www.nism.ac.

in

Workbook for
NISM - Series - II- B:
Registrars and Transfer Agents (Mutual Funds)
Certification Examination

5
www.nism.ac.in
 1. Introduction to Securities

1.1. Introduction to Equity and Debt

A firm requires money to conduct its operations. The funding of a
business can be of two dominant forms:
- Contribution by owners
- Loans from outsiders
Businesses are typically created by promoters, who bring in the initial
funds, to create and nurture a business. Later as the business grows
bigger, the need for money can be met by asking for more
contributions to the business from outsiders.

Capital used in running a business can be primarily classified based

on:
- The contributors of funds
- The period for which money is contributed
- The cost of the funds to the firm
- The rights that accrue to the contributors of the funds

Contributors
Fund brought in by promoters and owners of the business is called
equity capital. Equity capital can be brought in at the start of a
business or at a later date as the business grows. Equity capital also
can be contributed by outside investors. To enable such contribution,
the business offers equity shares to outside investors, who become
share holders.

1
Funds brought in as loan is called debt capital. Those that contribute
debt capital are called as lenders to the business. Lenders can be
individuals or institutions including banks. To enable such lending, a
business issues debt instruments to investors, or obtains term loans
by mortgaging the assets of the company.

Time Period
The period for which capital is brought in may vary. Equity capital
cannot be taken out of the firm unless the firm is liquidated. Such
capital is for perpetuity.

Debt has to be repaid by the company after a certain period. The

period of repayment may be short-term (less than one year) or long-
term (usually up to 10 years) and is decided at the time such capital
is brought in.

Cost of Capital
The business has to pay a price for using equity or debt capital. The
cost may be fixed at the time the money is brought in and may
constitute an obligation for the company. Debt instruments usually
pay a periodic interest at a pre-determined rate.

The cost of capital may vary depending on the earnings of the

company, as is the case with equity capital.

Rights of the Contributors

The contributors of capital enjoy certain rights and obligations
depending upon the type of capital that they have brought in. Equity

2
investors enjoy rights such as ownership and voting rights and rights
to share the profits of the company. Debt investors have the right to
receive periodic interest and return of the capital on the expiry of the
fixed period. The contributors of debt capital may have their rights
secured against the assets of the company.

1.2. Features of Equity Capital

Those who contribute equity capital to the company buy equity
shares, when they are issued by the company. They are called
equity shareholders of the company.

Limited liability
Equity capital is issued with limited liability. This means, if the
creditors to a business are not able to recover their dues, equity
shareholders will not be asked to pay up. The liability of equity
shareholders in a company is limited to their contribution made or on
any amount unpaid which they have agreed to pay.

Face value
The total equity capital required by a company is divided into smaller
denomination called the face value or par value of the equity shares.
For example, if a company has an equity capital of Rs 10,00,000,
this can be divided into:
- one lakh shares with a face value of Rs 10; or
- two lakh shares with a face value of Rs 5; or
- ten lakh shares with a face value of Re 1.
Equity shares were earlier issued as certificates; now they are
invariably issued in electronic/dematerialised form.
3
The par value or face value of the shares can be changed
subsequently, if the company so desires. This is called a split or a
consolidation of shares. If a share with a face value of Rs 10 is
divided into two shares with par values of Rs 5 each, it is called a
split. If 5 shares of Rs 2 face value each are clubbed into one share
of Rs 10, it is called a consolidation of shares.

Authorised capital
The maximum amount of equity capital that a company will have is
defined in the Memorandum of Association (MoA) of the company
and is called its authorised capital. The authorised capital of a
company can be increased or reduced subsequently by the
company.

Issued capital
The company may issue a portion of its authorised capital as and
when it requires capital. The capital may be issued to the promoters,
public or to specified investors. The portion of authorised capital that
has been issued to investors is called issued capital. Capital can be
raised at various times as and when the company requires it,
provided the sum of all capital issued is less than or equal to the
authorised capital of the company.

The capital may be issued by the company either at its face value or
at a premium (higher than the face value) or at a discount (lower
than the face value). The issued capital will take into account only
the face value of the shares issued. The remaining portion paid by
the investor is accounted under the share premium account (liability

4
side of the balance sheet) or share discount account (asset side of
the balance sheet).

Paid-up capital
When investors subscribe to the capital issued by a company, they
may be required to pay the entire price at the time of issue or in
tranches (instalments) as application money, allotment money and
call money. The portion of the issued capital that has been fully paid-
up by the allottees is the paid-up capital of the company.

A company decides that the maximum equity capital it needs is Rs20

cr. In the initial stages, the need is Rs.10cr. It issues equity shares of
Rs.10 face value, at par. Investors are required to pay Rs.5 per
share with application, Rs.2 on allotment, and balance Rs.3 after it
has been called. What is the authorised, issued and paid-up capital
of the company, before the issue, after application, after allotment
and after the call?

Before the issue:

Authorised capital: Rs 20 Cr

After application:
Authorised capital: Rs 20 Cr
Issued capital: Rs 10 Cr
Paid up capital: Rs 5 Cr

5
After allotment:
Authorised capital: Rs 20 Cr
Issued capital: Rs 10 Cr
Paid up capital: Rs 7 Cr

After first call:

Authorised capital: Rs. 20 Cr
Issued capital: Rs 10 Cr
Paid up capital: Rs 10 Cr

Thus it can be seen that the paid up capital is always less than or
equal to issued capital; issued capital is always less than or equal to
authorised capital. Authorised capital is the maximum amount that
can be issued or paid up.

Ownership rights
Equity represents ownership of the company. Equity share holders
are part-owners of the company. The extent of their ownership is
defined by their portion of the shares held in issued capital.

For example, if a company has an issued capital of Rs.10 Cr made

up of 1cr shares of Rs.10 each, an investor who holds 10 lakh equity
shares is a part-owner with 10% stake in the company.

Equity shareholders have the right to participate in the management

of the company. They can do this through voting rights. Each equity
share carries one vote. Major decisions of the company require

6
resolutions to be passed, which have to be voted by a majority or
more of the equity shareholders.
Equity capital entitles its contributors to participate in the residual
profits of the company. After meeting all expenses and provisions,
whatever is the profit that remains in the books belongs to equity
share holders.

Liquidity and return

Equity shares are first issued by a company. They are then listed on
the stock exchange, where they can be transferred from one investor
to another. Such transactions are between existing shareholders,
and therefore do not result in change in the capital structure of the
company. Equity capital is for perpetuity. It cannot be redeemed and
the company does not have to repay it.
The return from equity capital is in the form of dividends from the
profits of the company and appreciation in the value of the holdings.
There is no guarantee of dividends or capital appreciation on equity
capital.

1.3. Features of Debt Capital

Debt capital refers to the borrowings of a company. Those
contributing equity capital are owners of the company; those that
contribute debt capital are lenders or creditors of the company.

Debt is raised by companies by issuing securities such as

debentures, bonds and commercial paper to the lenders. The terms
at which the borrowing is being made, such as, the period, the
interest and other features are mentioned in the document (or

7
certificate) that represents the debt security. Debt securities are also
issued in electronic form.
Debt is raised by the company for a fixed period after which it has to
be repaid. The period of borrowing will vary depending upon the
need of the company.

The company has to pay periodic interest for the sum they have
borrowed as decided at the time of the borrowing. Interest is usually
a percentage of the par value of the debt instrument. The interest
that the company has to pay will depend upon the risk of default
associated with the company and the credit policy followed by the
bank.

The lenders may have the right against the assets of the company if
the company fails to pay interest and/or return the principal amount
borrowed. Lending can also be unsecured, where such rights do not
exist. Debt instruments may be listed on a stock exchange, in which
case investors can buy or sell them. Debt instruments provide pre-
defined income at specific intervals and the redemption proceeds on
maturity.

1.4. Hybrid Structures

Companies may raise capital in a form that combines the features of
both debt and equity. These are called hybrid instruments.

Convertible debentures
Convertible debentures pay interest like any other debt instrument till
the date of conversion into equity shares. The terms of conversion,

8
such as the number of equity shares that each debenture will be
converted into and the price at which conversion will take place will
be mentioned at the time of the issue of the debt instrument.

Preference shares
Preference shares resemble debt instruments because they offer
pre-determined rate of dividend. However, they do not have a fixed
maturity period or a right over the assets of the company. They have
a preference in the payment of dividend over ordinary equity shares
and in the return of capital, if the company is wound up.

9
Key Points
1. The capital structure of the company comprises of equity
and debt in varying proportions.
2. Equity and debt capital differ on the rights and obligations
for the investor and the company.
3. The equity capital of a company is divided into
denominations called face value or par value. The
denomination is usually Rs 10, Rs 5, Rs 2, and Re 1.
4. The memorandum and articles of association define the
upper limit on the equity capital that a company can raise.
This is called the authorised capital of the company.
5. The issued capital is that portion of the authorised capital
that has been issued and the paid up capital is that portion
of the issued capital that has been paid up by the allottees.
6. Equity capital implies ownership and higher risk for
investors. For the company it is higher cost capital but
without the obligation of repayment.
7. Debt capital implies regular return and security for the
investor. For the company there is an obligation to make
periodic interest payments and to repay the capital on
maturity.
8. Hybrid products are created that have a combination of the
features of equity and debt capital.

10
Quick Recap

Fill in the Blanks

1. _______ is for perpetuity from the point of view of the
company.
2. Equity capital gives returns from _________ and
__________ for the investor.
3. The denomination in which equity capital is issued is
called_______
4. Debt capital has fixed ________
5. The interest that a company will have to pay on the debt
raised will depend upon its _______.

State True or False

1. Companies prefer equity capital because it is less
expensive.
2. The Authorised capital of the company can be raised if the
company wants to increase the capital once it is fixed.
3. The paid-up capital of a company can be higher than its
issued capital.
4. Debt capital is always raised for short-term periods.
5. Debt instruments are listed and traded on the secondary
markets.

11
Answers:

Fill in the Blanks:

1- Equity capital
2- Dividends
Capital Appreciation
3- Face or Par Value
4-Maturity
5- Default Risk

True or False:

1- True
2-True
3-False
4-False
5-True

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 2. Characteristics of Equity Shares

2.1 Investors in Equity Shares

A company raises equity capital to meet its need for long-term funds
for expansion or continuing operations of the company. Equity capital
does not impose any liability on the company in terms of returns or
repayment. However, when a company issues equity capital, the
investors also get control and ownership. Their ownership rights
depend on the proportion of issued capital that they hold.

A company can raise capital from different categories of investors.

Different categories of investors have different requirements in terms
of returns, risk and management control.

Promoters
Promoters are the group of investors who set up the company and
bring in the initial capital required to start the business. This is the
risk capital that allows the business to leverage and to protect it from
fluctuations in earnings. At this stage the entire control of the
company is with the promoters. They bring in additional capital as
and when required.

As the capital needs of the business grow, promoters find that they
cannot meet the company’s need for funds. Equity is then issued to
eligible investors such as institutions and retail public investors.

Promoters usually retain the majority shareholding in the company

so that they can continue to control its affairs even after their stakes
13
are diluted. The stage at which the promoters bring in the initial
capital is the riskiest as the business is in the nascent stage and has
a high risk of failure.

Institutional Investors
Institutional investors include financial institutions, venture capital
companies, mutual funds and foreign financial institutions, banks
among others. These are professional investors who have the ability
to evaluate the business proposition, the risks associated with it and
the expected returns.

The company may allot shares to such investors through a private

placement of shares where the regulatory requirements are much
less as compared to a public issue of shares. The risks and returns
will depend upon the stage at which the institutional investors bring
in capital.

Some like venture capital firms may be willing to bring in capital for
companies in the start-up stage or even later while others like
financial institutions invest in more established firms. Institutional
investors such as venture capital firms may be actively involved in
the management of the company while others like mutual funds may
be more passive investors who are more interested in the returns
that their investment can generate rather than in the management of
the company.
Apart from the attractiveness of the business proposition, institutional
investors would also be interested in factors such as exit options,
since many of them may hold a significant proportion of the equity
capital. Many institutional investors like venture capitalists,
14
encourage a company to offer its shares to the public investors as an
exit option for themselves.

Public Investors
When the equity shares are held by promoters and a few investors, it
is said to be closely held. Such companies are also private
companies, which are not required to disclose too much of
information about themselves to the public.

When a company offers its equity shares to the public at large, it

moves from being a privately held company, to a publicly held
company, which agrees to disclose periodic information about its
operations and business to the public.

Investors, other than promoters, participate in the equity of a

company when a company comes out with a public issue of shares.
A public issue of shares requires regulatory compliance with SEBI’s
guidelines and regulations governing listing of the shares on a stock
exchange.

Public investors in shares may be retail investors, high net worth

individuals (HNI) or institutional investors. Retail investors, and to a
great extent HNIs, are more interested in the returns that they can
generate from their investment from capital appreciation in the value
of the shares and dividend rather than in the control and
management of the company. They hardly exercise their voting
rights.
Large stake holders and institutional shareholders actively participate
in the affairs of the company. Some large institutional investors are
15
also given a seat on the board of the company. Regulations require
extensive and timely disclosures of all information that affects the
interests of the public investors in a company.

2.2 Features of Equity Share Capital

Equity share capital has distinct features which define its risk and
return. These features determine the suitability of raising equity
capital for the company over other sources of financing such as debt.
For the investors, the risk and return in the equity investment
determine whether such investment is appropriate for their needs.

Ownership rights
Issuing ordinary equity capital implies that the company is giving
ownership rights to the shareholders. Investors are given voting
rights which allow them to vote on important decisions taken by the
company. The voting rights are in proportion to the number of shares
held by the investor and allow them to express their views by voting
for or against a proposal.

Ownership rights in a company also mean that the investors who

hold equity shares are entitled to participate in the residual profits of
the company. This participation will be in the form of dividends that
are periodically declared by the company. The company may also
allot bonus shares to its shareholders from the reserves of the
company.

16
Equity capital is for perpetuity
A company is not required to return the equity capital to the investor.
Investors who do not want to hold the capital of the company can sell
the shares in the stock market to other investors who may want to
buy the shares. This is, however, possible only if the shares are
listed on a stock exchange. The company does not redeem or repay
the amount invested to the investor in equity shares.

Returns are not fixed

Investment in equity shares does not come with a guarantee of
income or security for the investor. The income for the investor from
equity is from dividends and capital appreciation. Neither of these is
guaranteed by the company or any other entity.

At the time of the issue of shares the company does not commit to
pay a periodic dividend to the investor or a pre-fixed date for
payment of dividend, if any. The investor cannot take any action
against the company if dividends are not declared or if the share
value depreciates.

The profits made by the company, after all contractual and regulatory
payments have been made, are for the benefit of its equity
shareholders. These profits are either distributed to the investors as
dividend or retained as reserves which add to the net worth of the
company and the inherent value of its equity shares.

17
2.3 Risks in Equity Investing

No fixed return
The return in the form of dividend from equity is not pre-defined
either in terms of the percentage of dividend or the date on which the
payment will be made. Dividend is paid if the company makes
sufficient profits and the management of the company feels it is
appropriate for some of the profits to be distributed among the
shareholders.

In case the company makes losses or the profits made by the

company is ploughed back for the expansion and other operations of
the company, the shareholders may not get a dividend.

The other source of return for the holder of equity shares is the
appreciation in the price of the share in the secondary market. This
constitutes the major portion of the return for the equity investor.
If the company’s performance is bad or if the stock markets are
going through a downturn, the value of the shares may actually
depreciate leading to a loss for the investor. There is no guarantee
that the principal amount invested in equity shares will remain intact.

No fixed tenor
Equity shares are issued for perpetuity. This means that there is no
period of maturity after which the money will be returned to the
shareholders. Investors who want to exit their investments may do so
by selling the shares on the stock exchange to other investors.

18
The investor who is selling all his shares ceases to be a shareholder
of the company. The shares are transferred to the buyer who now
gets all the rights and obligations associated with it. Transactions
between investors on the secondary market do not increase or
decrease the share capital of the company. The risk to the
shareholder arises if the shares are illiquid and not easily sold at its
market value or if the shares are unlisted. The investor’s investment
may get stuck without an exit option.

No collateral security
Equity capital is not secured by the assets of the company. The cash
and assets of the company are first applied to settle the claims of the
lenders and creditors. The claims of the equity shareholders always
rank last in order of preference. During the normal course of
operations of the company, dividends are payable to the equity
shareholders only after the expenses, interest and taxes are
provided for. In the event of liquidation of the company, the equity
shareholders are only entitled to a refund of capital after the claims
of all the other creditors are satisfied from the auction sale of the
company’s assets.

2.4 Dividend from Equity Shares

Equity shareholders are entitled to share in the residual profits of the
company. One way to do this is through the dividend that the
company may periodically declare.

Dividend declared by a company is not pre-fixed in terms of the

percentage of the dividend or the period when it will be declared.
Dividends are declared by the company when there is sufficient
19
profits that can distributed among the shareholders. The board of
directors of the company will take a decision on the dividend to be
declared. Shareholders approve such dividend proposed by the
board, in an annual general meeting.

Dividend is declared as a percentage of the face value of the shares.

A 40% dividend declared by company will translate into a dividend of
Rs 4 for a share with a face or par value of Rs 10 (10*40/100), Rs 2
for a share with a face value of Rs5 (5*40/100).

Dividend for a company is usually declared at the end of a year

which is called the final dividend. Companies may also declare
dividends during the year. This is called interim dividend.

Dividend income received on equity shares is exempt from tax for

the investor at this time. The company is however required to pay a
dividend distribution tax on the dividend.

The dividend declared by a company is a percentage of the face

value of its shares. When the dividend received by an investor is
compared to the market price of the share, it is called the dividend
yield of the share.

For example, a company declares a dividend of 60% on its shares

which have a face value of Rs 2. The market price of the share is Rs
80. The dividend yield is the dividend amount, which is Rs 1.2 (Rs
2*60/100) as a ratio of the market price which is Rs 80. The dividend
yield is therefore 1.2/80*100= 1.5%.

20
The dividend yield of a share is inversely related to its share price. If
the price of equity shares moves up, the dividend yield comes down,
and vice versa.

2.5 Preference Shares

When we talk of shares of a company we usually refer to the
ordinary shares of a company. A company may also raise equity
capital with varying rights and entitlements. These are called
preference shares because they may offer certain special features or
benefits to the investor. Some benefits that investors in ordinary
equity capital have, such as, voting rights, may instead not be
available to preference share holders. Preference shares are usually
given preference over equity shares in the payment of dividends and
the repayment of capital if the company is wound up.

Dividend is paid to the preference share holder at a fixed rate

mentioned at the time of the issue of the shares. The terms of issue
may allow the preference share holders to participate in the residual
profits too in some defined ratio. These are called participating
preference shares.

Preference shareholders are paid dividend only if the company has

sufficient profits. The unpaid dividend may be carried forward to the
following year(s) and paid if there are profits to pay the dividends, if
the terms of issue of the shares so allow. Such shares are called
cumulative preference shares.

21
The returns for the preference shares are only from the dividend the
company pays. These shares are usually not listed and there is not
much scope for capital appreciation. This is because these shares
do not participate in the profits of the company. Their value is not
affected by the over-performance or under-performance of the
company.

Though preference shares are similar to debentures, they differ on

the following points:
- A preference share holder is a shareholder of the company.
A debenture holder is a creditor of the company.
- A debenture is usually secured on the assets of the
company. A preference share is not secured since it is not a
borrowing.
- The coupon interest on the debenture is an expense to be
paid by the company before calculating the profits on which
tax has to be paid. Dividends on preference shares are paid
from the residual profits of the company after all external
liabilities, including tax, have been paid.

2.6 Rights Issue of Shares

A company may raise equity capital from its investors at various
times, provided it is within the authorised capital limits of the
company. Whenever a company makes a fresh issue of shares, it
has an impact on the existing shareholders since their proportionate
holding in the shares of the company gets diluted.

22
For example, a company may have 10 lakh shares of Rs.10 each,
amounting to an issued and paid-up capital of Rs. 1cr. If it issues
another 10 lakh shares, to increase its capital, the proportion held by
existing shareholders will come down by half, as the issued and paid
up capital has doubled. This is called as dilution of holdings. To
prevent this, section 81 of the Company’s Act requires that a
company which wants to raise more capital through an issue of
shares must first offer them to the existing shareholders. Such an
offer of shares is called a rights issue.

The rights shares are offered to the existing investors in a proportion

as approved by the board of a company. For example, the company
may choose to issue rights at 1 for 1, to double its capital. This
means each existing shareholders will get one equity share for every
one equity share that they already hold.

The issued and paid up capital will double, but proportionate

holdings will not change. Ratio of rights issues need not always be
one. They can be 1:2, 2:3, 2:5 and so on, depending on the decision
of the board of the company.

