You are on page 1of 162

Training on Mutual Funds

for AMFI Certification

Uma Shashikant
Prudential ICICI AMC Ltd
About the NCFM-AMFI Examination

• The exam is now available in 2 languages :


Hindi and English.
• Candidates can take the computer based
exam at the NSE centers or the written
exams arranged by Prudential ICICI or UTI,
and conducted by UTIICM.
• The computer based exam is only in English.
The written exam is in English and Hindi.
• Last date to clear the exam is December 31,
2003 for employees of mutual funds who
deal with customers (Sales, marketing and
customer care).
Format of the Exam

• Multiple choice examination


Example:
The NAV of an open-ended fund has to be disclosed
° Every Friday
° Every Monday
° Every Day
° None of the above
• All questions are multiple choice with four or
five options.
Marks
• The paper has 69 questions, with 38
questions of 1 mark each and 31 questions of
2 marks each.
• Candidates have to score a minimum of 50%
to pass.
• A wrong answer will lead to negative marking
of 25%.
– If you get a 2 mark question wrong,
you loose 2 marks for getting it wrong,
and 0.5 marks as penalty for the wrong
answer (25% of 2).
– The marks for each question is given along with
the question.
Question paper design

• Each chapter has a weightage: not


disclosed. Read the whole book.
• The question bank has questions stored
for each chapter.
• The paper is generated by the computer,
by randomly choosing from the bank.
• The question paper for each candidate is
different. In the written exam, there are
5 sets of papers in the hall.
Chapters and Weightages

No of
Chapter questions No of marks
1&2 6 7
3&4 2 3
5 4 4
6,7,8,9 14 22
10,11,12 7 10
13,14 4 6
15,16 7 11
17 - 22 25 37
69 100
Attempting the paper

• There are 2 hours to do the paper. Most


do it in 1 hour.
• Written exam:
– There is an answer sheet with boxes for each
question. Color the appropriate box with
pencil.
– Valuation is done using an optical reader.
Results are announced in 10 days
• NSE Online Exam
– Answers are chosen with the click of the
mouse
– Results is known as soon as the paper is
submitted.
Some tips

• It is not a great idea to read the paper


fully. Attempt questions as you see
them.
• Mark and keep aside questions for which
you are not sure of the answers. Revert
only to these questions.
• Do not revise and redo the questions
that have been already attempted.
• Remember the negative marking.
Session 1: Structure and Regulation

• Introduction
• Mutual fund products
• Sponsor-Trustee-AMC
• Other constituents
• Regulatory framework
• Merger and acquisitions
What Is a Mutual Fund?

A mutual fund is a pool of


money collected from investors
and is invested according to
stated investment objectives

Terms to know
– Mutual
– Pool
– Investment objectives
Characteristics of a Mutual Fund

• Investors own the mutual fund.


• Professional managers manage the
affairs for a fee.
• The funds are invested in a portfolio of
marketable securities, reflecting the
investment objective.
• Value of the portfolio and investors’
holdings, alters with change in market
value of investments.
Advantages of Mutual Funds

• Portfolio diversification
• Professional management
• Reduction in risk
• Reduction in transaction cost
• Liquidity
• Convenience and flexibility
Disadvantages of Mutual Funds

• No control over costs


• No tailor-made portfolios
• Issues relating to management
of a portfolio of mutual funds
Mutual Fund Products

• Open ended funds


– Initial issue for a limited period
– Continuous sale and repurchase
– Size of the fund changes as
investors enter and exit
– NAV-based pricing
Mutual Fund Products

• Closed end funds


– Sale of units by fund only during
IPO
– Listing on exchange and liquidity
for investors
– Size of fund is kept constant
– Price in the market is usually at a
discount
Equity Funds
• Pre-dominantly invest in equity
markets
– Diversified portfolio of equity shares
– Select set based on some criterion
• Diversified equity funds
– ELSS as a special case
• Primary market funds
• Small stock funds
• Index funds
• Sectoral funds
Debt Funds
• Predominantly invest in the debt
markets
– Diversified debt funds
– Select set based on some criterion
• Income funds or diversified debt funds
• Gilt funds
• Liquid and money market funds
• Serial plans or fixed term plans
Balanced Funds
• Investment in more than one asset
class
– Debt and equity in comparable proportions
– Pre-dominantly debt with some exposure to
equity
– Pre-dominantly equity with some exposure
to debt
• Education plans and children’s plans
Investment Options
• Investors can achieve income and
growth objectives in all funds
– Dividend option
• Regular dividend
• Ad-hoc dividend
– Growth option
– Re-investment option
• Most funds provide multiple options
and the facility to switch between
options
Basis for Classification
• Risk
– Sectoral funds are most risky; money market
funds are least risky
• Tenor
– Equity funds require a long investment
horizon; liquid funds are for the short term
liquidity needs
• Investment objective
– Equity funds suit growth objectives; debt
funds suit income objectives
Risk and Return

Sectora
l funds
Return Equity
funds
Index
funds
Balance
d funds
Debt
Funds
Gilt
funds
ST debt
funds Risk
Liquid
funds
Fund Structure &
Constituents

• 3-tier structure
– Sponsor
– Trustee
– AMC
Sponsor

• Promoter of the the mutual


fund
• Creates AMC and appoints
trustees
• Criteria
– Financial services business
– 5-year track record
– 3-year profit making record
– At least 40% contribution to AMC
capital
Trustees

