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Chapter 19
MUTUAL FUNDS
I ndirect Investing
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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
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Entities In A Mutual Fund Operation
A mutual fund represents a vehicle for collective
investment. In India, the following entities are involved ina 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 mutualfund entrusted with the job of protecting the interest of
unitholders. Appointed by the sponsor, the trustees are
typically a corporate body (a trustee company)
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Entities In A Mutual Fund Operation
Asset Management Company (AMC) The AMC, referredto 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.
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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
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Equity Schemes
Equity schemes (all called growth schemes) invest the bulk
of their corpus (8595 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
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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
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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
Fixed Maturity Plans
Cash Schemes
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Open-Ended Schemes vs. Closed-Ended
The subscription to a closed-ended scheme is kept open only
for a limited period whereas an open-ended scheme acceptsoffers 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 schemespermits 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.
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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 companys 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 onecompany.
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 10percent of its NAV in case of a close ended scheme.
Mutual funds shall mark all investments to market.
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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 funds investments + Receivables +Accrued incomeLiabilitiesAccrued expenses
NAV =Number of shares or units outstanding
Repurchase and Reissue Price The repurchase and reissue price ofan open-ended scheme are closely linked to its NAV
Discount Closed-ended schemes typically trade at a discount over
their NAV
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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 aparticular 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
+
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Costs Of Investing
There are four costs associated with mutual fundinvesting:
Initial Issue Expenses
Entry Load
Exit Load
Annual Recurring Expenses
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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 schemes 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.
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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
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Pros & Cons
Pros
Diversification
Professional Management
Liquidity
Assured Allotment Small Investment
Tax Advantages
Transparency
Cons
Cost
Lack of Thrill
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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.
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SUMMING UP
A mutual fund represents a vehicle for collective investment.
In India, the following entitles 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 invests 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.
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The investments of a mutual fund are subject to certain
regulations.
The key financial numbers of mutual fund schemes 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.
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Mutual funds offers 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.
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