Investors have to subscribe to a rights issue, by paying for and

buying the equity shares being offered. The rights issue is kept open
for a fixed period during which investors subscribe to the shares or
can also sell/renounce their right entitlement.

A rights issue of shares must follow all SEBI’s regulation on issue of

shares. The company must issue a letter of offer giving details of the
issue including the purpose for which funds are being raised. The
23
draft letter of offer must be filed with SEBI at least 30 days prior to
filing the same with the designated stock exchange.

An abridged letter of offer must be dispatched to all investors at least

one week before the issue opens. Investors can also apply on a plain
paper if they do not receive the application form. The investors are
given the option to receive the shares in dematerialised form.

A company cannot withdraw a rights issue after announcing it. If the

company does so, it will not make an application for listing any
securities within a minimum period of 12 months from such
withdrawal.

24
Key Points
1. Equity capital may be raised from the promoters, institutions
and the public at various points in time.
2. Ordinary equity shares give ownership rights to the investor.
This includes voting rights and the right to participate in the
residual profits of the company.
3. Equity capital is for perpetuity. This means the company
does not have to repay the capital that is raised from
investors.
4. Investors can however exit from the investment by selling
the shares in the secondary market to other investors.
5. Returns from equity are in the form of dividend and capital
gains when the shares are sold in the secondary markets.
6. Investors receive dividends only if there are profits and the
company decides to distribute them. Dividends are declared
as a percentage of the face or par value of the shares.
7. The dividend yield of a share compares the dividend paid to
the market price of the share.
8. The risk in equity investing arises from the fact that returns
from equity are not fixed and the secondary market for the
shares may be illiquid making it difficult for the investor to
exit.
9. Preference shares give the investor a fixed rate of dividend
and priority over ordinary equity shareholders in repayment
of capital if the company goes into liquidation.
10. Rights shares are further shares issued to existing
shareholders in proportion to their existing holding.

25
Quick Recap

Fill in the Blanks

1. _____ rights give the equity investor a say in the
management of the company.
2. A 20% dividend declared on face value of Rs 10 and market
price of Rs 120 translates into a dividend payout of Rs.
_____.
3. When market price goes up dividend yield goes______.
4. Cumulative preference shareholders can carry forward
_______
5. The price of at which rights shares are issued are decided
by ________

State True or False

1. Retail investors usually participate in the equity of a
company at its inception stage.
2. A company may not declare a dividend even if there are
profits.
3. Preference share holders get preference over debenture
holders in the payment of dividend.
4. Preference share holders and debenture holders are
creditors of the company.
5. Rights shares, if subscribed to, maintains the investors
proportionate holding of the investor in the company.

26
Answers:

Fill in the blanks:

1- Voting
2- Rs 2
3-Down
4- Unpaid dividend
5-Company

State True or False:

1- False
2-True
3-False
4-False
5- True

27
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left blank
intentionally

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 3. Other Securities

Companies can raise capital using equity and debt instruments. The
basic features of these instruments can be modified to suit the
specific requirements of the borrowers or lenders. Such
modifications bring advantages such as wider participation, better
management of cash flows and better return prospects.

3.1 Warrants
Warrants are securities usually issued by companies along with a
debenture to make the debt issue more attractive to the investors.
Warrants give the investors in the debentures, the right to buy shares
of the company in the future.

Warrants are usually attached to a debenture issue of the company

to make the debenture more attractive. The number of shares that
the warrant entitles the holder to subscribe to, the price at which
such shares can be bought and the period during which the warrant
can be exercised are specified at the time of the issue.

Warrants will be exercised if the share price at the time of exercise is

higher than the price at which the investors have the option to buy
the shares. For example, assume a warrant enables an investor to
buy an equity share of a company at Rs.100. The warrant will be
exercised if, when it is due to be exercised, the price of the share in
the markets is more than Rs.100. If the market price is less than
Rs.100, the investor can always buy from the market, rather than use
the option to buy the same share at a higher price. When warrants

29
are exercised they result in additional shares being issued by the
company and a dilution in the stake of the existing shareholders.

Warrants may be traded on the stock exchange as a security

separate from the debenture with which it was issued. Warrants
usually have a longer lifetime (usually in years) as compared to
option contracts which they closely resemble.

Warrants may be used by promoters to increase their stake in the

company. SEBI requires that shares issued to promoters as a result
of exercising the option on the warrant will have a lock-in of three
years from the date the shares are allotted.

3.2 Convertible Debentures

Convertible debentures are debt instruments that can be converted
into equity shares of the company at a future date. The security has
features of both debt and equity. It pays periodic coupon interest just
like any other debt instrument.

At the time of redemption of the debenture, the investors can choose

to receive shares of the company instead of cash.

The issuer specifies the details of the conversion at the time of

making the issue. This will include:
- The date on which the conversion will be made
- The ratio of conversion i.e. the number of shares that
the investor will be eligible to get for each debenture

30
 - The price at which the shares will be allotted to the
investor on conversion. Usually this is at a discount to
the market price
- The proportion of the debenture that will be converted
into equity shares.

Debentures may be fully convertible debentures (FCD) where the

entire face value of the debenture is converted into equity shares or
they may be partly convertible debentures (PCD) where a portion of
the debenture is converted into equity. The non convertible portion
will continue to remain as debentures and will be repaid in cash on
redemption.

The advantage to the issuer of convertible debenture lies in the fact

that convertible debentures usually have a lower coupon rate than
pure debt instruments. This is because the yield to the investor in
such debenture is not from the coupon alone but also the possibility
of capital appreciation in the investment once the debentures are
converted into equity. Moreover, the issuer does not have to repay
the debt on maturity since shares are issued in lieu of repayment.
The disadvantage to this is that holding of the existing shareholders
get diluted when fresh shares are issued on conversion.

The investors in a convertible debenture have the advantage of

equity and debt features. They earn coupon income in the initial
stages, usually when the company’s project is in its nascent stage.
Once the debenture is converted into shares, the investor may
benefit from the appreciation in the value of the shares.

31
An issue of convertible debentures by way of a public issue will have
to abide by the regulations of SEBI. The guidelines also require that
the investors be given the option of not converting the debenture into
shares, if the price at which conversion is to be made is not defined
at the time of the issue.

3.2.1 Depository Receipts

Depository receipts (DRs) are financial instruments that represent
shares of a local company but are listed and traded on a stock
exchange outside the country. DRs are issued in foreign currency,
usually dollars.

To issue a DR, a specific quantity underlying equity shares of a

company are lodged with a custodian bank, which authorises the
issue of depository receipts against the shares. Depending on the
country of issue and conditions of issue, the DRs can be converted
into equity shares.

DRs are called American Depository Receipts (ADRs) if they are

listed on a stock exchange in the USA such as the New York stock
exchange. If the DRs are listed on a stock exchange outside the US,
they are called Global Depository Receipts (GDRs). The listing
requirements of stock exchanges can be different in terms of size of
the company, state of its finances, shareholding pattern and
disclosure requirements.

When DRs are issued in India and listed on stock exchanges here
with foreign stocks as underlying shares, these are called Indian
Depository Receipts (IDRs)
32
The shares of a company that form the basis of an ADR/GDR/IDR
issue may be existing shares i.e. shares that have already been
issued by the company. These shareholders now offer the shares at
an agreed price for conversion into DRs. Such a DR issue is called a
sponsored issue.

The company can also issue fresh shares which form the underlying
for the DR issue. The funds raised abroad have to be repatriated into
India within a specified period, depending on the exchange control
regulations that will be applicable.

The company whose shares are traded as DRs gets a wider investor
base from the international markets. Investors in international
markets get to invest in shares of company that they may otherwise
have been unable to do because of restrictions on foreign investor
holdings. Investors get to invest in international stocks on domestic
exchanges. Holding DRs gives investors the right to dividends and
capital appreciation from the underlying shares, but not voting rights.

The steps in issuing DRs are the following.

- The company has to comply with the listing
requirements of the stock exchange where they
propose to get the DRs listed.
- The company appoints a depository bank which will
hold the stock and issue DRs against it.
- If it is a sponsored issue, the stocks from existing
shareholders are acquired and delivered to the local
custodian of the depository bank. Else the company

33
 issues fresh shares against which the DRs will be
issued.
- Each DR will represent certain number of underlying
shares of the company.

Once the custodian confirms that the shares have been received by
them, the depository bank in the foreign country will issue the
depository receipts to the brokers to trade in the chosen stock
exchange where the DRs have been listed. DRs may feature two-
way fungibility, subject to regulatory provisions. This means that
shares can be bought in the local market and converted into DRs to
be traded in the foreign market. Similarly, DRs can be bought and
converted into the underlying shares which are traded on the
domestic stock exchange.

SEBI has laid down the guidelines to be followed by companies for

IDRs. This includes the limit on the money raised by a company in
India, a one year lock-in on the conversion of IDRs to shares, the
availability of IDRs to only resident Indian investors and not to FIIs.

3.3 Foreign Currency Convertible Debenture (FCCB)

FCCBs are a foreign currency (usually dollar) denominated debt
raised by companies in international markets but which have the
option of converting into equity shares of the company before they
mature.

The payment of interest and repayment of principal is in foreign

currency. The conversion price is usually set at a premium to the

34
current market price of the shares. FCCB allow companies to raise
debt at lower rates abroad. Also the time taken to raise FCCBs may
be lower than what takes to raise pure debt abroad.

An Indian company that is not eligible to raise equity capital in the

domestic market is not eligible to make an FCCB issue either.
Unlisted companies that have raised capital via FCCB in foreign
markets are required to list the shares on the domestic markets
within a stipulated time frame.

FCCBs are regulated by RBI notifications under the Foreign

Exchange Management Act (FEMA). The Issue of Foreign Currency
Convertible Bonds and Ordinary Shares (Through Depository
Receipt Mechanism), 1993 lays down the guidelines for such issues.

The issue of FCCBs should be within the limits specified by RBI from
time to time. Public issue of FCCB will be managed by a lead
manager in the international markets. Private placement of FCCBs is
made to banks, financial institutions, foreign collaborators, foreign
equity holders holding at least 5% stake.

The maturity of FCCB will be not less than five years. Proceeds from
FCCB shall not be used for stock market activities or real estate. If it
is to be used for financing capital expenditure, it can be retained
abroad.

The expenses shall be limited to 4% of the issue size in case of

public issue and 2% in the case of private placement. Within 30 days
of the issue a report has to be furnished with RBI giving details of the
35
amount of FCCBs issued, the name of the investors outside India to
whom the FCCBs were issued and the amount and the proceeds
that have been repatriated into India.

36
Key Points
1. Instruments can be created with features of equity and debt
to suit the specific needs of the borrower and lender.
2. Warrants give the investor the option to buy shares of the
company in future. They are traded separately in the
market.
3. Convertible debentures come with the feature that they can
be converted into shares of the company at a future date.
4. The price and conversion ratio are decided at the time of
the issue. Till conversion, the debenture will pay coupon
interest like other debt instruments.
5. The issue of convertible debentures is regulated by SEBI’s
norms for issue, price and lock-in.
6. Depository receipts are instruments that represent
underlying shares of a local company but listed on a foreign
stock exchange. The issue has to meet the requirements of
the stock exchange where it proposes to list the DRs.
7. An Indian Depository Receipt (IDR) is listed on an Indian
stock exchange and represents the shares of a foreign
company. An IDR issue has to meet the specifications laid
down by SEBI.
8. DRs can be converted into the underlying shares and vice
versa.
9. FCCBs are issued as convertible debentures abroad, with
the debt component in foreign currency and the equity on
conversion, into Indian equity shares.

37
Quick Recap

Fill in the Blanks

1. Warrants are usually issued along with _________.
2. Warrants resemble __________.
3. The non-convertible portion of a partly convertible debenture is
________ on maturity.
4. The stocks which underlie a DR issue are held by a __________.
5. Holders of DRs do not have _______ rights.

State True or False

1. Warrants have to be compulsorily exercised by the holder on the
specified date.
2. Convertible debentures may be fully or partly converted into equity
shares.
3. A convertible debenture issue does not have to be credit rated
since it is going to be converted into shares.
4. Investors in convertible debentures may be given the option of not
converting the holding into shares.
5. A sponsored DR issue has existing shareholders offering their
shares for conversion into DRs.

38
Answers:

Fill in the blanks:

1-Debentures
2-Call Options
3- Repaid in cash
4- Depository Bank/ (Local Custodian)
5- Voting

State True or False:

1- False
2-True
3-False
4-True
5-True

39
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left blank
intentionally

40
 4 Debt Securities

4.1 Features of a Debt Security

A debt security denotes a contract between the issuer (company)
and the lender (investor) which allows the issuer to borrow a sum of
money at pre-determined terms.

These terms are referred to as the features of a bond and include the
principal, coupon and the maturity of the bond. In Indian securities
markets, a debt instrument denoting the borrowing of a government
or public sector organizations is called a bond and the borrowings by
the private corporate sector is called debenture. The terms bonds
and debentures are usually used interchangeably these days.

The principal is the amount which is being borrowed by the issuer.

Each debenture represents a portion of this principal amount
borrowed. The face value or par value of the debenture is the
amount of the principal that is due on each debenture. The face
value of a debenture is usually Rs100.

The coupon is the rate of interest to be paid by the borrower to the

lender. This is a percentage that is applied to the face value or par
value of the bond. The periodicity (annual, semi-annual, or quarterly.)
with which the interest will be paid is also agreed upon.

The maturity of a bond refers to the date on which the contract

requires the borrower to repay the principal amount. Once the bond
is redeemed or repaid, it is extinguished and ceases to exist.
41
Each of these features of a bond can be modified to create
instruments that meet the specific requirements of the borrower or
the lender. A plain vanilla bond will have a fixed term to maturity with
coupon being paid at pre-defined periods and the principal amount is
repaid on maturity. The bond is usually issued at its face value, say
Rs100 and redeemed at par, the same Rs100.

The simple variations to this structure could be a slightly varied issue

price, higher or lower than par and a slightly altered redemption
price, higher or lower than par. In some cases, the frequency of the
interest payment could vary, from monthly, to quarterly and annual.
All these variations still come under the plain vanilla definition of a
bond, where the interest is paid at a fixed rate periodically, and
principal returned when the bond is retired. There are however many
ways in which bonds are differently structured, by tweaking their
features.

4.2 Varying Coupon Structures

Zero Coupon Bond
In such a bond, no coupons are paid. The bond is instead issued at
a discount to its face value, at which it will be redeemed. There are
no intermittent payments of interest. When such a bond is issued for
a very long tenor, the issue price is at a steep discount to the
redemption value. Such a zero coupon bond is also called a deep
discount bond.

The effective interest earned by the buyer is the difference between

the face value and the discounted price at which the bond is bought.
There are also instances of zero coupon bonds being issued at par,
42
and redeemed with interest at a premium. The essential feature of
this type of bonds is the absence of periodic interest payments.

Floating Rate Bonds

Instead of a pre-determined rate at which coupons are paid, it is
possible to structure bonds, where the rate of interest is re-set
periodically, based on a benchmark rate. Such bonds whose coupon
rate is not fixed, but reset with reference to a benchmark rate, are
called floating rate bonds.

For example, a company can issue a 5 year floating rate bond, with
the rates being re-set semi-annually with reference to the 1- year
yield on central government securities and a 50 basis point mark-up.
In this bond, every six months, the 1-year benchmark rate on
government securities is ascertained.

The coupon rate the company would pay for the next six months is
this benchmark rate, plus 50 basis points. The coupon on a floating
rate bond thus varies along with the benchmark rate, and is reset
periodically.

The other names, by which floating rate bonds are known, are
variable rate bonds and adjustable rate bonds. These terms are
generally used in the case of bonds whose coupon rates are reset at
longer time intervals of a year and above. These bonds are common
in the housing loan markets.

43
Other Variations
Some of other structures are: (a) deferred interest bonds, where the
borrower could defer the payment of coupons in the initial 1 to 3 year
period; (b) Step-up bonds, where the coupon is stepped up
periodically, so that the interest burden in the initial years is lower,
and increases over time.

4.3 Other Types of Bonds

Callable Bonds
Bonds that allow the issuer to alter the tenor of a bond, by redeeming
it prior to the original maturity date, are called callable bonds. The
call option provides the issuer the option to redeem a bond, if interest
rates decline, and re-issue the bonds at a lower rate. The investor,
however, loses the opportunity to stay invested in a high coupon
bond, when interest rates have dropped.

Puttable Bonds
Bonds that provide the investor with the right to seek redemption
from the issuer, prior to the maturity date, are called puttable bonds.
A put option provides the investor the right to sell a low coupon-
paying bond to the issuer, and invest in higher coupon paying bonds,
if interest rates move up. The issuer will have to re-issue the put
bonds at higher coupons.

Amortising Bonds
The structure of some bonds may be such that the principal is not
repaid at the end/maturity, but over the life of the bond. A bond in
which payments that are made by the borrower includes both interest
and principal, is called an amortising bond. Auto loans, consumer
44
loans and home loans are examples of amortising bonds. The
maturity of the amortising bond refers only to the last payment in the
amortising schedule, because the principal is repaid over time i.e.
redemption in more than one instalment.

Asset-backed Securities
Asset backed securities represent a class of fixed income products,
created out of pooling together assets, and creating bonds that
represent participation in the cash flows from the asset pool. For
example, select housing loans of a loan originator (say, a housing
finance company) can be pooled, and bonds can be created, which
represent a claim on the repayments made by home loan borrowers.
Such bonds are called mortgage–backed securities. In some
markets like India, these bonds are known as structured obligations
(SO). Assets with regular streams of cash flows are ideally suited for
creating asset-backed securities.

4.4 Classification of Debt Instruments

Issuers in Bond Markets
There are two broad ways in which bond markets can be segmented.
- Based on the type of borrower, we can segment the
market between the bonds issued by governments, and
those issued by non-government agencies like banks,
corporations and other such entities.
- Based on the tenor of the instrument, we can segment
the bond markets as short-term, medium term and long
term.

45
These are not mutually exclusive segments. The government issues
bonds to meet its requirements for various periods as does the
private sector. Each issued bond has an issuer and a tenor.

Government Securities comprises the central government bonds,

and quasi-government bonds issued by local governments, state
governments and municipal bodies. Government securities do not
have credit or default risk.

Corporate bond markets comprise pre-dominantly of short-term

commercial papers and long-term bonds. Another segment
comprises of short term paper issued by banks, in the form of
certificates of deposit. The rate at which this segment borrows
depends upon the credit quality of the borrower. The credit or default
risk of the borrower is defined by the credit rating of the bond. Higher
the credit rating lower is the risk of default.
Companies also raise fixed deposits from the retail investors to meet
their borrowing requirements. Such deposits are for a fixed term and
carry a pre-defined interest rate. The interest can either be paid
periodically, such as annual, semi-annual, or quarterly or it is paid
cumulatively at the end of the term along with the repayment of the
principal.

Company deposits are credit rated but unsecured borrowings of

companies and as such pay a higher interest rate on the deposit.
Since these are deposits and not a security, there is no liquidity in
such fixed deposits. The investors hold the deposits to maturity.

46
Treasury Bills
The government borrows for periods such as 91 days, 182 days and
364 days using these instruments. Treasury bills are issued through
an auction process which is managed by the RBI. Banks, mutual
funds, insurance companies, provident funds, primary dealers and
FIs bid in these auctions. The treasury bills are usually issued as
zero-coupon bonds.

CBLO
A Collateralised Borrowing and Lending Obligation (CBLO) is
created using government securities as collateral and held with the
Clearing Corporation of India Ltd. (CCIL) to enable borrowing. It is a
discounted instrument available for maturities from one day to up to
one year. Banks use the CBLO to borrow from mutual funds and
insurance companies.

Certificates of Deposit (CD)

Banks use CDs to meet their short-term needs for funds. CDs are
different from deposits because they involve creation of paper. This
makes the CD transferable before maturity. Secondary market
activity in CDs are however low.

Commercial Paper (CP)

CPs are short-term papers issued by companies to meet their
working capital requirements. They can be issued for various
maturities of up to 364 days. The popular CP is the 90-day CP. CPs
are unsecured credit-rated borrowings with a limited secondary
market.

47
Government Securities
Government securities, also called treasury bonds, are
predominantly issued to fund the fiscal deficit of the government.
Treasury bonds also set benchmark for pricing corporate paper of
varying maturities. All other borrowers in the system borrow at a
spread over this benchmark rate on government securities.

The instruments used in this segment are many, including fixed

coupon bonds, commonly referred to as dated securities, treasury
bills, floating rate bonds, zero coupon bonds and inflation index
bonds.

Treasury Bonds may have tenors ranging from a year to 30 years.

Corporate Bonds
The market for corporate debt securities is dominated by private
placements with large institutional investors. Public issue of
corporate debt securities are regulated by SEBI’s guidelines for the
same. The guidelines require the issue to be credit-rated,
appointment of a debenture trustee, creation of debenture
redemption reserve and creation of a charge on the assets of the
company.

