Preparatory Material for NISM-

Mutual Fund Distributors’ Examination

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Examination. c) 2015, Centre for Investment Education and Learning Pvt. Ltd. www.ciel.co.in 1
CHAPTER 1 - CONCEPT AND ROLE OF A MUTUAL FUND (6 Marks)

1.1 Introduction
 A mutual fund is a collective investment vehicle, which pools investors’ money and invests it.
 Those who contribute to the pool are the ones who get the benefit (mutuality principle).
 Benefits accrue in the proportion to the investors’ share in the pool.
 A mutual fund product is described by its investment objective that defines the risk return
profile of the fund.
 Before investing, investors match their objectives with the funds’ investment objectives.
 Mutual funds offer different “schemes” with different investment objectives for investors.
 Every mutual fund scheme holds an investment portfolio. A portfolio is a collection of
securities.
 Mutual funds can invest only in marketable securities.
 The mutual fund portfolio has to be marked to market. ‘Marking to market’ is a process of
using market price to value the investment portfolio.
 Value of the investment portfolio changes with a change in market price of the securities.
 Mutual funds are first offered to an investor in a NFO (New Fund Offer).
 Unit capital is the corpus of the fund and is calculated as number of units * face value.
 Assets Under Management (AUM) of a mutual fund is calculated as Market value of portfolio
+ current assets
 A mutual fund does not hold any long-term assets or liabilities.
 Net assets are calculated as Market value of portfolio + current assets – Current liabilities –
Accrued expenses.
 Net Asset Value (NAV) is the value per unit at current market prices and is calculated as net
assets divided by units outstanding.
 The net assets of a mutual fund may go up or down due to various reasons. Some of them
are:
 entry or exit of investors
 income from dividends or interest
 expenses
 realised gains or losses
 unrealised gains or losses.
 Following are the advantages of mutual funds:
 Portfolio diversification
 Low transaction cost
 Professional fund management
 Higher flexibility
 Protection of investor interest
 Tax advantages
 Liquidity
 Systematic investments
 Following are limitations of mutual funds:
 Portfolios are not customised or personalised to each investor
 Too many product variants
 No control over costs.

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1.2 Mutual Fund Products
 SEBI has introduced categorisation of open-end mutual funds to ensure uniformity in
characteristics of similar type of schemes launched by different mutual funds. This will help
investors to evaluate the different options available before making informed decision to
invest.
 Open ended funds do not have a fixed maturity date. These funds accept continuous sale
and re-purchase requests at fund offices and ISCs.
 Transactions of open ended funds are NAV-based. Unit capital of this kind of fund is not
fixed.
 Closed end funds run for a specific period and are offered in an NFO but are closed for
further purchases after the NFO.
 Closed end funds are required to be compulsorily listed on a stock exchange, in order to
provide liquidity. Unit capital if a closed end fund is kept constant.
 Interval fund is a variant of closed-ended funds. These are primarily closed-ended but
become open-ended at specific intervals. Minimum duration of interval is 15 days.
 Specified Transaction Period (STP) is the duration when they become open-ended. The
minimum STP is 2 days, no redemption allowed except during STP.
 Interval schemes also have to be mandatorily listed.
 Debt funds invest in short and long term debt instruments with an objective of earning
regular income.
 Equity invest in equity securities for capital appreciation.
 Hybrid funds invest in a combination of equity and debt for both income and capital
appreciation.
 Equity funds have a greater degree of risk as compared to a debt funds
 Liquid funds are the least risky, as they invest in very short-term securities
 Active funds seek to invest in securities and sectors that may offer a better return than the
index.
 Active funds manage the allocation to market securities and cash and may perform better or
worse than the market index. Active funds incur a higher cost than passive funds.
 Passive funds replicate a market index. They invest in the same securities and in the same
proportion as that of the index. An index fund replicates the index.
 Investment management of a passive fund does not involve active stock or sector selection.
Hence, expenses of a passive fund are lower than that of an active fund.
 Portfolio of a passive fund is modified each time the index composition changes. Index fund
is an example of a passive fund.
 Performance of passive funds with their peers is measured with the help of tracking error.
 Equity funds are recommended for the long term (five years and above)
 Balanced funds are recommended for three years and above
 Debt funds are recommended for medium term (one year and above)
 Short duration funds are recommended for the short term (up to one year)
 Liquid funds are recommended for ultra-short periods (up to a month)
 Equity funds invest in equity shares; Debt funds invest in debt securities;
 Money market funds invest in money market securities; Commodity funds invest in
commodity-linked securities;
 Real estate funds invest in property-linked securities; Gold funds invest in gold-linked
securities
 liquid funds invest very short term maturity debt securities with less than 91 days to
maturity.

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  Primary source of income for money market or liquid funds is interest. Marking to market is
not followed for securities less than 91 days to maturity.
 Money market or liquid funds ensure safety of principal and offer superior liquidity. These
funds are used primarily by large corporate investors and institutional investors.
 Floating rate funds invest largely in floating rate debt securities. Primary source of income for
these funds is interest income which is in line with the market interest rates.
 Because of their nature, these floating rate funds have lower mark to market risk. Floating
rate funds are attractive when the interest rates are rising.
 Cash or Treasury Management Funds are similar to liquid funds. These funds choose
securities with slightly longer tenor of up to 364 days.
 Gilt funds invest in government securities of medium and long-term maturities. Since
investment is made in government securities, there is no risk of default.
 Gilt funds are exposed to interest rate risk, depending upon maturity profile.
 Income funds invest in medium-term and long-term securities issued by the government,
banks and corporate. These are in the form of medium duration and long duration funds.
 Income funds enjoy the benefit of higher coupon. These funds are exposed to higher credit
risk. Due to long term orientation these funds are also exposed to high interest rate risk.
 Maturity profile of a dynamic bond fund varies according to the interest rate view.
 High-yield debt funds seek higher interest income by investing in debt instruments that have
lower credit ratings. These funds are also known as ‘junk bond funds’ and are not permitted
in India.
 Fixed Maturity Plans (FMPs) are closed-end funds that invest in debt instruments with
maturities that match the term of the scheme. On maturity the debt securities are redeemed
and paid to investors. FMPs carry no interest rate risk. These schemes are ideal for investors
looking for predictable return.
 Short duration funds combine long and short term debt securities with Macaulay duration of
the portfolio between 1 to 3 years. These funds earn interest from short term securities and
capital gains from long term securities.
 Diversified equity funds invest in equity shares across various sectors, sizes and industries
and are less risky compared to other equity funds.
 Thematic equity funds funds follow a particular theme and invest in multiple sectors and
stocks falling within that theme. These funds are less diversified than a diversified equity
fund.
 Sector equity funds invest in a given sector. Sector funds are concentrated funds and
feature high risk because sector performances tend to be cyclical.
 Focused funds are equity funds that restrict portfolio to a particular number of selected
securities. These funds have selection risk.
 Growth funds invest in companies whose earnings are expected to grow at an above-average
rate.
 Value funds identify stocks of good quality companies whose real worth has not been
realised yet.
 Mid-cap and Small-cap funds focus on smaller and emerging companies for their higher
growth potential.
 To ensure uniformity of investment universe for equity schemes, SEBI has defined large cap,
mid cap and small cap as follows:
o Large Cap: 1st -100th company in terms of full market capitalization
o Mid Cap: 101st -250th company in terms of full market capitalization
o Small Cap: 251st company onwards in terms of full market capitalization

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  Dividend Yield Funds: These funds invest in companies that have a high dividend yield.
 Dividend yield funds are attractive in bearish and over-valued markets due to less volatility
and regular dividend income.
 Index funds are passive funds based on equity indices.
 Equity-Linked Savings Scheme (ELSS) offers tax benefits u/s 80C of the Income Tax Act.
Investment up to Rs. 150,000 in a year in such funds can be deducted from taxable income
of individual investors.
 An ELSS scheme must hold at least 80% of the portfolio in equity securities. ELSS schemes
have a lock-in period of 3 years from the date of investment.
 Conservative Hybrid Funds are debt oriented schemes with smaller allocation to equity (10%
to 25%). These funds offer periodic distribution of dividends, though there is no assurance of
such payout.
 Aggressive hybrid funds are equity-oriented hybrids that invest 65% to 80% in equity. These
funds are aimed at investors who seek growth from equity but want protection from volatility.
 Dynamic Asset Allocation Funds are dynamic funds that can change proportion between debt
and equity depending upon market outlook.
 Capital Protection-Oriented Funds invest in debt securities with a derivative instrument or
equity shares. These funds structure a portfolio such that ‘Amount invested + Interest =
Investor’s principal’.
 Fund of Funds (FOFs) invest in funds of same fund house or various fund houses (Multi-
manager).
 An FoF scheme chooses funds according to its investment objective. Fund of fund schemes
have two levels of expenses - underlying fund level and FoF level.
 International Funds invest in foreign securities or foreign funds. A ‘Feeder‘fund ties up with
the ‘Host’ fund in a FoF structure. An investor who has invested in an international fund
investing in US securities will benefit when the dollar depreciates. NAV of an international
fund is affected by changes in forex rates.
 In an international fund, weakness in the foreign currency can adversely impact the total
return to the investor. Appreciation in the foreign currency will boost portfolio performance.
 Arbitrage funds take equal and opposite exposure in the spot and future markets. These
funds earn a return due to difference in price in the two markets. Arbitrage funds carry low
risk and return similar to debt funds.
 Exchange Traded Funds (ETF)are open-ended funds that track a market index. Units of ETFs
are listed like shares on the stock exchange.
 Sale and re-purchase transactions of ETFs are executed on stock exchange using demat.
accounts. Transactions are executed at market prices, which may be different from the NAV.
 In India, direct investment in commodity futures is not allowed. Indian commodity funds
usually invest in stocks of commodity companies or commodity ETFs.
 Gold Funds are structured as ETFs.
 A REIT is a fund investing directly in real estate through properties or mortgages. Regulations
for launching REITs in India are yet to be passed.
 Infrastructure debt funds invest 90% of their assets in debt securities or securitised debt
instruments of infrastructure companies.
 InvITs are trusts registered with SEBI that invest in the infrastructure sector

1.3 Role of Mutual Funds

 Mutual funds offer products that enable access to various markets to investors.

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  With respect to the issuers of various securities, mutual funds are institutional investors
seeking better return, lower risk.
 The mutual fund industry is competitive and well-regulated.
 Public sector mutual funds came in 1980s and the private/foreign funds came in 1990s.
 About 60% of assets are in short term debt funds, favoured by institutional investors.
 Regulators and the mutual fund industry have taken various measures to increase retail
participation.

CHAPTER 2 - FUND STRUCTURE AND CONSTITUENTS (4 Marks)

2.1 Structure of Mutual Funds

 Mutual funds have a three-tier structure of Sponsor-Trust-Asset Management Company.
 Sponsor promotes the mutual fund and sets up the AMC. Sponsor’s role is similar to that of a
promoter of a company.
 Sponsor appoints the Board of Trustees and Board of Directors of the AMC. Sponsor seeks
regulatory approval for launch of mutual fund.
 In order to be a sponsor, SEBI has laid down eligibility criteria as follows:
a. At least 5 years experience in the financial services industry
b. Positive net worth over the last 5 financial years
c. Profits over the last 3 out of 5 years
d. At least 40% contribution to the capital of the AMC.
 Mutual fund is structured as a trust, overseen by a Board of Trustees. Trustees are
appointed by the sponsor with SEBI approval.
 Trust deed is executed by the Sponsor in favour of the trustees. Trustees can be a Board of
Trustees or Trustee Company. Working of a Trustee company is handled by its Board of
Directors.
 Investors in the mutual fund are beneficiaries of the trust. Trustees must act on behalf of the
investors.
 Sponsor must appoint at least 4 trustees. At least 2/3rds of the members have to be
independent.
 Trustees appoint the AMC to manage the affairs of the fund. The Board of Trustees oversee
the working of the AMC and management of the mutual fund.
 Key decisions of the AMC require trustee approval. Trustees meet at least 6 times in a year.
 Asset Management Company (AMC) is the investment manager of the mutual fund. AMC is
appointed by the Trustees, with SEBI approval.
 Investment Management Agreement is executed between the trustees and the AMC.
 An AMC should have a net worth of at least Rs.50 crore at all times.
 AMCs in existence before May 2014 have to comply with the net worth requirement of Rs.
50 crores within 3 years of the date of the SEBI circular.
 At least 50% of members of the board of an AMC have to be independent.
 The AMC of one mutual fund cannot be an AMC or trustee of another fund.
 AMCs cannot engage in any business other than that of financial advisory and investment
management.
 An AMC must invest seed capital of 1% of the amount raised subject to maximum of Rs.50
lakh in all open-ended schemes through the lifetime of the scheme.

