FINANCIAL MARKETS AND SERVICES{5TH SEM}

UNIT-5 MUTUAL FUNDS:

MUTUAL FUNDS :
 A mutual fund is a professionally managed investment fund that pools money from
many investors to purchase securities. These investors may be retail or institutional
in nature.
 Mutual funds have advantages and disadvantages compared to direct investing in
individual securities. The primary advantages of mutual funds are that they provide
economies of scale, a higher level of diversification, they provide liquidity, and they
are managed by professional investors.
 On the negative side, investors in a mutual fund must pay various fees and expenses.
 Primary structures of mutual funds include open-end funds, unit investment trusts,
and closed-end funds.
 Exchange-traded funds (ETFs) are open-end funds or unit investment trusts that
trade on an exchange. Mutual funds are also classified by their principal investments
as money market funds, bond or fixed income funds, stock or equity funds, hybrid
funds or other. Funds may also be categorized as index funds, which are passively
managed funds that match the performance of an index, or actively managed funds.
 The mutual fund industry in India started in 1963 with the formation of Unit Trust of
India, at the initiative of the Government of India and Reserve Bank of India. The
history of mutual funds in India can be broadly divided into four distinct phases

HISTORY :
First Phase - 1964-1987
Unit Trust of India (UTI) was established in 1963 by an Act of Parliament. It was set up by the
Reserve Bank of India and functioned under the Regulatory and administrative control of
the Reserve Bank of India. In 1978 UTI was de-linked from the RBI and the Industrial
Development Bank of India (IDBI) took over the regulatory and administrative control in
place of RBI. The first scheme launched by UTI was Unit Scheme 1964. At the end of 1988
UTI had Rs. 6,700 crores of assets under management.
Second Phase - 1987-1993 (Entry of Public Sector Funds)
1987 marked the entry of non-UTI, public sector mutual funds set up by public sector banks
and Life Insurance Corporation of India (LIC) and General Insurance Corporation of India
(GIC). SBI Mutual Fund was the first non-UTI Mutual Fund established in June 1987 followed
by Canbank Mutual Fund (Dec 87), Punjab National Bank Mutual Fund (Aug 89), Indian Bank
Mutual Fund (Nov 89), Bank of India (Jun 90), Bank of Baroda Mutual Fund (Oct 92). LIC
established its mutual fund in June 1989 while GIC had set up its mutual fund in December
1990.
Third Phase - 1993-2003 (Entry of Private Sector Funds)
With the entry of private sector funds in 1993, a new era started in the Indian mutual fund
industry, giving the Indian investors a wider choice of fund families. Also, 1993 was the year
in which the first Mutual Fund Regulations came into being, under which all mutual funds,
except UTI were to be registered and governed. The erstwhile Kothari Pioneer (now merged
with Franklin Templeton) was the first private sector mutual fund registered in July 1993.
The 1993 SEBI (Mutual Fund) Regulations were substituted by a more comprehensive and
revised Mutual Fund Regulations in 1996. The industry now functions under the SEBI
(Mutual Fund) Regulations 1996.
Fourth Phase - since February 2003
In February 2003, following the repeal of the Unit Trust of India Act 1963 UTI was bifurcated
into two separate entities. One is the Specified Undertaking of the Unit Trust of India with
assets under management of Rs. 29,835 crores as at the end of January 2003, representing
broadly, the assets of US 64 scheme, assured return and certain other schemes. The
Specified Undertaking of Unit Trust of India, functioning under an administrator and under
the rules framed by Government of India and does not come under the purview of the
Mutual Fund Regulations.

CLASSIFICATIONS OF MUTUAL FUNDS :

1) Money market funds: These funds invest in short-term fixed income securities such
as government bonds, treasury bills, bankers’ acceptances, commercial paper and
certificates of deposit. They are generally a safer investment, but with a lower
potential return then other types of mutual funds. Canadian money market funds
try to keep their net asset value (NAV) stable at $10 per security.
2) Fixed income funds: These funds buy investments that pay a fixed rate of return like
government bonds, investment-grade corporate bonds and high-yield corporate
bonds. They aim to have money coming into the fund on a regular basis, mostly
through interest that the fund earns. High-yield corporate bond funds are generally
riskier than funds that hold government and investment-grade bonds.
3) Equity funds: These funds invest in stocks. These funds aim to grow faster than
money market or fixed income funds, so there is usually a higher risk that you could
lose money. You can choose from different types of equity funds including those
that specialize in growth stocks (which don’t usually pay dividends), income funds
(which hold stocks that pay large dividends), value stocks, large-cap stocks, mid-cap
stocks, small-cap stocks, or combinations of these.
4) Balanced funds: These funds invest in a mix of equities and fixed income securities.
They try to balance the aim of achieving higher returns against the risk of losing
money. Most of these funds follow a formula to split money among the different
types of investments. They tend to have more risk than fixed income funds, but less
risk than pure equity funds. Aggressive funds hold more equities and fewer bonds,
while conservative funds hold fewer equities relative to bonds.
 5) Index funds: These funds aim to track the performance of a specific index such as
the S&P/TSX Composite Index. The value of the mutual fund will go up or down as
the index goes up or down. Index funds typically have lower costs than actively
managed mutual funds because the portfolio manager doesn’t have to do as much
research or make as many investment decisions.
6) Specialty funds: These funds focus on specialized mandates such as real estate,
commodities or socially responsible investing. For example, a socially responsible
fund may invest in companies that support environmental stewardship, human
rights and diversity, and may avoid companies involved in alcohol, tobacco,
gambling, weapons and the military.
7) Fund-of-funds: These funds invest in other funds. Similar to balanced funds, they
try to make asset allocation and diversification easier for the investor. The MER for
fund-of-funds tend to be higher than stand-alone mutual funds.

