Financial Markets and Operations

Module 4

Mutual funds

Section A

Short answer questions carries 2 marks each.

1. What is a mutual fund?

mutual fund is an investment vehicle where many investors pool their money to
earn returns on their capital over a period. This corpus of funds is managed by
an investment professional known as a fund manager or portfolio manager. The
gains (or losses) on the investment are shared collectively by the investors in
proportion to their contribution to the fund.
2. Distinguish between open ended scheme and close ended scheme.
Open ended schemes buy and give units on a regular basis and allow investors
to enter and exit in accordance to their benefit. The units can be purchased and
traded even after the NFO(New Fund Offer) period. The units are bought and
sold at the NAV that is net asset value. The amount of extra-unit moves higher or
lower every time the Asset Management Company gives or repurchases the
current units.
Closed-Ended fund issues a fixed amount of units that are sold/purchased on the
stock exchange. They are introduced by NFO to allocate money and then trade
in the open market just like stocks. The value of the fund is based on NAV, the
original cost of the fund is influenced by demand and supply as it permits to trade
at the cost higher or lower its real value.
So, closed-end funds can buy and sell at premiums or discounts to their NAVs.
Units of closed-end funds are traded by brokers.
3. What is growth fund?
The main objective of growth funds is capital appreciation. These funds put a
significant portion of the money in stocks. These funds can be relatively more
 risky due to high exposure to equity and hence it is good to invest in them for the
long-term.
4. Explain balanced fund.
A balanced fund is a mutual fund that typically contains a component of stocks
and bonds. A mutual fund is a basket of securities in which investors can
purchase. Typically, balanced funds stick to a fixed asset allocation of stocks and
bonds, such as 70% stocks and 30% bonds.
5. What do you meant by leverage fund?
Leveraged mutual funds are just like regular mutual funds, but use leverage to
increase their returns, delivering multiples of the index or benchmark they track.
The funds are often labeled “ultra,” “bull” or “2X” and some use derivatives such
as options, futures and swaps to boost performance
6. What are MMMF?
Money market fund is an open-ended mutual fund that invests in short-term debt
securities such as US Treasury bills and commercial paper. Money market funds
are managed with the goal of maintaining a highly stable asset value through
liquid investments, while paying income to investors in the form of dividends.
7. What is income fund?
An income fund is a type of mutual fund or exchange-traded fund (ETF) that
emphasizes current income, either on a monthly or quarterly basis, as opposed
to capital gains or appreciation. Such funds usually hold a variety of government,
municipal, and corporate debt obligations, preferred stock, money market
instruments, and dividend-paying stocks.
8. As the name suggests, income funds try to provide investors with a stable
income. These are debt funds that invest mostly in bonds, government securities
and certificate of deposits, etc. They are suitable for different -term goals and for
investors with a lower-risk appetite.
9. What is ELSS funds?
Equity linked saving schemes are subclass of diversified equity fund . Investment
in an ELSS fetch tax deduction u/s 80 C of income tax act . An ELSS fund
operates much like an equity fund except a lock in period of 3 years .
10. What are offshore funds?
These kinds of Mutual funds mobilize savings from foreign countries in foreign
[Link] may invest them in Indian companies.
11. Define NAV.
NAV is the market value of the securities held by the scheme. Mutual Funds
invest the money collected from investors in securities markets. Since market
value of securities changes every day, NAV of a scheme also varies on day to
day basis. The NAV per unit is the market value of securities of a scheme divided
by the total number of units of the scheme on any particular date.
12. Explain ETF and GTF.
Exchange-traded funds, commonly known as ETFs, are a collection of various
securities such as bonds, shares, money market instruments, etc., that often
track an underlying asset
It is a mutual fund scheme which combines the best features of open and close
in schemes
Gold ETFs:
Such securities offer investors the path to hold claims in the bullion market
without making it necessary to purchase physical gold. You could also purchase
ETFs that focus on precious metals in general.
13. What is NFO?
A new fund offer (NFO) refers to the initial sale of fund shares issued by an
investment company to investors. Similar to an IPO in the stock
market, NFOs are intended to raise capital for the fund and attract investors.
14. How mutual fund units are priced?
The easiest way to find out the price of a mutual fund is to look at its net asset
value. NAV is the total value of a mutual fund’s assets, less all of its liabilities.
Many mutual funds use this number to determine the price for transacting units of
the fund. When you buy and sell mutual funds, you typically do so at the NAV.
The sale price is NAV plus entry load it’s called offer price
The repurchase price is NAV minus exit load it is called the bid price
15. Who is AMC?
 An asset management company (AMC) is a firm that invests pooled funds from
clients, putting the capital to work through different investments including stocks,
bonds, real estate, master limited partnerships, and more. Asset management
companies are colloquially referred to as money managers or money
management firms.
16. Explain AMFI.
The Association of Mutual Funds in India (AMFI) is dedicated to developing the
Indian Mutual Fund Industry on professional, healthy and ethical lines and to
enhance and maintain standards in all areas with a view to protecting and
promoting the interests of mutual funds and their unit [Link] is a
representative of the RBI, SEBI, finance ministry and other bodies related to
money market investments. An important role of AMFI in Mutual Funds is to
distribute information about these investments and also conduct various
workshops about different funds.