2.2 Mutual Fund Constituents

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  AMCs appoint other external agencies to support the functions of the mutual fund. These are
called constituents. The following table shows the summary of the role of each constituent:
Constituent Role
Custodian Hold funds and securities
R&T Agent Keep and service investors’ records
Banks Enable collection and payment
Auditor Audit scheme accounts
Distributors Distribute fund products to investors
Brokers Execute transactions in securities
Fund Accountants NAV calculation
 Mutual fund constituents (except custodians) are appointed by the AMC with the approval of
the trustees.
 All mutual fund constituents have to be registered with SEBI. They are usually paid fees for
their services.
 An R&T Agent is responsible for issue and redeeming units and updating the unit capital
account.
 R&T Agent accept and process investor transactions such as purchase, redemption and
switches. They create, maintain and update investor records.
 R&T Agents are responsible for bank the payment instruments given by investors and
notifying the AMC.
 R&T Agents process payouts to investors in the form of dividends and redemptions and send
statutory and periodic information to investors.
 A custodian holds cash and securities of the mutual fund.
 Custodian is appointed by the Trustees and is the only constituent NOT directly appointed by
the AMC.
 A custodian must be independent of the sponsor and its associates.
 Functions of the custodian include delivering and accepting securities and cash, tracking
and completing corporate actions and payouts on the securities, and coordinating with the
depository participants (DPs).
 Custodial functions cannot be done in-house by the AMC.
 Distributors are appointed by the AMC in order to sell mutual fund units to investors.
 Distributors enable the reach of mutual fund products across geographical locations.
 Commission is paid to distributors on sale of mutual fund units. There’s no exclusivity in
mutual fund distribution.
 Sponsor and its associates may act as the distributors of the fund.
 Brokers execute buy and sell transactions of the fund managers.
 Banks provide collection and payment services. Payment instruments are collected in
mutual fund scheme accounts.
 Banks carry out redemption and dividend payments.
 Auditors audit the books of the mutual fund.
 Account of each mutual fund scheme is kept separately.
 Auditors of mutual fund are different from auditors of the AMC.
 To avoid duplication of KYC formalities by the client every time they open an account with a
Sebi-registered intermediary, Sebi has introduced the system of KYC Registration Agencies
(KRA).
 Intermediaries include mutual funds, DPs, stock brokers, portfolio managers, venture capital
funds and collective investment schemes.

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  The KRA is a centralized agency which will maintain and make available the information
provided by a client to an intermediary to comply with the KYC norms.
 The intermediary has to upload the information onto the KRA system and dispatch the
supporting documents. The KRA will send a letter to the investor within 10 days of receipt of
the same confirming the details. Subsequent account opening by the client with any other
intermediary will just require the information to be downloaded from the KRA system and
verified.
 cKYC is a structure to allow investors to complete KYC only once before interacting with
various entities across the financial sector. cKYC is managed by CERSAI (Central Registry of
Securitization Asset Reconstruction and Security Interest of India) and will act as CKYCR
(Central KYC Registry) of the Government of India.
 Sebi has also mandated an In Person Verification (IPV) of the client by the intermediary with
whom the client conducts the KYC formalities. The name, designation, organisation and
signature of the person doing the IPV should be recorded on the KYC form.
 The AMC and distributors who are KYD compliant are authorised to conduct IPV of mutual
fund investors. In case of direct applicants, IPV conducted by a scheduled commercial bank
can be relied upon.
 Payment aggregators provide the means for facilitating payment from the consumer
via credit cards or bank transfer to the mutual fund. The mutual fund is paid by the
aggregator.


CHAPTER 3 - LEGAL AND REGULATORY FRAMEWORK (10 MARKS)

3.1 Key Agencies in Regulation

 SEBI is primarily responsible for safeguarding the interests of the investors.
 Indian mutual funds are supervised and regulated by SEBI (Mutual Funds) Regulations,
1996.
 SEBI issues amendments and circulars to the regulations from time to time.
 SEBI was set up by the SEBI Act, 1992 and is supervised by the Ministry of Finance.
 All the mutual fund constituents such as registrars, custodians, brokers, collecting banks
must be registered with SEBI.
 Distributors have to clear the mandatory certification prescribed by SEBI.
 AMC and Trustee company are also governed by the Companies Act and Indian Trusts Act
respectively.
 RBI regulates banks in India. Banks can act as sponsors, custodians, bankers and
distributors of mutual funds.
 Mutual funds also invest in money market instruments and g-secs.
 Money and debt markets are regulated by RBI and to that extent, mutual funds are subject
to regulations laid down by RBI.
 Mutual funds enter into listing agreement with stock exchanges for closed-ended funds/ETFs
that are listed on stock exchanges.
 They are subject to regulatory and disclosure requirements laid down in the listing
agreement.
 AMFI is an industry association. It is not a Self Regulating Organisation (SRO). It cannot form
rules of its own. An SRO is set up by a statutory body which sets out policy framework,
leaving micro regulation to SRO.

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  AMFI is responsible for recommending best business practices and code of conduct for
members. It represent the industry to regulators and policy makers.
 AMFI conducts conduct investor awareness programmes and disseminates information on
mutual funds.
 AMFI Code of Ethics (ACE) sets out guidelines for mutual fund’s relationship with investors,
intermediaries and the public. It has been adopted by SEBI as a part of the mutual fund
regulation.
 AMFI Guidelines and Norms for Intermediaries (AGNI) is a code of conduct for mutual fund
intermediaries.
 Distributors have to pass the NISM exam and get register with AMFI in order to get the AMFI
Registration Number (ARN).
 AMFI can issue notice, impose penalties and cancel the registration of distributors.

3.2 Guidelines on Unauthenticated News

 Market intermediaries to have internal code of conduct and controls to not encourage or
circulate rumours or unverified information obtained from client, industry, any trade or any
other sources without verification.
 Access to Blogs/Chat forums/Messenger sites etc. should either be restricted under
supervision or access should not be allowed.
 Logs for any usage of such Blogs/Chat forums/Messenger sites shall be treated as records
and the same should be preserved.
 Employees can forward any market related news received by them either in their official
mail/personal mail/blog or in any other manner, only after the same has been seen and
approved by the Compliance Officer.

3.3 Investment Restrictions for Schemes

 General Restrictions
o Buying and selling of securities is on delivery basis.
o Shall not advance any loans.
o Mutual fund scheme cannot invest in the unlisted or privately placed securities of
any associate or group company of the sponsor.
o Investment in the listed securities of the group companies of the sponsor is limited
to 25% of the net assets.
o They may invest in other schemes of the same Mutual Fund or other Mutual Funds,
limited to not more than 5% of the net asset value of the scheme.
o No fees are charged on such investments. This does not apply to Fund of Funds.
o All the Mutual Fund schemes cannot own more than 10% of a company paid up
capital bearing voting rights.

 Restrictions pertaining to investment in Debt Securities:

o A mutual fund scheme cannot invest more than 10% of its NAV in debt instruments
issued by a single issuer. This can be extended to 12% with the approval of the
trustees.
o Investment in unrated debt securities of a single issuer is limited to 10% of its net
assets and the total investments in such securities cannot exceed 25%.
o These limits do not apply to investments in Government securities, treasury bills and
CBLO.

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 o Investments in Short-term deposits with all scheduled commercial banks is limited
to 15% of the net assets of the scheme. This can be raised to 20% with the approval
of the trustees.
o The Scheme cannot invest in the short-term deposits of a bank that has invested in
the scheme.
o No management fee will be charged for such investments by the scheme.

 Group Exposure:
o Mutual Funds/AMCs should ensure that the total exposure of debt schemes shall
not exceed 25% of the net assets of the scheme.

 Restrictions pertaining to investment in Equity:

o At least 80% of the ELSS’ funds should be invested in equity and equity-linked
securities.
o A mutual fund scheme cannot invest more than 10% of its net assets in the equity
shares and equity related instruments of a company.
o Not more than 5% of the net assets of the scheme will be invested in unlisted equity
shares and equity related instruments.

3.4 Distributor Due Diligence

 AMCs are required to put in place a due diligence process to evaluate distributors at the time
of empanelment and subsequent review
 The due diligence initially will be applicable to those distributors satisfying one or more of the
following conditions :
a) Multiple point presence in more than 20 locations.
b) AUM raised over Rs.100 crore across industry in the non-institutional category but
including high net worth individuals (HNIs).
c) Over one crore p.a. received as commission across industry.
d) Over Rs 50 lakh received as commission from a single mutual fund.
 The distributors will be evaluated on the following aspects:
a) Experience and proficiency in the business.
b) History of regulatory compliance and conduct
c) Checks and balances to delink sales and client relationship from the process of
customer risk and mutual fund scheme evaluation processes.
d) Process for periodic review and categorization of products and risk profile of the
investors.
 Customer relationship and transaction to be categorized as “Advisory” and “Execution only”.
 Advisory: Where a distributor offers advice while distributing a product based on its
suitability for the investor’s risk appetite and need.
 Execution only: Where transactions are conducted despite the unsuitability of the
product to the investor’s requirements being communicated to the investor. No fee to
be charged on such transactions except transactions charges as applicable.
 Compliance and Risk Management process of distributor should have processes for:
a) Criteria used for review of products, periodicity of review.
b) Factors for determining risk appetite of customer.
c) Review of transactions, exceptions, escalation and resolution process by internal audit.
d) Recruitment, training, certification and performance review of all personnel engaged.
e) Customer on-boarding, relationship management process, service standards, grievance
handling mechanism.

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 f) Internal/external audit process, their comments and observation relating to the MF
distribution business.
g) Findings of ongoing review from sample survey of investors.

3.5 Rights of Investors

 NAV and Sale and Purchase prices should be disclosed on AMFI website by 9pm every
business day. FoFs can publish their NAV by 10 am of the next business day.
 NAV should be published in at least 2 newspapers with nationwide circulation.
 Detailed portfolio disclosure in the prescribed format should be made every 6 months within
one month of the close of half-year.
 Closed-end debt funds and interval funds have to publish their portfolios on website within 3
working days of every month-end.
 It is a voluntary industry practice to disclose summarised portfolio to unit holders every
month through the factsheet
 Key documents of mutual fund and AMC may be inspected by investors such as Trust deed,
Investment management agreement, Custodial services agreement, R&T agreement,
Memorandum of Association (MOA) & Articles of Association (AOA) of the AMC.
 Mutual funds have to report annually the number of investor complaints under specific
heads and extent of redressal of complaints received.
 AMCs to provide investors the option of receiving scheme annual accounts or abridged
summary through email. If email-ID is not available, physical copies to be sent to investors.
Investors can ask for physical copies even if the email-ID is registered with the mutual fund.
 In case of delay in dispatching dividend warrants or redemption proceeds, the AMC has to
pay the unit-holder interest at the rate of 15% p.a.
 Investors in whose folios transactions have taken place during a calendar month should
receive Consolidated Account Statement (CAS) by the 10th of the next month.
 CAS to be sent every half yearly (September/ March)by the 10 th of the next month giving
holding at the end of the six months, across all schemes of all mutual funds, to all such
investors in whose folios no transaction has taken place during that period.
 Soft copy of the Statement of Accounts shall be emailed to the unit holders instead of a
physical statement if mandated by investor.
 In case of open-ended funds, statement of accounts (SOA) to be dispatched within 5
working days.
 In case of closed-end funds, the mutual fund should give an option to investors either to
receive the statement of accounts or to hold units in dematerialised form.
 AMC shall Issue SOA or issue units in demat within 5 working days of closure of initial
subscription of closed-end funds. On request of unitholder, AMC shall issue units in demat
form within 2 working days for a closed end scheme listed on a stock exchange.

Summary of Service Standards imposed by Sebi

Transaction Turnaround Time

Allotment of units in a NFO 5 days from NFO closing date

Allotment of units in a ELSS NFO 30 days from NFO closing date

Refund of money 5 business days from NFO closing date

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Dispatch of Statement of account - NFO or 5 working days from closure of subscription list
request by unitholder / request
Dispatch of Consolidated Account 10 days from end of each calendar month if
Statement (CAS) transaction has taken place during the month.

Dispatch of dividend warrants 30 days from date of dividend declaration

Dispatch of redemption proceeds 10 working days from transaction request

3.6 Redressal of Investor Complaints

 Investor must first approach the Investor Service Centre (ISC). If not resolved, then approach
the personnel at senior levels in the AMC. If not resolved, then the investor may approach
Sebi.
 If the investor is not satisfied with the Sebi ruling, the investor may approach Securities
Appellate Tribunal (SAT)
 Mutual funds should annually disclose details of complaints received from all sources on
their website, AMFI website and in annual report.
 Compliant can also be initiated through SCORES (SEBI Complaint Redress System).
 SCORES is the Centralized web based system for lodging and tracking investor complaints.
 Anyone who has a grievance against a listed company or against any market intermediaries,
can file a complaint using SCORES.
 The registered complaint is scrutinized by Sebi to determine if the subject matter falls under
their purview. If yes, it forwards the complaint to the concerned entity with an advice to send
a written reply to the investor and file an action taken report in SCORES.
 The entity is required to submit action taken report within a reasonable period, not later than
30 days.

3.7 Other Rights

 The mutual fund has to deploy unclaimed dividend and redemption amounts in the money
market.
 AMC can recover investment management and advisory fees on management of these
unclaimed amounts, at a maximum rate of 0.50% p.a.
 AMC is expected to make a continuous effort to remind the investors through letters to claim
their dues.
 The annual report has to mention the unclaimed amount and the number of such investors
for each scheme.
 If the investor claims the money within 3 years, then payment is based on prevailing NAV i.e.
after adding the income earned on the unclaimed money
 If the investor claims the money after 3 years, then payment is based on the NAV at the end
of 3 years.
 If an investor wishes to change his broker, a letter to the mutual fund indicating change of
ARN needs to be submitted by the investor. No NoC is required.
 Proceeds of the folio in the event of death will go to the nominee appointed by the
unitholder.
 Unit certificate is like a balance confirmation certificate and may be provided upon request
within 30 working days.
 Unit certificate is not transferable and only specifies number of units held by the investor. It
does not serve any operational purpose.
 Units shall be freely transferable either by act of parties (sale or gift of units) or by operation
of law (Transmission of units). Exception: ELSS Schemes during lock- in period.

