Unit 5 selection is based on the risk and return
analysis.
Portfolio Management
I. PORTFOLIO CONSTRUCTION:
The process of blending together the broad asset
classes so as to obtain optimum return with
minimum risk is called portfolio construction.
Two approaches in portfolio construction
--Traditional
--Markowitz efficient frontier approach
In traditional approach- the investor’s needs in terms
of income and capital appreciation are evaluated and
appropriate securities are selected to meet the same.
In Markowitz model, portfolios are constructed to
maximize the expected return for a given level of
risk.
Traditional Approach:
Steps in traditional approach
1. Analysis of constraints like income needs,
liquidity, time horizon, safety, tax
considerations and temperament.
2. Determination of objectives like current
income, growth in income, capital
appreciation, preservation of capital.
3. Selection of portfolio - bond and common
stock, bond, common stock.
4. Assessment of risk and return
5. Diversification – selection of industries,
selection of companies in the industry,
determining the size of participation
Markowitz Approach/Modern approach:
1. Markowitz gives more attention to the
process of selecting the portfolio.
2. The stocks are not selected on the basis of
need for income or appreciation, but the
1
3. The asset allocation process – choose the
portfolio that meets the requirement of the
investor.
 The risk taker – choose high risk
portfolio- getting the expected return.
 Investor with low risk tolerance- choose
low level of risk
 Neutral investor – choose medium level
of risk
4. Managing the portfolio –
 Passive approach – the investor
would maintain the percentage
allocation for asset classes and keep
the security holdings within its place
over the established holding period.
 Active approach- investor
continuously assesses the risk and
return of the securities within the
asset classes and changes them
accordingly.
Concept of MPT
1. The fundamental concept behind MPT is that
the assets in an investment portfolio should
not be selected individually, each on their
own merits. Rather, it is important to
consider how each asset changes in price
relative to how every other asset in the
portfolio changes in price.
2. Investing is a tradeoff between risk and
expected return. In general, assets with
higher expected returns are riskier. For a
given amount of risk, MPT describes how to
select a portfolio with the highest possible
expected return. Or, for a given expected
return, MPT explains how to select a
portfolio with the lowest possible risk
3. MPT is therefore a form of diversification.
Under certain assumptions and for
specific quantitative definitions of risk and
 return, MPT explains how to find the best
possible diversification strategy.
II. PORTFOLIO ANALYSIS:
The efficiency of each portfolio can be evaluated
only in terms of the expected return and risk of the
portfolio as such. Thus determining the expected
return and risk of different portfolios is a primary
step in portfolio management. This step is
designated as portfolio analysis.
Expected Return Of A Portfolio:
It is simply the weighted average of the return of the
individual securities held in the portfolio.
The average of a probability distribution of possible
returns, calculated by using the following formula:
E(R) = Expected Return of a portfolio
Pi = proportion of funds invested in security i
Ri = return on security i
OR
Where
 E[Rp] = the expected return on the portfolio,
 N = the number of stocks in the portfolio,
 wi = the proportion of the portfolio invested
in stock i, and
 E [Ri] = the expected return on stock i.
Risk of a portfolio:
The variance of return and standard deviation of
return are alternative statistical measures that are
used for measuring risk in investment.
2
Variance & Standard Deviation:
Variance for Two Assets:
σ² = X1² σ1² + X2² σ2² + 2(X1X2 ρ12 σ1σ2)
Variance for N assets:
Standard Deviation =
Covariance:
Covariance is a statistical measure of how 1
investment moves in relation to another.
Covariance between two securities A and B can
be calculated using the following formula:
 If 2 investments tend to be up or down
during the same time periods, then they
have positive covariance
 If the highs and lows of 1 investment
move in perfect coincidence to that of
another investment, then the 2 investments
have perfect positive covariance.
 If 1 investment tends to be up while the
other is down, then they have negative
covariance.
 If the high of 1 investment coincides with
the low of the other, then the 2 investments
have perfect negative covariance.
 If there is no discernable pattern to the up
and down cycles of 1 investment
 compared to another, then the
investments have no covariance.
Correlation:
 Because covariance numbers cover a
wide range, the covariance is
normalized into the correlation
coefficient, which measures the degree
of correlation, ranging from -1 for a
perfectly negative correlation to +1 for a
perfectly positive correlation.
2 Portfolio risk declining as the number of securities
in the portfolio increases, but the risk reduction
ceases when the unsystematic risk is eliminated.
II. PORTFOLIO SELECTION:
The proper goal of portfolio construction would
be to generate a portfolio that provides the highest
return and the lowest risk. Such a portfolio would
be known as optimal portfolio. The process of
finding the optimal portfolio is described as
portfolio selection.

