Ch 4 Mutual Funds

Q1. What is a Mutual Fund ?

Ans:1. Mutual fund is a professionally managed type of collective investment scheme that pools money from many
investors and invests it in stocks, bonds, short-term money market instruments and other securities.

2. Mutual funds have a fund manager who invests the money on behalf of the investors by buying / selling stocks, bonds etc.

3. investors prefer mutual funds is because mutual funds offer diversification. An investor‘s money is invested by the mutual
fund in a variety of shares, bonds and other securities thus diversifying the investor‘s portfolio across different companies and
sectors. This diversification helps in reducing the overall risk of the portfolio.

4. Mutual funds primarily deal in investor‘s money. Therefore a clear structure is laid out to ensure
proper governance. Mutual Funds in India follow a 3-tier structure
a. Sponsor : Sponsor (the First tier), who thinks of starting a mutual fund. The Sponsor approaches the Securities & Exchange
Board of India (SEBI), which is the market regulator and also the regulator for mutual funds.
The sponsor should have sound track record and general reputation of fairness and integrity in all his business transactions.
Sound track record shall mean the sponsor should
• Be carrying out the business of financial services for not less than five years
• Have positive net worth in all the preceding five years
• The net worth in the immediately preceding financial year is more than the capital contribution in the asset management
company
• Has profits after depreciation, interest and tax in three of out the five preceding years including the fifth year
The sponsor has contributed / contributes not less than 40% of the net worth of the asset management company

b.Trust :i. Once approved by SEBI, the sponsor creates a Public Trust (the Second tier) as per the Indian Trusts Act, 1882.
Trusts have no legal identity in India and cannot enter into contracts.
ii. Once the Trust is created, it is registered with SEBI after which this trust is known as the mutual fund. It is important to
understand the difference between the Sponsor and the Trust. They are two separate entities. Sponsor is not the Trust; i.e.
Sponsor is not the Mutual Fund. It is the Trust which is the Mutual Fund.

c.Trustee : a.Trusts have no legal identity in India and cannot enter into contracts, hence the Trustees are the people
authorized to act on behalf of the Trust. Contracts are entered into in the name of the Trustees.
b. The Trustees role is not to manage the money. Their job is only to see, whether the money is being managed as per stated
objectives. Trustees may be seen as the internal regulators of a mutual fund.

d. AMC :a. Role of the Asset Management Company (the Third tier) is to manage the investor’s money .
b.Trustees appoint the Asset Management Company (AMC), to manage investor‘s money.
c. The AMC in return charges a fee for the services provided and this fee is borne by the investors as it is deducted from the
money collected from them.
d. The AMC‘s Board of Directors must have at least 50% directors, who are not associate of, or associated in any manner
with, the sponsor or any of its subsidiaries or the trustees.
e.The AMC has to be approved by SEBI. The AMC functions under the supervision of its Board of Directors, and also under
the direction of the Trustees and SEBI. It is the AMC, which in the name of the Trust, floats and manages schemes by buying
and selling securities.
f.In order to do this, the AMC needs to follow all rules and regulations prescribed by SEBI and as per the Investment
Management Agreement it signs with the Trustees.
g.Whenever the fund intends to launch a new scheme, the AMC has to submit a Draft Offer Document to SEBI. This draft
offer document, after getting SEBI approval becomes the offer document of the scheme. The Offer Document (OD) is a legal
document and investors rely upon the information provided in the OD for investing in the mutual fund scheme.
e. Custodian : a.The assets of the mutual fund scheme are held by the custodian. A custodian‘s role is safe keeping of
physical securities and also keeping a tab on the corporate actions like rights, bonus and dividends declared by the companies
in which the fund has invested.
b. The Custodian is appointed by the Board of Trustees. Since the custody of the assets is separated from the
management it protects the investors against fraud and misappropriation.
c. The holdings are held in the Depository through Depository Participants (DPs). Only the physical securities are held by the
Custodian. The deliveries and receipt of units of a mutual fund are done by the custodian or a depository participant at the
instruction of the AMC and under the overall direction and responsibility of the Trustees.

Q2. What is an NFO?

a.Once the 3 – tier structure is in place, the AMC launches new schemes, under the name of the Trust, after getting approval
from the Trustees and SEBI. The launch of a new scheme is known as a New Fund Offer (NFO).
b. It is like an invitation to the investors to put their money into the mutual fund scheme by subscribing to its units.
Q3. What is the role of a Registrar and Transfer Agents?
Ans: Registrars and Transfer Agents (RTAs) perform the important role of maintaining investor records. All the New Fund
Offer (NFO) forms, redemption forms (i.e. when an investor wants to exit from a scheme, it requests for redemption) go to the
RTA‘s office where the information is converted from physical to electronic form .

Q4. What is the Procedure for investing in an NFO?