• Fiduciary responsibility for


investor funds
• Appointed by sponsor with
SEBI approval
• Registered ownership of
investments is with Trust
• Board of trustees or Trustee
Company
• Appoints all other constituents
Trustees
• At least 4 trustees
– 2/3 should be independent
• Trustees of one mutual fund
cannot be trustee of another
mutual fund
– Independent trustee
– Board approval
• Right to seek regular
information and remedial
action
• All major decisions need
Asset Management Company
• Responsible for operational
aspects of the mutual fund
• Investment management
agreement with trustees
• Registered with SEBI
• Rs. 10 crore of net worth to be
maintained at all times
• At least 1/2 of the board
members to be independent
Asset Management Company
• Appoints other constituents
• Cannot have any other
business interest
• Structured as a private limited
company
– Sponsor and associates hold
capital
• AMC of one MF cannot be
trustee of another MF
• Quarterly reporting to Trustees
Other Constituents
• Custodian
– Investment back-office
• Registrar and Transfer agent
– Investor records and transactions
• Broker
– Purchase and sale of securities
– 5% limit per broker
• Auditor
– Separate auditor for AMC and
mutual fund
Regulatory Framework
• SEBI (Mutual Fund) Regulations,
1996
• RBI as regulator
– Guarantees of sponsors in bank-
sponsored mutual funds
– Regulator of G-Secs and money
markets
• Stock exchange
– listed mutual funds
Regulatory Framework
• Companies Act
– AMCs and Trustee Company
– DCA as regulator
– RoC for Compliance
– CLB for prosecution and penalties
• Office of the public trustee
– Registration
– Complaints against trustees
UTI: Differences
• Formed as a trust under UTI
Act, 1963
• Voluntary submission to SEBI
regulation
• No separate sponsor or AMC
• Major Differences
– Assured return schemes
– Different accounting norms
– Ability to take and make loans
Self-regulatory Organisations
• Derive powers from regulator
• Ability to make bye-laws
• Example : Stock exchanges
• Industry Associations
– Collective industry opinion
– Guidelines and recommendation
– Example: Association of Mutual
Funds in India
Mergers and Acquisitions
• Scheme takeover
– One AMC buys schemes of
another AMC
– Organic growth in assets
– No change in AMC stakes
• AMC merger
– Two AMCs merge
– Similar to merger of companies
– Sponsor stakes change
Mergers and Acquisitions
• AMC take-over
– Stake of one sponsor in a AMC
bought out by another sponsor
– Change in AMC and sponsor
• Investor rights
– No prior approval needed
– Option to exit at NAV
– Right to be informed
• Uma Shashikant
• Head, Training and Development
• Prudential ICICI AMC Ltd
• Contractor Bldg, III Floor
• Ballard Estate, Mumbai –400 038
• Ph: 283 4325/269 7989 Ext 325
• Email:uma_shashikant@pruicici.com
Session 2: Offer Document

• Offer Document
• Key Information Memorandum
• Application and form of holding
• Distribution channels
• Investors rights
• Taxation of Income and capital gain
• NAV and Load
Offer Document
• Legal offer from AMC to
investor
• Contains vital information
about Fund and schemes
• SEBI approved format
• KIM is a mandatorily enclosed
to application forms
• Investor has no recourse for
not having read the OD/KIM
Period of Validity
• Updated every 2 years for OEFs
• Regular Addendum for results
• Updated for every major
change
• Change in the AMC or Sponsor of
the mutual fund.
• Change in the load structures.
• Changes in the fundamental
attributes of the schemes.
• Changes in the investment
options to investors; inclusion or
deletion of options.
Fundamental Attributes
• Scheme type
• Investment objective
• Investment pattern
• Terms of the scheme with
regard to liquidity
• Fees and expenses
• Valuation norms and
accounting policies
• Investment restrictions
Changes in Fundamental
Attributes
• Investors have right to be
informed
• Public announcement by AMC
• Option to exit without load
• SEBI and Trustee approval
• New offer document
Contents of Offer Document
• Preliminary information
• Summary information about the mutual
fund, the scheme and the terms of offer.
• Mandatory disclaimer clauses as required
by SEBI.
• Glossary of terms in the offer document,
which defines the terms used.
• Standard and scheme specific risk
factors pertaining to the scheme being
offered.
Fund Specific Information
• Constitution of fund, details of
sponsor, trustees and AMC.
• Financial history of sponsor(s) for
3 years, in summary form.
• Director of Boards of the trustees
and the AMC.
• Details of key personnel of the
AMC.
• Details of Fund constituents
Details of the Scheme
• Dates of IPO
• details regarding sale and
repurchase.
• Minimum subscription and face value
• Initial issue expenses
• current scheme and the past
schemes.
• Special facilities to investors
• Eligibility for investing
• documentation required.
• Procedure for applying, and subsequent
operations relating to transfer, redemption,
nomination, pledge and mode of holding of
units.
Loads and Expenses
• Load and the annual recurring
expenses
• Proposed scheme and other
schemes
• Comparison with offer document
numbers
• Scheme expenses (3 years)
• Condensed financial
information (3 years)
Unit Holder Rights
• Rights of unit holders
• services
• information
• protection of rights and problem
resolution.
• Details of information disclosure and
their periodicity.
• Documents available for inspection
• Details of pending litigation and
penalties
Unit Holder Rights
• Cannot sue the mutual fund
• Complaints against AMC, sponsor
and BoT
• 75% unit holders can
• wind up a scheme
• seek AMC termination
• Prospective investor has no
rights
• Right to redeem for
fundamental changes
Associate Transactions
• Summary information on associate
companies being used as
constituents.
• Summary information of associates
investing in schemes of the mutual
fund.
• Summary information on investment
made by mutual fund schemes in
associate company securities.
Verification and Due Diligence
• SEBI: Format and Content
• Trustee Approval
• Compliance Office certifies that
– information contained therein is true
and fair
– is in accordance with SEBI regulations
– constituents of the fund are all SEBI
registered entities.
• The AMC is responsible for the
contents and the accuracy of
information
Investing in a Fund Scheme
• Units or amount
• Certificates and account
statement
• Minimum amount
• Initial offer and subsequent
buying
• List of eligible investors
– Check eligibility with offer document
– Foreign investors not eligible (FII
Regulations)
• Documents for classes of
investors
Distribution Channels