 An uncorrelated investment For portfolio selection the following models can

pair would have a correlation coefficient be used.
close to zero.
 Markowitz model.

 Single index model

 Multiple index model

Reduction of Portfolio Risk through
Diversification: Markowitz model:

The process of combining securities in a portfolio Feasible set of portfolios:

is known as diversification. The aim of
diversification is to reduce total risk without With a limited number of securities an investor
sacrificing portfolio return. can create a very large number of portfolios by
combining these securities in different
proportions. These constitute the feasible set of
portfolios in which the investor can possibly
invest. This is known as the portfolio opportunity
set.

Each portfolio in the opportunity set is

characterised by an expected return and a measure
of risk.

A portfolio will dominate another if it has either a

lower standard deviation and the same expected
return as the other, or a higher expected return and
the same standard deviation as the other.

3
Portfolios that are dominated by other portfolios
are known as inefficient portfolios.
An investor would not be interested in all the
portfolios in the opportunity set. He would be
interested only in the efficient portfolios.
Efficient Frontier:
Consider portfolios A, B, C, D, E and F. Their
expected return is taken along Y axis and the SD
is taken along X-Axis.

Efficient set of portfolios:

To understand the concept of efficient portfolios,

let us consider the following example:

Portfolio Expected Standard

No Return% Deviation
1 5.6 4.5
2 7.8 5.8
3 9.2 7.6
4 10.5 8.1
5 11.7 8.1
6 12.4 9.3
7 13.5 9.5 From the graph, it is obvious that the portfolios F
8 13.5 11.3 and E have the same expected return but portfolio
9 15.7 12.7 E has less risk. Hence portfolio E would be
10 16.8 12.9 preferred to Portfolio F.

If we compare portfolio no. 4 and 5, for the same The portfolios C and E have same risk but
SD of 8.1, portfolio no. 5 gives a higher expected portfolio E offers more return for the same risk.
return of 11.7, making it more efficient than Hence portfolio E would be preferred to portfolio
portfolio no.4. C.

Again if we compare portfolio no.7 and 8, for the
same expected return of 13.5%, the SD is lower
for portfolio no.7, making it more efficient than
portfolio no.8. Thus, the selection of portfolios by
the investor will be guided by two criteria:
 Given two portfolios with the same
expected return, the investor would prefer
the one with the lower risk.
 Given two portfolios with the same risk,
the investor would prefer the one with the
higher expected return.
Thus in the risk return space, an investor would be
moving towards the left in search of decreasing
risk and upwards in search of increasing returns.
Portfolio C would be preferred to portfolio A
because it offers less risk for the same level of
return.
In the opportunity set of portfolios represented in
diagram, portfolio C has the lowest risk compared
to all other portfolios. Here portfolio C in the
diagram represents the global minimum variance
portfolio.

4
Similarly comparing portfolios A and B, we find
that portfolio B is preferable to portfolio A
because it offers higher return for the same level
of risk. Hence portfolio B represents portfolio
with highest expected return among all the
portfolios in the feasible set.
Thus we find that portfolios lying in the North
West boundary of the shaded area are more
efficient than all the portfolios in the interior of
the shaded area. This boundary of the shaded area
is called the efficient frontier because it contains
all the efficient portfolios in the opportunity set.
The set of portfolios lying between the global
minimum variance portfolio and the maximum
return portfolio on the efficient frontier represents
the efficient set of portfolios.
The efficient frontier is a concave curve in the risk
return space that extends from the minimum
variance portfolio to the maximum return
portfolio.
Selection of Optimal Portfolio:
Rational investors will obviously prefer to invest
in the efficient portfolios. The particular portfolio
that an individual investor will select from the
efficient frontier will depend on that investors’
5
degree of aversion of risk. A highly risk averse
investor will hold a portfolio on the lower left
hand segment of the efficient frontier, while an
investor who is not too risk averse will hold one
on the upper portion of the efficient frontier. The
optimal portfolio for an investor would be the one
at the point of tangency between the efficient
frontier and his risk-return utility or indifference
curve.
Single Index Model:
The basic notion underlying the single index
model is that all stocks are affected by movements
in the stock market.
The return on an individual security is assumed to
depend on the return on the market index. The
return of an individual security may be expressed
as:
Ri  i  i Rm  ei
Ri = Return on individual security
αi = components of security i’s return that is
independent of the market’s performance.
Rm = Market return
βi = constant that measures the expected change in
Ri given a change in Rm
ei = Error term representing the random or
residual return
For portfolio:
 Single Index Model for a portfolio of
stocks:
 R p   p   p Rm  e p 1. It refers to the evaluation of the
performance of the portfolio.
 The variance of Rp is: 2. It is essentially the process of comparing
the return earned on a portfolio with the

