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INTRODUCTION TO MUTUAL FUND AND ITS VARIOUS
ASPECTS.
Mutual fund is a trust that pools the savings of a number of investors who share a
common financial goal. This pool of money is invested in accordance with a
stated objective. The joint ownership of the fund is thus Mutual, i.e. the fund
belongs to all investors. The money thus collected is then invested in capital
market instruments such as shares, debentures and other securities. The income
earned through these investments and the capital appreciations realized are shared
by its unit holders in proportion the number of units owned by them. Thus a
Mutual Fund is the most suitable investment for the common man as it offers an
opportunity to invest in a diversified, professionally managed basket of securities
at a relatively low cost. A Mutual Fund is an investment tool that allows small
investors access to a well-diversified portfolio of equities, bonds and other
securities. Each shareholder participates in the gain or loss of the fund. Units are
issued and can be redeemed as needed. The funds Net Asset value (NAV) is
determined each day.
Investments in securities are spread across a wide cross-section of industries and
sectors and thus the risk is reduced. Diversification reduces the risk because all
stocks may not move in the same direction in the same proportion at the same
time. Mutual fund issues units to the investors in accordance with quantum of
money invested by them. Investors of mutual funds are known as unit holders.
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When an investor subscribes for the units of a mutual fund, he becomes part
owner of the assets of the fund in the same proportion as his contribution amount
put up with the corpus (the total amount of the fund). Mutual Fund investor is also
known as a mutual fund shareholder or a unit holder.
Any change in the value of the investments made into capital market instruments
(such asshares, debentures etc) is reflected in the Net Asset Value (NAV) of the
scheme. NAV is defined as the market value of the Mutual Fund scheme's assets
net of its liabilities. NAV of a scheme is calculated by dividing the market value
of scheme's assets by the total number of units issued to the investors.
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HISTORY OF THE INDIAN MUTUAL FUND INDUSTRY
The mutual fund industry in India started in 1963 with the formation of Unit Trust
of India, at the initiative of the Government of India and Reserve Bank. Though
the growth was slow, but it accelerated from the year 1987 when non-UTI players
entered the Industry.
In the past decade, Indian mutual fund industry had seen a dramatic improvement,
both qualities wise as well as quantity wise. Before, the monopoly of the market
had seen an ending phase; the Assets Under Management (AUM) was Rs67
billion. The private sector entry to the fund family raised the Aum to Rs. 470
billion in March 1993 and till April 2004; it reached the height if Rs. 1540 billion.
The Mutual Fund Industry is obviously growing at a tremendous space with the
mutual fund industry can be broadly put into four phases according to the
development of the sector. Each phase is briefly described as under.
First Phase1964-87
Unit Trust of India (UTI) was established on 1963 by an Act of Parliament by the
Reserve Bank of India and functioned under the Regulatory and administrative
control of the Reserve Bank of India. In 1978 UTI was de-linked from the RBI
and the Industrial Development Bank of India (IDBI) took over the regulatory and
administrative control in place of RBI. The first scheme launched by UTI was
Unit Scheme 1964. At the end of 1988 UTI had Rs.6,700 crores of assets under
management.
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Second Phase1987-1993 (Entry of Public Sector Funds)
1987 marked the entry of non- UTI, public sector mutual funds set up by public
sector banks and Life Insurance Corporation of India (LIC) and General Insurance
Corporation of India (GIC). SBI Mutual Fund was the first non- UTI Mutual Fund
established in June 1987 followed by Canbank Mutual Fund (Dec 87), Punjab
National Bank Mutual Fund (Aug 89), Indian Bank Mutual Fund (Nov 89), Bank
of India (Jun 90), Bank of Baroda Mutual Fund (Oct 92). LIC established its
mutual fund in June 1989 while GIC had set up its mutual fund in December
1990.At the end of 1993, the mutual fund industry had assets under management
of Rs.47,004 crores.
Third Phase1993-2003 (Entry of Private Sector Funds)
1993 was the year in which the first Mutual Fund Regulations came into being,
under which all mutual funds, except UTI were to be registered and governed. The
erstwhile Kothari Pioneer (now merged with Franklin Templeton) was the first
private sector mutual fund registered in July 1993.
The 1993 SEBI (Mutual Fund) Regulations were substituted by a more
comprehensive and revised Mutual Fund Regulations in 1996. The industry now
functions under the SEBI (Mutual Fund) Regulations 1996. As at the end of
January 2003, there were 33 mutual funds with total assets of Rs. 1,21,805 crores.