17. What do you meant by lock in period?

Lock in period is the time period during which investors are restricted to redeem
or sell their investments. During a lock in period, investors can’t sell their
investments. However, once the lock in period ends, investors are free to sell
their investments.

Section B
Short essay questions carries 5 marks each.
1. Explain the features of mutual funds.
• Professional Management and Regulations
o Most mutual funds are managed by qualified and experienced investment
advisers who are registered with the Securities Exchange Commission
(SEC). SEC has laid down strict laws and regulations to safeguard
investors’ interests. This helps to boost investor confidence.

• Diversification
 o Most mutual funds spread investments across a wide range of companies,
industry sectors based on market capitalization. Equity mutual funds
invest in shares of a variety of companies whereas debt funds invest in
Treasury securities, bonds, and other fixed-income securities. This
diversification helps hedge investors against the risk of loss in some
company’s or sector.

• Low Minimum Investment

o Mutual funds pool money from a huge number of investors with common
interests. They are ideal even for investors with little money to invest.
Investors can make a relatively low initial investment, low subsequent
monthly purchases, or both. Investors of mutual funds can benefit from
lower trading costs as mutual funds buy and sell a variety of asset classes
in large volumes. This helps investors’ to benefit from economies of scale.

• Liquidity
o Mutual funds are highly liquid more than most individual stocks, deposits,
and bonds. Investors can readily redeem all or part of their investments at
the next calculated Net Asset Value (NAV) at any point in time in an open-
ended fund. This can be done after subtracting any fees and charges
assessed on redemption and on any business day. Mutual fund
companies are obliged to send investors to pay for the shares within 1 to 7
working days, though many funds provide payment sooner through a
standardized process.

• Costs Regardless of Negative Returns

o Investors in mutual funds incur costs such as sales charges, annual fees,
management fees, operating fees among other expenses in spite of-of
how the mutual fund performs. Investors may also have to pay taxes on
any capital gains allocation they get from the fund. These mutual funds
associated costs lower the investment returns.
 • Lack of Control
o Investors of mutual funds cannot directly control which securities they
want to be included in the funds’ portfolios. If you invest in a mutual fund,
you give the entire control of your portfolio to the mutual fund investment
managers who keep track of markets and find the best investment
opportunities on your behalf.

• Transparency
o Mutual fund investors receive detailed and timely information on how your
money is invested as well.
2. Explain types of ETF’s.

Types of Exchange Traded Funds (ETFs)

There are several ETFs available to suit the demands of almost all investors. Following
are some types of ETFs available to an individual:

1. Bond ETFs

These are typical ETFs designed to provide exposure to different types of bonds.
Investing in bonds is a good way to mitigate the ups and downs of investing and
diversifying a portfolio.

2. Currency ETFs:

These securities allow an investor to participate in currency market transactions without

purchasing a specific currency. The motive of such investments is to track and benefit
from the price fluctuations of a particular currency or a basket of currencies.

3. Inverse ETFs:

Such funds are designed to return the opposite of what is offered by the underlying
market index. With these funds, share prices move in the opposite direction of the
inverse ETFs’ share.
4. Liquid ETFs:

These funds try to minimize price risks and enhance returns by investing in a basket of
short-term government securities, such as money and money market instruments with
short maturities, while simultaneously attempting to maintain liquidity.

5. Gold ETFs:

Such securities offer investors the path to hold claims in the bullion market without
making it necessary to purchase physical gold. You could also purchase ETFs that
focus on precious metals in general.

