Mutual Fund Mgt

8/9/2019 Mutual Fund Mgt

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Professional Management

Mutual Funds provide the services of experienced and skilled professionals, backed by adedicated investment research team that analyses the performance and prospects of companiesand selects suitable investments to achieve the objectives of the scheme.

Diversification

Mutual Funds invest in a number of companies across a broad cross-section of industriesand sectors. This diversification reduces the risk because seldom do all stocks decline atthe same time and in the same proportion. You achieve this diversification through aMutual Fund with far less money than you can do on your own.

Convenient Administration

Investing in a Mutual Fund reduces paperwork and helps you avoid many problems such as baddeliveries, delayed payments and follow up with brokers and companies. Mutual Funds save yourtime and make investing easy and convenient.

Return Potential

Over a medium to long-term, Mutual Funds have the potential to provide a higher return as theyinvest in a diversified basket of selected securities.

Low Costs

Mutual Funds are a relatively less expensive way to invest compared to directly investing in thecapital markets because the benefits of scale in brokerage, custodial and other fees translate intolower costs for investors.

Liquidity

In open-end schemes, the investor gets the money back promptly at net asset valuerelated prices from the Mutual Fund. In closed-end schemes, the units can be sold on astock exchange at the prevailing market price or the investor can avail of the facility ofdirect repurchase at NAV related prices by the Mutual Fund.

Transparency

You get regular information on the value of your investment in addition to disclosure on thespecific investments made by your scheme, the proportion invested in each class of assets andthe fund manager's investment strategy and outlook.

Flexibility

Through features such as regular investment plans, regular withdrawal plans and dividendreinvestment plans, you can systematically invest or withdraw funds according to yourneeds and convenience.

Affordability

Investors individually may lack sufficient funds to invest in high-grade stocks. A mutual


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fund because of its large corpus allows even a small investor to take the benefit of itsinvestment strategy.

Choice of Schemes

Mutual Funds offer a family of schemes to suit your varying needs over a lifetime.

Well Regulated

All Mutual Funds are registered with SEBI and they function within the provisions of strictregulations designed to protect the interests of investors. The operations of Mutual Funds areregularly monitored by SEBI. The net asset value of the fund is the cumulative market value ofthe assets fund net of its liabilities. In other words, if the fund is dissolved or liquidated, by sellingoff all the assets in the fund, this is the amount that the shareholders would collectively own. Thisgives rise to the concept of net asset value per unit, which is the value, represented by theownership of one unit in the fund. It is calculated simply by dividing the net asset value of the fundby the number of units. However, most people refer loosely to the NAV per unit as NAV, ignoringthe "per unit". We also abide by the same convention.

Calculation of NAV

The most important part of the calculation is the valuation of the assets owned by the fund. Onceit is calculated, the NAV is simply the net value of assets divided by the number of unitsoutstanding. The detailed methodology for the calculation of the asset value is given below.

Asset value is equal to

Sum of market value of shares/debentures

+ Liquid assets/cash held, if any

+ Dividends/interest accrued

Amount due on unpaid assets

Expenses accrued but not paid

Details on the above items

For liquid shares/debentures, valuation is done on the basis of the last or closing market price onthe principal exchange where the security is traded

For illiquid and unlisted and/or thinly traded shares/debentures, the value has to be estimated.

For shares, this could be the book value per share or an estimated market price if suitablebenchmarks are available. For debentures and bonds, value is estimated on the basis of yields ofcomparable liquid securities after adjusting for illiquidity. The value of fixed interest bearingsecurities moves in a direction opposite to interest rate changes Valuation of debentures andbonds is a big problem since most of them are unlisted and thinly traded. This gives considerableleeway to the AMCs on valuation and some of the AMCs are believed to take advantage of thisand adopt flexible valuation policies depending on the situation.

Interest is payable on debentures/bonds on a periodic basis say every 6 months. But, with everypassing day, interest is said to be accrued, at the daily interest rate, which is calculated by


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dividing the periodic interest payment with the number of days in each period. Thus, accruedinterest on a particular day is equal to the daily interest rate multiplied by the number of dayssince the last interest payment date.

Usually, dividends are proposed at the time of the Annual General meeting and become due onthe record date. There is a gap between the dates on which it becomes due and the actual

payment date. In the intermediate period, it is deemed to be "accrued".

Expenses including management fees, custody charges etc. are calculated on a daily basis.

The end of millennium marks 36 years of existence of mutual funds in this country. The ridethrough these 36 years is not been smooth. Investor opinion is still divided. While some are formutual funds others are against it.

UTI commenced its operations from July 1964 .The impetus for establishing a formal institutioncame from the desire to increase the propensity of the middle and lower groups to save and toinvest. UTI came into existence during a period marked by great political and economic

uncertainty in India. With war on the borders and economic turmoil that depressed the financialmarket, entrepreneurs were hesitant to enter capital market.The already existing companies found it difficult to raise fresh capital, as investors did notrespond adequately to new issues. Earnest efforts were required to canalize savings of thecommunity into productive uses in order to speed up the process of industrial growth.The then Finance Minister, T.T. Krishnamachari set up the idea of a unit trust that would be "opento any person or institution to purchase the units offered by the trust. However, this institution aswe see it, is intended to cater to the needs of individual investors, and even among them as far aspossible, to those whose means are small."

His ideas took the form of the Unit Trust of India, an intermediary that would help fulfill the twinobjectives of mobilizing retail savings and investing those savings in the capital market andpassing on the benefits so accrued to the small investors.

UTI commenced its operations from July 1964 "with a view to encouraging savings andinvestment and participation in the income, profits and gains accruing to the Corporation from theacquisition, holding, management and disposal of securities."Different provisions of the UTI Actlaid down the structure of management, scope of business, powers and functions of the Trust aswell as accounting, disclosures and regulatory requirements for the Trust.

One thing is certain the fund industry is here to stay. The industry was one-entity showtill 1986 when the UTI monopoly was broken when SBI and Canbank mutual fund enteredthe arena. This was followed by the entry of others like BOI, LIC, GIC, etc. sponsored bypublic sector banks. Starting with an asset base of Rs0.25bn in 1964 the industry hasgrown at a compounded average growth rate of 26.34% to its current size of Rs1130bn.

The period 1986-1993 can be termed as the period of public sector mutual funds (PMFs). Fromone player in 1985 the number increased to 8 in 1993. The party did not last long. When theprivate sector made its debut in 1993-94, the stock market was booming.

The opening up of the asset management business to private sector in 1993 saw internationalplayers like Morgan Stanley, Jardine Fleming, JP Morgan, George Soros and CapitalInternational along with the host of domestic players join the party. But for the equity funds, theperiod of 1994-96 was one of the worst in the history of Indian Mutual Funds.


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1999-2000 Year of the funds

Mutual funds have been around for a long period of time to be precise for 36 yrs but the year1999 saw immense future potential and developments in this sector. This year signaled the yearof resurgence of mutual funds and the regaining of investor confidence in these MFs. This timearound all the participants are involved in the revival of the funds ----- the AMCs, the unit holders,

the other related parties. However the sole factor that gave lifr to the revival of the funds was theUnion Budget. The budget brought about a large number of changes in one stroke. An insight ofthe Union Budget on mutual funds taxation benefits is provided later.

It provided centrestage to the mutual funds, made them more attractive and provides acceptabilityamong the investors. The Union Budget exempted mutual fund dividend given out by equity-oriented schemes from tax, both at the hands of the investor as well as the mutual fund. Nolonger were the mutual funds interested in selling the concept of mutual funds they wanted to talkbusiness which would mean to increase asset base, and to get asset base and investor base theyhad to be fully armed with a whole lot of schemes for every investor .So new schemes for newIPOs were inevitable. The quest to attract investors extended beyond just new schemes. Thefunds started to regulate themselves and were all out on winning the trust and confidence of theinvestors under the aegis of the Association of Mutual Funds of India (AMFI)

One cam say that the industry is moving from infancy to adolescence, the industry is maturingand the investors and funds are frankly and openly discussing difficulties opportunities andcompulsions.

Future Scenario

Future Scenario

The asset base will continue to grow at an annual rate of about 30 to 35 % over the next fewyears as investors shift their assets from banks and other traditional avenues. Some of the olderpublic and private sector players will either close shop or be taken over.

Out of ten public sector players five will sell out, close down or merge with stronger players inthree to four years. In the private sector this trend has already started with two mergers and onetakeover. Here too some of them will down their shutters in the near future to come.

