Mutual

Funds: A Beginner's Module

NCFM Module Examination Details

S Module Name Test No. Maxi Nega Pass Allowable access to
r. Dura Of mum tive mark Candidate at Test Centre
N tion Qu Marks Mark s
O (in es ing Open Nor Reg Finan
min tions Office mal cial
ular
utes) Spre Dis /Sci Calcu
ad tri entific lator
Shee butio Calcu
t n lator
Table

FOUNDATION

1 Financial Markets: A Beginners’ Module 120 60 100 NO 50 NO NO YES NO

2 Mutual Funds : A Beginners' Module 120 60 100 NO 50 NO NO YES NO

3 Currency Derivatives: A Beginner’s Module 120 60 100 NO 50 NO NO YES NO

4 Equity Derivatives: A Beginner’s Module 120 60 100 NO 50 NO NO YES NO

5 Interest Rate Derivatives: A Beginner’s 120 60 100 NO 50 NO NO YES NO

Module

6 Commercial Banking in India: A Beginner’s 120 60 100 NO 50 NO NO YES NO

Module

7 FIMMDA-NSE Debt Market (Basic) Module 120 60 100 YES 60 YES NO YES NO

8 Securities Market (Basic) Module 120 60 100 YES 60 NO NO YES NO

9 Clearing Settlement and Risk Management 60 75 100 NO 60 YES NO YES NO

Module

1 Banking Fundamental - International 90 48 48 YES 29 YES NO YES NO

0

1 Capital Markets Fundamental - 90 40 50 YES 30 YES NO YES NO

1 International

INTERMEDIATE
1 Capital Market (Dealers) Module 105 60 100 YES 50 NO NO YES NO

2 Derivatives Market (Dealers) Module 120 60 100 YES 60 NO NO YES NO

3 Investment Analysis and Portfolio 120 60 100 YES 60 NO NO YES NO

Management

4 Fundamental Analysis Module 120 60 100 YES 60 NO NO YES NO

5 Operation Risk Management Module 120 75 100 YES 60 NO NO YES NO

6 Options Trading Strategies Module 120 60 100 YES 60 NO NO YES NO

7 Banking Sector Module 120 60 100 YES 60 NO NO YES NO

8 Treasury Management Module 120 60 100 YES 60 YES NO YES NO

9 Insurance Module 120 60 100 YES 60 NO NO YES NO

1 Macroeconomics for Financial Markets 120 60 100 YES 60 NO NO YES NO

0 Module

1 NSDL–Depository Operations Module # 75 60 100 YES 60 NO NO YES NO

1

1 Commodities Market Module 120 60 100 YES 50 NO NO YES NO

2

1 Surveillance in Stock Exchanges Module 120 50 100 YES 60 NO NO YES NO

3

1 Technical Analysis Module 120 60 100 YES 60 NO NO YES NO

4

1 Mergers and Acquisitions Module 120 60 100 YES 60 NO NO YES NO

5

1 Back Office Operations Module 120 60 100 YES 60 NO NO YES NO

6

1 Wealth Management Module 120 60 100 YES 60 NO NO YES NO

7

8 Project Finance Module 120 60 100 YES 60 NO NO YES NO

9 Venture Capital and Private Equity Module 120 70 100 YES 60 NO NO YES NO

0 Financial Services Foundation Module ### 120 45 100 YES 50 NO NO YES NO

2 NSE Certified Quality Analyst $ 120 60 100 YES 50 NO NO YES NO

1

2 NSE Certified Capital Market Professional 120 60 100 NO 50 NO NO YES NO

2 (NCCMP)

2 US Securities Operation Module 90 41 50 YES 30 YES NO YES NO

3

ADVANCED

1 Algorithmic Trading Module 120 100 100 YES 60 YES NO YES NO

2 Financial Markets (Advanced) Module 120 60 100 YES 60 YES NO YES NO

3 Securities Markets (Advanced) Module 120 60 100 YES 60 YES NO YES NO

4 Derivatives (Advanced) Module 120 55 100 YES 60 YES YES YES NO

5 Mutual Funds (Advanced) Module 120 60 100 YES 60 YES NO YES NO

6 Options Trading (Advanced) Module 120 35 100 YES 60 YES YES YES YES

7 Retirement Analysis and Investment 120 77 150 NO 50 YES NO YES YES

Planning

8 Retirement Planning and Employee Benefits 120 77 150 NO 50 YES NO YES YES
 **

9 Tax Planning and Estate Planning ** 120 77 150 NO 50 YES NO YES YES

1 Investment Planning ** 120 77 150 NO 50 YES NO YES YES

0

1 Examination 5/Advanced Financial Planning 240 30 100 NO 50 YES NO YES YES

1 **

1 Equity Research Module ## 120 49 60 YES 60 YES NO YES NO

2

1 Financial Valuation and Modeling 120 100 100 YES 60 YES NO YES YES
3

1 Mutual Fund and Fixed Income Securities 120 100 60 YES 60 YES NO YES YES
4 Module

1 Issue Management Module ## 120 55 70 YES 60 YES NO YES NO

5

1 Market Risk Module ## 120 40 65 YES 60 YES NO YES NO

6

1 Financial Modeling Module ### 120 30 100 YES 50 YES NO YES NO

7

1 Business Analytics Module ### 120 66 100 NO 50 YES NO YES NO

8

# Candidates securing 80% or more marks in NSDL-Depository Operations Module ONLY will be certified as ‘Trainers’.
### Module of IMS Proschool
## Modules of Finitiatives Learning India Pvt. Ltd. (FLIP)
** Financial Planning Standards Board India (Certified Financial Planner Certification) FPSB India Exam
$ SSA Business School
The curriculum for each of the modules (except Modules of Financial Planning Standards Board India, Finitiatives
Learning India Pvt. Ltd. and IMS Proschool) is available on our website: www.nseindia.com
Preface

About NSE Academy

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Contents
CHAPTER 1 : MUTUAL FUNDS...............................................................................5
1.1 INTRODUCTION............................................................................................5 1.2
MUTUAL FUNDS : STRUCTURE IN INDIA...........................................................7 1.3
WHO MANAGES INVESTOR’S MONEY? ..............................................................8 1.4
WHO IS A CUSTODIAN?.................................................................................8 1.5
WHAT IS THE ROLE OF THE AMC? ...................................................................9 1.6
WHAT IS AN NFO? ........................................................................................9 1.7
WHAT IS THE ROLE OF A REGISTRAR AND TRANSFER AGENTS? ........................ 10 1.8
WHAT IS THE PROCEDURE FOR INVESTING IN AN NFO?................................... 10 1.9
WHAT ARE THE INVESTOR’S RIGHTS & OBLIGATIONS? .................................... 11 1.10
POINTS TO REMEMBER................................................................................ 12

CHAPTER 2 : MUTUAL FUND PRODUCTS AND FEATURES – EQUITY FUNDS.......... 13

2.1 WHAT ARE THE DIFFERENT SCHEMES OFFERED BY MUTUAL FUNDS? ................. 13
2.2 CATEGORY WISE FUNDS.............................................................................. 13 2.3
WHAT ARE OPEN ENDED AND CLOSE ENDED FUNDS? ...................................... 13 2.4
WHAT ARE EQUITY ORIENTED FUNDS? .......................................................... 14
2.4.1 Introduction ................................................................................... 14 2.4.2
Equity Fund Definition ...................................................................... 14 2.5 WHAT IS
AN INDEX FUND?........................................................................... 16 2.6 WHAT ARE
DIVERSIFIED LARGE CAP FUNDS? ................................................. 17 2.7 WHAT ARE
MIDCAP FUNDS? ......................................................................... 17 2.8 WHAT ARE
SECTORAL FUNDS?...................................................................... 18 2.9 OTHER
EQUITY SCHEMES ............................................................................ 18 2.9.1
Arbitrage Funds ............................................................................... 18 2.9.2 Multicap
Funds ................................................................................ 18 2.9.3 Quant Funds
................................................................................... 18 2.9.4 International Equities
Fund................................................................ 18 2.9.5 Growth
Schemes.............................................................................. 18 2.9.6
ELSS.............................................................................................. 19 2.9.7 Fund of
Funds ................................................................................. 20 2.10 WHAT IS THE
IMPORTANCE OF BASIC OFFER DOCUMENTS (SID AND SAI)?......... 20 2.11 WHAT IS THE
KEY INFORMATION DOCUMENT ................................................. 21 2.12 WHAT IS NAV?
........................................................................................... 21 2.13 WHAT ARE
EXPENSES INCURRED IN RELATION TO A SCHEME ........................... 23 2.14 WHAT IS
 EXPENSE RATIO? ........................................................................... 24 2.15 WHAT IS
PORTFOLIO TURNOVER? ................................................................. 25

1
2.16 HOW DOES AUM AFFECT PORTFOLIO TURNOVER? ........................................... 26
2.17 HOW TO ANALYSE CASH LEVEL IN PORTFOLIOS?............................................. 26
2.18 WHAT ARE EXIT LOADS?.............................................................................. 26
2.19 POINTS TO REMEMBER................................................................................ 27

CHAPTER 3 : EXCHANGE TRADED FUNDS (ETFS) ................................................ 29

3.1 INTRODUCTION TO EXCHANGE TRADED FUNDS.............................................. 29 3.2
SALIENT FEATURES..................................................................................... 30 3.3
WHAT ARE REITs ........................................................................................ 31 3.4
WHY GOLD ETF .......................................................................................... 31 3.5
WORKING.................................................................................................. 32
3.5.1 During New Fund Offer (NFO) ............................................................ 32 3.5.2 On
an ongoing basis ......................................................................... 32 3.6 SOVEREIGN
GOLD BONDS ........................................................................... 33 3.6.1 Product
Details of Sovereign Gold Bonds ............................................. 34 3.7 MARKET MAKING
BY APS ............................................................................. 35
3.8 CREATION UNITS, PORT FOLIO DEPOSIT AND CASH COMPONENT...................... 37
(AN EXAMPLE)
3.9 POINTS TO REMEMBER................................................................................ 38

CHAPTER 4 : DEBT FUNDS ................................................................................. 39

4.1 SALIENT FEATURES..................................................................................... 39 4.2
WHAT IS INTEREST RATE RISK?.................................................................... 40 4.3
WHAT IS CREDIT RISK?............................................................................... 41 4.4
HOW IS A DEBT INSTRUMENT PRICED? ......................................................... 42 4.5
DEBT MUTUAL FUND SCHEMES..................................................................... 45
4.5.1 Fixed Maturity Plans ......................................................................... 45 4.5.2
Capital Protection Funds.................................................................... 46 4.5.3 Gilt
Funds ....................................................................................... 46 4.5.4 Balanced
Funds ............................................................................... 46 4.5.5 MIPs
.............................................................................................. 46 4.5.6 Child Benefit
Plans ........................................................................... 46 4.6 POINTS TO
REMEMBER................................................................................ 47

CHAPTER 5 : LIQUID FUNDS.............................................................................. 48

5.1 SALIENT FEATURES..................................................................................... 48 5.2
VALUATION OF SECURITIES ......................................................................... 49 5.3
FLOATING RATE SCHEME ............................................................................. 49 5.4
WHAT IS PORTFOLIO CHURNING IN LIQUID FUNDS? ....................................... 50 5.5
STRESS TESTING OF ASSETS ...................................................................... 50 5.6
POINTS TO REMEMBER................................................................................ 51
 2
CHAPTER 6 : TAXATION .................................................................................... 52
6.1 CAPITAL GAINS TAXATION ........................................................................... 52
6.2 INDEXATION BENEFIT ................................................................................. 53 6.3
DIVIDEND DISTRIBUTION TAX ..................................................................... 53 6.4
WHY FMPS ARE POPULAR? ........................................................................... 54 6.5
POINTS TO REMEMBER................................................................................ 54

CHAPTER 7 : REGULATIONS .............................................................................. 56

7.1 OVERVIEW ................................................................................................ 56 7.2
WHAT IS THE NAME OF INDUSTRY ASSOCIATION FOR THE MUTUAL FUND INDUSTRY? . 57

7.3 WHAT ARE THE OBJECTIVES OF AMFI? .......................................................... 57 7.4

PRODUCT LABELLING IN MUTUAL FUNDS – RISKOMETER ................................. 57 7.5
ADVANTAGES OF MUTUAL FUNDS ................................................................. 58 7.6
WHAT IS A SYSTEMATIC INVESTMENT PLAN (S I P)?........................................ 59 7.7
WHAT IS SYSTEMATIC TRANSFER PLAN (STP)? ............................................... 60 7.8
WHAT IS SYSTEMATIC WITHDRAWAL PLAN (SWP)?.......................................... 61

7.9 CHOOSING BETWEEN DIVIDEND PAYOUT, DIVIDEND REINVESTMENT AND GROWTH

OPTIONS – WHICH ONE IS BETTERFOR THE INVESTOR? ..................... 61
7.9.1 Growth Option................................................................................. 61 7.9.2
Dividend Payout Option..................................................................... 61 7.9.3 Dividend
Reinvestment Option ........................................................... 62 7.10 POINTS TO
REMEMBER ............................................................................... 63

CHAPTER 8 : PERFORMANCE EVALUATION......................................................... 64

8.1 OVERVIEW ............................................................................................... 64 8.2
COLOR CODING AND PRODUCT LABELLING IN MUTUAL FUNDS ......................... 64 8.3
POINTS TO REMEMBER................................................................................ 65

CHAPTER 9 : GROWTH OF ONLINE PLATFORMS FOR MUTUAL FUNDS ................. 66

9.1 NMF II ..................................................................................................... 66 9.2
TYPES OF TRANSACTIONS ........................................................................... 66 9.3
KYC .......................................................................................................... 67 9.4
FEATURES OF NMF II................................................................................... 67 9.5
BENEFITS OF NMF II TO INVESTORS ............................................................. 67 9.6
SCREEN SHOTS.......................................................................................... 67 9.7
NAV APPLICABILITY .................................................................................... 73 9.8
CONCLUSION............................................................................................. 74

MODEL TEST ..................................................................................................... 75

3
Note: Candidates are advised to refer to NSE’s website: www.nseindia.com, click on ‘NCFM’
 link and then go to ‘Announcements’ link, regarding revisions/updations in NCFM
modules or launch of new modules, if any.

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4
CHAPTER 1 MUTUAL FUNDS

1.1 INTRODUCTION
A mutual fund is a professionally managed type of collective investment scheme that pools
money from many investors and invests it in stocks, bonds, short-term money market
instruments and other securities. Mutual funds have a fund manager who invests the money
on beha lf of the investors by buying / selling stocks, bonds etc.

Mutual Fund Industry Statistics (India) - September 2016

Scheme Name Rs. Cr Increase/ Change Growth
Decrease (%)

Asset Under
Management (AUM)
1,609,370 294839 22.43%
🡅
(YoY)

Asset Under
Management (AUM)
1,609,370 169669 11.79%
🡅
(MoM)

There are various asset classes in which an investor can invest his savings depending on his
risk appetite and time horizon viz. real estate, bank deposits, post office deposits, shares,
debentures, bonds etc. While investing in these asset classes an individual would need to
study the risk and reward closely.

Example
Mr. X proposes to invest in shares of M/s. Linked Ltd.

This requires a detailed analysis of the

• performance of the company
• understanding the future business prospects of the company
• track record of the promoters and the dividend, bonus issue history of the company etc.

However, the above process is cumbersome and time consuming.

Alternatively an investor can utilize professional expertise to achieve superior returns at

acceptable risk. This is done by investing through mutual funds which offer various types of
schemes. The fund manager studies and analysis numerous stocks before selection for
inclusion in the mutual fund scheme. Therefore an individual investor benefits from
professional fund management. Another reason why investors prefer mutual funds is
because mutual funds offer diversification. An investor’s money is invested by the mutual
fund in a variety of shares, bonds and other securities thus diversifying the investor’s
portfolio across different companies and sectors. This diversification helps in reducing the
overall risk of the portfolio.

Indian Scenario

In India gold has been the single largest form of savings. Bank deposits, post office schemes
and other traditional savings instruments have been extremely popular and continue to be

5
so even today. Against this background, if we look at approximately Rs.16 lakh crores 1
which Indian Mutual Funds are managing, then it is no mean an achievement. However a
country traditionally putting money in safe, risk-free investments has started to invest in
stocks, bonds and shares – thanks to the mutual fund industry.
The Rs.16 Lakh crores stated above, includes investments by the corporate sector as well.
Going by various reports, not more than 5% of household savings are channelized into the
markets, either directly or through the mutual fund route. Not all parts of the country are
contributing equally into the mutual fund corpus. 8 cities account for over 60% of the total
assets under management in mutual funds. These are issues which need to be addressed
jointly by all concerned with the mutual fund industry. Market dynamics are making industry
players to look at smaller cities to increase penetration. Competition is ensuring that costs
incurred in managing the funds are kept low and fund houses are trying to give more value
for money by increasing operational efficiencies and cutting expenses. As of September 30,
2016, there are around 39 Mutual Funds in the country as per AMFI. Together they offer
around 11460 schemes to the investor.

