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Module 2.12

Mutual Fund Operations

Mutual Fund – The Structure and Types

Investing directly in equity shares and debt instruments may be difficult for

a large number of investors. Ignorant investors want to know more about the

company, the promoters, the competition, factors affecting the business, sentiments

of the market, investment environment etc. to become a successful investor. In

such a case, investors can go for investing in financial assets indirectly through a

mutual fund.

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. Basket of securities here means a group of

securities. Here the fund manager will find the basket of securities or a port folio

which is able to diversify the risk and generate return. Funds are invested in a pool

of marketable securities reflecting the investment objectives.

A mutual fund represents a vehicle for collective investment. When an

investor participants in a mutual fund schemes, he becomes a part owner of the

investments held under that scheme. Mutual funds are corporation that accept

money from investors and use this money to buy stocks, long term bonds, and

short term debt instruments issued by business or government.

Mutual fund is a trust that pools the savings of investors. The money

collected is then invested in financial market instruments such as shares,

debentures and other securities. A mutual fund is a financial service organization

that receives money from share holders; invest it, ear return on it.

Mutual Fund – The Definition

Securities and Exchange Board of India (Mutual Funds) Regulation, 1996 define

mutual find as “a fund established in the form of trust to raise monies through the

sale of units to the public or a section of the public under one or more schemes for

investing in securities, including money market instruments”.

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So a mutual fund is a special type of institution, a trust or investment

company which acts as an investment intermediary and channelizes the savings of

a large number of people to the corporate securities in such a way that investors get

steady return, capital appreciation at low risk. So thrust of the mutual fund is

steady return and capital appreciation with minimum risk.

When an investor invests in a Mutual Fund scheme, he receives units in

return. The price of each mutual fund unit is called its Net Asset Value. NAV of a

Mutual Fund Scheme is calculated by dividing the total value of assets that the

fund has by the total number of units issued.

Return of Mutual Fund

An investor invests his valuable money to earn return – either as income, in

the form of interest or dividends or as capital gains resulting from changes in

the market value of the security.

Return is the yield that an investment generates over a period of time.

It is the Percentage increase or decrease in the value of the investment in that

period.

The return can be expressed in two ways:

(a) Absolute Return and

(b) Annualized Return

Absolute Return

Absolute return also known as point to point returns, calculate the simple

return on initial investment.

To calculate this return we need the present NAV.

In this method the duration of holding fund is not important.

One usually uses absolute return to calculate return for a period of less than

one year.

#Annualized Return#

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Annualized Return is the amount of money the investment has earned for the

investor per annum.

It helps to compare the performance of various mutual funds.

Mutual Fund – The Types of Return

The Mutual funds give returns in two ways namely, capital appreciation and

dividend.

1) Capital Appreciation

Capital Appreciation is an increase in the value of the units of

the fund. As the value of individual securities in the fund increases, the fund’s unit

price increases. An investor can book a profit by selling the units at prices higher

than the price at which he bought the units.

2) Dividend Distribution

The profit earned by the fund is distributed among unit holders

in the form of dividends. Dividend distribution may be of two types. It can either

be re invested in the fund or can be on paid to the investor.

Net Asset Value (NAV)

The Net Asset Value of a fund is the market value of the assets minus the

liabilities on the day of valuation.

The Net Asset Value of a unit is the net asset value of fund divided by the

number of outstanding units.

NAV = Market Price of Securities + Other Assets – Total liabilities + Units

Outstanding as at the NAV date.

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NAV – Calculation

Examples: Bhatia took Units of a mutual fund scheme, whose total value of its

investment (in shares, bonds etc) is Rs. 1000 lakh and the mutual fund has issued

Rs. 40 lakh units to investors.

In this case, The Net Asset Value of the Scheme will be Rs. 25 (that is 1000

lakh divided by 40 lakh). Here the 1000 lakh was the total value of the

investment and the number of units is 40 lakh.