The secondary market for long-term bonds is concentrated in the

government securities segment. In this segment too, trading primarily
happens in the benchmark securities. Trades in the government
securities segment as well as the corporate bond segment are
reported to the exchanges.

48
4.5 Yield from Debt Instruments
The returns to an investor in bonds, is primarily made up of the
coupon payments. However, if the investor acquires or sells the bond
at a price that is different from the par value the returns can vary
from the coupon. Therefore, the coupon rate of the bond is not an
indicator of the returns on the bond, but merely helps in computing
what cash flows would accrue periodically, to the investor.

We use the term ‘yield’, rather than ‘coupon rate’, to denote the
returns to the investor.

Current Yield
Current yield simply compares the coupon of a bond with its market
price. For example, if a bond paying an annual coupon of 12% is
trading in the markets for Rs. 109.50, we compute the current yield
as:
12/109.5
=10.95%

Yield to Maturity (YTM)

Yield to maturity (YTM) is a popular and extensively used method for
computing the return on a bond investment. Every bond is made up
of a set of cash flows that accrue at various points in time, from the
time the bond is acquired, until it is sold or redeemed.

We can then use the very well known principle in finance, to value
the bond: the price at which a series of future cash flows should sell
is the sum of the discounted value of these cash flows. The rate

49
which equates the discounted value of the cash flows with the price
of the bond is the yield to maturity of the bond.

4.5.1 Credit Rating

The biggest risk faced by investors in debt securities is the possibility
of the lender not honouring their commitment on payment of interest
on the borrowing and repayment of the principal on maturity of the
instruments.
The ability of the borrower to meet its obligation will depend upon
factors internal and external to the business. Lenders therefore
evaluate these factors associated with the borrower before entering
into the transaction. The decision of a lender on whether or not to
lend to a borrower and at what cost would be determined by the risk
associated with the borrower. This risk of the possibility of a default
on obligations by the borrower is called the credit risk of the
borrower.

The credit risk of a borrower is evaluated by credit rating agencies.

Credit rating agencies have to be registered with SEBI and abide by
the regulation laid down in SEBI (Credit Rating) Regulations, 1999 in
the conduct of such evaluations.

The credit rating agencies consider all the qualitative and

quantitative factors that impact the business of the borrower and
consequently their ability to meet their financial obligations. The
appraisal is done by industry experts and the information collected
not only from the borrower but from other sources as well. Based on
their appraisal, the rating committee of the credit rating agency will
assign a rating to the borrowing. Rating is therefore an exercise that
50
converts into a symbol the ability and willingness of the company to
service the instrument proposed to be issued.

The credit rating assigned to an instrument is not static but is

dynamic. This means that the credit risk associated with a borrowing
may change over time. Credit rating agencies are required by SEBI
to constantly monitor factors that affect the status of the instrument
and to reassign a rating if the credit quality of the instrument
improves or deteriorates.

The rating symbols usually used by rating agencies are described in

the table below:
Rating Instrument Description Implication
Symbol
AAA,LAAA Long-term Investment Highest Safety
P1,A1+ Short- term Grade

FAAA Fixed Deposit

AA,LAA Long-term Investment High Safety
P2,A1 Short- term Grade

FAA Fixed Deposit

A,LA Long-term Investment Adequate
P3,A2 Short- term Grade Safety

FA Fixed Deposit
BBB,LBBB Long-term Investment Moderate
A3 Short- term Grade Safety

BB,LB Long-term Speculative Inadequate

A4 Short- term Grade Safety
51
FB Fixed Deposit
B, LB Long-term Speculative High Risk
P4 Short- term Grade

Fixed Deposit
C,LC Long-term Speculative Substantial
Short- term Grade Risk

FC Fixed Deposit
D,LD Long-term Speculative Default
P5,A5 Short- term Grade

FD Fixed Deposit
NM Long-term Speculative Not Meaningful
Short- term Grade

(Rating symbols used by CRISIL, ICRA)

52
Key Concepts
1. The three basic features of a debt instrument are the principal
amount that has to be repaid, a coupon interest that has to be
paid on the principal amount till it is repaid and a maturity period
at which the debt or the principal amount is repaid.
2. The three features of a debt instrument can be modified to
create instruments such as zero coupon bonds and bonds with
put and call options.
3. Debt markets can be segmented based on the issuer as
government bonds and corporate debentures and based on
maturity as long and short term bonds.
4. Issuers use different types of instruments to raise debt in the
short-term and long-term markets.
5. The yield from a bond can be calculated either as the current
yield which relates the coupon income to the market price of the
bond or as the YTM which is the internal rate of the bond that
would accrue if the bond is held until maturity.
6. The interest that is paid on a debt instrument depends on the
credit risk associated with it and the term of borrowing.
7. The credit risk associated with a bond is measured by an
exercise called credit rating undertaken by credit rating agencies
such as Crisil and Icra, Care and Fitch.

53
Quick Recap

Fill in the Blanks

1. _________ of a bond refers to the interest payable on a
bond.
2. Bonds are segmented as long and short term based on
their ______.
3. Call and put options modify the _________ of the bond.
4. The government uses ______________ to borrow for the
short-term.
5. A bond with a higher credit rating will pay _______ interest
rates.

State True or False

1. Bonds with sinking fund provisions alter the maturity of the
bond.
2. A ceiling limits the minimum interest that an investor will
receive from a floating rate bond.
3. All government securities are tax-free bonds.
4. Money market refers to the market for short-term borrowing
of the government.
5. Fixed deposits raised by companies are unsecured but
rated borrowings.
6. CPs are mostly issued to banks because the stamp duty is
lower.
7. The corporate bond market is dominated by public issues of
bonds.

54
 8. The prices of bonds are directly related to interest rate
movements.
9. The YTM of a bond is the yield that investors will earn on
holding a bond to maturity.
10. The credit rating assigned to a bond will change with a
change in the financial viability of the borrower.

55
Answers:

Fill in the Blanks:

1- Coupon
2- Term to maturity
3- Maturity
4- Treasury Bills
5 - Lower

State True or False:

1-True
2-False
3- False
4- False
5-True
6-True
7-False
8- False
9- True
10- True

56
 5 Mutual Funds

A mutual fund is an investment option, where investors contribute

small amounts of money. These contributions are pooled together to
make it a large sum. This sum is then invested in various securities.

When we say 'mutual fund' we are referring to the money contributed

by the investors. When we say 'portfolio' we are referring to the
securities in which the investments have been made.

A mutual fund thus enables investors to participate in securities

markets and invest in equity shares, bonds and such instruments by
pooling their money together. A mutual fund will state its objective up
front. This indicates how the money will be invested and how the
portfolio will be constructed. Investors choose a fund, which matches
their own objectives.

For example, an equity fund may state that its objective is to invest in
equity shares to generate long term growth. An investor, who likes to
invest in a portfolio of equity shares, will buy the units of this fund. A
liquid fund may state that its objective is to provide steady return
from investing in money markets over the short term. Investors
having a short term surplus may decide to invest it in such a fund.

5.1 Collective Investment Vehicle

A mutual fund is a collective investment vehicle. Usually a mutual
fund product is first described by its investment objective. Investors

57
then invest their money in the product. The money is pooled together
and is invested according to the stated objective.

Example
HDFC Income Fund is a debt fund that invests pre-dominantly in
debt instruments, with the objective of generating regular income for
its investors.

DSPBR Top 100 Equity Fund is a fund that seeks to generate capital
appreciation from a portfolio of equity shares of the 100 largest listed
companies.

Fund managers invest the pool of money into securities such as

equity and debt, according to the stated investment objective of the
fund. The risk and return of the fund depend on the investment
portfolio of the fund. The benefits from the investment portfolio
accrue to those that contribute to the pool. There is thus mutuality in
the contribution and the benefit. Hence the name ‘mutual’ fund.
When a mutual fund pools money from several investors, each
investor does not contribute the same sum of money. Depending on
their needs and preferences, investors put in money into the fund.
Therefore each investor’s share in the pool of funds is not equal.

5.2 Proportionate Share of Benefits

The benefits from the fund accrue to all investors in proportion to
their share in the pool.

58
Example
Three investors invest Rs 10,000, Rs 20,000 and Rs 30,000
respectively in a mutual fund. So the pooled sum is Rs 60,000. The
money is invested and gains Rs 12000 over time. This means, the
pool is now worth Rs 72,000. The value of the investors’ holding in
the mutual fund also goes up proportionately (in the ratio of 1:2:3) to
Rs 12,000, Rs 24,000 and Rs 36,000 respectively.

Investors can contribute into a fund or redeem and take away their
contributions, depending on the nature of the pool. In a closed end
fund, investors tend to stay until maturity. If a fund is open-ended,
investors can come in and move out at will. Therefore, there is the
need to standardize the contributions of investors to be able to
objectively measure their share in the fund.

5.3 Units Vs Shares

When investors subscribe to a mutual fund, they buy a share in the
pool of funds. This share is called a unit of the mutual fund scheme.
The investment in a mutual fund is represented to the investor in
units.
A mutual fund investor is called a unit holder just as an investor in
equity shares is called a share holder. The ownership of the fund is
jointly held by all the unit holders. Just as investors in equity hold
shares of a company, mutual fund investors hold units of the fund.
Each unit has a face value. This is typically Rs 10 per unit for most
mutual funds.

59
Equity shares are offered to investors for the first time in an IPO
(Initial public offering). Mutual funds are offered for the first time to
investors in an NFO (New fund offer).

Subsequently equity shares are bought and sold on the stock

exchange.

Mutual fund units can usually be bought and sold through the fund
itself. Funds enable continuous transactions at their offices and at
investor service centres. Sometimes mutual funds are listed and can
be bought and sold on the stock exchange.

Unit Capital
Investments are made in rupee terms by the investor. But the fund
will always record this investment in terms of number of units.
Number of units = Invested amount/price per unit.
For example,
If the value of a unit is Rs 10, and
2000 units have been sold at Rs 10 each,
the value of the pool is
10 x 2000 = Rs 20,000.
For example,
If the price of 1 unit is Rs 10.225, and
amount invested is Rs 20,000,
the number of units issued against this investment is
20,000/10.225 = 1955.99 units.

60
Units can thus be denoted also as a fractional value. Unit capital is a
term used to denote the corpus of a fund. This is nothing but the total
face value of ALL the units issued by a fund.

For example, if a fund has issued 10,000 units so far, its unit capital
is 10,000 x 10 (FV) = Rs 1,00,000.

According to the SEBI Regulations, each mutual fund scheme has to

have a separate account. Therefore the unit capital of each scheme
is maintained to reflect its current corpus.

5.4 Assets under Management (AUM)

A portfolio is a collection of securities. These securities can be equity
shares, bonds, debentures, deposits, money market instruments,
derivatives and the like. Mutual funds can invest only in marketable
securities, or securities that can be traded in a market and therefore
have a market price.

The value of the fund’s portfolio changes with changes in market

value of the securities that have been bought. The portfolio is
updated every day, to represent its current market value. This
process is called ‘marking to market’.

The market value of the portfolio is known as the assets under

management (AUM) of the fund. The value of the portfolio changes
every time there is a change in market price of the securities that a
mutual fund holds.

61
Consider this table:

Security No of Market Market Market Market

shares Price Value Price Value
Day 1(Rs) Day 1(Rs) Day 2 (Rs) Day 2 (Rs)
L&T 1000 2500 2500000 2700 2700000
Finolex 2000 50 100000 53 106000
Sun 1000 1400 1400000 1300 1300000
Pharma
ICICI 1000 750 750000 700 700000
Bank
Total 4750000 4806000
(Rs)
Number of Units 475000 475000
Value per unit (Rs) 10 10.12

As the market price of the shares changes, the value of the portfolio
has changed from Rs 47.5 lakh to Rs48.06 lakh. Therefore if the
units had been issued at Rs. 10 each, there would be 475,000 units.
Their market value will now be 4806,000 / 475,000, which is
Rs.10.12 per units. The value per unit is higher than 10 because the
value of the portfolio have also moved up.

The value of the investors’ unit holdings also changes along with the
market value of the portfolio. The current market value per unit is
called the net asset value (NAV). NAV can move up or down,
depending upon whether the value of the portfolio has moved up or
down.

62
If value of the portfolio falls from 4750000 to 4500000, when the
prices of the shares held in the portfolio fall, this will led to the NAV
per unit falling from Rs.10 to Rs.9.47. Thus the current value of a unit
depends on the value of the portfolio of the fund, and can go up and
down with changes in the market value of the portfolio.

5.5 Fund Recurring Expenses (FRE)

The activities associated with portfolio management involve costs
and fees. These expenses are charged to the fund. Regulations
cover what kind of costs can be charged to the fund and also
prescribe limits on these expenses. These expenses are called fund
recurring expenses (FRE).

FRE is usually represented as a percentage of AUM. These

expenses are charged to the AUM of the fund on a daily accrual
basis.

FRE, for instance, if calculated at 2.5% of the AUM it is divided by

365 to get the daily accrual. The value of the portfolio is re-calculated
daily and represented as market value (AUM). The expenses (FRE)
are accrued everyday and charged to AUM.

5.6 Net Assets

Net assets refer to the net value of the portfolio, after charging the
daily FRE. When we divide the net assets of a fund by the number of
units issued, we get net asset value (NAV) per unit. Net assets of a
mutual fund may change with the change in the market value of the
portfolio or change in the expenses charged to the fund.

63
When the net assets of a fund are divided by the number of units in
the fund, we get the market value per unit, which is called the net
asset value (NAV) per unit. NAV thus includes both market value and
expenses charged to the fund.

Mutual funds declare the NAV of all their schemes every business
day. Mutual fund NAVs are published in newspapers as well as on
the website of AMFI (www.amfiindia.com).

5.7 Assets and Liabilities in a Mutual Fund Portfolio

When we refer to total assets, we are referring to the market value of
the mutual fund portfolio. A mutual fund rarely holds any other long-
term asset in its balance sheet. There may be few receivables and
accrued income, which are current assets. These are added to the
portfolio value to get the total assets of the fund. Similarly on the
liability side, a mutual fund does not have long-term liabilities. The
assets are fully funded by the unit capital contributed by the
investors. Therefore when we refer to liabilities, we are referring to
current liabilities, in terms of payables that may be due.

The expenses associated with managing the portfolio are accrued as

current liabilities and are paid as they become due. Therefore net
assets of a fund refer to the market value of the portfolio, plus
accrued incomes, less any current liabilities and accrued expenses.
Net asset value (NAV) is a per unit representation of the net assets
of a fund. NAV is a very frequently used term in the mutual fund
industry. It refers to the current value per unit, deriving out of the
current value of the mutual fund portfolio.

64
Example 1
The market value of a fund’s portfolio is Rs 700 Crore. If the current
liabilities are Rs.50 Crore, what are the net assets?
Net assets = Portfolio value less liabilities
= 700 – 50
= Rs 650 Crore

Example 2
Assume that the net assets of a fund are Rs 750 Crore. The unit
capital (face value Rs10) is Rs 250 Crore. What is the NAV?

Number of units = Unit capital/Face value

= 250/10
= 25 Crore units
NAV = Net asset /number of units
= 750/25
= Rs 30 per unit

Example 3
If a fund’s NAV was Rs 15 and the number of units was 100 Crore,
what are its net assets?

Net Assets = NAV x Number of units

= 15 x 100
= Rs 1500 Crore

65
5.8 Advantages of Mutual Funds
The following are the advantages of mutual funds to investors:
- Portfolio diversification from securities spread over various
companies, industries, issuers and maturities. The portfolio
will not be affected by the bad performance of one or few of
the securities.
- Low transaction cost from economies of scale. Since the
fund invests large sums of money, the transaction cost
comes down. Small amounts of investors get benefits of the
large pool.
- Professional managers who are employed by mutual funds
offer their expertise in managing the investors’ funds, given
their knowledge of markets and securities, according to the
investment objective of the scheme.
- Portfolio diversification and the professional management of
funds offer reduction in risk for the investor. The investment
is always in a managed portfolio and not a single stock or
sector.
- Investors can choose their investment to suit their particular
needs and preferences. Minimum investment is low for
most funds. Investors can choose from dividend and growth
options. Mutual fund transactions are flexible and easy to
conduct.
- Mutual funds structure the portfolio in such a way that they
are able to provide liquidity to the investor. Investors can
take their money out when they need it.

66
Key Points
1. Mutual funds are collective investment vehicles that pool
together investors’ funds and invest them in securities
according to stated investment objectives.
2. An investor’s holding in a mutual fund is denoted in units.
The face value of the units is usually Rs 10.
3. The value of the unit goes up or down depending on the
value of the underlying securities.
4. The AUM of the fund is the market value of its portfolio. This
less the FRE and current liabilities of the fund is the Net
Assets of the fund.
5. The FRE of a fund are expressed as a percentage of its
AUM. The expenses that can be included and the limit are
specified by regulations.
6. The expenses are charged to the fund on a daily basis.
7. The NAV of a unit is the per unit representation of the net
assets of the fund.
8. Mutual funds give the advantages of lower risk from
diversification and professional management, lower costs
and convenience and flexibility to the investor.

67
Quick Recap

Fill in the Blanks

1. The securities that a fund invests in depend upon its ________.
2. Marking to market is the process of valuing the security at
_________
3. The type of expenses that can be charged to a fund and the limit
is decided by _______.
4. A mutual fund cannot have ________ liabilities on its balance
sheet.
5. Mutual funds have lower risks because of ________ & _______.

State True or False

1. Units of a mutual fund have a similar connotation as shares of a
company.
2. The unit capital of a fund is the number of units issued x NAV of
the fund.
3. The funds of each scheme are maintained in a separate bank
account.
4. The value of a unit cannot go below its face value.
5. FRE is charged to the fund at the end of the financial year.

68
Answers:

Fill in the Blanks:

1- Investment objective
2-Market price
3-SEBI
4-Long-term
5-Portfolio diversification & Professional management

State True or False:

1- True
2- False
3- True
4-False
5-False

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70
 6. SEBI - Role and Regulations

The existence of an efficient and stable financial system is essential

to make the securities market vibrant, wide reaching and effective.
An efficient capital market ensures that resources are priced and
allocated correctly in an economy. Institutions and mechanisms that
enable this must be supported by regulatory structures that will
streamline and enable the proper functioning of the securities
markets. The purpose of securities regulation should be to have
markets that are fair, transparent and efficient and ensure protection
of the investor’s interests.

In India the prime regulators are the Reserve Bank of India (RBI),
the Securities Exchange Board of India (SEBI), the Ministry of
Corporate Affairs and the Department of Economic Affairs (DEA).
Both RBI and SEBI have been set up through Acts of the Parliament
which define their role and responsibilities.

SEBI is the apex regulator of the securities market and also

responsible for its orderly growth and protection of the investor’s
interests. The RBI, as the manager of public debt, is responsible for
the primary issue of government securities, all contracts involving
such securities and money market instruments. Other regulators
such as the Insurance Regulatory Development Authority (IRDA) and
the Pension Fund Regulatory and Development Authority have been
set up with the specific mandate to regulate the functioning and
growth of particular industries.

71
6.1 SEBI’s Role
The preamble of SEBI provides for “The establishment of a Board to
protect the interests of investors in securities and to promote the
development of and to regulate the securities market.” The objective
of SEBI is therefore to facilitate the growth and development of the
capital markets in terms of mechanisms, participants and securities
and to ensure the protection of the investors in the securities market.

The SEBI Act entrusts the responsibility of inspection, investigation

and enforcement of the activities, systems and mechanisms of the
institutions and intermediaries of the securities market. SEBI has
been assigned the powers of recognizing and regulating the
functions of a stock market under the Securities Contracts
Regulation Act (SCRA).

The requirements for granting recognition to a stock exchange

include representation of SEBI on the board of the stock exchange
and an undertaking to make and amend their rules only with the prior
approval of SEBI. The stock exchanges have to furnish periodic
reports to the regulator and submit bye-laws for SEBI’s approval.
Stock exchanges are required to send monitoring reports daily and
for every settlement. SEBI has set up surveillance mechanisms, both
internal and at stock exchanges, to deal with unfair trade practices.
Measures such as circuit filters, price bands and caps have led to
enhanced safety in the market.

An integrated surveillance mechanism which tracks the activities of

the stock exchanges, the brokers, depository, R&T agents,
custodians and clearing agents aim at timely identification of

72
fraudulent activities. SEBI and the central government have over-
riding powers under the SCRA in all matters relating to the stock
markets.

Regulating market intermediaries through registration and

supervision is a primary function of the securities market regulator.
Market intermediaries such as brokers, sub-brokers, R&T agents,
depositories, custodians, bankers, merchant bankers, portfolio
managers and underwriters have to get themselves registered under
the respective regulations of SEBI.