Data Source: Mutualfundindia.com

Let us now look at some trends in mutual funds in India over the 10 year period from
September 2015 to September 2016:

Growth in Assets under Management over years

Year on Year increase in number of Accounts / Folios in India Mutual Fund Industry
Year No of Folios (In Crores)

Mar-12 4.65

Mar-13 4.28

Mar-14 3.95

Mar-15 4.17

Mar-16 4.77

Sept-16 5.05

6
This module is designed to meet the requirements of both the investor as well as the
industry , mainly those proposing to enter the mutual fund industry. Investors need to
understand the nuances of mutual funds, the workings of various schemes before they
invest; since their money is being invested in risky assets like stocks/ bonds (bonds also
carry risk). The language of the module is kept simple and the explanation is peppered with
‘concept clarifiers’ and examples.
Let us now try and understand the characteristics of mutual funds in India and the different
types of mutual fund schemes available in the market.

1.2 MUTUAL FUNDS: STRUCTURE IN INDIA

Mutual funds primarily deal in investor’s money. Therefore a clear structure is laid out to
ensure proper governance.

Mutual Funds in India follow a 3-tier structure.

There is a Sponsor (the First tier), who thinks of starting a mutual fund. The Sponsor
approaches the Securities & Exchange Board of India (SEBI), which is the market regulator
and also the regulator for mutual funds.

The mutual fund industry is governed by the SEBI (mutual fund) Regulations, 1996 and
such other notifications that may be issued by the regulator from time to time. The sponsor
should have sound track record and general reputation of fairness and integrity in all his
business transactions. Sound track record shall mean the sponsor should

• Be carrying out the business of financial services for not less than five years •

Have positive net worth in all the preceding five years

• The net worth in the immediately preceding financial year is more than the capital
contribution in the asset management company

• Has profits after depreciation, interest and tax in three of out the five preceding years
including the fifth year

The sponsor has contributed / contributes not less than 40% of the net worth of the asset
management company

7
Once approved by SEBI, the sponsor creates a Public Trust (the Second tier) as per the
Indian Trusts Act, 1882. Trusts have no legal identity in India and cannot enter into
contracts, hence the Trustees are the people authorized to act on behalf of the Trust.
Contracts are entered into in the name of the Trustees. Once the Trust is created, it is
registered with SEBI after which this trust is known as the mutual fund.

It is important to understand the difference between the Sponsor and the Trust. They are
two separate entities. Sponsor is not the Trust; i.e. Sponsor is not the Mutual Fund. It is the
Trust which is the Mutual Fund.

The Trustees role is not to manage the money. Their job is only to see, whether the money
is being managed as per stated objectives. Trustees may be seen as the internal regulators
of a mutual fund.

1.3 WHO MANAGES INVESTOR’S MONEY?

This is the role of the Asset Management Company (the Third tier). Trustees appoint the
Asset Management Company (AMC), to manage investor’s money. The AMC in return
charges a fee for the services provided and this fee is borne by the investors as it is
deducted from the money collected from them. The AMC’s Board of Directors must have at
least 50% directors, who are not associate of, or associated in any manner with, the
sponsor or any of its subsidiaries or the trustees. The AMC has to be approved by SEBI. The
AMC functions under the supervision of its Board of Directors, and also under the direction
of the Trustees and SEBI. It is the AMC, which in the name of the Trust, floats and manages
schemes by buying and selling securities. In order to do this, the AMC needs to follow all
rules and regulations prescribed by SEBI and as per the Investment Management
Agreement it signs with the Trustees.

Whenever the fund intends to launch a new scheme, the AMC has to submit a Draft Offer
Document to SEBI. This draft offer document, after getting SEBI approval becomes the offer
document of the scheme. The Offer Document (OD) is a legal document and investors rely
upon the information provided in the OD for investing in the mutual fund scheme. The
Compliance Officer has to sign the Due Diligence Certificate in the OD. This certificate says
that all the information provided inside the OD is true and correct. This ensures that there is
accountability and somebody is responsible for the OD. In case there is no compliance
officer, then senior executives like CEO, Chairman of the AMC has to sign the due diligence
certificate. The certificate ensures that the AMC takes responsibility of the OD and its
contents.

1.4 WHO IS A CUSTODIAN?

The assets of the mutual fund scheme are held by the custodian. A custodian’s role is safe
keeping of physical securities and also keeping a tab on the corporate actions like rights,
bonus and dividends declared by the companies in which the fund has invested. The
Custodian is appointed by the Board of Trustees. Since the custody of the assets is separated
from the management it protects the investors against fraud and misappropriation.

8
The custodian also participates in a clearing and settlement system through approved
depository companies on behalf of mutual funds, in case of dematerialized securities. In
India today, securities (and units of mutual funds) are no longer held in physical form but in
dematerialized form with the Depositories. The holdings are held in the Depository through
Depository Participants (DPs). Only the physical securities are held by the Custodian. The
deliveries and receipt of units of a mutual fund are done by the custodian or a depository
participant at the instruction of the AMC and under the overall direction and responsibility
of the Trustees. Regulations provide that the Sponsor and the Custodian must be separate
entities.

1.5 WHAT IS THE ROLE OF THE AMC?

The role of the AMC is to manage investor’s money on a day to day basis. Thus it is
imperative that people with the highest integrity are involved with this activity. • The AMC
cannot deal with a single broker beyond a certain limit of transactions. • The AMC cannot
act as a Trustee for some other Mutual Fund. The responsibility of preparing the OD lies with
the AMC.
• Appointments of intermediaries like independent financial advisors (IFAs), national and
regional distributors, banks, etc. is also done by the AMC. Finally, it is the AMC which is
responsible for the acts of its employees and service providers.

As can be seen, it is the AMC that does all the operations. All activities by the AMC are done
under the name of the Trust, i.e. the mutual fund.

The AMC charges a fee for providing its services. SEBI has prescribed limits for this. This fee
is borne by the investor as the fee is charged to the scheme, in fact, the fee is charged as a
percentage of the scheme’s net assets. An important point to note here is that this fee is
included in the overall expenses permitted by SEBI. There is a maximum limit to the
amount that can be charged as expense to the scheme, and this fee has to be within that
limit. Thus regulations ensure that beyond a certain limit, investor’s money is not used for
meeting expenses.

1.6 WHAT IS AN NFO?

Once the 3 – tier structure is in place, the AMC launches new schemes, under the name of
the Trust, after getting approval from the Trustees and SEBI. The launch of a new scheme is
known as a New Fund Offer (NFO). We see NFOs coming up in markets regularly. It is like
an invitation to the investors to put their money into the mutual fund scheme by subscribing
to its units. When a scheme is launched, the distributors talk to potential investors and
collect money from them by way of cheques or demand drafts. Mutual funds cannot accept
cash. (Mutual funds units can also be purchased on-line through a number of intermediaries
who offer on-line purchase / redemption facilities). Before investing, it is expected that the
investor reads the Offer Document (OD) carefully to understand the risks associated with
the scheme.

9
1.7 WHAT IS THE ROLE OF A REGISTRAR AND TRANSFER AGENTS?
Registrars and Transfer Agents (RTAs) perform the important role of maintaining investor
records. All the New Fund Offer (NFO) forms, redemption forms (i.e. when an investor
wants to exit from a scheme, it requests for redemption) go to the RTA’s office where the
information is converted from physical to electronic form. How many units will the investor
get, at what price, what is the applicable NAV, how much money will he get in case of
redemption, exit loads, folio number, etc. is all taken care of by the RTA.

1.8 WHAT IS THE PROCEDURE FOR INVESTING IN AN NFO?

But before investing in mutual funds or NFOs, the investor must have the KYC in place. The
mutual funds or the KYC Registration Agencies (KRAs) must be approached to complete the
KYC formalities. KYC or know your customer is a form that must be filled giving all details of
investor like name, age, address along with supporting documents like PAN Card and
address proof. Once this is done, the investor is to have a bank account and a demat
account for transactions in mutual fund units for incoming and outgoing of money and units.

Once these formalities are complete, the investor has to fill a form, which is available with
the distributor or online. The investor must read the Offer Document (OD) before investing in
a mutual fund scheme. In case the investor does not read the OD, he must read the Key
Information Memorandum (KIM), which is available with the application form. Investors have
the right to ask for the KIM/ OD from the distributor.

Once the form is filled and the cheque is given to the distributor, he forwards both these
documents to the RTA. The RTA after capturing all the information from the application form
into the system, sends the form to a location where all the forms are stored and the cheque
is sent to the bank where the mutual fund has an account. After the cheque is cleared, the
RTA then creates units for the investor. The same process is followed in case an investor
intends to invest in a scheme, whose units are available for subscription on an on-going
basis, even after the NFO period is over. In an online system, this entire process is carried
out electronically from filling of forms to online payment to allotment of units in the demat
account of the investor.

10
Fund Constituents

1.9 WHAT ARE THE INVESTOR’S RIGHTS & OBLIGATIONS?

Some of the Rights and Obligations of investors are:-
⬥ Investors are mutual, beneficial and proportional owners of the scheme’s assets. The
investments are held by the trust in fiduciary capacity (The fiduciary duty is a legal
relationship of confidence or trust between two or more parties).
⬥ In case of dividend declaration, investors have a right to receive the dividend within 30
days of declaration.
⬥ On redemption request by investors, the AMC must dispatch the redemption proceeds
within 10 working days of the request. In case the AMC fails to do so, it has to pay an
interest @ 15%. This rate may change from time to time subject to regulations.
⬥ In case the investor fails to claim the redemption proceeds immediately, then the
applicable NAV depends upon when the investor claims the redemption proceeds. ⬥ Investors
can obtain relevant information from the trustees and inspect documents like trust deed,
investment management agreement, annual reports, offer documents, etc. They must
receive audited annual reports within 6 months from the financial year end. ⬥ Investors can
wind up a scheme or even terminate the AMC if unit holders representing 75% of scheme’s
assets pass a resolution to that respect.
⬥ Investors have a right to be informed about changes in the fundamental attributes of a
 scheme. Fundamental attributes include type of scheme, investment objectives and
policies and terms of issue.
⬥ Lastly, investors can approach the investor relations officer for grievance redressal. In
case the investor does not get appropriate solution, he can approach the investor
grievance cell of SEBI. The investor can also sue the trustees.

11
The offer document is a legal document and it is the investor’s obligation to read the OD
carefully before investing. The OD contains all the material information that the investor
would require to make an informed decision.

It contains the risk factors, dividend policy, investment objective, expenses expected to be
incurred by the proposed scheme, fund manager’s experience, historical performance of
other schemes of the fund and a lot of other vital information.

It is not mandatory for the fund house to distribute the OD with each application form but if
the investor asks for it, the fund house has to give it to the investor. However, an abridged
version of the OD, known as the Key Information Memorandum (KIM) has to be provided
with the application form.

1.10 POINTS TO REMEMBER:

• Mutual funds are collective investment schemes that pool together investors’ money and
invest with a common objective.
• While India is traditionally a nation of savers and investors in gold and fixed deposits,
mutual funds is now gaining popularity as an investment avenue due to the various
options and products offered.
• Mutual funds take the form of trusts, They have a three tier structure with a sponsor, an
asset management company and a trust. While the sponsor floats the AMC, the trust
ensures that the operations are as per the stated objective. The AMC professionally
manages the money and invests the same. The assets of the mutual fund are held by a
custodian.
• The registrars and transfer agent handle the investor records of the mutual funds. • An
NFO is a new fund offer, where an investor can invest in the new scheme launched by the
mutual fund. The investor fills the form with the registrar or online and this is submitted to
the mutual fund, which then allots the units to the investor. The investor should read the
offer document carefully before investing.
• Investors have certain rights and obligations which they should be aware of before
investing in a mutual fund.
 12
CHAPTER 2 : MUTUAL FUND PRODUCTS AND
FEATURES – EQUITY FUNDS

A variety of schemes are offered by mutual funds. It is critical for investors to know the
features of these products, before money is invested in them.

2.1 WHAT ARE THE DIFFERENT SCHEMES OFFERED BY MUTUAL FUNDS?

1) Equity funds – funds that primarily invests in equity shares of companies. 2) Debt
funds - funds which invest in debt instruments such as short and long term bonds,
government securities, t-bills, corporate paper, commercial paper, call money etc. 3) Hybrid
funds - These are funds which invest in debt as well as equity instruments 4) Gold ETF –
An exchange traded fund that buys and sells gold.

5) Real estate funds – These funds invest in properties

2.2 CATEGORY WISE FUNDS

Scheme wise composition of Assets i.e. Debt / Equity / Liquid
Scheme wise composition of assets

Year Debt Equity Liquid Money ETFs & FOFs

Oriented oriented Market
schemes schemes

Mar-12 50% 33% 15 2%

Mar-13 57% 27% 14 2%

 Mar-14 52% 22% 24.30% 1.70%

Mar-15 44.10% 30.90% 23.50% 1.50%

Mar-16 43.50% 31.10% 23.70% 1.70%

Of the total assets under management of all mutual funds debt funds are the major
contributor which includes income funds and gilt funds.

2.3 WHAT ARE OPEN ENDED AND CLOSE ENDED FUNDS? • Equity Funds
(or any Mutual Fund scheme for that matter) can either be open ended or close ended.

13
• An open ended scheme allows the investor to enter and exit at his convenience, anytime
(except under certain conditions) whereas a close ended scheme restricts the freedom
of entry and exit.
• Whenever a new fund is launched by an AMC, it is known as New Fund Offer (NFO). Units
are offered to investors at the par value of Rs. 10/ unit.
• In case of open ended schemes, investors can buy the units even after the NFO period is
over. Thus, when the fund sells units, the investor buys the units from the fund and
when the investor wishes to redeem the units, the fund repurchases the units from the
investor. This can be done even after the NFO has closed. The buy / sell of units takes
place at the Net Asset Value (NAV) declared by the fund.
• The freedom to invest after the NFO period is over is not there in close ended schemes.
Investors have to invest only during the NFO period; i.e. as long as the NFO is on or the
scheme is open for subscription. Once the NFO closes, new investors cannot enter, nor
can existing investors exit, till the term of the scheme comes to an end. However, in
order to provide entry and exit option, close ended mutual funds list their schemes on
stock exchanges. This provides an opportunity for investors to buy and sell the units
from each other. This is just like buying / selling shares on the stock exchange. This is
done through a stock broker. The outstanding units of the fund does not increase in this
case since the fund is itself not selling any units.
• Sometimes, close ended funds also offer ‘buy-back of fund shares / units”, thus offering
another avenue for investors to exit the fund. Therefore, regulations drafted in India
permit investors in close ended funds to exit even before the term is over.

2.4 WHAT ARE EQUITY ORIENTED FUNDS?

2.4.1 Introduction

Equity funds account for around 30% of the total AUM managed by mutual funds. A scheme
might have an investment objective to invest largely in equity shares and equity-related
investments like convertible debentures. The investment objective of such funds is to seek
capital appreciation through investment in this growth asset. Such schemes are called equity
schemes.

Equity funds essentially invest the investor’s money in equity shares of companies. Fund
managers try and identify companies with good future prospects and invest in the shares of
such companies. The prices of listed securities fluctuate based on liquidity, international
scenario and numerous other factors. Therefore investment in equity funds carries higher
risk. It is necessary for an investor to understand the features of equity investments in
terms of risk and return before investing.

2.4.2 Equity Fund Definition

Equity oriented Funds are funds that invest the investor’s money in equity and related
instruments of companies.

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Section 115 T of the Income Tax Act, 1961 lays down that equity oriented fund means such
fund where the investible funds are invested by way of equity shares in domestic companies
to the extent of more than 65% of the total proceeds of such fund

In case of equity funds investors need not pay long term capital gains. Hence it is important
that this investment norm is met by the fund.

Example

“Equity long term” is a fund hosted by ABC Mutual Fund. This fund has invested 100% of the
funds in international equities. Although this fund is also an equity fund from the investors’
asset allocation point of view, but the tax laws do not recognise these funds as Equity Funds
and hence investors have to pay tax on the Long Term Capital Gains made from such
investments.

Equity Funds are of various types and the industry keeps innovating to make products
available for all types of investors. Relatively safer types of Equity Funds include Index
Funds and diversified Large Cap Funds, while the riskier varieties are the Sector Funds.
International Funds, Gold Funds (not to be confused with Gold ETF) and Fund of Funds are
some of the different types of funds, which are designed for different types of investor
preferences. These funds are explained later.

Equity Funds can be classified on the basis of market capitalisation of the stocks they invest
in – namely Large Cap Funds, Mid Cap Funds or Small Cap Funds – or on the basis of
investment strategy the scheme intends to have like Index Funds, Infrastructure Fund,
Power Sector Fund, Quant Fund, Arbitrage Fund, Natural Resources Fund, etc. These funds
are explained later.

Equity Oriented Funds risk pyramid

Equity funds do not guarantee any minimum returns. In terms of risk barometer for equity
funds, index funds are the least risky as they mirror the index stocks, followed by the
diversified large cap funds. Mid cap and sector focus funds are considered more risky.

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

The objective of a typical Index Fund states – ‘This Fund will invest in stocks comprising the
Nifty 50 and in the same proportion as in the index’. The fund manager will not indulge in
research and stock selection, but passively invest in the Nifty 50 scrips only, i.e. 50 stocks
which form part of Nifty 50, in proportion to their market capitalisation. Due to this, index
funds are known as passively managed funds. Such passive approach also translates into
lower costs as well as returns which closely tracks the benchmark index return (i.e. Nifty 50
for an index fund based on Nifty 50). Index funds never attempt to beat the index returns,
their objective is always to mirror the index returns as closely as possible.

Tracking Error

The difference between the returns generated by the benchmark index and the Index Fund
is known as tracking error. By definition, Tracking Error is the variance between the daily
returns of the underlying index and the NAV of the scheme over any given period.

