NISM MF Distributors Certification Duration 2 Days

PROGRAM OBJECTIVES
At the end of the program you will be able to:

Explain the Concept, Role and Functioning of Mutual Funds Appreciate the need for a sales person to act as a financial planner for the client

Preparation for passing NISM Certification Test.

Rules of NISM Certification Test

Duration of the test is 2 hours The question paper consists of 100 questions of 1 mark each Each question paper may be different You will be given four options

Minimum pass marks is 50

There is negative marking for wrong answers, 25% marks deducted for every wrong answer You will have questions on numericals, use of calculator is allowed To register and take the examination please visit www.nism.ac.in
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Recommended Reading Material

Workbook for NISM Mutual Fund Distributors Certification Examination(can be downloaded from www.nism.ac.in)

Reference Books:

Mutual Funds in India H. Sadhak Indian Mutual Funds Handbook Sundar Sankaran How Mutual Funds Work Fredman and Wiles
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Chapter 1

Concept and Role of a Mutual Fund

Basic Mutual Fund Concepts

Collective Investment Vehicle

Pool of investors money invested according to pre-specified investment objectives Range of products known as Mutual Fund Schemes

Mutuality in contribution and benefit

Profits or losses belong to the investors Benefits accrue in the proportion to the share in the pool

Product is described by its Investment Objective

Fund managers invest as per investment objective Investors match their objectives with the funds investment objectives Investment objective defines the risk return profile of the fund

Mutual Fund Units

What shares is to equity, units is to mutual funds

Mutual fund investor is called a unit holder

Mutual funds are first offered to an investor in NFO (New Fund Offer) Subsequently, mutual funds units may be bought and sold through the fund itself

Continuous transactions at fund offices or investor service centres Purchase and redemptions Some funds may be listed on stock exchange

Unit Capital is the corpus of the fund

Number of Units * Face Value Changes depending upon the nature of the fund Open-ended Fund - Investors come in and move out any time Closed-ended Fund - Investors stay till maturity
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Investment Portfolio
Portfolio is a collection of securities
equity shares, bonds, debentures, deposits, money market instruments, derivatives and the like

Mutual funds can invest only in marketable securities Value of the investment portfolio changes with a change in market price of the securities Marking to market
Process of using market price to value an investment portfolio is known as marking to market

Unrealised gains or Unrealised losses

Gains or losses in values of the securities held in the portfolio, but not realized through a sale

Total Assets
Market Value of all the securities held in the portfolio
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Net Assets
Assets Under Management (AUM)

Total Assets + Current Assets

Mutual Fund does not hold any long term assets or liabilities
Mutual funds are not permitted to borrow

Short-term liabilities

Fund running expenses

Net Assets = Total assets + Accrued income Current liabilities Accrued expenses Net Asset Value

Value per unit at current market prices Net assets divided by units outstanding

Changes in Net Assets

The net assets of a mutual fund may go up due to the following reasons:

Entry of new investors Income from dividends or interest Realised gains from sale of investments Unrealised gain from increase in the value of the investments

The net assets may go down due to the following reasons:

Redemption by existing investors Expenses to be paid Realised losses from sale of investments Unrealised losses from decrease in the value of the investments

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Investing through MFs

Advantages 1. Professional Management 2. Portfolio Diversification 3. Economies of Scale 4. Liquidity 5. Flexibility & Convenience Disadvantages 1. Lack of Portfolio Customization 2. Choice Overload

6. Regulatory Comfort
7. Tax Benefits
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Types of Funds
Open-ended Funds

Does not have a fixed maturity date Accept purchases and redemptions at any time Purchase and redemption transactions happen on a continuous basis at fund offices and ISCs Transactions are based on NAV of the fund Unit capital is not fixed

Close-ended Funds

Run for a specific period Closed-end funds are offered in an NFO but are closed for further purchases after the NFO Compulsorily listed on a stock exchange to provide liquidity during the life of the fund Unit capital of a closed-ended fund is kept constant

Interval Funds

Variant of closed-ended funds Primarily closed-ended but become open-ended at specific intervals Specified Transaction Period
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Fund Classification
Based on investment objective

Debt funds investing in short and long term debt instruments Equity funds investing in equity securities Hybrid funds investing in a combination of equity and debt Other funds including international, commodity, and fund of funds.

Based on investment risk

Equity funds have a greater degree of risk as compared to a debt funds Liquid funds are the least risky, as they invest in very short-term securities

Based on investment style

Actively Managed Funds Passive Funds

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Fund Classification-2
Based on investment horizon

Equity funds are recommended for the long term (five years and above) Balanced funds are recommended for three years and above Income funds are recommended for medium term (one year and above) Short term debt funds are recommended for the short term (up to one year) Liquid funds are recommended for ultra-short periods (up to a month)

Based on investment categories

Equity funds invest in equity shares; Debt funds invest in debt securities; Money market funds invest in money market securities; Commodity funds invest in commodity-linked securities; Real estate funds invest in property-linked securities; Gold funds invest in gold-linked securities

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Debt Funds - 1

Money Market or Liquid Funds

Very short term maturity Invest in debt securities with less than 91 days to maturity Treasury bills, commercial papers and certificate of deposits Primary source of income is interest No mark to market for securities less than 91 days to maturity Low risk of NAV fluctuation Safety of principal and superior liquidity Used primarily by large corporate investors and institutional investors Park their surplus funds for short periods of time

Floating Rate Funds

Invest largely in floating rate debt securities Earn an interest income in line with the market interest rates Lower mark to market risk Attractive when the interest rates are rising

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Debt Funds - 2
Gilt Funds

invest in government securities of medium and long-term maturities No risk of default High interest rate risk, depending upon maturity profile

Diversified Debt Funds

invest in medium-term and long-term securities issued by the government, banks and corporates

Benefit of higher coupon

Higher credit risk High interest rate risk due to long term orientation

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Debt Funds - 3
High-yield Debt Funds

Seek higher interest income by investing in debt instruments that have lower credit ratings Also known as junk bond funds

Fixed Maturity Plans

Closed-end funds that invest in debt instruments with maturities that match the term of the scheme Debt securities are redeemed on maturity and paid to investors

No interest rate risk

Issued in a series by a mutual fund Issued for various time horizons

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Equity Funds
Diversified Equity Funds

Invest in equity shares across various sectors, sizes and industries

Less risky

Thematic Equity Funds

Choose the equity shares and sectors they would hold in their portfolio based on a theme Infrastructure, service industries, consumer spending, financial industry Multiple sectors and stocks falling within a theme Less diversified than a diversified equity fund

Sector Equity Funds

Invest in a given sector, such as technology, banking or pharma. Concentrated funds and feature high risk

Sector performances tend to be cyclical

Mirror the performance of a sector

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Strategy-Based Equity Funds

Growth Funds

Invest in companies whose earnings are expected to grow at an above-average rate

Value Funds

Identify stocks of good quality companies that are currently undervalued by the market

Mid-cap and Small-cap funds

Focus on smaller and emerging companies for their higher growth potential

Dividend Yield Funds

Income from dividends and invest in companies that have a high dividend yield Also known as Equity Income Funds

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Equity-Linked Savings Scheme

Some equity schemes are designated as ELSS at the time of launch
Offer tax benefits u/s 80C

Investment up to Rs. 100,000 in a year in such funds can be deducted from taxable income of individual investors

ELSS must hold atleast 80% of the portfolio in equity securities

Lock-in period of 3 years from the date of investment

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Hybrid Funds
Monthly Income Plans
Smaller allocation to equity (5% to 25%) Larger allocation to debt, pre-dominantly debt-oriented Regular income from debt securities and equity for long-term growth Periodic distribution of dividends, though there is no assurance

Balanced Funds

Equity-oriented hybrids that invest up to 65% in equity

The allocation to debt offers a cushion from the risk of an all equity portfolio
For investors who seek growth from equity but want protection from volatility

Asset Allocation Funds

Dynamic Funds that can change proportion between debt and equity depending upon market outlook

Capital Protection-Oriented Funds

Debt securities with a derivative instrument or equity shares Structured portfolio such that Amount invested + Interest = Investors principal Investment in debt may be combined with debt and equity derivatives
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Other Types of Funds-1

Fund of Funds (FoF)

Invests in other funds Funds may be of same fund house or various fund houses (Multi-manager) Portfolio manager makes the choice of funds according to investment objective Two levels of expenses- underlying level and FoF level

International Funds

Invest in securities issued in foreign markets Invests in foreign securities or foreign funds Host fund is the international fund Feeder fund is the fund launched in India Feeder fund ties up with the Host fund in an FoF structure

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Other Types of Funds - 2

Arbitrage Funds

Take equal and opposite exposure in different markets Earn a return due to difference in price in the two markets For example, equity in cash market and futures market Low risk, return similar to the debt funds

Exchange Traded Funds (ETF)

Open-ended funds that track a market index

Units are listed like shares on the stock exchange

Purchase and sale transactions are executed on stock exchange Demat accounts are used Transactions at market prices, which may be different from the NAV

Commodity Funds

Invest in commodity ETFs, commodity stocks or in international commodity futures contracts In India, direct investment in commodity futures is not allowed Indian commodity funds usually invest in stocks of commodity companies Gold Funds are structured as ETFs
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Role of Mutual Funds

To the investor

they offer products that enable access to various markets a diversified investment opportunity at a low cost

To the issuers of various securities,

they are institutional investors seeking better return, lower risk ability to monitor and evaluate investment options efficiently

Industry competitive and well-regulated

Mutual funds have grown from a single player (UTI) in 1964 to 40 players in 2010
There are about 850 mutual products in the market Public sector mutual funds came in late 1980s and the private and foreign funds came since the 1990s Most of the assets of the mutual fund industry are in short term debt funds (about 60%), which are favoured by institutional investors

Several measures are being taken by regulators and the industry to increase the participation of retail investors in mutual funds

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Chapter 2

Fund Structure and Constituents

Structure of Mutual Funds

Three-tier structure of Sponsor-Trust-Asset Management Company based on SEBI (Mutual Funds) Regulations, 1996

Sponsor creates the mutual fund and sets up the AMC Mutual fund is structured as a trust, overseen by a Board of Trustees Trustees appoint the AMC to manage the funds

Sponsor

Promotes the mutual fund

Appoints the Board of Trustees and Board of Directors of the AMC Seeks regulatory approval Eligibility criteria At least five years experience in the financial services industry A good financial track record of at least three years prior to registration of the fund. (Positive net worth is essential) At least 40% contribution to the capital of the AMC

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Mutual Fund as a Trust

Investors in the mutual fund are beneficiaries of the trust Trustees are appointed by the Sponsor with SEBI approval

May be a set of individuals or a Trustee company The sponsor will have to appoint at least 4 trustees.

