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

Sectoral
funds
Return Equity
funds
Index
funds
Balanced
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 trustee
approval
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 the scheme
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 be done
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)
= 95.494
 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 one’s life goals
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 business

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
Invested 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
Invest
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!!