But this does not mean there is no room for other players. The market will witness a flurry of newplayers entering the arena. There will be a large number of offers from various assetmanagement companies in the time to come. Some big names like Fidelity, Principal, Old Mutualetc. are looking at Indian market seriously. One important reason for it is that most major playersalready have presence here and hence these big names would hardly like to get left behind.

The mutual fund industry is awaiting the introduction of derivatives in India as this would enable itto hedge its risk and this in turn would be reflected in its Net Asset Value (NAV).

SEBI is working out the norms for enabling the existing mutual fund schemes to trade inderivatives. Importantly, many market players have called on the Regulator to initiate the processimmediately, so that the mutual funds can implement the changes that are required to trade inDerivatives.

May the Net Asset Values grow!!


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Market Trends

A lone UTI with just one scheme in 1964, now competes with as many as 400 odd products and34 players in the market. In spite of the stiff competition and losing market share, UTI still remainsa formidable force to reckon with.

Last six years have been the most turbulent as well as exiting ones for the industry. New playershave come in, while others have decided to close shop by either selling off or merging withothers. Product innovation is now pass with the game shifting to performance delivery in fundmanagement as well as service. Those directly associated with the fund management industrylike distributors, registrars and transfer agents, and even the regulators have become moremature and responsible.

The industry is also having a profound impact on financial markets. While UTI has always been adominant player on the bourses as well as the debt markets, the new generation of private fundswhich have gained substantial mass are now seen flexing their muscles. Fund managers, by theirselection criteria for stocks have forced corporate governance on the industry. By rewardinghonest and transparent management with higher valuations, a system of risk-reward has beencreated where the corporate sector is more transparent then before.

Funds have shifted their focus to the recession free sectors like pharmaceuticals, FMCG andtechnology sector. Funds performances are improving. Funds collection, which averaged at lessthan Rs100bn per annum over five-year period spanning 1993-98 doubled to Rs210bn in 1998-99. In the current year mobilization till now have exceeded Rs300bn. Total collection for thecurrent financial year ending March 2000 is expected to reach Rs450bn.

What is particularly noteworthy is that bulk of the mobilization has been by the private sectormutual funds rather than public sector mutual funds. Indeed private MFs saw a net inflow of Rs.7819.34 crore during the first nine months of the year as against a net inflow of Rs.604.40 crorein the case of public sector funds.

Mutual funds are now also competing with commercial banks in the race for retail investors

savings and corporate float money. The power shift towards mutual funds has become obvious.The coming few years will show that the traditional saving avenues are losing out in the currentscenario. Many investors are realizing that investments in savings accounts are as good aslocking up their deposits in a closet. The fund mobilization trend by mutual funds in the currentyear indicates that money is going to mutual funds in a big way. The collection in the first half ofthe financial year 1999-2000 matches the whole of 1998-99.

India is at the first stage of a revolution that has already peaked in the U.S. The U.S. boasts of anAsset base that is much higher than its bank deposits. In India, mutual fund assets are not even10% of the bank deposits, but this trend is beginning to change. Recent figures indicate that inthe first quarter of the current fiscal year mutual fund assets went up by 115% whereas bankdeposits rose by only 17%. (Source: Thinktank, The Financial Express September, 99) This isforcing a large number of banks to adopt the concept of narrow banking wherein the deposits are

kept in Gilts and some other assets which improves liquidity and reduces risk. The basic fact liesthat banks cannot be ignored and they will not close down completely. Their role asintermediaries cannot be ignored. It is just that Mutual Funds are going to change the way banksdo business in the future.


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Banks v/s Mutual Funds

BANKS MUTUAL FUNDSReturns Low BetterAdministrative exp. High LowRisk Low ModerateInvestment options Less More

Network High penetration Low but improvingLiquidity At a cost BetterQuality of assets Not transparent TransparentInterest calculation Minimum balance between 10th. & 30th. Of every monthEverydayGuarantee Maximum Rs.1 lakh on deposits None

Global Scenario

Some basic facts-

The money market mutual fund segment has a total corpus of $ 1.48 trillion in the U.S.against a corpus of $ 100 million in India.

Out of the top 10 mutual funds worldwide, eight are bank- sponsored. Only Fidelity andCapital are non-bank mutual funds in this group.

In the U.S. the total number of schemes is higher than that of the listed companies whilein India we have just 277 schemes

Internationally, mutual funds are allowed to go short. In India fund managers do not havesuch leeway.

In the U.S. about 9.7 million households will manage their assets on-line by the year2003, such a facility is not yet of avail in India.

On- line trading is a great idea to reduce management expenses from the current 2 % oftotal assets to about 0.75 % of the total assets.

72% of the core customer base of mutual funds in the top 50-broking firms in the U.S. areexpected to trade on-line by 2003.

(Source: The Financial Express September, 99)

Internationally, on- line investing continues its meteoric rise. Many have debated about the

success of e- commerce and its breakthroughs, but it is true that this aspect of technology couldand will change the way financial sectors function. However, mutual funds cannot be left farbehind. They have realized the potential of the Internet and are equipping themselves to performbetter.

In fact in advanced countries like the U.S.A, mutual funds buy- sell transactions have alreadybegun on the Net, while in India the Net is used as a source of Information.


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Such changes could facilitate easy access, lower intermediation costs and better services for all.A research agency that specializes in internet technology estimates that over the next four yearsMutual Fund Assets traded on- line will grow ten folds from $ 128 billion to $ 1,227 billion ;whereas equity assets traded on-line will increase during the period from $ 246 billion to $ 1,561billion. This will increase the share of mutual funds from 34% to 40% during the period.

(Source: The Financial Express September ,99)

Such increases in volumes are expected to bring about large changes in the way Mutual Fundsconduct their business.

Here are some of the basic changes that have taken place since the advent of the Net.

Lower Costs: Distribution of funds will fall in the online trading regime by 2003 . Mutual funds could bringdown their administrative costs to 0.75% if trading is done on- line. As per SEBI regulations , bond funds cancharge a maximum of 2.25% and equity funds can charge 2.5% as administrative fees. Therefore if theadministrative costs are low , the benefits are passed down and hence Mutual Funds are able to attract mireinvestors and increase their asset base.

Better advice: Mutual funds could provide better advice to their investors throughthe Net rather than through the traditional investment routes where there is anadditional channel to deal with the Brokers. Direct dealing with the fund could helpthe investor with their financial planning.

In India , brokers could get more Net savvy than investors and could help the investorswith the knowledge through get from the Net.

New investors would prefer online : Mutual funds can target investors who areyoung individuals and who are Net savvy, since servicing them would be easier onthe Net.

India has around 1.6 million net users who are prime target for these funds and this could

just be the beginning. The Internet users are going to increase dramatically and mutualfunds are going to be the best beneficiary. With smaller administrative costs more fundswould be mobilized .A fund manager must be ready to tackle the volatility and will have tomaintain sufficient amount of investments which are high liquidity and low yieldinginvestments to honor redemption.

Net based advertisements: There will be more sites involved in ads and promotion ofmutual funds. In the U.S. sites like AOL offer detailed research and financial details aboutthe functioning of different funds and their performance statistics. a is witnessing agenesis in this area . There are many sites such as indiainfoline.comand indiafn.comthatare doing something similar and providing advice to investors regarding theirinvestments.

In the U.S. most mutual funds concentrate only on financial funds like equity and debt. Some likereal estate funds and commodity funds also take an exposure to physical assets. The latter typeof funds are preferred by corporates who want to hedge their exposure to the commodities theydeal with.

For instance, a cable manufacturer who needs 100 tons of Copper in the month of January couldbuy an equivalent amount of copper by investing in a copper fund. For Example, PermanentPortfolio Fund, a conservative U.S. based fund invests a fixed percentage of its corpus in Gold,


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Silver, Swiss francs, specific stocks on various bourses around the world, short term and long-term U.S. treasuries etc.

In U.S.A. apart from bullion funds there are copper funds, precious metal funds and real estatefunds (investing in real estate and other related assets as well.).In India, the Canada basedDundee mutual fund is planning to launch a gold and a real estate fund before the year-end.

In developed countries like the U.S.A there are funds to satisfy everybodys requirement, but inIndia only the tip of the iceberg has been explored. In the near future India too will concentrate onfinancial as well as physical funds.