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  Unitholders have an option to receive allotment of units in demat form is available in all
schemes. An option is provided to the investor in the subscription form for providing demat
account details.
 Mutual funds co-ordinate with DP to provide demat statement to unit holders. Units in demat
form are also freely transferable.
 Mutual funds need to send a written communication to ALL unit holders about the proposed
change. An option to exit without exit load should be given to the unit holders.
 A scheme can be wound up by a resolution by unit holders holding at least 75% of assets in
the scheme. Trustees can wind up the scheme by seeking consent of the unitholders.
 If there is a change in sponsor or the AMC, an option to redeem without exit load needs to be
provided to the investors.
 The AMC or the sponsor do not directly hold the funds or securities belonging to the
investors. The Custodian is independent of the Sponsor.
 A unit holder cannot sue the Trust as the Trust is only a notional entity.
 Unit holders do not have recourse for ignorance. They are expected to have read and
understood the offer document before investing.
 A prospective investor has no rights with respect to the fund, the AMC or intermediaries.
 Investors also have limited rights for redressal as they are neither shareholders nor
depositors. Investments cannot be protected and redressal of complaints is not obligatory.

CHAPTER 4 - OFFER DOCUMENT (OD) (6 Marks)

4.1 Format and Content

 An offer document is a legal representation of the offer of the mutual fund scheme to the
investors. It is prepared before a new fund offer (NFO) and is approved by Sebi.
 Sebi only vets the OD to ensure that all required information is provided. SEBI does not
approve or disapprove the offer document.
 It defines the contractual relationship between investor and the mutual fund.
 It is a vital source of information about the mutual fund and the scheme and investors are
expected to read and understand OD before investing.
 Format of the offer document is prescribed by SEBI. There are two components of the offer
document: Statement of Additional Information(SAI) and Scheme Information Document(SID)
 SEBI has prescribed that the NFO period must be limited to 15 days, except in case of ELSS
and RGESS schemes the NFO can be upto 30 days.
 After NFO, open-ended scheme opens for re-purchase and sale after allotment. Closed-
ended scheme gets listed on stock exchange.
 Allotment must be completed within 5 days of NFO closure. Scheme must open for
transactions within 5 working days of allotment.
 Offer document of a new fund needs to be approved by the trustee and draft needs to be
filed with SEBI.
 SEBI usually takes 21 days to clear offer document, subject to changes, if any. NFO must be
made within 6 months of SEBI clearance.

4.2 Statement of Additional Information (SAI) and Scheme Information Document (SID)
 The SAI contains generic information about the mutual fund and is common to all schemes.
 SAI contains details of the sponsor and financial history, names and addresses of the Board
of Trustees, details of AMC, key personnel and Board of Directors of AMC.
 SAI also contains details of various fund constituents and investor service officer’s details.

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  SAI contains financial information of the mutual fund including performance of existing
schemes on yearly basis, scheme expenses and loads applicable.
 AI lays down the rights of investor. It is filed only once with SEBI in the prescribed format.
 Material changes to the SAI need to be updated immediately. If there are no material
changes, SAI to be updated every year, with 3 months at the end of Financial Year.
 SID is filed with SEBI for approval before launch of a new scheme. It contains information
specific to a scheme.
 SID contains information on scheme type (open or closed end), investment objective, asset
allocation, investment strategies, terms with regard to liquidity, fees and expenses,
benchmark for the scheme, and investment restrictions, if any.
 Projected returns cannot be shown in SID.
 SID contains mandatory disclosures and disclaimers, fundamental attributes and risk factors
pertaining to the scheme.
 SID includes borrowing policy of the fund, policy on inter-scheme transfers, and methodology
of calculation of NAV, sale and purchase price.
 Operational details such as NFO period, plans, options and loads, NFO price and basis for
subsequent pricing are in the SID.
 SID also contains application process, minimum investment amount, investment facilities
such as SIPs, SWPs and switches, and eligibility of investors who can invest.
 The date of commencing ongoing sale and re-purchase, maturity date, if scheme is closed-
ended, list of Official Points of Acceptance (OPAT) are details found in the SID.
 An open-ended scheme’s SID must be valid at all times and updated version of the SID must
be available on the mutual fund’s website.
 Material changes to the SID need to be updated immediately.
 If there are no material changes, SID needs to be updated every year, within 3 months of
the end of the financial year.
 Schemes launched after September 30 must update SID after next financial year end.
 Mutual Funds issue an addendum to notify any change in the information provided till such
time they are incorporated in the SID or SAI every year.
 Addendums have to be approved by trustees and notified to SEBI.
 Addendum must be published in two newspapers.
 Addendum needs to be prominently displayed on the notice board at the official points of
acceptance of application forms.

4.3 Fundamental Attributes and KIM

 Fundamental attributes are essential features of the scheme. Risk and return parameters
are defined by the fundamental attributes.
 Whenever a change is proposed to the fundamental attributes, it requires the approval of the
trustees and SEBI.
 Information about the change in fundamental sttributes should to be given to investors with
an option to exit the scheme without paying an exit load.
 Merger or consolidation of schemes shall not be seen as change in fundamental attribute of
the surviving scheme if the fundamental attributes of the scheme that remains in existence
after merger (surviving scheme) do not change.
 Mutual funds should be able to demonstrate that the circumstances merit merger or
consolidation of schemes and the interest of the unitholders of surviving scheme is not
adversely affected.
 Risk factors may be standard or scheme-specific.

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  Standard risk factors apply across mutual fund schemes. For example “Mutual funds are
subject to market risk” is a standard risk factor.
 Scheme-specific risk factors apply to the specific scheme. For example risk factors such as a
scheme being the first scheme of a mutual fund or risk of concentration in a sector fund are
specific to a fund.
 Application forms contain abridged and concise version of the OD, known as Key Information
Memorandum (KIM).
 A KIM must accompany every application form. Format for KIM is prescribed by SEBI.
 KIM must be updated at least once a year.
 KIM contains information such as NFO open and close date, investment objective and asset
allocation pattern of the scheme and scheme-specific operational details,
 The names of the AMC and trustee company, performance history of the scheme and the
benchmark for one, three and five years and since inception are in the KIM.
 Expenses and loads applicable to the scheme and investor services and rights are also
found in the KIM.

4.4 Additional Disclosures for Debt Schemes

 Closed-end debt oriented mutual funds to make the following disclosures:
a) Credit evaluation policy for investments in debt instruments
b) List of sectors in which the scheme will not invest
c) Type of instruments that the scheme would be investing in CDs, CPs, NCDs, Treasury
bills, Securitized debt etc.
d) Floors and ceilings within a 5% range of the allocation intended against each sub-asset
class and credit rating
e) Variations between disclosure list and final portfolio will not be permissible
 Sebi circular dated September 13, 2012 has mandated mutual funds to make following
disclosures for debt schemes:
a) Total exposure in a particular sector not to exceed 30% of the net assets of the scheme.
This excludes investments in Bank CDs, CBLO, G-Secs, T-Bills and AAA rated securities
issued by Public Financial Institutions and Public Sector Banks.
b) Schemes were the above condition is not being met, must meet the same within a
year’s time from the issue of the circular.
c) Disclosures regarding the same should be made in both SID and KIM

4.5 Product Labeling of Mutual funds

 Mutual funds are required to ‘Label’ their schemes on the following parameters:
a) Nature of scheme in an indicative time horizon (short/medium/long term)
b) A brief about the investment objective (in a single line sentence) followed by kind of
product in which investor is investing (Equity/Debt).
c) Level of risk, depicted by ‘Riskometer’ as under:
o Low - principal at low risk
o Moderately Low - principal at moderately low risk
o Moderate - principal at moderate risk
o Moderately High -- principal at moderately high risk
o High - principal at high risk
d) A disclaimer saying: “Investors should consult their financial advisers if they are not
clear about the suitability of the product.
e) Product labels are to be disclosed in scheme advertisements and on the Front page of
initial offering application forms, KIM and SID.

CHAPTER 5 - FUND DISTRIBUTION AND CHANNEL MANAGEMENT PRACTICES (8 Marks)

5.1 Who can invest?

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  Following types of investors are eligible to invest in Mutual funds:
 Companies & partnership firms
 Individuals & Hindu undivided families (HUFs)
 Trusts & charitable institutions
 Banks & financial institutions
 Non-banking finance companies (NBFCs)
 Insurance companies, Provident funds, Mutual funds
 Foreign institutional investors (FIIs), Non resident Indians (NRIs), Persons of Indian origin
(PIOs)
 HUFs can invest through Karta. Minors can invest through a guardian.
 The ‘Who Can Invest’ section of the offer document of a scheme specifies the categories of
investors eligible to invest in a mutual fund scheme.
 The individual investor category includes retail investors, HNIs, minors and NRIs.
 Retail investors may depend upon the distributor to provide the information and analysis.
HNIs may demand a better quality of service.
 In case of institutional investors, investment in mutual fund must be approved by the
management committees and board of directors as the case may be.
 Copy of Board’s resolution and charter of the institution are required to be submitted to the
fund house. Application needs to be signed by authorised signatories.

5.2 Distribution Channels

 Independent Financial Advisors (IFAs) are Individual distributors. They establish personal
long-term contacts across investment products.
 Institutional Distributors can be distribution houses, banks, or non-banking finance
companies. They mobilise investments through their employees and network of sub-brokers.
 Institutional distributors have a wide branch network and large client base and greater
geographical reach. They have standardised processes.
 AMC’s channel managers service the institutional distributors. Institutional distributors
provide in-house research and product recommendations to investors.
 Online Mutual Fund Distribution happens directly to investors through internet. Investors are
able to view current holdings at latest NAV and conduct sale/re-purchase transactions
online.
 Investor creates an account which is password protected and thus ensures convenient and
paper-less transactions. No cheque writing is required.
 Distribution through Stock Exchanges has been enabled through trading platforms of
brokers.
 Mutual funds tie up with PSU banks to reach out to the non urban locations for distribution
of their products.
 In order to be eligible, brokers must clear NISM MFD Certification, obtain ARN and empanel
as distributor with AMC.
 Transactions can be executed on NSE’s NEAT MFSS and BSE’s STAR Mutual Fund Platform
which is open from 9am to 3 pm. Mutual funds can choose to tie up with any stock
exchange.
 AMCs appoint distributors by entering into Distribution agreements which spell out the terms
and conditions of their appointment.
 Distributor empanelment form must be filled up while seeking empanelment with an AMC.
The form includes details such as personal details, names of key people handling sales and
operations, business details.

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  AMC has the power to terminate agreement at any time, after due notice.
 In order to be appointed as a distributor, Individual distributors and employees of
institutional distributors have to clear the NISM MFD certification examination.
 After clearing the examination, they need to obtain the ARN. Institutions in the distribution
business also need to get registered with AMFI.
 Validity of certification examination is three years after which distributors can take
continuing professional education (CPE) training in order to revalidate the certification.
 SEBI has allowed postal agents, retired government and semi-government officials (class III
and above or equivalent), retired teachers and retired bank officers with a service of at least
10 years to distribute simple performing mutual fund schemes.
 These distributors can be empanelled with minimal registration requirements and a
simplified certification process as compared to standard requirements for empanelment of
mutual fund distributors.
 Such distributors can only sell diversified equity schemes, fixed maturity plans (FMPs) and
index schemes that have returns equal to or better than their scheme benchmark returns
during each of the last three years.

5.3 Distributor Commission

 SEBI does not prescribe rules on the minimum or maximum rate of commission. However,
Distributors are not allowed to charge commissions on their own investment.
 Initial commission is paid up-front. Entry load has been banned since Aug 1, 2009.
 Investors have the power to decide the payment to advisors for their services.
 Distributors have to disclose the commissions they earn on comparable schemes when they
recommend a scheme to the investor.
 The commissions paid to distributors in respect of its non-institutional retail and HNI
investors should be disclosed on the mutual fund’s website. This is applicable to distributors
satisfying one of more of the conditions specified earlier for due diligence.
 Trail commission is paid as long as the investor remains invested in the fund. It is calculated
on the current market value (units brought in by the distributor x current NAV of the units).
 AMFI has banned trail commission for transferred assets from one distributor to another.
 Sebi circular dated September 13, 2012 - in addition to the total commission and expenses
paid to distributors, AMC shall make annual disclosures on its website on:
a) distributor-wise gross inflows (indicating whether the distributor is an associate or group
company of the sponsor(s) of the mutual fund),
b) net inflows,
c) average assets under management and
d) ratio of AUM to gross inflows
e) If the data shows that a distributor has excessive portfolio turnover ratio, i.e. more than
two times the industry average, AMC shall conduct additional due-diligence of such
distributors.
 Mutual Funds / AMCs shall also submit the above data to AMFI. AMFI shall disclose the
consolidated data in this regard on its website.

5.4 Know Your Distributor (KYD)

 AMFI has introduced the KYD process in order to verify the details of the distributor. KYD
Process is handled by the CAMS Point of Service (PoS). KYD is a pre requisite for
appointment as a distributor.
 KYD involves verification of documents such as PAN card and proof of address. Biometric
impression of the index finger of the right hand of the ARN holder is captured.

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  In case of institutional distributors, bio-metric process is undertaken for its authorised
personnel. Acknowledgement is given OTC and must be submitted at the time of
empanelment with the AMC.

