BASICS OF MUTUAL FUNDS

 BASICS OF MUTUAL FUND

 Mutual Fund is a pool of money, invested by many investors.

 The money is finally invested in stocks, bonds, money market instruments
etc.
 The fund is managed by experienced and expert professionals.
 Mutual Fund is set up in the form of trust.
 This trust has a sponsor, trustee, Asset Management Company.
 The trust is registered with securities and Exchange Board of India (SEBI).
 The Asset Management Company is also approved by SEBI.
 Fund managers make strategic investment in order to accomplish growth.
 Investors get units of the mutual fund according to the amount they
invest.
 The Asset Management Company is responsible for managing the
investments for the various schemes operated by mutual fund.
Disadvantages of Mutual Funds

Disadvantages include high expense ratios and sales charges, management

abuses, tax inefficiency, and poor trade execution. Here's a more detailed look
at both the advantages and disadvantages of this investment strategy.
High Expense Ratios and Sales Charges

If you're not paying attention to mutual fund expense ratios and sales charges,
they can get out of hand. Be very cautious when investing in funds with
expense ratios higher than 1.50%, as they are considered to be on the higher
cost end. Be wary of advertising fees and sales charges in general. There are
several good fund companies out there that have no sales charges. Fees
reduce overall investment returns.
Management Abuses

Churning, turnover, and window dressing may happen if your manager is

abusing their authority. This includes unnecessary trading, excessive
replacement, and selling the losers prior to quarter-end to fix the books.
Tax Inefficiency

Like it or not, investors do not have a choice when it comes to capital

gains payouts in mutual funds. Due to the turnover, redemptions, gains, and
losses in security holdings throughout the year, investors typically receive
distributions from the fund that are an uncontrollable tax event .

ADVANTAGE OF MUTUAL FUNDs

 
Mutual funds are one of the most popular investment choices in the U.S.
Advantages for investors include advanced portfolio management, dividend
reinvestment, risk reduction, convenience, and fair pricing. Disadvantages
include high fees, tax inefficiency, poor trade execution, and the potential for
management abuses.
 
There are many reasons why investors choose to invest in mutual funds with
such frequency. Let's break down the details of a few.
Advanced Portfolio Management

When you buy a mutual fund, you pay a management fee as part of your
expense ratio, which is used to hire a professional portfolio manager who buys
and sells stocks, bonds, etc. This is a relatively small price to pay for getting
professional help in the management of an investment portfolio.
Dividend Reinvestment

As dividends and other interest income sources are declared for the fund, they
can be used to purchase additional shares in the mutual fund, therefore
helping your investment grow.

Risk Reduction (Safety)

Reduced portfolio risk is achieved through the use of diversification, as most

mutual funds will invest in anywhere from 50 to 200 different securities—
depending on the focus. Numerous stock index mutual funds own 1,000 or
more individual stock positions.
Convenience and Fair Pricing

Mutual funds are easy to buy and easy to understand. They typically have low
minimum investments and they are traded only once per day at the closing
net asset value (NAV). This eliminates price fluctuation throughout the day
and various arbitrage opportunities that day traders practice.

STRUCTURE OF MUTUAL FUNDS IN INDIA

 

