Mutual Funds

What is a Mutual Fund (MF)?

Common pool of funds contributed by investors and

invested in accordance to the objectives.

Investments are held in a trust of which the

investors alone are the joint beneficial owners.

Trustees oversee the management by investment

manager.
Structure of Mutual Fund
 What is an Asset Management Company (AMC)?

• Investment manager of the mutual fund.

• Appointed by the trustees, with SEBI approval.

• Trustees and AMC enter into an investment management agreement.

• Required to invest seed capital of 1% of amount raised subject to a maximum of Rs.50 lakh in
all open-ended schemes.

• Should have a net worth of at least Rs.50 crore at all times.

• At least 50% of members of the board of an AMC have to be independent.

• AMC of one mutual fund cannot be an AMC or trustee of another fund.

• AMCs cannot engage in any business other than that of financial advisory and investment
management
How does a Mutual Fund Work?

• Pool of investors
money.
• Invested according to
pre-specified
investment objectives.
• Benefits accrue to
those that contribute to
this pool.
• There is thus mutuality
in the contribution and
the benefit.
• Hence the name
‘mutual’ fund.
 Mutual Fund Advantages

• Broad diversification
• Diversified stock funds hold large and small company stocks
broadly spread across industries and economic sectors
• Diversified bond funds hold bonds with different maturities,
coupon, and credit quality

 Ability to retain professional investment management

at a reasonable cost
 Investor convenience
 Mutual Fund Disadvantages
 Volatility can be significant
 Diversification
doesn’t protect investors from the risk of
loss from an overall decline in financial markets
 Mutual fund regulation doesn’t eliminate the risk of an
investment falling in value

• High management fees and sales commissions

• Entry and Exit load funds
 Mutual fund expenses
• Operating expense ratio: total of investment advisory
fees and costs of legal and accounting services, etc.,
expressed as a percentage of the fund’s average net
assets (range from 0.2% to 2%)
• Lowest for money market mutual fund and highest
for international stock funds
• Tend to be lowest for large, liquid funds
• Load charges: one time sales commissions
• Front-end loads (charged at the time of purchase)
• Back-end loads (charged at the time of sales of
shares)
• Low-end funds: sales fee ranging from 1% to 3%
• 12b-1 fees: marketing and distribution costs
• No-load funds: fund without front-end or back-end
load charges
 Net asset Value

Market Value of Assets  Portfolio Liabilities

NAV 
# of Shares Outstanding
Example
– XYZ Mutual Fund owns assets totaling $10M and
liabilities equal to $500,000 with 500,000 shares
outstanding
– Therefore, NAV is:
 Net asset Value

• NAV: per share value of a mutual fund’s investment holding.

Market Value of Assets  Portfolio Liabilities

NAV 
# of Shares Outstanding

Example
• A mutual fund has $100 mil in assets and $3 mil in short term
liabilities. 10.765 mil shares outstanding. What is the NAV?
• Solution
($100 mil - $3 mil) / 10.765 mil = $9.0107 per share
• If a mutual fund’s net asset value is $30.00 and the fund
sells its shares for $31.00, what is the load fee as a
percentage of the net asset value?

• Load fee: $31- $30 = $1

• Load fee as a percent of net asset value: $1/$30 =
3.3333%
 Classification of Mutual Funds

Classification of Mutual Funds

Based on Investment Based on

Based on Structure
Objective Investment Style

Open Ended
Debt Funds Passive Funds
Funds

Closed Ended
Equity Funds Active Funds
Funds

Interval Funds Hybrid Funds

 Classification - Based on Structure

• No fixed maturity date.

Open Ended • Accept continuous sale and re-purchase requests.
• Transactions are NAV-based.
Funds • Unit capital is not fixed.

• Run for a specific period.

Closed • Offered in an NFO but are closed for further purchases
after NFO.
Ended Funds • Unit capital is kept constant.

Interval • Variant of closed-ended funds.

• Becomes open-ended at specific intervals.
Funds • Have to be mandatorily listed.
Classification - Based on Investment Objective

Debt • Invest in short and long term debt instruments.

• Aim to provide regular income.
Funds
Equity • Invest in equity securities.
• Aim to provide growth and capital appreciation over

Funds long term.

Hybrid • Invest in a combination of equity and debt securities.