The regulations specify the net worth, experience, infrastructure and

other requirements necessary for an intermediary to be eligible for
registration. The registration given, if found eligible, has been made
permanent subject to certain conditions under the Securities and
Exchange Board of India (Intermediaries) Regulations, 2008
discussed later in this chapter.

SEBI makes routine inspections of the intermediaries functioning in

the securities markets to ensure compliance with prescribed
standards. It can also order investigations into the operations of any
of the constituents of the securities market for activities such as price
manipulation, artificial volume creation, insider trading, violation of
the takeover code or any other regulation, public issue related
malpractice or other unfair practices. Investigation is based on
SEBI’s surveillance activities or those of the stock exchange. A
preliminary probe is conducted after which, if necessary, a full-
fledged investigation is undertaken.

73
SEBI has the powers to call for information, summon persons for
interrogation, examine witnesses and conduct search and seizure. If
the investigations so require, SEBI is also empowered to penalize
violators. The penalty could take the form of suspension, monetary
penalties and prosecution.

SEBI also has the mandate to ensure the streamlined functioning of

the primary markets. It has laid out the eligibility, norms and rules to
be followed for the public issue of securities in the Disclosure and
Investor Protection Guidelines.

The guidelines specify the minimum net worth requirements for an

issuer, the minimum public holding to be maintained and the lock-in
on the holdings of the promoters. SEBI has also specified the roles
and responsibilities of intermediaries in the primary markets such as
the merchant bankers, underwriters, R&T agents and brokers in the
guidelines for each intermediary.

These guidelines impose minimum disclosure requirements on the

issuer to ensure that investors have all the relevant information
before making the investment. The listing agreement that companies
enter into with the stock exchange has clauses for continuous and
timely flow of relevant information to the investors, corporate
governance and investor protection. SEBI investigates and penalizes
the non-conformance to the guidelines by the issuers and
intermediaries.

SEBI’s has laid down regulations to prevent insider trading and unfair
trade practices which are detrimental to the interests of the investor.
74
Insider trading refers to the dealing in securities by persons
connected with a company having material information that is not
available to the public.

Such persons include the directors and employees of the company,

associates such as bankers and tax consultants or government
employees who get sensitive information. The SEBI (Prohibition of
Insider Trading Regulations), 1992 seeks to prevent insider trading
which erodes the confidence of the common investor in the securities
markets.
SEBI’s guidelines require companies to have comprehensive code of
conduct to prevent such activity. This includes appointing a
compliance officer to enforce it, ensuring periodic disclosure of
holding by all persons considered as insiders and ensuring data
confidentiality and adherence to the requirements of the listing
agreement on flow of price sensitive information.

If an insider trading charge is proved through SEBI’s investigations,

the penalties include monetary penalties, criminal prosecution,
prohibiting persons from securities markets and declaring
transactions as void.

6.2 Investor Education and Protection Fund (IEPF)

The IEPF is a fund created by the Ministry of Corporate Affairs for
promoting investors’ awareness and protecting their interests. The
fund is created out of contributions from the central government,
state government, companies and institutions.

75
Apart from this, unpaid dividends, matured debentures and deposits,
application and call money due for refund and interest on them shall
form part of the fund provided such money has remained unpaid and
unclaimed for a period of seven years from the date they were due
for payment.

The fund shall conduct investor education programs through the

media and seminars. It will fund investor education projects of
institutions and organizations engaged in the same and which
applies for resources to conduct such programs.

6.3 SEBI Regulations for Registrars and Transfer Agents

Registrar and Transfer (R&T) agents are identified as ‘intermediaries’
by the SEBI Act and are regulated by SEBI. They have to abide by
the regulations and guidelines of the regulator. The primary
regulations that govern the functioning of the R&T agents are as
follows:
1. Securities and Exchange Board of India (Registrars to an Issue
and Share Transfer Agents) Regulations, 1993.
2. Securities and Exchange Board of India (Intermediaries)
Regulations, 2008
3. Securities and Exchange Board of India (Depositories and
Participants) Regulations, 1996

76
Securities and Exchange Board of India (Registrars to an Issue
and Share Transfer Agents) Regulations, 1993
The SEBI (Registrars to an Issue and Transfer Agents) Regulations
came into effect in 1993 and amended periodically. These
regulations govern the constitution, capital adequacy, obligations and
responsibilities inspection and reporting norms that the R&T agent
has to abide by. The broad heads under these regulations are:

a) Application for Registration: An application has to be made in the

prescribed format to SEBI for registration as an R&T agent. An entity
can take on assignments as a registrar and/or transfer agent only
after obtaining the certificate from SEBI. The application can be for
registration as a category I intermediary which allows the applicant to
act as registrar and transfer agent or category II which allows the
applicant to act as registrar or transfer agent. The application shall
be evaluated on the basis of:
a. Available infrastructure
b. Past experience
c. Capital adequacy
d. Integrity of partners and promoters

b) Capital Adequacy: The net worth requirement for a category I

applicant is Rs.6 lacs and for a category II applicant Rs. 3 lacs. Net
worth for the purpose of this regulation is defined as paid-up capital
and free reserves in case of a body corporate and in case of
partnerships and proprietorship it is value of the capital contributed
and free reserves.

77
c) Obligations and Responsibilities: The regulations require an R&T
agent shall:
a. Abide by the code of conduct
b. Not act as R&T agent for an associate company
c. Maintain proper books and accounts and records
d. Appoint a compliance officer to ensure compliance with the
regulations

d) Inspection of R&T agent’s operations: The regulator, SEBI, may

inspect the operations of an agent either on receiving a complaint
from an investor or otherwise to ensure compliance with the
regulations. The R&T agent is required to give all information and co-
operation to enable the inspection.

e) Cancellation/Suspension of Certificate: SEBI may suspend or

even cancel the registration granted to an R&T agent in case of non-
compliance with the provisions of the regulations. Such a penalty will
be imposed only after holding an enquiry into the facts of the case
and issuing a show cause notice to the R&T agent.

Securities and Exchange Board of India (Intermediaries)

Regulations, 2008
SEBI overseas and regulates the functioning of intermediaries such
as brokers, R&T agents, Merchant bankers, Depository participants
and Bankers, under specific regulations and guidelines issued by the
regulator. The Securities and Exchange Board of India
(Intermediaries) Regulations, 2008 consolidates the common

78
requirements which apply to all intermediaries and will apply to all
intermediaries. The salient features of the Regulations are as under:

(a) The Regulations put in place a comprehensive regulation which

will apply to all intermediaries. The common requirements such as
grant of registration, general obligations, common code of conduct,
common procedure for action in case of default and miscellaneous
provisions have been provided in the approved Intermediaries
Regulations.

(b) Application for registration: An applicant may file application in

the prescribed format along with additional information as required
under the relevant regulations along with the requisite fees. Such
application may be made through the respective stock exchange,
clearing corporation or depository participants if the intermediary is to
be associated with these institutions. These institutions will examine
the eligibility and other criterion before forwarding the application to
SEBI.

The existing intermediaries who have already been registered under

the relevant regulations have to file the disclosure in the specified
Form. The disclosures shall be made public by uploading the
information on the website specified by SEBI.
If a registered intermediary wants to operate as an intermediary in a
new category, they need to file for registration by giving additional
shortened forms disclosing the specific requirements of the new
category as per the relevant regulations.

79
(c) The application will be considered based on factors such as
eligibility criteria, activities in the securities market of persons
associated with the applicant and whether the applicant can be
considered ‘Fit and Proper’ based on integrity, competence,
including financial net worth, and past history.

(d) The registration granted to intermediaries has been made

permanent subject to the compliance of the SEBI Act, regulations,
updation of relevant disclosures and payment of fees.

(e) Intermediaries are required under the regulation to:

• Appoint a compliance officer who will give a report to the
regulator on adherence to all obligations responsibilities and
eligibility criteria.
• Redress investor grievance within 45 days from receipt of such
complaint and to maintain records of the same.
• Make complete disclosure of interest before making any
recommendation to invest in any security to a client.
• Abide by the specified code of conduct in terms of protecting
investors’ interests, disclosing all information, maintaining high
levels of service, have adequate infrastructure, exercise due
diligence in all activities.

(f) SEBI can undertake inspection of the books and records of an

intermediary, after giving due notice, in the interest of investors. The
intermediary is required to give all cooperation in this exercise.

(g) The certificate granted to an intermediary may be revoked if it

fails to comply with the requirement of the regulations or any other
80
guidelines issued from time to time. A show cause notice is issued to
the intermediary before such action is taken.

(h) While common requirements will be governed by the new

Regulations, the intermediary-specific requirements will continue to
be as per the relevant regulations applicable to individual
intermediaries.

Securities and Exchange Board of India (Depositories and

Participants) Regulations, 1996
R&T agents are a category of intermediaries who are allowed to be
participants of a depository under the SEBI (Depositories and
Participants) Regulations, 1996. R&T agents have to abide by the
regulations for their activities in this capacity. The application as
participant must be made in accordance with the regulations and the
certificate shall be granted if the depository concerned and SEBI are
satisfied as to the eligibility and competence of the R&T agent.
Under the regulations, the participant:

a) Undertakes to pay the fees, maintain records, address investor

complaints within the specified time and comply with all requirements
subject to which the certificate was granted.

b) Undertakes to abide by the code of conduct for participants which

require them to
a. Do all activities in such a way that investors’ interest are
protected
b. Address investor complaints promptly

81
c. Co-operate with the regulator in case of any enquiry pr inspection
d. Have mechanisms in place, such as the maker-checker concept,
to ensure there are checks and balances in all the transactions.
e. Maintain records and data carefully.
f. Have good corporate governance policies in place.

c) The participant shall agree to:

a. Enter into agreements with the beneficiary owners according to
the bye-laws of the depository
b. Separate accounts shall be opened for each beneficial owner
and the accounts shall be managed separately.
c. They must have continuous electronic connectivity with the
depository.
d. The participants must have good accounting systems and
procedures in place. Records should be maintained as required
and periodic reports sent to SEBI.
e. They must maintain records of all transactions between the
investors and the participants- dematerialisation,
rematerialisation, records of instructions and approvals.
f. Integrity of data should be ensured and it should be protected
from damage, loss or misuse. Records should be maintained
depository-wise if the participant is associated with more than
one depository.

82
Key Points
1. SEBI and RBI along with the Ministry of Corporate Affairs
and Department of Economic Affairs regulate the
functioning and participants of the securities markets.
2. SEBI is responsible for the orderly development of capital
markets and the protection of investors’ interests.
3. SEBI undertakes registration of intermediaries, surveillance
of market activities, inspection and investigation and
enforcement of penalties for violations.
4. The Disclosure and Investor Protection guidelines of SEBI
lay down the norms and rules for the primary markets.
5. SEBI has the authority to grant recognition to stock
exchanges and oversee trading and settlement
mechanisms, surveillance of the stock exchange
participants, approving the bye-laws and listing agreement
of the stock exchange and inspection of the records of the
intermediaries.
6. The SEBI (Prohibition of Insider Trading) Regulations, 1992
seeks to prevent dealing in securities by people categorised
as ‘insiders.
7. The IEPF has been set up by the central government to
educate and protect investors.
8. The IEPF is funded by government grants and funds from
unpaid dividend, mature deposits and debentures,
application money.

83
Quick Recap

Fill in the Blanks

1. The Apex regulator of the securities markets is ________.
2. The RBI is responsible for the issue of __________.
3. Powers to regulate stock exchange were given to SEBI by____
4. SEBI insists on the _________ of market participants under the
specific regulations.
5. Insider trading is controlled by the regulations of __________.
6. The IEPF is funded by unpaid dividends remaining unclaimed
for at least_________.

State True or False

1. SEBI’s guidelines apply to government securities.
2. IRDA regulates the activities of the insurance industry only.
3. The protection of investor interest is a secondary objective of
SEBI.
4. Stock exchanges have been given complete powers to regulate
and are not controlled by SEBI.
5. SEBI has the power to enforce penalties.

84
Answers:

Fill in the blanks:

1- SEBI,
2- Government securities,
3- SCRA,
4-Registration,
5-SEBI,
6- Seven years

State True or False

1- False
2- True
3- False
4- False
5- True

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86
 7. Mutual Fund Structure and Constituents

Mutual funds may be structured either as a company in which

investors hold shares or as a trust in which investors are the
beneficiaries. In the USA, where mutual funds first began, they are
set up as investment companies. In the UK, open-ended funds are
created in the form of unit trusts while closed-end funds are set up as
investment trusts or companies.

In India, mutual
funds are created as
trusts. The investors
are the beneficial
owners of the
investments held by
the trust. The
structure to be
followed by mutual
funds in India is laid
down in SEBI
(Mutual Fund)
Regulations, 1996. Mutual funds in India follow a three-tier structure
of sponsor, trust and asset management company (AMC).

The sponsor promotes the fund and sets up the AMC. The mutual
fund itself is structured as a trust. It is managed by trustees in the
beneficial interest of the unit holders. Trustees appoint an asset
management company (AMC) to manage the funds.

87
7.1 Sponsor
The sponsor is the promoter of a mutual fund, who sets up the trust
and the AMC, appoints the custodian, board of trustees and the
board of directors of the AMC. The sponsor seeks regulatory
approval for the mutual fund.

SEBI has laid down the eligibility criteria for a sponsor. A sponsor
should:
- have at least five years experience in the financial services
industry.
- have a good financial track record for at least three years
prior to registration of the fund. (Positive net worth is
essential).
- contribute at least 40% of the capital of the asset
management company (AMC).
Sponsors can be Indian companies, banks or financial institutions,
foreign entities or a joint venture between the two.

Examples
ICICI Prudential Mutual Fund has been set up by ICICI Bank and
Prudential Plc, as a joint venture. Both sponsors have contributed to
the capital of the AMC.

Mutual funds like Reliance Mutual Fund and HDFC Mutual Fund are
sponsored fully by Indian entities. Funds like JP Morgan Mutual Fund
and Fidelity Mutual Fund are sponsored fully by foreign entities.

88
7.2 Trustees
The mutual fund itself is set up as a trust. Trustees are appointed by
the sponsor with SEBI approval, to act on behalf of the investors.
Trustees act as the protectors of the unit holders’ interests and are
the primary guardians of the unit holders’ funds and assets.

The trust deed is executed by the sponsor in favour of the trustees

and it deals with the establishment of the trust, the authority and
responsibility of the trustees towards the unit holders and the AMC.

Trustees can be appointed as a Board of trustees, or formed as a

trustee company by the sponsor. The board of such trustee company
oversees the mutual fund.

The trustees have the fiduciary responsibility of protecting the

beneficiaries of the trust, namely the investors in the mutual fund. At
least two-thirds of the members of the board of trustees have to be
independent of the sponsor. The board of trustees has to meet at
least six times in a year. Trustees are paid a fee for their services.

SEBI regulations for trustees govern the appointment and functions

of the trustees. There are aspects of general and specific due
diligence to be exercised by trustees, to oversee the working of the
AMC and the management of the mutual fund.

7.3 Asset Management Company (AMC)

Asset Management Company (AMC) is the investment manager of
the mutual fund. The AMC is set up by the sponsor, and registered

89
with SEBI. AMCs can be structured as public or private limited
companies. Most AMCs in India are private limited companies. The
capital of the AMC is contributed by the sponsor and its associates.

AMCs specialise
in investment management.
They manage money for a fee,
usually determined as a
percentage of the assets
under management (AUM).
AMCs are appointed by
trustees to manage the mutual
fund. But AMCs do not have
any access to the investors'
money.

AMCs are the face of mutual funds. They set up offices, employ staff,
create and market products, mobilise funds through distributors,
manage the money and report the portfolio performance to trustees
and investors.

AMC is appointed to manage a mutual fund by the trustees of the

fund, in consultation with the sponsor and with the approval of SEBI.
The rights and obligations of the AMC are specified in the Investment
Management agreement signed between the trustees and the AMC.
SEBI regulations for AMCs require that:
- AMCs should have a net worth of at least Rs 10 Crore at all
times.

90
 - 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. Statutory disclosures
regarding AMC operations should be periodically submitted to SEBI.

7.4 Constituents
AMCs focus on managing the portfolio of the mutual fund. The
functional divisions in a typical AMC can be classified as, fund
management, operations, sales and marketing, customer service,
compliance, finance and accounts.

They out-source several operations and functions to other

constituents. The core function is fund management, which cannot
be out-sourced.

AMCs have their direct sales teams, and also appoint distributors to
sell their products. Portions of the operations functions such as
investor records, fund accounting and valuation are out-sourced.

Mutual fund constituents (except custodians) are appointed by the

AMC with approval of the trustees.

All constituents have to be registered with SEBI. Constituents are

paid fees for their services.
91
The following table lists the various constituents and their roles:
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

Core functions in these areas are done in-house, while other

functions are outsourced to constituents. Some funds choose to do
some of these functions in-house. For example, Franklin Templeton
Mutual Fund services its investors on its own.

7.5 Custodians
Custodians hold the cash and securities of the mutual fund and are
responsible for their safekeeping. They hold actual custody of the
assets of the mutual fund.
Custodians are appointed by the sponsor. They represent the only
constituent not directly appointed by the AMC. Custodians should be
independent of the sponsor. That is, a sponsor cannot be a
custodian of the fund as well.

Example
ICICI Bank is a sponsor of ICICI Prudential Mutual Fund. It is also a
custodian bank. But it cannot offer its custody services to ICICI
Prudential Mutual fund, because it is also the sponsor of the fund.

92
Custodians settle the securities transactions of the mutual fund. This
function involves:
- Delivering and accepting securities and cash, to complete
transactions made in the investment portfolio of the mutual fund.
- Tracking and completing corporate actions and payouts such as
rights, bonus, offer for sale, buy back offers, dividends, interest
and redemptions on the securities held by the fund.
- Coordinating with the Depository Participants (DPs) who hold
the securities account of the mutual fund schemes.
Some custodians also offer fund accounting and valuation services
to mutual funds.

7.6 Registrar and Transfer Agents

Registrar and transfer agents (R&T agents) are primarily responsible
for providing services to the investors. They accept and process
investor transactions. R&T agents are paid a fee for their services.

They also operate investor service centres (ISCs) which act as the
official points for accepting investor transactions with a fund.

R&T functions include:

- Issuing and redeeming units and updating the unit capital
account.
- Enabling investor transactions such as purchase,
redemption and switches.
- Creating, maintaining and updating investor records.
- Banking the payment instruments (cheques and drafts)
given by investors and notifying the AMC.
93
 - Processing payouts to investors in the form of dividends
and redemptions.
- Sending statutory and periodic information to investors.

7.7 Other Constituents

Banks provide collection services to mutual funds. Investor cheques
and drafts are collected into the mutual fund scheme accounts by
banks. Auditors audit the books of the mutual fund. There are
separate auditors for the AMC’s accounts. Brokers execute the buy
and sell transactions of the fund managers.

Distributors
AMCs appoint distributors who sell the mutual fund units to investors
on behalf of the mutual fund. Distributors may work for more than
one mutual fund. There is no exclusivity in mutual fund distribution. A
distributor may also appoint sub-brokers for the purpose
of distributing units.

The sponsor or an associate may act as a distributor for the fund

with which they are associated. For example, ICICI Bank is the
sponsor of ICICI Prudential Mutual Fund also one of its distributors.

Distributors may be individuals or institutions such as banks, Non-

Banking Finance Companies (NBFCs) or broking and
distribution companies. Individual distributors form the largest
geographical network.

94
7.8 Regulation of Mutual Funds
Mutual funds in India are regulated by SEBI (Mutual Funds)
Regulations, 1996. SEBI regulations define the activities of the
mutual fund on aspects relating to registration, management,
products, investments, accounting, valuation, investor services and
investor protection. Mutual fund investors have recourse to the
trustees, AMC and SEBI, in that order, for the redressal of their
complaints.
Mutual funds in India are subject to the SEBI (Mutual Fund)
Regulations, 1996. Some key aspects of SEBI (MF) Regulations are:
- Mutual funds have to obtain SEBI approval before they set
up their business.
- AMCs have to be registered with SEBI before they get into
the business of investment management.
- The constitution and management of the mutual fund, AMC
and custodian have to be according to the regulations.
- All mutual fund constituents such as custodians, R&T
agents, bankers and brokers have to seek SEBI registration
before they work for mutual funds.
- Mutual fund products’ offer documents have to be created
in a standard format and filed with SEBI for approval before
being offered to investors.
- Investment objectives, accounting and valuation of the
portfolio have to be as per SEBI regulations.
- Mutual funds have to submit periodic reports and are
subject to SEBI inspection and audit.
- Mutual funds also have an industry association called the
Association of Mutual Funds in India (AMFI).