Trustees must act on behalf of the investors

Guardians of unitholders funds and assets

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

Clauses laid down by SEBI

Board of Trustees

Oversee the working of the AMC and management of the mutual fund Key decisions of the AMC require trustee approval Must meet at least 6 times in a year At least 2/3rds of the members have to be independent

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Asset Management Company

AMC is the investment manager of the mutual fund

Responsible for running of the day to day operations

Investment Management Agreement between the trustees and the AMC

Lays down rights and obligations of the AMC AMC seeks approvals and supervision by the Trustees Board of Trustees is the internal regulator

AMC is appointed by the trustees, with SEBI approval

AMCs should have a net worth of at least Rs10 crore at all times At least 50% of members of the board of an AMC have to be independent. The AMC of one mutual fund cannot be an AMC or trustee of another fund. AMCs cannot engage in any business other than that of financial advisory and investment management

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Other Fund Constituents

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

All mutual fund constituents have to be registered with SEBI

They are usually paid fees for their services
Constituent Custodian R&T Agent Banks Auditor Fund Accountants Distributors Brokers Role Hold funds and securities Keep and service investors records Enable collection and payment Audit scheme accounts Performs the role of calculating the NAV Distribute fund products to investors Execute transactions in securities

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Custodian
Hold the securities of the mutual fund

Responsible for their safekeeping

Appointed by the Sponsor

Only constituent NOT directly appointed by the AMC Must be independent of the Sponsor and its associates

Functions of the Custodian

Delivering and accepting securities and cash to complete portfolio transactions

Tracking and completing corporate actions and payouts on the securities held by the fund Coordinating with the DPs who hold the securities account of the mutual fund schemes

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Registrars and Transfer Agents

Create and maintain investor records and service them Accept and process investor transactions Operate Investor Service Centres (ISCs) R&T functions

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

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Distributors
Appointed by the AMC in order to sell mutual fund units to investors on behalf of the AMC Enable the reach of mutual fund products across geographical locations Commission is paid to distributors on sale of mutual fund units

Theres no exclusivity in mutual fund distribution

Sponsor and its associates may act as the distributors Distributors may be individuals or institutions such as banks, NBFCs or broking and distribution companies Must pass the certification examination mandated by SEBI and conducted by the NISM (NISM Series V A Mutual Fund Distributors Certification Exam)

Must obtain AMFI Registration Number (ARN) after clearing the examination, to empanel as distributors with a mutual fund

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Brokers, Banks and Auditors

Brokers execute buy and sell transactions of the fund managers Banks provide collection and payment services

Payment instruments are collected in mutual fund scheme accounts Carry out redemption and dividend payments

Auditors audit the books of the mutual fund

Account of each mutual fund scheme is kept separately Auditors of mutual fund are different from auditors of the AMC

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Chapter 3

Legal and Regulatory Environment

SEBI as the Regulator

Indian mutual funds are supervised and regulated by the SEBI

SEBI (Mutual Funds) Regulations, 1996 Various amendments and circulars from time to time

SEBI was set up by the SEBI Act, 1992 and is supervised by Ministry of Finance Regulation of Constituents

SEBI regulates registrars, custodians, brokers, collecting banks and the like

Distributors must clear the mandatory certification prescribed by SEBI

Constituents must be registered with SEBI AMC and Trustee company are also governed by the Companies Act and Indian Trusts Act respectively

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RBI and Stock Exchanges

RBI regulates banks in India Banks can act as sponsors, custodians, bankers and distributors of mutual funds Mutual funds also invest in money market instruments and g-secs

Money and debt markets are regulated by RBI Subject to regulations laid down by RBI

Closed-ended funds/ETFs are listed on stock exchanges Listing agreement with stock exchanges

Subject to regulatory and disclosure requirements

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Association of Mutual Funds in India (AMFI)

AMFI is industry association of mutual fund industry

It is not a Self Regulating Organisation (SRO)

AMFIs functions

Recommends best business practices and code of conduct for members. Represents the industry to regulators and policy makers in SEBI, RBI and the government Conducts investor awareness programmes Disseminates information

AMFI Registration Number (ARN)

Distributor is empanelled by a mutual fund ONLY after registration with AMFI

AMFI Code of Ethics (ACE) for AMCs

Dealing with investors, intermediaries and the public Adapted as a supplement in the Fifth Schedule of the SEBI (Mutual Fund) Regulations

AMFI Guidelines and Norms for Intermediaries (AGNI)

SEBI has made it mandatory for distributors to follow the code AMFI is authorised by SEBI to seek explanation, issue warnings, or cancel the registration
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Summary of Mandated Service Standards by SEBI

Transaction Allotment of units in a NFO (other than ELSS) Allotment of units in a ELSS NFO Dispatch of Statement of Account (on-going) Turnaround Time 5 days from NFO closing date 30 days from NFO closing date 10 working days from transaction request

Dispatch of transactions)

Statement

of

Account

(Systematic

10 days from end of calendar quarter

Dispatch of dividend warrants Dispatch of redemption proceeds

30 days from date of dividend declaration 10 working days from transaction request

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Investor Rights for Service Standards

Delay in dispatching dividend warrants or redemption proceeds

AMC has to pay the unit-holder interest at the rate of 15% p.a

Systematic investors can make a special request for Statement of Account

Must receive their Statements of Account within 10 days

Dormant investor must receive a Statement of Account once a year Soft copy of Statement of Account may be sent to investors every month

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Special Transactions
Change of Broker

Letter to the mutual fund indicating change of ARN

Nomination

Nominee appointed by the unitholder Proceeds of the folio in the event of death will go to the nominee

Unit Certificate

May be provided upon request within 30 working days

No operational purpose

Demat holding

In order to transact units on stock exchange AMC/MF to co-ordinate with DP to provide demat statement to unit holders

40

Investor Rights for Information Disclosure

NAV and Sale and Repurchase prices disclosed on AMFI website by 9pm every business day .FoFs can publish their NAV by 10 am of the next business day

Detailed Portfolio disclosure in the prescribed format every 6 months

One English daily and one regional newspaper Within 1 month of the close of half-year

Close-ended debt funds and Interval funds have to publish their portfolios on website

Within 3 working days of every month-end

Summarised portfolio disclosure to unit holders every month through Factsheet

Voluntary industry practice

Scheme-wise annual report to be mailed to all unit-holders

Within 4 months of financial year-end

Key documents may be inspected by investors

Detailed offer document, Key Information Memorandum, Annual Report Trust Deed, Investment Management Agreement, Custodial Services Agreement, R&T Agent Agreement and Memorandum & Articles of Association of the AMC
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Rights With Respect to Fund Management

Change in Fundamental Attributes

Mutual fund to send a written communication to ALL unit holders about the proposed change In one English daily and one regional newspaper Option to exit for at least 30 days without exit load before the implementation of the change

Termination of AMC or winding up of a Scheme by unit holders

Resolution by unit holders holding at least 75% of assets in the scheme

Termination of AMC or winding up of a Scheme by Majority of Trustees

Seek the consent of unit holders

Change in Sponsor or the AMC

Unit holders have the right to be informed Option to redeem without exit load

Structural Protection

The AMC or the sponsor do not directly hold the funds or securities belonging to the investors Custodian is independent of the Sponsor
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Limits to Investor Rights

Cannot sue the Trust

Unit holders are not a separate entity different from the Trust The Trust is only a notional entity

Principle of caveat emptor (let the buyer beware)

Unit holders cannot seek legal recourse on the grounds of not having read, understood or noticed information disclosed

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

Neither shareholders nor depositors Investments cannot be protected Offer document discloses all pending investor complaints

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Chapter 4

Offer Document

Role of the Offer Document (OD)

Legal representation of the offer of the mutual fund scheme to the investors Contractual relationship between investor and the mutual fund based on OD Source of information

Background information on the mutual fund and the scheme

Investors are expected to read and understand OD before investing Format prescribed by SEBI Offer Document for a new fund

AMC seeks trustee approval and files draft OD with SEBI for approval OD is available on SEBI website for public viewing SEBI approval usually comes within 21 days, subject to changes, if any

NFO must be made within 6 months of SEBI approval of the OD

SEBI only vets the OD to ensure that all required information is provided. It does not approve or recommend the scheme being offered.(Disclaimer Clause)

45

New Fund Offer Process

Application forms contain abridged version of the OD, known as Key Information Memorandum (KIM) Complete OD available to investors on website NFO period must be limited to 15 days, except for ELSS up to 30 days Open-ended scheme opens for re-purchase and purchase after allotment Close-ended scheme gets listed on stock exchange Allotment must be completed and scheme open for transactions within 5 working days of NFO closure Components of Offer Document

Statement of Additional Information(SAI)

Information generic to all schemes of a mutual fund

Scheme Information Document(SID) Information specific to a scheme

46

Statement of Additional Information(SAI)

Contains generic information of the mutual fund

Details of the sponsor and financial history Names and addresses of the Board of Trustees Details of AMC, key personnel and Board of Directors of AMC Details of various fund constituents Investor service officers details

Contains financial information of the mutual fund

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

Lays down the rights of investor w.r.t information, services and redressal

Filed only once with SEBI in the prescribed format

47

Scheme Information Document(SID)

Filed with SEBI for approval before launch of a new scheme Information specific to a certain scheme

Scheme type (open or closed end) Investment objective Asset allocation

Investment strategies
Terms with regard to liquidity Fees and expenses Benchmark for the scheme Investment restrictions, if any Mandatory disclosures and disclaimers

48

Fundamental Attributes and Risk Factors

Fundamental attributes are essential features of the scheme

Risk and return parameters are defined by the fundamental attributes

The fundamental attributes of a scheme may be changed provided:

The approval of the trustees and SEBI is taken. Investors are informed about the proposed change and given the option to exit the scheme without paying an exit load. The AMC makes a public announcement of the change in at least two newspapers.

Risk Factors may be standard or scheme-specific Standard risk factors apply across mutual fund schemes irrespective of whether it is an equity fund or a debt fund.

