Management of Financial Services

Broad Spectrum of Financial

Services
 What is Financial Service?
Mutual Fund
 Risk Aversion Risk Management

Bank Deposits, PPF,

NSC, Insurance, Mutual Funds
Kisan Vikas Patra etc.

Low Risk/Low Return Managed Risk/High Return

Basics of Investments:
1. Mutual Funds invest only in shares.
2. Mutual Funds are prone to very high risks/actively traded.
3. Mutual Funds are very new in the financial market.
4. Mutual Funds are not reliable and people rarely invest in them.
5. The good thing about Mutual Funds is that you don’t have to pay
attention to them.
1. Equity Instruments like shares form only a part of
the securities held by mutual funds. Mutual funds
also invest in debt securities which are relatively
much safer.
2. The biggest advantage of Mutual Funds is their
ability to diversify the risk.
3. Mutual Funds are their in India since 1964. Mutual
Funds market is very evolved in U.S.A and is there
for the last 60 years.
4. Mutual Funds are the best solution for people who
want to manage risks and get good returns.
5. The truth is as an investor you should always pay
attention to your mutual funds and continuously
monitor them. There are various funds to suit
investor needs, both as a long term investment
vehicle or as a very short term cash management
vehicle.
6. US-64 is very much a part of the market and is not
immune to its vagaries. The crisis has risen due to
mismanagement of the fund.
A mutual fund is a common pool of money into which investors place
their contributions that are to be invested in different types of
securities in accordance with the stated objective.
An equity fund would buy equity assets – ordinary shares,
preference shares, warrants etc.
A bond fund would buy debt instruments such as debenture bonds,
or government securities/money market securities.
A balanced fund will have a mix of equity assets and debt
instruments.
Mutual Fund shareholder or a unit holder is a part owner of the
fund’s asset.
 Operations Flow Chart

(Reference: amfiindia.com)
Phase I – 1964 – 87: In 1963, UTI was set up by Parliament under UTI
act and given a monopoly. The first scheme launched by UTI was Unit
Scheme-64. Later in ’70’s and ’80’s, UTI started offering some special
purpose schemes like ULIP and Children’s Gift Growth Fund. Master
share, the first equity fund was launched in 1986. These were launched to
suit the needs of different class of investors.

Phase II – 1987 – 93: 1987 marked the entry of non-UTI, Public Sector
mutual funds. Some of the mutual funds launched during this period are
SBI Mutual Fund, Canbank Mutual Fund, LIC Mutual Fund, Indian Bank
Mutual Fund, GIC Mutual Fund and PNB Mutual Fund.
Also marked a spurt in launch of assured funds like
Cantriple, Magnum Triple, BOI Double Square Plus. Equity funds with
assured returns were launched which later ended in disaster.
Phase III – 1993 – 96: Permission was granted for entry of private sector
funds. It gave greater choice to the Indian Investors. These private funds
have brought in with them the latest product innovations, investment
management techniques and investor servicing technology that makes
the Indian mutual fund industry vibrant and growing. This phase also
marked the launch of an open-end funds.

Phase IV – 1996: Investor friendly regulatory measures have been taken

both by SEBI to protect the investor, and by the government to enhance
investor’s returns through tax benefits.
•Portfolio diversification: It enables him to hold a diversified investment
portfolio even with a small amount of investment like Rs. 2000/-.

•Professional management: The investment management skills, along

with the needed research into available investment options, ensure a
much better return as compared to what an investor can manage on his
own.

•Reduction/Diversification of Risks: The potential losses are also

shared with other investors.

•Reduction of transaction costs: The investor has the benefit of

economies of scale; the funds pay lesser costs because of larger volumes
and it is passed on to the investors.

•Wide Choice to suit risk-return profile: Investors can chose the fund
based on their risk tolerance and expected returns.
• Liquidity: Investors may be unable to sell shares directly, easily and
quickly. When they invest in mutual funds, they can cash their investment
any time by selling the units to the fund if it is open-ended and get the
intrinsic value. Investors can sell the units in the market if it is closed-
ended fund.

• Convenience and Flexibility: Investors can easily transfer their holdings

from one scheme to other, get updated market information and so on.
Funds also offer additional benefits like regular investment and regular
withdrawal options.

•Transparency: Fund gives regular information to its investors on the

value of the investments in addition to disclosure of portfolio held by their
scheme, the proportion invested in each class of assets and the fund
manager's investment strategy and outlook
• No control over costs: The investor pays investment
management fees as long as he remains with the fund, even while
the value of his investments are declining. He also pays for funds
distribution charges which he would not incur in direct investments.

• No tailor-made portfolios: The very high net-worth individuals or

large corporate investors may find this to be a constraint as they will
not be able to build their own portfolio of shares, bonds and other
securities.