• Proportion of equity and debt may vary.
• Aim to provide for both income and capital
Funds appreciation.
 Classification - Based on Investment Style

Passive
• Replicate a market index.
• Invest in same securities and in same proportion as that of
index.
• No active selection of any stock / sector.

Funds • Expenses are lower.

• Portfolio is modified every time index composition changes.

Active
• Invests in securities and sectors that may offer a better return
than the index.
• Actively manage the allocation to market securities and cash.
• May perform better or worse than the market index.

Funds • Incur a higher cost than passive funds.

• An investor buys shares in a mutual fund for $20 per
share. At the end of the year the fund distributes a
dividend of $2.00, and after the distribution the net asset
value of a share is $22.00. What would be the investor’s
percentage return on the investment?

• The investor received $2.00 and experienced

appreciation of $2 ($22-$20) for a total gain of $4.00.

• On an investment of $20, the return (for one year) is

• $4.00/$20 = 20%.
• A closed-end investment company is currently selling for
$10 and its net asset value is $10. You decide to
purchase 100 shares. During the year, the company
distributes $1 per share in dividends. At the end of the
year, you sell the shares for $12. At the time of the sale,
net asset value is $13. What percentage return do you
earn on the investment if no commissions were charged?

• The value of the shares rose from $1,000 to $1,200,

hence the capital gain is $200, and the company made a
distribution of $100.
• The percentage return is ($1200 + 100)/$1,000-1 = 30%
• A closed-end investment company is currently selling for $10 and
you purchase 100 shares. During the year, the company
distributes $1 in dividends. At end of the year, you sell the shares
for $12. The commission on each transaction (purchase and sale)
is $50. What percentage return do you earn on the investment?
• This problem adds the commissions on the purchase and sale.
• The percentage return is
• ($1200 + 100 – 50)/($1,000 + 50)-1
• = 19.05%
• You buy 100 shares in a mutual fund at its net asset
value of $10. The fund charges a load fee of 6 percent.
During the year, the mutual fund distributes $1 in
dividends. You redeem the shares for $12 per share,
and the fund does not charge an exit fee. What
percentage return do you earn on the investment?
• The percentage return
• = ($200 + 100)/($1,000 + 60)-1
• = 2.83%
• Unlike the commissions in the previous question, the
load fee is paid only when the shares are purchased.
• You buy 100 shares in a no-load mutual fund at its net
asset value of $10. During the year, the mutual fund
distributes $1 in dividends. You redeem the shares for
$12 per share, but the fund charges a 6 percent exit
fee. What percentage return do you earn on the
investment?
• The problem removes the upfront load fee but
introduces the exit fee.
• The percentage return
• = ($1,200 + 100 - $1,200 x 0.06)/($1,000)-1
• = 22.8%
• You buy 100 shares in a no-load mutual fund at its net
asset value of $10. During the year, the mutual fund
distributes $1 in dividends. You redeem the shares for
their net asset value of $13, and the fund does not
charge an exit fee. What percentage return do you earn
on the investment?
• In this problem, the investor acquires shares in a fund
that charges neither a load nor an exit fee. In addition,
the selling price is the net assets value of $13 so
capital gain is $300.
• The percentage return is ($300 + 100)/$1,000 = 40%.
 Categorization of Mutual Fund Schemes
 Categorization of open-end mutual funds:
- To ensure uniformity in characteristics of similar type of schemes launched by
different mutual funds.
- Helps investors to evaluate different options available before making informed
decision to invest.
Hybrid
Schemes

Debt
Schemes Solution oriented
Schemes

Categorization of
Equity
Schemes Mutual Fund Other
Schemes
Schemes
 How to invest in Mutual Funds?

Via Physical Mutual Via Online Mode

Fund Application (Website of Mutual
Form Fund)

Via AMFI Registered

Mutual Fund
Via Mobile App of
Distributor (using
Mutual Fund
physical form/ online/
mobile app)
 Investment Modes in Mutual Funds

Lump-sum • One time investment.

• Usually, large sum of money is invested in one go.
Investment • Investor faces risk of volatility in markets.

