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NISM Series - V-A

Mutual Fund Distributors Exam
Training Module

Knowise Learning Academy India Pvt. Limited

Concept & Role of a Mutual Fund
Chapter 1
Understanding Mutual Funds

Investment Vehicle

Pool of Funds created by investors

Returns accrue in the proportion of Investment

Investment Objective
- Every sheme has a specific Investment Objective

Mutual funds are first offered to an investor in NFO
(New Fund Offer)

Unit Capital is the corpus of the fund
- Number of Units * Face Value
- Face Value is usually Rs.10 per unit
- Increase/Decrease due to market changes
Mutual Fund: Concept
Mutual Fund Portfolio

Portfolio’s are made on “Don’t put all your eggs in one basket” theory.

Portfolio is a collection of various securities

Value of the investment portfolio changes with a change in market price of

the securities

Portfolio’s are aligned to market for valuation purposes – Mark to

Markets(M2M)

Unrealized gains or Unrealized losses

Total Assets - Market Value of all the securities held in the portfolio
Net Assets

Assets Under Management (AUM) = Total Assets + Current Assets

Mutual Fund does not hold any long term assets or liabilities

Net Assets = Total assets + Accrued income – Current liabilities – Accrued
expenses

Net Asset Value = Net assets divided by total units outstanding
- Value per unit at current market prices

The net assets of a mutual fund may go up/down due to the following
reasons:
– Entry /exit of investors
– Income from dividends or interest/ Expenses
– Realised gains/losses
– Unrealised gains/losses
Profitability Matrix

Interest Income

+ Dividend Income

+ Realized Capital Gains

+ Valuation (Unrealized) Gains

- Realized Capital Losses

- Valuation Losses

- Scheme Expenses

When this matrix is positive the NAV goes up

When it is in negative the NAV of the fund falls
Advantages & Limitations

Advantages
– Portfolio diversification
– Low transaction cost
– Professional fund management
– Convenient Options
– Regulatory Comfort
– Tax Benefits
– Liquidity
– Systematic Investments

Limitations
– Lack of Portfolio Customization
– Choice Overload (800+ schemes to choose from)
Sale & Repurchase

Sale Transactions (Purchase by Investors)

– When existing investors buy additional units or new investors buy units of the
open ended scheme, it is called a sale transaction. It happens at a sale price,
which is equal to the NAV.

Re-purchase Transactions (Selling by Investors)

– When investors choose to return any of their units to the scheme and get back
their equivalent value, it is called a re-purchase transaction. This happens at a
re-purchase price that is linked to the NAV.
– It is also called as Redemption.
– Exit Load(if any will be deducted before paying to the investors)
Mutual Funds - Structure

Open ended Funds

– Without Fixed Maturity
– Accept on-going sale & re-purchase requests at fund offices & ISCs
– Liquidity is very high, Unit Capital is not fixed.

Close –ended Funds

– Run for a specific period
– Units can be purchase only during NFO
– Compulsorily listed on Stock exchange to provide liquidity
– Unit Capital is constant

Interval Funds
– Close-ended in structure but become open-ended in specific period
– Specific Transaction Period is minimum 2 days. No redemptions during STP.
– Minimum duration of interval period is 15 days.
– Also to be listed in stock exchange.
Based on Investment Categories

Money market funds invest in money market securities

Debt funds invest in debt securities

Equity funds invest in equity shares

Hybrid Funds invests in a combination of 2 asset classes

Other types of Funds
– Arbitrage Funds
– International Funds
– Real estate funds invest in property-linked securities
– Gold funds invest in gold-linked securities
– Commodity funds invest in commodity-linked securities
– Exchange Traded Funds
Debt Funds - I

Liquid Funds or Money Market Funds:

– Invest in money market securities
– Invest in debt securities less than 61 (earlier 91) days to maturity.
– Safety of principal and superior liquidity.
– Interest rate risk very low.

Cash or Treasury Management Funds:

– Risk & Return profile almost like liquid Funds
– Choose securities with slightly longer tenor of up to 364 days.

Floating Rate Funds:

– Invest largely in floating rate debt securities.
– Better returns in rising interest rate scenario.
Debt Funds - II

Gilt Funds:
– Invest in government securities of medium and long-term maturities.
– High on Interest rate risk due to long maturity period.
– Zero in Default Risk.

Income Funds:
– Invests in corporate bonds and government securities of medium and long
tenor.
– Subject to interest and credit risk/default risk

Dynamic bonds funds:

– Maturity vary with interest rate view
Debt Funds - III

Fixed Maturity Plans (FMPs):

– Hold securities with maturities that match the tenor of the closed fund.
– No interest rate risk.
– FMPs are close-ended in nature.

High yield or junk bond funds:

– Earn higher coupon income by holding low credit quality bonds.
– Very high on Default Risk.
– Not allowed in India.
Equity Funds – Portfolio wise

Diversified Equity Funds :

– Invest in equity shares across various sectors, market caps and industries.
– Most popular amongst equity funds.

Thematic Equity Funds:

– Multiple sectors and stocks falling within a theme.
– Less diversified than a pure Diversified Equity Fund.
– Perform really well when theme plays out.

Sector Equity Funds:

– Invest in a given sector .
– Exposed to Concentration Risk
– Performance tends to be cyclical & hence very risky.
Examples

Diversified Equity Funds :

– UTI Mastershare Fund
– HDFC Equity Fund
– Franklin india Bluechip Fund

Thematic Equity Funds:
– Reliance Media & Entertainment Fund
– Canara Robeco F.O.R.C.E Fund
– Sundaram PSU Opportunities

Sector Equity Funds:
– SBI Pharma Fund
– ICICI Prudential FMCG Fund
– Tata Infrastructure Fund
Equity Funds: Strategy based

Growth Funds:
– Invest in companies whose earnings are expected to grow at an above-average
rate. Aggressive in nature.

Value Funds:
– Identify stocks of good quality companies whose real worth has not been realised
yet. Trading below Book value.

Large Cap Funds:

– Invest in Large & Blue-chip companies only.
– More stable & Less risky.

Mid-cap and Small-cap funds:

– Focus on smaller and emerging companies for their higher growth potential.
– High Risk, High Return Category, Less Stable.
Equity Funds - Others

Dividend Yield Funds/Equity Income Funds:

– Invest in companies that have a high dividend yield.
– Attractive in bear and over-valued markets due to less volatility and regular
dividend income

Index Funds:
– Passive funds based on equity indices.
– Portfolio replicates Index performance.
– Low expense ratio
Equity Linked Saving Scheme

Some equity funds are launched as ELSS schemes

– Also known as Tax Saving Scheme
– Diversified Equity Fund
– Offer tax benefit under Sec 80C
– Investments up to Rs. 1,00,000 in a year can be deducted from taxable income
of individual investors.
– Open-ended in structure but has a Lock-in period of 3 years from date of
Investment
– Portfolio should have at least 80% in equity shares.
Hybrid Funds

Monthly Income Plans

– For investors who seek regular income usually monthly.
– Pays by monthly dividends though no assurance.
– Debt oriented with equity exposure usually in the range of 5% to 30%

Balanced Funds
– Invests in both Debt & Equity
– Ideal proportion 50:50. But 40:60, 60:40 also available.
– Equity provides growth where as Debt gives stability & regular income.