5.5 Sales Practices

 Distributor actions must be in the interest of the unit holders. Distributors have to follow
AMFI's code of ethics (ACE) as well as those prescribed by the concerned AMC, AMFI and
SEBI.
 AMFI and fund houses have put in place a set of guidelines to be followed by the distributors.
These include the following:
 Distributor is accountable for the activities of the sub-brokers
 Distributors must have complete knowledge of the product on offer.
 Distributors must know their clients’ needs and profile.
 The product chosen must meet the clients’ requirements
 Distributors must encourage good investment habits such as long-term and regular
investment.
 Distributors must provide good and efficient after-sales service.

5.6 Advertisement Guidelines

 SEBI has permitted celebrity endorsements at industry level for the purpose of
increasing awareness of Mutual Funds as a financial product category. However,
such celebrity endorsements of Mutual Funds at industry level are subject to the
following conditions:

 Returns to be presented as point to point return on a standard investment of Rs 10,000, in
addition to the CAGR:
 For schemes in existence for more than 3 years, performance to be provided:
 since inception: and
 for as many 12 month periods as possible for the last 3 years.
 For schemes which have been in existence for less than 3 years, returns to be provided:
 since inception: and
 for as many 12 month periods as possible
 Benchmark indices for the same periods have to be shown to enable comparison.
 A scheme’s performance has to also be compared with additional benchmarks:
a) The Sensex or Nifty (equity funds)
b) 10 year GOI paper (debt funds)
c) 1 year treasury bill (short term funds)
 Performance to be shown in rupees as well as CAGR.
 The performance of all schemes managed by the fund manager of the scheme being
advertised has to be disclosed.
 In case the number of schemes managed by a fund manager is greater than six:
 the AMC to disclose the total number of schemes managed
 the performance data of the top 3 and bottom 3 schemes.

CHAPTER 6: ACCOUNTING, VALUATION AND TAXATION (10 Marks)

6.1 Definitions

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  Unit capital or corpus of the fund is calculated as:
Unit Capital (Corpus) = Total outstanding units * face value per unit
 Purchase of units increases unit capital; redemption reduces unit capital.
 Unit capital is shown on the liabilities side of the balance sheet. Mutual fund has only
current liabilities, and no long term liabilities.
 The portfolio + any accrued income and receivables = Assets of the scheme
 Net assets = Assets - Liabilities
 NAV per unit = Net assets of a scheme / number of outstanding units.
 Valuation day is every business day when NAV is calculated.
 Net assets of can go up when there is a realized income or an appreciation in the market
value of the scheme’s assets.
 Net assets will go down when there is a realized loss or depreciation in the market value.
 Expenses and income are accrued every day.
 NAV is rounded off to two decimal places for all schemes and to four decimal places for
liquid schemes.
 Example:
 The net assets of a fund are Rs.200cr.
 The current liabilities are Rs.20 cr.
 The unit capital is Rs.50 cr and the face value per unit is Rs.10. What is the NAV of the
fund?
 Total outstanding units = 50cr/ Rs. 10
 NAV = (Current assets – Current liabilities) = (200cr – 20 cr)/ 5 crore = Rs. 175
Total outstanding units

6.2 Sale and Repurchase Price

 If an entry load is imposed, the investor pays a price that is more than the NAV. SEBI has
banned entry loads, so no entry loads can be charged to investors.
 Sale Price needs to be the same as NAV (subject to deduction of applicable transaction
charges, if any).
 Upfront commission is to be paid by investor directly to the distributor, based on his
assessment of various factors including the service rendered by the distributor.
 Exit load is imposed on NAV to arrive at the re-purchase price. NAV less NAV x % exit load =
repurchase (redemption) price.
 Exit load reduces the repurchase price by the amount of load. Exit load cannot be varied
based on the type of investor.
 CDSC (Contingent Deferred Sales Charge) is a variable exit load applied on the basis of the
period for which the investor stays invested.
 All exit loads or CDSC charged to investors shall be entirely credited back to the scheme.
 SEBI has allowed a transaction charge of Rs. 100 for mutual fund subscriptions above Rs.
10,000.
 An additional amount of Rs. 50 can be charged from a first time mutual fund investor.
 Charges are restricted to purchase transactions only.
 The transaction charges are deducted by the AMC from the subscription amount and paid to
the distributor and the balance will be invested.
 In case of SIPs, the transaction charge shall be applicable only if the total commitment
through the SIP amounts to Rs 10,000 and above. The charge can be recovered over 3-4
instalments.
 There can be an “opt-out” of charging the transactions charge at a distributor level though
not at investor level.
 Distributor cannot choose to charge one investor and not charge another.

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  Distributor shall have option to opt-in or opt out of levying transaction charge based on type
of the product.
 Transaction Charge(s) will not be deducted if:
a) Purchase/Subscription is not routed through any distributor
b) Purchase/ Subscription through a distributor for less than Rs. 10,000;
c) Transactions such as Switches, STP i.e. all such transactions wherein there is no
additional cash flow at a Mutual Fund level similar to Purchase/Subscription.
d) Purchase/Subscriptions through any stock exchange.
 The account statement must reflect the net investment as the gross subscription less
transaction charge and provide the units allotted against net investment.
 The AMC will ensure that the distributor does not engage in mal-practices to enhance
commissions.

6.3 Applicable NAV

 NAV is computed on business days for all schemes. Except liquid funds, for which NAV is
computed every calendar day.
 Mutual fund transaction documents have to be submitted at designated Official points of
acceptance (OPoA).
 All financial transactions received at OPoAs have to be time stamped. Time stamp
determines the applicable NAV according to Sebi’s cut-off time regulations.
 For all non-liquid funds, the applicable NAV is prospective (NAV is not known at the time of
investment).
 Same day NAV will apply for all redemption transactions received before 3pm on a business
day. Transactions received after cut-off will get the NAV of the next business day.
 Applicable NAV for purchase transactions is different depending on scheme type.
a) For all funds except liquid funds, cut-off time is 3pm.
b) For liquid funds the cut-off time is 2pm.
 In case of purchase transaction in equity and debt-oriented funds, where the value of the
transaction is more than Rs.2 lacs:
a) The NAV of the same day will apply only if funds have been realised and credited to the
scheme account before cut-off.
b) If not, the NAV of the day in which funds were credited will apply.
 The allotment of units at the applicable NAV for a day will therefore depend upon:
a) Receiving application before cut-off time
b) Funds credited to the scheme’s account before cut-off time
c) Funds available for utilization without using any credit facilities
 Liquid funds purchase transactions are subject to a different treatment. The NAV is
computed every calendar day. Also, the funds are utilised on the same day, if credited to the
scheme, since cut off is earlier.
 Applicable NAV for a liquid fund is NAV of the day previous to the day on which funds were
credited and available for use by the scheme.
 The applicable NAV for liquid fund purchases depends upon
a) Receiving application before cut-off time
b) Funds credited to the scheme’s account before cut-off time
c) If both conditions are met, previous calendar day’s NAV is applied
 Review these rules to be able to answer questions regarding applicable NAV:
Type of Scheme Transaction Cut off time Applicable NAV

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Equity oriented funds • Purchases 3.00 pm • Same day NAV if received
and debt funds (except before cut off time.
liquid funds) in respect • Switch in • Next business day NAV for
of purchases less than applications received after
Rs. 2 lacs cut off time.
Liquid fund • Purchases 2.00 pm • Previous day NAV if received
before cut off time and
• Switch ins funds are realised.
• If received after cut off time,
NAV of the day previous to
funds realisation.

Equity Oriented Funds, • Redemptions 3.00pm • Same day NAV if received

Debt funds, Liquid funds before cut off time.
• Switch out • Next business day NAV for
applications received after
cut off time.
Equity oriented funds • Purchases 3.00pm NAV of the business day on which
and debt funds (except funds for the entire amount of
liquid funds) in respect • Switch- in subscription / purchase as per the
of transaction of Rs. Rs. application are available for
2 lacs or more utilization before the cut-off time will
apply.
 Time stamping is done in order to record the time at which a transaction was received at an
official point of acceptance.
 Electronic time stamp is mandatory to determine the applicable NAV for a financial
transaction.
 The location code, machine identifier, date, time (hh:mm) and running serial number are
generated in every time stamp.
 The time stamping machine records three impressions for purchase:
 the application form or transaction slip,
 the back of the payment instrument, and
 the acknowledgement.
 For redemption transactions all three impressions are on the redemption request.
 In case of online and stock exchange transactions the time stamp is as per server/trading
system time.
 The time of transaction done through various online facilities / electronic modes offered by
the AMC, for the purpose of determining the applicability of NAV, would be the time when the
request for purchase / sale / switch of units is received in the servers of AMC/RTA.

6.4 Scheme Expenses

 Expenses that can be borne by the mutual fund scheme are regulated by SEBI.
 Any expense that is not chargeable, or exceeding the limits, has to be borne by the AMC.
 Initial issue expenses are expenses on advertisement, commissions, and launch of the
scheme during an NFO. Expenses related to an NFO cannot be charged to the
scheme/investor.
 Fund Recurring Expenses are expenses incurred to manage the money mobilised from the
investor.

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  SEBI specifies heads of expenses that can be charged to the scheme and the maximum
expense, as percentage of net assets,that can be so charged.
 Recurring expenses are charged on an accrual basis, and reduced from the assets of the
scheme, before computing NAV.
 Expenses, identified as being direct expenses incurred to manage the fund, can be charged
to the scheme. These expenses include:
 Investment management fees
 Marketing and selling expenses
 Fees of custodians
 Fees of registrar and transfer agents
 Audit fees
 Trustee fees
 Costs relating to investor communication
 Costs of statutory disclosure and advertisements

 Expenses other than those listed above, cannot be charged to the scheme. Fines and
penalties also cannot be charged to the scheme.
 The limits for expenses charged to the fund are as per the following slabs:
 2.5% on the first Rs 100 crore of net assets
 2.25% on the next Rs 300 crore of net assets
 2% on the next Rs 300 crore of net assets
 1.75% on the balance net assets
 The net assets in the above slabs are taken as weekly average net assets.
 Debt funds are required to charge 0.25% lower in each of the above slabs.
 Index funds cannot charge more than 1.5% as recurring expense.
 Liquid funds and debt funds cannot charge any investment management fees for funds
parked in short-term bank deposits.
 Fund of funds invest in other funds, therefore there may be two layers of expenses, one for
the FoF and the other for the schemes in which the FoF invests.
 FoFs can charge Management fees + Scheme recurring expenses + expenses levied by
underlying schemes not more than 2.50% of net assets.
 Any expense incurred over and above the maximum prescribed limits has to be borne by the
AMC.
 Exceptions are as follows:
a) Additional TER for mobilisation from non- top 30 cities upto 30 bps
b) Additional TER upto 20 bps incurred towards permissible expense heads
c) Brokerage and transaction costs for execution of trades (if included in the transaction
cost) not exceeding 0.12% for cash market transactions and 0.05% for derivative
transactions.
d) Service tax on Investment Management Fees
 Additional TER can be charged up to 30 basis points on daily net assets of the scheme if new
inflows from beyond top-30 cities (top 30 based on AMFI data) is at least:
a) 30% of gross new inflows in the scheme or
b) 15% of the average AUM (year to date) of the scheme, whichever is higher.
 If such inflows are less than higher of above, additional TER:
= Daily net assets X 30 basis points X New inflows from beyond top 30 cities
365 (or 366 w.e. applicable) X Higher of (a) or (b) above
 Additional charged as above shall be clawed back in case the same is redeemed within a
period of 1 year from the date of investment.

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  Investment management fee can be decided by the AMC and chargeable within the TER
limits (upto 2.25% for debt schemes and upto 2.5% for equity schemes on average net
assets).
 Service tax payable on investment management fees can be charged over and above TER.
 Service tax on other services such as R&T, Custody, fund accounting shall be charged within
TER limits, i.e. within the limit of upto 2.5% of average net assets for equity schemes and
2.25% of average net assets for debt schemes as the case may be.
 Service tax on exit load shall be paid out of the exit load proceeds and exit load net of service
tax shall be credited to the scheme.
 Service tax on brokerage and transaction cost paid for asset purchases shall be within the TER
limits.
 All new schemes shall have single plan with single expense structure.
 In case of existing schemes, only one plan will continue for fresh subscriptions.
 Existing investors to continue to remain invested in their respective plan.
 All schemes shall have separate plan for direct investments. This plan will feature a lower
expense ratio as it will exclude distribution expenses, commission. No commission shall be
paid from Direct Plan.
 AMC can charge GST to the schemes within the limits prescribed under SEBI (Mutual Fund)
Regulations
 GST on fees paid on investment management and advisory fees shall be charged to the
scheme in addition to the overall limits specified earlier.
 GST on other than investment and advisory fees shall be charged to the scheme within the
maximum limit of TER.

6.5 Accounting Policies

 Accounts of each mutual fund scheme have to be maintained separately.
 SEBI Regulations have laid down accounting treatment of various items.
 Average cost should be used to determine the holding cost of the securities
 Investments should be accounted on the transaction date, not on the settlement date.
 Dividends, bonus and rights received by a mutual fund scheme should be recognized on the
ex-date.
 Distributable surplus is the amount available for paying dividends. This includes realized
gains, accrued income and unrealized losses but does not include unrealized gains.
 Unrealised losses must be reduced from the distributable surplus. Unit Premium Reserve is
not available for dividend distribution.
 Valuation of the mutual fund portfolio is done on every business day.
 Equity shares are valued at the last traded price on the valuation day.
 If no traded price is available for an equity share, the closing price of the previous trading
day (not more than 30 days before) shall be taken for valuation.
 If it is a thinly traded share, fair value as per Sebi-approved valuation formula shall be
followed.
 In case of debt securities, those with residual maturity < 60 days shall be valued at weighted
average price if traded on the valuation date. Non-traded debt securities will be valued on
amortization basis.
 In case of Debt Securities with residual maturity > 60 days, if they are traded securities, they
will be valued at weighted average price. Non-traded valuation shall be based on Crisil yield
matrix.
 In case of holding of gold by a gold ETF, the same is valued at the AM fixing price of London
Bullion Market Association (LBMA) in US dollars per troy ounce for gold having a fineness of
995.0 per thousand.

