In the context of Indian stock markets, there is lack of consensus with regards to the definition of large caps, mid caps and small caps. So most fund houses have their own definitions for various stock categories.
The situation is no different on the mutual fund side. There is no unanimity in what constitutes a large cap fund. Basically, there are two breeds of large cap funds. One is the predominantly large cap variety, whereas the other is the ‘true blue’ large cap category.
Predominantly large cap funds have the liberty to invest smaller portion of their assets in mid caps, thereby diversifying their holdings. Conversely, ‘true blue’ large cap funds invest only in large cap stocks. While the former is a common breed in the domestic mutual fund industry, the latter is bit of a rarity.
DSP ML Top 100 Equity Fund (DMLT) belongs to the rare breed of pure large cap funds. But before venturing into its investment proposition, let’s first understand the benefits of investing in large cap funds.
Benefits of investing in large cap stocks/funds
Large cap companies typically have well-established track records in terms of earnings/profitability among other factors. These companies are also well-researched as information on them is widely available, so the chances of making a wrong investment call are relatively lower. This makes their performance more predictable when compared to their mid/small cap peers. Large cap funds, given their investments in large cap stocks, imbibe similar traits. These funds are also less risky compared to mid and small cap funds. It is due to these reasons we advocate that investors with risk appetite must invest in well-managed large cap funds, so as to infuse stability in their portfolios over the long-term.
DMLT’s investment proposition
DMLT is an open-ended diversified equity fund from the stable of DSP Merrill Lynch Fund Managers. The fund’s name as well as its investment objective - ‘to invest in equity securities and equity related securities of the 100 largest corporates, by market capitalisation, listed in India’, clearly defines its investment mandate. And in line with its investment objective, large cap stocks dominate the fund’s portfolio.
The fund is mandated to invest atleast 90% of assets in equities and related instruments, while upto 10% of the assets can be invested in debt and money market instruments. For stock picking, it adopts a combination of the top down and bottom up approaches. It invests in both, growth as well as value stocks.
There are two kinds of people. The first type are ones-- who look rich i.e those who have a flaunting lifestyle. The other one's are rich but you cant gauge the richness from their lifestyle. There are a lot of salaried middle class class people who belong to the first category. They flaunt a rich life style ( Thanks to the high salaries and EMI facilities !!).Nothing wrong in enjoying one's money. But one shouldn't end up eating out all his current income and future income. You should also save and invest for your future. If you do not save even for contingencies, you may face a disaster when some unforeseen event happens. In this fast moving world, all things including permanency of employment, longevity of work life, etc have changed drastically. We should really work towards financial independence. i.e making money work for us , so that it can take care of all our future needs. So, being rich is more important than looking rich when you are working towards financial independence.
Markets might have been in a state of turmoil for the last few months, but it seems that nothing unnerves mutual fund investors. Nearly 4.5 lakh Systematic Investment Plans or SIPs were added to the mutual fund kitty early this year, at the time when the Indian capital markets witnessed their biggest quantum fall.
SIP by SIP is the way to go for mutual fund investors and it seems market volatility doesn't have much of bearing. Between September to December 2007, when the markets were on its fastest upside, the industry added 2 lakh SIPs.
But contrastingly, in the first three months of this year, when heightened volatility loomed over the Indian stock markets, four and a half lakh SIPs were added. The total number of SIPs now stands at a whopping 2.9 million.
Madhusudan Kela, CIO, Reliance MF said, “I think we have had a 3-5 year bull run which is bearing on the investor's mind. Many have realized corrections of this nature can possibly be a good entry.”
Sanjay Sinha, CIO, SBI MF said, “Unlike the falls that we saw in May 2004 and May 2006, in which the investors chose to go away from the funds or not come in at all, in this fall since January, we have actually seen money coming into almost all our funds. This is a very significant development and if this sustains we are going to see retail participation far more than what it has been in last three years."
What's more, in the same volatile period early this year, 75 lakh new folios were created as compared to the quarter before, that saw just 26 lakh folios coming in. The number of SIPs is growing at a healthy 42% YoY. And it's not just the top 20 urban centres that are contributing to this growth. Experts say, as the reach widens across the country with more number of players stepping in, investors from smaller towns are also increasingly participating. This perhaps may be a sign of more maturity amongst investors.