Capital Protection-Oriented Funds

– Debt securities(Zero Coupon Bonds) with a derivative instrument or equity
shares
– ‘Amount invested + Interest = Investor’s principal’
Other Funds - I

Fund of Funds (FoFs):

– Invests in other Mutual Funds instead of securities
– Charges higher when compared to basic mutual funds
– Taxed as non-equity funds even if invests 100% in equity.

International Funds:
– Invests in foreign securities.
– Alternatively, a local (Feeder) fund invests in a foreign (Host) fund.
– Exposed to Currency/Foreign Exchange risk.

Arbitrage Funds:
– Take equal and opposite exposure in different markets.
– Earn a return due to difference in price in the two markets.
– Low risk return profile as the portfolio is hedged.
Other Funds - II

Exchange Traded Funds (ETFs):

– Open-ended funds that track a market index.
– Units are listed like shares on the stock exchange.
– Sale and re-purchase transactions are executed on stock exchange.
– Demat accounts are required to do transactions
– Gold ETF is an example.

Commodity Funds:
– In India, direct investment in commodity futures is not allowed.
– Indian commodity funds usually invest in stocks of commodity companies or
commodity ETFs
Funds based on Management style

Passive Funds
– Replicate a market index
– Invest in the same securities and in the same proportion
– No active stock or sector selection
– Portfolio is modified every time the index composition changes
– Expenses are lower

Active Funds
– Seek to invest in securities and sectors that may offer a better return than the
index
– Actively manage the allocation to market securities and cash
– May perform better or worse than the market index
– Incurs a higher cost than passive funds
Fund Structure & Constituents
Chapter 2
Mutual Fund – Structure

Mutual Funds: 3 -Tier structure

Sponsor

Sponsor - Who starts up a Mutual Fund

Appoints the Board of Trustees and Board of Directors of the AMC

Seeks regulatory approval from SEBI for setting up a Mutual Fund

Eligibility criteria
− At least 5 years experience in the financial services industry
− Positive net worth over the last 5 financial years
− Profits over the last 3 out of 5 years
− At least 40% contribution to the capital of the AMC
Trustee

Investors in the mutual fund are beneficiaries of the trust

Trustees must act on behalf of the investors

Either Trustees or Trustee Company.

Trust deed is executed by the Sponsor in favor of the trustees

Board of Trustees
− Oversee the working of the AMC and management of the mutual fund
− Key decisions of the AMC require trustee approval
− Sponsor must appoint at least 4 trustees
− At least 2/3rds of the members have to be independent (Not associated with
sponsor in any way)
− Must meet at least 6 times in a year
SEBI Regulations for Trustee

Trustees are appointed by the Sponsor with SEBI approval

Every trustee has to be a person of ability, integrity and standing.

A person who is guilty of moral turpitude cannot be appointed trustee

A person convicted of any economic offence or violation of any securities

laws cannot be appointed as trustee.
Asset Management Company (AMC)

AMC is the investment manager of the mutual fund

Investment Management Agreement between the trustees and the AMC

AMC is appointed by the trustees, with SEBI approval

− AMC should have a net worth of at least Rs10 crore at all times
− 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
Key Personnel at AMC

Business Head – Managing Director, Executive Director or CEO

Chief Investment Officer (CIO) – Responsible for overall investments of the
fund.

Fund Managers – As per SEBI regulations, every scheme requires a fund
manager, though the same fund manager may manage multiple schemes.
They report to the CIO.

Chief Marketing Officer (CMO) - Responsible for mobilizing money under
the various schemes.

Chief Operations Officer (COO) - Handles all operational issues

Compliance Officer -
– Ensures all the legal compliances.
– Signs Due Diligence certificate in Offer Document
– Works closely with Trustees & reports directly to head of AMC
Constituents & Roles

Constituent Role

Custodian Hold funds and securities

R&T Agent Keep and service investors’ records, process

transactions, process payouts
Banks Enable collection and payment

Auditor Audit scheme accounts, Separate auditors for

Mutual Fund & AMC
Distributors Distribute fund products to investors

Brokers Execute transactions in securities

Fund Accountants NAV calculation

Other Fund Constituents

All mutual fund constituents have to be registered with SEBI

They are usually paid fees for their services.

Mutual fund constituents (except custodians) are appointed by the AMC
with the approval of the trustees.

Custodians are appointed by the sponsor. Sponsor or its subsidiary cannot
act as custodian.

Sponsor can also be a distributor to its own fund.
– Kotak Bank(Sponsor) also sells Kotal Mutual Fund through its banking channel

R&T activities can be done in-house or outsourced.
– Usually outsourced.
– CAMS, KARVY

Auditor of the schemes & auditor of AMC has to be different.

Fund Accounting is usually done in-house.
Example

Mutual Fund Trust • Kotak Mahindra Mutual Fund

Sponsor • Kotak Mahindra Bank Limited

Trustee • Kotak Mahindra Trustee Co. Limited

AMC • Kotak Mahindra Asset Mgmt Co. Limited

• Deustche Bank, StanChart,

Custodian • Bank of Nova Scotia (Gold)

RTA • Computer Age Mgmt Services (CAMS)

Legal & Regulatory Environment
Chapter 3
SEBI – The Regulator

Sebi was set up by the Sebi Act, 1992 and is

supervised by Ministry of Finance

Indian mutual funds are supervised and regulated
by Sebi (Mutual Funds) Regulations, 1996
– Amendments and circulars from time to time

Regulation of Constituents
– Sebi regulates registrars, custodians, brokers,
collecting banks and the like
– Constituents must be registered with Sebi
– Distributors must clear the mandatory certification
prescribed by Sebi
– AMC and Trustee company are also governed by
the Companies Act and Indian Trusts Act
respectively
Self Regulatory Organizations (SROs)

SROs frames their rules & regulations to regulate their own members.

SEBI only lay down only broad policy frame work & leave the micro
regulations to SROs

Mutual Funds are not SROs

The Institute of Chartered Accountants of India (ICAI) is a SRO and it

regulates its own members.

All stock exchanges are SROs.

RBI & Stock Exchanges

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
– Subject to regulations laid down by RBI

Closed-ended funds/ETFs are listed on stock exchanges

Listing agreement with stock exchanges
– Subject to regulatory and disclosure requirements
Association of Mutual Funds in India (AMFI)

Amfi is industry association

– It is not a Self Regulatory Organization (SRO)

Amfi’s functions
– Recommends best business practices and code of
conduct for members.
– Represents the industry to regulators and policy
makers
– Conducts investor awareness programmes
– Disseminates informAmfi Registration Number
(ARN)

Amfi is authorised by Sebi to seek explanation,

issue warnings, or cancel the registrationation
 ACE & AGNI

Amfi Code of Ethics (ACE)

– AMFI has drafted a Code of Ethics to be followed by the Asset Management
Companies in their operations and in their dealings with investors,
intermediaries and the public.
– Adapted as a supplement in the Fifth Schedule of the Sebi (Mutual Fund)
Regulation

Amfi Guidelines and Norms for Intermediaries (AGNI)
– Amfi has framed a set of guidelines and code of conduct for intermediaries
who sell and distribute mutual fund products.
– Sebi has made it mandatory for distributors to follow this code of conduct.
– If a distributor breaches the code of conduct, Amfi is authorised by Sebi to
seek explanation, issue warnings, or cancel the registration of the
intermediary for repeat violation of the code.
– These actions are performed within the stipulations in the code of conduct
and an intermediary can appeal to Amfi to seek redressal.
Investment Objective

It defines the broad investment charter. In simple words, the purpose of

the scheme.

