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PROGRAM OBJECTIVES
2
Rules of NISM Certification Test
Reference Books:
4
Chapter 1
6
Mutual Fund Units
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
7
Investment Portfolio
Portfolio is a collection of securities
equity shares, bonds, debentures, deposits, money market instruments, derivatives and the
like
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
Total Assets
Market Value of all the securities held in the portfolio
8
Net 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
9
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
10
Investing through MFs
Advantages Disadvantages
3. Economies of Scale
4. Liquidity
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
13
Fund Classification-2
14
Debt Funds - 1
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
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
19
Equity-Linked Savings Scheme
Investment up to Rs. 100,000 in a year in such funds can be deducted from taxable income
of individual investors
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
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
26
Mutual Fund as a Trust
27
Asset Management Company
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
29
Custodian
30
Registrars and Transfer Agents
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
33
Chapter 3
35
RBI and Stock Exchanges
36
Association of Mutual Funds in India (AMFI)
37
Summary of Mandated Service Standards by SEBI
Allotment of units in a NFO (other than ELSS) 5 days from NFO closing date
38
Investor Rights for Service Standards
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
Within 3 working days of every month-end
Summarised portfolio disclosure to unit holders every month through Factsheet
Voluntary industry practice
Scheme-wise annual report to be mailed to all unit-holders
Within 4 months of financial year-end
Key documents may be inspected by investors
Detailed offer document, Key Information Memorandum, Annual Report
Trust Deed, Investment Management Agreement, Custodial Services Agreement, R&T Agent
Agreement and Memorandum & Articles of Association of the AMC
41
Rights With Respect to Fund Management
42
Limits to Investor Rights
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)
47
Scheme Information Document(SID)
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.
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
51
Addendum
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
52
Key Information Memorandum
53
Chapter 5
Fund Distribution and Channel Management
Practices
Individual and Institutional Distribution Channels
55
Newer Channels of Mutual Fund Distribution
56
Appointment of Distributor
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
60
SEBI Advertisement Code
64
Valuation Principles
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
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
69
Investment Management Fees
70
Accounting Policies
71
Valuation Norms
72
Tax Aspects for Mutual Funds
A mutual fund is recognized as a pass-through structure and is exempted from income tax
Dividends, interest and capital gains earned by the mutual fund scheme itself is fully exempt
from tax
Dividends are exempt from tax in the hands of the investor
Dividends are subject to dividend distribution tax (DDT) depending on the type of scheme
and investor
To be paid directly by the fund, before distribution of the dividend
Equity-oriented Fund
Scheme that has more than 65% of its net assets in equity securities
Not subject to DDT
Non-equity oriented funds are subject to DDT
Liquid funds - 25% for all categories of investors
Non-equity oriented, non-liquid funds - 12.5% by individuals and HUFs
20% by all other categories of investors
Surcharge and cess as applicable would be added
73
Capital Gains and Securities Transaction Tax
Short term capital gain (STCG) / Short term capital loss (STCL)
Capital gain or loss realised by sale of units within a period of 12 months
Long term capital gain (LTCG) / Long term capital loss (LTCL)
Gain or loss from sale after a holding period of one year
Indexation
Adjusting the purchase price for inflation for purposes of determining capital gains
The cost of inflation index to be used for indexation is published every year by the CBDT
(Central Board of Direct Taxes)
Mutual funds are not subject to Wealth Tax in the hands of the investor
Securities Transaction Tax
