chapter iii completed

8/2/2019 Chapter III Completed

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3. CHAPTER

3. MUTUAL FUND AN INSTRUMENT OF CAPITAL MARKET

3.1. Introduction to Capital Market3.1.1. Capital market securities

3.1.1.1. Interest rate securities

3.1.1.2. Zero-rated coupons3.1.1.3. Asset-backed bonds3.1.2. Regulation of the market3.1.3. Issues of new securities3.1.4. Trading principles and systems3.1.5. Value determination of bonds

3.1.5.1. Zero-rated coupon bonds3.1.5.2. Interest rate bonds

3.2. Role of a Capital Market in Economic Development3.2.1. Regulation of the Capital Market3.2.2. The Capital Markets Influence on International

Trade3.2.3. The Primary and Secondary Markets3.2.4.Capital market in India-Market Structure, Functions

& Framework3.3. Instruments of Capital Market3.4. Performance of Mutual Fund in Indian Capital Market

3.4.1. Association of Mutual Funds in India (AMFI)3.4.2. The objectives of Association of Mutual Funds in

India3.4.3. The sponsors of Association of Mutual Funds in India3.4.4. Future of Mutual Fund in India

3.5. Development of Mutual Fund in India3.5.1. Mutual Funds Industry comes to India3.5.2. Scope for growth and development of Mutual Fund in

India3.5.3. Growth of Mutual Fund Business in India3.5.4. Scope for development of Mutual Fund Business in

India3.6. Organizational Structure of Mutual Funds

3.6.1. Organization Structure of Indian Mutual Funds3.6.2. Organization Sructure of the Unit Trust of India3.6.3. Organization Structure of Mutual Funds of Public

Sector Banks3.7. Regulatory Measures by SEBI

3.7.1. Mutual Funds Industry in India- Regulatory Measuresby SEBI

3.7.2. Appointment of Trustees- Eligibility Criteria, Duties& Code of Conduct for Trustees

3.7.3. Constitution and Management of Asset ManagementCompany (AMC) and Custodian


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3.7.4. Schemes of Mutual Fund Procedure for launching ofschemes

3.7.5. Investment Objectives and Valuation Policies3.7.6. A Message to Investors Relating to Investment in

Mutual Fund

3.8. P.K Kaul committee and its recommendations3.8.1. Constitution of PK Kaul Committee3.8.2. Recommendations of PK Kaul Committee on the

Manner of Discharging of Responsibilities by theTrustees under the SEBI (Mutual Funds)

Regulations, 19963.8.3. Recommendations of PK Kaul Committee on the,

Manner of Discharging of Responsibilities by theTrustees under the SEBI (Mutual Funds)

Regulations, 1996 (Contd.)3.9. UTI Crisis and After

3.9.1. UTI Crisis & After - The Public Outcry3.9.2. How the Crisis Originated3.9.3. UTI Crisis - Recommendations of the Deepak Parekh

Committee3.9.4. Finance Minister Bales out UTI - UTI Mutual Fund

Comes into Existence3.10. Recent Development of Mutual Funds in India3.11. Mutual Funds Companies in India3.12. Steps to invest in Mutual Funds3.13. Risks the Investor may confront by Investing in a Mutual Fund


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3. CHAPTER

MUTUAL FUND AN INSTRUMENT OF CAPITAL MARKET

3.1. Introduction to Capital Market

The capital market is the market for the issue and trading of long-term securities. The termin this instance is measured as the term to maturity of the security and in order to be classified as acapital market instrument, the term to maturity should be longer than 3 years. During the tradingof these instruments, the securities traded are informally classified into short-term, medium-termand long-term securities depending on their term to maturity. Where the term to maturity of theinstrument is up to five years, the security is classified as a short-term capital marketinstrument. Where the term to maturity is five to ten years, the security is classified as mediumterm, and where the term to maturity is more than 10 years, the security is known as long-term.

The primary market is the market for the first issue of securities. This issue is normally doneby means of a public issue or by private placement. The secondary market is the market for tradingsecurities once they have been issued. The secondary market has a big influence on the issues in

the primary market, as the market rate is determined in the secondary market. Issues in theprimary market at below market rate, determined in the secondary market, would be issued at adiscount on the nominal value of the instrument. If the volumes traded in the secondary market arehigh it could be an indicator that an excess of long-term money is available in the market, and itmay thus be an opportune time to issue new securities into the market by means of the primarymarket. Therefore, if the liquidity in the secondary market is high, chances are that new issueswould be more successful than in an illiquid market.

3.1.1. Capital market securities

Instruments issued and traded in the capital market differ in certain characteristics, such as: term to maturity (as discussed above) interest rate paid on the nominal value interest payment dates nominal amount in issue.

3.1.1.1. Interest rate securities


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The interest paid on the nominal amount of capital market securities (called the coupon rate)appears on the certificate received by the holder (the investor) of such a security. This coupon rateis one of the parameters used to determine the consideration paid for the security when traded inthe secondary market. Most securities are issued at a fixed coupon rate such as the Eskom 168(E168) security that is issued at a coupon rate of 11%. This means that the registered holder of an

Eskom E168 certificate will receive 11% interest per year (NACSA) on the nominal amount of theinstrument. The nominal amounts are in multiples of R1 million, and the interest on the E168 ispaid biannually on 1 June and 1 December. The holder of an E168 with a nominal value of R1million will thus receive R55 000 on 1 June and R55 000 on 1 December. Certain securities are,however, issued at a variable coupon rate, where the coupon rate is then linked to a well-knowninterest rate such as the prime overdraft rate or the 90-day BA rate.

Capital market securities are physical certificates and the issuer of the security keeps aregister of owners. This register is used by the borrower (issuer) to pay interest to the lender(owner of the security) on the interest payment dates indicated on the certificate. When aninstrument is sold to a new owner in the secondary market, the buyer is registered as the newowner on the settlement date of the transaction. For administrative purposes the register of the

issuer closes for registration of new owners, normally one month prior to the interest paymentdate. The date when the register closes is known as the last day to register (LDR). This meansthat the person or company who is registered as the owner one month before the interest paymentdate (on LDR), will receive the interest on the payment date.If a bond is sold and settled between the LDR and the interest payment date, the seller will receivethe interest payment. The buyer is then known to buy the instrument "ex interest"(withoutinterest). However, if a transaction takes place before the LDR, the buyer buys the instrument"cum interest"(including interest), because he will be registered as the owner before the registercloses, and will receive the next interest payment.

3.1.1.2. Zero-rated coupons

Long-dated (securities with long terms to maturity) zero-rated coupons are capital marketinstruments issued by borrowers of money. These instruments do not earn interest on the capitalamount invested by the lender, and are therefore issued and traded at a discount on the nominalvalue, similar to discount instruments in the money market such as BAs and treasury bills.The market value (nominal value less discount) of zero (or nil)-rated coupon bonds depends on theyield that the investor (lender) expects on his investment. The redemption amount, which is theonly cash inflow for the investor, is equal to the nominal value of the bond, and is thus known tothe investor. Since the redemption date is also known, the investor can calculate the amount thathe is willing to pay for the bond according to the yield (expressed in terms of interest rate) that hewants to earn on the investment. This yield on zero-rated coupon bonds is normally linked to themarket rate on long-term (capital market) investments.

3.1.1.3. Asset-backed bonds

Where an asset exists which represents cash inflow stream such as a normal loan orinvestment, a bond can be issued to fund this asset. The bond income is then derived or backed by


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the income stream of the asset. The performance on the bond is then dependent on the assetperformance.3.1.2. Regulation of the market

The market was unregulated in terms of trading up to the 1980s. Trading took place on anOTC basis and the settlement system, which is still used in some cases, where physical settlements

take place on the second Thursday after the transaction. With the new bond exchange, settlementwill come in line with international standards, with settlement taking place three days after thetransaction by electronic means.In 1989 the Financial Markets Control Act was promulgated which regulated the initiation andexistence of financial markets. The Bond Market Association was formed to establish an exchangeand from this the Bond Exchange of South Africa (BESA) was established as a formal financialexchange licensed under the act on 15 May 1996. BESA is responsible for the listing/delisting ofinstruments, its members and the surveillance of trading activities.

Members of BESA include resident banking groups, large issuers, stockbrokers and anumber of major resident financial institutions and intermediaries meeting specific requirements.BESA members are allowed to act as agent and principal (dual trading capacity), or as principal

only. A Guaranty Fund has been established in order to protect the investing public against theconsequences of the insolvency of members.

3.1.3. Issues of new securities

The major issuers of bonds in South Africa at present are the Republic of South Africa("RSA") through the Treasury and semi-governmental bodies such as Eskom, Development Bankof Southern Africa, Telkom, Transnet and Land Bank. Government bonds are commonly referredto as "gilts". Intermediaries such as brokers and banks (especially merchant banks) are often usedby borrowers to administer the issuing of new bonds.

