Mutual Funds

Prof Ravichandran
 Definition
• A trust that pools the savings of
investors who share a common
financial goal is known as mutual
fund.
 Definition
• The money collected is then invested in
financial instruments such as shares,
debentures and other securities the
income and capital appreciation realized
are shared by its unit holders in
proportion to the number of units
owned by them.
 Definition
• Investment in securities are
spread over a wide cross
section of industries and
sectors reducing the risk of
the portfolio.
 Definition
• Mutual funds are mobilizers of saving of the
small investors in instruments like stock and
money market instruments.
• Mutual funds are corporation that accept money
from investors and use this money to buy
stocks, long term bonds, short term debt
instruments issued by businesses or Govt.
 Features
• Mobilizing small savings: mutual funds mobilize
funds by selling their own shares known as units. This
gives the benefit of convenience and satisfaction of
owning shares in many industries. Mutual fund invest
in various securities and pass on the returns to the
investors.
• Investment Avenue: the basic characteristic of a mutual
fund is that it provides an ideal avenue for investment
for investors and enables them to earn a reasonable
return with better liquidity. It offers investors a
proportionate claim on the portfolio of assets that
fluctuate in value.
 Features
• Professional management: mutual fund
provides investors with the benefit of
professional and expert management of their
funds.
• Mutual fund employees professionals/experts
who manage the investment portfolios
efficiently and profitably. Investors are
relieved from the responsibility of following
the markets on a regular basis.
• Diversified investment: mutual fund have the advantage of
diversified investment of funds in various industries and
sectors. This is beneficial to small investors who cannot afford
to buy shares of established companies at high prices. Mutual
fund allow millions of investors who have investments in
variety of securities of different companies.
• Better liquidity: mutual fund have the distinct advantage of
better liquidity of investment. There is always a market
available for mutual funds. In case of mutual funds it is
obligatory that units are listed and traded thus offering our
secondary markets for the funds. A high level of liquidity is
possible for the fund holders because of more liquid securities
in the mutual fund portfolio.
• Reduced risks: the risk on mutual fund is minimum.
This is because of expert management diversification ,
liquidity and economies of scale in transaction cost.
• Investment protection: mutual funds are regulated by
guidelines and legislative provisions put in place by
regulatory agencies such as SEBI in order protect the
investor interest the mutual funds are obligated to
follow the provisions laid down by the regulators.
• Switching facility: mutual funds provide investors
with the flexibility to switch from one scheme to
another, this flexibility enables investors to switch
from income scheme to growth scheme and from close
ended scheme to open ended scheme.
• Tax benefits: mutual funds offer tax shelter to the
investors by investing in various tax saving
schemes under the provisions provided by the
income tax act.
• Low transaction cost: the cost of purchase and sale
of MF’s is relatively lower.
• Investment protection: mutual funds are regulated
by guidelines and legislative provisions put in
place by regulatory agencies such as SEBI in order
protect the investor interest the mutual funds are
obligated to follow the provisions laid down by the
regulators.
• Switching facility: mutual funds provide
investors with the flexibility to switch from one
scheme to another, this flexibility enables
investors to switch from income scheme to
growth scheme and from close ended scheme to
open ended scheme.
• Tax benefits: mutual funds offer tax shelter to the
investors by investing in various tax saving
schemes under the provisions provided by the
income tax act.
• Low transaction cost: the cost of purchase and
sale of MF’s is relatively lower.
• Economic development: MF’s contribute to
economic development by mobilizing savings
and channelizing them to more productive
sectors of the economy.
• Convenience: MF units can be traded easily
with little or no transaction cost.
TYPES OF MUTUAL FUNDS
 By Structure:

1. Open-ended Funds

2. Closed-ended Funds

3. Interval Funds
 Products and Schemes
• Investors have the option of choosing from a wide variety of
schemes in a mutual fund depending upon their requirements.