Mutual funds and the Budget 2000-2001

Important measures

Deletion of sections 54 EA and 54 EB of the Income Tax Act, 1961. The above two sections provided relief from capital gains tax if investments were made in

specified securities and locked in for a period of 3 years in the case of 54EA and 7 yearsin the case of 54EB. Mutual fund units were one of the specified securities and thisresulted in a lot of money realised as profit from sale of securities being reinvested in themarket through mutual funds.

With the withdrawal of the exemption to mutual funds, investors have lost out on a veryviable alternative for tax saving and funds also would be faced with the problem of hotmoney as there would no longer be any lock in period for investments. It is estimatedthat 54EA investments formed approximately 15% of the corpus.

Increase in dividend tax from 10% to 20% for debt funds.

The existing dividend tax payable by debt schemes has been doubled to 20%. This would lead to

a reduction in returns available to investors by approximately 1.5% from the average ofapproximately 14%. This is expected to hurt retail investment in debt schemes and could lead toa pull out and reduced mobilisation. Two implications of this move could be:

Reinvestment of dividends by investors; since capital gains would be taxed at a lowerrate as compared to dividend, investors would prefer to reinvest dividend and earn long-term capital appreciation.

Switch over from debt to equity schemes; since open ended equity schemes are freefrom paying dividend tax, these schemes could attract some of the investment that ispulled out from debt schemes.

Instead of taxing debt schemes so as to bring parity between the banks and mutual funds, it iswidely felt that the finance minister could have simply extended some of the benefits enjoyed by

mutual funds to banks and FIs. The experience with mutual funds has in any case shown thatturning dividends tax free in the hands of investors has simply improved collections, widened the

tax base and reduced procedural delays. Regulatory Aspects

Schemes of a Mutual Fund

The asset management company shall launch no scheme unless the trustees approvesuch scheme and a copy of the offer document has been filed with the Board.


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Every mutual fund shall along with the offer document of each scheme pay filing fees.

The offer document shall contain disclosures which are adequate in order to enable theinvestors to make informed investment decision including the disclosure on maximuminvestments proposed to be made by the scheme in the listed securities of the groupcompanies of the sponsor A close-ended scheme shall be fully redeemed at the end of

the maturity period. "Unless a majority of the unit holders otherwise decide for its rolloverby passing a resolution".

The mutual fund and asset management company shall be liable to refund the applicationmoney to the applicants,-

(i) If the mutual fund fails to receive the minimum subscriptionamount referred to in clause (a) of sub-regulation (1);

(ii) If the moneys received from the applicants for units are inexcess of subscription as referred to in clause (b) of sub-regulation (1).

The asset management company shall issue to the applicant whose application has beenaccepted, unit certificates or a statement of accounts specifying the number of unitsallotted to the applicant as soon as possible but not later than six weeks from the date ofclosure of the initial subscription list and or from the date of receipt of the request fromthe unit holders in any open ended scheme.

Rules Regarding Advertisement:

The offer document and advertisement materials shall not be misleading or contain anystatement or opinion, which are incorrect or false.

Investment Objectives And Valuation Policies:

The price at which the units may be subscribed or sold and the price at which such unitsmay at any time be repurchased by the mutual fund shall be made available to theinvestors.

General Obligations:

Every asset management company for each scheme shall keep and maintain properbooks of accounts, records and documents, for each scheme so as to explain itstransactions and to disclose at any point of time the financial position of each schemeand in particular give a true and fair view of the state of affairs of the fund and intimate tothe Board the place where such books of accounts, records and documents aremaintained.

The financial year for all the schemes shall end as of March 31 of each year. Everymutual fund or the asset management company shall prepare in respect of each financialyear an annual report and annual statement of accounts of the schemes and the fund asspecified in Eleventh Schedule.

Every mutual fund shall have the annual statement of accounts audited by an auditor whois not in any way associated with the auditor of the asset management company.

Procedure For Action In Case Of Default:


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On and from the date of the suspension of the certificate or the approval, as the casemay be, the mutual fund, trustees or asset management company, shall cease to carryon any activity as a mutual fund, trustee or asset management company, during theperiod of suspension, and shall be subject to the directions of the Board with regard toany records, documents, or securities that may be in its custody or control, relating to itsactivities as mutual fund, trustees or asset management company.

Restrictions On Investments:

A mutual fund scheme shall not invest more than 15% of its NAV in debt instrumentsissued by a single issuer, which are rated not below investment grade by a credit ratingagency authorized to carry out such activity under the Act. Such investment limit may beextended to 20% of the NAV of the scheme with the prior approval of the Board ofTrustees and the Board of asset management company.

A mutual fund scheme shall not invest more than 10% of its NAV in unrated debtinstruments issued by a single issuer and the total investment in such instruments shallnot exceed 25% of the NAV of the scheme. All such investments shall be made with theprior approval of the Board of Trustees and the Board of asset management company.

No mutual fund under all its schemes should own more than ten per cent of any

company's paid up capital carrying voting rights. Such transfers are done at the prevailing market price for quoted instruments on spot

basis.The securities so transferred shall be in conformity with the investment objective of thescheme to which such transfer has been made.

A scheme may invest in another scheme under the same asset management company orany other mutual fund without charging any fees, provided that aggregate interschemeinvestment made by all schemes under the same management or in schemes under themanagement of any other asset management company shall not exceed 5% of the netasset value of the mutual fund.

The initial issue expenses in respect of any scheme may not exceed six per cent of thefunds raised under that scheme.

Every mutual fund shall buy and sell securities on the basis of deliveries and shall in all

cases of purchases, take delivery of relative securities and in all cases of sale, deliver thesecurities and shall in no case put itself in a position whereby ithas to make short sale or carry forward transaction or engage in badla finance.

Every mutual fund shall, get the securities purchased or transferred in the name of themutual fund on account of the concerned scheme, wherever investments are intended tobe of long-term nature.

Pending deployment of funds of a scheme in securities in terms of investment objectivesof the scheme a mutual fund can invest the funds of the scheme in short term deposits ofscheduled commercial banks.

No mutual fund scheme shall make any investment in;

i. Any unlisted security of an associate or group company of thesponsor; or

ii. Any security issued by way of private placement by anassociate or group company of the sponsor; or

The listed securities of group companies of the sponsorwhich is in excess of 30% of the net assets [of all theschemes of a mutual fund]


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No mutual fund scheme shall invest more than 10 per cent of its NAV in the equity sharesor equity related instruments of any company. Provided that, the limit of 10 per cent shallnot be applicable for investments in index fund or sector or industry specific scheme.

A mutual fund scheme shall not invest more than 5% of its NAV in the equity shares orequity related investments in case of open-ended scheme and 10% of its NAV in case ofclose-ended scheme.

Frequently Asked Questions

Why had mutual funds in India performed so poorly in the past?

Most investors associate mutual funds with Mastergain, Monthly Equity Plans of SBI MutualFund, UTI and Canbank Mutual Fund and of course Morgan Stanley Growth Fund. This is sobecause these funds truly had participation from masses, with a fund like Morgan Stanley havingmore than 1 million investors. Investors feel that after 5 years, Morgan Stanley Growth Fund unitsstill trade below the original IPO price of Rs 10.

It is incorrect to think that all mutual funds have performed poorly. If one looks at some incomefunds, they have come with reasonable returns. It is only the performance of equity funds, which

has been poor. Their poor performance has been amplified by the closed end discounts ie unitsof these funds quoting at sharp discounts to their NAV resulting in an even poorer return to theinvestor.

One must remember that a Mutual Fund does not provide assured returns and neither can it"manufacture" returns out of thin air. Returns provided by mutual funds are a function of thereturns in the underlying asset class in which the fund invests. Good funds can beat returns intheir asset class to some extent but thats all. Eg take the case of a sector specific fund like apharma fund which invests only in shares of pharmaceutical companies. If the Govt. comes withnew regulation that severely restricts the pricing freedom of these companies resulting in negativeoutlook for the sector, the prices of all stocks in the sector could fall substantially resulting in asevere erosion in the NAV of the fund. No one can do anything about it. A good fund managerwould probably sell part of the fund before prices fall too much and wait for an opportune time to

reinvest at lower levels once the dust has settled. In that case, the NAV of the fund would fall to alesser extent but fall it will. If the investor in the fund has invested in some stocks in the sectoron his own, in all probability, his personal investments may have depreciated to a larger extent.