ADVANTAGES OF MUTUAL FUNDS:

1) Diversification: Mutual funds spread their holdings across a number of different
investment vehicles, which reduces the effect any single security or class of securities
will have on the overall portfolio. Because mutual funds can contain hundreds or
thousands of securities, investors aren’t likely to be fazed if one of the securities
doesn’t do well.
2) Expert Management:Many investors lack the financial know-how to manage their
own portfolio. However, non-index mutual funds are managed by professionals who
dedicate their careers to helping investors receive the best risk-return trade-off
according to their objectives.
3) Liquidity: Mutual funds, unlike some of the individual investments they may hold,
can be traded daily. Though not as liquid as stocks, which can be traded intraday,
buy and sell orders are filled after market close.
4) Convenience: If you were investing on your own, you would ideally spend time
researching securities. You’d also have to purchase a huge range of securities to
acquire holdings comparable to most mutual funds. Then, you’d have to monitor all
those securities. Choosing a mutual fund is ideal for people who don’t have the time
to micromanage their portfolios.
5) Reinvestment of Income: Another benefit of mutual funds is that they allow you to
reinvest your dividends and interest in additional fund shares. In effect, this allows
you to take advantage of the opportunity to grow your portfolio without paying
regular transaction fees for purchasing additional mutual fund shares.
6) Range of Investment Options and Objectives: There are funds for the highly
aggressive investor, the risk averse, and the middle-of-the-road investor – for
example, emerging markets funds, investment-grade bond funds, and balanced
funds, respectively. There are also life cycle funds to ramp down risk as you near
retirement. There are funds with a buy-and-hold philosophy, and others that are in
 and out of holdings almost daily. No matter your investing style, there’s bound to be
a perfect fund to match it.
7) Affordability: For as little as $50 per month, you can own shares in Google (NASDAQ:
GOOG), Berkshire Hathaway (NYSE: BRK.A), and a host of other expensive securities
via mutual funds. At the time of this writing, a share of Berkshire Hathaway costs
over $119,000 a share.

DISADVANTAGES OF MUTUAL FUNDS:

1) No Control Over Portfolio: If you invest in a fund, you give up all control of your
portfolio to the mutual fund money managers who run it.
2) Capital Gains: Anytime you sell stock, you’re taxed on your gains. However, in a
mutual fund, you’re taxed when the fund distributes gains it made from selling
individual holdings – even if you haven’t sold your shares. If the fund has high
turnover, or sells holdings often, capital gains distributions could be an annual event.
That is, unless you’re investing via a Roth IRA, traditional IRA, or employer-sponsored
retirement plan like the 401k.
3) Fees and Expenses: Some mutual funds may assess a sales charge on all purchases,
also known as a “load” – this is what it costs to get into the fund. Plus, all mutual
funds charge annual expenses, which are conveniently expressed as an annual
expense ratio – this is basically the cost of doing business. The expense ratio is
expressed as a percentage, and is what you pay annually as a portion of your account
value.
4) Over-diversification: Although there are many benefits of diversification, there are
pitfalls of being over-diversified. Think of it like a sliding scale: The more securities
you hold, the less likely you are to feel their individual returns on your overall
portfolio. What this means is that though risk will be reduced, so too will the
potential for gains. This may be an understood trade-off with diversification, but too
much diversification can negate the reason you want market exposure in the first
place.
5) Cash Drag: Mutual funds need to maintain assets in cash to satisfy investor
redemptions and to maintain liquidity for purchases. However, investors still pay to
have funds sitting in cash because annual expenses are assessed on all fund assets,
regardless of whether they’re invested or not. According to a study by William
O’Reilly, CFA and Michael Preisano, CFA, maintaining this liquidity costs investors
0.83% of their portfolio value on an annual basis.