6. Index ETFs:

Index funds track the performance of their underlying index. They are further subdivided
into replication and representative ETFs. Index funds that invest entirely in the securities
underlying the index are called replication ETFs. On the contrary, representative ETFs
are those that invest a majority of their fund corpus in representative samples and the
remaining in other securities such as futures, options, etc.

3. Explain the features of ETF.

1. Liquidity:
ETFs can be sold throughout the day over stock exchanges, though some funds
are more frequently traded than others. The more regularly a fund is traded, the
easier it is to find a willing seller or buyer.

2. Lower cost:
ETFs have much lower expense ratios than traditional mutual funds. This is
because ETF shareholders are not mandated to pay for the team of managers,
analysts, and brokers to trade funds on their behalf or manage the fund’s inflows
and outflows.
[Link]:
 Unlike mutual funds that are only instructed to disclose their holdings quarterly,
ETFs disclose the fund’s holdings and its NAV daily for open-ended schemes
and close-ended schemes.

[Link]:
ETFs allow investors to diversify their portfolio across horizontals such as
industries, sectors, styles, or countries. ETFs are also traded on virtually every
major asset class, currency, and commodity in the world.
4. State benefits of investing in mutual fund.
Liquidity
The most important benefit of investing in a Mutual Fund is that the investor can
redeem the units at any point in time. Unlike Fixed Deposits, Mutual Funds have
flexible withdrawal but factors like the pre-exit penalty and exit load should be
taken into consideration.

1Diversification
The value of an investment may not rise or fall in tandem. When the value of one
investment is on the rise the value of another may be in decline. As a result, the
portfolio’s overall performance has a lesser chance of being volatile.
Diversification reduces the risk involved in building a portfolio thereby further
reducing the risk for an investor. As Mutual Funds consist of many securities,
investor’s interests are safeguarded if there is a downfall in other securities so
purchased.

2Expert Management
A novice investor may not have much knowledge or information on how and
where to invest. The experts manage and operate mutual funds. The experts
pool in money from investors and allocates this money in different securities
thereby helping the investors incur a profit.

3 Flexibility to invest in Smaller Amounts

Among other benefits of Mutual Funds the most important benefit is its flexible
nature. Investors need not put in a huge amount of money to invest in a Mutual
Fund. Investment can be as per the cash flow position.

[Link] – Mutual Funds are Easy to Buy

Mutual Funds are easily accessible and you can start investing and buy mutual
funds from anywhere in the world.
[Link] for Every Financial Goals
The best part of the Mutual Fund is the minimum amount of investment can be
Rs. 500. And the maximum can go up to whatever an investor wishes to invest.
[Link] and Transparency
With the introduction of SEBI guidelines, all products of a Mutual Fund have been
labeled. This means that all Mutual Fund schemes will have a color-coding. This
helps an investor to ascertain the risk level of his investment, thus making the
entire process of investment transparent and safe.
[Link] cost
In a Mutual Fund, funds are collected from many investors, and then the same is
used to purchase securities. These funds are however invested in assets which
therefore helps one save on transaction and other costs as compared to a single
transaction.
[Link] Tax Saving Option
Mutual Funds provide the best tax saving options. ELSS Mutual Funds have a
tax exemption of Rs. 1.5 lakh a year under section 80C of the Income Tax Act.
[Link] Lock-in Period
Tax Saving Mutual Funds have the lowest lock-in periods of only 3 years. This is
lower as compared to a maximum of 5 years for other tax saving options like FD,
ULIPs, and PPF.
[Link] Tax on the Gains
With Equity linked saving scheme you can save tax up to Rs. 1.5 Lakh a year
under section 80C of Income Tax (IT) Act. All other types of Mutual Funds are
taxable depending on the type of fund and tenure.
 5. Discuss the disadvantages of mutual fund.
[Link] to Manage the Mutual Fund scheme
As mentioned above, Market Analysts or Fund Managers manage and operate
the mutual funds. These Fund Managers work for the fund houses that manage
huge investments every day. This requires a lot of efficiencies, expertise, and
experience in the subject matter.
[Link]
Due to dilution, it is not recommended to invest in too many Mutual Funds at the
same time. Diversification, although saves an investor from major losses, also
restricts one from making a higher profit.
[Link]-in Periods
Equity-linked Saving Scheme (ELSS) have a longer lock-in period of 3 years.
This debars an investor from withdrawing the investment before the lock-in
period is over. However, withdrawing these funds before the lock-in period could
lead to huge penalties.
[Link] control over investment decision.