Investment Objective of a Diversified Equity scheme could be
– “To generate capital appreciation from a portfolio of predominantly equity
related securities”

Investment Objective of a Diversified Debt scheme could be
– “To generate income by investing predominantly in a wide range of debt and
money market securities”

Investment Objective of a Balanced Scheme could be
– “To achieve growth by investing in equity and equity related investments,
balanced with income generation by investing in debt and money market
instruments”
Investment Policy

Investment Policy describes the portfolio nature in greater detail

– “The portfolio will generally comprise of equity and equity related instruments
of around 30 companies, which may go upto 39 companies”

– “Investment will be predominantly in mid-cap stocks”

– “More than 50% will be invested in equity and equity related securities; the
rest would be in debt and money market securities”
Investment Strategy

Investment Objective & Investment Policy are pre-decided & form a part
of Offer Document.

Investment Strategy is based on market movement & decided by
Investment Management Team from time to time

– “Should we increase the liquidity component in a scheme”

– “Should we go overweight on the Cement sector ”

– “Should be take exposure in pharma sector”

Investor rights for Information Disclosure

NAV and Sale and Purchase prices disclosed on Amfi website by 9pm every
business day
– FoFs can publish their NAV by 10 am of the next business day

Detailed Portfolio disclosure in the prescribed format every 6 months
– Within 1 month of the close of half-year

Closed-ended debt funds and interval funds have to publish their
portfolios on website
– Within 3 working days of every month-end

Summarised portfolio disclosure to unit holders every month through
Factsheet
– Voluntary industry practice

Scheme-wise annual report to be mailed to all unit-holders
– Within 6 months of financial year-end
 Service Standards imposed by SEBI

Transaction Turnaround Time

Allotment of units in a NFO (other than ELSS) 5 days from NFO closing date

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

Dispatch of Statement of account (on-going) 10 working days from transaction request

Dispatch of Statement of account 10 days from end of calendar quarter

(Systematic transactions)

Dispatch of dividend warrants 30 days from date of dividend declaration

Dispatch of redemption proceeds 10 working days from transaction request

Investor Rights for Service Standards

Delay beyond the permissible time in redeeming or dispatching dividend

warrants
– AMC to pay unit-holders interest at the rate of 15% p.a.

Systematic investors can make a special request for statement of account

– Must receive their statements of account within 10 days

Dormant investor must receive a statement of account once a year

Unclaimed Dividend & Redemption Amount

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.

Recovery of such unclaimed amounts by the investors is as follows:

– 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

AMC is expected to make a continuous effort to remind the investors

through letters to claim their dues.
Investor Complaints Resolution Process

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

– Investors can log on to www.scores.gov.in & launch their complaints against
any SEBI registered intermediary. SEBI will first view if the complaint falls
under its purview or not. If yes than it will forward the same to respective
intermediary & same have file an action taken report in not more than 30
days.

If the investor is not satisfied with the Sebi ruling, the investor may
approach Securities Appellate Tribunal (SAT)
Special Transactions

Change of Broker
– Letter to the mutual fund indicating change of ARN or going direct.
– No NoC required by AMC

Nomination
– Proceeds of the folio in the event of death will go to the nominee appointed
by the unit holder
– Up to three nominees are allowed
– Nomination can be done at the time purchase or later with the help of a
written application
– Nominee can be a minor in that case guardian details are provided
– In case of joint holders the folio will be transmitted in the name of surviving
unit holders & not to nominee
Transferability & Demat Holdings

Free transferability of units

– Units shall be freely transferable either by act of parties (sale) or by operation
of law (Transmission of units).
– Exception : ELSS Schemes during lock- in period cannot be transmitted

Demat holding
– Unitholders have an option to receive allotment of units in demat form is
available in all schemes
– Co-ordinate with DP to provide demat statement to unit holders
– Units in demat form are also freely transferable.
Account Statement & Unit Certificate

Statement of Account (SoA)

– proof of investment in the mutual fund for the investor.
– It is sent by the mutual fund after every transaction within 10 business days of
the transaction
– Account statement captures the transactions carried out by the investor for a
particular period and holdings as on a particular date.
– It contains KYC details, PAN verification status, unit balance, transaction
summary, bank account, address and value of investment as on that date.

Unit Certificate
– Only specifies number of units held by investor
– May be provided upon request within 30 working days
– No operational purpose
Rights in relation to Fund Management

Change in Fundamental Attributes

– Mutual fund to send a written communication to ALL unit holders about the
proposed change
– Option to exit without exit load

Termination or winding up by unit holders
– Resolution by unit holders holding at least 75% of assets in the scheme

Termination or winding up by trustees
– Seek the consent of unit holders

Change in Sponsor or the AMC
– Option to redeem without exit load

Structural Protection
– The AMC or the sponsor do not directly hold the funds or securities belonging
to the investors
– Custodian is independent of the Sponsor
Investor Rights - Limitations

Caveat Emptor – Buyer Beware. No recourse for ignorance.

Cannot sue the Trust

– The Trust is only a notional entity

A prospective investor has no rights with respect to the fund, the AMC or
intermediaries

Limits to redressal
– Neither shareholders nor depositors
– Investments cannot be protected
– Redressal of complaints is not obligatory
– Offer document discloses all pending investor complaints
Consolidated Account Statement

AMCs are required to send an email and/or SMS confirming the

transaction within 5 business days of any financial transaction.

A Consolidated Account Statement (CAS) by 10th of succeeding calendar

month in folios where transaction has taken place during that month.

If an email id is registered with the AMC, only a CAS via email will be sent.

If there are no transactions in a folio during any 6 month period, a CAS

detailing holding across all schemes of all mutual funds shall be sent at the
end of every such six month period.
Offer Document
Chapter 4
Offer Document - Significance

Legal representation of the offer of the

mutual fund scheme to the investors

Contractual relationship between investor

and the mutual fund based on OD

Source of information

Investors are expected to read and

understand OD before investing

SEBI does not approve or disapprove the

contents of the offer document. Format also
prescribed by SEBI
New Fund Offer Process

Application forms contain abridged version of the OD, known as Key

Information Memorandum (KIM)

NFO period must be limited to 15 days, except for ELSS upto 30 days

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 for a new fund

Trustee approval and draft OD filed with Sebi for validation

Sebi’s validation usually comes within 21 days, subject to changes, if

any .

NFO must be made within 6 months of Sebi’s consent.

