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
3

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

4

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

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

8

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

10

Investing through MFs

Advantages

Disadvantages

1. Professional Management

1. Lack of Portfolio
Customization

2. Portfolio Diversification

2. Choice Overload

3. Economies of Scale
4. Liquidity
5. Flexibility & Convenience
6. Regulatory Comfort
7. Tax Benefits
11

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

12

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

13

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

14

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

15

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

16

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

17

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

18

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

19

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

20

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

21

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

22

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

23

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

24

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

26

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

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

Guardians of unitholders funds and assets

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

27

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

28

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

Role

Custodian

Hold funds and securities

R&T Agent

Keep and service investors records

Banks

Enable collection and payment

Auditor

Audit scheme accounts

Fund Accountants

Performs the role of calculating the NAV

Distributors

Distribute fund products to investors

Brokers

Execute transactions in securities

29

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

30

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

31

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

32

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

33

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

35

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

36

Association of Mutual Funds in India (AMFI)

AMFI is industry association of mutual fund industry

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)

It is not a Self Regulating Organisation (SRO)

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

37

Summary of Mandated Service Standards

by SEBI
Transaction

Turnaround Time

Allotment of units in a NFO (other than ELSS)

5 days from NFO closing date

Allotment of units in a ELSS NFO

30 days from NFO closing date

Dispatch of Statement of Account (on-going)

10 working days from transaction request

Dispatch of Statement of Account (Systematic

10 days from end of calendar quarter
transactions)
Dispatch of dividend warrants

30 days from date of dividend declaration

Dispatch of redemption proceeds

10 working days from transaction request

38

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

39

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

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 3 working days of every month-end

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
41

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

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

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

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

42

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

43

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

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

Abridged and concise version of the offer document

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

55

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

Assets
=
Market value of Investments + Receivables
+ Accrued income + Other Assets
Liabilities =
Liabilities

NAV of a Unit =

Accrued expenses + Payables + Other

Net Assets of the Scheme

Number of Units Outstanding

Q: Can you calculate NAV if total assets and total No.of units
are given?
63

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
For Equity
For Bond
Assets
Funds
Funds
For first Rs.100 crs

2.50%

2.25%

For next Rs.300 crs

2.25%

2.00%

For next Rs.300 crs

2.0%

1.75%

On Balance Average
Weekly Assets

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)

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

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

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

NA

15%

Exempt

On redemptions
@0.25%

25%

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

oriented

Liquid funds

12.5%
Other non-equity (individuals and Marginal rate
oriented funds
HUFs)
20% of taxation
(others)

10%
without
indexation
or
Not applicable
20%
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 microSIP 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

Cut-off time varies for liquid fund purchases

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

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

Subsequent transaction SoA

Amount, price, and units are mentioned

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 exdividend NAV
91

Investment Options An Illustration

Growth

Dividend Payout

Dividend Reinvestment

NAV at the
beginning

Rs.10

Rs.10

Rs.10

Number of Units

100

100

100

NAV after 1 year

Rs.12

Rs.12

Rs.12

Dividend of 10%
declared

No

Yes

Yes

Dividend Amount

Nil

Rs.100

Rs.100

NAV post dividend

Rs.12

1100/100 = Rs.11

1100/100 = Rs.11

Number of units
held

100

100

100+(100/11)
=109.09

Value of investment

100x12=1200

100x11=1100

109.09 x 11=1200

Pre-tax return on
investment

Rs.200 capital
gain

Rs.100 dividend+
Rs.100 capital gain

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. 1 st, 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 predefined 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

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

Issued for a tenor from 2 to 30 years

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

Simple Return =

(NAV at the end) - (NAV at the start) X 100

(NAV at the start)

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

= 100 units x Rs 10.50 = Rs 1050

= 100 units x Rs 2 = Rs 200

No of units reinvested
End value

= 200/10 = 20 units

= 120 units x Rs 11 = Rs 1320

Total return

= ((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

Market benchmarks are independent portfolios that are not managed

May be changed only with trustees approval

Computed independently by exchanges, publications, research agencies

Benchmark return has to be presented when they advertise the schemes

116
performance

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

The funds should have a similar investment pattern

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

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

118

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

119

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

121

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%.

122

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

123

Chapter 9

Scheme Selection

RISK LEVEL

DEBT FUNDS

HYBRID FUNDS

HIGH

EQUITY FUNDS
Sector Funds

Balanced Funds based

on Flexible Asset
Allocation
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

125

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

126

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

127

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

128

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 growthoriented 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
129

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
130

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
131

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

132

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

133

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

135

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

137

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

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

142

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

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
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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

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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

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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:

Individuals with regular income tend

to have a higher risk appetite

Job security:

Individuals with higher job security

may be willing to assume higher risk

Dependents:

Risk appetite decreases as the

number of dependents increases

Earning members:

Risk appetite increases as the

number of earning members
increases

Attitude:

Individuals willing to experiment may

have a higher risk appetite

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
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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

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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

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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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