E.g. Mutual funds are subject to market risk

Scheme-specific risk factors apply to the specific scheme for which the OD has been prepared

E..g First scheme of a mutual fund E.g. Risk of concentration in a sector fund
49

Other Information
Indicative asset allocation and type of securities that the fund will invest in Borrowing policy of the fund period and limits on borrowing Policy and regulations on inter-scheme transfers Methodology of calculation of NAV, Sale and Purchase Price Operational details:

Period of offer

Plans, options and loads

NFO price and basis for subsequent pricing Application process Minimum investment amount Investment facilities such as SIPs, SWPs and switches Investors eligible to invest Date of commencing ongoing sale and purchase Maturity date, if scheme is closed-ended List of Official Points of Acceptance (OPAT)
50

Modifications to SAI and SID

Open-ended schemes SID must be valid at all times

Updated version to be available on website

Changes to SID

Material changes to be updated immediately Changes to fundamental attributes Changes to investment options

Changes in load structure

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

Changes to SAI

Material changes to be updated immediately Changes to Sponsor/AMC Changes to key personnel

No material changes, SAI to be updated every year, with 3 months at the end of FY

51

Addendum
Appendix to the Offer Document Mutual Funds issue an addendum to notify any change in the information provided till such time they are incorporated in the SID or SAI every year Addendums have to be approved by trustees and notified to SEBI Addendum must be published in two newspapers To be prominently displayed on the notice board at the official points of acceptance of application forms

52

Key Information Memorandum

Seeks to provide key fund information to the investor before investing

Abridged and concise version of the offer document

A copy of the KIM must accompany every application form

KIM contains all information for on-going transactions

Format for KIM is prescribed by Sebi

Must be updated at least once a year

Contents of KIM:

Investment objective and asset allocation pattern of the scheme. Scheme-specific operational details. Names of the AMC and trustee company. Performance history of the scheme and the benchmark for one, three and five years and since inception. Expenses and loads applicable to the scheme. Investor services and rights.

53

Chapter 5

Fund Distribution and Channel Management Practices

Individual and Institutional Distribution Channels

Individual distributors are known as Independent Financial Advisors (IFAs)

Agreement with AMC to act as distributor Establish personal long term contacts across investment products

Institutional distributors can be distribution houses, banks, or non-banking finance companies

Employees and Sub-brokers

Wide branch network and large client base Greater geographical reach Standardised process for acquiring, servicing and advising institutional distributors AMCs have to deal with one entity rather than several individuals AMCs channel managers service the institutional distributors Provide in-house research and product recommendations to investors

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Newer Channels of Mutual Fund Distribution

Online Mutual Fund Distribution

Websites allow investors to make investments online, view current holdings at latest NAV and conduct sale/purchase transactions Investor creates an account with mutual fund/distributor website Account is password protected Convenient and paper-less transactions No cheque writing is required, payment can be made through credit card.

Distribution through Stock Exchanges

Sebi has allowed stock exchange brokers to conduct mutual fund transactions through their trading platforms with the NSE and BSE Brokers must clear NISM MFD Certification, obtain ARN and empanel as distributor with AMC NSEs NEAT MFSS and BSEs STAR Mutual Fund Platform Open from 9am to 3 pm Mutual funds tie up with the stock exchanges to offer their funds through trading platforms
56

Appointment of Distributor
AMCs appoint mutual fund distributors by entering into distribution agreements

A distributor has to be empanelled by a mutual fund before being able to distribute its products to investors

Pre-requisites for being appointed as a distributor:

Individual distributors and employees or representatives of institutional distributors have to clear the NISM Mutual Fund Distributor (MFD) certification examination Need to obtain the AMFI Registration Number (ARN) before they can seek empanelment with AMCs Institutions in the distribution business also need to get registered with AMFI The certification examination is valid for a period of three years, after which it has to be revalidated by attending a Continuing Professional Education (CPE) training

Empanelment form must be filled up while seeking empanelment

Personal details, names of key people handling sales and operations, business details

Appointment / termination of distributor is the discretion of the AMC

Does not require SEBI approval

57

Distribution Agreement
Lists down the terms and conditions of the appointment of the distributors AMC has the power to terminate agreement at any time, after due notice

Follow the Code of Ethics by the AMFI and Mutual funds

Clauses of the agreement:

Ensure that the KIM is given along with the application form to investors Inform investors that there is no recourse to the distributor for any problems in the investment. Offer units only at the public offering price currently in effect and not offer differential pricing. Commit to keeping the transactional details confidential. Commit to abide by instructions from the AMC and the statutory codes, guidelines and circulars. Not issue advertisement or publicity material other than that provided or approved by the AMC. Ensure that the risk factors are mentioned along with performance and other related information. Provide all the information that the AMC may ask for from time to time. Ensure that all employees who are engaged in selling or marketing of mutual funds have an ARN. Undertake not to attract investors through temptation of rebate of commission or gifts.
58

Distributor Commissions
There are no SEBI rules on the minimum or maximum rate of commission

influenced by commissions paid by other competing funds and the type of scheme

Distributors are not allowed to charge commissions on their own investment Initial Commission is paid up-front

Entry load charged from investors was used by mutual funds to pay commissions to brokers Entry load has been banned since Aug 1, 2009 Investors have the power to decide the payment to advisors for their services Distributors have to disclose the commissions they earn on comparable schemes when they recommend a scheme to the investor

Trail commission is paid as long as the investor remains invested in the fund

Calculated on the current market value (units brought in by the distributor x current NAV of the units) Paid for the time period of which the investor remains with the fund AMFI has imposed a ban on trail commission for transferred assets Money saved by AMC is to be used for investor education
59

Sales Practices
Distributor actions must be in the interest of the unit holders Distributors have to follow AMFI's code of ethics (ACE) as well as well as those prescribed by the concerned AMC, AMFI and SEBI. AMFI and fund houses have put in place a set of guidelines to be followed by the distributors. These include the following:

A mutual fund is not accountable for the activities of the sub-brokers of a distributor.

Distributors must have complete knowledge of the product on offer.

Distributors must know their clients needs and profile. The product chosen must meet the clients requirements. Distributors must encourage good investment habits such as long-term and regular investment. Distributors must provide good and efficient after-sales service.

60

SEBI Advertisement Code

SEBI has prescribed advertisement code for mutual funds which is mandatory and is as under:

Standard measures to compare such as Annual Yield, CAGR etc. Annualised yields for at least one, three, five years & since launch For less than 1 year performance, Absolute Return without annualisation Past gains may not repeat in future Risk factors prominently stated Appropriate benchmark to be chosen Any ranking of fund to be explained
61

Chapter 6

Accounting, Valuation and Taxation

NAV Computation
Net Assets = Sum total of all Assets - Liabilities of the Fund = Market value of Investments + + Accrued income +

Assets Receivables Other Assets Liabilities =

Accrued expenses + Payables + Other Liabilities

NAV of a Unit =

Net Assets of the Scheme Number of Units Outstanding

63

Q: Can you calculate NAV if total assets and total No.of units are given?

Exercise
Calculate NAV of Fund Unit in the following case:

No. of units: 10,000 Market value of investments in Govt. Securities : Rs. 1 lakh Market Value of investments in Corporate Bonds:Rs. 1 lakh

Other Assets of the fund: Rs. 20,000/Liabilities of the fund: Rs. 25,000/Payables by the fund: Rs. 5,000-

64

Valuation Principles
Valuation day is every business day when NAV is calculated Valuing the mutual fund portfolio using current market prices of the securities it holds,

is called marking to market

Net assets can go up when there is a realized income or an appreciation in the market value of the schemes assets. Net assets will go down when there is a realized loss or depreciation in the value of the schemes assets.

Expenses and income are accrued every day

Accrued income may be dividends or interest receivable Accrued expenses are usually the fund recurring expenses charged daily to the scheme but paid monthly or annually.

NAV of mutual fund schemes have to be posted on the AMFI website every business day, by 9 pm. NAV is rounded off up to at least two decimal places for equity and balanced schemes and to four decimal places for liquid, index and other debt schemes.
65

Purchase and Redemption Price

Purchase price to the investor is the sale price to the mutual fund; redemption price to the investor is the re-purchase price to the mutual fund

Entry Load

Imposed on the NAV to arrive at purchase price Investor pays a price that is more than the NAV

No entry loads can be charged to investors Exit Load

Imposed on NAV to arrive at the redemption price Reduces the redemption price

Exit load cannot be varied based on the type of investor; it has to apply uniformly to all investors in a scheme

CDSC (Contingent Deferred Sales Charge)

Variable exit loads applied on the basis of the period for which the investor stays invested

Exit loads or CDSC charged to investors in excess of 1% has to be credited back to the scheme.
66

Scheme Expenses
Expenses borne by the mutual fund scheme regulated by SEBI Any expense that is not chargeable, or exceeding the limits, has to be borne by the AMC Initial Issue Expenses

Incurred to meet expenses on advertisement, commissions, and launch of the scheme during an NFO

Expenses related to an NFO cannot be charged to the investor. They have to be borne by the AMC

Fund Recurring Expenses

Incurred to manage the money mobilised from the investor The heads of expenses that can be charged to the scheme. The maximum expense, as percentage of net assets, that can be so charged Accrual basis, and reduced from the assets of the scheme, before computing NAV

67

Chargeable and Non-Chargeable Expenses

Expenses, identified as being direct expenses incurred to manage the fund, can be charged to the scheme

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 disclosure and advertisements

Expenses other than those listed above, cannot be charged to the scheme Fines and penalties also cannot be charged to the scheme

68

Maximum Recurring Expenses

Recurring Expenses cannot exceed the following regulatory limits

Average Weekly Assets

For first Rs.100 crs For next Rs.300 crs For next Rs.300 crs On Balance Average Weekly Assets

For Equity Funds

2.50% 2.25% 2.0% 1.75%

For Bond Funds

2.25% 2.00% 1.75% 1.50%

Calculate max. Recurring Expenses that MF can charge if average weekly net assets are Rs.1,000 Core in Equity / Debt scheme
69

Investment Management Fees

Most significant head of expenses charged to the scheme The limits on AMC fees are as follows:

1.25% on the first Rs. 100 crore of net assets 1% on the remaining net assets over and above Rs 100 crore.

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

An index scheme is passively managed

The expense limits for Index schemes (including ETFs) is : Recurring expense limit (including management fees) is 1.50% , Management Fees is 0.75%.

Fund of funds invest in other funds, and therefore cannot charge more than 0.75% as

fees.

