amfi ttt part1 241008

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AMFI Certification ExaminationTutorial

AMFI Certification ExaminationTutorial

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Copyright Aditya Birla Nuvo Limited 2008

About the AMFI Examination

Candidates can take the computer based exam at the NSE centers

or the written exams conducted by UTIICM

The exam is now available in 2 languages : Hindi and English

– The computer based exam is only in English.

– The written exam is in English and Hindi

Registration on the NSE exams can be done on-line at

www.nseindia.com

Registration for written exams can be done by downloading the

application forms from www.iicm.com

2

http://www.nseindia.com/

http://www.iicm.com/

http://www.iicm.com/

http://www.nseindia.com/

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Question Paper Design

Each chapter has a weightage in the exams.

– Not disclosed by AMFI

– Indicated in the CIEL book

There are 72 questions

– 44 questions of 1 mark each ; 28 questions of 2 marks each

– 42 questions from part 1; 30 questions from part 2

The paper is generated by randomly choosing from the question

bank

– The question paper for each candidate is different

– In the written exam, there are 5 sets of papers in the hall3

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Attempting the paper

There are 2 hours to do the paper, most people do it in 1 hour

Written exam

– There is an answer sheet with boxes for each question. Color the

appropriate box with pencil.

– Valuation is done using an optical reader. Results are announced in 10

days.

NSE Online exam – Answers are chosen with the click of the mouse

– Results is known as soon as the paper is submitted

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Some Tips

It is not a great idea to read the paper fully, attempt questions as

you see them.

– Reading fatigue sets in.

Mark and keep aside questions for which you are not sure of the

answers, revert only to these questions.

– Revising all questions can create confusion.

– Do not revise and redo the questions that have been already attempted.

Negative marking

– 25% of the marks of a question is reduced for a wrong answer.

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Approximate Weighting

Concept, History & Type of Mutual Funds (10 Marks)

Fund Structure & Constituents (4 Marks)

Legal & Regulatory Framework (5 Marks)

Offer Document (9 Marks)

Mutual Fund Distribution & Sales Practices (6 Marks)

Accounting Valuation & Taxation (9 Marks)

Investor Services (3 Marks)

Investment Management (6 Marks)

Return, Risk, Performance & Fund Selection (8 Marks)

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Approximate Weighting -2

Financial Planning Concept & Process (4 Marks)

Life Cycles & Wealth Cycles (4 Marks)

Creating & Recommending a Model Portfolio (5 Marks)

Investment Strategies (5 Marks)

Investment Products (7 Marks)

Business Ethics for Mutual Fund (4 Marks)

7

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8

Chapter 1

Concept, History & Type of Mutual Funds

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9

What is a Mutual Fund?

A mutual fund is a pool of investors’ money

The money collected is invested based on pre-specified investmentobjectives

– HDFC Income Fund

– DSPML Top 100 Equity Fund

The investment objective of a fund determines its investment portfolio and

its risk and return.

The benefits from the pool is shared only by the investors who contributed

to it

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Proportionate Share

Contribution to the pool is not equal

– Hence the share is not equal, but proportionate

Investor A 10000 12000

Investor B 20000 24000

Investor C 30000 36000

Total 60000

Gain over time 12000

Current Value 72000

Current

Value of the

Investment

isproportionate

72000

10

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11

Nature of the Pool

The contribution to the pool depends upon the type of scheme

– In an open-ended scheme investors can invest and redeem at any

time

– In a closed-end fund, contribution to the fund happens only at the

time of creation of the pool and redemption at the time of maturity

Method to measure the contribution is standardized

Share of the pool is called “Unit”

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12

Units Vs. Shares

Shares Units

Investor in shares - Share holder Mutual fund investor - Unit holder

Holds the share of the company Holds the units of the fund

Share has a face value Unit has a face value

First time issue - IPO (InitialPublic Offering)

First time issue - NFO (NewFund Offer)

Subsequent transactions in

stock exchange

Subsequent transaction through

the fund (sometimes listed)

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13

Portfolio of a Fund

The money pooled is invested in a portfolio of marketablesecurities such as:

– Equity shares

– Bonds and debentures

– Money market instruments

– Derivatives

Securities are tradable and have a market price. The portfolio value changes with changes in the market price of

the underlying securities.

The value of the investor’s holding changes with a change in the

portfolio value.

If we divide the value of the portfolio by the number of units, weget the net asset value (NAV) per unit.

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Valuation of Portfolio - Example

Consider a pool of money contributed by different investors.

Investor A - Rs. 3000000

Investor B - Rs. 1000000

Investor C - Rs. 500000

Investor D - Rs. 400000Investor E - Rs. 56000

Total - Rs. 4956000

14

Numericals not in the exam; only for understanding

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15

Valuation of Portfolio - 2

Day 1 Day 10Security No.

of

Shares

Market

Price

Market

Value

Market

Price

Market Value

L & T 1000 2700 2700000 2900 2900000

Finolex 2000 53 106000 57 1140000

Sun Pharma 1000 1400 1400000 1300 1300000

ICICI Bank 1000 750 750000 700 700000

Total 4956000 6040000

If the NAV of the fund was Rs.10 at the start, it would now be

Rs.12.18 at the end of 10 days, when the value of the portfolio

moved up.

Note: Numericals not in the exam; only for understanding

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16

Assets and Liabilities of the Fund

The total assets of a mutual fund refers to the current value of its

portfolio. – No other long-term assets are held in the balance sheet.

– Current assets and accrued income are added to the portfolio

value.

The assets are funded completely by the investors’ contribution

– No long-term liabilities in the balance sheet. – Current liabilities and accrued expenses are deducted from the

portfolio value.

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Net Assets

Net assets of the mutual fund

= Market value of the portfolio

+ (Accrued income and current assets)

- (Accrued expenses and current liabilities)

Net asset value of a unit (NAV)

= Net assets / Number of units

Net assets of the fund = NAV * Number of units

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18

Advantages of a Mutual Fund

Portfolio Diversification

– The portfolio is spread across industries, companies, issuers and

maturities.

Low Transaction Cost

– Benefits of economies of scale accrue to the investor since the

fund invests large sums of money in the market.

Professional Managers

– The fund managers have expertise in sector evaluation and

security selection.

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Advantages of Mutual Funds - 2

Reduction in Risk

– Portfolio diversification and professional management of the funds

leads to a reduction in risk for the investor.

Flexibility

– The choice of products and options allow investors to structure

their investment and returns in the way that suits them.

Liquidity – Mutual fund portfolios are managed to provide liquidity and easy

exit options to investors.

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20

Disadvantages of Mutual Funds

No Customization

– The selection of sectors and securities in the portfolio is according

to the view of the fund manager.

No control over fund management cost

– Investors do not directly control fund running expenses

– Upper limit on costs is prescribed by regulation

Too many options to choose from

– Fund selection can be difficult when there are too many of the

same kind.

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21

History of Mutual Funds

Phase I (1964 to 1987)

– UTI was set up and governed by Unit Trust of India Act ,1963

– First scheme was Unit Scheme 1964

– First diversified equity scheme was Master share launched in

1986

Phase II (1987 to 1993)

– Banks and insurance companies allowed to set up funds in 1987

– SBI mutual fund was the first bank-sponsored fund – SEBI was formed in 1988 and regulatory powers given in 1992

Phase III (1993 to 1996)

– Kothari Pioneer was the first private sector mutual fund in 1993

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22

History of Mutual Funds - 2

Phase IV (1996 to 1999)

– Three Tier structure of Sponsor - Trust – AMC was implemented.