Let us extend this example to an analysis of the investment climate in the last 7 years. The stockmarkets have done very badly in the last seven years. The BSE Sensex crossed 3000 for the firsttime in early 1992. Since then it has gone up and come down several times but has remained inthe same range. Effectively, for a seven-year investment period, the total return has been almostzero. The prices of many leading stocks of yesteryear have fallen by more than 50% in theseseven years. If one considers the fact that the Sensex has been changed several times, with allthe weak stocks having been weeded out, the effective returns on the old Sensex, existing in1992, have been substantially negative. The following table gives some of the prices of stocksconsidered "blue chips" in 1992, in 1994 and the prices prevailing at present.

Price in Rs

Name of the Company 1992 high 1994 high Current price

Tata Steel 552 336 114

Grasim Industries 650 793 234

Century Textiles 490 550 40


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Raymond 250 263 65

Arvind Mills 353 290 9

ICICI 290 197 109

It is quite obvious that if a fund had invested in any of these shares in 1992 or subsequently in the

1994 boom, and if it remained invested in the share, then it would be confronting a huge fall inNAV. This is exactly what had happened.

A similar table for prices of shares of Public Sector Undertakings (PSUs) is given below.

Price in Rs

Name of the Company 1994 high Present price

MTNL 325 161

HPCL 550 130

SAIL 83 6

Most mutual fund managers took some time to realize the changed circumstances wherein theopen economy ushered in by the liberalization took the full impact of the global deflation incommodity prices. This problem was compounded further by the Asian crisis after which cheapimports from Asia caused severe pressure on profits.

To add to this, most funds had invested some part of their portfolio in medium sized "growth"companies. Many of these companies have performed even worse than bigger ones and quite afew have seen share prices dip more than 90% from their 1994 highs. More important, fundscould not sell these shares because of complete lack of liquidity with, at best, few hundred sharesbeing traded every day.

Meanwhile, shares of companies in sectors like consumer goods (FMCG) and software, were

showing good growth and they went up rapidly in price. Most fund managers were unwilling to sellshares of erstwhile "blue chips" at low prices and buy shares of emerging "blue chips" at highprices. This resulted in poor performance and negative returns.

One more issue is that the fund managers in many funds were not "professionally qualified andexperienced". This is especially true of some of the funds floated by nationalized banks. Some ofthese individuals were transferred from the parent organization and did not really know muchabout investment management.

Lastly, investors would do well to have a look at the investments, which they made on their own.In most cases, they would have done much worse than the mutual funds. We have receivednumerous requests for advice from individual investors on what to do about their owninvestments. If that were any indicator, investors would have done really badly.

Is it true that globally mutual funds underperform benchmark indices? Why are smartmoney managers unable to do as well as the market? Or is it that they are not smart at all?What are the limitations of mutual funds?

It is 100% true that globally, most mutual fund managers underperform the asset class that theyare investing in, over the very long-term. It is not true that the fund managers are dumb; thisunder performance is largely the result of limitations inherent in the concept of mutual funds.These limitations are as follows:


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Entry and exit costs: Mutual funds are a victim of their own success. When a large bodylike a fund invests in shares, the concentrated buying or selling often results in adverseprice movements ie at the time of buying, the fund ends up paying a higher price and whileselling it realizes a lower price. This problem is especially severe in emerging markets likeIndia, where, excluding a few stocks, even the stocks in the Sensex are not liquid, let alonestocks in the NSE 50 or the CRISIL 500. So, there is simply no way that a fund can beat theSensex or any other index, if it blindly invests in the same stocks as those in the Sensexand in the same proportion. For obvious reasons, this problem is even more severe forfunds investing in small capitalization stocks. However, given the large size of the debtmarket, excluding UTI, most debt funds do not face this problem

Wait time before investment: It takes time for a mutual fund to invest money.Unfortunately, most mutual funds receive money when markets are in a boom phase andinvestors are willing to try out mutual funds. Since it is difficult to invest all funds in oneday, there is some money waiting to be invested. Further, there may be a time lag beforeinvestment opportunities are identified. This ensures that the fund underperforms theindex. For open-ended funds, there is the added problem of perpetually keeping somemoney in liquid assets to meet redemptions. The problem of impracticability of quickinvestments is likely to be reduced to some extent with the introduction of index futures.

Fund management costs: The costs of the fund management process are deducted fromthe fund. This includes marketing and initial costs deducted at the time of entry itself,called "load". Then there is the annual asset management fee and expenses, togethercalled the expense ratio. Usually, the former is not counted while measuring performance,while the latter is. A standard 2% expense ratio means that, everything else being equal,the fund manager underperforms the benchmark index by an equal amount.

Cost of churn: The portfolio of a fund does not remain constant. The extent to which theportfolio changes is a function of the style of the individual fund manager ie whether he isa buy and hold type of manager or one who aggressively churns the fund. It is alsodependent on the volatility of the fund size ie whether the fund constantly receives freshsubscriptions and redemptions. Such portfolio changes have associated costs of

brokerage, custody fees, registration fees etc. which lowers the portfolio returncommensurately.

Change of index composition: World over, the indices keep changing to reflect changingmarket conditions. There is an inherent survivorship bias in this process, with the badstocks weeded out and replaced by emerging blue chips. This is a severe problem in Indiawith the Sensex having been changed twice in the last 5 years, with each change beingquite substantial. Another reason for change index composition is Mergers &Acquisitions. The weightage of the shares of a particular company in the index changes ifit acquires a large company not a part of the index.

Tendency to take conformist decisions: From the above points, it is quite clear that theonly way a fund can beat the index is through investment of some part of its portfolio in

some shares where it gets excellent returns, much more than the index. This will pull upthe overall average return. In order to obtain such exceptional returns, the fund managerhas to take a strong view and invest in some uncommon or unfancied investment options.Most people are unwilling to do that. They follow the principle "No fund manager ever gotfired for investing in Hindustan Lever" ie if something goes wrong with an unusualinvestment, the fund manager will be questioned but if anything goes wrong with the bluechip, then you can always blame it on the "environment" or "uncontrollable factors"knowing fully well that there are many other fund managers who have made the samedecision. Unfortunately, if the fund manager does the same thing as several others of hisclass, chances are that he will produce average results. This does not mean that if a fund


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manager takes "active" views and invests in heavily researched "uncommon" ideas, thefund will necessarily outperform the index. If the idea does not work, it will result in poorfund performance. But if no such view is taken, there is absolutely no chance that the fundwill outperform the index.

Should an investor invest in a mutual fund despite its limitations or no?

Yes. Investor should invest some part or their investment portfolio in mutual funds. In fact someinvestors may be better off by putting their entire portfolio in mutual funds. This is on account ofthe following reasons:

On their own, uninformed investors could perform much worse than mutual funds. Diversification of risks which is difficult for an investor to achieve with the small amount of

funds at his disposal Possibility of investing in small amounts as and when the investor has funds to invest Unquestioned service of transaction processing, tracking of investments, collecting

dividends/interest warrants etc. Debt funds in India offer exposure to a diversified portfolio of bonds/debentures, which is

possible, only if the investor is investing millions of rupees. Further, they offer easy

liquidity and tax benefits. Debt funds thus offer a great proposition that is impossible forordinary investors to replicate on their own. This proposition compares favorably againstcompeting investments like small savings.

Investors require analytical capability and access to research and information and needto spend an enormous amount of time to make investment decisions and keep monitoringthem. Some people have the inclination and the time to make better decisions than fundmanagers do, but the vast majority does not. Those who can are advised to invest somepart of their money into funds, especially debt funds, to diversify their risk. They may alsonote that one of the objectives of this site is to help them improve the odds in their favor.

Are mutual funds safe? Are returns on mutual funds guaranteed by Government of India,or Reserve Bank or any other government body?

Any mutual fund is as safe or unsafe as the assets that it invests in. There are two basiccategories of mutual funds with others being variations or mixtures of these. Firstly, there arethose that invest purely in equity shares (called equity funds or " growth funds") and secondly,there are those that invest purely in bonds, debentures and other interest bearing instrumentscalled "income" or "debt" funds. The NAV of growth funds fluctuates in line with the fluctuation ofthe shares held by them. They can also witness face substantial erosion in value, which could bepermanent in some cases. On the other hand, prices of debt instruments fluctuate to a muchlesser degree and an income fund is extremely unlikely to face erosion in value especially of thepermanent kind.

Most mutual funds have qualified and experienced personnel, who understand the risks ofinvesting. But, nobody is immune from making mistakes. However, funds diversify the investmentportfolio substantially so that default in any single investment (in the case of an income fund) will

not affect the overall performance of a fund in a significant manner. In the event of default of apart of the portfolio, an income fund is extremely unlikely to face erosion in face value.