Bonds can be issued in the primary market using several different methods. As withequities, bonds can be issued by way of public subscription where a prospectus is issued whichcontains details of the company issuing the bond, and of the bond itself. The public can thensubscribe to the bond, and the borrower or an intermediary on behalf of the borrower will allocatebonds to subscribers on issue date by means of a certain process.Bonds can also be issued through private placing. This method is used when the borrower (or anintermediary on behalf of the borrower) places bonds with certain investors selected by theborrower. The selected investor would then receive a certain amount of bonds at issue date andpay the borrower the issue price for the bonds received.

A third method used to issue bonds is known as the "tender"method. The borrower orintermediary will issue a media statement that bonds will be issued in the market on a certain date.The details of the bonds and the capitalisation of the issue (total nominal amount to be issued) willalso be communicated. Interested parties are then invited to tender before a certain date for thesebonds. Tenders from interested parties would normally consist of the nominal amount plus thepercentage of the nominal amount that the interested party is willing to pay for the bonds at issue,for example, a tender for R5 million worth of bonds at 97% of the nominal amount. If this tendersucceeds, the tendering party will take up R5 million worth of bonds at issue date and pay theborrower (R5 000 000 x 97%) = R4 850 000. The borrower usually allots the bonds in order ofhighest tenders first, but it is in his power to decide who will receive bonds at issue date.

Another method that is used to issue new instruments is known as the "tap"method,whereby not all the bonds are allocated at the first issue (which can be done by any of the above


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three methods). If, for instance, a borrower wants to issue R100 million worth of bonds he canchoose to issue only R60 million at the first issue. The borrower or intermediary then startscreating a secondary market for these instruments by buying and selling the issued instruments inthe secondary market. This process, where one party buys and sells the same instrument in themarket, is known as market making. The market maker thus has a bid (to buy) and an offer (to

sell) in the market for the same instrument, trying to create an active and liquid market in thisinstrument. The "tap"method is then used by the borrower or intermediary, whereby moreinstruments are sold in the market than that bought back. By using this method, the amount of theloan is increased, often without the market realising it. This method can also be used in inverseform to decrease the total outstanding loan. The ultimate borrower in the capital market can usethe tap method, because he is allowed to trade in his own securities. This is however not possiblein the equities market because a company is not allowed to buy its own shares according to theCompanies Act.

3.1.4. Trading principles and systems

Capital market instruments or bonds are instruments that represent future cash flow streams.

In the case of an interest-paying bond, the cash flow will be made up of periodic interest paymentsand the nominal amount at redemption date. In the case of nil or zero-rated coupon bonds, thecash flow is a single payment of the nominal or redemption amount at the redemption date.

As can be seen from the value determination in 4.6, the values of these instruments aredetermined by discounting the cash flows back to the current date at an applicable rate (the yield ormarket rate). If the rate used to discount the cash flows back to a present value is high, the presentvalue is low. If the rate used to discount the cash flows is low, the current value is high. This rateused for discounting the cash flows will be the yield that the investor would receive (known as theyield-to-maturity or YTM) on his original investment (the physical investment being the presentvalue) if he keeps the bond up to maturity.

Bonds are thus traded in terms of yields-to-maturity expressed as interest rates. The rate atwhich the bond traded for a specific day or period would be known as the market rate for thatspecific day or period.

South African bonds can be screen traded, or by open outcry, through a BESA member.Screen trading takes place through intermediaries such as FCB or IMB. Bids and offers receivedtelephonically from players in the market are quoted on a screen. This screen is available totraders in the market. If a trader wants to trade on one of the bids or offers quoted, he phones theintermediary (FCB or IMB) who then lets the other party to the transaction know that the deal isclosed and the detail thereof. Both parties have to book the deal with BESA who matches the dealand sends a report of deals done to every member at the end of the day. Trading hours on BESAare from Monday through to Friday from 07h00 to 17h00. Bonds are exempt from marketablesecurities tax and stamp duty.A dealer's note or a capital market transaction note is normally completed by the dealer, mostly onscreen, who then hands it to the administrative section for confirmation, settlement and accountingpurposes. The dealer or capital market transaction note normally has at least the followinginformation indicated the name of the bond traded, e.g. E168 the nominal amount traded the rate or yield at which traded (from which the settlement amount or value will be calculated) the counter party whether the transaction is a buy or a sell


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the date and time of the transaction the settlement date (which differs from the transaction date) the dealer's name and signature.Dealers do different kinds of transactions. If a dealer acts only as an agent, transactions are donein such a manner that the dealer's company has no open position. A back-to-back deal, for

instance, is a transaction where the instrument involved is bought and sold, resulting in no openposition for the trader.Small participators in the market often do not have the funds to settle the transaction on the

settlement date. If such a trader in the market is of the opinion that rate will decrease, resulting inan increase in value of the security, he could do the following deal:

He could buy the instrument for settlement in three days time (for this example, assumethat the first settlement date is 1 March). If the rates have not moved down on 1 March, hewill want to keep the instrument, but does not have the cash to settle the transaction. He canthen do a transaction with a large institution where he sells the instrument to them forsettlement on 1 March, and buys the instrument back from them for settlement on 4 March.This transaction, where an instrument is simultaneously bought and sold to the same party for

different settlement dates, is called a carry transaction. The trader's position for 1 March is anet nil position because he has bought and sold the instrument. He must, however, settle on 4March, or do a similar carry transaction for that date. Since the implementation of the T+3settlement period on the bond exchange (settlement within three working days of thetransaction), these transactions have mainly been replaced by scrip lending (see below) orfuture swaps transactions.An instrument can be sold short in the capital market (a bear sale). If an instrument is sold

on 1 April for settlement on 4 April, without the seller physically owning the instrument, it can bebought back before 4 April for settlement on 4 April. Alternatively, the certificates needed tosettle the transaction could be borrowed from a large institution owning some of these instrumentsand not trading in them. Security will have to be given, and credit risk checks will be done on the

borrower. This is known as scrip lending. Scrip lending typically costs the borrower between 2%and 3% per year of the value of the scrip for the period that the scrip is being borrowed.Some institutions that have scrip on hand also offer physical/future swap transactions. This

means that the person or institution that is short of scrip because of a bear sale, can swap thephysical scrip and a future to sell the same stock, with the institution that has the scrip on handphysically. The difference between the buying price of the physical stock and the selling price ofthe future contract will be the profit that the facilitator would make.

3.1.5. Value determination of bonds3.1.5.1. Zero-rated coupon bonds

A simple way of determining the trading value of these assets is by expressing the nominalvalue of the coupon as a percentage of the nominal value plus the yield that the investor wants toearn on his investment over the period, for example:TV = NV/(1+i)^n (for clarity x^n = x to the power of n)

TV - trading value

NV - nominal value


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i - yield in terms of rate (for the transaction)

n - periods left to redemption date (To be expressed in the same time zones as yieldrate periods)

Example:

If the investor wants to earn 12% interest on his investment and the remaining period toredemption is 2 years, then the amount that he would be willing to pay for a zero-rated couponwith a nominal value of R2 million would be:TV = R2 000 000/(1+0.12)^2TV = R1 590 0003.1.5.2. Interest rate bonds

To calculate the consideration that the buyer of a bond would pay to the seller, all the cashflows belonging to the buyer should be discounted back to the settlement date, at the rate at whichthe transaction is done (YTM). The "all-in-price"of a bond is this present value that expresses theconsideration that the buyer of a bond would pay to a seller, and takes into account the nextinterest payment that the buyer would receive if the transaction was cum interest, or the next

interest payment that the seller would receive if the transaction was ex interest.The all-in price is calculated as:AIP = V^(d1/d2) x [0,5c x (AV + e) + 100 x V^n]Where

AIP = the all-in price

d1 =number of days from settlement date to next interest date (to calculate the interestportion belonging to the buyer)

d2 = number of days from last interest date to next interest date

i = the yield (interest rate expressed as a number) at which the transaction is done

V = 1/(1 + i/200) is the present value of one payable in six months' time at the YTM

c = the coupon rate expressed as a number

n =the number of complete six month periods (if interest is paid every six months) fromnext interest date to redemption date

AV = (1 - V^n) / (i/200)

e = 1 if the transaction is cum interest and 0 if the transaction is ex interest.