– Dividends from mutual funds became exempt from tax in 1999.

Phase V (1999 to 2004)

– The UTI Act was repealed and UTI came into Sebi’s fold in 2003.

– Assets in 2001 were Rs1,50,000 crore.

Phase VI (2004 onwards)

– Marked by mergers, acquisitions and entry of international players.

– Currently there are 35 players managing nearly 600,000 crore in assets.

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23

Classification of Mutual Funds

Mutual fund products can be classified as follows:

Based on Life Span – Open and closed end funds

Based on Asset Class

– Equity, debt, money markets, gilts and the like

– Funds may also invest in a combination of asset classes

Based on Management Style

– Passive and active funds

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No fixed maturity date.

Offered during NFO for the first time. – Investors can buy redeem on a continuous basis

after the fund re-opens for transactions.

– On-going transactions are done at NAV-based

prices.

Unit capital is not fixed but changes with purchase

and redemption.

Transactions can be restricted by the fund under

special situations.

Open-ended Funds

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Closed End Funds

Specified maturity date

– Offered during the NFO for the first time

– Redeemed on maturity date

Closed for further purchase and redemption after NFO

– Some funds may offer redemption at NAV-based prices

Listed on Stock exchange

– Prices determined by liquidity in the market

– Can be at premium or discount to NAV

Unit capital does not change after NFO

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Equity Funds

Pre-dominantly invest in equity markets

– Diversified portfolio of equity shares

– Select set of equity shares based on selection criterion

Diversified equity funds

– ELSS is a special case with tax concessions

Growth funds & Value funds

Mid & small stock funds

Index funds

Specialty funds (sector and thematic funds)

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Debt Funds

Predominantly invest in the debt markets

– Diversified debt funds

– Select set based on some criterion

Income funds or diversified debt funds

Gilt funds – short and long term gilt fund

Liquid and money market funds

Serial plans or fixed maturity plans

Erstwhile assured return funds

27

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Hybrid Funds

Investment in more than one asset class

– Debt and equity in varying proportions

– Pre-dominantly debt with some exposure to equity

• MIPs

• Education plans and children’s plans

– Pre-dominantly equity with some exposure to debt

• Balanced funds

• Retirement plans

• Growth & Income funds

– Asset allocation funds

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Other Funds

Commodity funds

– Invest in commodity stocks and futures

Real estate funds

– Invest in real estate linked products and in property

International funds

– Invest in global ETFs, funds and securities

Fund of funds

– Invest in other funds

– Two layers of management fees

ETFs

– Passive funds linked to an index

– Bought and sold on the exchange29

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Basis for Classification

Risk

– Sector funds are most risky; money market funds are least risky

Tenor

– Equity funds require a long investment horizon; liquid funds are

for the short term liquidity needs

Investment objective

– Equity funds suit growth objectives; debt funds suit income

objectives

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31

Classification - Asset class

Fund type Securities held

Equity Funds - Shares

Income Funds - Bonds / Government securities

Money Market Funds(Liquid)

- Short maturity fixed incomeinstruments

Hybrid Funds - Shares & fixed income instruments

Commodity Funds - Gold, commodity stocks and futures

Real Estate Funds - Real estate

Fund of Funds - Other funds

Gilt Funds - Government securities

High Yield Debt Funds - Debt instruments with lower creditrating

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32

Classification - Asset class

- Sector, Diversified

- Country, Regional, Global

- Value, Growth, Combination

Equity

- Large cap, Mid cap, Small cap

- G-Sec, Gilt,

- High yield

Fixed Income

- Floating rate income

Hybrid - MIP, Balanced Fund, Asset Allocation Fund

- Children’s fund

- Pension Fund

Special purpose

- ELSS

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33

Classification - Management Style

Passive Funds

– No active call on stock or proportion

– Follows a chosen market index in terms of stocks and weightage in the

portfolio

– Index Funds, ETFs follow a passive style

Active Funds

– Actively managed by the fund manager

– Tries to deliver better returns than the market index

– A particular market index is chosen as benchmark

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Chapter 2Fund Structure and Constituents

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Mutual Fund Structures

Mutual funds may be structured as a company or as a trust

– In a company structure, investors hold shares.

– In a trust, investors are the beneficiaries.

– In the UK, closed-end funds are set up as companies and open-end

funds as unit trusts.

– In USA , funds are set up as investment companies.

35

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Mutual Fund Structure in India

In India, the structure to be followed by mutual funds is specified in

Sebi’s (Mutual Fund) Regulations of 1996. – Three-tier structure of Sponsor, Trust, AMC (Asset Management

Company)

Sponsor promotes the fund and sets up the AMC.

The mutual fund is the trust supervised by the trustees.

Trustees appoint the AMC to manage the funds.

Sebi’s regulations lays down the eligibility norms, role and

responsibilities of each constituent.

36

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Sponsor of a Mutual Fund

The sponsor is the promoter of the mutual fund

The role of the sponsor includes

– Setting up the trust & AMC and contribute capital

– Appointing the members of the Board of trustees and AMC

– Appointing the custodian

– Seeking regulatory approvals

A sponsor of a mutual fund can be

– An Indian company /Bank /Financial institution (Reliance)

– A Foreign entity (JPMorgan, Fidelity)

– A Joint venture (ICICI Prudential, Birla Sunlife)

37

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Regulatory Norms

Sebi’s regulations for mutual funds has laid down the eligibility

norms for a sponsor:

– At least 5 years experience in the financial services industry

– Good financial track record• Positive net worth in the immediately preceding three years

– At least 40% of the AMC’s capital to be contributed by the sponsor.

38

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Trustees of a Mutual Fund

The sponsor registers the mutual fund as a trust and appoints the

trustees with the approval of SEBI – The trustees can be constituted either as Board of Trustees or Trustee

Company

– Trustees have to meet at least 6 times in a year

– Trustees are paid a fee for their services

Trustees have fiduciary responsibility to protect the interest of the

investors

• The authority and responsibility of the trustees are laid down in

the trust deed

39

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Role of the Trustees

Registered ownership of investments is with the trust

•

At least two-thirds of the trustees should be independent of thesponsor

Trustees of one mutual fund cannot be trustee of another mutual

fund

– Independent trustee

– Board approval

Right to seek regular information and remedial action

All major decisions need trustee approval

40

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Asset Management Company (AMC)

The AMC is the investment manager of a mutual fund appointed by

the trustees:

– Set up by the sponsor as a public or private company through

contribution of capital.

– The investment management agreement lays down the role andresponsibilities of the AMC.

– The AMC reports to the trustees periodically and have to provide all

information when ever required.

The creation, marketing and management of mutual fund products is

the responsibility of the AMC.

41

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Regulatory Norms for AMC

The AMC has to be registered with Sebi which has laid down the

eligibility norms :

– An AMC must have a net worth of at least Rs. 10 crore at all times.

– 50% of the members of the board have to be independent.

– The AMC of one mutual fund cannot be the AMC/Trustee of another

mutual fund.

– An AMC cannot engage in any business other than investment

management.

– The AMC must make periodic statutory disclosures to SEBI.

42

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Outsourced Functions of AMC

The core function of the AMC is the management of the fund

portfolio.

