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.

• 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 questions 6 2 4 14 7 4 7 25 69

Chapter 1&2 3&4 5 6,7,8,9 10,11,12 13,14 15,16 17 - 22

No of marks 7 3 4 22 10 6 11 37 100

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 Index funds Balance d funds Equity funds

Debt Funds ST debt funds Gilt funds


Liquid funds

Fund Structure & Constituents
• 3-tier structure
– Sponsor – Trustee – AMC


• 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

• 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

• 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 banksponsored 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

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 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 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

• 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.

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).

• 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 hands of investors in the
– 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.

• 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 markets Terminology Yield and duration Investment styles

• Debt

• 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: 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 borrower of default by the

• 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% Cannot impact NAV by more than 2%


Sale and repurchase of units



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%.

• 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.

Expenses that cannot be charged

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 investment – CAGR with dividend re-

• 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 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 reinvested?

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 reinvestment of dividend at exdividend 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.

• 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? the financial • Is a person who uses
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

• 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

• Commercial Paper • Debentures

Instruments issued by companies
– Short term borrowing of companies – 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 Value Unit Holding 1000 2000 3000 4000 5000 6000 7000 8000 9000 10000 12.5 11.25 10.75 11 12.75 13.35 13.85 14.45 13.85 13.5 Units Cumulative To Balance I nvest 0.00 80 80 900.00 97.78 177.78 1911.11 101.29 279.07 3069.77 84.57 363.64 4636.36 28.52 392.16 5235.29 57.28 449.44 6224.72 55.98 505.42 7303.25 48.22 553.63 7667.82 96.19 649.82 8772.56 90.92 740.74

• 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.

Asset Allocation and Model Portfolios

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 rebalanced – 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!!

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