Applicable only for equity-oriented funds and equity and derivative securities
Payable by the mutual fund on purchase and sale transactions on the stock exchanges
at 0.125% for equity and 0.017% for derivatives
Payable by the investor at 0.125% on listed equity-oriented schemes and at 0.25% on
redemption of equity-oriented fund
74
Calculating Capital Gain Tax - An Example
75
Tax Provisions
10% without
Marginal rate
Liquid funds 25% indexation or 20% Not applicable
of taxation
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
79
Know Your Customer (KYC)
The identity of those entering into financial transactions must be known and verified
Proof of identity of the customer, proof of residence, Permanent Account Number and
photograph are verified to comply with KYC norms
Identified service provider: CSDL Ventures Ltd
Designated acceptance points: Points of Service (PoS)
KYC once completed, is valid across mutual funds
Investors have to submit a photocopy of the KYC acknowledgement along with application
forms
KYC compliance is mandatory for all joint investors in a folio, for purchase transactions
of Rs.50,000 or above
KYC for investment by a minor
Compliance by guardian
KYC for investment by Power of Attorney
Compliance by the investor and the holder of attorney
80
PAN and Micro-SIP
PAN is mandatory for all investors in a mutual fund, irrespective of invested amount
(Exception: Micro SIP)
Micro-SIP are exempted from requirement of PAN card
Annual investment does not exceed Rs.50,000 made by individuals, NRIs, minors and
sole-proprietary firms
Exemption not available for HUFs and PIOs or non-individual investors
Alternate valid photo identification documents must be provided instead
Investor is also required to provide an undertaking that their total micro-SIP
investments in a year do not exceed Rs.50,000
81
Purchase Transactions
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
84
Redemption Transactions
85
Applicable NAV
86
Cut-off Time and Applicable NAV
87
Time Stamping
88
Statement of Account (SoA)
Proof of investment
SoAs are despatched by the R&T agent, after every transaction
Within 10 business days of the transaction
In case of NFO, SoA must be despatched within 5 business days of allotment
In case of SIP, SoA is sent every quarter
Fresh purchase SoA
Amount, price, and units are mentioned
Subsequent transaction SoA
Amount, price, balance units, current market value are mentioned
Received through post, courier, email
89
Transactions Through Stock Exchange Brokers
90
Investment Options
The underlying portfolios for all options are the same, only post-tax returns are different
Growth option
Gains made in the portfolio from income and appreciation are retained and gains are reflected
in NAV
Investor must redeem units to realise gains
Realised profit/loss is treated as capital gains or loss
Dividend Pay-out
Fund declares dividend from realised profits after trustee approval
Amount and frequency varies and depends upon distributable surplus
Ex-dividend NAV: NAV after the dividend is declared and paid out
Cum-dividend NAV: NAV after dividend has been declared but not paid out
NAV falls after dividend payout to the extent of dividend paid
Dividend Re-investment
Dividend is re-invested in the same scheme by buying additional units at the ex-dividend NAV
91
Investment Options An Illustration
100+(100/11)
Number of units held 100 100
=109.09
92
Systematic Investment Plans
93
SWP and STP
Switches
Redemption and purchase transaction rolled into one
Redeeming scheme is called source scheme switch out leg
Purchasing scheme is called target scheme switch in leg
Can also be done from one option to another
Saves time and effort in moving funds from one scheme/option to another
R&T carried out the transactions in the investors records
Exit loads not charged for switch within options
Exit loads charged as applicable for inter-scheme switch
Triggers
Automated purchase, redemption, switch or dividend decisions based on pre-defined
events
Pre-defined event may be Sensex levels, return targets etc.
95
Other Transactions
96
Chapter 8
98
Equity Schemes - Fundamental and Technical Analysis
99
Earnings and Book Value Per Share
100
Debt Securities
Debt securities represent an underlying loan
Borrower is the issuer; Lender is the buyer
Debt instruments have a face or par value, are issued for a specific period.
Debt instruments mature on a specific date called the maturity date.
Tenor is the distance in time to maturity.