• Individual agents
• Distribution companies
• Banks and NBFCs
• Direct marketing channels
Individual Agents

• Wide network
• No exclusivity
• Certification
– New agents from November 2001
– Exiting agents by March 2003
• Commission structure
– Initial and Trail
• Loyalty and volume incentives
Institutional Distributors

• Banks
– HNIs and personal banking
• Distribution companies
– NBFCs
– Service and collection
– Advisory
• Direct Marketing
– Direct Service Agents
– Investor Service Centres
Procedure

• Proof of purchase
– Certificate
– Account statement
• Application
– Joint holding
– Minor
– Nomination
– PAN number
– Tax status
– Folio number
– Bank details
NAV and Load
• Sale and repurchase price are NAV-based
– Cut-off time for NAV
• Load is a charge on the NAV
– Entry load is charged on NAV
and increases the sale price
– Exit load is charged on NAV and
reduces the repurchase price
• Load is defined as a percentage
• CDSC is variable exit load, charged
depending on duration of stay in the fund
• Loads are subject to SEBI Regulation and
vary depending on industry practice
Entry Load : Example

If the entry load (sales load) for a scheme is 1.5%


and the NAV of the scheme is Rs. 24.50, the investor
who wants to buy the units will not be able to buy at
Rs. 24.50. He will pay

= 24.5 + (24.5*1.5/100)

= 24.5 + 0.3675

= 24.8675
Exit Load : Example

If a fund imposes an exit load of 1.25%, the


investor who repurchases his units, will get
a price that is:

= 24.5 – (24.5*1.25/100)

= 24.5 - 0.30625

= 24.19375
SEBI Regulations : Load
There are 2 regulatory requirements:

– The sale price cannot be more than


107% of the NAV and the repurchase
price cannot be less than 93% of the
NAV. That is, the maximum load can be
only 7%.

– The repurchase price cannot be less than


93% of the sale price.

– For a close ended fund, the limits are set


at 5% of NAV.
Example
If the NAV is Rs. 10,
• Sale price cannot be higher than Rs.
10.7.
• Repurchase price cannot be lower
than Rs. 9.3.
• However, the mutual fund cannot
charge both these prices.
• If the sale price is Rs. 10.7, the
repurchase price cannot be lower
than Rs. 9.95 (10.7*0.93).
• If the repurchase price is Rs. 9.3, the
sale price cannot be higher than
Rs.10 (9.3/0.93).
Taxation
• Mutual fund is exempt from paying
taxes (Section 10 (23D))
• Income for investors
– Dividend
– Capital gain
• Present position (AMFI examination)
– Dividend exempt from tax.
– Fund pays dividend distribution tax
at 10%.
– Open end funds with >50% in equity,
fully exempt. No tax is paid by the
fund or the investor.
Taxation:Finance Act 2002-03
• Dividend fully taxable in the
hands of investors
– TDS @10% for dividends above Rs.1000
– Deductions under Section 80L along with
other interest and dividend income, up to
Rs. 9000.
• Section 88 benefit reduced
– GTI less than 1.5 lakhs :20%
– GTI >1.5 lakhs < 5 lakhs:15%
– GTI > 5 lakhs, no rebate.
Treatment of Capital Gains

• Long term: > 12 months


• Short term: < 12 months
• Long term capital gains subject to
indexation benefit
– 20% +surcharge after indexation
– 10% + surcharge without indexation
– Applicable surcharge for the exam:
2%
• Short term capital gains taxed at
marginal rate of taxation.
Indexation
• Investor buys on March 31,
1999 and sells on April 1, 2000.
What is the indexation
adjustment factor?
– 1998-99 - 351
– 1999-2000 - 386
– 2000-01 - 406
• Investor buys on April 1, 1998
and sells on March 31, 2001.
What is the indexation
adjustment factor?
Capital Markets and Mutual
Funds
• Equity
– Market and products
– Asset classes
– Investment styles
– Value indicators
• Debt
– Debt markets
– Terminology
– Yield and duration
– Investment styles
• Investment restrictions
Equity Investment

• Investment Options
– Equity shares
– Preference shares
– Convertibles
– Equity with Warrants
Investment Strategies
• Growth and value
• Active and passive
• Large and small cap
• Cyclical stock
• Stock selection
– P/E ratio
– Dividend yield
– Undervalued companies
• Fundamental analysis
• Technical analysis
• Quantitative analysis
Debt Markets
• Tenor
– short and long
– put and call options