Generally, mutual funds are not guaranteed by anybody. However, in the Indian context, some ofthe mutual funds have floated "guaranteed" or "assured" return schemes which guarantee acertain annual return or guarantee a buyback at a specified price after some time. Examples ofthese include funds floated by the UTI, Canbank Mutual Fund, SBI Mutual Fund, LIC Mutual Fundetc. Many of these funds have not earned returns that they promised and the asset managementcompanies of the respective mutual funds or their sponsors have made good their promises. The


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biggest case pertains to the US 64, which never guaranteed any returns but is being bailed out bythe Government due to the millions of individuals who have invested in it.

Can the foreign mutual funds operating in India take investors money outside the country?

A mutual fund and the company that manages it are 2 entirely different companies. Legally

speaking, a mutual fund is a trust formed and registered under the Indian Trust Act. The sponsorasset management company is formally appointed by the trustees of the trust to manage moneyon their behalf eg DSP Merrill Lynch equity fund is a mutual benefit trust registered under theIndian Trust Act. The trustees have appointed DSP Merrill Lynch Asset Management CompanyPvt. Ltd. to manage the funds in the trust and the company cannot touch one rupee from the trustexcept to the extent of the fees that it receives for managing the funds.

Repatriation of money outside India comes under the purview of the Foreign ExchangeRegulation Act, 1973 which specifies the situations in which money can be remitted outside India.Under the act, banks that repatriate money on behalf of their clients have to ensure compliancewith various legal formalities and ensure that the entity, which remits money, is entitled to do so.Any failure or violation leads to serious consequences for both the remitter and the bank. Moneycollected by a mutual fund domestically is not allowed to be remitted outside India. However, with

the repeal of FERA, 1973, regulations are likely to be eased.

Is mutual funds outperformance always good?

Mutual fund performance of index may not always be a positive indicator. In several cases onenotices that the funds performance is very lop sided and is driven by few scrips. In other wordsthe fund manager has taken significantly higher risks and in the game of probability he wouldhave made more money. But it is very likely that if his call had not been right, he would haveunder performed and lost badly. From an investors point of view, when he is looking at such out-performances in the past, he cannot derive confidence and comfort in the fund managers' abilityto repeat the performance in future. As markets are not rational, there is no methodology in theworld to scientifically predict stock prices. Therefore it is not possible for anyone to beat themarket on a consistent basis and hence there is no guarantee that the fund manager would

perform well all the while.

How does one see through the marketing hype given out by mutual funds?

It is amazing how fund marketers can come up with statistics to show how their particular fundhas done extremely well. Standard techniques include the following:

Defined period returns: Some period is depicted in which the particular fund outperformedothers or some benchmark. One should look very carefully at start and end dates theycan always be chosen in a way that shows the fund in a favorable light

Outperformance vs performance: Sustained periods of low absolute performance are a

cause for concern. It is all right to look at relative returns with respect to benchmarkindices; but there is no sense if a particular fund produces absolute returns less than thedeposit interest rates, even after a few years of existence.

Promise of long term performance: Lack of performance is often explained away astemporary with promises of good performance in the long term. Few define what this "longterm" is 1 or 2 or 5 or 10 years. Do not forget that the longer the period, the longer is theuncertainty in between in other words, would you want to wait for 10 years to get anuncertain 2% higher returns as compared to the certain returns that you get in say thePublic Provident Fund.


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Rupee cost averaging: This is a term that has found its way into the marketing literature ofall mutual funds. What it means is that if you put in a fixed amount of money every monthin a fund, then, in months when the NAV is low, the investor gets more units whichbenefits him when the NAV rises. Do not forget the implicit assumption behind this thatthe NAV will rise eventually. If it does not, you are no better off than by not buying.

Equities are the best bet in the long run: Ask this to any investor who put money in theSensex in 1992. After a long run of 7 years, the investor is down on his investment by 50%.He would have been better off by investing in other avenues.

What went wrong with US64?

Basically, for a period of 2-3 years, the UTI distributed more dividend to the unitholders of US 64than the return earned from the investments in the scheme. This reduced the value of the residualinvestments in the scheme. This problem was compounded by the persistent fall in the prices ofshares, especially the shares of companies in basic commodity industries like cement, steel,manmade fibres etc. and shares of public sector units. Throughout this period, when the NAV ofUS 64 was going down, UTI kept increasing the sale and repurchase prices of US 64 units. Thestock market collapse after the Pokhran II nuclear tests was the last straw, which resulted in the

erosion of the schemes book reserves and a wide difference between the actual NAV and thesale/repurchase price.

When this became known, it set a panic amongst investors of US 64. Many people felt that ifthere were large-scale redemptions, UTI would not be able to meet them without support ofoutside bodies like the RBI. Further, theoretically, if all investors wanted to redeem their US 64units on the same day, the US 64 simply did not have the money to meet the redemptions on itsown (due to the difference between NAV and the repurchase price).

What went wrong with Morgan Stanley?

Morgan Stanley raised large corpus (more than Rs10bn) in around early 1994. The entireexercise in fund raising was centered on the hype of the fund being the first fund promoted by an

internationally acclaimed asset management company. It was marketed like any other publicissue and fund investors rushed to invest in the scheme hoping to get superior returns. No onebothered to explain to them that Morgan Stanley AMC was a service provider - providing them theservice of investment advice and management. No one explained to them that they were notinvesting in a share of a company in fact the artificial gray market premium served to perpetratethis feeling.

The IPO was a great success. It ensured that the name "Morgan Stanley" was now a part of thedreams of more than 1 million Indians.

The fund raising exercise, unfortunately, coincided with the peak of stock market boom. Indianstock markets lack depth and are quite illiquid. The fund managers were compelled to invest inequities in a big hurry as a number of Foreign Institutional Investors were investing huge sums ofmoney in the country resulting in a mad rush for equity stocks. The funds managers invested aconsiderable amount of money in smaller companies with low floating stock and low marketcapitalization, either through the secondary market or through private placements. Thesecompanies had experienced the highest appreciation in prices in the immediate past.

The market position started changing from late 1994. The boom in the market made it possible formany companies to raise equity capital and literally hundreds of public/rights issues opened forsubscriptions every week, many of them at high issue prices. There were also massive privateplacements of equity shares and GDR issues at huge premiums. There were very few companies


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which did not wash their hands in this great gravy train. This deluge of paper soaked up moneyand reduced the amount available for fresh investment both from resident Indians, domesticmutual funds and from foreign institutional investors.

At this time, the RBI commenced on its tight money policy in a bid to control inflation from raisingits head. Money supply tightened and bond yields started increasing dramatically. High industrial

growth and tight money created a shortage for credit and rates started going sky high. Manycorporates and banks started redeeming their holdings in the Unit Trust of India and other mutualfunds. This put major pressure on the market, which was already showing signs of weakness.What followed was the great crash.

And in this crash, the biggest losers were the smaller capitalization stocks. Many of these stockslost more than 90% of their peak prices.

Morgan Stanley AMC restructured the funds portfolio at big losses.

As the NAV went below par, investors confidence was shattered. Being a closed-ended schemethe Morgan Stanleys mutual fund unit is also listed on the stock markets. Crisis of confidence ledto its price on the stock exchange crashing and it started quoting at a steep discount to its NAV.

The fund started buying back units in order to reduce the discount and also to boost the NAV(buying back units at prices below the NAV results in a profit, which will reduce the NAV). Givenits large corpus size no amount of buy back or otherwise support could help boost the investorconfidence.

Since then the equity markets have gone nowhere with the index still below the level at which thefund was invested. Most of the stocks in the Sensex have performed poorly with marketspunishing commodity companies and companies with non-transparent Indian managements. Totop it, many erstwhile bluechips have reported disastrous financial performances.

Consequently, the NAV of MSGF mirrors this gory saga of the Indian markets. In fact, the fundinvested considerable amount of money in FMCG, pharmaceutical and software companies at theright time which improved the NAV from 1998 onwards.

How important is an AMC (Asset Management Company) behind a mutual fund?

AMC controls the operations and functioning of a mutual fund. It is very critical to the performanceof a mutual fund as it decides on the style of functioning, people who are going to manage thefunds, the commitment to service quality and overall supervision.