The accrued interest is the interest portion of the next interest payment that is liable to theseller if the transaction is cum interest, and in the case of an ex interest transaction, the accruedinterest is the portion liable to the buyer.Accrued interest is calculated as follows:If cum interest:

d2 - d1 x c

Al = 365If ex interest:d1 x c

Al = 365Where

Al = Accrued interestThe clean price of a bond is the discounted cash flows of a bond ignoring the consequences of exand cum interest payments, and is mainly used for accounting purposes. The clean price (CP) is


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calculated as follows:CP = AIP - AlExtensive example: determination of trading valueThe following stock relates to the transactions described below:

Stock: Eskom E168Date of maturity: 1 June 2008

Nominal amount R1 million

Coupon - annual: 11,00%

Interest dates: June 1 and December 1

a) The stock is sold on 28 June 1996 at a yield of 16%, settlement date 6 July 1996. Calculate the value that the buyer will pay (all-in price).

The determinants of this equation will be as follows:d1 = 148d2 = 183

i = 16V = 0,925926c = 11n = 23AV = 10,3711e = 1AIP = R747 709

Calculate the clean price.Al = 10 548CP = R737 161

b) The stock is sold on 1 November 1996 at a yield of 15,5%, settlement date 9 November 1996. Calculate the consideration (all-in price).

In this case the following determinants are relevant:d1 = 22d2 = 183i = 15,5V = 0,928074c = 11n = 23AV = 10,58531e = 0

AIP = R755 025 Calculate the clean price.

Al = -6 630CP = R761 655

3.2. Role of a Capital Market in Economic Development


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The primary role of the capital market is to raise long-term funds for governments, banks,and corporations while providing a platform for the trading of securities.This fundraising is regulated by the performance of the stock and bond markets within the capitalmarket. The member organizations of the capital market may issue stocks and bonds in order toraise funds. Investors can then invest in the capital market by purchasing those stocks and bonds.

The capital market, however, is not without risk. It is important for investors to understandmarket trends before fully investing in the capital market. To that end, there are various marketindices available to investors that reflect the present performance of the market.3.2.1. Regulation of the Capital Market

Every capital market in the world is monitored by financial regulators and their respectivegovernance organization. The purpose of such regulation is to protect investors from fraud anddeception. Financial regulatory bodies are also charged with minimizing financial losses, issuinglicenses to financial service providers, and enforcing applicable laws.3.2.2. The Capital Markets Influence on International Trade

Capital market investment is no longer confined to the boundaries of a single nation.Todays corporations and individuals are able, under some regulation, to invest in the capital

market of any country in the world. Investment in foreign capital markets has caused substantialenhancement to the business of international trade.3.2.3. The Primary and Secondary Markets

The capital market is also dependent on two sub-markets the primary market and thesecondary market. The primary market deals with newly issued securities and is responsible forgenerating new long-term capital. The secondary market handles the trading of previously-issuedsecurities, and must remain highly liquid in nature because most of the securities are sold byinvestors. A capital market with high liquidity and high transparency is predicated upon asecondary market with the same qualities.

A capital market is a market where both government and companies raise long term funds totrade securities on the bond and the stock market. It consists of both the primary market where newissues are distributed among investors, and the secondary markets where already existent securitiesare traded

3.2.4.Capital market in India-Market Structure, Functions & FrameworkThe Corporate Sector draws its capital needs from the following sources:

1. Promoters Contribution,2. Equity & Preference Capital raised from the shareholders (generally referred to as equity

capital),3. Bonds/Debentures raised from the Public (generally referred to as Debt Capital),4. Term Loans from Banks & Financial Institutions,5. Short-term Working Capital from Banks,6. Unsecured Loans & Deposits, and7. Internal generation of Funds (Profits/surpluses re-ploughed).

Of the sources enumerated above, item No.1 and 2 are held permanently and form the risk capital.These are not repayable. Item No.3 is raised from the market for duration of 10 to 15 years ormore, but this has to be eventually repaid. We call the source as Corporate Debt Market, and fundsraised as II Tier Capital. The debt market consists of such corporate debt and also public debt(government securities & Treasury Bills) Managed by the RBI. The others sources at item 4 to 6are supplementary or stand-by sources and these are all to be repaid as per contracted terms. Item


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No.4 is negotiated & raised for 3 to 7 years from Banks/FIs, but normally not exceeding 10 years.Short-term working capital Loan is generally a revolving facility and held over the years subject tosatisfactory dealings and abiding by the terms & conditions stipulated by the lending Institution.Unsecured Loans & Deposits are at best supplementary sources, but these are not very dependable.Internal generation of funds (profits & surpluses are used to eventually redeem the debt borrowings

mentioned at item No.3 to 6.The basic capital edifice of a corporate body is built from item 1 to 3 above. With the strength ofthis edifice it is possible to raise the remaining sources at item No.4 to 6. This introduces us to theCapital Market (covering equity and corporate debt capital). Promoters equity constitutes acomparatively a smaller portion, and hence the primary source of capital for a large CorporateInstitutions is from the Capital Market (providing the equity capital & debt capital to business,trade & industry)

Composition of Equity/Corporate Debt MarketThis is the market consisting of large number of individual investors, household

savers, professionals, agriculturists, who are able to a retain a part of their current earnings. They

form the class of capital providers. On the other side the Corporate bodies engaged in Industry,trade and other business ventures are the productive users of significant amount of capital. It is theCapital market that transforms the savings of large number of individuals to productive channel tomeet the demands of capital for Industry, trade and business.

The individual savers are not organised. They can invest if they could secure the trust andconfidence that the funds invested would be prudently employed and they could normally expect toget a fair return/reward on their hard-earned savings. This is the function of organised capitalmarket to regulate market forces to ensure fair dealings, to motivate savings on the part of theinvestors and to secure smooth flow of savings/capital from investors to capital seekers forproductive needs.

Stock market is also referred to as the Corporate Debt or Capital Market. While the moneymarket, which deals with short-term financial needs of business and industry is restricted to fundsneeded for a period of one year or less, instruments of the debt/capital markets are raised formedium or long term needs. Indian Stock Market consists of three distinct segments:

1. The Public Debt Market i.e. the market for Government securities (also called Gilt-edgedMarket). These are interest bearing and dated securities. This market is regulated by RBI,the Central Bank of the country and banker to the Government.

2. PSU Bonds Market i.e. Bonds floated by public Sector units, nationalised banks andfinancial Institutions for raising Tier-II capital and also debentures floated by corporates.This is represented as the Corporate Debt Market.

3. The Equity Market for raising of equity or preference share capital by all corporates.Money invested in company shares is not refundable, but if the shares are listed in a stockexchange these can be sold or purchased, thus providing liquidity to such investments.Shares do not carry interest, but shareholders can participate in sharing the profits of thecorporate body declared by way of dividends, bonus shares etc. While the hope ofreceiving attractive dividends motivates the public to subscribe to the share capital,declaring dividend is not a legal obligation on the part of the companies, and hence not aright on the part of the shareholders. But shareholders enjoy various other rights asconferred by the Indian Companies Act, 1956. Indian Public companies generally followthe objective of increasing shareholders wealth as the prime goal of financial management.


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At this context it is relevant to mention about two categories of stock market, i.e. Primary market covering new public issues of all categories of securities, including G-sec,

bonds and equity/preference capital. Secondary market, which deals with already issued securities of all types. Transactions of

the secondary market are carried out through one of the authorised stock exchanges, where

the traded security is listed.The Primary Stock MarketIt is also called the market for public issues. This market refers to the raising of new capital

(equity or debt i.e. equity shares, preference shares, debentures or Rights Issues) by corporates.Newly floated companies or existing companies may tap the equity market by offering publicissues. When equity shares are exclusively offered to the existing shareholders, it is called "RightsIssue". When a Company after incorporation initially approaches the public for the first time forsubscription of its public issue it is called Initial Public Officer (IPO). Successful floating of a newissue requires careful planning, timing of the issue and comprehensive marketing efforts. Theservices of specialised institutions, like underwriters, merchant bankers and registrars to the issueare available for the corporate body to handle this specialised job. Underwriters are financial

institutions, which undertake to secure a committed quantum of equity/debt subscribed by thepublic, failing which they accept these shares/bonds as their own investment. It is referred to as theissue or that part of getting devolved on the underwriters. The transactions relating to the primarymarket i.e. public/rights issues are not carried out through stock exchanges. However there iseffective regulation of SEBI at every stage of a public issue. This is done through merchantbankers, underwriters and registrars to the issue each acting at different points. Subscriptions to thenew issue are collected at specific branches of one or more collecting banks within a prescribedspan of time, represented by the dates of opening of the issue and closing of the issue.

Secondary Stock MarketThe Secondary Market deals with the sale/purchase of already issued equity/debts by the

corporates and others. The sale/purchase of these securities are carried out at the specific StockExchange(s), where the companies get their public issues listed for trading. The main function ofthe secondary market is to provide liquidity to the listed securities by enabling a holder to easilyconvert the securities into cash through the stock exchanges. An individual or an Institution caneither hold a portfolio of securities as a permanent investment, or he can hold a basket of securitiesfor short-periods and engage in buying and selling them to gain from market fluctuations. Thesecondary market also acts as an important indicator of the investment climate in the economy.When prices of existing securities are rising and there is large trading in the existing shares, such aboom in the secondary market correspondingly signifies that new issues if floated at that point oftime would be successfully subscribed.

