Term Paper

Introduction to mutual funds

There are a lot of investment avenues available today in the financial market
for an investor with an investable surplus. He can invest in Bank Deposits,
Corporate Debentures, and Bonds where there is low risk but low return. He
may invest in Stock of companies where the risk is high and the returns are
also proportionately high. The recent trends in the Stock Market have shown
that an average retail investor always lost with periodic bearish tends. People
began opting for portfolio managers with expertise in stock markets who
would invest on their behalf. Thus we had wealth management services
provided by many institutions. However they proved too costly for a small
investor. These investors have found a good shelter with the mutual funds.

Mutual fund industry has seen a lot of changes in past few years with
multinational companies coming into the country, bringing in their
professional expertise in managing funds worldwide. In the past few months
there has been a consolidation phase going on in the mutual fund industry in
India. Now investors have a wide range of Schemes to choose from
depending on their individual profiles.

A mutual fund is a professionally managed type of collective investment

scheme that pools money from many investors and invests typically in
investment securities (stocks, bonds, short-term money market instruments,
other mutual funds, other securities, and/or commodities such as precious
metals).

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The mutual fund will have a fund manager that trades (buys and sells) the
fund's investments in accordance with the fund's investment objective. In the
U.S., a fund registered with the Securities and Exchange Commission (SEC)
under both SEC and Internal Revenue Service (IRS) rules must distribute
nearly all of its net income and net realized gains from the sale of securities
(if any) to its investors at least annually.

Most funds are overseen by a board of directors or trustees (if the U.S. fund
is organized as a trust as they commonly are) which is charged with ensuring
the fund is managed appropriately by its investment adviser and other
service organizations and vendors, all in the best interests of the fund's
investors.

Since 1940 in the U.S., with the passage of the Investment Company Act of
1940 (the '40 Act) and the Investment Advisers Act of 1940, there have been
three basic types of registered investment companies: open-end funds (or
mutual funds), unit investment trusts (UITs); and closed-end funds. Other
types of funds that have gained in popularity are exchange traded funds
(ETFs) and hedge funds, discussed below.

History of mutual funds

The mutual fund industry in India started in 1963 with the formation of Unit
Trust of India, at the initiative of the Government of India and Reserve Bank
the. The history of mutual funds in India can be broadly divided into four
distinct phases.

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First Phase – 1964-87: Unit Trust of India (UTI) was established on 1963
by an Act of Parliament. It was set up by the Reserve Bank of India and
functioned under the Regulatory and administrative control of the Reserve
Bank of India. In 1978 UTI was de-linked from the RBI and the Industrial
Development Bank of India (IDBI) took over the regulatory and
administrative control in place of RBI. The first scheme launched by UTI
was Unit Scheme 1964. At the end of 1988 UTI had Rs.6,700 crores of
assets under management.

Second Phase – 1987-1993 (Entry of Public Sector Funds): 1987 marked

the entry of non- UTI, public sector mutual funds set up by public sector
banks and Life Insurance Corporation of India (LIC) and General Insurance
Corporation of India (GIC). SBI Mutual Fund was the first non- UTI Mutual
Fund established in June 1987 followed by Canbank Mutual Fund (Dec 87),
Punjab National Bank Mutual Fund (Aug 89), Indian Bank Mutual Fund
(Nov 89), Bank of India (Jun 90), Bank of Baroda Mutual Fund (Oct 92).
LIC established its mutual fund in June 1989 while GIC had set up its
mutual fund in December 1990.
At the end of 1993, the mutual fund industry had assets under management
of Rs.47,004 crores.

Third Phase – 1993-2003 (Entry of Private Sector Funds): With the entry of
private sector funds in 1993, a new era started in the Indian mutual fund
industry, giving the Indian investors a wider choice of fund families. Also,
1993 was the year in which the first Mutual Fund Regulations came into
being, under which all mutual funds, except UTI were to be registered and
governed. The erstwhile Kothari Pioneer (now merged with Franklin

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Templeton) was the first private sector mutual fund registered in July 1993.
The 1993 SEBI (Mutual Fund) Regulations were substituted by a more
comprehensive and revised Mutual Fund Regulations in 1996. The industry
now functions under the SEBI (Mutual Fund) Regulations 1996.
The number of mutual fund houses went on increasing, with many foreign
mutual funds setting up funds in India and also the industry has witnessed
several mergers and acquisitions. As at the end of January 2003, there were
33 mutual funds with total assets of Rs. 1,21,805 crores. The Unit Trust of
India with Rs.44,541 crores of assets under management was way ahead of
other mutual funds.