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

70

Accounting Policies
Accounts of each mutual fund scheme have to be maintained separately SEBI regulations indicate the specific accounting treatment of various items in a mutual fund schemes account Distributable surplus for the purpose of paying dividend includes realized gains, accrued income and unrealized losses but does not include unrealized gains

Mutual funds can distribute dividends only out of realized profits

Unrealised gains cannot be distributed as dividends

Unrealised losses must be reduced from the distributable surplus Unit Premium Reserve is not available for dividend distribution

Average cost should be used to determine the holding cost of the securities Investments should be accounted on the transaction date, not on the settlement date Dividends, bonus and rights received by a mutual fund scheme should be recognized on the ex-date

71

Valuation Norms
Valuation of the mutual fund portfolio is done on every business day

Business day is a day when the securities markets in which the fund has invested is open

Equity shares are valued at the last traded price on the valuation day

If no traded price available, the closing price of the previous trading day (not more than 30 days before) can be taken In case of thinly traded share, SEBI-approved valuation methodology is adopted to arrive at the fair value

Debt securities are valued either at market prices if traded, or as per SEBI norms for
valuation

Securities with residual maturity < 91 days to be valued at weighted average price if traded on the valuation date Non-traded debt securities will be valued on amortization basis

Securities with residual maturity > 91 days to be valued at weighted average price if traded on valuation date If no traded price available, valuation based on yield matrix Crisil provides Crisil Yield Matrix used across the industry
72

Tax Aspects for Mutual Funds

A mutual fund is recognized as a pass-through structure and is exempted from income tax Dividends, interest and capital gains earned by the mutual fund scheme itself is fully exempt

from tax
Dividends are exempt from tax in the hands of the investor Dividends are subject to dividend distribution tax (DDT) depending on the type of scheme and investor

To be paid directly by the fund, before distribution of the dividend

Equity-oriented Fund

Scheme that has more than 65% of its net assets in equity securities Not subject to DDT

Non-equity oriented funds are subject to DDT

Liquid funds - 25% for all categories of investors

Non-equity oriented, non-liquid funds - 12.5% by individuals and HUFs 20% by all other categories of investors

Surcharge and cess as applicable would be added

73

Capital Gains and Securities Transaction Tax

Short term capital gain (STCG) / Short term capital loss (STCL)

Capital gain or loss realised by sale of units within a period of 12 months

Long term capital gain (LTCG) / Long term capital loss (LTCL)

Gain or loss from sale after a holding period of one year

Indexation

Adjusting the purchase price for inflation for purposes of determining capital gains The cost of inflation index to be used for indexation is published every year by the CBDT (Central Board of Direct Taxes)

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

Applicable only for equity-oriented funds and equity and derivative securities

Payable by the mutual fund on purchase and sale transactions on the stock exchanges
at 0.125% for equity and 0.017% for derivatives Payable by the investor at 0.125% on listed equity-oriented schemes and at 0.25% on redemption of equity-oriented fund
74

Calculating Capital Gain Tax - An Example

Mr. Arun invests Rs.2 lacs in MF units during FY 97-98

In F.Y. 2007-08, he sells units and gets Rs.3,36,930

CII 2007-08 : 551, CII 97-98 : 331 Indexed purchase cost (2,00,000 x 551 / 331) = Rs.3,32,930 Capital Gains : Rs.3,36,930 3,32,930 = Rs. 4,000 Long Term Capital Gain Tax is Rs.4,000* 20%=Rs.800 or 10% of Rs.1,36,930/- i.e. Rs.13,693/Obviously he will select the option of paying Rs. 800/- and not Rs.13,693 as long term capital gain tax.

75

Tax Provisions

Fund Type

DDT

STCG

LTCG

STT

Equity funds

oriented

NA

15%

Exempt

On redemptions @0.25%

Liquid funds

25%

10% without Marginal rate indexation or 20% Not applicable of taxation after indexation

12.5% (individuals 10% without Other non-equity Marginal rate and HUFs) 20% indexation or 20% Not applicable oriented funds of taxation (others) after indexation

76

Chapter 7

Investor Services

Investors in Mutual Funds

Investors Eligible to Invest in Mutual funds

Individuals & Hindu undivided families (HUFs) Companies & partnership firms Trusts & charitable institutions Banks & financial institutions Non-banking finance companies (NBFCs) Insurance companies Provident funds Mutual funds Foreign institutional investors (FIIs) Non resident Indians (NRIs) Persons of Indian origin (PIOs)

Resident individual investors are the largest segment

Retail and HNI

HUFs can invest through Karta Overseas Corporate Bodies and foreign citizens (except PIOs) are not eligible
78

Retail and Institutional Investors

The Who Can Invest section of the offer document of a scheme specifies the categories of investors eligible to invest in a mutual fund scheme The individual investor category includes retail investors, HNIs, minors and NRIs

Retail investors may depend upon the distributor to provide the information and analysis HNIs may demand a better quality of service. Minors can invest through a guardian

Institutional investors invest as per their charter and internal processes

Approval of management committees and board of directors Boards resolution and charter of the institution are required

Authorised signatories are individuals authorised to sign document

79

Know Your Customer (KYC)

The identity of those entering into financial transactions must be known and verified

Proof of identity of the customer, proof of residence, Permanent Account Number and photograph are verified to comply with KYC norms

Identified service provider: CSDL Ventures Ltd

Designated acceptance points: Points of Service (PoS)

KYC once completed, is valid across mutual funds

Investors have to submit a photocopy of the KYC acknowledgement along with application forms

KYC compliance is mandatory for all joint investors in a folio, for purchase transactions of Rs.50,000 or above KYC for investment by a minor

Compliance by guardian

KYC for investment by Power of Attorney

Compliance by the investor and the holder of attorney

80

PAN and Micro-SIP

PAN is mandatory for all investors in a mutual fund, irrespective of invested amount (Exception: Micro SIP) Micro-SIP are exempted from requirement of PAN card

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

Alternate valid photo identification documents must be provided instead

Investor is also required to provide an undertaking that their total micro-SIP investments in a year do not exceed Rs.50,000

81

Purchase Transactions
Fresh purchases are made by investors by submitting an application form complete in all respects

Open a new folio Minimum investment amount During an NFO or after the scheme opens for purchases

Additional Purchases are subsequent purchases after fresh purchase

Can be made under the existing folio

Can be made using a transaction slip Minimum additional investment amount

Transaction Slip

Folio number to identify the investor Used for redemptions, additional purchases, switches and even non-financial transactions such as change of address or change of bank details Has to be signed according to the mode of holding of the folio, to be valid

82

Payment Instruments
Payment is usually made by cheque

Local cheques accounts in same city but different banks Outstation cheques accounts in different banks in different cities At-par cheques work like local cheques

Demand drafts are accepted from locations where an ISC is not available Mutual funds do not accept cash, outstation cheques, money orders, stale cheques or post dated cheques (except for SIPs)

Electronic Payment Instruments

Schemes account details are essential Proof of transfer must be appended along with the application EFT, RTGS, ECS, Direct transfer, SWIFT Widely used for making liquid fund purchases by institutional investors

ASBA (Application Supported by Blocked Amount)

Sebi has allowed for NFO applications Money goes out of the investors bank account only on allotment
83

Payment Instruments NRIs and FIIs

Non-resident external (NRE)

Foreign currency accounts

Funds can be repatriated on redemption

Non-resident ordinary (NRO)

Indian rupee accounts Funds cannot be repatriated on redemption

Foreign currency non-resident (FCNR)

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

Source of funds determines repatriability of funds on redemption

Redemptions to NRIs are subject to TDS on the capital gains made in the transaction

Redemptions to NRIs are in Indian rupees

FIIs use non-resident rupee accounts for investments in India

Funds fully repatriable on redemption

84

Redemption Transactions
Redemption may be specified in terms of units or rupees The repurchase price is the applicable NAV minus exit load Redemption request has to be filed by joint holders as per mode of holding

In case of corporate investors, authorised signatories have to sign the redemption request

If a redemption request reduces the balance to below minimum limit, then all the units standing to the credit of the folio will be redeemed and the folio closed Redemptions are either made directly into the bank account, or by cheques on which the bank account details are pre-printed Mutual funds are required to service redemption requests within 10 working days

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

85

Applicable NAV
Cut-off time determines the NAV applicable for the transaction

NAV applied to a transaction depends upon the time when the transaction request was received by the mutual fund and the type of scheme

NAV is computed on business days for all schemes

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

Cut-off time varies for liquid fund purchases

Historical NAV is possible

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

86

Cut-off Time and Applicable NAV

Transaction

Cut-off time

Applicable NAV

Liquid fund purchases

12.00 noon

NAV of the day prior to the day on which clear funds are available

Liquid fund redemptions

3.00 pm

NAV of transaction day

Non-Liquid fund purchases

3.00 pm

NAV of transaction day

Non-Liquid fund redemptions

3.00 pm

NAV of transaction day

87

Time Stamping
Record the time at which a transaction was received at an OPAT

OPATs - Mutual fund offices and designated investor service centres (ISCs)

The time stamp is mandatory to determine the applicable NAV for a financial
transaction

Electronic time stamping requirement for all mutual fund purchase and redemption transactions

The time stamping machine captures the time of receipt of a transaction The location code, machine identifier, date, time (hh:mm) and running serial number are generated in every time stamp The time stamping machine records three impressions for purchase:

the application form or transaction slip,

the back of the payment instrument, and

the acknowledgement.

