Chapter 1 : Concept and Role of Mutual Funds

Learning Objective

This unit seeks to introduce the concept of mutual funds, highlight the advantages they offer, and describe the salient features of various types of mutual fund schemes.

Mutual funds are a vehicle to mobilize moneys from investors, to invest in different markets and securities

The primary role of mutual funds is to assist investors in earning an income or building their wealth, by participating in the opportunities available in the securities markets.

In order to accommodate investor preferences, mutual funds mobilize different pools of money. Each such pool of money is called a mutual fund scheme. Mutual funds address differential expectations between investors within a scheme, by offering various options, such as dividend payout option, dividend reinvestment option and growth option. An investor buying into a scheme gets to select the preferred option also.

The investment that an investor makes in a scheme is translated into a certain number of Units in the scheme. The number of units multiplied by its face value (Rs10) is the capital of the scheme its Unit Capital When the profitability metric is positive, the true worth of a unit, also called Net Asset Value (NAV) goes up.

When a scheme is first made available for investment, it is called a New Fund Offer (NFO).

The money mobilized from investors is invested by the scheme as per the investment objective committed. Profits or losses, as the case might be, belong to the investors. The investor does not however bear a loss higher than the amount invested by him.

The relative size of mutual fund companies is assessed by their assets under management (AUM). The AUM captures the impact of the profitability metric and the flow of unit-holder money to or from the scheme.

Investor benefits from mutual funds include professional management, portfolio diversification, economies of scale, liquidity, tax deferral, tax benefits, convenient options, investment comfort, regulatory comfort and systematic approach to investing.

Limitations of mutual funds are lack of portfolio customization and an overload of schemes and scheme variants.

Open-ended funds are open for investors to enter or exit at any time and do not have a fixed maturity. Investors can acquire new units from the scheme through a sale transaction at their sale price, which is linked to the NAV of the scheme. Investors can sell their units to the scheme through a re-purchase transaction at their re-purchase price, which again is linked to the NAV.

Close-ended funds have a fixed maturity and can be bought and sold in a stock exchange.

Interval funds combine features of both open-ended and closed ended schemes.

Actively managed funds are funds where the fund manager has the flexibility to choose the investment portfolio, within the broad parameters of the investment objective of the scheme.

Passive funds invest on the basis of a specified index, whose performance it seeks to track.

Gilt funds invest in only treasury bills and government securities

Diversified debt funds on the other hand, invest in a mix of government and non-government debt securities

Junk bond schemes or high yield bond schemes invest in companies that are of poor credit quality.

Fixed maturity plans are a kind of debt fund where the investment portfolio is closely aligned to the maturity of the scheme.

Floating rate funds invest largely in floating rate debt securities

Liquid schemes or money market schemes are a variant of debt schemes that invest only in debt securities of less than 91-days maturity.

Diversified equity funds invest in a diverse mix of securities that cut across sectors.

Sector funds invest in only a specific sector.

Thematic funds invest in line with an investment theme. The investment is more broad-based than a sector fund; but narrower than a diversified equity fund.

A mutual fund is a pool of money collected from Investors and is invested according to stated investment objectives. The birth place of Mutual Fund is U.S.A. Mutual fund investors are like shareholders and they own the fund. Mutual fund investors are not lenders or deposit holders in a mutual fund. Everybody else associated with a mutual fund is a service provider, who earns fee. The money in the mutual fund belongs to the investors and nobody else. Mutual funds invest in marketable securities according to the investment objective. The value of the investments can go up or down, changing the value of the investors holdings. The net asset value (NAV) of a mutual fund fluctuates with market price movements. The market value of the investors funds is also called as net assets. Investors hold a proportionate share of the fund in the mutual fund.

New investors come in and old investors can exit at prices related to net asset value per unit. Advantages of mutual funds to investors are: Increases the purchasing power of the investors Portfolio diversification Professional management Reduction in risk Reduction in transaction cost Liquidity Convenience and flexibility Disadvantages of mutual funds to investors are: No control over costs No tailor made portfolios Problems of managing a large portfolio of funds Important Milestones in the MF history in India 1963: UTI (special privileges assured return schemes, guarantees, loans) 1987: Public Sector MFs 1993: Private Sector MFs 1995: AMFI was set-up (internal checks & balances, representation to the govt and consumer education publish a book titled Making Mutual Funds Work for You an Investors Guide) 1996: SEBI (MF) Regulations 1999: Dividend income made tax free in the hands of investor 2003: UTI Act repealed (level playing field, UTI split, UTIMF created) 2004-onwards: Consolidation & Growth (AUM at the end of FY 2004-05 was appx. Rs.153,000 crores) UTI was the only mutual fund during the period 1963-1988. UTI was the only fund for a long period and enjoyed monopoly status. UTI is governed by the UTI Act, 1963 In 1987 banks, financial institutions and insurance companies in the public sector were permitted to set up mutual funds.