Sebi only vets the OD to ensure that all required information is

provided
Offer Document: Components

Offer is divided into two parts:

– Statement of Additional Information (SAI)
– Scheme Information Document (SID)

Though they are separate documents, legally SAI is considered to be a part

of SID
Statement of Additional Information

Contains generic information of the mutual fund and is common to all

schemes.
– 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
– Details of various fund constituents
– Investor service officer’s details

Contains financial information of the mutual fund

– Performance of existing schemes on yearly basis
– Scheme expenses and loads applicable

Filed only once with Sebi in the prescribed format

Scheme Information Document

Filed with Sebi for approval before launch of a new scheme

Information specific to a certain scheme

– Highlights and summary of the scheme
– Scheme type (open or closed end)
– Investment objective
– Asset allocation
– Investment strategies
– Terms with regard to liquidity
– Fees and expenses
– Benchmark for the scheme
– Investment restrictions, if any
– Mandatory disclosures and disclaimers

Projected returns cannot be shown in SID

Risk Factors

Risk Factors may be standard or scheme-

specific

Standard risk factors apply across mutual

fund schemes
– E.g. Mutual funds are subject to market risk

Scheme-specific risk factors apply to the

specific scheme
– E..g First scheme of a mutual fund
– E.g. Risk of concentration in a sector fund
Other Information

Indicative asset allocation and type of securities that the fund will invest in

Borrowing policy of the fund

Policy on inter-scheme transfers

Methodology of calculation of NAV, Sale and Purchase Price

Operational details:
– NFO period
– Plans, options and loads
– NFO price and basis for subsequent pricing
– Application process
– Minimum investment amount
– Investment facilities such as SIPs, SWPs and switches
– Investors eligible to invest
– Date of commencing ongoing sale and re-purchase
– Maturity date, if scheme is closed-ended
– List of Official Points of Acceptance (OPAT)
Modifications to SAI and SID

Open-ended scheme’s SID must be valid at all times

– Updated version to be available on website

Changes to SID
– Material changes to be updated immediately
– No material changes, SID to be updated every year, within 3 months of the
end of the FY

Schemes launched after September 30 must update SID after next
financial year end

Changes to SAI
– Material changes to be updated immediately
– No material changes, SAI to be updated every year, with 3 months at the end
of FY
Key Information Memorandum

Abridged and concise version of the offer document

Must accompany every application form

Format for KIM is prescribed by Sebi
– Must be updated at least once a year

Contents of KIM:
– NFO open and close date
– Investment objective and asset allocation pattern of the scheme.
– Scheme-specific operational details.
– Names of the AMC and trustee company.
– Performance history of the scheme and the benchmark for one, three and five
years and SINCE INCEPTION
– Expenses and loads applicable to the scheme.
– Investor services and rights.
Fund Distribution and Channel Management Practices
Chapter 5
Eligible Investors in Mutual Funds in India

Individuals & Hindu undivided families (HUFs)

Companies & partnership firms

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)

Qualified Foreign investors (QFIs) – Recently permitted

Note: Overseas Corporate bodies are not eligible to invest

Retail & institutional Investors

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.
– Minors can invest through a guardian

Institutional investors
– Approval of management committees and board of directors
– Board’s resolution and charter of the institution are required
– Authorised signatories
Online & Stock Exchange route

Online Mutual Fund Distribution

– Online investments, view current holdings at latest NAV and conduct sale/re-
purchase transactions
– Investor creates an account
– Convenient and paper-less transactions
– No cheque writing is required

Distribution through Stock Exchanges
– Stock exchange brokers to conduct mutual fund transactions through their
trading platforms
– Brokers must clear NISM MFD Certification, obtain ARN and empanel as
distributor with AMC
– NSE’s NEAT MFSS and BSE’s STAR Mutual Fund Platform
– Open from 9am to 3 pm
– Mutual funds can choose to tie up with any stock exchange
Institutional Distributors & IFAs

Institutional distributors can be distribution houses, banks, or non-

banking finance companies
– Employees and Sub-brokers
– Wide branch network and large client base
– Greater geographical reach
– Standardised processes
– AMC’s channel managers service the institutional distributors

Individual distributors are known as Independent Financial Advisors

(IFAs)
– Establish personal long term contacts across investment products
Becoming a Distributor

Pre-requisites for being appointed as a distributor:

– Individual distributors and employees of institutional distributors have to clear
the NISM MFD certification examination
– Need to obtain the ARN
– Institutions in the distribution business also need to get registered with Amfi
& complete KYD formalities.

Distribution agreements with AMCs on Empanelment

– Terms and conditions of appointment
– AMC has the power to terminate agreement at any time, after due notice
Distribution Commissions

No Sebi rules on the minimum or maximum rate of

commission

Distributors are not allowed to charge commissions
on their own investment

Initial Commission is paid up-front
– It’s a one time payment paid immediately
– Entry load has been banned since Aug 1, 2009

Trail commission is paid as long as the investor
remains invested in the fund
– 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
– Money saved by AMC is to be used for investor
education
Know Your Distributors (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)

– Document verification
• PAN card and proof of address
– Bio-metric process
• Impression of the index finger of the right hand of the ARN holder
• 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
Distributors - Role & Responsibilities

Distributor actions must be in the interest of the unit holders

Distributors have to follow AMFI's code of ethics (ACE) as well 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.
Accounting, Valuation and Taxation
Chapter 6
NAV Calculation

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

Only current liabilities, No long term liabilities
– Current liabilities, Payables, Accrued expenses

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

NAV is rounded off to two decimal places for all schemes and to four
decimal places for liquid schemes.
Sale & Re-purchase

Entry Load
– Imposed on the NAV to arrive at sale price
– Investor pays a price that is more than the NAV

No entry loads can be charged to investors

Exit Load
– Imposed on NAV to arrive at the re-purchase price
– Reduces the re-purchase price

Exit load cannot be varied based on the type of investor

CDSC (Contingent Deferred Sales Charge)
– Variable exit loads applied on the basis of the period for which the investor
stays invested
– Exit loads or CDSC charged to investors should be credited back to the
scheme.
Valuation principles

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.
Applicable NAV - Rules

Cut-off time determines the NAV applicable for the transaction

NAV is computed on business days for all schemes

– Except liquid funds, for which NAV is computed every calendar day

Cut-off time varies for liquid fund purchases

– Historical NAV is possible

For all non-liquid funds, the applicable NAV is prospective

Liquid Fund investments and debt funds investments above Rs.1 crore
are subject to realization of clear funds. (old rule)
 Cut-off Time and Applicable NAV

Transaction Cut-off time Applicable NAV

NAV of the day prior to the day on which

Liquid fund purchases 2.00 pm
clear funds are available

Liquid fund redemptions 3.00 pm NAV of transaction day

NAV of transaction day if the amount is less

than 2 lacs. If more than 2 lacs NAV of the
Non-Liquid fund purchases 3.00 pm
day when the funds are cleared subject to
cut off timings rule.