Coupon rate is the annual rate of interest paid on the par value of the bond
Issued by the government, public limited companies, banks and financial institutions
Government securities are also called gilts and have no credit risk
Issued for a tenor from 2 to 30 years
Money market securities are issued for a tenor of less than 1 year
Treasury bills, commercial papers and certificates of deposit
Floating rate securities
Interest payable periodically is reset with reference to the benchmark or base rate
A spread is added to the benchmark rate to arrive at the coupon
Zero coupon bonds are issued at a discount and redeemed at par
101
Total Return in Debt Portfolios
Consists of accrual income that comes from interest received on the portfolio and
capital gains (losses) from changes in the value of the portfolio
Price of a bond responds to changes in market interest rates in an inverse relationship
An increase in interest rates leads to a fall in price of existing bonds
A fall in interest rates leads to gains in the price of existing bonds
The debt portfolio would show a mark-to-market gain if interest rates fall
The debt portfolio would show a mark-to-market loss if interest rates gain
The change in price of floating rate bond is limited due to interest rate changes
Coupon is linked to the market benchmark
Changes in interest rates reflected in the coupon itself
102
Implementing the Interest Rate View
A security of longer maturity would fluctuate a lot more, as compared to short tenor
securities
Debt analysts work with a related concept called modified duration
Modified Duration is a technical measure of bonds sensitivity to changes in interest
rates
Higher the modified duration of a bond, higher the interest rate sensitivity of a bond
Average maturity and modified duration are directly related
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
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 = 100 units x Rs 10.50 = Rs 1050
Dividends = 100 units x Rs 2 = Rs 200
No of units reinvested = 200/10 = 20 units
End value = 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
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
115
Benchmarks
116
Equity and Debt Fund Benchmarks
Equity fund benchmarks
Investment objectives and asset allocation in the portfolio are the basis for determining the
appropriate benchmark
E.g. Small and mid-cap funds benchmark BSE 500, Diversified funds benchmark BSE 100
Large cap funds benchmark BSE Sensex/Nifty, Banking sector funds benchmark BSE
Bankex
Debt fund benchmarks
Appropriate index would be one whose composition reflects the composition of the debt fund
portfolio in terms of tenor and composition
ICICI Securities Si-Bex, Mi-Bex, Li-Bex
Crisils LiquiFEX, STBEX, Gilt Bond Index, AAA Corporate Bond Index
Hybrid fund benchmarks
Asset allocation and composition of the benchmark should be similar to that of the fund
Crisil Mipex, Crisil Balancex
Gold ETFs are benchmarked against the price of gold
Real estate funds against real estate indices
Funds that invest in markets other than India, use appropriate indices of that market
117
Peer Group Benchmarks
118
Other Financial Products as Comparable Benchmarks
While comparing mutual funds with other products of a similar nature the effect of
taxes and costs must be considered
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
123
Chapter 9
Scheme Selection
RISK LEVEL DEBT FUNDS HYBRID FUNDS EQUITY FUNDS
HIGH Sector 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
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
128
Size, Age and Style of Equity 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
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
135
Chapter 10
Selecting the Right Investment Products for
Investors
Physical Assets and Financial 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
140
Bank Deposits
141
Equity Shares
142
Debentures / Bonds and Company Deposits
143
Institutional Bonds
144
Public Provident Fund (PPF)
145
Small Saving Schemes
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
148
Chapter 11
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
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
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
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
Accumulation Phase
Accumulate and save for the long-term
Choose growth-oriented investments
Have a long-term investing horizon and can allocate savings to equity
e.g. saving for childs education
Transition Phase
Withdrawal of funds for some financial goals while accumulating for retirement
Middle-aged investors
Have both equity and debt in their portfolio, as they have a medium-term horizon
e.g. withdraw from savings to meet the immediate education expenses of a child while at the
same time saving for retirement
Distribution Phase
Reaping stage
Depend on investment income
Retired investors
Income-oriented, preferring debt to equity
158
Inter-generational Wealth Transfer and Sudden
Wealth Surge
Wealth-creating investors
Willing to take risks, investing in equity and risky assets
Comfort of accumulated wealth
Any short-term loss will not seriously impair their financial position
Wealth-preserving investors
Wealthy investors may not always be risk-taking equity investors
Cautious about the wealth they have accumulated and focus on preserving its value
Choose conservative investments, such debt and government securities
Focus on regular income from accumulated wealth
160
Chapter 12
Recommending Model Portfolios and Financial
Plans
Model Portfolios and Risk Profiling
Model Portfolio
Creating an investment portfolio after considering the goals, investment horizon and
required return
Created for a given combination of risk, return and investing horizon
Ascertain the risk preferences of investors using risk profiling
Risk Profiling
Willingness of the investor to assume risk and to bear the possible loss in the
portfolio in order to ascertain appropriate asset allocation
Risk appetite is influenced by their personal and financial situation
Risk Profiling Tools are used to generate risk appetite scores for investors
Surveys, questionnaires and proprietary risk profiling tools
Scenario analysis
Past history of the actual transactions of the investors
162
Risk Appetite and Asset Allocation
Age: Older investors may have lower risk
appetite than younger investors
Accumulated capital: The higher the accumulated capital,
higher is the risk appetite
Stability of income: 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
163
Strategic and Tactical Asset Allocation
165
Revision and Re-balancing
166
167