Evolution and Regulatory Framework ofMutual Funds

K.Suresh Babu

Vice President – Treasury

Reliance Capital Ltd.

Sunday, July 26, 2009 at SIES Management Institute

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Session 1 Agenda for Discussion

Mutual Fund and Basic Terms Evolution of Mutual Funds Growth of Mutual Fund Industry

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What is Mutual Fund ? A Fund

Established in the form of a Trust;

To raise monies thru the sale of units to the public under one or more schemes

For investing in securities including money market/ gold/ gold related instruments or real estates.

Pools the savings of a number of investors who share a common financial goal.

Investment of pooled savings by Fund Managers of a Mutual Fund in capital market instruments such as shares, debentures and other securities.

Sharing of income earned through investment and capital appreciation realised by unit holders in proportion to the number of units owned by them.

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Why Mutual Funds ?

Operates on the principle of ‘strength in numbers’ Small investments within the affordable reach and with a wide choice of schemes Spreads the investment risks by diversified portfolio Professionally managed basket of securities at a relatively low cost Easy liquidity by redemption at NAV based prices Transparency & Flexibility Well regulated Tax benefits

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Investing in Mutual FundsRisk Return Matrix

Higher Risk Higher Risk

Lower Return Higher Return

Equity

Lower Risk Lower Risk

Lower Return Higher Return

Bank FDs/

Postal Savings Mutual Funds

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How Mutual Fund is formed ?

Constituted in the form of a Trust

Instrument of Trust in the form of a Trust Deed

Registered under the Indian Registration Act, 1908

Executed by the Sponsor in favour of the Trustee indicated in the Trust Deed

Trust Deed contains clauses as per the Regulations that are necessary for safeguarding the interests of unit holders

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Mutual Fund – The Basic Terms

Unit

The interest of the unit holder in a Scheme which consists of each unit representing one undivided share in the assets of a Scheme

Unit holder

A person holding units in a Scheme of a Mutual Fund

Net Asset Value (NAV) per unit

Market value of the securities held by the Scheme on any particular date.

Value of all assets minus value of liabilities

(Unit Capital plus reserves) divided by no. of units

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Mutual Fund – The Basic Terms

Sale Price / Offer Price

Price payable for investment in a Scheme

Repurchase Price / Redemption Price

Price at which units are repurchased by Mutual Fund

Repurchase Load / Back-end Load / Exit Load

Charge collected by a Scheme when it buys back the units from the unit holders

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Types of Mutual Fund Schemes By Tenor

Open ended: offers units without specifying any duration for redemption.

Close ended: where the period of maturity is specified

By Asset class

Equity, Debt or Income, Balanced Schemes, Gold Exchange Traded Funds, Money Market Funds

By Position philosophy

Sector Specific (min 65%), Fixed Maturity Schemes

By Geography

Country Funds, Offshore Funds

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Types of Mutual Fund Schemes Capital Protected Schemes

Protects the capital invested thru orientation of its portfolio structure. Close ended and no repurchase before the maturity.

Index Fund

Invests in securities in the same proportion as an index of securities

Fund of Funds

Invests primarily in other schemes of the same MF or other MFs

Real Estate Mutual Fund Scheme

Invests directly or indirectly in real estate assets or other permissible assets. Close ended Scheme and listed.

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Schemes of a Mutual Fund

Plans: Dividend & Growth

Options: Payout & Reinvestment

Sub-options: Yearly, Half yearly, Quarterly, Monthly, Weekly, Daily

Sub-plans: Systematic Investment Plan

Systematic Withdrawal Plan

Systematic Transfer Plan

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Mutual Fund Options for Dividend

Growth Dividend Div-Reinvst

No.of Units 1,000 1,000 1,000

Face Value Rs.10 Rs.10 Rs.10

NAV Rs.15 Rs.15 Rs.15

Div.Declared per unit --- Rs. 5 Rs. 5

New NAV Rs.15 Rs.10 Rs.10

No.of Units (Ex-Div) 1,000 1,000 1,500

Value of Units Rs.15,000 Rs.10,000 Rs.15,000

Div. Declared --- Rs. 5,000 ---

Total Rs.15,000 Rs.15,000 Rs.15,000

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Evolution of Mutual Funds

The first investment trust, Eendragt Maakt Magt (in English it means ‘Unity Creates Strength’) setup by a Dutch merchant in 1774 followed by more investment trusts.