• Managing a portfolio of funds: Availability of a large number of

funds can actually mean too much choice for the investor. So, he
may again need advice on how to select a fund to achieve his
objectives.

•Delay in redemption: It takes 3-6 days for redemption of the units

and the money to flow back into the investor’s account.
Broad Types of Mutual Funds
Open-end Fund
• Available for sale and repurchase at all times based on the net asset
value (NAV) per unit.
• Unit capital of the fund is not fixed but variable.
• Fund size and its total investment go up if more new subscriptions
come in than redemptions and vice-versa.

Closed-end Fund
• One time sale of fixed number of units.
• Investors are not allowed to buy or redeem the units directly from the
funds. Some funds offer repurchase after a fixed period. For example,
UTI MIP offers a repurchase after 3 years.
• Listed on stock exchange and investors can buy or sell units through
the exchange.
• Units maybe traded at a discount or premium to NAV based on
investor’s perception about the funds future performance and other
market factors.
Marketing a new mutual fund scheme involves initial expenses.
These expenses are charged to the investors through loads and are
recovered from the investors in different ways:
• Front-end or entry load is charged to the investor at the time of
his entry into the scheme.
• Back-end or exit load is charged to the investor at the time of his
exit from the scheme.
• Deferred load is charged to the investor over a period of time.
• Contingent deferred sales charge: Different amount of loads are
charged to the investor depending upon the time period the investor
has stayed with the fund. The longer he stays with the fund, lesser
the amount of exit fund he is charged.

Very often, AMC’s do not charge any initial expenses to the investor
in the IPO. These are hence are no-load funds. In no-load funds,
the investors get units for the complete amount invested.
Money Market Funds/Cash Funds
• Invest in securities of short term nature I.e. less than one year
maturity.
• Invest in Treasury bills issued by government, Certificates of
deposit issued by banks, Commercial Paper issued companies and
inter-bank call money.
• Aim to provide easy liquidity, preservation of capital and moderate
income.
Gilt Funds
• Invest in Gilts which are government securities with medium to
long term maturities, typically over one year.
• Gilt funds invest in government paper called dated securities.
• Virtually zero risk of default as it is backed by the Government.
• It is most sensitive to market interest rates. The price falls when
the interest rates goes up and vice-versa.
Debt Funds/Income Funds
• Invest in debt instruments issued not only by government, but also
by private companies, banks and financial institutions and other
entities such as infrastructure companies/utilities.
• Target low risk and stable income for the investor.
• Have higher price fluctuation as compared to money market funds
due to interest rate fluctuation.
• Have a higher risk of default by borrowers as compared to Gilt
funds.
• Debt funds can be categorized further based on their risk profiles.
• Carry both credit risk and interest rate risks.
Equity Funds:
• Invest a major portion of their corpus in equity shares issued by
companies, acquired directly in initial public offering or through
secondary market and keep a part in cash to take care of
redemptions.
• Risk is higher than debt funds but offer very high growth potential
for the capital.
• Equity funds can be further categorized based on their investment
strategy.
• Equity funds must have a long-term objective.
Balanced Funds:
• Has a portfolio comprising of debt instruments, convertible
securities, preference and equity shares.
• Almost equal proportion of debt/money market securities and
equities. Normally funds maintain a Equity-Debt ratio of 55:45 or
60:40.
• Objective is to gain income, moderate capital appreciation and
preservation of capital.
• Ideal for investors with a conservative and long-term orientation.
 Options Available to the
Investor
 Product Return Safety Liquidity Tax Conven-
Benefit ience
Bank Low High High No High
Deposit
Equity High Low High or No Moderate
Instruments Low
Debentures Moderate Moderate Low No Low

Fixed Moderate Low Low No Moderate

Deposits by
Companies

Bonds Moderate Moderate Moderate Yes Moderate

 Product Return Safety Liquidity Tax Conven-
Benefit ience
RBI Relief Moderate High Low Yes Moderate
Bonds
PPF Moderate High Low Yes Moderate

National Moderate High Low Yes Moderate

Saving
Certificate

National Moderate High Low Yes Moderate

Saving
Scheme

Monthly Moderate High Low Yes Moderate

Income
Scheme
 Product Return Safety Liquidity Tax Conven-
Benefit ience
Life Moderate High Low Yes Moderate
Insurance
Mutual Moderate Moderate High No High
Funds
(Open-end)
Mutual Moderate Moderate High Yes High
Funds
(Closed-
end)
• Bank Deposits cater to investor class that look for safety and
accepts a relatively low return. They cannot be compared with equity
funds but with debt funds.

•A bank deposit is guaranteed by the bank for repayment of principal

and interest whereas a debt fund has no contractual guarantee for
repayment of principal or interest.

• In bank deposits, the investor has to assess the risk in terms of

credit ratings of the bank which gives an indication of the financial
soundness of the bank. However, a debt fund is not rated by any
agency. The investor has to assess the risk on the portfolio held by
the fund.