Fourth Phasesince February 2003
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In February 2003, following the repeal of the Unit Trust of India Act 1963 UTI
was bifurcated into two separate entities. One is the Specified Undertaking of the
Unit Trust of India with assets under management of Rs.29,835 crores as at the
end of January 2003, representing broadly, the assets of US 64 scheme, assured
return and certain other schemes
The second is the UTI Mutual Fund Ltd, sponsored by SBI, PNB, BOB and LIC.
It is registered with SEBI and functions under the Mutual Fund Regulations.
consolidation and growth. As at the end of September, 2004, there were 29 funds,
which manage assets of Rs.153108 crores under 421 schemes.
WORKING OF MUTUAL FUND:-
A Mutual Fund is a collection of stocks, bonds, or other securities owned by
a groupof investors and managed by a professional investment
company. For an individualinvestor to have a diversified portfolio is difficult.
But he can approach to such companyand can invest into shares.
Mutual funds have become very popular since they makeindividual
investors to invest in equity and debt securities easy. When investors
invest a particular amount in mutual funds, he becomes the unit holder
of corresponding units. Inturn, mutual funds invest unit holders money
in stocks, bonds or other securities that earninterest or dividend. This
money is distributed to unit holders. If the fund gets money byselling
some stocks at higher price the unit holders also are liable to get capital
gains.
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CATEGORIES OF MUTUAL FUND:
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Mutual funds can be classified as follow:
Based on their structure:
Open-ended funds: Investors can buy and sell the units from the fund, at any
point of time.
Close-ended funds: These funds raise money from investors only once.
Therefore, after the offer period, fresh investments can not be made into the fund. If
the fund is listed on a stocks exchange the units can be traded like stocks (E.g.,
Morgan Stanley Growth Fund). Recently, most of the New Fund Offers of close-
ended funds provided liquidity window on a periodic basis such as monthly or
weekly. Redemption of units can be made during specified intervals. Therefore,
such funds have relatively low liquidity.
Based on their investment objective:
Equity funds: These funds invest in equities and equity related instruments.
With fluctuating share prices, such funds show volatile performance, even losses.
However, short term fluctuations in the market, generally smoothens out in the
long term, thereby offering higher returns at relatively lower volatility. At the
same time, such funds can yield great capital appreciation as, historically, equities
have outperformed all asset classes in the long term. Hence, investment in equity
funds should be considered for a period of at least 3-5 years. It can be further
classified as:
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i) Index funds- In this case a key stock market index, like BSE Sensex or Nifty
is tracked. Their portfolio mirrors the benchmark index both in terms of
composition and individual stock weightages.
ii) Equity diversified funds- 100% of the capital is invested in equities spreading
across different sectors and stocks.
iii|) Dividend yield funds- it is similar to the equity diversified funds except that
they invest in companies offering high dividend yields.
iv) Thematic funds- Invest 100% of the assets in sectors which are related
through some theme.
e.g. -An infrastructure fund invests in power, construction, cements sectors etc.
v) Sector funds- Invest 100% of the capital in a specific sector. e.g. - A banking
sector fund will invest in banking stocks.
vi) ELSS- Equity Linked Saving Scheme provides tax benefit to the investors.
Balanced fund: Their investment portfolio includes both debt and equity. As a
result, on the risk-return ladder, they fall between equity and debt funds. Balanced funds
are the ideal mutual funds vehicle for investors who prefer spreading their risk across
various instruments. Following are balanced funds classes:
i) Debt-oriented funds -Investment below 65% in equities.
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ii) Equity-oriented funds -Invest at least 65% in equities, remaining in debt.
Debt fund: They invest only in debt instruments, and are a good option for
investors averse to idea of taking risk associated with equities. Therefore, they
invest exclusively in fixed-income instruments like bonds, debentures,
Government of India securities; and money market instruments such as
certificates of deposit (CD), commercial paper (CP) and call money. Put your
money into any of these debt funds depending on your investment horizon and
needs.
i) Liquid funds- These funds invest 100% in money market instruments, a large
portion being invested in call money market.
ii) Gilt funds ST- They invest 100% of their portfolio in government securities of
and T-bills.
iii) Floating rate funds - Invest in short-term debt papers. Floaters invest in debt
instruments which have variable coupon rate.
iv) Arbitrage fund- They generate income through arbitrage opportunities due to
mis-pricing between cash market and derivatives market. Funds are allocated to
equities, derivatives and money markets. Higher proportion (around 75%) is put in
money markets, in the absence of arbitrage opportunities.
