New Word 2007 SujaDocument

7/31/2019 New Word 2007 SujaDocument

1/24

Chapter 1 : Concept and Role of Mutual Funds

Learning Objective

This unit seeks to introduce the concept of mutual funds, highlight the advantages they offer, and

describe the salient features of various types of mutual fund schemes.

Mutual funds are a vehicle to mobilize moneys from investors, to invest in different markets and

securities

The primary role of mutual funds is to assist investors in earning an income or building their wealth,

by participating in the opportunities available in the securities markets.

In order to accommodate investor preferences, mutual funds mobilize different pools of money.

Each such pool of money is called a mutual fund scheme. Mutual funds address differential

expectations between investors within a scheme, by offering various options, such as dividend

payout option, dividend reinvestment option and growth option. An investor buying into a scheme

gets to select the preferred option also.

The investment that an investor makes in a scheme is translated into a certain number of Units in

the scheme. The number of units multiplied by its face value (Rs10) is the capital of the scheme its

Unit Capital

When the profitability metric is positive, the true worth of a unit, also called Net Asset Value (NAV)

goes up.

When a scheme is first made available for investment, it is called a New Fund Offer (NFO).

The money mobilized from investors is invested by the scheme as per the investment objective

committed. Profits or losses, as the case might be, belong to the investors. The investor does not

however bear a loss higher than the amount invested by him.


2/24

The relative size of mutual fund companies is assessed by their assets under management (AUM).

The AUM captures the impact of the profitability metric and the flow of unit-holder money to or

from the scheme.

Investor benefits from mutual funds include professional management, portfolio diversification,

economies of scale, liquidity, tax deferral, tax benefits, convenient options, investment comfort,

regulatory comfort and systematic approach to investing.

Limitations of mutual funds are lack of portfolio customization and an overload of schemes and

scheme variants.

Open-ended funds are open for investors to enter or exit at any time and do not have a fixed

maturity. Investors can acquire new units from the scheme through a sale transaction at their sale

price, which is linked to the NAV of the scheme. Investors can sell their units to the scheme through

a re-purchase transaction at their re-purchase price, which again is linked to the NAV.

Close-ended funds have a fixed maturity and can be bought and sold in a stock exchange.

Interval funds combine features of both open-ended and closed ended schemes.

Actively managed funds are funds where the fund manager has the flexibility to choose the

investment portfolio, within the broad parameters of the investment objective of the scheme.

Passive funds invest on the basis of a specified index, whose performance it seeks to track.

Gilt funds invest in only treasury bills and government securities

Diversified debt funds on the other hand, invest in a mix of government and non-government debt

securities

Junk bond schemes or high yield bond schemes invest in companies that are of poor credit quality.


3/24

Fixed maturity plans are a kind of debt fund where the investment portfolio is closely aligned to the

maturity of the scheme.

Floating rate funds invest largely in floating rate debt securities

Liquid schemes or money market schemes are a variant of debt schemes that invest only in debt

securities of less than 91-days maturity.

Diversified equity funds invest in a diverse mix of securities that cut across sectors.

Sector funds invest in only a specific sector.

Thematic funds invest in line with an investment theme. The investment is more broad-based than a

sector fund; but narrower than a diversified equity fund.

A mutual fund is a pool of money collected from Investors and is invested according to stated

investment objectives.

The birth place of Mutual Fund is U.S.A.

Mutual fund investors are like shareholders and they own the fund.

Mutual fund investors are not lenders or deposit holders in a mutual fund.

Everybody else associated with a mutual fund is a service provider, who earns fee.

The money in the mutual fund belongs to the investors and nobody else.

Mutual funds invest in marketable securities according to the investment objective.

The value of the investments can go up or down, changing the value of the investors holdings.

The net asset value (NAV) of a mutual fund fluctuates with market price movements.

The market value of the investors funds is also called as net assets.

Investors hold a proportionate share of the fund in the mutual fund.


4/24

New investors come in and old investors can exit at prices related to net asset value per unit.

Advantages of mutual funds to investors are:

Increases the purchasing power of the investors

Portfolio diversification

Professional management

Reduction in risk

Reduction in transaction cost

Liquidity

Convenience and flexibility

Disadvantages of mutual funds to investors are:

No control over costs

No tailor made portfolios

Problems of managing a large portfolio of funds

Important Milestones in the MF history in India

1963: UTI (special privileges assured return schemes, guarantees, loans)

1987: Public Sector MFs

1993: Private Sector MFs

1995: AMFI was set-up (internal checks & balances, representation to the govt and consumer

educationpublish a book titled Making Mutual Funds Work for You an Investors Guide)

1996: SEBI (MF) Regulations

1999: Dividend income made tax free in the hands of investor

2003: UTI Act repealed (level playing field, UTI split, UTIMF created)

2004-onwards: Consolidation & Growth (AUM at the end of FY 2004-05 was appx. Rs.153,000 crores)

UTI was the only mutual fund during the period 1963-1988.