Fortunately, the price of shares invested by the scheme appreciated by 10

percent.

Then the total value of investments becomes Rupees one thousand one

hundred lakh.

The Net Asset Value of the unit held by Bhatia increases to Rs. 27. 50 (that

is one thousand one hundred lakh divided by 40 lakh.

Similarly, NAV would decrease if the value of investments decreases.

Features of Mutual Fund

1) Mobilize fund from small as well as large investors. It is considered as a

good avenue for small investors because it can be started with an amount of

Rs. 500 or 1000 etc.

2) Provide an ideal avenue to small investors

3) Regulated by SEBI: Mutual funds in India are regulated by the securities and

exchange board of India.

4) Contribute to the economic development

5) Expert opinion: Each mutual fund scheme is managed by a fund manager or

a team of fund managers who have a high level of knowledge as well as

professional experience in investing.

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The Structure of Mutual Fund

Mutual Fund – The Structure

All mutual funds whether promoted by public sector or private sector entities

including those promoted by foreign entities are governed by the same set of

regulations.

In India, the following entities are involved in a mutual fund operation: The

sponsor of the mutual fund, the trustees, the asset management company, the

custodian and the registrar and transfer agents.

(a) Sponsor

A sponsor is required for setting up and establish Mutual fund.

The functions of a sponsor may be that of the functions of a promoter of a

company.

The sponsor has to obtain a license from SEBI for which it has to satisfy

several conditions relating to capital profits, track record, default free

dealings and so on.

Sponsors maybe banks or financial institutions

Example

ICICI Bank and the Prudential Ltd. are the sponsors of ICICI prudential

Mutual Fund

(b) Mutual Fund Trust

A mutual fund can also be set up as a trust under Indian Trust Act 1881.

Then it has to be registered with SEBI

The investors of the fund are the beneficiaries of the trust.

Example

ICICI Prudential mutual fund is set up as a trust named prudential ICICI

Mutual Fund Trusts

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(c) Asset Management Company (AMC)

The Asset Management Company also referred to as the investment

manager, is a separate company appointed by the trust to run the mutual

fund.

The asset management company should have certificate from the SEBI to act

as portfolio managers under SEBI

The Asset Management Company (AMC) handles all operation matters

such as designing the schemes, launching the schemes, managing

investments and interacting with investors.

The AMC designs and manage the mutual fund schemes, as per the

guidelines of SEBI

It manages money collected from diverse investors

Example

Prudential ICICI Asset Management Company is the AMC of ICICI

Prudential Fund

(d) Custodian

An independent organization is usually appointed as the custodian to take

custody of securities and other assets of a mutual fund.

The custodian is responsible for the receipt and delivery of securities,

collecting income, distributing dividends etc.

The custodian can serve more than one fund at a time where as AMC can

work only for one fund.

Example: HDFC bank is the custodian of ICICI Prudential Fund

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(e) Registrar and Transfer Agents

Registrar and Transfer Agent handle communication with investors (Unit

holders), maintain investor data, dispatch account statements etc. to the

investors.

Example

ICICI InfoTech Service Ltd. Is the RTA of ICICI Prudential Fund

Now we will see the categories of mutual funds

Mutual Fund – The Types

There are a number of Mutual Funds to suit the needs and preferences of

investors.

(a) According to Ownership- It can be classified in to Public sector& Private

Sector.

(i) Public Sector Mutual Fund: UTI started mutual fund business in India

since 1964 and had a monopoly for 23 years. In 1987, SBI came to the

scene with SBI mutual fund. Thereafter a number of public sector

banks of organization came to the picture.

Example: Ind Bank Mutual fund, Can bank mutual fund, Bank of

India Mutual fund PNB-MF, LIC- MF etc.

(ii) Private Sector Mutual Fund: Seeing the success and growth of Mutual

Funds in the Indian capital market, Government allowed private sector

corporates to join the band wagon of mutual fund industry in 1992.

