NPTEL Course

Course Title: Security Analysis and Portfolio Management

Instructor: Dr. Chandra Sekhar Mishra

Module-3
Session-6
Organization and Function of Equity and Debt Markets
Outline
Mutual Fund Concept
Players in Mutual Fund Industry
Types of Mutual Funds
Mutual Funds Performance Evaluation
Mutual Fund: A Mutual Fund is a trust that pools the savings of a number of investors who share a
common financial goal. The money thus collected is then invested in capital market instruments such as
shares, debentures and other securities. The income earned through these investments and the capital
appreciation realised are shared by its unit holders in proportion to the number of units owned by them.
Thus a Mutual Fund is the most suitable investment for the common man as it offers an opportunity to
invest in a diversified, professionally managed basket of securities at a relatively low cost1. The holders of
mutual fund units are known as unit holders. The profits or losses are shared by unit holders in proportion
to their investment.
Figure 5.1: Mutual Fund Operation Flow Chart

www.amfiindia.com

Source: www.amfiindia.com
Players in Mutual Fund Industry in India
Role of Mutual Funds in Financial Market and Economic Growth
Channelisation of Household Savings into investment
Augmenting Resource Mobilization in the Primary Market
Substantiating Small Investors Investment Avenues
Providing Liquidity Facility (entry and exit options) to Investors
Contributing to Growth in GDP
Advantages of investing in Mutual Funds
Professional Management: The funds are managed by managers having requisite qualification
and experience.
Diversification: Instead of putting the investment in a limited number of instruments, the investor
can have benefit of investing indirectly in several instruments.
Return Potential and Low Costs: Because of large amount of money collected from the investors,
the AMCs have got the scale to invest in number of instruments of different issuers. This can lead
to lower operating cost and better return potential.
Liquidity: The mutual fund units can be traded in market. The AMCs also facilitate entry and exit
options for schemes like open ended. When needed, investors can convert the mutual funds into
cash.
Transparency: The AMCs are required to disclose about investments in different instruments and
the charges are also informed to the investors. This ensures transparency in the end use of money
collected from investors.
Flexibility and choice of schemes: The investors have plethora of schemes of different mutual
funds and can be flexible in their investment objective like growth, income or mix of growth and
income.
Tax benefits: Investment in select mutual funds can have help reduce the tax burden of the
investors.
Well regulated: the entire process of mutual fund is well regulated by regulatory authorities. In
India it is regulated by SEBI.
Structure / Organization of a Mutual Fund
Sponsor: Sponsors are like promoter of a company (here mutual fund). Typically financial
companies act as sponsors.
Asset Management Company (AMC): AMC manages funds by making investments into different
types of securities as mandated by the fund objective.
Board of Trustees: The trustees are vested with the general power of superintendence and
direction over AMC. They monitor the performance and compliance of SEBI Regulations by the
mutual fund.
Custodians: Registered with SEBI (in case of India) custodian holds the securities of various
schemes of the fund in its custody.
Securities and Exchange Board of India (SEBI) in case of India: All mutual funds are required to
be registered with SEBI before they launch any scheme. SEBI Regulations require that at least
two thirds of the directors of trustee company or board of trustees must be independent i.e. they
should not be associated with the sponsors. Also, 50% of the directors of AMC must be
independent.
2

Unitholders: The investors holding the units of mutual fund scheme have rights in proportion to
their investment.
Figure 5.2: Organization of a Mutual Fund

Source: www.amfiindia.com
Key Terms in Mutual Fund:

Net Asset Value (NAV): The NAV of a mutual fund is the total value of investments held by a
mutual fund scheme. This varies daily since the prices of the securities held for the mutual fund
scheme also vary. The NAV per unit is the market value of securities of a scheme divided by the
total number of units of the scheme on any particular date. Sale Price
Sales price: the price that is charged when one invests in a mutual fund unit.
Repurchase Price: the price charged by the AMC while buying back an unit of an open ended
scheme.
Redemption Price: The price at which the close ended schemes are redeemed and cash given to
the investors.
Sales Load/ Front-end Load: The charge collected by a unit while a fund sells the units.
Repurchase or Back-end Load: The charge collected by a unit while a fund repurchases the
units from unit holders.

Types of Mutual Fund Schemes: Mutual fund schemes can be classified on the basis of different criteria
as below:
By Structure:
Open-Ended Fund: An open-ended fund is a collective investment which can issue and redeem
shares at any time. Example: Axis Triple Advantage Fund; Birla Sun Life Freedom Fund.
Close-Ended Fund: It can issue shares of mutual fund only in the beginning and cant redeem or
reissue till the end of their fixed investment duration. Example: Templeton India Childrens Asset
Plan-Education Plan; UTI - Infrastructure Advantage Fund.