The financial strength and the commitment of the AMC sponsors to the business are very keyissues. This is because most AMCs lose money in the first few years of operations. In mostcases, these losses are much more than the capital requirements stipulated by SEBI. Hence, asponsor which is financially weak or which cannot capital to the business either because of itsinability or unwillingness will result in an unhealthy operation. There will be a tendency to cut

corners and unwillingness to spend money to expand operations. This is the last place wherehigh quality persons would want to remain and work. The AMC then remains stunted and thesponsors lose interest. The worst affected are the investors. This is exactly what has happenedwith some AMCs promoted by Indian business houses.

This is also a problem that has afflicted some of the AMCs floated by nationalized banks. In theseorganizations, the traditional thinking is prevalent which can be summarized as "money is power".Since mutual fund business did not have access to too much money, a posting in the AMCbecame punishment postings for some personnel who were not doing well in the parentorganization or who lost out in the organizational politics. The management of the banks also did


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not allow these AMCs to become independent viable businesses. The CEOs of the AMCs did nothave any clue of the mutual fund business and neither were they interested in it the entire effortwas spent in getting a posting back in the parent. The fund managers had no experience in theactivity making a mockery of "professional management". The sad results are there to see. Someof the parents had to provide funds to bridge the gap in "assured return schemes". It looksextremely likely that some of these AMCs will no longer exist in a few years.

How and against what should you benchmark the performance of a mutual fund?

All mutual funds have different objectives and therefore their performance would vary. A mutualfunds performance should be benchmarked against mutual funds of similar type or India infolinemutual fund index for a particular type. eg equity fund index, income fund index or balanced fundindex or liquid fund index. One can also benchmark the fund against the Sensex or any otherbroadbased index for the particular asset class.

One has to be very careful about choosing the comparison period. Ideally, one should comparethe performance of equity or an index fund over a 1-2 year horizon. Any comparison over ashorter period would be distorted by short term, volatile price movements. Comparisons over alonger period need to be interpreted carefully by looking at other factors such as change in

individuals managing the fund, one time investment successes etc. Similarly, the idealcomparison period for a debt fund would be 6-12 months while that for a liquid/money marketfund would be 1-3 months. Apart from the entire period, one should also compare theperformance in smaller intervals within the same period say intervals of one month duration.

To make comparison meaningful, one has to compare the average annual compounded rate ofreturn. This adjusts for comparisons of differing period and also facilitates comparison acrossdifferent classes. The return also incorporates dividend payouts. Thus, for example, one can saythat ABC income fund has given a compounded annual growth rate (CAGR) of 13% p.a. includingdividends in the last 2 years while XYZ income fund has given a CAGR of 13.2% p.a. over thelast 3 years.

Apart from NAV, what other parameters can be compared across different funds of the

same category?

Apart from plain numerical comparison of NAVs, several other things can be checked, egcorrelation of changes in NAV with changes in portfolio composition andappreciation/depreciation in valuation of individual items, increase in the size of the corpus etc. Indebt funds, it is useful to compare the extent to which the growth in NAV comes from interestincome and from changes in valuation of illiquid assets like bonds and debentures. It is alsouseful to compare expense ratios of funds eg Birla Income Plus has an expense ratio of 1.7%which is one of the lowest expense ratios of all income funds in the industry this means that,everything else being equal, the performance of that fund will be higher by 0.55% than otherfunds, which have an expense ratio of 2.25%. Last, but not the least, one has to compare the riskprofile of two funds. For income funds, this could mean credit quality of the portfolio and thefluctuations in the NAV with periodic changes in the interest rate environment. For equity funds, it

could mean the volatility of the NAV with the ups and downs in the market or the percentageexposure to smaller company shares etc.

How different are styles of different mutual funds?

Different mutual funds have very different investing styles. These styles are a function of theindividuals managing the fund with the overall investment objectives and policies of theorganization acting as a constraint. These are manifest in things like


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Portfolio turnover Buy and hold strategy versus frequent investment changes

Kind of investments made small versus large companies, multi baggers (investmentswhich yield high gains) versus percentage players (investing in shares which will givesmall gains in line with the market), high quality low yield bonds versus low quality high yield bonds

Asset allocations Varying percentage of cash depending on aggressive views onmarkets

The following examples serve to illustrate a few styles of equity fund managers

Some fund managers are passive value seekersand some are value creators. The former typebuys undervalued assets and patiently waits for the market to discover the value. The latteraggressively promote the undervalued stocks that they have bought.

Some fund managers restrict themselves to liquid stocks while some thrive on illiquid stockswhich offer themselves easily to large price changes.

Some fund managers are masters of the momentum game and seek to buy stocks that are inmarket fancy. They attach lesser importance to fundamentals and believe that a rising stock priceand favorable momentum indicators imply that fundamentals are changing. In effect, they arefollowing the philosophy, " The trend is my friend". Other fund managers go more by deepfundamental analysis completely ignoring price movements. They do not mind price going downand are in fact happy to buy more.

Some fund managers are growth investors ie they buy stocks with a high P/E using theforecasted growth to justify the high valuation. Others are value investors who buy shares withlow P/E or P/BV multiples - typically companies rich with undervalued assets.

When you buy a mutual fund unit what exactly do you buy?

When you buy a mutual fund unit you are buying a part of the equity or debt portfolio owned bythe mutual fund. In other words you are buying a part ownership of various companies and whenyou buy a debt mutual fund you are buying a part right to title to debt securities. In other wordsyou step into the shoes of owners or lenders indirectly. The value of your part of the assets willfluctuate in line with the value of the individual components of the portfolio on the stock or thebond market.

In effect, you are buying a bundle of services as follows:

Investment management which means investment advice and execution rolled into one

Diversification of investment risk buying a larger basket of securities reduces the overall

risk of investment

Asset custody which means registration and physical custody of assets, ensuringcorporate actions like payment of dividend and interest, bonus, rights entitlements etc

Portfolio information which means calculating and disseminating ownership informationlike NAV, assets owned, etc on a periodic basis

Liquidity Ability to speedily disinvest assets and obtain disinvestment proceeds


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The mutual fund exploits economies of scale in research, execution and transaction processing toprovide the first three services at low costs. The pooling of money makes it possible to offer thefourth service (since all investors are unlikely to exit at the same time). In addition, one also getsbenefits like special tax concessions.

What you do not get is a guaranteed way of making money. There is no way that a mutual fund

can insulate the investor from the vagaries of the market place and ensure that he always makesmoney. In addition, one is implicitly taking the risk of bad service quality in any of the fourelements above including investment management.

What are load and no-load funds? Why are loads charged?

Some asset management companies (AMCs) levy service charges for allowing subscribers entryinto/exit from mutual fund schemes. The service charge is termed as entry/exit load and suchschemes are called "load" schemes. In contrast, funds for which no entry/exit charge is levied arecalled no-load funds.

The load is levied to cover the up-front cost incurred by the AMC in the process of marketing andselling the fund and other one-time transaction processing costs.

Why is the buy and sell price different for some mutual fund units and same for others?

Buying and selling prices are different for those mutual funds which have up front sales chargesor entry loads. Usually, the selling price is the NAV while the buying price incorporates the servicecharge or the load. In case the fund is a no-load fund, there is no difference between the buyingand selling prices. We have a detailed section on the characteristics of all mutual fund schemes,which tells you the exact load charged by respective funds.

Where can one obtain information on the market price of specific mutual fund units?

Buying and selling prices for units of open-ended mutual funds are declared every day. You can

obtain this information on our website. Check out the section on mutual funds.

Most closed-ended mutual funds are listed on the stock exchanges. The trading volume in someof the widely held mutual fund units is considerable. The latest NAV and market price informationof closed-ended mutual funds is available on our website.

All the above information is also available on the stock market page of popular newspapers.

Why do returns from debt/income mutual funds fluctuate from period to period despitethem being invested in fixed interest instruments?

The returns differ from year to year on account of the following reasons:

An income fund invests in instruments from which it earns two kinds of returns The first comesfrom interest income. The second comes from any increase in the market price of investedinstruments. The second component could also be negative when there is a fall in the marketvalue of the invested instruments. The rise and fall in market prices of debt instruments is afunction of the prevailing interest rates. Thus changes in interest rate environment causefluctuations in returns.

Secondly, income mutual funds invest in an array of instruments with different maturity.Whenever any debt instrument in which the fund has invested is redeemed, the redemption


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proceeds have to be reinvested in a fresh instrument(s). This fresh investment would earn a rateof return depending on the prevailing interest rate which could be higher or lower than thatprevailing in the earlier period. Accordingly, the overall return of the portfolio will change.

