Mutual Funds – Everything About Mutual Funds

SEBI (Mutual Fund) Regulations 1993 defines Mutual Fund as “a fund established in the form of a trust by a sponsor to raise money by the trustees through the sale of units to the public under one or more schemes for investing securities in accordance with these regulations”.

Before I start this article is seriously long (over 4000 words), but you’re sure to get your money’s worth (hehehe). If you don’t have time to read it now, feel free to bookmark it or print it out for later reading.

Definition

SEBI (Mutual Fund) Regulations 1993 defines Mutual Fund as “a fund established in the form of a trust by a sponsor to raise money by the trustees through the sale of units to the public under one or more schemes for investing securities in accordance with these regulations” The rationale behind a mutual fund is that there a large number of investors who lack the time and or the skills to manage their money.

Hence, professional fund managers, acting on behalf of the Mutual Fund, manage the investments (investor’s money) for their benefit in return for a management fee. The organization that manages the investment is called the Asset Management Company (AMC). Thus, a Mutual Fund is the most suitable investment for the common person as it offers an opportunity to invest in a diversified, professionally managed basket of securities at a relatively low cost. Anybody with an investible surplus of as little as a few thousand rupees can invest in mutual fund .Each mutual fund scheme has defined investment objective and strategy.

A Draft offer documents is to be prepared for launching a fund. Typically, it specifies the investment objectives of the fund, the risk associated, the cost involved in the process and the broad rules for entry into and exit from funds and others areas of operation. As you probably know, mutual funds have become extremely popular over the last couple of decades what was once just another obscure instrument is now part of daily lives. More than 80 million people or one half of the household in America invest in mutual funds. That means that, in the United States alone, trillions of dollars alone are invested in mutual fund. In fact, too many people, investing means buying mutual funds After all, its common knowledge that investing in mutual fund is (or at least should be) better than simply letting cash waste away in a saving account but for most people, that’s where the understanding of fund ends.

Mutual fund is a mechanism for pooling the resources by issuing unit to the investors and investing funds in securities in accordance with the objective as disclosed in offer document. Investment in securities is spread across a wide section of industry and sector and the risk is reduced. Diversification reduces the risk because all stock may or may not move in the same direction in the same proportion to their proportion at the same time. Mutual fund issues units to the investors in accordance with quantum of money invested by them. Investor of mutual are called unit holders.The profit or losses are shared by the investors in proportion to their investment. The mutual fund usually comes out with a number of schemes with different investment objectives which are launched from time to time. A mutual fund is required to be registered with the SEBI, which regulates securities markets before it can collect fund from the public.

A mutual fund is nothing more than a collective stock and /or bonds. You can think of a mutual fund as a company that brings together a group of people and invests their money in stock, bonds and other securities Each investors owns shares which represent a portion of holding of the fund.

In India, SEBI (Mutual Fund) Regulations, 1996 regulates the structure of mutual funds. Mutual funds in India are constituted in the form of a Public Trust created under The Indian Trusts Act, 1882.

History of mutual funds

The origin of mutual fund industry in India is with the introduction of the concept of mutual fund by UTI in the year 1963. Though the growth was slow, but it accelerated from the year 1987 when non-UTI players entered the industry.

In the past decade, Indian mutual fund industry had seen dramatic improvements, both quality wise as well as quantity wise. The mutual fund industry in India started in 1963 with the formation of unit Trust of India, at the initiative of the government if India and reserve bank.

1. First phase (1964-1987)

• The Unit Trust if India (UTI) was established in the year 1963 by passing an act in the parliament.
• 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, which is popularly known as US-64.
• At the end of 1988 UTI had Rs.6, 700 crores of assets under management.

