Mutual Fund Market -

The Mutual Fund Market

Mutual Funds (MFs) are investment vehicles that pool together the money contributed by investors which the fund invests in a portfolio of securities that reflect the common investment objectives of the investors. Each investor’s share is represented by the units issued by the fund. The value of the units, called the Net Asset Value (NAV), changes continuously to reflect changes in the value of the portfolio held by the fund. MF schemes can be classified as open-ended or close-ended. An open-ended scheme offers the investors an option to buy units from the fund at any time and sell the units back to the fund at any time. These schemes do not have any fixed maturity period. The units can be bought and sold anytime at the NAV linked prices. The unit capital of closed-ended funds is fixed and they sell a specific number of units. Units of closed-ended funds can be bought or sold in the Stock Market where they are mandatorily listed.


Key Concepts of Mutual Fund Market


a)                  Units: Just as an investors investments in equity of a company is represented in number of shares, or investments in debt is represented in number of bonds or debentures, each investor’s holding in a mutual fund is represented in terms of units that is derived from the amount invested. Each unit represents one share of the fund. For example, A &B invests in GTX Equity fund when the price of each unit isRs.10. A invests Rs.5,000 and B Rs.10,000. The number of units allotted is calculated as amount invested/price per units

A : Rs.5000/Rs.10 = 500 units

B : Rs.10000/Rs.10= 1000 units

The units are first offered to the investors at the time the scheme is launched through a new fund offer (NFO). Subsequently, depending upon the structure of the scheme, the fund may or may not issue fresh units to investors.


b)                  Net Assets: The assets of a mutual fund scheme are the current value of the portfolio of securities held by it. There may be some current assets such as cash and receivables. Together they form the total assets of the scheme. From this, the fees and expenses related to managing the fund such as fund manager’s fees, charges paid to constituents, regulatory expenses on advertisements and such are deducted to arrive at the net assets of the scheme. This belongs to the investors in the fund who have been allotted units and no other entity has a claim to it. The Net assets of a scheme will go up whenever investors buy additional units in the scheme and bring in funds, or when the value of the investments held in the portfolio goes up, or when the securities held in the portfolio earns income such as dividends from shares or interest on bonds held. Similarly, the net assets of the scheme will go down if investors take out their investments from the scheme by redeeming their units or if the securities held in the portfolio fall in value or when expenses related to the scheme are accounted for. The net assets of the scheme are therefore not a fixed value but keep changing with a change in any of the above factors.


c)                  Net Asset Value (NAV): The net asset per unit of a scheme is calculated as Net assets/Number of outstanding units of the scheme. This is the Net asset value (NAV). The NAV of the scheme will change with every change in the Net Assets of the scheme. All investor transactions are conducted at the current NAV of the scheme.


d)                  Mark to Market: The current value of the portfolio forms the base of the net assets of the scheme and therefore the NAV. It means that if the portfolio was to be liquidated, then this would be the value that would be realised and distributed to the investors. Therefore the portfolio has to reflect the current market price of the  securities held. This process of valuing the portfolio on a daily basis at current value is called marking to market. The price is taken from the market where the security is traded. If the security is not traded or the price

available is stale, then SEBI has laid down the method for valuing such securities.


e)                  Schemes Structures: Mutual fund schemes can be structured as open-ended or closed-end schemes. 


An open-ended scheme allows investors to invest in additional units and redeem investment continuously at current NAV. The scheme is for perpetuity unless the investors decide to wind up the scheme. The unit capital of the scheme is not fixed but changes with every investment or redemption made by investors. A closed-end scheme is for a fixed period or tenor. It offers units to investors only during the new fund offer (NFO). The scheme is closed for transactions with investors after this. The units allotted are redeemed by the fund at the prevalent NAV when the term is over and the fund ceases to exist after this. In the interim, if investors want to exit their investment they

can do so by selling the units to other investors on a stock exchange where they are mandatorily listed. The unit capital of a closed end fund does not change over the life of the scheme since transactions between investors on the stock exchange does not affect the fund.