UTI was the only fund for a long period and enjoyed monopoly status.

UTI is governed by the UTI Act, 1963

In 1987 banks, financial institutions and insurance companies in the public sector were permitted to

set up mutual funds.


5/24

SEBI got regulatory powers in 1992.

SBI Mutual Fund was the first bank-sponsored

mutual fund to be set up.

The first mutual fund product was UTIs

Master Share in 1986.

The private sector players were allowed to setup mutual funds in 1993.

In 1996 the mutual fund regulations were

substantially revised and modified.

In 1999 dividends from mutual funds were made

tax exempt in the hands of investors.

Mutual funds can be open ended or closed ended,

Load or No-Load, Taxable or Tax exempt,

Commodities and Real Estate funds.

In an open ended fund, sale and repurchase of

units happen on a continuous basis, at NAV

related prices, from the fund itself.

The corpus of open ended funds, therefore,

changes everyday.


6/24

A closed end fund offers units for sale only in the

NFO. It is then listed in the market.

In closed end fund investors wanting to buy or sell

units have to do so in the stock markets.

The corpus of a closed end fund remains

unchanged.

Mutual funds also offer equity linked savings

schemes (ELSS) that have the following features:

3 year lock in

Minimum investment of 90% in equity markets at

all times

Open ended or closed end

Rebate under section 80C for investments up to

Rs. 1,00,000/-

Gilt funds are funds that invest only in

government securities

Sectoral funds are also called as specialty funds.

Equity funds are risky; liquid funds have the

lowest risk.


7/24

Equity funds are for the long term; liquid funds

are for the short term.

Investors choose funds based on their objectives,

risk appetite, time horizon and return

expectations.

Load is charged to the investor when the investor

buys or redeems (repurchases) units.

Load is an adjustment to the NAV, to arrive at the

price.

Load that is charged on sale of units is called as

Entry Load.

An entry load will increase the price, above the

NAV, for the investor.

Load that is charged when the investor redeems

his units is called an Exit Load.

Exit load reduces the redemption proceeds of the

investor.

Load is primarily used to meet the expenses

related to sale and distribution of units.


8/24

An exit load that varies with the holding period of

an investor is called a (Contingent Deferred Sales

Charge) CDSC.

The repurchase price cannot be less than 95% of

the sale price.

What is the first thing you look for when you invest in a liquid fund? Its safety, right? After the

fiasco that liquid funds went through during the 2008 credit crisis, where many liquid schemes had

to sell off their underlying holdings or securities at throwaway prices, the capital markets

regulator, Securities and Exchange Board of India (Sebi), has not been taking any chances. Over

the past three years, it has consistently reduced the risk levels that a liquid fund can take, while

making their net asset values (NAVs) as realistic as possible. In fact, some experts claim that the

Indian mutual funds (MF) debt fund regulations are on paras far as risk contaminant is

concernedwith those in many developed markets. After all, your funds underlying scrips must

reflect their true worth.

Effective 30 September, your liquid fund will further de-risk itself. All holdings that mature beyond

60 days will be marked to market; these will, therefore, endure daily volatility. But this seemingly

innocuous change is a part of a bigger change in Sebis mindset.

Rules-based to principles-based

In February 2012, Sebi changed its advertising and

debt fund valuation guidelines to

principles-based from rules-based

which was earlier the case. This

means that instead of Sebi defining

rules, followed by more rules later toadd to the previous ones, Sebi will

lay down broad guidelines and their

end objective. MFs then have to


9/24

devise their own policies to ensure

that the objective is met.

As Shubho Roy, legal consultant at

National Institute of Public

Finance and Policy, and Ajay

Shah, professor, National

Institute of Public Finance and

Policy, wrote in a blogpost

titled Movement at Sebi

towards principles-based

regulationon Shahs

blog www.ajayshahblog.blogsp

ot.com, in March soon after

Sebis guidelines came out,

statutory warnings on cigarette

boxes are a good example of

how rules-based guidelines can

lead to companies finding


10/24

loopholes and circumventing

regulations. The rules require

that the font in which the

statutory warning is printed

should have a minimum

height. Firms get around thisby printing the warning in the

required height, but reducing

the width of the characters to a

ridiculously low size, so that itis very difficult for readers to

decipher. Thereby, they are

able to comply with the

directive for statutorywarnings, yet defeat the

purpose of warning buyers,

write Roy and Shah.