Quantum is coming out with an Index fund: NFO opens: 9th June 2008 NFO closes: 20th June 2008 Objective of the fund: To invest in stocks of companies comprising S&P CNX Nifty Index and endeavour to achieve return equivalent to the Nifty by 'passive' investment. Minimum Investment: INR 5000
Mutual funds pressed sales in equities for a third day in a row on Thursday, 22 May 2008. Mutual funds sold shares worth a net Rs 92.20 crore Thursday, compared to outflow of Rs 44.50 crore on Wednesday, 21 May 2008. Mutual funds had pressed sales worth a net Rs 488.70 crore on Tuesday, 20 May 2008. Mutual funds outflow of Rs 92.20 crore on Thursday, 22 May 2008, was a result of gross purchases Rs 548.80 crore and gross sales Rs 640.90 crore. Sensex lost 336.05 points or 1.95% at 16,907.11 on that day. Mutual funds outflow reached Rs 728.30 crore in the month of May 2008, till 22 May 2008. Mutual funds had sold shares worth a net Rs 111.50 crore in April 2008. They had offloaded shares worth Rs 1971.30 crore in March 2008.
In order to make offer documents (ODs) and Key Information Memorandum (KIM) more reader friendly, Securities And Exchange Board of India (SEBI) has given its nod to mutual fund houses to simplify it. A committee set up by the Association of Mutual Funds in India (AMFI) had recommended that the existing offer documents may be split into two parts namely Statement of Additional Information (SAI), which will incorporate all statutory information on mutual funds, and Scheme Information Document (SID). All mutual fund scheme ODs filed with SEBI on or after 1 June 2008 will have to be prepared in the new set-up. Fund houses, which have already filed their ODs for which SEBI has not yet suggested changes, may be required to modify the same in the format of SID and SAI after receiving the final observations. However, the schemes, which have already received final observations from SEBI, can use the old OD format provided they are launched on or before 31 July 2008. But, in this case SID has to be adopted. SEBI has asked fund houses to file a single SAI (common for all the schemes) as a one-time filing. The SAI shall be filed along with the first draft SID for any scheme filed on or after 1 June 2008.
Standard Chartered Asset Management Co. Pvt. Ltd comes out with another arbitrage fund. Objective of the fund: The investment objective of the scheme is to generate income (absolute to low volatility returns) by taking advantage of opportunities in the cash and the derivative segments of the equity markets including the arbitrage opportunities available within the derivative segment, by using other derivative based strategies and by investing the balance in debt and money market instruments. Minimum Investment amount INR 10,000 Fund Manager: Mr. Rajiv Anand
The market is a roller coaster and let know one tell you otherwise. In the short term the market outlook may seem uncertain. But on the longer horizon Indian markets look very good. The government has been making conscious business friendly policies; the fiscal deficit too is getting under control. India continues to be one of the fastest growing economies in the world. These factors coupled with many others are ensuring India’s position as a global destination. To grow personal capital from India’s growth one has to choose the correct investment avenue.
Choosing between the plentiful available mutual funds and schemes is not easy. A well thought out and well-planned decision is one that will bear fruits in the long run. Thus a structured approach to fund selection with a systematic checklist to achieve it is of utmost importance. Even though there are many available methods of product comparisons, one doesn’t want to be weighed down by all of them. Dwelling into too many numbers, will only lead to further confusion. Therefore only a few areas of comparison are of true importance and will be comprehensive enough to produce a thorough comparison.