Non-Liquid fund redemptions 3.00 pm NAV of transaction day

Time Stamping

A process to find the time of receipt of the application at the OPOA

The 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

Online and stock exchange transactions
– Time stamp is as per server/trading system time
Scheme Expenses

Expenses borne by the mutual fund scheme regulated by Sebi

Any expense that is not chargeable, or exceeding the limits, has to be
borne by the AMC

Initial Issue Expenses
– 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
– Incurred to manage the money mobilised from the investor
– Sebi specifies heads of expenses that can be charged to the scheme.
– The maximum expense, as percentage of net assets, that can be so charged
– Accrual basis, and reduced from the assets of the scheme, before computing
NAV
Fund Running charges

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

Any expense incurred over and above the maximum prescribed limits has
to be borne by the AMC
Investment Management Fees

Most significant head of expenses charged to the scheme

The limits on AMC fees are as follows:
– 1.25% on the first Rs. 100 crore of net assets
– 1% on the remaining net assets over and above Rs 100 crore.

Liquid funds and debt funds cannot charge any investment management
fees for funds parked in short-term bank deposits

Index funds cannot charge more than 1.5% as recurring expense, of which
not more than 0.75% can charged as investment management fees.

FoFs charge 0.75% as their Investment Management fees.

– Including the expenses of the fund in which it invests, the overall expense to
the investor in a fund of funds cannot exceed the expense limits prescribed.
Some Accounting Policies

Accounts of each mutual fund scheme have to be maintained separately

Distributable surplus includes realized gains, accrued income and

unrealized losses but does not include unrealized gains
– Unrealized losses must be reduced from the distributable surplus

Average cost should be used to determine the holding cost of the

securities

Dividends, bonus and rights received by a mutual fund scheme should be

recognized on the ex-date
 Valuation Policy

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

Debt Securities with residual maturity < 61 days

– Valued at weighted average price if traded on the valuation date
– Non-traded debt securities will be valued on amortization basis

Debt Securities with residual maturity > 61 days

– Traded securities to be valued at weighted average price
– Non-traded valuation based on Crisil yield matrix
Capital Gains and Securities Transaction Tax

Short term capital gain (STCG) / Short term capital loss (STCL)
– Capital gain or loss realised by sale of units within a period of 12 months

Long term capital gain (LTCG) / Long term capital loss (LTCL)
– Gain or loss from sale after a holding period of one year
– Indexation

Mutual funds are not subject to Wealth Tax in the hands of the investor

Securities Transaction Tax
– Payable by the mutual fund on purchase and sale transactions on the stock
exchanges at 0.125% for equity and 0.017% for derivatives
– Payable by the investor at 0.125% on listed equity-oriented schemes and at
0.25% on redemption of equity-oriented fund
 Tax Provisions

Fund Type DDT STCG LTCG STT

Equity oriented On redemptions

NA 15% Exempt
funds @0.25%

25%(individuals 10% without

Marginal rate
Liquid funds and HuFs) 30% indexation or 20% Not applicable
of taxation
(Others) after indexation

12.5% (individuals 10% without

Other non-equity Marginal rate
and HUFs) 30% indexation or 20% Not applicable
oriented funds of taxation
(others) after indexation
Set Off Provisions

Set-off
– Facility to reduce the capital gains by deducting the capital loss incurred or
carried forward

Rules for Set-off

– 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.

No set-off benefit for LTCL from equity-oriented funds

LTCL from a non-equity oriented fund, can set it off only against LTCG from
non-equity oriented funds
Dividend Stipping

Buying into a mutual fund prior to declaration of dividend, and selling the
units after dividends at the ex-dividend price
– Investor earns tax-free dividends and capital loss for set-off

Section 94(7) 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
– Not available for set-off
Investor Services
Chapter 7
Investor Information

An application can have 3 joint holders

– Investments jointly or on either or survivor basis

Signature is the identity of the investor
– Signatures for all joint holders 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
– Sending dividends and redemption proceeds

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
Know Your Customer (KYC)

Proof of identity of the customer, proof of residence, Permanent Account

Number and photograph are verified to comply with KYC norms

Identified service provider: CSDL Ventures Ltd

KYC once completed, is valid across mutual funds

KYC acknowledgement captures PAN of the investor
– Investors have to submit a photocopy of the KYC acknowledgement along with
appl forms

Mandatory for all joint investors in a folio, irrespective of value of
transaction or type of investor from January 2011

KYC for investment by a minor
– Compliance by guardian
PAN and Micro-SIP

PAN is mandatory for all investors in a mutual fund, irrespective of

invested amount (Exception: Micro SIP)

Micro-SIP are exempted from requirement of PAN card

– Annual investment does not exceed Rs.50,000 made by individuals, NRIs,
minors and sole-proprietary firms
– Exemption not available for HUFs and PIOs or non-individual investors

Alternate valid photo identification documents must be provided instead

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
– 12 month rolling or April-March financial year
Sale Transactions

Fresh purchases are made by investors by submitting an application form

complete in all respects
– Open a new folio
– Minimum investment amount

Additional Purchases are subsequent purchases after fresh purchase

– Can be made under the existing folio using a transaction slip
– Minimum additional investment amount

Transaction Slip
– Folio number to identify the investor
– Used for redemptions, additional purchases, switches and non-financial
transactions
– Has to be signed according to the mode of holding
Payment Instruments

Local cheques, At-par cheques, Demand Drafts

Mutual funds do not accept cash, money orders, stale cheques or

post dated cheques (except for SIPs)

Third-Party cheques are not allowed, except for the following:

– grandparents/parents making payments not exceeding Rs.50,000 on
behalf of a minor
– employer making payments on behalf of employee through payroll
deductions
– custodian on behalf of FIIs

Electronic Payment Instruments

ASBA

ASBA (Applications Supported by Blocked Amount) facility extended to

investors subscribing to mutual fund NFOs w.e.f 1 October, 2010.

– This facility is in addition to cheques/ DDs as modes of payment

– Investors can avail of ASBA through banks specified in Sebi list

– ASBA is an application containing an authorization to block the application

money in the bank account, for subscribing to an issue.

– Application money is debited from the bank account only if application is

selected for allotment.
Payment Instruments – NRIs and FIIs

Source of funds determines repatriability of funds on re-purchase

Non-resident external (NRE) - Foreign currency accounts
– Funds can be repatriated on re-purchase

Non-resident ordinary (NRO) - Indian rupee accounts
– Funds cannot be repatriated on re-purchase

Foreign currency non-resident (FCNR) - Payment remitted from abroad
– Foreign Inward Remittance Certificate (FIRC) is a proof that an individual has
received a payment in foreign currency from outside the country

Re-purchase to NRIs are 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
– Funds fully repatriable on re-purchase
Re-purchase Transactions

Re-purchase may be specified in terms of units or rupees

The repurchase price is the applicable NAV minus exit load

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

Proceeds are sent by direct credit or cheques

Service re-purchase requests within 10 working day

– Failing this, AMCs have to pay a penal interest of 15% per annum to the unit
holders
Investment Options

The underlying portfolios for all options are the same, only post-tax
returns are different

Growth option
– Gains made in the portfolio are retained and reflected in NAV
– Realised profit/loss is treated as capital gains or loss
– Tax deferral is possible by investing in growth option

Dividend Pay-out
– Fund declares dividend from realised profits after trustee approval
– Amount and frequency varies and depends upon distributable surplus
– Ex-dividend NAV and Cum-dividend NAV
– NAV falls after dividend payout to the extent of dividend paid

Dividend Re-investment
– Dividend is re-invested in the same scheme by buying additional units at the
ex-dividend NAV
 Investment Options – An Illustration