2. Second phase (1987-1993)

• In the year 1987, public sector mutual funds setup by public sector banks, life insurance Corporation of India and general insurance of India are came in to existence.
• The end of 1993 marked Rs.47, 004 as assets under management
• The following are the non-UTI mutual funds at initial stages.
  1. SBI mutual fund in June 1987.
  2. Can bank mutual fund in December 1987.
  3. LIC mutual fund in June 1989.
  4. GIC mutual fund in June 1990
  5. Punjab National Bank mutual fund in august 1989.

3. Third phase (1993-2003)

• Entry of private sector funds- a wide choice to Indian investors in mutual fund.
• 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 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.
• As at the end of January 2003, there were 33 mutual funds with total assets of Rs. 1,21,805 crores.

4. Fourth phase (since 2003 February)

Following the repeal of the UTI act in February 2003, it was UTI bifurcated into 2 separate entities.

• One is the specified undertaking of the UTI with asset under management of Rs.29835/- crass at the end of January 2003
• 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.
• At the end March 2000 UTI had more than Rs.76,000 crores of AUM.

As at the end of September, 2004, there were 29 funds, which manage assets of Rs.153108 crores under 421 schemes

TYPE OF MUTUAL FUND SCHEMES

Wide variety of mutual fund schemes exists to cater to the needs such as financial position, risk tolerance and return expectations etc. the table below gives an overview into the existing types of schemes in the industry.

By structure

• Open-Ended schemes
• Close-Ended schemes
• Interval schemes

By investment objectives

• Growth/Equity schemes
• General purpose
• Money market
• Guilt funds
• Balanced schemes

Other schemes

• Tax saving schemes
• Sector specific schemes
• Index schemes

Open-ended schemes

A type of mutual fund where there are no restrictions on the amount of shares the fund will issue. If demand is high enough the fund will continue to issue shares no matter how many investors there are. Open-end funds also buy back shares when investors wish to sell.

Most of the funds available in the marketplace are open-end funds. Open-end funds are generally managed actively and are priced according to their net assets value (NAV). Open-end funds are wide ranging. Some open-end funds are more conservative and provide consistent returns with low risk, and some are more aggressive in seeking to make capital gains through constant trading.

Close-ended schemes

Under this scheme the corpus of the fund and its duration are prefixed. In other words the corpus of the fund and the number of units are determined in advance. Once the subscription reaches the pre-determined level, the entry of investors is closed. After the expiry of the fixed period, the entire corpus is disinvested and the proceeds are distributed to the various unit holders in proportion to their holdings. Thus, the fund ceases to be a fund, after the final distribution.

Close end schemes are usually more illiquid as compared to open-end schemes and hence trade at a discount to the NAV. This discount towards the NAV closer to the maturity date of the scheme.

Interval schemes

These schemes combine the features of open ended schemes. They may be traded on the stock exchange or may be open for sale or redemption during predetermined intervals at NAV based prices.

Growth/Equity schemes

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.

Equity schemes are hence not suitable for investors seeking regular income or needing to use their investments in the short term. They are ideal for investors who have a long term investment horizon. The NAV prices of equity fund fluctuates with market value of the underlying stock which are influenced by external factors such as social, political as well as economic.

General Purpose Equity Schemes

The investment objectives of general purpose equity schemes do not restrict them to invest in specific industries or sectors. They thus have a diversified portfolio of companies across a large spectrum of industries. While they are exposed to equity price risks, diversified general purpose equity funds seek to reduce the sector or stock specific risks through diversification. They mainly have market risk exposure.

These schemes, also commonly known as income schemes, investment in debt securities such as corporate bonds, debentures and government securities. These schemes are ideal for conservative investors or those who are not in a position to take higher equity risks. However, as compared to the money market schemes they do have a higher price fluctuations risk and compared to gilt fund they a higher credit risk.

These schemes invest in money market, bonds and debentures of corporate companies with medium and long term maturities. These schemes primarily target current income instead of capital appreciation. Hence, a substantial part of the distributable surplus is given back to the investor by way of dividend distribution. These schemes usually declare quarterly dividends and are suitable for conservative investors who have medium to long term investment horizon and are looking for regular income through dividend or steady capital appreciation. Reliance income and income plus fund are examples this schemes.