95
Key Points
1. Mutual funds in India are created as trusts and have a three
tier structure of sponsor, trust and AMC.
2. The investors are the beneficial owners of the assets held in
the trust promoted by the sponsor and managed by the
AMC for a fee.
3. A mutual fund may be sponsored by a bank, financial
institution or companies whether foreign or Indian or a joint
venture.
4. The trustees are responsible for protecting the interest of
the investor in the mutual fund.
5. The AMC is the invest manager of the mutual fund. The
AMC handles the business of creating a mutual fund
product, marketing it, collecting funds, investing the funds
according to the investment objective of the fund and
manage the assets.
6. The AMC delegates several operations of managing the
mutual funds to other constituents such R&T agents,
Custodians, Brokers and Distributors appointed by them.
7. All the constituents used must be registered with SEBI
under the relevant guidelines. They are paid a fee for their
services.
8. The R&T agent maintains the records of the investor and is
responsible for the operational aspects of buying and
redeeming units and other transactions initiated by the
investors.
9. Distributors are the conduit between the fund and the
investors. They usually deal with more than one fund.

96
Quick Recap

Fill in the Blanks

1. The _______ are responsible for protecting the interest of
the investors in the mutual fund.
2. At least _______ trustees must be independent of the
sponsor.
3. The functioning of the AMC is overseen by the _______.
4. An AMC must have a minimum net worth of __________.
5. The remuneration of the constituents of a mutual fund is in
the form of _______

State True or False

1. The sponsor contributes to the capital of the AMC.
2. The trustees can be organized either as a trustee company
or a Board of trustees.
3. The funds of the investor are held in the AMCs account to
enable them to invest and manage it.
4. An AMC can manage the funds of more than one mutual
fund.
5. The sponsor of a fund can act as its custodian if it has the
required experience and SEBI registration.

97
Answers:

Fill in the blanks:

1-Trustees
2-2/3rds
3-Trustees
4-Rs 10 Crores at all times
5-Fees

State True or False:

1-True
2-True
3-False
4-False
5-False

98
 8. Mutual Fund Products

The term 'scheme' or 'plan' usually indicates the various products a

mutual fund offers. The term 'fund' is also used to refer to a mutual
fund product. When we say mutual fund, we are not referring to a
particular product.

For example, HDFC mutual

fund is not a single product,
but represents all the
schemes and products
under that umbrella.

HDFC Top 200 Fund, on

the other hand, refers to a
specific product of HDFC
mutual fund, which is an
equity scheme, investing in the top 200 stocks in the equity market.

The mutual fund is an umbrella entity, and there are several

funds/schemes/plans with distinct objectives underneath this entity.
Investors invest in a specific fund/scheme/plan. The products offered
by a mutual fund are known as schemes, or funds.

8.1 Product Differentiation

Mutual funds offer a range of products to investors. These products
are designed to meet the varying needs of investors.

99
Investors who are willing to take higher risks for higher level of return
tend to choose equity products. Investors who seek regular income
and a lower level of risk tend to choose debt products.

The investing horizon also tends to influence the choice of products.

Long term investors may choose equity, while investors with short to
medium term horizons choose debt and debt-oriented products.

Investors also tend to take a view on the market and investment

opportunities. When they anticipate an appreciation in equity for
example, they prefer equity products over debt products.

To meet the diverse needs of investors, mutual funds offer a range of

equity, debt and hybrid products. They also deploy different
investment strategies to achieve their investment objectives.

A mutual fund is created when investors pool their money. In

practice, the product is first defined. The money is pooled later,
based on this definition.

8.2 Open-ended Funds

An open-ended fund gets its name from the fact that it does not have
a maturity date. The end date of the fund is open. An open-ended
fund offers units to investors for the first time during the new fund
offer (NFO).

Investors can buy (purchase) and sell (redeem) units of an open-

ended fund, at the mutual fund offices or their investor service
100
centres (ISCs) on a continuous basis. The prices at which purchase
and redemption transactions take place in a mutual fund are based
on the net asset value (NAV) of the fund.

The unit capital of an open-ended fund is therefore not fixed, but

varies according to the purchase and redemption transactions of
investors. An open-ended fund can restrict the purchase and
redemption of units only under special circumstances.

8.3 Closed-end Funds

Closed-end funds run for a specific period. On the specified maturity
date, all units are redeemed and the scheme comes to a close.
Closed-end funds are offered in an NFO but are closed for further
purchases after the NFO.

The units may be listed on a stock exchange to provide liquidity.

Investors buy and sell the units among themselves, at the price
prevailing in the stock market. Thus the size of a listed closed-end
fund is kept constant, as buying and selling happens in the
secondary market, without recourse to the fund itself. The units may
trade on the exchange at a discount or premium to the NAV
depending upon investors' perception. The units of a closed-end
fund tend to usually trade at a discount.

Some closed-end funds offer redemption of units as to provide

liquidity to the investors. Several closed-end funds do not list, but
provide redemption facility to investors. Normally investors do
not redeem their units before the maturity date with the fund. In some
cases they may do so after paying exit charges to leave the fund
101
mid-way. In these cases, there is a change in the unit capital of the
fund.

8.4 Product Creation Process

The AMC describes the portfolio. This description is then given a
product name. An offer document is created with the product details.
The offer document is approved by the trustees and SEBI. The
product is open for subscription to investors as a New Fund Offer
(NFO).

After the money is collected, fund managers begin to construct the

portfolio. Investors are allotted units against their investment.

A mutual fund product is basically defined in terms of the investment

portfolio. The portfolio features of a mutual fund product are defined
in terms of:
- Which is the asset class the portfolio will invest in?
Equities? Debt? Both?
- What are the limits on investing in the chosen asset
classes?
- Will it invest in the entire range or choose some niche – like
small cap equity or short term debt?
- What will the portfolio be managed for – growth, income,
both?
- Will the portfolio use specific strategies?
- What is the benchmark to compare the performance of the
portfolio with?

102
A mutual fund product can also be understood in terms of its
operational features relating to investor participation. These are:
- What are the types of investors eligible to buy the units?
- How can the investor buy the units?
- What is the price of the units?
- What are the rules of entering and exiting the portfolio?
- What are the income streams the investor can expect?
- What will be the tax implication of these income streams?

Mutual fund products typically combine different portfolio and

operational features.

8.5 Offer document, Addendum and KIM

SEBI requires that AMCs provide relevant and complete
information to help the investor take an informed decision to invest in
mutual funds. All such information is provided in the offer document
of the scheme.

The Offer Document (OD) is available free of cost at any of the ISCs
or AMC offices. The OD has to be in the format prescribed by SEBI.
According to the regulations, with effect from June1, 2008 the
information has to be provided in two parts.

Statement of Additional Information (SAI)

The SAI contains information common to all schemes of a mutual
fund. It is filed with SEBI as a one-time filing.

103
The information includes:
- Details of the Sponsor, trustee, AMC and other
constituents.
- Condensed financial information of all the schemes of
the mutual fund.
- Rights of unit holders, investor grievance redressal.
- Investment valuation norms.
- Other common information.
The SAI has to be updated every financial year. Any material
changes have to be incorporated immediately.

Scheme Information Document (SID)

Information about the mutual fund scheme is provided in the Scheme
Information Document (SID). This includes:
- Name and type of scheme.
- Issue dates - open, close and re-issue.
- Names of sponsor, trustee, AMC and other
constituents.
- Summary of the scheme features
- Fees and expenses of the scheme.
- Performance, in case of an existing scheme.
- Mandatory disclosures and disclaimers.

The SID has to be updated every financial year if there is no change

in the material factors. If there is a change in the fundamental
attributes, the SID has to be revised immediately. For other changes,
the AMC issues an addendum which is attached to the existing SID.

104
Every Addendum has to be approved by trustees, and displayed
prominently at the Investor Service Centres (ISCs). AMCs generally
send the copy of the addendum to the ISCs for the information of
investors.

The information in the addendum is included in the SAI or SID as the

case may be, when they are revised and reprinted every year. Until
then, all the issued addenda have to be attached to the older version
of the SAI/SID.
Key information memorandum (KIM) is a synopsis of important
information contained in the SID. It also contains information that is
useful for filling up the application form. The application form is
appended to the KIM. According to regulation, both application form
and KIM have to be printed together and made available to the
investor. The format for the KIM is prescribed by SEBI.

8.6 Categorisation of Products

Funds can be classified based on where they invest in, what
objectives they pursue and the amount of risk they assume in the
investment portfolio. Investors tend to choose mutual fund products
based on their investment objective, time horizon, market outlook
and risk appetite.

Mutual funds offer a range of products, keeping in mind these

diverse needs of investors. Products are defined in terms of where
they will invest, what objectives they will pursue, and the kind of risk
they feature.
Several products offer a combination of these factors. For example,
a liquid fund focuses on short term debt markets, is for investors with
105
short investment horizon, and features a low level of risk. It thus
serves multiple investor objectives. Some products may be focused
on a single objective. For example, a sector fund is focused on a
specific sector, and is suitable to an investor who has a view on the
sector and likes to implement that view by buying the sector fund.

Investment categories
Funds can be classified depending on investment category (also
called asset class) they focus on. For example, 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; and gold funds invest in gold-linked securities.

Investment Objective
The objective of funds can be used to classify them. For example,
growth funds seek capital appreciation and therefore invest in equity;
income funds invest with the objective of generating regular income
and seek debt securities; and monthly income plans seek to derive
regular income with some growth and have a bit of equity along with
debt.
Investment Risk
Funds can be grouped according to the risk associated with the
investment objective and portfolio. 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.

106
8.7 Debt Funds
Debt funds invest predominantly in debt securities. Debt securities
have a fixed term and pay a specific rate of interest. There are
several types of debt funds that invest in various segments of the
debt market. Debt securities are broadly classified as short term
securities (money market securities) and long term securities (bonds,
debentures). Very short term debt securities provide a steady but low
level of return. Longer term debt securities have the potential to
provide a higher level of return, but their price can fluctuate.

In debt markets, there is also categorisation based on default risk.

This is usually denoted by credit rating. A debt security with a higher
credit rating like AAA, has lower risk of default than say, BBB rating.

Liquid or Money Market Funds

Very short term debt funds are also called as liquid funds or money
market funds. They invest in short term debt instruments. Liquid
funds invest in debt securities with less than one year to
maturity such as treasury bills, commercial papers and certificate
of deposits.

Since liquid funds have very short-term maturity, the risk of

NAV fluctuation is low. Liquid funds provide safety of principal and
liquidity. Examples: Kotak Liquid Fund, Principal Liquid Fund.

107
Short Term Debt Funds
Debt funds that invest in securities with slightly longer term than
liquid funds are called short term debt funds. Examples: ICICI
Prudential Short Term Fund, Reliance Short Term Fund.

Income Funds
Debt funds that invest pre-dominantly in a wide range bonds are
called income funds. Income funds predominantly in invest in
medium-term and long-term debt instruments that are issued by the
government, companies, banks and financial institutions.

There is a higher risk of default in these funds as compared to gilt

funds, since they invest in securities issued by non-government
agencies that carry the risk of default. They have a higher interest
rate risk than money market funds since they invest in longer-term
securities. These funds aim at providing regular income rather than
capital appreciation. Examples: Reliance Income Fund, Templeton
India Income Builder Fund.

Gilt Funds
Funds that invest in government securities are also called gilt funds.
Gilt funds invest in government securities of medium and long-
term maturities. These funds do not have the risk of default since
the issuer of the instruments is the government.

Gilt funds have a high degree of interest rate risk, depending on their
maturity. If interest rates go up, the value of a debt security goes
down. This response to changes in interest rates is called interest

108
rate risk. Higher the maturity profile, higher the interest rate risk.
Examples: ICICI Prudential Gilt Fund, Principal Gilt Fund.

Floating Rate Funds

Floating rate debt funds are those that invest in a class of debt
instruments, whose interest rates are not fixed, but change
depending on a market benchmark. Examples: Templeton India
Floating Rate Fund, ICICI Prudential Short Term Floating Rate Fund.

High-yield Debt Funds

These funds seek higher interest income by investing in
debt instruments that have lower credit ratings and therefore higher
risk of default. Lower the credit rating, higher the interest a borrower
pays. These high-yield funds and are also called as junk bond funds.

Fixed maturity plans (FMPs)

Fixed maturity plans (FMPs) are closed-end funds that invest in debt
instruments with maturities that match the term of the scheme. The
debt securities are redeemed on maturity and paid to investors. An
FMP structure eliminates the interest rate risk for investors if the fund
is held by them until maturity. These funds usually have a shorter
term.

Typically FMPs are issued for maturity periods of 91 days, 190 days,
390 days and 750 days. Funds issue FMPs in a series, offering one
fund after another has matured.

109
Consider the following table for comparison of debt funds:
Return Risk Liquidity
Liquid fund Low Low High
Gilt fund Medium Medium High
Income fund Medium Medium High
High yield fund High High High
FMPs Low Low Low

The risk in a gilt fund comes from interest rate changes; there is no
credit risk. FMPs hold lower risks only for investors holding the fund
until maturity.

8.8 Equity Funds

Equity funds invest in equity shares issued by companies. The risk of
such funds is higher than that of debt funds. However, the risk
levels can differ depending upon the investment strategies adopted
by the fund manager. Equity funds can be classified by their
investment strategy as diversified, aggressive, growth, value and
sector funds.

The equity market is made up of large number of equity stocks.

These equity stocks can be classified according to the industry they
belong to, or their size. There are several types of equity funds.
Each one is defined to invest in some segment of the equity market.

110
Diversified Equity Funds
These are funds that can invest in the broad equity markets, without
any restrictions. These funds also feature a lower risk, compared to
equity funds that invest in a specific sector or category of equity
markets.
Examples: HDFC Equity Fund, HSBC Equity Fund.

Large Cap Funds

These are funds that focus on the equity shares of large sized
companies. Large companies are usually well established, and the
shares are easy to buy and sell. Large cap companies also feature
lower risk, due to their long performance track record and history.
Examples: Franklin India Blue-chip Fund, Kotak 30 Fund.

Mid Cap Funds

These are funds that focus on equity shares of medium sized
companies. These are usually the second rung companies in the
market and bought for their potential to become big. Risk of failures
especially during the turn in business cycles, can also be high.
Examples: Sundaram BNP Paribas Select Mid Cap Fund

Small Cap Funds

These are funds that focus on equity shares of small companies,
many of them typically new and upcoming companies. They are
bought for their future potential, but they can be difficult to buy and
sell in large quantity.
Examples: DSPBR Small and Mid Cap Fund

111
Sector Funds
These are funds that focus on companies in a particular sector,
appealing to investors who think that the performance of stocks in
this sector would be better than that of the broad market.
Examples: Reliance Banking Fund, JM Pharma Fund

8.9 Strategy-based Classification

A mutual fund may invest in equity or debt markets. But the portfolio
may be managed with a certain strategy to create a differentiation.

Some equity funds follow a stock selection strategy, which they think
will bring about superior performance. These may include investing
in turn-around stocks or special situations. Some equity funds may
be created to capture a certain theme, such as infrastructure. This
may require investing across a set of sectors that benefit from that
theme. These can also be called multi-sector funds or thematic
funds.

Some equity funds are created with the intention of generating

dividend income for the investors. There are equity funds that are
created with strategic intent in their names, such as an opportunity
fund, a flexi-cap fund, a core-and-satellite fund, indicating how they
are likely to create their portfolio.

Some funds are managed passively, selecting the same stocks in a

given index, in the same proportion. They do not actively choose
stocks and sectors. These are index funds. They can also be issued

112
as Exchange traded funds (ETFs) that list on the stock exchange
and can be bought or sold on the stock exchange.

Debt funds invest in fixed income paying securities. These securities

come with their defined interest income, which is paid unless there is
a default. But their market value does not remain constant. Since
mutual fund products have to be ‘marked to market’, the NAV of the
debt funds also changes. For debt funds that invest in long term
securities, the interest income and NAV fluctuation is higher, while
for the short term funds, both are lower. Therefore debt fund
strategies focus on balancing these factors.

Some debt funds have a proportion of their portfolio invested in long

term securities, to get advantage of any appreciation in value. They
balance the short term and long term securities depending on their
view of the markets. Such funds are known as flexible or dynamic
debt funds.

Some debt funds pre-dominantly invest in short term securities, but

hold a smaller proportion of funds in the long term. This is to enable
earning the higher return of a long-term debt, while at the same time,
not exposing the portfolio to risks from long-term debt.

Equity Linked Saving Schemes (ELSS)

Some diversified equity funds that are specially designated as equity
linked saving schemes (ELSS) give tax benefits to the investors on
their investment. Investment up to Rs. 100,000 in a year in such
funds can be deducted from taxable income of individual investors,
as per Section 80C of the Income Tax Act. ELSS hold at least 80%
113
of their portfolio in equity securities. Such funds have a lock-in period
of 3 years from the date of investment.

8.10 Hybrid Funds

Funds that have a combination of asset classes such as debt and
equity in their portfolio are called hybrid funds. Some mutual fund
products invest in both equity and debt markets. The objective is to
bring to the investor the benefit of strategically investing in both
markets, in a single product.

There are three broad types of hybrid funds:

- Predominantly debt-oriented hybrids
- Predominantly equity-oriented hybrids
- Dynamic asset allocation hybrids

Predominantly Debt-oriented Hybrids

These funds invest mostly in the debt market, but invest 5% to 35%
in equity. The investor gets some growth benefits of equity along with
income from debt investments. Some of these funds are packaged
as ‘monthly income funds’ and ‘children’s investment funds’.

The objective in these funds is to generate income from the debt

portfolio, without taking on the risk of equity. The allocation to equity
is kept lower, to enable growth and a small increase in return,
without the high risk of fluctuation in NAV that comes with equity.
Many of these schemes also feature a periodic payout of dividend.

114
Predominantly Equity-oriented Hybrids
These funds invest in the equity market, but invest up to 35% in debt,
so that some income is generated. Such hybrids are also called
balanced funds.

Balanced funds are suitable to those investors who seek the growth
opportunity in equity investment, but do not have a very high risk
appetite. The exposure to debt balances out the risks, and enables a
combination of growth and lower risk. The proportions in equity and
debt are managed tactically by the fund managers based on their
view of the markets.

Dynamic Asset Allocation Funds

These funds have the flexibility to invest in a 0-100% range in equity
or debt markets. They switch out of equity markets if the risks are
high, and invest in debt. They switch back into equity when markets
move up again. Depending on the view of the fund managers, the
switch between equity and debt is done. Therefore the portfolio of
the scheme can swing between a high allocation to equity and a high
allocation to debt.
Instead of the investor doing the switches – incurring costs and
taxes, the fund does it within the portfolio. Sometimes quantitative
models are used as triggers for deciding the switch. The change in
allocation is then done on auto-mode.

115
8.11 Other Types of Funds
Foreign security funds invest in securities of other markets. These
are also called international funds. The government has also
permitted Indian investors to invest in international markets through
such mutual funds.

Commodity funds abroad invest directly in commodities such as

precious metals, edible oils or grains or through futures contracts.
Indian commodity funds predominantly invest in commodity
companies as direct investments have not been permitted.

Real estate funds invest in real estate directly or lend to real

estate developers or buy securities of housing companies and
sectors related to housing and property. They can also invest in debt
instruments issued by housing projects.

Fund of Funds (FoF) invest in other mutual funds. Its portfolio is

made up of other fund schemes that are combined to serve the given
investment objective. FoFs may invest in money market instruments
directly, to manage their cash flows. An FoF involves two layers of
fund management fees.

116
Key Points
1. A mutual fund offers various products designed to suit the
varying needs of investors for investment horizon, return
and risk.
2. Open-ended funds allow investors to invest and exit from
their investment in the mutual fund at any time at NAV
related prices.
Closed-end funds have a fixed maturity date.
3. Information about the scheme is provided in the offer
document which is divided into two parts. The Statement of
additional information (SAI) contains information common to
the fund. The Scheme Information Document (SID) contains
information specific to the scheme.
4. The KIM is the condensed version of the offer document
and has to accompany every application form.
5. Debt funds can be categorized on the basis of the segment
of the debt market in which they invest in.
6. Equity funds can be segmented based on the investment
strategies adopted and the segment of the equity market in
which the fund invests in.
7. Hybrid funds have portfolios that have exposure to both
equity and debt in varying proportions.
8. There are mutual funds that invest in markets such as real
estate, gold, foreign securities and units of other mutual
fund schemes.

117
Quick Recap

Fill in the Blanks

1. The units of an open-ended fund are available for purchase
continuously at_______
2. Investors buy closed-end funds during _______
3. A mutual fund product is created by ______
4. Information in the __________ is common to all schemes of
a mutual fund.
5. A Scheme information Document is revised ________ for
changes in material information.
6. Mutual fund products can be categorized based on
_________, __________ and _________.
7. Liquid funds invest in debt securities with __________ to
maturity.
8. Gilt funds do not have _______ risk.
9. High yield debt funds are high ______ funds.
10. Large cap funds have low _______ risk.
11. ETFs are _______ funds.
12. Debt funds that invest in _________ debt securities have
higher interest income and higher NAV fluctuations.
13. Dynamic asset allocation funds can have ________%
exposure to equity or debt.
14. ELSS schemes are required to hold at least _____% of
assets in equity.