Regulatory Framework of Mutual Funds

The Securities and Exchange Board of India (SEBI) is the primary regulator of mutual funds in India. SEBI’s Regulations called the SEBI(Mutual Funds) Regulations, 1996, along with amendments made from time to time, govern the setting up a mutual fund and its structure, launching a scheme, creating and managing the portfolio, investor protection, investor services and roles and responsibilities of the constituents. Apart from SEBI, other regulators such as the RBI are also involved for specific areas which involve foreign exchange transactions such as investments in international markets and investments by foreign nationals and the role of the banking system in the mutual funds industry in India. The Association of Mutual Funds in India (AMFI) is the industry body that oversees the functioning of the industry and recommends best practices to be followed by the industry members. It also represents the industry’s requirements to the regulator, government and other stakeholders.


Products of Mutual Fund Market

The primary way of categorizing mutual fund products is on the basis of the asset class in which the scheme will invest. Equity funds, debt funds, hybrid funds, gold funds and real estate funds are types of funds based on this categorization.


A.   Equity Funds

Equity funds invest in a portfolio of equity shares and equity related instruments. Since the portfolio comprises of the equity instruments, the risk and return from the scheme will be similar to directly investing in equity markets. Equity funds can be further categorized on the basis of the strategy adopted by the fund managers to manage the fund


ü  Passive & Active Funds: Passive funds invest the money in the companies represented in an index such as Nifty or Sensex in the same proportion as the company’s representation in the index. There is no selection of securities or investment decisions taken by the fund manager as to when to invest or how much to invest in each security. Active funds select stocks for the portfolio based on a strategy that is intended to generate higher return than the index. Active funds can be further categorized based on the way the securities for the portfolio are selected.


ü  Diversified Equity funds: Diversified equity funds invest across segments, sectors and sizes of companies. Since the portfolio takes exposure to different stocks across sectors and market segments, there is a lower risk in such funds of poor performance of few stocks or sectors.


ü  Based on the segment of the market: Equity funds may focus on a particular size of companies to benefit from the features of such companies. Equity stocks may be segmented based on market capitalization as largecap, mid-cap and small-cap stocks.

a.      Large- cap funds invest in stocks of large, liquid blue-chip companies with stable performance and returns.

b.      Mid-cap funds invest in mid-cap companies that have the potential for faster growth and higher returns. These companies are more susceptible to economic downturns and evaluating and selecting the right companies becomes important. Funds that invest in such companies have a higher risk of the companies selected not being able to withstand the slowdown in revenues and profits. Similarly, the price of the stocks also fall more when markets fall.

c.       Small-cap funds invest in companies with small market capitalisation with intent of benefitting from the higher gains in the price of stocks. The risks are also higher.


ü  Based on Sectors and Industries: Sector funds invest in companies that belong to a particular sector such as technology or banking. The risk is higher because of lesser diversification since such funds are concentrated in a particular sector. Sector performances tend to be cyclical and the return from investing in a sector is never the same across time. For example, Auto sector, does well, when the economy is doing well and more cars, trucks and bikes are bought. It does not do well, when demand goes down. Banking sector does well, when interest rates are low in the market; they don’t do well when rates are high. Investments in sector funds have to be timed well. Investment in sector funds should be made when the fund manager expects the related sectors, to do well. They could out-perform the market, if the call on sector performance plays out. In case it doesn’t, such funds could underperform the broad market. Reliance Banking Fund, SBI Magnum Sector Funds are examples of sector funds.


ü  Based on Themes: Theme-based funds invest in multiple sectors and stocks that form part of a theme. For example, if the theme is infrastructure then companies in the infrastructure sector, construction, cement, banking and logistics will all form part of the theme and be eligible for inclusion in the portfolio. They are more diversified than sector funds but still have a high concentration risks.