[Link] not guaranteed.

6. Explain the constitution and management of Mutual Fund.

Section C

Long essay questions carries 15 marks each.

[Link] organisational setup of Mutual Fund in India.

Sponsor
A sponsor is any person or entity that can set up a mutual fund scheme to generate
income through fund management. The sponsor can be said as the first layer of the
three-tier structure of mutual funds in India. The sponsor is required to approach SEBI
and get a mutual fund scheme approved. The sponsor cannot work alone. It needs to
create a Public Trust under the Indian Trust Act 1882 and get the same registered with
SEBI.
Trust And Trustees
Trust and trustees make up the second layer of the structure of mutual funds. Trustees
are also known as the protectors of the fund and are employed by the fund sponsor. As
the name suggests, they have a very important role in maintaining the trust of the
investors and to oversee the growth of the fund. SEBI mandates the trustees to provide
a report on the fund and the functioning of the AMC on a half-yearly basis. Trustees can
be created either in the form of Board of Trustees or a Trust Company. The Trustees
supervise the entire functioning of the AMC and regulate the operations of the mutual
fund schemes.
Asset Management Company
An AMC is the third working layer in the structure of mutual funds. An AMC floats
various schemes of mutual fund in the market, pursuant to the needs of the investors
and the nature of the market. They create mutual funds along with the trustee and the
sponsor and then oversee its development. While creating the scheme, they take help
of bankers, brokers, RTAs auditors etc. and enter into an agreement with them. An
AMC is a company formed under Companies Act and needs to be registered under
SEBI. Similar to the Trustees, an AMC also needs to ensure that there is no conflict of
interest amongst them, the sponsor and the trustees.

Custodian
A Custodian is an entity, which is responsible for the safekeeping of the securities.
Custodians are registered with SEBI and are responsible for the transfer and delivery of
units and securities. Custodians also enable investors in updating their holdings at a
particular point of time and help them in keeping track of their investments. Along with
the primary job of safekeeping, custodians are also in charge of the collection of
corporate benefits such as bonus issue, interest, dividends etc.

Registrar And Transfer Agents

RTAs are an important link between fund managers and investors. They cater to the
fund managers by updating them with the investor details and to investors by delivering
the benefits of the fund to them. RTAs are SEBI registered entities who process the
applications of mutual funds, help with investor KYC, manage and deliver periodical
statements of investments, update records of investors and process investor requests.
Link-in time, Karvy etc. are some of the famous RTAs in India and they provide the
requisite operational support to the AMC in mutual fund activities.
Other Participants
Some other participants in the structure of mutual funds are brokers, auditors, and
bankers. The brokers are responsible to attract investors and help to disseminate the
fund. The brokers help investors in sell, purchase of units and provide with their
valuable advice. Brokers also study the market trend and predict the future movement
of the market. Unlike brokers, auditors are an independent internal watchdog, who audit
the financials of the AMC, Trustee, and Sponsor and provide their report. Bankers are
also an important participant, who act as collecting agents on behalf of the fund
manager.

2. Define mutual fund. What are the different types of Mutual funds.

Mutual fund is a financial instrument that pools money from different investors. The
pooled money is then invested in securities like stocks of listed companies, government
bonds, corporate bonds, and money market instruments.

As an investor, you don’t directly own the company’s stocks that mutual funds
purchases. However, you share the profit or loss equally with the other investors of the
pool. This is how the word “mutual” is associated with a mutual fund.

You get the advantage of the expertise of the fund manager and regulatory safety of the
Securities Exchange and Board of India (SEBI). The professional fund manager
ensures a maximum return to investors.

The three broad categories of mutual funds are:

1. Equity Mutual Funds

Equity mutual funds invest the pooled money majorly in stocks of different companies.
Hence, equity mutual funds have an inherent higher market risk. Factors like earnings,
revenue forecasts, management changes, and company & economic policy impact price
movements and the returns. Returns from equity mutual funds have high fluctuations.
Hence, you should invest, if you have a fair understanding of the asset class risks
associated with equity.

Types of Equity Funds

Equity fund can be further categorized depending on market capitalization and sectors.

Based on Market Capitalization

Large-cap Equity Funds – Invest in shares of large-cap companies that are well-
established with a track record of performing consistently over a longer time period.
These companies have sound fundamentals and are least affected by business cycles.