Portfolio: Portfolio is very important while comparing schemes. Even though some of the underlying stocks in portfolios could be similar, most portfolios have differing mandates and investment philosophies. As a result it is rather important to understand the stance the manager has taken while building his scheme portfolio. The portfolio will not only determine the future outcome of your investment but will also tell you how risky the product is and hence if it is appropriate for your appetite. For example, an equity scheme, which invests in companies, could be safer than one that invests in mid. The portfolio for debt instruments is determined on duration of securities. A high duration, high return investment is potentially volatile and risky; while a short duration investment Portfolio is less risky. This is where we come to the next parameter of comparison
Risk: In today’s scenario, investments that generate meaningful post tax; post inflation returns have risks attached to them. These are market risk, credit risk, government policy risk etc. At this point one has to understand how much risk he is willing to take in order to generate higher return. The rule of thumb is that the more risk one is willing to take the better the returns potential. The measurement for risk to return is known as Sharpe Ratio. The higher the value, the better the risk attached to the scheme is managed. A volatile investment can also be very risky. Thus this aspect must also be quantified. Standard deviation will help us understand the volatility of a scheme vis-à-vis its benchmark. Be aware a riskier investment is not always better and a sure fire way to generate superior returns.
Performance comparisons: These are the most favored methods of investors and amongst the easiest. Performance numbers are available in plentiful. But performance is only measured in hindsight, and can never be guaranteed in the future. Also performance can only be compared across similar categories of funds. For example, performance or return comparison between an equity scheme and a debt scheme should never be done. It must be kept in mind that comparison happens only between similar funds. A large cap fund should be compared with another large cap fund and not a mid cap fund. Thus compare apples to apples only. Performance and return comparison should be conducted usually when one has decided on the above-mentioned factors like risk and product category.
Fund management and Institutional backing: Since trusting your hard earned savings to some one can never be easy, it is important to evaluate their money managing capabilities. The markets are a game of understanding numbers and involve immense skill to generate growth from these numbers. Only a very capable person with a lot of experience can generate capital appreciation in today’s confusing market swings while managing risk.
Investment horizon: It is very important to determine investments based on one’s time horizon viz equity typically being volatile should be considered for investment horizon of 1 to 3 years. While the short term debt schemes should be considered for investment horizons of up to 1 year.
It is therefore important to invest with a fund house with a good track record. It is also important to give due weightage to the quality and track record of the spouses of the fund. After evaluating these parameters and choosing a scheme one can be reasonable sure that the investment they are going into is the right one. At this point I would like to stress, that any of these parameters could only be a guiding star and not a guarantee for the future. Choosing an investment avenue is like getting into a marriage, so do it wisely. Happy Investing!
Fact No. 1: Over a long term horizon, equity investments have given returns which far exceed those from the debt based instruments. They are probably the only investment option, which can build large wealth.
Fact No. 2: In short term, equities exhibit very sharp volatilities, which many of us find difficult to stomach.
Fact No. 3: Equities carry lot of risk even to the extent of loosing ones entire corpus.
Fact No. 4: Investment in equities require one to be in constant touch with the market.
Fact No. 5: Equity investment requires a lot of research.
Fact No. 6: Buying good scrips require one to invest fairly large amounts.
Systematic Investing in a Mutual Fund is the answer to preventing the pitfalls of equity investment and still enjoying the high returns. And it makes all the more sense today when the stock markets are booming