The Foreign and Colonial Govt Trust formed in London in 1868.

The Massachusetts Investors Trust formed in US in 1924.

The Great Depression in 1929 lead to the birth of powerful regulators with enactment of legislations

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Growth in the US Mutual Fund Industry

The $ 500 million AUM in 1940 rose to $ 17 billion by 1960

With new investment exposures and higher returns than banks, the AUM had reached $ 95 billion by the end of 1970

With more maturity in the financial markets, the AUM had reached $ 7.4 trillion in 2004 with a retail investor base of 91 million.

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Evolution of MF industry in India1964-1987 - Birth of UTI

UTI gave birth to MF industry in December 1963 with the enactment of UTI Act and under RBI’s control and later delinked in 1978 to IDBI

The first IPO, US 64 in July 1964 mobilised 126,000 applications for Rs.17.40 crores and later AUM crossed Rs.1000 crores in 1991

The second scheme, ULIP launched in 1971

UTI Mastershare, India’s first true mutual fund scheme launched in 1986 and total AUM reached Rs.6,700 crores at the end of 1988.

AUM of UTI reaches Rs.6,700 crores in 1988

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Evolution of MF industry in India1987-1993 – Entry of Public Sector

PSU banks and insurers allowed to float mutual funds in 1987

SBI was first to launch mutual fund in Nov 1987 followed by Canbank in Dec 1987, LIC in 1989 and Indian Bank in 1990

The AUM of UTI crossed Rs.38,247 crores and PSU funds Rs.8,757 crores by 1993.

Investors shifting away from bank deposits to mutual funds by allocating > 6% of the savings to fund investments

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Evolution of MF industry in India1993-1996 – Entry of Private Sector

The entry of private sector and foreign players allowed in 1993. Kothari Pioneer was the first private fund house to start operations followed by 11 others.

Morgan Stanley was the first foreign player in 1994.

SEBI was setup in 1993 to regulate the MF industry with SEBI Mutual Fund Regulations came in force in 1996.

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Evolution of MF industry in India1996-2003 – Regulated Markets

Deregulation and liberalisation introduced competition and provided impetus to the growth of the industry

33 Mutual Funds with AUM of Rs.121,805 crores; UTI with Rs.44,541 crores AUM ahead of others.

UTI bifurcated in 2002 and came under SEBI purview.

SEBI tightened regulations, banned agents from giving commissions to investors, made AMFI registration compulsory for new agents.

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Evolution of MF industry in India2003-2004 – Growth Phase

UTI bifurcation in February 2003

Assured return schemes (US 64) with AUM of Rs.29,835 crores into specified undertaking of UTI under the Administrator controlled by Govt.

UTI Mutual Fund with AUM of Rs.76,000 crores comes under the purview of SEBI

AUM reaches Rs.153,108 crores by September 2004 with 29 funds and 421 schemes.

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Evolution of MF industry in IndiaJuly 1993 - June 2008 (15 years growth)

Beginning of the era of privatisation in July 1993

11 times growth in AUMs from Rs.47,000 crores to Rs.530,000 crores in 15 years

Top 5 of 35 MF houses account for more than half of the MF industry’s AUM.

Four of the Top 5 fund houses are privately owned.

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Unit holding Pattern of Mutual Fund Industry – March 2009

Category No.of Investors Net Assets (Rs.crs)

Individuals 460,75,763 (96%) 155,283 (37%)

NRIs 9,71,430 ( 2%) 22,821 ( 5%)

FIIs 146 (<1%) 4,983 (1 %)

Corporates/ Institutions 5,75,938 (1%) 236,233 (56%)

Total 476,23,277 419,321

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AUM - June 2009

Average AUM as at the end of June 2009 increased to Rs.670,937 crs

An increase of Rs.106,185 crs (18.80%) over Rs.564,752 crs as at June 2008.

Of the total AUM of Rs.670,937 crs as at the end of June 2009,

Bank sponsored (4) Rs.113,386 crs

Institutional (1) Rs. 32,415 crs.

Private Sector (30) Rs.525,136 crs.