 p2   p2 m2   2 (ep )
return earned on one or more other
portfolios or on a benchmark portfolio.
3. Portfolio evaluation= performance
Multi-Index Model: measurement + performance evaluation

Many researchers have found that there are Measuring Portfolio Return:
influences other than market that cause stocks to
move together. ( NAVt  NAVt-1) + Dt + Ct
Rp =
NAVt  1
According to this model, return on security i is
NAVt = NAV per unit at the end of the holding
given by
period.
Ri = αi +βmRm+ β1R1+ β2R2+ β3R3+ei
NAVt-1 = NAV per unit at the beginning of the
No of parameters required to estimate the risk- holding period.
return of a portfolio using the Markowitz model is
Dt = cash disbursements per unit during the
2N + [N (N-1)/2] holding period.

No of parameters required to estimate the risk- Ct = capital gains disbursements per unit during
return of a portfolio using the Sharpe Index model the holding period.
is
Measuring the reward per unit of risk:
3N + 2
Sharpe Ratio (Reward to Variability ratio):
III. PORTFOLIO REVISION:

Portfolio revision involves changing the existing

mix of securities. This may be effected either by
changing the securities currently included in the
portfolio or by altering the proportion of funds
invested in the securities. The ultimate aim of
portfolio revision is maximisation of returns or
minimization of risk.

IV. PORTFOLIO EVALUATION:

6
Treynor’s Ratio: Assumptions:

1) All individual seller or buyer cannot affect

Jensen Measure:
Capital Asset pricing Model
Introduction:
 CAPM is a model for pricing an individual
security or portfolio.
 In finance, the capital asset pricing model
(CAPM) is used to determine a theoretically
appropriate required rate of return of
an asset, if that asset is to be added to an
already well-diversified portfolio, given that
asset's non-diversifiable risk.
 CAPM is concerned with two key questions
 What is the relationship between risk
and return for an efficient portfolio?
The concept:
(CML)
 What is the relationship between risk
and return for an individual security?
(SML)
the price of a stock i.e. all investors are price
takers.
2) All investors are rational and risk averse.
3) All information is available at the same time
to all investors.
4) All investors aim to maximize economic
utilities.
5) Investors make their decisions only on the
basis of the expected returns, standard
deviations and covariance of all pair of
securities.
6) All investors assumed to have homogeneous
expectations during the decision making
period.
7) The investor can lend and borrow any
amount of funds at the riskless rate of
interest.
8) No transaction cost i.e. no cost involved in
buying and selling of stocks.
9) No personal income tax
10) Assets are infinitely divisible. According to
this assumption, investor could buy any
quantity of share.
11) Unlimited quantum of short sales is allowed.
 We know CAPM is a model for pricing an
individual security or portfolio.