MF’s are classified as follows:
– Operational classification:
• Open ended scheme: when a fund is accepted and
liquidated on a continuous basis by a MF manager, it is
called as open ended scheme. The fund manager buys and
sells units constantly as demanded by the investors. The
capitalization of the funds changes constantly as it is
always open for the investors to buy or sell their units. The
scheme provides excellent liquidity facility to the
investors. The buying and selling of units takes place at a
declared NAV(Net Asset Value)
• Close ended scheme:
when a units of a scheme liquidated
only after the expiry of a specified period it is known as
close ended fund. Such funds have fixed capitalization
and remain with the mutual fund manager, units of close
ended schemes are traded on stock exchange in the
secondary market.
• The price is determined on the basis of supply and
demand. There are 2 prices for such funds, one that is
market determined and the other is NAV based the
market price may be above or below NAV.
• Managing a close ended scheme is comparatively easy
for the fund Manager.
• The fund can be liquidated after a specified period.
• Interval scheme:
• it is kind of close ended scheme with a feature
that it remains open during a particular part of
the year for the benefit of investors, to either off
load or to undertake purchase of units at a NAV.
 Return based classification
• Income fund scheme: this scheme is customised to suit the
needs of investors who are particular about regular returns.
The scheme offers maximum current income where by the
income earned by the units is distributed periodically there are
2 types of such schemes, one that earns a target constant
income at relatively low risk while the other offers maximum
possible income.
• Growth scheme: it is a MF scheme that offers the advantage of
capital appreciation of the underlying investment such funds
invest in growth oriented securities that are capable of
appreciating in the long run. The risk attached with such funds
is relatively higher.
• Conservative fund Scheme: a scheme that aims at providing a
reasonable rate of return, protecting the value of investment and
achieving capital appreciation is called a conservative fund
scheme. It is also known as middle of road funds as it offers a
blend of the above features. Such funds divide their portfolio in
stocks and bonds in such a way that it achieves the desired
objective.
 Investment based classification
• Equity fund: such fund invest in equity shares they carry a high
degree of risk such fund do well in favorable market
conditions. Investments are made in equity shares in diverse
industries and sectors.
• Debt funds: Such fund invest in debt instruments like bonds
and debentures. These funds carry the advantage of secure and
steady income there is little chance of capital appreciation.
Such funds carry no risk. A variant of this type of fund is called
liquid fund which specializes in investing in short term money
market instruments.
• Balanced funds: such scheme have a mix of debt and equity in
their portfolio of investments. The portfolio is often shifted
between debt and equity depending upon the prevailing market
conditions.
• Sectoral fund: Such fund invest in specific sectors of the economy.
The specialized sectors may include real estate infrastructure, oil
and gas etc, offshore investments, commodities like gold and silver.
• Fund of Funds: such funds invest in units of other mutual funds
there are a number of funds that direct investments into specified
sectors of economy. This makes diversified and intensive
investments possible.
• Leverage funds: the funds that are created out of investments with
not only the amount mobilized from investors but also from
borrowed money from the capital markets are known as leveraged
funds. Fund managers pass on the benefit of leverage to the mutual
fund investors. Additional provisions must be made for such funds
to operate. Leveraged funds use short sale to take advantage of
declining markets in order to realize gains. Derivative instruments
like options are used by such funds.
• Gilt fund : These funds seek to generate returns through investment in
govt. securities. Such funds invest only in central and state govt.
securities and REPO/ reverse REPO securities. A portion of the corpus
may be invested in call money markets to meet liquidity requirements.
Such funds carry very less risk. Their prices are influenced only by
moment in interest rates.
• Indexed funds: these funds are linked to specific index. Funds
mobilized under such schemes are invested in securities of companies
included in the index of any exchange. The fund performance is
linked to the growth in concerned index.
• Tax saving schemes: certain MF schemes offer tax rebate on
investments made in equity shares under section 88 of income tax act.
Income may be periodically distributed depending on surplus.
