Mutual Funds
Mutual Fund
A trust that pools together the resources of investors to make a foray
into investments in the capital market thereby making the investor to be a
part owner of the assets of the mutual fund.
The fund is managed by professional money managers who invest money
collected from various investors in stocks, bonds and/or other securities
according to stated investment objectives of the Scheme.
The Fund House charges fees based on the value of the assets for
managing and administering the investment portfolio.
Anybody with an investible surplus of as little as a few thousand rupees can
invest in mutual funds by buying units of a particular mutual fund scheme that
has a defined investment objective and strategy.
The income earned through these investments and capital appreciation
realized by the scheme is shared amongst its unit holders in proportion to the
units owned by them.
Classification of Mutual Funds
Functional Mutual Funds
Open-Ended funds - Investor can enter and exit any time. Indefinite
redemption period.
Close-Ended funds - Investor can invest into the scheme during
new fund offer or from the stock market after the units have been
listed. Investor can exit at the expiry of the scheme or by selling in the
stock market.
Interval Funds - Combination of open ended and close ended
structure. These schemes are open for both purchase and redemption
during pre-specified intervals (viz. monthly, quarterly, annually etc.) at
prevailing NAV based prices. They are not required to be listed on
stock exchanges. Maturity period is not defined.
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Portfolio Mutual Funds
Equity Funds
Growth Funds - long term capital appreciation.
Aggressive Funds - super normal returns in startups, IPOs and
speculative shares.
Income Funds - Maximize present income by investing in safe
stock that pay high dividends.
Debt Funds
Bond Funds - investment in fixed income securities.
Risks - Interest rate risk, credit risk, prepayment risk and
reinvestment risk.
Gilt Funds - Treasury Bills & dates securities issued by the State
and Central Governments.
Special Funds
Index Funds
International Funds
Offshore Funds
Sector Funds
Money Market Funds
Fund of Funds
Capital Protection Oriented Fund
Gold Funds
Quant Funds
Ownership Mutual Funds
Public Sector Mutual Funds
Private Sector Mutual Funds
Foreign Mutual Funds
Sometime the term ‘Quant Fund Manager’ is confused with the term ‘Index
Fund Manager’ but it should be noted that both terms are different because
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while the Index Fund Manager entirely hands off the investment decision
purely based on the concerned Index, the Quant Fund Manager designs and
monitors models and makes decisions based on the outcomes.
Types of Schemes
Balanced Funds
They make strategic allocation to both debt and equities.
Diversified Equity Funds
Contains a wide array of stocks - reduced amount of concentration
risk in the fund.
Flexicap Fund
Multicap Fund
Contra Fund
Index Fund
Dividend Yield Fund
Equity Linked Savings Scheme (ELSS)
Save taxes under Section 80 C of the Income Tax Act.
Participate in the growth of the capital market, having a lock-in-
period of three years.
Gives better returns than any traditional tax savings instrument.
Moreover, by investing in an ELSS through a Systematic Investment
Plan (SIP), one can not only avoid the problem of investing a lump sum
towards the end of the year but also take advantage of “averaging”.
Options for earning Income from Mutual Fund Schemes:
Growth/Appreciation or Cumulative Option: The investor gets income
only at the time of withdrawal of investment. Till the time of withdrawal,
the return gets accumulated & is paid back to the investor at the time of
withdrawal in the form of capital gain.
Dividend Option: At a regular frequency may be monthly/quarterly/half
yearly or Annual, the Scheme declares dividend to the unitholders of the
Scheme. Dividend option is further divided in two sub-options as under:
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Dividend Payout Option: Dividends are paid out to the unit holders
under this option. However, the NAV of the units falls to the extent of
the dividend paid out and applicable statutory levies.
Dividend Re-investment Option: The dividend that accrues on units
under option is re- invested back into the scheme at ex-dividend NAV.
Hence, investors receive additional units on their investments in lieu of
dividends.
Sector Funds
These funds are highly focused on a particular sector or industry. The
basic objective is to enable investors to take advantage of industry cycles.
Since sector funds ride on market cycles, they have the potential to offer
good returns if the timing is perfect. However, they are more vulnerable to
downside risk protection as compared to diversified equity funds.
Sector funds should constitute only a limited portion of one’s portfolio,
as they are much riskier than the diversified equity funds. Besides, sector
funds are not suitable for first time investors into Mutual Funds.
For example, Real Estate Mutual Funds invest in real estate properties
and earn income in the form of rentals and capital appreciation from the
developed properties. Also, some part of the fund corpus is invested in
equity shares or debentures of companies engaged in real estate
business or developing real estate development projects. REMFs are
required to be close-ended in nature and listed on the stock exchange.
Thematic Funds
A Thematic fund focuses on trends that are likely to result in the ‘out-
performance’ by certain themes, sectors or companies. The theme could
vary from multi-sector, international exposure, commodity exposure etc.
