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Transcript of Investment Analysis · Investment Avenues, Factors Influencing Selection of ... 1.12 Financial...

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Investment Analysisand

Portfolio Management(As per the Revised Syllabus 2016 - 17 of Mumbai University for T.Y.BMS, Semester – V)

Pawan JhabakP.G.D.Ed.M., M.Com. (Finance)

Ex. Vice Principal, Rustomjee Business School,Dahisar (West), Mumbai – 68.

MUMBAI NEW DELHI NAGPUR BENGALURU HYDERABAD CHENNAI PUNELUCKNOW AHMEDABAD ERNAKULAM BHUBANESWAR KOLKATA

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© Author

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by anymeans, electronic, mechanical, photocopying, recording and/or otherwise without the prior written permission of thepublisher.

First Edition : 2016

Published by : Mrs. Meena Pandey for Himalaya Publishing House Pvt. Ltd.,“Ramdoot”, Dr. Bhalerao Marg, Girgaon, Mumbai - 400 004.Phone: 022-23860170/23863863, Fax: 022-23877178E-mail: [email protected]; Website: www.himpub.com

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DTP by : Nilima Jadhav

Printed at : Rose Fine Art, Mumbai. On behalf of HPH.

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Preface

“Genius is the ability to reduce the complicated to the simple.” … Albert EinstienI earnestly hope that the book will make complicated subject IAPM simple to understand and

score high marks in exams.I look forward for constructive suggestion from the readers and teachers.I am thankful to one and all who have contributed directly or indirectly to make new edition possible.This book is user-friendly and different. As one goes through the book, one will feel the difference,

and this will help to master Portfolio Management in an enjoyable manner, with lifetime utility.The book covers ‘University’ Prescribed Syllabus with Practical Dimension !! Let’s L-Earn !!

Best Wishes!!Million Thanks.

AuthorPawan V. Jhabak

[email protected]

Visiting Faculty Amity Business School. Lala Lajpatrai College.

Ex. Visiting Faculty Vivekanand Education Society. Rajiv Gandhi Institute of Technology. S.K. Somaiya. Narsee Monjee College. Usha Pravin Gandhi. Bhavan’s College (Andheri). Rizvi College. S.K. Somaiya. Akbar Peerbhoy. Bhurani College. Poddar College etc.

Ex. Vice Principal Rustomjee Business School.

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Syllabus

BACHELOR OF MANAGEMENT STUDIES PROGRAMME AT SEMESTER V WITH EFFECTFROM THE ACADEMIC YEAR 2016-2017

Investment Analysis and Portfolio Management[60 Lectures: 3 Credit]

MODULES AT A GLANCE

Sr.No.

Modules No. ofLectures

1 Introduction to Investment Environment 152 Risk-Return Relationship 153 Portfolio Management and Security Analysis 154 Theories, Capital Asset Pricing Model and Portfolio Performance Measurement 15

Total 60

OBJECTIVES

Sr.No.

Objectives

1 To acquaint the learners with various concepts of finance.2 To understand the terms which are often confronted while reading newspapers, magazines, etc.

for better correlation with the practical world.3 To understand the various models and techniques of security and portfolio analysis.

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UnitNo.

Name of the Topic No. ofLectures

Unit 1 Introduction to Investment Environment (15)(a) Introduction to Investment Environment

Introduction, Investment Process, Criteria for Investment, Typesof Investors, Investment vs. Speculation vs. Gambling,Investment Avenues, Factors Influencing Selection ofInvestment Alternatives.

(b) Capital Market in India Introduction, Concepts of Investment Banks, its Role and

Functions, Stocks, Market Index, The NASDAQ, SDL, NSDL,Benefits of Depository Settlement, Online Share Trading and itsAdvantages, Concepts of Small Cap, Large Cap, Midcap andPenny Stocks.

Unit 2 Risk-Return Relationship (15) Meaning, Types of Risk–Systematic and Unsystematic Risk,

Measurement of Beta, Standard Deviation, Variance, Reductionof Risk through Diversification, Practical Problems onCalculation of Standard Deviation, Variance and Beta.

Unit 3 Portfolio Management and Security Analysis (15)(a) Portfolio Management

Meaning and Concept, Portfolio Management Process,Objectives, Basic Principles, Factors Affecting InvestmentDecisions in Portfolio Management, Portfolio Strategy Mix.

(b) Security Analysis Fundamental Analysis, Economic Analysis, Industry Analysis,

Company Analysis, Technical Analysis – Basic Principles ofTechnical Analysis, Uses of Charts: Line Chart, Bar Chart,Candlestick Chart, Mathematical Indicators; Moving Averages,Oscillators.

Unit 4 Theories, Capital Asset Pricing Model and Portfolio PerformanceMeasurement

(15)

(a) Theories Dow Jones Theory, Elloit Wave Theory, Efficient Market

Theory.(b) Capital Asset Pricing Model

Assumptions of CAPM, CAPM Equation, Capital Market Line,Security Market Line.

(c) Portfolio Performance Measurement Meaning of Portfolio Evaluation, Sharpe’s Ratio (Basic

Problems), Treynor’s Ratio (Basic Problems), Jensen’sDifferential Returns (Basic Problems).

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Question Paper PatternDuration:2.5 hours 75 Marks

N.B: 5 questions of 15 marks each.All questions are compulsory.

Q. 1 Attempt any 2(a) Theory – Introduction Investment Environment 7.5 Marks(b) Theory – Introduction to Investment Environment 7.5 Marks(c) Theory – Capital Market in India 7.5 Marks

Q. 2. Attempt any 2(a) Sum – Risk and Return – Standard Deviation 7.5 Marks(b) Sum – Risk and Return – Beta 7.5 Marks(c) Theory Risk and Return 7.5 Marks

Q. 3. Attempt any 2(a) Theory – Portfolio Management 7.5 Marks(b) Theory – Security Analysis 7.5 Marks(c) Sum Fundamental Analysis 7.5 Marks

Q. 4. Attempt any 2(a) Theory – Dow Jones/Elloit/Efficient Market 7.5 Marks(b) Sum CAPM 7.5 Marks(c) Sum Portfolio Perfomance Measurement 7.5 Marks

Q. 5. Case Study Investment Avenues 15 Marks

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ContentsUnit 1

Introduction to Investment Environment

1 (a) Introduction to Investment Environment/InvestmentOverview

1 – 32

1 (b) Capital Market in India 33 – 56

Unit 2Risk-Return Relationship

2 Risk-Return Relationship 57 – 85

Unit 3Portfolio Management and Security Analysis

3 (a) Portfolio Management 86 – 94

3 (b) Security Analysis 95 – 119

Unit 4Theories, Capital Asset Pricing Model and Portfolio

Performance Measurement

4 (a) Theories 120 – 126

4 (b) Capital Asset Pricing Model 127 – 132

4 (c) Portfolio Performance Measurement 133 – 151

Model IAPM Paper 152 – 153

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1

Chapter 1(a)INTRODUCTION TO

INVESTMENTENVIRONMENT

Structure:1.1 Introduction1.2 Meaning of Investment1.3 Investment Attributes1.4 Elements/Attributes/Criteria/Factors Influencing Selection of Investments1.5 Risk Preference of Investors/Types of Investors1.6 Investment and Speculation1.7 Investment Avenues1.8 Non-marketable Financial Assets1.9 Money Market Instruments

1.10 Bonds or Debentures1.11 Equity Shares1.12 Financial Derivatives1.13 Life Insurance1.14 Real Assets1.15 Education1.16 Business1.17 Mutual Fund1.18 Problems + Solutions1.19 Review Questions

1.1 IntroductionInvestors choose to hold groups of securities rather than single security that offers greater

expected returns. They believe that a combination of securities held together will give a beneficialresult if they are grouped in a manner to secure higher return after taking into consideration the risk

UNIT IIntroduction to Investment Environment

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Investment Analysis and Portfolio Management2

element. Traditional portfolio analysis has been of a very subjective nature but it has proved success tosome investors who have made their investments by making analysis of individual securities throughevaluation of return and risk conditions. The investor has been able to get the maximum return at theminimum risk. The normal method of calculating the return on individual security is to find out theamount of dividends, price earning ratios, holding period and an estimate of the market value of thesecurities. The modern portfolio theory believes in the maximisation of return through a combinationof securities. It deals with the relationship between different securities and interrelationships of risksbetween them. An investor can achieve greater success by making a choice of investment outlets andcombining a security of low risk with another security of high risk.

1.2 Meaning of InvestmentThe concept of investment has many meanings. Investment is the employment of funds with

the aim of getting return on it. It is the commitment of funds which have been saved from currentconsumption with the hope that some benefits will be received in future. Thus, it is a reward forwaiting for money. Savings of the people are invested in assets depending on their risk appetite andreturn potential.