Subscriptions made Upto Rs.10000 are eligible for tax rebate under
section 88 for such scheme. The investment of the scheme includes
investment in equity, preference shares and convertible debentures
and bonds to the extent 80-100% and rest in money market
instruments.
 Fund Structure
Fund Sponsor

Trustees

Asset Management
Company

Depository Agent

Custodian
 Structure Of Mutual Funds In India
• Mutual Funds in India follow a 3-tier structure.
• The first tier is the sponsor who thinks of starting the
fund.
• The second tier is the trustee. The Trustees role is not to
manage the money. Their job is only to see, whether the
money is being managed as per stated objectives. Trustees
may be seen as the internal regulators of a mutual fund.
• Trustees appoint the Asset Management Company (AMC)
who form the third tier, to manage investor’s money.
• The AMC in return charges a fee for the services provided
and this fee is borne by the investors as it is deducted
from the money collected from them
 Sponsor
• Any corporate body which initiates the launching of a
mutual fund is referred to as “The sponsor”.
• The sponsor is expected to have a sound track record
and experience in financial services for a minimum
period of 5 years and should ensure various
formalities required in establishing a mutual fund.
• According to SEBI, the sponsor should have
professional competence, financial soundness and
reputation for fairness and integrity.
• The sponsor contributes 40% of the net worth of the
AMC. The sponsor appoints the trustee, The AMC
and custodians in compliance with the regulations.
 Trustee
• Sponsor creates a public trust and appoints trustees.
• Trustees are the people authorized to act on behalf of the
Trust. They hold the property of mutual fund.
• Once the Trust is created, it is registered with SEBI after
which this trust is known as the mutual fund.
• The Trustees role is not to manage the money but their job is
only to see, whether the money is being managed as per
stated objectives. Trustees may be seen as the internal
regulators of a mutual fund.
• A minimum of 75% of the trustees must be independent of
the sponsor to ensure fair dealings.
• Trustees appoint the Asset Management Company (AMC),
to manage investor’s money.
 Custodian
• A custodian’s role is keeping custody of the securities that
are bought by the fund manager and also keeping a tab on
the corporate actions like rights, bonus and dividends
declared by the companies in which the fund has invested.
• The Custodian is appointed by the Board of Trustees. The
custodian also participates in a clearing and settlement
system through approved depository companies on behalf
of mutual funds, in case of dematerialized securities.
• Only the physical securities are held by the Custodian. The
deliveries and receipt of units of a mutual fund are done by
the custodian or a depository participant at the instruction
of the AMC and under the overall direction and
responsibility of the Trustees. Regulations provide that the
Sponsor and the Custodian must be separate entities.
 Asset Management Company (AMC)
• Trustees appoint the Asset Management Company (AMC), to
manage investor’s money. The AMC in return charges a fee
for the services provided and this fee is borne by the investors
as it is deducted from the money collected from them.
• The AMC’s Board of Directors must have at least 50% of
Directors who are independent directors. The AMC has to be
approved by SEBI. The AMC functions under the supervision
of it’s Board of Directors, and also under the direction of the
Trustees and SEBI.
• It is the AMC, which in the name of the Trust, floats new
schemes and manage these schemes by buying and selling
securities. In order to do this the AMC needs to follow all
rules and regulations prescribed by SEBI and as per the
Investment Management Agreement it signs with the Trustees.
 AMC cont-
• The role of the AMC is to manage investor’s money on a day
to day basis. Thus it is imperative that people with the highest
integrity are involved with this activity.
• The AMC cannot deal with a single broker beyond a certain
limit of transactions.
• The AMC cannot act as a Trustee for some other Mutual
Fund.
• The responsibility of preparing the OD(offer documents) lies
with the AMC.
• Appointments of intermediaries like independent financial
advisors (IFAs), national and regional distributors, banks, etc.
is also done by the AMC.
• Finally, it is the AMC which is responsible for the acts of its
employees and service providers.