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Status of AUM - June 2009

No.of Schemes AAUM (Rs.crs)

Income/ Debt oriented 485 488,653

Growth/ Equity oriented 341 162,242

Balanced Schemes 37 15,732

Exchange Traded Fund 18 1,636

Fund of Funds 10 2,673

Total 891 670,937

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Session 2Agenda for Discussion

Constituents of Mutual Fund Pricing & Regulations Investment Restrictions & Valuation Norms Accounting Policies & Standards

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Mutual Fund Constituents

Sponsors Trustees Asset Management Company Agents/ Distributors Custodians/ Depositories Fund Accountants Registrar & Transfer Agents The Regulator - SEBI

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Sponsors of Mutual Fund

Initiates the idea to setup a mutual fund and establishes the mutual fund

Should have a sound track record and general reputation of fairness and integrity in all business transactions

Contributes at least 40% of the networth of the AMC

Should not have been guilty of fraud or has not been convicted of an offence involving moral turpitude or has not been found guilty of any economic offence

Has a net worth of not less than Rs.10 crs

Appoints the AMC, Trustee and Custodian

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Trustees

Holds the property of the mutual fund in trust for the benefits of the unit holders

Persons of integrity not convicted of any economic offence or violation of security laws

Internal regulators to protect the interests of unit holders.

Appointed by Sponsors with SEBI’s prior approval

Minimum 4 trustees with two-thirds be independent.

No Director/ Employee of a MF shall be eligible to be appointed as a Trustee of any other MF.

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Rights and Obligations of the Trustees

Accountable as the Custodian of the funds/ property of MF and hold them in trust for the unit holders’ benefit

Appoints AMC and enters into an IMA for making investments Appoints Custodian and enters into a Custodian Agreement, appoints Key

Personnel, Compliance Officer, R&T and designs internal control mechanism. General and Specific Due diligence before the launch of any scheme by MF Reviews quarterly all transactions of the MF, service contracts of AMC,

investors complaints/ redressal mechanism and reports half yearly to SEBI Right to obtain information from the AMC and to terminate the appointment of

AMC Appoints different auditors for MF and AMC.

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Asset Management Company

Investment Manager – Responsible to Trustees Sound track record and reputation for fairness and integrity with a minimum net

worth of Rs.10 crores One-half to be ‘independent directors’ No AMC/ Directors/ Officers of AMC shall be eligible to be appointed as a

Trustee of any MF. Appointment can be terminated by majority of unit holders or by Trustees Handles operational matters from launching schemes to managing them to

interacting with investors Ensures that AMC Board has at least 50% directors who are not associated with

the Sponsor or Trustees. Directors of AMC shall not hold the office of Director of another AMC Submits information / documents to the Trustees periodically

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Obligations of the Asset Management Company

Shall maintain proper books of account, records for each Scheme.

Shall follow the accounting policies and standards and provide details of distribution and accumulation of income accruing to the unit holders in a fair manner.

Shall submit quarterly report on the functioning of MF Schemes to the Trustees.

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Responsibilities of the Asset Management Company

Management of schemes as per the IMA

Due Diligence in all investment decisions

Responsible for regulatory compliance and submits quarterly reports to Trustees, SEBI on fund activities

Charges AMC fee as per Regulations

Appoints key personnel / R&T and set up systems for investment management, accounting, internal audit etc.

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Code of Conduct by AMC and Trustees

Shall maintain high standards of service, exercise due diligence, ensure proper care and exercise independent professional judgement.

Not to organise, operate, manage the portfolio of Schemes in the interests of sponsors, AMC and Trustees.

Disseminate to all unit holders of adquate, accurate, timely information about the investment policies, objectives, financial position and general affairs of the Scheme.

Avoid excessive concentration of business with broking firms and avoid conflicts of interest in managing the Scheme affairs.