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  Valuation policy should follow SEBI investment valuation norms and AMC shall publish the
same.
 AMC & sponsor will be liable to compensate for unfair treatment to any investor due to
inappropriate valuation.

6.6 Taxation
 A mutual fund is a pass-through structure and is exempted from income tax
 The fund itself pays no tax on the investment income it earns
 In the hands of the investors:
 Dividends are exempt from tax
 Capital gains are taxable depending on their nature
 Short term capital gain or loss (STCG)/(STCL): Capital gain or loss realised by sale of units
within a period of 12 months in case of equity funds and 36 months in case of non equity
funds.
 Long term capital gain or loss (LTCG)/(LTCL): Gain or loss from sale after a holding
period of one year in case of equity funds, 36 months in case of non equity funds.
 Indexation benefits are available for long term capital gains in case of debt funds.
 Indexed cost of an asset = Cost of purchase X ( Index in year of sale/index in year of
purchase)
 Mutual funds are not subject to Wealth Tax in the hands of the investor
 Funds with at least 65% of assets in equity are equity-oriented
 Dividend Distribution Tax (DDT) is to be paid by the fund, before distribution of the
dividend
 Equity oriented funds – 10%
 Liquid funds - 25% for individuals/HUFs/NRIs, 30% for others
 Non-equity oriented, non-liquid funds – 25% for individuals / HUFs/NRIs,
30% for others
 Surcharge and cess as applicable
 For the purpose of determining the tax payable, the amount of distributed income be
increased to such amount as would, after reduction of tax from such increased
amount, be equal to the income distributed by the Mutual Fund. This will result in
higher rate of effective DDT.
 Capital Gains Taxation

Individuals/HUF# Domestic Company# NRI# (tax deducted at

the time of
redemption)
Equity oriented schemes
LTCG (units held for 10% without indexation 10% 10%
more than 12 months)
STCG (units held for 15% 15% 15%
12 months or less)
Other than Equity Oriented Schemes
LTCG (units held for 20% with indexation 20% with indexation Listed: 20% with
more than 36 months) indexation
Unlisted: 10% without
indexation

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STCG(units held for 36 30%* 30% 30%*
months or less)
* assuming investor falls in highest tax bracket; # surcharge and cess as applicable

Note: The Finance Act, 2018 has removed the blanket exemption from tax on long term capital gains
from STT paid equity oriented mutual funds. LTCG exceeding Rs. 1 lakh per year will be taxed at
10% without indexation benefit.

 STT is applicable only for equity-oriented funds and equity and derivative securities. STT is
payable by the mutual fund on purchase and sale transactions on the stock exchanges, at
0.1% for equity shares.
 Investors have to pay STT at 0.001% on mutual fund purchase and sale transactions that
they conduct on listed equity-oriented schemes in the stock exchanges.
 If they transact with the fund directly, STT is payable at 0.001% by investors on redeeming
units of an equity oriented fund.
 Set off is a facility to reduce the capital gains by deducting the capital loss incurred or
carried forward.
 Rules for Set-off are as under:
 STCL can be set off against long/short-term capital gains.
 LTCL can be set off only against long-term capital gains
 STCL/LTCL can be set off only against capital gains.
 Buying into a mutual fund prior to declaration of dividend, and selling the units after
dividends at the ex-dividend price is called dividend stripping.
 The investor earns tax-free dividends and capital loss for set-off. Section 94(7) of Income Tax
Act has plugged this loophole.
 If an investor acquires a unit any time in the period of 3 months before the ex-dividend date,
and sells it within a period of 9 months from the ex-dividend date, such capital gain will not
available for set-off.
 Section 94(8) plugged loophole for dividend distribution in the form of bonus units. Loss in
the value of units will be deemed to be the purchase price of the bonus units.

CHAPTER 7 - INVESTOR SERVICES (12 Marks)

7.1 Investor Information in the Application form

 An application can have 3 joint holders. Investments can be made jointly or on either or survivor
basis.
 Signature is the identity of the investor. All joint holders have to sign the application form as per
holding pattern.
 Address of the investor is to enable physical identification of the investor’s location. No post box
numbers accepted
 Bank account detail is a mandatory detail. Mutual funds send dividends and redemption
proceeds to the bank account mentioned in the application form.
 Folio number is allotted on the first purchase. Investors can hold units of multiple schemes of a
fund house, under one folio.
 Subsequent investments can be made by quoting the existing folio number.
 To check flow of illegal money into the financial system, Prevention of Money Laundering Act
(PMLA) was promulgated.
 As per PMLA, identity of the customer in a financial transaction has to be verified.
 KYC (Know your customer) norm is part of this process.

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 Proof of identity of the customer, proof of residence, Permanent Account Number and
photograph are verified to comply with KYC norms.
 KYC acknowledgement captures PAN of the investor.
 KYC once completed, is valid across mutual funds. Investors have to submit a photocopy of the
KYC acknowledgement along with application forms.
 KYC is mandatory for all joint investors in a folio, irrespective of the purchase amount.
 In case of investment by a minor, KYC compliance of guardian is required.
 For investments under power of attorney, KYC compliance of the investor as well as the power of
attorney holder is required.
 E-KYC is a Aadhaar based KYC verification service launched by UIDAI. SEBI has declared that e-
kyc shall be valid process for KYC verification. Client details and photograph maintained under
UIDAI as a e-KYC process.
 PAN is mandatory for all investors in a mutual fund, irrespective of invested amount (Exception:
Micro SIP)
 Micro-SIP is exempted from requirement of PAN card only in case of investments by individuals,
NRIs, minors and sole-proprietary firms if the annual investment does not exceed Rs.50,000.
 Micro-SIP exemption is not available for HUFs and PIOs or non-individual investors.
 In place of PAN, alternate valid photo identification documents must be provided by micro-SIP
investors.
 Investor is also required to provide an undertaking that their total micro-SIP investments across
all mutual funds in a year do not exceed Rs.50,000 on a 12 month rolling period or April-March
financial year.
 SEBI has mandated a uniform KYC format and supporting documents for compliance by clients.
 Applicable for transactions with mutual funds, DPs, stock brokers, portfolio managers, venture
capital funds and collective investment schemes.
 Part I will have information required by and common to all the above intermediaries. Additional
information as required by each category of intermediaries can be obtained in part II of the form.
 Proof of identity, proof of address and self-attested supporting documents have to be provided in
part I.
 The exemption available for investors in micro-SIPs of mutual funds from providing PAN card
details will continue to apply.
 Investments on behalf of the state/central governments, UN entities/multi-lateral agencies
exempt from paying tax in India, investors residing in Sikkim are also exempt from the PAN
requirement.

7.2 Purchase Transactions

 Fresh purchases are made by investors by submitting an application form complete in all
respects.
 Purchase transactions are denominated in amount, not units.
 Once a valid application is received, a new folio is opened.
 The application should be supported by a payment instrument of at least the minimum
investment amount mentioned in the SID/KIM.
 Additional Purchases are subsequent purchases after fresh purchase and can be made under
the existing folio using a transaction slip.
 Transaction slip is used by an existing investor for making redemptions, additional purchases,
switches and non-financial transactions.
 Folio number of the investor needs to be quoted on the transaction slip in order to identify the
investor. It has to be signed according to the mode of holding.

7.3 Payment Instruments

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 Payment instruments accepted for mutual fund transactions are as under:
a) Local cheques, Outstation cheques, At-par cheques, Cash upto Rs.50,000
b) Demand drafts are accepted from locations where an ISC is not available
c) Electronic payment instruments
 Mutual funds do not accept money orders, stale cheques or post dated cheques (except for
SIPs).
 Third-Party cheques are not allowed, except for the following:
a) grandparents/parents making payments not exceeding Rs.50,000 on behalf of a minor
b) employer making payments on behalf of employee through payroll deductions
c) custodian on behalf of FIIs
 Electronic payment can be made through EFT, RTGS, ECS, Direct transfer and SWIFT.
 The quickest method of transferring funds is RTGS.
 Electronic payment instruments are widely used for making liquid fund purchases by institutional
investors.
 In order to use electronic payment instruments for effecting mutual fund transactions, the
scheme’s account details are essential. Proof of transfer must be appended along with the
application.
 Cash investments in mutual funds to the extent of 50,000/- per investor, per mutual fund, per
financial year shall be allowed.
 It has been introduced as a move to enhance reach of mutual fund products amongst small
investors.
 Conditions for investment in cash:
a) compliance with Prevention of Money Laundering Act, 2002, Rules, Circulars issued by SEBI
b) AMC should have sufficient systems and procedures in place for accepting cash
transactions.
 Repayment with regard to dividends and redemptions can be made only through banking
channel.
 SEBI has permitted applications under ASBA for mutual fund NFO applications. Under ASBA, the
money goes out of the investor’s bank account only on allotment.

7.4 Investments by NRIs

 In case of NRI investments, source of funds determines repatriability of funds on re-purchase.
 NRI investors can make mutual fund investments using the following accounts:
a) Non-resident external (NRE) is a foreign currency account. If subscription is made
using an NRE account, funds received on redemption can be fully repatriated.
b) Non-resident ordinary (NRO) is an Indian rupee account, funds cannot be repatriated
on re-purchase.
c) Foreign currency non-resident (FCNR) is used when payment is remitted from abroad.
d) Foreign Inward Remittance Certificate (FIRC) is a proof that an individual has made a
payment in foreign currency from outside the country.
 Re-purchase to NRIs is subject to TDS on the capital gains made in the transaction.
 Redemption proceeds to NRIs are in Indian rupees.
 FIIs use non-resident rupee accounts for investments in India so that funds are fully
repatriable on re-purchase.

7.6 Re-purchase Transactions

 Re-purchase may be specified in terms of units or rupees.
 The repurchase price is the applicable NAV minus exit load.

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  Re-purchase request has to be filed by joint holders as per mode of holding.
 If a re-purchase request reduces the balance to below minimum limit, then all the units
standing to the credit of the folio will be redeemed and the folio closed.
 Repurchase proceeds are sent by direct credit or cheques with the registered bank account
number of the investor.
 Repurchase requests need to be processed within 10 working days. Failing this, AMCs have
to pay a penal interest of 15% per annum to the unit holders.

7.7 SOA and CAS

 SOA acts as a proof of investment in mutual funds. SoAs are dispatched by the R&T agent,
after every transaction within 10 business days of the transaction.
 In case of NFO, SoA must be dispatched within 5 business days of allotment. In case of SIP,
SoA is sent every quarter.
 When a fresh purchase is made, the amount invested, price, and units are mentioned in the
SOA.
 For subsequent transactions, the SoA mentions the amount invested, price, balance units
and current market value.
 SOA can be received through post, courier or email.
 Within 5 business days of any financial transactions, a email and/or SMS shall be sent
confirming the transaction with basic details like allotment date, Units allotted and NAV.
 A Consolidated Account Statement (CAS) for each calendar month will be sent by post/email
on or before 10th of the succeeding month.
 If an email id is registered with the AMC, only a CAS via email will be sent. For the purpose of
sending CAS, investors will be identified across mutual funds by their Permanent Account
Number (PAN). Where PAN is not available, the account statement shall be sent to the Unit
holder
 Further, where there are no transactions in a folio during any six month period, a CAS
detailing holding across all schemes of all mutual funds at the end of every such six month
period (i.e. September/March), shall be sent by post/e-mail by the 10th day of the month
following that half year, to all such Unit holders.
 SoA to be sent to investors who have not transacted during the last 6 months prior to the
date of generation of account statements.
 SoA for such dormant folios must reflect the latest closing balance and value of the Units
prior to the date of generation of the account statement.
 SoA may be generated and issued along with the Portfolio Statement or Annual Report of the
Scheme for dormant investors.
 Alternately, soft copy of the account statements shall be mailed to the investors’ e-mail
address, instead of physical statement, if so mandated.

7.8 Transactions through Stock Exchanges and Brokers

 In case of transactions through the stock exchange, transactions are placed like orders to
the brokers.
 Contract note generated with an electronic time stamp and sale /re-purchase requests are
handled by brokers.
 Allotment of units on sale and release of funds on re-purchase is handled by R&T agents.
 Folio details are sent to R&T agents by brokers and responsibility of settlement lies with the
AMC and R&T agents.

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  Transactions through the stock exchange may be in physical form or through demat account.
Demat statement is considered as the SoA to the investor.
 Demat transactions are settled through depository; physical transactions are settled through
R&T Agent.

