Portfolio Construction is all about investing in a range of funds that work together to

create an investment solution for investors. Building a portfolio involves understanding

the way various types of investments work, and combining them to address your
personal investment objectives and factors such as attitude to risk the investment and
the expected life of the investment. When building an investment portfolio there are
two very important considerations.

The first is asset allocation, which is concerned with how an investment is spread across
different asset types and regions. The second is fund selection, which is concerned
with the choice of fund managers and funds to represent each of the chosen asset
classes and sectors.

Both of these considerations are important, although academic studies have consistently
shown that in the medium to long term, asset allocation usually has a much larger
impact on the variability of a portfolio's return.

To help in choosing a suitable asset allocation we have created a Risk Profiler that helps
identify your attitude to risk and therefore better identify a combination of investments
to build a portfolio.

With such a vast number of investment funds to choose from, spanning the full range of
asset classes and world markets it is easy to become confused when choosing which
investments to make. It is even more difficult to choose the right combination of
investment to potentially meet your investment goals.

Portfolio Construction

Commonly, there are two approaches in the construction of the portfolio of securities
viz. traditional approach and Markowitz efficient frontier approach. In the traditional
approach, investor’s needs in terms of income and capital appreciation are evaluated
and appropriate securities are selected to meet the needs of the investor. The common
practice in the traditional approach is to evaluate the entire financial plan of the
individual. In the modern approach, portfolios are constructed to maximize the
expected return for a given level of risk. It views portfolio construction in terms of the
expected return and the risk associated with obtaining the expected return.

Traditional approach
The traditional approach basically deals with two major decisions. They are:

a. Determining the objectives of the portfolio.

b. Selection of securities to be included in the portfolio.

Normally this is carried out in four to six steps. Before formulating the objectives, the
constraints of the investor should be analyzed. Within the given frame work of
constraints, objectives are formulated. Then based on the objectives, securities are
selected. After that, risk and return of the securities should be studied. The investor has
to assess the major risk categories that he is trying to minimize. Compromise on risk
and non risk factor has to be carried out. Finally the relative portfolio weights are
assigned to securities like bonds, stocks and debentures and then diversification is
carried out.

Steps in traditional approach

1. Analysis of constraints
a. Income needs (current income and constant income)
b. Liquidity
c. Safety of principal
d. Time horizon
e. Tax considerations
f. Temperaments ofthe investors.
 2. Determination of objectives
a. Current income
b. Growth in income
c. Capital appreciation
d. Preservation of capital
3. Selection of portfolio.

Selection of portfolio depends upon various objectives of investors.

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A Objective and asset mix.
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Growth of income and asset mix.
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Capital appreciation and asset mix.
MMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMM
Safety of principal and asset mix.

Risk and return analysis:

The traditional approach to portfolio building has some basic assumptions. First, the
individuals prefers larger to smaller returns from securities. To achieve these goal
investors has to take more risk. The ability to achieve higher returns is dependent upon
his ability to judge risk and his ability to take specific risk. These risks may be interest
rate risk, purchasing power risk, financial risk and market risk.

Diversification:

Once the asset mix is determined and risk and return are analyzed, the final step is the
diversification of portfolio. Financial risk can be minimized by commitments to top
quality bonds, but these securities offer poor resistance to inflation. Stocks provide
better inflation protection than bond but are more vulnerable to financial risks.
Investors have to select industries appropriate to his investment objectives. Each
industry corresponds to specific goals of the investors. Likewise investors has to select
two or more companies in each industries as a part of diversification In the stock
portfolio, he has to adopt the following steps which are shown in the following figure.
Modern approach:

In the modern approach, portfolios are constructed to maximise the expected return for
a given level of risk. It views portfolio construction in terms of the expected return and
the risk associated with obtaining the expected return

Harry Markowitz, the author of the modern portfolio theory and introduced the
analysis of the portfolio investments in his article ‘Portfolio Selection’ published in the
Journal of Finance in 1952. Markowitz approach is viewed as a single period approach.
His article mainly discusses the portfolio formation by considering the expected rate of
return and risk of individual stocks and their interrelationship as measured by
correlation.