Concept Clarifier – Tracking Error

 Tracking Error is the Standard Deviation of the difference between daily returns of the
index and the NAV of the scheme (index fund). This can be easily calculated on a
standard MS office spreadsheet, by taking the daily returns of the Index, the daily
returns of the NAV of the scheme, finding the difference between the two for each day
and then calculating the standard deviation of difference by using the excel formula for
‘standard deviation’.
In simple terms it is the difference between the returns delivered by the underlying
index and those delivered by the scheme. This difference may arise on account of any
of the following reasons
• The fund manager may buy/ sell securities anytime during the day, whereas the
underlying index will be calculated on the basis of closing prices of the Nifty 50 stocks.
• Cash position in the scheme
• If the index’s portfolio composition changes, it will require some time for the fund
manager to exit the earlier stock and replace it with the new entrant in the index. •
Dividend accrued but not distributed
• Accrued expenses
A lower tracking error is desirable.

The fund with the least Tracking Error will be the one which investors would prefer since it is
the fund tracking the index closely. Tracking Error is also function of the scheme expenses.
Lower the expenses lower the Tracking Error. Hence an index fund with low expense ratio,
generally has a low Tracking Error.

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2.6 WHAT ARE DIVERSIFIED LARGE CAP FUNDS?
Another category of equity funds is the diversified large cap funds.

Cap refers to market capitalization. Market capitalization refers to aggregate valuation of the
company based on the current market price and the number of shares issued. Accordingly
companies are classified into
✔ Large cap companies– typically the top 100 to 200 stocks which feature in Nifty 50
✔ Mid cap companies– Stocks below large cap which belong to the mid cap segment ✔
Small cap – companies – Typically stocks with market capitalization of less than Rs.
5000 cr.

Large cap funds restrict their stock selection to the large cap stocks It is generally perceived
that large cap stocks are those which have sound businesses, strong management, globally
competitive products and are quick to respond to market dynamics. Therefore, diversified
large cap funds are considered as stable and safe. The stocks command high liquidity.

However, since equities as an asset class are risky, there is no return guarantee for any type
of fund. These funds are actively managed funds unlike the index funds which are passively
managed, In an actively managed fund the fund manager pores over data and information,
researches the company, the economy, analyses market trends, takes into account
government policies on different sectors and then selects the stock to invest. This is called
as active management.

A point to be noted here is that anything other than an index funds are actively managed
funds and they generally have higher expenses as compared to index funds. In this case,
the fund manager has the choice to invest in stocks beyond the index. Thus, active decision
making comes in. Any scheme which is involved in active decision making is incurring higher
expenses and may also be assuming higher risks. This is mainly because as the stock
selection universe increases from index stocks to large caps to midcaps and finally to small
caps, the risk levels associated with each category increases above the previous category.

The logical conclusion from this is that actively managed funds should also deliver higher
returns than the index, as investors must be compensated for higher risks. But this is not
always so. Studies have shown that a majority of actively managed funds are unable to beat
the index returns on a consistent basis year after year. Secondly, there is no guaranteeing
which actively managed fund will beat the index in a given year. Index funds therefore have
grown exponentially in some countries due to the inconsistency of returns of actively
managed funds.

2.7 WHAT ARE MIDCAP FUNDS?

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

17
2.8 WHAT ARE SECTORAL FUNDS?
Funds that invest in stocks from a single sector or related sectors are called Sectoral funds.
Examples of such funds are Banking Funds, IT Funds, Pharma Funds, Infrastructure Funds,
etc. Regulations do not permit funds to invest over 10% of their Net Asset Value in a single
company. This is to ensure that schemes are diversified enough and investors are not
subjected to concentration risk. This regulation is relaxed for sectoral funds and index funds.

Example
AAA Mutual Fund has a banking sector fund. The fund objective is to generate continuous
returns by actively investing in equity and equity related securities of companies in the
Banking Sector and companies engaged in allied activities related to Banking Sector.

2.9 OTHER EQUITY SCHEMES:

2.9.1 Arbitrage Funds

These invest simultaneously in the cash and the derivatives market and take advantage of
the price differential of a stock in the cash and derivative segment by taking opposite
positions in the two markets (for e.g. cash and stock futures).

2.9.2 Multi cap Funds

These funds can, theoretically, have a small cap portfolio today and a large cap portfolio
tomorrow. The fund manager has total freedom to invest in any stock from any sector.

2.9.3 Quant Funds

In case of these funds quantitative models are used for stock selection and allocation of
weights based on company’s size, financial performance and liquidity.

Example
XYZ Mutual Fund has recently launched a quant fund. The SID (scheme information
document) specifies the use of a quantitative model for aspects like
• Stock price – parameters based on periodic moving average of price, market capitalization
• Financial parameters – based on key indicators such as EPS, PE, PAT, EBDIT margins
(historical and forecasted).

2.9.4 International Equities Fund

This is a type of fund which invests in stocks of companies outside India. This can be a Fund
of Fund, whereby, we invest in one fund, which acts as a ‘feeder’ fund for some other
fund(s), .i.e invests in other mutual funds, or it can be a fund which directly invests in
overseas equities. These may be further designed as ‘International Commodities Securities
Fund’ or ‘World Real Estate and Bank Fund’ etc.

2.9.5 Growth Schemes

A mutual fund whose aim is to achieve capital appreciation by investing in growth stocks.
They focus on companies that are experiencing significant earnings or revenue growth,
rather

18
than companies that pay out dividends. A growth fund aims to produce capital appreciation
by investing in growth stocks. They focus on industries and specific companies that are in
the phase of signification revenue growth rather than high dividend payouts. These
companies are in the growth phase and hence require a holding period of 5-10 years. Hence
a higher risk tolerance is required. The time horizon for return is medium to long term.

Example
PU Mutual Fund has a Growth companies fund that has an investment objective to invest in
companies / stocks with high growth rates or above average potential.

The fund managers will follow an active investment strategy and will be focusing on rapid
growth companies (or sectors). The selection of stocks will be growth measures such as
Enterprise Value/EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization),
forward price/sales, and discounted EPS (Earning per Share). The primary focus will be to
identify ‘high growth’ companies, especially in sectors witnessing above average growth. A
combination of top-down (macro analysis to identify sectors) and bottom-up approach
(micro analysis to pick stocks within these sectors) will be employed. The switch between
companies and sectors to be identified based on relative valuations, liquidity and growth
potential.

Concept Clarifier – Growth and Value Investing

 Investment approaches can be broadly classified into Growth based and Value Based.
While Growth investing refers to investing in companies with high growth potential,
Value investing approach is based upon the premise that a stock/ sector is currently
undervalued and the market will eventually realize its true value. So, a value investor
will buy such a stock/ sector today and wait for the price to move up. When that
happens, the Value investor will exit and search for another undervalued opportunity.

Hence in Growth investing, it is the growth momentum that the investor looks for,
whereas in Value investing, the investor looks for the mismatch between the current
market price and the true value of the investment.

Contra Funds can be said to be following a Value investing approach. For example,
when interest rates rise, people defer their purchases as the cost of borrowing
increases. This affects banks, housing and auto sectors and the stocks of these
companies come down. A Value fund manager will opine that as and when interest rates
come down these stocks will go up again; hence he will buy these stocks today, when
nobody wants to own them. Thus he will be taking a contrarian call. The risk in Growth
investing is that if growth
momentum of the company goes down slightly, then the stock’s price can go down
rather fast, while in Value investing, the risk is that the investor may have to wait for a
really long time before the market values the investment correctly.

2.9.6 ELSS

Equity Linked Savings Schemes (ELSS) are equity schemes, where investors get tax benefit
upto Rs. 1.5 lacs under section 80C of the Income Tax Act. These are open ended schemes
but have a lock in period of 3 years. These schemes serve the dual purpose of equity

19
investing as well as tax planning for the investor. However it must be noted that investors
cannot, under any circumstances, get their money back before 3 years from the date of
investment.

2.9.7 Fund of Funds

These are funds which do not directly invest in stocks and shares but invest in units of other
mutual funds which in their opinion will perform well and give high returns. Almost all
mutual funds offer fund of funds schemes.

Let us now look at the internal workings of an equity fund and what must an investor know
to make an informed decision.

Concept Clarifier – AUM

 Assets Under Management (AUM) represents the money which is managed by a mutual
fund in a scheme. Adding AUMs for all schemes of a fund house gives the AUM of that
fund house and the figure arrived at by adding AUMs of all fund houses represents the
industry AUM.

AUM is calculated by multiplying the Net Asset Value (NAV – explained in detail later) of
a scheme by the number of units issued by that scheme.

A change in AUM can happen either due to redemptions or inflows. In case of sharp
market falls, the NAVs are expected to move down. This may lead to redemption
pressures and the AUMs may come down. Conversely, if the outlook on country and
markets is positive, it may lead to inflow of funds leading to overall increase in the
AUM. Also if the fund is able to produce superior returns as compared to the benchmark
(e.g. Nifty, it may result in inflows into the scheme, leading to an increase in the AUM.

2.10 WHAT IS THE IMPORTANCE OF BASIC OFFER DOCUMENTS (SID

AND SAI)?
Prior to investing, every investor needs to be aware of the basic objective, term and
investment philosophy of the scheme. These are fundamental features of the fund and
cannot be altered by the fund house without investor approval.

Mutual Fund Offer Documents have two parts:

• Scheme Information Document (SID), which has details of the scheme • Statement
of Additional Information (SAI), which has statutory information about the mutual fund,
that is offering the scheme.

The above documents are prepared by the fund house and vetted by SEBI. Investor can
download these documents from the mutual fund website. Investors should understand and
analyse them prior to investing.

Every offer document clearly states that

“The particulars of the Scheme have been prepared in accordance with the Securities and
Exchange Board of India (Mutual Funds) Regulations 1996, (herein after referred to as ‘SEBI

20
(MF) Regulations’) as amended till date, and filed with SEBI, along with a Due Diligence
Certificate from the AMC. The units being offered for public subscription have not been
approved or recommended by SEBI nor has SEBI certified the accuracy or adequacy of the
Scheme Information Document.
The Scheme Information Document sets forth concisely the information about the scheme
that a prospective investor ought to know before investing. Before investing, investors
should also ascertain about any further changes to this Scheme Information Document after
the date of this Document from the Mutual Fund / Investor Service Centres / Website /
Distributors or Brokers.
The investors are advised to refer to the Statement of Additional Information (SAI) for
details of ________ Mutual Fund, Tax and Legal issues and general information on
www.__________. (Website address)
SAI is incorporated by reference (is legally a part of the Scheme Information Document).
For a free copy of the current SAI, please contact your nearest Investor Service Centre or
log on to our website.
The Scheme Information Document should be read in conjunction with the SAI and not in
isolation”.

2.11 WHAT IS THE KEY INFORMATION DOCUMENT?

The Key Information Memorandum (KIM) is a summary of the SID and SAI. As per SEBI
regulations, every application form is to be accompanied by the KIM.

The important contents of KIM are:

• Name of the AMC, mutual fund, Trustee, Fund Manager and scheme • Dates of
Issue Opening, Issue Closing & Re-opening for Sale and Re-purchase • Plans and
Options under the scheme

• Risk Profile of Scheme

• Price at which Units are being issued and minimum amount / units for initial purchase,
additional purchase and re-purchase
• Benchmark
• Dividend Policy
• Performance of scheme and benchmark over last 1 year, 3 years, 5 years and since
inception.
• Loads and expenses
• Contact information of Registrar for taking up investor grievances

2.12 WHAT IS NAV?

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

21
Concept Clarifier – NAV
 Assets Rs. Crs. Liabilities Rs. Crs. Shares 345 Unit Capital 300 Debentures 23
Reserves & Surplus 85.7 Money Market Instruments 12

Accrued Income 2.3 Accrued 1.5

Expenditure
Other Current Assets 1.2 Other Current Liabilities 0.5 Deferred Revenue Expenditure
4.2

387.7 387.7

Units Issued (Cr.) 30

Face Value (Rs.) 10
Net Assets (Rs.) 385.7
NAV (Rs.) 12.86

The above table shows a typical scheme balance sheet. Investments are entered under
the assets column. Adding all assets gives the total of Rs.387.7 cr. From this if we
deduct the liabilities of Rs.2 cr. I.e. Accrued Expenditure and Other Current Liabilities,
we get Rs. 385.7 cr. as Net Assets of the scheme.

The scheme has issued 30 crs. units @ Rs.10 each during the NFO. This translates in
Rs.300 crs. being garnered by the scheme then. This is represented by Unit Capital in
the Balance Sheet. Thus, as of now, the net assets worth Rs.385.7 cr are to be divided
amongst 30 crs. units. This means the scheme has a Net Asset Value or NAV of
Rs.12.86.

The important point that the investor must focus here is that the Rs. 300 crs. garnered
by the scheme has increased to Rs.387 crs., which translates into a 29.23% gain,
whereas, the return for the investor is 28.57% (12.86-10/ 10 = 28.57%).

Formula for NAV

Market value of investments + receivables + accured income +

other assets – accured expenses – other payables – other liabilities
NAV = as of valuation date
No. of units outstanding

22
Concept Clarifier – Fund Fact Sheet
 After an investor has entered into a scheme, he must monitor his investments regularly.
This can be achieved by going through the Fund Fact Sheet. This is a monthly document
which all mutual funds have to publish.

This document gives all details as regards

• the AUMs of all its schemes
• top holdings in all the portfolios of all the schemes
• loads, minimum investment
• performance over 1, 3, 5 years and also since launch
• Comparison of scheme’s performance with the benchmark index (most mutual fund
schemes compare their performance with a benchmark index such as the Nifty 50)
over the same time periods
• fund managers outlook
• portfolio composition
• expense ratio
• portfolio turnover
• risk adjusted returns
• equity/ debt split for schemes
• YTM for debt portfolios and other information which the mutual fund considers
important from the investor’s decision making point of view.

In a nutshell, the fund fact sheet is the document which investors must read,
understand and keep themselves updated with.

2.13 WHAT ARE EXPENSES INCURRED IN RELATION TO A SCHEME?

There are two types of expenses incurred by a scheme
❖ Initial issue expenses – these expenses are incurred when the NFO is made. These
need to be borne by the AMC.
❖ Recurring expenses – These expenses are incurred regularly. These include o

fees paid to trustees, custodians, auditor, registrar and transfer agents o

selling and commission expenses

o listing fees and depository fees

o expenses related to investor communication

o service tax

SEBI has clearly laid down limits for expenses that can be charged to the scheme.

23
The limits for schemes other than index schemes are as follows:
Net Assets (Rs crs.) Equity Schemes Debt Schemes Upto Rs.100
 crs. 2.50% 2.25%

Next Rs.300 crs. 2.25% 2.00%

Next Rs.300 crs. 2.00% 1.75%

Excess over Rs.700 crs. 1.75% 1.50%

• The above percentages are to be calculated on the average daily net assets of the
scheme. The expense limits (including management fees) for index schemes (including
Exchange Traded Funds) is 1.5% of average net assets.
• In case of a fund of funds scheme, the total expenses of the scheme including weighted
average of charges levied by the underlying schemes shall not exceed 2.50 per cent of
the average daily net assets of the scheme.

In addition to the limits specified, the following costs or expenses may be charged to the
scheme, namely
• brokerage and transaction costs which are incurred for the purpose of execution of trade
and is included in the cost of investment, not exceeding 0.12% in case of cash market
transactions and 0.05% in case of derivatives transactions
• expenses not exceeding of 0.30% of daily net assets, if the new inflows from such cities
as specified by the Board from time to time are at least - (i) 30 per cent of gross new
inflows in the scheme, or; (ii) 15 per cent of the average assets under management
(year to date) of the scheme, whichever is higher: Provided that if inflows from such
cities is less than the higher of sub-clause (i) or sub- clause (ii), such expenses on daily
net assets of the scheme shall be charged on proportionate basis
• additional expenses not exceeding 0.20 per cent of daily net assets of the scheme

Any expenditure in excess of the limits specified above shall be borne by the asset
management company or by the trustee or sponsors.

Mutual funds/AMCs shall launch new schemes under a single plan and ensure that all new
investors are subject to single expense structure. Investors, who have already invested as
per earlier expense structures based on amount of investment, will be subject to single
expense structure for all fresh subscription.

2.14 WHAT IS EXPENSE RATIO?

Among other things that an investor must look at before finalising a scheme, is that he must
check out the Expense Ratio.

24
Concept Clarifier – Expense Ratio
 Expense Ratio is defined as the ratio of expenses incurred by a scheme to its Average
Weekly Net Assets. It means how much of investors’ money is going for expenses and
how much is getting invested. This ratio should be as low as possible. Assume that a
scheme has average weekly net assets of Rs 100 cr. and the scheme incurs Rs.1 cr. as
annual expenses, then the expense ratio would be 1/ 100 = 1%. In case this scheme’s
expense ratio is comparable to or better than its peers then this scheme would qualify
as a good investment, based on this parameter only.
If this scheme performs well and its AUM increases to Rs. 150 cr in the next year
whereas its annual expenses increase to Rs. 2 cr, then its expense would be 2/ 150 =
1.33%. It is not enough to compare a scheme’s expense ratio with peers. The scheme’s
expense ratio must be tracked over different time periods. Ideally as net assets
increase, the expense ratio of a scheme should come down.

Investors today have an option of investing through direct plans. Since the direct plans do
not entail distributor commissions, they may have a lower expense ratio.