ü  Based on Investment Style: The strategy adopted by the fund manager to create and manage the fund’s portfolio is a basis for categorizing funds. The investment style and strategy adopted can significantly impact the nature of risk and return in the portfolio.Passive fund invests only in the securities included in an index and does not feature selection risks. However, the returns from the fund will also be only in line with the market index. On the other hand, active funds use selection and timing strategies to create portfolios that are expected to generate returns better than the market returns. The risk is higher too since the fund’s performance will be affected negatively if the selected stocks do not perform as expected. The type of funds based on strategies and styles for selection of securities include Growth Funds portfolios feature companies whose earnings are expected to grow at a

a.      rate higher than the average rate. These funds aim at providing capital appreciation to the investors and provide above average returns in bullish markets. The volatility in returns is higher in such funds.

b.      Value Funds seek to identify companies that are trading at prices below their inherent value with the expectation of benefiting from an increase in price as the market recognizes the true value. Such funds have lower risk. They require a longer investment horizon for the strategy to play out.

c.       Dividend yield Funds invest in stocks that have a high dividend yield. These stocks pay a large portion of their profits as dividend and these appeals to investors looking for income from their equity investments. The companies typically have high level of stable earnings but do not have much potential for growth or expansion. They therefore pay high dividends while the stock prices remain stable. The stocks are bought for their dividend payout rather than for the potential for capital appreciation.


ü  Equity Linked Savings Schemes (ELSS): ELSS is a special type of equity fund investment which gives the investor tax deduction benefits under section 80C of the Income Tax Act up to a limit of Rs.1,50,000 per year. An ELSS must hold at least 80% of the portfolio in equity securities. The investment made by the investor is locked-in for a period of three years during which it cannot be redeemed, transferred or pledged.


B.   Debt Funds

Debt funds invest in a portfolio of debt instruments such as government bonds, corporate bonds and money market securities. Debt instruments have a pre-defined coupon or income stream. Fund managers have to manage credit risk, i.e. the risk of default by the issuers of the debt instrument in paying the periodic interest or repayment of principal. The credit rating of the instrument is used to assess the credit risk and higher the credit rating, lower is the perceived risk of default. Debt instruments may also see a change in prices or values in response to changes in interest rates in the market. The degree of change depends upon features of the instrument such as its tenor and instruments with longer tenor exhibit a higher sensitivity to interest rate changes. Fund managers make choices on higher credit risk for higher coupon income and higher interest rate risk for higher capital gains depending upon the nature of the fund and their evaluation of the issuer and macro-economic factors. Debt funds can be categorized based on the type of securities they hold in the portfolio.


ü  Short Term Debt Funds

a.      Money Market or Liquid Funds are very short term maturity. They invest in debt securities with less than 91 days to maturity. However, there is no mark to market for securities less than 60 days to maturity and this reduces the volatility in these funds. The primary source of return is interest income. Liquid fund is a very short term fund and seeks to provide safety of principal and superior liquidity. It does this by keeping interest rate and credit risk low by investing in very liquid, short maturity fixed income securities of highest credit quality.

b.      Ultra short-term plans are also known as treasury management funds, or cash management funds. They invest in money market and other short term securities of maturity up to 365 days. The objective is to generate a steady return, mostly coming from accrual of interest income, with minimal NAV volatility.

c.       Short Term Plans combines short term debt securities with a small allocation to longer term debt securities. Short term plans earn interest from short term securities and interest and capital gains from long term securities. Fund managers take a call on the exposure to long term securities based on their view for interest rate movements. If interest rates are expected to go down, these funds increase their exposure to long term securities to benefit from the resultant increase in prices. The volatility in returns will depend upon the extent of long-term debt securities in the portfolio. Short term funds may provide a higher level of return than liquid funds and ultra-short term funds, but will be exposed to higher mark to market risks.