In India, the structure of Mutual Funds is a three-tier structure with a few

other significant components. It is not just the different banks or AMCs that
create or float different mutual fund schemes; instead, there are other players
that are involved in the structure of mutual funds. The primary watchdog in all
these transactions is the Securities Exchange Board of India (‘SEBI’) under
whom each entity is required to be registered with. The inception of SEBI
(Mutual Funds) Regulations, 1996, revolutionized the structure of mutual funds
and since then all the entities are regulated under it. Currently, mutual funds
comprise of five basic participants, namely a Sponsor, Mutual Fund
Trustee, Asset Management Company, Custodian & Registrar and a Transfer
Agent.
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. Once the trust is
created, the Trustee is registered with SEBI and is appointed as the trustee of
the fund in order to safeguard the interest of the unit holders and to adhere
the SEBI Mutual Fund regulations The Sponsor subsequently creates an Asset
Management Company under the Companies Act, 1956 to deal with the fund
management. There are certain eligibility criteria to become a Sponsor, as
prescribed under:
a. The Sponsor must have profit in 3 of the last 5 years including immediately
preceding year.
b. The Sponsor must have a minimum of 5 years of experience in financial
services.
c. The net worth of the Sponsor must be positive for all the preceding five
years.
d. Out of the total net worth of the AMC, 40% must be participated by the
Sponsor.
As seen above, the position of a Sponsor is crucial and they should have high
credibility. Strict norms show that the sponsor must have enough liquidity and
faithfulness to return the money of an innocent investor, in case of a financial
meltdown.
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. The SEBI has tightened the rule of transparency so as to avoid any
conflict of interest between the Sponsor and the AMC. Without the permission
and approval of the Trust, an AMC cannot float a new mutual fund scheme. It
is important for the Trustees to act independently and take appropriate
measures to safeguard the hard earned money of the investors. The Trustees
are also required to be registered under SEBI, and SEBI further regulates their
registration by either suspending or revoking the registration if found
breaching any conditions.
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.

Other Participants in the Structure of Mutual Funds

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 managers.
These are the participants who play a key role in the management of mutual
funds. Each participant has their individual role to play. However, their
functions are interlinked with each other. Mutual fund regulations are the
bible by which all the participants are bound together, to perform their
functions more diligently and without prejudice to the interest of the investors.
HISTORY OF MUTUAL 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.
 
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.
At the end of 1993, the mutual fund industry had assets under management of
Rs. 47,004 crores.
 
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.
The number of mutual fund houses went on increasing, with many foreign
mutual funds setting up funds in India and also the industry has witnessed
several mergers and acquisitions. As at the end of January 2003, there were 33
mutual funds with total assets of Rs. 1, 21,805 crores. The Unit Trust of India
with Rs. 44,541 crores of assets under management was way ahead of other
mutual funds.
 
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.
The second is the UTI Mutual Fund, sponsored by SBI, PNB, BOB and LIC. It is
registered with SEBI and functions under the Mutual Fund Regulations. With
the bifurcation of the erstwhile UTI which had in March 2000 more than Rs.
76,000 crores of assets under management and with the setting up of a UTI
Mutual Fund, conforming to the SEBI Mutual Fund Regulations, and with
recent mergers taking place among different private sector funds, the mutual
fund industry has entered its current phase of consolidation and growth.
The graph indicates the growth of assets over the years.
 
Note:
Erstwhile UTI was bifurcated into UTI Mutual Fund and the Specified
Undertaking of the Unit Trust of India effective from February 2003. The Assets
under management of the Specified Undertaking of the Unit Trust of India has
therefore been excluded from the total assets of the industry as a whole from
February 2003 onwards.

Risk Involved in Mutual Funds

All investments involve some form of risk, which should be evaluated them
potential rewards when an investment is selected.
 Market risk
At times the prices or yields of all the securities in a particular market rise or
fall due to broad outside influences. When this happens, the stock prices of
both an outstanding, highly profitable company and a fledgling corporation
may be affected. This change in price is due to “market risk”.

Interest rate risk

Sometimes referred to as “loss of purchasing power”. Whenever inflation
sprints forward faster than the earnings on your investment, you run the risk
that you will actually be able to buy less, not more. Inflation risk also occurs
when prices rise faster than your returns.

Credit risk
In short, how stable is the company or entity to which you lend your money
when you invest? How certain are you that it will be able to pay the interest
you are promised, or repay your principal when the investment matures?