– Functions other than core activities are outsourced to constituents

The constituents of a mutual fund are appointed to take care of

specific activities:

– Appointed by the AMC

• Custodians are an exception and are appointed by the sponsor directly

– Should be registered with SEBI & approved by Trustees

– Paid a service fee

– Governed by the agreement entered into with the AMC and Sebi’s

regulations43

R l f O h C i

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Role of Other Constituents

Different constituents and their roles are:

• Custodian s Hold funds & securities

• R & T Agents Keep records & service investor needs

• Banks Handle collection & payment

• Auditors Audit scheme accounts

• Distributors Distribute fund products to investors

• Brokers Execute security transactions

44

C t di

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Custodians

Custodians hold the cash and securities of the mutual fund and are

responsible for the safekeeping of the assets

The custodian must be an entity independent of the sponsor

The functions of the custodian include:

– Complete the transactions, deliver & accept cash & securities

– Track and complete corporate actions & payouts

• Rights, bonus, dividends, & interests

• Sale & buy back offers, redemptions

– Coordination with depository participants (DP)

– Some custodians may offer fund accounting & valuation services

45

R & T Agents

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R & T Agents

The R&T agents are the record keepers of a mutual fund

They operate Investor Service Centers (ISCs) that are official points to

accept and process transactions

They are primarily responsible to provide investor services and are paid a

fee for their services

– Issue & redeem units, update unit capital

– Enable investor transactions

– Create, maintain and update investor records

– Bank the payment instruments & notify AMC

– Process redemption and dividend payouts

– Send periodic statutory information to investors

46

Other Constituents

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Other Constituents

Banks

– Provide collection services

– Investor cheques / DDs are collected into scheme accounts

Auditors

– Audit the books of mutual funds

– Separate auditors for AMC accounts

Brokers – Execute buying & selling stocks as instructed by the fund managers

– Give research reports on securities to the AMC

47

Distributors

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Distributors

AMCs appoint non-exclusive distributors to sell mutual fund units

A distributor can appoint multiple sub-brokers

A distributor can be

– An individual (IFA - Independent Financial Advisor)

– Institutions such as banks

– Non-banking finance companies (NBFC)

– Broking & distribution companies

IFAs & employees of corporate distributors have to

– Clear AMFI Certification Exam

– Empanel with a mutual fund

– Take refresher course once in five years 48

Take-over and Merger

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Take over and Merger

– Scheme Take-over

• Schemes of one fund are taken-over by another fund.

– AMC Take-over

• Sponsor of one AMC sells their equity holding to another sponsor.

– AMC Merger• Two AMCs merge their operations

• Structure of AMC and holdings of the sponsors change.

– AMC Change

• Trustees may terminate one AMC and appoint another.

49

Unit holders & Merger Take-over

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Unit holders & Merger, Take over

Re-organization requires the approval of trustees and SEBI

AMC merger/ take-over requires the approval of high court

Investors of open-ended schemes

– Need not approve the merger / take over

– Need to be informed – advertisements & individual communication

– Need to given the option to exit without paying exit load

75% of voting rights must approve the reorganization in case of a

close-end scheme

– Approval sought through postal ballot

– No response is deemed to be an approval

Key documents are amended after the change

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Chapter 3Legal and Regulatory Framework

SEBI - Primary Regulator

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SEBI - Primary Regulator

All activities of mutual funds are defined and regulated by SEBI

Investor complaints redressal is done by trustees, AMC & SEBI

UTI came under SEBI’s regulation in 2003

– Now all the UTI schemes are managed by UTI AMC

– UTI’s Assured returns scheme are under a special undertaking

Role of RBI

Bank sponsored mutual funds are regulated by both SEBI & RBI

RBI also regulates money markets and gilt markets

52

Other Regulators

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Other Regulators

The ministry of finance is the apex supervisor

– SEBI and RBI are governed by Acts of Parliament

• (SEBI Act 1992, RBI Act 1949)

– Appeals against SEBI are made to the Securities Appellate Tribunal

The Company Law Board (CLB) is the regulator under the

Company’s Act 1956

– AMC & trustee company are formed as companies

– Complaints against directors are escalated to CLB

– Dept of company affairs can prosecute the company directors

– The Registrar of companies ensures compliance

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Other Regulators -2

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Other Regulators 2

Indian Trust Act

– Mutual funds are set up as trusts

– Governed by Indian Trust Act,1882

– Office of the Public Trustee and Charity Commissioner supervise theBoard of trustee company

Stock Exchange

– Listing regulations govern the schemes listed on the stock exchange

54

Self- Regulatory Organizations

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g y g

Self-regulatory organizations (SROs) are the second tier in the

regulatory structure

– Formed as an industry association & registered with regulatory body

– Granted SRO status by the regulator

– Given limited powers by the regulator

AMFI is not a Self Regulatory Organization

– AMFI is an association of mutual funds

– It provides guidelines to mutual funds

– Regulations are issued by SEBI – AMFI board is appointed by AMCs and made up of AMC

representatives

55

Rights of Unit holders

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g

Unit holders of a mutual fund have certain rights

– Timely service

– Receive information that may affect their investments

Units holders with 75% or more of unit capital

– Can terminate an AMC

– Can wind up a scheme

There are limits to investors’ rights:

– No legal recourse to the mutual fund itself

– No recourse for failure to read the offer document

– Investors are not shareholders in the AMC

– Investments are not protected under Companies Act56

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Chapter 4Offer Document

Source of Information

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The offer document (OD)provides all information that an investor

needs to evaluate a mutual fund

– The OD is first prepared at the time of an NFO

– It is a legal document

– Investors are required to read the OD before investing

The AMC prepares the OD with the approval of the trustees

– The format is prescribed by Sebi

– Has to be filed with Sebi for approval

– Sebi can ask for changes

58

Due Diligence Certificate

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g

The AMC is responsible for the accuracy of information in the OD

The Due diligence certificate is signed by the compliance officer ofthe AMC

– It is part of the offer document

The due diligence certificate states that

– The OD is prepared as per Sebi’s regulations

– Information in the OD is accurate

– All the constituents associated with the mutual fund are registered with

Sebi

59

Updating the OD

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p g

The OD must have relevant information to help make appropriate

investment decisions

The OD prepared at the time of the NFO will have to be updated for

changes

Sebi prescribes the frequency with which the OD has to be revised

– OD of open ended schemes are revised every two years

– OD of closed-end schemes do not require revision

(The format and revision rules have been changed by Sebi with

effect from June 1, 2008)

60

Addendum to OD

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The changes in the material information in the offer document is

intimated through an addendum

– Attached as an appendix to the OD

– Approved by trustees and notified to Sebi

– Has to be published in two news papers and displayed in all OPoAs

The information in the addendum is included in the OD when the OD

is revised

Change in material information includes

– Change in sponsor, AMC

– Change in fundamental attributes, loads, options in the scheme61

Contents of the OD - Risks

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The risk in a mutual fund scheme may be standard or scheme

specific risks

Standard risks are common to all mutual fund schemes

– All schemes are subject to market risks

– Past performance is not indicative of future performance

Scheme specific risks depend upon the investment objective, asset

allocation and strategy of a fund

– A sector fund has risk of concentration

– The first scheme of a fund house has the risk of no past history

62

Contents of the OD- Constituents

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The OD gives background information about the constituents of the

mutual fund.

Information about the sponsor in the OD includes:

– Name and financial history of the past three years

– Liability of the sponsor for assured return scheme, if any

Information about the trustees includes:

– Name and address of the trustees

– Details of independent trustees

– Summary of trust deed provision

Contents of the OD- Constituents

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Information about the AMC includes:

– Details of the directors

– Information of the key personnel

Information is provided of other constituents such as custodian, R&T

agent and auditor

The offer document gives information for the preceding three years

Information in the OD is limited to the schemes of the fund house.