1. It’s an expert’s field – Let’s leave it to themManagement of the fund by the professionals or experts is one of the key advantages of investing through a mutual fund. They regularly carry out extensive research - on the company, the industry and the economy – thus ensuring informed investment. Secondly, they regularly track the market. Thus for many of us who do not have the desired expertise and are too busy with our vocation to devote sufficient time and effort to investing in equity, mutual funds offer an attractive alternative. 2. Putting eggs in different baskets Another advantage of investing through mutual funds is that even with small amounts we are able to enjoy the benefits of diversification. Huge amounts would be required for an individual to achieve the desired diversification, which would not be possible for many of us. Diversification reduces the overall impact on the returns from a portfolio, on account of a loss in a particular company/sector. 3. It’s all transparent & well regulated The Mutual Fund industry is well regulated both by SEBI and AMFI. They have, over the years, introduced regulations, which ensure smooth and transparent functioning of the mutual funds industry. This makes it safer and convenient for investors to invest through the mutual funds. 4. Market timing becomes irrelevant One of the biggest difficulties in equity investing is WHEN to invest, apart from the other big question WHERE to invest. While, investing in a mutual fund solves the issue of ‘where’ to invest, SIP helps us to overcome the problem of ‘when’. SIP is a disciplined investing irrespective of the state of the market. It thus makes the market timing totally irrelevant. And today when the markets are high, it may not be prudent to commit large sums at one go. With the next 2-3 years looking good from Indian Economy point of view, one can expect handsome returns thru’ regular investing. 5. Does not strain our day-to-day finances Mutual Funds allow us to invest very small amounts (Rs 500 – Rs 1000) in SIP, as against larger one-time investment required, if we were to buy directly from the market. This makes investing easier as it does not strain our monthly finances. It, therefore, becomes an ideal investment option for a small-time investor, who would otherwise not be able to enjoy the benefits of investing in the equity market. 6. Reduces the average cost In SIP we are investing a fixed amount regularly. Therefore, we end up buying more number of units when the markets are down and NAV is low and less number of units when the markets are up and the NAV is high. This is called rupee-cost averaging. Generally, we would stay away from buying when the markets are down. We generally tend to invest when the markets are rising. SIP works as a good discipline as it forces us to buy even when the markets are low, which actually is the best time to buy. 7. Helps to fulfill our dreams The investments we make are ultimately for some objectives such as to buy a house, children’s education, marriage etc. And many of them require a huge one-time investment. As it would usually not be possible raise such large amounts at short notice, we need to build the corpus over a longer period of time, through small but regular investments. This is what SIP is all about. Small investments, over a period of time, result in large wealth and help fulfill our dreams & aspirations.
AMFI Mutual Fund (Advisor) Module Revision Kit 2008 This AMFI Revision Kit has been prepared by ICICI Prudential AMC Ltd. in association with Pivot Training Pvt. Ltd. No part of this document may be reproduced for any purpose, without the written consent of ICICI Prudential AMC Ltd. Some Exam related pointers 1. The examination required to be taken by distributors is the ‘AMFI Mutual Fund (Advisor) Module’. 2. The exam is of 2-hour duration. 3. Examination has 72-75 Multiple Choice Questions (appx. 50 Questions are for 1 mark each and balance appx. 25 for 2 marks each). 4. Max Marks is 100. 5. Pass percentage is 50. 6. The exam has negative marking (25% of the question score). 7. Be careful about the language of the question. 8. AMFI expects candidates to be thorough with the key concept before taking the exam and this is evident in the type of questions in the current examination. 9. Please review the contents of this revision kit very thoroughly before the exam along with Practice Tests available separately. 10. A read-through of the AMFI Workbook would be an added advantage for the exam taker. Good Luck! CHAPTER 1 CONCEPT AND ROLE OF MUTUAL FUNDS A mutual fund is a pool of money, which is collected from many investors and is invested by an asset management company to achieve some common objectives of the investors. The birth place of Mutual Fund is U.S.A. Advantages of Mutual Fund • Increases the purchasing power of the investors • Allows participation in the securities market with small investments • Enables them to have a well-diversified portfolio (‘Diversification’ is best described by the tem “don’t put all your eggs in one basket”) • Reduction of risk • Money would be managed by professionals at low cost • Reduction of transaction cost (economies of scale) • Liquidity (conversion into cash without loss of value) • Convenience and Flexibility Disadvantages of Mutual Fund • No control over cost • No tailor made portfolio • Managing a portfolio of funds Evolution of Mutual Funds In India Phase 1- 1964-87: Growth of Unit Trust of India The first scheme launched by