to the tune of Rs 1,000 (1,000 units x Rs.10 (Face value) x 10%)
You have chosen to have this dividend reinvested back into the scheme at the prevailing NAV of Rs.16.00 (i.e. NAV on 30 September 2005. You receive additional units (Dividend due / NAV on 30 September 2005) 62.5 units (Rs 1,000 / Rs 16.00)
You want to evaluate the performance of your investment on 31 December 2005
The NAV of each unit of this was on 31 December 2005 was Rs 21.00
Appreciation in the NAV of original units (NAV on 31 December 2005 minus your purchase price on 1 January 2005) Rs 7.00 (Rs.21.00 minus Rs.14.00)
Total appreciation value of original units is Rs 7,000 (1,000 units x Rs 7 per unit)
Appreciation in NAV of new units i.e. units received on reinvesting dividend) is (NAV on 31 December 2005 minus dividend reinvestment NAV) Rs 5 (Rs.21.00 – Rs 16.00)
Total value of new units is Rs 1312.50 (Rs 21 x 62.5 units)
Total appreciation (Original units + new units) Rs 8,312.50 (Rs 7,000 + Rs.1312.5)
Total cost of investment Rs 14,000
Return on investment (Total appreciation / Total cost x 100) 59.38% (Rs 78,312.50 / Rs 14,000 x 100)
Since the investment is held for one year, no need to annualize the return.

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Other measures:

Other measures like Standard Deviation and Sharpe Ratio (not required to be declared statutorily) can reveal a lot about the fund. Standard Deviation measures the degree of volatility a fund exposes its investors to, while the Sharpe Ratio measures returns delivered per unit of risk borne.

II) Measuring Performance vis-à-vis Benchmark

The method of evaluating performance of mutual funds on standalone basis as discussed above gives only a partial picture. To make the exercise meaningful, there has to be a benchmark against which the performance is measured. The stock indices are good benchmarks for relative comparisons. For instance, if you want to know whether the performance of any diversified equity mutual fund has been good or bad, what you can do is simply compare the returns from such funds with that of the BSE Sensex or the NSE Nifty. You also have broader indices such as the BSE 100 that would also help you to analyze the performance of diversified mutual funds.

In market terminology, if the returns generated by a diversified mutual fund are higher than the Sensex or the Nifty, you could say that the fund has ‘outperformed the market’. And, if the Sensex or the Nifty has reported higher gains than the fund, the fund has ‘under performed the market’.

However, this comparison applies to diversified mutual funds. If you have invested in sector funds, these must be compared with the sectoral indices. Comparing a Pharma fund with a BSE Healthcare index would be more appropriate than comparing it with the BSE 30 Sensex. The National Stock Exchange and the Bombay Stock Exchange haves developed various sectoral indices based on sectors such as banking, pharmaceuticals & healthcare, information technology and so on.

There are other indices, such as the BSE Mid Cap and the BSE Small Cap, which can be used as benchmarks to evaluate the performance of mid and small cap mutual funds.

AMFI Indices

CRISIL, the country’s leading credit rating agency, has developed various indices in consultation with AMFI (Association of Mutual Funds in India) for benchmarking the performance of mutual funds with higher component of debt. These indices act as a representative for a particular group or universe of schemes. These indices includes

  • CRISIL Composite Bond Fund Index
  • CRISIL MIP Blended Index
  • CRISIL Balanced Fund Index
  • CRISIL Liquid Fund Index
  • CRISIL Short-Term Bond Fund Index

Further, ICICI Securities and Finance Company Ltd (ICICI Securities) in consultation with AMFI has launched a series of indices for benchmarking the performance of individual funds against an index that is representative of the universe of that fund. These indices includes

  • I-Sec Si-BEX
  • I-Sec Mi-BEX
  • I-Sec Li- BEX
  • I-Sec Composite Index

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 MUTUAL FUND INVESTING STRATEGIES

In order to help you to simplify the decision of when to invest and disinvest and make it as beneficial as possible, mutual funds now offer Systematic Investment Plan (SIP), Systematic Withdrawal Plan (SWP) and Systematic Transfer Plans (STP).

Systematic Investment Plans

SIPs involve making investments of fixed sums of money in a particular scheme at predetermined periodical intervals of time (monthly, quarterly or annually). As this technique results in buying more units when the price is low and less units when the price is high, it has been found to lower the average cost per unit purchased, irrespective of whether the market is climbing, falling or generally volatile. Further, in addition to sparing you from the need to time the market, it makes investing relatively simple as fund houses allow you to invest using post dated cheques, ECS transfers, etc.

Systematic Withdrawal Plans

SWPs can be used to regularly disinvest either fixed amounts or some or all of the appreciation that is generated from your investment in the scheme. This allows you to receive a regular income from your investment in a scheme or simply invest the gains from the scheme elsewhere. All you have to do to utilize this facility is fill in a form that is available with the fund house, intimating them about your preferences (fixed or appreciation withdrawal).

Systematic Transfer Plans

Through STPs you can transfer fixed amounts of money at regular intervals (monthly or quarterly) from one scheme to another. You can activate this facility by giving your fund house one-time standing instructions to execute such transfers. These plans effectively automate both the processes of investing and disinvesting.

 MUTUAL FUNDS V/S PORTFOLIO MANAGEMENT SERVICES (PMS)

In portfolio management services, the portfolio manager advises or directs the client on how he should invest his portfolio of securities or funds. The services could be discretionary or non-discretionary. In case of discretionary services, the approval of the client is required before investments are made whereas in case of non discretionary services, the portfolio manager makes investment decision on the basis of parameters that have been agreed upon between the client and the portfolio manager.