7.9 Investment Options and Plans

 Direct and Regular Plans: Mutual funds offer investors two plans or routes for investors to
invest in a mutual fund the Direct Plan and the Regular Plan. The direct plan is for investors
who wish to invest directly in the mutual fund without routing the investment through a
distributor. The Plan will have a lower expense ratio since there are no distribution expenses
or commissions involved. The plan will have a separate NAV that will reflect the lower
expenses under this plan.
 Mutual fund schemes offer various options and plans.
 The underlying portfolios for all options are the same, only post-tax returns are different.
 In a growth option, gains made in the portfolio are retained and reflected in NAV.
Only when redemption is made, profit/loss is realized and is treated as capital gains or loss.
Tax deferral is possible by investing in growth option.
 In a dividend pay-out option, the fund declares dividend from realised profits after trustee
approval.
 Amount and frequency of dividend payout varies and depends upon distributable surplus.
 NAV falls after dividend payout to the extent of dividend paid and dividend distribution tax (if
applicable).
 The NAV before dividend payout is called as cum dividend NAV, and the NAV after dividend
payout is the Ex-dividend NAV.
 In the dividend re-investment option, dividend declared is not paid out but is re-invested in
the same scheme by buying additional units at the ex-dividend NAV.
 See the following table to compare the three options:
Growth Dividend Payout Dividend Re-investment
NAV at the beginning Rs.10 Rs.10 Rs.10
Number of Units 100 100 100
NAV after 1 year Rs.12 Rs.12 Rs.12
Dividend of 10% declared No Yes Yes
Dividend Amount Nil Rs.100 Rs.100
NAV post dividend Rs.12 1100/100 = Rs.11 1100/100 = Rs.11
Number of units held 100 100 100+(100/11) =109.09
Value of investment 100x12=1200 100x11=1100 109.09 x 11=1200
Pre-tax return on investment Rs.200 capital Rs.100 dividend+ Rs.100 dividend+ Rs.100 capital
gain Rs.100 capital gain gain*
7.10 Systematic Transactions
 In a Systematic Investment Plan (SIP) investment of a predetermined amount is periodically
invested into a mutual fund scheme.
 Applicable NAV is the NAV on the date of the installment.
 Period of commitment of SIP can vary e.g. 6 months, 1 year, 3 years, 5 years.
 The investor needs to specify certain intervals at which investment must be made e.g.
monthly, quarterly, half-yearly.
 Investment is made on standard dates e.g. 1st, 5th, 10th, 15th of every month as provided by
the AMC.
 Since a fixed amount is invested on given dates, more units are bought if NAV is low; lesser
units if NAV is high. This is called rupee cost averaging.

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  SIP can be initiated along with NFO.
 SIP can be made through various payment modes such as post dated cheques, electronic
clearing service and standing instruction for direct transfer.
 Systematic Withdrawal Plan (SWP) refers to periodic redemptions made from the scheme at
the prevailing NAV (less exit load as applicable).
 Investor must specify the date of withdrawal and the period of withdrawal. SWP may be
specified in terms of number of units or amount.
 SWP is ideal for an investor who wants to have regular income but avoid bearing dividend
distribution tax.
 Systematic Transfer Plan (STP) is a transfer of a specified sum from one scheme to another
within the same fund house.
 STP helps in re-balancing portfolio. Re-purchase is made from the source scheme and
investment of re-purchase proceeds is made into the destination scheme.
 In effect, STP amounts to SWP from source scheme and SIP into destination scheme.
 As STP involves repurchase from source scheme, capital gains (STCG/LTCG) shall apply.
 A switch is a redemption and purchase transaction rolled into one.
 The source scheme/option is the switch out leg and the target scheme /option is the switch
in leg. The R&T carries out the transactions in the investor’s records.
 Exit loads are not charged for switch within options of the same scheme. However, exit loads
are charged, as applicable, for inter-scheme switches.
 Triggers are automated purchase, redemption, switch or dividend decisions based on pre-
defined events. Pre-defined event may be Sensex levels, return targets etc.

7.11 Non-Financial Transactions

 Change in personal information such as name, bank account details, joint holder details,
signatories, status etc are non financial transactions.
 These transactions are based on documents provided as proof.
 Mutual fund units can be pledged to borrow funds.
 The amount of loan depends on the value of units on the date of borrowing and the margin.
 Units pledged are marked under lien in the folio and cannot be redeemed.
 Individual unit holders can make nominations of upto 3 persons for mutual fund investments
they hold.
 Nominations can be changed.
 The nomination form has to be signed by all joint holders.
 A minor can be appointed as a nominee.
 Nominee rights are subservient to that of the joint holders.

Chapter 8 - Risk, Return and Performance of Funds (10 Marks)

8.1 Equity Securities

 Equity is issued by companies to investors when they contribute to the capital.
 Equity shareholders enjoy ownership privileges such as dividends and voting rights.
 There is no guarantee of income or principal, however, there is potential for capital
appreciation.
 The drivers of risk and return in an equity portfolio depend on the style used by the fund
manager to create the portfolio.
 Market cap = Outstanding shares of the company * current share price

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  Large cap shares are shares of big companies which have characteristics such as high
liquidity, stability and a large size.
 Small and mid-cap shares are shares of smaller companies that are not very liquid and have
a growth potential.
 The drivers of risk and return in an equity portfolio depend on the style used by the fund
manager to create the portfolio.
 Style refers to the factors that may lead to the choice of stocks to be held in the fund, such
as growth or value.
 Value style focuses on picking up the stock only if the price is right; a growth style focuses
on earning potential, and may reckon that a good stock may not be available cheap.
 Active management endeavours to outperform the index by altering weighting to sectors,
stock selection and market timing.
 Passive management simply replicates the index.
 In an active management style, stocks are selected based on research and analysis.
 Fundamental Analysis refers to evaluation of the earning capability of a stock, leading to the
determination of its fair value.
 This analysis judges whether the stock is undervalued or overvalued.
 In a fundamental analysis, a stock evaluated in the context of industry and macro factors.
 An actively managed equity portfolio is created after considering the overall situation for the
economy, industry and company. This is called the economy-industry-company (EIC) analysis
framework.
 Stock selection may be top-down, starting with identifying macro-economic factors first, then
identifying industries, and then evaluating and selecting companies.
 If the fund manager first identifies the stock for investment first and then validates this
decision by evaluating the industry and overall economic prospects, it is a bottom-up style of
stock selection.
 Top-down is for sector selection; Bottom up is for stock selection
 Technical analysis involves study of stock prices and volumes, plotted as charts, to identify
patterns that may indicate buying or selling interest in stocks.
 EPS is profit after tax per share. It indicates how much the market is willing to pay per rupee
of earning of a stock.
 EPS is computed as: Profit after tax(PAT) / No. of shares issued
 Price earnings ratio (PE Ratio) is arrived by dividing Market price with Earnings per share.
 Historical PE is computed using past earnings. Forward PE computed using future earnings.
 Low PE means the stock is undervalued and high PE means the stock is overvalued.
 Book value per share is calculated as net worth (share capital plus reserves and surpluses)
of the company divided by the number of shares.
 Market price/book value per share to arrive at Price-Book Value (PBV) ratio.
 A PBV less than one, indicates that the share is selling at a price lower than its book value,
and may therefore be undervalued.
 Dividend yield is the dividend per share divided by the current market price of the stock.

8.2 Debt Securities

 Debt securities represent an underlying loan. Borrower is the issuer; Lender is the buyer.
 Debt instruments have a face or par value, are issued for a specific period.
 Debt instruments mature on a specific date called the maturity date. Tenor is the distance in
time to maturity.
 Coupon rate is the annual rate of interest paid on the par value of the bond.

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  Government securities are also called gilts and have no credit risk. Gilts are issued for
maturity of 2 to 30 years.
 Money market securities are issued for a tenor of less than 1 year.
 In case of floating rate securities, interest payable periodically is reset with reference to the
benchmark or base rate. A spread is added to the benchmark rate to arrive at the coupon
 Zero coupon bonds are issued at a discount and redeemed at par. (Coupon for a floating
rate security is Base + Spread)
 Return of a debt portfolio is made up of accrual income that comes from interest received
and capital gains (losses) from changes in the value of the portfolio.
 Price of a bond responds to changes in market interest rates in an inverse relationship. A
debt portfolio may therefore hold both components.
 The debt portfolio would show a mark-to-market gain if interest rates fall.The debt portfolio
would show a mark-to-market loss is interest rates gain.
 The change in price of floating rate bond is limited due to interest rate changes since
changes in interest rates are reflected in the coupon itself.
 The effect of change in interest rate varies due to tenor and cash flow structure.
 Modified Duration is a technical measure of bond’s sensitivity to interest rates.
 Higher the modified duration of a bond, higher the interest rate sensitivity of a bond.
 Average maturity and modified duration are directly related.
 Yield curve shows the relationship between the interest rates and the tenor, on a given day.
 The yield curve usually slopes upward indicating that the interest rate for a longer tenor is
higher than that of the shorter tenor.
 Yield spread is the difference in yield across tenors, for the same credit quality.
 Difference between the rate for a bond with credit risk and the government bond for the
same tenor is called credit spread.
 Interest rates of all non-govt bonds are higher and depend on their credit rating.
 Higher the credit rating of a bond, higher is the perceived safety and lower the credit spread.
Bonds with higher credit rating are issued at lower rates; and vice versa.

8.3 Gold and Real Estate

 Investors prefer to hold gold when their risk aversion goes up.
 Gold is a growth asset and generates no income.
 In rupee terms, the return from gold tends to increase when the rupee depreciates and
decrease when the rupee appreciates.
 Return from real estate is cyclical. It is a long-term investment and oriented towards capital
appreciation.
 Rent is a source of income but the yield may be low.
 Liquidity of real estate is very low.

8.4 Measures of Return

 Absolute return = (NAV at the end) - (NAV at the start) X 100
(NAV at the start)
 SEBI prescribes simple absolute returns as the return representation for periods less than
one year for all funds except liquid funds.
 Simple Absolute return is calculated for period less than 1 year because it captures accurate
return only for a short period.
 Example:

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  The NAV of a fund was Rs 23.45 on January 31, 2012 and Rs 27.65 on March 31,
2012.
 The absolute return earned by the investor who invested at the start of the period
and is evaluating his investment at the end of the period, would be:
= ((27.65 – 23.45)/23.45) x 100
= 17.91%
 Simple Annualised Return is absolute return multiplied by annualising factor ‘365/n’ or
‘12/n’.
 Annualization of returns from Liquid funds, for periods less than a year, is allowed by SEBI.
 Example:
o An investor bought a unit at Rs 10.50 on Jan 1, 2012 and sold it for Rs 11.50 on
April 30, 2012.
o The absolute return to the investor is:
o (11.50 -10.50)/10.50 = 1/10.50 = 9.52%
o This is the return earned over the period Jan 1, 2012 to 30 April, 2012.
o If we were to ask, what would be the return per annum, we would annualise the
return as follows:
o = 9.52% x 365/120
o = 28.96% p.a
 Compounded Annual Growth Rate (CAGR) is the rate of return arrived at after allowing for
returns to be reinvested
 r = (V1/V0)1/n - 1, where: V0 is the value at the start; V1 is the value at the end; n is the holding
period in years; and r is the CAGR.
 Performance published by mutual funds use the CAGR method for periods greater than one
year.
 Example:
 An investor purchased mutual fund units at Rs.12 each and redeemed them after three
years for Rs.26 each. What is his CAGR?
 CAGR = ((26/12)^(1/3)) – 1 = 29.4%
 In the case of a dividend option, the CAGR is computed by assuming that the dividends were
reinvested at the ex-dividend NAV.
 Example:
 An investor bought 100 units of a fund at Rs 10.50 each. He received a dividend of Rs 2
per unit, which he reinvested at the ex-dividend NAV of Rs 10 each.
 If he sold his holdings at Rs 11 per unit, what is the total return?
Begin value = 100 units x Rs 10.50 = Rs 1050
Dividends = 100 units x Rs 2 = Rs 200
No of units reinvested = 200/10 = 20 units
End value = 120 units x Rs 11 = Rs 1320
Total return = ((1320-1050)/1050) x 100 = 25.71%
 Holding period returns (HPR) calculate the return on an investment for the period it is held. If
the investment is held for over 1 year, CAGR is used and absolute returns is calculated for
holding periods less than one year.

8.5 Measures of Risk

 Market (Portfolio) risk is a standard risk in mutual fund products.
 Market risk in equity arises from changes in prices due to changes in underlying
fundamental and technical factors.

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  In debt instruments, changes in macro economic factors, those change the market
expectations for interest rates.
 Interest rate risk depends on average maturity and duration of the portfolio.
 The average maturity of liquid and very short term debt funds is too low for market risks to
be significant.
 Mutual funds manage market risks through diversification
 Liquidity risks refers to inability to buy or sell securities at fair price.
 Small and mid-cap funds, closed end funds may find it difficult to exit illiquid stocks without
impacting the price.
 Secondary markets in corporate bonds of lower credit quality are not very liquid.
 Money market securities help in ensuring sufficient liquidity.
 Mutual funds have a right to temporarily stop redemptions if they perceive higher illiquidity in
the markets.
 Mutual funds are not permitted to borrow in order to invest. There is no risk of leverage in a
mutual fund.
 Mutual funds can borrow for 6 months (maximum) to meet short term liquidity requirements.
 Total borrowings must not exceeding 20% of net assets.
 Credit risk refers to risk of default in payment of interest or principal, or both, by an issuer of
debt securities.
 Deterioration of the credit quality will result in falling prices and net asset values.
 Credit risk is assessed from the credit rating. A high credit rating indicates a low degree of
default risk.
 It is therefore safe to invest in instruments that are credit rated by agencies registered with
SEBI. Mutual funds carry out their own internal credit research as well.
 Risk is defined as the variance of actual returns from expected returns.
o MS Excel function = var(range containing the return time series)
o Standard deviation is the square root of variance
o MS Excel function =stdev(range containing the return time series)
 A higher standard deviation means greater volatility in return and greater risk.
 Modified duration measures risk in a debt fund with respect to market factors.
 Higher the modified duration/average maturity greater the market risk of the fund and vice
versa.
 Market risk may be systematic or unsystematic.
 Systematic risk is not diversifiable.
 Unsystematic risk is company specific and can be reduced by diversification.
 Beta is a measure of the systematic risk in an equity portfolio.
 Beta measures the sensitivity of the fund's returns to changes in the market index.
 A beta of 1 means the fund is likely to move along with the market.
 Funds with beta > 1 are likely be more risky than the market and are aggressive funds.
 Funds with beta < 1 tend to be less risky compared to the market and are defensive funds.