UTI was Unit Scheme 1964. It was the first open-ended scheme in the country. Phase 2 – 1987-93: Entry of Public Sector Funds State bank of India established the first non-UTI mutual fund-SBI mutual fund in November 1987. Phase 3 – 1993-96: Emergence of Private Funds – Private and foreign fund houses were permitted to set up MFs in India. Kothari Pioneer was the first private sector fund. Phase 4 – 1996-99: Growth and SEBI Regulations A set of regulations for all mutual funds operating in India was introduced with SEBI (Mutual Fund) regulations, 1996. Phase 5 – 1999-2004: Emergence of a large and uniform industry In February 2003, UTI Act was repealed, UTI was split into two and UTI no longer had a special legal status and it also adopted the same structure as any other fund in India. UTI Mutual Fund is the present name of the erstwhile Unit Trust of India. Phase 6 – 2004 onwards: Period of Consolidation & Growth In this period the industry has witnessed a spate of mergers and takeovers. Also more and more new international and private sector players are entering the fray. This period also saw the growth of the industry Important Milestones in the MF history in India 1963: UTI (special privileges – assured return schemes, guarantees, loans) 1987: Public Sector MFs 1993: Private Sector MFs 1995: AMFI was set-up (internal checks & balances, representation to the govt and consumer education – publish a book titled “Making Mutual Funds Work for You – an Investor’s Guide”) 1996: SEBI (MF) Regulations 1999: Dividend income made tax free in the hands of investor 2003: UTI Act repealed (level playing field, UTI split, UTIMF created) 2004-onwards: Consolidation & Growth (AUM at the end of FY 2004-05 was appx. Rs. 153,000 crores) Types of Funds Open-ended funds vs. Closed-ended funds An open-ended fund is one that sells and repurchases units at all times. Investor buys into the scheme and redeems from the fund house directly. Subscription at all times is not mandatory. Redemption must be permitted within certain obvious conditions. The corpus changes everyday OEFs are subject to higher redemption pressure. The scheme calculates its NAV on a daily basis. A close-ended fund Close Ended Funds have a fixed tenure of say 1/2/3/4/5 etc years. After the closure of its NFO, no new units of M.F are available for sale from the fund house directly. Exit option is available to investors in two ways: a) exit window or b) listing on a stock exchange Units are repurchased by the fund itself through intermittent periodic exit windows. The fund corpus in such a case can only reduce. The units of listed funds are traded usually at discount to its NAV. The Unit capital of such a fund remains constant, thus no redemption pressure. Debt Funds, Equity Fund, Liquid (MMMF) and Balanced (Hybrid) Funds Debt Funds or (Income Funds): A fund can be classified as Debt Fund, which invests primarily in Debt (loan) Securities. Debts fund can be further classified as: Gilt Funds: invests primarily in Govt Securities or Gilts (Govt. borrowing programme) Diversified Debt: invests in different varieties of Debt Securities i.e. say Govt Securities, Corporate Debts, Securities of different Maturities etc. Income fund: invests in Debt securities so as to provide regular income to Investors. Diversified Debt Fund: a fund that invests in all available types of debt - securities issued by entities across all industries and sectors. Focused Debt Fund: invest only in specified securities and thus have a higher risk than diversified debt funds. High Yield Debt Fund: seek to obtain higher interest returns by investing in debt instruments that are considered below investment grade. Assured Return Funds: an Indian variant, were being offered by erstwhile UTI and now no longer offered. Fixed Term Plan Funds: essentially close-end in nature and usually for term less than a year. Being of short duration they are not listed on the stock exchange. Invest in such securities whose residual maturity is equal to the scheme tenor. Equity Funds: A fund that invests primarily in equity (ownership) instruments. Equity Funds can be further classified as: Diversified Equity Fund: investing in a mix of equity from different sectors Index Funds: Portfolio replicates a selected Index Sectoral Fund: invests in equity instruments of one sector for eg. Technology Fund, Pharma Fund, Banking Fund etc. Aggressive Growth Fund: target maximum capital appreciation, invest in less researched or speculative shares Growth Fund: This fund invests in equities of Growth companies only i.e. the companies which have the potential to grow at higher rate in future Large Cap/Mid Cap/Small Cap Fund: These Funds invests in equities of Large/Mid/ Small Cap companies respectively. Specialty (or Thematic) Funds: have a narrow portfolio orientation and invest in companies that meet pre-defined criteria. Eg. Infrastructure Fund or ASEAN Fund Equity Linked Saving Scheme (ELSS) an Indian Variant: Investment in these schemes entitle the investor an income