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v) Gilt funds LT- They invest 100% of their portfolio in long-term government
securities.
vi) Income funds LT- Typically, such funds invest a major portion of the
portfolio in long-term debt papers.
vii) MIPs- Monthly Income Plans have an exposure of 70%-90% to debt and an
exposure of 10%-30% to equities.
viii) FMPs- fixed monthly plans invest in debt papers whose maturity is in line
with that of the fund.
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INVESTMENT STRATEGIES
1. Systematic Investment Plan: under this a fixed sum is invested each month on
a fixed date of a month. Payment is made through post dated cheques or direct
debit facilities. The investor gets fewer units when the NAV is high and more
units when the NAV is low. This is called as the benefit of Rupee Cost Averaging
(RCA)
2. Systematic Transfer Plan: under this an investor invest in debt oriented fund
and give instructions to transfer a fixed sum, at a fixed interval, to an equity
scheme of the same mutual fund.
3. Systematic Withdrawal Plan: if someone wishes to withdraw from a mutual
fund then he can withdraw a fixed amount each month.
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RISK V/S. RETURN:
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s i m i l a r l y , a s e c t o r s t o c k f u n d ( w h i c h i n v e s t s i n a s i n
g l e i n d u s t r y , s u c h a s t el ec ommu ni ca ti on s) i s a t ri sk t ha t i ts
pr ic e wi ll de cl in e due to deve lo pme nts in it sindustry. A stock fund that
invests across many industries is more sheltered from this risk defined as industry
risk.
Following is a glossary of some risks to consider when investing in mutual funds:CALL
RISK:-The possibility that falling interest rates will cause a bond issuer to
redeem or call itshigh-yielding bond before the bond's maturity date.
COUNTRY RISK:-The possibility that political events (a war, national elections), financial problems
(risinginflation, government defaul t), or natural disasters (an earthquake, a
poor harvest) willweaken a country's economy and cause investments in that
country to decline.CREDIT RISK:-
The possibility that a bond issuer will fail to repay interest and principal
in a timelymanner. Also called default risk.
CURRENCY RISK:-The possibili ty that returns could be reduced for Americans investi
ng in foreignsecurities because of a rise in the value of the U.S. dollar against
foreign currencies. Alsocalled exchange-rate risk.
INCOME RISK:-The possibility that a fixed-income fund's dividends will decline as a
result of fallingoverall interest rates.
INDUSTRY RISK:-The possibility that a group of stocks in a single industry will decline in
price due todevelopments in that industry.
INFLATION RISK:-The possibility that increases in the cost of living will reduce or eliminate
a fund's realinflation-adjusted returns.
INTEREST RATE RISK:-The possibility that a bond fund will decline in value because of an
increase in interestrates.MANAGER RISK:-
The possibility that an actively managed mutual fund's investment adviser
will fail
toexecute the fund's invest ment strategy effectively resulting in the
fa ilure of st at ed objectives
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Market risk
The possibility that stock fund or bond fund prices overall will decline over short
or evenextended periods. Stock and bond markets tend to move in cycles,
with periods when prices rise and other periods when prices fall.
PRINCIPAL RISK:-The possibility that an investment will go down in value, or "lose money,"
from theoriginal or invested amount.
HOW RISK IS MEASURED:-There are two ways in which you can determine how risky a fund is.
STANDARD DEVIATION:-Standard Deviation is a measure of how much the actual performance of a
fund over a period of time deviates from the average performance.
SinceStandard Deviation is a measure of risk, a low Standard Deviation isgood.
SHARPE RATIO:-T h i s r a t i o l o o k s a t b o t h , r e t u r n s a n d r i s k , a n d d e l i v e r s a s i n g l
e me a s u r e t h a t i s proportional to the risk adjusted returns.
Since Sharpe Ratio is a measure of risk-adjusted returns, a high
Sharpe Ratio is good."
Advantages & Disadvantages of Mutual Funds1.Professional Management
Mutual Funds provide the services of experienced and skilled professionals,
backed by a
dedicated investment research team that analyses the performance and prospects of
companies
and selects suitable investments to achieve the objectives of the scheme. This risk
of default by
any company that one has chosen to invest in, can be minimized by investing in
mutual funds as
the fund managers analyze the companies financials more minutely than an
individual can do as
they have the expertise to do so. They can manage the maturity of their portfolio
by investing ininstruments of varied maturity profiles.
2.Diversification
Mutual Funds invest in a number of companies across a broad cross-section of
industries and
sectors. This diversification reduces the risk because seldom do all stocks decline
at the same
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time and in the same proportion. You achieve this diversification through a Mutual
Fund with far
less money than you can do on your own.