Fourth Phase – since February 2003: In February 2003, following the

repeal of the Unit Trust of India Act 1963 UTI was bifurcated into two
separate entities. One is the Specified Undertaking of the Unit Trust of India
with assets under management of Rs.29,835 crores as at the end of January
2003, representing broadly, the assets of US 64 scheme, assured return and
certain other schemes. The Specified Undertaking of Unit Trust of India,
functioning under an administrator and under the rules framed by
Government of India and does not come under the purview of the Mutual
Fund Regulations.
The second is the UTI Mutual Fund Ltd, sponsored by SBI, PNB, BOB and
LIC. It is registered with SEBI and functions under the Mutual Fund
Regulations. With the bifurcation of the erstwhile UTI which had in March
2000 more than Rs.76,000 crores of assets under management and with the
setting up of a UTI Mutual Fund, conforming to the SEBI Mutual Fund
Regulations, and with recent mergers taking place among different private
sector funds, the mutual fund industry has entered its current phase of

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consolidation and growth. As at the end of September, 2004, there were 29

funds, which manage assets of Rs.153108 crores under 421 schemes.

ADVANTAGES OF MUTUAL FUNDS

There are numerous benefits of investing in mutual funds and one of the key
reasons for its phenomenal success in the developed markets like US and
UK is the range of benefits they offer, which are unmatched by most other
investment avenues. We have explained the key benefits in this section. The
benefits have been broadly split into universal benefits, applicable to all
schemes, and benefits applicable specifically to open-ended schemes.

Affordability: A mutual fund invests in a portfolio of assets, i.e. bonds,

shares, etc. depending upon the investment objective of the scheme. An
investor can buy in to a portfolio of equities, which would otherwise be
extremely expensive. Each unit holder thus gets an exposure to such
portfolios with an investment as modest as Rs.500/-. This amount today
would get you less than quarter of an Infosys share! Thus it would be
affordable for an investor to build a portfolio of investments through a
mutual fund rather than investing directly in the stock market.

Diversification : The nuclear weapon in your arsenal for your fight against
Risk. It simply means that you must spread your investment across different
securities (stocks, bonds, money market instruments, real estate, fixed
deposits etc.) and different sectors (auto, textile, information technology
etc.). This kind of a diversification may add to the stability of your returns,
for example during one period of time equities might under perform but

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bonds and money market instruments might do well enough to offset the
effect of a slump in the equity markets. Similarly the information technology
sector might be faring poorly but the auto and textile sectors might do well
and may protect your principal investment as well as help you meet your
return objectives. Variety Mutual funds offer a tremendous variety of
schemes. This variety is beneficial in two ways: first, it offers different types
of schemes to investors with different needs and risk appetites; secondly, it
offers an opportunity to an investor to invest sums across a variety of
schemes, both debt and equity. For example, an investor can invest his
money in a Growth Fund (equity scheme) and Income Fund (debt scheme)
depending on his risk appetite and thus create a balanced portfolio easily or
simply just buy a Balanced Scheme.

Professional Management: Qualified investment professionals who seek to

maximize returns and minimize risk monitor investor's money. When you
buy in to a mutual fund, you are handing your money to an investment
professional who has experience in making investment decisions. It is the
Fund Manager's job to (a) find the best securities for the fund, given the
fund's stated investment objectives; and (b) keep track of investments and
changes in market conditions and adjust the mix of the portfolio, as and
when required.
Tax Benefits: Any income distributed after March 31, 2002 will be subject
to tax in the assessment of all Unit holders. However, as a measure of
concession to Unit holders of open-ended equity-oriented funds, income
distributions for the year ending March 31, 2003, will be taxed at a
concessional rate of 10.5%.