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State True or False
1. Scheme refers to a product offered by a mutual fund
2. Once the money is pooled from the investors, the fund
defines the investment objective and strategy of the
scheme.
3. The NAV of the existing investors in an open-ended
scheme comes down when an investor redeems units.
4. Closed-end funds may be listed on the stock exchange to
provide liquidity to investors.
5. A mutual fund requires the approval of the trustees only
before the scheme is offered to the public.
6. The format of the KIM is decided by each fund.
7. Liquid funds have stable NAVs because they invest in very
short-term paper.
8. Income funds have higher interest rate risk because they
invest in non-government securities too.
9. FMPs are low risk funds for all investors.
10. Mid and small cap funds invest in the shares of middle and
small sized companies for the future growth potential
11. Sector funds are highly diversified funds.
12. Real estate funds cannot invest directly in property.

119
Answers:

Fill in the blanks:

1- NAV based prices,

2- NFO,
3- AMC,
4-Statement of Additional Information,
5- Immediately,
6-, Objective, Strategy, Risk,
7- less than one year ,
8-Default,
9- Risk,
10- Liquidity,
11- Passive,
12- Long-term,
13- 0-100%,
14- 80%.

State True or False

1- True 2- False 3- False

4-True 5- False 6- False
7- True 8- False 9- False
10-True 11- False 12- False

120
 9. Tax Aspects of Mutual Fund Products

Mutual funds offer returns to investors in two forms – dividends and

capital gains. When a mutual fund pays out a dividend, investors
earn a dividend income, taxed under that head in their hands.

On the other hand, if investors earn a gain out of the sale of their
units, such gains are subject to different tax treatment as capital
gains.

As the portfolio value changes, the fund's NAV also changes.

Investors can redeem their units at any time, at a price that is based
on the NAV. If investors redeem their units at a price that is higher
than their purchase price, they earn a capital gain.

As the value of the portfolio changes over time, and there is an

appreciation in the NAV, the mutual fund can decide to pay out some
of the profits made. These payouts are called dividends. If dividend
is paid out, the AUM of the fund will drop to that extent, because that
amount of assets have been liquidated, and the cash has been paid
out.

In the following example, the market value has appreciated to Rs 12

per unit. When Re 1 is paid out as dividend the NAV drops by the
same amount to Rs 11. This is because, the net assets have come
down after the payout, but the number of units in the fund has not
changed.

121
 The tax treatment for capital
gains and dividends is
different. Capital gains are
taxed as short term capital
gains (STCG) if the investor
has held the investment for
a period less than 1 year.

If the holding period is for

more than 1 year, the gain is
taxed as long term capital
gain (LTCG).

Dividends on the other hand, are completely exempt from tax in the
hands of the investor. They are however subject to Dividend
Distribution Tax (DDT) which is paid directly by the mutual fund
before it distributes dividends to the investor.
The tax treatment for equity oriented funds and other funds are also
different. An equity oriented fund is one that has invested not less
than 65% of its funds in equity shares.

Any fund that has less than 65% in equity is not an equity-oriented
fund, and receives a different tax treatment. Liquid funds, debt funds
and debt-oriented hybrids fall in this category.

9.1 Taxation of Capital Gains

Short term capital gains (STCG) for equity-oriented funds are taxed
at 15%. In case of all other funds, STCG is taxed at the applicable
rate of tax. That is, the STCG will be added to the taxable income of
122
the investors and taxed normally, at the rate applicable to their level
of taxable income.

Long term capital gains (LTCG) are exempt from tax in the case of
equity-oriented funds. In the case of all other funds they are taxed at
10% without indexation or 20% after indexation. Indexation refers to
recalculating the purchase price, after adjusting for inflation index, as
published by the Income Tax authorities.

Securities Transaction Tax (STT) refers to the tax that has to be paid
at the time of redemption, in the case of equity-oriented schemes, at
the rate specified by the IT authorities. At present, the applicable rate
is 0.25%

9.2 Dividends and DDT

Mutual fund dividends are exempt from taxation. The treatment of
dividends paid by equity-oriented schemes, other schemes and liquid
funds varies. Dividends of equity oriented mutual funds are exempt
from tax and dividend distribution tax (DDT). All other funds are
subject to DDT.

DDT is paid directly by the mutual fund. Before dividends are paid
out, the applicable DDT is deducted from the distributable surplus
and the dividends are paid to investors. There is no impact on the
rate of dividend that investors get, but the net assets of the fund will
reduce to the extent of dividend and DDT.

123
The rate of DDT that applies to individual investors (including Hindu
Undivided Families (HUF)) is lower (12.5%) than that applies to all
other types of investors (20%).

Institutional investors are taxed at a higher rate compared to

individuals for all non-equity oriented funds, except liquid funds. All
liquid funds (defined as funds that have more than 90% of assets
invested in instruments with less than 1 year maturity) are subject to
higher rate of DDT (25%).

9.3 Investment Options

Mutual funds offer investors three options:
- Growth option - enables booking the capital gains.
- Dividend option - pays out dividends to investors.
- Dividend reinvestment option - dividend is not paid out, but
reinvested back in the scheme.

124
The underlying portfolio is the same, but the tax implication to the
investors can be in the form of dividend or capital gain, depending on
the option they choose.

The units and the AUM are bifurcated for purposes of computing
NAV. The NAV of the dividend and growth options will be different.
An investor's choice between dividend and growth options depends
on several factors such as need for income, tax status and time
period.
Those who need income, choose the dividend option. Those
investors who have a longer term investment horizon and are looking
for growth, choose the growth option.

The tax status of the investor is important because of the difference

in the tax treatment of dividends and capital gains. A retired
investor who does not have taxable income may choose a growth. If
he chose the dividend option, the dividend payout will be subject to
DDT.

All mutual funds feature dividend and growth options in virtually all
their schemes. Therefore every NAV published by the fund will have
to be identified along with the option it belongs to. In mutual fund
communications on scheme performance, the growth option NAV is
usually used.

When the number of options is increased due to the presence of

institutional options, where the FRE is different, the NAV is also
different for each of these options. That is why in certain schemes,
there is a long list of NAVs.
125
Key Points
1. The returns from mutual funds may from dividend or capital
appreciation.
2. Dividends are paid out of the realized profits of the fund and
as such reduce the NAV to the extent of the payout.
3. Capital gains accrue to the investor only when the units are
sold and not merely on appreciation.
4. Dividend Distribution Tax is paid by debt funds on the
dividends before it is distributed. The rate of DDT depends
on the type of fund and type of investor.
5. Dividends from all funds are exempt from tax in the hands
of the investor.
6. For equity funds, short-term capital gains are taxed at 15%
and long term capital gains are exempt from tax.
7. For debt funds, short-term capital gains are taxed at the
investor’s marginal tax rate and long-term gains are taxed
at 10% without indexation and 20% with indexation benefits.
8. Investors choose between growth, dividend and re-
investment options based on their need and the tax
implications.
9. The NAV for the growth and dividend options of a scheme
will be different.

126
Quick Recap

Fill in the Blanks

1. Dividends from mutual funds are __________.
2. An equity oriented scheme has at least ______% of assets
in equity.
3. Short-term capital gains from equity funds are taxed at
_____%.
4. STT is paid at the time of redemption from ________ funds.
1. 5._______ funds are exempt from dividend distribution tax.
5. Liquid funds have more than ____% invested in instruments
with maturities of less than one year.
6. The number of units held by an investor goes up in ______
option.
7. In communications made by the mutual fund the NAV of the
_____ option is used.

State True or False

1. All short-term gains are taxed at 15%.
2. Long-term capital gains from all funds are exempt from tax.
3. Institutional investors pay higher DDT at 20%.
4. Liquid funds pay higher DDT at 25%.
5. The NAV in a re-investment option comes down after
payment of dividend.
6. Tax implications affect the choice of an investor between
the various options offered by a mutual fund.

127
7. The NAV of the dividend and dividend re-investment option
will be different.
8. Mutual funds may offer separate plans within a scheme
which have different expense ratios.

128
Answers:

Fill in the blanks:

1- Exempt from tax in the hands of the investor

2- 65%
3-15%
4- Equity
5- Equity
6-90%
7- Reinvestment
8- Growth

State True or False:

1- False
2- False
3- True
4- True
5- True
6-True
7-False
8-True

129
This page has been
left blank
intentionally

130
 10. Operational Concepts
10.1 New Fund Offer (NFO)
A mutual product begins its life on the NFO start date. Investors can
begin to invest in the fund from this date. The NFO close date is
defined in the offer document. During the NFO period (open date to
close date) the fund are purchased at the NFO price.

Allotment
Once the NFO closes, there is a 'no transaction period' (usually 5
days). During this period, the investors’ account folio details are
created, cheques are banked, bounced cheques are returned, and
the final list of unit holders who form the register of investors for the
just closed NFO is created.

Once allotment is completed, investors are sent their statements of

account, showing their investment in the fund and the number of
units. This process of allotment has to be completed within 5 days
from the NFO close date.

Inception Date
The fund begins to declare its NAV from the next day of allotment.
The date of allotment is the inception date of the fund, when its NAV
is set at face value. Transactions in the fund can begin from the next
day when the first NAV of the fund will be declared.

On-going Offer
On-going or continuous offer indicates that transactions are resumed
in a fund after the allotment is over. NAV is declared every day and
131
purchases and redemptions can happen at NAV related prices
during the on-going offer period. If the fund is open-ended, fresh
units can be purchased and allotted units can be redeemed at prices
linked to the NAV on an on-going basis. If the fund has a closed end,
then no new purchases happen.

Redemptions may happen after the allotment date according to the

terms of the fund offer. A closed end fund has fixed term at the end
of which all units are redeemed.

Ongoing purchases and redemptions have to be based on

NAV. Consider a simple example. An investor buys 1 unit in a
scheme during NFO at Rs 10. There is a 10% appreciation in
portfolio after that. Therefore, NAV goes up to Rs 11. What happens
if a new investor is allowed to buy another unit at Rs 10? The total
assets of the fund will be Rs 21, and NAV drops to 21/2 = Rs 10.50
per unit.

The NAV has fallen to Rs 10.5, because another unit was purchased
at Rs 10. If the new unit was purchased at Rs 11, total net assets
would be Rs 22 and the NAV unchanged at Rs 11 per unit. To be fair
to both investors, the price charged to investors for buying or selling
units has to be based on NAV.

10.2 Transaction Cycle

The operating cycle of a mutual fund can be summarized as below:
- Investor transaction is accepted by ISCs/AMC
- Transaction is intimated to R&T back office

132
 - NAV is applied to the transaction
- Units are added (purchase) or reduced (redemption) in the
folio of investors
- Inflow and outflow resulting from transactions is reported to
the AMC Treasury
- Units issued and redeemed for the day are consolidated
- Unit capital is updated for increase/decrease from the
transactions
- Unit capital is communicated to AMC fund accounts
- Portfolio is valued by fund accounts/custodian
- NAV computation is done using the portfolio value and
updated unit capital
- NAV is communicated to R&T for applying to investor
transactions

When investor transactions are received at the ISC during a

business day, the applicable NAV of that transaction is not known.
The AMC (or its custodian) computes the NAV at the end of the day,
after the markets have closed.

NAV is calculated as:

(Market value of the portfolio - Expenses and liabilities) / (Number of
units outstanding)

The number in the denominator can be provided by the R&T agent,

only after processing the purchase and sales transactions, for which
they need the applicable NAV. Therefore transactions can be
processed only the next day based on NAV of previous day. After
133
processing the transactions, the updated unit capital is
communicated to the AMC.

NAV of Day T thus includes portfolio value of Day T (Numerator) and

the unit capital of day T minus 1 (Denominator). Valuation process
must be completed such that NAV is computed and updated by 9.00
PM on the AMFI site (regulatory requirement).

All transactions are captured by R&T by day-end for next day’s

reports to fund house for cash flow projection. NAV (Day T) =
(Market value of scheme’s investments + current assets – current
liabilities as on Day T) / (No. of units outstanding as on Day T-1).

Other things remaining constant, any increase in outstanding units in

the denominator without a corresponding increase in the
numerator representing the investment of funds received, will
depress the NAV.

10.3 Time Stamping

Market fluctuations can cause the NAV to be volatile. In such
situations, investors will be anxious about transacting at the correct
NAV. In a product like a liquid fund, there is a risk of losing interest
on the investment, or paying a price that is different from market
levels, if the NAV is not appropriate.

It is therefore very critical to record the time at which a transaction

was received and use this information to determine the applicable
NAV for a transaction. SEBI has imposed electronic time stamping

134
as a mandatory requirement for financial transactions related to
mutual funds, for the same reason.

The time stamping guidelines defined by SEBI have to be complied

with at all official points of acceptance of investor transactions.
Mutual fund offices and designated investor service centres (ISCs)
are official points of acceptance.

The time stamping machine captures the time of receipt of a

transaction at the ISC. The machine records a required number of
impressions, usually three. A document that has to be time-stamped
is passed through a slot in the machine. The location code, machine
identifier, date, time (hh:mm) and running serial number are
generated in every time stamp.

All financial transactions are processed in the R&T system as per

the applicable NAV according to the recorded time stamp on the
document.
As per the SEBI Regulations, a document evidencing purchase and
its corresponding payment instrument should have the same time
stamp serial number. That is, an application form and the
accompanying cheque should have identical time stamping
impressions.

Time stamping of transactions

In case of purchase transactions, the three impressions are affixed
on
- the application form or transaction slip,

135
 - the back of the payment instrument, and
- the acknowledgement.

In case of a purchase accompanied by an electronic fund transfer,

fax copy of the form and of the transfer instruction, are time-
stamped. It may be noted that an AMC may instruct the R&T not to
accept and time-stamp investor requests received by fax.

Some transactions such as redemption, switches and transfers are

not accompanied by a payment instrument. For such transactions all
three impressions of the time stamp are affixed on the
transaction request itself. If such a document requires an
acknowledgement, two time stamps are affixed on the document and
the third on the acknowledgement.

Non-financial transactions are not accompanied by a payment

instrument. For such transactions all three impressions of the time
stamp are affixed on the transaction request itself.

Risk Controls in Time Stamping

The time stamp impression has to be affixed on a blank space in a
document. Care has to be taken to ensure that the time stamping
impression does not overwrite anything in the documents. Since the
time stamp impression is used for determining applicable NAV, it has
to be clear, legible and readable.

Since the AMC offices are official points of acceptance, they also
receive transactions and time stamp them. The applicable NAV is

136
based on the time stamp made at the AMC office. Therefore, for
document control purposes the ISCs only time stamp the cover sheet
received from the AMC.

Offices of distributors are not official points of acceptance. Therefore,

they cannot time stamp the transactions received at their offices.
Each transaction request received at the ISC in a bunch from
distributors should be individually time stamped. The NAV on these
transactions is applied as per the time stamp on each individual
transaction request. This is irrespective of the time of receipt of the
bunch.

Applications for fresh purchases or additional purchases should

always be accompanied by a payment instrument. Since the time
stamp on the application and the instrument should be identical, it
should be ensured that both are received together.

If at the time of carrying out basic checks, a document is found to be

incomplete the transaction request should not be time stamped. It
should be returned over the counter for corrections. If an error is
found in a transaction request that has been accepted and time-
stamped, it should not be returned (even if the transaction is found
unacceptable). AMCs may provide specific instructions for such
situations.

The following are time stamping machine maintenance procedures

that are to be followed at the ISC:

137
 - In order to ensure that all the machines at the ISC are in
workable condition, they have to be tested every day as per
a laid down process.
- The machine should remain locked at all times except when
replacement of ribbon or ink cartridge is required. The key
should be kept in the custody of the ISC head.
- A machine log should be maintained at a branch level. The
log should be used to record instances of the machine
having been opened. This includes replacement of cartridge
and break down.
- Every morning, the first time stamp serial number should be
verified with that of the last time stamp serial number of the
previous day, to ensure that it is continuous.
- Daily control reports are generated by all official points of
acceptance, indicating the first, last and the time stamp
serial number at cut-off time, for transactions received
during the day.

10.4 Applicable NAV

The applicable NAV for a financial transaction is according to the
time stamp. This eliminates uncertainty associated with financial
transactions and brings in uniformity in their treatment.

The applicable NAV for a mutual fund transaction will depend upon:
The day of the transaction
The time of the transaction
The type of scheme

138
The day of the transaction matters because markets and funds do
not work every day. Both may not be open on a given transaction
day. If it is not a business day for the fund, there would be no NAV
on that date. Liquid funds publish NAV every calendar day, as the
change in NAV is only made up of interest accrual.

The time of the transaction is stamped on the transaction

documents. The applicable NAV will depend on the time of receiving
the transaction. Cut-off time has been prescribed by SEBI for
various categories of funds and transactions.

Applicable NAV for liquid funds varies from other funds. Liquid fund
remittances may be made electronically and deployed on the same
day. Therefore they have an earlier cut-off time.

The cut off time for liquid funds is 2 pm. If the funds can be deployed
the same day, the investor can be given the previous day's NAV.
The applicable NAV for liquid funds is the NAV of the day prior to the
business day of realisation of funds.

The applicable NAV for transactions received on a business day,

depend on the cut-off time, as summarized in the table below:

139
Transaction Cut-off Applicable NAV
Liquid purchases Before 2pm NAV on clear
funds
Liquid purchases After 2 pm NAV on clear
funds
Liquid redemptions Before 3.00 pm Today’s NAV
Liquid redemptions After 3.00 pm Next business
day NAV
Non-Liquid purchases Before 3.00 pm Today’s NAV
Non-Liquid redemptions Before 3.00 pm Today’s NAV
Non-Liquid purchases and After 3.00 pm Next business
redemptions day NAV

140
Key Points
1. The investors buy units at the NFO price only during the
NFO.
2. The process of allotment of units has to be completed within
30 days from the closure of the NFO.
3. On-going purchase and sales from an open-ended fund is
made ay NAV based prices from the day after the inception
date.
4. The transactions of an investor are processed on the next
day of receipt using the previous day’s NAV.
5. Transactions are done at the applicable NAV for the
transaction.
6. The applicable NAV depends upon the day and time of
submitting the transaction request and the type of scheme.
7. A time stamp must be affixed on the transaction
slip/application form, payment instrument and
acknowledgement slip.
8. Since the applicable NAV would depend upon the time that
the application is received, time stamping procedures have
to be adhered to strictly.
9. The applicable NAV for purchase transaction in liquid funds
is the NAV of the day prior to the business day on which
funds are realized. The cut off time is 12.00 pm
10. For all other transaction for all schemes, the applicable NAV
is the NAV of the business day on which the request is
received provided it is received before the cut off time of
3.00pm.

141
Quick Recap

Fill in the Blanks

1. During the NFO the investors buy units at ________.
2. The inception date of a fund is the _________.
3. The portfolio of a fund is valued by __________
4. The updated NAV for a day has to be made available on
AMFI’s website by _______ every day.
5. Details of the unit capital required for calculating NAV is
provided by __________.
6. The official points of acceptance of mutual fund applications
are _______ and ________.
7. The cut-off time for liquid fund redemptions is _________.
8. The applicable NAV for a purchase transaction of an equity
fund received on a business day at 12.05pm is the NAV of
_________.

State True or False

1. During the “No Transactions” period, a fund allows only
redemptions but no fresh purchases.
2. The NAV calculated for a particular day uses the portfolio
value of that day but the unit capital of the previous day.
3. The time stamp put at the distributor’s end can be used to
decide the applicable NAV.
4. The time stamp should be affixed on the application form as
well as on the payment instrument and should have the
same time details if the transaction has to be processed.

142
 5. For transactions such as switches and redemptions, three
time stamps are fixed on the transaction slip.
6. For equity fund purchase transactions the day of transaction
is the day on which the funds are cleared for investment.
7. NAV is calculated for all calendar days for all schemes.

143
Answers:

Fill in the Blanks:

1-NFO Price
2- Allotment date
3- Fund accounts/Custodian
4-9.00pm
5-R&T agent
6- AMC offices, ISC
7- 3.00pm
8- The same day

State True or False

1- False
2-True
3-False
4- True
5- True
6-False
7-False

144
 11. Investors in Mutual Funds

There are two broad categories of investors in a mutual fund:

individual investors and institutional investors. The investment
process and the documentation details are different for both these
categories.

Investors above 18 years of age are classified as resident

individuals. An individual investor who is under 18 years of age is
called a minor.

Unless specifically mentioned as non-resident, all individual investors

are assumed to be resident. A resident is an Indian citizen, who has
stayed in India for at least 182 days in a financial year.