• Interest payment
– Fixed and floating
– Periodic vs discounted

• Credit quality
– Gilt, guaranteed, and others

• Traded and non-traded


Price and Yield
• Increase in rates reduces value of
existing bonds.
• Decrease in rates increases value
of existing bonds
• Price and yield are inversely
related
• The relationship between yield
and tenor can be plotted as the
yield curve.
Current Yield and YTM

• Coupon as a percentage of
current market price
• If we bought a 8% bond at Rs.
110, the current yield is:

= (8/110)*100
= 7.27%
Yield to Maturity

• Rate at which present value of future


cash flows equals the current market
price.
• Given price, YTM can be calculated
through iteration.
• Given YTM, price can be computed,
using the YTM rate to discount the
future cash flows.
Interest Rate Sensitivity

• Measured by a number called


duration.
• If duration is 3 years, and
interest changes by 1%, price
of the bond will change in the
opposite direction, by 3%.
Example

• Example: Duration of a bond is


4 years. Yield spreads
increases by 1.5%. what is the
change in price?

• = 1.5 *4

• = -6%
Credit Risk

• Probability of default by the


borrower

• Change in credit rating:


– downgrade increases the yield
and decreases the price
– upgrade decreases the yield and
increases the price.
Debt Portfolio Management
Styles
• Buy and hold
– Portfolio exposed to interest rate risk.
• Duration management
– increase duration if rates are expected to
fall
– decrease duration if rates are expected
to rise
• Credit selection
– invest in low grade bonds that are likely
to be upgraded.
Investment Restrictions

• Invest only in marketable


securities.
• Investment only on delivery
basis
• A mutual fund under all its
schemes, cannot hold more
than 10% of the paid-up capital
of a company.
Investment Restrictions

• Not more than 10% of its NAV in a single


company.
– Exceptions: Index Funds and Sectoral funds
• Rated investment grade issues of a
single issuer cannot exceed 15% of the
net assets
– Can be extended to 20%, with the approval of
the trustees.
• Investment in unrated securities of one
company cannot exceed 10% of the net
assets of a scheme and not more than
25% of net assets of a scheme can be in
such securities.
Investment Restrictions

• Investment in unlisted shares cannot


exceed
– 5% of net assets for an open-ended scheme,
– 10% of net assets for a close-ended scheme.
• Mutual funds can invest in ADRs/GDRs
– up to a maximum limit of 10% of net assets
or $50 million, whichever is lower.
– The limit for the mutual fund industry as a
whole is $500 million.
• Mutual funds can also invest in a limited
manner in treasury bonds and AAA rated
corporate debt issued outside India.
Inter-scheme Transfer

– Such transfers happen on a


delivery basis, at market prices.
– Such transfers should not result in
significantly altering the
investment objectives of the
schemes involved.
– Such transfer should not be of
illiquid securities, as defined in
the valuation norms.
– One scheme can invest in another
scheme, up to 5% of net assets.
No fee is payable on these
investments.
Investment in Sponsor
Company
– A mutual fund scheme cannot
invest in unlisted securities of the
sponsor or an associate or group
company of the sponsor.
– A mutual fund scheme cannot
invest in privately placed
securities of the sponsor or its
associates.
– Investment by a scheme in listed
securities of the sponsor or
associate companies cannot
exceed 25% of the net assets of
Other Limits
• Mutual funds cannot make loans
• Mutual funds can borrow upto
20% of net assets for a period not
exceeding 6 months.
• Derivatives can be used only after
informing investors
• Any change in investment
objectives requires information to
investor, and provision of option
to exit at NAV, without exit load.
Accounting and Valuation
Aspects
• Net assets
• Accounting policy
• Initial issue expenses
• Operating expenses: Limits
• AMC fees
• Disclosure and reporting norms
• Valuation norms
Net Assets
• Market value of investments
• Plus current assets and other
assets
• Plus accrued income
• Less current liabilities and other
liabilities
• Less accrued expenses
• NAV = Net assets/Number of
units
Factors Impacting NAV