2.1.5.5 Assumptions of Markowitz Theory:

The Markowitz Theory is based on the following assumptions:

(1) Investors are willing to maximise their utility with a given level of income or money.
(2) Investors have the right to access the fair and correct information.
(3) The markets are efficient and take in the information rapidly and completely.
(4) Investors may try to minimise the risk and maximise return.
(5) Investors’ decisions are based on returns and risk.
(6) Investors choose in an order of high to low returns at the given level of risk.

2.1.5.6 Markowitz model

Markowitz model is a theoretical structure for analysis of risk and return and their
inter-relationships. He used the statistical analysis for measurement of risk and for
selection of assets in a portfolio in an efficient manner. His theory led to the concept of
efficient portfolios. An efficient portfolio is expected to yield the highest return for a
given level of risk or lowest risk for a given level of return. Markowitz showed how to
select the combination of securities by taking into account the correlation between the
returns on these stocks. He suggested the way of reducing risk is diversification. The
diversification plays a very important role in the modern portfolio theory.
Diversification in investing is a number of different securities rather than concentrating
in one or two securities. The diversification assures the benefit of obtaining the
anticipated return on the portfolio. In a diversified portfolio, some securities may not
perform as expected but other securities may exceed expectations with the effect that
the actual results of the portfolio will be reasonably close to the anticipated results. This
is called as the Modern Portfolio Theory. It highlights the risk return trade-off. If the
investor wants a higher return, he has to take higher risk. But he prefers a high return
but a low risk and hence the problem of a trade-off.

The Markowitz model should be used in selecting the most desirable portfolio involves
the use of indifference curves. Indifference curves represent an investor’s preferences
for risk and return. These curves should be drawn, putting the investment return on the
vertical axis and the risk on the horizontal axis. Markowitz approach, the measure for
investment return is expected rate of return and a measure of risk is standard deviation.
The indifference curves for the individual risk-averse investors are presented in the
following picture

In the above picture, each indifference curve (I1, I2 and I3) represents the most desirable
investment or investment portfolio for an individual investor. That means, that any of
investments (or portfolios) plotted on the indifference curves (A, B, C or D) are equally
desirable to the investor. All portfolios that lie on a given indifference curve are equally
desirable to the investor and cannot intersect.
An investor has an infinitive number of indifference curves. Every investor has a map of
the indifference curves representing his or her preferences for expected returns and risk
for each potential portfolio.

Markowitz says, as the investor needs to evaluate all these portfolios on return and risk
basis. His theory answers this question by efficient set theorem. Efficient set of
portfolios involves the portfolios that the investor will find optimal ones. These
portfolios are lying on the ‘northwest boundary’ of the feasible set and are called an
efficient frontier.

The efficient frontier

can be described by the curve in the risk-return space with the highest expected rates of
return for each level of risk. Feasible set is opportunity set, from which the efficient set
of portfolios can be identified. The feasibility set represents all portfolios that could be
formed from the number of securities and lie within the boundary of the feasible set. In
the feasible set, the investments having highest returns with less risk will be considered
as optimal ones, in the above picture the assets between A and B having highest return
with less risk can be seen. So, it may be considered as optimal and the remaining all
including in feasible set will be considered as inefficient. The efficient frontier becomes
the tangential line, it may be called as Capital Market Line (CML) and the portfolio at
the point at which it is tangential (point M) is called the Market Portfolio.

What is CAPM?

The CAPM is used to identify the investor required rate of return under the
unchangeable risk conditions. The CAPM was introduced by Jack Treynor, William
Sharpe, John Lintner and Jan Mossin based on the earlier work of Harry Markowitz on
diversification and modern portfolio theory.
CAPM is most often used to determine what the fair price of an investment. The Capital
Asset Pricing Model explaining how the risky securities are priced in which depends on
the tradeoff between risk and return, and it works on with additional two key
assumptions. The first one is in market each and every investor can borrow and lend the
money at the risk free rate. The second one is that all investors are having similar
expectations in the market.

The CAPM takes into account of the asset's sensitivity to systematic risk. The systematic
risk referred as beta (β). The basic idea in CAPM is, competitive equilibrium is exists
across the capital market, the unsystematic risks can be eliminated through diversifying
and systematic risk only creating impact on the expected returns and that one is linearly
related with coefficient of beta.