An individual investor, who is residing outside India, is called an NRI

(Non Resident Indian). Such individuals can either be Indian citizens
or a Person of Indian Origin (PIO). A PIO is one whose spouse,
parent or grandparent is an Indian citizen or an NRI. Foreign
nationals who are neither NRIs nor PIOs are not eligible to invest in
Indian mutual funds.

Hindu undivided family is an Indian structure where the pool of

money belonging to a family is managed by a senior male member of
the family, identified as ‘karta’. Transactions on behalf of HUF are
done by the karta, in his name. He indicates that he is acting on
behalf of HUF, by writing the "HUF" alongside his name.

145
11.1 Investor Information
Individual investors investing in mutual funds are required to provide
the following information when they invest in mutual funds:

Name
Name of the investor is used to identify the person in whose name
the investment has been made. In a mutual fund, the beneficiary is
the person who is holding the folio.

Signature
Signature is the identity of the investor in the records of the mutual
fund. It is verified for every transaction. All valid transactions should
carry the signature of the investor.

Joint holders
An application can have three joint holders. They may decide to hold
their investments jointly or on either or survivor basis. All joint holder
signatures are captured in the R&T system.

Address for correspondence

The address of the investor is to enable physical identification of the
investor’s location. Therefore, post box numbers are not accepted.
In case of an NRI investor, overseas address is required. Address
of the first holder is the address for correspondence in the investor
records.

146
11.2 PAN and KYC Norms
Permanent Account Number (PAN) is an identification number
issued by the Income Tax authorities. PAN has been notified as the
single identification number for all financial market transactions.

All mutual fund investors, irrespective of the amount they are

investing, should provide a copy of their PAN card with their
applications. For first time investors, PAN copy is verified against
the original.

In order to ensure that illegal funds are not routed into Indian
markets, the government has promulgated the Prevention of Money
Laundering Act (PMLA). According to this Act, the identity of those
entering into financial transactions must be known and verified. The
procedure to do this is now known as KYC (Know Your Customer)
norms.

KYC norms apply to opening bank accounts, trading accounts,

demat accounts and all such financial relationships. Proof of identity
of the customer, and proof of residence are verified to comply with
KYC norms.

In case of mutual funds, the investor is required to complete the KYC

formalities with an identified service provider (currently CVL - CSDL
Ventures Ltd). KYC application forms have to be filled up and
handed in, after verification with originals, at designated acceptance
points.

147
KYC once completed, is valid across mutual funds. Investors have
to submit photocopy of KYC acknowledgement along with application
forms.
11.3 Other categories
Minors are investors whose age is less than 18 years on the date of
investment. If the application is made in the name of the minor, date
of birth has to be compulsorily provided.

Minors are not authorised to enter into contracts on their own behalf,
or issue cheques to third parties. Therefore the financial transactions
of minors are conducted on their behalf by their guardian.

Guardians have to provide all details, as if they were investing in the

mutual fund themselves. Guardian's PAN is provided. Guardians
also sign the application and payment instruments on behalf of
minors.

NRIs and PoA

RBI regulates the foreign currency coming into and going out of
India. The Foreign Exchange Management Act (FEMA) is the
regulation that applies for all transactions that involve foreign
currency. There is no specific RBI permission required for NRIs
investing in mutual funds.

NRI investors have to use payment instruments that clearly show the
sources of their funds. If the investment was made from an NRE
(Non Resident External) account, they will be able to repatriate the
funds on redemption. NRE accounts are foreign currency accounts.

148
Investments made from NRO (Non Resident Ordinary) accounts
cannot be redeemed and repatriated abroad. NRO accounts are
rupee accounts.

If NRIs use a foreign currency demand draft or direct remittance from

their overseas bank to invest, they will have to provide a Foreign
Inward Remittance Certificate (FIRC) from their banker. This proves
that the source of funds was in foreign currency, and the proceeds
can be repatriated on redemption.

Individual investors can empower someone they trust, to do

transactions on their behalf. This is done by executing a Power of
Attorney (PoA). This facility is mostly used by NRIs who are unable
to manage their mutual fund transactions staying in a foreign
country.

Since minors cannot enter into valid contracts, there is no question of

a PoA for a minor. The guardian plays a role similar to a PoA holder
acting on behalf of the minor.

A Power of Attorney has two parties – the grantor who is the primary
investor who grants the rights; and the Attorney (or holder of PoA)
who is authorised to execute an agreed set of actions on behalf of
the grantor.

PoA holders usually exercise all the rights of an investor in a mutual

fund. They can do normal transactions such as purchase and

149
redemption of units. They also operate the bank account of the
investor. The rights of the PoA holder are defined in the PoA.

The grantor's signature is recorded in the folio for purposes of

verification. The grantor can continue to operate the account even
after giving a PoA.

Mutual fund investors can nominate someone to receive the

investment proceeds in the event of their death. Nominees can be
minors, in which case, the details of guardian will also have to be
provided.

First holders cannot be guardians of a minor nominee. This amounts

to investors nominating themselves.

PoA holders are usually not authorised to change the nomination

details in an investor’s folio. They also cannot be a nominee of the
original investor.

11.4 Institutional Investors

The following are various types of institutional investors who invest in
mutual funds:

Private and Public Companies

These are companies set up under the Indian Companies Act, and
have the Memorandum of Association (MoA) and Articles of
Association (AoA) which lay out what their objectives and functions
are. They are governed by their Board of Directors.
150
Partnership Firms
These are firms set up by individuals who are partners coming
together under a partnership deed.

Association of Persons
These are associations set up by individuals to undertake a set of
activities as defined by the terms of their charter.

Societies and Trusts

These are organisations that pool individual contributions and
manage them according to set objectives. Trusts and societies can
be set up for social, religious, and educational purposes.

Banks and Financial Institutions (FIs)

Banks are set up under the Banking Regulation Act. Financial
institutions are either set up by an Act or as corporations.

Foreign Institutional Investors (FIIs)

FIIs are foreign institutions that are permitted to invest in the Indian
securities markets after having obtained registration as FII from
SEBI.

Overseas Corporate Bodies (OCBs)

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OCBs are organisations founded by NRIs, or entities in which
majority stake is held by NRIs. OCBs are currently prohibited from
investing in Indian mutual funds.

Individual investors invest in their own capacity. Institutional

investors have to follow a process before they can invest in mutual
funds. Institutions usually authorise specific individuals to execute
the investment decision on their behalf. The process for institutional
investors investing in mutual funds involves the following three
components:
- Authorisation for the organisation to undertake
investment activity has to be in its charter.
- Managers need approvals before investing the funds of
the institution in mutual funds.
- Authorised signatories should be designated to execute
the decision on behalf of the organisation.

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Key Points
1. Individual investors and Institutional investors are the two
broad categories of mutual fund investors.
2. Individual investors can either be resident or Non resident
investors (NRI). NRIs may be Indian citizens or PIO.
3. The ‘karta‘ undertakes transactions on behalf of a Hindu
Undivided Family.
4. Individual investors have to provide information such as
name, address, bank account details, and information about
joint holders.
5. Investors need to have a PAN to be able to invest in mutual
funds and comply with the ‘Know Your Customer’ (KYC)
norms.
6. A minor can invest in a mutual fund through a guardian. The
guardian has to provide all information as if they were
applying for themselves.
7. NRI investors invest in mutual funds using their NRO or
NRE account. If the original investment was made from the
NRE account, the funds are repatriable on redemption.
Investments made from the NRO account cannot be
repatriated.
8. Individual investors can empower another person to act on
their behalf by executing a Power of Attorney (PoA).
9. Institutional investors are allowed to invest in mutual funds.
At the time of making the investment they need to provide
authorization for the investment, approval for the same and
a list of signatories who can act on their behalf.

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Quick Recap

Fill in the Blanks

1. The two types of investors in mutual funds are _____and
_______ investors.
2. Individual investors above the age of 18 are classified as
_________ investors.
3. An NRI may be a/an __________ or ________.
1. 4._________ and ________ are not allowed to invest in
mutual funds in India.
2. 5.________ conducts the transactions on behalf of the
HUF.
3. 6. A mutual fund can have upto ________ joint holders.
8. The single identification number for all financial transactions
is the ______
9. KYC norms is applicable for mutual fund transactions
__________
10. In a mutual fund transaction by a minor the PAN details of
the _______ has to be given
11. NRI investments made by a foreign currency demand draft
out should be accompanied by ______ for funds to be
repatriable.
12. ________ cannot be a nominee of a mutual fund investor.
13. The authorization for an institutional investor to undertake
an investment is found in ________

154
State true or False
1. Investors are categorized as individual or institutional
investors because the documentation required for both are
different.
2. All Indians who have stayed outside the country for any
length of time are classified as NRIs.
3. The address of any of the joint holders can be specified as
the address for correspondence.
4. Only investors investing more than Rs 50,000 need to
provide PAN details.
5. KYC application form can be submitted for verification to the
mutual fund distributor.
6. Minors execute a PoA in favour of their guardian.
7. All investments made out of NRE accounts are repatriable.
8. An investor can directly operate their account even after
granting a PoA.
9. If the institutional investor is allowed to invest as per its
charter then no further approvals are required.

155
Answers:

Fill in the Blanks:

1-Individual, Institutional,
2- Resident,
3-Indian citizen or PIO,
4-Foreign nationals and Overseas Corporate Bodies,
5- Karta,
6- Three,
7-PAN,
8- Above Rs 50,000,
9- Guardian,
10-FIRC,
11- PoA,
12-Its charter.

State True or False

1-True 2-False 3-False

4-False 5- False 6-False
7-True 8- True 9- False

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 12 Banking Operations in Mutual Funds

12.1 Bank Accounts

A mutual fund scheme has several bank accounts through which it
receives and pays out money for various purposes. The types of
accounts maintained are as under:
- Collection Accounts are maintained to receive investments
into schemes from investors.
- Investment Accounts are maintained by the custodian bank,
to settle securities transactions.
- Redemption Accounts are specifically funded to payout
investors.
- Expense Accounts are used to meet regular fund running
expenses.

A mutual fund does not keep money in the bank accounts idle. Idle
funds do not earn any return. At the same time, it is also important to
make all payments that become due, on time. Mutual funds
therefore need to manage their cash balances efficiently. Banks
enable mutual funds to efficiently use their cash balances by
providing a facility called Cash Management Service (CMS).

A mutual fund scheme may appoint one or more collecting bankers.

The names of such banks and their branches are listed in the NFO
application form. Since the NFO price applies uniformly to all
purchases during the NFO period, there is no time stamping
requirement. Therefore the branches of the collecting bank are also
available for collecting NFO applications and payment instruments.

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Investors use various payment options — cheques, demand draft
(DDs), auto-debits and the like for buying mutual fund units. These
payment instruments collected at ISCs and AMC offices are also
deposited into the collecting bank. Deposit into the collecting bank
account is done by using manual pay-in slips or pay-in slips
generated from the system using scheme CMS codes.

The collecting banks provide a CMS code for each scheme. Its bank
branches upload the soft copy of the pay-in details into its CMS. The
collecting banker notifies the AMC and the R&T agent about the
status of the deposited instrument.

The functions of collecting bankers are as follows:

- They collect payment instruments through the clearing
process to realise the funds paid by the investors.
- They provide reverse feeds showing the cleared or
bounded status of the instruments.
- The NFO collecting bankers accept NFO applications.
After the NFO, they provide a ‘collections confirmation
certificate’. The bank’s collection figures are reconciled
with the R&T agent’s records before allotting units to
investors.

12.2 Payment Instruments

Mutual funds do not accept or disburse cash. Payment instruments
like cheques and demand drafts are used in transactions with
investors.

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Payment instruments differ in terms of how the funds are collected
from the payer’s account into the beneficiary’s account. This transfer
usually involves more than one bank, or more than one branch of the
same bank, and sometimes a centralized clearing agency.

The clearing process determines the time it takes for the funds to
move out of the payer’s account into the account of the beneficiary.
Mutual funds do not accept cash, money orders or out-station
cheques.

Consider the table

alongside. The scheme’s
collection account is with
HDFC Bank.

Investors make payments

from their bank accounts.
Depending on the bank and
branch, the cheques will go
through different clearing
processes.

Transfer Cheque
If the investor holds accounts in the same bank, then the cheque
only involves a transfer of funds within the same bank. (Row 1 of the
table).

159
Local Cheque
If the investor’s account is with another bank but in the same city, the
collecting bank will have to go through the local clearing house, to
get the cheque collected. (Row 2 of the table).

Outstation Cheque
If the paying bank account is located in another city, the cheque will
have to go through two clearing houses at two different locations.
(Row 3 of the table).

In a select number of cities, where the volume of transactions is very

high, there is a segregation of cheques whose value is higher than a
given amount, say Rs 1 lakh. These cheques, called High Value
(HV) cheques, are put through a preferential process and cleared on
the same day.

HV cheques must be MICR enabled (Magnetic Ink Character

Recognition (MICR) is an electronic coding at the bottom of the
cheque that enables overnight clearing).

Banks offer multi-city cheques or at par cheques facility to their

preferred or current account customers. At par implies that the
instrument is as good as drawn on any other branch of the same
bank. An at-par cheque is a local cheque when presented at any of
the bank’s branches and goes into local clearing.

160
12.3 Electronic Payment Instruments and DDs
Electronic payment instruments are modern facilities, where the
clearing process need not be initiated by the mutual fund. The
investor completes the transfer of funds, and provides the proof of
such transfer to the mutual fund. In order to complete the electronic
transfer of funds, investors must know the scheme’s account details.
AMCs provide this information to investors.

Electronic Fund Transfer (ETF) is a facility to move funds from one

account to another at specific times of the day. Transfer happens
thrice a day at 12 noon, 2 pm and 4 pm.

Real Time Gross Settlement (RTGS) is a facility to move funds

electronically on an instant basis. Funds are immediately transferred
from one bank to another.

Electronic Clearing System (ECS) is a batch process, where funds

are moved from or to several accounts, simultaneously, on given
dates. Electronic instruments are mostly used by large institutional
investors. Retail investors use ECS for their systematic investment
plans.

In cases where mutual funds are unable to reach investors in certain

locations and provide for a branch or ISC, they accept DDs and also
bear the charges. Demand drafts have to be payable on any bank in
the nearest ISC or mutual fund branch's clearing area. It will be sent
by the collection bank for local clearing.

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Demand draft charges are usually not reimbursed by the mutual
fund. The mutual fund instead bears the charges incurred to buy the
DD, subject to limits, and treats the gross amount as the amount
invested.

For example, assume the investor likes to invest Rs.10,000. If the

fund agrees to bear the DD charges of Rs.200, the value of the DD
attached to the application would be Rs 9,800. The DD would be
drawn on a bank branch local to the ISC/mutual fund location. The
amount invested would be Rs 10,000, which is the DD value plus the
DD charges the AMC has agreed to bear.

Electronic payment modes are used for making liquid scheme

purchases for historic NAV. These instruments should be stamped
with a confirmation by the paying banker that funds are available for
bring into effect the said transfer.

If a purchase is accompanied by an internet/wire transfer, since no

banking is involved, the application form/transaction request and
transfer instruction acknowledged by the bank may be faxed to the
AMC or ISC and will be accepted.

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Key Points
1. Mutual funds use separate designated accounts for
collection, investment, expenses and redemption.
2. Collecting banks give the AMC and R&T agent feedback on
the status of the deposited instruments.
3. During an NFO, the banks also collect NFO applications
along with the payment instruments and provide reports on
the collection to the R&T agent.
4. Investors use various payment instruments to buy mutual
fund products.
5. Transfer cheques are used to transfer funds between two
accounts of the same bank.
6. Local cheques are used for transfer of funds between
accounts held in the same city but in different banks.
7. Out-station cheques are used when the accounts are held
in different banks in different cities.
8. Investors also use At-Par cheques that work like local
cheques and go into local clearing.
9. High value cheques are cheques for more than a specified
amount and are cleared the same day.
10. Electronic fund transfers such as RTGS, EFT and ECS are
initiated by the investor who provides proof of the transfer
along with the application form.
11. Demand Drafts (DD) are accepted as payment instruments
where a location is not serviced by an ISC or branch.

163
Quick Recap

Fill in the Blanks

1. Funds received from investors are paid into the
__________.
2. _________ account is used meeting the expenses of
running the fund.
3. CMS code is provided for each _________.
4. Investors cannot use ______ and ______ for investing in
mutual funds.
5. A transfer cheque is used if the investor and the mutual
fund have the bank account in ________.
6. An At-Par cheque is equivalent to a ______ cheque.
7. To complete an electronic fund transfer, the investor must
have information about _________.
8. 8._________ is an electronic fund transfer method that
moves funds instantaneously.
9. ECS is used by retail investors for _________.
10. Electronic payment modes are usually used for buying units
of _______ schemes.

164
State True or False
1. The investment made by investors is held in the investment
account.
2. The cash management service provided by banks help
funds use cash efficiently.
3. The collection bank is responsible for the funds received in
the on-going purchase of units only.
4. If both the investor and the mutual fund have the bank
accounts in the same city local cheques are used for fund
transfer.
5. To qualify for high value clearing, it is sufficient if the
cheques are for at least a minimum specified amount.
6. Demand draft is an accepted mode of payment for all
investors in mutual funds.
7. If payment for an investment of Rs 10,000 is received by
DD and a DD charge of Rs 200 is deducted from it, the
mutual fund will make the investment for Rs 10,000.

165
Answers:

Fill in the Blanks:

1-Collection account
2-Expense account
3- Scheme of a Mutual fund
4-Cash, Out-station cheques
5-The same bank
6- Local
7-Scheme’s bank account
8- RTGS
9-SIP
10- Liquid

State True or False:

1-False
2- True
3- False
4- True
5- False
6- False
7- True

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 13 Financial Transactions

13.1 Application Form

The application form is the first point of contact between an investor
and a mutual fund. The information captured in the application form
is entered in the R&T records. The investor is then assigned a folio
number. A folio is a like a bank account, created for a fund house
and its investor. Investors can hold units under multiple schemes of
a fund house, in a folio. Folios have a number assigned to them by
the R&T agents.

An investor fills out the details in the application form and signs it. In
order to verify subsequent transactions from the investor, the
investor’s signature is scanned and maintained in the R&T system
with the investor records. For subsequent purchase transactions, if
the folio number is quoted, several fields in an application form need
not be filled up again.

The fields in the application form are largely standardized across

mutual funds, because of the mandatory information required. There
are however, minor differences in the presentation, detail and font
sizes. Some of the fields in the application form are mandatory, for
the application to be correct and complete. The application
form should then be checked and validated for these fields before
accepting it.
The following are mandatory fields:
- Investor status in terms of resident/non-resident
- Details of bank account

167
- Complete address of first holder
- Date of birth and guardian details for minors
- PAN details
- Signature of applicants.

13.2 Transaction Slip

The application form is designed to capture all investor information
for the first time. Investors can use a transaction slip for most
subsequent transactions. A transaction slip has the folio number to
identify the investor in the system.

The transaction slip is designed to capture multiple transaction type

requests. Investors use it for carrying out redemptions, additional
purchases, switches and even non-financial transactions such as
change of address or change of bank details. It has to be signed
according to the mode of holding of the folio, to be valid.

Most AMCs provide transaction slip as a counterfoil to the account

statement sent to the investor. The transaction slip has the folio
number and account number of the investor, pre-printed. An investor
can either use a pre-printed transaction slip form or he can use a
blank transaction slip, which is available with AMC branches,
distributors and ISCs.

13.3 Payment Instruments

Payment instruments have to be accepted from investors only if they
are valid. When a payment instrument is received it has to be
ensured that:

168
 - Scheme name is mentioned on the instrument, and is same
as on the application form.
- Short name or abbreviation used for scheme name is one of
valid alternatives as per offer document/AMC instructions.
- The cheque date is current or valid (not stale or more than 6
months old).
- The cheque is not post-dated.
- Amount in words and figures matches with the investment
amount.
- Cheque is signed.
- Cheque is not mutilated.
- Cheque is drawn on a local bank branch or is at-par.
- DD is accepted only if investor is from a city not serviced by
an ISC.
- In case of NRI applications with cheque, cheque is drawn
on NRE or NRO or FCNR account.
- In case of NRI applications with DD, banker’s FIRC
(Foreign Inward Remittance Certificate) is enclosed.

13.4 Purchase Transactions

Mutual fund units can be purchased during NFO or after the scheme
opens for on-going offer (if open-ended) after allotment of NFO units.
When a new investor applies for units either during NFO or during
continuous offer, it is called fresh purchase. Fresh purchases are
made by investors by submitting an application form complete in all
respects.

169
After the fresh purchase, every subsequent purchase by the unit
holder is called additional purchase. Additional units can be
purchased by using a transaction slip. An existing investor may
decide to make additional purchases under a new folio. This will be
considered as fresh purchase.