Unlike a sector fund, thematic funds have a broader outlook.
However, the downside is that the market may take a longer time to
recognize views of the fund house with regards to a particular theme,
which forms the basis of launching a fund.
Arbitrage Funds
Typically, these funds promise safety of deposits, but better returns, tax
benefits and greater liquidity.
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The open-ended equity scheme aims to generate low volatility returns
by investing in a mix of cash equities, equity derivatives and debt markets.
The fund seeks to provide better returns than typical debt instruments and
lower volatility in comparison to equity.
Arbitrage fund seeks to capitalize on the price differentials between the
spot and the futures market.
Hedge Fund
A Hedge Fund is a lightly regulated investment fund that escapes most
regulations by being a sort of private investment vehicle being offered to
selected clients.
The big difference between a hedge fund and a mutual fund is that the
former does not reveal anything about its operations publicly and charges
a performance fee. Typically, if it outperforms a benchmark, it takes a cut
off the profits. Of course, this is a one-way street; any losses are borne by
the investors themselves. Hedge funds are aggressively managed
portfolio of investments which use advanced investment strategies such
as leveraged, long, short and derivative positions in both domestic and
international markets with the goal of generating high returns (either in an
absolute sense or over a specified market benchmark). It is important to
note that hedging is actually the practice of attempting to reduce risk, but
the goal of most hedge funds is to maximize return on investment.
Cash Fund
Cash Fund is an open-ended liquid scheme that aims to generate
returns with lower volatility and higher liquidity through a portfolio of very
short dated debt and money market instrument.
Cash Funds offer growth and dividend options.
Exchange Traded Funds
Exchange Traded Funds (ETFs) are hybrids product that combine the
features of listed stocks and index fund. These funds are listed on the
stock exchanges and their prices are linked to the underlying index. The
authorized participants act as market makers for ETFs.
ETFs can be bought and sold like any other stock on an exchange. In
other words, ETFs can be bought or sold any time during the market hours
at prices that are expected to be closer to the NAV at the end of the day.
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Therefore, one can invest at real time prices as against the end of the day
prices as is the case with open-ended schemes.
There is no paper work involved for investing in an ETF. These can be
bought like any other stock by just placing an order with a broker. ETFs
may be attractive as investments because of their low costs, tax
efficiency, and stock-like features. An ETF combines the valuation feature
of a mutual fund or unit investment trust, which can be bought or sold at
the end of each trading day for its net asset value, with the tradability
feature of a closed-end fund, which trades throughout the trading day at
prices that may be more or less than its net asset value. Following types
of ETF products are available in the market:
Index ETFs - Most ETFs are index funds that hold securities and
attempt to replicate the performance of a stock market index.
Commodity ETFs - Commodity ETFs invest in commodities, such as
precious metals and futures.
Bond ETFs - Exchange-traded funds that invest in bonds are known
as bond ETFs. They thrive during economic recessions because
investors pull their money out of the stock market and invest into
bonds (for example, government treasury bonds or those issues by
companies regarded as financially stable). Because of this cause-and-
effect relationship, the performance of bond ETFs may be indicative of
broader economic conditions.
Currency ETFs - The funds are total return products where the
investor gets access to the FX spot change, local institutional interest
rates and a collateral yield.
Fixed Maturity Plans
Closely ended mutual funds in which an investor can invest
during a New Fund Offer (NFO). FMPs usually invest in Certificates
of Deposits (CDs), Commercial Papers (CPs), Money Market
Instruments and Non-Convertible Debentures over fixed
investment period.
In New Fund Offers, during the course of which FMPs are
issued, are later traded on the stock exchange where they are
listed. But, the trading in FMPs is very less. So, basically FMPs
are not liquid instruments.
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Free from any interest rate risk because FMPs invest in debt
instruments that have the same maturity as that of the fund.
Carry credit risk, as there is a possibility of default by the debt
issuing company.
Advantages of Mutual Fund
Professional Management
Diversification
Convenient Administration
Higher Returns
Low Cost of Management
Liquidity
Transparency
Other Benefits - systematic withdrawal and systematic investment
plans; switch from one scheme to another without any restrictions except
in case of Tax Savings Fund which restricts switch out for first 3 years of
its investments.