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In case of Individuals and Hindu Undivided Families a deduction upto Rs.

9,000 from the Total Income will be admissible in respect of income from
investments specified in Section 80L, including income from Units of the
Mutual Fund. Units of the schemes are not subject to Wealth-Tax and Gift-
Tax.
Regulations: Securities Exchange Board of India (“SEBI”), the mutual
funds regulator has clearly defined rules, which govern mutual funds. These
rules relate to the formation, administration and management of mutual
funds and also prescribe disclosure and accounting requirements. Such a
high level of regulation seeks to protect the interest of investors

Benefits of Open-ended Schemes:

Liquidity: In open-ended mutual funds, you can redeem all or part of your
units any time you wish. Some schemes do have a lock-in period where an
investor cannot return the units until the completion of such a lock-in period.
Convenience: An investor can purchase or sell fund units directly from a
fund, through a broker or a financial planner. The investor may opt for a
Systematic Investment Plan (“SIP”) or a Systematic Withdrawal Advantage
Plan (“SWAP”). In addition to this an investor receives account statements
and portfolios of the schemes.

Flexibility: Mutual Funds offering multiple schemes allow investors to

switch easily between various schemes. This flexibility gives the investor a
convenient way to change the mix of his portfolio over time.
Transparency: Open-ended mutual funds disclose their Net Asset Value

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(“NAV”) daily and the entire portfolio monthly. This level of transparency,
where the investor himself sees the underlying assets bought with his
money, is unmatched by any other financial instrument. Thus the investor is
in the know of the quality of the portfolio and can invest further or redeem
depending on the kind of the portfolio that has been constructed by the
investment manager.

RISK FACTORS OF MUTUAL FUNDS

The Risk-Return Trade-off:
The most important relationship to understand is the risk-return trade-off.
Higher the risk greater the returns/loss and lower the risk lesser the
returns/loss. Hence it is upto you, the investor to decide how much risk you
are willing to take. In order to do this you must first be aware of the different
types of risks involved with your investment decision.

Market Risk: Sometimes prices and yields of all securities rise and fall.
Broad outside influences affecting the market in general lead to this. This is
true, may it be big corporations or smaller mid-sized companies. This is
known as Market Risk. A Systematic Investment Plan (“SIP”) that works on
the concept of Rupee Cost Averaging (“RCA”) might help mitigate this risk.

Credit Risk: The debt servicing ability (may it be interest payments or

repayment of principal) of a company through its cashflows determines the
Credit Risk faced by you. This credit risk is measured by independent rating
agencies like CRISIL who rate companies and their paper. A ‘AAA’ rating
is considered the safest whereas a ‘D’ rating is considered poor credit
quality. A well-diversified portfolio might help mitigate this risk.

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Inflation Risk: Inflation is the loss of purchasing power over time. A lot of
times people make conservative investment decisions to protect their capital
but end up with a sum of money that can buy less than what the principal
could at the time of the investment. This happens when inflation grows
faster than the return on your investment. A well-diversified portfolio with
some investment in equities might help mitigate this risk.

Interest Rate Risk: In a free market economy interest rates are difficult if
not impossible to predict. Changes in interest rates affect the prices of bonds
as well as equities. If interest rates rise the prices of bonds fall and vice
versa. Equity might be negatively affected as well in a rising interest rate
environment. A well-diversified portfolio might help mitigate this risk.

Political/Government Policy Risk: Changes in government policy and

political decision can change the investment environment. They can create a
favorable environment for investment or vice versa.

Liquidity Risk: Liquidity risk arises when it becomes difficult to sell the
securities that one has purchased. Liquidity Risk can be partly mitigated by
diversification, staggering of maturities as well as internal risk controls that
lean towards purchase of liquid securities.