There are two concepts of investment1. Economic Investment: The concept of economic investment means additions to the capital

stock of the society. The capital stock of society is the goods which are used in the productionof other goods. The term investment implies the formation of new and productive capital inthe form of new construction and produce durable instrument such as plant and machinery,inventories and human capital are also included in this concept. Thus, an investment, ineconomic terms means an increase in building, equipment, gold, etc.

2. Financial Investment: This is an allocation of monetary resources to assets that are expectedto yield some gain and return over a given period of time. It is a general or extended sense ofthe term. It means an exchange of financial claims such as shares and bonds, real estate, etc.Financial investment involves contracts written on pieces of paper such as shares anddebentures. People invest their funds in Shares, Debentures, Fixed deposits, National SavingCertificates, Life Insurance Policies, Provident Funds, etc. In their view, investment is acommitment of funds to derive future income in the form of interest, dividends, pensionbenefits and the appreciation of the value of their principal capital.

Meaning of SecurityA security means a document that gives its owner a specific claim of ownership of a particular

financial asset. Financial market provide facilities for buying and selling of financial claims andservices. Thus, securities are the financial instruments which are bought and sold in the financialmarket for investment. The important financial instruments are shares, debentures, bonds, etc. Otherfinancial instruments are also known as securities such as Treasury Bills, Mutual Fund Units, FixedDeposits, Insurance Policies, Post Office Savings like National Savings Certificates, Kisan VikasPatras, Public Provident Funds, etc.

1.3 Investment AttributesEvery investor has certain specific objectives to achieve through his long-term/short-term

investment. The objectives include safety and security of the funds invested (principal amount),

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Introduction to Investment Environment 3

profitability (through interest, dividend and capital appreciation) and liquidity (convertibility into cashas and when required). These objectives are universal in character as every investor will like to have afair balance of these three financial objectives.

Investment avenue selected should be suitable for achieving both the objectives (financial andpersonal). Merits and demerits of various investment avenues need to be considered in the context ofsuch investment objectives.

1.4 Elements/Attributes/Criteria/Factors influencing selectionof Investments

(a) Return: Investors buy or sell financial instruments in order to earn return on them. The returnon investment is the reward to the investors. The return includes both current income andcapital gains or losses, which arises by the increase or decrease of the security price.

(b) Risk: Risk is the chance of loss due to variability of returns on an investment. In case of everyinvestment, there is the chance of loss. It may be loss of interest, dividend or even principalamount of investment. However, risk and return are inseparable. Return is a precise statisticalterm and it is measurable. But the risk is not precise statistical term. However, the risk can bequantified. The investment process should be considered in terms of both risk and return.

(c) Time: Time is an important factor in investment. It offers several different courses of action.Time period (i.e., short-term or long-term) mainly depends on the type of the investor. Astime moves on, analysts believe that conditions may change and investors may revaluate theexpected return and risk for each investment.

(d) Liquidity: An investment in shares can be readily converted into cash with the help of astock exchange. Investment should be liquid as well as marketable. The portfolio shouldcontain a planned proportion of high-grade and readily saleable investment. Bank F.D, Gold,Silver can also be readily converted into cash. Real Estate is comparatively Illiquid.

(e) Safety: Safety means protection for investment against loss under reasonable variations. In orderto provide safety, a careful regular review of economic and industry trends is necessary. In otherwords, errors in portfolio are sometimes unavoidable and it therefore requires appropriatediversification. Every investor wants that his basic amount of investment should remain safe.

(f) Tax Incentives: Investors try to minimise their tax liabilities from the investments. Theportfolio manager has to keep a list of such investment avenues along with the risk-returnprofile, tax implication, yields and other details. An investment programme withoutconsidering tax implications may be tax inefficient to investor. (PPF, EPF, Mutual Fund(ELSS) and Real Estate are tax efficient investment.)

The objectives can be classified on the basis of the investor’s approach as follows:(a) Short-term high priority objectives: Investors have a high priority towards achieving

certain objectives in a short time. For example, a young couple will give high priority to buy ahouse. Thus, investors will go for high priority objectives and invest their money accordingly.

(b) Long-term high priority objectives: Some investors look forward and invest on the basis ofobjectives of long-term needs. They want to achieve financial independence on retirement.For example, investing for post retirement period or education of a child, etc... Investorsusually prefer a diversified approach while selecting different types of investments.

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Investment Analysis and Portfolio Management4

(c) Low priority objectives: These objectives have low priority in investing. These objectivesare not painful. After investing in high priority objectives, investors can invest in these lowpriority objectives. For e.g., provision for tour, domestic appliances, car, etc.

(d) Money making objectives: Investors put their surplus money in this kind of investment.Their objective is to maximise wealth. Usually, investors invest in shares of companies, Realestate, commodities, F&O, etc. to achieve money making objectives.

1.5 Risk Preference of Investors/Types of InvestorsInvestors can be classified into different groups depending on their attribute towards risk.

Broadly the investors can classify themselves as:1. Risk averse investor.2. Risk neutral.3. Risk taker/seeker.1. Risk averse: The normal behaviour pattern of such group shows preference for investments

of low market rate risk and interest rate risk. He would prefer Government securities, lifeinsurance policies, Post offices schemes on which he is sure of getting continuous return.He/She would not be ready to pay any extra amount for any uncertain or unexpected action.Risk averse investor wants potential higher return for marginal increment risk.

2. Risk neutral: Such investor is willing to pay for making an investment provided they get areturn of equal values. Their investment trends show that they try to take higher risky stocksin their totals investment even though the return remains same.

3. Risk Taker/Seeker: This group of investors doesn’t mind paying more than the expectedvalue of assets for an uncertain future. They believe in high return for a greater risk. Suchinvestors emerge as potential gamblers. Risk-seeking investors are willing to invest forpotential less return even though it has higher increment risk.

1.6 Investment and Speculation“Speculation, is an activity, quite contrary to its literal meaning, in which a person assumes high

risk, often without regard for the safety of his invested principal, to achieve large capital gains.” Thetime span in which the gain is sought to be made is usually very short.

Investment involves putting money into an asset which is not necessarily marketable in order toenjoy a series of returns. The investor sacrifices some money today in anticipation of a financial returnin future.

An investment can be distinguished from speculation in three ways – risk, capital gain and timeperiod. Risk has a definite financial meaning. It is a possibility of incurring a loss in a financialtransaction. Investment involves limited risk/manageable risk while speculation is considered as aninvestment of funds with high risk. The purchase of a security for earning a stable return over a periodof time is an investment whereas the primary motive to earn high profits through price changes istermed as speculation. Thus, speculation involves buying a security at low price and selling at a highprice to make quick capital gain or vice versa, i.e., Intra-day trading. Investment involves longer termallocation of funds whereas speculation involves holding a security for a short-term and tradingquickly for earning higher gain. Also speculation generally involves high leverage.

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Introduction to Investment Environment 5

Warren Buffett stated Capital Market is a place where money moves from “Disinvestor to aninvestor”.

If one wants to increase his chances to profit one might try to speculate. Just like investment,speculation can be defined as the practice of risky financial transaction with the aim of gaining profitfrom short or medium-term market value fluctuations. In this practice, very little attention is paid tothe fundamental market value of a security whereas focus is shed upon price movements. It is alsodefined as the act of placing funds on a financial vehicle with the intention of getting satisfactoryreturns over a small amount of time. Speculators show an interest in bonds, stocks, commodity futures,fine art, collectibles, currencies, real estate and derivatives.

What is Gambling?Gambling can be defined as the wagering of means on an uncertain event with the aim of gaining

additional assets or money. This act is usually carried out in casinos, via lotteries and slot machineswhile illegal gambling is also carried out all over the world. Gambling requires elements such asconsideration, chance, prize, and its outcome makes itself visible within a short amount of time.

The most striking factor about gambling is that only a small amount of money must be paid inanticipation of a large sum of money. One can take the example of the lottery, which requires a fee ofa small amount and yet a jackpot of a stupendous amount in return.

What is the difference between Gambling and Speculation?Gambling and Speculation are similar in the manner in which they can acquire profit in a short

amount of time. However, both these methods are risky enterprises that require one to employ one’shard earned money in a not-so-stable practice.

One would need skills to become a good speculator. There are so many factors one would need tostudy and master to excel in this area. While, gamblers prosper just because of plain luck.

Gambling is a higher risk activity when compared to speculation. Speculation is a relativelylower risk activity if one studies and practices the art of speculation enough.