Comparison between mutual funds and PMS
  • The cost of investing is higher in the case of portfolio management services as compared to mutual funds.
  • The minimum investment in portfolio management is very high as compared to mutual funds.
  • Mutual funds offer hassle free investing as the investor need not continuously track individual stocks, which may be required in case of portfolio management.
 CHECKLIST FOR MUTUAL FUND INVESTING
  • Draw up your asset allocation.
  • Identify funds that fall into your buy list.
  • Obtain and read the offer documents. You could do this online on IDBIpaisabuilder.in or by either asking your broker or the asset management companies.
  • Match your objectives with that of the fund. Read through the offer documents and check to see whether the mutual funds identified meet your investment needs in terms of equity share and bond weightage, downside risk protection, tax benefits offered, dividend payout policy, sector focus etc.
  • Check out the fund’s past performance.
  • Look for `load' costs, annual expenses of the fund and sales loads. These can take away a significant portion of your returns.
  • Look for size and credentials. As far as possible, avoid investing in funds with an asset base of less than Rs 25 crores.
  • Check out the customer service delivery mechanism of the mutual fund you choose. Can you get in touch with them easily? How often do they send you portfolio updates? Do they circulate investor newsletters?
  • Diversify, but not too much. Do not hold just one fund in each asset category.
  • Monitor regularly and review your mutual fund portfolio. Try to review your mutual fund holdings at least once a quarter. You can do it easily on the portfolio tracker at IDBIpaisabuilder.in 11. Invest regularly through the SIP option. It will work in your interest.

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 MYTH BUSTERS
Myth 1:

New Fund Offerings (NFOs) offer a better deal than existing funds It is better to buy units in a new fund offering at Rs 10 than an existing fund at a higher NAV.

Reality:

The performance of the mutual fund whether existing or new scheme solely depends on factors like the skills and investment strategies adopted by the fund managers, quality of the portfolio, exposure to various industries and so on. In fact, when it comes to investment there is no difference between new schemes selling at par value or existing schemes selling at higher price. The return, as a percentage of the capital which you have invested, will determine which investment was a better choice.

Myth 2:

Shares generate higher returns The stock market is more exciting and direct investing in shares generates higher returns than mutual funds.

Reality:

The returns the mutual funds generate depend on the type of mutual fund scheme you select. That goes for shares too; the return you receive could be good or bad depending on the stock that you choose. For instance, index funds usually report returns that are in sync with the index which they try to mirror while pure equity funds can outperform the index by a wide margin.

Myth 3:

Investing in mutual funds is an expensive proposition Mutual funds charge various expenses such as entry and exit loads, annual asset management fees and other expenses.

Reality:

Though mutual funds levy various fees they are not an expensive proposition. When you invest directly too there are certain expenses that you will have to bear. In fact, the additional charges that you pay towards fund management, etc., end up benefiting you since it results in investment decisions which are better researched and more meticulous monitoring of the performance of your investments on a continuous basis.

Myth 4:

Mutual funds guarantee returns Some mutual funds assure their investors a certain level of returns.

Reality:

Mutual funds are subject to market risks and do not guarantee any kind of returns to unit holders. The performance of mutual fund schemes should be compared with benchmark indices and judged accordingly. It is quite possible that even the best of fund managers may not be able to deliver consistent returns over the years.

Myth 5:

Lower NAVs translate into better investment opportunities Mutual funds with lower NAVs can generate better returns.

Reality:

Low NAVs do not mean a ‘cheap’ investment opportunity. You need to look at the long term returns generated by the scheme in question. Here, returns mean capital appreciation and dividend paid, if applicable. The track record of the fund manager and the composition of the portfolio of the schemes are also critical factors which you should consider while choosing the right scheme.

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 JARGON BUSTER
Account Statement

- A statement issued by the mutual fund house, giving details of transactions and holdings of an investor. This is normally issued in lieu of a unit certificate.

Asset Allocation

- When you divide your money among various types of investments, such as stocks, bonds, and short-term investments (also known as "instruments"), you are allocating your assets. The way in which your money is divided is called your asset allocation.

Benchmark

- A parameter against which the performance of a scheme can be compared. For example, the performance of an equity scheme can be benchmarked against the BSE Sensex. In this case, the BSE Sensex will be known as the benchmark index.

Beta

- It shows the sensitivity of the fund to movements in the benchmark. A beta of more than 1 indicates an aggressive fund and the value of the fund is likely to rise or fall more than the benchmark. A beta of less than 1 implies a defensive fund that will rise or fall less than the benchmark. A beta of 1 indicates that the fund and the benchmark will react identically.

Cut-off time

- In respect of all mutual funds regulated by SEBI, fresh subscriptions and redemptions are processed at a particular NAV. Every fund specifies a cut-off time in respect of fresh subscriptions and redemption of units. All requests received before the cut-off time are processed at that day's NAV and thereafter, at the next day's NAV.

Dividend

- When companies pay part of their profits to shareholders, those profits are called dividends. A mutual fund's dividend is money paid to shareholders from investment income the fund has earned. The amount of each share's dividend depends on how well the company has performed.

Growth Fund

- A mutual fund whose primary investment objective is long-term growth of capital. It invests principally in common stocks with significant growth potential.

Income Fund

- A mutual fund that primarily seeks current income rather than growth of capital. It will tend to invest in stocks and bonds that normally pay high dividends and interest.

Load

- A sales charge or commission charged by certain mutual funds ("load funds") to cover their selling costs.

Portfolio Churning

- Switching investments between different stocks in the market, with a view to give unit holders a better yield by taking advantage of market conditions.

Record Date

- The date on which the fund determines who its unitholders are; "unitholders of record" receive the fund's income dividend and/or net capital gains distribution.

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