Since the fundamental of portfolio theory is eliminating non-systematic risks of

investors through diversification, the investors can choose the best portfolio from assets
of different risk and return characteristics, to guarantee the minimum overall risk; also,
they can find a investment portfolio with the maximum return under a given risk or a
portfolio with the minimum risk under a given return

2.2 Advantages of the CAPM

Eliminates Unsystematic Risk

CAPM considers only systematic risk, by diversifying the portfolio unsystematic risk
can be avoided.

ii) Systematic Risk & Investment Appraisal

CAPM takes into consideration of systematic risk, and use the relationship between
required return and systematic risk for the investment appraisal.

iii) Ease of Use

CAPM is a easy method of calculating the outcomes based on required rate of returns.
Based on theoretically-derived relationship between required return and systematic
risk. It is seen as a much easier method of calculating the cost of equity.

Disadvantages of the CAPM

The CAPM endure from a number of drawbacks and limitations. .

 ● To utilize the CAPM required the following values of the risk-free rate of return,
the return on the market, or the Equity Risk Premium (ERP) and the equity beta.
● The risk-free rate of return is not fixed

● A short-term average value can be used in order to smooth out this volatility.

● Finding a value for the Equity Risk Premium is more difficult.

● The value of beta is not constant

● CAPM variables can be assumed constant in successive future periods

2.4 Assumptions of CAPM

Based on the following assumptions CAPM is working, they are as follows:

● Perfect capital market: according to this assumption all assets are marketable,
there is no transaction cost, taxes, inflation, or short selling restrictions.
● Investors can their investments based on expected return and standard
deviation. All financial assets are fully separable and can be sold at any time at
the market price.
● Investors can borrow or lend unlimited amounts at a risk-free (or zero risk) rate.

● All investors have the same expectations related to the market.

● All the investors can are having the same equal rights and information

● Single-period transaction horizon: A common investment period is believed by

the CAPM in order to make comparable the returns on different securities.
CAPM Equilibrium

The properties of equilibrium are now decided based on the CAPM assumptions. In the
market each and every one has the same information and expectations, which lead them
to build the similar portfolio frontier for risky assets and assess them based on expected
return and risk. The common portfolio developed by the investors consists of risky
market portfolio and the risk-free asset.

Portfolio Frontier

If everyone constructed the similar portfolio, which will make the differences in
between the investors return. That is the proportion of risky and risk free asset. If an
investor is not a risk taker, in is portfolio higher proportion will be the risk-free assets.
If he is a risk taker, his portfolio may hold a larger proportion of the market portfolio.
The market portfolio is supposed to be well-diversified. Every one of the investors are
purchasing the similar risky portfolio, no short selling, so equilibrium exist there
 Efficient frontier and market portfolio

Risk-return Trade off:

When investors are well diversified, they evaluate the attractiveness of a security based
upon its contribution to portfolio risk, rather than its volatility per se. The intuition is
that an asset with a low correlation to the tangency portfolio is desirable, because it
shifts the frontier to the left.

2.6 Security market line (SML)

The security market line (SML) explains the relationship of the expected return and
systematic risk (beta) and shows how the market reward-risk impact on individual
securities. The SML predicts the securities reward risk ratio based on overall market
and expects the securities return and risk is equal to overall market return and risk.
SML considers only the systematic risk, which is market oriented and is not able to
change or eliminate by diversification. Beta is the measure of risk of an investment
related to the whole market, and is used in the SML. It helps to measure the reward-to-
risk ratio for any security in relation to the overall market’s.

The SML curve indicating the return and risk how positively related. The higher the
risk yields the higher rate of return. The Beta of Market portfolio is always one, But the
individual securities can have the Beta greater than 1 or lesser than 1. The Beta is lesser
than 1 are less volatile securities and those with Betas above 1 are called aggressive and
volatile securities.