In Brief1. Gambling and speculation are vehicles to profit easily.2. The probability to succeed in either gambling or speculation is undetermined.3. The success of a speculator would be because of his skills and knowledge while the success of

a gambler would be due to his luck.4. Gambling can be done without thinking while speculation needs in-depth study.5. Speculation needs a lot more hard work compared to gambling.

1.7 Investment AvenuesThe following points are considered for selecting suitable investment avenue:A bewildering range of investment alternatives is available. They fall into two broad categories,

viz., financial assets and real assets. Financial assets are paper (or electronic) claims on some issuersuch as the government or a corporate body. The important financial assets are equity shares,corporate debentures, government securities, deposit with banks, mutual fund units, insurance policies,and derivative instruments.

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Investment Analysis and Portfolio Management6

Real assets are represented by tangible assets like residential house, commercial property,agricultural farm, gold, precious stones, and art objects. As the economy advances, the relativeimportance of financial assets tends to increase. Of course, by and large, the two forms of investmentsare complementary and not competitive.

Although the discussion is fairly up to date, the rapid changes in the world of investments leadsto the creation of new investment alternatives. If you understand the basic characteristics of majoralternatives currently available, you will have the background to understand new alternatives as andwhen they appear.

1.8 Non-marketable Financial Assets1. Bank Deposits: Perhaps, the simplest of investment avenues, by opening a bank account and

depositing money in it one can make a bank deposit. There are various kinds of bank accounts:current account, savings account and fixed deposit account. While a deposit in a currentaccount does not earn any interest, deposit in other kinds of bank accounts earn interest. Theimportant features of bank deposits are as follows: Deposits in scheduled banks are very safe because of the regulations of the Reserve Bank

of India and the guarantee provided by the Deposit Insurance Corporation, whichguarantees deposits up to ` 1,00,000 per depositor of a bank.

The interest rate on fixed deposits varies with the term of the deposit. In general, it islower for fixed deposits of shorter term and higher for fixed deposits of longer term.

If the deposit period is less than 90 days, the interest is paid on maturity; otherwise it isgenerally paid quarterly.

Bank deposits enjoy exceptionally high liquidity. Banks now offer customers the facilityof premature withdrawals of a portion or whole of fixed deposits. Such withdrawalswould earn interest rates corresponding to the periods for which they are deposited.

Loans can be raised against bank deposits.2. Post Office Savings Account: A post office savings account is similar to a savings bank

account. Its salient features are as follows: The interest rate is 6 per cent per annum. The interest is tax exempt. The amount of first deposit should be at least ` 20 for an ordinary account and ` 250 for

a cheque book account. The maximum balance that can be held is ` 50,000 for a single account and ` 1,00,000

for a joint account.3. Post Office Time Deposits (POTDs): Similar to fixed deposits of commercial banks,

POTDS have the following features: Deposits can be made in multiplies of ` 50 without any limit. The interest rates on POTDs are, in general, slightly higher than those on bank deposits. The interest is calculated half-yearly and paid annually. No withdrawal is permitted upto six months.

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Introduction to Investment Environment 7

After six months, withdrawals are permitted. However, on withdrawals made between sixmonths and one year, no interest is payable. On withdrawals after one year, but before theterm of deposit, interest is paid for the period the deposit has been held, subject to a penaldeduction of 2 percent.

A POTD account can be pledged. Deposits in 10 years to 15 years Post Office Cumulative Time Deposit Account can be

deducted before computing the taxable income under Section 80C.4. Monthly Income Scheme of the Post Office (MISPO): A popular scheme of the post office,

the MISPO is meant to provide regular monthly income to the depositors. The salient featuresof this scheme are as follows: The term of the scheme is 6 years. The minimum amount of investment is ` 1,000. The maximum investment can be

` 3,00,000 in a single account or ` 6,00,000 in a joint account. The interest rate is 8.0 per cent per annum, payable monthly. A bonus of 10 per cent is

payable on maturity. There is no tax deduction at source. There is a facility of premature withdrawal after one year, with 5 per cent deduction

before 3 years.5. Kisan Vikas Patra (KVP): A scheme of the post office, the Kisan Vikas Patra has the

following features: The minimum amount of investment is ` 1,000. There is no maximum limit. The investment doubles in 8 years and 7 months. Hence, the compound interest rate

works out to 8.4 per cent. There is no tax deduction at source. KVPs can be pledged as a collateral security for raising loans. There is a withdrawal facility after 2½ years.

6. National Savings Certificate: Issued at the post offices, National Savings Certificate has thefollowing features are as follows: It comes in denominations of ` 100, ` 500, ` 1,000, ` 5,000 and ` 10,000. It has a term of 6 years. Over this period ` 100 becomes ` 160.1. Hence, the compound

rate of return works out to 8.16 per cent. The investment in NSC can be deducted before computing the taxable income under

Section 80C. It can be pledged as collateral for raising loans.

7. Company Deposits: Many companies, large and small, solicit fixed deposits from the public.Fixed deposits mobilised by manufacturing companies are regulated by the Company LawBoard and fixed deposits mobilised by finance company (more precisely non-banking financecompanies) are regulated by the Reserve Bank of India. The key features of company depositsin India are as follows:

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Investment Analysis and Portfolio Management8

For a manufacturing company the term of deposits can be one to three years, whereas fora non-banking finance company it can very between 25 months to five years.

A manufacturing company can mobilise, by way of fixed deposits, an amount equal to 25per cent of its net worth from the public and an additional amount equal to 10 per cent ofits worth from its shareholders. A non-banking finance company, however, can mobilisea higher amount.

The interest rates on company deposits are higher than those on bank fixed deposits, butso is risk.

Company deposits have to be necessarily credit-rated. Depositors don’t get any tax benefit on company deposits. However, no income tax is

deducted at source if the interest income is up to ` 5,000 in a financial year.8. Employee Provident Fund Scheme: A major vehicle of savings for salaried employees, the

provident fund scheme has the following features: Each employee has a separate provident fund account in which both the employer and

employee are required to contribute a certain minimum amount on a monthly basis. The employee can choose to contribute additional amounts, subject to certain restrictions. While the contribution made by the employer is fully tax exempt (from the point of view

of the employee), the contributions made by the employee can be deducted beforecomputing the taxable income under Section 80C.

Provident fund contributions currently earn a compound interest rate of 8.5 per cent perannum that is totally exempt from taxes. The interest, however, is accumulated in theprovident fund account and not paid annually to the employee. This results into long-termwealth generation/retirement corpus.

EPF is not subject to attachment under any court order.9. Public Provident Fund Scheme: One of the most attractive investment avenues available in

India, the Public Provident Fund (PPF) scheme has the following features: Individuals and HUFs can participate in this scheme. A PPF account may be opened at

any branch of State Bank of India or its subsidiaries or at specified branches of the otherpublic sector banks.

Though the period of a PPF account is stated to be 15 years, the number of contributionshas to be 16. This is because the 15 years period is calculated from the financial yearfollowing the date on which the account is opened. Thus, a PPF account matures on thefirst day of the 17th year.

The subscriber to a PPF account is required to make a minimum deposit of ` 100 per year.The maximum permissible deposit per year is ` 1,00,000.

Deposits in a PPF account can be deducted before computing the taxable income underSection 80C.

PPF deposits currently earn a compound interest rate of 8.0 per cent per annum, which istotally exempt from taxes. The interest, however, is accumulated in the PPF account andnot paid annually to the subscriber.

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Introduction to Investment Environment 9

The balance in a PPF account is fully exempt from wealth tax. Further, it is not subject toattachment under any order or decree of a court.

1.9 Money Market InstrumentsDebt instruments, which have a maturity of less than one year at the time of issue are called

money market instruments. These instruments are highly liquid and have negligible risk. The majormoney market instruments are treasury bills, certificates of deposit, commercial paper, and repos. Themoney market is dominated by the government, financial institutions, banks, and corporates.Individual investors scarcely participate in the money market directly. A brief description of moneymarket instruments is given below.

1. Treasury Bills: Treasury bills are the most important money market instrument. Theyrepresent the obligations of the Government of India which have a primary tenor like 91 daysand 364 days. They are sold on an auction basis every week in certain minimumdenominations by the Reserve Bank of India. They do not carry an explicit interest rate (orcoupon rate). Instead, they are sold at a discount and redeemed at par. Hence, the implicityield of a Treasury bill is a function of the size of the discount and the period of maturity.Though the yield on Treasury bills is somewhat low, they have appeal for the followingreasons: They can be transacted readily and there is a very active secondary market for them. Treasury bills have nil credit risk and negligible price risk (thanks to their short tenor).