2.15 WHAT IS PORTFOLIO TURNOVER?

Fund managers keep churning their portfolio depending upon their outlook for the market,
sector or company. This churning can be done very frequently or may be done after sufficient
time gaps. There is no rule which governs this and it is the mandate of the scheme and the
fund managers’ outlook and style that determine the churning. However, what is important
to understand is that a very high churning frequency will lead to higher trading and
transaction costs, which may eat into investor returns. Portfolio Turnover is the ratio
which helps us to find how aggressively the portfolio is being churned.

While churning increases the costs, it does not have any impact on the Expense Ratio, as
transaction costs are not considered while calculating expense ratio. Transaction costs are
included in the buying & selling price of the scrip by way of brokerage, STT, cess, etc. Thus
the portfolio value is computed net of these expenses and hence considering them while
calculating Expense Ratio as well would mean recording them twice – which would be
incorrect.

Concept Clarifier – Portfolio Turnover

Portfolio Turnover is defined as ‘Lesser of Assets bought or sold/ Net Assets’. A scheme
with Rs.100 cr as net assets sells Rs.20 cr. of its investments. Thus its Portfolio Turnover
Rate would be 20/ 100 = 20%.
If this scheme’s net assets increase to Rs.120 cr and the fund manager decides to churn
the entire portfolio by exiting all stocks, then the Portfolio Turnover would be 120/ 120
= 100%.
If the fund manager churns the entire portfolio twice in a single year then we would say
that the Portfolio Turnover rate is 200% or that the portfolio is churned once every 6
months. Liquid funds have very high portfolio turnover due to less maturity of the paper.
Once the paper matures, the fund manager has to buy another security, thus churning
the portfolio.

25
2.16 HOW DOES AUM AFFECT PORTFOLIO TURNOVER?
The scheme’s size i.e. the AUM can also have an impact on the performance of the scheme.
In case the scheme performs well and thereby attracts a lot of money flow, it may happen
that the fund manager may not be able to deploy that extra money successfully as he may
not find enough opportunities. Thus an increased fund size may result in lower returns. If
the fund manager tries to acquire significantly large quantities of a stock, the buying
pressure may lead to higher stock prices, thereby higher average cost for the scheme. Also,
if the holdings by the scheme in any stock are huge, then exit may be difficult as selling
from the scheme itself can put pressure on the prices. Thus the first share may be sold at a
higher price and as the supply increases the prices may fall, and the last share may get sold
at a lower price.

A scheme with a very small AUM does not face these problems but has its own set of
problems. The Expense Ratio of such a scheme will be very high as expenses are calculated
as a percent of Average Weekly Net Assets. As the fund size increases, the Expense Ratio
tends to go down.

Similarly Portfolio Turnover will be magnified as the denominator (Average Net Assets) is
small and hence the turnover appears to be very high.

Thus, the investor must look at AUM for the previous few months, say last 12 months and
compare the same with that of the industry and also similar schemes. If it is found that the
scheme’s performance is in line or better than its peers consistently, even though the AUM is
increasing, then it can be a fair indicator that increased AUM is not a problem for the fund
manager.

2.17 HOW TO ANALYSE CASH LEVEL IN PORTFOLIOS?

The next logical point of focus must be the Cash Level in the scheme. The Cash level is the
amount of money the mutual fund is holding in Cash, i.e. the amount not invested in stocks
and bonds but lying in cash.

If the scheme is having higher than industry average cash levels consistently, more so in a
bull market, it will lead to a inferior performance by the scheme than its peers. However, in
a falling market, it is this higher cash level that will protect investor wealth from depleting.
Hence whenever one is analyzing cash levels, it is extremely important to see why the fund
manager is holding high cash levels. It may be so that he is expecting a fall therefore he is
not committing large portions of monies. It may be so in a bull market or a bear market.
The strategy could be to enter once the prices correct. High cash levels can also be seen as
a cushion for sudden redemptions and in large amounts.

2.18 WHAT ARE EXIT LOADS?

Exit Loads, are paid by the investors in the scheme, if they exit one of the scheme before a
specified time period. Exit Loads reduce the amount received by the investor. Not all
schemes have an Exit Load, and not all schemes have similar exit loads as well. Some
schemes have

26
Contingent Deferred Sales Charge (CDSC). This is nothing but a modified form of Exit Load,
where in the investor has to pay different Exit Loads depending upon his investment period.

If the investor exits early, he will have to bear more Exit Load and if he remains invested for
a longer period of time, his Exit Load will reduce. Thus the longer the investor remains
invested, lesser is the Exit Load. After some time the Exit Load reduces to nil; i.e. if the
investor exits after a specified time period, he will not have to bear any Exit Load.

Earlier there was a difference between the sale price and the NAV, the difference being the
‘entry load’. However SEBI has banned entry loads since May 2009. Further exit loads /
CDSC have to be credited back to the scheme immediately i.e. they are not available for the
AMC to bear selling expenses. Upfront commission to distributors will be paid by the investor
directly to the distributor, based on his assessment of various factors including the service
rendered by the distributor. Currently for equity funds / bonds funds redeemed within 1 year
are charged 1% exit load. However liquid funds and money market funds normally have
zero exit loads.

2.19 POINTS TO REMEMBER

A variety of schemes are offered by mutual funds. It is critical for investors to know the
features of these products, before money is invested in them. These include the following: 1)
Equity funds – funds that primarily invests in equity shares of companies. 2) Debt funds -
funds which invest in debt instruments such as short and long term bonds,
government securities, t-bills, corporate paper, commercial paper, call money etc. 3)
Hybrid funds - These are funds which invest in debt as well as equity instruments 4)
Gold ETF – An exchange traded fund that buys and sells gold.

5) Real estate funds – These funds invest in properties

There are other types of funds within these broad categories, which the investor must be
aware of. They include the following:
• Index Funds invest in stocks comprising indices, such as the Nifty 50, which is a broad
based index comprising 50 stocks.
• Large cap funds restrict their stock selection to the large cap stocks • Midcap funds, invest
in stocks belonging to the mid cap segment of the market. • Funds that invest in stocks from
a single sector or related sectors are called Sectoral funds.

• Other equity funds ELSS and Fund of funds

Investments in new fund offers is through the offer documents as issued the mutual funds.
These offer documents have two parts:
• Scheme Information Document (SID), which has details of the scheme • Statement of
Additional Information (SAI), which has statutory information about the mutual fund, that is
offering the scheme.

27
The Key Information Memorandum (KIM) is a summary of the SID and SAI. As per SEBI
regulations, every application form is to be accompanied by the KIM.

Another importance concept to be kept in mind is the NAV of the scheme. The NAV or Net
Assets Value of a scheme is the market value of assets of the scheme less all scheme
liabilities. . NAV i.e. net asset value is calculated by dividing the value of Net Assets by the
outstanding number of Units.

After an investor has entered into a scheme, he must monitor his investments regularly.
This can be achieved by going through the Fund Fact Sheet.

There are two types of expenses incurred by a scheme

Initial issue expenses – these expenses are incurred when the NFO is made. These need to
be borne by the AMC.

Recurring expenses – These expenses are incurred regularly.

Expense Ratio is defined as the ratio of expenses incurred by a scheme to its Average
Weekly Net Assets. It means how much of investors’ money

Portfolio Turnover is the ratio which helps us to find how aggressively the portfolio is being
churned.

Exit Loads, are paid by the investors in the scheme, if they exit one of the scheme before a
specified time period. Exit Loads reduce the amount received by the investor. Not all
schemes have an Exit Load, and not all schemes have similar exit loads as well.

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CHAPTER 3 : EXCHANGE TRADED FUNDS (ETFS)

3.1 INTRODUCTION TO EXCHANGE TRADED FUNDS

Exchange Traded Funds (ETFs) are mutual fund units which investors buy/ sell from the
stock exchange, as against a normal mutual fund unit, where the investor buys / sells
through a distributor or directly from the AMC. ETF as a concept is relatively new in India. It
was only in early nineties that the concept gained in popularity in the USA.

ETFs have relatively lesser costs as compared to a mutual fund scheme. This is largely due
to the structure of ETFs. While in case of a mutual fund scheme, the AMC deals directly with
the investors or distributors, the ETF structure is such that the AMC does not have to deal
directly with investors or distributors. It instead issues units to a few designated large
participants, who are also called as Authorised Participants (APs), who in turn act as market
makers for the ETFs.

The Authorised Participants provide two way quotes for the ETFs on the stock exchange,
which enables investors to buy and sell the ETFs at any given point of time when the stock
markets are open for trading. ETFs therefore trade like stocks. Buying and selling ETFs is
similar to buying and selling shares on the stock exchange. Prices are available on real time
and the ETFs can be purchased through a stock exchange broker just like one would buy /
sell shares.

Due to these lower expenses, the Tracking Error for an ETF is usually low. Tracking Error is
the acid test for an index fund/ ETF. By design an index fund/ index ETF should only replicate
the index return. The difference between the returns generated by the scheme/ ETF and
those generated by the index is the tracking error.

Assets in ETFs

Practically any asset class can be used to create ETFs. Globally there are ETFs on Silver,
Gold, Indices (SPDRs, Cubes, etc), etc. In India, we have ETFs on Gold, Indices such as Nifty
50, Bank Nifty etc.).

Index ETF

An index ETF is one where the underlying is an index, say Nifty 50. The APs deliver the
shares comprising the Nifty, in the same proportion as they are in the Nifty, to the AMC and
create ETF units in bulk (These are known as Creation Units). Once the APs get these units,
they provide liquidity to these units by offering to buy and sell through the stock exchange.
They give two way quotes, buy and sell quote for investors to buy and sell the ETFs. ETFs
therefore have to be listed on stock exchanges. There are many ETFs presently listed on the
NSE. For further details please check NSE website http://www.nseindia.com/products/
content/equities/etfs/etfs_launched_on_nse.htm.

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3.2 SALIENT FEATURES
• An Exchange Traded Fund (ETF) is essentially a scheme where the investor has to buy/
sell units from the market through a broker (just as he/ he would by a share). • An investor
must have a demat account for buying ETFs (For understanding what is demat please refer
to NCFM module ‘Financial Markets : A Beginners’ Module). • An important feature of ETFs is
the huge reduction in costs. While a typical Index fund would have expenses in the range of
1.5% of Net Assets, an ETF might have expenses around 0.75%. In fact, in international
markets these expenses are even lower. In India too this may be the trend once more Index
Funds and ETFs come to the market and their popularity increases. Expenses, especially in
the long term, determine to a large extent, how much money the investor makes. This is
because lesser expenses mean more of the investor’s money is getting invested today and
over a longer period of time, the power of compounding will turn this saving into a
significant contributor to the investors’ returns.
 Scheme A B

Investment (Rs.) 10000 10000

Expense Ratio 1.50% 0.75%

Term (Years) 25 25

Compounded Average Growth Rate (CAGR) 12% 12%

Amount (Rs.) 116508.16 140835.93

Difference (Rs.) 24327.77

If an investor invests Rs.10,000 in 2 schemes each, for 25 years, with both the schemes
delivering returns at a CAGR of 12% and the only difference being in the expenses of the
schemes, then at the end of the term, while scheme A would have turned the investment
into Rs.1.16 Lakhs, scheme B would have grown to Rs.1.40 Lakhs – a difference of
Rs.24,327.77. Post expenses, scheme A’s CAGR comes out to be 10.32%, while scheme B’s
CAGR stands at 11.16%.

Concept Clarifier – Buying/ Selling ETFs

An investor can approach a trading member of NSE and enter into an agreement with
the trading member. Buying and selling ETFs requires the investor to have demat and
trading accounts. The procedure is exactly similar to buying and selling shares. The
investor needs to have sufficient money in the trading account. Once this is done, the
investor needs to tell the broker precisely how many units he wants to buy/ sell and at
what price.

Investors should take care that they place the order completely. They should not tell the
broker to buy/ sell according to the broker’s judgement. Investors should also not keep
signed delivery instruction slips with the broker as there may be a possibility of their
misuse. Placing signed delivery instruction slips with the broker is similar to giving blank
signed cheques to someone.

30
3.3 WHAT ARE REITs?
REITs or Real Estate Investment Trusts are similar to mutual funds. They invest in real
estate assets and give returns to the investor based on the return from the real estate. Like
a mutual fund, REITs collect money from many investors and invest the same in real estate
properties like offices, residential apartments, shopping malls, hotels, warehouses). These
REITs are listed on stock exchanges. The investors can directly buy and sell units from the
stock exchanges.

REITs are actually trusts and hence their assets are in the hands of an independent trustee,
held on behalf of the investor. The trustee is bound to ensure compliance with applicable
laws and protect the rights of the unit holders.

Income takes the form of rentals and capital gains from property which is distributed to
investors as dividends. Money is raised from unit holders through IPO (Initial Public Offer).
3.4 WHY GOLD ETF?
Gold ETFs (G-ETFs) are a special type of ETF which invests in Gold and Gold related
securities. This product gives the investor an option to diversify his investments into a
different asset class, other than equity and debt.

Traditionally, Indians are known to be big buyers of Gold; an age old tradition. Gold as an
asset class is considered to be safe This is because gold prices are difficult to manipulate and
therefore enjoy better pricing transparency. When other financial markets are weak, gold
gives good returns. It also enjoys benefit of liquidity in case of any emergency.

We buy Gold, among other things for children’s marriages, for gifting during ceremonies etc.
Holding physical Gold can have its’ disadvantages:
1. Fear of theft
2. Payment Wealth Tax
3. No surety of quality
4. Changes in fashion and trends
5. Locker costs
6. Lesser realisation on remoulding of ornaments

G-ETFs can be said to be a new age product, designed to suit our traditional requirements.
G-ETFs score over all these disadvantages, while at the same time retaining the inherent
advantages of Gold investing.

In case of Gold ETFs, investors buy Units, which are backed by Gold. Thus, every time an
investor buys 1 unit of G-ETFs, it is similar to an equivalent quantity of Gold being
earmarked for him some w here. Thus his units are ‘as good as Gold’.

Say for example 1 G-ETF = 1 gm of 99.5% pure Gold, then buying 1 G-ETF unit every
month for 20 years would have given the investor a holding of 240gm of Gold, by the time
his child’s marriage approaches (240 gm = 1 gm/ month * 12 months * 20 Years). After 20

31
years the investor can convert the G-ETFs into 240 gm of physical gold by approaching the
mutual fund or sell the G-ETFs in the market at the current price and buy 240 gms. of gold.

Secondly, all these years, the investor need not worry about theft, locker charges, quality of
Gold or changes in fashion as he would be holding Gold in paper form. As and when the
investor needs the Gold, he may sell the Units in the market and realise an amount
equivalent to his holdings at the then prevailing rate of Gold ETF. This money can be used to
buy physical gold and make ornaments as per the prevailing trends. The investor may also
simply transfer the units to his child’s demat account as well. Lastly, the investor will not
have to pay any wealth tax on his holdings. There may be other taxes, expenses to be borne
from time to time, which the investor needs to bear in mind while buying / selling G-ETFs.

3.5 WORKING
The G-ETF is designed as an open ended scheme. Investors can buy/ sell units any time at
then prevailing market price. This is an important point of differentiation of ETFs from
similar open ended funds. In case of open ended funds, investors get units (or the units are
redeemed) at a price based upon that day’s NAV. In case of ETFs, investors can buy (or sell)
units at a price which is prevailing at that point of time during market hours. Thus for all
investors of open ended schemes, on any given day their buying (or redemption) price will
be same, whereas for ETF investors, the prices will vary for each, depending upon when
they bought (or sold) units on that day.

The way Gold ETFs work is as under:

3.5.1 During New Fund Offer (NFO)

⬥ AMC decides of launching G-ETF
⬥ The SID, SAI and KIM are prepared as per SEBI guidelines
⬥ Investors invest in the fund and the AMC gives units to investors in return

AMC buys Gold of specified quality at the prevailing rates

3.5.2 On an ongoing basis

⬥ Authorised Participants (typically large institutional investors) give money/ Gold to AMC ⬥
AMC gives equivalent number of units bundled together to these authorized participants
(AP)
⬥ APs split these bundled units into individual units and offer for sale in the secondary
market
⬥ Investors can buy G-ETF units from the secondary markets either from the quantity being
sold by the APs or by other retail investors
⬥ Retail investors can also sell their units in the market

The Gold which the AP deposits for buying the bundled ETF units is known as ‘Portfolio
Deposit’. This Portfolio Deposit has to be deposited with the Custodian. A custodian is
someone who handles the physical Gold for the AMC. The AMC signs an agreement with

32
the Custodian, w here all the terms and conditions are agreed upon. Once the AP deposits
Gold with the custodian, it is the responsibility of the custodian to ensure safety of the Gold,
otherwise he has to bear the liability, to the extent of the market value of the Gold.

The custodian has to keep record of all the Gold that has been deposited/ withdrawn under
the G-ETF. An account is maintained for this purpose, which is known as ‘Allocated Account’.
The custodian, on a daily basis, enters the inflows and outflows of Gold bars from this
account. All details such as the serial number, refiner, fineness etc. are maintained in this
account. The transfer of Gold from or into the Allocated Account happens at the end of each
business day. A report is submitted by the custodian, no later than the following business
day, to the AMC.