7
For individual security:
 Here we make use of security market line
(SML).
 Security market line (SML) is the graphical
representation of the Capital asset pricing
model. It displays the expected rate of return
of an individual security as a function of
systematic, non-diversifiable risk (its beta).
 The SML enables us to calculate the reward-
to-risk ratio for any security in relation to
that of the overall market.
 Therefore, when the expected rate of return
for any security is deflated by its beta
coefficient, the reward-to-risk ratio for any
individual security in the market is equal to
the market reward-to-risk ratio, thus:
 The market reward-to-risk ratio is effectively
the market risk premium and by rearranging
The efficient frontier:
the above equation and solving for E (Ri), we
obtain the Capital Asset Pricing Model
(CAPM).
8
 When used in portfolio management, the
SML represents the investment's opportunity
cost (investing in a combination of the
market portfolio and the risk-free asset).
 All the correctly priced securities are plotted
on the SML.
 The assets above the line are undervalued
because for a given amount of risk (beta),
they yield a higher return.
 The assets below the line are overvalued
because for a given amount of risk, they yield
a lower return.
 There is a question what the SML is when
beta is negative. A rational investor should
reject all the assets yielding sub-risk-free
returns, so beta-negative returns have to be
higher than the risk-free rate. Therefore, the
SML should be V-shaped
 CAPM assumes that the risk-return profile of
a portfolio can be optimized- an optimal
portfolio displays the lowest possible level of
risk for its level of return.
 Additionally, since each additional asset
introduced into a portfolio further diversifies
the portfolio. All such optimal portfolio
comprises the efficient frontier.
“Efficient frontier is the set of achievable
portfolio combinations that offer the highest
rate of return for a given level of risk. “
For pricing a portfolio:
 We make use of CML. It is the tangent line
drawn from the point of the risk free asset to
the feasible region for risky assets.
 The tangency point M represents the market
portfolio, so named since all rational
investors should hold their risky assets in the
same proportions as their weights in the
market portfolio.
 In the presence of a risk-free asset, all
efficient frontier lie on the CML.
 Investors hold only portfolios on CML.
 The risk of an efficient frontier portfolio is its
Standard deviation.
 CML gives the trade-off between portfolio
risk and return.
 The price of one unit risk for an efficient
portfolio is
9
Formula:
 All points along the CML have superior
risk-return profiles to any portfolio on
the efficient frontier, with the exception
of the Market Portfolio, the point on the
efficient frontier to which the CML is the
tangent.
 From a CML perspective, this portfolio is
composed entirely of the risky asset, the
market, and has no holding of the risk
free asset, i.e., money is neither invested
in, nor borrowed from the money market
account.
 Addition of leverage (the point R) creates
levered portfolios that are also on the
CML.
Implications: CML vs. SML:

 Every investor puts their money into two

 Both specify a relation between risk and
pots: the riskless asset and a single portfolio
Expected return:
of risky assets –tangent portfolio.

 All investors hold the risky assets in same Expected Return = “Time Premium” + “Risk

proportion; Premium”

-they hold the same risky portfolio, the Where

tangent portfolio.
“Risk Premium” = “quantity of risk” × “price
 The tangent portfolio is the market portfolio.
of risk”
 Combining the risk free asset and the market
portfolio gives the portfolio frontier.  Measure of risk.

 The risk of an individual asset is –In the CML, risk is measured by σ.

characterized by its co-variability with the
market portfolio. –In the SML, risk is measured by β.

 The part of the risk that is correlated with the  Applicability:

market portfolio, the systematic risk, cannot
be diversified away. –CML is applicable only to an investor’s
final (combined) portfolio (which is
-Bearing systematic risks need to be
efficiently diversified, with no unique risk)
rewarded.
.In the CAPM world, everybody holds
 The part of an asset’s risk that is not
portfolios which lie on the CML.
correlated with the market portfolio, the non-
systematic risk can be diversified away by –SML is applicable to any security, asset or
holding a frontier portfolio. portfolio (which may contain both
components of risk). In a CAPM world every
-Bearing non-systematic risk need not be
asset lies on the SML.
rewarded.

 For any asset i, Summary:

 The CML is a line that is used to show the
rates of return, which depends on risk-free
rates of return and levels of risk for a
specific portfolio. SML, which is also called