2. Certificates of Deposits: Certificates of deposits (CDs) represent short-term deposits whichare transferable from one party to another. Banks and financial institutions are the majorissuers of CDs. The principal investors in CDs are banks, financial institutions, corporates,and mutual funds. CDs are issued in bearer or registered form. They generally have a maturityof 3 months to 1 year. CDs carry a certain interest rate.CDs are a popular form of short-term investment for mutual funds and companies for thefollowing reasons: Banks are normally willing to tailor the denominations and maturities to suit the needs of

the investors. CDs are generally risk-free. CDs are generally offer a higher rate of interest than treasury bills or term deposits. CDs are transferable.

3. Commercial Paper: Commercial paper represents short-term unsecured promissory notesissued by firms that are generally considered to be financially strong. Commercial paperusually has a maturity period of 90 days to 180 days. It is sold at a discount and redeemed atpar. Hence, the implicit rate is function of the size of discount and the period of maturity.

4. Repos: The term “repo” is used as an abbreviation for Repurchase Agreement or ReadyForward. A “repo” involves a simultaneous “sale and repurchase” agreement.A “repo” works as follows. Party A needs short-term funds and Party B wants to make ashort-term investment. Party A sells securities to Party B at a certain price and simultaneouslyagrees to repurchase the same after a specified time at slightly higher price. The differencebetween the sale price and the repurchase price represents the interest cost of party.

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Investment Analysis and Portfolio Management10

A “reserve repo” is the opposite of “repo” – it involves an initial purchase of an assetfollowed by a subsequent sale. It is a safe and convenient form of short-term investment.

1.10 Bonds or DebenturesBonds or debentures represent long-term debt instruments. The issuer of a bond promises to pay

a stipulated stream of cash flows. This generally comprises of periodic interest payments over the lifeof the instrument and principal payment at the time of redemption(s).

This section discusses the following instruments: government securities, RBI savings bonds,private sector debentures, PSU bonds, and preference shares.

1. Government Securities: Debt securities issued by the central government, state government,and quasi-government agencies are referred to as government securities or gilt-edgedsecurities. Three types of instruments are issued. An investment that resembles a company debenture. It carries the name of the holder(s)

and is registered with the Public Debt Office (PDO). For transfer, it has to be lodged withthe PDO along with a duly completed transfer deed. The PDO pays interest to the holdersregistered with it on the specified date of payment.

2. Savings Bond: A popular instrument, RBI Savings Bonds have the following features: Individuals, HUFs, and NRIs can invest in these bonds. The minimum amount of investment is ` 1,000. There is no maximum limit. The maturity period is 5 years form the date of issue. There are two options: the cumulative option and the non-cumulative option. The interest rate is 8.0 per cent per annum, payable half-yearly. Under the cumulative

option, ` 1,000 becomes ` 1,480 after 5 years.3. Private Sector Debentures: Akin to promissory notes, debentures are instruments meant for

raising long-term debt. The obligation of a company towards its debenture holders is similarto that of a borrower who promises to pay interest and principal at specified times. Theimportant features of debentures are as follows: When a debenture issue is sold to the investing public, a trustee is appointed through a

deed. The trustee is usually a bank or a financial institution. Entrusted with the role ofprotecting the interest of debenture holders, the trustee is responsible for ensuring that theborrowing firm fulfils its contractual obligations.

Typically, debentures are secured by a charge on the immovable properties, both presentand future, of the company by way of an equitable mortgage.

Debentures sometimes carry a ‘call’ feature which provides the issuing company with anoption to redeem the debentures at a certain price before the maturity date. Sometimes,the debentures may have a ‘put’ feature which gives the holder the right to seekredemption at specified times at predetermined prices.

Debentures may have a convertible clause which gives the debenture holder the option toconvert the debentures into equity shares on certain terms and conditions that are pre-specified.

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Introduction to Investment Environment 11

4. Public Sector Undertaking Bonds: Public Sector Undertakings (PSUs) issue debentures thatare referred to as PSU bonds. There are two broad varieties of PSU bonds: taxable bonds andtax-free bonds. While PSUs are free to set the interest rates on taxable bonds, they cannotoffer more than a certain interest rate on tax-free bonds which is fixed by the Ministry ofFinance. More important, a PSU can issue tax-free bonds only with the prior approval of theMinistry of Finance.

5. Preference Shares: Preference shares represent a hybrid security that partakes somecharacteristics of equity shares and some attributes of debentures. The salient features ofpreference shares are as follows: Preference shares carry a fixed rate of dividend. Preference dividend is payable only out of distributable profits. Hence, when there is

inadequacy of distributable profits, the question of paying preference dividend does notarise.

Dividend on preference shares is generally cumulative. Dividend skipped in one year hasto be paid subsequently before equity dividend can be paid.

Preference shares are redeemable and the redemption period is usually 8 to 12 years. Currently preference dividend is tax exempt, in hands of investor.

1.11 Equity SharesEquity capital represents ownership capital. Equity shareholders collectively own the company.

They bear the risk and enjoy the rewards of ownership. Of all the forms of securities, equity sharesappear to be the most romantic. While fixed income investment avenues may be more important tomost of the investors, equity shares seem to capture their interest the most. The potential rewards andpenalties associated with equity shares make them an interesting, even exciting, proposition. Nowonder, equity investment is a favourite topic of conversation in parties and get-togethers.

Terminology: The amount of capital that a company can issue as per its memorandum representsthe authorised capital. The amount offered by the company to the investors is called the issued capital.That part of the issued capital that has been subscribed to by the investors is called the subscribedcapital; the actual amount paid is called the paid-up capital. Typically, the issued, subscribed, andpaid-up capital are the same.

The par value is stated in the memorandum and written on the share scrip. The par value ofequity shares is generally ` 10 or Re. 1. Infrequently, one comes across par values like ` 5, ` 50 and` 1,000. There is a proposal to make the par value uniformly at Re. 1. The issue price is the price atwhich the equity share is issued. When the issue price exceeds the par value, the difference is referredto as the share premium.

The book value of an equity share is equal to:

sharesequitydingtanoutsofNumbersurplusandservesRecapitalequityupPaid

Rights of Equity Shareholders: As owners of the company, equity shareholders enjoy thefollowing rights:

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Investment Analysis and Portfolio Management12

Equity shareholders have a residual claim to the income of the firm. This means that theprofit after tax less preference dividend belongs to equity shareholders. However, the board ofdirectors has the prerogative to decide how it should be split between dividends and retainedearnings. Dividends provide current income to equity shareholders and retained earnings tendto increase the intrinsic value of equity shares. Note that equity dividends are presently taxexempt in the hands of the recipient. The company paying the dividend is required to pay thedividend distribution tax.

Equity shareholders elect the board of directors and have the right to vote on every resolutionplaced before the company. The board of directors, in turn, appoints the top management ofthe firm. Hence, equity shareholders, in theory, exercise an indirect control over theoperations of the firm. In practice, however minority equity shareholders are scattered, ill-organised, passive and indifferent as they often fail to exercise their collective powereffectively.

Equity shareholders enjoy the pre-emptive right which enables them to maintain theirproportional ownership by purchasing the additional equity shares issued by the firm. The lawrequires companies to give existing equity shareholders the first opportunity to purchase, on apro rata basis, additional issue of equity capital. For example, if you own 1,000 equity sharesin a company that has 1,000,000 outstanding shares, you are entitled to subscribe to 200shares if the company proposes to issue 200,000 additional shares. The equity shareholders ofthe company may, however, forfeit this right partially or totally, to enable the company tomake a issue.

As in the case of income, equity shareholders have a residual claim over the assets of thecompany in the event of liquidation. Claims of all others: debenture holders, secured lenders,unsecured lenders, preferred shareholders, and other creditors, are prior to the claim of equityshareholders.

Hence they are ultimate risk bearers. Equity shares are high risk-high return security.

Stock Market Classification: In stock market parlance, it is customary to classify equity sharesas follows:

1. Blue-chip Shares → Shares of large, well-established, and financially strong companies withan impressive record of earnings and dividends. [e.g., HDFC, HUL]

2. Growth Shares → Shares of companies that have a fairly entrenched position in a growingmarket and which enjoy an above average rate of growth as well asprofitability. [e.g., Asian Paints, Infosys etc.]

3. Income Shares → Shares of companies that have fairly stable operations, relatively limitedgrowth opportunities, and high dividend payout ratios. [e.g., ONGC]

4. Cyclical Shares → Shares of companies that have pronounced cyclicality in theiroperations. [e.g., Tata Steel, Hindalco]

5. Defensive Shares → Shares of companies that are relatively unaffected by the ups and downsin general business conditions. [e.g., SBI]

6. SpeculativeShares

→ Shares that tend to fluctuate widely because there is a lot of speculativetrading in them. [e.g., Reliance Communication, DLF, L&T, etc.]

