Chapter 9: Mutual Funds

A Mutual Fund is a trust established in the form of a trust to raise money from a number of
investors by launching its scheme and investing that money into money market and capital
market securities. The income earned through this investment is shared amongst the investors
(called as unit holders) of the scheme in proportion to the number of units held by them.
Small investors, who generally lack the expertise to invest in the securities on their own,
prefer such collective investment vehicles. Mutual Funds thus provide diversification,
liquidity and professional management to the investors who individually cannot afford it.

There is a three tier structure for mutual funds in India.

1. Sponsor – He is the person who creates the trust.
2. Board of Trustees – They have overall responsibilities for the management of the
trust.
3. Asset Management Company (AMC) – It is incorporated under the Companies Act,
1956 to manage the funds raised on behalf of trustees. It enters into an Investment
Management Agreement with the trustees for the management of the fund for a fee.

Besides these three organs, there are two more bodies involved in the working of a Mutual
Fund –
1. Custodian – He is the person who carries on the activities of safe keeping of the
securities on behalf of his clients.
2. Transfer Agent – He receives and processes the application of unit holders. He also
handles the grievances of unit holders; perform data entry services and despatch unit
certificates / account statements to unit holders.

Advantages of Mutual Fund –

 Professional management
 Diversification
 Convenient administration
 Return potential
 Low cost
 Liquidity
 Transparency

Risks involved in Mutual Funds

 Excessive diversification can result in weak focus on good securities
 Too much concentration on blue chip securities (their price are high) can result in
average returns
 Poor planning of investment can result in low returns
 High turnover can result in high transactional costs, thus lowering the returns
 Failure to identify the risks
 Investing in securities without proper research

Types of Mutual Fund Schemes

A. By Structure:

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(1) Open Ended Scheme – These schemes give the investors an option to subscribe to the
units of the scheme at any time and have the units repurchased by the Fund also at any time.
They do not have a fixed maturity period. The investors can conveniently buy and sell the
units at the NAV (Net Asset Value) related values, NAV being determined by the Mutual
Fund.
(2) Close Ended Scheme – A scheme whose offer for subscription is open for a limited period
only and where the units can be redeemed only after a specified time. They have a fixed
maturity period (generally 3 – 7 years). The investors can invest directly in the scheme at the
time of issue and later he can trade in the units on the stock exchange where they are listed.

Open Ended Scheme Close Ended Scheme

Corpus is variable due to ongoing purchase Corpus is fixed – new units cannot be offered
and redemption. beyond a limit.
No listing on stock exchange – transaction is The units are listed on stock exchange, where
done directly with the Mutual Fund. they are traded.
Only one price i.e. NAV which is determined There are two values – NAV and Market
by the Mutual Fund. price.
Highly liquid. Mostly liquid.
No fixed maturity period. Fixed maturity period.

B. By investment Objective:
(1) Growth Scheme / Fund – These schemes normally invest a majority of their funds in
equity and aim to provide capital appreciation. These schemes are suitable for investors who
want to invest for long term, do not want regular income and are ready to bear the risk.
(2) Income Scheme / Fund – These schemes provide regular income to the investors as they
invest in fixed income securities like bonds, debentures, etc.
(3) Balanced Scheme / Fund – They aim to provide growth and income by distributing a part
of the income and capital gains they earn. They invest in equity as well as fixed income
securities.
(4) Money Market Scheme / Fund – They provide very low risk, carry liquidity and moderate
income. They invest in money market securities, which are for short term and the returns are
also low like Treasury Bills, Commercial paper, Certificate of Deposit, Call Money market,
etc. They are good for investors who want to invest for short periods.
(5) High Growth Scheme – They invest in high returns and high risk securities. Their aim is
to provide capital appreciation over long term period. They are good for aggressive investors,
who are ready to bear high risks.

C. Other Schemes:
(1) Tax Saving Schemes – These schemes offer tax rebate to investors under tax laws. This is
made possible because the Government offers tax incentives for investment in specified
avenues, for example Equity Linked Savings Scheme (ELSS), Pension Scheme, etc.
(2) Special Schemes – It covers industry specific schemes (i.e. they invest in a particular
industry only), sectoral schemes (invest in a particular group of shares), index schemes
(invest in the shares of a particular index like Sensex, Nifty, etc.).
(3) Real Estate Schemes / Fund – These are close ended schemes which invest in real estate
and properties.
(4) Off Shore Funds – Such schemes invest in securities of foreign companies with prior RBI
approval.
(5) Leverage Funds – They also take loan for the purpose of investment.

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(6) Hedge Funds – These are unregistered private funds which pool the savings of big
individual investors and institutions. They use the funds for speculative purpose also. They
are also known as Rich Man’s Mutual Fund.
(7) Fund of Funds – They invest in units of other mutual funds.
(8) New Direction Funds – They invest in companies involved in upcoming businesses,
where risk is high and probable returns are also high.

NAV (Net Asset Value)

It is the value of the assets of each unit of the scheme. If it is more than face value, there is
appreciation of investment and vice-versa.
Market Value of Scheme's Investments + Current
NAV = Assets – Current Liabilities and Provisions
Number of Units Outstanding

NAV should be published in at least two daily newspapers at intervals not exceeding one
week. NAV should be calculated upto 4 places of decimal.

Mutual Fund Costs

There are two types of costs involved in mutual funds –

(A) Operating expenses – These are expenses incurred in operations of mutual funds and they
involve investment management fees, custodial fees, audit fees, trustee fees, transfer agent’s
fees, etc. Total operating expenses cannot exceed the limit prescribed by SEBI regulations.
The excess expenditure, if any, has to be borne by AMC or trustees or sponsors.