For redemption transactions all three impressions are on the redemption request

88

Statement of Account (SoA)

Proof of investment SoAs are despatched by the R&T agent, after every transaction

Within 10 business days of the transaction

In case of NFO, SoA must be despatched within 5 business days of allotment In case of SIP, SoA is sent every quarter Fresh purchase SoA

Amount, price, and units are mentioned

Subsequent transaction SoA

Amount, price, balance units, current market value are mentioned

Received through post, courier, email

89

Transactions Through Stock Exchange Brokers

Transactions are placed like orders to the brokers Contract note generated with an electronic time stamp Receipt of purchase requests and redemption requests is handled by brokers Allotment of units against purchase and release of funds on redemption, is handled by the R&T agents Folio details are sent to R&T agents by brokers Settlement is not guaranteed by the stock exchange or clearing corporation

Responsibility of settlement lies with the AMC and R&T agents

May be in physical form or through demat account

Demat statement is considered as the SoA to the investor

Demat transactions are settled through credit and debit instructions to the depository
Physical transactions are settled through R&T Agent

90

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

Gains made in the portfolio from income and appreciation are retained and gains are reflected in NAV Investor must redeem units to realise gains Realised profit/loss is treated as capital gains or loss

Dividend Pay-out

Fund declares dividend from realised profits after trustee approval Amount and frequency varies and depends upon distributable surplus Ex-dividend NAV: NAV after the dividend is declared and paid out Cum-dividend NAV: NAV after dividend has been declared but not paid out NAV falls after dividend payout to the extent of dividend paid

Dividend Re-investment

Dividend is re-invested in the same scheme by buying additional units at the ex-dividend NAV

91

Investment Options An Illustration

Growth NAV at the beginning Number of Units NAV after 1 year Dividend of 10% declared Dividend Amount Rs.10 100 Rs.12 No Nil Dividend Payout Rs.10 100 Rs.12 Yes Rs.100 Dividend Re-investment Rs.10 100 Rs.12 Yes Rs.100

NAV post dividend

Number of units held Value of investment Pre-tax return on investment

Rs.12
100 100x12=1200 Rs.200 capital gain

1100/100 = Rs.11
100 100x11=1100 Rs.100 dividend+ Rs.100 capital gain

1100/100 = Rs.11 100+(100/11) =109.09

109.09 x 11=1200 Rs.100 dividend+ Rs.100 capital gain*

92

Systematic Investment Plans

Investors invest a sum periodically into a mutual fund scheme Applicable NAV is the NAV on the date of the instalment Rupee cost averaging

Buying more units when the market is low and less units when the market is high

Period of commitment of SIP can vary e.g. 6 months, 1 year, 3 years, 5 years Specific intervals at which investment must be made e.g. monthly, quarterly, half-yearly Investment is made on specific dates e.g. 1st, 5th, 10th, 15th of every month Can be initiated along with NFO

First instalment is upon allotment Second instalment comes after the fund opens for subscription

Payment modes Post dated cheques, electronic clearing service, standing instruction
for direct transfer

93

SWP and STP

Systematic Withdrawal Plan

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

Systematic Transfer Plan

Periodically transfer a specified sum from one scheme to another within the same fund house Helps in re-balancing portfolio Redemption from source scheme Investment of redemption proceeds into the destination scheme SWP from source scheme and SIP into destination scheme

Capital gains apply, STCG/LTCG

94

Switches and Triggers

Switches

Redemption and purchase transaction rolled into one Redeeming scheme is called source scheme switch out leg Purchasing scheme is called target scheme switch in leg Can also be done from one option to another Saves time and effort in moving funds from one scheme/option to another

R&T carried out the transactions in the investors records

Exit loads not charged for switch within options Exit loads charged as applicable for inter-scheme switch

Triggers

Automated purchase, redemption, switch or dividend decisions based on pre-defined events Pre-defined event may be Sensex levels, return targets etc.

95

Other Transactions
Service requirements or Non-financial transactions

Change in personal information such as name, bank account details, joint holder details, signatories, status etc Based on documents provided as proof

Mutual fund units can be pledged with banks and finance companies to borrow funds

The amount of loan depends on the value of units on the date of borrowing and the margin

Units pledged are marked under lien in the folio and cannot be redeemed

Investors can nominate the person to whom the units can be transferred in the event of their death

Nominations can be changed Nomination has to be signed by all joint holders Nominee can be a minor Nominee rights are subservient to that of the joint holders

96

Chapter 8

Risk, Return and Performance of Funds

Drivers of Returns in a Scheme

The portfolio is the main driver of returns in a

mutual fund scheme. The underlying factors are different for each asset class.

98

Equity Schemes - Fundamental and Technical Analysis

There are two disciplines of securities analysis : Fundamental & Technical Fundamental Analysis

Entails review of the companys fundamentals viz. financial statements, quality of management, etc The analyst sets price targets, based on financial parameters like EPS, P/E Ratio Judge whether the stock is undervalued or overvalued Stock evaluated in the context of industry and macro factors

Technical analysis

Study of stock prices and volumes, plotted as charts Identify patterns that may indicate whether there is a dominance of buying or selling interest in stocks

Portfolio Building Approach Top down and Bottom up

Top down approach starts with macro, then industry and then company Bottom up approach starts with company, then industry and then macro Top-down is for sector selection; Bottom up is for stock selection
99

Earnings and Book Value Per Share

Earnings per share (EPS)

Profit after tax per share Market price /Earnings per share to arrive at Price-Earning (PE) ratio indicates how much the market is willing to pay per rupee of earning of a stock Historical PE computed using past earnings Forward PE computed using future earnings

Low PE means undervalued and high PE means overvalued

Book Value Per share

Net worth (share capital plus reserves and surpluses) of the company divided by the number of shares Market price/Book value per share to arrive at Price-Book Value (PBV) ratio A PBV less than one, indicates that the share is selling at a price lower than its book value, and may therefore be undervalued

100

Debt Securities
Debt securities represent an underlying loan

Borrower is the issuer; Lender is the buyer Debt instruments have a face or par value, are issued for a specific period. Debt instruments mature on a specific date called the maturity date. Tenor is the distance in time to maturity. Coupon rate is the annual rate of interest paid on the par value of the bond Issued by the government, public limited companies, banks and financial institutions

Government securities are also called gilts and have no credit risk

Issued for a tenor from 2 to 30 years

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

Treasury bills, commercial papers and certificates of deposit

Floating rate securities

Interest payable periodically is reset with reference to the benchmark or base rate A spread is added to the benchmark rate to arrive at the coupon

Zero coupon bonds are issued at a discount and redeemed at par

101

Total Return in Debt Portfolios

Consists of accrual income that comes from interest received on the portfolio and capital gains (losses) from changes in the value of the portfolio Price of a bond responds to changes in market interest rates in an inverse relationship

An increase in interest rates leads to a fall in price of existing bonds A fall in interest rates leads to gains in the price of existing bonds

The debt portfolio would show a mark-to-market gain if interest rates fall

The debt portfolio would show a mark-to-market loss if interest rates gain
The change in price of floating rate bond is limited due to interest rate changes

Coupon is linked to the market benchmark Changes in interest rates reflected in the coupon itself

102

Implementing the Interest Rate View

A security of longer maturity would fluctuate a lot more, as compared to short tenor securities Debt analysts work with a related concept called modified duration Modified Duration is a technical measure of bonds sensitivity to changes in interest rates

Higher the modified duration of a bond, higher the interest rate sensitivity of a bond

Average maturity and modified duration are directly related

Fund manager alters strategy based on interest rate view

If interest rates are expected to increase, the fund manager will hold buy bonds of shorter tenor, so that the capital losses are reduced If interest rates are expected to fall, bonds of longer tenor will be bought, to enhance the capital gains

103

Yield Spread and Credit Spread

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

It is drawn for g-secs, which do not have any credit risk

Yield curve usually slopes upward indicating that the interest rate for a longer tenor is higher
than that of the shorter tenor

A longer tenor bond may feature a higher rate compared to a lower tenor bond

Yield spread is the difference in yield across tenors, for the same credit quality Difference between the rate for a bond with credit risk and the government bond for the same tenor is called credit spread

Interest rates of all non-govt bonds are higher and depend on their credit rating Higher the credit rating of a bond, higher is the perceived safety and lower the credit spread. Bonds with higher credit rating are issued at lower rates; and vice versa

104

Investment in Gold and Real Estate

Gold as an investment class

Investors prefer to hold gold when their risk aversion goes up Gold is a growth asset and generates no income The returns from gold tend to be affected by the strength of the US Dollar, in which its price is denominated In rupee terms, the return from gold tends to increase when the rupee depreciates and decrease when the rupee appreciates

Real Estate as an investment class

Does well in times of economic boom Return from real estate is cyclical

Sensitive to interest rates

It is a long-term investment and oriented to capital appreciation rather than income Rent is a source of income but the yield may be low Liquidity is very low and getting out of an investment may be long-drawn and expensive
105

Measures of Returns on Investment

Simple Return

Converting to a percentage By comparing the NAV over two points in time we can estimate the return that fund has earned over the period Return can be positive or negative, depending on whether the end NAV is higher or lower than the start NAV (NAV at the end) - (NAV at the start) X 100 (NAV at the start)

Simple Return =

SEBI prescribes simple absolute returns as the return representation for periods less than one year for all funds except liquid funds Example: The NAV of a fund was Rs 23.45 on January 31, 2009 and Rs 27.65 on March 31, 2010.
The absolute return earned by the investor who invested at the start of the period and is evaluating his investment at the end of the period, would be: = ((27.65 23.45)/23.45) x 100 = 17.91%

106

Annualised Return
Returns can be standardized as if they were held for a one year period Simple Return is multiplied by annualising factor 365/n or 12/n for holding period in days and months respectively Annualization of returns from Liquid funds, for periods less than a year, is allowed by SEBI Example:
An investor bought a unit at Rs 10.50 on Jan 1, 2010 and sold it for Rs 11.50 on April 30, 2010. The Simple Return to the investor is: (11.50 -10.50)/10.50 = 1/10.50 = 9.52% However, this is the return earned over the period Jan 1, 2010 to 30 April, 2010. If we were to ask, what would be the return per annum, we would annualise the return as follows: = 9.52% x 365/120 = 28.96% p.a

107

Compounded Annual Growth Rate(CAGR)

Compounded rate at which the investment has grown from one point to another Compounding means return has been earned not just on the invested principal, but also on

the returns generated periodically

CAGR refers to the rate of return arrived at after allowing for returns to be reinvested r = (V1/V0)1/n - 1

V0 is the value at the start; V1 is the value at the end; n is the holding period in years; and r is the CAGR.

Return and performance data published by mutual funds use the CAGR method for periods greater than one year

Example:
An investor purchased mutual fund units at Rs.12 each and redeemed them after three years for Rs.26 each. What is his CAGR? CAGR = (26/12)^(1/3) 1 = 29.4%
108

CAGR for Dividend Reinvestment

In the case of a dividend option, we can compute the CAGR by assuming that the dividends were reinvested at the ex-dividend NAV Example:
An investor bought 100 units of a fund at Rs 10.50 each. He received a dividend of Rs 2 per unit, which he reinvested at the ex-dividend NAV of Rs 10 each. If he sold his holdings at Rs 11 per unit, what is the total return to A? Begin value Dividends No of units reinvested End value Total return = 100 units x Rs 10.50 = Rs 1050 = 100 units x Rs 2 = Rs 200 = 200/10 = 20 units = 120 units x Rs 11 = Rs 1320 = ((1320-1050)/1050) x 100

= 25.71%

109

Investor Return vs. Represented Return

The investors investment may not have been made on the dates used to calculate represented return

Investors may make additional investments or withdraw funds at different times.