Highly Regulated
Economies of scale
Flexibility
Convenience
Drawbacks of Mutual Fund
No guarantee of Return
Some schemes may underperform against the benchmark index
Does not necessarily lead to a similar gain for every investor du to
different entry & exit points for each investor
In case of a massive fall in the value of the stocks held in the
Portfolio, the investor may lose principal in the short-term; if the
investment is held for a longer term, the chances of losing principal
are very remote & negligible
Diversification does not ensure maximizing returns
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Selection of Proper Fund
Cost Factor
Fund management fees as a part of Annual Recurring Expenses
Exit may get charged if withdrawn before a stipulated period, known
as “Exit Load”
Net Asset Value (NAV)
Value per unit of Portfolio holding
Market value of total assets of the Fund — total liabilities attributable to
those assets on a per unit basis
NAV changes daily
NAV is computed on per unit basis i.e., Net Asset Value / No. of
Outstanding Units
NAV = Net asset of the scheme / No. of units outstanding
Net Assets of the Scheme = Market value of investments +
Receivables + Other accrued income + other assets - Accrued
Expenses - Other Payables - Other Liabilities
Entry and Exit Load in Mutual Funds
Entry load: Charged at the time an investor purchases the units of a
scheme. The entry load percentage is added to the prevailing NAV at the
time of allotment of units
To that extent, the investor is allotted lesser no. of units
Exit load: Charged at the time of redeeming (or transferring an
investment between schemes). The exit load percentage is deducted from
the NAV at the time of redemption (or transfer between schemes)
Goes into the pool of funds of the scheme and not with the Asset
Trail Commission
Amount that a mutual fund investor pays to his advisor each year, to
provide incentive to the advisor to review their customer’s holdings and to
give advice
Expense Ratio
Percentage of the assets that were spent to run a mutual fund
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Does not include brokerage costs for trading the portfolio
Side Pocketing
Separation of risky or doubtful assets from other investments and cash
holdings to make sure that money invested in a mutual fund, which is
linked to stressed assets, gets locked, until the fund recovers the money
from the company or could avoid distress selling of illiquid securities
Tracking Error
Divergence or deviation of a fund’s return from the benchmarks return
The tracking error can be calculated on the basis of corresponding
benchmark return vis a vis quarterly or monthly average NAVs
Higher the tracking error higher is the risk profile of the fund
To replicate the return of any benchmark index the tracking error should
be near to zero.
The Tracking Error is calculated as follows:
∑ (d − dˉ)2
TE =
n−1
d = Differential return
d = Average differential return
n = No. of observation
Evaluation of Mutual Funds
Quantitative Parameters
Risk Adjusted Returns
Return of a Mutual Fund relative to the risk it assumed as
benchmarked against the market and industry risk
Benchmark Returns
Quality or set of standards against which performance of Mutual
Fund can be measured
A good Mutual Fund performs over and above its benchmark
during all phases of market, this excess return is known as ‘Alpha’
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Comparison to Peers
Comparison of relative performance of fund with its peers (of
same category)
Comparison of Returns across different economic and market
cycles
Evaluating performance during different economic and market
cycles due to special economic or market condition a Mutual Fund
might have outperformed/underperformed for a short time
Financial Measures
Expense Ratio
Sharpe Ratio
Treynor Ratio
Sortino Ratio
Qualitative Parameters
Quality of Portfolio
Under normal circumstances, the fund having lower Portfolio
Turnover ratio is considered to be better
Quality of stocks and securities in the portfolio of the Mutual
Funds is an important qualitative parameter
Track record and competence of Fund Manager
The competence of a Fund Manager is assessed from his/her
knowledge and ability to manage in addition to past performance.
Credibility of Fund House Team
Redemption of units, crediting of dividend, providing adequate
information etc. of any mutual fund house
Role of fund managers in mutual funds
Gatekeeper of funds of any Mutual Fund
Actively Managed Funds
Use of extensive research, judgement and due diligence, he/she
has to outperform the market and generate positive alpha.
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Contrary to Actively Managed Funds, in these types of
Funds, mainly Fund Manager’s role is to match the return of
the underlying index with the minimum Tracking Error
Passively Managed Funds
Compliance of various Guidelines as laid down by SEBI, AMFI
etc
Ensuring various reporting such as Expenses Ratio, redemption
of funds etc
Ensuring that investors are aware of various required details and
rules
Ensuring that all required documents are furnished on time
Constant Monitoring the Performance of the Fund
Creation of Wealth and Protection
Control over the works outsourced to third parties
Role of FIIs in Mutual Funds
Foreign Institutional Investors are large foreign groups with substantial
investible funds, registered abroad with a view to investing in other
nations to invest in equity market, hedge funds, pension funds and mutual
funds
Have strong research team which guides them to invest in a country
with a possibility of strong return in equity market
FIIs are an important source of capital in any economy especially in
developing economies. Normally, FIIs fuel a bullish market for a short
period of time and hence the nation experiences a strong inflow of foreign
currency in its financial system at that time
Foreign Institutional Investors can buy units of domestic mutual funds
either directly from the issuer of such securities or through a registered
stock broker on a recognized stock exchange in India. These investments
are subject to limits notified by SEBI
Enhanced Corporate Governance: FIIs before making investment in any
Mutual Fund carries out thorough due diligence of Corporate Governance.
Hence, Corporate Governance is improved to a great extent
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Improved Competition in Market: With the investment of FIIs in Mutual
Funds improvement takes place in the capital market
Improved Inflow of Capital in the economy: With the investment of funds
in Mutual Funds in the economy not only employment is generated but the
position of Foreign Exchange also improves
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