SEBI got regulatory powers in 1992. SBI Mutual Fund was the first bank-sponsored mutual fund to be set up. The first mutual fund product was UTIs Master Share in 1986. The private sector players were allowed to set up mutual funds in 1993.
In 1996 the mutual fund regulations were substantially revised and modified. In 1999 dividends from mutual funds were made tax exempt in the hands of investors. Mutual funds can be open ended or closed ended, Load or No-Load, Taxable or Tax exempt, Commodities and Real Estate funds. In an open ended fund, sale and repurchase of units happen on a continuous basis, at NAV related prices, from the fund itself. The corpus of open ended funds, therefore, changes everyday.

A closed end fund offers units for sale only in the NFO. It is then listed in the market. In closed end fund investors wanting to buy or sell units have to do so in the stock markets. The corpus of a closed end fund remains unchanged. Mutual funds also offer equity linked savings schemes (ELSS) that have the following features: 3 year lock in Minimum investment of 90% in equity markets at all times Open ended or closed end Rebate under section 80C for investments up to Rs. 1,00,000/Gilt funds are funds that invest only in government securities Sectoral funds are also called as specialty funds. Equity funds are risky; liquid funds have the lowest risk.

Equity funds are for the long term; liquid funds are for the short term. Investors choose funds based on their objectives, risk appetite, time horizon and return expectations. Load is charged to the investor when the investor buys or redeems (repurchases) units. Load is an adjustment to the NAV, to arrive at the price. Load that is charged on sale of units is called as Entry Load. An entry load will increase the price, above the NAV, for the investor. Load that is charged when the investor redeems his units is called an Exit Load. Exit load reduces the redemption proceeds of the investor. Load is primarily used to meet the expenses related to sale and distribution of units.

An exit load that varies with the holding period of an investor is called a (Contingent Deferred Sales Charge) CDSC. The repurchase price cannot be less than 95% of the sale price.
What is the first thing you look for when you invest in a liquid fund? Its safety, right? After the fiasco that liquid funds went through during the 2008 credit crisis, where many liquid schemes had to sell off their underlying holdings or securities at throwaway prices, the capital markets regulator, Securities and Exchange Board of India (Sebi), has not been taking any chances. Over the past three years, it has consistently reduced the risk levels that a liquid fund can take, while making their net asset values (NAVs) as realistic as possible. In fact, some experts claim that the Indian mutual funds (MF) debt fund regulations are on paras far as risk contaminant is concernedwith those in many developed markets. After all, your funds underlying scrips must reflect their true worth. Effective 30 September, your liquid fund will further de-risk itself. All holdings that mature beyond 60 days will be marked to market; these will, therefore, endure daily volatility. But this seemingly innocuous change is a part of a bigger change in Sebis mindset. Rules-based to principles-based

In February 2012, Sebi changed

its advertising and

debt fund valuation guidelines to principles-based from rules-based which was earlier the case. This means that instead of Sebi defining rules, followed by more rules later to add to the previous ones, Sebi will lay down broad guidelines and their end objective. MFs then have to

devise their own policies to ensure that the objective is met. As Shubho Roy, legal consultant at National Institute of Public

Finance and Policy, and Ajay Shah, professor, National Institute of Public Finance and Policy, wrote in a blogpost titled Movement at Sebi towards principles-based regulation on Shahs blog www.ajayshahblog.blogsp ot.com, in March soon after Sebis guidelines came out, statutory warnings on cigarette boxes are a good example of how rules-based guidelines can lead to companies finding

loopholes and circumventing regulations. The rules require that the font in which the statutory warning is printed should have a minimum height. Firms get around this by printing the warning in the required height, but reducing the width of the characters to a ridiculously low size, so that it is very difficult for readers to decipher. Thereby, they are able to comply with the directive for statutory warnings, yet defeat the purpose of warning buyers, write Roy and Shah.

As far as valuations of their holdingsbe it equity or debt are concerned, broadly, Sebi wants fund houses to adhere to the principle of fair valuation. While its easier to value equity securities because equity markets are liquid and a large
segment of equity scrips are traded and, therefore, carry a market price, debt markets are a different ball game. They are illiquid and typically long-term bonds which dont get traded daily. Up till now, Sebi had prescribed a detailed set of guidelinesthey first came out in 2001 and later in 2002to debt funds on how to value their

underlying securities, depending on whether they are traded and also their maturity periods. Now Sebi wants fund houses to value their debt securities the way they wish, but they must ensure that the scrips are valued as realistically as possible. The boards of the asset management company (AMC) and the trustees must approve the valuation policies. All fund houses must list their valuation policies on their websites. I think principles-based regulation is a good idea and we should move there. Rules-based regulation is just inviting a continual dog-fight between

regulators and the industry, where the industry looks for loopholes. But at the same time, we have to see that principlesbased regulation also requires commensurate modifications in the regulatory strategy. One, the burden of compliance with principles should fall on the top management and not on the compliance officer. Two, Sebi needs higher quality staff in order to enforce principles-based regulation. Three, we have to strengthen Securities Appellate Tribunal so that we have more capable judges disposing off a larger workflow, says Shah. Valuing underlying securities

Crisil matrix: Because debt scrips are illiquid and many do not have a trading price, valuing them could be tricky. Credit rating agencies Crisil Ltd and Icra Ltd send matrices every day to all MFs. Every day, these agencies collate traded prices of all government securities (G-secs) across different modified duration and then give a suitable mark-upin terms of yieldsfor other rated instruments. Expressed in years, modified duration tells you how much your debt fund would get affected if interest rates (a debt securitys or your bond funds yield) were to move up or down by 1%.