•Bank deposits are not totally free from risk and generally give lower
returns. A conservative debt fund can give higher returns than a bank
deposit, even though there is no contractual guarantee as in a
deposit.
While instruments like shares give high returns at the cost of high risk,
instruments like NSC and bank deposits give lower returns and higher
safety to the investor.

Mutual Funds aim to strike a balance between risk and return and
give the best of both to the investor.
Fund Structure and its
Constituents
 Fund Sponsor

Trustees

Asset Management
Company

Depository Agent

Custodian
The Fund Sponsor
• Any person or corporate body that establishes the Fund and registers
it with SEBI.
• Form a Trust and appoint a Board of Trustees.
• Appoints Custodian and Asset Management Company either directly
or through Trust, in accordance with SEBI regulations.

SEBI regulations also define that a sponsor must contribute

at least 40% to the net worth of the asset management
company.
Trustees
• Created through a document called the Trust Deed that is executed by
the Fund Sponsor and registered with SEBI.
• The Trust-the mutual fund may be managed by a Board of Trustees- a
body of individuals or a Trust Company- a corporate body.
• Protector of unit holders interests.
• 2/3 of the trustees shall be independent persons and shall not be
associated with the sponsors.
Rights of Trustees:
• Approve each of the schemes floated by the AMC.
• The right to request any necessary information from the AMC.
• May take corrective action if they believe that the conduct of the
fund's business is not in accordance with SEBI Regulations.
• Have the right to dismiss the AMC,
• Ensure that, any shortfall in net worth of the AMC is made up.
Obligations of the Trustees:
• Enter into an investment management agreement with the AMC.
• Ensure that the fund's transactions are in accordance with the Trust
Deed.
• Furnish to SEBI on a half-yearly basis, a report on the fund's
activities
• Ensure that no change in the fundamental attributes of any scheme or
the trust or any other change which would affect the interest of unit
holders is happens without informing the unit holders.
• Review the investor complaints received and the redressal of the same
by the AMC.
• Acts as an invest manager of the Trust under the Board Supervision
and direction of the Trustees.
• Has to be approved and registered with SEBI.
• Will float and manage the different investment schemes in the name of
Trust and in accordance with SEBI regulations.
• Acts in interest of the unit-holders and reports to the trustees.
• At least 50% of directors on the board are independent of the
sponsor or the trustees.
Obligation of Asset Management Company:

 Float investment schemes only after receiving prior approval from

the Trustees and SEBI.
 Send quarterly reports to Trustees.
 Make the required disclosures to the investors in areas such as
calculation of NAV and repurchase price.
 Must maintain a net worth of at least Rs. 10 crores at all times.
 Will not purchase or sell securities through any broker, which is
average of 5% or more of the aggregate purchases and sale of
securities made by the mutual fund in all its schemes.
 AMC cannot act as a trustee of any other mutual fund.
 Do not undertake any other activity conflicting with managing the
fund.
Custodian
• Has the responsibility of physical handling and safe keeping of the
securities.
• Should be independent of the sponsors and registered with SEBI.

Depositories
• Indian capital markets are moving away from physical certificates for
securities to ‘dematerialized’ form with a Depository.
• Will hold the dematerialized security holdings of the Mutual Fund.
Distribution Channels
Mutual Funds are primary vehicles for large collective investments, working
on the principle of pooling funds.
A substantial portion of the investments happen at the retail level.
Agents and distributors are a vital link between the mutual funds and
investors.
Agents
- Is a broker between the fund and the investor and acts on behalf of the
principal.
- He is not exclusive to the fund and also sells other financial services. This
in a way helps him to act as a financial advisor.

Distribution Companies
- Is a company which sells mutual funds on behalf of the fund.
- It has several employees or sub-broker under it.
- It manages distribution for several funds and receives commission for its
services.
Banks and NBFCs
- Several banks, particularly private and foreign banks are involved in a
fund distribution by providing similar services like that of distribution
companies.
- They work on commission basis.