S
O
SML is Security Market Line, OS is the risk-free return, OP is the return of the market,
and its e Beta is 1; securities below Beta 1 are les volatile and others are highly volatile
securities in the market. SML can be represented symbolically by an equation as

Ri = Rf + Bi (Rm - Rf)
Ri is the return on the security, i,
Rf is Risk-free return
Rm is Market return.
βi is Beta of Scrip i related to Market Risk

If Rf = 15, Rm = 20 Bi = 1.5, which is more risky than the market average, then

Ri = 15 + 1.5 (20 - 15)

= 15 + 15 = 22.5% which is higher than the market return

Suppose the Bi is less risky than the market at 0.75 then

Ri = 15 + 0.75 (20 - 15)
= 15 + 7.5 = 18.75%, which is lower than the market return

From the above, we can calculate the expected return on a security and able to compare
it with the market return as greater or lesser than that. It can be a return on a security as
distinguished from a portfolio. In the SML if If Ri = Rf = 0 we can understand as the
security is correctly priced and its SML curve goes through the origin.
 Ri- Rf measures the excess return which varies with the risk taken, if market Beta = 1.
The security market line involves that the security and port-folio should be on SML, If
they are correctly priced. Beta values should then correctly represent the contribution to
the risk of the security to the portfolio. The SML curve presumed as significant in
portfolio selection and investment decision.
All assets lying above the SML are undervalued and those below the SML are
overvalued. The undervalued securities will provide more returns and vice versa.

2.7 Capital Market Line (CML)

The efficient frontier of CAPM is called as Capital Market Line (CML). The capital
market line reflects the relationship of total risk and expected return. Total risk includes
both systematic and unsystematic risks. It may also include the risk free assets to reduce
the total risk. CML helps to combine the risk-free assets with risky assets for a best
portfolio, whose risk-return profiles are greater to those of portfolios on the efficient
frontier.

Capital Market Line

The CAPM has two parts of the capital market return, one is for taking risk free return,
and the other for baring the risky, and both are measured by the slope of the CML line.
The capital market line is the parenthesis line to the efficient frontier that passes
through the risk-free rate on the expected return axis. All competent portfolios must
recline on this line which describes that there is a linear relationship between risk and
return for the selected financial assets chosen in equilibrium. Any financial asset above
the line will be preferred by the investors. The particular financial assets price will rise
or falls, until in equilibrium it lies on the line. The opposite applies to any portfolio
below the line. Its price will fall and return will rise, until it lies on the line. The CML
can be estimated based on the following formula

Rp = Rf + Rm - Rf

Rp is the return on the security, i,

Rf is Risk-free return
Rm is Market return.
is standard deviation of Market

is standard deviation of portfolio

Capital Asset pricing Model (CAPM)

CAPM and Single Index

CAPM is a renowned and acknowledged single factor model, CAPM is still one of the
best alternatives in the estimation of expected return for individual stocks and other
financial securities. CAPM helps to take the decisions like portfolio optimization, capital
budgeting, and performance evaluation. In CAPM the risk involved with the security is
called as Beta and it measured based on the in the security's covariance with the market
portfolio.

The CAPM model has three testable propositions: (1) the relationship between expected
return of a asset and its risk is linear, (2) beta is a absolute measure of a risk of a asset (3)
high risk should be rewarded by higher expected market return.

To identify the linearity between the expected return and risk of the security need to
make a hypothesis that the capital market is perfect and there is no information or
transaction cost. CAPM mentions as the expected return is based on risk and return
relationship. The main variation is that is imitative from the postulation about the
determination of returns. The returns are based on an equilibrium theory. In the single-
index model, the ‘I’ is typically believed as the market index. CAPM provides a enough
set off hypothesis for the single index model to be the true representation of the return.

The CAPM formula for estimating the returns according to Sharpe and Lintner
assumptions of risk-free borrowing and lending are expressed as follows:

E (Ri) = Rf + β [E (RM) - Rf] (1)

Where E (Ri) is the expected rate of return on the stocki, Rfis the rate of return on the
risk-free asset, and E (RM) is the expected rate of return on the market. This model is
called the single-factor model (Black, 1972) because it has only one independent
variable which is the market excess return [E (R)]

Where market Beta:

βiM = COV (Ri RM) (2)

σ² (RM)

Critique of the CAPM

The CAPM has also some disparages for its assumptions and Fama and French also
argues on the estimates of the cost of equity of CAPM are surely even less precise for
individual firms and projects. According to them the CAPM is also unrealistic in the
following cases
● Unrestricted Risk-Free Borrowing and Lending