Money Market Schemes

These schemes invest in short term instruments such as commercial papers, certificates of deposits (CD’S), treasury bills (T-bill) and over night money (call). These schemes are the least volatile of all types of schemes because of their investments in money market instruments with short term maturities. These schemes have becomes popular with institutional investors and high net worth individuals having short term surplus funds.

Guilt Funds

These primarily invest in government debts. Hence, the investor usually does not have to worry about credit risk since government debt is generally credit risk free. Reliance Gilt Securities Fund – Short Term Gilt Plan & Long Term Gilt Plan are best example of such scheme.

Balanced Schemes

These schemes invest in both equities as well as debt. By investing in a mix of this nature, balanced schemes seek to attain the objective of income and moderate capital appreciation. Such schemes are ideal for investors with a conservative long term orientation. Reliance balanced fund is an example of such schemes.

Tax Saving Schemes

Investors (Individuals and Hindu undivided families (HUFs)) are being encouraged to invest in equity markets through equity linked savings scheme (ELSS) by offering them a tax rebate. Units purchased cannot be assigned/ transferred/ pledged/ redeemed/ switched-out until completion of 3years from the date of allotment of the respective units. The scheme is subject to securities and exchange board of India (Mutual Funds) regulations 1996 and the notifications issued by the Ministry of Finance (Department of economic Affairs), government of India regarding ELSS. Subject to such conditions and limitations, as prescribed under section 88 of the income tax act, 1961, subscriptions to the units not exceeding Rs.10000 would be eligible to a deduction, from income tax an amount equal to 20% of the amount subscribed. Reliance Tax Saver (ELSS) Fund is an example of such fund.

Sector specific equity schemes:

These schemes restrict their investing to one or more pre defined sectors e.g. technology sector. They depend upon the performance of these select sectors only and are hence inherently more risky than general purpose equity schemes. These schemes are ideally suited for informed investors who wish to take a view and risk on the concerned sector. Reliance Banking Fund, Reliance Diversified Power Sector Fund, Reliance Pharma Fund, Reliance Media & Entertainment Fund are perfect examples of sector specific funds.

Index schemes:

An index is used as a measure of performance of the market as a whole, or a specific sector of the market. It also serves as a relevant benchmark to evaluate the performance of mutual funds. Some investors are interested in investing in the market in general rather than investing in any specific fund. Such investors are happy to receive the returns posted by the markets. As it not practical to invest in each and every stock in the market in proportion to its size, these investor s are comfortable investing in a fund that they believe is a good representative of the entire market. Index funds are launched and managed for such investors. An example to such a fund is the Reliance index fund.

Advantages of investing in a Mutual Fund are:

• Diversification: The best mutual funds design their portfolios so individual investments will react differently to the same economic conditions. For example, economic conditions like a rise in interest rates may cause certain securities in a diversified portfolio to decrease in value. Other securities in the portfolio will respond to the same economic conditions by increasing in value. When a portfolio is balanced in this way, the value of the overall portfolio should gradually increase over time, even if some securities lose value.
• Professional Management: Most mutual funds pay topflight professionals to manage their investments. These managers decide what securities the fund will buy and sell.
• Regulatory oversight: Mutual funds are subject to many government regulations that protect investors from fraud.
• Liquidity: It’s easy to get your money out of a mutual fund. Write a check, make a call, and you’ve got the cash.
• Convenience: You can usually buy mutual fund shares by mail, phone, or over the Internet.
• Low cost: Mutual fund expenses are often no more than 1.5 percent of your investment. Expenses for Index Funds are less than that, because index funds are not actively managed. Instead, they automatically buy stock in companies that are listed on a specific index
• Transparency: mutual fund provide information on each scheme about the specific investment made there-under and so on
• Flexibility: currently most funds have regular investment plans, regular withdrawal plans and dividend reinvestment scheme. A great deal of flexibility is assured in the process.
• Choice of schemes: mutual funds offer a variety of schemes to suit varying needs of investors.
• Tax benefits: Tax Benefit under 80C
• Well regulated: The funds are registered with the Securities and Exchange Board of India and their operations are continuously monitored.