64

Fundamental Attributes of a Scheme

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The fundamental attributes of a scheme define the risk and return

characteristics of a scheme

– Type of scheme

– Investment objective

– Investment Pattern

– Terms with regard to liquidity

– Fes and expenses

– Accounting and valuation and investment norms

The suitability of a scheme for an investor’s needs depends on its

fundamental attributes

Change in Fundamental Attributes

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The fundamental attributes of a scheme may change

– Approval of the trustees and Sebi is required

– Investors need to be informed of the change and given the option to exit

without paying exit load

– Details have to be published in at least two national papers

The OD of a scheme has to be revised

The investment by the investor may require review for continued

suitability

66

Financial Information in the OD

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The OD provides information of the performance of existing

schemes for the last three years

– Financial summary of existing schemes

– Investor complaints and redressal for existing schemes

The OD provides the details of expenses of existing schemes

– Expenses as a percentage of weekly average net assets

– Variation between estimates and actuals

– Loads and initial expenses

Information on Investor Services

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The offer document will give information on the services and

information that an investor can expect

– Process for addressing investor grievance

– Information that is given and their periodicity

Investors can ask to inspect documents related to the fund

– Investment management agreement and Trust deed

– Annual reports of AMC and schemes

– Agreements entered into with R&T agent, custodian and other

constituents

Information on Investments

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Information on the investment pattern and strategy of the fund

– Allocation to asset classes and types of securities

– No information on specific securities the fund may invest in

Details of the borrowing policy of the fund

Details of the investment in the sponsor group companies

Policy on inter-scheme transfers and valuation of securities

Information on the method of calculating NAV, sale and redemptionprice

69

Operational Details of the Scheme

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The OD gives information that is essential for the investor to

complete the investment process

– The period of NFO

– The NFO price for subsequent transactions

– Minimum initial and subsequent investment

– Plans ,options and loads

– Availability of forms, payment instruments and submission

– Investors eligible to invest

– Facilities such as switch and SIPs

– Date of commencement of on-going purchase and sale

Key Information Memorandum (KIM)

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KIM is the abridged version of the OD

– Must accompany every application form

– Is updated regularly

– Key information is available both in the OD and KIM

A first time investor should refer to the OD for information. An

existing investor can use the KIM for continuing transactions

The format of the KIM is prescribed by Sebi

Information in the KIM

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• The KIM contains the crucial information required by an investor

Investment objective, asset allocation

Scheme specific operational details

Expenses and loads

Details of key constituents

Performance history of the scheme and its benchmark

Investor rights and services

72

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Chapter 5Mutual Fund Distribution & Sales Practices

Types of Investors

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Offer document clearly specifies the investors eligible to invest in themutual fund scheme

– Some schemes may have restrictions

Some categories of investors are: – Individuals & Hindu undivided Families (HUF)

– Companies & Partnership firms

– Trusts & charitable institutions

– Banks & Financial institutions

– Non-banking finance companies (NBFC)

– Insurance companies

– Provident funds – Mutual funds

– Foreign Institutional Investors (FII)

– Non resident Indians (NRI) & Persons of Indian Origin (PIO)

74

Features of Investor Categories

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Resident investor is the largest segment of investors

Institutional investors

– Are smaller in number, larger in ticket size

– They need to have specific internal approval for investing

FIIS need to register with SEBI before investing

Foreign citizens and overseas corporate bodies are not allowed to invest in

mutual funds

NRIs and PIOs can invest without separate approval from RBI

75

Individual Investors

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Individual investors require advice to make their investments

– Retail or HNI

The documents

– PAN mandatory for all investors including NRI

– KYC norms to be fulfilled for all investments above Rs.50,000

Upto three joint holders are allowed

– Complete address to be provided for first holder

– All communication goes to the first holder

Bank details have to be provided mandatorily

76

Institutional Investors

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Have specific needs and investment profile

– Prudential guidelines

Need Board approval before investment

– Approval, Trust Deed, RoC, MoA to be submitted for investment

List of Authorized signatories is mandatory

May not require investment advise

May not go through intermediaries

– Direct sales channels

77

Intermediaries

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Mutual funds may employ distributors to reach their products

(channels)

There are non-exclusive individual and institutional channels

Individual distributors

– Establish personal long term relationship with investors

– Hand-hold the investor through the process

– Have evolved as financial planners providing personalized service

Institutional channels

– Have large depositor / client base

– Client acquisition process is standardized 78

Features of distribution channels

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Individual distributors (IFA)

– Agreement with AMC

– Non-exclusive

– Have sub-brokers

– Limited research information to clients

Institutional

– Have many employees and sub-brokers

– Large foot print in terms of branches

– AMC deals with single entity instead of large number of investors

– Have established client base & offer multiple products

– Able to give research based advice 79

Appointment of Distributors

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AMC appoints the distributor

– SEBI approval is not required

– The sponsor can be a distributor

– Employees cannot be distributors

The distributor enters into an agreement with the AMC

– Terms of appointment

– Periodicity of commission payment

The distributor is the investor’s contact with the mutual fund

– Copy of KIM to be given along with application to the investor

– Information to investor that there is no recourse to distributor

– Units will be allotted to the investor at Public Offer Price80

Commission to Distributors

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Primary form of remuneration for the distributor is commission

– Commission is split as up-front and trail

– Commission is paid at the discretion of the fund

– No maximum / minimum limit prescribed by SEBI

– Commission is influenced by market practice

– Equity schemes have higher commission than debt schemes

– No commission for own investment

Distributors tend to pass the commission to the investor (rebating)

– This practice is banned by SEBI

81

Guidelines on Selling Practices

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Product to be sold keeping the interest of the investor in mind

– No specific regulation on investor servicing

AMFI guidelines are:

– Mutual funds are not accountable for the sub-broker’s activities

– Distributors should have complete knowledge of offered products

– They should know the clients’ need and profile

– Chosen product must meet the clients’ requirements

– They should encourage good long-term investment habits

– They should provide good & efficient service

Mutual funds should follow SEBI guidelines for marketing

82

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Chapter 6Accounting, Valuation, and Taxation

Unit Capital and Portfolio Value

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Number of outstanding units multiplied by face value per unit is theunit capital.

– This is shown on the liability side of the balance sheet.

– This is also called the corpus of the scheme.

The investment portfolio, along with any accrued income andreceivables represents the assets of the scheme.

A scheme has some short-term liabilities, payables and accruedexpenses.

Nets assets of a scheme are computed as assets minus liabilities.

Net asset value (NAV) is a per unit representation of a scheme’s net

assets and is computed as

– Net assets/Number of units outstanding

84

NAV Computation and Posting

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NAV is calculated every business day, also called as valuation day,

for all mutual fund schemes.

NAV has to be posted on the AMFI website every business day by 9

pm.

NAV is impacted by the following factors:

– Purchase and sale of investments by fund managers

– Valuation of investments held in the portfolio

– Valuation of other assets and liabilities of the scheme

– Sale and purchase of units by investors

85

NAV Representation

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Expense and income are accrued on a daily basis.

Calculation of NAV includes all incomes and expenses accrued untilthe valuation date.

Any transaction that impacts the NAV by more than 1% should notbe excluded in computation.

– Any errors to computation to be rectified in 7 business days.

NAV is rounded off to 4 decimal points for liquid funds, and twodecimal points for other schemes.

NAV is published in the newspapers for investor information.

86

Applicable NAV

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The price at which investors can buy or sell their units depends

on the NAV after adjustment for the load.

Applicable NAV depends on the cut-off time for the transaction.