3.Convenient Administration
Investing in a Mutual Fund reduces paperwork and helps you avoid many
problems such as bad
deliveries, delayed payments and follow up with brokers and companies. Mutual
Funds save
your time and make investing easy and convenient.
4.Return Potential
Over a medium to long-term, Mutual Funds have the potential to provide a higher
return as they
invest in a diversified basket of selected securities. Apart from liquidity, these
funds have also
provided very good post-tax returns on year to year basis. Even historically, wefind that some of
the debt funds have generated superior returns at relatively low level of risks. On
an average debt
funds have posted returns over 10 percent over one-year horizon. The best
performing funds
have given returns of around 14 percent in the last one-year period. In nutshell we
can say that
these funds have delivered more than what one expects of debt avenues such as
post office
schemes or bank fixed deposits. Though they are charged with a dividend
distribution tax on
dividend payout at 12.5 percent (plus a surcharge of 10 percent), the net income
received is still
tax free in the hands of investor and is generally much more than all other avenues,
on a post tax
basis.
5.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 into
lower costs for investors.
6.Liquidity
In open-end schemes, the investor gets the money back promptly at net asset value
related prices
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from the Mutual Fund. In closed-end schemes, the units can be sold on a stock
exchange at the
prevailing market price or the investor can avail of the facility of direct repurchase
at NAV
related prices by the Mutual Fund. Since there is no penalty on pre-mature
withdrawal, as in the
cases of fixed deposits, debt funds provide enough liquidity. Moreover, mutual
funds are betterplaced to absorb the fluctuations in the prices of the securities as a
result of interest rate variation
and one can benefits from any such price movement.
7.Transparency
Investors get regular information on the value of your investment in addition to
disclosure on the
specific investments made by your scheme, the proportion invested in each class of
assets andthe fund manager's investment strategy and outlook.
8.Flexibility
Through features such as regular investment plans, regular withdrawal plans and
dividend
reinvestment plans; you can systematically invest or withdraw funds according to
your needs and
convenience.
9.Affordability
A single person cannot invest in multiple high-priced stocks for the sole reason that
his pockets
are not likely to be deep enough. This limits him from diversifying his portfolio as
well as
benefiting from multiple investments. Here again, investing through MF route
enables an
investor to invest in many good stocks and reap benefits even through a small
investment.
Investors individually may lack sufficient funds to invest in high-grade stocks. A
mutual fund
because of its large corpus allows even a small investor to take the benefit of itsinvestment
strategy.
10.Choice of SchemesMutual Funds offer a family of schemes to suit your varying
needs over a lifetime.
11.Well Regulated
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All Mutual Funds are registered with SEBI and they function within the provisions
of strict
regulations designed to protect the interests of investors. The operations of Mutual
Funds are
regularly monitored by SEBI.
12.Tax Benefits
Last but not the least, mutual funds offer significant tax advantages. Dividends
distributed by
them are tax-free in the hands of the investor. They also give you the advantages of
capital gains
taxation. If you hold units beyond one year, you get the benefits of indexation.
Simply put,
indexation benefits increase your purchase cost by a certain portion, depending
upon the yearly
cost-inflation index (which is calculated to account for rising inflation), therebyreducing the gap
between your actual purchase costs and selling price. This reduces your tax
liability. Whats
more, tax-saving schemes and pension schemes give you the added advantage of
benefits under
Section 88. You can avail of a 20 per cent tax exemption on an investment of up to
Rs 100000 in
the scheme in a year.
Disadvantages of mutual fundsMutual funds are good investment vehicles to navigate the complex and
unpredictable world of
investments. However, even mutual funds have some inherent drawbacks.
Understand these
before you commit your money to a mutual fund.
1.No assured returns and no protection of capital
If you are planning to go with a mutual fund, this must be your mantra: mutual
funds do not offer
assured returns and carry risk. For instance, unlike bank deposits, your investment
in a mutualfund can fall in value. In addition, mutual funds are not insured or guaranteed by
any government
body (unlike a bank deposit, where up to Rs 1 lakh per bank is insured by the
Deposit and Credit
Insurance Corporation, a subsidiary of the Reserve Bank of India). There are strict
norms for any
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fund that assures returns and it is now compulsory for funds to establish that they
have resources
to back such assurances. This is because most closed-end funds that assured returns
in the early-
nineties failed to stick to their assurances made at the time of launch, resulting in
losses to
investors. A scheme cannot make any guarantee of return, without stating the name
of the
guarantor, and disclosing the net worth of the guarantor. The past performance of
the assured
return schemes should also be given.