Direct Marketing
- Mutual funds sell their own products through their sales officers and
employees of the AMC.
- This channel is normally used to mobilise funds from high net worth
individuals and institutional investors.
Agent Commissions
- No rules prescribed for governing the maximum or minimum
commissions payable by a fund to its agents.
- As per SEBI regulations, 1996 all initial expenses including brokerage
charges paid to agents cannot exceed 6% of resources raised under
the scheme.
- Excess distribution charges have to be borne by the AMC.
- A no-load fund is authorised to charge the schemes with the commissions
paid to agents as part of the regular management and marketing expenses
allowed by SEBI.
Accounting and Taxation
Calculating Net Asset Value
Unit Capital is the investor’s subscriptions. In mutual funds it is not
treated as a liability.
Investments made on behalf of the investors are reflected on the assets
side of the balance sheet.
There are liabilities of short-term nature.
Fund’s Net Asset = Asset – Liabilities
Net Asset Value = Net Assets of the scheme / No. of Outstanding Units
i.e
NAV = (Market value of investments + Receivables + Other Accrued
Income + Other assets – Accrued Expenses – Other Payables – Other
liabilities) / ( No. of Units Outstanding as at the NAV date)
The factors affecting the NAV are as following:
 Capital Gains or Losses on the sale or purchase of the Investment
securities.
 Dividend and income earned on the assets.
 Capital Appreciation in the underlying value of the stocks held in the
portfolio.
 Other assets and liabilities.
 Number of units sold or purchased.
SEBI regulations for NAV
• The day on which NAV is calculated by a fund is called valuation
date.
• NAV of all schemes must be calculated and published at least
weekly.
• This is applicable to both open-end and closed-end fund.
• Some closed end funds (Monthly Income Schemes) that are not listed
on stock exchange may publish it monthly-quarterly.
SEBI Guidelines for Pricing of Units:

 The mutual fund shall ensure that the re-purchase price is not
lower than 93% of the NAV.
 The sale price is not higher than 107% of the NAV. Repurchase
price of closed end scheme shall not be lower than 95% of the
NAV.
 The difference between the repurchase price and the sale price
of the units shall not exceed 7% of the sale price.
Since investments held by a mutual fund in its portfolio are to
be marked to the market, the NAV includes two components:
a) Realized gains or losses.
b) Unrealized gains or losses.

As per SEBI guidelines, unrealized appreciation cannot be

distributed by a fund, whereas the realized gain can be
distributed.
Investment Management Fees and Advisory Fees:

 1.25% of the first Rs.100 crores of weekly average net assets

outstanding in the accounting year.
 1% weekly average net assets in excess of Rs. 100 crores.
 A no load scheme can charge an additional management fee up to
1% of weekly average net assets outstanding in the accounting year.
Total expenses charged by the AMC to a scheme,
excluding issue or redemption expenses but including
investment management and advisory fees have
following limits:
 2.5% - On the first Rs. 100 crores of average weekly net assets
 2.25% - On the next Rs. 300 crores of average weekly net assets
 2% - On the next Rs. 300 crores of average weekly net assets
 75% - On the balance of average weekly net assets
 For bond funds, the above percentages are required to be lower by
0.25%
Taxation in the Hands of the Fund
 Income earned by any mutual fund registered with SEBI or set up by a
public sector bank/Financial Institution or authorised by RBI is exempt
from tax.
 Income distributed to unit holders by a closed-end or debt fund has to
pay a distribution tax of 10% plus surcharge of 1% I.e. a tax of 11%.
This tax is also applicable to distributions made by open-end funds
which have less than 50% allocation to equity.
The Impact on the Fund and the Investor
 Due to the tax payment by the fund, the NAV and the value of the
investor’s investment will come down.
 The tax bears no relationship to the investor’s tax bracket.
 This tax makes the income schemes less attractive than growth
schemes.
 The fund cannot avoid tax even if the investor chooses to reinvest the
distribution back into the fund.
Taxation in the Hands of the Investor
Tax Rebate available on Subscriptions to Mutual Funds (In accordance
with Section 88 of Income Tax Act)
 Investments up to Rs. 60,000 in units of any specified mutual fund
qualifies for tax rebate to the extent of 20% of such investment.
 In case of ‘Infrastructure Bonds, investments up to Rs. 70,000 is eligible
for 20% tax rebate.
 Total investment eligible for tax rebate cannot exceed Rs. 60,000.
 Investment up to Rs. 10,000 in an equity linked saving scheme (ELSS)
qualifies for tax rebate of 20%.
Taxation in the Hands of the Investor
Dividend Tax : The tax paid by the investor on receiving dividends from a
mutual fund. There is no dividend tax to be paid at the investor’s end.
 There is no dividend tax deduction from NAV in all funds which are open-
end and with over 50% allocation of investment to equities.

 Tax of 10.2% is deducted from the NAV by the fund in the following
cases:
- All closed end funds including equity.
- All open end funds with less than 50% allocation in equity.
Taxation in the Hands of the Investor
Capital Gains on Sale of Units: Capital Gains tax is charged when
something is sold at profit. If the investor sells his units and earns “Capital
Gains”, the investor is subject to the Capital Gains Tax.
If the units are held for less than 12 months, they will be treated as short
term capital gain. Otherwise,t hey are called long term capital gains.

For short term, capital gains = Sale consideration – (Cost of Acquisition +

Cost of Improvements + Cost of Transfer)
The tax charged depends on the income bracket of the investor.