(b) On the basis of Operation

On the basis of operations, mutual fund can be categorized in to two, namely

open ended fund and close ended fund.

(i) Open ended Fund: In the case of open ended fund, the size and period

of the fund is not fixed in advance. Investors are free to buy and sell

number of units at any point of time. It is more liquid and flexible. These

units are not publically traded.

Now let’s have look on the types of open ended mutual funds

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Stock Fund: As the name implies, stock mutual funds invest mainly in

common stocks. The objective of a stock fund is long term capital

appreciation versus generating income. Stock fund may be of various types

namely, large cap, mid cap, small cap and international.

Stock Fund – The Types

Large Cap: It primarily invests in blue chip companies- large well

known industrials, utilities, technology and financial services

companies with large market capitalization. Large cap stocks are

perceived to be less risky than smaller capitalized companies.

Mid Cap: These primarily invest in companies whose market

capitalization is smaller than large caps but larger than small caps.

Mid caps are generally considered more risky than large cap stocks

but have a higher return expectation.

Small Cap: Primarily invest in emerging companies, thought to have

potential for future growth and profit. Small caps are generally

considered as riskiest stocks compared to larger capitalized firms but

carry the expectations of high returns. Small cap funds are subject to

greater volatility than those in other asset categories.

International: Primarily invests in stocks traded on foreign

exchanges but purchased in the United States by U.S. fund companies.

International funds are subject to additional risks such as currency

fluctuations, political instability and the potential for liquid markets.

(ii) Close ended Fund: Under this, duration of the funds is fixed in advance.

The main aim of this fund is capital appreciation.

(c) On the basis of Return

On the basis of return, the mutual funds can be categorized as income fund,

growth fund and conservative funds. Let’s see one by one

1. Income fund: Income Fund generates regular and periodic return to its

members. It mainly focuses on fixed income securities like bonds and

debentures.

2. Growth Fund: These funds mainly focus on capital appreciation and

are for a long period of time. It does not offer regular income to the

investors.

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3. Conservative Fund: This aims at providing a reasonable rate of return,

protecting the value of the investment and getting capital appreciation.

Hence the investment is made in growth oriented securities.

(d) On the basis of Investment

1) Equity fund: It consists of equity based instruments. It carried a high

degree of risk

2) Balanced Fund: It is the mixture of debt and equity in the portfolio of

investment. It aims at distributing the regular income and capital

appreciation.

3) Fund of Fund: Fund of one mutual fund is invested in the units of

another mutual fund.

4) Taxation Fund: A growth oriented fund offers tax rebate to the

investors. It is suitable to salaried people.

5) Leverage fund: In this case funds are invested from the amount

mobilized from the small investors as well as money borrowed from

capital market.

6) Bond Funds: These fund Block resources in bonds only. The purpose

of this fund is to earn fixed and regular income.

7) Guilt Fund: Funds are invested in guilt edged securities.

8) Value Fund: A value fund is a fund that allows a value investing

strategy and seeks to invest in stocks that are deemed to be

undervalued in price based on fundamental characteristics’.

9) Debt Fund: Debt funds are mutual funds that invest in fixed income

securities like bonds and Treasury bill, guilt fund, monthly income

plans, short term plans, liquid funds and fixed maturity plans are some

of the investment options in debt funds.

10) Hybrid Fund: Hybrid fund is an investment fund that is

characterized by diversification among two or more asset classes.

These funds typically invest in a mix of stocks and bonds.

11) Index Fund: An index fund is a type of mutual fund with a

portfolio constructed to match or track the components of a financial

market index. An index fund is said to provide broad market

exposure, low operating expenses and low operating turnover.

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12) Dividend Fund: A dividend fund seek to provide investors with

income from common and preferred shares or stock which yield

dividends in cash and stock on a regular occurring basis.