 Registrar and Transfer Agents
• The registrar and transfer agents are appointed by the
AMC. AMC pay compensation to these agents for
their services. They carry out the following functions
• Receiving and processing the application forms of
investors
• Issuing unit certificates
• Sending refund orders
• Giving approval for all transfers of units and
maintaining records
• Repurchasing the units and redemption of units
• Issuing dividend or income warrents
 Fund Accountants
• Fund accountants are appointed by the AMC. The are in
charge of maintaining proper books of accounts relating
to the fund transactions and management. The perform
the following functions
• Computing the net asset value per unit of the scheme on
a daily basis
• Maintaining its books and records
• Monitoring compliance with the schemes, investment
limitations as well as SEBI regulations
• Preparing and distributing reports of the schemes for the
unit holders and SEBI and monitoring the performance
of mutual funds custodians and other service providers.
 Lead Manager
• Lead manager carry out the following functions:
– Selecting and coordinating the activities of
intermediaries such as advertising agency, printers,
collection centers.
– Carrying out extensive campaign about the scheme
and acting as marketing associates to attract
investors.
– Assisting the AMC to approach potential investors
through meetings, exhibitions, contacts,
advertising, publicity and sales promotion.
 Investment Advisors
• Investment advisors carry out market and security
analysis.
• Advising the AMC to design its investment strategies
on a continuous basis.
• They are paid for their professional advice regarding
fund investment on the average weekly value of the
fund’s net assets.
 Legal Advisors
• Legal advisors are appointed to offer legal guidance
about planning and execution of different schemes.
• A group of advocates and solicitors may be appointed
as legal advisors.
• Their fee is not associated with net assets of the fund.
 Auditors and Underwriters
• An auditor is appointed by the AMC and must
undertake independent inspection and verification of
its accounting activities.
• Mutual funds also undertake the activities of
underwriting issues. Such activities generate an
additional source of income for mutual funds. Prior
approval from SEBI is necessary for undertaking
such activity
 Working mechanism of AMC
• Creating fund manager: A fund manager is responsible for
managing the funds of the AMC. The fund manager should be an
independent agency but in India a single fund manager handles many
schemes simultaneously. The basic function of fund managers is to
decide the rate, time, kind and quantum of securities to be brought
and sold. The fund manager ensures the success of the fund scheme.
• Research and Planning: the research and planning cell of AMC
undertake research activities relating to securities as well as
prospective investors the results of the study are analyzed to draft
future policies governing investments.
• Creating dealers: Dealers having a deep understanding of stock
market operations may be created by the AMC in order to execute
sales and purchase transactions in the capital and money market.
Dealers should comply with all formalities of sale and purchases
through brokers.
 Portfolio Management Process In Mutual Fund
• Setting investment goals: The first task of managing the portfolio of
mutual fund is to identify and set the goals for the proposed scheme the
goal is set keeping in mind the nature of the scheme, risk and return,
market condition, regulatory norms, size of the issue and investor
protection.
• Identifying specific securities: Efforts are made to analyze and identify
the right securities where the fund should invest in. security analyses is
carried out and risk and return characteristics are evaluated.
• Portfolio designing: it involves making an ideal mix of debt and equity
securities of corporate, govt. etc. It is concerned with decisions regarding
the type of securities to be bought, the quantum and timing of issue.
Portfolio design is carried out on the basis of research and analyses of
stock market and devising investment strategies. The portfolio should be
well diversified so as to reduce the total risk of the portfolio.
• Portfolio revision: The portfolio must be reviewed periodically keeping
in mind the risk return characteristics, the revision of the portfolio is
done by keeping in mind the dynamic investment climate
 Operational Efficiency of Mutual funds
• Net Returns: the operational of a mutual fund is best judged
by its ability to earn for the investors better and safe returns in
the form of capital appreciation and the dividends or income
received on such investment.