For long term capital gains, the investor gets the benefit of ‘Indexation’ by
which his purchase price is marked up by an inflation index.
Cost of acquisition or improvement = actual cost of acquisition or
improvement * cost of inflation index for year of transfer/cost of inflation
index for year of acquisition or improvement.
The tax charged is either 10% or (20% - rate of inflation).
In-dept classification of Mutual
Funds
• Broad fund types by Nature of Investments: Mutual funds may
invest in equities, bonds or fixed income securities, or short-term
money market securities. So, we have Equity, Bond and Money
Market Funds.

• Broad fund types by Investment Objective: Investors and hence

mutual funds pursue different objectives while investing.
- Growth funds invest for medium to long term capital appreciation.
- Income funds invest to generate regular income and preservation
of capital with little emphasis on capital appreciation.
-Value funds invest in equities that are considered under-valued
today, whose value will be unlocked in future.

• Broad fund types by Risk Profile: Fund’s portfolio and its

investment objective imply different risk levels. Equity funds have a
greater risk of capital loss than a debt fund. Money Market funds are
exposed to lesser risk than Bond funds.
Diversified Debt Funds:
• Invests in all available types of debt securities, issued by entities
across all industries and sectors.
• Derives benefit of risk reduction through risk diversification.

Focused Debt Funds:

• Have a narrow focus with less diversification in its investments.
• Include Sector, Specialized and Offshore debt funds.
• Have a higher risk as compared to diversified debt funds.

High Yield Debt Funds:

• Invest in debt instruments that are not backed by tangible assets
and considered “below investment grade”.
• May earn higher returns though at the cost of higher risk.
Assured Return Funds- An Indian Variant:
• Assured Return or Guaranteed Monthly Income Plans are
essentially Debt/Income funds.
• Returns are indicated in advance for all the future years of the
closed-end funds.
• Any shortfall is borne by the sponsors or managers.
• Market regulator, SEBI has been discouraging fund managers
from offering assured return schemes. If offered, explicit guarantee
is required from a guarantor whose name is specified in advance in
the offer document of the scheme.
Aggressive Growth Funds
• Objective is to earn very high returns for the investor.
• Target is maximum capital appreciation.
• Invest in less researched or speculative shares and may adopt
speculative investment strategies.
• High volatility and risk as compared to other funds.

Growth Funds:
• Objective is capital appreciation over a long time, 7 - 10 years span.
• Invest in companies whose earnings are expected to rise at an
above average rate.
• These companies will be considered to have growth potential, but
not entirely unproven and speculative.
• Less volatile than aggressive growth funds.
Specialty Funds
• Thematic funds that have a theme for investments.
• Narrow portfolio orientation and invest only in companies that meet
pre-defined criteria.
• Diversification is limited to one type of investment.
• More volatile than diversified funds.
• Specialty funds are further sub-categorized based on their
investments.

Diversified Equity Funds:

• Invest only in equities except for a very small portion in liquid
money market securities.
• It is not focused on any one or few sectors or shares.
• Reduce the sector or stock specific risks through diversification.
• Lower risks than growth funds.
Sector Funds:
• Portfolios consists of investments in only in one industry or sector of the
market such as IT, Pharmaceuticals or FMCG.
• Higher level of company or sector specific risk than diversified funds.

Offshore Funds:
• Invest in equities in one or more foreign countries.
• Sensitive to foreign exchange rate risk and economic conditions of the
countries they invest in.

Small-Cap Equity Funds:

• Invest in shares of companies with relatively low market capitalization
that that of big blue chip companies.
• More volatile than other funds as smaller companies are not very liquid.
• In terms of investment style, it may be aggressive-growth or growth type
or even value fund.
Equity Linked Savings Schemes - an Indian Variant:
• Investment in these schemes entitles the investor to claim an income tax
rebate.
• Usually has a lock-in period of 3 years before the end of which funds
cannot be withdrawn.
• There are no specific restrictions on the investment objectives for the
fund managers.
• Generally, such funds would be Diversified Equity Funds.

Equity Income Funds:

• Objective is to give high level of current income along with some steady
capital appreciation.
• Invest in shares of companies with high dividend yields and do not
fluctuate as much as other shares. Ex - Power/Utility sector.
• Less volatile and risky than other equity funds.
Equity Index Funds:
• The objective is to match the performance of the stock market by
tracking an index that represents the overall market.
• Invests in shares that constitute the index and in the same proportion.
• Sensitive to overall market risk.
• Example: UTI Nifty Fund

Value Funds:
• Invest in fundamentally sound companies whose shares are currently
under-priced in the market.
• Have lower risk as compared to Growth Funds and take a long term
approach.
• Often invested in cyclical industries.
• Example: Templeton India Growth fund that has shares of
Cement/Aluminum and other cyclical industries.
Growth & Income Funds:
• Strike a balance between capital appreciation and income for the
investor.
• Portfolio is a mix between companies with good dividend paying
records and those with potential for capital appreciation.
• Less risky than growth funds but more risky than income funds.