(B) Sales charge – Also called as sales load, these include expenses for distribution and
marketing. These are charged to investors at the time of investment / redemption. These are
of two types:
(i) Entry Load or Front-end Load – It is a one time fixed fees which is paid by an investor
while buying units. The public offer price (POP) will be calculated as follows –
POP = NAV
1 – Front-end Load
(ii) Exit Load or Back-end Load – It is a fixed fee for redemption load and is paid at the time
of redeeming or selling the units. Calculation of redemption price will be as follows –
Redemption price = NAV
1 + Back-end Load
Note:- The front-end or back-end load in any combination shall not be more than 7%.

Roll Over of a Scheme

A close ended scheme can be roll over but for this a resolution has to be passed by unit
holders. Those unit holders who are absent or do not agree to the resolution, their units will
be redeemed. Switch over from one scheme to another scheme of same mutual fund is
allowed.

Provisions of SEBI (Mutual Fund) Regulations, 1996

Regulation 7 lays down the eligibility criteria which should be fulfilled by an applicant in
order to get registration certificate –

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 (1) The sponsor should have a sound track record and general reputation of fairness and
integrity. Sound track record means
(a) The sponsor is in the business of financial services from at least past 5 years.
(b) The net worth is positive in the immediately preceeding 5 years.
(c) The net worth in the immediately preceeding year is more than the capital
contribution of the sponsor in the AMC.
(d) The sponsor is into profits after providing for depreciation, interest and tax, in 3 out of
the past 5 years.
(2) The sponsor contributes at least 40% of the net worth of the AMC.
(3) The fund is in the form of a trust and the trust deed has been approved by SEBI.
(4) Sponsor or its directors should not have been guilty of fraud or any offence involving
moral turpitude.
(5) Trustees have been appointed to regulate the fund.
(6) AMC has been appointed to manage the fund.
(7) Custodian has been appointed for safe custody of investments.

The instrument of trust should be in the form of a deed duly registered under Indian
Registration Act, 1908. It should contain the clauses as specified in Schedule II of SEBI
regulations. The trustees and AMC shall enter into an investment management agreement,
which should contain all clauses as specified in Schedule IV of SEBI regulations.

Mutual Fund should abide by the code of conduct specified by SEBI. Advertisements should
be in accordance with Schedule VI of SEBI regulations.

Due Diligence by Trustees

(1) Trustees should be discerning in the appointment of directors of AMC.
(2) They should ensure that the trust property is properly protected, held and
administered.
(3) They should ensure that all service providers are registered with SEBI and should
check their service contracts.
(4) They should immediately report to SEBI about any special developments.
(5) They should obtain internal audit reports and compliance certificate on regular basis.
(6) They should prescribe and adhere to code of ethics.
(7) They should communicate in writing to AMC.
(8) They should maintain a record of their decisions and minutes of the meeting.

Every close ended scheme should be listed in a recognised stock exchange within a specified
period. A close ended scheme can be converted into an open ended scheme. The scheme of
mutual fund should be open for subscription for not more than 45 days. Guaranteed returns
can be provided only if they are guaranteed by the sponsor or AMC.

Investment Objectives
Investment should be made in accordance with the investment objectives of the scheme. The
funds can be invested in the securities (of both money market and capital market), privately
placed debentures, securitised debt instruments, gold or gold related instruments, real estate
assets, etc. Other aspects are given in Schedule VII of SEBI regulations.

Investment Valuation Norms

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For the purpose of investment, securities are classified as traded and non-traded securities.
When a security is not traded on any stock exchange for a period of 30 days prior to the
valuation date, it is treated as a non-traded security.

(1) Traded securities are valued as per the current price of any particular stock exchange.
(where it is listed)
(2) Non-traded securities shall be valued “in goods faith” by the AMC on the basis of
appropriate methods approved by the board of AMC.
(3) Right shares will be valued as per the following formula –
Number of right shares (ex-rights price – right offer price)
Number of original shares
(4) All expenses and incomes accrued upto the valuation date shall be considered for
computation of NAV.
(5) Thinly traded securities should be valued as specified in SEBI Guidelines.
(6) NAV should be calculated on the basis of total number of units outstanding on the
valuation date.

Accounting Policies (given in Schedule IX of SEBI Regulations)

(1) All investments should be marked-to-market and should be shown in the balance
sheet at market value.
(2) Dividend income should be recognised on the date the share is quoted on ex-dividend
basis and not on the date of declaration.
(3) Interest income must be accrued on a day to day basis as it is earned.
(4) The weighted average cost method must be followed in determining the holding cost
of investment.
(5) Transactions for trading should be recognised on the trading date and not on
settlement date.
(6) Bonus shares should be recognised on the day on which the shares are quoted on ex-
bonus basis (same thing will also apply to right shares).
(7) Cost of investment should include brokerage, stamp charges, etc.
(8) Underwriting commission should be recognised as revenue only when there is no
obligation on the scheme.

Other Aspects
Books of accounts should be kept separately for each scheme. Financial year shall end on 31st
March. Dividend can be declared and should be paid within 30 days of declaration.
Redemption or repurchase proceeds should be paid in 10 working days. Annual report should
be sent to SEBI and to all investors (unit holders). Other general provisions as applicable to
other intermediaries shall also apply.

Exchange Traded Fund (ETF)

ETF is a new variety of mutual funds which first became available in 1993. They started in
the US through the concept of purchasing power funds, super shares, etc. They are similar to
index mutual funds. They represent a basket of securities which are traded on the exchange.
Intra day trading is allowed in case of ETFs, annual expenses are low and they avail tax
benefits. Commission on trading is high and their performance is different from the
performance of market index.