tax deduction u/s 80C (max Rs. 1 lakh in year 2007-08). These are open-ended funds but investment in these schemes (including the reinvested dividends) gets locked-in for a period of 3 years. Value Funds: try to seek out fundamentally sound companies whose shares are currently under-priced in the market. These fund add those shares to their portfolio that are selling at low price-earnings ratios, low market to book value ratios and are believed to be undervalued compared to their true potential. Equity Income or Dividend Yield Funds: invest in stocks which have a high Div Yield i.e., Div to Market Price ratio Balanced Funds: These Funds invest in both equity & debt instruments in varying proportion. Some have higher proportion of Equity while others have high proportion of Debt. Growth and Income Funds: Unlike income focused or growth focused funds these funds seek to strike a balance between capital appreciation and income for the investor. These funds would be less risky than pure growth funds, though more risky than income funds. Asset Allocation Funds: where the fund manager has the flexibility to change the allocation of funds between equity and debt as per own perceptions about direction of the market. Commodity Funds: specialize in investing in different commodities directly or through shares of commodity companies or through commodity futures contracts. A most common example of commodity fund is the so-called Precious Metals Funds. As of date, Indian MF industry does not have commodity funds except the ones that invest in Gold. Real Estate Funds: would invest in real estate directly, or may fund real estate developers, or lend to them, or buy shares of housing finance companies. As of date there are no pure real estate mutual funds in the country as SEBI guidelines are awaited. Exchange Traded Funds: It tracks a market index and trades like a single stock on the stock exchange. It is a unique category of open-ended index funds which gets listed on the stock market. It combines the features of open-ended as well as close-ended schemes. Fund of Funds: invests in a portfolio of the units of other mutual fund schemes. Liquid Funds (Money Market) Mutual Funds: These Funds are actually Debt Funds, which Invests in Money Market & Call Money Market Debt Securities (T-bills, Commercial Paper & Certificate of Deposits). These Funds have very little Interest Rate Risk and are considered safer than even Gilt or other Debt Funds. Load and No Load Funds: Funds that charge front-end (Entry), back-end (Exit) or deferred (Contingent Deferred Sales Charge – CDSC) loads are called load funds. Funds that make no such charges are called no-load funds. In India, SEBI has defined a load as the one-time fee payable by the investor to allow the fund to meet initial issue expenses including brokers’ commission, advertising and marketing expenses etc. As per SEBI definition ONLY those funds that charge an entry load are considered as load funds. Risk Hierarchy of Mutual Funds RETURN SECTORAL DIVERSIFIED INDEX BALANCED INCOME GILT MMMF RISK Quick Wit 1. A close-ended mutual fund has a fixed a. NAV b. Fund size c. Rate of return d. Number of distributors 2. An investor in a close-ended mutual fund can get his/her money back by selling his/her units a. Back to the fund b. To a special trust at NAV c. On a stock exchange where the fund is listed d. To the agent through which he/she subscribed to the units of the fund 3. A mutual fund is not a. Owned jointly by all investors b. A company that manages investment portfolios of high net worth individuals c. A pool of funds used to purchase securities on behalf of investors d. A collective investment vehicle 4. The a. b. c. d. most important advantage of a money market mutual fund is Quick capital appreciation High regular income Safety of principal No loads funds target Low risk and stable income Protection of principal High growth with risk Long term capital appreciation UTI, the first mutual funds were started by Private sector banks Public sector banks Financial institutions Non-banking finance companies 5. Debt a. b. c. d. 6. After a. b. c. d. 7. “Making mutual funds work for you – the investor’s guide” was published by: a. SEBI b. AMFI c. UTI d. Investor Education and Protection Fund 8. A mutual fund is: a. a partnership b. a pass through vehicle c. a private trust d. an association of persons 9. Which one is more diversified? a. Fund A which invests in Shares in India b. Fund B which invests in shares in India and USA both c. Both are equally diversified d. Insufficient information 10. An a. b. c. d. investor should not invest in a mutual fund if His capital base is large He is able to carry out detailed investment research and monitor the stock market Both the above None of the above 11. Fixed Term Plan series are (as per AMFI Workbook) a. Closed ended b. Generally short term in nature c. Not listed on stock exchange d. All of the above Answers 1. b 2. c 3. b 4. c 5. a 6. b 7. b 8. b 9. b 10.c 11.d (as per AMFI