Sale and purchase of securities

Cannot impact NAV by more than 2%

Sale and repurchase of units

Cannot impact NAV by more than 2%

Valuation of assets

Accrual of income and expenses

Cannot impact NAV by more than 1%
Frequency of NAV Calculation
• Everyday by 8.00 p.m on AMFI
website
• Open ended funds: Daily
• Close ended funds: weekly
• Exempt funds: CEFs which are
not listed (UTI’s Monthly
income schemes)
Historic and Prospective NAV
• Business day definition and
applicable NAV are stated in
the offer document
• Cut off time for each scheme is
also announced.
• Prospective NAV applies to
applications made before the
cut-off time.
Accounting Policies
• Investments to be marked to market
according to SEBI Guidelines.
• Unrealised appreciation cannot be
distributed.
• Profit or loss on average cost basis.
• Dividend on ex-dividend date.
• Sale and purchase accounted on
trade date.
• Brokerage and stamp duties are
capitalised and added to cost of
acquisition or sale proceeds.
Sources of Income
• Interest
• Dividend
• Profit from sale of investments
• Other income
• Extra-ordinary income
Initial Issue Expenses
• Expenses incurred in floating
schemes
• Limit of 6%; excess expenses to
be borne by AMC/sponsor
• CEF : Amortise on weekly basis
until maturity
• OEF : Amortise over period not
exceeding 5 years
• No-load fund: additional fees
Operating Expenses
• Investment management fees
• Custodian’s fees
• Trustee Fees
• Registrar and transfer agent fees
• Marketing and distribution expenses
• Operating expenses
• Audit fees
• Legal expenses
• Costs of mandatory advertisements
and communications to investors
Limits on Expenses
• For net assets up to Rs. 100 crore:
2.5%
• For the next Rs. 300 crore of net
assets: 2.25%
• For the next Rs. 300 crore of net
assets: 2%
• For the remaining net assets:
1.75%
• Applied on the weekly average
net assets of the mutual fund
scheme.
• On debt funds the limits on
expenses are lower by 0.25%.
Expenses that cannot be
charged
• Penalties and fines for infraction of laws.
• Interest on delayed payments to unit holders.
• Legal, marketing and publication expenses
not attributable to any scheme.
• Expenses on investment and general
management.
• Expenses on general administration,
corporate advertising and infrastructure costs.
• Expenses on fixed assets and software
development expenses.
• Such other costs as may be prohibited by
SEBI.
Investment Management
Fees
• For the first Rs. 100 crore of net
assets: 1.25%
• For net assets exceeding Rs. 100
crore: 1.00%
• 1% higher fee for no load funds
• Balance of DRE not included in net
assets for computing investment
management fee and expense
limits.
Reporting Requirements
• Audited accounts within 6 months of
closure of accounts.
• Publish within 30 days of the closure
of the half-year, unaudited abridged
accounts.
• Summary of the accounts has to be
mailed to all unit holders.
• File with SEBI:
– A copy of the annual report
– Six monthly unaudited reports
– Quarterly movement in net
assets of the fund
– Quarterly portfolio statements
Specific Disclosures
• Complete portfolio to be
disclosed every six months.
– Industry practice: monthly
disclosure.
• Any item of expenditure which
is more than 10% of total
expenses
• NPAs, provisioning, NPAs as %
of total assets.
• Number of unit holders holding
more than 25% of unit capital.
Non Performing Asset

An asset shall be classified as an


NPA,
if the interest and/or principal
amount have not been received or
have remained outstanding for one
quarter, from the day such
income/installment has fallen due.

Such assets will be classified as


NPAs, soon after the lapse of a
quarter from the date on which
payments were due.
Treatment of NPAs

• Accrual to be stopped.
• Income accrued until date of
classification to be provided for.
• Provisioning for principal due
– In graded manner after 3 months
of classification.
– Complete write off in 15 months
from classification
Valuation Principles

• Market price for all frequently


traded securities
• Illiquid and thinly traded equity
– Valuation procedure
• Debt:
– < 182 days accrual principal.
– > 182 days common valuation
methodology
• Illiquid securities to not exceed
15% of net assets.
Valuation: Equity

• Market price for Liquid shares


– Price should not be more than 30 days old
• Fair valuation for Illiquid shares
– Earnings based SEBI approved model
• Fair Valuation for Thinly traded shares
– Less than Rs. 5 lakh value and Less than
50,000 shares
Valuation Debt

• YTM based for Gilt and Corporate


securities with investment grade rating
• 25% discount for speculative grade
performing assets
• NPA norms for NPAs
• Accrual for money market securities
Liquid securities

• Last traded price in the


exchange where the security
is principally traded.
• Previous traded date as long
as such date is not over 30
days ago.
Thinly Traded Securities

• Equity shares
–Traded value in a month is less
than Rs. 5 lakhs; and
–Total volume of shares traded is
less than 50,000 shares a month.
• Debt security
–Traded value of less than Rs. 15
crore in the 30 days prior to the
valuation date.
Valuation of Thinly Traded
Equity
• Book value of the share
• Earnings capitalisation value
– Discount the industry P/E
by 75%
• Average of the two methods
– 10% discount for illiquidity
• Earning capitalisation is zero if
– EPS if negative
– Accounts not available for
9 months after closing
date.
• If illiquid securities are more than 5% of
the portfolio, independent valuation to
Valuation of a Thinly Traded
Debt Security (<182 Days)

For example, if a security was issued at Rs.


90 and redeemable at Rs. 100, after 364
days, the accrued interest for each day
is
= 10/364
= 0.02747
The value of the security is increased by
2.747 paise every day, so that the
security is worth Rs. 100 on the date of
maturity.
If it has to be valued 200 days after
issuance, its value is
90+(0.02747*200)
Valuation of other debt securities
(>182 days)
• G-Secs are valued at market prices or
using the CRISIL Gilt valuer.
• Corporate bonds are valued at market
prices or using the CRISIL Bond valuer.
• Both these methods use duration to
classify bonds and assign a rate for each
duration bucket.
Session 6: Risk and Return
• Return Methods
– Change in NAV
– Total Return
– Total Return with dividend re-
investment
– CAGR
• Risk
– Standard deviation
– Beta and Ex-Marks
• Benchmark and comparison
Computing Returns
• Sources of return
– Dividend
– Change in NAV
• Return = Income earned for
amount invested over a given
period of time
• Standardise as % per annum
Alternate Methodologies
• Computing return
– Percentage change in NAV.
– Simple total return
– ROI or Total return with
dividend re-investment
– Compounded rate of growth
Percentage Change in NAV
• Assume that change in NAV is the
only source of return.
• Example:
– NAV of a fund was Rs. 23.45 at
the beginning of a year
– Rs. 27.65 at the end of the year.
• Percentage change in NAV
= (27.65 – 23.45)/23.45 *100
= 17.91%
Annualising the Rate of
Return
If NAV on Jan 1, 2001 was Rs. 12.75 and
the NAV on June 30, 2001 was Rs. 14.35,