Mid-cap Equity funds – Invest in shares of mid-cap companies. Mid-sized companies

have relatively lower stability in terms of performance. But have the potential to grow
more than the large-cap companies.

Small-cap Funds – Invest in shares of small-cap companies. Small-cap companies have

the highest potential to grow or fail. Thus, small-cap funds have a high-risk exposure but
also offer an opportunity to generate the highest returns.

Multi-cap funds – Invest in a defined proportion across all market caps. Based on cues
and trend analysis, the fund manager allocates aggressively to capitalize on the
volatility.

Sector Based Equity Funds: Sector-based equity funds invest in stocks of a specific
sector. For example, sectors like FMCG, technology, and pharma. Sector funds are
prone to business cycle risk and sector getting out of focus.

2. Debt Mutual Funds

A debt mutual fund invests a major portion of the pooled corpus in debt instruments like
government securities, corporate bonds, debentures, and money-market instruments.
The bond issuers “borrow” from investors by giving an assurance of steady and regular
interest income. Thus, debt funds are less risky compared to equity funds. The debt
fund manager ensures that the fund is invested in the highest-rated securities. The best
credit rating signifies the creditworthiness of the issuer in terms of regular interest
payments and principal repayment.

Type of Debt Funds

Following are the debt funds available in India:

Dynamic Bond Funds: Dynamic bond fund investment basket comprises of both shorter
and longer maturities. The debt fund manager aggressively tweaks the portfolio
composition based on changing interest rate regime. This aggressiveness makes the
debt fund dynamic, hence the name.

Liquid Funds: The short maturity of the underlying securities (not more than 91 days)
makes the liquid funds almost risk-free. It is better than parking funds in saving bank
accounts as it gives better returns with much-needed liquidity. You can redeem liquid
funds almost instantly. If you are short-term investors then debt funds like liquid funds
could be better as you get returns in the range of 6.5 to 8%. Liquid funds are an
effective tool to meet emergency fund needs.

Income Funds: Fund managers invest majorly in securities with longer maturities to
have more stability and regular interest income flow. Most of the income funds have an
average maturity of 5 to 6 years.

Short-Term and Ultra Short-Term Debt Funds: There is another category in the maturity
range of 1 to 3 years. The fund manager takes a call on interest rate regime and invests
in securities with maturity of the said range. This is suitable for those investors who are
risk-averse and looking for interest rate movement safety.

Gilt Funds: Gilt funds invest only in high-rated government securities. Since the
government rarely defaults, it has zero risks. You can park your money in this
instrument to have assured returns in longer maturity range.

Credit Opportunities Funds: Credit Opportunities Funds are a relatively riskier

instrument that focuses more on higher returns by holding low-rated bonds or taking a
call on credit risks. The fund manager of credit opportunity funds relies more on interest
rate volatility to earn higher returns.

Fixed Maturity Plans: These closed-ended debt funds invest in fixed income securities
like government bonds and corporate bonds. You invest only during the initial offer
period and your money remains locked-in for a fixed tenure, which could be months or
years.
Some popular types of mutual funds based on investor objectives:

#1. Growth Oriented Scheme

As the name suggests the primary goal of this type of mutual fund is to ensure wealth
creation in the medium and long-term.

Aligned with the objective, the fund manager allocates the corpus predominantly (over
65%) in equities. With a focus on higher returns, the manager aggressively shuffles the
portfolio to reap the benefits of market movements.

#2. Income Oriented Scheme

The objective of the regular income could be achieved only when the underlying assets
assure a steady return.

To meet the objective, fund manager of income funds allocate a major portion of the
corpus in fixed income securities such as government securities, bonds, corporate
debentures, and money market instruments.

Lesser risks and assured return makes it safe for regular income as dividends.
However, these products have very limited potential for wealth creation in the defined
period.

#3. Balanced Fund

The name comes from the asset allocation as the fund is allocated in both equities and
debt instruments in defined proportions. The objective of the balanced fund is to have
reasonable growth and regular income with the lowest possible risk.

Fund managers of these funds normally allocated approx 60% in equities and rest on
debt instruments. NAV of balanced funds is less volatile as compared to equity funds.

The balanced objective is suitable for those who want to have advantages of market
movements and the safety of the debt market.
#4. Liquid Fund

The objective of these schemes is to ensure liquidity, capital protection, and reasonable
income in the short-term.

Most of the pooled fund is invested in short-term safe instruments like government
securities, treasury bills, certificates of deposit, commercial paper, and inter-bank call
money.