Functions of the Capital Market1. The organised and regulated capital market motivates individual to save and invest funds.

The availability of safe and profitable source of investment is an essential criteria tocreate propensity to save and invest on the part of the earning public.

2. It provides for the investors a safe and productive channels for investment of savings andsecure the recurring benefit of return thereon, as long as the savings are retained.


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3. It provides liquidity to the savings of the investors, by developing a secondary capitalmarket, and thus makes even short term savings, consistently available for long-term users

4. It thus mobilises savings of large number of individuals, families and associations andmake the same available for meeting the large capital needs of organised industry, tradeand business and for progress and development of the country as a whole and its economy.

To discharge these functions, the organised capital market accepts a dual responsibility To develop the market and to promote savings & Investment; To regulate the players in the market vis-a-vis the investor and to enforce market

discipline, through market regulators and registered intermediaries. Such that theunorganised small man is able to deal through these regulatory bodies and theintermediaries, and need not necessarily has to come into direct contact with the ultimateseekers of his savings.To understand the regulatory and control systems in-built in the market, we must study the

structural framework of the capital market. The capital market consist of the following elements.1. One the one hand are the innumerable, but not organised savers, and2. At the other end are those seeking capital from the capital market;

3. Regulatory Body :SEBI (the Securities & Exchange Board of India) an autonomous and statutory bodyacts as the market regulator and market developer. It regulates and controls the capital users and allfunctionaries between the users and the investors.

4.The Stock Exchanges :There are 23 Stock Exchanges registered with SEBI and under its regulation. They

provide a transparent and safe (risk-free) forum of a market for investors to transact and investtheir funds

5.The Depositories :The depositories are innovative institutions, who are able to render the market paperless by

holdings securities electronically, providing ease and speed for those transacting in the market6.The Registered Intermediaries :

They consist of brokers, sub-brokers, Trading and Clearing Members, portfolio managers,Bankers to Issue, merchant bankers, registrars, underwriters and credit rating agencies. They allprovide a basket of services to the investors to lesson risk and make transacting earlier and smooth.They are all registered with SEBI and act under the regulation of SAEBI abiding by the Code ofConduct prescribed for each of them governing their respective roles.

So vast and well established is the market that the daily turn over in the main StockExchange in the Country National Stock Exchange of India averages Rs.2000 Crores presently andbound to multiply further in the coming future.

3.3. Instruments of Capital Market

There are a number of capital market instruments used for market trade, including stocks,bonds, debentures, T-bills, foreign exchange, fixed deposits, and others. These are used by theinvestors to make a profit out of their respective markets.

All of these are called capital market instruments because these are responsible forgenerating funds for companies, corporations, and sometimes national governments.


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This market is also known as securities market because long term funds are raised throughtrade on debt and equity securities.

These activities may be conducted by both companies and governments.

This market is divided into primary capital market and secondary capital market.

The primary market is designed for the new issues and the secondary market is meant for

the trade of existing issues. Stocks and bonds are the two basic capital market instruments used in both the primary and

secondary markets. There are three different markets in which stocks are used as the capitalmarket instrument: the physical, virtual, and auction markets.

Bonds, however, are traded in a separate bond market. This market is also known as a debt,credit, or fixed income market.

Trade in debt securities are done in this market. There are also the T-bills and Debentureswhich are used as capital market instruments by the investors.

These instruments are more secured than the others, but they also provide less return thanthe other capital market instruments.

While all capital market instruments are designed to provide a return on investment, therisk factors are different for each and the selection of the instrument depends on the choiceof the investor.

The risk tolerance factor and the expected returns from the investment play a decisive rolein the selection by an investor of a capital market instrument.

Capital market instruments should be selected only after doing proper research in order toincrease one

3.4. Performance of Mutual Fund in Indian Capital Market

Let us start the discussion of the performance of mutual funds in India from the day theconcept of mutual fund took birth in India. The year was 1963. Unit Trust of India invitedinvestors or rather to those who believed in savings, to park their money in UTI Mutual Fund.

For 30 years it goaled without a single second player. Though the 1988 year saw some newmutual fund companies, but UTI remained in a monopoly position.

The performance of mutual funds in India in the initial phase was not even closer tosatisfactory level. People rarely understood, and of course investing was out of question. But yes,some 24 million shareholders was accustomed with guaranteed high returns by the begining ofliberalization of the industry in 1992. This good record of UTI became marketing tool for newentrants. The expectations of investors touched the sky in profitability factor. However, peoplewere miles away from the preparedness of risks factor after the liberalization.

The Assets Under Management of UTI was Rs. 67bn. by the end of 1987. Let meconcentrate about the performance of mutual funds in India through figures. From Rs. 67bn. theAssets Under Management rose to Rs. 470 bn. in March 1993 and the figure had a three timeshigher performance by April 2004. It rose as high as Rs. 1,540bn.

The net asset value (NAV) of mutual funds in India declined when stock prices startedfalling in the year 1992. Those days, the market regulations did not allow portfolio shifts intoalternative investments. There were rather no choice apart from holding the cash or to furthercontinue investing in shares. One more thing to be noted, since only closed-end funds were floatedin the market, the investors disinvested by selling at a loss in the secondary market.

The performance of mutual funds in India suffered qualitatively. The 1992 stock marketscandal, the losses by disinvestments and of course the lack of transparent rules in the where about


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rocked confidence among the investors. Partly owing to a relatively weak stock marketperformance, mutual funds have not yet recovered, with funds trading at an average discount of 10-20 percent of their net asset value.

The supervisory authority adopted a set of measures to create a transparent and competitveenvironment in mutual funds. Some of them were like relaxing investment restrictions into the

market, introduction of open-ended funds, and paving the gateway for mutual funds to launchpension schemes.The measure was taken to make mutual funds the key instrument for long-term saving. The

more the variety offered, the quantitative will be investors.At last to mention, as long as mutual fund companies are performing with lower risks and

higher profitability within a short span of time, more and more people will be inclined to investuntil and unless they are fully educated with the dos and donts of mutual funds.

3.4.1. Association of Mutual Funds in India (AMFI)

With the increase in mutual fund players in India, a need for mutual fund association in Indiawas generated to function as a non-profit organisation. Association of Mutual Funds in India

(AMFI) was incorporated on 22nd August, 1995.AMFI is an apex body of all Asset Management Companies (AMC) which has been registeredwith SEBI. Till date all the AMCs are that have launched mutual fund schemes are its members. Itfunctions under the supervision and guidelines of its Board of Directors.

Association of Mutual Funds India has brought down the Indian Mutual Fund Industry to aprofessional and healthy market with ethical lines enhancing and maintaining standards. It followsthe principle of both protecting and promoting the interests of mutual funds as well as their unitholders.

3.4.2.The objectives of Association of Mutual Funds in IndiaThe Association of Mutual Funds of India works with 30 registered AMCs of the country. It

has certain defined objectives which juxtaposes the guidelines of its Board of Directors.The objectives are as follows:

This mutual fund association of India maintains a high professional and ethicalstandards in all areas of operation of the industry.

It also recommends and promotes the top class business practices and code ofconduct which is followed by members and related people engaged in theactivities of mutual fund and asset management. The agencies who are by anymeans connected or involved in the field of capital markets and financial servicesalso involved in this code of conduct of the association.

AMFI interacts with SEBI and works according to SEBIs guidelines in the mutual fundindustry.

Association of Mutual Fund of India do represent the Government of India, theReserve Bank of India and other related bodies on matters relating to the MutualFund Industry.

It develops a team of well qualified and trained Agent distributors. It implements aprogramme of training and certification for all intermediaries and other engaged in themutual fund industry.

AMFI undertakes all India awarness programme for investors in order to promote properunderstanding of the concept and working of mutual funds.


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At last but not the least association of mutual fund of India also disseminate information onMutual Fund Industry and undertakes studies and research either directly or inassociation with other bodies.

3.4.3. The sponsors of Association of Mutual Funds in India

Bank Sponsored SBI Fund Management Ltd. BOB Asset Management Co. Ltd. Canbank Investment Management Services Ltd. UTI Asset Management Company Pvt. Ltd.

Institutions

GIC Asset Management Co. Ltd. Jeevan Bima Sahayog Asset Management Co. Ltd.

Private Sector

Indian:-

BenchMark Asset Management Co. Pvt. Ltd.