Percentage change in NAV


= (14.35 – 12.75)/12.75 x 100
= 12.55%

Annualised return:
= 12.55 x 12/6
= 25.10%
Total Return
Investor bought units of a mutual fund
scheme at a price of Rs.12.45 per unit.
He redeems the investment a year later, at
Rs. 15.475 per unit.
During the year, he also receives dividend
at 7%.
The rate of return on his investment can
be computed as
=((15.475 – 12.45) + 0.70)/12.45 x 100
= (3.725/12.45) x 100
= 29.92%
Total Return or ROI
Method
• (Value of holdings at the end of the
period - value of holdings at the
beginning of the period)/ value of
holdings at the beginning of the period x
100
• Value of holdings at the beginning of the
period = number of units at the
beginning x begin NAV.
• Value of holdings end of the period =
(number of units held at the beginning
+ number of units re-invested) x end
NAV.
• Number of units re-invested =
dividends/ex dividend NAV.
ROI Method: Example
An investor buys 100 units of a
fund at Rs. 10.5 on January 1,
2001. On June 30, 2001 he
receives dividends at the rate of
10%. The ex-dividend NAV was
Rs. 10.25. On December 31,
2001, the fund’s NAV was Rs.
12.25.

What is the total return on


investment with dividends re-
invested?
ROI Method: Solution
• The begin period value of the
investment is = 10.5 x 100 =
Rs. 1050
• Number of units reinvested
= 100/10.25 = 9.756 units
• End period value of investment
= 109.756 x 12.25 = Rs. 1344.51
• The return on investment is
=(1344.51-1050)/1050 x 100
= 28.05%
Compounded Annual Growth
Rate
• CAGR is the rate at which
investment has grown from begin
point to the end point, on an
annual compounding basis.

V0(1+r)n = V1

r =((V1/V0)1/n)-1

Where n is the holding period in


years.
CAGR: Example 1

An investor buys 100 units of a fund


at Rs. 10.5 on January 6, 2001. On
June 30, 2001 he receives dividends
at the rate of 10%. The ex-dividend
NAV was Rs. 10.25. On March 12,
2002, the fund’s NAV was Rs. 12.25.

Compute the CAGR.


CAGR: Solution

• The begin period value of the investment is

= 10.5 x 100 = Rs. 1050


• Number of units reinvested
= 100/10.25 = 9.756 units
• End period value of investment
= 109.756 x 12.25 = Rs. 1344.51
• Holding period = 6/01/01 - 12/3/02
= 431 days
• The CAGR is
=(1344.51/1050)365/431 - 1 x 100
= 23.29%
Returns: Industry Practice
• Growth Option: CAGR implicit in
the change in holding period
NAVs.
• Dividend Option: CAGR implicit in
the change in value over the
holding period, assuming re-
investment of dividend at ex-
dividend NAV.
• Less then 1 year, simple return
without compounding or
annualisation.
• Some funds use simple
annualised return, without
compounding.
SEBI Regulations

• Standard measurements and


computation
• Compounded annual growth rate
for funds over 1 year old.
• Return for 1,3 and 5 years, or
since inception, which ever is
later.
• No annualisation for periods less
than a year.
Risk in Mutual Fund Returns
• Risk arises when actual returns
are different from expected
returns.
• Historical average is a good proxy
for expected return.
• Standard deviation is an
important measure of total risk.
• Beta co-efficient is a measure of
market risk.
• Ex-marks is an indication of
extent of correlation with market
index.
Benchmarks
• Relative returns are important
than absolute returns for mutual
funds.
• Comparable passive portfolio is
used as benchmark.
• Usually a market index is used.
• Compare both risk and return,
over the same period for the fund
and the benchmark.
• Risk-adjusted return, is the return
per unit of risk.
SEBI Guidelines
• Benchmark should reflect the
asset allocation
• Same as stated in the offer
document
• Growth fund with more than 60%
in equity to use a broad based
index.
• Bond fund with more than 60% in
bonds to use a bond market
index.
• Balanced funds to use tailor-made
index
• Liquid funds to use money market
instruments.
Other Measures of Performance
• Tracking error
– Tracking error for index funds should be
nil.
• Credit quality
– Rating profile of portfolio should be
studied
• Expense ratio
– Higher expense ratios hurt long term
investors
• Portfolio turnover
– Higher for short term funds and lower for
longer term funds.
• Size and portfolio composition
Session 7: Financial Planning

• Concept of financial planning


• Mapping life cycles and wealth cycles
• Financial products
• Asset allocation
• Model portfolios
• Fund selection
What is Financial Planning?
•Financial planning comprises
–Defining a client's profile and goals
–Recommending appropriate asset
allocation
–Monitoring financial planning
recommendations
•The objective of financial planning is to
ensure that the right amount of money is
available at the right time to the investor
to be able to meet his financial goals.
•Tax implications on investment income
can affect the choice of products and the
financial plan.
•Financial planning is more than mere
tax planning.
Steps in Financial Planning