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Introduction to Investment Environment 13

Note that the above classification is only indicative. It should not be regarded as rigid andstraitjacketed. Often you can’t pigeonhole a share exclusively in a single category. In fact, manyshares may fall into two (or even more) categories.

Peter Lynch’s ClassificationThere are different ways of classifying shares. Here is Peter Lynch’s classification of companies

(and by derivation shares).

1. SlowGrowers

→ Large and ageing companies that are expected to grow slightly faster thanthe gross national product. [e.g., RIL, Sterlite Indus.]

2. Stalwarts → Giant companies that are faster than slow growers but are not agile climbers.[e.g., HUL, L&T, Microsoft]

3. Fast Growers → Small, aggressive new enterprises that grow at 20 to 50 per cent a year [e.g.,UBER Cabs, Ola Cabs, Facebook ]

4. Cyclicals → Companies whose sales and profit rise and fall in a regular, though notcompletely predictable fashion. [e.g., Tata Steel, DLF]

5. Turnarounds → Companies which are steeped in accumulated losses but which show signsof recovery. Turnaround companies have the potential to make up lostground quickly. [e.g., Ispat Indus, Tata Motors]

6. Asset Plays → Companies that have valuable assets which have been somewhatoverlooked by the stock market. [e.g., MTNL, Godrej Industries, BombayDyeing]

1.12 Financial DerivativesA derivative is an instrument whose value depends on the value of some underlying asset. Hence,

it may be viewed as a side bet on that asset. From the point of view of investors and portfoliomanagers, futures and options are the two most important financial derivatives. They are used forhedging and speculation. Trading in these derivatives has begun in India.

Futures: A futures contract is an agreement between two parties to exchange an asset for cash ata predetermined future date for a price that is specified today. The party which agrees to purchase theasset is said to have a long position and the party which agrees to sell the asset is said to have a shortposition.

The party holding a long position benefits if the price increases, whereas the party holding theshort position loses if the price increases and vice versa. To illustrate this point, consider a futurescontract between to parties, viz., A and B. A agrees to buy 1,000 shares of Acme Chemicals at ` 100from B to be delivered 90 days hence. A has a long position and B has a short position. On the 90thday, if the price of Acme Chemicals happens to be ` 105, A gains ` 5,000 [1,000 × (105 – 100)]whereas B loses 5,000. On the other hand, if the price of Acme Chemicals on the 90th day happens tobe ` 95, A loses ` 5,000 [1,000 × (95 – 100)] whereas B gains ` 5,000.

Options: An option gives its owner the right to buy or sell an underlying asset (our focus herewill be on equity shares) on or before a given date at a predetermined price. Note that optionsrepresent a special kind of financial contract under which the option holder enjoys the right (for whichhe pays a price), but has no obligation, to do something.

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Investment Analysis and Portfolio Management14

There are two basic types of options: Call options and put options. A call option gives theoption holder the right to buy a fixed number of shares of a certain stock, at a given exercise price onor before the expiration date. To enjoy this option, the option buyer (holder) pays a premium to theoption writer (seller) which is non-refundable. The writer (seller) of the call option is obliged to sellthe shares at the specified price, if the buyer chooses to exercise the option.

A put option gives the option holder the right to sell a fixed number of shares of a certain stock ata given exercise price on or before the expiration date. To enjoy this right, the option buyer (holder)pays a non-refundable premium to the option seller (writer). The writer of the put option is obliged tobuy the shares at the specified price, if the option holder chooses to exercise the option.

1.13 Life InsuranceThe basic customer needs met by life insurance policies are protection and savings. Policies that

provide protection benefits are designed to protect the policyholder (or his dependents) from thefinancial consequence of unwelcome events such as death or long-term sickness/disability. Policiesthat are designed as savings contracts allow the policyholder to build up funds to meet specificinvestment objective such as income in retirement or repayment of a loan. In practice, many policiesprovide a mixture of savings and protection benefits.

The common types of insurance policies are: Endowment Assurance Money Back Plan Whole Life Assurance Unit Linked Insurance Plan Term Assurance Immediate Annuity Deferred Annuity Riders

Endowment Assurance: There are basically two variants of this policy: (a) Non-participating(Without Profit) Endowment Assurance and (b) Participating (With Profit) Endowment Assurance.

Money Back Plan: This is a popular savings cum protection policy because it provides lumpsum at periodic intervals. For example, given an initial sum assured of ` 1000 and a term of 20 years,the policy may provide for part payment of the sum assured as follows:

20% at the end of 5 years 20% at the end of 10 years 20% at the end of 15 years 40% at the end of 20 years

This policy is a usually sweetened by providing a guaranteed addition to the initial sum assuredevery year.

The money back policy illustrated above is a non-participating policy. The policy can also beoffered in the “participating” format in which case the guaranteed additions will be replaced by“bonuses”.

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Introduction to Investment Environment 15

Whole Life Assurance: This policy provides a benefit on the death of the policyholder wheneverthat might occur. Basically, it provides long-term financial protection to the dependents. It isparticularly useful as a means of protecting some of the expected wealth transfer that a parent wouldbe aiming to make his or her children when he or she died. Without this policy, the wealth transfer islikely to be very small if the parent died young. Such policies can also be a tax-efficient way oftransferring wealth at any age depending on legislation (often reducing the liability to inheritance tax).

Unit Linked Insurance Plan: A unit-linked plan is also an investment-oriented product. Ascompared to the other investment plans, the investment portion of the unit linked plan functions like amutual fund. It is invested in a portfolio of debt and equity instruments, in conformity with theannounced investment policy. Hence, it grows or erodes in line with the performance of that portfolio.Of course, throughout the period of investment, the policyholder enjoys an insurance cover asstipulated. It has become very popular recently since it meet twin objective of Insurance and GrowthInvestment.

Term Assurance:This is a pure protection policy, which provides benefits on the death of thepolicyholder within a specified term, say 5 years or 10 years or 20 years or whatever. Premiums maybe paid regularly over the term of the policy (or some shorter period) or as a single premium at theoutset. Generally, there is no payment if the policyholder survives to the end of the policy. However,there are term assurance policies, which offer some proportion of premiums paid on survival to thematurity date of the policy. It gives relatively highest cover for low premium.

Riders: Riders are add-ons to the life insurance policies described above. These add-ons can bepurchased with the base policy on payment of a small additional premium.

The commonly offered riders in the Indian context are: Accidental Death Benefit (ADB) Rider Critical Illness (CI) Rider Waiver of Premium (WoP) Rider Term Rider

Considerations in choosing a policy bear in mind the following considerations: Review your own insurance needs and circumstances. Choose the kind of policy that has

benefits that most closely fit your needs. A life insurance agent or a financial advisor can helpyou in this task.

Be sure that you can handle premium payments. Can you afford the initial premium? If thepremium increases later and you still need insurance, can you still afford it?

Don’t buy life insurance unless you intend to stick with your plan. It may be very costly ifyou quit during the early years of the policy’s term.

If you are thinking of surrendering your insurance policy or replacing it with a new one, youshould carefully assess the surrender value and the rights and benefits of the new policyvis-à-vis the existing policy.

Also one should select reputed Insurance Company which has track-record of setting claimspromptly, even though the premium is marginally higher as compared to other InsuranceCompany.

Online Purchase of Insurance Policy, reduces the premium for same cover/benefit.

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Investment Analysis and Portfolio Management16

Health Insurance (also called Medi-Claim) ia another important Insurance policy. An individualis advised to buy family floater plan that adequately covers Hospital and Operation Expenses. Incometax deduction is available U/S 80 D.

1.14 Real AssetsUnlike financial assets, real assets are tangible or physical in nature. The major types of real

assets are as follows:(i) Real Estate

Residential house Commercial property Urban and semi-urban land Agricultural farm Time share in a holiday resort

(ii) Precious Metals Gold (Highest overall return in 2016) Silver Instead of physical gold an investor can now buy ‘Gold Sovereign Bonds’ and earn 2.5%

interest as well as capital appreciation.(iii) Precious Stones

Diamonds Others

(iv) Art Objects and Collectibles Paintings Sculpture Antiques Others

The pros and cons of investing in real assets are as follows:

Pros ConsInflation hedge Illiquid marketsEfficient diversification High spread and commissionsPsychic pleasure Maintenance effortSafe haven Maintenance Charges

1.15 EducationIt is also a form of investment, since it helps to raise income potential of candidate in future. The

father of Vikram Pandit (CEO Citigroup) said my only investment was ‘education’ of Vikram.

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Introduction to Investment Environment 17

Generally a candidate gets better job/package after undergoing master course as compared to earlierjob. Hence, more number of people are now doing MBA in India as well as MBA from abroad.