Cholamandalam Asset Management Co. Ltd. Credit Capital Asset Management Co. Ltd. Escorts Asset Management Ltd. JM Financial Mutual Fund Kotak Mahindra Asset Management Co. Ltd. Reliance Capital Asset Management Ltd. Sahara Asset Management Co. Pvt. Ltd Sundaram Asset Management Company Ltd. Tata Asset Management Private Ltd.

Predominantly India Joint Ventures:-

Birla Sun Life Asset Management Co. Ltd. DSP Merrill Lynch Fund Managers Limited HDFC Asset Management Company Ltd.

Predominantly Foreign Joint Ventures:-

ABN AMRO Asset Management (I) Ltd. Alliance Capital Asset Management (India) Pvt. Ltd. Deutsche Asset Management (India) Pvt. Ltd. Fidelity Fund Management Private Limited Franklin Templeton Asset Mgmt. (India) Pvt. Ltd. HSBC Asset Management (India) Private Ltd. ING Investment Management (India) Pvt. Ltd. Morgan Stanley Investment Management Pvt. Ltd. Principal Asset Management Co. Pvt. Ltd. Prudential ICICI Asset Management Co. Ltd. Standard Chartered Asset Mgmt Co. Pvt. Ltd.


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3.4.4. Future of Mutual Fund in India

By December 2004, Indian mutual fund industry reached Rs 1,50,537 crore. It is estimatedthat by 2010 March-end, the total assets of all scheduled commercial banks should be Rs 40,90,000crore.

The annual composite rate of growth is expected 13.4% during the rest of the decade. In the

last 5 years we have seen annual growth rate of 9%. According to the current growth rate, by year2010, mutual fund assets will be double.Let us discuss with the following table:

Aggregate deposits of Scheduled Com Banks in India (Rs.Crore)

Month/Year Mar-98 Mar-00 Mar-01 Mar-02 Mar-03Mar-04

Sep-04 4-Dec

Deposits 605410 851593 989141 1131188 1280853 - 1567251 1622579

Change in % over lastyr

15 14 13 12 - 18 3

Source - RBI

Mutual Fund AUMs Growth

Month/Year Mar-98 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Sep-04 4-Dec

MF AUM's 68984 93717 83131 94017 75306 137626 151141 149300

Change in % over last yr 26 13 12 25 45 9 1

Source - AMFI

Some facts for the growth of mutual funds in India

100% growth in the last 6 years.

Number of foreign AMC's are in the que to enter the Indian markets like FidelityInvestments, US based, with over US$1trillion assets under managementworldwide.

Our saving rate is over 23%, highest in the world. Only channelizing these savings inmutual funds sector is required.

We have approximately 29 mutual funds which is much less than US having more than800. There is a big scope for expansion.

'B' and 'C' class cities are growing rapidly. Today most of the mutual funds areconcentrating on the 'A' class cities. Soon they will find scope in the growing cities.

Mutual fund can penetrate rurals like the Indian insurance industry with simple andlimited products.

SEBI allowing the MF's to launch commodity mutual funds.

Emphasis on better corporate governance.

Trying to curb the late trading practices.

Introduction of Financial Planners who can provide need based advice.

3.5. Development of Mutual Fund in India


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Mutual funds really captured the public's attention in the 1980s and '90s when mutual fundinvestment hit record highs and investors saw incredible returns. However, the idea of poolingassets for investment purposes has been around for a long time. Here we look at the evolution ofthis investment vehicle, from its beginnings in the Netherlands in the eighteenth century to itspresent status as a growing, international industry with fund holdings accounting for trillions of

dollars in the United States alone.In the BeginningHistorians are uncertain of the origins of investment funds; some cite the closed-end

investment companies launched in the Netherlands in 1822 by King William I as the first mutualfunds, while others point to a Dutch merchant named Adriaan van Ketwich whose investment trustcreated in 1774 may have given the king the idea. Van Ketwich probably theorized thatdiversification would increase the appeal of investments to smaller investors with minimal capital.The name of van Ketwich's fund, Eendragt Maakt Magt, translates to "unity creates strength". Thenext wave of near-mutual funds included an investment trust launched in Switzerland in 1849,followed by similar vehicles created in Scotland in the 1880s.

The idea of pooling resources and spreading risk using closed-end investments soon took

root in Great Britain and France, making its way to the United States in the 1890s. The BostonPersonal Property Trust, formed in 1893, was the first closed-end fund in the U.S. The creation ofthe Alexander Fund in Philadelphia, Pennsylvania, in 1907 was an important step in the evolutiontoward what we know as the modern mutual fund. The Alexander Fund featured semi-annualissues and allowed investors to make withdrawals on demand.The Arrival of the Modern Fund

The creation of the Massachusetts Investors' Trust in Boston, Massachusetts, heralded thearrival of the modern mutual fund in 1924. The fund went public in 1928, eventually spawning themutual fund firm known today as MFS Investment Management. State Street Investors' Trust wasthe custodian of the Massachusetts Investors' Trust. Later, State Street Investors started its ownfund in 1924 with Richard Paine, Richard Saltonstall and Paul Cabot at the helm. Saltonstall wasalso affiliated with Scudder, Stevens and Clark, an outfit that would launch the first no-load fundin 1928. A momentous year in the history of the mutual fund, 1928 also saw the launch of theWellington Fund, which was the first mutual fund to include stocks and bonds, as opposed to directmerchant bank style of investments in business and trade.Regulation and Expansion

By 1929, there were 19 open-end mutual funds competing with nearly 700 closed-endfunds. With the stock market crash of 1929, the dynamic began to change as highly-leveragedclosed-end funds were wiped out and small open-end funds managed to survive.

Government regulators also began to take notice of the fledgling mutual fund industry. Thecreation of the Securities and Exchange Commission (SEC), the passage of the Securities Act of1933 and the enactment of the Securities Exchange Act of 1934 put in place safeguards to protectinvestors: mutual funds were required to register with the SEC and to provide disclosure in theform of a prospectus. The Investment Company Act of 1940 put in place additional regulations thatrequired more disclosures and sought to minimize conflicts of interest. (For further reading, seePolicing The Securities Market: An Overview Of The SEC.)

The mutual fund industry continued to expand. At the beginning of the 1950s, the numberof open-end funds topped 100. In 1954, the financial markets overcame their 1929 peak, and themutual fund industry began to grow in earnest, adding some 50 new funds over the course of the


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decade. The 1960s saw the rise of aggressive growth funds, with more than 100 new fundsestablished and billions of dollars in new asset inflows.

Hundreds of new funds were launched throughout the 1960s until the bear market of 1969cooled the public appetite for mutual funds. Money flowed out of mutual funds as quickly asinvestors could redeem their shares, but the industry's growth later resumed.

3.5.1. Mutual Funds Industry comes to India

In India, the Mutual Fund industry started with the setting up of Unit Trust of India in 1964,as a single State Monopoly. Twenty-three years later Public Sector banks and financial institutionswere permitted to establish Mutual Funds in 1987. The Industry was brought under the control ofSEBI and opened for private sector participation in 1993.The private sector and foreign Institutions began setting up Mutual Funds thereafter. The fastgrowing industry is regulated by the Securities and Exchange Board of India (SEBI). A Mutualfund in India is registered / incorporated as a public trust. As per Clause 14 of SEBI guidelines- Amutual fund shall be constituted in the form of a trust and the instrument of trust shall be in theform of a deed, duly registered under the provisions of the Indian Registration Act, 1908 (16 of

1908) executed by the sponsor in favour of the trustees named in such an instrument. If the TrustDeed so provides the trustees can appoint an Asset Management Company for the day to dayadministration of the MF and investment of its funds.

3.5.2. Scope for growth and development of Mutual Fund in India

Mutual Fund Industry in its true spirit rooted in a free market and oriented towardscompetitive functioning with the dedicated goal of service to the investors can be said to havesettled in India only in 1993. However the industry took its roots much earlier with the setting upof the Unit Trust In India (UTI) in 1964 by the Government of India. During the last 36 years, UTIhas grown to be a dominant player in the industry with assets of over Rs.72,333.43 Crores as ofMarch 31, 2000. The UTI is governed by a special legislation, the Unit Trust of India Act, 1963. In1987 public sector banks and insurance companies were permitted to set up mutual funds andaccordingly since 1987, 6 public sector banks have set up mutual funds. Also the two Insurancecompanies LIC and GIC established mutual funds. Securities Exchange Board of India (SEBI)formulated the Mutual Fund (Regulation) 1993, which for the first time established acomprehensive regulatory framework for the mutual fund industry. Since then several mutualfunds have been set up by the private and joint sectors

3.5.3. Growth of Mutual Fund Business in India

The Indian Mutual fund business has passed through three phases. The first phase wasbetween 1964 and 1987, when the only player was the Unit Trust of India, which had a total assetof Rs. 6,700/- crores at the end of 1988. The second phase is between 1987 and 1993 during whichperiod 8 funds were established (6 by banks and one each by LIC and GIC). The total assets undermanagement had grown to Rs. 61,028/- crores at the end of 1994 and the number of schemes were167. The third phase began with the entry of private and foreign sectors in the Mutual fundindustry in 1993. Kothari Pioneer Mutual fund was the first fund to be established by the privatesector in association with a foreign fund. The share of the private players has risen rapidly sincethen.