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% No Yes Yes
declared
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 Rs.200 capital Rs.100 dividend+ Rs.100 Rs.100 dividend+ Rs.100
investment gain capital gain capital gain*
Systematic Investment Plans

Invest a sum periodically into a mutual fund scheme

– Applicable NAV is the NAV on the date of the instalment

Rupee cost averaging

Period of commitment of SIP can vary e.g. 6 months, 1 year, 3 years, 5
years

Specific intervals at which investment must be made e.g. monthly,
quarterly, half-yearly

Investment is made on specific dates e.g. 1st, 5th, 10th, 15th of every month

Can be initiated along with NFO

Payment modes – Post dated cheques, electronic clearing service,
standing instruction for direct transfer
SWP and STP

Systematic Withdrawal Plan

– Periodic redemptions at the prevailing NAV (less exit load as applicable)
– Investors periodically book profits and generate regular income
– Investor must specify the date of withdrawal, the period of withdrawal
– May be specified in terms of number of units or amount

Systematic Transfer Plan
– Periodically transfer a specified sum from one scheme to another within the
same fund house
– Helps in re-balancing portfolio
– Re-purchase from source scheme
– Investment of re-purchase proceeds into the destination scheme
– SWP from source scheme and SIP into destination scheme

Capital gains apply, STCG/LTCG
Switches and Triggers

Switches
– Redemption and purchase transaction rolled into one
– Source scheme/option – switch out leg
– Target scheme /option– switch in leg
– R&T carried out the transactions in the investor’s records
– Exit loads not charged for switch within options
– Exit loads charged as applicable for inter-scheme switch

Triggers
– Automated purchase, redemption, switch or dividend decisions based on pre-
defined events
– Pre-defined event may be Sensex levels, return targets etc.
Risk, Return and Performance of Funds
Chapter 8
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
– 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

Large cap shares are shares of big companies
– Very liquid
– Stability and large size

Small and mid-cap shares are shares of smaller companies
– Not very liquid
– Growth potential
Fundamental & Technical Analysis

Fundamental Analysis
– Evaluation of the earning capability of a stock, leading to the determination of
its fair value
– Judge whether the stock is undervalued or overvalued
– Stock evaluated in the context of industry and macro factors

Economy-Industry-Company analysis (EIC) analysis

– Bottom up approach – starts with company, then industry and then macro
– Top down approach – starts with macro, then industry and then company
– Top-down is for sector selection; Bottom up is for stock selection

Technical analysis
– Study of stock prices and volumes, plotted as charts
– Identify patterns that may indicate whether there is a dominance of buying or
selling interest in stocks
EPS & P/E Ratio

Earnings per share (EPS)

– Net Profit divided by total no. of shares issued

Price /Earnings Ratio

– Market price /Earnings per share to arrive at Price-Earning (PE) ratio
– Indicates how much the market is willing to pay per rupee of earning of a
stock
– Historical PE computed using past earnings
– Forward PE computed using future earnings
– Low PE means undervalued and high PE means overvalued
Debt Securities

Debt securities represent an underlying loan

– Borrower is the issuer; Lender is the buyer
– Face/Par value, Maturity Date, Tenor, Coupon rate

Government securities are also called gilts and have no credit risk
– Issued for maturity 2 to 30 years

Money market securities are issued for a tenor of less than 1 year

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
Debt Funds – Total Return

Price of a bond responds to changes in market interest rates in an inverse

relationship
– Modified Duration is a technical measure of bond’s sensitivity
– Higher the modified duration of a bond, higher the interest rate sensitivity of a
bond
– Average maturity and modified duration are directly related

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
– Changes in interest rates reflected in the coupon itself
Yield Spread & Credit Spread

Yield curve shows the relationship between the interest rates and the
tenor, on a given day

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
Simple Absolute 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

Example: The NAV of a fund was Rs 23.45 on January 31, 2009 and Rs
27.65 on March 31, 2010. 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%
Annulization

Absolute return multiplied by annualising factor ‘365/n’ or ‘12/n’

Animalization of returns from Liquid funds, for periods less than a year, is
allowed by Sebi

Example:
An investor bought a unit at Rs 10.50 on Jan 1, 2010 and sold it for Rs 11.50 on
April 30, 2010.
The absolute return to the investor is:
(11.50 -10.50)/10.50 = 1/10.50 = 9.52%
However, this is the return earned over the period Jan 1, 2010 to 30 April, 2010. If
we were to ask, what would be the return per annum, we would annualise the
return as follows:
= 9.52% x 365/120
= 28.96% p.a
Compounded Annual Growth Rate (CAGR)

Rate of return arrived at after allowing for returns to be reinvested

r = (V1/V0)1/n - 1
– 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%
CAGR for Dividend Reinvestment

In the case of a dividend option, compute the CAGR 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 to A?
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%
Risks in Mutual Fund Investing

Market risks refers to a change in the price of the security.

– In equity changes in underlying fundamental and technical factors
– In debt instruments, changes in macro economic factors, that change the
market expectation for interest rates
– Extent interest rate risk depends on average maturity and duration of the
portfolio
– Mutual funds manage market risks through diversification

Liquidity risks may not enable buying or selling easily as may be required
– Large sized Small and mid-cap funds find it difficult to exit illiquid stocks
without impacting the price
– Secondary markets in corporate bonds of lower credit quality are not very
liquid

Credit risk is assessed from the credit rating
– A high credit rating indicates a low degree of default risk.
Measuring Risk

Risk is defined as the variance of actual returns from expected returns

– MS Excel function = var (range containing the return time series)

Standard deviation is the square root of variance

– 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 debt fund w.r.t. market factors

– Higher the modified duration/average maturity greater the market risk of the
fund and vice versa
Systematic & Unsystematic Risk

Total risk comprises of systematic or unsystematic risk

– 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

– Measures the sensitivity of the fund's returns to changes in the market index
– Markt Beta is always 1.
– 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
Benchmarks

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

Commonly used benchmarks:
– Market benchmark return
– Peer group return
– Return on other comparable financial products

Mutual funds have to indicate market benchmarks while filing the OD

Market benchmarks are independent portfolios that are not managed

Benchmark return has to be presented when they advertise the scheme’s
performance
Commonly used Benchmarks

Fund Type Benchmark

Large cap fund BSE Sensex/S&P CNX Nifty
Diversified equity fund BSE 100
Small/Mid cap fund BSE 500
Liquid fund Crisil Liquid Fund Index (Crisil LiquiFEX)
Gilt fund I-Sec Si-Bex, Mi-Bex, Li-Bex (Short term, medium
term and long term respectively)
Balanced Fund Crisil Balanced Fund Index (Crisil Balancex)
Income Fund Crisil Composite Bond Fund Index (Crisil CompBEX)
Banking Fund/Pharma Fund/Auto BSE Bankex/BSE Healthcare/BSE Auto Index
Fund
Gold ETFs Price of Gold
Real Estate Mutual funds Real estate indices
Sharpe & Treynor Ratio

Return generated relative to the risk taken by the fund to generate the
return

Sharpe Ratio
– Compares the return of a fund with its risk
– Return is measured as the excess return over a risk free rate (Return of the
fund – risk free rate)
– Sharpe ratio = Excess return / Standard Deviation

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

Compares the excess return over the risk free rate of a fund with its risk,
measured by beta
– Excess return = Return of the fund – risk free rate of return
– Beta measures only systematic risk, Standard deviation measures total risk
– Treynor Ratio = Excess return/Beta

Higher the Treynor ratio, better the fund performance
Manager’s Alpha

It is also called as Fund Manager’s Alpha or simply Alpha.