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GROWTH OF MUTUAL FUNDS IN INDIA

The Indian Mutual Fund has passed through three phases. The first phase
was between 1964 and 1987 and the only player was the Unit Trust of India,
which had a total asset of Rs. 6,700 crores at the end of 1988. The second
phase is between 1987 and 1993 during which period 8 Funds were
established (6 by banks and one each by LIC and GIC). The total assets
under management had grown to 61,028 crores at the end of 1994 and the
number of schemes was 167.
The third phase began with the entry of private and foreign sectors in the
Mutual Fund industry in 1993. Kothari Pioneer Mutual Fund was the first
Fund to be established by the private sector in association with a foreign
Fund.
As at the end of financial year 2000(31st march) 32 Funds were functioning
with Rs. 1, 13,005 crores as total assets under management. As on august
end 2000, there were 33 Funds with 391 schemes and assets under
management with Rs 1, 02,849 crores.
The securities and Exchange Board of India (SEBI) came out with
comprehensive regulation in 1993 which defined the structure of Mutual
Fund and Asset Management Companies for the first time. Several private
sectors Mutual Funds were launched in 1993 and 1994. The share of the
private players has risen rapidly since then. Currently there are 34 Mutual
Fund organizations in India managing 1, 02,000 crores.

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GROWTH IN ASSETS UNDER MANAGEMENT

CURRENT STATE OF MUTUAL FUNDS IN INDIA

India has been amongst the fast growing markets for mutual funds since
2004, witnessing a CAGR of 29 percent in the five year period from 2004-
2008 as against the global average of 4 percent. The increase in average
profitability and revenue however has not been commensurate with the
AUM growth in the last five years.

Low share of global assets under management , low penetration level,

limited share of mutual funds in the household financial savings and the
climbing growth rates in the last few years that are amongst the highest in
the world, all point to the future potential of the Indian mutual fund industry.

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ANALYSIS OF MUTUAL FUNDS SCHEMES

The fact sheet provides the historical data about the various schemes offered
by the AMC, investment pattern, dividend history, ratings given, Fund
Managers’ Credentials, etc.

Equity or Growth Scheme

These schemes, also commonly called Growth Schemes, seek to invest a
majority of their funds in equities and a small portion in money market
instruments. Such schemes have the potential to deliver superior returns over
the long term. However, because they invest in equities, these schemes are
exposed to fluctuations in value especially in the short term. In this equity or
growth scheme segment I selected the following schemes in the selected
AMC’s

Balanced Scheme
The aim of Balanced Funds is to provide both growth and regular income.
Such schemes periodically distribute a part of their earning and invest both
in equities and fixed income securities in the proportion indicated in their
offer documents. This proportion affects the risks and the returns associated
with the balanced fund - in case equities are allocated a higher proportion,
investors would be exposed to risks similar to that of the equity market.
Balanced funds with equal allocation to equities and fixed income securities
are ideal for investors looking for a combination of income and moderate
growth. In this balanced fund scheme segment I selected the following
schemes in the selected AMC’s

SBI Magnum Balance Fund has not been given any rating by CRISIL but it

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has been performing well. The investments of the Funds are well diversified
in both Equity and Debt. The total Equity Holdings as on April 30th stands
at 67.77% of the total assets. It has out performed CRISIL Balanced Fund
Index by 45.38% for the 52 weeks period.

Principal Balanced Fund has ranked CP3 by CRISAL, which means average
in the open-ended balanced Fund category and ranks within the top 70% of
the 19 schemes in this category. It has invested 67% in Equity and about
16% in Government Securities. In Equity it invested primarily in
Pharmaceuticals, Construction Materials, Automobiles and banks.

Franklin Templeton India Balanced Fund invested about 70% of its assets in
Equity and 75% in Debts. The recent additions to its portfolio are Reliance
Industries, Asian paints and BPCL. It invests primarily in IT consulting, auto
parts equipment, Banks, Tele Electrical industrial conglomerates. It invested
mainly in the AAA rated Debts.

Kotak Balance Fund has invested close to 70% in Equity and about 30% in
Debt instruments and Short Term Deposits. The Fund has a well-diversified
portfolio of equity with prime investments in BHEL, Siemens EID parry,
Bulrampur Chini and SBI. In the debt Instruments it has invested in Railway
Bonds and 2003 maturing Government Stock.