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Custodian & Fund Administrators

Provide post-trading and custodial services for schemes

Keep securities and other instruments belonging to the Scheme in safe custody

Ensure the benefits due to the holdings of the MF are recovered

Be responsible for loss of or damage to the securities due to negligence

Accounting policies and standards prescribed by SEBI

NPA provisioning

Scheme Accounting, NAV computation and Audit

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R & T Agent Accepting and processing investors’ applications for issue and redemption of

units on behalf of fund

Handle communications with investors

Perform data entry services

Despatch account statements

Processing redemption and dividend pay-out

Payment of brokerage to agents

Systems facilities and back up of investors’ records

Responsible for customer service

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Agents & Distributors

Appointed by AMC

May act on behalf of different Funds

Independent individuals are appointed as Agents

Should be AMFI registered

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Regulators

SEBI

AMFI

RBI

Ministry of Finance

Company Law Board

Stock Exchanges for listed schemes

Office of the Public Trustee

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Pricing - Net Asset Value

Indicates the Market Value of the assets of a Scheme minus its liabilities

Indicates the Price at which units are subscribed/ sold and are repurchased/ redeemed

Calculated for each Plan or Scheme of the Fund every day including the close ended Schemes (other than ELSS) and published in 2 daily newspapers.

Value of Net Assets divided by the number of units outstanding in each Scheme/ Plan on the valuation date.

Updating the on the AMFI website by 10 am the following business day

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Load Structure

Exit Loads (Entry Loads since waived for all Mutual Fund Schemes effective August 1, 2009)

Redemption Price not lower than 93% of NAV

Of the Exit Load charged to investors, a maximum of 1% of the redemption proceeds shall be maintained in a separate account which can be used by the AMC to pay commission to the distributors and meet marketing / selling expenses. Any balance shall be credited to the Schemes immediately.

Adequate disclosure in the OD / SID/ SAI and modifications prospectively

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Regulations - Advertisements

Shall not be misleading or contain false and incorrect information

Shall disclose the investment objectives of each Scheme, names of the Settlor, Trustee and make a statement that all MF investments are subject to market risks and there can be no assurance that the fund’s objectives will be achieved.

Shall disclose prominently the risk factors

Shall be in conformity with the Advt code specified and submitted to SEBI within 7 days from the date of issue.

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Regulations – Borrowing Powers Shall not borrow except to meet temporary liquidity needs of MFs for

repurchase, redemption of units or payment of interest/ dividend to the unit holders.

Shall not borrow > 20% of net assets of the Scheme and duration shall not exceed 6 months.

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Regulations – Expenses of Scheme

Clear identification and appropriation of expenses in individual Schemes. AMC advisory fee at :

1.25% of weekly average net assets outstanding for the Scheme in each year for the net assets upto Rs.100 crs and 1% of the excess over Rs.100 crs.0.75% of the weekly average net assets in case of Index Fund Scheme

Recurring expenses at 2.50% for the first Rs.100 crs of average weekly net assets; 2.25% for next Rs.300 crs., 2% on the next Rs.300 crs. And 1.75% on the balance of the assets.1.5% for Index Funds.Expenses Chargeable:Marketing / Selling expenses; brokerage, R&T/ Audit/ Custodian/ Trustee fees; Cost of statutory advertisements; Cost of providing statement of accounts, cheques for redemption/ dividend warrants.

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Regulatory RestrictionsClose-ended Schemes

Disclosure of portfolio of debt oriented close ended and interval Schemes/ Plans on a monthly basis within 3 days

Prohibition of disclosure of indicative portfolio/ yields in debt/ fixed income Schemes.

Restrictions on investments in/ purchase of debt and money market securities with maturity of upto 91 days only effective May 09.

Mandatory listing of units of all close ended Schemes (except ELSS) launched after December 12, 2008. Such units shall not be repurchased before the maturity.

Repurchase price of units of close ended Schemes prior to December 12, 2008 not lower than 95% of the NAV.

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Investment Restrictions

Investments in accordance with the investment objectives of the relevant MF Scheme

Inter-Scheme transfer of investments done at prevailing market price, without charging AMC fee and as per the investment objectives of the relevant Scheme.

Buy/ Sell securities on delivery basis and get transferred in relevant MF Scheme.

No investment in unlisted / listed security-privately placed of group company of the Sponsor.

Restrictions on lending in call money market

Derivatives for hedging and portfolio rebalancing as per norms

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Investment Restrictions Not invest more than 15% of NAV in rated debt and 10% in unrated debt issued

by a single issuer.

No MF under all Schemes own >10% of any company’s paid up capital.

Not to invest >10% of the Scheme’s NAV in equity of any company, except in case of index fund/ sector specific fund.