10
 a Characteristic Line, is a graphical
representation of the market's risk and return
at a given time.
 While standard deviation is the measure of
risk in CML, Beta coefficient determines the
risk factors of the SML.
 While the Capital Market Line graphs define
efficient portfolios, the Security Market Line
graphs define both efficient and non-
efficient portfolios.
 The Capital Market Line is considered to be
superior when measuring the risk factors.
 Where the market portfolio and risk free
assets are determined by the CML, all
security factors are determined by the SML.
Arbitrage Pricing Theory
Introduction:
 APT is one of the tools used by the investors
and portfolio managers.
 The CAPM explains the return of the
securities on the basis of their respective
betas.
 The alternative model developed in asset
pricing by Stephen Ross is known as APT.
 As its name implies the APT describes a
mechanism used by investors to identify an
asset such as a share of common stock, which
is incorrectly priced. Investors
subsequently bring the price of the security
back into alignment with its actual value.
Arbitrage:
It is a process of earning profit by taking
advantage of differential pricing for the same
asset. The profit generated is riskless. The APT
assumes that each stock’s return to the investors
is influenced by several independent factors.
Arbitrage Pricing Theory:
 The arbitrage pricing theory (APT) is a
multifactor mathematical model used to
describe the relation between the risk and
expected return of securities in financial
markets.
 It computes the expected return on a security
based on the security’s sensitivity to
movements in macroeconomic factors. The
resultant expected return can then be used to
price the security.
Assumption:
1. Capital Markets are perfectly competitive.
2. Investors always prefer more wealth to less
wealth.
3. Perfect competition prevails and there is no
transaction cost in the market: frictionless
market
4. Investors have homogeneous expectations.
Arbitrage portfolio:
can
 According to APT, an investor tries to find
out the possibility to increase returns from
his portfolio without increasing the funds in
11
 portfolio. He also likes to keep the risk at the
same level.
 For example investor holds A, B and C
securities and he wants to change the
proportion of the securities without any
additional financial commitment.
 The change in proportion of securities can be
denoted by XA, XB and XC.
 The increase in the investment in the security
A could be carried out only if he reduces the
proportion of investment either in B or C
because it has already stated that the investor
tries to earn more income without increasing
his financial commitment.
 Thus the changes in different securities will
add up to zero. This is the basic requirement
of an arbitrage portfolio.
∆XA+∆XB+∆XC=0
 The factor sensitivities indicate the
responsiveness of security’s return to a
particular factor. The sensitiveness of the
securities to any factor is the weighted
average of the sensitivities of the securities,
weights being the changes made in the
proportion.
bA∆XA + bB∆XB + bC∆XC=0
Arbitrage Mechanism:
 In the APT context, arbitrage consists of
trading in two assets – with at least one being
mispriced. The arbitrageur sells the asset
which is relatively too expensive and uses the
12
proceeds to buy one which is relatively too
cheap.
 When the investor is long the asset
and short the portfolio (or vice versa) he has
created a position which has a positive
expected return (the difference between asset
return and portfolio return) and which has a
net-zero exposure to any macroeconomic
factor and is therefore risk free (other than
for firm specific risk). The arbitrageur is thus
in a position to make a risk-free profit:
 Where today's price is too low:
The implication is that at the end of
the period the portfolio would have
appreciated at the rate implied by the
APT, whereas the mispriced asset
would have appreciated at more than
this rate. The arbitrageur could
therefore:
Today:
1 short sell the portfolio
2 buy the mispriced asset with the
proceeds.
At the end of the period:
1 sell the mispriced asset
2 use the proceeds to buy back
the portfolio
3 pocket the difference.
Where today's price is too high:
The implication is that at the end of the
period the portfolio would have appreciated
 at the rate implied by the APT, whereas the
mispriced asset would have appreciated
at less than this rate. The arbitrageur could
therefore:
Today:
1 short sell the mispriced asset
2 buy the portfolio with the proceeds.
At the end of the period:
1 sell the portfolio
2 use the proceeds to buy back the
inflation, spread between long term and short term
interest rates and spread between long grade and
high grade bonds.
Furthermore, Ross stated that the return on a stock
must follow a very simple relationship that is
described by the following APT formula:
Expected Return = rf + b1 (factor 1) + b2 (factor 2)... + bn
(factor n)
r = rf + β1f1 + β2f2 + β3f3 + ⋅⋅⋅+ βnfn

mispriced asset
Where:
3 pocket the difference.

The APT model:  rf = the risk free interest rate, which is the
interest rate the investor would expect to
There are two models of Arbitrage pricing theory: receive from a risk-free
investment. Typically, U.S. Treasury Bills
1. Two Factor Model, according to Stephen
are used for U.S. dollar calculations, while
Ross, returns of the securities are influenced
German Government bills are used for the
by a number of macroeconomic. Among
Euro
these: growth rate of industrial production,
 b = the sensitivity of the stock or security to
rate of inflation, spread (variability) between
each factor
short term and long term interest rates and
 factor = the risk premium associated with
spread (variability) between long-grade and
each factor
high-grade bonds.
2. According to the Single Factor Model the The APT model also states that the risk premium of
return is influenced only by the sensitivity, a stock depends on two factors:
i.e., the responsiveness of a security’s return
to a particular factor.  The risk premiums associated with each of
the factors described above
The APT formula:
 The stock's own sensitivity to each of the
According to Stephen Ross, returns of securities are factors; similar to the beta concept
influenced by a number of macroeconomic factors
such as growth rate of industrial production, rate of