SBI Magnum Income Fund is performing very well right from the inception
with generous payment of dividends has been assigned AAA rating by
CRISIL. The Fund invests about 90% in AAA rated securities and more than
60% of its investments have a maturity ranging between 3 to 10 years. I has

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come with bonuses in Jan 2003 1:3 and September 2003 1:10. However, it
under perform vis-à-vis CRISIL Comp. Bond Fund index by 0.14.

Principal Income Fund has ranked CP3 by CRISAL, which means average
in the open-ended debt category and ranks within the top 70% of the 21
schemes in this category. The investments have average maturity of 7.3
years with more than 50% investments having a maturity of above 7 years. It
has invested close to 50% in Government Securities, above 40% in
NCD/Deep Discount Bonds.

Franklin Templeton India Income Fund has most of the investments in low
risk AAA and sovereign securities. Above 45% of the investments are in
Gilt, 25% in PSU/PFI bonds and 24% in corporate Debts. The average
maturity of this scheme is at 4.87 years. The performance of the Fund is
inline with CRISIL Composite Bond Fund.

Kotak Liquid Fund has invested about close to 25% in corporate Debt, 10%
in public sector undertakings, about 25% in money market instruments. It
has also invested 40% in term deposits. The average maturity of portfolio is
2.3 years. Almost all the instruments are well rated implying they are safe
instruments also their investments are highly diversified.

VALUATION OF MUTUAL FUND

The net asset value of the Fund is the cumulative market value of the assets

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Fund net of its liabilities. In other words, if the Fund is dissolved or

liquidated, by selling off all the assets in the Fund, this is the amount that the
shareholders would collectively own. This gives rise to the concept of net
asset value per unit, which is the value, represented by the ownership of one
unit in the Fund. It is calculated simply by dividing the net asset value of the
Fund by the number of units. However, most people refer loosely to the
NAV per unit as NAV, ignoring the “per unit”. We also abide by the same
convention.

Basis for Analysis

Net Asset Value (NAV) is the best parameter on which the performance of a
mutual fund can be studied. We have studied the performance of the NAV
based on the compounded annual return of the Scheme in terms of
appreciation of NAV, dividend and bonus issues. WE have compared the
Annual returns of various schemes to get an idea about their relative
standings.

Calculation of NAV
The most important part of the calculation is the valuation of the assets
owned by the Fund. Once it is calculated, the NAV is simply the net value of
assets divided by the number of units outstanding. The detailed methodology
for the calculation of the net asset value is given below.
The net asset value is the actual value of a unit on any business day. NAV is
the barometer of the performance of the scheme. The net asset value is the
market value of the assets of the scheme minus its liabilities and expenses.
The per unit NAV is the net asset value of the scheme divided by the number

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of the units outstanding on the valuation date.

Mutual funds vs. other investments

Mutual funds offer several advantages over investing in individual stocks.

For example, the transaction costs are divided among all the mutual fund
shareholders, which allows for cost-effective diversification. Investors may
also benefit by having a third party (professional fund managers) apply
expertise and dedicate time to manage and research investment options,
although there is dispute over whether professional fund managers can, on
average, outperform simple index funds that mimic public indexes.

Yet, the Wall Street Journal reported that separately managed accounts
(SMA or SMAs) performed better than mutual funds in 22 of 25 categories
from 2006 to 2008. This included beating mutual funds performance in
2008, a tough year in which the global stock market lost US$21 trillion in
value. In the story, Morningstar, Inc said SMAs outperformed mutual funds
in 25 of 36 stock and bond market categories. Whether actively managed or
passively indexed, mutual funds are not immune to risks. They share the
same risks associated with the investments made. If the fund invests
primarily in stocks, it is usually subject to the same ups and downs and risks
as the stock market.

BIBLIOGRAPHY

Websites:

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1. http://www.indiastudychannel.com

2. www.amfiindia.com

3. www.in.kpmg.com/TL_Files/Pictures/Mutual-Fund

Reference Books:

 Financial Institutions and Markets – L.M. Bhole

 Investment Management – V.K. Bhalla

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