Mutual funds have their drawbacks and may not be for everyone:

• No Guarantees: No investment is risk free. If the entire stock market declines in value, the value of mutual fund shares will go down as well, no matter how balanced the portfolio. Investors encounter fewer risks when they invest in mutual funds than when they buy and sell stocks on their own. However, anyone who invests through a mutual fund runs the risk of losing money.
• Fees and commissions: All funds charge administrative fees to cover their day-to-day expenses. Some funds also charge sales commissions or “loads” to compensate brokers, financial consultants, or financial planners. Even if you don’t use a broker or other financial adviser, you will pay a sales commission if you buy shares in a Load Fund.
• Taxes: During a typical year, most actively managed mutual funds sell anywhere from 20 to 70 percent of the securities in their portfolios. If your fund makes a profit on its sales, you will pay taxes on the income you receive, even if you reinvest the money you made.
• Management risk: When you invest in a mutual fund, you depend on the fund’s manager to make the right decisions regarding the fund’s portfolio. If the manager does not perform as well as you had hoped, you might not make as much money on your investment as you expected. Of course, if you invest in Index Funds, you forego management risk, because these funds do not employ managers.

MAJOR PLAYERS

1. Bank Sponsored
   1. Joint Ventures – Predominantly Indian
      1. SBI Funds Management Private Ltd.
   2. Others
      1. BOB Asset Management Co. Ltd.
      2. Canbank Investment Management Services Ltd.
      3. UTI Asset Management Co. Private Ltd.
2. Institutions
   1. Jeevan Bima Sahayog Asset Management Co. Ltd.
3. Private Sector
   1. Indian
      1. Benchmark Asset Management Co. Private Ltd.
      2. Cholamandalam Asset Management Co. Ltd.
      3. Credit Capital Asset Management Co. Ltd.
      4. Escorts Asset Management Ltd.
      5. J. M. Financial Asset Management Private Ltd.
      6. Kotak Mahindra Asset Management Co. Ltd.
      7. Reliance Capital Asset Management Ltd.
      8. Sahara Asset Management Co. Private Ltd
      9. Sundaram Asset Management Co. Ltd.
      10. Tata Asset Management Ltd.
   2. Joint Ventures – Predominantly Indian
      1. Birla Sun Life Asset Management Co. Ltd.
      2. DSP Merrill Lynch Fund Managers Ltd.
      3. HDFC Asset Management Co. Ltd.
      4. Prudential ICICI Asset Management Co. Ltd.
   3. Joint Ventures – Predominantly Foreign
      1. ABN AMRO Asset Management (India) Ltd.
      2. Deutsche Asset Management (India) Private Ltd.
      3. Fidelity Fund Management Private Ltd.
      4. Franklin Templeton Asset Management (India) Private Ltd.
      5. HSBC Asset Management (India) Private Ltd.
      6. ING Investment Management (India) Private Ltd.
      7. Morgan Stanley Investment Management Private Ltd.
      8. Principal Pnb Asset Management Co. Private Ltd.
      9. Standard Chartered Asset Management Co. Private Ltd

Structure of the Indian mutual fund industry

The Indian mutual fund industry is dominated by the Unit Trust of India and which has a total corpus of Rs 700bn collected from more than 20 million investors .The UTI has many fund /schemes in all categories i.e. equity, balanced, income etc with some being open ended and some being closed ended. The United Scheme 1964 commonly referred to as US64, which is a balanced fund, is the biggest scheme with a corpus of about Rs 200bn URI was floated by financial institution and is governed by a special act of the parliament. Most of its investors believe that the UTI is government owned and controlled, which, while legally incorrect, is true for all practical purposes.