1.16 BusinessStarting one’s own business enterprise is an another important investment alternative. A small

initial investment ($ 500) has grown to ($ 40 + billion) for Steve Jobs, Mark Zukerberg, Bill Gates,Dhirubhai Ambani, L.N. Mittal, Warren Buffet, Sachin & Binny Bansal, etc.)

Hence, there is increased focus on entrepreneurship in various management colleges.

1.17 Mutual FundMutual 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 common pool of money into which investors place their contributions to be invested in

accordance with a stated objective. The ownership of the fund is joint or mutual. The fund belongs to all investors. Ownership is proportionate to contribution made by one.

The flow chart below describes broadly the working of a mutual fund:

Investors

Pool their money with

Fund Manager

Invest in

Securities

Generates

Returns

Passed back to

Frequently Used Terms Net Asset Value (NAV): Net Asset Value is the market value of the assets of the scheme

minus its liabilities. The per unit NAV is the net asset value of the scheme divided by thenumber of units outstanding on the Valuation Date.

Sale Price: Is the price you pay when you invest in a scheme. Also called Offer Price. It mayinclude a entry load. SEBI has proposed to do away with entry load.

Repurchase Price: Is the price at which a closed-end scheme repurchases its units and it mayinclude a back-end load. This is also called Bid Price.

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Investment Analysis and Portfolio Management18

Redemption Price: Is the price at which open-ended schemes repurchase their units andclosed-end schemes redeem their units on maturity. Such prices are NAV related.

Sales Load: Is a charge collected by a scheme when it sells the units. Also called, ‘Front-end’load. Schemes that do not charge a load are called ‘No Load’ schemes.

Repurchase or ‘Back-end’ Load: Is a charge collected by a scheme when it buys back theunits from the unit holders. It is also called as exit load.

History of Mutual Funds Phase 1 (1964-87) : Growth of UTI Phase 2 (1987-93) : Entry of PSU Banks and Financial Institutions and MFs Phase 3 (1993-96) : Emergence of Private Sector Mutual Funds Phase 4 (1996-99) : SEBI Regulations for Investors’ Protection Phase 5 (1999-2004) : UTI Act 1963 repealed in Feb 2003 Phase 6 (2004 onwards) : Consolidation and Growth

In year 2009, AUM has crossed ` 5 lakh crore. In May 2010, AUM has crossed ` 8 lakh crore. Out of this, 4 lakh crore is in short-term debt funds. In Mar 2016 AUM has crossed ` 15 lakh crore.

Types of Mutual Fund

Open-ended Funds Do not Have a Fixed Maturity DateThe products offered by a mutual fund are known as schemes, or funds. Mutual fund schemes can

be classified in several ways.

360000340000320000300000280000260000240000200000180000160000140000

120000

100000

80000

60000

40000

200000

25 4564

47000

121805

8719079464

139616

149554

231862

326388

Phase IV Since Feb 03

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Introduction to Investment Environment 19

A basic classification of the type of fund is based on whether a fund is open-ended or closed-end.

An open-ended fund gets its name from the fact that it does not have a maturity date. The enddate of the fund is open. An open-ended fund offers units to investors for the first time during the newfund offer (NFO).

Investors can buy (purchase) and sell (redeem) units of an open-ended fund, at the mutual fundoffices or their investor service centre (ISCs) on a continuous basis.

The prices at which purchase and redemption transactions take place in a mutual fund are basedon the net asset value (NAV) of the fund.

The unit capital of an open-ended fund is therefore not fixed, but varies according to the purchaseand redemption transactions of investors.

An open-ended fund can restrict the purchase and redemption of units only under specialcircumstances.

Closed-end Funds are Redeemed at MaturityClosed-end funds run for a specific period. On the specified maturity date, all units are redeemed

and the scheme comes to a close.

Closed-end funds are offered in an NFO but are closed for further purchases after the NFO.

The units may be listed on a stick exchange to provide liquidity. Investors buy and sell the unitsamong themselves, at the price prevailing in the stock market.

Thus, the size of a listed closed-end fund is kept constant, as buying and selling happens in thesecondary market, without recourse to the fund itself.

The units may trade on the exchange at a discount or premium to the NAV depending uponinvestor’s perception. The units of a closed end fund tend to usually trade at a discount.

Some funds offer buy-back of units as to provide liquidity to the investors. Several closed-endfunds do not list, provide redemption facility to investors.

Normally, investors do not redeem their units before the maturity date with the fund. In somecases they may do so after paying exit charges to leave the fund mid-way.

Funds can be Classified in Several WaysFunds can be classified based on where they invest in, what objectives they pursue and the

amount of risk they assume in the investment portfolio.

Investment categoriesFunds can be classified depending on investment category (also called asset class) they focus on.

For example, equity funds invest in equity shares; debt funds invest in debt securities; money marketfunds invest in money market securities; commodity funds invest in commodity-linked securities; realestate funds invest in property-linked securities; and gold funds invest in gold-linked securities.

Investment ObjectiveThe objective of funds can be used to classify them. For example, growth funds seek capital

appreciation and therefore invest in equity; income funds invest with the objective of generating

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Investment Analysis and Portfolio Management20

regular income and seek debt securities; and monthly income plans seek to derive regular income withsome growth and have a bit of equity along with debt.

Investment RiskFunds can be grouped according to the risk associated with the investment objective and portfolio.

Equity funds have a greater degree of risk as compared to a debt funds. Liquid funds are the least risky,as they invest in very short-term securities.

Liquid funds have the lowest riskDebt funds invest predominantly in debt securities. Debt securities have a fixed term and pay a

specific rate of interest.

There are several types of debt funds that invest in various segments of the debt market.

Money Market or Liquid FundsMoney market funds or liquid funds invest in debt securities with less than one year to maturity

such as treasury bills, commercial papers and certificate of deposits.Since liquid funds have very short-term maturity, the risk of NAV fluctuation is low. Liquid

funds provide safety of principal and liquidly.

Gilt FundsGilt funds invest in government securities of medium and long-term maturities. These funds do

not have the risk of default since the issuer of the instruments is the government.

Gilt funds have a high degree of interest rate risk, depending on their maturity. If interest rates goup, the value of a debt security goes down.

This response to changes in interest rates is called interest rate risk. Higher the maturity profile,higher the interest rate risk.

High yield debt funds are risky

Income FundsIncome funds predominantly invest in medium-term and long-term debt instruments that are

issued by the government, companies, banks and financial institutions.

There is a higher risk of default in these funds as compared to gilt funds, since they invest insecurities issued by non-government agencies that carry the risk of default.

They have a higher interest rate risk than money market funds since they invest in longer-termsecurities. These funds aim at providing regular income rather capital appreciation.

High-yield Debt FundsThese funds seek higher interest income by investing in debt instruments that have lower credit

ratings and therefore higher risk of default. Lower the credit rating, higher the interest a borrower pays.These high-yield funds and are also called as junk bond funds.

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Introduction to Investment Environment 21

Assured Return FundsThese funds were quite popular in the early years of the Indian mutual fund industry. The

erstwhile UTI used to have several such funds. SEBI now permits assured return schemes only wherethe guarantor is specifically mentioned and gives details of the net worth of such guarantor, who willmake good any shortfall.

Fixed Maturity Plans are Closed-end Short-term FundsFixed maturity plans (FMPs) are closed-end funds that invest in debt instruments with maturities

that match the term of the scheme. The debt securities are redeemed on maturity and paid to investors.

An FMP structure eliminates the interest rate risk for investors if the fund is held by them untilmaturity. These funds usually have a shorter term.

Typically FMPs are issued for maturity periods of 91 days, 190 days, 390 days and 750 days.Funds issue FMPs in a series, offering one fund after another has matured.

Consider the following table for comparison of debt funds:

Return Risk LiquidityLiquid fundGilt fundIncome fundHigh yield fundAssured return funds*FMPs

LowMediumMedium

HighLowLow

LowHigh

MediumHighLowLow

HighHighHighHighLowLow

*No longer offered.

The risk in a gilt fund comes from interest rate changes; there is no credit risk. FMPs hold lowerrisk only for investors holding the fund until maturity.

Equity funds are for long-term growthEquity funds invest in equity shares issued by companies. The risk of such funds is higher than

that of debt funds. However, the risk levels can differ depending upon the investment strategiesadopted by the fund manager.

Equity funds can be classified by their investment strategy as diversified, aggressive, growth,value and specialty funds.

Diversified equity funds look at investment opportunities across sectors, sizes and industries.They are less risky because of the diversified nature of the portfolio.

Growth funds invest in companies whose earnings are expected to grow at an above-averagerate.

Aggressive growth funds tend to target maximum capital appreciation by investing in smallersized and riskier equity shares.