2.Restrictive gains
Diversification helps, if risk minimization is your objective. However, the lack of
investment
focus also means you gain less than if you had invested directly in a singlesecurity.Assume, Reliance appreciated 50 per cent. A direct investment in the
stock would appreciate by
50 per cent. But your investment in the mutual fund, which had invested 10 per
cent of its corpus
in Reliance, will see only a 5 per cent appreciation.
3.Taxes
During a typical year, most actively managed mutual funds sell anywhere from 20
to 70 percent
of the securities in their portfolios. If your fund makes a profit on its sales, you will
pay taxes on
the income you receive, even if you reinvest the money you made.
4.Management risk
When you invest in a mutual fund, you depend on the fund's manager to make the
right decisions
regarding the fund's portfolio. If the manager does not perform as well as you had
hoped, you
might not make as much money on your investment as you expected. Of course, if
you invest in
Index Funds, you forego management risk, because these funds do not employmanagers.
Fund Management Style & Structuring of Portfolio
Factors affecting Management style of a scheme
Its one thing to understand mutual funds and their working; its another to ride on
this potent
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investment vehicle to create wealth in tune with your risk profile and investment
needs. Here are
seven factors that go a long way in helping an AMC meet its investors investmentobjectives.
The factors listed below evaluate factors affecting the management style of a
mutual fund
scheme.
Knowing the profile
Investors investments reflect his risk-taking capacity. Equity funds might lurewhen the
market is rising and peers are making money, but if you are not cut out for the risk
that
accompanies it, dont bite the bait. So, check if the investors objective matchesyours.
Investors will invest only after they have found their match. If they are racked byuncertainty,
they seek expert advice from a qualified financial advisor.
Identifying the investment horizon
How long on an average does the investor want to stay invested in a fund is as
important as
deciding upon your risk profile. Investors would invest in an equity fund only if
they are
willing to stay on for at least two years. For income and gilt funds, have a one-year
perspective at least. Anything less than one year, the only option among mutual
funds is
liquid funds.Declare and Inform
Watch what you commit. Investors look out for the Offer Document and Key
Information
Memorandum (KIM) before they commit their money to a fund. The offer
document contains
essential details pertaining to the fund, including the summary information (type of
scheme,
name of the Asset Management Company and price of units, among other things),
investmentobjectives and investment procedure, financial information and risk factors.
The fund fact sheet
Fund fact sheets give investors valuable information of how the fund has
performed in the
past. It gives investors access to the funds portfolio, its diversification levels andits
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performance in the past. The more fact sheets they examine, the better is their
comfort level.
Diversification across fund housesIf Investors are routing a substantial sum through mutual funds, they would
diversify across
fund houses. That way, they spread their risk.
Chasing incentivesSome financial intermediaries give upfront incentives, in the form of a percentage
of the
investors initial investment, to invest in a particular fund. Many amateur investors
get lured
into such incentives and invest in such attractive schemes, which may not meet
their future
expectations. The ideal investors focus would be to find a fund that matches his
investmentneeds and risk profile, and is a performer.Tracking investments
The investors job doesnt end at the point of making the investment. They do track
your
investment on a regular basis, be it in an equity, debt or balanced fund.
Portfolio management is an important foundation of mutual fund business. The
performance of
the fund measured by the risk adjusted returns produced by the investor arises
largely by
successful portfolio management function. After collecting the investors funds,
effective
portfolio management will have to give returns acceptable to the investor; else, the
investor may
move to better performing funds.
From the investors perspective, the need for successful portfolio management
function is
obviously paramount. However, in the complex world of financial markets,
portfolio
management is a specialist function.
Now how a fund manager manages the portfolio would depend on the type of thefund he is
managing. The funds can be broadly classified as equity funds and debt funds.
Equity Portfolio Management:
When the fund contains more than 65% equity, it is called as an equity fund. Thus
such type of a
fund would need equity portfolio management.
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An equity portfolio managers task consists of two major steps:a)Constructing a portfolio of equity shares or equity linked instruments that is
consistent
with the investment objective of the fund and
b)Managing or constantly re-balancing the portfolio to produce capital appreciation
and
earnings that would reward the investors with superior returns.