SEBI’s Guidelines on Mutual Fund

1) A mutual fund shall be constituted in the form of a trust, and registered

under the provisions of the Indian Registration Act, 1908

2) The sponsor should have a sound track record and general reputation of

fairness and integrity in all his business transactions.

3) Appoint an Asset Management Company (AMC) to manage the fund

4) The minimum net worth of the AMC shall be 10 crore.

5) The AMC shall not undertake any other business activities except in the

nature of management and advisory services.

6) The AMC shall submit quarterly report to the trustees regarding the

transaction during the period.

7) No scheme shall be launched by the AMC unless such scheme is approved

by the trustees

8) Every mutual fund shall compute the Net Asset Value (NAV) of each

scheme by dividing the net asset of the scheme by the number of units

outstanding on the valuation date.

9) The NAV of the scheme shall be calculated and published at least in two

daily news papers of intervals of not exceeding one week.

10) While determining the price of the units, the mutual fund shall ensure

that the repurchase price is not lower than 93% of the NAV.s

11) Every AMC shall maintain and preserve for a period of 8 years its

book of accounts, records and documents

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Associations of Mutual Funds in India (AMFI)

AMFI is an apex body of all Asset Management Companies

It invests the pooled funds of retail investors in securities in line with the

stated investment objectives

Examples of AMFI Includes: Tats Asset Management Company formed by

Tata mutual fund, Birla Sun Life y Asset Management Company, formed

jointly by Aditya Birla Group and Sun Life Financial.

AMFI – The Objectives

1) To maintain and achieve high professional and ethical standards in the

operation of mutual funds

2) The second aim of AMFI is To promote better business practices and to

frame a code of conduct to be followed by all the members engaged in

mutual fund business

3) The next aim of AMFI is To represent SEBI on all matters regarding the

functioning of mutual fund Industry

4) To represent to the government , RBI and other related official bodies on all

matters regarding the Mutual Fund

5) To conduct nationwide investor awareness program to popularize the

concept and working of mutual funds among the masses

6) To act as a watchdog for the mutual fund operations in India

#Systematic Investment Plan (SIP) #

Systematic Investment Plan is a way to invest in mutual fund regularly.

The idea is to set apart a sum every month or quarter.

People like such a system because it helps them to save regularly and build

up an investment.

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SIP has brought mutual funds within the reach of an average person as it

enables even those with tight budgets to invest Rs. 5000 or Rs. 1000 on a

regular basis in place of making a heavy, one time investment.

SIP – The Features

1) A specific amount should be invested for a continuous period at regular

intervals under this plan

2) SIP is similar to a regular saving scheme like a recurring deposit.

3) SIP allows the investor to buy units on a given date every month.

4) The investor automatically participates in the market swings once the option

for SIP is made

Mutual Fund – The Advantages

As an investment avenue, Mutual Funds provide many benefits to the

investors and economy. See some of the benefits of the mutual funds:

1) Port folio Diversification: An investor undertakes risk if he invests all his

funds in a single security. Mutual funds invest in a number of companies

across various industries and sectors. It helps to diversify the risk of

investors.

2) Expert supervision and Management: Generally a small investor need not be

an expert in portfolio management. He will be not in a position to find the

optimal portfolio. Mutual funds have a team of experts and it invests

professionally.

3) Ensure liquidity: Investors cannot sell the securities held by him easily. In

case of mutual funds, they can easily encash their investment by selling their

units to the fund if it is an open ended scheme or selling them on a stock

exchange if it is a close ended scheme.

4) Reduces Risk: Mutual funds invest in multiple assets, risks are reduced as

losses in a few can be balanced by gains in others.

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5) Tax Advantages: Certain mutual funds offer tax advantage. In order to

encourage saving mentality, section 80C benefit is extended to mutual fund

subscription also.

6) Investors Protection: Mutual fund schemes are functioning under SEBI

guidelines. No scope for manipulation and transparency is there. Investors’

interest is well protected.