Asset Allocation Funds:

• Follow variable asset allocation policy.
• Move in an out of an asset class (equity, debt, money market or
even non-financial assets)
• Asset allocation funds that follow more stable allocation policies are
like balanced funds.
• Asset allocation funds that follow more flexible allocation policies are
like aggressive growth or speculative funds.
Automatic Re-investment Plans
Allows the investor to re-invest in additional units the amount of dividends
or other distributions made by the fund instead of receiving it in cash.
 Investment takes place at ex-dividend NAV.
 The investors reap the benefit of compounding his investments.

Automatic Investment Plans

 Allows the investor to invest a fixed sum periodically. Enables him to save
in a disciplined and phased manner.
 Such funds help in ‘rupee cost averaging’.
 Mode of investment could be through direct debit to investor’s salary or
bank account.
 Voluntary Accumulation Plan, a modified version of AIP allows the
investor flexibility in terms of amount and frequency of investment.
Systematic Withdrawal Plans
 Allow systematic withdrawals from his fund investment on a periodic
basis.
 The investor must withdraw a specific minimum amount and also maintain
a minimum balance in his fund account.
 The amount withdrawn is treated as redemption of units at the applicable
NAV as specified in the Offer Document.
 SWPs are different from MIPs. SWPs allows investors to get back the
principal amount invested while MIP’s will only pay the income part on
regular basis.
Systematic Transfer Plans
 Allow the investor to transfer on a periodic basis from one scheme to
another within the same fund family.
 A transfer will be treated as redemption of units from one scheme and
investment of units in another scheme.
 Such redemption and investment will be at applicable NAV as mentioned
in the Offer Document.
Measuring and Evaluating
Mutual Fund Performance
The Investor Perspective
-To make intelligent decisions on whether he should continue with the
investment or not.
- He needs the basic knowledge of fund evaluation to judge the
performance of the fund.

The Advisor’s Perspective

-The potential investors would expect the advisor to give them a proper
advise on which funds have good performance.
- In order to compare different funds, the advisor must have the correct
knowledge and appropriate measures of evaluating the fund performance.
Change in NAV
- most commonly used by investors to evaluate fund performance and
most commonly published by fund managers.
- Easily understood and applied to any type of fund.
- Should be interpreted in light of the investment objective of the fund,
current market conditions and alternative investment returns.
- Long term growth fund or infrastructure fund will give low returns in the
initial years.
NAV Change in absolute terms:
(NAV at the end of period) – (NAV at the beginning of period)

NAV Change in percentage terms:

(Absolute change in NAV/NAV at the beginning of period) * 100

Annualised NAV Change:

{[(Absolute Change in NAV/NAV at the beginning)/months
covered]*12}*100
No, percentage NAV change cannot give a correct picture as it does not
take into account the interim dividends paid. The correct measure here is
Total Return Method.
Total Return Method
- It takes into account the dividends paid in the interim period and is
suitable for all types of funds.
- It must be interpreted in the light of market conditions and investment
objective of the fund.
- Its limitation is that it ignores the fact that distributed dividends also get
reinvested if received during the year.

Total Return is:

[(Distributions + Change in NAV)/NAV at the beginning of the period]* 100
Return on Investment or Total Return with Dividends Reinvested at
NAV
-The shortcoming of Total return is overcome by computing the Total
Return with reinvestment of dividends in the fund at the NAV on the date
of distribution.
- Is a measure of cumulative wealth accumulation and is the same as ROI.
- Appropriate for measuring performance of accumulation plans,
monthly/quarterly income income schemes debt funds that distribute
interim dividends.

ROI or Total Return with Reinvestment is:

{(Units Held + div/ex-dNAV) * endNAV – begin NAV} /begin NAV * 100
Cumulative Aggregate vs. Average Annualised Returns
- Absolute NAV’s do not give a complete picture. Consistent performance
with respect to Total Return and compounded annual return is of
importance.
- Children’s Gift Fund and Rajalakshmi of UTI are based on cumulative
returns.
- When Cumulative Returns are received at the end of a long period,
Annualised Average Compound Rate of Return must be calculated from
the cumulative figure.
- Comparisons between two such schemes is possible only after the
Cumulative Returns are converted into Average Annualised Returns.

Formula for conversion:

A = P*(1+R/100)N where P = principal invested, A = Maturity value of the
investment, N = Period of investment in years, R = annualised compound
rate in percentage.
Following things should also be considered while comparing fund
performance:

Use long-term performance data

– The longer the period covered by fund performance data, the more
reliable would be the conclusions about the funds record.

Compare the Same Time Periods

- it is imperative to use the performance data over the same periods of
time as returns over different periods vary due to different market
conditions.
Less than One Year Periods
- if the fund performance data relates to a period of less than one year, it
should not be annualised.
- Money market funds are an exception due to their short term horizon.