How To Identify Which Kind Of Stocks To Include?The equity portfolio manager has available to him a whole universe of equity
shares and other
instruments such as preference shares, warrants or convertible debentures issued by
many
companies. Even within each category of equity instruments, shares of one
company may bevery different in terms of their potential than shares of other companies. So how
does the fund
manager go about choosing the different types of stocks, in order to construct his
portfolio? The
general answer is that his choice of shares to be included in funds portfolio must
reflect the
investment objective of the fund. More specifically, the equity portfolio manager
will choose
from a universe of invisible shares in accordance with:
a)The nature of the equity instrument, or a stocks unique characteristics, andb)A certain investment style or philosophy in the process of choosing.
Thus, you may see a mutual funds equity portfolio include shares of diversecompanies.
However, in reality, the group of stocks selected will have certain unique
characteristics, chosen
in accordance with the preferred investment style, such that the portfolio as a
whole is consistent
with the schemes objectives.
Indian economy is going through a period of both rapid growth and rapidtransformation. Thus,
the industries with the growth prospects or blue chip shares of yesterday are no
longer certain to
continue to be in that category tomorrow. New sectors like software or
technology stocks have
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matured and newer sectors such as biotechnology are now making an entry in the
investment
markets. In this process of rapid change, the stock selection task of an active fund
manager in
India is by no means simple or limited. We will therefore, review how different
stocks are
classified according to their characteristics.
Ordinary shares:Ordinary shareholders are the owners if the company and each share entitles the
holder to
ownership privileges such as dividends declared by the company and voting rights
at the
meetings. Losses as well as the profits are shared by the equity shareholders.
Without any
guaranteed income or security, equity share are a risk investment, bringing withthem the
potential for capital appreciation in return for the additional risk that the investor
undertakes.
Preference Shares:
Unlike equity shares, preference shares entitle the holder to dividends at the fixed
rates subject to
availability of profits after tax. If preference shares are cumulative, unpaid
dividends for years of
inadequate profits are paid in subsequent years. Preference shares do not entitle the
holder to
ownership privileges such as voting rights at the meetings.
Equity Warrants:
These are long term rights that offer holders the right to purchase equity shares in a
company at a
fixed price (usually higher than the current market price) within specified period.
Warrants are in
the nature of options on stocks.
Convertible Debentures:
As the term suggests, these are fixed rate debt instruments that are converted intospecified
number of equity shares at the end of the specified period. Clearly, convertible
debentures are
debt instruments until converted; when converted, they become equity shares.
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EQUITY CLASSES:Equity shares are generally classified on the basis of either the market
capitalization or the
anticipated movement of company earnings. it is imperative for the fund manager
to understand
these elements of the stocks before he selects them for inclusion in the portfolio.
Classification in terms of Market Capitalization
Market Capitalization is equivalent to the current value of a company, i.e., current
market
price per share times the number of outstanding shares. There are Large
Capitalization
Companies, MidCap Companies and SmallCap Companies. Differentschemes of a fund
may define their fund objective as a preference for the Large or mid or the SmallCap
Companies shares. For example, the tax plan of ICICI Prudential AMC isessentially a mid-
cap fund where as the tax plan of Reliance is large-cap fund. Large Cap shares are
more
liquid and hence easily tradable. Mid or Small Cap shares may be thought of as
having
greater growth potential. The stock markets generally have different indices
available to track
these different classes of shares.
Classification in terms of Anticipated Earnings
In terms of anticipated earnings of the companies, shares are generally classified
on the basis
of their market price relation to one of the following measures:
Price/Earning Ratio is the price of the share divided by the earnings per share and
indicated what the investors are willing to pay for the companys earning potential.
Young and fast growing companies usually have high P/E ratios and theestablished
companies in the mature industries may have lower P/E ratios.
Dividend Yield for a stock is the ratio of dividend paid per share to the current
market
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price. In India, at least in the past, investors have indicated the preference for the
high
dividend paying shares. What matters to the fund managers is the potential
dividend
yields based on earning prospects.
Cyclical Stocks are the shares of companies whose earnings are correlated with the
state of the economy.
Growth Stocks are shares of companies whose earnings are expected to increase at
the
rates that exceed the normal market levels.
Value Stocks are share of companies in mature industries and are expected to yield
low growth in earnings. These companies may, however, have assets whose valueshave not been recognized by investors in general. Funds manager may try to
identify
such currently undervalued stocks that in their opinion can yield superior returns
later.
Approaches to Portfolio Management (Fund Management Style):
Mutual funds can be broadly classified into two categories in terms of the fund
management
style i.e. actively managed funds and passively managed funds (popularly referred
to as index
funds).