Value funds seek to identify stocks of fundamentally strong companies that are currentlyundervalued by the market. Such stocks tend to have low price-earnings ratios.

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Investment Analysis and Portfolio Management22

Specialty funds invest in a given sector or industry, such as technology or banking. Since theyare concentrated funds, the risks are higher. Sector performance tends to be cyclinal. These are alsoknown as sector funds.

Mid-cap funds and small-cap funds focus on the investment opportunities in smaller-sized andemerging companies. Smaller company stocks tend to offer a higher return due to their higher earninggrowth, but are less liquid and therefore riskier.

Equity Linked Saving Schemes (ELSS)Some diversified equity funds that are specially designated as equity linked saving schemes

(ELSS) give tax benefits to the investors on their investment. Investment up to ` 100,000 in a year insuch funds can be deducted from taxable income of individual investors under Section 80 C.

ELSS hold at least 80% of their portfolio in equity securities. Such funds have a lock-in period of3 years from the date of investment.

Rajiv Gandhi Equity Saving Scheme (RGESS)In budget (12 – 13), additional deduction of 20%, is proposed for ` 50,000 investment in shares

or Equity Mutual fund by an individual earning less than ` 10,00,000 p.a. It has lock-in period of 3years.

Equity Index FundsThese are passive funds that invest in the shares that constitute a particular market index and in

the same proportion as they are represented in the index. These funds take only overall market risk.The fund manager does not take an active call on a stock or its proportion in the portfolio.

Dividend Yield FundsThese funds concentrate on current income from dividends and invest in companies that have a

high dividend yield.

Some funds combine equity and debt

Funds that have a combination of asset classes such as debt equity in their portfolio are calledhybrid funds.

Monthly Income PlansThese funds invest predominantly in debt securities, with a small allocation to equity, to provide

growth. These funds also feature periodic distribution of dividends, though there is no assurance of thesame.

Balanced FundsThese funds have a mix of equity and debt in a pre-specified proportion. They balance between

equity and debt. Usually about 65% of the fund is invested in equity and the rest is invested in debt.

Growth-and-Income FundsThese funds invest in companies with high dividend payouts as well as companies with the

potential for growth. These funds try to combine growth with some income.

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Introduction to Investment Environment 23

Asset Allocation Funds/Dynamic FundsAlso called as dynamic funds, these funds change the proportion of equity and debt in their

portfolio depending on the fund manager’s perception of the market. They have the flexibility to investup to 100% in debt or in equity, depending on the view of the manager.

Other Types of FundsFunds investing in other types of asset classes are also available. Foreign security funds invest in

securities of other markets. These are also called international funds. The government has alsopermitted Indian investors to invest in international markets through such mutual funds.

Commodity funds abroad invest directly in commodities such as precious metals, edible oils or grainsor through futures contracts. Indian commodity funds predominantly invest in commodity companies.

Real estate funds invest in real estate directly or lend to real estate developers or buy securitiesof housing companies and sectors related to housing and property. They can also invest in debtinstruments issued by housing projects.

Exchange traded funds (ETFs) are funds that are traded in market. They are traded like shareson the stock exchange at the prevailing NAV. ETF units can also be exchanged for the underlyingunits of the index. Recently, GOLD ETF and Silver ETF has emerged as popular investment avenue.

Fund of funds invest in other mutual funds. Its portfolio is created by combining several fundsthat serve a given investment objective. The expenses in a fund of funds can be higher, because of twolayers of fund managers in the structure.

SIP under systematic investment plan of mutual fund an investor can invest small / same amountevery month. It helps to

(a) Avg. cost(b) Build long-term higher wealth.

A new investor is advised to invest in INDEX ETF via SIP for long term Wealth Creation.

Sector Funds

Diversified Equity Funds

Index Funds

Balanced Funds

Debt Funds

Glit Funds

MMMF

High returnLow return

Risk High

Risk Low

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Investment Analysis and Portfolio Management24

Constituents of a Mutual FundSponsor, Trustees, Asset Management Company, Custodian /Depository Participant, R&T Agent,

Distributors, Banker

SEBI has now proposed no commission to be paid to distributors by Mutual Fund house andonline Investment in Mutual Fund. This will reduce cost of investor and thereby, generate higherreturn on his investment.

AMFI Code of Ethics for MFs Funds to be managed in the interest of unit holders Unit holders to be treated equally and fairly Ensure meaningful disclosures Avoid conflict of interest [e.g., front loading, insider trading] Ensure segregate accounting Stick to ethical standards and fairness in dealings High standards of care, diligence, services and disclosure announcements

How to maximize benefits of mutual funds - Investing in equity mutual fundsHow does one select a good mutual fund?

Quality of promoters Track record and years of existence Investment philosophy and process Quality of team Product basket Adherence to compliance www.valveresearchonline.com

Unit Holders

Sponsors

AMCTrustees

The Mutual Fund

Custodian

SEBI

Transfer Agent

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Introduction to Investment Environment 25

Summary Mutual funds are an effective medium of participating in the capital markets. One doesn’t have to be an expert in capital markets. Convenient and cost-effective way of accumulating wealth over long term. Start early-save and invest in capital market via Mutual Fund’s Systematic investment plan

popularly referred as ‘SIP’ in Index ETF. Colour code to indicate Risk Blue = Low risk, Yellow = Medium risk, Brown = High risk

Also now Mutual Fund has to indicate Risk via Riskometer.

Levels of Risk Sample RiskometerRisk Level Interpretation

1. Low Level Principle at low risk2. Moderately Low Principal at moderately low

risk3. Moderate Principal are moderate risk4. Moderately High Principal at moderately high

risk5. High Principal at high risk

Advantages/Merits Mutual FundDiversificationThe best mutual funds design their portfolios so individual investmentswill react differently to the same economic conditions. Keep your eggs indifferent baskets.

Professional ManagementMost mutual funds pay toplight professionals to manage theirinvestments. These managers decide what securities the fund will buyand sell.

Rgulatory oversightMutual funds are subject to many government regulations that protectinvestors from fraud.

Moderate

Riskometer

Investors understand But their principal will be at moderate risk

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Investment Analysis and Portfolio Management26

LiquidityIt’s easy to get your money out of a mutual fund. Write a applications,make a call, and you’ve got the money. Online redemption of units isproposed by SEBI.

ConvenienceYou can usually buy mutual fund units by over the Internet or by simplysubmitting a signed application form at a Pos (point of service).

Low CostMutual fund expenses are often no more than 1.5 per cent of yourinvestment. Expenses for Index. Funds are less than that, because indexfunds are not actively managed. Instead, they automatically buy stock incomposition that are listed on a specific index.

Tax BenefitsSec. 80 C Investing in ELSS gives tax advantage to investors. The flip

side is investment is locked for 3 years. Also a present Equity MutualFunds are exempt from Long-term Capital Gain Tax.Sec. 80 CCG Additional deduction upto 50,000 is available underRGESS

Note: In Oct. 2011 HDFC Mutual Fund emerged No.1 Mutual Fund as per AMC. RelianceMutual Fund is second. UTI was ranked sixth.

Computation of NAVThe Net Asset Value is the market value of the assets of the Mutual Fund Scheme minus its

liabilities. The net asset value of the mutual fund unit is computed as follows:

NAV =dingtanOutsUnitsofNumber

ExpensesAccruedandsLiabilitieIncomeAccruedFundofValueMarket

Thus, the factors affecting the NAV of Mutual Fund are as follows:(i) Sale and purchase of securities.

(ii) Sale and purchase of units.(iii) Valuation of assets.(iv) Accrued income and expenses.

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Introduction to Investment Environment 27

The Rate of Return on a mutual fund is calculated as follows:

100NAV

periodtheduringPaidDividendNAVNAVturnReofRateb

be

Where,

NAVe = Net Assets Value of the end of the period

NAVb = Net Assets Value at the beginning of the period.

The compounded annual return and mutual fund scheme represents the return to investors from ascheme since the date of issue. It includes reinvestment of dividends and makes adjustments for bonusand rights. It is calculated on NAV basis. It reflects the return generated by the fund manager on NetAssets Value. In this calculation, it is assumed that the dividend is reinvested at the NAV prevailingon the day it is paid.

It is to be noted that N.A.V of Scheme declines to the extent of dividend payment. It is money ofunit holders that is given to oneself. Also since, any new similar scheme will invest in same market, itdoes-not make any difference if one invest at ` 10 NAV at Launch (NFO) or invest in an existingscheme at a current higher NAV Other things remaining same, return will remain same.

1.18 Problems + Solutions

Illustration 1A Mutual Fund Scheme has assets of ` 180 million and liabilities of ` 12 million. The number of

outstanding units is 10 million. Calculate the net assets value of the scheme.