– For all non-liquid schemes, the cut-off time for both purchase and

redemption is 3 pm.

– The cut-off time for liquid fund purchases is 12 noon

NAV is computed on business days for all schemes.

– for liquid funds, NAV is computed every calendar day.

87

Loads

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The price at which an investor purchases or redeems a mutual fund

unit is based on the NAV, adjusted for load.

Load refers to expenses incurred on marketing and distribution of a

scheme that can be recovered from the price.

Loads are of two types: Entry load applies for purchases; exit load

applies for redemptions.

Entry load means the investor pays a purchase price that is more

than the NAV, by the amount of load.

Exit load means the investor receives a redemtpion price that is less

than the NAV, by the amount of load. 88

Entry Load

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An investor wants to invest Rs 5000 in XYZ Growth Fund which has

an NAV of Rs 45. The investor also has to pay an entry load of

2.25%.

The price at which the units will be allotted is

– NAV + Load = Rs 45+ 2.25% of Rs 45

– = Rs 45+ Rs 1.0125

– = Rs 46.0125

– The investor will be allotted 108.666 units.

– (5000 / 46.0125).

89

SEBI Regulations

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SEBI regulations impose a limit on the maximum load that a

fund can charge.

An open ended fund can charge a maximum load of 7%.

A closed end fund can charge a maximum load of 5%.

The redemption price cannot be less than 93% of the purchase

price.

– If the NAV is Rs 10, the maximum purchase price can be Rs10.70.

– The minimum redemption price can be Rs 9.30.

90

Expenses

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Only scheme-specific expenses can be charged to the fund. These

expenses are:

– Investment management fees

– Marketing and selling expenses

– Fees of custodians

– Fees of registrar and transfer agents

– Audit fees

– Trustee fees

– Costs relating to investor communication

– Costs of statutory advertisements

Expenses incurred on AMC offices, staff salaries and technology

are borne by AMC and not charged to the scheme.91

Limits to Expenses

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The limits for expenses charged to the fund are as per the following

slabs:

– 2.5% on the first Rs100 crore of net assets – 2.25% on the next Rs300 crore of net assets

– 2% on the next Rs300 crore of net assets

– 1.75% on the balance net assets

The net assets in the above limit are taken as weekly average net

assets.

Debt funds are required to charge 0.25% lower in each of the aboveslabs.

Fund of funds can charge a maximum of 0.75% only as recurring

expenses. 92

Investment Management Fees

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The limits on investment management fees are as follows:

– 1.25% on the first Rs. 100 crore of net assets

– 1% on the remaining net assets over and above Rs.100 crore.

Example

A fund has net assets of Rs 800 crore. What is the limit on the

investment management fees that the AMC can charge to the fund?

– For the first 100cr @ 1.25% = 1.25 crore

– On the balance 700cr @ 1% = 7 crore

– Total fees that the AMC can charge = 8.25 crore

93

Accounting Policies

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Mutual funds can distribute dividends only out of realized profits.

Dividends, bonus and rights should be recognized on the ex-date.

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

securities.

Investments must be accounted on the transaction date, not on

the settlement date.

Scheme-wise annual reports have to be drawn according to SEBI

approved format

94

Valuation Policies

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Uniform policies of valuation are set by AMFI and approved by

SEBI.

Valuation policies to be disclosed to investors in the offer document.

The fair value of a security is the closing price at the markets on the

valuation date, in case of liquid securities.

In the case of illiquid securities, a valuation methodology is adopted

to arrive at the fair value.

Valuation of the mutual fund portfolio is done on every business

day.

95

Valuation of Equity Shares

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Equity shares are valued at the last traded price on the stock

exchange where they are principally traded.

If not traded, the closing price of the previous trading date can betaken.

– Not be more than 30 days before the valuation date.

A thinly traded share is defined as one where, in the preceding 30

days:

– The traded value is less than Rs 5 lakh, and

– The traded volume is less than 50,000 shares Thinly traded shares can be valued at the last traded price or at fair

valuation approved by the trustees.

96

Valuation of Debt Securities

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Closing price can be taken if it is not over 15 days old.

A debt security is thinly traded, if its traded value in the previous

one month is less than Rs.5 crore. Fair valuation for debt securities is done based on the yield provided

by Crisil and used uniformly across the industry.

– Government securities are valued using the Crisil gilt valuer. – Corporate securities are valued using the Crisil bond valuer.

If a corporate security is not of investment grade (credit rating below

BBB) it is valued at a discount of 25% on its face value. Money market securities with days to maturity not exceeding one

year, are not marked to market.

97

Illiquid Securities

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An illiquid security is defined as one that is thinly traded, non-tradedor unlisted.

If a security is illiquid, it cannot be accurately valued.

Such securities cannot exceed:

– 15% of net assets in an open-ended scheme.

– 20% of net assets in a closed end scheme.

Mutual funds cannot – transfer illiquid securities between schemes

– purchase illiquid securities from sponsors or associate companies.

Mutual funds disclose on a half-yearly basis:

– the holding of illiquid securities, scheme-wise

– in amount and as a percentage of net assets.

98

Taxation

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A mutual fund is exempted from income tax under Section 10(23D)

of the Income Tax Act.

Mutual funds distribute income as dividend, or allow the appreciation

to accumulate.

– They offer dividend and growth options to investors.

Mutual fund dividends are exempt from tax, in the hands of

the investors as per Section 10(35) of the IT Act.

– There is no tax deduction at source (TDS) on mutual fund dividends.

99

Taxation of Dividends

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Dividends are subject to dividend distribution tax (DDT)

– for equity-oriented schemes holding less than 65% in equity

DDT is payable at the rate of

– 12.5% for investments by individuals and Hindu undivided families

(HUFs)

– 20% for investments by all other categories

– 25% for all categories in a liquid scheme

DDT has to be paid directly by the fund, before distribution of

the dividend to the investor.

100

Taxation of Capital Gains

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Capital gain or loss realised:

– Within 12 months is called short-term capital gain or loss.

– After 12 months is called long-term capital gain or loss.

For an equity oriented fund,

– STCG is taxable at 15%

– LTCG is exempted from tax

For non-equity oriented funds

– STCG is taxable at the marginal rate of tax of the investor and LTCG is

taxable at 10% without indexation or 20% with indexation.

Securities transactions tax (STT) is payable at 0.25% by investors

on redeeming units of an equity-oriented fund.

101

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Chapter 7Investor Services

Investor Information

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The investor provides information to the mutual fund at the time of

investment

– Mandatory information to be provided as required by Sebi

The application form is used to buy units

– Available along with the KIM

– Instructions for filling up application is available in the KIM & Offer

Document

The completed application from has to be submitted at the AMC’s

office or ISC

– Distributors assist in filling up and submitting application forms103

Documents for Investing

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The Offer document and KIM describes the investment process to

be followed by each category of investors

Individual investors have to provide PAN details with the

applications

– Maximum of three joint holders are allowed in a mutual fund

Institutional investors must be permitted by their charter to invest in

mutual funds

– Approval of the governing body must accompany the application form

signed by the authorized signatories

NRIs and FIIs have been given blanket permission to invest by RBI104

Payment Instruments

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The application form for buying units of a mutual fund must be

accompanied by a payment instrument

– Minimum investment in a scheme

The accepted payment instruments are mentioned in the offer

document/KIM of the scheme – Cheques and Demand drafts

– Instruments not accepted as valid

Source of investment for NRI/FII investment is important

– NRO, NRE, FCNR accounts & FIRC

– Repatriation of redemption proceeds 105

Investor Folio and Account Statement

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The information provided in the application form is captured under a

folio created

– Consolidation of holdings

– Creation of multiple folios

– Use of transaction slips for additional purchase

The proof of investment in a mutual fund is the account statement

– Gives details of financial and non-financial transactions

Mutual funds allow investors to use a common application form to

invest in different schemes of the fund house

106

Redemption of Investment

Investors can specify their redemption request in units or amount

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Investors can specify their redemption request in units or amount