7) Low Cost: Mutual funds are a relatively less expensive way to invest in the

capital market compared to directly investing the capital markets because the

benefits of economies of scale is passed on to the investors.

8) Affordability: 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 benefits of its investment strategy.

Mutual Fund – The Limitations

In spite of the above mentioned merits, the same is not free from limitations:

See some of the criticisms leveled against the mutual funds;

1) No insurance: Mutual fund, although regulated by the SEBI, are not insured

against losses. It is possible that investors could even loss their entire

investment in some extreme cases.

2) Fee and Expenses: Investor has to pay investment management fee and fund

distribution costs as a percentage of the value of his investments as long as

he hold the units, irrespective of the performance of the fund.

3) Poor Performance: Returns on a mutual fund are by no means guaranteed.

4) Loss of control: In the case of mutual funds, the investment decision will be

taken by the find manager. Investors have no right to interfere in the

decision making process of a mutual fund manager. The managers of mutual

funds make all of the decisions about which securities to buy and sell and

when to do so.

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5) In adequate disclosure: Even though transparency is claimed in mutual fund

business, certain information which is crucial for the investors may not be

made available.

6) Inadequate Research: Mutual fund organizations are supposed to do lot of

research before investing. Research requires the services of highly talented

professionals.

Exchanged Traded Fund

An Exchange Traded Fund is an investment fund traded on stock exchanges,

almost like stocks. An EFT holds assets such as stocks, commodities, bonds etc.

EFT will be traded close to its asset value. It combines the features of both close

ended index fund and open ended index fund. EFT will be listed on the stock

exchanges like a close ended index fund. The ownership of fund can be easily

bought, sold or transferred like the shares, because the EFT shares are traded on

stock exchanges.

EFT – The Features

1) Trading Features: EFT can be traded just like individual stocks and it will be

listed on stock exchanges and each unit can be traded like an individual

stock of RIL, L and T, Infosys etc. Investors can buy or sell the EFT units

throughout the day.

2) Real Time Price information: The second feature of mutual fund is it

provides real time price information. In the case of mutual funds, Net Asset

Value is made known at the end of the day. But in the case of EFTs real

time price information is available.

3) Low tracking Error: Tracking Error means the difference between the

returns of a fund and returns of the index. Tracking error arises due to the

differences on the composition of securities, management fees, expenses like

handling of dividend etc. Efts has very low tracking error because majority

of them do not offer cash subscriptions or cash redemptions like mutual fund

units.

4) Lower brokerage and other expenses: EFTs generally follows a passive

investment strategy, these results in lower brokerage expenses, lower

management fee etc.

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5) Features of Tax benefits: Mutual funds do frequent buying and selling of

securities to beat the market. These results in frequent capital gains and the

tax expenses are passed on to the investors. On the other hand, EFTs do not

attempt frequent buying and selling and this results in reduced tax expenses.

Majority of EFTs are eligible for Rajiv Gandhi Equity Saving Schemes-

deductions under Section 80 CCG of the income tax Act.

6) Security Supermarket Facility: Investors can gain access to commodities,

debt securities, even world indices without having to open separate accounts

for trading in different asset classes. To invest in EFTs, An equity trading

account is just sufficient.

Exchanged Traded Fund

An Exchange Traded Fund is an investment fund traded on stock exchanges,

almost like stocks. An EFT holds assets such as stocks, commodities, bonds etc.

EFT will be traded close to its asset value. It combines the features of both close

ended index fund and open ended index fund. EFT will be listed on the stock

exchanges like a close ended index fund. The ownership of fund can be easily

bought, sold or transferred like the shares, because the EFT shares are traded on

stock exchanges.

EFT – The Features

1) Trading Features: EFT can be traded just like individual stocks and it will be

listed on stock exchanges and each unit can be traded like an individual

stock of RIL, L and T, Infosys etc. Investors can buy or sell the EFT units

throughout the day.