ü  Long Term Debt Funds

Long term debt funds are structured to generate total returns made up of both interest income and capital appreciation from the securities held. Since the price of securities may go up or down resulting in gains or losses, the total returns tend to be more volatile than short term debt funds that focus primarily on earning coupon income. The value of bond held in a long term portfolio, changes with change in interest rates. Since market interest rates and value of a bond are inversely related, any fall in the interest rates causes a mark-to-market gain in a bond portfolio and vice versa. Therefore in a falling interest rate scenario, when investors in most fixed income products face a reduced rate of interest income, long term debt funds post higher returns. This is because the interest income is augmented by capital gains and result in a higher total return. The extent of change in market prices of debt securities is linked to the average tenor of the portfolio – higher the tenor, greater the impact of changes in interest rates. Long term debt funds choose the tenor of the instruments for the portfolio, and manage the average maturity of the portfolio, based on scheme objectives and their own interest rate views.


ü  An Income Fund is a debt fund which invests in both short and long term debt securities of the Government, public sector and private sector companies with a view to generate income. An income fund may allocate a portion of the portfolio to government securities to meet the need for liquidity in the portfolio. Corporate debt securities enable higher interest income due to the credit risk associated with them. In the corporate bond market, an income fund tries to manage interest income from buying bonds at a spread to Government securities and manages capital gains by taking a view on the interest rate movements and credit spread. Thus, income funds feature both interest rate risk and credit risk.


ü  Gilt Funds invest in government securities of medium and long-term maturities. There is no risk of default and liquidity is considerably higher in case of government securities. However, prices of government securities are very sensitive to interest rate changes. Long term gilt funds have a longer maturity and therefore, higher interest rate risk as compared to short term gilt funds. Gilt funds are popular with investors mandated to invest in G-secs such as provident funds or PF trusts.


ü  Dynamic Debt funds seek flexible and dynamic management of interest rate risk and credit risk. That is, these funds have no restrictions with respect to security types or maturity profiles that they invest in. Dynamic or flexible debt funds do not focus on long or short term segment of the yield curve, but move across the yield curve depending on where they see the opportunity for exploiting changes in yields. Duration of these portfolios are not fixed, but are dynamically managed. If the manager believes that interest rates could move up, the duration of the portfolio is reduced and vice versa.


ü  Floating rate funds invest primarily in floating rate debt instruments. In these instruments the coupon is not fixed for the term of the instrument but is periodically revised with reference to the market rate. If interest rates in the markets go up, the coupon for these instruments are also revised upwards and vice versa. The reset period is defined when the bond is issued, say every 6 months, as also the market benchmark which will be referred to determine current rates. Since the coupon of the bond will be in line with the market rates, there is low interest rate risk in the bonds. These funds give the benefit of higher coupon income when interest rates are on the rise, without the risk of falling bond prices.


ü  Fixed Maturity Plans (FMPs) are closed-end funds that invest in debt securities with maturities that match the term of the scheme. The debt securities are redeemed on maturity and paid to investors. FMPs are issued for various maturity periods ranging from 3 months to 5 years. Mutual fund companies typically keep FMPs in the pipeline, issuing one after another, particularly depending upon demand from corporate investors in the market. The return of an FMP depends on the yield it earns on the underlying securities. The investments may be spread across various issuers, but the tenor is matched with the maturity of the plan. An FMP structure eliminates the interest rate risk or price risk for investors if the fund is held passively until maturity. Therefore, even if the price of bonds held in the portfolio moves up or down, as long as the fund receives the interest payouts and the original investment on maturity, the FMP does not suffer significant risks. This makes FMPs the preferred investment in a rising interest rate environment, as investors can lock into high yields.


C.   Hybrid Funds

Hybrid funds invest in a combination of debt and equity securities. The allocation to each of these asset classes will depend upon the investment objective of the scheme. The risk and return in the scheme will depend upon the allocation to equity and debt and how they are managed. A higher allocation to equity instruments will increase the risk and the expected returns from the portfolio. Similarly, if the debt instruments held are short term in nature for generating income, then the extent of risk is lower than if the portfolio holds long-term debt instruments that show greater volatility in prices.