8.6 Performance Evaluation

 Benchmark is a portfolio that generates an independent level of return, representing an
asset class or investment style.
 Choice of a benchmark for a fund depends on its objectives and the asset classes in which it
invests.
 Mutual funds have to indicate market benchmarks while filing the SID.
 Benchmark return has to be presented when they advertise the scheme’s performance.

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  With effect from February 1, 2018, the mutual fund schemes are benchmarked to the Total
Return variant of an Index (TRI). The Total Return variant of an index takes into account all
dividends/ interest payments that are generated from the basket of constituents that make
up the index in addition to the capital gains.
 Commonly used benchmarks:
 Market indices
 Idependently computed index benchmarks (crisl benchmarks)
 Peer group return
 Return on other comparable financial products
 Diversified equity funds typically choose the following benchmark indices: S&P BSE
Sensex, S&P BSE 200, S&P BSE 500, Nifty 50, Nifty 100, Nifty 500.
 Thematic and Sectoral Funds choose the following benchmark indices: S&P BSE Bankex,
S&P BSE FMCG Index, Nifty Infrastructure Index and Nifty Energy Index
 NSE has indices for the G-Sec market such as Nifty composite G-sec index, Nifty 4-8 Year G-
sec index, Nifty 10 year benchmark G-sec index etc.
 BSE also has certain indices for Government securities such as the S&P BSE India Sovereign
Bond Index, S&P BSE India Government Bill Index.
 ICICI Securities’ Sovereign Bond Index (I-Bex) has sub-indices catering to three contiguous
maturity buckets viz: Si-Bex (1 to 3 years), Mi-Bex (3 to 7 years) and Li-Bex (more than 7
years).
 Benchmark for debt schemes are developed by research and rating agencies recommended
by AMFI such as CRISIL, ICICI Securities and NSE.
 Hybrid funds invest in a mix of debt and equity. Therefore, the benchmark for a hybrid fund
is a blend of an equity and debt index.
 Return generated relative to the risk taken by the fund to generate the return is called risk
adjusted return.
 Sharpe ratio compares the return of a fund with its risk. Sharpe ratio = Excess return /
Standard Deviation
 Return is measured as the excess return over a risk free rate (Return of the fund – risk free
rate).
 For the Sharpe ratio to be high, a fund needs to post a higher return for the same risk, or
lower risk for the same return.
 Example:
 An equity fund posted a return of 25% with a standard deviation of 16%.
 The benchmark posted a return of 22% with a standard deviation of 12%.
 If the risk free rate was 6%, the risk adjusted return measured by the Sharpe ratio would
be as follows:
 For the fund: (25-6)/16 = 1.1875
 For the benchmark: (22-6)/18 = 1.3333
 Though the fund has higher absolute return, it has a higher risk comapred to the
benchmark, so its Sharpe rario is lower.
 Treynor ratio compares the excess return over the risk free rate of a fund with its risk,
measured by beta.
 Treynor Ratio = Excess return/Beta. Higher the Treynor ratio, better the fund performance.
 Beta measures only systematic risk, Standard deviation measures total risk
 Example:
 An equity fund posted a return of 25% with a beta 1.2.
 The benchmark posted a return of 22% with a beta of 1.

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  If the risk free rate was 6%, the risk adjusted return measured by the Treynor ratio would
be as follows:
 For the fund: (25-6)/1.2 = 15.83
 For the benchmark: (22-6)/1 = 16
 Manager’s Alpha means the excess return after adjusting for beta
 Example:
 An equity fund posted a return of 30% with a beta 1.2.
 The benchmark posted a return of 22% with a beta of 1.
 If the risk free rate was 6%, the risk adjusted return measured by the Manager’s alpha
would be as follows:
 Excess return of the fund: 30% – 6% (risk free rate) = 24%.
 Given its beta of 1.2 and benchmark return of 22%, its excess return should have been
19.2%.
 Therefore the alpha of the fund is 4.8%.
 A consistent performer is a fund which is able to give better returns than the benchmark
across time periods on a risk-adjusted basis.
 Tracking error measures the consistency in returns.
 The standard deviation of excess return is called the tracking error.
 Lower the tracking error, higher the consistency in performance.
 If the excess returns come with higher risk, they may not be consistent.
 If the standard deviation is high, the returns may not be consistent.
 Since index funds replicate the index, their performance is amongst peer group is compared
using tracking error. Tracking error for index fund should to be zero.

CHAPTER 9 - SCHEME SELECTION (10 Marks)

9.1 Selection of Equity Funds

 Equity funds that have consistently generated better returns than the benchmark over
different market situations are preferred for their consistent performance.
 Investors are also interested in the ability of the fund to protect downside risk in time of
market downturn.
 Longer term performance over 3, 5, 7 or 10 should be used to select equity funds rather
than short term returns.
 Ideally, cash levels should not be over 10% of the net assets.
 Holding cash is a defensive stance, hoping to protect the portfolio from a steep fall in stock
prices.
 The fund manager’s cash call may turn out to be right or wrong, implying a risk for the
investor.
 Different equity funds have different levels of diversification in the portfolio based on the
investment objective. Eg. a sector fund is less diversified than a thematic fund.
 If the top 10 stocks in the portfolio account for more than 40% of the net assets, the
portfolio is said to be concentrated.
 If the top 3 sectors in a diversified equity fund account for over 40% of the net assets, the
equity fund is termed to be concentrated.
 Thematic/sector fund will have a higher sector concentration and hence chosen tactically.
 The market cap of the stocks in the portfolio should be in line with the portfolio objectives.
 Large cap fund should be predominantly have large cap stocks. Large cap fund has lower
risk of liquidity and earning shocks. In a difficult industry scenario, investments should
largely be made in funds investing in frontline stocks.

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  A diversified fund that has too much exposure to small cap stocks is risky. Small/mid cap
funds are suited for aggressive investors.
 Portfolio turnover ratio = total sales or purchases of a fund (whichever is lower) divided by
the average net assets of the fund.
 Higher the ratio, greater the frequency of trading, and lower the average holding period.
 Average holding period = 365/Portfolio Turnover Ratio.
 Low turnover indicates that the fund manager has high conviction in the stocks selected.
Frequent trading increases transaction costs of the scheme.
 Liquidity refers to the option to exit the fund. An open-ended fund enables investors to exit
the fund, when they choose to.
 Closed end funds or ELSS should be chosen only if the investor is sure of a longer holding
period. However, in order to ensure liquidity, closed end funds are now required to be listed.
 Size of the equity fund influences the performance. Funds with a large size may be difficult
to liquidate and rebalance.
 Finding suitable stocks becomes tougher as the size increases in case of mid-cap and small
cap funds and sector funds.
 Longer age of the fund presents a longer track record for evaluation. In case of an old fund,
the investor will have the ability to judge performance over a longer period of time.
 Style of fund performance defines risk-return profile. An actively managed fund is riskier than
a passive fund.
 Dividend yield funds are less risky, compared to growth-oriented funds.
 Large cap funds may be larger in size and less volatile; small cap funds may be smaller in
size and more volatile.
 In a bullish market, growth funds outperform; in a bearish market, value funds outperform.
 Value funds tend to perform better over a period of time.

9.2 Selection of Debt funds

 Debt funds are differentiated by the segment of the debt market they invest in.
 Fund managers construct portfolios including securities whose tenor is linked to the
objectives.
 Investing horizon of the investor may be matched to the average maturity.
 Average maturity indicates the extent of interest rate risk in the portfolio.
 Higher the average maturity of a debt fund, greater the interest rate risk of the fund.
 Yield indicates the return on the portfolio. Funds with shorter tenors may feature a lower
yield.
 Higher the proportion of securities to be valued every day on mark-to-market basis, and
higher the average maturity, higher the interest rate risk in the portfolio
 Expense ratio is very important in debt funds. A debt fund with lower expense ratio should be
preferred to those with higher expense ratios.
 Institutional plans are offered with lower expense ratios for large investors.
 Credit rating of instruments in the portfolio indicates the extent of credit risk.
 Extent of papers with low credit quality in the portfolio indicates the extent of risk.
 Funds may compromise credit quality for a higher yield than peer group average.
 Floating rate funds are preferred in rising interest rate scenario
 FMPs are not affected by interest rate risk
 Liquid funds have lowest interest rate risk
 Performance of debt funds is typically evaluated for periods from three months to one year.
 Funds with stable returns and regular dividends are preferred.

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  Debt fund performances, within a given peer group does not vary too much.
 Large holding of cash and equivalents will reduce the returns.
 Funds with low credit quality may be giving a high return.
 Portfolio with a large number of securities is more liquid.
 Large-sized debt funds can manage inflows and outflows, expenses and liquidity, better than
smaller funds.

9.3 Selection of Hybrid and Other funds

 Hybrid funds can have an equity or debt-orientation.
 Hybrid funds provide an indicative allocation to equity and debt, usually within a range.
 Performance of a hybrid fund depends on the allocation to asset classes and changes to this
allocation.
 It is difficult to compare hybrid funds with varying allocations. The securities held within the
portfolio, under each asset class, impact performance.
 The regularity of the dividend and the predictability of the amount of dividend are important.
 Value of gold ETFs will be in line with the price of gold.
 Funds that invest in gold-linked company stocks may behave more like equity funds.
 Performance of arbitrage funds should be comparable to that of short term debt funds.
These funds may offer limited liquidity, and may be exposed to volatility from basis risks.
 A multi-manager fund of funds may be a better choice. FoFs should be chosen based on
investment objective of the fund.
 Fund of funds are evaluated based on their ability to select and manage a portfolio of funds.
 In an International fund risk and return depends on strategy they adopt to invest in
international markets.
 International funds carry both liquidity and currency risks.

9.4 Source of Information on Mutual funds

 Monthly factsheets of fund houses provide information on fund performance, and portfolio
composition.
 Information about funds is also found on investment-oriented websites and websites of Amfi
and Sebi and respective mutual funds
 Agencies that use mutual fund data to create comparisons and reports for product
comparison and selection provide fund performance information.
 Rankings and ratings of funds are widely available, after classification of funds into a peer
group.
 Information providers for mutual funds:
 Value Research at www.valueresearchonline.com
 Icra online at www.mutualfundsindia.com
 CRISIL at www.crisilfundservices.com
 Morning Star at www.morningstar.co.in
 Lipper at www.lipperweb.com

CHAPTER 10 - SELECTING THE RIGHT INVESTMENT PRODUCTS FOR INVESTORS (9 Marks)

 Physical assets have a physical and material form. For example: gold and real estate.
 Return on physical assets is in the form of appreciation over time.
 Physical assets are preferred by investors due their tangible nature. However, physical
assets are exposed to hazards such as fire, theft or floods.

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  Financial assets involve investing money for some cash flows in the future.
 Financial assets do not have a tangible form. For example: Bank deposits, company
deposits, equity shares, government saving instruments, bonds and debentures.
 Financial assets because of their nature, are protected from physical harm. Financial assets
help in financing the economic activity and are encouraged by the government over physical
assets.
 Investment in gold acts as a hedge against inflation.
 One can hold gold in physical form in the form of Gold bonds, Gold coins and bars.
 Gold can be held in a financial form in 3 ways:
 Buying gold in the commodity futures market
 Buying gold-linked funds
 Buying gold exchange traded funds (ETFs)
 Mutual funds in India have launched gold-linked schemes that may invest in physical gold,
international gold funds, or in securities of gold mining companies.
 Some funds also offer hybrid products that combine gold with other assets such as bonds,
commodities and equity.
 There are many advantages of holding gold in the form of mutual funds.
 Gold-linked funds are exempt from wealth tax.
 Since they are in the form of a mutual fund unit, they become long-term capital assets after
a holding period of one year.
 Investors have nomination facility which is not available to investors in physical gold.
 Real Estate as an investment is preferred by investors but is beyond the means of small
investors.
 It is not easy to quickly liquidate investments in real estate at an appropriate price. There is a
high concentration risk attached to real estate investments.
 Real estate mutual funds (REMFs) enable investors to receive benefits of investing in real
estate with a small investment through a mutual fund product.
 The portfolio of REMFs can be made up of direct investment in real estate, debt instruments
issued by developers, or securitised loans.
 Bank deposit is a preferred form of investment with small investors.
 Bank deposits offer the facility to access funds anytime.
 Investors find it easy to invest in bank deposits due to their familiarity with their bank and
are considered as a safe investment option.
 However, term deposits usually impose a penalty for premature withdrawal.
 Yield on bank deposits is quite low and investors cannot benefit from changes in interest
rates.
 Interest income from bank deposits is taxable.
 NPS, launched in May 2009, is regulated by PFRDA and has an objective of saving for a
retirement corpus.
 Contributions made by the individual are managed by professional portfolio managers.
 NPS does not offer guarantee of returns.
 The minimum investment is Rs.500 a month or Rs.6000 annually. There is no upper limit on
investment.
 Investment mix in NPS is selected by the contributor.
 An NPS account can be opened through identified Points of Presence.
 Permanent Retirement Account Number (PRAN) will be allotted.
 Tier I (Pension account): The amount invested in this account cannot be withdrawn
before the end of the term.