Systematic •
•
Staggered Investment.
Period of commitment - 6 months, 1 / 3 / 5 years.
Investment •
•
Specific intervals - monthly, quarterly, half-yearly.
Made on specific dates e.g. 1st, 5th, 10th, 15th of
Plan (SIP) every month.
 Investment Modes in Mutual Funds

Direct Mutual Fund Regular Mutual Fund

• Directly offered by fund house. • Bought through an
• No involvement of third party intermediary.
agents – brokers or • Intermediaries can be brokers,
distributors. advisors or distributors.
• No commissions and • Commissions and brokerage
brokerage. paid.
• Have low Expense ratio • High Expense ratio as there
(because of no commissions). are commissions to pay.
• Have high NAV. • Low NAV.
• Return is higher due to a lower • Return is lower due to a higher
expense ratio expense ratio
 Mutual Fund Plans – Growth vs Dividend Options

• Gains made in portfolio are retained and reflected in NAV.

Growth • Realized profit/loss is treated as capital gains or loss.
Option • No increase or decrease in number of units, except if units
are purchased or sold, by the investor.

• Fund declares dividend from realized profits.

Dividend • Amount and frequency varies and depends upon distributable
Payout surplus.
Option • NAV falls after dividend payout to the extent of dividend paid.

• Dividend is re-invested in same scheme by buying additional

Dividend units at ex-dividend NAV.
Reinvestment • Number of units standing to the credit of the investor,
Option increases each time a dividend is declared, and reinvested
back into the scheme.
 How to check information about
the Mutual Funds (Offer Document)?

Statement of • Contains generic and statutory information of

mutual fund.
additional • Contains financial information of mutual fund.
information • Lays down rights of investor.
• Other additional information.
(SAI)

• Scheme type (open or closed end).

Scheme • Investment objective.
• Asset allocation.
information • Investment strategies.
document •
•
Terms with regard to liquidity.
Fees and expenses.
(SID) • Other information relating to the scheme.

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 Risk-o-Meter and its importance

Six levels of risk for mutual fund Importance of Risk-o-meter :

schemes:
- Helps align risk that a fund carries with
i. Low Risk the risk profile of the investor.
ii. Low to Moderate Risk
iii. Moderate Risk - Equity as asset class: Volatile: High risk
iv. Moderately High Risk - Debt as asset class: Stable: Low risk
v. High Risk and - Hybrid: Moderate: Depends on
vi. Very High Risk allocation and concentration

20
Analyzing Mutual Funds
Mutual Funds Seek Relative Returns
• Most mutual funds invest in a predefined style, such as
"small cap value", or into a particular sector, such as
the technology sector.
• To measure performance, the mutual fund's returns
are compared to a style-specific index or
benchmark.
• For example, if you buy into a "small cap value" fund,
the managers of that fund may try to outperform the
S&P Small Cap 600 Index.
• Less active managers might construct the portfolio by
following the index and then applying stock-picking
skills to increase (overweigh) favoured stocks and
decrease (under weigh) less appealing stocks.
Analyzing Mutual Funds
• A mutual fund's goal is to beat the index or "beat the
bogey", even if only modestly.

• If the index is down 10% while the mutual fund is down only
7%, the fund's performance would be called a success.

• On the passive-active spectrum, on which pure index

investing is the passive extreme, mutual funds lie
somewhere in the middle as they semi-actively aim to
generate returns that are favorable compared to a
benchmark.
 Exchange Traded Funds
• A collection of security that trades on the stock market and is similar to a stock.

• An ETF tracks an index, a commodity or a basket of assets like an index fund, but
trades like a stock on an exchange.

• ETFs experience price changes throughout the day as they are bought and sold.

• Because it trades like a stock, an ETF does not have its net asset value (NAV)
calculated every day like a mutual fund does.

• By owning an ETF, you get the diversification of an index fund as well as the ability
to sell short, buy on margin and purchase as little as one share.

• Another advantage is that the expense ratios for most ETFs are lower than those of
the average mutual fund.

• When buying and selling ETFs, you have to pay the same commission to your broker
that you'd pay on any regular order.
 Exchange Traded Funds
• One of the most widely known ETFs is called the Spider (SPDR), which
tracks the S&P 500 index and trades under the symbol SPY.

• The easiest way to highlight the advantage of the ETF trading like a
stock is to compare it to the trading of a mutual fund.

• Mutual funds are priced once per day, at the close of business. Everyone
purchasing the fund that day gets the same price, regardless of the time of
day their purchase was made.

• Because, like traditional stocks and bonds, ETFs can be traded intraday,
they provide an opportunity for speculative investors to bet on the direction
of shorter-term market movements through the trading of a single security.