11/24

As far as valuations of their

holdingsbe it equity or debt

are concerned, broadly, Sebi

wants fund houses to adhere to

the principle of fair valuation.

While its easier to value equitysecurities because equity

markets are liquid anda large

segment of equity scrips are

traded and, therefore, carry a

market price, debt markets are a

different ball game. They are

illiquid and typically long-term

bonds which dont get traded

daily. Up till now, Sebi had

prescribed a detailed set of

guidelinesthey first came out in

2001 and later in 2002to debt

funds on how to value their


12/24

underlying securities, depending

on whether they are traded and

also their maturity periods.

Now Sebi wants fund houses to

value their debt securities the

way they wish, but they must

ensure that the scrips are valued

as realistically as possible. The

boards of the asset management

company (AMC) and the trustees

must approve the valuationpolicies. All fund houses must list

their valuation policies on their

websites.

I think principles-basedregulation is a good idea and we

should move there. Rules-based

regulation is just inviting a

continual dog-fight between


13/24

regulators and the industry,

where the industry looks for

loopholes. But at the same time,

we have to see that principles-

based regulation also requires

commensurate modifications in

the regulatory strategy. One, theburden of compliance with

principles should fall on the top

management and not on the

compliance officer. Two, Sebineeds higher quality staff in order

to enforceprinciples-based

regulation. Three, we have to

strengthen Securities AppellateTribunal so that we have more

capable judges disposing off a

larger workflow, says Shah.

Valuing underlying securities


14/24

Crisil matrix: Because debt

scrips are illiquid and many do

not have a trading price, valuing

them could be tricky. Credit rating

agencies Crisil Ltd and Icra Ltd

send matrices every day to all

MFs. Every day, these agenciescollate traded prices of all

governmentsecurities (G-secs)

across different modified

duration and then give a suitablemark-upin terms of yieldsfor

other rated instruments.

Expressed in years, modified

duration tells you how much yourdebt fund would get affected if

interest rates (a debt securitys or

your bond funds yield) were to

move up or down by 1%.


15/24

For instance, as on 25 July 2012,

as per Crisils matrix, the G-sec

yield for a scrip that comes with a

modified duration of 0.25 and 0.5

years was 8.39%. As per this

matrix, the mark-up for a AAA-

rated security for a similarmodified duration is 0.86%.

If your fund has invested in a

AAA-rated security and if the

security gets traded on a givenday (25 July in this example), it

will take the traded price. But if

the security doesnt get traded,

your fund then refers to this Crisilmatrix. A 0.86% mark-up of a

AAA-rated instrument over the G-

sec yield means that the AAA-

instruments yield is 9.25%


16/24

(8.39% + 0.86%). Given the

derived yield (9.25%) and the

modified duration (0.250.5

years), the debt fund then arrives

at the price of its AAA holding and

accounts for it while calculating

its NAV.

On account of different types of

debt securities, rating agencies

now give several matrices daily to

MFs. For instance, Crisil sendsone matrix for traditional bonds,

another one to measure the yields

of bonds issued by non-banking

finance companies and real estatecompanies, yet another one for

short-term instruments and a few

other for other types of

instruments.


17/24

The matrices are devised looking

at trades that have taken place

across trading platforms for

benchmark securities using Crisils

proprietary model. They seek to

represent the indicative valuation

levels for securities for aparticular rating category and

tenor., says Jiju Vidyadharan,

director, funds and fixed income

Research, Crisil.Discretionary mark-up and

mark-down: Till June 2012,

when the new Sebi guidelines

came into force, debt funds wereallowed some discretion to value

their debt scrips. For instance, for

securities that were rated by

credit rating agencies of duration


18/24

of up to two years, debt funds

were allowed to provide a mark-

up of 100 basis points (bps) on

the upside and 50 bps on the

downside. A basis point is one-

hundredth of a percentage point.

Since the new regulations areprinciples-based, discretionary

mark-ups are now removed and

the fund houses are free to use

any mark-ups or mark-downsthey want.

Heres what this means. Say your

debt fund bought an ABC

companys bonda AAA-ratedinstrumentat a yield of 9.60%.