• Steps in financial planning are:


– Asset Allocation
– Selection of fund
– Studying the features of a scheme
• Financial planning is concerned only with
broad asset allocation, leaving the actual
selection of securities and their management
to fund managers.
• A fund manager has to closely follow the
objectives stated in the offer document,
because financial plans of investors are chosen
using these objectives.
Investor and Financial Planner

• The financial planner can only work with


defined goals and cannot take up larger
objectives that are not well defined.
• The client is responsible ultimately for
realizing the goals of the financial plan.
• The basis of genuine investment advice
should be financial planning to suit the
investor's situation
• Risk tolerance of an investor is not
dependent on the market, but his own
situations.
Who is a Financial
Planner?
• Is a person who uses the financial
planning process to help another person
determine how to meet his or her life
goals
• Key functions of a FP is to help people
identify their financial planning needs,
priorities and the products that are most
suitable to meet their needs
Benefits of Financial
Planning
• Provides direction and
meaning to financial
decisions
• To understand how each
financial decision effects
other areas of one’s finances
• By viewing each financial
decision as part of a whole
one can consider its short
and long term effects on
MFs in Financial Planning

• Forms the core foundation and


building block for any type of
FP
• Variety of products available to
suit any need or combination of
needs
• Barring life and property
insurance, rest of the product
portfolio can be created out of
bouquet of MFs
Why should a Fund
distributor become an FP
• Strong potential demand for such
services

• Limited supply of financial


planners

• Ability to establish Long term


relationships

• Ability to build a profitable


Attributes of a Good Financial
Planner

Understands:
• The universe of investment products
• Risk-return attributes
• Tax and estate Planning

• Has the ability to convert life cycles


of investors into need and preference
based financial products
• Organised approach to work
• Excellent communication and
interpersonal skills
Process of FP in Practice

• Step I: Establish and define


the relationship with the client

• Step II: Define the client’s


goals

• Step III: Analyse and evaluate


client’s financial status

• Step IV: Determine and shape


the client’s risk tolerance level
Process of FP in practice

• Step V: Ascertain client’s tax


situation

• Step VI: Recommend the appropriate


asset allocation and specific
investments

• Step VII: Executing the plan

• Step VIII: Periodic Review


Life Cycle and Wealth Cycle

• Life Cycle classification of investors


– Childhood stage
– Young adult
– Young married with children
– Middle age
– Retirement
– Post retirement
• The ability of an investor to save, his income
and dependence on investment income, his
investment horizon and risk taking ability
depend on the phase of the life cycle he is in.
Wealth Cycle Classification

• Accumulation Stage
– Investor is earning and has ability to invest and
requires no supplementary income from investments
• Transition Stage
– Investor is able to save, but has also started drawing
on his investments to meet his financial goals.
• Distribution Stage
– Investor is not earning and has ability to invest has
reduced and requires supplementary income from
investments
Other Wealth Stages

• Inter-generational Fund Transfer


– The investment of funds depends on the the
beneficiary
• Sudden Wealth Surge
– Investments on funds from winnings and
lotteries to be done carefully. It is safe to
invest in a short tern fund and allocate
assets later.
• Affluent Investors
– Wealth creating investors prefer to invest in
equity
– Wealth preserving investors prefer to invest
in debt
Products Available

• Physical Assets – Gold & Real Estate


• Bank Deposits
• Corporate –Shares, Bonds,
Debentures & Fixed Deposits
• Government – G. Secs, PPF, RBI
Relief Bonds and other personal
Investments
• Financial Institutions – Bonds, Shares
• Insurance Companies – Insurance
Policies
Physical assets

• Investors like the idea of physical


possession of gold and property.
• These products are believed to be
hedges against inflation.
• These products are illiquid and cannot be
sold easily.
• For purchase of property, initial
investment may be very high.
Bank Deposits
• Available since a long period of time
• Large geographical network –
transactions made easy &
convenient
• Fund transfer mechanism available
• Perception of bank deposits being
free of default; Deposits guaranteed
up to Rs 1 lakh per depositor
• Electronic facilities make it liquid
and easy to use
PPF
• 15 years deposit product made
available through banks.
• 9.5% p.a. interest payable on
monthly balances
• Minimum Rs. 100 & maximum Rs.
60,000 p.a investment allowed.
• Tax benefits u/s 88 under IT Act.
• Interest receipt and withdrawal of
principal exempt from tax.
• Limited liquidity available. 50% of
the balance at the end of the 4th year
can be withdrawn from the 7th year.
RBI Relief Bonds

• Issued by banks on behalf of the RBI


• Tenure of five years
• 8.5% p.a. interest payable s.a.
• Proposed to be converted to floating
rate instrument linked to
government yields
• Option to receive or reinvest interest
• Interest income exempt from tax
Other Government Schemes

• IVP & KVP issued by central


government & sold by post
offices
• Interest is taxable
• Investor identity is protected
and investment in cash is
possible
Other Government Schemes

• Post office savings and RD –


gives fixed rate of interest but
are not liquid.
• These are government
guaranteed deposits
• Attractive for their safety and
cash investment options
Instruments issued by
companies
• Commercial Paper
– Short term borrowing of companies
• Debentures
– Secured borrowings of companies
• Equity Shares
– Liquid but no assurance of principal
• Preference Shares
– Fixed dividend form post tax profit
• Fixed Deposits
– Unsecured borrowings. Not liquid.
• Bonds of FI
– Unsecured borrowings
How to Compare Products