Inflation risk
Changing interest rates affect both equities and bonds in many ways. Investors
are reminded that “predicting” which way rates will go is rarely successful. A
diversified portfolio can help in offsetting these changes.
An industries’ key asset is often the personnel who run the business i.e.
intellectual properties of the key employees of the respective companies.
Given the ever-changing complexion of few industries and the high
obsolescence levels, availability of qualified, trained and motivated personnel is
very critical for the success of industries in few sectors. It is, therefore,
necessary to attract key personnel and also to retain them to meet the
changing environment and challenges the sector offers. Failure or inability to
attract/retain such qualified key personnel may impact the prospects of the
companies in the particular sector in which the fund invest.

Exchange risks

A number of companies generate revenues in foreign currencies and may have

Investments or expenses also denominated in foreign currencies. Changes in
exchange rates may, therefore, have a positive or negative impact on
companies which in turn would have an effect on the investment of the fund.

Investment risks

The sectoral fund schemes, investments will be predominantly in equities of

select companies in the particular sectors. Accordingly, the NAV of the
schemes are linked to the equity performance of such companies and may be
more volatile than a more diversified portfolio of equities.

Changes in government policy

Changes in Government policy especially in regard to the tax benefits may

impact the business prospects of the companies leading to an impact on the
investments made by the fund.

MUTUAL FUNDS- DO’s and DONT’s

We all have come across ads which say that “Mutual Funds are subject to
market risk, please read the offer document carefully before investing”.
Likewise there are many dos and don’ts one has to keep in mind before getting
into investing in mutual funds. The following points might help one to optimize
his/her investment decision—

Assess yourself:
Self-assessment of one’s needs; expectations and risk profile is of prime
importance failing which; one will make more mistakes in putting money in
right places than otherwise. One should identify the degree of risk bearing
capacity one has and also clearly state the expectations from the investments.
Irrational expectations will only bring pain.
Try to understand where the money is going:
It is important to identify the nature of investment and to know if one is
compatible with the investment. One can lose substantially if one picks the
wrong kind of mutual fund. In order to avoid any confusion it is better to go
through the literature such as offer document and facts sheets that mutual
fund companies provide on their funds.
Don't rush in picking funds, think first:
One first has to decide what he wants the money for and it is this investment
goal that should be the guiding light for all investments done. It is thus
important to know the risks associated with the fund and align it with the
quantum of risk one is willing to take. One should take a look at the portfolio of
the funds for the purpose. Excessive exposure to any specific sector should be
avoided, as it will only add to the risk of the entire portfolio. Mutual funds
invest with a certain ideology such as the "Value Principle" or "Growth
Philosophy". Both have their share of critics but both philosophies work for
investors of different kinds. Identifying the proposed investment philosophy of
the fund will give an insight into the kind of risks that it shall be taking in
future.

Invest. Don’t speculate:

A common investor is limited in the degree of risk that he is willing to take. It is
thus of key importance that there is thought given to the process of
investment and to the time horizon of the intended investment. One should
abstain from speculating which in other words would mean getting out of one
fund and investing in another with the intention of making quick money. One
would do well to remember that nobody can perfectly time the market so
staying invested is the best option unless there are compelling reasons to exit.
Don’t put all the eggs in one basket:
This old age adage is of utmost importance. No matter what the risk profile of a
person is, it is always advisable to diversify the risks associated. So putting
one’s money in different asset classes is generally the best option as it averages
the risks in each category. Thus, even investors of equity should be judicious
and invest some portion of the investment in debt. Diversification even in any
particular asset class (such as equity, debt) is good. Not all fund managers have
the same acumen of fund management and with identification of the best man
being a tough task, it is good to place money in the hands of several fund
managers. This might reduce the maximum return possible, but will also
reduce the risks.
Be regular:
Investing should be a habit and not an exercise undertaken at one’s wishes, if
one has to really benefit from them. As we said earlier, since it is extremely
difficult to know when to enter or exit the market, it is important to beat the
market by being systematic. The basic philosophy of Rupee cost averaging
would suggest that if one invests regularly through the ups and downs of the
market, he would stand a better chance of generating more returns than the
market for the entire duration. The SIPs (Systematic Investment Plans) offered
by all funds helps in being systematic.