A third reason can be active view taking by the fund manager eg a fund manager can take a viewthat interest rates are expected to rise. Accordingly, he would disinvest a large part of his

holdings and convert them into cash so as to avoid loss in the value of his holdings. If this view iswrong, he may end up having a low return on a large part of his portfolio, since cash is invested inlow yielding money market avenues. On the other hand, if the view is right, the cash can bedeployed in higher yielding instruments after interest rates rise, thus improving the overall returnand more important avoiding the loss.

There is a fourth reason, which is relevant only for open-ended income funds. Such funds have afluctuating level of idle cash (depending on the level of fresh collections) which is typicallyinvested in low yielding money market instruments. This causes change in the rate of return.

Lastly, there is always the possibility of a credit loss for any income mutual fund ie losses arisingout of default in any of the instruments in which the fund has invested. The fund will declare a lowreturn in the period in which such losses show up.

What are the risks associated in investing in income mutual funds and how should onefind out about these?

Income funds invest in a diversified portfolio of debt instruments which provide interest income.There is a possibility that some of these instruments are of low credit quality and the issuers ofthese instruments default in the payment of interest or principal. Such losses, called "creditlosses", constitute an area of risk for income funds. The process of diversification mitigates thisrisk ie by the fund investing in a number of debt instruments. However, it should be noted that thefunds returns could be eroded considerably if even 10% of the investments have credit qualityproblems. Also, the problem can be accentuated for investors who are investing for a short periodif the losses show up in a particular period resulting in a short term decline in NAV. Investors cancheck the credit quality of the investment portfolio, which is published by most funds on a

quarterly basis.

The second area of risks comes from the fluctuations in the prices of the underlying instrumentsin which the fund invests. Any rise in interest rates will result in a fall in the value of theinvestments causing a dip in the NAV. The fall in value is maximum for longer dated instrumentsand negligible for short dated instruments. Hence, the risk is higher in a fund that has aninvestment portfolio with a higher average maturity. This can again be checked from theinvestment portfolio, which is published by the funds.

Even if interest rates rise by 2-3%, the fall in NAV for most mutual funds is unlikely to exceed 5%.Similarly, a portfolio with as high as 10% of poor quality instruments will result in a fall in NAV by10%. Regular interest income will take care of the losses in a few months. Thus, there is unlikelyto be permanent erosion of capital in most reasonable circumstances. Hence, debt or income

funds have a much lower risk than equity funds, which can have permanent erosion in value.

Todays environment is characterized by a deep industrial recession and consequent high level ofdefaults on loans provided by banking sector to industry. In such a scenario, it may be prudent tolook at the credit quality aspect very carefully before investing in an income mutual fund.

What are the tax benefits available for investing in mutual funds?

The tax benefits for investing in mutual funds are as follows:


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Twenty percent of the amount invested in specified mutual funds (called equity linked savingsschemes or ELSS and loosely referred to as "tax savings schemes") is deductible from the taxpayable by the investor in a particular year subject to a maximum of Rs2000 per investor. Thisbenefit is available under section 88 of the I.T. Act.

Investment of the entire proceeds obtained from the sale of capital assets for a period of three

years or investment of only the profits for a period of 7 years, exempts the asset holder frompaying capital gains tax. This benefit is available under section 54EA and 54EB of the I.T. Act,provided the capital asset has been sold prior to April 1, 2000 and the amount is invested beforeSeptember 30, 2000.

The mutual fund is completely exempt from paying taxes on dividends/interest/capital gainsearned by it. While this is a benefit to the fund, it is the indirect benefit of unitholders as well. Thisbenefit is available to the mutual fund under section 10 (23D) of the I.T. Act.

A mutual fund has to pay a withholding tax of 10% on the dividends distributed by it under therevised provisions of the I.T. Act putting them on par with corporates. However, if a mutual fundhas invested more than 50% of its assets into equity shares, then it is exempt from paying any taxon the dividend distributed by it, for a period of three years, by an overriding provision. This

benefit is available under section 115R of the I.T. Act.

The investor in a mutual fund is exempt from paying any tax on the dividend received by him fromthe mutual fund, irrespective of the type of the mutual fund. This benefit is available under section10(33) of the I.T. Act.

The units of mutual funds are treated as capital assets and the investor has to pay capital gainstax on the sale proceeds of mutual fund units sold by him. For investments held for less than oneyear the tax is equal to 30% of the capital gain. For investments held for more than one year, thetax is equal to 10% of the capital gains. The investor is entitled to indexation benefit whilecomputing capital gains tax. Thus if a typical growth scheme of an income fund shows a rise of12% in the NAV after one year and the investor sells it, he will pay a 10% tax on the selling priceless cost price and indexation component. This reduces the incidence of tax considerably. This

concession is available under section 48 of the I.T. Act. The following calculations show this inmore detail:

Purchase NAV = Rs 10

Sale NAV = Rs 11.2

Indexation component = 8%

Capital gains = 11.2 10(1.08)

= 11.2 10.8

= 0.4

Capital gains tax = 0.4*0.1 = 0.04.

If an investor buys a fresh unit in the closing days of March and sells it in the first week of April ofthe following year, he is entitled to indexation benefit for two financial years which close in the twoMarch ending periods. This is termed as double indexation and lowers the tax even furtherespecially for income funds. In the above example, the calculation would be as follows:


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Capital gains = 11.2 10(1.08)(1.08)

= 11.2 11.7

= -0.5

Thus there would be no capital gains tax.

Glossary

Advisor

The organization employed by a mutual fund to give professional advice on the fund'sinvestments and to supervise the management of its assets.

Asked or Offering Price

The price at which a mutual fund's shares can be purchased. The asked or offering price meansthe current net asset value (NAV) per share plus sales charge, if any. For a no-load fund, theasked price is the same as the NAV.

Asset Allocation Fund

A fund that spreads its portfolio among a wide variety of investments, including domestic andforeign stocks and bonds, government securities, gold bullion and real estate stocks. This givessmall investors far more diversification than they could get allocating money on their own. Someof these funds keep the proportions allocated between different sectors relatively constant, whileothers alter the mix as market conditions change.

Automatic Reinvestment

A service offered by most mutual funds whereby income dividends and capital gain distributionsare automatically invested into the fund by buying additional shares and thus building up holdingsthrough the effects of compounding.

Balanced Fund

A mutual fund that maintains a balanced portfolio, generally 60% bonds or preferred stocks and40% common stocks.

Bid or Sell Price

The price at which a mutual fund's shares are redeemed (bought back) by the fund. The bid orredemption price means the current net asset value per share, less any redemption fee or back-end load.

Bond Fund


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A mutual fund whose portfolio consists primarily of corporate or Government bonds. These fundsgenerally emphasize income rather than growth.

Bond Rating

System of evaluating the probability of whether a bond issuer will default. Various firms analyze

the financial stability of both corporate and government bond issuers. Ratings range from AAA orAaa (extremely unlikely to default) to D (currently in default). Bonds rated BBB or below are notconsidered to be of investment grade. Mutual funds generally restrict their bond purchases toissues of certain quality ratings, which are specified in their prospectuses.

Capital Appreciation Fund

A mutual fund that seeks maximum capital appreciation through the use of investment techniquesinvolving greater than ordinary risk, such as borrowing money in order to provide leverage, short-selling and high portfolio turnover.

Capital Gains Distributions

Payments (usually annually) to mutual fund shareholders of gains realized on the sale of portfoliosecurities.

Capital Growth

A rise in market value of a mutual fund's securities, reflected in its net asset value per share. Thisis a specific long-term objective of many mutual funds.

Certificate of Deposit

Interest-bearing, short-term debt instrument issued by banks and thrifts.

Closed-End Investment Company

An investment company that offers a limited number of shares. They are traded in the securitiesmarkets, usually through brokers. Price is determined by supply and demand. Unlike open-endinvestment companies (mutual funds), closed-end funds do not redeem their shares.

Commercial Paper

Short-term, unsecured promissory notes with maturities no longer than 270 days. They are issuedby corporations, to fund short-term credit needs.

Common Stock Fund

An open-end investment company whose holdings consist mainly of common stocks and usuallyemphasize growth.

Confirm Date

The date the fund processed your transaction, typically the same day or the day after your tradedate.


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Contingent Deferred Sales Charge (CDSC)

A fee (or back-end load) imposed by certain funds on shares redeemed within a specific periodfollowing their purchase. These charges are usually assessed on a sliding scale, such as fourpercent to one percent of the amounts redeemed, with the fee reduced each year the units areheld.