– Returns are calculated keeping in mind the expenses
incurred while earning such returns which include
trusteeship fee, management fee, administrative fee, fund
accounting fee, initial charges, brokerage etc. SEBI has
fixed an overall limit on expenses as per the regulations.
• Net Asset Value: It is another parameter to measure the
operational efficiency of the fund. The intrinsic value of a unit
under a specific scheme is referred to as the NAV of the scheme.
The value gives an idea of the amount that may be obtained by the
unit holder on sale of the unit to the mutual fund company
NAV (per unit) = Total Market Value – Fund liabilities
No. of outstanding Units
• Load : The initial expenses that are incurred by a mutual fund in
relation to the scheme operated by it is referred to as the load of
the scheme. According to SEBI guidelines a certain percentage of
load must be borne by the expected scheme.
• Disclosures: A highly transparent nature of mutual fund is said to
operate to benefit the investors and service their needs. MFs are
supposed to follow certain norms and ample disclosures for their
operation. Disclosures are made through half yearly and annual
reports where all the information relating to the scheme is
disclosed.
• Investor protection: the fund manager is supposed to follow
certain safe guards to protect the interest of the investors. Unit
certificates are to be issued within 6 weeks from the date of
closure of subscriptions. Units submitted for transfer should be
executed within 30 days. A dividend warrants are to be
dispatched within 42 days of declaration of dividend.
Repurchase proceeds should be dispatched within 10 working
days from the date of redemption. SEBI takes all possible
safeguards such as conducting inspections of the mutual funds
to ensure that investors interests are protected. Defaulting
AMC are prohibited from issuing new schemes.
 Evaluation of Mutual Funds
• It is essential that the performance of Mutual fund is
evaluated and appraised. Such appraisal helps the
fund to compare itself with other funds besides being
a potential source of information to the present and
prospective investors.
• Evaluation includes simple evaluation tools to
sophisticated models which take into consideration
the risk and uncertainty associated with the returns.
Some of the models used are Treynor’s Model and
Sharpe’s Model
• Sharpe’s Performance Index: It offers a single
value for performance ranking of different funds or
portfolio. It measures the risk premium of the
portfolio in terms of its total risk.
• Sharpe’s Index = Average portfolio return – Risk free rate of return
Standard Deviation of Portfolio
= Rp – Rf
σp
• Treynor’s Performance Index: Here the
fund’s performance is measured against the
market performance. It is used to calculate
return per unit of market risk.
• Treynor’s Index = Average portfolio return – Risk free rate of return
Market risk of Portfolio
= Rp – Rf
βp
 Advantages of Mutual Funds
• Mutual Funds give investors best of both the worlds. Investor’s
money is managed by professional fund managers and the money is
deployed in a diversified portfolio. Mutual Funds help to reap the
benefit of returns by a portfolio spread across a wide spectrum of
companies with small investments.
• A mutual fund analyses the investments for investors as fund
managers assisted by a team of research analysts analyze the market
daily.
• Investors can enter / exit schemes anytime they want (at least in open
ended schemes). They can invest in an SIP, where every month, a
stipulated amount automatically goes out of their savings account into
a scheme of their choice.
• There may be a situation where an investor holds some shares, but
cannot exit the same as there are no buyers in the market. Such a
problem of illiquidity generally does not exist in case of mutual funds,
as the investor can redeem his units by approaching the mutual fund.
• As more and more AMCs come in the market, investors will
continue to get newer products and competition will ensure
that costs are kept at a minimum.
• Investors can either invest with the objective of getting capital
appreciation or regular dividends i.e., mutual fund are
structured to suit the needs of all investors.
• An investor with limited funds might be able to invest in only
one or two stocks / bonds, thus increasing his / her risk.
However, a mutual fund will spread its risk by investing a
number of sound stocks or bonds. A fund normally invests in
companies across a wide range of industries, so the risk is
diversified.
• Mutual Funds regularly provide investors with information on
the value of their investments. Mutual Funds also provide
complete portfolio disclosure of the investments made by
various schemes and also the proportion invested in each asset
type.