● Relation between Market Beta and Expected Return

● CAPM focuses only on risk and return of one-period portfolio

Arbitrage pricing theory (APT)

CAPM single factor model, using the systematic and companies specific risk related to
the overall market return. CAPM model uses stock beta as the only risk measure the
arbitrage pricing theory is a multifactor model. To overcome the minuses in CAPM
Ross pointed a more general multiple factor structure for the returns generating
process, known as the Arbitrage Pricing Theory (APT). The APT is a multifactor model
used to describe the relation between the risk and expected return of securities. It
estimates the expected return for a security based on the security’s sensitivity to
movements in multiple macroeconomic factors. Then use the resultant expected return
to price the security. The APT works on three postulates. They are, the multifactor
model describes the relation between the risk and return of a security. Second, the
distinctive risk can be diversified away. Finally, efficient financial markets do not allow
for continuing arbitrage opportunities.

Arbitrage Pricing Theory Formula

The APT formula comprises a variable for each factor, and then a factor beta for each
factor, indicating the security’s sensitivity to movements in that factor.

A two-factor version of the arbitrage pricing theory formula is as follows:

E(rj) = rf + bj1RP1 + bj2RP2 + bj3RP3 + bj4RP4 + ... + bjnRPn

where:
E(rj) = the asset's expected rate of return
rf = the risk-free rate
bj = the sensitivity of the asset's return to the particular factor
RP = the risk premium associated with the particular factor

The APT was a radical one which allows the user to evaluate the security. Other pricing
models, just helps to know whether the security is undervalued or overvalued but APT
is very useful because it test the portfolios are exposed to certain factors.

Expected Rate of Return and Risk of Portfolio

The expected rate of return of the portfolio can be calculated in some alternative ways.
The Markowitz model focus was on the terminal value and applied for all the securities
in the portfolio. The expected rate of return of a portfolio should depend on the
expected rates of return of each security included in the portfolio. This alternative
method for calculating the expected rate of return on the portfolio is the weighted
average of the expected returns.

The contribution of each

security to the portfolios’ expected rate of return depends on its expected return and its
proportional share from the initial portfolio’s market value (weight).
2.1.5.8 Portfolio Risk
As like the previous methods, one might not be able to use the standard deviation to
measure the risk in portfolio because relationship between the securities in the same
portfolio must be taken into account. The relationship between the assets can be
estimated through covariance and coefficient of correlation. Covariance is more useful
for identification of the direction of relationship (positive or negative), coefficients of
correlation is the convenient measure of intensity and direction of the relationship
between the assets.

Here: Wa or Wb - portfolio’s
Portfolio A and B= Wa + Wb
Here: Sa or Sb Standard deviation of security A and B.
Kab- Coefficient of correlation between the returns of security A and B.

Standard deviation of the portfolio consisting n securities:

Here: Wi or Wj - portfolio’s initial value

Here: S1 or S2 are Standard deviation of security A and B.
Kij Coefficient of correlation between the returns of security A and B.

2.1.5.9 Evaluation of Portfolio Performance

Evaluation of the portfolios’ performance is necessary for investors. Performance

evaluation also indicates the areas of effectiveness as well as development in the
investment.

Portfolio performance evaluation is based on two fundamental concepts –

1. Return is related to risk and so the performance of a portfolio cannot be evaluated

only based on its return.

2. Two mutually exclusive and exhaustive approaches to portfolio management are

flaccid and active management.

2.1.5.10 Basic method of Assessing

The basic method of assessing the portfolio performance consist of the following

● Performance measurement

● Performance attribution

● Performance appraisal

Performance measurement involves the computing the return of a portfolio over a

specific period of time.