The money which the AP deposits for buying the bundled ETF units is known as ‘Cash
Component’. This Cash Component is paid to the AMC. The Cash Component is not
mandatory and is paid to adjust for the difference between the applicable NAV and the
market value of the Portfolio Deposit. This difference may be due to accrued dividend,
management fees, etc. The bundled units (which the AP receives on payment of Portfolio
Deposit to the custodian and Cash Component to the AMC) are known as Creation Units.
Each Creation Unit comprises of a pre-defined number of ETFs Units (say 25,000 or 100 or
any other number).

Thus, now it can be said that Authorised Participants pay Portfolio Deposit and/ or
Cash Component and get Creation Units in return.

Each Creation Unit consists of a pre-defined number of G-ETF Units. APs strip these Creation
Units (which are nothing but bundled G-ETF units) and sell individual G-ETF units in the
market. Thus retail investors can buy/ sell 1 unit or it’s multiples in the secondary market.

3.6 SOVEREIGN GOLD BONDS

• The Government of India in October 2015 launched the Sovereign Gold Bonds Scheme •
SGB scheme offer investors returns that are linked to gold price and provides benefits
similar to investment in physical gold
• SGBs are issued by the Reserve Bank of India on behalf of the Government of India and
distributed through Agents like banks, designated post offices and Stock Holding Corp. •
Exchanges to be appointed as Agents from Tranche IV onwards
• SGBs are issued on payment of rupees and denominated in grams of gold and can be held
in demat and paper form
• SGBs can be used as collateral for loans and can be traded on stock exchanges •
Can be bought initially through Stock brokers / Mutual Fund Distributors •
Commission would be 99bps.

33
3.6.1 Product Details of Sovereign Gold Bonds
SI. No. Item Details

1 Product name Sovereign Gold Bond 2016-17 – Series ***

2 Issuance To be issued by Reserve Bank India on behalf of the

Government of India.

3 Eligibility The Bonds will be restricted for sale to resident Indian

entities including individuals, HUFs, Trusts, Universities
and Charitable Institutions.

4 Denomination The Bonds will be denominated in multiples of gram(s)

of gold with a basic unit of 1 gram.

5 Tenor The tenor of the Bond will be for a period of 8 years

with exit option from 5th year to be exercised on the
interest payment dates.

6 Minimum size Minimum permissible investment will be 1 grams of

gold.

7 Maximum limit The maximum amount subscribed by an entity will not

be more than 500 grams per person per fiscal year
(April March). A self-declaration to this effect will be
obtained.
 8 Joint holder In case of joint holding, the investment limit of 500
grams will be applied to the first applicant only.

9 Issue price Price of Bond will be fixed in Indian Rupees on the

basis of simple average of closing price of gold of 999
purity published by the India Bullion and Jewellers
Association Limited for the week (Monday to Friday)
preceding the subscription period.

10 Payment option Payment for the Bonds will be through cash payment
(upto a maximum of Rs. 20,000) or demand draft or
cheque or electronic banking.

11 Issuance form Government of India Stock under GS Act, 2006. The

investors will be issued a Holding Certificate. The
Bonds are eligible for conversion into demat form.

12 Redemption price The redemption price will be in Indian Rupees based

on previous week’s (Monday-Friday) simple average of
closing price of gold of 999 purity published by IBJA.

13 Sales channel Bonds will be sold through banks, Stock Holding

Corporation of India Limited (SHCIL), designated post
offices as may be notified and recognised stock
exchanges viz., National Stock Exchange of India
Limited and Bombay Stock Exchange, either directly
or through agents.

14 Interest rate The investors will be compensated at a fixed rate of

2.75 per cent per annum payable semi-annually on
the initial value of investment.

34
SI. No. Item Details

15 Collateral Bonds can be used as collateral for loans. The loan to

value (LTV) ratio is to be set equal to ordinary gold
loan mandated by the Reserve Bank from time to
time.

16 KYC Documentation Know-your-customer (KYC) norms will be the same as

that for purchase of physical gold. KYC documents
such as Voter ID, Aadhaar card/PAN or TAN /Passport
will be required.

17 Tax treatment The interest on Gold Bonds shall be taxable as per the
provision of Income Tax Act, 1961 (43 of 1961). The
capital gains tax arising on redemption of SGB to an
individual has been exempted. The indexation benefits
will be provided to long term capital gains arising to
any person on transfer of bond

18 Tradability Bonds will be tradable on stock exchanges/NDS-OM

from a date to be notified by RBI.
 19 SLR eligibility The Bonds will be eligible for Statutory Liquidity Ratio
purposes.

20 Commission Commission for distribution of the bond shall be paid

at the rate of 1% of the total subscription received by
the receiving offices and receiving offices shall share
at least 50% of the commission so received with the
agents or sub agents for the business procured
through them.

3.7 MARKET MAKING BY APS

APs are like market makers and continuously offer two way quotes (buy and sell). They earn
on the difference between the two way quotes they offer. This difference is known as bid-ask
spread. They provide liquidity to the ETFs by continuously offering to buy and sell ETF units.

If the last traded price of a G-ETF is Rs 1000, then an AP will give a two way quote by
offering to buy an ETF unit at Rs 999 and offering to sell an ETF unit Rs. 1001. Thus
whenever the AP buys, he will buy @ 999 and when he sells, he will sell at 1001, thereby
earning Rs. 2 as the difference. It should also be understood that the impact of this
transaction is that the AP does not increase/ decrease his holding in the ETF. This is known
as earning through Dealer Spreads. APs also play an important role of aligning the price of
the unit with the NAV. This
is done by exploiting the arbitrage opportunities.

It should be understood that it is not only APs who can sell ETF units in the market. Retail
investors get liquidity by selling their units as well. So it is not always that the buyer of units
is necessarily buying fro m APs – the seller at the other end may be a retail investor who
wishes to exit.

35
As explained earlier, the custodian maintains record of all the Gold that comes into and goes
out of the scheme’s Portfolio Deposit. The custodian makes respective entries in the
Allocated Account thus transferring Gold into and out of the scheme at the end of each
business day. The custodian has no right on the Gold in the Allocated Account.

The custodian may appoint a sub-custodian to perform some of the duties. The custodian
charges fee for the services rendered and has to buy adequate insurance for the Gold held.
The premium paid for the insurance is borne by the scheme as a transaction cost and is
allowed as an expense under SEBI guidelines. This expense contributes in a small way to
the tracking error.

36
The difference between the returns given by Gold and those delivered by the scheme is
known as Tracking Error. It is defined as the variance between the daily returns of the
underlying (Gold in this case) and the NAV of the scheme for any given time period.

Gold has to be valued as per a specific formula mandated by regulations. This formula takes
into account various inputs like price of Gold in US $/ ounce as decided by the London
Bullion Markets Association (LBMA) every morning, the conversion factor for ounce to Kg,
the prevailing USD/ INR exchange rate, customs duty, octroi, sales tax, etc.

3.8 CREATION UNITS, PORTFOLIO DEPOSIT AND CASH COMPONENT

(AN EXAMPLE):
Let us look at the following example to understand Creation Units, Portfolio Deposit and
Cash Component in detail.

Assumption: 1 ETF unit = 1 gm of 99.5% pure Gold

During New Fund Offer (NFO)

Amount Invested (Rs.): 5000
Price of 1 gm of Gold (Rs.): 1000
Since 1 ETF unit = 1 gm of Gold
Issue Price (Rs.) = 1000
Units Allotted (Number = Investment/ Issue Price): 5

Creation Units
1 Creation Unit = 100 ETF units
NAV (Rs.) = 1050
Price of 1 gm of Gold (Rs.): 1000
So, 100 Units will cost (Rs.) = 1050 * 100 = 1,05,000
100 ETF will be equal to 100 gm of Gold
Therefore, value of Portfolio Deposit (Rs.) = 1000 * 100 = 1,00,000
Hence Cash Component (Rs.) = 1,05,000 – 1,00,000 = 5,000

Thus it can be seen by depositing Gold worth Rs.1,00,000 as Portfolio Deposit and Rs. 5,000
as Cash Component, the Authorised Participant has created 1 Creation Unit comprising of
100 ETF units.

Let us now see how the Authorised Participant ensures parity between the NAV and market
price of the ETFs.

As can be well understood, the price of ETF will be determined by market forces, and
although it is linked to the prices of Gold, it will not mirror the exact movements at all given
points of time. This will happen due to excess buying or selling pressure on the ETFs, due to
which prices may rise or fall more than the Gold price. Such exaggerated movements
provide opportunity for arbitrage, which the APs exploit and make risk less gains. This
process also ensures that prices of ETF remain largely in sync with those of the underlying.

37
Consider a case where the demand for ETFs has increased due to any reason. A rise in
demand will lead to rise in prices, as many people will rush to buy the units, thereby putting
an upward pressure on the prices.

This can be explained by the following example

Price of Gold (Rs. / gm) = 1000
NAV (Rs.) = 1050
CMP of ETF units (Rs.) = 1200

In such a situation an AP will buy Creation Units and sell ETFs in the market.
 To purchase 1 Creation Unit, he will have to deposit Gold worth Rs 1,00,000 (Price of Gold *
number of ETF units in Creation Units * gm per ETF) as Portfolio Deposit with the custodian
and balance Rs. 5,000 as Cash Component with the AMC.

Once he has the Creation Unit, he will sell individual ETF units in the market at Rs. 1200/
unit, thereby making a profit of Rs. 150 (1200 - 1050) per unit.

As he buys physical Gold the price of Gold will increase. Similarly as he sells fresh ETF units
in the market, the supply of ETFs will increase. These two actions will lead to increase in
Gold prices and reduction in ETF prices, thereby removing the anomaly in the prices of the
ETF units and the underlying.

Similarly, if ETF prices fall way below the price of Gold, APs will buy ETF units cheap and
redeem them in Creation Unit lot size. Such an action will reduce supply of ETFs from the
market and increase the supply of physical Gold (Gold held with Custodian will come into the
market). Both these actions will help align prices of underlying and ETF units as ETF prices
will increase due to buying (and subsequent cutting of supply) and price of physical Gold will
reduce due to fresh supply in the market.

3.9 POINTS TO REMEMBER

Exchange Traded Funds (ETFs) are mutual fund units which investors buy/ sell from the
stock exchange, as against a normal mutual fund unit, where the investor buys / sells
through a distributor or directly from the AMC.

Practically any asset class can be used to create ETFs. Globally there are ETFs on Silver,
Gold, Indices (SPDRs, Cubes, etc), etc. In India, we have ETFs on Gold, Indices such as Nifty
50, Bank Nifty etc.).

An index ETF is one where the underlying is an index, say Nifty 50.

An Exchange Traded Fund (ETF) is essentially a scheme where the investor has to buy/ sell
units from the market through a broker (just as he/ he would by a share).

An investor can approach a trading member of NSE and enter into an agreement with the
trading member. Buying and selling ETFs requires the investor to have demat and trading
accounts.

Gold ETFs (G-ETFs) are a special type of ETF which invests in Gold and Gold related securities.

APs are like market makers and continuously offer two way quotes (buy and sell). They earn
on the difference between the two way quotes they offer. This difference is known as bid-ask
spread. They provide liquidity to the ETFs by continuously offering to buy and sell ETF units.

38
CHAPTER 4 : DEBT FUNDS

4.1 SALIENT FEATURES

Debt funds are funds which invest money in debt instruments such as short and long term
bonds, government securities, t-bills, corporate paper, commercial paper, call money etc. The
fees in debt funds are lower, on average, than equity funds because the overall management
costs are lower. The main investing objective of a debt fund is usually preservation of capital
and generation of income. Performance against a benchmark is considered to be a
secondary consideration. Investments in the equity markets are considered to be fraught
with uncertainties and volatility. These factors may have an impact on constant flow of
returns. Which is why debt schemes, which are considered to be safer and less volatile have
attracted investors.

Debt markets in India are wholesale in nature and hence retail investors generally find it
difficult to directly participate in the debt markets. Not many understand the relationship
between interest rates and bond prices or difference between Coupon and Yield. Therefore
venturing into debt market investments is not common among investors. Investors can
however participate in the debt markets through debt mutual funds.

One must understand the salient features of a debt paper to understand the debt market.

Debt paper is issued by Government, corporates and financial institutions to meet funding
requirements. A debt paper is essentially a contract which says that the borrower is taking
some money on loan and after sometime the lender will get the money back as well as some
interest on the money lent.

Concept Clarifier – Face Value, Coupon, Maturity

Any debt paper will have Face Value, Coupon and Maturity as its standard characteristics.

Face Value represents the amount of money taken as loan. Thus when an investor
invests Rs.100 in a paper, at the time of issuing the paper, then the face value of that
paper is said to be Rs. 100. For our understanding point of view, Face Value is that
amount which is printed on the debt paper. The borrower issues this paper; i.e. takes a
loan from the investor as per this Face Value. So, if the Face Value is Rs. 100, the
borrower will take a loan of Rs.100 from the investor and give the paper to the investor.

Next question is what the investor will earn from this investment. This can be found by
looking at the ‘Coupon’ of the paper. The Coupon represents the rate of interest that the
borrower will pay on the Face Value. Thus, if the Coupon is 8% for the above discussed
paper, it means that the borrower will pay Rs.8 (8/100 X 100)every year to the investor
as interest income. It must be understood that the Face Value and the Coupon of a debt
paper never change. There are some papers where the Coupon changes periodically,
but again, for the moment we will ignore such paper. Since the investor will earn a fixed
income (8% on Rs.100 or Rs.8 per year in our example), such instruments are also
known as Fixed Income securities.

39
Finally the question arises, for how long the borrower has taken a loan. This can be
understood by looking at the ‘Maturity’. So if the paper in our example says that the
maturity of the paper is 10 years, it means that for 10 years the investor will receive
Rs.8 as interest income and after 10 years, he will get his Principal of Rs.100 back.

Thus now we can say, about the paper in our example that the borrower has taken a
Rs.100 loan, for a period of 10 years, and he has promised to pay 8% interest annually.

This is the most basic form of debt paper. There can be modifications made to the issue
price, coupon rate, frequency pf coupon payment, etc., but all these modifications are out of
these basic features.

Interest rates can either be fixed or floating. Under fixed interest rates, the interest rate
remains fixed throughout the tenure of the loan. Under floating rate loans, the rate of
interest is a certain percentage over the benchmark.

Example

A Ltd. has borrowed against a debt instrument, the rate be G-Sec plus 3%. Therefore if the
G-Sec moves up, the rate of interest moves up and if the G-Sec moves down the interest
rate moves down.

Prima facie debt instruments looks risk free. However two important questions need to be
asked here:
1. What if interest rates rise during the tenure of the loan?
2. What if the borrower fails to pay the interest and/ or fails to repay the principal?

In case interest rates rise, then the investor’s money will continue to grow at the earlier
fixed rate of interest; i.e. the investor loses on the higher rate of interest, which his money
could have earned. In case the borrower fails to pay the interest it would result in an
income loss for the investor and if the borrower fails to repay the principal, it would mean
an absolute loss for the investor. A prospective debt fund investor must study both these
risks carefully before entering debt funds.

4.2 WHAT IS INTEREST RATE RISK?

The first risk which we discussed is known as the Interest Rate Risk. This can be reduced
by adjusting the maturity of the debt fund portfolio, i.e. the buyer of the debt paper would
buy debt paper of lesser maturity so that when the paper matures, he can buy newer paper
with higher interest rates. So, if the investor expects interest rates to rise, he would be
better off giving short- term loans (when an investor buys a debt paper, he essentially gives
a loan to the issuer of the paper). By giving a short-term loan, he would receive his money
back in a short period of time. As interest rates would have risen by then, he would be able
to give another loan (again short term), this time at the new higher interest rates. Thus in a
rising interest rate scenario, the investor can reduce interest rate risk by investing in debt
paper of extremely short-term maturity.

40
Concept Clarifier – Interest Rate Risk

In our example, we have discussed about a debt paper which has a maturity of 10 years
and a coupon of 8%. What will happen if interest rates rise after 2 years to 10%? The
investor would have earned Rs.8 for 2 years and will earn Rs.8 yet again in the 3rd year
as well. But had he got the Rs.
100 with him (which he had invested 2 years ago), instead of investing at 8%, he would
have preferred to invest @ 10%. Thus by investing in a long term paper, he has locked
himself out of higher interest income.
The best way to mitigate interest rate risk is to invest in papers with short- term
maturities, so that as interest rate rises, the investor will get back the money invested
faster, which he can reinvest at higher interest rates in newer debt paper.
However, this should be done, only when the investor is of the opinion that interest
rates will continue to rise in future otherwise frequent trading in debt paper will be
costly and cumbersome.
Alternatively the interest rate risk can be partly mitigated by investing in floating rate
instruments. In this case for a rising interest rate scenario the rates moves up, and for a
falling interest rate scenario the rates move down.

4.3 WHAT IS CREDIT RISK?

The second risk is known as Credit Risk or Risk of Default. It refers to the situation where
the borrower fails to honour either one or both of his obligations of paying regular interest
and returning the principal on maturity. A bigger threat is that the borrower does not repay
the principal. This can happen if the borrower turns bankrupt. This risk can be taken care of
by investing in paper issued by companies with very high Credit Rating. The probability of
a borrower with very high Credit Rating defaulting is far lesser than that of a borrower with
low credit rating. Government paper is highest in safety when it comes to credit risk (hence
the description ‘risks free security’).