D.   Other Funds


ü  Fund of Funds (FoF) is a mutual fund that invests in other mutual funds. It does not hold securities in its portfolio, but other funds that have been chosen to match its investment objective. These funds can be either debt or equity, depending on the objective of the FoF. A FoF either invests in other mutual funds belonging to the same fund house or belonging to other fund houses. FoFs belonging to various mutual fund houses are called multi-manager FoFs, because the AMCs that manage the funds are different. AFoF looks for funds that fit into its investment objective. It specialises in analyzing funds, their performance and strategy and adds or removes funds based on such analysis.


ü  Exchange Traded Funds (ETFs) hold a portfolio of securities that replicates an index and are listed and traded on the stock exchange. The return and risk on ETF is directly related to the underlying index or asset. The expense ratio of an ETF is similar to that of an index fund. ETFs are first offered in a New Fund Offer (NFO) like all mutual funds. Units are credited to demat account of investors and ETF is listed on the stock exchange. Ongoing purchase and sale is done on the stock exchange through trading portals or stock brokers. Settlement is like a stock trade, and debit or credit is done through the demat account. ETF prices are real-time and known at the time of the transaction, unlike NAV which is computed end of a business day. Their value changes on a real-time basis along with changes in the underlying index.

ü  Physical Gold G ETF

ü  International Funds invest in mark ets outside India, by holding certain foreign securities in their portfolio. The eligible securities in Indian international funds include equity shares of companies listed abroad, ADRs and GDRs of Indian companies, debt of companies listed abroad, ETFs of other countries, units of index funds in other countries, units of actively managed mutual funds in other countries. International equity funds may also hold some of their portfolios in Indian equity or debt. They can also hold some portion of the portfolio in money market instruments to manage liquidity.


ü  Arbitrage funds aim at taking advantage of the price differential between the cash and the derivatives markets. Arbitrage is defined as simultaneous purchase and sale of an asset to take advantage of difference in prices in different markets. The difference between the future and the spot price of the same underlying is an interest element, representing the interest on the amount invested in spot, which can be realized on a future date, when the future is sold. A completely hedged position makes these funds a low-risk investment proposition. They feature lower volatility in NAV, similar to that of a liquid fund.


ü  Real Estate Mutual Funds invest in real estate either in the form of physical property or in the form of securities of companies engaged in the real estate business. SEBI’s regulations require that at least 35% of the portfolio should be held in physical assets. Securities that these funds can invest in include mortgage-backed securities and debt issuances of companies engaged in real estate projects. Not less than 75% of the net assets of the scheme shall be in physical assets and such securities. Assets held by the fund will be valued every 90 days by two valuers accredited by a credit rating agency. The lower of the two values will be taken to calculate the NAV. These funds are closed-end funds and have to be listed on a stock exchange.


ü  Real Estate Investment Trusts (REIT) are trusts registered with SEBI that invest in commercial real estate assets. The REIT will raise funds through an initial offer and subsequently through follow-on offers, rights issue and institutional placements. The price of the units on offer will be determined through a book-building process or other manner specified by SEBI.


ü  Infrastructure Debt Schemes are closed-ended schemes with a tenor of at least Five years that invest in debt securities and securitized debt of infrastructure companies. 90% of the fund’s portfolio should be invested in the specified securities. The remaining can be invested in the equity shares of infrastructure companies and in money market instruments. The NAV of the scheme will be disclosed at least once each quarter. The minimum investment allowed in these schemes is for Rs. 10Million and the minimum face value of each unit shall be Rs. 1Million. As a closed-ended scheme the units of the scheme will be listed on a stock exchange. An Infrastructure Debt Scheme can be set up by an existing mutual fund or a new fund set up for this purpose. The sponsor and key personnel must have adequate experience in the infrastructure sector to be able to launch the scheme.


ü  Infrastructure Investment Trusts(InvIT) are trusts registered with SEBI that invest in the infrastructure sector. The InvIT will raise funds from the public through an initial offer of units. The offer shall be for not less than Rs. 2.5Billion and the value of the proposed assets of the InvIT shall not be less than Rs. 5Billion. The trust will have a minimum 25% public float and at least 20 investors. The minimum subscription size will be Rs. 1Million.  The units will be listed on a stock exchange. 


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