Performance appraisal is an estimation of how well a portfolio has been done over the
period. If there is no cash flow in the market, the portfolio's return is simply a
percentage change in its value during the evaluation period. The portfolio evaluation
can be estimated as

Rp = (MVE - MVB)/MVB

Where MVE = market value of the portfolio at the end of the evaluation period

MVB = market value of the portfolio at the beginning of the evaluation period

(Or)

When there are cash flows, the portfolio evaluation can be estimated as

Rp = (MVE - MVB - Contributions + Withdrawals) / MVB + Contributions

Where MVB = the value of the portfolio just before any contributions

MVE = the value of the portfolio just after any withdrawals

2.1.5.11 Calculation of Portfolio Returns

In the portfolio evaluations, if the period of evaluation is t, market value at the initial of
the period is MV0 and at the end of the period is MVt. Further, the cash inflows at the
start and end of the time period t are CF 0 and CFt. The return from the portfolio for this
period can be computed as:
2.1.5.12 Portfolio Return Components

The portfolio returns can be divided into three components.

P=M+S+A

Where, P is the expected return of the portfolio; M is the market return; S is the
difference between ideal return and market return; A is the active return.

2.1.5.13 Performance Attribution

The active return can be attributed into three components.

1. Pure sector selection: Pure sector selection assumes holding the same sectors in
the portfolio but in different proportions.
2. Within-sector selection return: here in portfolio, the assets are belonging to all
the sectors in the same proportion and the returns are generated by adjusting the
weights of securities in each sector.
3. Allocation/selection interaction return: This model consists of the weights of
both the securities and the sectors in the portfolio. Any increase in the weight of
a security will also increase the weight of that sector.

Where, RV = Value added return wP, j = Portfolio weight of sector j wB, j = Benchmark
weight of sector j RP, j = Portfolio return of sector j RB, j = Benchmark return of sector j RB =
Return of portfolio’s benchmark S = Number of sectors

PERFORMANCE EVALUATION
In order to determine the risk-adjusted returns of investment portfolios, several eminent
authors have worked since 1960s to develop composite performance indices to evaluate
a portfolio by comparing alternative portfolios within a particular risk class. The most
important and widely used measures of performance are:

● Treynor Measure

● Sharpe Measure

● Jenson Model
 ● Fama Model

The Treynor Measure

Developed by Jack Treynor, this performance measure evaluates funds on the basis of
Treynor's Index. This Index is a ratio of return generated by the fund over and above
risk free rate of return (generally taken to be the return on securities backed by the
government, as there is no credit risk associated),b during a given period and
systematic risk associated with it (beta). Symbolically, it can be represented as:

Treynor's Index (Ti) = (Ri - Rf)/Bi.

Where, Ri represents return on fund, Rf is risk free rate of return and Bi is beta of the
fund.

The Sharpe Measure

In this model, performance of a fund is evaluated on the basis of Sharpe Ratio, which is
a ratio of returns generated by the fund over and above risk free rate of return and the
total risk associated with it. According to Sharpe, it is the total risk of the fund that the
investors are concerned about.

So, the model evaluates funds on the basis of reward per unit of total risk. Symbolically,
it can be written as:

Sharpe Index (Si) = (Ri - Rf)/Si

Where, Si is standard deviation of the fund.

While a high and positive Sharpe Ratio shows a superior risk-adjusted performance of a
fund, a low and negative Sharpe Ratio is an indication of unfavorable performance.

Comparison of Sharpe and Treynor

Sharpe and Treynor measures are similar in a way, since they both divide the risk
premium by a numerical risk measure. The total risk is appropriate when we are
evaluating the risk return relationship for well-diversified portfolios. On the other hand,
the systematic risk is the relevant measure of risk when we are evaluating less than
fully diversified portfolios or individual stocks.
Jenson Model
Jenson's model proposes another risk adjusted performance measure. This measure was
developed by Michael Jenson and is sometimes referred to as the Differential Return
Method. This measure involves evaluation of the returns that the fund has generated vs.
the returns actually expected out of the fund given the level of its systematic risk. The
surplus between the two returns is called Alpha, which measures the performance of a
fund compared with the actual returns over the period. Required return of a fund at a
given level of risk (Bi) can be calculated as:

Ri = Rf + Bi (Rm - Rf)

Where, Rm is average market return during the given period.

Fama Model

The Eugene Fama model is an extension of Jenson model. This model compares the
performance, measured in terms of returns, of a fund with the required return
commensurate with the total risk associated with it. The difference between these two is
taken as a measure of the performance of the fund and is called net selectivity.