Funds represent pre-tax returns.

Actual post tax returns may be different depending on the tax status of the investor and the taxability of the return

The published return is for the growth option. An investor choosing a dividend option
may have a different holding period return Investors may have a lower return if they pay an exit load, which makes their redemption price lower than the NAV . In this case return has to be computed using the redemption price, not the NAV.

Mutual funds cannot promise or assure returns to investors

110

Market Risks
Market risk is a standard risk in mutual fund products

Investment portfolio mark-to-market every business day Returns would vary with variations in the market values

Market risk in equity arises from changes in prices due to changes in underlying fundamental and technical factors In debt instruments, changes in macro economic factors, that change the market expectations for interest rates

Interest rate risk

Mutual funds manage market risks through diversification

Equity shares in a single stock cannot exceed 10% of the net assets. Debt securities of a single borrower cannot normally exceed 15% of net assets; with trustee approval maximum of 20% of net assets. The holdings of a mutual fund across all its schemes cannot be over 10% of the paid up capital of a single company

The average maturity of liquid and very short term debt funds is too low for market risks to be significant
111

Liquidity Risks
Liquidity risks may not enable buying or selling easily as may be required Small and mid-cap funds find it difficult to exit such stocks without impacting the price

Fund managers are wary of a large portfolio size

Secondary markets in corporate bonds of lower credit quality are not very liquid Money market securities help in ensuring sufficient liquidity

May impact portfolio returns negatively

Right to temporarily stop redemptions if they perceive higher illiquidity in the markets Illiquid and thinly traded securities cannot be more than 5% of net assets in a closed end fund; and not over 10% of net assets in an open ended fund Every scheme shall have at least 20 investors and that a single investor shall not hold over 25% of the unit capital of the scheme

No leveraging is allowed in Indian mutual funds

May borrow for 6 months (max) to meet short term liquidity requirements Not exceeding 20% of net assets

112

Credit Risk
Default in payment of interest or principal, or both, by an issuer of debt securities Deterioration of the credit quality will result in falling prices and net asset values Credit risk is assessed from the credit rating A high credit rating indicates a low degree of default risk. Invest in instruments that are credit rated by agencies registered with SEBI. Investment in unrated debt securities of one company cannot exceed 10% of the net assets of a scheme. Not more than 25% of net assets of a scheme can be in such unrated securities across issuers Mutual funds carry out their own internal credit research as well

113

Measuring Risk
Risk is defined as the variance of actual returns from expected returns Standard deviation is the square root of variance

MS Excel function =stdev(range containing the return time series) A higher standard deviation means greater volatility in return and greater risk

Market risk may be systematic or unsystematic

Systematic risk is not diversifiable, as it is caused by market-wide factors that may impact the performance of a range of stocks. Unsystematic risk is company specific and can be reduced by diversification

Beta is a measure of the systematic risk in an equity portfolio

Measures the sensitivity of the fund's returns to changes in the market index A beta of 1 means the fund is likely to move along with the market. Funds with beta > 1 are likely be more risky than the market and are aggressive funds

Funds with beta < 1 tend to be less risky compared to the market and are defensive funds

Modified duration measures risk in debt fund w.r.t. market factors

Higher the modified duration greater the market risk of the fund and vice versa Higher the average maturity, higher the risk
114

Relative Return
Performance of mutual funds is measured on a relative basis

Absolute returns are meaningless

Underperformance or Outperformance vis--vis the market benchmark There is no assurance of return Invests in a set of marketable securities Performance of a fund must be measured w.r.t.

The market that it operates in Investment objectives

Every mutual fund product is mandatorily required to specify the benchmark to which its performance could be compared

115

Benchmarks
Portfolio that generates an independent level of return, representing an asset class or investment style

Market index is typically used to benchmark performance

Choice of a benchmark for a fund depends on its objectives and the asset classes in which it invests Commonly used benchmarks:

Market benchmark return

Peer group return Return on other comparable financial products

Mutual funds have to indicate market benchmarks while filing the OD at the time of launch

May be changed only with trustees approval

Market benchmarks are independent portfolios that are not managed

Computed independently by exchanges, publications, research agencies

Benchmark return has to be presented when they advertise the schemes performance
116

Equity and Debt Fund Benchmarks

Equity fund benchmarks

Investment objectives and asset allocation in the portfolio are the basis for determining the appropriate benchmark E.g. Small and mid-cap funds benchmark BSE 500, Diversified funds benchmark BSE 100 Large cap funds benchmark BSE Sensex/Nifty, Banking sector funds benchmark BSE Bankex

Debt fund benchmarks

Appropriate index would be one whose composition reflects the composition of the debt fund portfolio in terms of tenor and composition ICICI Securities Si-Bex, Mi-Bex, Li-Bex Crisils LiquiFEX, STBEX, Gilt Bond Index, AAA Corporate Bond Index

Hybrid fund benchmarks

Asset allocation and composition of the benchmark should be similar to that of the fund
Crisil Mipex, Crisil Balancex

Gold ETFs are benchmarked against the price of gold Real estate funds against real estate indices

Funds that invest in markets other than India, use appropriate indices of that market 117

Peer Group Benchmarks

Relative benchmarking with the peer group

Performance of a fund in comparison to other funds in the same category A fund that has performed better than the average of its peer group is said to be an outperformer

The funds being compared should invest in the same asset class

An equity fund cannot be compared with a debt or balanced fund.

The funds should have a similar investment pattern

A diversified equity fund cannot be compared with small cap or a mid cap fund.

The investment objective of the funds should be similar

An equity fund that focuses on the capital goods sector cannot be compared with a banking sector fund. A gilt fund cannot be compared with an income fund.

Research agencies providing ratings and rankings enable peer group comparison

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Other Financial Products as Comparable Benchmarks

Absolute benchmarks are useful for a broader understanding of the product

Other products of similar nature Debt fund return vis--vis the return on a bank deposit MIP return vis--vis the return on PO Monthly Income Scheme

While comparing mutual funds with other products of a similar nature the effect of

taxes and costs must be considered

Mutual funds cannot provide absolute returns

They perform as per the asset classes they invest in and the market returns for these asset classes

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Risk-Adjusted Return
Risk-adjusted return is used to evaluate consistency of returns

Consistent return means return comes with a lower risk Return generated relative to the risk taken by the fund to generate the return

Sharpe Ratio

Compares the return of a fund with its risk Return is measured as the excess return over a risk free rate (Return of the fund risk free rate)

It is common to use the 91-day Treasury bill rate as the indicator of the risk free rate
Sharpe ratio = Excess return / Standard Deviation

For the Sharpe ratio to be high, a fund needs to post a higher return for the same risk, or lower risk for the same return Example:
An equity fund posted a return of 25% with a standard deviation of 16%. The benchmark posted a return of 22% with a standard deviation of 12%. If the risk free rate was 6%, the risk adjusted return measured by the Sharpe ratio would be as follows:
For the fund: (25-6)/16 = 1.1875 For the benchmark: (22-6)/18 = 1.3333 120

Treynor Ratio
Compares the excess return over the risk free rate of a fund with its risk, measured by beta

Excess return = Return of the fund risk free rate of return Beta measures only systematic risk, Standard deviation measures total risk Treynor Ratio = Excess return/Beta

Higher the Treynor ratio, better the fund performance

Example:
An equity fund posted a return of 25% with a beta 1.2. The benchmark posted a return of 22% with a beta of 1. If the risk free rate was 6%, the risk adjusted return measured by the Treynor ratio would be as follows: For the fund: (25-6)/1.2 = 15.83 For the benchmark: (22-6)/1 = 16

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Managers Alpha
Use the Treynor measure to ask if the manager posted an excess return over the benchmark, after adjusting for market risk Example:
An equity fund posted a return of 30% with a beta 1.2. The benchmark posted a return of 22% with a beta of 1. If the risk free rate was 6%, the risk adjusted return measured by the Managers alpha would be as follows: Excess return of 30% 6% (risk free rate) = 24%. Given its beta of 1.2, its excess return should have been 19.2%. Therefore the alpha of the fund is 4.8%.

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Tracking Error
A consistent performer is a fund which is able to give better returns than the benchmark across time periods on a risk-adjusted basis

Tracking error measures the consistency in returns The standard deviation of excess return is called the tracking error Lower the tracking error, higher the consistency in performance

If the excess returns come with higher risk, they may not be consistent

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

Tracking error of an index fund will have to be zero

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Chapter 9

Scheme Selection

RISK LEVEL HIGH

DEBT FUNDS

HYBRID FUNDS
Balanced Funds based on Flexible Asset Allocation

EQUITY FUNDS
Sector Funds

Growth Funds High Yield Debt Funds Diversified Equity Funds Index Funds Value Funds Equity Income Funds/Dividend Yield Funds Balanced Funds based on Fixed Asset Allocation Monthly Income Plans Capital Protection Oriented Funds Diversified Debt Funds Gilt Funds

LOW

Money Market Funds/Liquid Schemes

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Performance and Cash Levels of Equity Funds

Mutual fund products differ primarily in terms of return, risk and desirable investing horizon Consistent Performance

Consistently generate better returns than the benchmark over different market situations and longer time periods Ability of the fund to protect downside risk in time of market downturn Longer term performance over 3, 5, 7 or 10 should be used to select equity funds

Cash Levels

Cash holdings in an equity fund should not be over 10% of the net assets A high level of cash may imply that the fund manager is trying to time the market Holding cash is a defensive stance, hoping to protect the from a steep fall in stock prices The fund managers cash call may turn out to be right or wrong, implying a risk for the investor

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Concentration and Market Cap of Equity Funds

Portfolio Concentration

Level of diversification based on portfolio objective If the top 10 stocks in the portfolio account for more than 40% of the net assets, a fund may be concentrated and can have a higher risk If the top three sectors in a diversified equity fund account for over 40% of the net assets the fund may be concentrated A thematic or sector fund will have a higher sector concentration Thematic and sector funds are chosen tactically

Market Capitalisation

Should be in line with the objectives of the portfolio

Large cap fund should be predominantly large cap

Large cap fund has lower risk of liquidity and earning shocks Diversified fund having too much exposure to small caps is risky Small/mid cap funds are suited for aggressive investors
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Portfolio Turnover and Liquidity of Equity Funds