Concept Clarifier – Credit Risk or Risk of Default

Different borrowers have different levels of credit risks associated and investors would
like to know the precise risk level of a borrower. This is done by a process known as
Credit Rating. This process is carried by professional credit rating agencies like
CRISIL, ICRA etc. In India, credit rating agencies have to be registered with SEBI and
are regulated by SEBI (Credit Rating) Regulations, 1999.

These credit rating agencies analyse companies on various financial parameters like
profitability, cash flows, debt, industry outlook, impact of economic policies, etc. based on
which instruments are classified as investment grade and speculative grade. Looking at
these ratings, the borrower comes to know the risk level associated with the corporate.

Some of CRISIL’s rating symbols are given below:

AAA – These are the safest among corporate debentures. This rating implies investors can
safely expect to earn interest regularly as well as the probability of default of their principal
is as good as nil.

41
BBB – These instruments are safe, however, in case environment changes, there is a
probability that the coupon payment and principal repayment ability may be hampered.

The above 2 ratings represent the topmost and lowest rating of investment grade securities.
Anything less than BBB is termed as speculative grade. The rating grade ‘D’ represents
default. Such companies are already in default and only liquidation of assets will result in
realization of principal and/ or interest.

4.4 HOW IS A DEBT INSTRUMENT PRICED?

Debt fund investing requires a different analysis, and understanding of basic bond market
concepts is essential. There exist some relationships between yields and bond prices,
between years to maturity and impact of change in interest rates, between credit risk and
yields, and so on. We need to understand each of these relationships before we can start
investing in debt funds.

The price of an instrument (equity / bond) is nothing but the present value of the
future cash flows. (for understanding the meaning of present value, please refer to NCFM
module ‘Financial Markets : A Beginners Module’). In case of bonds, there is no ambiguity
about future cash flows, as is the case of equities. Future cash flows in case of bonds are the
periodic coupon payments that the investor will receive. Future cash flows for equities are
the dividends than the investor may receive. Bond coupon payments are known right at the
beginning, whereas there is no surety about a share paying dividends to an investor. Thus
different investors/ analysts have different earning projections for equities, and hence each
participant has a different view on the present value of a share. Bond cash flows being
known,
there is no confusion about what the present value of each future cash flow should be.
Concept Clarifier – Compounding & Discounting

Suppose an investor invests Rs.100 (initial investment) in a bank FD @ 8% for 10 years,

then to calculate the amount that he will receive after 10 years, we will use the
compound interest formula given below –

A = P * (1 + r)t

Substituting P = 100, r = 8% and t = 10 years, we get the value for A as Rs.

215.89. This process is known as compounding.

Instead of calculating the final amount after 10 years, if the investor says he needs
Rs.215.89 after 10 years and we know that a bank FD is offering 8% per annum, we
need to calculate how much money he should invest today to reach a value of Rs.
215.89 after 10 years.

Again we use the same formula, but slightly tweaked. Here we solve for P (initial
investment), as against for A in the previous example.

P = A / (1 + r)t

Substituting A = 215.89, r = 8% and t = 10 years, we can find the value of P as Rs. 100.

42
This process is the exact opposite of compounding and this is known as discounting. This
is the process used in bond markets to find the price of a bond. We add the present
values (PV) of all future cash flows to arrive at the price of the bond. The r is
substituted by the Yield To Maturity (YTM) while calculating the PV of bond’s future cash
flows.

An important factor in bond pricing is the Yield to Maturity (YTM ). This is rate applied to
the future cash flow (coupon payment) to arrive at its present value. If the YTM increases,
the present value of the cash flows will go down. This is obvious as the YTM appears in the
denominator of the formula, and we know as the denominator increases, the value of the
ratio goes down. So here as well, as the YTM increases, the present value falls.

Concept Clarifier – YTM

 Yield To Maturity (YTM) is that rate which the investor will receive in
case: 1. He holds a bond till maturity and

2. He reinvests the coupons at the same rate

It is a measure of the return of the bond. Yield to maturity is essentially a way to

measure the total amount of money one would make on a bond, but instead of
expressing that figure as a Rupee amount, it is expressed as a percentage—an annual
rate of return. For example, Company - ABC International Ltd.:
1. Bond purchased for Rs.950. Coupon rate 8%. Bond maturity 3 years 2. Its par value
(the amount the issuer will refund you when the bond reaches maturity) is Rs.1000.
3. Current earning = Rs.50 (Rs.1000 – Rs.950).
4. The coupon rate is the annual interest rate paid yearly by the issuer.

The YTM is calculated as follows:

Dates Cash flows

1-Jan-10 (950)

31-Dec-10 80

31-Dec-11 80

31-Dec-12 1080

YTM 10.01%

The above has been computed by using XIRR formula is MS Excel.

In the explanation for compounding, we have assumed that the interest earned after 1
year, gets reinvested in the FD for the remaining 9 years @ 8%. Similarly the interest
earned after 2 years (Interest on the initial investment plus the interest earned on the
interest reinvested after 1 year) is again reinvested in the FD at the same rate of 8% for
the remaining 8 years, and so on. The second point mentioned above means exactly
this.

43
This may be true for bank FDs, where we get the benefit of cumulative interest,
however, for bonds; the coupon (interest income) is a cash outflow every year and not
a reinvestment as in case of FDs. So there is no reinvestment here. Even if the investor
receives the coupon as a cash outflow, and intends to reinvest the same, there is no
guarantee that for 10 years he will be able to reinvest the coupon, each year @ 8%.

Thus, YTM is based upon some assumptions (i.e. you will be reinvesting the interest
earned at the coupon rate), which may not always be true. In spite of its shortcomings,
YTM is an important indicator to know the total return from a bond.

As mentioned earlier, price of a bond is the present value of future cash flows. Thus if all the
present values go down (due to increase in YTM), then their sum will also go down.

This brings us to an important relation – As interest rates go up, bond prices come
down. Let us try and understand this!

Let us say a bond is issued with a term to maturity of 3 years, coupon of 8% and face value
of Rs.100. Obviously, the prevailing interest rates during that time have to be around 8%. If
the prevailing rates are higher, investors will not invest in a 8% coupon bearing bond, and if
rates are lower, the issuer will not issue a bond with 8% coupon, as a higher coupon means
higher interest payments for the issuer.

The cash flows for the bond and the Present Values (PVs) of these cash flows are as given
below –

@ 8 % discounting Year 0 Year 1 Year 2 Year 3

Pays 100

Present Value of To
Rs.8 : Rs.7.41 Receive
Rs.8

Present Value of To
Rs.8 : Rs.6.86 Receive
Rs.8

Present Value of To
Rs.108 : Rs. 85.73 Receive
Rs.108

Price = 7.41 + 6.86 + 85.73 = 100 (This is the Present Value of all the future
cash flows in Year 1, Year 2 and Year 3)

By using the discounting formula we can find the PVs of all the 3 cash flows. The investor
will get Rs.8 as interest payment each year, whereas in the final year, the investor will also
get the Rs.100 principal back (along with Rs.8 as the last interest). Here we will use 8% as
the rate of discounting. This means that the investor will have to invest Rs.7.41 today @ 8%
per annum for the next 1 year to get Rs.8. Similarly, he will have to invest Rs.6.86 today @
8% per annum for the next 2 years to get Rs.8 after 2 years and finally he will have to invest
Rs.85.73 @ 8% per annum for the next 3 years to get Rs. 108 after 3 years.

Adding all the PVs, we get the CMP of the bond as Rs.100. (in this example we assume
interest rates prevalent in the market have remained at 8% and investors are happy earning
8% by investing in this bond).

44
Now, if interest rates in the market rise immediately to 9% after the bond is issued, we will
have to use 9% as the rate of discounting (investors would like to earn 9% from this bond).
In that case the cash flows and their PVs will be :

@ 9% discounting Year 0 Year 1 Year 2 Year 3

Pays Rs. 97.47

Present Value of Rs. To

8 : Rs. 7.34 Receive
Rs.8

Present Value of Rs. To

8 : Rs. 6.73 Receive
 Rs.8

Present Value of Rs. To

8 : Rs. 83.40 Receive
Rs.108

Price = 7.34 + 6.73 + 83.40 = 97.47 (This is the Present Value of all the
future cash flows in Year 1, Year 2 and Year 3)

As can be seen, the investor will invest less today, i.e. the price of the bond will go down as
the interest rates in the markets have increased. When interest rates rise in the economy, it
does not translate into the coupon rate changing. As can be seen here, the investor will
continue to get Rs.8; i.e. 8% of the FV of Rs.100. However, he will try to earn 9% return by
adjusting his initial investment. The bond price in the market will therefore fall as the
interest rates in the market goes up. Thus we can say that bond prices and interest
rates move in opposite directions.

Relationship between interest rates and debt mutual fund schemes : As interest
rates fall, the NAV of debt mutual funds rise, since the prices of the debt
instruments the mutual fund is holding rises.

As interest rates rise, the NAV of debt mutual funds fall, since the prices of the
debt instruments the mutual fund is holding falls.

Therefore it is paramount to consider interest rate movements and security

maturity prior to investing in any debt instrument.

4.5 DEBT MUTUAL FUND SCHEMES

4.5.1 Fixed Maturity Plans (FMP)

FMPs have become very popular in the past few years. FMPs are essentially close ended debt
schemes. The money received by the scheme is used by the fund managers to buy debt
securities with maturities coinciding with the maturity of the scheme. There is no rule which
stops the fund manager from selling these securities earlier, but typically fund managers
avoid it and hold on to the debt papers till maturity. Investors must look at the portfolio of
FMPs before investing. If an FMP is giving a relatively higher ‘indicative yield’, it may be
investing in slightly riskier securities. Thus investors must assess the risk level of the
portfolio by looking at the credit ratings of the securities. Indicative yield is the return which
investors can expect from the FMP. Regulations do not allow mutual funds to guarantee
returns, hence mutual funds give investors an idea of what returns can they expect from

45
the fund. An important point to note here is that indicative yields are pre-tax. Investors will
get lesser returns after they include the tax liability.

4.5.2 Capital Protection Funds

These are close ended funds which invest in debt as well as equity or derivatives. The
scheme invests some portion of investor’s money in debt instruments, with the objective of
capital protection. The remaining portion gets invested in equities or derivatives instruments
like options. This component of investment provides the higher return potential. It is beyond
the scope of this book to explain how Options work. For that you may need to refer to NCFM
modules ‘Financial Markets: A Beginners’ Module’ or ‘Derivatives Markets (Dealers) module’.
It is important to note here that although the name suggests ‘Capital Protection’, there is no
guarantee that at all times the investor’s capital will be fully protected.

4.5.3 Gilt Funds

These are those funds which invest only in securities issued by the Government. This can be
the Central Govt. or even State Govts. Gilt funds are safe to the extent that they do not
carry any Credit Risk. However, it must be noted that even if one invests in Government
Securities, interest rate risk always remains.

4.5.4 Balanced Funds

These are funds which invest in debt as well as equity instruments. These are also known as
hybrid funds. Balanced does not necessarily mean 50:50 ratio between debt and equity.
There can be schemes like MIPs or Children benefit plans which are predominantly debt
oriented but have some equity exposure as well. From taxation point of view, it is important
to note how much portion of money is invested in equities and how much in debt. This point
is dealt with in greater detail in the chapter on Taxation.

4.5.5 MIPs

Monthly Income Plans (MIPs) are hybrid funds; i.e. they invest in debt papers as well as
equities. Investors who want a regular income stream invest in these schemes. The objective
of these schemes is to provide regular income to the investor by paying dividends; however,
there is no guarantee that these schemes will pay dividends every month. Investment in the
debt portion provides for the monthly income whereas investment in the equities provides
for the extra return which is helpful in minimising the impact of inflation.

4.5.6 Child Benefit Plans

These are debt oriented funds, with very little component invested into equities. The
objective here is to capital protection and steady appreciation as well. Parents can invest in
these schemes with a 5 – 15 year horizon, so that they have adequate money when their
children need it for meeting expenses related to higher education.

46
4.6 POINTS TO REMEMBER
Debt funds are funds which invest money in debt instruments such as short and long term
bonds, government securities, t-bills, corporate paper, commercial paper, call money etc.

Any debt paper will have Face Value, Coupon and Maturity as its standard characteristics.

Interest rates can either be fixed or floating.

The interest rate risk be reduced by adjusting the maturity of the debt fund portfolio.

Credit Risk or Risk of Default refers to the situation where the borrower fails to honour
either one or both of his obligations of paying regular interest and returning the principal on
maturity.

The price of an instrument (equity / bond) is nothing but the present value of the future
cash flows.

An important factor in bond pricing is the Yield to Maturity (YTM ). This is rate applied to the
future cash flow (coupon payment) to arrive at its present value.

An important relation to remember is that: As interest rates go up, bond prices come down.

Fixed Maturity Plans are essentially close ended debt schemes. The money received by the
scheme is used by the fund managers to buy debt securities with maturities coinciding with
the maturity of the scheme.

Capital protection funds are close ended funds which invest in debt as well as equity or
derivatives.

Balanced funds invest in debt as well as equity instruments. These are also known as hybrid
funds.

Monthly Income Plans (MIPs) are also hybrid funds; i.e. they invest in debt papers as well
as equities. Investors who want a regular income stream invest in these schemes.

Child Benefit Plans are debt oriented funds, with very little component invested into equities.
The objective here is to capital protection and steady appreciation as well.

47
CHAPTER 5 : LIQUID FUNDS

5.1 SALIENT FEATURES

Liquid funds carry an important position as an investment option for individuals and
corporates to park their short term liquidity. y Corporates can get a better return that they
would in a bank account for a relatively acceptable level of risk.

Concept Clarifier – Money Markets

 Term to maturity of a debt paper is one of the most important characteristic of a debt
paper. Debt papers can have term to maturity of as high as 20 years and more or as
low as 90 days and less. The market for short term paper; i.e. paper with less than 1
year maturity attracts numerous participants , volumes and money. This is because the
demand for short term money by corporates, financial institutions and Government is
huge. At the same time, there is a class of investors with which there is an availability of
short term funds.
Due to this constant demand and ready investors, the volumes in trades of this short
term paper have increased so much that this segment is classified as a separate
segment in the debt markets and is known as Money Markets.
Money Market refers to that part of the debt market where paper with with a short
term maturity1 year is traded. Commercial Papers, Certificate of Deposits, Treasury
Bills, Collateralised Borrowing & Lending Obligations (CBLOs), Interest Rate Swaps
(IRS), etc. are the instruments which comprise this market.

Liquid mutual funds are schemes that make investments in debt and money market
securities with maturity of up to 91 days only.

In case of liquid mutual funds cut off time for receipt of funds is an important consideration.
As per SEBI guidelines the following cut-off timings shall be observed by a mutual fund in
respect of purchase of units in liquid fund schemes and the following NAVs shall be applied
for such purchase:
• where the application is received up to 2.00 p.m. on a day and funds are available for
utilization before the cut-off time without availing any credit facility, whether, intra-day
or otherwise – the closing NAV of the day immediately preceding the day of receipt of
application
• where the application is received after 2.00 p.m. on a day and funds are available for
utilization on the same day without availing any credit facility, whether, intra-day or
otherwise – the closing NAV of the day immediately preceding the next business day
• irrespective of the time of receipt of application, where the funds are not available for
utilization before the cut-off time without availing any credit facility, whether, intra-day
or otherwise – the closing NAV of the day immediately preceding the day on which the
funds are available for utilization.
This is relevant since corporates park their daily excess cash balances with liquid funds.

48
5.2 VALUATION OF SECURITIES
1) All money market and debt securities, including floating rate securities, with residual
maturity of up to 60 days shall be valued at the weighted average price at which they
are traded on the particular valuation day. When such securities are not traded on a
particular valuation day they shall be valued on amortization basis.
2) All money market and debt securities, including floating rate securities, with residual
maturity of over 60 days shall be valued at weighted average price at which they are
traded on the particular valuation day. When such securities are not traded on a
particular valuation day they shall be valued at benchmark yield/ matrix of spread over
risk free benchmark yield obtained from agency(ies) entrusted for the said purpose by
 AMFI.
3) The approach in valuation of non traded debt securities is based on the concept of using
spreads over the benchmark rate to arrive at the yields for pricing the non traded
security.
a. A Risk Free Benchmark Yield is built using the government securities as the base. b. A
Matrix of spreads (based on the credit risk) are built for marking up the benchmark
yields.
c. The yields as calculated above are Marked up/Marked-down for ill-liquidity risk d.
The Yields so arrived are used to price the portfolio.

Concept Clarifier – Interest accrual

Suppose a 90 Day Commercial Paper is issued by a corporate at Rs. 91. The paper will
redeem at Rs. 100 on maturity; i.e. after 90 days. This means that the investor will earn
100 – 91 = Rs. 9 as interest over the 90 day period. This translates into a daily earning
of 9/ 90 = Rs. 0.10 per day. (assuming zero coupon)

It is important to note here that although we said that the investor will earn 10 paise
every day, there is no cash flow coming to the investor. This means that the interest is
only getting accrued.

Now if the investor wishes to sell this paper after 35 days in the secondary market, what
should be the price at which he should sell? Here we add the total accrued interest to
the cost of buying and calculate the current book value of the CP. Since we are adding
interest accrued to the cost, this method is known as Cost Plus Interest Accrued
Method.

If 10 paise get accrued each day, then in 35 days, 35 * 0.10 = Rs. 3.5 have got accrued.