2) Real Time Price information: The second feature of mutual fund is it

provides real time price information. In the case of mutual funds, Net Asset

Value is made known at the end of the day. But in the case of EFTs real

time price information is available.

3) Low tracking Error: Tracking Error means the difference between the

returns of a fund and returns of the index. Tracking error arises due to the

differences on the composition of securities, management fees, expenses like

handling of dividend etc. Efts has very low tracking error because majority

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of them do not offer cash subscriptions or cash redemptions like mutual fund

units.

4) Lower brokerage and other expenses: EFTs generally follows a passive

investment strategy, these results in lower brokerage expenses, lower

management fee etc.

5) Features of Tax benefits: Mutual funds do frequent buying and selling of

securities to beat the market. These results in frequent capital gains and the

tax expenses are passed on to the investors. On the other hand, EFTs do not

attempt frequent buying and selling and this results in reduced tax expenses.

Majority of EFTs are eligible for Rajiv Gandhi Equity Saving Schemes-

deductions under Section 80 CCG of the income tax Act.

6) Security Supermarket Facility: Investors can gain access to commodities,

debt securities, even world indices without having to open separate accounts

for trading in different asset classes. To invest in EFTs, An equity trading

account is just sufficient.

Top Mutual Fund Companies in India

1) ICICI Prudential Mutual Fund

It is a joint venture between ICICI Bank in India and Prudential Plc,

in UK.

It was started in the year 1993.

With the AUM (Asset under Management) size of approximately

3lakh crore, ICICI Prudential Asset Management Company (AMC) is

the largest Asset Management Company in the Country.

2) HDFC Mutual Fund

HDFC Mutual Fund is at the second number by the size of AUM.

With fund size of nearly Rs. 3 lakh crore, it is one of the largest

mutual fund companies or AMC in the Country.

3) Aditya Birla Sun Life Mutual Fund

It is formerly known as Birla Sun Life Asset Management Company,

this fund house is the 3rd

largest in terms of AUM size.

It is a joint venture between the Aditya Birla Group in India and Sun

Life Financial Inc of Canada.

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4) Reliance Mutual Fund

With assets under Management of Approximately Rs. 2.5 lakh crore,

reliance mutual fund is one of India’s leading mutual fund companies.

5) SBI Mutual Fund

6) L & T Mutual Fund

L & T Investment Management Limited is the Asset Management

Company for all L & T mutual Fund schemes.

L& T finance holding limited (LTFH), a listed company is the sponsor

for the AMC.

7) Kotak Mahindra Mutual Fund

Kotak Mahindra Mutual Fund is a part of the Kotak group established

in 1985.

KotakMahindra Asset Management Company is the asset manager for

Kotak Mahindra Mutual Fund

8) IDSP Mutual Fund

IDSP Asset Management Company Ltd. Was established in 2000.

IDFC Financial Holding Company Limited holds the entire share

holding in IDFC Asset Management Company.

9) UTI Mutual Fund

UTI is one of the oldest and largest mutual funds in India.

UTI Mutual Fund is a part of Unit Trust of India.

It was registered with SEBI in 2003.

It is promoted by SBI, LIC, Bank of Baroda and PNB

10) Mirea Asset Mutual Fund

Mirea Asset was founded in 1997. It is sponsored by Mirae Asset

Global Investment Co. limited, South Korea.

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References

Pendhakar, V G (2003): Unit Trust of India: Retrospect and Prospect, USB

Publishers’ Distributors, Ltd. New Delhi.

Sadhak, H (1998): Mutual Funds in India: Marketing Strategies and

Investment Practices, Sage Publishers, New Delhi.

Chander, R. (2002): Performance Appraisal of Mutual Funds in India. Excel

Books, Mumbai.

Khan M Y. (2013):Financial Services, McGraw Hill Education (India)

Private Limited, New Delhi.