• The large amount of Mutual Funds offer the investor
a wide variety to choose from. An investor can pick
up a scheme depending upon his risk/ return profile
• All the Mutual Funds are registered with SEBI and
they function within the provisions of strict regulation
designed to protect the interests of the investor
 Regulations
• Regulations ensure that schemes do not invest beyond a
certain percent of their NAVs in a single security. Some of
the guidelines regarding these are given below
• No scheme can invest more than 15% of its NAV in rated
debt instruments of a single issuer. This limit may be
increased to 20% with prior approval of Trustees. This
restriction is not applicable to Government securities.
• No scheme can invest more than 10% of its NAV in
unrated paper of a single issuer and total investment by
any scheme in unrated papers cannot exceed 25% of NAV.
• No fund, under all its cshemes can hold more than 10% of
company’s paid up capital
• No scheme can invest more than 10% of its NAV in a
single company.
• If a scheme invests in another scheme of the same or
different AMC, no fees will be charged. Aggregate
inter scheme investment cannot exceed 5% of net
asset value of the mutual fund
• No scheme can invest in unlisted securities of its
sponsor or its group entities.
• Schemes can invest in unlisted securities issued by
entities other than the sponsor or sponsor’s group.
Open ended schemes can invest maximum of 5% of
net assets in such securities whereas close ended
schemes can invest upto 10% of net assets in such
securities
• Schemes cannot invest in listed entities belonging to
the sponsor group beyond 25% of its net assets
 SEBI Mutual Fund Regulations
• The regulations governing the functioning of mutual funds in
India were introduced by SEBI in Dec 1996. The objectives of
these regulations was to bring in existence the regulatory
norms for the formation, operation and management of mutual
funds in India. The regulations also laid down the broad
guidelines on investment valuation, investment restriction,
advertising code and code of conduct for mutual funds and
AMCs.
 Registration of mutual funds
• Every mutual fund shall be registered with SEBI
through an application to be made by the sponsor in a
prescribed format accompanied by an application fee
of Rs.25000.
• Every mutual fund shall pay Rs.25lakhs towards
registration fee and Rs:2.5lakhs per annum as service
fees.
• Registration shall be granted by the board on
fulfillment of conditions such as sponsor’s, sound
track record of 5yrs integrity, net worth etc.
 Regulations for the trust
• Mutual fund shall be constituted in the form of a trust under the provisions
of Indian Registrations Act and provisions laid down by SEBI.
• A trustee should be person of integrity, ability, and should not have been
found guilty or being convicted of any economic offence or violation of
securities law.
• At least 50% of the trustees shall be independent trustees.
• The trustees and the AMC with SEBI’s prior approval shall enter into an
investment management agreement.
• The trustees shall ensure the AMC has the necessary infrastructure and
personnel.
• The trustees shall ensure that AMC is monitoring security transaction with
brokers.
• The trustees shall ensure that the EMC has been managing the scheme
independently.
• The trustees should fulfill all its duties in order to protect the interest of the
investors.
 Regulations for AMC
• It should have a sound track record, reputation and fairness in
transaction.
• The sponsor or trustee shall appoint an AMC with SEBI’s
approval.
• The appointment of the AMC can be terminated by majority of
trustees or by 75% of unit holders.
• The directors of AMCs should have adequate professional
experience.
• At least 50% of the director’s of the AMC should not be
associated with the sponsors or it’s subsidiaries or the trustees.
• The chairman of the AMC should not be trustee of any other
mutual fund.
• The AMC shall have a minimum net worth of Rs.10 crores.
• The AMC shall not act as an AMC for any other mutual funds.
 Regulations for custodians
• The mutual fund shall appoint a custodian to carry
out the custodian services for the schemes of the
fund.
• The agreement with the custodian shall be entered
into with prior approval of trustees.
 Regulations for Schemes of mutual funds
• All the schemes to be launched by the AMC should be approved by the
trustees and are to be filed with SEBI.