The cost of the investor was Rs. 91 and Rs. 3.5 have got accrued as interest, so the
current book value is 91 + 3.5 = Rs. 94.5

5.3 FLOATING RATE SCHEME

These are schemes where the debt paper has a Coupon which keeps changing as per the
changes in the interest rates. Thus there is no price risk involved in such paper. We know
when rates go up, bond prices go down. However, if the rates increase and so also the
coupon changes and increases to the level of the interest rates, there is no reason for the

49
price of the paper to fall, as the investor is compensated by getting higher coupon, in line
with the on going market interest rates. Investors prefer Floating Rate funds in a rising
interest rate scenario.

5.4 WHAT IS PORTFOLIO CHURNING IN LIQUID FUNDS?

A liquid fund will constantly change its portfolio. This is because the paper which it invests in
is extremely short term in nature. Regularly some papers would be maturing and the
scheme will get the cash back. The fund manager will use this cash to buy new securities
and hence the portfolio will keep changing constantly. As can be understood from this,
Liquid Funds will have an extremely high portfolio turnover.
Liquid Funds see a lot of inflows and outflows on a daily basis. The very nature of such
schemes is that money is parked for extremely short term. Also, investors opt for options
like daily or weekly dividend. All this would mean, the back end activity for a liquid fund
must be quite hectic – due to the large sizes of the transactions and also due to the large
volumes.

As in equities, we have different index for Large caps, Midcaps & Small caps, similarly in
bonds we have indices depending upon the maturity profile of the

constituent bonds. These indices are published by CRISIL e.g. CRISIL long term bond index,
CRISIL liquid fund index etc.

5.5 STRESS TESTING OF ASSETS1

It is important for mutual funds to ensure sound risk management practices are applied to
ensure that the portfolio of liquid funds and money market funds is sound and any early
warnings can be identified:
• AMCs should have stress testing policy in place which mandates them to conduct stress
test on all Liquid Fund and MMMF Schemes. The stress test should be carried out
internally at least on a monthly basis, and if the market conditions require so, AMC
should conduct more frequent stress test.
• The concerned schemes shall be tested on the following risk parameters, among others
deemed necessary by the AMC:
• Interest rate risk
• Credit risk
• Liquidity & Redemption risk
• While conducting stress test, it will be required to evaluate impact of the various risk
parameters on the scheme and it’s Net Asset Value (NAV). The parameters used and the
methodology adopted for conducting stress test on such type of scheme, should be detailed
in the stress testing policy, which is required to be approved by the Board of AMC. • This
policy should be reviewed by the Board of the AMC and Trustees.

1
CIR/IMD/DF/03/2015 April 30, 2015

50
5.6 POINTS TO REMEMBER
Liquid funds carry an important position as an investment option for individuals and
corporates to park their short term liquidity.

Liquid mutual funds are schemes that make investments in debt and money market
securities with maturity of up to 91 days only.

In case of liquid mutual funds cut off time for receipt of funds is an important consideration.

Valuation of securities is done by various methods as enumerated above in the chapter.

Floating Rate Schemes are schemes where the debt paper has a Coupon which keeps
changing as per the changes in the interest rates.

Portoflio churning in liquid schemes happens more often due the short term nature of
securities invested in.
It is important for mutual funds to ensure sound risk management practices are applied to
ensure that the portfolio of liquid funds and money market funds is sound and any early
warnings can be identified

51
CHAPTER 6 : TAXATION

Taxation in case of Mutual Funds must be understood, primarily, from Capital

Gains, Securities Transaction Tax (STT) and Dividends point of view. Tax rules differ for
equity and debt schemes and also for Individuals, NRIs, OCBs and corporates.

Investors also get benefit under section 80C of the Income Tax Act if they invest in a special
type of equity scheme, namely, Equity Linked Savings Scheme.

6.1 CAPITAL GAINS TAXATION

1. Equity mutual funds
Long Term Capital Gains (More than 12 0%
months holding period)

Short Term Capital Gains 15% basic tax plus surcharge

(Less than or equal to 12 months holding period) plus other cess that may be
applicable
To understand Capital Gains Taxation, definitions of equity and debt schemes must be
understood; similarly difference between Long Term and Short Term must also be
understood.

1. Equity schemes
• As per SEBI Regulations, any scheme which has minimum 65% of its average weekly
net assets invested in Indian equities, is an equity scheme.
• If the mutual fund units of an equity scheme are sold / redeemed / repurchased after 12
months, the profit is exempt.
• However if units are sold before 12 months it results in short term capital gain. The
investor has to pay 15% as short term capital gains tax.
• While exiting the scheme, the investor will have to bear a Securities Transaction Tax (STT)
@ 0.001% of the value of selling price.

Investors in all other schemes have to pay capital gains tax, either short term or long term.
In case a scheme invests 100% in foreign equities, then such a scheme is not considered to
be an equity scheme from taxation angle and the investor has to pay tax even on the long
term capital gains made from such a scheme.

2. Mutual fund schemes (other than equity) i.e. debt funds, liquid schemes, gold
ETF, short term bond funds etc.

All other funds (other than equity)

Long Term Capital Gains Residents – 20% with indexation benefit

(More than 3 6 months holding period)
FII – 10% without indexation benefit

Short Term Capital Gains Marginal Rate of Tax

(Less than or equal to 36 months Profit added to income
holding period)

52
• In case such units are sold within 36 months, the gain is treated as short term capital
gains. The same is added to the income of the tax payer and is taxed as per the
applicable tax slab including applicable surcharge and cess depending on the status
of the tax payer. This is known as taxation at the marginal rate.
• Long term capital gains arise when the units are sold beyond 36 months. Here the
taxation rules are
o For resident investor - 20% (plus surcharge and cess as applicable) (with indexation)
o For FII - 10% basic tax (plus surcharge and cess as applicable) on long term capital gains
(without indexation)

6.2 INDEXATION BENEFIT

Indexation is a procedure by which the investor can get benefit from the fact that inflation
has eroded his returns.

Indexation works on the simple concept that if an investor buys a unit @ Rs. 10 and sells it
@ Rs. 30 after 5 years, then his profit of Rs. 20 per unit needs to be adjusted for the
inflation increase during the same time period. This is because inflation reduces purchasing
power. What Rs. 100 could have bought when he bought the unit @ Rs.10, would now have
increased in price due to inflation. Thus he can now buy less for the same Rs. 100.

If during the same time, inflation has increased by 12%, then the adjusted cost of the unit
purchased (at today’s price) would be Rs. 10 * (1 + 12%) = Rs. 11.2.

So his profit would not be Rs. 20, but Rs. 30 – Rs. 11.2 = Rs. 18.8.

The cost inflation index is notified by the Central Government (form 1981 up to 2015-16).
The same is used by the tax payer for calculating long term capital gains.

Example

An investor purchased mutual fund units in January 2006 of Rs.10,000. The same was sold
in the previous year for Rs.25,000. Long term capital gains applicable is as follows: ✔ FII -
Without availing indexation benefit - Pay 10% on Rs,15,000 (Rs.25000 – Rs.10,000) =
Rs.1,500

✔ Resident - Calculate indexed cost of acquisition (Rs.10,000 X 1081/ 497) = Rs.21,751,

Capital gains = Rs.25,000 – Rs.21,751 = Rs.3,249, Tax@20% on Rs.3249 = Rs.650

6.3 DIVIDEND DISTRIBUTION TAX

The dividend declared by mutual funds in respect of the various schemes is exempt from tax
in the hands of investors. In case of debt mutual funds, the AMCs are required to pay
Dividend Distribution Tax (DDT) from the distributable income. This ensures ease in tax
collection. However, in case of equity funds no DDT is payable.

53
The rates for DDT are as follows:
✔ For individuals and HUF – 25% (plus surcharge and other cess as applicable)
✔ For others – 30% (plus surcharge and other cess as applicable)

✔ On dividend distributed to a non-resident or to a foreign company by an Infrastructure

Debt Fund – 5% (plus surcharge and other cess as applicable)

6.4 WHY FMPS ARE POPULAR?

A fixed maturity plan is a close ended debt fund for a specified period. The maturity of the
papers invested in is matched with the duration of the plan.

Consider a case where Investor A invests Rs.100,000 in a bank fixed deposit @9%
for 3 years and Investor B invests Rs.100,000 in a 3 year FMP. The indicative yield
of the FMP is assumed also to be at 9%. We shall analyze the tax benefit of
investing in an FMP.

For Investor A, the interest income per annum is 100,000 X 9% = Rs.9,000. Each year the
investor would have to pay tax of Rs.2,700 (30%, assuming he is taxed at the maximum
marginal rate). Total tax payable in 3 years is Rs.8,100.

For Investor B, since the investment is over 36 months, it would qualify as long term capital
gains.
When the investor entered the fund, the cost inflation index was at 939 and when he exited
at maturity the cost inflation index had risen to 1081.

Thus the new indexed cost of acquisition will become Rs.100,000 X 1081/939 = Rs.115,122

Now the profit will be equal to 115,122 – 100,000 = Rs.15,122

Since we have taken the benefit of indexation, the applicable tax rate will be 20%,
(surcharge / cess excluded for calculation)

So the tax payable will be equal to 15,122 * 20% = Rs.3,024.

The point to be observed here is that FMP is giving a higher return (post tax) as compared
to a bank FD. This is true only if the investor is in the 30% tax bracket.

However Bank fixed deposit offer premature withdrawal facility; hence they offer better
liquidity as compared to FMP.

Under section 10(23D) of the Income tax Act, 1961, income earned by a Mutual Fund
registered with SEBI is exempt from income tax.

6.5 POINTS TO REMEMBERS

Taxation in case of Mutual Funds must be understood, primarily, from Capital

Gains, Securities Transaction Tax (STT) and Dividends point of view. Tax rules differ for
equity and debt schemes and also for Individuals, NRIs, OCBs and corporates.

54
Investors also get benefit under section 80C of the Income Tax Act if they invest in a special
type of equity scheme, namely, Equity Linked Savings Scheme.

Capital gains tax must be paid on all mutual fund schemes except equity schemes.

Indexation is a procedure by which the investor can get benefit from the fact that inflation
has eroded his returns.

The dividend declared by mutual funds in respect of the various schemes is exempt from tax
in the hands of investors. In case of debt mutual funds, the AMCs are required to pay
Dividend Distribution Tax (DDT) from the distributable income.
 55
CHAPTER 7 : REGULATIONS

7.1 OVERVIEW
Regulations ensure that schemes do not invest beyond a certain percent of their NAVs in a
single security. Some of the guidelines regarding these are given below: ⬥ No scheme can
invest more than 10% of its NAV in rated debt instruments of a single
issuer wherein the limit is reduced to 10% of NAV which may be extended to 12% of
NAV with the prior approval of the Board of Trustees and the Board of Asset Management
Company.2
⬥ No scheme can invest more than 10% of its NAV in unrated paper of a single issuer and
total investment by any scheme in unrated papers cannot exceed 25% of the NAV. ⬥ No
mutual fund scheme shall invest more than 30% in money market instruments of an issuer:
Provided that such limit shall not be applicable for investments in Government securities,
treasury bills and collateralized borrowing and lending obligations. ⬥ No fund, under all its
schemes can hold more than 10% of company’s paid up capital carrying voting rights.

⬥ No scheme can invest more than 10% of its NAV in equity shares or equity related
instruments of any company of a single company. Provided that, the limit of 10% shall
not be applicable for investments in case of index fund or sector or industry specific
scheme.
⬥ If a scheme invests in another scheme of the same or different AMC, no fees will be
charged. Aggregate inter scheme investment cannot exceed 5% of net asset value of
the mutual fund.
⬥ No scheme can invest in unlisted securities of its sponsor or its group entities. ⬥ Schemes
can invest in unlisted securities issued by entities other than the sponsor or sponsor’s
group. Open ended schemes can invest maximum of 5% of net assets in such securities
whereas close ended schemes can invest upto 10% of net assets in such securities.
⬥ Schemes cannot invest in listed entities belonging to the sponsor group beyond 25% of its
net assets.
⬥ Total exposure of debt schemes of mutual funds in a particular sector (excluding
investments in Bank CDs, CBLO, G-Secs, T Bills, short term deposits of scheduled
commercial banks and AAA rated securities issued by Public Financial Institutions and
Public Sector Banks) shall not exceed 25% of the net assets of the scheme. An additional
exposure to financial services sector not exceeding 5% of the net assets of the scheme
shall be allowed only by way of increase in exposure to Housing Finance Companies
(HFCs) for HFCs rated AA and above and registered with National Housing Bank (NHB).

2
SEBI/HO/IMD/DF2/CIR/P/2016/35

56
⬥ Total exposure of debt schemes of mutual funds in a group (excluding investments in
securities issued by Public Sector) shall not exceed 20% of the net assets of the scheme.
Such investment limit may be extended to 25% of the net assets of the scheme with the
prior approval of the Board of Trustees. 3

There are many other mutual fund regulations which are beyond the purview of this module.
Candidates are requested to refer to AMFI-Mutual Fund (Advisors) Module for more
information.

7.2 WHAT IS THE NAME OF INDUSTRY ASSOCIATION FOR THE

MUTUAL FUND INDUSTRY?
AMFI (Association of Mutual Funds in India) is the industry association for the mutual fund
industry in India which was incorporated in the year 1995.

7.3 WHAT ARE THE OBJECTIVES OF AMFI?

The Principal objectives of AMFI are to:

1) Promote the interests of the mutual funds and unit holders and interact with regulators
SEBI/RBI/Govt./Regulators.

2) To set and maintain ethical, commercial and professional standards in the industry and to
 recommend and promote best business practices and code of conduct to be followed by
members and others engaged in the activities of mutual fund and asset management.

3) To increase public awareness and understanding of the concept and working of mutual
funds in the country, to undertake investor awareness programmes and to disseminate
information on the mutual fund industry.

4) To develop a cadre of well trained distributors and to implement a programme of training

and certification for all intermediaries and others engaged in the industry.

7.4 PRODUCT LABELLING IN MUTUAL FUNDS – RISKOMETER4

The product labeling in mutual funds shall be based on the level of risk which shall be as
under:

• Low- principal at low risk

• Moderately Low - principal at moderately low risk

• Moderate - principal at moderate risk

• Moderately High - principal at moderately high risk

• High - principal at high risk

There shall be pictorial depiction of risk named ‘riskometer’ which shall appropriately depict
the level of risk in any scheme.

3
SEBI/HO/IMD/DF2/CIR/P/2016/35 February 15, 2016
4
CIR/IMD/DF/4/2015 April 30, 2015

57
The following depicts a scheme having moderate risk

Mutual funds may ‘product label’ their schemes on the basis of the best practice guidelines
issued by Association of Mutual Funds in India (AMFI) in this regard.

7.5 ADVANTAGES OF MUTUAL FUNDS

• Mutual Funds give investors best of both the worlds. Investor’s money is managed by
professional fund managers and the money is deployed in a diversified portfolio. Retail
investors cannot buy a diversified portfolio for say Rs.5000, but if they invest in a mutual
fund, they can own such a portfolio. Mutual Funds help to reap the benefit of returns by
a portfolio spread across a wide spectrum of companies with small investments.
• Investors may not have resources at their disposal to do detailed analysis of companies.
Time is a big constraint and they may not have the expertise to read and analyze
balance sheets, annual reports, research reports etc. A mutual fund does this for
investors as fund managers, assisted by a team of research analysts, scan this data
regularly.
• Investors can enter / exit schemes anytime they want (at least in open ended schemes).
They can invest in an SIP, where every month, a stipulated amount automatically goes
out of their savings account into a scheme of their choice. Such hassle free arrangement
is not always easy in case of direct investing in shares.
• There may be a situation where an investor holds some shares, but cannot exit the same
as there are no buyers in the market. Such a problem of illiquidity generally does not
exist in case of mutual funds, as the investor can redeem his units by approaching the
mutual fund.
• As more and more AMCs come in the market, investors will continue to get newer
products and competition will ensure that costs are kept at a minimum. Initially mutual
fund schemes could invest only in debt and equities. Then they were allowed to invest in
derivative instruments. Gold ETFs were introduced, investing in international securities
was allowed and recently real estate mutual funds where also in the process of being
cleared. We may one day have commodity mutual funds or other exotic asset classes
oriented funds. Thus it is in investor’s best interest if they are aware of the nitty gritties
of MFs.

58
• Investors can either invest with the objective of getting capital appreciation or regular
dividends. Young investors who are having a steady regular monthly income would
prefer to invest for the long term to meet various goals and thus opt for capital
appreciation (growth or dividend reinvestment options), whereas retired individuals,
who have with them a kitty and would need a monthly income would like to invest with
the objective of getting a regular income . This can be achieved by investing in debt
oriented schemes and opting for dividend payout option. Mutual funds are therefore for
all kinds of investors.
• An investor with limited funds might be able to invest in only one or two stocks / bonds,
thus increasing his / her risk. However, a mutual fund will spread its risk by investing in
a number of sound stocks or bonds. A fund normally invests in companies across a wide
range of industries, so the risk is diversified.
• Mutual Funds regularly provide investors with information on the value of their
investments. Mutual Funds also provide complete portfolio disclosure of the investments
made by various schemes and also the proportion invested in each asset type.
• Mutual Funds offer investors a wide variety to choose from. An investor can pick up a
scheme depending upon his risk/ return profile.
• All the Mutual Funds are registered with SEBI and they function within the provisions of
strict regulation designed to protect the interests of the investor.