Required return can be calculated as:

Ri = Rf + Si/Sm*(Rm - Rf)

Where, Sm is standard deviation of market returns. The net selectivity is then calculated
by subtracting this required return from the actual return of the fund.

MUTUAL FUNDS:
A mutual fund is a professionally managed type of collective investment that pools
money from many investors to buy stocks, bonds, short-term money market
instruments, and/or other securities. In the United States, a mutual fund is registered
with the Securities and Exchange Commission (SEC) and is overseen by a board of
directors (if organized as a corporation) or board of trustees (if organized as a trust).
The board is charged with ensuring that the fund is managed in the best interests of the
fund's investors and with hiring the fund manager and other service providers to the
fund. The fund manager, also known as the fund sponsor or fund management
company, trades (buys and sells) the fund's investments in accordance with the
fund's investment objective.
A fund manager must be a registered investment advisor. Funds that are managed by
the same fund manager and that have the same brand name are known as a "fund
family" or "fund complex".
The Investment Company Act of 1940 (the 1940 Act) established three types of
registered investment companies or RICs in the United States: open-end funds, unit
investment trusts (UITs); and closed-end funds. Recently, exchange-traded funds
(ETFs), which are openend funds or unit investment trusts that trade on an exchange,
have gained in popularity. While the term "mutual fund" may refer to all three types of
registered investment companies, it is more commonly used to refer exclusively to the
open-end type.
Hedge funds are not considered a type of mutual fund. While they are another type of
commingled investment scheme, they are not governed by the Investment Company
Act of 1940 and are not required to register with the Securities and Exchange
Commission (though many hedge fund managers now must register as investment
advisors).
Mutual funds are not taxed on their income as long as they comply with certain
requirements established in the Internal Revenue Code. Specifically, they must diversify
their investments, limit ownership of voting securities, distribute most of their income
to their investors annually, and earn most of the income by investing in securities and
currencies.[2] Mutual funds pass taxable income on to their investors. The type of
income they earn is unchanged as it passes through to the shareholders. For example,
mutual fund distributions of dividend income are reported as dividend income by the
investor. There is an exception: net losses incurred by a mutual fund are not distributed
or passed through to fund investors.

Outside of the United States, mutual fund is used as a generic term for various types of
collective investment vehicles available to the general public, such as unit trusts, open-
ended investment companies (OEICs, pronounced "oyks"), unitized insurance funds,
UCITS (Undertakings for Collective Investment in Transferable Securities, pronounced
"YOU-sits") and SICAVs (société d'investissement à capital variable, pronounced "SEE-
cavs").

Advantages of mutual funds

Mutual funds have advantages compared to direct investing in individual securities.These
include:
● Increased diversification

● Daily liquidity

● Professional investment management

 ● Ability to participate in investments that may be available only to larger investors

● Service and convenience

● Government oversight

● Ease of comparison
Disadvantages of mutual funds
Mutual funds have disadvantages as well, which include[
● Fees

● Less control over timing of recognition of gains

● Less predictable income

● No opportunity to customize

Types of mutual funds

There are three basic types of registered investment companies defined in the
Investment Company Act of 1940: open-end funds, unit investment trusts (UITs); and
closed-end funds. exchange-traded funds (ETFs)are open-end funds or unit investment
trusts that trade on an exchange.

Open-end funds
Open-end mutual funds must be willing to buy back their shares from their investors at
the end of every business day at the net asset value computed that day. Most open-end
funds also sell shares to the public every business day; these shares are also priced at
net asset value. A professional investment manager oversees the portfolio, buying and
selling securities as appropriate. The total investment in the fund will vary based on
share purchases, redemptions and fluctuation in market valuation.

Closed-end funds
Closed-end funds [15] generally issue shares to the public only once, when they are
created through an initial public offering. Their shares are then listed for trading on a
stock exchange. Investors who no longer wish to invest in the fund cannot sell their
shares back to the fund (as they can with an open-end fund). Instead, they must sell
their shares to another investor in the market; the price they receive may be
significantly different from net asset value. It may be at a "premium" to net asset value
(meaning that it is higher than net asset value) or, more commonly, at a "discount" to
net asset value (meaning that it is lower than net asset value). A professional investment
manager oversees the portfolio, buying and selling securities as appropriate.
Unit investment trusts
Unit investment trusts or UITs issue shares to the public only once, when they are
created. Investors can redeem shares directly with the fund (as with an open-end fund)
or they may also be able to sell their shares in the market. Unit investment trusts do not
have a professional investment manager. Their portfolio of securities is established at
the creation of the UIT and does not change. UITs generally have a limited life span,
established at creation.