It tells by what margin Fund Manager has outperformed the
Index/Benchmark.

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 30% – 6% (risk free rate) = 24%. Given its beta of 1.2, its excess
return should have been 19.2%. Therefore the alpha of the fund is 4.8%.
Tracking Error

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
– Time series of excess returns and compute standard deviation of such excess
returns
– If the standard deviation is high, the returns may not be consistent

Tracking error of an index fund will have to be zero

Scheme Selection
Chapter 9
Risk Levels – Various Funds
Portfolio Features

Extent of portfolio diversification will impact risk and return

The segment of market in which the fund invests: Large/mid/small, will
impact the liquidity risk and return too

Extent of cash holding will have an impact on returns
• Holding cash is a defensive stance, hoping to protect the from a steep fall in stock
prices

Portfolio turnover ratio = total sales or purchases of a fund (w.e. 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

Consistency in returns over longer period is also looked upon.
Size, Age and Style of Equity Funds

Size of the fund influences the performance

– Difficult to liquidate, rebalance or alter the composition of very large
portfolios
– Stock selection tough for mid-cap and small cap funds and sector funds

Longer age of the fund presents a longer track record for evaluation
– Ability to judge performance over a longer period of time

Style of fund performance defines risk-return profile
– An actively managed fund 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
Average Maturity and Yield 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
Debt Fund – Features

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 with lower expense ratios for large investors

Special Structures
– Floating rate funds preferred in rising interest rate scenario
– FMPs not affected by interest rate risk
– Liquid funds have lowest interest rate risk

Portfolio Features
– 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
Selecting a Hybrid Fund

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

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
Selecting Other Funds

Gold Funds
– 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

Fund of Funds
– A multi-manager fund of funds may be a better choice
– Chosen based on investment objective
– Evaluated based on their ability to select and manage a portfolio of funds

International Funds
– Risk and return depends on strategy they adopt to invest in international
markets
Selecting the Right Investment Products for Investors
Chapter 10
Physical Assets Vs. Financial Assets

Physical assets have a physical and material form

– E.g., gold and real estate
– Return in the form of appreciation over time
– Preferred by investors due their tangible nature
– Exposed to hazards such as fire, theft or floods

Financial assets involve investing money for some cash flows in the future
– Does not have a tangible form
– E.g., Bank deposits, company deposits, equity shares, government saving
instruments, bonds and debentures
– Protected from physical harm
– Help in financing the economic activity
– Encouraged by government over physical assets
Guaranteed and Non-Guaranteed Investments

Guaranteed Investments
– Principal or interest or both are assured by an agency like the government
– E.g. Government saving schemes

Non-Guaranteed Investments
– Investments that do not provide any guarantee for periodic payouts or return
of capital
– E.g. equity shares, debentures and mutual funds
Investing in Gold

Hedge against inflation

Gold in physical form - Gold bonds, Gold coins and bars

Holding gold in the financial form
– Buying gold in the commodity futures market
– Buying gold-linked funds
– Buying gold exchange traded funds (ETFs)

Indian Mutual Funds’ Gold-linked funds
– Gold ETFs
– International gold funds
– Securities of gold-linked companies

Advantages of holding gold in mutual funds
– Exempted from wealth tax
– Long-term capital assets after a holding period of one year
– Nomination facility to investors, not available in physical gold
Real Estate Investment

Real Estate holding in physical form

– Preferred by investors
– Is beyond the means of small investors
– Not easy to quickly liquidate investments in real estate at an appropriate price
– Risk of concentration is high

Real Estate Mutual Funds (REMFs)

– Enable investors to receive benefits of investing in real estate with a
small investment
– Direct investment in real estate, debt instruments issued by developers,
or securitised loans
Bank Deposits

Preferred form of investment with small investors

– Facility to access funds anytime
– Familiarity with their bank
– Considered safe investment option

Limitations of bank deposits

– Penalty for premature withdrawal
– Yield on bank deposits is quite low

Investors cannot benefit from changes in interest rates
• Interest income from bank deposits is taxable
Equity Shares

Popular among urban investors

– Part ownership in the company

Benefits:
– Growth and appreciation of capital invested
– Liquidity from listing on stock exchanges
– Higher long-term returns as compared to other investment options

Not easy for retail investors
– Need research support, as well as expertise to select the right stocks
– Need a large amount of capital to diversify

Mutual funds offer the advantage of diversified and professionally
managed equity portfolio to retail investors, even with a small outlay
Debentures / Bonds and Company Deposits

Debentures/bonds represent borrowings of companies

– Pay a floating or fixed rate of interest
– Privately placed to institutional investors

Debentures offered to retail investors must be secured and listed
– Liquidity is quite low
– Investors must be wary of credit quality vis-a-vis rate of interest

Company deposits are unsecured deposits to investors

– Compulsorily credit rated
– Rate of interest is usually higher than that of bank deposits
– Interest on company deposits is taxable
– Liquidity is low
– Investors must be wary of default risk
Public Provident Fund (PPF)

Risk-free deposit that is made with the government

– An individual can have only one PPF account in his or her name
– Annual contribution – Rs.500 – Rs.100,000
– Compulsory to make deposits every year
– Contributions up to Rs 100,000 p.a. eligible for tax deduction under Section
80C
– Contributions have to be made for 15 years
– Tax-free interest rate fixed by the government.
– Limited liquidity
– Interest and the redemption proceeds at maturity are exempt from tax
Small Saving Schemes

Run by National Small Savings Organization through the state

governments
– National Savings Certificate (NSC), Kisan Vikash Patra (KVP), Senior Citizens’
Savings Scheme and post office saving schemes
– Preferred by small investors
– Guarantee on principal and interest
– Offer a fixed, but low rate of interest
– Have to be held until maturity
– Interest rates are fixed by the government, and revisions are not done very
frequently
Insurance as an Investment

Life insurance
– Protection against loss of income due to unexpected death or disability of an
earning member
– ‘Sum assured’ is the obligation of policy holder
– Require the payment of regular premium by the policyholder

Types of life insurance policies
– Pure term policy – sum assured paid to the nominee
– Endowment policy- sum assured+bonuses paid to the nominee on death or to
the policyholder on the maturity

Seek protection and as an avenue for saving/investment
– Compulsory saving e.g. ULIP
– Tax benefits u/s 80C

Insurance is primarily as a protection product and not an investment or tax
saving product
New Pension Scheme

Launched in May 2009 is regulated by PFRDA

Save for a retirement corpus
– Contributions made by the individual are managed by professional portfolio
managers
– No guarantee of returns
– The minimum investment is Rs.500 a month or Rs.6000 annually. No upper limit on
investment
– Investment mix selected by the contributor
– Equity (E), credit risk bearing debt instruments (C) and government securities (G)
•Invest the entire corpus in C or G, investment in E is capped at 50%
•Auto choice option - exposure to equity keeps reducing as the age increases

Open an NPS account through identified Points of Presence
– Tier I (Pension account). The amount invested cannot be withdrawn before the
end of the term.
– Tier-II (Savings account). The amount invested can be withdrawn
– Permanent Retirement Account Number (PRAN) will be allotted
Helping Investors with Financial Planning
Chapter 11
Financial Needs & Goals

Financial Needs
– 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
• Wanting to protect a family’s income from any unforeseen risk is a protection need.
This is met by insurance
• Need for funds to meet the expense on the college education a child is an
investment need. This is met through saving and investment.