Mutual funds incur expenses such as advertisement costs,

commission to distributors, and printing costs towards selling and
marketing a scheme. To meet these expenses, funds charge entry
load or sales load.
The investor pays entry load as a one-time charge at the time
of purchasing units. SEBI has prescribed the upper limit for the entry
load. In case of open ended funds, the load cannot be over 7%; in
case of closed end funds load cannot be over 5%

Entry load is a percentage of the NAV of the unit. In an NFO, load is

charged as percentage of the face value. Entry load increases the
price at which an investor buys units. Hence, for the same amount
invested, units allotted to investors paying a load are lesser, as
compared to units allotted without load. It may be noted that SEBI
has abolished entry load vide its circular SEBI/IMD/CIR No. 4/
168230/09 applicable from August 1, 2009. However the candidate
should be familiar with the concept.

Investors can also buy without an entry load. The application has to
be marked direct, and submitted by the investor at the ISC or mutual
fund office, without going through the distributor.

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13.5 Statement of Account (SoA)
Statement of account is proof of investment for the investor. R&T
agents, on behalf of mutual funds, despatch SoAs to investors,
whenever there is a transaction on a folio. As per SEBI regulations,
the dispatch date should not be later than 10 business days from the
date of the transaction.

Even if there is no transaction on a folio, investors are entitled to get

their updated SoA, once a year, for all folios they hold with a mutual
fund. An SoA is sent when an investor makes a fresh purchase
transaction. The amount, price, and units are shown. For
subsequent transactions, apart from these details, the balance units
in the folio and their current market value are also shown.

Unit holders receive account statement by ordinary post or courier. If

an investor chooses to receive the account statement by e-mail,
the R&T sends a soft copy through secured e-mail.

AMCs specify in the scheme offer document, the number of days

within which they would dispatch account statement to unit holders,
say, three business days (from date of acceptance of valid
transaction slip or application form to date of despatch).

13.6 Systematic Investment Plan (SIP)

Most mutual funds offer the investors Systematic Investment Plan
(SIP), a facility to make periodic or recurring purchases in mutual
fund schemes. An SIP is like a recurring deposit with a mutual fund.
An SIP can be viewed as a series of purchase transactions. The

171
difference between an SIP and a regular purchase transaction are as
follows:

Feature Regular SIP Investment

Investment
Minimum Usually Rs 5000 Usually Rs 1000. Lower
Investment in case of ELSS
schemes. Few funds offer
SIPs with instalment of Rs
100 or Rs 50 as well.
Entry Load1 Applicable Applicable in most cases.
Some mutual funds may
not charge entry load for
SIPs.
Payment Valid cheque on Post-dated cheques or
Mode investment date electronic transfer options
on a set of future dates.
Account Within 10 working Every quarter. Mutual
Statement days of investment funds may choose to send
the statement after every
instalment.

1It may be noted that SEBI has abolished entry load vide its circular
SEBI/IMD/CIR No. 4/ 168230/09 applicable from August 1, 2009.
However the candidate should be familiar with the concept.

Investors commit a periodic investment over a chosen length of time.

AMCs offer specific intervals in which SIP investment can be made.

172
These can be monthly, quarterly, half yearly or annual. SIPs are to
be made on specific dates, for example - 5th, 15th or 25th of a
month. SIPs can be committed for six months, one year, or even
more.

An investor can invest over a year by selecting a date, for example

15th of the month, and invest Rs. 1000 each, on the 15th of every
month for the entire year. SIPs can be made along with an NFO.
The first instalment is at the NFO purchase price and is allotted like
an NFO. The second instalment begins after the scheme reopens
for continuous purchase transactions.

Payment Instruments for SIPs

Post dated cheques (PDCs): Investor issues cheques for each SIP
instalment, which have to be deposited in the bank on that date.

ECS Mandate: ECS is available in select locations as given by the

AMC. Investors fill up the ECS mandate form and submit it with their
application.

Standing Instruction (SI): If the investor holds an account in the same

bank as the scheme, he can give a standing instruction to his bank to
transfer the money on the SIP date.

Mandates for direct debit of bank accounts require signatures of

holders of the bank account, according to the mode of operation of
the account (joint or either or survivor).

173
The applicable NAV for an SIP is the NAV on the instalment date or
if that day is a holiday, then the NAV of the next business day.

13.7 Redemption
After the NFO, when a scheme re-opens, the continuous offer is for
both purchase and redemption of units. Redemption refers to
investors' request to return their investments in a fund.

In case of open-ended funds, on redemption the units are

extinguished or cancelled and are not re-issued. Redemption alters
the unit capital of an open ended scheme. Therefore outstanding
unit capital is communicated by the R&T agents, after processing all
purchase and redemption transactions for every business day.

In case of closed end funds, redemption of units happens only on the

maturity date of the scheme. Redemption may be allowed during
specified periods before maturity date or at a cost as specified in the
offer document.

Investors can specify the redemption of units held in a folio either in

terms of number of units or as amount in rupees. Where redemption
is specified in amount, the investor must ensure that the value of
their holding is sufficient to meet the amount.

Investors can redeem all or part of the units in a folio; or they can
redeem all or part of the amount in the folio. The redemption request
has to be equal to or more than the minimum amount or units

174
specified in the offer document. Mutual funds may specify the
minimum balance to be maintained in a folio after redemption.

Exit Load
Exit load has the effect of reducing the redemption price for the
investor. If the investor has specified the redemption in unit terms,
the redemption value comes down because of the load.

For example, at an NAV of Rs 20 per unit, redeeming 1000 units will

get the investor Rs 20,000. However, if the exit load is 1%, the
redemption price is 20 - 0.20 = Rs 19.80. Therefore the redemption
proceeds are Rs 19,800 for 1000 units.

If the amount to be redeemed is specified, the number of units that

has to be redeemed goes up after applying the exit load. In the
above example, the investor has to redeem 1010.10 units to get a
redemption amount of Rs 20,000. Loads are charged to investors at
the discretion of the AMC and are mentioned in the offer document.
They are subject to an overall limit imposed by SEBI.
Mutual fund investors are required to indicate in the application
form, their preference for receiving redemption proceeds. The
proceeds can be paid by cheque or through direct credit as
indicated. As per SEBI mandate, the account holder's bank account
and bank details have to be printed on the redemption cheques, to
prevent fraudulent encashment.

Redemption cheques are drawn payable to the first holder in a folio.

Mutual funds cannot issue third party payments. If the AMC's paying
bank is not present in the location where the investor is, redemption
175
proceeds are paid by demand draft. If the investor redeems units
purchased on multiple dates, redemption will be made on a first-in-
first-out basis.

Redemption proceeds have to be paid within 10 working days of

receiving the request. Delays attract a 15% penal interest to be paid
by the AMC.

Redemption proceeds have to be paid to NRI investors as per the

RBI Regulations in force. The general rule to remember is that
redemption payments have to be paid according to the source of
funds of the purchase transaction.

Those investments that have been made from NRE or FCNR

accounts or by remittance of foreign exchange from abroad can be
paid on a repatriation basis. If the investor mandates, such payment
can be made into a non-repatriable account. If the investment has
been made from a rupee account, or an NRO account, redemption
cannot be paid into a repatriable account. Capital gains arising on
redemption have to be deducted at source for NRI investors.

13.8 Switches
A switch is a redemption and purchase transaction rolled into one. A
redeeming scheme is called source scheme from which money is
switched out. The purchasing scheme is called target scheme, into
which the money is switched in. Switch can also be done from one
option to another. An investor who has chosen a growth option can
switch to a dividend option, for example.

176
The following are steps an investor would have to normally take to
move from one scheme to the other:
- Fill a redemption request and submit it (Day T)
- Receive redemption cheque and deposit it in bank (Day
T+3/T+4)
- Receive cleared funds in bank account (Day T+5)
- Fill a purchase request for the desired scheme and submit
with a cheque (Day T+5)

The above steps spread across five days can be crunched into a
single transaction in switch request. There is no need for funds to
move out and in through a bank. The transaction will be put through
by the R&T in the books.
AMCs may or may not charge loads to switch transactions.
Generally, no entry or exit load is charged for switching within
options of the same scheme. For inter-scheme switching, the AMC
may specify an independent load structure, which may differ based
on the nature of the source scheme and the target scheme, whether
it is liquid, equity, or debt fund.

Switch transactions always have two legs – the switch-out leg and
the switch-in leg. Switch-out leg is treated as redemption and switch-
in leg is treated as purchase. Both options are processed at the
respective Applicable NAV of the scheme/plan/option.

The procedure to determine the applicable NAV for switch

transactions is similar to the process for individual purchase and
redemption transactions.

177
13.9 Systematic Withdrawal and Transfer
Mutual funds also offer investors systematic transfer plans and
systematic withdrawal plans.

Systematic Transfer Plan (STP) is a periodic redemption from one

scheme and investment into another scheme of the same fund. STP
allows unit holders to transfer fixed sums from an existing scheme to
another scheme of the same mutual fund. Click here to read why
investors opt for STP.
Systematic Withdrawal Plan (SWP) is a facility for periodic or
recurring redemptions. This facility allows unit holders to withdraw
sums from an existing scheme at periodic intervals. Unit holders can
redeem or purchase units at the Applicable NAV on the respective
SWP/ STP dates. However, if any of the dates on which the
redemption / transfer is sought is a non-business day, the units are
redeemed at the Applicable NAV of the next business day.

An account statement is sent to a unit holder within 10 working days

from the date of the transaction. The first account statement confirms
the first systematic transaction. The account statement confirming
subsequent systematic transactions is sent on a quarterly basis.

Some funds give investors the choice of withdrawing or transferring a

fixed sum over a defined period. This is known as the fixed option.
Under this option, a unit holder withdraws or switches a fixed amount
of not less than the minimum from his unit account.

Investors can also opt for withdrawing or transferring only the

appreciation on the investment. This is known as the appreciation
178
option. Under this option, a unit holder withdraws or switches an
amount equal to the periodic appreciation on the original investment.

A unit holder can redeem or switch only proportionate number of

units, which when multiplied by the applicable NAV equals the
appreciation in the investment over the last period.

179
Key Points
1. The R&T agent captures the information about an investor
under a folio created for the investor.
2. Subsequent transactions of the investor can be conducted
using the transaction slip
3. The payment instrument attached to the application must be
checked for validity.
4. Mutual funds charge an entry load when investments are
made through a distributor.
5. The statement of Account (SoA) sent by the R&T agent is
the proof of investment in the mutual fund for the investor.
6. Systematic investment plan (SIP) allows investor to invest a
fixed sum of money periodically in a mutual fund scheme.
7. An investor can use post-dated cheques, ECS or standing
instruction as the payment mode for a SIP.
8. Investors can choose to withdraw their investment by
redeeming the units held in a mutual fund. Redemption can
be specified either in amount or units.
9. A switch transaction combines redemption from one
scheme and purchase of another of the same fund house
into one.
10. A systematic transfer plan allows periodic transfers from
one scheme to another.
11. A systematic withdrawal plan allows periodic redemptions.

180
Quick Recap

Fill in the Blanks

1. Details of guardian have to be mandatorily provided for
investment made by_______.
2. The transaction slip has the _______ mentioned on it to
identify the investor in the system.
3. Fresh purchase transaction has to be done by the investor
using ________.
4. The maximum entry load that an investor can impose on a
purchase transaction in an open-ended scheme is ______.
5. The face value of a unit is Rs 10 and the NAV is Rs 24. The
scheme has an entry load of 2%. The purchase price for the
investor is _______.
6. _______ investors do not pay an entry load
7. SoA has to be dispatched within ______ days of
transaction.
8. The minimum amount to be invested through an SIP is
usually ______ than that for regular investment.
9. The redeemed units from an open-ended fund are
________.
10. Exit load has the effect of _______ the redemption amount
for the investor.
11. Capital gains on redemptions made by NRIs are
__________.
12. The switch –out leg of a switch implies ________

181
State True or False
1. A mutual fund investor can have many folios in a fund.
2. A transaction slip is used to make a fresh purchase.
3. An investor can use only the pre-printed transaction slip that
accompanies the account statement for valid transactions.
4. A post-dated cheque is not a valid payment instrument.
5. The R&T agent creates a folio using the information in the
transaction slip.
6. The current value of the units is shown in the SoA.
7. The SoA has to be sent to the investor immediately after
each instalment of SIP is invested.
8. SIPs can be made along with an NFO.
9. Investors cannot redeem all the units held in a folio.
10. Units bought earlier are redeemed first.
11. Redemption proceeds may be paid to a third party on
receiving instructions from the investor.

182
Answers:

Fill in the Blanks:

1-Minor
2- Folio Number
3- Application form
4-7%
5- Rs24.48
6- Direct
7- Ten
8- Lower
9- Extinguished
10-Reducing
11-Deducted at source
12-Redemption

State True or False:

1-True 2- False 3- False

4- True 5- False 6-True
7- False 8-True 9-False
10-True 11- False

183
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left blank
intentionally

184
 14 Non Financial Transactions

Investors may need to update or change the personal information

given to the mutual fund. Address for communication, bank details,
and change in status among others, may require change from time to
time. These transactions are non-financial transactions. They do not
have a financial or NAV implication.

An investor becomes a unit holder of a mutual fund after buying units

of the fund. Investors provide general information about themselves
in the application form at the time of purchase. The registrar and
transfer agent captures the contact address, bank account, status,
plan or option chosen and all other relevant information. The R&T
links the information given in the application to the folio allotted to the
investor. In other words, folio number is a unique identification
number that helps R&T recognise an investor.

14.1 Change of Address (CoA)

Investors provide their address and contact details in the application
form during the first purchase. R&T agent captures this information
and maintains it. The statement of account (SoA) and other statutory
communication goes to the address for communication mentioned by
the investor.

Investors may request a change of address or contact details only by

applying to CVL, by using a KYC update form, where they will
provide their new address. They should mention their PAN details
and the new address. They also have to submit documentary proof
for the change of address
185
After updating the new address in the records, CVL communicated
the change in address to the R&T agents, who will update all the
folios of the investor, across mutual funds, using the PAN as the
identification for the investor. Change of address requests are no
longer accepted at AMC offices or the investor service centres of
R&T agents.

14.2 Change of Bank Details (CoB)

It is mandatory to provide details of investor’s bank account at the
time of investing in a mutual fund. As per SEBI regulations, dividend
and redemptions are payable only to the investor’s bank accounts
registered with R&T. Investors may register multiple bank accounts
and indicate the default account into which the redemption proceeds
should be paid. They can add and delete form the list of registered
bank accounts. Investors may request a change in the bank details
either at the time of a redemption or otherwise through the
prescribed format for change in bank details.

Investors should provide the complete details of the bank account for
the CoB request to be valid. This includes bank name, branch
name, MICR (where applicable), IFSC code (where applicable)
account number and type of account. The investor should also
submit a cancelled blank cheque to enable verification of the bank
details.

14.3 Change in Option

Investors choose a dividend option or growth option when they apply
for a scheme. Investors who have chosen the dividend option in a
mutual fund investment select between dividend payout option -
186
where the dividends are paid out to the investor by cheque re-
investment option - where additional units equivalent to the dividend
amount is issued to the investor.

Investors may want to change from growth payout to reinvestment

option. To request this change, investors can use the either the
transaction slip (switch option provided in the slip) or write a letter to
the mutual fund. Investors have to provide the folio details.

If the investor decides to change the dividend option, there is no

financial implication. This is because the NAV for dividend payout
and dividend reinvestment is the same. Therefore, change of
dividend payout option is a non-financial transaction and not a
financial transaction.

14.4 Change in Name (Individual Investors)

Investors may request a change of name under which they have
invested in a mutual fund scheme. Common cases for change of
name are women who like to change their maiden name to married
name. In such cases, investors must submit a letter requesting the
change.

Documents that should accompany the request letter are:

- Name change certificate by a regulatory authority
- Official Gazette copy
- Copy of Marriage Certificate
- Details of the Folio

187
 - Signature of the account holder (the unit holder whose
name is being changed must sign with the old signature and
the new signature)
- Bank account details with the new name incorporated.

14.5 Change in Corporate Name or Status

Change in corporate status refers to the change from a private
limited company to a public limited company or from a partnership
firm into a private limited company. Change in the name of a
company can happen when there is a merger or acquisition, or the
board decides to change the name. The investments in the old name
will have to now be held in the new name, for valid transactions to
happen.

The following documents should accompany the change of status

request:
- The name change certificate from the Registrar of
Companies.
- An authorisation to invest, approval from the board, and list
of authorised signatories.

Change in Authorised Signatories

Institutional investors authorise officials to sign on their behalf.
Companies change or replace authorised signatories from time to
time. Officials holding senior positions in institutions change.
Companies recruit new officials when old ones leave or get
transferred. As a result, authorised signatories change.

188
R&T is given this information so that the necessary validation of the
investment transaction happens with the updated authorised
signatories list.

The corporate or institution should submit the following documents to

register a change in authorized signatories:
- Certified true copy of the Board of Directors resolution
authorising the change
- Instruction letter from the corporate or institution signed
by the existing authorised signatory with names and
specimen signatures of the new signatories.

189
Key Points
1. The personal information given by the investor in the
application may be required to be changed. The address,
bank details and option chosen are the common changes
that are made.
2. These changes do not have a financial implication. The
changes are made in the records of the R&T agent.
3. A request for a change of address may be done using the
transaction slip. The R&T agent updates the records and
sends confirmation to the old and new addresses.
4. An investor may request a change of bank details for a
particular transaction or for all transactions in a folio.
5. Investors may request a change of name in which the units
are held.
6. An institutional investor such as a company may request a
change in the name.

190
Quick Recap

Fill in the Blanks

1. Changes in the personal information of the investor are
made by the _______.
2. Change in option from growth to dividend will ______ the
number of units held by the investor.
3. A change in option from dividend re-investment to dividend
will _______ the number of units held by the investor.
4. The request for a change in name of the holder is made
through ________.

State True or False

1. A change in the personal information implies creating a new folio.
2. Change in information can be made only through the pre-printed
transaction slip.
3. Change in bank details can be requested at the time of
redemption or otherwise.
4. Change in the name of the individual holder is not allowed.
5. A change in the authorized signatories of an institutional investor
has to be accompanied by a copy of the board resolution for the
same.

191
Answers:

Fill in the Blanks:

1- R&T agent
2- Increase
3-Not Change
4-A letter

State True or False:

1-False
2-False
3-True
4-False
5-True

192
List of Abbreviations

ADR American Depository Receipt

AMC Asset Management Company
AUM Assets Under Management
CBLO Collateralized Borrowing Lending Obligation
CD Certificate of Deposit
CMS Cash Management Service
CoA Change of Address
CoB Change of Bank
CP Commercial Paper
CSDL Central Securities Depository Limited
DD Demand Draft
DDT Dividend Distribution Tax
DR Depository Receipt
ECS Electronic Clearing System
EFT Electronic Fund Transfer
ELSS Equity Linked Saving Scheme
ETF Exchange Traded Fund
FCCB Foreign Currency Convertible Bond
FCD Fully Convertible Debenture
FCNR Foreign Currency Non Resident
FEMA Foreign Exchange Management Act
FI Financial Institution
FII Foreign Institutional Investor
FIRC Foreign Inward Remittance Certificate
FMP Fixed Maturity Plan
FoF Fund of Funds
FRE Fund Recurring Expense
GDR Global Depository Receipt

193
HNI High Net worth Individual
HUF Hindu Undivided Family
HV High Value
IDR Indian Depository Receipt
IEPF Investor Education and Protection Fund
IPO Initial Public Offer
IRDA Insurance Regulatory Development Authority
ISC Investor Service Centre
KIM Key Information Memorandum
KYC Know Your Customer
LTCG Long term Capital Gain
MICR Magnetic Ink Character Recognition
MIP Monthly Income Plan
MoA Memorandum of Association
NAV Net Asset Value
NBFC Non Banking Finance Company
NFO New Fund Offer
NRE Non Resident External
NRI Non Resident Indian
NRO Non Resident Ordinary
NSDL National Securities Depository Limited
NSE National Stock Exchange
OCB Overseas Corporate Bodies
OD Offer Document
PCD Partially Convertible Debenture
PDC Post- dated Cheque
PIO Persons of Indian Origin
PMLA Prevention of Money Laundering Act
PoA Power of Attorney
R&T Registrar and Transfer
RBI Reserve Bank of India
194
RTGS Real Time Gross Settlement
SAI Statement of Additional Information
SCRA Securities Contract Regulation Act
SEBI Securities and Exchange Board of India
SI Standing Instruction
SID Scheme Information Document
SIP Systematic Investment Plan
SO Structured Obligation
SoA Statement of Account
STCG Short Term Capital Gain
STP Systematic Transfer Plan
STT Securities Transaction Tax
SWP Systematic Withdrawal Plan
YTM Yield to Maturity

195
Notes

196
 Notes

197
Notes

198
 www.nism.ac.in

Workbook for
NISM - Series - II- B:
Registrars and Transfer Agents (Mutual Funds)
Certification Examination

5
www.nism.ac.in