13
Risk Premium = r - rf = b(1) x (r factor(1) - rf) +
b(2) x (r factor(2) - rf)... + b(n) x (r factor(n) - rf)
 If the expected risk premium on a stock were
lower than the calculated risk premium using
the formula above, then investors would sell
the stock.
 If the risk premium were higher than the
calculated value, then investors would buy
the stock until both sides of the equation
were in balance. Arbitrage is the term used
to describe how investors could go about
getting this formula, or equation, back into
balance.
MUTUAL FUNDS
MUTUAL FUND - CONCEPT
- A Mutual Fund is a trust that pools the savings of a
number of investors who share a common financial
goal.
- The money thus collected is then invested in
capital market instruments such as shares,
debentures and other securities.
- The income earned through these investments and
the capital appreciation realized is shared by its
unit holders in proportion to the number of units
owned by them.
Thus a Mutual Fund is the most suitable
investment for the common man as it offers an
opportunity to invest in a diversified,
professionally managed basket of securities at a
14
relatively low cost. Buying a mutual fund is like
buying a small slice of a big pizza.
Definition:
 As per the (SEBI) Mutual Fund
regulation, 1996 define ‘Mutual fund’ as a
fund established in the form of a trust to
raise monies through the sale of units to
the public under one or more schemes for
investing in securities, including money
market instrument. So, a mutual fund is a
special type of institution, a trust or an
investment company which acts as an
investment intermediary and channelizes
the saving of large number of people to the
corporate securities in such a way that
investors get steady returns, capital
appreciation and a low risk.
 As per Mutual Fund Book, published by
investment company institute of the U.S.,
“A Mutual Fund is a financial service
organization that receives money from
investors, invests it and earns returns on
it.
REGISTRATION OF MUTUAL FUND
 MF proposed by a sponsor has to be set up as
a trust under the Indian Trust Act, 1882, (and
not as a company under the Companies Act,
1956).
 All MFs should be registered with the SEBI.
 Overall the working of MFs is mainly
governed by UTI Act, 1963, Indian Trust
 Act, 1882, Companies Act, 1956, Securities  The sponsor (s), The Board of Trustees
Contract Act, 1956. (BOT) or Trust Company,
 Overall regulation of MF is done by the  Asset Management Company (AMC-
MOF of the Government of India, the RBI, conducts necessary research, and based on it,
and the SEBI. manages the fund or portfolio, and it is also
responsible for floating, managing,
redeeming the schemes),
MUTUAL FUND FLOW CYCLE /
 The custodian (responsible for co-ordinating
MECHANISM
with brokers, the actual transfer and storage
of stocks, and handling the property of the
Trust), and
 The Unit holders.

Cost related to MF:

 Management fees
 Non- management expenses
 Service fees
ORGANISATION OF A MUTUAL FUND  Investor fees and expenses
 Brokerage

Advantages of Mutual Fund

Professional Management

Mutual Funds provide the services of experienced

and skilled professionals, backed by a dedicated
investment research team that analyses the
performance and prospects of companies and selects
suitable investments to achieve the objectives of the
scheme.

Diversification
Key parties or players or special bodies or
Mutual Funds invest in a number of companies
constituents in organizing MFs are:
across a broad cross-section of industries and