The second largest categories of mutual funds are the ones floated by nationalized banks. Can bank Asset management floated by Canara Bank and SBI Funds Management floated by the State Bank of India are the largest of these. GIC AMC floated by General Insurance Corporation and Jeevan Bima Sahayog AMC floated by the LIC are some of the prominent ones. The aggregate corpus of funds managed by this category of AMC’s is about Rs 150 billion

The third largest categories of the mutual funds are the once floated by the private sector and by the foreign asset management companies. The largest of these are Prudential ICICI AMC and Birla SUN LIFE AMC. The aggregate corpus of the asset managed by this category of AMC s is in excess of Rs 250bn.

Recent trends in the mutual fund industry

The most important in the mutual fund industry is the aggressive expansion of the foreign owned mutual fund companies and the decline of the companies floated by the nationalized bank and smaller private sector players.Many nationalized banks got into the mutual fund business in the early nineties and go off to a good start due to the stock market boom prevailing then. These banks did not really understand the mutual fund business and they just viewed it as another kind of banking activity. Few hired specialized staff and generally choose to transfer staff from the parent organization. Some schemes had offered guaranteed returns and their patent organization had to bail out these AMCs by paying large amount of money the difference between the guaranteed and actual returns. The service level was also bad. Most of these AMCs have not been able to retain staffs, float, and new schemes etc.and it is doubtful whether barring a few expectations, they have serious plans of continuing the activity in a major way.

The experience of some of the AMCs floated by private sector Indian companies was also very similar. They quickly realized that the AMCs business is a business, which makes money in the long term and requires deep pocketed support in the intermediate years. Some have sold out to foreign owned companies, some have merged with the others and there is general restructuring going on.

The foreign owned companies have deep pockets and have come in here with the expectation of a long haul. They can be credited with introducing many new practices such as new product innovation, sharp improvement in the service standards and disclosure, usage of technology, broker education etc.In fact, they have forced the industry to upgrade itself and service levels of the organization like UTI have improved dramatically in the last few years in response to the competition provided by these.

Future scenario

The asset base will continue to grow at an annual rate of about 30 to 35% over the next few years as investor’s shift their asset from banks and other traditional avenues. Some of the older public and private sector players will either close or be taken over.Out of ten public sectors players five will sell out, close down or merge with strong players in three to four years. In the private sector this trend has already started with two mergers and one takeover. Here too some of them will down their shutter in the near future to come.

But this does not mean there is no room for other players. The market will witness a flurry of new players entering the area. There will be a large number of offers from various asset management companies in times to come. Some big names like Fidelity, Principal and Old Mutual etc. are looking at Indian market seriously.

The mutual fund industry is awaiting the derivation in India as this would enable it to hedge its risk and this in turn would be reflected in its Net Asset Value (NAV).

SEBI is working out the norms for enabling the existing mutual fund scheme to trade in derivatives. Importantly, many market players have called on the Regulator to initiate the process immediately, so that the mutual funds can implement the changes that are required to trade in derivates.

Role of SEBI in mutual fund

In the year 1992 SEBI act was passed. The objectives of SEBI are – to protect the interest of investors in securities, to promote the development of, and to regulate the securities market. As far as mutual are concerned, SEBI formulates policies and regulation the mutual fund to protect the interest of the investors. SEBI notified regulation for mutual funds in 1993. Thereafter mutual fund sponsored by private sector entities were allowed to enter the capital market. The regulations were fully revised in 1996 and been amended. Therefore, from time to time SEBI has also issued guidelines to the mutual fund from time to time to protect the interest of the investors.

All mutual funds whether promoted by public sector or private sector entities including those promoted by foreign entities are governed by the same set of regulation. There is no distinction in regulatory requirement of the mutual fund and all are subject to monitoring and inspecting by SEBI. The risks associated with the scheme launched by mutual funds sponsored by these entities are of similar type