• Compare options by nature of


investments – Characteristics,
benefits and risks.
• Current performance and
suitability
– Taxability, age, risk profile.
Why MF is the Best Option

• Mutual funds combine the


advantages of each of the
investment products
• Dispense the short comings of
the other options
• Returns get adjusted for the
market movements
Strategies for Investors

• Harness the power of


compounding
• Start early
• Have realistic expectations
• Invest regularly
Useful Strategies

• Rupee Cost Averaging


• Value Averaging
• Jacob’s rebalancing strategy
• Graham’s 50:50 rebalancing
strategy
Rupee Cost Averaging

° Invest regularly a
predetermined amount

° Invests in more units when


the market is low; less when
the markets are high.

° Reduces the average cost of


purchase
Rupee Cost Averaging
Amount NAV Number Cum Value of
I nvested per of units number of holding
(Rs) unit bought units
1000 12.5 80.00 80.00 1000.00
1000 11.25 88.89 168.89 1900.00
1000 10.75 93.02 261.91 2815.56
1000 11 90.91 352.82 3881.03
1000 12.75 78.43 431.25 5498.47
1000 13.35 74.91 506.16 6757.22
1000 13.85 72.20 578.36 8010.30
1000 14.45 69.20 647.57 9357.32
1000 13.85 72.20 719.77 9968.78
1000 13.5 74.07 793.84 10716.86
Average cost 12.60
Value Averaging

 Invest regularly to achieve a


predetermined value

 Books profits at a high, and


adds units at the low, and
enables meeting financial goals.

 Reduces the average cost of


purchase
Value Averaging
Target NAV Per Value Of Units Cumulative
Value Unit Holding To Balance
I nvest
1000 12.5 0.00 80 80
2000 11.25 900.00 97.78 177.78
3000 10.75 1911.11 101.29 279.07
4000 11 3069.77 84.57 363.64
5000 12.75 4636.36 28.52 392.16
6000 13.35 5235.29 57.28 449.44
7000 13.85 6224.72 55.98 505.42
8000 14.45 7303.25 48.22 553.63
9000 13.85 7667.82 96.19 649.82
10000 13.5 8772.56 90.92 740.74
Asset Allocation and Model
Portfolios
• Deciding the allocation of funds
amongst equity, debt and
money market.
• Incorporating product, investor
profile and preferences in the
portfolio.
• Equity, debt and money market
products are called asset
classes. Allocating resources to
each of these is called asset
allocation.
Graham’s Model Portfolio

• Based on the 50:50 rule.


• Basic managed portfolio.
• Basic indexed portfolio.
• Simple managed portfolio.
• Complex managed portfolio.
• Readymade portfolio.
Bogle’s Strategic Asset Allocation

• Combine age, risk profile and


preferences in asset allocation
– Older investors in distribution phase
• 50% equity;50% debt
– Younger investors in distribution phase
• 60% equity; 40% debt
– Older investors in accumulation phase
• 70% equity; 30% debt
– Younger investors in accumulation phase
• 80% equity; 20% debt
Fixed and Flexible Asset
Allocation
• Fixed ratio between asset classes
– Portfolio has to be periodically re-
balanced
– Disciplined approach
– Enables investor to book profits in a
rising market and invest more in a falling
market.
• Flexible allocation
– No re-balancing; asset class proportions
can vary when prices change.
– If equity returns are higher than debt
returns, equity allocation will go up at a
faster rate.
Developing a Model Portfolio

• Develop long term goals


– Investment avenues, time horizon, return
and risk
• Determine asset allocation
– Allocation to broad asset classes
• Determine sector distribution
– Allocation of sectors of the mutual fund
industry
• Select specific fund schemes for
investment
– Compare products and choose actual
funds to invest in
Jacob’s Model Portfolios

• Accumulation phase
– Diversified equity: 65 - 80%
– Income and gilt funds: 15 - 30%
– Liquid funds: 5%
• Distribution phase
– Diversified equity: 15 - 30%
– Income and gilt funds: 65 - 80%
– Liquid funds: 5%
Fund Selection
• Equity funds: Characteristics
– Fund category
• Suitability to investor objective
– Investment style
• Growth vs Value
– Age of the fund
• Experience preferred to new fund
– Fund management experience
– Size of the fund
• Larger funds have lower costs
– Performance and risk
Equity Funds: Selection
Criteria
• Percentage holding in cash.
• Concentration in portfolio.
• Market capitalisation of the fund.
• Portfolio turnover.
• Risk Statistics
– Beta
– Ex-Marks
– Gross dividend yield
– Funds with low beta, high ex-marks and
high gross dividend yield is preferable
Debt Funds: Selection Criteria
– A smaller or new debt fund may
not necessarily be risky
– Total return rather than YTM is
important
– Expense very important
• High expense ratios lead to yield
sacrifice
– Credit quality
• Better the rating of the holdings, safer
the fund
– Average maturity
• Higher average maturity means
higher duration and interest rate risk
Money Market Funds
– Liquidity and high turnover
rate
• Shorter term instruments are
turned over more frequently.
– Protection of principal
invested
• NAV fluctuation limited due to
low duration and low levels of
interest rate risk.
– Credit quality of portfolio
– Low expense ratio
Thank you and all the very
best!!

You might also like