15
sectors. This diversification of investment ensures
regular returns and capital appreciation at reduced
risk.
Convenient Administration
Investing in a Mutual Fund reduces paperwork and
helps you avoid many problems such as bad
deliveries, delayed payments and follow up with
brokers and companies. Mutual Funds save your
time and make investing easy and convenient.
Return Potential
Over a medium to long-term, Mutual Funds have the
potential to provide a higher return as they invest in
a diversified basket of selected securities.
Low Costs
Mutual Funds are a relatively less expensive way to
invest compared to directly investing in the capital
markets because the benefits of scale in brokerage,
custodial and other fees translate into lower costs for
investors.
Liquidity
A peculiar advantage of a mutual fund is that
investment made in its schemes can be converted
into cash without heavy expenditure on brokerage,
delays, etc. According to the regulation of SEBI, a
mutual fund in India is required to ensure liquidity.
Transparency
Investors get regular information on the value of
their investment in addition to disclosure on the
specific investments made by their scheme, the
16
proportion invested in each class of assets and the
fund manager's investment strategy and outlook.
Flexibility
Through features such as regular investment plans,
regular withdrawal plans and dividend reinvestment
plans, you can systematically invest or withdraw
funds according to your needs and convenience.
Affordability
Investors individually may lack sufficient funds to
invest in high-grade stocks. A mutual fund because
of its large corpus allows even a small investor to
take the benefit of its investment strategy.
Choice of Schemes
Mutual Funds offer a family of schemes to suit your
varying needs over a lifetime.
Well Regulated
All Mutual Funds are registered with SEBI and they
function within the provisions of strict regulations
designed to protect the interests of investors. The
operations of Mutual Funds are regularly monitored
by SEBI.
Problems of mutual fund in India
 Lack of Innovation.
 Inadequate Research.
 Conventional pattern of investment.
 No provision for performance guarantee.
 Inadequate disclosures.
 Delays in service
 No rural sector investment base
Management of mutual funds Repurchase Price

The mutual funds are bought and sold on the basis of (Market Value of Assets –
Liabilities) -
units, and the investors are called the unit holders (as
in the equity market, the investors are called (Brokerage Charges, Commission,
shareholders). Taxes, Stamp Duty, other
Management and Administrative
The governing body of mutual funds is SEBI. expenses)

When you invest in a mutual fund, you are buying Repurchase Price = ---------------------------------------------

units or portions of the mutual fund and thus on Number of fund’s units outstanding
investing becomes a shareholder or unit holder of the
fund. The investors profit and loss are determined as
per the units of mutual funds they hold as per the
NAVs.

Unlike a stock price, NAV changes constantly

(NAVt-NAVt-1) +Dividends
according to the forces of supply and demand, NAV + Capital Gains
is determined by the daily closing value of the
Rate of Return on Units = ----------------------------------
underlying securities in a fund's portfolio (total net
NAVt-1
assets) on a per share basis.
Where:
NAV = Net asset - Net liability….

No. of shares currently issued and outstanding NAV = Net Asset Value

Net asset= Market value of funds investment + t = Current Year

receivable + accrued income
t-1 = Previous Year
Sales Price
SEBI has provided the 4 tier system for managing
(Market Value of Assets – Liabilities) + the MFs. The 4 constituents’ are-:
(Brokerage Charges, Commission,
1. Sponsor - The sponsor initiates the idea to set up
Taxes, Stamp Duty, other Management
and Administrative expenses) a mutual fund. It could be a registered company,
scheduled bank or financial institution. A sponsor
Sales Price = --------------------------------------------------------
has to satisfy certain conditions, such as on capital,
Number of fund’s units outstanding
track record (at least five years' operation in

17
financial services), default-free dealings and a • Principal Underwriter-Sells fund shares,
general reputation of fairness. either directly to the public or through other
firms (such as broker dealers).
2. Trust/board of trustees- The sponsor appoints
• Transfer Agent- Executes shareholder
the trustees. Trustees hold the responsibility towards
transactions, maintains records of
unit holders by protecting their interests. Trustees
transactions and other shareholders' account
check the market schemes, and secure necessary
activities, and sends account statements and
approvals. They check if the AMC's investments are
other documents to shareholders.
within defined limits, whether the fund's assets are
• Independent Public Accountant- Certifies
protected, and also ensure that unit holders get their
the fund's financial statements
due returns

3. Custodian- It is an independent organization,

which takes custody of securities and other assets of
a mutual fund. In public sector mutual funds, the
sponsor or trustee generally also acts as the
custodian. Its responsibilities include receipt and
delivery of securities, collecting income, distributing
dividends, safekeeping of units and segregating
assets and settlements between schemes. Custodians
can service more than one fund.

4. Fund Managers/AMC-They are the ones who

manage your money. An AMC takes investment
decisions, compensates investors through dividends,
maintains proper accounting and information for
pricing of units, calculates the NAV, and provides
information on listed schemes and secondary market
unit transactions. It also submits quarterly reports to
the trustees. A fund's AMC can neither act for any
other fund nor undertake any business other than
asset management.

Except the above following authorities are also

related with the management of MFs.

18