Returns since Inception

-SEBI requires returns to be compared since the inception of a scheme
using Rs. 10 as the base amount.
- Adjustments have to be made in case loads are paid.
The Expense Ratio
- Indicator of fund’s efficiency and cost effectiveness.
- It is defined as the ratio of total expenses to average net assets of the
fund.
- Past and estimated expense figures and ratios are disclosed in the Offer
Document.
- Fluctuations in the ratio across periods require that an average over
three to five years be used to judge a fund’s performance. Also it should
be evaluated in the light of the fund size, average account size and
portfolio composition.
- Funds with small corpus size will have higher expense ratio.
- If a fund’s income levels or returns are small say a debt fund with 10%
return, expense ratio becomes important and difference of even 0.5%
between two funds can make lot of difference.
The Income Ratio
- Defined as its net investment income divided by its net assets for the
period.
- Useful for measuring income oriented funds, particularly debt funds and
not suitable for funds looking for capital appreciation.
- Cannot be used in isolation, but only with expense ratio and total return.
Portfolio Turnover Rate
- Measures the buying and selling done by a fund.
- A 100% turnover implies that the manager replaced his entire portfolio
during the period in question, lets say one year.
- A 50% turnover implies that the manager replaced his entire portfolio in 2
years.
- Most useful while evaluating equity and balance funds, but not
appropriate for equity funds with a value-based long term investment
philosophy.
- Higher T/o does not necessarily mean greater efficiency and must be
seen in relation to the total return to the investor.
Fund Size
- Small fund are easier to manoeuvre and can achieve their objectives
easily.
- Large funds benefit from economies of scale.

Cash Holdings
-A large cash holding allows the fund to strengthen its position in preferred
securities without liquidating others.
- Allows cushion against decline in market prices of shares or bonds.
Importance of Benchmarking
- A funds performance can be judged in relation to investor’s expectations.
- However, it is important for the investor to define his expectations in
relation to certain “guideposts”.
- These guideposts or indicators of performance can be thought of as
benchmarks against which a fund’s performance ought to be measured.
- For instance, BSE-30 will be a benchmark for diversified equity fund and
BSE IT index for tech funds.

While an advisor needs to look at the absolute measures of

performance, he needs to select the right benchmark to evaluate a
fund’s performance, so that he can compare the measured
performance figures against the selected benchmark.
Basis for choosing an Appropriate Performance Benchmark
The appropriate benchmark has to be selected by reference to:
1. The Asset Class it invests in. Thus, an equity fund has to be judged by
from an appropriate benchmark from the equity market and so on.
2. The fund’s stated Investment Objective.

There are three types of benchmarks that can be used to evaluate a

fund’s performance:
1. Relative to the market as a whole.
2. Relative to other mutual funds.
3. Relative to other comparable financial products or investments options
open to the investor.
Equity Funds
• Index Funds- a base index:
- If an investor were to chose an equity index fund, he can expect to
get the same return as on the Index, called the Base Index.
- For index funds, the benchmark is clear and pre-specified by the fund
manager in advance.
• Tracking Error:
- an Index Fund invests in all of the stocks included in the index
calculation, in the same proportion as the stocks’ weight in the index.
- An index funds actual return may be better or worse by what is
called the “tracking error.”
- The tracking error arises from the practical difficulties faced by the
fund manager in trying to remain in line with the weight that the stocks
enjoy in the index.
• Active Equity Funds:
- Using appropriate market index.
- The appropriate index to be used to evaluate a broad-based equity
fund should be decided on the basis of the size and the composition of
the fund’s portfolio.
- If the fund has a large portfolio, a broader market index like BSE 100
or 200 or NSE 100 may be used to benchmark rather than S&P NIFTY
or BSE 30.
- An actively managed fund expects to beat the index.
• Sector Funds:
- Benchmark will be the relative Sectoral Index.
- An investor in Infotech or Pharma Sector funds can expect the same
return as the relative sectoral indices.
In other words, the choice of a correct equity index as a benchmark
also depends upon the investment objective of the fund. For example,
a small cap fund has to be compared with a small cap index.
• Debt Funds:
- Using appropriate debt market index.
- A broad based bond fund or debt fund should be benchmarked with
broad based debt index whereas a narrower Government Securities
Fund, only the Government Sector sub-segment of the broad based
index has to be used.
- Closed-end funds with clear maturity can be compared with bank
deposits.
- I-SEC’s I-BEX is most commonly used by some analysts.