Actively managed funds are the ones wherein the fund manager uses his skills and
expertise to
select invest-worthy stocks from across sectors and market segments. The sole
intention ofactively managed funds is to identify various investment opportunities
in the market in order to
clock superior returns, and in the process outperform the designated benchmark
index. in active
fund management two basic fund management styles that are prevalent are:
)Growth Investment Style: wherein the primary objective of equity investment is to
obtain capital appreciation. This investment style would make the funds manager
pick
and choose those shares for investment whose earnings are expected to increase at
the
rates that exceed the normal market levels. They tend to reinvest their earnings and
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generally have high P/E ratios and low Dividend Yield ratio.
)
Value Investment Style: wherein the funds manager looks to buy shares of those
companies which he believes are currently under valued in the market, but whose
worth he estimates will be recognized in the market valuation eventually.
On the contrary, passively managed funds/index funds are aligned to a particular
benchmark
index like the S&P CNX Nifty or the BSE Sensex. The endeavor of these funds is
to mirror the
performance of the designated benchmark index, by investing only in the stocks of
the index
with the corresponding allocation or weightage.
Investing in index funds is less cumbersome as compared to investing in actively
managed funds.
Broadly speaking, investors need to consider two important aspects i.e. the expenseratio and the
tracking error (i.e. the difference between the returns clocked by the designated
index and index
fund).
Conversely, investing in actively managed funds demands a deeper review and
understanding of
the fund house's investment philosophy; also the investor needs to decide on the
kind of funds he
wishes to invest in - a large cap/mid cap/small cap fund among othersSuccessful
Equity Portfolio Management:
Portfolio Management skills are innate in nature and strong intuitive traits from the
portfolio
manager. Nevertheless, there are certain principles of good equity management
that any portfolio
manager can follow to improve his performance.
Set realistic target returns based on appropriate benchmarks.
Be aware of the level of flexibility available while managing the portfolio.
Decide on appropriate investment philosophy, i.e., whether to capitalize on
economiccycles, or to focus on the growth sectors or finding the value stocks.
Develop an investment strategy based on the investment objective, the time frame
for the
investment and economic expectations over this period.
Avoid over diversification. Although diversification is a major strength ofmutual
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funds, the portfolio manager must avoid the temptation to invest into very large
number
of securities so as to maintain focus and facilitate sound tracking.
Develop a flexible approach to investing. Markets are dynamic and it is
impossible to buy
stocks for all seasons
Debt Portfolio Management:
Debt portfolio management has to contend with the construction and management
of portfolio of
debt instruments, with the primary objective of generating income. Just as the
equity fund
manager has to identify suitable stocks from a larger universe of equity shares, a
debt fund
manager has to select from a whole universe of debt securities he wants to invest
in.Debt schemes of a mutual fund have a short maturity period, generally up to oneyear.
Nevertheless, some schemes regarded as debt schemes do have maturity period a
little longer
than a year, say, eighteen months. Thus in the context of debt mutual funds,depending upon
the maturity period of the scheme, the funds managers invest more in market-traded
instruments or the debt securities. The difference in market-traded instruments
and debt
securities is that the former matures before one year and the later after a year.
Instruments in Indian Debt Market:
The objective of a debt fund is to provide investors with a stable income stream.
Hence, a debt
fund invests mainly in instruments that yield a fixed rate of return and where the
principal is
secure. The debt market in India offers the following instruments for investment by
mutual
funds.
Certificate of Deposit:Certificate of Deposits (CD) are issued by scheduled commercial banks excluding
regional rural
banks. These are unsecured negotiable promissory notes. Bank CDs have a
maturity period of 91
days to one year, while those issued by financial institutions have maturities
between one and
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three years.
Commercial Paper:
Commercial Paper (CP) is a short term, unsecured instrument issued by corporate
bodies (public
and private) to meet short term working capital needs. Maturity varies between 3
months and 1
year. This instrument can be issued to the individuals, banks, companies and other
corporate bodies registered or incorporated in India. CPs can be issued to NRIs on
nonrepairable andnontransferable basis.
Corporate Debentures:
Debentures are issued by manufacturing companies with physical assets, as
secured instruments,
in the form of certificates. They are assigned credit rating by the rating agencies.
All publiclyissued debentures are listed on the exchanges.
Floating Rate Bond (FRB):
These are short to medium term interest bearing instruments issued by financial
intermediaries
and corporations. The typical maturity is of these bonds is 3 to 5 years. FRBs
issued by the
financial institutions are generally unsecured while those form private corporations
are secured.