Aggregate value of illiquid securities not to exceed 15% of the total assets of the Scheme

No MF shall invest > 30% of its net assets in MMIs of an Issuer except for investments in GSec, TBs and CBLOs.

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Regulations on Investments in ADRs/ GDRs/ Foreign Securities

Overall ceiling limit of USD 7 bln.

Individual MF sub-ceiling 10% of net assets managed as on March 31 of each relevant year subject to a maximum of USD 300 mln. Per MF.

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Investment Restrictions - NFOs

No Scheme shall park more than 15% of the net assets in STDs of all banks together. (Can be raised to 20% with Trustees’ approval)

No Scheme shall park more than 10% of the net assets in STDs with anyone scheduled bank.

Tenor not to exceed 91 days.

No funds of a Scheme shall be parked in STDs of a bank which has invested in that Scheme.

No AMC charges on parking of funds in STDs in case of liquid/ debt oriented Schemes.

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Investment Valuation Norms

Value of the traded securities shall be at the last quoted closing price on any Exchange on the valuation day or day not more than 30 days before.

Non-traded securities shall be valued in good-faith by AMC. All expenses and incomes accrued upto the valuation date shall be

considered for computation of NAV. Valuation of Debt instruments and G-Sec on Y-to-M basis on the prevailing

market rates with appropriate discount for lower liquidity, if any. The value of Rights Shares, until their trading, shall be calculated on the basis

of the number of rights divided by original shares multiplied by the difference between ex and cum Rights offer.

All investments shall be shown at market value with necessary provision for exclusion of unrealised gain arising out of appreciation of investment which cannot be distributed to unit holders.

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Session 3 Agenda for Discussion

Investors Rights and Information Investors Service Standards The Road Ahead for Mutual Fund Industry

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Investors Rights – Initial/ Regular Subscription

Right to get refund of application money within 6 weeks from closure of subscription if MF fails to receive the minimum subscription.

Entitled for interest at 15% pa from the expiry of 6 weeks from closure of subscription for failure to get refund

15% interest for delayed redemptions of more than 10 working days. AMC liable for penalty for failure to despatch redemption proceeds within stipulated time.

Unclaimed redemptions and dividend at the prevailing NAV up to 3-year period

Uniform cut-off timings for applicable NAV

Minimum investors limit of 20 and 25% of the AUM

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Investor’s Rights

Right to obtain any information and inspect material documents Right to receive Scheme portfolio before the expiry of one month from the close

of each half year unless published in local newspapers Right to receive the Schemewise Annual Report of a MF or abridged summary

within 4 months from accounting closure. Right to approve change in Fundamental Attributes of the Scheme Right to wind up a Scheme and terminate the AMC with 75% voting If NAV of a Scheme differs by >1% due to non-recording of transactions,

whereby unit holders are allotted/ charged at higher/ lower price for sale/ purchase of their units, the AMC shall pay the difference in amount to/ by the Scheme.

Investor Complaints Redressal Mechanism

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Investor’s Right to Information

Easy availability of Scheme Information Document (SID)/ Statement of Additional Information (SAI) to all Distributors and confirmation thereof by Trustees to SEBI

Updation of SID / KIM within 3 months from the end of the financial year for the Schemes launched in the I-HY and within 3 months of the end of subsequent financial year for Schemes launched in II-HY.

Updation of SID once a year thereafter.

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What to look at the Offer Document Main features of the Scheme, Risk Factors

Recurring expenses charged, Load structure

Sponsor’s track record

Work experience of Fund Manager and Key Personnel of AMC

Performance of other Schemes launched by the MF in the past

Pending litigations and penalties imposed.

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Investor’s Right to InformationAccount Statements

Statement for every transaction within 10 working days Statement if specifically requested within 5 working days Statement along with Portfolio Statement or Annual Report for no transactions in

a year Statement for SIP/ STP/ SWP transactions once in a quarter within 10 working

days Right to get Statement of accounts within 6 weeks from the closure of initial

subscription in NFO. Allotment of units and despatch of account statement within 30 days in respect

of initial/ regular subscription.

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Investors Service Standards - Dividend DistributionUniform Standards

Dividend quantum and record date be fixed by the Trustees and public notice within 1 day

Dividend subject to availability of distributable surplus and NAV adjusted to the extent of dividend distributed at the close of record date

Record date shall be 5 calendar days from the notice

Notice not compulsory for schemes having frequency of dividend distribution from daily upto monthly dividend

Despatch the dividend warrants within 30 days of the declaration.