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Within a short period of seven years after 1993 the growth statistics of the business of MutualFunds in India is given in the table below:

Net Assets of Mutual Funds as at 3l.03.2000

[Source: Website of SEBI]

The net assets of all domestic schemes of mutual funds were Rs.1,07,946.10 crores as onMarch 31, 2000 as against Rs. 68,193.08 crores as on March 31, 1999 .The details are given below :

Amount(Rs Crs)

Percentage(%)

UTI 72,333.43 67.00

Public Sector 10,444.78 9.68

Private Sector 25,167.89 23.32

Total 1,07,946.10 100.00

During the year 1999-2000, the share of UTI in the total assets of the mutual funds industryhas declined to 67% from 77.9% in 1998-99. Net assets of other public sector mutual funds havealso shown a decline from 12.09% in 1998-99 to 9.68% in 1999-2000. However, net assets ofprivate sector mutual funds have increased from 9.97% in 1998-99 to 23.32% in the year 1999-2000.

There are 34 private Mutual Funds in the fray and they have seized about 25% of the marketshare in the brief period of 7 years, mobilizing above Rs.25000 Crores from the public

3.5.4. Scope for development of Mutual Fund Business in India

A Mutual Fund is the most suitable investment for the common man as it offers an

opportunity to invest in a diversified, professionally managed basket of securities at a relativelylow cost. India has a burgeoning population of middle class now estimated around 300 million. Atypical Indian middle class family can have liquid savings ranging from Rs.2 to Rs.10 Lacs today.Investments in Banks are liquid and safe, but with the falling rate of interest offered by Banks onDeposits, it is no longer attractive. At best a part can be saved in bank deposits, but what is theother sources of investment for the common man? Mutual Fund is the ready answer. Viewed inthis sense globally India is one of the best markets for Mutual Fund Business, so also for Insurancebusiness. This is the reason that foreign companies compete with one another in setting upinsurance and mutual fund business units in India. The sheer magnitude of the population ofeducated white collar employees provides unlimited scope for development of Mutual FundBusiness in India.

The alternative to mutual fund is direct investment by the investor in equities and bonds orcorporate deposits. All investments whether in shares, debentures or deposits involve risk: sharevalue may go down depending upon the performance of the company, the industry, state of capitalmarkets and the economy; generally, however, longer the term, lesser the risk; companies maydefault in payment of interest/ principal on their debentures/bonds/deposits; the rate of interest onan investment may fall short of the rate of inflation reducing the purchasing power. While riskcannot be eliminated, skillful management can minimise risk. Mutual Funds help to reduce riskthrough diversification and professional management. The experience and expertise of Mutual


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Fund managers in selecting fundamentally sound securities and timing their purchases and sales,help them to build a diversified portfolio that minimises risk and maximises returns.

3.6. Organization Structure of Mutual Funds

"The mutual funds can be organised in two ways. One, the Trust structure and the other, the

Company structure. In both these structures, there is an entity which undertakes the designing andmarketing of schemes, raises money from the public under the schemes and manages the money on

behalf of its owners. This entity is the fund manager or an Asset Management Company (AMC) .

To segregate the collected funds from this entity's own funds, the corpus is placed in a legalvehicle. It is the character of this legal vehicle that determines the character of the Fund itself. If

this vehicle is a corporate entity then the fund acquires the name of an investment company as in

the US and UK and if the entity is a Trust, the fund acquires the name of mutual fund as in UK andIndia, for example. Irrespective of the nature of the structure, what is more fundamental is that in

view of the fiduciary role of the AMC or the fund manager towards the public, there is a need for

supervision of the activities of the AMC or fund manager by a separate body. This supervisory role

is fulfilled by the Board of Trustees and in a corporate structure by the Board of directors of the

Investment company."

1

3.6.1. Organization Structure of Indian Mutual Funds

There are four constituents of a mutual fund in India,1. the sponsor,2. the board of Trustees or Trustee company,3. the asset management company and4. the custodian.

The sponsor is the Settlor of the Trust which holds Trust property on behalf of investors who arethe beneficiaries of the Trust. The sponsor is also required to contribute at least 40% of the capitalof the asset management company which is formed for managing the assets of the Trust. The assetsof the Trust comprise of properties of the schemes which are floated by the asset managementcompany with the approval of the Trustees. Schemes may have different characteristics - they maybe open or closed ended or may have a particular investment focus or portfolio composition.Finally, the safe custody of assets of the Trust is entrusted to one or more custodians

3.6.2. Organization Structure of the Unit Trust of India

"Unit Trust of India (UTI), which has a structure different from the three tiered structure of

other mutual funds in India was established by the Government of India to encourage private

savings and investment. It was formed under a special Act of Parliament, viz. The Unit Trust ofIndia Act, 1963 as a corporate body. The promoter-sponsor of UTI is the Government of India

through the Reserve Bank and Financial institutions. In the true sense however they were the only

owners of the initial units of the UTI. The UTI Act provides that the general superintendence,direction and management of the affairs and business of the Trust shall vest in a Board of Trustees

which may exercise all `powers and do all acts and things which may be exercised or done by the

Trust". The Board of Trustees comprises nominees of the Central Government, RBI, IDBI, LICSBI, participating financial institutions and an Executive Trustee to be appointed by IDBI. The


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UTI Act stipulates that there shall be an Executive Committee which shall consist of The Chairmanof the Board, Executive Trustee and two other Trustees. Subject to such general or specialdirections as the Board may from time to time give, the Executive Committee shall be competentto deal with any matter within the competence of the Board of Trustees. The Executive Committeein effect, performs the asset management functions. Thus, the activities of the Executive

Committee which itself comprises members of the Board of Trustees, are overseen by the Board ofTrustees themselves. In matters involving public interest, the Central Government and the ReserveBank of India have powers to give directions.

"The management structure of UTI is thus distinct from the remaining mutual funds in morethan one way. First, unlike other mutual funds, it is a statutory body corporate and not a Trust

under the Indian Trusts Act. Second, there is no separate asset management company with a

separate Board of directors of AMC to manage the schemes. The functions of the Board ofdirectors of AMC, and Trustees are combined in the Executive Committee and Board of UTI. The

Sponsors exist in the form of Government and IDBI, though they do not hold any equity in the

Trustee company or AMC for none exists. SEBI at present regulates UTI through a special

regulatory dispensation effective from July 1, 1994 which inter alia requires UTI to file offer

documents in accordance with the SEBI (Mutual Funds) Regulations and allows SEBI to inspectUTI. This arrangement in SEBI's view is only an intermediate step and according to SEBI, it

would be desirable to amend or repeal the UTI Act to bring UTI and other mutual funds under acommon regulatory framework. In the meanwhile UTI has set up three separate asset management

Committees as directed by SEBI"1

3.6.3. Organization Structure of Mutual Funds of Public Sector Banks

When the public sector banks were allowed to set up mutual funds, the first mutual fund wasset up by the State Bank of India in 1987 prior to the establishment of SEBI. State Bank of Indiapreferred to adopt the Trust route and set up the mutual fund as a Trust under the Indian Trust Act1882. Other mutual funds followed suit and thus Trusts set up under the Indian Trusts Act came tobe the adopted legal form of mutual funds in India. The author or Settlor of the Trust came to beprincipal Trustee and also functioned as the fund manager.

These mutual funds combined the role of Trustee, fund manager and custodian in thesponsoring bank. There was little demarcation in the role and responsibilities and the structure wasopen to conflict of interests.

Other mutual funds that were set up later adopted the same pattern and thus, over time,Trusts set up under the Indian Trusts Act became the accepted legal form for establishment ofMutual Funds in India. The author or Settlor of the Trust became the principal Trustee and alsofunctioned as the fund manager.

With the establishment of SEBI under the SEBI Act, 1992, mutual funds other than the UTI,were for the first time brought under the regulatory purview of SEBI. At that time, no speciallegislation similar to the UTI Act existed under which the mutual funds could be incorporated.Historically, SEBI found that mutual funds had been set up by public sector banks adopting thetrust route because using the route of the Companies Act appeared to be more complex as it couldhave also led to multiple regulatory jurisdiction. Sufficient information is not available as towhether, at this stage, a rigorous examination of the advantages and disadvantages of the twoalternative routes were undertaken or not. Nonetheless, the SEBI (Mutual Funds) Regulationsprovided for setting up of mutual funds as Trusts under the Indian Trusts Act of 1882. It may notbe out of place to mention that the Indian Trusts Act of 1882 was enacted to govern private Trusts


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and envisaged a different manner of conduct and supervision of operations. Quite clearly, it did notat that time take into account the nature of activities that will be involved in the functioning ofmutual funds.