Assume, on this day, the Crisils

and Icras determined matrix

yield for a AAA-rated instrument


19/24

for a similar modified duration is a

yield of 9.20%. This means, your

debt fund has used a mark-up of

40 bps. Since the 40 bps mark-up

was within the overall limit of 100

bps, this was allowed.

However, assume that on account

of an unforeseen event, equity

and debt market collapse; bond

prices fall hard. Since bond prices

and yield move in oppositedirections, yields will shoot up. If

your debt funds underlying bond

gets downgraded in terms of its

credit rating, its price falls and,correspondingly, its yield goes

up. Assume, its yield goes up to

15% and your fund has to value it

at the end of the day to


20/24

determine its own NAV. Also

assume, on that same day, the

matrix determined yield for

similar rated and equivalent

duration bonds is 12%. If your

debt fund were to have valued

the ABC companys bond at 15%(the prevailing market yield of

that specific bond), that would

have been a mark-up of 300 bps;

a 100 bps mark-up would haveallowed your debt fund to value

this scrip at 13% at most.

Your debt fund had no choice,

therefore, but to value that bondat maximum 13%.

Post June 2012, debt fund NAVs

should be in a better position to

capture these market


21/24

movements, says Vikrant Mehta,

headfixed income, AIG Global

Asset Management Co. (India)

Ltd.

The new Sebi guidelines have

removed the defined mark-ups

and have left it upon the fund

manager to decide an appropriate

mark-up or mark-down.

60-day limit: This is a simple

rule. Effective 30 September, all

securities maturing after 60 days

will be marked to market. Those

securities that mature before 60

days will continue to be amortized(a method that debt funds use to

value very short-term securities).

However, amortization will need


22/24

to be more realistic than before,

following matrices very closely.

After Sebi gave fund houses the

freedom to come out with their

own valuation policies in

February, there were discussions

at the level of the Association of

Mutual Funds in India (Amfi), the

industry trade body. Then the

Amfi valuations committee came

up with a detailed set ofguidelines keeping in mind

Sebis objective to value

securities as realistically as

possibleto guide the MFindustry. All AMCs have largely

stuck to these guidelines with

some variations here and there.


23/24

We checked out the debt fund

valuation policies of seven fund

houses including larger ones such

as HDFC Asset Management Co.

Ltd and ICICI Prudential Asset

Management Co. Ltd to smaller

ones such as AIG Global AssetManagement Co. (India) Pvt. Ltd

to get an idea of what fund

houses are up to. Mostly, their

policies are the same withnegligible differences. Sebi has

asked fund houses to review the

policies periodically.

[email protected] - Find More Articles On:

Debt FundMutual Funds

Liquid Funds

Investor
http://www.livemint.com/articles/keywords.aspx?kw=Debt%20Fundhttp://www.livemint.com/articles/keywords.aspx?kw=Debt%20Fundhttp://www.livemint.com/articles/keywords.aspx?kw=Mutual%20Fundshttp://www.livemint.com/articles/keywords.aspx?kw=Mutual%20Fundshttp://www.livemint.com/articles/keywords.aspx?kw=Liquid%20Fundshttp://www.livemint.com/articles/keywords.aspx?kw=Liquid%20Fundshttp://www.livemint.com/articles/keywords.aspx?kw=Investorhttp://www.livemint.com/articles/keywords.aspx?kw=Investorhttp://www.livemint.com/articles/keywords.aspx?kw=Investorhttp://www.livemint.com/articles/keywords.aspx?kw=Liquid%20Fundshttp://www.livemint.com/articles/keywords.aspx?kw=Mutual%20Fundshttp://www.livemint.com/articles/keywords.aspx?kw=Debt%20Fund


24/24

Investment

READ MORE ARTICLES BY:

Kayezad E. Adajania

Share on facebookShare on twitter

4 comments:
http://www.livemint.com/articles/keywords.aspx?kw=Investmenthttp://www.livemint.com/articles/keywords.aspx?kw=Investmenthttp://www.livemint.com/articles/Authors.aspx?author=Kayezad%20E.%20Adajania&type=wahttp://www.livemint.com/articles/Authors.aspx?author=Kayezad%20E.%20Adajania&type=wahttp://www.facebook.com/mint.livehttp://www.facebook.com/mint.livehttp://www.facebook.com/mint.livehttp://www.livemint.com/articles/Authors.aspx?author=Kayezad%20E.%20Adajania&type=wahttp://www.livemint.com/articles/keywords.aspx?kw=Investment

Documents

New Word 2007 SujaDocument