• The offer document should contain adequate disclosures to enable the
investors to make informed decisions.
• Advertisement of schemes should be in conformance with SEBI’s code.
• The listing of closed ended schemes is mandatory and it should be listed on a
recognized stock exchange within 6 months of its subscriptions.
• Units of close ended schemes can be opened for redemption at a fixed
interval.
• The AMC shall specify in the offer document the minimum subscription to
be raised under the scheme.
• The AMC may repurchase, reissue the units of close ended schemes.
• The units of close ended schemes can be converted into open ended schemes.
• Any scheme on mutual fund shall not be opened for subscription after 45
days.
• The mutual fund and AMC shall be liable to refund the application money to
the applicants if minimum subscription is not received.
 Exchange Traded Fund (ETF)
• Exchange Traded Funds (ETFs) are mutual fund units which
investors buy or sell from the stock exchange, as against a normal
mutual fund unit, where the investor buys / sells through a
distributor or directly from the AMC.
• ETFs have relatively lesser costs as compared to a mutual fund
scheme
• The ETF structure is such that the AMC does not have to deal
directly with investors or distributors. It instead issues units to a
few designated large participants, who are also called as Authorized
Participants (APs), who in turn act as market makers for the ETFs.
• The Authorized Participants provide two way quotes for the ETFs
on the stock exchange, which enables investors to buy and sell the
ETFs at any given point of time when the stock markets are open
for trading
• Prices are available on real time and the ETFs can be
purchased through a stock exchange broker just like
one would buy / sell shares. There are huge
reductions in marketing expenses and commissions in
case of ETFs.
• Assets in ETFs: Practically any asset class can be
used to create ETFs. Globally there are ETFs on
Silver, Gold, Indices etc. In India, we have ETFs on
Gold, Indices such as Nifty, Bank Nifty etc.
 Characteristics of ETFs
• An Exchange Traded Fund (ETF) is essentially a
scheme where the investor has to buy/ sell units from
the market through a broker (just as he would by a
share).
• An investor must have a demat account for buying
and selling ETFs.
• An important feature of ETFs is the huge reduction in
costs. While a typical Index fund would have
expenses in the range of 1.5% of Net Assets, an ETF
might have expenses around 0.75%
 Hedge Funds
• Hedge funds are aggressively managed portfolio of
investments that uses advanced investment strategies
such as leveraged, long, short and derivative positions in
both domestic and international markets with the goal of
generating high returns,
• Hedge funds are most often set up as private investment
partnerships that are open to a limited number of
investors and require a very large initial minimum
investment
• Hedge funds are a more risky variant of mutual funds.
Hedge funds are aimed at high net worth investors. They
operate with high fee structures and are less closely
monitored by the regulatory authorities.
• The risk in hedge funds is higher on account of the following
features
• Risky investment styles
• Hedge funds take extreme positions in the market, including
short-selling of investments.
• Ex. In a normal long position, the investor buys a share at
say, Rs. 15. The worst case is that the investor loses the entire
amount invested. The maximum loss is Rs. 15 per share.
• Suppose that the investor has short-sold a share at Rs. 15.
There is a profit if the share price goes down. However, if the
share price goes up, to say, Rs. 20, the loss would be Rs. 5
per share. A higher share price of say, Rs. 50 would entail a
higher loss of Rs. 35 per share. Thus, higher the share price
more would be the loss. Since there is no limit to how high a
share price can go, the losses in a short selling transaction are
unlimited.
• Borrowings: Normal mutual funds accept money
from unit-holders to fund their investments. Hedge
funds invest a mix of unit-holders’ funds (which are
in the nature of capital) and borrowed funds (loans).
Unlike capital, borrowed funds have a fixed capital
servicing requirement. Even if the investments are at
a loss, loan has to be serviced. However, if
investments earn a return better than the cost of
borrowed funds, the excess helps in boosting the
returns for the unit-holders