By Investment Objective:
Growth Fund: These funds provide the opportunity for capital appreciation and invests major part
of the corpus in equity shares. These funds are also known as equity schemes. The investors
might not get any regular income (i.e. dividend) on the units held. These funds are suitable for
investors having an appetite for risk and those who are comfortable waiting for a long term i.e. 3
years or more. These funds provide options to investors in terms of capital appreciation/ dividend.
Example: AIG India Equity Fund- Regular Plan- Growth Option; Baroda Pioneer PSU Equity
Fund- Dividend Option;
Income Fund: The aim of these funds to provide regular and steady income to the unit holders.
Such schemes invest in debt securities like g-secs, corporate bonds and money market
instruments. Such schemes are comparatively less riskier compared to equity schemes. However
the opportunity for capital appreciation is limited. These funds are suitable for retired people.
Example: FT India Monthly Income Plan-Monthly Dividend; HDFC High Interest FundQuarterly Dividend Option;
Balance Fund: Such funds provide both growth and income to investors and invest the corpus in
equity as well as debt securities. The risk involved in such schemes is moderate. Example:
Fidelity India Children's Plan - Marriage Fund; ICICI Prudential Balanced Plan;
Specialized Fund: The investment of a particular fund can be limited to a particular sector/ type of
instruments of investment etc. These funds are targeted towards investors who would like to an
exposure to a particular sector or class. Examples:
Sectoral fund (invests in stocks of companies in a specific industry/ sector): Prudential-ICICI
Technology; Money market Fund (invests in money market instruments): Reliance Liquid Plan,
BOB Liquid Fund, UTI Money Market Fund
Offshore Fund (Invests in International Market): Magnum Fund.
Tax Savings Funds (investors get tax rebate/ exemption by investing in such schemes): GIC Tax
Saver, UTI Master Equity Plan, Franklin India Taxshield,

Classification Based on management Style: There are two broad types of investment strategies
viz. Active and Passive. Passive strategy is a strategy of holding a portfolio of securities without
attempting to outperform other investors through superior market forecasting. Types of Passive
Portfolios are:
o Index Funds: It attempts to design a portfolio to replicate the performance of a specific
index i.e. benchmark index. The difference arises between benchmark index and portfolio
because of cash flow, company mergers and bankruptcies.
o Customized Funds: In this case the benchmark index is a customized rather than a
published index. This has been made because of two reasons viz. constraints on allowable
securities and to provide adequate diversification.
o Factor/Style Funds: This type of fund replicates a benchmark geared to mimic the
performance of a given stock factor such as growth, small capitalization or high yield.
o It can also be specialized or titled towards specific sector or industries such as the energy
sector.
Other Categorizations: Some of the funds may not fit the types as discussed above. Some such
funds are:
o Contra Fund: Diversified equity funds are mutual funds that invest in the shares of
various companies in different sectors. In this respect, a contra fund is a diversified equity
4

fund. It parts company with other diversified equity funds in the types of stocks it
chooses to invest in. As the name suggests, it follows a contrarian view to investing. This
means the fund manager will deliberately bypass the popular stocks that everyone else is
chasing. Instead, he will invest in companies that are not in fashion. Usually the fund
managers invest in undervalued stocks fulfilling criteria fundamental strength,
underperformance and change in the business environment. Examples: JM Contra, Tata
Contra, UTI Contra, ING Contra, etc.
Quant Funds: These funds make the investment decision based on quantitative analysis
and simulation. Distributors usually do not advise the retail investors in favour of quant
funds because of complications involved.
Example:
Reliance Quant Fund: 20 stocks are chosen from the Nifty universe, based on
fundamentals, valuations, momentum and quality of management and with application of
a quantitative model based on these parameters which was back-tested for the last 10
years. Every Friday, screening is done and the fund managers take a call to buy or sell a
certain stock.
Benchmarks Strap: Tactical Asset Allocation Programme: Under the assumption of a
mean reversion, equity exposure under the scheme is raised at lower prices and reduced
at higher prices.

Mutual Funds Performance Evaluation: Different types of techniques are suggested for evaluating
fund performance. Credit rating agencies also rate different mutual fund schemes. Some of the techniques
are explained below.
Total Return (TR) = (Dividend + Change in NAV) / NAV at Beginning of the Period
Expense Ratio: Ratio of total recurring expenses to average net assets. Small funds have higher
expense ratios. Smaller average account size funds have larger expense ratio. Stock funds have
larger expense ratio. Offshore funds have higher expense ratio
Portfolio Turnover Rate
o Amount of Buying and selling done by management
o Lesser of assets purchased or sold / funds net assets
Size of the Fund
Analyzing fund management (Comparison to Benchmark)
Mutual Fund Rating in India
CAREs Fund Rating Quality: This rating is based on the parameters as below:
Credit Scoring which is a function of the credit quality/rating of the security and its residual
maturity essentially based on historical data.
Management Quality
o AMCs organization setup, qualifications/ experience of senior management team.
o AMCs track record in fund management
o Credentials of AMC sponsors and the board of trustees.
Operations & Risk Management Systems:
o MIS and risk management systems in various operational areas.
o Systems for regular monitoring of the portfolio as well as transactions
o The accounting systems, disclosure levels and regulatory compliance
5

o The quality of trading and back office systems.