Custodian

The bank or trust company that maintains a mutual fund's assets, including its portfolio ofsecurities or some record of them. Provides safekeeping of securities but has no role in portfoliomanagement.

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Daily Dividend Fund

This term applies to funds that declare their income dividends on a daily basis and reinvest ordistribute monthly.

Deferred Compensation Plan

A tax-sheltered investment plan to which employees of state and local governments can defer apercentage of their salary.

Distributor

An individual or a corporation serving as principal underwriter of a mutual fund's shares, buyingshares directly from the fund, and reselling them to other investors.

Diversification

The policy of spreading investments among a range of different securities to reduce the risksinherent in investing.

Rupee-Cost Averaging

The technique of investing a fixed sum at regular intervals regardless of stock marketmovements. This reduces average share costs to the investor, who acquires more shares inperiods of lower securities prices and fewer shares in periods of high prices. In this way, investingrisk is spread over time.

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Exchange Privilege (Or switching privilege)

The right to transfer investments from one fund into another, generally within the same fundgroup, at nominal cost.

Ex-Dividend Date


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The date on which a fund's Net Asset Value (NAV) will fall by an amount equal to the dividendand/or capital gains distribution (although market movements may alter the fund's closing NAVsomewhat). Most publications which list closing NAVs place an "X" after a fund name on its ex-dividend date.

Expense Ratio

The ratio of total expenses to net assets of the fund. Expenses include management fees, thecost of shareholder mailings and other administrative expenses. The ratio is listed in a fund'sprospectus. Expense ratios may be a function of a fund's size rather than of its success incontrolling expenses.

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Fiscal Year

An accounting period consisting of 12 consecutive months.

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Global Fund

A fund that invests in both Indian. and foreign securities.

Growth Fund

A mutual fund whose primary investment objective is long-term growth of capital. It investsprincipally in common stocks with significant growth potential.

Income Dividend

Payment of interest and dividends earned on the fund's portfolio securities after operatingexpenses are deducted.

Income Fund

A mutual fund that primarily seeks current income rather than growth of capital. It will tend toinvest in stocks and bonds that normally pay high dividends and interest.

Index Fund

A mutual fund that seeks to mirror general stock-market performance by matching its portfolio toa broad-based index, most often the S&P CNX Nifty index.

International Fund

A fund that invests in securities traded in markets outside India.

Investment Company


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A corporation, partnership or trust that invests the pooled monies of many investors. It providesgreater professional management and diversification of investments than most investors canobtain independently. Mutual funds, or "open-end" investment companies, are the most popularform of investment company.

Investment Objective

The financial goal (long-term growth, current income, etc.) that an investor or a mutual fundpursues.

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Junk Bond

A speculative bond rated BB or below."Junk bonds" are generally issued by corporations ofquestionable financial strength or without proven track records. They tend to be more volatile andhigher yielding than bonds with superior quality ratings. "Junk bond funds" emphasize diversifiedinvestments in these low-rated, high-yielding debt issues.

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LoadA sales charge or commission assessed by certain mutual funds ("load funds,") to covertheir selling costs. The commission is generally stated as a portion of the fund's offeringprice, usually on a sliding scale from one to 8.5%.

Load Fund

A mutual fund that levies a sales charge up to 6%, which is included in the offering price of itsshares, and is sold by a broker or salesman. A front-end load is the fee charged when buying intoa fund; a back-end load is the fee charged when getting out of a fund.

Low-Load Fund

A mutual fund that charges a small sales commission, usually 3.5% or less, for the purchase of itsshares.

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Management Fee

The amount a mutual fund pays to its investment adviser for services rendered, includingmanagement of the fund's portfolio. In general, this fee ranges from .5% to 1% of the fund's assetvalue.

Money Market Fund

A mutual fund that aims to pay money market interest rates. This is accomplished by investing insafe, highly liquid securities, including bank certificates of deposit, commercial paper, governmentsecurities and repurchase agreements. Money Market funds make these high interest securitiesavailable to the average investor seeking immediate income and high investment safety.

Mutual Fund


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An open-end investment company that buys back or redeems its shares at current net assetvalue. Most mutual funds continuously offer new shares to investors.

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Net Asset Value Per Share

The current market worth of a mutual fund share. Calculated daily by taking the funds total assetssecurities, cash and any accrued earnings deducting liabilities, and dividing the remainder by thenumber of shares outstanding.

No-Load Fund

A commission-free mutual fund that sells its shares at net asset value, either directly to the publicor through an affiliated distributor, without the addition of a sales charge.

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Payable Date

The date on which distributions are paid to shareholders who do not want to reinvest them. Thisdate can be anywhere from one week to one month after the Record Date.

Payroll Deduction Plan

An arrangement between an employer and a mutual fund, authorized by the employee, throughwhich a specified sum is deducted from an employee's salary to buy shares in the fund.

Portfolio Turnover Rate

The rate at which the fund's portfolio securities are changed each year. If a fund's assets totalRs100mn and the fund bought and sold Rs100mn worth of securities that year, its portfolioturnover rate would be 100%. Aggressively managed funds generally have higher portfolioturnover rates than do conservative funds that invest for the long term. High portfolio turnoverrates generally add to the expenses of a fund.

Prospectus

An official document that each investment company must publish, describing the mutual fund andoffering its shares for sale. It contains information required by the Securities and ExchangeCommission.

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Record Date

The date the fund determines who its shareholders are; "shareholders of record" who will receivethe fund's income dividend and/or net capital gains distribution. Frequently the business dayimmediately prior to the Ex-Dividend Date.

Redemption Fee


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A fee charged by a limited number of funds for redeeming, or buying back, fund shares.

Redemption Price

The price at which a mutual fund's shares are redeemed (bought back) by the less expensivefund. The redemption price is usually equal to the current net asset value per share.

Regional Fund

A mutual fund that concentrates its investments within a specific geographic area, usually thefund's local region. The objective is to take advantage of regional growth potential before thenational investment community does.

Reinvestment Date (Payable Date)

The date on which a share's dividend and/or capital gains will be reinvested (if requested) inadditional fund shares.

Reinvestment Privilege

A service that most mutual funds offer whereby a shareholder's income dividends and capitalgains distributions are automatically reinvested in additional shares.

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Sector Fund

A fund that operates several specialized industry sector portfolios under one umbrella. Transfersbetween the various portfolios can usually be executed by telephone at little or no cost.

Short Selling

The sale of a security which is not owned by the seller. The "short seller" borrows stock fordelivery to the buyer, and must eventually purchase the security for return to the lender.

Specialty Fund

A mutual fund specializing in the securities of a particular industry or group of industries or specialtypes of securities.

Systematic Investment Plans

In case of Systematic Investment Plans, instead of a lump sum amount, investor invests a pre-

specified amount in a scheme at pre-specified intervals at the then prevailing NAV.

Systematic Withdrawal Plans

Many mutual funds offer withdrawal programs whereby shareholders receive payments from theirinvestments. These payments are usually drawn from the funds dividend income and capital gaindistributions, if any, and from principal only when necessary.

Underwriter


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The organization that acts as the distributor of a mutual fund's shares to broker/dealers and thepublic.

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Variable Annuity

A type of insurance contract that guarantees future payments to the holder, or annuitant, usuallyat retirement. The annuity's value varies with that of the underlying portfolio securities, which mayinclude mutual fund shares. All monies held in the annuity accumulate tax-deferred.

Voluntary Plan

A flexible plan for capital accumulation, involving no specified time frame or total sum to beinvested.

Yield

Income or return received from an investment, usually expressed as a percentage of marketprice, over a designated period. For a mutual fund, yield is interest or dividend before any gain orloss in the price per share.

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Zero Coupon Bond

Bond sold at a fraction of its face value. It appreciates gradually, but no periodic interest

payments are made. Earnings accumulate until maturity, when the bond is redeemable at full facevalue. Nonetheless, interest is taxable as it accrues.

List Of Books:

Investment Policy and Performance of Mutual Funds

M.Jayadev

Mutual Funds Management and Working

Lalitb K. Bansal

Mutual Funds a Comprehensive Approach

Dr. Peeush Rajan Agrawal

Working at Mutual Fund Organization in India

P. Mohana Rao


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How Mutual Funds Work

A. J. Friedman & Russ Wiles

The Future of Fund Management in India

Tushar Waghmare

Mutual Funds in India

S. Krishnamurti

New provision introduced to prevent dividend stripping

Documents

Mutual Fund Mgt