SEBI, while framing the Mutual Fund Regulations, gave a lot of consideration to two majorfactors, one, that mutual funds garner large moneys from the pubic for investment in a dynamic

market place which require specialisation on the part of persons performing these functions.Secondly, there could arise potential conflicts of interest which were to be avoided by ensuringarm's length relationship between various functionaries. Such stipulation of arm's lengthrelationship ensures that the person who performs a function is answerable to another and does notassess or judge his own performance. The Regulations stipulated a three tiered structure of entititesfor carrying out different functions of a mutual fund, but placed the primary responsibility on thetrustees. Internationally, irrespective of the route adopted, a three tiered structure exists and there isa segregation between the responsibility of fund management and the trustee or supervisoryresponsibility.

"Considering the inherent fiduciary nature of the functions, arm's length relationships were

sought to be built into the various constituents of a mutual fund, primarily through separate

entities and delineating the role and responsibility of the asset management companies and theTrustees and regulations on affiliate transactions. Arm's length relationships were also expected to

be achieved by requiring a certain proportion of Trustees to be independent of the sponsor,requiring independent directors on the board of the AMC and requiring an independent custodian

to be appointed."1

3.7. Regulatory Measures by SEBI

3.7.1. Mutual Funds Industry in India- Regulatory Measures by SEBI

SECURITIES AND EXCHANGE BOARD OF INDIA (MUTUAL FUNDS)

REGULATIONS, 1996

The fast growing industry is regulated by the Securities and Exchange Board of India (SEBI)since inception of SEBI as a statutory body. SEBI initially formulated "SECURITIES ANDEXCHANGE BOARD OF INDIA (MUTUAL FUNDS) REGULATIONS, 1993" Providingdetailed procedure for establishment, registration, constitution, management of Trustees, AssetManagement Company, about schemes/products to be designed, about investment of fundscollected, general obligation of MFs, about Inspection, audit etc. Based on experience gained andfeedback received from the market SEBI revised the guidelines of 1993 and issued freshGuidelines in 1996 titled "SECURITIES AND EXCHANGE BOARD OF INDIA (MUTUALFUNDS) REGULATIONS, 1996". The said regulations as amended from time to time is in forceeven today. The salient features of these Regulatory measures are discussed in subsequent articles.

The SEBI Mutual Fund Regulations contain ten chapters and twelve schedules. Chapterscontaining material subjects relating to regulation and conduct of business by Mutual Funds(i.e.chapters II to VII are discussed in the subsequent pages. Chapter I relates to definition of legalterms and other preliminary matters. Chapter VIII relates to powers of SEBI for inspection andaudit of Mutual Funds, while Chapter IX deals with "Offences & Penalties"(Procedure for ActionIn Case of Default). Chapter X deals with Miscellaneous Issues like "Saving" & "Repeal" clausesetc. You may visit SEBI website and access the original Regulations in case of need. The Table ofContents of the Regulations are given hereunderChapter I: PreliminaryChapter II: Registration of Mutual Fund


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Chapter III: Constitution and Management of Mutual Fund and Operation of Trustees, EtcChapter IV: Constitution and Management of Asset Management Company and CustodianChapter V: Schemes of Mutual FundChapter VI: Investment Objectives and Valuation PoliciesChapter VII: General Obligations

Chapter VIII: Inspection and AuditChapter IX: Procedure for Action In Case of DefaultChapter X: MiscellaneousSchedule I: FormsForm A - Application for the Grant of Registration of Mutual FundForm B - Certificate of RegistrationForm C - Trusteeship of The Mutual FundForm D - Asset Management CompanySchedule II: FeesSchedule III: Contents of The Trust DeedSchedule IV: Contents of The Investment Agreement

Schedule V: Code of ConductSchedule VI: Advertisement CodeSchedule VII: Restrictions on InvestmentsSchedule VIII: Investment Valuation NormsSchedule IX: Accounting Policies and StandardsSchedule X: Initial Issue ExpensesSchedule XI: Annual ReportSchedule XII: Half Yearly Financial Results

What is the Procedure for Registering a Mutual Fund with SEBI?

(Chapter: 2 of SEBI Regulations 1996)

An applicant proposing to sponsor a mutual fund in India must submit an application inForm A along with a fee of Rs.25,000. The application is examined and once the sponsor satisfiesthe prescribed eligibility criteria the registration certificate is issued subject to the payment ofregistration fees of Rs.25.00 lacs.Eligibility Criteria for Registration (Regulation: 7)For the purpose of grant of a certificate of registration, the applicant has to fulfill the following,namely:-

a. the sponsor should have a sound track record and general reputation of fairness andintegrity in all his business transactions;

Explanation: For the purposes of this clause "sound track record" shall mean the sponsor should,-i. be carrying on business in financial services for a period of not less than five years; and

ii. the net worth is positive in all the immediately preceding five years; andiii. the net worth in the immediately preceding year is more than the capital contribution of the

sponsor in the asset management company; andiv. (iv) the sponsor has profits after providing for depreciation, interest and tax in three out of

the immediately preceding five years, including the fifth year.(aa) the applicant is a fit and proper person

b. in the case of an existing mutual fund, such fund is in the form of a trust and the trust deedhas been approved by the Board;


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c. the sponsor has contributed or contributes atleast 40% to the networth of the assetmanagement company;

Provided that any person who holds 40% or more of the net worth of an asset managementcompany shall be deemed to be a sponsor and will be required to fulfil the eligibility criteriaspecified in these regulations;

d. the sponsor or any of its directors or the principal officer to be employed by the mutualfund should not have been guilty of fraud or has not been convicted of an offense involvingmoral turpitude or has not been found guilty of any economic offence.

e. appointment of trustees to act as trustees for the mutual fund in accordance with theprovisions of the regulations;

f. appointment of asset management company to manage the mutual fund and operate thescheme of such funds in accordance with the provisions of these regulations;

g. appointment of a custodian in order to keep custody of the securities and carry out thecustodian activities as may be authorised by the trustees.

Terms & Conditions for Registration (Regulation: 10)The registration granted to a mutual fund under regulation 9, shall be subject to the following terms

and conditions:-a. the trustees, the sponsor, the asset management company and the custodian shall complywith the provisions of these regulations;

b. the mutual fund shall forthwith inform the Board, if any information or particularspreviously submitted to the Board was misleading or false in any material respect;

c. the mutual fund shall forthwith inform the Board, of any material change in the informationor particulars previously furnished, which have a bearing on the registration granted by it;

d. payment of fees as specified in the regulations and the Second Schedule.(Rs.25 Lacs)Constitution of the Mutual Fund (Regulation: 14)A mutual fund shall be constituted in the form of a trust and the instrument of trust shall be in theform of a deed, duly registered under the provisions of the Indian Registration Act, 1908 (16 of1908) executed by the sponsor in favour of the trustees named in such an instrument.Contents of trust deed (Regulation: 15)

1. The trust deed shall contain such clauses as are mentioned in the Third Schedule and suchother clauses which are necessary for safeguarding the interests of the unit holders.

2. No trust deed shall contain a clause which has the effect of-i. limiting or extinguishing the obligations and liabilities of the trust in relation to any

mutual fund or the unit holders; orii. (ii) indemnifying the trustees or the asset management company for loss or damage

caused to the unit holders by their acts of negligence or acts of commissions oromissions.

Qualification prescribed for selection of persons as Trustees, Dutie/obligations of Trustees andCode of Conduct prescribed are discussed in the next article3.7.2. Appointment of Trustees- Eligibility Criteria, Duties & Code of

Conduct for Trustees

Eligibility Criteria (Regulation: 16)

1. A mutual fund shall appoint trustees in accordance with these regulations.2. No person shall be eligible to be appointed as a trustee unless -

1. he is a person of ability, integrity and standing; and2. has not been found guilty of moral turpitude; and


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3. has not been convicted of any economic offence or violation of any securitieslaws; and

4. has furnished particulars as specified in Form C(to the Schedule of theRegulations)

3. An asset management company or any of its officers or employees shall not be eligible to

act as a trustee of any mutual fund.4. No person who is appointed as a trustee of a mutual fund can be appointed as a trustee ofany other mutual fund unless -

1. such a person is an independent trustee referred to in sub-regulation (5); and2. prior approval of the mutual fund of which he is a trustee has been obtained for

such an appointment.5. Two thirds of the trustees shall be independent persons and shall not be associated with

the sponsors or be associated with them in any manner whatsoever.6. In case a company is appointed as a trustee then its directors can act as trustees of any

other trust provided that the object of the trust is not in conflict with the object of themutual fund.