– Partial redemption and full redemption

The redemption request has to signed by the holders according totheir mode of holding

– Authorized signatories to sign for institutional investors

The redemption proceeds are paid into the bank account of the firstholder

– Mandatory to provide bank account details in the application form

– Repatriation of NRI redemption will depend upon source of funds – The redemption proceeds have to be paid within 10 working days

107

Investment Options-I

I i h l i i d

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Investment options help investors invest and structure returns

according to their specific requirements

Automatic Reinvestment Plans

– Dividend re-invested and not paid-out

– Gives compounding benefits

Systematic Investment Plans

– Periodic investment of fixed amounts

– Allows rupee cost averaging

108

Investment Options-II

S t ti T f Pl

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Systematic Transfer Plans

– Allows periodic transfer of funds between schemes

– Transaction is done at applicable NAV

– Loads and taxes apply

Systematic Withdrawal Plans – Is used by investors who want regular income

– Reduces the units standing to the credit of the investor

– Loads and taxes apply

109

Facilities Offered by Mutual Funds

On line transactions ith the m t al f nds

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On-line transactions with the mutual funds

Cheque- writing facility

– Third party cheques cannot be written

Pledging of units

– Units under lien cannot be redeemed

Nomination facility

– Can be modified by the investor

Periodic information to the investor on performance, portfolio and

markets

110

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Chapter 8Investment management

I

Investment Portfolio of a Mutual Fund

The portfolio of a mutual fund is a collection of securities and

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The portfolio of a mutual fund is a collection of securities and

financial instruments

– Selection of securities depends upon the investment objective of the

fund

Equity and debt are the two broad categories of securities used to

create a fund portfolio

– Dynamics of the markets and strategies used by fund managers

– Types of instruments

– Sebi’s regulations govern the investments made by a fund

112

Types of Equity Instruments

Ordinary Equity Shares

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Ordinary Equity Shares

– Implies ownership

– No guarantee of principal or income

– Capital appreciation is the primary attraction

Preference Shares – Dividend paid at fixed rates

– May be cumulative and participating

– No voting rights

Equity Warrants

113

Categorization of Equity Instruments- I

Based on market capitalization

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Based on market capitalization

– Number of shares X Current market price

– Large, mid and small cap shares

– Varying risk return profile of and suitability of each category

– The objective of the fund would decide the selection of stocks

– Separate indices track each category

114

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Categorization of Equity Instruments- III

Growth stocks

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Growth stocks

– Earnings grow at faster than average rates and are ploughed back

– Have high P/E ratios and low dividend yields

Value stocks

– Undervalued shares with low P/E and high dividend yields

– Potential to earn profits when such shares find favor with markets

Cyclical stocks

– Earnings are linked to economic cycles

– Have low P/E and high dividend yield

116

Equity Fund Management Strategies

Passive fund management style

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Passive fund management style

– Strategy of investing in an index’s shares in the same proportion

– No stock selection or portfolio rebalancing except when the index

changes

– Costs of investments is kept low

Active fund management style

– Aims at bettering the index return through active stock selection and

portfolio rebalancing

– Higher fund management cost

117

Equity Fund Management Tools

Fundamental analysis

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u da e ta a a ys s

– Research into qualitative and quantitative factors that affect the

performance of the company

– Economy-industry-company analysis

Technical analysis

– Use of price data to identify future price movement patterns

Quantitative analysis

– Use of mathematical decision making models for fund management

118

Equity Fund Management Functions

Fund Managers

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g

– Take decisions on style, allocation and stock selection

Security Analysts

– Track companies in which the fund has invested and potential

opportunities

– Use fund management tools like fundamental and technical analysis

Security Dealers

– Members of the stock exchange

– Execute buy and sell orders for the fund

119

Features of Debt Instruments

Debt instruments represent a loan

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p

– Can be bought from issuer or in the secondary markets

Par value is the principal amount borrowed which is repaid on

redemption

Coupon is the rate of interest payable on the par value

Maturity is the term of borrowing

– Call and put option modify the maturity

120

Classification of Debt Instruments

Based on issuer

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– Differ in terms of credit quality

Based on tenor

– Instruments with less than one year to maturity are called money market

instruments

– Long-term borrowings are issued for up to 30 years

Based on interest payments

– Fixed and floating rates of interest

– Zero coupon and deep discount bonds

121

Money Market Instruments

Certificate of Deposits

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– Unsecured borrowings of banks

Commercial papers

– Credit rated paper to meet working capital requirements of companies

Treasury bills – Issued by the government for tenors of 91,182 and 364 days

Call and Notice markets & Repos

– Borrowings for overnight to 14 days

– CBLOs are securitized repos with liquidity

122

Long-Term Debt Instruments

Corporate Debentures are secured credit rated instruments

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– Listed on stock exchanges if publicly issued

– Usually privately placed

– May be fixed or floating rate bonds

– May be issued as convertible debentures

Government securities are issued by RBI through auctions

– Issued for maturities between 1 to 30 years

Bonds issued by FIs are unsecured borrowings

– May have tax concessions

123

Debt Fund Portfolio

A debt fund’s portfolio depends upon its investment objective

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– Liquid funds invest in money market securities

– Income funds invest in a combination of long-term debt securities

– Gilt funds invest only in government securities

– Dynamic bond funds actively manage the maturity of the portfolio

– FMPs invest in securities with maturities that match the tenor of the fund

Mutual funds do not give loans

124

Bond Yield Measures

Current yield of a bond is the coupon as a percentage of current

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market price

If we bought a 8% bond at Rs. 110, the current yield is

= (8/110)*100

= 7.27% The YTM is the rate at which present value of future cash flows

equals the current market price

Given price, YTM can be calculated through iteration

Given YTM, price can be computed, using the YTM rate to discountthe future cash flows.

125

Risks in Debt Securities

Interest rate risk is the increase or decrease in the price of bonds

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with a change in rates

Credit risk is the risk of default in meeting obligations of interest and

repayment

– Government securities are not credit rated

– The credit risk of other bonds are measured by credit rating

– Credit spread is the excess interest paid by other borrowers over what

the government is paying for the same tenor

– Higher the credit rating, lower is the spread

126

Risks in Debt Securities

Reinvestment risk

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– The risk of reinvestment of interest income at lower rates

– Affects total income

Liquidity risk

– The risk of not being able to sell the bond close to its value

Inflation Risk

– The reduction in the value of fixed payments

Call risk

– The redemption by the issuer of a high interest debt prior to maturity

127

Managing Interest Rate Risk

The sensitivity of the price of a bond to changes in interest rates is

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measured by a number called duration

– Interest rate risk is different across bonds

– Duration is not equal to the tenor of the bond

If duration is 3 years, and interest changes by 1%, price of the bond

will change in the opposite direction, by 3%

128

Debt Fund Management Strategies

Buy and hold

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– Portfolio exposed to interest rate risk