Government Securities:
These are medium to long term interestbearing obligations issued through theRBI by the
Government of India and state governments.
Treasury Bills:
T-bills are short term obligations issued through the RBI by the Government of
India at a
discount. The RBI issues T-bills for tenures: now 91 days and 364 days. These
treasury bills are
issued through an auction procedure. The yield is determined on the basis of bids
tendered andaccepted Public Sector Undertakings (PSU) Bonds:
PSU are medium and long term obligations issued by public sector companies in
which the
government share holding is generally greater than 51%. Some PSU Bonds carry
tax exemptions.
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The minimum maturity is 5 years for taxable bonds and 7 years for tax-free bonds.
PSU bonds
are generally not guaranteed by the government and are in the form of promissory
notes
transferable by endorsement and delivery.
Credit Selection:
Some debt managers look to investing in a bond in anticipation of changes on OTS
credit rating.
An upgrade of a bonds credit rating would lend to increase in its price, therebyleading to a
superior return. The fund would need to analyze the bonds credit quality so as toimplement this
strategy. Usually, debt funds will specify the proportion of assets they will hold in
instruments
of different credit quality/ratings, and hold these proportions. Active creditselection strategy
would imply frequent trading of bonds in anticipation of changes in ratings. While
being an
active risk management strategy, it does not take away the interest rate,
prepayment or credit
risks that are faced by any debt fund.
Prepayment Prediction:
As noted earlier some bonds allow the issuers the option to call for redemption
before maturity. a
fund which holds bonds with this provision is exposed to the risk of high yielding
bonds being
called back before maturity when interest rates decline. The fund manager would
therefore strive
to hold bonds with low prepayment risk relative to yield spread. Or try to predict
the course of
the interest rates and decide what the prepayment is likely to be, and then increase
or decrease his exposure. In any case, the risks faced by such fund managers are
the same as any other. What
matters at the end is the yield performance obtained by the fund manager.Interest Rates and Debt Portfolio Management:
No matter which investment strategy is followed by a debt fund manager, debt
securities are
always exposed to interest rate risk, as their price is directly dependent on them.
While they may
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yield fixed rates of returns, their market values are dependent on interest rate
movements, which
in turn affect the performance of fund portfolio of which they are a part. Hence, it
is essential to
understand the factors that affect the interest rates. While this is an intricate subject
in itself, we
have summarized below some key elements that have a bearing on interest rate
movements:
Inflation: simply put, inflation is the percentage by which prices of goods and
services in the
economy increase over a period of time. This increase may be on account of
factors arising
within the countrychange in production levels, mechanisms for distribution ofgoods, etc,
and/or on account of changes in the countrys external balance of paymentsposition. In India,
inflation is generally measured by the Wholesale Price Index although t he
Consumer Price
Index is also tracked. When the inflation rate rises, money becomes dearer, leading
to an increase
in the general level of interest rates.
Exchange Rate: a key factor in determining exchange rates between any two
currencies is their
relative purchasing power. Over a period, the relative purchasing power between
two currencies
may change based on the performance of the respective economies. The
consequent change in
exchange rates can affect interest rate levels in the country.Policies of the Central
Bank: the central bank is the apex authority for regulation of the
monetary system in a country. In India, this role is played by the Reserve Bank.
The RBIspolicies have a strong bearing on interest rate levels in the economy. If the RBI
wishes to curb
excess liquidity in a monetary system, it could impose a higher liquidity ratio onbanks and
institutions. This would restrict credit leading to an increase in interest rates.
Similarly, and
increase in RBIs bank rate has the effect of increasing interest rate levels. RBI
may also
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undertake open operations in Treasury Bills and Government securities with the
intention of
restricting / relaxing liquidity, thereby impacting the interest rates.
Use of Derivatives for Debt Portfolio Management:
As explained above, a debt portfolio is always exposed to the interest rate risk.
Hence,
derivatives contracts can be used to reduce or alter the risk profile of the portfolios
containing
debt instruments. Interest rate derivatives contracts can be exchange traded or
privately traded
(on the OTC market). Thus, a portfolio manager can sell interest rate futures or buy
interest rate
put options, usually on an exchange, to protect the value of his debt portfolio. Hecan also buy
or sell forward contracts or swaps bilaterally with other market players on OTCmarket. In India,
interest rate swaps and forward rate agreements were introduced in 1999, though
the market for
these contracts has not yet fully developed. In 2004, the National Stock Exchange
has introduced
futures on Interest Rates. Interest rate options are not yet available for trading on
exchange.