Approval of the Board for Appointment of Trustee (Regulation: 17)

1. No trustee shall initially or any time thereafter be appointed without prior approval of theBoard.

2. The existing trustees of any mutual fund may form a trustee company to act as a trusteewith the prior approval of the Board.

Rights and Obligations of the Trustees (Regulation: 18)

1. The trustees and the asset management company shall with the prior approval of theBoard enter into an investment management agreement.

2. The investment management agreement shall contain such clauses as are mentioned inthe Fourth Schedule and such other clauses as are necessary for the purpose of makinginvestments.

3. The trustees shall have a right to obtain from the asset management company suchinformation as is considered necessary by the trustees.

4. The trustees shall ensure before the launch of any scheme that the asset managementcompany has;-

1. systems in place for its back office, dealing room and accounting;2. appointed all key personnel including fund manager(s) for the scheme(s) and

submitted their bio-data which shall contain the educational qualifications,past experience in the securities market with the trustees, within 15 days of their

appointment;3. appointed auditors to audit its accounts;4. appointed a compliance officer who shall be responsible for monitoring the

compliance of the Act, rules and regulations, notifications, guidelines instructionsetc issued by the Board or the Central Government and for redressal of

investors' grievances;5. appointed registrars and laid down parameters for their supervision;6. prepared a compliance manual and designed internal control mechanisms

including internal audit systems;7. specified norms for empanelment of brokers and marketing agents.


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4. (a) The compliance officer appointed under clause (d) of sub-regulation (4) shallimmediately and independently report to the Board any non-compliance observed by him.

5. The trustees shall ensure that an asset management company has been diligent inempanelling the brokers, in monitoring securities transactions with brokers and avoidingundue concentration of business with any broker.

6. The trustees shall ensure that the asset management company has not given any undue orunfair advantage to any associates or dealt with any of the associates of the assetmanagement company in any manner detrimental to interest of the unitholders.

7. The trustees shall ensure that the transactions entered into by the asset managementcompany are in accordance with these regulations and the scheme.

8. The trustees shall ensure that the asset management company has been managing themutual fund schemes independently of other activities and have taken adequate steps toensure that the interest of investors of one scheme are not being compromised with thoseof any other scheme or of other activities of the asset management company.

9. The trustees shall ensure that all the activities of the asset management company are inaccordance with the provisions of these regulations.

10. Where the trustees have reason to believe that the conduct of business of the mutual fundis not in accordance with these regulations and the scheme they shall forthwith take suchremedial steps as are necessary by them and shall immediately inform the Board of theviolation and the action taken by them.

11. Each trustee shall file the details of his transactions of dealing in securities with theMutual Fund on a quarterly basis.

12. The trustees shall be accountable for, and be the custodian of, the funds and property ofthe respective schemes and shall hold the same in trust for the benefit of the unit holdersin accordance with these regulations and the provisions of trust deed.

13. The trustees shall take steps to ensure that the transactions of the mutual fund are inaccordance with the provisions of the trust deed.

14. The trustees shall be responsible for the calculation of any income due to be paid to themutual fund and also of any income received in the mutual fund for the holders of theunits of any scheme in accordance with these regulations and the trust deed.

15. The trustees shall obtain the consent of the unit holders -1. whenever required to do so by the Board in the interest of the unit-holders; or2. whenever required to do so on the requisition made by three-fourths of the unit

holders of any scheme; or3. when the majority of the trustees decide to wind up or prematurely redeem the

units; or15. A. The trustees shall ensure that no change in the fundamental attributes of any scheme

or the trust or fees and expenses payable or any other change which would modify thescheme and affects the interest of unit holders, shall be carried out unless, -

1. a written communication about the proposed change is sent to each unit holderand an advertisement is given in one English daily newspaper having

nationwide circulation as well as in a newspaper published in the language ofthe region where the Head Office of the mutual fund is situated; and

2. the unit holders are given an option to exit at the prevailing Net Asset Valuewithout any exit load.


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16. The trustees shall call for the details of transactions in securities by the key personnel ofthe asset management company in his own name or on behalf of the asset

management company and shall report to the Board, as and when required.17. The trustees shall quarterly review all transactions carried out between the mutual funds,

asset management company and its associates.

18. The trustees shall quarterly review the networth of the asset management company andin case of any shortfall, ensure that the asset management company make up for theshortfall as per clause (f) of sub-regulation (1) of regulation 21.

19. The trustees shall periodically review all service contracts such as custody arrangements,transfer agency of the securities and satisfy itself that such contracts are executed in theinterest of the unit holders.

20. The trustees shall ensure that there is no conflict of interest between the manner ofdeployment of its net worth by the asset management company and the interest of the unitholders.

21. The trustees shall periodically review the investor complaints received and the redressalof the same by the asset management company.

22. The trustees shall abide by the Code of Conduct as specified in the Fifth Schedule.23. The trustees shall furnish to the Board on a half yearly basis, -1. a report on the activities of the mutual fund;2. a certificate stating that the trustees have satisfied themselves that there have been

no instances of self dealing or front running by any of the trustees, directors andkey personnel of the asset management company;

3. a certificate to the effect that the asset management company has been managingthe schemes independently of any other activities and in case any activities of the naturereferred to in sub-regulation (2) of regulation 24 have been undertaken by the assetmanagement company and has taken adequate steps to ensure that the interest of the unitholders are protected.

24. The independent trustees referred to in sub-regulation (5) of regulation 16 shall give theircomments on the report received from the asset management company regarding theinvestments by the mutual fund in the securities of group companies of the sponsor.

25. Trustees shall exercise due diligence as under: A. General Due Diligence:

1. the Trustees shall be discerning in the appointment of the directors on the Boardof the asset management company.

2. Trustees shall review the desirability of continuance of the asset managementcompany if substantial irregularities are observed in any of the schemes and

shall not allow the asset management company to float new schemes.3. The trustee shall ensure that the trust property is properly protected, held and

administered by proper persons and by a proper number of such persons.4. The trustee shall ensure that all service providers are holding appropriate

registrations from the Board or concerned regulatory authority.5. The Trustees shall arrange for test checks of service contracts.6. Trustees shall immediately report to Board of any special developments in the

mutual fund.B. Specific Due Diligence:

The Trustees shall:


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1. obtain internal audit reports at regular intervals from independent auditorsappointed by the Trustees.

2. obtain compliance certificates at regular intervals from the asset managementcompany.

3. hold meeting of trustees more frequently.

4. consider the reports of the independent auditor and compliance reports of assetmanagement company at the meetings of trustees for appropriate action.5. maintain records of the decisions of the Trustees at their meetings and of the

minutes of the meetings.6. prescribe and adhere to a code of ethics by the Trustees, asset management

company and its personnel.7. communicate in writing to the asset management company of the deficiencies and

checking on the rectification of deficiencies.26. Notwithstanding anything contained in sub-regulations (1) to (25), the trustees shall not

be held liable for acts done in good faith if they have exercised adequate duediligence honestly.

27. The independent directors of the trustees or asset management company shall payspecific attention to the following, as may be applicable, namely:-1. the Investment Management Agreement and the compensation paid under the

agreement.2. service contracts with affiliates - whether the asset management company has

charged higher fees than outside contractors for the same services.3. selection of the asset management company's independent directors4. securities transactions involving affiliates to the extent such transactions are

permitted.5. selecting and nominating individuals to fill independent directors vacancies.6. code of ethics must be designed to prevent fraudulent, deceptive or manipulative

practices by insiders in connection with personal securities transactions.7. the reasonableness of fees paid to sponsors, asset management company and any

others for services provided.8. principal underwriting contracts and their renewals. Any service contract with the

associates of the asset management company.CODE OF CONDUCT GOVERNING TRUSTEES & AMC OF MUTUAL FUNDS

1. Mutual fund schemes should not be organised, operated, managed or the portfolio ofsecurities selected, in the interest of sponsors, directors of asset management companies,members of Board of trustees or directors of trustee company, associated persons as inthe interest of special class of unit holders rather than in the interest of all classes of unitholders of the scheme.

2. Trustees and asset management companies must ensure the dissemination to all unitholders of adequate, accurate, explicit and timely information fairly presented in a simplelanguage about the investment policies, investment objectives, financial position andgeneral affairs of the scheme.

3. Trustees and asset management companies should avoid excessive concentration ofbusiness with broking firms, affiliates and also excessive holding of units in a schemeamong a few investors.


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4. Trustees and asset management companies must avoid conflicts of interest in managingthe affairs of the schemes and keep the interest of all unit holders paramount in allmatters.

5. Trustees and asset management companies must ensure scheme wise segregation of bankaccounts and securities accounts.

6. Trustees and asset management

chapter iii completed

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