Portfolio turnover ratio = total sales or purchases of a fund (w.e. is lower) divided by the average net assets of the fund

Higher the ratio, greater the frequency of trading, and lower the average holding period High turnover means the stocks held in a portfolio are changed very frequently Low turnover indicates that the fund manager has high conviction in the stocks selected High ratio indicates market timing and momentum trading Frequent trading increases transaction costs of the scheme

Liquidity is the option to exit the fund

An open-ended fund enables investors to exit the fund, when they choose to Closed end funds or ELSS should be chosen only if the investor is sure of a longer holding period

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Size, Age and Style of Equity Funds

Size of the fund influences the performance

It is more difficult to liquidate, rebalance or significantly alter the composition of very large portfolios Finding suitable stocks to invest in may also become a challenge as the size increases especially for mid-cap and small cap funds and sector funds

Longer age of the fund presents a longer track record for evaluation

An existing fund has a track record for evaluation, while the new fund has none Ability to judge performance over a longer period of time

Style of fund performance defines risk-return profile

An actively managed fund may be riskier than a passive fund Dividend yield funds that focus on value and are less risky, compared to growth-oriented funds Large cap funds may be larger in size and less volatile; small cap funds may be smaller in size and more volatile In a bullish market, growth funds may outperform value funds; in a bearish market, value funds outperform growth funds
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Average Maturity and Yield of Debt Funds

Debt funds are differentiated by the segment of the debt market they invest in

Fund managers construct portfolios including securities whose tenor is linked to the objectives Investing horizon of the investor may be matched to the average maturity

Average maturity indicates the extent of interest rate risk in the portfolio

Higher the average maturity of a debt fund, greater the interest rate risk of the fund

Yield of a debt fund portfolio indicates the return on the portfolio Funds with shorter tenors may feature a lower yield compared to funds with higher average maturity

Higher the proportion of securities to be valued every day on mark-to-market basis, and higher the average maturity, higher the interest rate risk in the portfolio In a falling interest rate scenario, debt funds with higher average maturity offer higher returns from capital gains

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Expense Ratio, Credit Quality and Special Structures of Debt Funds

Expense ratio is very important in debt funds

Higher expense will directly reduce the return of the fund A debt fund with lower expense ratio should be preferred to those with higher expense ratios Institutional plans with lower expense ratios for large investors

Credit rating of instruments in the portfolio indicates the extent of credit risk

Extent of papers with low credit quality in the portfolio

Funds may compromise credit quality for a higher yield than peer group average
Gilt funds do not carry credit risk

Special Structures

Floating rate funds have a low interest rate risk and are a good investment option when interest rates are rising FMPs hold securities that have the same tenor as the fund and are held to maturity They are not affected by interest rate risk Liquid funds invest in securities with maturity <91 days. They have lowest interest rate risk
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Performance and Portfolio Features of Debt Funds

Performance of debt funds need not be evaluated over long periods of time

Performance of debt funds is typically evaluated for periods from three months to one year Funds with stable returns and regular dividends are preferred Debt fund performances, within a given peer group does not vary too much

Portfolio Features

Large holding of cash and equivalents such as CBLO will reduce the returns
Funds with low credit quality may be giving a high return A debt fund portfolio with a large number of securities is more liquid and more flexible Large-sized debt funds can manage inflows and outflows, expenses and liquidity, better than smaller funds

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Selection of Hybrid Funds

Hybrid funds can have an equity or debt-orientation

Each component must be evaluated using the various parameters for each one

Hybrid funds provide an indicative allocation to equity and debt, usually within a range

Performance of a hybrid fund depends on the allocation to asset classes and changes to this allocation

It may be difficult to compare hybrid funds with varying allocations

The securities held within the portfolio, under each asset class, will impact
performance The regularity of the dividend and the predictability of the amount of dividend are factors used in selection of funds

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Selection of Other Fund Types

Gold Funds

Value of gold ETFs will be in line with the price of gold Funds that invest in gold-linked company stocks may behave more like equity funds than commodity funds

Arbitrage Funds

Seek to benefit from simultaneous exposure in equity and equity derivative markets performance of these funds should be comparable to that of short term debt funds Limited liquidity

Fund of Funds

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

International Funds

Risk, return and performance may vary depending on strategy they adopt to invest in international markets

134

Sources of Information on Mutual Funds

Monthly factsheets of fund houses Information founds on investment-oriented websites Websites of Amfi and Sebi and respective mutual funds Agencies that use mutual fund data to create comparisons and reports for product comparison and selection Rankings and ratings of funds after classification of funds into a peer group Information providers for mutual funds:

Value Research at www.valueresearchonline.com Icra online at www.mutualfundsindia.com CRISIL at www.crisilfundservices.com

Morning Star at www.morningstar.co.in

Lipper at www.lipperweb.com

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Chapter 10

Selecting the Right Investment Products for Investors

Physical Assets and Financial Assets

Physical assets have a physical and material form

E.g., gold and real estate Return is usually in the form of appreciation over time Physical assets are typically preferred by investors due their tangible nature Exposed to hazards such as fire, theft or floods, which may erode their value

Financial assets involve investing money for some cash flows in the future

Underlying claim or entitlement to interest, dividends or principal invested does not have a tangible form
E.g., Bank deposits, company deposits, equity shares, government saving instruments, bonds and debentures Protected from physical harm

Help in financing the economic activity

Encouraged by government over physical assets

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Guaranteed and Non-Guaranteed Investments

Guaranteed Investments

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

Non-Guaranteed Investments

Investments that do not provide any guarantee for periodic payouts or return of capital

E.g. equity shares, debentures and mutual funds

138

Gold as an Investment
Hedge against inflation Holding gold in the physical form

Gold bonds, Gold coins and bars

Holding gold in the financial form

Buying gold in the commodity futures market Traded in commodity exchanges like the NCDEX and MCX with prices linked to gold prices

Buying gold-linked funds

Buying gold exchange traded funds (ETFs)

Indian Mutual Funds Gold-linked funds

Gold ETFs International gold funds Securities of gold mining companies

Advantages of holding gold in financial form

Gold-based mutual fund schemes and ETFs are exempted from wealth tax Investments in gold mutual funds are long-term capital assets after a holding period of one year Mutual fund schemes offer nomination facility to investors, not available in physical gold
139

Real Estate as an Investment

Real Estate holding in physical form

Preferred by investors Is beyond the means of small investors capital required is large transaction costs may be high

Not easy to quickly liquidate investments in real estate at an appropriate price

Risk of concentration is high

Not easy to diversify

Real Estate Mutual Funds (REMFs)

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

140

Bank Deposits
Preferred form of investment with small investors

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

Limitations of bank deposits

Penalty for premature withdrawal

Yield on bank deposits is quite low

Effect of inflation on returns

Investors cannot benefit from changes in interest rates No possibility to benefit from capital gains in a falling interest rate scenario Interest income from bank deposits is taxable Post-tax returns from bank deposits can be lower as compared to debt mutual funds for an investor in a high tax bracket DDT is lower than the investors marginal tax rates

141

Equity Shares
Popular among urban investors

Represents part ownership in the company

Investment in equity shares offers:

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

Not easy for retail investors

Need research support, as well as expertise to select the right stocks Need a large amount of capital to create a diversified portfolio of equity shares

Mutual funds offer the advantage of diversified and professionally managed equity

portfolio to retail investors, even with a small outlay

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Debentures / Bonds and Company Deposits

Debentures/bonds represent borrowings of companies

Pay a floating or fixed rate of interest

Privately placed to institutional investors

Debentures offered to retail investors have to be secured by the assets of the borrower and are listed on the stock exchanges

Liquidity of debentures is quite low and investors may end up holding them to maturity Investors must be wary of instruments offering a high rate of interest, as they can have a low credit quality

Company deposits are unsecured deposits to investors

Pay regular interest on the deposit and return the principal on maturity Compulsorily credit rated Rate of interest is usually higher than that of bank deposits because the credit risk is higher Interest on company deposits is taxable Liquidity is low and investors have to hold them to maturity

Investors in company deposits must be wary of default risk

143

Institutional Bonds
Financial institutions such as IFCI, NABARD and NHB issue bonds

Listed on stock exchanges Usually offered with two options: Periodic interest payments (monthly, quarterly or annual) Deep discount option that pays no interest but has a redemption value which is higher than the issue price.

Unsecured and have to be compulsorily credit rated.

Infrastructure bonds for tax saving

Infrastructure bonds are eligible for tax benefits under Section 80C of the Income Tax Act (deduction up to Rs 1.20 lakh on amount invested)

Infrastructure bonds for saving capital gains

Investment of capital gains within 6 months, in such notified bonds, exempts the investor from paying capital gains tax on the amount invested (Section 54 EC) Notified bonds are bonds issued by NABARD, NHB and NHAI

144

Public Provident Fund (PPF)

Risk-free deposit that is made with the government

Can be opened by individual investors An individual can have only one PPF account in his or her name Annual contribution (deposit by the investor into the PPF account) can be between Rs 500 to Rs 70000 Compulsory to make deposits every year Penalties are levied

Contributions up to Rs 70000 per annum are eligible for tax deduction under Section 80C of the Income Tax Act. Contributions have to be made for 15 years Tax-free interest rate fixed by the government, currently at 8% per annum

Interest is compounded Interest rates have fallen from 12% to 8% p.a. Limited liquidity Interest and the redemption proceeds at maturity are exempt from tax

145

Small Saving Schemes

Run by National Small Savings Organisation through the state governments

National Savings Certificate (NSC), Kisan Vikas Patra (KVP), Senior Citizens Savings Scheme and post office saving schemes Preferred by small investors Guarantee on principal and interest Offer a fixed, but low rate of interest and are bought for their safety than for their return Have to be held until maturity Very limited liquidity

Interest rates are fixed by the government, and revisions are not done very frequently Last revision was in 2002

146

Insurance
Life insurance

Protection against loss of income due to unexpected death or disability of an earning member Sum assured is the obligation of policy holder Require the payment of regular premium by the policyholder Surrender value is paid out in case of termination of policy

Types of life insurance policies

Pure term policy, where the sum assured is paid to the nominee on the policyholder's death. Endowment policy, where the sum assured, along with accumulated bonuses, is paid to the nominee in case of the death of the policyholder or to the policyholder on the maturity

Investors seek insurance both for protection and as an avenue for savings and investment

Compulsory saving e.g. ULIP Tax benefits u/s 80C

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

Term policies do not offer any return Investors tend to over-commit premium Many policies offer limited flexibility
147

New Pension Scheme

Launched in May 2009 is regulated by PFRDA Save for a retirement corpus

Contributions made by the individual are managed by professional portfolio managers No guarantee of returns The minimum investment is Rs.500 a month or Rs.6000 annually, with no upper limit on investment Managed according to the investment mix selected by the contributor. The options available are equity (E), credit risk bearing debt instruments (C) and government securities (G) Investor can invest the entire corpus in C or G, investment in E is capped at 50% Auto choice option where the exposure to equity keeps reducing as the age of the contributor increases

Open an NPS account through identified Points of Presence

Tier I (Pension account). The amount invested cannot be withdrawn before the end of the term. Tier-II (Savings account). The amount invested can be withdrawn to meet any financial contingencies. Permanent Retirement Account Number (PRAN) will be allotted
148

Chapter 11

Helping Investors with Financial Planning

Financial Needs and Financial Goals

Financial Needs

Financial needs occur at various stages in ones life to meet life goals Financial needs can be classified as investment needs and protection needs Wanting to protect a familys income from any unforeseen risk is a protection need. This is met by insurance Need for funds to meet the expense on the college education a child is an investment need. This is met through saving and investment.