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  Tier-II (Savings account). The amount invested can be withdrawn.
 One needs to have a running Tier I account in order to be eligible to open a Tier II
account.
 Investment mix under Tier II can be selected by the contributor.
 The funds contributed will be managed according to the investment mix selected by the
contributor.
 The options available are equity (E), credit risk bearing debt instruments (C) and government
securities (G).
 While an investor can choose to invest the entire corpus in C or G, investment in E is capped
at 50%.
 A separate asset class A (Alternative Investment Products) has been created for private
sector NPS subscribers in addition to the existing asset classes. Investment in Asset Class A
can be upto 5% and consists of:
 Commercial mortgage based securities
 Units issued by Real Estate Investment Trusts regulated by SEBI
 Asset Backed Securities regulated by SEBI
 Units issued by Infrastructure Investment Trusts regulated by SEBI
 Alternate Investment Funds (AIF Category I and II) registered by SEBI
 There is also an auto choice option where the exposure to equity keeps reducing as the age
of the contributor increases.
 NPS subscribers are allotted a unique identification number known as Permanent
Retirement Account Number (PRAN) which is applicable across employers or Pension Fund
Managers.

CHAPTER 11 - FINANCIAL PLANNING (7 Marks)

 Financial needs occur at various stages in one’s life to meet ’life goals’.
 Financial needs can be classified as investment needs and protection needs.
 Financial need that can be described in terms of the amount of money that may be required
to fulfil the need and the time when the money would be required is called a financial goal.
 Future value of goals can be estimated based on current cost, time to goal and the expected
rate of inflation.
 [FV=current cost*{1+rate of inflation}^time]. Use the FV function in MS Excel
 Example:
 It costs Rs.8 lakh to put a child through formal college education today.
 If a family likes to estimate what this cost will be when their child, who is now 6 years
old, is ready for college education at 16 years of age?
 = 8 x (1.07)^ 10 = 15.7 lakh
 Example:
 Suppose the investor indicates that an amount of Rs.5 lakh has been saved already for
this goal, and he likes to know what is the rate at which it should be invested to meet
the goal:
 ((Estimated future value/invested amount)^investment horizon ) – 1
 ((15.7/5)^(1/10)) -1 = 12.12%
 Use the RATE function in MS Excel
 Example:
 For an estimated expense of Rs.15.7 lakh after 10 years, the investor chooses to invest
in a diversified equity portfolio, expected to earn an average return of 14% p.a. The
amount to be invested today can be computed as:
 Future value of goal/(1+expected return)^investment horizon

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  15.7/((1+14%)^10) = 4.23 lakh
 Use the PV function in MS Excel
 Example:
 Instead of investing Rs.15.7 lakh in a lumpsum as mentioned in the earlier example, the
investor may choose SIP.
 Use the PMT function in MS Excel
 The amount to be invested today in SIP:
 PMT(rate of return, number of periods, PV (blank), FV)
 PMT(14/12, 10*12, , 15.7 lakh)=Rs.6060

11.2 Financial Planning

 Financial planning considers the overall situation of the investor.
 A financial plan proposes an asset allocation to match the investor’s risk profile.
 Financial planning involves creating an investment plan and asset allocation strategy to
meet financial goals.
 It also calls for periodic review of the plan and portfolio and taking corrective measures.
 The objective of financial planning is to ensure that the financial goals are met through
proper planning and management of finances.
 It creates a road map in terms what has to be done to achieve the goals.
 It also ensures the right combination of savings and investment.
 It reviews current and expected income and expenses and the ability to save and invest.
 Financial planners advise investors on managing their finances such that goals are
achieved.
 They have a good understanding of investment options available and their suitability.
 They work with clients on their overall financial situation and not just one or two aspects.
 They review the financial plan periodically so that it continues to be relevant to the investor’s
needs and situation.
 Steps in financial planning:
 Establish the client relationship.
 Ascertain the clients’ needs and define with them, their financial goals
 Gather data about the clients’ financial status. Analyse the data to prepare a current
financial position statement.
 Understand how much of loss clients can withstand and for what period
 Understand and explain the tax situation to the clients.
 Suggest allocation to asset classes and specific schemes
 Execute the plan by making the specified investments
 Review and suggest changes in asset allocation
 Investor needs and preferences vary depending upon their situation.
 A commonsense approach to understanding these differences in preferences is to look at
which stage of life they are in.
 Childhood Stage: This stage represents dependence on parents to meet expenses. Any gifts
received can be invested for the long-term as there is no immediate requirement for funds.
 Young Adult Stage: This is the start of the earning phase. Investing in equity must begin in
this stage preferably through Equity SIPs. Life insurance may be necessary to protect income
from disability or illness. In this stage of life, an individual is partially dependent.
 Young married stage: In this stage, there is a need to provide for emergencies and protect
income from death, injuries or loss is high. A couple has joint responsibility to create and
adhere to budgets and to control expenses. The need for term insurance is high.

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  Married with Children Stage: In this stage, less money is available for investment. Health
and life insurance is important as protection needs are more important than investment
needs at this stage.
 Married with Older Children Stage: In this stage, there is higher ability to save and invest.
Investment needs take precedence over protection needs. Focus is on repayment of loans
and saving for retirement.
 Pre-retirement Stage: In this stage, people start setting aside increased amounts to protect
their life style, post-retirement. Pension products and health insurance are preferred choices
for investors.
 Retirement Stage: Persons in this stage of life require at least 2/3rd of their last income.
They focus on income generation and protect wealth from the effects of inflation.
 The wealth stage approach assumes that the accumulation of wealth goes through various
phases. There are three wealth cycle stages as follows:
 Accumulation Phase: Investors in this stage are able to accumulate and save for the long-
term and choose growth-oriented investments. They have a long-term investing horizon and
can allocate savings to equity. e.g. saving for child’s education.
 Transition Phase: This phase is characterized by middle-aged investors. They have both
equity and debt in their portfolio, as they have a medium-term horizon. e.g. withdraw from
savings to meet the immediate education expenses of a child while at the same time saving
for retirement.
 Distribution Phase /Reaping stage: Investors in this stage depend on investment income and
are usually retired investors. These investors are income-oriented, preferring debt to equity.
 Inter-generational Wealth Transfer stage: In this stage, investors pass on their wealth to the
next generation or to organisations and trusts. They focus on the goals of the beneficiaries
and require advice on creating trusts and wills and estate planning.
 Sudden Wealth Surge: Sudden wealth surge is a wealth stage where the investor
experiences a sudden surge in wealth from unexpected flow of funds.e.g. lottery, sudden
appreciation in shares, inheritance of wealth. In this stage, it is important that the investor
evaluate tax implications. Investments can be made in low-risk products like a liquid fund till
such time a proper financial plan is drawn.

CHAPTER 12: RECOMMENDING MODEL PORTFOLIOS AND FINANCIAL PLANS (8 Marks)

12.1 Model Portfolios and Risk Profiling
 A model portfolio is created for a given combination of risk, return and investing horizon.
 Risk profile is influenced by investor’s personal and financial situation.
 Risk Profiling Tools are used to generate risk appetite scores for investors. These can be in
the form of surveys, questionnaires and proprietary risk profiling tools.
 Scenario analysis may also be used to carry out risk profiling. Past history of the actual
transactions of the investors may also be a good risk profiling tool.
 Asset allocation involves making the decision about the proportions in which investments
would be divided between asset classes.
 It takes into account correlation between asset classes.
 The asset allocation for an investor would have to be tweaked based upon the ability and
willingness of the investor to assume risk.
Factor Relationship with Risk Appetite
Age Older investors may have lower risk appetite than younger investors
Accumulated capital Higher the accumulated capital, higher is the risk appetite
Stability of Income Individuals with stable income tend to have higher risk appetite
Job Security Individuals with higher job security may be willing to assume higher risk

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Dependents Risk appetite decreases as number of dependents increases
Earning members Risk appetite increases as number of earning members increases
Attitude Individuals willing to experiment may have a higher risk appetite

12.2 Types of Asset Allocation

 Strategic asset allocation (SAA) is driven completely by his need for return and risk profile.
 Model portfolio is an example of SAA. For example, an investor desiring a return of 14% over
10 years, with a moderate appetite for risk, may choose to have 60% of his investments in
equity (expected return of 18%) and 40% in debt (expected return of 8%).
 Tactical Asset Allocation (TAA) involves active management of the proportions in various
asset classes based on the expectation of the performance of different asset classes.
 For example, if the advisor expects the equity markets to correct and he may tactically
reducing the allocation to equity and increasing the allocation to debt.
 TAA is carried out by fund managers, expert advisors and experienced investors.
 In Fixed Asset Allocation, investor chooses a strategic asset allocation and decides to
rebalance periodically to the same ratio.
 For example, imagine a portfolio has an allocation of 60% in equity and 40% in debt and that
equity markets are doing well. Value of equity portfolio goes upto 70%. The investor will sell
part of the equity holdings and bring it down to 60% of the portfolio value and invest in debt
and restore the proportion to 40%.
 Flexible Asset Allocation involves choosing an asset allocation and letting it move along with
the market without rebalancing.
 If equity does well and the allocation increases, they allow it to run, without rebalancing to a
fixed ratio.
 Model portfolios are indicative and asset allocations may have to be revised and rebalanced
based on investor needs.
 Examples:
a) Proportion to equity for an investor may change as he moves away from accumulation
phase into transition phase
b) Allocation to riskier assets reduces as life stage changes from young adult to married
with children stage
c) Allocation to income-oriented assets increases are investor approaches retirement
d) A retired investor whose retirement income is well taken care of and is looking to
generate a corpus for a grandchild may be willing to take a greater exposure to equity
as he ages

12.3 Behavioral Biases in Investment Decision Making

 Confirmation bias – a tendency of people to favor information that confirms their pre-existing
beliefs or hypotheses.
o For example, investors who might have bought a stock which had fallen heavily and
sitting on huge losses will also look for positive news and information about the
company, just to support their decision to hold on to the investment to sell at a
profit in the future.
o Such investors may also tend to interpret ambiguous evidence as supporting their
existing position.
 Overconfidence bias - People like to believe in their superior ability in making the ‘right’
decisions.
o In investing, overconfident investors and traders tend to believe they are better than
everyone else in choosing best stocks and other investment avenues.

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 o Similarly, they may believe that they are spot on in terms of best times to enter and
exit a position.
o This may often lead to hasty and regrettable decisions.
o For example, investors who made a few easy successful investments start believing
themselves and think they have the capacity better than others in selecting winning
investments.
 Disposition bias –Winners get out, losers stay back. Disposition effect is the tendency of an
investor to sell winners too early and hold losers too long.
o The disposition effect is harmful to investors because it may lead to higher capital
gains tax payouts and hence, lower tax-adjusted return.
o Instead, following the advice of “cut your losses and let your profits run” enables
investors to engage in disciplined investment management that can generate higher
returns.
 Familiarity bias – This bias occurs when investors prefer familiar investments despite the
seemingly obvious gains from diversification.
o For example, investors display a preference for domestic assets with which they are
more familiar as compared to international diversification.
o An implication of familiarity bias is that investors hold suboptimal portfolios.
 Anchoring bias – Anchoring is the tendency to hold on to a belief and apply the same while
making future judgments.
o Anchoring occurs when people base their decisions on the first source of
information to which they are exposed.
o Few times investors also would anchor to a price only below which they will buy.
o By this, they may miss the opportunity to invest. Others may use the ‘52 week high’
price of a stock as an anchor and may decide to sell a stock only at that previous
high.
o Such investors may not be able to change their decision based on new data,
changes in the company fundamentals or investment scenario.
o They face the risk of being stuck with their belief and may refrain from taking the
correct investment call.
 Representativeness bias – Representativeness results in investors labeling an investment as
good or bad based on its recent performance.
o Consequently, they buy stocks after prices have risen expecting those increases to
continue and ignore stocks when their prices are below their intrinsic values.
o Similar investor behavior is typically seen for well-performing mutual funds, which
see huge inflows.
o Instead, investors should spend their time and energies analyzing whether past
performance is likely to be repeated in the future.
 Social Proof bias – Social proof or trend chasing bias is a psychological condition where
people assume the actions of others to reflect correct behavior for a given situation.
o For example, if an IPO of a company does well, then companies in same sector will
announce their IPOs and investors will invest blindly without even checking the
fundamentals.
o To avoid this, bias, investors should resist following the herd or jumping on the
bandwagon.
 Self-attribution bias – Investors who suffer from self-attribution bias tend to attribute
successful outcomes to their own actions and bad outcomes to external factors.
o Investors afflicted with self-attribution bias may become overconfident, which can
lead to overtrading and underperformance.
o Keeping track of personal mistakes and successes and developing accountability
mechanisms such as seeking constructive feedback from others.

This material is a summary of the classroom training content of CIEL’s training program for NISM-MFD 44
Examination. ©2018, Centre for Investment Education and Learning Pvt. Ltd. www.ciel.co.in