Duration management

– increase duration if rates are expected to fall

– decrease duration if rates are expected to rise

Credit selection

– invest in low grade bonds that are likely to be upgraded

129

Investment in Derivatives

Derivatives derive their value from an underlying security

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– Futures

– Options

– Swaps

Derivatives are used to rebalance or hedge their portfolios

Sebi’s regulations require mutual funds to inform the investors

before using derivatives

– Explain the benefits in the offer document with simple examples

130

Investment Regulations

A mutual fund’s investment is governed by Sebi’s regulations which

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aim at

– A minimum level of diversification

– Protecting the investor’s interests

A mutual fund can

– Invest only in marketable securities

– Investment only on delivery basis

– Mutual funds can borrow up to 20% of net assets for a period not

exceeding 6 months

131

Investment Restrictions

A mutual fund under all its schemes, cannot hold more than 10% of

the paid-up capital of a company

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the paid up capital of a company

Not more than 10% of its NAV in a single company

– Exceptions: Index Funds and Sectoral funds

Debt instruments with investment grade rating of a single issuer

cannot exceed 15% of the net assets

– Can be extended to 20%, with the approval of the trustees

Investment in unlisted shares cannot exceed

– 5% of net assets for an open-ended scheme

– 10% of net assets for a close-ended scheme

132

Investment in Group Companies

A mutual fund scheme cannot invest in unlisted securities of the

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sponsor or an associate or group company of the sponsor

A mutual fund scheme cannot invest in privately placed securities of

the sponsor or its associates

Investment by a scheme in listed securities of the sponsor orassociate companies cannot exceed 25% of the net assets of the

scheme

133

Inter-Scheme Transfers

Inter-scheme transfers happen on a delivery basis, at market prices

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Such transfers should not result in significantly altering the

investment objectives of the schemes involved

Such transfer should not be of illiquid securities, as defined in the

valuation norms One scheme can invest in another scheme, up to 5% of its net

assets

– No management fee is payable on these investments

134

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Chapter 9Return, Risk, Performance and Fund Selection

Returns From Mutual Funds

The components of the returns from a mutual fund investment are

Di id d

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– Dividends

– Capital Gains

Dividends are paid out to investors who choose the dividend option

Capital gains is the difference between the acquisition price andsale price of units

– Realized when units are sold

136

Methods of Return Calculation

The methods of calculating returns from mutual funds are

Ch i NAV th d

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– Change in NAV method

– Total Return Method

– Return on Investment method

– Compounded annual growth rate method (CAGR)

The suitable method of calculating returns depends on the

investment objective of the investor

The performance data published by mutual funds use the CAGR

method for the growth option of a scheme

137

Change in NAV Method

Calculates the return between two dates

E l

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Example:

– NAV of a fund was Rs. 23.45 at the beginning of a year

– NAV of the fund was Rs. 27.65 at the end of the year

Percentage change in NAV= (27.65 – 23.45)/23.45 *100

= 17.91%

This method considers only the change in NAV between two dates

– Dividend paid, if any, is not considered

138

Total Return Method

Calculates the return by considering both dividend and capital

appreciation.

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Example

– Investor bought units of a mutual fund scheme at a price of Rs.12.45

per unit

– He redeems the investment a year later, at Rs. 15.475 per unit

– During the year, he also receives dividend at 7%

The rate of return on his investment can be computed as

= ((15.475 – 12.45) + 0.70)/12.45 x 100

= (3.725/12.45) x 100 = 29.92%

Does not consider the re-investment of dividend

139

Return on Investment (RoI) Method

The RoI is calculated using the formula

(Value of holdings at the end of the period value of holdings at the

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– (Value of holdings at the end of the period - value of holdings at the

beginning of the period)/ value of holdings at the beginning of the period

x 100

– Value of holdings at the beginning of the period = number of units at the

beginning x begin NAV

– Value of holdings end of the period = (number of units held at the

beginning + number of units re-invested) x end NAV

– Number of units re-invested = dividends/ex dividend NAV

140

RoI Method - Example

An investor buys 100 units of a fund at Rs. 10.5 on January 1, 2007.

On June 30 2007 he receives dividends at the rate of 10% The

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On June 30, 2007, he receives dividends at the rate of 10%. The

ex-dividend NAV was Rs. 10.25. On December 31, 2007, the fund’s

NAV was Rs. 12.25.

– The begin period value of the investment is = 10.5 x 100 = Rs. 1050

– Number of units reinvested = 100/10.25 = 9.756 units

– End period value of investment = 109.756 x 12.25 = Rs. 1344.51

– The return on investment =(1344.51-1050)/1050 x 100

= 28.05%

141

Compounded Annual Growth Rate

CAGR is the rate at which investment has grown from begin point to

the end point on an annual compounding basis

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the end point, on an annual compounding basis

– V0(1+r)n = V1

– r =((V1 /V0)1/n)-1

Where

– V0 is the value at the start

– V` is the value at the end

– n is the holding period in years

– r is the CAGR

142

Expense and Income Ratios

Expense ratio is calculated as

– Total expenses/Average net assets X 100

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Total expenses/Average net assets X 100

– It is a measure of efficiency of the fund

– Important in the evaluation of debt and liquid funds

– Fund size and account size has an impact on the expense ratios

Income ratio is calculated as

– Net investment income/Average net assets

– Useful for evaluating income-oriented funds

143

Turnover Ratio

Portfolio turnover ratio is calculated as

– Value of assets purchased or sold/Net Assets x 100

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Value of assets purchased or sold/Net Assets x 100

– Measures the trading activity in the portfolio

– A turnover rate of 200% means the portfolio was turned over twice

A high portfolio turnover ration implies higher transaction costs

– All costs related to trading are called transaction costs

Transaction costs have to evaluated in the light of the type of

scheme and investment objective

144

Portfolio Characteristics

Size of the fund

– A larger fund enjoys benefits of scale, a smaller fund is more agile

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A larger fund enjoys benefits of scale, a smaller fund is more agile

Cash holdings of a fund

– A high cash holding may impair performance in a rising market but

protect downside in a falling market

Funds hold some cash for redemption needs

– Deploying funds collected in an NFO may take time

145

Comparison of Mutual Fund Performance

The performance of mutual is compared to

– A benchmark

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– Peer group average

– Other financial products

The market index is used as a benchmark

– Choice depends on the investment objective of the fund

The performance of a fund has to be compared with other similar

funds to be relevant

146

Benchmark Comparison

Market benchmarks are independent portfolios that are not

managed by any fund manager

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g y y g

A fund’s chosen benchmark has to be mentioned in the offer

document

– Has to reflect the portfolio and investment objective of the fund

– Can be changed with approval of the trustees

Mutual fund performance is measured relative to the benchmark

– Investors look for absolute returns

147

Peer Group Comparison

The factors to be considered while selecting funds for peer group

comparison are:

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– They should invest in the same asset class

– Investment pattern must be similar

– The funds must have comparable investment objective

– The size and quality of assets must be comparable

Funds are ranked by grouping similar funds

148

Regulations for Return Computation

Returns should be calculated using the NAV of the growth option

– Load should not be included

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Returns have to be computed for 1,3,5,10 years and since inception

Returns for periods less than one year have to be absolute returns

– Liquid fund returns alone can be annualized for periods of less than 1 yr

Returns for periods more than on year has to calculated usingCAGR

Returns have to be disclosed for the fund and benchmark

149

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Chapter 9Return, Risk, Performance and Fund Selection

Returns From Mutual Funds

The components of the returns from a mutual fund investment are

– Dividends

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– Capital Gains

Dividends are paid out to investors who choose the dividend option

Capital gains is the difference between the acquisition price and

sale price of units

– Realized when units are sold

151

Methods of Return Calculation

The methods of calculating returns from mutual funds are

– Change in NAV method

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– Total return Method

– Return on investment method

– Compounded annual growth rate method (CAGR)

The suitable method of calculating returns depends on the

investment objective of the investor

The performance data published by mutual funds use the CAGR

method for the growth option of a scheme

152

Change in NAV Method

Calculates the return between two dates

Example:

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– NAV of a fund was Rs. 23.45 at the beginning of a year

– NAV of the fund was Rs. 27.65 at the end of the year

Percentage change in NAV

= (27.65 – 23.45)/23.45 *100

= 17.91%

This method considers only the change in NAV between two dates

– Dividend paid, if any, is not considered

153

Total Return Method

Calculates the return by considering both dividend and capital

appreciation.