Ongoing Review, Monitoring / Surveillance and Withdrawal of Rating
Rating Symbols: CARE AAAf .. CARE BBBf.., CARE Cf
Investment strategies: Although investors have the option to invest in mutual funds at any time, a
systematic process can also be followed by the investor while investing in mutual fund units. Some such
investment styles are explained below:
Systematic Investment Plan (SIP): Investors have to invest a fixed sum every month. (6 months to
10 years- through post-dated cheques or Direct Debit facilities). Fewer units when the share
prices are high, and more units when the share prices are low. Average cost price tends to fall
below the average NAV.
Systematic Transfer Plan (STP): Investors invest in debt oriented fund and give instructions to
transfer a fixed sum, at a fixed interval, to an equity scheme of the same mutual fund.
Systematic Withdrawal Plan (SWP): It is a financial plan that allows a unit holder to withdraw
money from an existing mutual fund portfolio at predetermined intervals. The money withdrawn
through a systematic withdrawal plan can be reinvested in another portfolio or used to pay for
something else.
Investment checklists:
Draw up your asset allocation:
o Financial goals & Time frame (Are you investing for retirement? A childs education? Or
for current income? )
o Risk Taking Capacity
Identify funds that fall into your Buy List
Obtain and read the offer documents
Match your objectives: In terms of equity share and bond weightings, downside risk protection,
tax benefits offered, dividend payout policy, sector focus.
Check out past performance: Performance of various funds with similar objectives for at least 3-5
years (managed well and provides consistent returns)
Think hard about investing in sector funds: For relatively aggressive investors, close touch with
developments in sector, regular review of portfolio are a must.
Look for `load' costs: Management fees, annual expenses of the fund and sales loads
Does the fund change fund managers often?
Diversify, but not too much
Invest regularly: MF- an integral part of your savings and wealth-building plan.
Mutual Funds Shortcomings
No guaranteed return
Fees, commissions and loads
Taxes
Subject to management risk
Dilution due to over diversification
Warning Signals: The investors should look for warning signals while continuing with investment in
mutual funds. Some such signals are stated as follows.
Fund's management changes
Performance slips compared to similar funds.
Fund's expense ratios climb
6

Beta, a technical measure of risk, also climbs.

Independent rating services reduce their ratings of the fund.
It merges into another fund.
Change in management style or a change in the objective of the fund.

References
Reilly and Brown (2006), Investment Analysis and Portfolio Management, 8e, Thomson (Cengage)
Learning, New Delhi
Bodie et al (2009), Investments, 8e, Tata McGraw Hill, New Delhi
Prasanna Chandra (2008), Investment Analysis and Portfolio Management, 3e, Tata McGraw Hill, New
Delhi
www.amfiindia.com
Questions and Answers
Q.1: Define mutual fund. State how does the mutual fund industry play a role in financial market?
Ans.: A Mutual Fund is a trust that pools the savings of a number of investors who share a common
financial goal. The money thus collected is then invested in capital market instruments such as shares,
debentures and other securities. By subscribing to mutual fund schemes, the investors are supposed to get
the benefit of diversification thus reduction in risk involved. Mutual fund industry play the following role
in financial market and economic growth.
Channelization of Household Savings
Augmenting Resource Mobilization in the Primary Market
Substantiating Small Investors Investment Avenues
Providing Liquidity Facility (entry and exit options) to Investors
Contributing to Growth in GDP
Q.2: What are the advantages of investing in mutual funds?
Ans.: the different advantages of investing in mutual funds are:
Professional Management by qualified/ experienced personnel
Diversification because of large number of stocks/ instruments
Convenient Administration because of large pool of funds
Return Potential
Low Costs
Liquidity (repurchase options provided by the AMC/ traded in the market)
Transparency ensured by the regulator (SEBI in case of India)
Flexibility in terms of amount involved, different types of schemes available
Tax benefits (in case of select tax savings schemes floated)
Well regulated
Q.3: What are different classifications of mutual funds?
Ans.: Mutual funds can be classified based on the following:
By Structure: Open ended/ Close ended
By Investment Objective: Growth/ Income/ Balanced
Specialized funds: Sectoral funds/ money market funds/ tax savings funds etc.
Base on load: no load or with load (entry or exit load) funds.

Q.4: What is a contra fund?

Ans.: A contra fund is a diversified equity fund. It parts company with other diversified equity funds in
the types of stocks it chooses to invest in. As the name suggests, it follows a contrarian view to investing.
This means the fund manager will deliberately bypass the popular stocks that everyone else is chasing.
Instead, he will invest in companies that are not in fashion. Usually the fund managers invest in
undervalued stocks fulfilling criteria fundamental strength, underperformance and change in the business
environment
Q.5: What are the warning signals to be observed while investing in mutual funds?
Ans.: the following warning signals should be observed while investing in mutual funds:
Fund's management changes
Performance slips compared to similar funds.
Fund's expense ratios climb
Beta, a technical measure of risk, also climbs.
Independent rating services reduce their ratings of the fund.
It merges into another fund.
Change in management style or a change in the objective of the fund.