Financial Goals

Financial need can be described in terms of the amount of money that may be required to fulfil the need and the time when the money would be required Assessment of financial goals begins with the estimate of future expenses for every milestone event

150

Estimating Financial Goals

Future value of goals can be estimated based on current cost, time to goal and the expected rate of inflation

The formula can be simplified as: [FV=current cost*{1+rate of inflation}^time] Use the FV function in MS Excel Example: It costs Rs.8 lakh to put a child through formal college education today. If a family likes to estimate what this cost will be when their child, who is now 6 years old, is ready for college education at 16 years of age? = 8 x (1.07)^ 10 = 15.7 lakh

Calculating the target rate of return

Investor has defined the amount to invest as well as the value of future goal Example: Suppose the investor indicates that an amount of Rs.5 lakh has been saved already for this goal, and he likes to know what is the rate at which it should be invested to meet the goal: ((Estimated future value/invested amount)^investment horizon ) 1 = ((15.7/5)^(1/10)) -1 = 12.12%

Use the RATE function in MS Excel

151

Estimating the Investment Amount

Calculating the amount to be invested today

Example: For an estimated expense of Rs.15.7 lakh after 10 years, the investor chooses to invest in a diversified equity portfolio, expected to earn an average return of 14% p.a. The amount to be invested today can be computed as: Future value of goal/(1+expected return)^investment horizon =15.7/((1+14%)^10) = 4.23 lakh

Use the PV function in MS Excel

Estimating the amount of periodic investment

Instead of investing Rs.15.7 lakh in a lumpsum, the investor may choose SIP Use the PMT function in MS Excel The amount to be invested today in SIP: PMT(rate of return, number of periods, PV (blank), FV) = PMT(14/12, 10*12, , 15.7 lakh)=Rs.6060

152

Financial Planning and its Objectives

Financial Planning

Reviewing the portfolio and revising the asset allocation, if required Define and implement the action plan for meeting financial goals Proposed asset allocation has to match the investors risk profile Creating an investment plan and asset allocation strategy to meet financial goals Considers the overall situation of the investor

Objectives of Financial Planning

Creates a road map in terms what has to be done to achieve the goals Ensure that the financial goals of the investor are met by the right combination of savings and investment The current and expected income and expenses and the ability to save and invest is reviewed Forces them to see which goals are realistic and what may have to be postponed, modified or even given up
153

Need for Financial Planners

Financial planners advise investors on managing their finances such that goals are achieved.

Identify the needs and financial situation of an investor Translate the needs into measurable financial goals Analyse risk profile of the investor Plan investments so that these goals can be achieved Suggest appropriate asset allocation Have a good understanding of investment options available and their suitability Work with clients on their overall financial situation and not just one or two aspects Reviewed periodically so that it continues to be relevant to the investors needs and situation

154

Steps in Financial Planning

Establish the client relationship. Ascertain the clients needs and define with them, their financial goals

Gather data about the clients financial status. Analyse the data to prepare a current
financial position statement. Understand how much of loss clients can withstand and for what period

Adjust choice of products to their risk preferences

Understand and explain the tax situation to the clients.

Try to optimise post-tax return on investments.

Suggest allocation to asset classes and specific schemes Execute the plan by making the specified investments Review and suggest changes in asset allocation

155

Life Cycle Approach in Financial Planning - 1

Younger investors do not seek income from investments, can take a long-term view and are willing to take risks. Older investors may be unwilling to take risks, given their limited investing horizon and dependence on investment income. Childhood Stage

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

Young Adult Stage

start of the earning phase Investing in equity must begin in this stage preferably through Equity SIPs Life insurance may be necessary to protect income from disability or illness Individual is partially dependent

Young married stage

Need to provide for emergencies and protect income from death, injuries or loss is high Couple has joint responsibility to create and adhere to budgets and to control expenses Need for term insurance is high
156

Life Cycle Approach in Financial Planning-2

Married with Children Stage

Higher expenses and less money is available for investment Health and life insurance is important as protection needs are more important than investment needs at this stage Saving for childrens education

Married with Older Children Stage

Higher ability to save and invest because income levels are higher

Investment needs take precedence over protection needs

Focus on repayment of loans and saving for retirement

Pre-retirement Stage

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

Retirement Stage

Investors have to pre-dominantly live off their investments Require at least 2/3rd of their last income Focus on income generation and protect wealth from the effects of inflation
157

Wealth Cycle Approach to Financial Planning

Accumulation Phase

Accumulate and save for the long-term Choose growth-oriented investments Have a long-term investing horizon and can allocate savings to equity e.g. saving for childs education

Transition Phase

Withdrawal of funds for some financial goals while accumulating for retirement Middle-aged investors Have both equity and debt in their portfolio, as they have a medium-term horizon

e.g. withdraw from savings to meet the immediate education expenses of a child while at the same time saving for retirement

Distribution Phase

Reaping stage Depend on investment income Retired investors Income-oriented, preferring debt to equity
158

Inter-generational Wealth Transfer and Sudden Wealth Surge

Inter-generational Wealth Transfer

Stage at which clients plan to pass on their wealth to the next generation or to organisations and trusts Focus on the goals of the beneficiaries e.g. if the wealth is being transferred to grown-up children, the assets could be invested in a balanced combination of equity and debt funds If the recipients are young, the wealth could be invested in long-term growth funds

Advice on creating trusts and wills and planning for their estate

Sudden Wealth Surge

Investor experiences a sudden surge in wealth from unexpected flow of funds e.g. lottery, sudden appreciation in shares, inheritance of wealth

Evaluate tax implications

Funds should be invested in low-risk products like a liquid fund till such time a proper financial plan is drawn Money received unexpectedly should be invested based on financial goals and risk preference
159

Financial Planning for Wealthy Investors

High net-worth investors

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

Wealth-creating investors

Willing to take risks, investing in equity and risky assets

Comfort of accumulated wealth

Any short-term loss will not seriously impair their financial position

Wealth-preserving investors

Wealthy investors may not always be risk-taking equity investors Cautious about the wealth they have accumulated and focus on preserving its value Choose conservative investments, such debt and government securities Focus on regular income from accumulated wealth

160

Chapter 12

Recommending Model Portfolios and Financial Plans

Model Portfolios and Risk Profiling

Model Portfolio

Creating an investment portfolio after considering the goals, investment horizon and required return Created for a given combination of risk, return and investing horizon Ascertain the risk preferences of investors using risk profiling

Risk Profiling

Willingness of the investor to assume risk and to bear the possible loss in the portfolio in order to ascertain appropriate asset allocation
Risk appetite is influenced by their personal and financial situation

Risk Profiling Tools are used to generate risk appetite scores for investors

Surveys, questionnaires and proprietary risk profiling tools Scenario analysis Past history of the actual transactions of the investors

162

Risk Appetite and Asset Allocation

Age: Older investors may have lower risk appetite than younger investors Accumulated capital: The higher the accumulated capital, higher is the risk appetite Stability of income: Job security: Dependents: Earning members: Individuals with regular income tend to have a higher risk appetite Individuals with higher job security may be willing to assume higher risk Risk appetite decreases as the number of dependents increases Risk appetite increases as the number of earning members increases Individuals willing to experiment may have a higher risk appetite

Attitude:

Asset allocation

Decision about the proportions in which investments would be divided between asset classes such as equity, debt, cash and others A model portfolio is indicative of the ideal asset allocation based on investor risk profile and goals
163

Strategic and Tactical Asset Allocation

Strategic Asset Allocation

Allocating the available resources between asset classes within the appropriate risk and return framework Model portfolio is an example Asset allocation is driven completely by his need for return and risk profile The investor and the financial planner agree to adhere to the strategic allocation most of the time

For example, an investor desiring a return of 14% over 10 years, with a moderate appetite for risk, may choose to have 60% of his investments in equity (expected return of 18%) and 40% in debt (expected return of 8%)

Tactical Asset Allocation

Active management of the proportions in various asset classes based on the expectation of the performance of different asset classes To defend the portfolio or earn additional returns For example, if the advisor expects the equity markets to correct and he may tactically reducing the allocation to equity and increasing the allocation to debt

Carried out by fund managers, expert advisors and experienced investors

164

Fixed and Flexible Asset Allocation

Fixed Asset Allocation

Choose a strategic asset allocation and decide to rebalance periodically to the same ratio Portfolio has an allocation of 60% in equity and 40% in debt and that equity markets are doing well Value of equity portfolio goes upto 70% Investor will sell part of the equity holdings and bring it down to 60% of the portfolio value and invest in debt and restore the proportion to 40%

Flexible Asset Allocation

Choose an asset allocation and let it move along with the market without rebalancing If equity does well and the allocation increases, they allow it to run, without rebalancing to a fixed ratio

165

Revision and Re-balancing

Model portfolios are indicative Asset allocations may have to be revised and rebalanced based on investor needs, from time to time

Review of performance of the suggested asset allocation Changes in investor preferences and needs

Examples:

Proportion to equity for an investor may change as he moves away from accumulation phase into transition phase
Allocation to riskier assets reduces as life stage changes from young adult to married with children stage Allocation to income-oriented assets increases are investor approaches retirement A retired investor whose retirement income is well taken care of and is looking to generate a corpus for a grandchild may be willing to take a greater exposure to equity as he ages

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