• Money Market Funds:

- Money market funds due to their short term nature are benchmarked
against the government funds of appropriate maturities.
- J.P.Morgan’s T-Bill index is used by analysts.
- NSE’s “mibid/mibor” rates that reflect interbank call money money
market interest rates can also be used as a benchmark.
While comparing two funds, it is extremely important to ensure that the
comparisons are meaningful and meet the following criteria:
 The Investment Objectives and Risk Profiles
- Of two funds being compared must be same.
- For example an equity fund cannot be compared with a debt fund.
 Portfolio Compositions
- Of the funds compared must be similar.
- High returns fund investing in high risk-prone securities cannot be
compared with a scheme that invests in low risk securities.
 Credit Quality and Average Maturity
- The credit ratings of the investments have to be comparable, for
example a security with investments in AAA is not same as AA-.
- A fund with maturity of 3 yrs is not same as the fund with 6yrs.
 Fund Size
- Funds of equal size should be compared.
Expense Ratio
- Expense ratios effect fund’s performance.

Even when two funds of similar characteristics are compared, their

returns must be calculated on the following comparable basis:

• Compare the returns over the same period only.

• Only annualised compound returns are comparable, I.e. data must be
available for long enough periods.
• Only after-tax returns of two different schemes should be compared.
 An investor will compare the mutual fund performance with other
-investment products like bank deposits, NSC’s Indira Vikas Patra etc.
 Only instruments of similar investment characteristics and with returns
and calculated over the same periods should be used for meaningful
comparisons.
While every fund is exposed to market risks, good funds should at least
match major market indices. An AMC or the fund managers must be
evaluated on the following criteria:
 Operate with long-term perspective.
 Do not indulge in excessive trading that generates high transaction
costs and in turn reduce the NAV/risk of loss.
 Turns out a more consistent performance rather than a one time high
and otherwise volatile performance record.
 Team of managers with successful records as against fund that are
managed by one individual.
 The reliability and track record of the sponsors.
 Performance record against competing managers running similar funds.
To track fund performance, the first step is to find the relevant information
on NAV, expenses, cash flow, appropriate indices etc. The common
sources of information are:

• Mutual Fund’s Annual and Periodic Reports include data on the

fund’s financial performance which are indicators for expense ratios and
total return. It also includes a listing of the fund’s portfolio holdings at
market value, statement of revenue and expenses, unrealized
appreciation/depreciation at year end and changes in net assets.

• Financial Press: Daily newspapers like Economic Times provide daily

NAV figures for open-end schemes and share prices of closed-end
schemes. There are also weekly supplements like Smart Investor of
Business Standard and Investor Guide of Economic Times also give
enough information for evaluation.
• Fund Tracking agencies like Credence and Value Research are
sources for MF performance data and evaluation.
• Newsletters: Many MFs, banks and non-banking firms catering to retail
investors publish their own newsletters.
• Prospectus: SEBI regulations requires sponsors to disclose
performance data relating to schemes being managed by them.
Investing for Long Term – the power of compounding
- Invest for the long term and let your money grow on a compound basis.
- Higher the frequency of compounding, greater the growth of capital.
- An advisor must enable the investor to understand the benefits of
compounding.

Example:
If MR. Kapoor invests Rs. 1000 @ 10% interest rate for 10 years and the
amount is compounded annually, this is how the money grows:
 Interest generated in the first year would be Rs. 80 (1,000*.08)
 Interest generated in the second year would be 86.4 [(1,000+ 80)*.08]
instead of 80
 Interest in the third year would be 93[(1000 + 80+ 86.4) * .08)
 And so on till the interest keeps growing each year, resulting in a total of
Rs. 2,600 at the end of 10
a) Buy and Hold
- Most common strategy adopted by investors and the most common
mistake.
- Long term investments does not necessarily mean buy and hold
without adjusting the portfolio.
- Continuous tracking needs to be for keeping the right funds.
b) Rupee Cost Averaging
- It is advisable to invest regularly in small amounts rather than
investing a lump sum at one go.
- A regular investor is always a winner.
- The disadvantage of this method is that it does not tell the investor
when to buy and sell a fund.
c) Value Averaging
- Investor keeps the target value of investment constant.
- He accordingly keeps changing the investment amount either by
increasing or decreasing the same.
Scenario 24.
Mrs. Sudhakar isDate
investing Rs. 1000 every month for NAV
Amount 3 months in ABC
mutual fund. Following are the details:
Invested
January 1000 R. 10/-
February 1000 Rs. 8/-

March 1000 Rs. 12.50

Check whether rupee cost averaging method will prove beneficial to Mrs.
Sudhakar.
 Date Amount NAV Units
Invested Purchased
January
Solution 24. 1000 R. 10/- 100
February 1000 Rs. 8/- 125
March 1000 Rs. 12.50 80

Average cost per unit under the plan = 3000/305 = Rs. 9.84
Average NAV = (10 + 8 + 12.50)/3 = Rs. 10.17
Average of the three NAV’s is higher than the figure achieved through
rupee-cost averaging.
So, we can say that rupee-cost-averaging is beneficial to Investors.
Thank You!