Exchange-traded funds
A relatively recent innovation, the exchange-traded fund or ETF is often structured as
an open end investment company, though ETFs may also be structured as unit
investment trusts, partnerships, investments trust, grantor trusts or bonds (as an
exchange-traded note). ETFs combine characteristics of both closed-end funds and
open-end funds. Like closed-end funds, ETFs are traded throughout the day on a stock
exchange at a price determined by the market. However, as with open-end funds,
investors normally receive a price that is close to net asset value. To keep the market
price close to net asset value, ETFs issue and redeem large blocks of their shares with
institutional investors.

Money market funds

Money market funds invest in money market instruments, which are fixed income
securities with a very short time to maturity and high credit quality. Investors often use
money market funds as a substitute for bank savings accounts, though money market
funds are not government insured, unlike bank savings accounts. Money market funds
strive to maintain a $1.00 per share net asset value, meaning that investors earn interest
income from the fund but do not experience capital gains or losses. If a fund fails to
maintain that $1.00 per share because its securities have declined in value, it is said to
"break the buck". Only two money market funds have ever broken the buck:
Community Banker's U.S.

Government Money Market Fund in 1994 and the Reserve Primary Fund in 2008. At the
end of 2009, money market funds accounted for 30% of the assets in all U.S. mutual
funds

Bond funds
Bond funds invest in fixed income securities. Bond funds can be subclassified according
to the specific types of bonds owned (such as high-yield or junk bonds, investment-
grade corporate bonds, government bonds or municipal bonds) or by the maturity of
the bonds held (short-, intermediate- or long-term). Bond funds may invest in primarily
U.S. securities (domestic or U.S. funds), in both U.S. and foreign securities (global or
world funds), or primarily foreign securities (international funds). At the end of 2009,
bond funds accounted for 20% of the assets in all U.S. mutual funds.[18]

Stock or equity funds

Stock or equity funds invest in common stocks. Stock funds may invest in primarily
U.S. securities (domestic or U.S. funds), in both U.S. and foreign securities (global or
world funds), or primarily foreign securities (international funds). They may focus on a
specific industry or sector. A stock fund may be subclassified along two dimensions: (1)
market capitalization and (2) investment style (i.e., growth vs. blend/core vs. value). The
two dimensions are oftener displayed in a grid known as a "style box." Market
capitalization or market cap is the value of a company's stock and equals the number of
shares outstanding times the market price of the stock. Market capitalizations are
divided into thefollowing categories:

● Micro cap

● Small cap

● Mid cap

● Large cap
While the specific definitions of each category vary with market conditions, large cap
stocks generally have market capitalizations of at least $10 billion, small cap stocks have
market capitalizations below $2 billion, and micro cap stocks have market
capitalizations below $300 million. Funds are also classified in these categories based on
the market caps of the stocks that it holds.

Stock funds are also subclassified according to their investment style: growth, value or
blend (or core). Growth funds seek to invest in stocks of fast-growing companies. Value
funds seek to invest in stocks that appear cheaply priced. Blend funds are not biased
toward either growth or value.
At the end of 2009, stock funds accounted for 45% of the assets in all U.S. mutual funds.
[19]
Hybrid funds
Hybrid funds invest in both bonds and stocks or in convertible securities. Balanced
funds, asset allocation funds, target date or target risk funds and lifecycle or lifestyle
funds are all types of hybrid funds.
Hybrid funds may be structured as funds of funds, meaning that they invest by buying
shares in other mutual funds that invest in securities. Most fund of funds invest in
affiliated funds (meaning mutual funds managed by the same fund sponsor), although
some invest in unaffiliated funds (meaning those managed by other fund sponsors) or
in a combination of the two. At the end of 2009, hybrid funds accounted for 6% of the
assets in all U.S. mutual funds