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Investor Service Standards - How to Invest

Prevention of Money Laundering & Know Your Customer (KYC)

KYC compliance mandatory for subscriptions of Rs.50,000/- above

Mandatory to provide IT PAN along with a self attested copy of PAN card

Bank account details mandatory

Email communication mandate

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Uniform Cut off timings & Applicable NAV for Liquid Schemes Purchases

Closing NAV of the day immediately preceding the day of receipt of application for applications received upto12 noon and funds available for utilisation on the same day.

Closing NAV of the day immediately preceding the next business day for applications received after 12 noon and funds available for utilisation on the same day.

Closing NAV of the day immediately preceding the day on which the funds are available for utilisation for applications received irrespective of time where funds are not available for utilisation on the day of application

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Uniform Cut off timings & Applicable NAV for Liquid Schemes Repurchases

Closing NAV of the day immediately preceding the next business day for applications received upto 3 pm

Closing NAV of the next business day for applications received after 3 pm

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Uniform Cut off timings & Applicable NAV for other than Liquid Schemes Purchases

Closing NAV of the day of receipt of applications for applications received upto 3 pm with a local cheque/ DD payable at the place where it is received.

Closing NAV of the next business day for applications received after 3 pm with a local cheque/ DD payable at the place where it is received.

Closing NAV of the day on which the cheque/ DD is credited for applications received with outstation cheques/ DDs not payable at the place where it is received.

Closing NAV of the day on which the funds are available for utilisation in respect of purchase of units in Income/ Debt oriented Schemes (other than Liquid Fund Schemes) with amount equal to or more than Rs.1 cr.

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Uniform Cut off timings & Applicable NAV for other than Liquid Schemes Repurchases

Closing NAV of the day of receipt of application for applications received upto 3 pm.

Closing NAV of the next business day for applications received after 3 pm.

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Tax Benefits

Income of MF exempt from IT Sec 10(23D)

MF will receive income without TDS

Exemption to open-ended equity MFs from paying distribution tax on dividends distributed

Exemption of income in the hands of unit holders Sec.10(35). No TDS on dividends distributed by MF.

Units not liable for Wealth-tax and Gift-tax

Specific tax laws for long term / short term capital gains, securities transaction tax, non-residents, foreign companies

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Tax Benefits

100% IT exemption on all Mutual Fund Dividends.

Equity Funds: STCG taxed at 15%

LTCG not applicable

Debt Funds: STCG is taxed as per slabs applicable

LTCG at 10% without indexation and 20% with indexation

Open-ended Funds with equity exposure of > 65% are exempt from payment of Dividend Tax for a period of 3 years from 1999-2000.

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How to know the performance of a MF Scheme Service standards, Professional management of AMC Watch the NAVs of all MFs Half yearly performance, returns/ yields in last 6 months/ 1 year/ 3 years/ 5

years and since inception of Schemes. Percentage of expenses of total assets in Scheme. Research reports on Schemes’ performance, Ranking of various Schemes in

terms of their performance. Comparison of performance with other MF Schemes in same category and

those of benchmarks like BSE Sensitive Index, S&P CNX Nifty etc. Portfolio details of Scheme and details on illiquid securities, investments in

unrated securities, NPAs etc.

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The Road Ahead

MF industry growing at 37.87% over the past 5 years

Worldwide MF assets were estimated to be around $26 trillion at the end of 2007, whereas Indian assets stood at $150 billion.

Domestic MF assets as a % of GDP stand at around 10%, while it is around 73% in the US.

While 33% US population invests in Mutual Funds, the figure for India is barely 3%

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The Road Ahead

A well regulated environment with liberalised and proactive economic reforms make mutual funds powerful wealth creation vehicles.

Potential retail market remaining untapped:

Retail investors held nine times more in bank deposits than in mutual funds barely beating inflation.

Given the fact that 95% of India’s population has not invested in equities so far, it would be a great time for the first time investors to build equity portfolio

India with a billion+ people has 350 million bank account holders but of those barely 30 million people have MF accounts and less than 13 million hold demat accounts.

Thank youFor your Time, Attention and Interest