Solution:

NAV =Unitsof.No

sLiabilitieAssets

=10

12180

= ` 16.8

Illustration 2The NAV of a fund was ` 46.90 at the beginning of the period and ` 58.30 at the end of the

period; what is the percentage change in NAV during the period?

Solution:

% Change in NAV = 100NAV

NAVNAV

b

be

10090.46

90.4630.58

= 24.31%

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Investment Analysis and Portfolio Management28

Illustration 3An investor bought units of a mutual fund scheme at a price of ` 12.45 per unit. The face value of

the unit is ` 10. He redeems the investment a year later at ` 24.80 per unit. During the year, he alsoreceives dividend at 5%. Compute the rate of return on his investment in the mutual fund.

Solution:

Rate of Return = 100NAV

Dividend])NAVNAV[(

b

be

= 10045.12

]50.0)45.1280.24[(

= 10045.1285.12

= 103.21%

Illustration 4An Investor buys 75 units of a fund at ` 9.5 on 1st January, 2010. On 30th June, 2010, he

receives dividend at the rate of 10%. The ex-dividend NAV was ` 10.25. On 31st December, 2010 thefund’s NAV was ` 15.25. Calculate the return on Investment.

Solution:The Beginning Value of Investment = 9.5 × 75

= ` 712.50

Dividend = 1 × 75 = ` 75

Number of Units Reinvested = units32.725.10

75

Total No. of Units = 75 + 7.32 = 82.32

End Period Value and Investment = 82.32 × 15.25= ` 1,255.38

Return on Investment = 100×MV

MVMV

b

be

= 100×50.712

50.71238.1255 = 100×50.71273.542 = 76.19%

Illustration 5If the applicable NAV is ` 22 and the exit or repurchase load is 2%, then find out the repurchase

price.

Solution:Repurchase Price = NAV × (1 – Exit Load) = ` 22 × (1 – 0.02)

= ` 21.56

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Introduction to Investment Environment 29

Illustration 6The following information is available for a close ended fund for the last 12 months.

Month NAV at the end of the Month(`)

Premium(Discount at the end of Month %)

January (beginning)JanuaryFebruaryMarchAprilMayJuneJuly

AugustSeptember

OctoberNovemberDecember

10.0010.2511.759.25

10.1511.2511.9512.2511.9012.3011.7510.9511.75

0.0- 4.00- 4.35- 2.35- 1.05- 4.75- 2.50- 6.50- 4.35- 6.92- 4.25- 1.25- 1.05

Return on the Market Index for the 12 months is 10.45%. If an investor has bought 100 units ofthis mutual fund at the beginning and sold at the end of the year, calculate his annual return andcomment.

Solution:Cost of purchasing Mutual Fund Units = 10 × 100 = 1000

Selling Price = [NAV × (1 – Exit load)] × 100

= [11.75 × (1 – 0.0105)] × 100

= 11.6266 × 100

= 1162.66

Annual Return = 100×MV

MVMV

b

be

= 100×1000

100066.1162

= 100×1000

66.162

= 16.27%

Comment: Since annual return is higher than Market Index, the Mutual Fund Scheme has out-performed the market.

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Investment Analysis and Portfolio Management30

Extra Practice Problems

Illustration 7You are a PMS (Portfolio Management Services) Consultant. A middle aged investor approaches

you to seek your advice on deploying his surplus funds of ` 20 lacs in various shares, schemes, bondsand Govt. Securities. Present to him any five investment schemes mentioning various merits anddemerits of each scheme. You may assume that he is willing to take risk to the extent of 30% of hisfunds. (MU, BMS, Apr. 2011)

Illustration 8You are a Chief Executive of a Multinational Investment and Portfolio Management Consultancy

firm, and you are in-charge of Marketing and Clients Support Dept. A prospective Investor with netSurplus of ` 10 lacs, visits your office for seeking your advice and engaging your services forinvesting the surplus.

You are required to suggest to the Client various Investment avenues/investment plans assumingthat:

(a) The client is a senior citizen, retired from a private sector employment.(b) The client is a middle aged housewife, also working on part time basis for NGO.

Please suggest your plans separately for both of these types of investor. (MU, BMS, Oct. 2011)

Illustration 9You are a Portfolio Management Consultant. A middle class investor with investible Funds of

` 15 lacs approaches you. He wants to know the following:(a) What are the investment avenues available to him which will give stable returns with

minimum risk ?(b) What are the various types of risks ? Please advice him (MU, BMS, Apr. 2012)

Illustration 10As a Portfolio Management Consultant, you are approached by a investor with investible funds of

` 25 lacs. He wants to know from you the following.(a) What are the investment avenues available to him which will give stable returns with

minimum risk?(b) What are the various types of risks? (MU, BMS, Oct. 2012)

Illustration 11You being a Portfolio Management Consultant, an investor with an investible surplus of ` 45

Lakhs and Income before tax of ` 10 Lakhs has approached you for advice. He wishes to know thefollowing:-

(a) What are the various investment avenues available to him, which will give him stable returnswith minimum risk?

(b) What are the various investment avenues available which minimize his income tax outflow?(MU, BMS, Apr. 2013)

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Introduction to Investment Environment 31

Illustration 12Rupesh Thakare, an Architect by profession, approaches you with ` 30 lakhs for advice on

investments. As a Portfolio-Manager, guide him on avenues available to him, which will give stablereturns with minimum risk. (MU, BMS, Oct. 2013)

Illustration 13Ms. Rashi a leading doctor of Mumbai approaches your portfolio Management Consultancy, with

an investible surplus of ` 30 lakhs. You are required to advice her on the following:(MU, BMS, Apr. 2014)

(a) What are the various investment opportunities available to her, which will give her stablereturns with minimum risk?

(b) Which are the investments which will minimize her income tax outflow?

Illustration 14You are Portfolio Management Consultant. Mr. Rao, an Academician, wish to invest

` 20,00,000/-. Suggest him with various investment avenues which will give stable returns withminimum risk. Present to him any five investment schemes mentioning various merits & demerits ofeach scheme. (MU, BMS, Apr. 2015)

Concept Testing

What Makes a Multibagger?Active equity investors constantly search for potential multibaggers. What can make a potential

multibagger? A stock of a company can be potential multibagger when: The external opportunity for the company is huge. The company has certain distinctive competencies that gives it an edge over competitors. The management of the company is ambitious, determined, and capable – it should indeed be

hungry to dominate the market. There is no governmental regulation on pricing that can subdue profits. The stock is available at a low price.

Stock of companies like Apple Microsoft, Intel, Hero Honda, Infosys, HDFC, and BerkshireHathway had such characteristics at some stage or the other.

Summary The bewildering range of investments fall into two broad categories, viz., financial assets and

real assets. The important financial assets are bank deposits, provident fund deposits, government

securities, equity shares, mutual fund shares, insurance policies, and financial derivatives. Theimportant real assets are residential house, commercial property, agricultural land, andprecious objects.

Equity shares represent ownership capital. It is customary to classify them as follows: bluechip shares, growth shares, income shares, cyclical shares, defensive shares, and speculativeshares.

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Investment Analysis and Portfolio Management32

A mutual fund is a vehicle for collective investment. Mutual fund schemes are broadlyclassified as follows: equity schemes, balanced schemes, and debt schemes.

A derivative is an instrument whose value depends on the value of some underlying asset.Futures and options are the two most important financial derivatives.

A futures contract is an agreement between two parties to exchange an asset for cash at apredetermined future date for a price that is specified today.

An option gives its owner the right to buy or sell an underlying asset on or before a givendate at a predetermined price.

The important types of insurance policies in India are: endowment assurance policy, moneyback policy, whole life policy, and term policy.

Start the search for your Multibagger.

Summary Evaluation of Various Investment Avenues

ReturnRisk Marketabilit

y/Liquidity Tax Shelter ConvenienceCurrentYield

Capitalappreciation

Equity Shares Low High High Fairly high High HighNon-convertible

Debentures High Negligible Low Average Nil High

Equity Schemes Low High High High High Very HighDebt Schemes Moderate Low Low High No tax on dividends Very HighBank Deposits Moderate Nil Negligible High Low Very high

Public ProvidentFund Nil Moderate Nil Average Section 80 C benefit Very high

Life InsurancePolicies Nil Moderate Nil Average Section 80 C benefit Very high

Residential House low Moderate Average Low High FairGold and Silver Nil Moderate Average High Nil Average

1.19 Review Questions1. Concept Testing

(a) Types of Investors(b) ELSS & SIP(c) Shares vs. Debentures

2. Long questions(a) Explain Investment Process(b) Investment vs Speculation vs Gambling(c) Explain Any 5 Investment Avenues.