– Financial Goals

Financial need 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
Financial Planning Formulae

FV = PV (1 + r)n

PV = FV / (1 + r)n

FV - Future Value

PV - Present Value

r - rate

n – number of compounding years
Estimating the worth of Financial Goals

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.10 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?
• = 10 x (1.07)^ 10 = 19.67 lakh

Calculating the target rate of return

– Example: Suppose the investor indicates that an amount of Rs.7 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
• = ((19.67/7)^(1/10)) -1 = 10.08%
• Use the RATE function in MS Excel
Estimating Investment Value

Calculating the amount to be invested today

– Example: For an estimated expense of Rs.19.67 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
• =19.67/((1+14%)^10) = 5.30 lakhs
– Use the PV function in MS Excel

• Estimating the amount of periodic investment

• Instead of investing Rs.19.67 lakh in a lumpsum, 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, , 19.67 lakh)=Rs.7592
Financial Planning & its Objectives

Financial Planning
– Considers the overall situation of the investor
– Propose asset allocation to match the investor’s risk profile
– Creating an investment plan and asset allocation strategy to meet financial
goals
– Reviewing the portfolio

Objectives of Financial Planning

– Creates a road map in terms what has to be done to achieve the goals
– Ensure the right combination of savings and investment
– Review current and expected income and expenses and the ability to save and
invest
Financial Planning Process

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
Life Cycle Approach in Financial Planning - 1

Childhood Stage
– Dependence on parents to meet expenses
– Gifts received may be invested for the future

Young Adult Stage
– 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
– Individual is partially dependent

Young married stage
– Need to provide for emergencies and protect income from death, injuries or
loss is high
– Couple has joint responsibility to create and adhere to budgets and to control
expenses
– Need for term insurance is high
Life Cycle Approach in Financial Planning-2

Married with Children 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
– Higher ability to save and invest
– Investment needs take precedence over protection needs
– Focus on repayment of loans and saving for retirement

Pre-retirement Stage
– Start setting aside increased amounts to protect their life style, post-
retirement
– Pension products and health insurance are preferred choices for investors

Retirement Stage
– Require at least 2/3rd of their last income
– Focus on income generation and protect wealth from the effects of inflation
Wealth Cycle Approach to Financial Planning

Accumulation Phase
– Choose growth-oriented investments
– Have a long-term investing horizon and can allocate savings to equity
• e.g. saving for child’s education

Transition Phase
– Middle-aged investors
– 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
– Depend on investment income
– Retired investors
– Income-oriented, preferring debt to equity
Wealth Transfer and Sudden Wealth Surge

Inter-generational Wealth Transfer

– Pass on their wealth to the next generation or to organisations and trusts
– Focus on the goals of the beneficiaries
– Advice on creating trusts and wills and estate planning

Sudden Wealth Surge

– e.g. lottery, sudden appreciation in shares, inheritance of wealth
– Evaluate tax implications
– Invested in low-risk products like a liquid fund till such time a proper financial
plan is drawn
– Financial Plan based on financial goals and risk preference
Financial Planning for Wealthy Investors

High net-worth investors

– Have adequate wealth to take care of typical financial goals such as education,
house etc
– Do not need goal based financial planning but need planning to manage their
wealth

Wealth-creating investors
– Willing to take risks, investing in equity and risky assets
– Comfort of accumulated wealth

Wealth-preserving investors
– Wealthy investors may not always be risk-taking
– Choose conservative investments, such debt and government securities
– Focus on regular income from accumulated wealth
Recommending Model Portfolios and Financial
Plans
Chapter 12
Model Portfolios and Risk Profiling

Model Portfolio
– Creating an investment portfolio after considering the goals, investment
horizon and required return
– Created for a given combination of risk, return and investing horizon

Risk Profiling
– Willingness of the investor to assume risk
– Influenced by their personal and financial situation

Risk Profiling Tools are used to generate risk appetite scores for investors
– Surveys, questionnaires and proprietary risk profiling tools
– Scenario analysis
– Past history of the actual transactions of the investors
Model Portfolios - Samples

Young call centre / BPO employee with no dependents

– 50% diversified equity schemes (preferably through SIP); 20% sector funds;
10% gold ETF, 10% diversified debt fund, 10% liquid schemes.

Young married single income family with two school going kids
– 35% diversified equity schemes; 10% sector funds; 15% gold ETF, 30%
diversified debt fund, 10% liquid schemes.

Single income family with grown up children who are yet to settle Down
– 35% diversified equity schemes; 15% gold ETF, 15% gilt fund, 15% diversified
debt fund, 20% liquid schemes.

Couple in their seventies, with no immediate family support

– 15% diversified equity index scheme; 10% gold ETF, 30% gilt fund, 30%
diversified debt fund, 15% liquid schemes.
Risk Appetite & Asset Allocation

Asset allocation
– Decision about the proportions in which investments would be divided
between asset classes
– Correlation between asset classes
Age: Old er in vestors may hav e low er risk
app etite th an you nger in vestors
Accum ulate d ca pit al: Th e h ighe r th e accu mula ted ca pita l,
high er is th e r isk ap petite
Sta bility of incom e: In div id ual s wi th regular incom e ten d
to hav e a h igher r isk ap petite
Jo b secur ity : In div id ual s wi th high er job secu rit y
may be w illing to a ssume h igher risk
Dep end ent s: Risk appet ite decrea se s as th e
nu mber of dep end ents incre ase s
Ear nin g mem be rs: Risk appet ite incre ase s as th e
nu mber of ear nin g mem bers
in cre ases
Attit ude : Individua ls willing to ex per im en t m ay
ha ve a higher r isk a pp etite
Strategic & Tactical Asset Allocation

Strategic Asset Allocation

– Model portfolio is an example
– Asset allocation is driven completely by his need for return and risk profile
• 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

– 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
• Carried out by fund managers, expert advisors and experienced investors
Fixed & Flexible Asset Allocation

Fixed Asset Allocation

– Choose a strategic asset allocation and decide to rebalance periodically to the
same ratio
• 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%.
• 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

– Choose an asset allocation and let 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
Revision & Rebalancing

Model portfolios are indicative

Asset allocations may have to be revised and rebalanced based on investor
needs

Examples:
– Proportion to equity for an investor may change as he moves away from
accumulation phase into transition phase
– Allocation to riskier assets reduces as life stage changes from young adult to
married with children stage
– Allocation to income-oriented assets increases are investor approaches
retirement
– 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
THANK YOU