7.6 WHAT IS A SYSTEMATIC INVESTMENT PLAN (SIP)?

The above chart shows how the NAV of a scheme has moved in a given year. There was no
way the investor could have known that in May the peak will be formed, after which the NAV
will slide for the rest of the year. The investor, by deciding to invest Rs.5000 regularly each
month automatically got the benefit of the swings. As can be seen, he got least number of
units in the months of Mar, Apr and May, whereas w hen the NAV continued its downward
journey subsequently, he accumulated higher number of units.

This is the benefit of disciplined investing. Many a times it is seen that in bear markets,
when the NAVs are at their rock bottom, investor are gripped by panic and either stop their
SIPs or worse, sell their units at a loss. Due to the in-built mechanism of SIP, investors
average cost reduces as can be seen from the chart below:

59
Averaging works both ways. Thus, when the NAV moves sharply in either direction, the
impact of averaging is clearly witnessed as the change in average cost for the investor is
only marginal.

Here it can be seen that although the NAV has swung in a range of Rs.80 to Rs.140, the
average cost for the investor has remained in the narrow range of Rs.100 to Rs.120. This is
the impact of averaging.

As can be seen, SIP helps in averaging cost of acquiring units; however STP can prove to be
even better than SIP.

There are a small section of investors like domestic staff, drivers and other employees
earning low incomes and who may not have PAN cards or other documentation required for
investing in mutual funds. They are advised by their employers to invest in SIPS. SEBI, in
order to facilitate their investments, has withdrawn the requirement of PAN for SIPs where
investments are not over Rs.50,000/- in a financial year. Such installments are called micro
SIPs.

7.7 WHAT IS SYSTEMATIC TRANSFER PLAN (STP)?

In SIP investor’s money moves out of his savings account into the scheme of his choice.
Let’s say an investor has decided to invest Rs 5,000 every month, such that Rs. 1,000 gets
invested on the 5th, 10th, 15th, 20th and 25th of the month. This means that the Rs.5000,
which will get invested in stages till 25th will remain in the savings account of the investor
for 25 days and earn interest @ 4-6%, depending on the bank.

If the investor moves this amount of Rs.5000 at the beginning of the month to a Liquid Fund
and transfers Rs.1000 on the given dates to the scheme of his choice, then not only will he
get the benefit of SIP, but he will earn slightly higher interest as well in the Liquid Funds as
compared to a bank FD. As the money is being invested in a Liquid Fund, the risk level
associated is also minimal. Add to this the fact that liquid funds do not have any e xit loads.
This is known as STP.

60
7.8 WHAT IS SYSTEMATIC WITHDRAWAL PLAN (SWP)?
SWP stands for Systematic Withdrawal Plan. Here the investor invests a lump sum amount
and withdraws some money regularly over a period of time. This results in a steady income
for the investor while at the same time his principal also gets drawn down gradually.

Say for example an investor aged 60 years receives Rs.20 lakh at retirement. If he wants to
use this money over a 20 year period, he can withdraw Rs. 20,00,000/ 20 = Rs.1,00,000
per annum. This translates into Rs.8,333 per month. (The investor will also get return on his
investment of Rs.20 lakh, depending on where the money has been invested by the mutual
fund). In this example we have not considered the effect of compounding. If that is
considered, then he will be able to either draw some more money every month, or he can
get the same amount of Rs.8,333 per month for a longer period of time.

The conceptual difference between SWP and MIP is that SWP is an investment style whereas
MIP is a type of scheme. In SWP the investor’s capital goes down whereas in MIP, the capital
is not touched and only the interest is paid to the investor as dividend.

7.9 CHOOSING BETWEEN DIVIDEND PAYOUT, DIVIDEND

REINVESTMENT AND GROWTH OPTIONS – WHICH ONE IS
BETTER FOR THE INVESTOR?
Investors often get confused between the above mentioned (Dividend Payout, Dividend
Reinvestment and Growth Options) three options which he has to choose while investing in
mutual fund’s units. These options have to be selected by the investor at the time of
purchasing the units and many a times investors feel that the dividend reinvestment option
is better than growth as they get more number of units. Let’s understand the three options :

7.9.1 Growth Option

Growth option is for those investors who are looking for capital appreciation. Say an investor
aged 25 invests Rs.1 lakh in an equity scheme. He would not be requiring a regular income
from his investment as his salary can be used for meeting his monthly expenses. He would
instead want his money to grow and this can happen only if he remains invested for a long
period of time. Such an investor should go for Growth option. The NAV will fluctuate as the
market moves. So if the scheme delivers a return of 12% after 1 year, his money would have
grown by Rs.12,000. Assuming that he had invested at a NAV of Rs.100, then after 1 year
the NAV would have grown to Rs.112.

Notice here that neither is any money coming out of the scheme, nor is the investor getting
more units. His units will remain at 1,000 (1,00,000/ 100) which he bought when he
invested Rs.1 lakh @ Rs. 100/ unit.

7.9.2 Dividend Payout Option

In case an investor chooses a Dividend Payout option, then after 1 year he would Receive
Rs. 12 as dividend. This results in a cash outflow from the scheme. The impact of this would
be that the NAV would fall by Rs.12 (to Rs. 100 after a year. In the growth option the NAV

61
became Rs. 112) . Here he will not get any more number of units (they remain at 1,000),
but will receive Rs.12,000 as dividend (Rs.12 per unit * 1,000 units).

Dividend Payout will not give him the benefit of compounding as Rs.12,000 would be taken
out of the scheme and will not continue to grow like money which is still invested in the
scheme.

7.9.3 Dividend Reinvestment Option

In case of Dividend Reinvestment option, the investor chooses to reinvest the dividend in
the scheme. So the Rs.12, which he receives as dividend gets invested into the scheme
again @ Rs.100. This is because after payment of dividend, the NAV would fall to Rs.100.

Thus the investor gets Rs.12,000/ Rs. 100 = 120 additional units. Notice here that although
the investor has got 120 units more, the NAV has come down to Rs.100.

Hence the return in case of all the three options would be same. For Growth Option, the
investor will have 100 units @ 112, which equals to Rs.1,12,000 while for Dividend
Reinvested Option the investor will have 1120 units @ Rs. 100 which again amounts to Rs.
1,12,000. Thus it can be seen that there is no difference in either Growth or Dividend
Reinvestment Plan.

It must be noted that for equity schemes there is no Dividend Distribution Tax, however for
debt schemes, investor will not get Rs.12 as dividend, but less due to Dividend Distribution
Tax. In case of Dividend Reinvestment Option, he will get slightly lesser number of units and
not exactly 120 to the extent of Dividend Distribution Tax.

In case of Dividend Payout option the investor will lose out on the power of compounding
from the second year onwards.

Concept Clarifier – Power of Compounding

Compound Interest refers to interest earned on interest. The formula for Compound
Interest is:

A = P *( 1 + r)t

Where,

A = Amount

P = Principal invested

r = rate of interest per annum t= Number of Years

As can be seen, the three variables that affect the final Amount are Principal, rate of
interest and time for which money is invested.

It is time which acts as the biggest determinant as it pulls up the value in an

exponential manner. Hence it is important to invest for the long term to get the benefit
of compounding.

62
7.10 POINTS TO REMEMBER
Regulations ensure that schemes do not invest beyond a certain percent of their NAVs in a
single security.

AMFI (Association of Mutual Funds in India) is the industry association for the mutual fund
industry in India which was incorporated in the year 1995.

The product labeling in mutual funds shall be based on the level of risk which is represented
pictorially.

Mutual funds have various advantages like professional management, expert fund managers,
investment through small amounts, etc.

Systematic investment plans helps the investor invest a certain sum of money every month.
This helps in regular saving as well as evens out the market differences over the period of
investment

SEBI, in order to facilitate investments in SIPS by small investors, has withdrawn the
requirement of PAN for SIPs where investments are not over Rs.50,000/- in a financial year.
Such instalments are called micro SIPs.

Transfer of funds from one mutual fund scheme to another at regular intervals is referred to
as systematic transfer plan.

In a Systematic Withdrawal Plan the investor invests a lump sum amount and withdraws
some money regularly over a period of time.

Investors must understand clearly the various options like dividend payout, dividend
reinvestment and growth options in mutual fund schemes and choose the one that helps
them achieve their goal.

63
CHAPTER 8 : PERFORMANCE EVALUATION

8.1 OVERVIEW
It is important to evaluate the performance of the mutual fund that you have invested in.
For this, you need certain benchmarks and performance evaluation methods.

Such performance can be quantified with the mathematical calculation of the historical
returns.

Risk adjusted returns

These measure the returns of the funds compared to the risk indicated over a period of time.
Suppose two funds have the same percentage of returns over a period of time, the lesser
risk funds have higher risk adjusted returns.

Benchmark

This is a stand measurement against which the fund’s returns are compared. The benchmark
helps to gauge whether how the fund has performed against the benchmark. Historical
returns of the funds will help you determine a relevant benchmark for your fund. For
example, returns of index funds are compared with the performance of the index.

Relative Performance with peers

How do mutual funds of the same category compare? Funds of the same category are
compared and their returns judged based on the returns fund to see how each fund is
performing.

Quality of stocks in the portfolio

If the fund has better quality stocks in its portfolio, it has an ability to get better returns on
capital invested. If returns are better, performance is better.

Track record and competence of the fund manager

The fund manager is the person who makes investment decisions and stock selection in the
portfolio. The best way to do this is to track past performance.

8.2 COLOR CODING AND PRODUCT LABELLING IN MUTUAL FUNDS

Color coding and product labelling is the framework issued by SEBI to all Mutual Funds,
effective from 1 July 2013. This mandates all mutual funds to label their products and
provide a color coding in their Key Information Memorandum (KIM), Scheme Information
Documents (SIDs), common application forms and all sorts of advertisements & marketing
materials; so that they are prominently visible to investors. A short one-line description on
the objective of the scheme, the nature of the scheme, the kind of instruments it will invest
in and the risk levels should form part of the color code labels. The color codes are as
follows:

64
Brown Color: Brown color indicates a high risk product. All equity funds such as diversified
funds, sectoral funds, index funds, large-cap funds and small-cap funds will carry a brown
colour code since the risk component in such schemes is high. PPFAS Long Term Value Fund
falls under this category.

Yellow Color: Yellow color would indicate medium risk. Hybrid products such as Monthly
Income Plans, balanced funds will fall under this category.

Blue Color: Blue color would indicate a low risk investment. Debt products like Fixed
Maturity Plans, short term funds, gilt funds, income funds would come under this category.

Also, product labelling mandates all Mutual Funds to label their schemes on certain
parameters. For eg: PPFAS Mutual Fund has a label entailing the investment objective of the
scheme as “To seek and generate long-term capital growth from an actively managed
portfolio primary of equity and equity related securities”.

As per the guidelines, every Mutual Fund scheme should carry a disclaimer that “Investors
should consult their financial advisers if in doubt whether this scheme is suitable for them.”

8.3 POINTS TO REMEMBER

It is important to evaluate the performance of the fund that an investor has invested in.
There are various parameters to do so. However, SEBI has also come up with a colour code
which all mutual funds are expected to implement. This gives a birds eye view of the risk of
each type of fund.

65
CHAPTER 9 : GROWTH OF ONLINE PLATFORMS
FOR MUTUAL FUNDS

9.1 NMF II
SEBI has allowed the mutual fund distributors to use the Exchange infrastructure for
facilitating mutual fund transactions for their clients. For this, NSE has developed an online
platform NMF II. This is an online platform which facilitates subscription, redemption,
Systematic Investment Plan (SIP), Systematic Withdrawal Plan (SWP), Systematic Transfer
Plan (STP), Switch and other transactions of mutual fund units.
NSE had launched the MFSS platform for facilitating mutual fund transactions by its
members. Subsequently, SEBI in October 2013 allowed use of Exchange infrastructure by
distributors. NMF II is a platform for facilitating transactions in mutual fund by distributors.
At present, MFSS and NMF II are different platforms. At a later stage, once all the key
features of MFSS are made available in NMF II, the MFSS platform may get merged into the
new NMF II.

NMF II is a web application and it can be accessed online from anywhere using a standard
internet connection.

9.2 TYPES OF TRANSACTIONS

NMF II platform supports financial transactions such as:
o Purchase (NFOs, fresh purchase, additional subscription)
o Redemptions
o Systematic Transactions
o Switch Transactions

Non-Financial information updation is facilitated for:-

o Change in Name
o Change in Address
o Change of Broker
o Change of Dividend payout option
o Change of Redemption payout option
o Change of Tax status
o Consolidation of Folios
o Lien Marked
o Lien Removed
o NFO Trades reject
o PAN Change
o Registration of nominee

66
The platform has a provision to enter details pertaining to non-financial information
updations on the platform; however the request for updations of non-financial information
along with relevant documents has to be submitted at the service centre for onward
submission to RTAs. Investor login does not have provision for updation of non-financial
information.

9.3 KYC
The investor has to be KYC compliant to be able to transact on the platform. For all new
investors with fresh KYC, for whom the KYC status is not verified or submitted (as reflected
on the KRA system which is separate from MF platform), the distributor shall do the initial
due diligence / In-person verification and upload the KYC information and supporting
scanned documents on the KRA system directly. KRA shall process the KYC application,
verify documents and provide the KYC acknowledgement to the investor. The investor will be
eligible to invest subsequent to the receipt of the KYC acknowledgement from the KRA.

NMF II supports payment of subscription amount by cheque, demand draft, online payment
through RTGS/ NEFT, internet banking and debit card.

9.4 FEATURES OF NMF II

The features available on NMF II platform are:-

o Multiple transactions through single cheque or single fund transfer. o Multiple modes
to make payment i.e. cheque, net banking, RTGS/NEFT, debit card. o Demat as well as

non demat transactions facilitated through the platform. o Access to investor KYC

through the platform.

o Real time tracking of order status.

o Sms / email intimation to the investors.

o Mail reports from RTA, facilitated on platform.

o Facility of Switch/SIP/SWP/STP available on the platform.

o Supports non- financial transactions.

9.5 BENEFITS OF NMF II TO INVESTORS

o Single consolidated view of investments done through multiple brokers / distributors. o

Single cheque for multiple investments.

o Access to the platform for online transactions.

o Single registration number on the platform.

o Reduction in risk associated with paper.

9.6 SCREEN SHOTS

Some screenshots from NMF II are provided here to see the transactions that investors can
carry out on NMF II

67
Login Screen
Single Order Entry Screen Across Multiple Schemes

68
Transaction Slip
69
Redemption Transaction

Switch Transaction

70
Systematic Registrations

Order Tracking Status

71
Portfolio Statements

Transaction Listing

72
Folio Enquiry
Product Summary Sample

9.7 NAV APPLICABILITY

The table below gives the applicability of the NAV as per cut off timings

73
9.8 CONCLUSION
NMF II is a web based online platform on NSE for the trading of mutual fund units. This has
been given to distributors of mutual funds as per SEBI directives. It has many features and
advantages to investors using the same.
 74
NCFM MODEL TEST PAPER
MUTUAL FUNDS : A BEGINNERS’ MODULE

Q:1 For anybody to start a mutual fund, relevant experience in financial services is
mandatory. [ 2 Marks ] (a) TRUE
(b) FALSE

Q:2 Mutual Funds in India follow a 3-tier structure. [2 Marks ] (a) TRUE
 (b) FALSE

Q:3 The sponsor registers the mutual fund with SEBI after forming the trust. [ 2 Marks ]

(a) FALSE
(b) TRUE

Q:4 Trustees manage investor’s money. [ 2 Marks ] (a) TRUE

(b) FALSE

Q:5 Fund managers of closed ended schemes are not allowed to churn portfolios as
frequently as open end schemes. [ 2 Marks ] (a) TRUE
(b) FALSE

Q:6 Only the physical securities are held by the Custodian. [ 2 Marks ] (a) TRUE
(b) FALSE

Q:7 The AMC cannot act as a Trustee for some other Mutual Fund. [ 2 Marks ] (a) TRUE
(b) FALSE

Q:8 Offer Document is not a legal document [ 2 Marks ] (a) TRUE

(b) FALSE

Q:9 Investors are mutual, beneficial and proportional owners of the scheme’s assets. [ 2
Marks ]
(a) TRUE
(b) FALSE

75
Q:10 Investors have a right to be informed about changes in the fundamental attributes of
a scheme. [ 2 Marks ] (a) TRUE
(b) FALSE

Q:11 A scheme with lower NAV is always better than a scheme with higher NAV. [ 2 Marks ]
(a) TRUE

(b) FALSE

Q:12 Index Funds invest in stocks comprising indices. [ 2 Marks ] (a) TRUE
(b) FALSE

Q:13 If a scheme has 45 cr units issued and has a FV of Rs. 10 and NAV is at 11.13, unit
capital (Rs. Cr) would be equal to [ 2 Marks ] (a) 500.85
(b) 50.85
(c) 950.85
(d) 450

Q:14 If a scheme issues more units, its NAV will [ 2 Marks ] (a) Have no impact
(b) Fall
(c) Rise
 (d) Can’t say

Q:15 Redemption of units translates into higher NAV. [ 2 Marks ] (a) TRUE
(b) FALSE

Q:16 Offer Document has to be provided by the advisor along with the application form. [ 2
Marks ]
(a) TRUE
(b) FALSE

Q:17 A fund fact sheet is published by mutual funds. [ 2 Marks ] (a) TRUE
(b) FALSE

Q:18 Fund fact sheet gives comparison of performance of each scheme with its
benchmark. [2 Marks ] (a) TRUE
(b) FALSE

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