Example

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Example

– Investor bought units of a mutual fund scheme at a price of Rs.12.45

per unit

– He redeems the investment a year later, at Rs. 15.475 per unit

– During the year, he also receives dividend at 7%

The rate of return on his investment can be computed as

= ((15.475 – 12.45) + 0.70)/12.45 x 100

= (3.725/12.45) x 100 = 29.92%

Does not consider the re-investment of dividend

154

Return on Investment (RoI) Method

The RoI is calculated using the formula

– (Value of holdings at the end of the period - value of holdings at the

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beginning of the period)/ value of holdings at the beginning of the periodx 100

– Value of holdings at the beginning of the period = number of units at the

beginning x begin NAV

– Value of holdings end of the period = (number of units held at the

beginning + number of units re-invested) x end NAV

– Number of units re-invested = dividends/ex dividend NAV

155

RoI Method - Example

An investor buys 100 units of a fund at Rs. 10.5 on January 1, 2007.

On June 30, 2007, he receives dividends at the rate of 10%. The

8/6/2019 AMFI TTT part1 241008



ex-dividend NAV was Rs. 10.25. On December 31, 2007, the fund’s

NAV was Rs. 12.25.

– The begin period value of the investment is = 10.5 x 100 = Rs. 1050

– Number of units reinvested = 100/10.25 = 9.756 units

– End period value of investment = 109.756 x 12.25 = Rs. 1344.51

– The return on investment =(1344.51-1050)/1050 x 100

= 28.05%

156

Compounded Annual Growth Rate

CAGR is the rate at which investment has grown from begin point to

the end point, on an annual compounding basis

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– V0(1+r)n = V1

– r =((V1 /V0)1/n)-1

Where

– V0 is the value at the start

– V` is the value at the end

– n is the holding period in years

– r is the CAGR

157

Expense and Income Ratios

Expense ratio is calculated as

– Total expenses/Average net assets x 100

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– It is a measure of efficiency of the fund

– Important in the evaluation of debt and liquid funds

– Fund size and account size has an impact on the expense ratios

Income ratio is calculated as

– Net investment income/Average net assets

– Useful for evaluating income-oriented funds

158

Turnover Ratio

Portfolio turnover ratio is calculated as

– Value of assets purchased or sold/Net Assets x 100

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– Measures the trading activity in the portfolio

– A turnover rate of 200% means the portfolio was turned over twice

A high portfolio turnover ratio implies higher transaction costs

– All costs related to trading are called transaction costs

Transaction costs have to be evaluated in the light of the type of

scheme and investment objective

159

Portfolio Characteristics

Size of the fund

– A larger fund enjoys benefits of scale, a smaller fund is more agile

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Cash holdings of a fund

– A high cash holding may impair performance in a rising market but

protect downside in a falling market

Funds hold some cash for redemption needs

– Deploying funds collected in an NFO may take time

160

Comparison of Mutual Fund Performance

The performance of mutual is compared to

– A benchmark

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– Peer group average

– Other financial products

The market index is used as a benchmark

– Choice depends on the investment objective of the fund

The performance of a fund has to be compared with other similar

funds to be relevant

161

Benchmark Comparison

Market benchmarks are independent portfolios that are not

managed by any fund manager

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A fund’s chosen benchmark has to be mentioned in the offer

document

– Has to reflect the portfolio and investment objective of the fund

– Can be changed with approval of the trustees

Mutual fund performance is measured relative to the benchmark

– Investors look for absolute returns

162

Peer Group Comparison

The factors to be considered while selecting funds for peer group

comparison are:

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– They should invest in the same asset class

– Investment pattern must be similar

– The funds must have comparable investment objective

– The size and quality of assets must be comparable

Funds are ranked by grouping similar funds

163

Regulations for Return Computation

Returns should be calculated using the NAV of the growth option

– Load should not be included

Returns have to be computed for 1,3,5,10 years and since inception

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p y p

Returns for periods less than one year have to be absolute returns

– Liquid fund returns alone can be annualized for periods of less than one

year

Returns for periods more than one year has to calculated using

CAGR

Returns have to be disclosed for the fund and benchmark

164

Risk in Mutual Fund Investment

Risk arises when actual returns are different from expected returns

– Historical average is a good proxy for expected return

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Risk in equity funds depends upon the portfolio characteristics,

strategy and fund manager’s ability

– Maybe company specific or market risk

– Equity investing is profitable over the long-term

Risk in debt funds arises due to interest rate and credit risks

165

Measures of Risk

Standard deviation measures the fluctuation of actual return around

the mean

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– Preferred because it is a measure of total return

– Drawback is that it uses past performance data

Beta measures the sensitivity of a fund’s return to changes in the

market index

– Funds with high beta are more volatile

– Measures only market risk

Ex-marks or R-squared measures the extent to which the

fluctuation in returns can be explained by market movements166

Other Measures of Risk

Risk Adjusted Return considers risk premium in relation to the risk of

the fund

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– Sharpe ratio & Treynor ratio

Alpha is the excess return generated by a fund over what is justified

by its risk measured by beta

The P/E ratio of a fund can be used to gauge its risk

Interest rate risk and credit risk are the main risks in a debt fund

– Average maturity and duration measures interest rate risk

– Credit rating and NPAs measure credit risk

167

Equity Fund Selection

Fund category

– Suitability to investor objective

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Investment style

– Growth vs Value

Age of the fund

– Experience and consistency preferred to new fund

Fund management experience

Size of the fund

– Larger funds have lower costs

Performance and risk

168

Equity Fund Portfolio Evaluation

Percentage holding in cash

Concentration in portfolio

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Market capitalisation of the fund

Portfolio turnover

Risk Statistics – Beta

– Ex-Marks

– Gross dividend yield

– Funds with low beta, high ex-marks and high gross dividend yield is

preferable 169

Selection of Debt Funds

Total return rather than YTM is important

Expense very important

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– High expense ratios lead to yield sacrifice

Credit quality

– Better the rating of the holdings, safer the fund

Average maturity

– Higher average maturity means higher duration and interest rate risk

Tax implication have to be considered while selecting options

170

Selection of Liquid Funds

Relative yield of the fund is important

– Trade-off between yield and credit quality

P i f i i l i d

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Protection of principal invested

– NAV fluctuation limited due to low duration and low levels of interest

rate risk.

Credit quality of portfolio

Low expense ratio

Investor composition and size of the fund

171

Selection of Balanced Funds

Evaluation and selection criteria would depend upon the fund’s

equity or debt orientation

R t i k t ill d d thi i t ti

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– Returns ,risk , cost will depend on this orientation

Portfolio will have lower ex-marks and beta

– Average maturity of the debt component indicates the risk

Portfolio balance should be maintained in line with investment

objectives

– Tax status will depend upon the portfolio composition

172