Ans:a. But before investing in mutual funds or NFOs, the investor must have the KYC in place. The mutual funds or the KYC
Registration Agencies (KRAs) must be approached to complete the KYC formalities
b. Once these formalities are complete, the investor has to fill a form, which is available with the
distributor or online.
c. In case the investor does not read the OD, he must read the Key Information Memorandum (KIM), which is available with
the application form. Investors have the right to ask for the KIM/ OD from the distributor.
d. Once the form is filled and the cheque is given to the distributor, he forwards both these
documents to the RTA.

e. After the cheque is cleared, the RTA then creates units for the investor .

Q5. What are the different schemes offered by Mutual Funds?

1) Equity funds – funds that primarily invests in equity shares of companies.

a.Equity funds essentially invest the investor‘s money in equity shares of companies.
b.Fund managers try and identify companies with good future prospects and invest in the shares of such companies.
c. The prices of listed securities fluctuate based on liquidity, international scenario and numerous other factors. Therefore
investment in equity funds carries higher risk. It is necessary for an investor to understand the features of equity investments
in terms of risk and return before investing.
2) Debt funds - funds which invest in debt instruments such as short and long term bonds,
government securities, t-bills, corporate paper, commercial paper, call money etc.
3) Hybrid funds - These are funds which invest in debt as well as equity instruments
4) Gold ETF – An exchange traded fund that buys and sells gold.
5) Real estate funds – These funds invest in properties.

Q6. What are open ended and Close Ended Funds?

• Equity Funds (or any Mutual Fund scheme for that matter) can either be open ended or close ended.
• An open ended scheme allows the investor to enter and exit at his convenience, anytime (except under certain conditions)
whereas a close ended scheme restricts the freedom of entry and exit.
• Whenever a new fund is launched by an AMC, it is known as New Fund Offer (NFO). Units are offered to investors at the
par value of Rs. 10/ unit.

Q7.Explain Index funds.

Ans: a.Index Funds invest in stocks comprising indices, such as the Nifty 50, which is a broad based index comprising 50
stocks. There can be funds on other indices which have a large number of stocks such as the Nifty Midcap 100 or Nifty 500.
b. Here the investment is spread across a large number of stocks. In India today we find many index funds based on the Nifty
50 index, which comprises large, liquid and blue chip 50 stocks.

Q8. What are Diversified large Cap Funds?

Another category of equity funds is the diversified large cap funds. Cap refers to market capitalization. Market capitalization
refers to aggregate valuation of the company based on the current market price and the number of shares issued. Accordingly
companies are classified into
Large cap companies– typically the top 100 to 200 stocks which feature in Nifty 50
Mid cap companies– Stocks below large cap which belong to the mid cap segment
Small cap – companies – Typically stocks with market capitalization of less than Rs. 5000 cr.
a.Large cap funds restrict their stock selection to the large cap stocks It is generally perceived that large cap stocks are those
which have sound businesses, strong management, globally competitive products and are quick to respond to market
dynamics. Therefore, diversified large cap funds are considered as stable and safe. The stocks command high liquidity.
b.However, since equities as an asset class are risky, there is no return guarantee for any type of fund. These funds are actively
managed funds unlike the index funds which are passively managed, In an actively managed fund the fund manager pores
over data and information, researches the company, the economy, analyses market trends, takes into account government
policies on different sectors and then selects the stock to invest. This is called as active management .

Q9. What are Midcap Funds?

Midcap funds, invest in stocks belonging to the mid cap segment of the market. Many of these midcaps are said to be the
̳emerging blue chips‘ or ̳tomorrow‘s large caps‘. There can be actively managed or passively managed mid cap funds. There
are indices such as the CNX Midcap index which tracks the midcap segment of the markets and there are some passively
managed index funds investing in the CNX Midcap companies.

Q10. Explain Other Equity Schemes:

Ans: 1 Arbitrage Funds
These invest simultaneously in the cash and the derivatives market and take advantage of the price differential of a stock in
the cash and derivative segment by taking opposite positions in the two markets (for e.g. cash and stock futures).
2 Multi cap Funds
These funds can, theoretically, have a small cap portfolio today and a large cap portfolio tomorrow. The fund manager has
total freedom to invest in any stock from any sector.
.3 Quant Funds
In case of these funds quantitative models are used for stock selection and allocation of weights based on company‘s size,
financial performance and liquidity.
4. International Equities Fund
This is a type of fund which invests in stocks of companies outside India. This can be a Fund of Fund, whereby, we invest in
one fund, which acts as a ̳feeder‘ fund for some other fund(s), .i.e invests in other mutual funds, or it can be a fund which
directly invests in overseas equities. These may be further designed as ̳International Commodities Securities Fund‘ or ̳World
Real Estate and Bank Fund‘ etc
5. Growth Schemes
A mutual fund whose aim is to achieve capital appreciation by investing in growth stocks. They focus on companies that are
experiencing significant earnings or revenue growth, rather than companies that pay out dividends.
6.ELSS
Equity Linked Savings Schemes (ELSS) are equity schemes, where investors get tax benefit upto Rs. 1.5 lacs under section
80C of the Income Tax Act. These are open ended schemes but have a lock in period of 3 years. These schemes serve the dual
purpose of equity investing as well as tax planning for the investor. However it must be noted that investors cannot, under any
circumstances, get their money back before 3 years from the date of investment.
Q11. What is the Importance of basic Offer Documents (SID AND SAI)?
Ans: Prior to investing, every investor needs to be aware of the basic objective, term and investment philosophy of the
scheme. These are fundamental features of the fund and cannot be altered by the fund house without investor approval.
Mutual Fund Offer Documents have two parts:
• Scheme Information Document (SID), which has details of the scheme
• Statement of Additional Information (SAI), which has statutory information about the mutual fund, that is offering the
scheme.
a.The Scheme Information Document sets forth concisely the information about the scheme that a prospective investor ought
to know before investing. Before investing, investors should also ascertain about any further changes to this Scheme
Information Document after the date of this Document from the Mutual Fund / Investor Service Centres / Website /
Distributors or Brokers.
b.The investors are advised to refer to the Statement of Additional Information (SAI) for details of
________ Mutual Fund, Tax and Legal issues and general information on www.__________.
(Website address)
SAI is incorporated by reference (is legally a part of the Scheme Information Document). For a free copy of the current SAI,
please contact your nearest Investor Service Centre or log on to our website.
The Scheme Information Document should be read in conjunction with the SAI and not in isolation‖.

Q12. What is the Key Information Document?

The Key Information Memorandum (KIM) is a summary of the SID and SAI. As per SEBI
regulations, every application form is to be accompanied by the KIM. The important contents of KIM are:
• Name of the AMC, mutual fund, Trustee, Fund Manager and scheme
• Dates of Issue Opening, Issue Closing & Re-opening for Sale and Re-purchase
• Plans and Options under the scheme
• Risk Profile of Scheme
• Price at which Units are being issued and minimum amount / units for initial purchase,
additional purchase and re-purchase
• Benchmark
• Dividend Policy
• Performance of scheme and benchmark over last 1 year, 3 years, 5 years and since
inception.
• Loads and expenses

Q13. What is NAV?

Net Assets of a scheme is the market value of assets of the scheme less all scheme liabilities. NAV i.e. net asset value is
calculated by dividing the value of Net Assets by the outstanding number of Units .
Formula for NAV

Q14. What are expenses incurred in relation to a ccheme?

Ans: There are two types of expenses incurred by a scheme
Initial issue expenses – these expenses are incurred when the NFO is made. These need to
be borne by the AMC.
Recurring expenses – These expenses are incurred regularly. These include
o fees paid to trustees, custodians, auditor, registrar and transfer agents
o selling and commission expenses
o listing fees and depository fees
o expenses related to investor communication
o service tax
SEBI has clearly laid down limits for expenses that can be charged to the scheme .
Q15. What is Expense Ratio?
Ans: Expense Ratio is defined as the ratio of expenses incurred by a scheme to i ts Average
Weekly Net Assets. It means how much of investors‘ money is going for expenses and
how much is getting invested. This ratio should be as low as possible.
Q16.What is Portfolio Turnover?
Ans:Portfolio Turnover is the ratio which helps us to find how aggressively the portfolio is being churned. While churning
increases the costs, it does not have any impact on the Expense Ratio, as
transaction costs are not considered while calculating expense ratio. Transaction costs are included
in the buying & selling price of the scrip by way of brokerage, STT, cess, etc. Thus the portfolio
value is computed net of these expenses and hence considering them while calculating Expense
Ratio as well would mean recording them twice – which would be incorrect.
Q17. How to Analyse Cash Level in Portfolios?
Ans: a.The next logical point of focus must be the Cash Level in the scheme. The Cash level is the amount of money the
mutual fund is holding in Cash, i.e. the amount not invested in stocks and bonds but lying in cash.
b.If the scheme is having higher than industry average cash levels consistently, more so in a bull market, it will lead to a
inferior performance by the scheme than its peers. However, in a falling market, it is this higher cash level that will protect
investor wealth from depleting.
Hence whenever one is analyzing cash levels, it is extremely important to see why the fund manager is
holding high cash levels.

Q18. What are Exit Loads?

Ans:Exit Loads, are paid by the investors in the scheme, if they exit one of the scheme before a specified time period. Exit
Loads reduce the amount received by the investor. Not all schemes have an Exit Load, and not all schemes have similar exit
loads as well. Some schemes have Contingent Deferred Sales Charge (CDSC). This is nothing but a modified form of Exit
Load, where in the investor has to pay different Exit Loads depending upon his investment period.