For instance, as on 25 July 2012, as per Crisils matrix, the G-sec yield for a scrip that comes with a modified duration of 0.25 and 0.5 years was 8.39%. As per this matrix, the mark-up for a AAArated security for a similar modified duration is 0.86%. If your fund has invested in a AAA-rated security and if the security gets traded on a given day (25 July in this example), it will take the traded price. But if the security doesnt get traded, your fund then refers to this Crisil matrix. A 0.86% mark-up of a AAA-rated instrument over the Gsec yield means that the AAAinstruments yield is 9.25%

(8.39% + 0.86%). Given the derived yield (9.25%) and the modified duration (0.250.5 years), the debt fund then arrives at the price of its AAA holding and accounts for it while calculating its NAV. On account of different types of debt securities, rating agencies now give several matrices daily to MFs. For instance, Crisil sends one matrix for traditional bonds, another one to measure the yields of bonds issued by non-banking finance companies and real estate companies, yet another one for short-term instruments and a few other for other types of instruments
.

The matrices are devised looking at trades that have taken place across trading platforms for benchmark securities using Crisils proprietary model. They seek to represent the indicative valuation levels for securities for a particular rating category and tenor., says Jiju Vidyadharan, director, funds and fixed income Research, Crisil. Discretionary mark-up and mark-down: Till June 2012, when the new Sebi guidelines came into force, debt funds were allowed some discretion to value their debt scrips. For instance, for securities that were rated by credit rating agencies of duration

of up to two years, debt funds were allowed to provide a markup of 100 basis points (bps) on the upside and 50 bps on the downside. A basis point is onehundredth of a percentage point. Since the new regulations are principles-based, discretionary mark-ups are now removed and the fund houses are free to use any mark-ups or mark-downs they want. Heres what this means. Say your debt fund bought an ABC companys bonda AAA-rated instrumentat a yield of 9.60%. Assume, on this day, the Crisils and Icras determined matrix yield for a AAA-rated instrument

for a similar modified duration is a yield of 9.20%. This means, your debt fund has used a mark-up of 40 bps. Since the 40 bps mark-up was within the overall limit of 100 bps, this was allowed. However, assume that on account of an unforeseen event, equity and debt market collapse; bond prices fall hard. Since bond prices and yield move in opposite directions, yields will shoot up. If your debt funds underlying bond gets downgraded in terms of its credit rating, its price falls and, correspondingly, its yield goes up. Assume, its yield goes up to 15% and your fund has to value it at the end of the day to

determine its own NAV. Also assume, on that same day, the matrix determined yield for similar rated and equivalent duration bonds is 12%. If your debt fund were to have valued the ABC companys bond at 15% (the prevailing market yield of that specific bond), that would have been a mark-up of 300 bps; a 100 bps mark-up would have allowed your debt fund to value this scrip at 13% at most. Your debt fund had no choice, therefore, but to value that bond at maximum 13%. Post June 2012, debt fund NAVs should be in a better position to capture these market

movements, says Vikrant Mehta, headfixed income, AIG Global Asset Management Co. (India) Ltd. The new Sebi guidelines have removed the defined mark-ups and have left it upon the fund manager to decide an appropriate mark-up or mark-down. 60-day limit: This is a simple rule. Effective 30 September, all securities maturing after 60 days will be marked to market. Those securities that mature before 60 days will continue to be amortized (a method that debt funds use to value very short-term securities). However, amortization will need

to be more realistic than before, following matrices very closely. After Sebi gave fund houses the freedom to come out with their own valuation policies in February, there were discussions at the level of the Association of Mutual Funds in India (Amfi), the industry trade body. Then the Amfi valuations committee came up with a detailed set of guidelines keeping in mind Sebis objective to value securities as realistically as possibleto guide the MF industry. All AMCs have largely stuck to these guidelines with some variations here and there.

We checked out the debt fund valuation policies of seven fund houses including larger ones such as HDFC Asset Management Co. Ltd and ICICI Prudential Asset Management Co. Ltd to smaller ones such as AIG Global Asset Management Co. (India) Pvt. Ltd to get an idea of what fund houses are up to. Mostly, their policies are the same with negligible differences. Sebi has asked fund houses to review the policies periodically. kayezad.a@livemint.com
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Kayezad E. Adajania

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