workbook) CHAPTER 2 FUND STRUCTURE AND CONSTITUENTS MF Structure in the USA: In the USA MF’s are set up as investment companies. MF Structure in the UK In UK MF’s have two alternative structures • Open-end funds are in the form of Unit trusts • Close-end funds are in the form of corporate entities or Investment Trusts MF Structure in INDIA • In India Open end and Close end funds are constituted along one unique structure as unit trusts. A mutual fund may have several different schemes, open and close ended, under it • Open ended and Close ended schemes are governed by the same regulations and the regulatory body, SEBI (M F) Regulations, 1996. Legal Structure of Mutual Funds SPONSOR TRUSTEE AMC CUSTODIAN R&T AGENT The Fund Sponsor Sponsor is defined under the SEBI regulations as any person who, acting alone or in combination with another body corporate, establishes a mutual fund. Sponsor must possess a sound financial track record over five years prior to registration. Sponsor could be a bank, a corporate or a financial institution. The sponsor of a fund will form a trust and appoint a board of trustees. The sponsor will also appoint an AMC as fund managers and will also appoint a custodian to hold the fund in accordance with SEBI regulations. The sponsor must be profit making in at least 3 out of previous 5 years, including the last year Net worth (Share Capital plus reserves & surplus) of the Sponsor must be positive To qualify as a sponsor he must contribute at least 40% of the net worth of the AMC Mutual Funds as Trusts A mutual fund in India is constituted in the form of a Public Trust created under the Indian Trusts Act, 1882. Under the Indian Trust Act the trust or the Fund has no independent legal capacity itself. Trustees The Trustee is an independent body acts as protector of the unit holder. They ensure that the fund is managed by the AMC as per the defined objectives and in accordance with the Trust Deed and SEBI Regulations. The trust is created through a document called the trust deed that is executed by the Fund Sponsor in favor of the Trustees. Role of Trustees The role of the Trustees is to safeguard the interest of the investor/unit-holder of the fund – Fiduciary Capacity. The trustees make sure that the funds are invested according to the investor’s mandate and objective. The board of trustees is appointed by Sponsor with SEBI approval and at least 2/3rd of the board of trustees should be independent. Trustees of one mutual fund cannot be trustee of another mutual fund. Trustee of one mutual fund cannot be AMC of another & vice versa. The board of trustees is required to meet at least 4 times in a year to review the AMC. Trust created through a document called the ‘Trust Deed’, executed by the Fund Sponsor in favour of the Trustees. Rights of Trustees The trustees appoint the AMC with the prior approval of SEBI. They also approve each of the schemes floated by the AMC. They have the right to request any necessary information from the AMC concerning the operations of various schemes managed by the AMC. Trustees have the right to dismiss the AMC with the approval of SEBI and in accordance with the regulations. The trustees have the right to ensure that, based on their quarterly review of the AMC’s networth; any shortfall in the networth is made up by the AMC. Obligations of Trustees The trustees must enter into an Investment Management Agreement (IMA) with the AMC according to Fourth schedule of SEBI (MF) Regulations, 1996. They must ensure that the fund’s transactions are in accordance with the trust deed. The trustees are responsible for ensuring that the AMC has proper system and procedures in place and has appointed key personnel including Fund managers and a compliance officer, besides the other constituents such as the auditors and registrars. The trustees must ensure due diligence on part of the AMC for empanelment of brokers. The trustees must furnish to SEBI on a half yearly basis. Asset Management Company (AMC) The AMC is created by and its capital contributed by the Sponsor (at least 40%). The AMC is appointed as fund managers of a mutual fund by the trustees (through the IMA). The Net worth of the AMC must be Rs. 10 crore at all times. Minimum ½ of the directors must be independent. AMC of one fund cannot be Trustee of another. AMC of one fund can do advisory business with other funds (domestic as well as offshore). Other Fund Constituents Custodian and Depositories Appointed by the board of trustees for safekeeping (in case of physical securities) or participating in any clearing system through approved depository companies on behalf of mutual fund (in case of dematerialized securities). The custodian should be an entity independent of the sponsor and is required to be registered with SEBI. Custodians function as investment back office of a mutual fund. Bankers are appointed for holding bank accounts and providing remittance services. Registrar and Transfer Agents are responsible for issuing and redeeming units of the MF and providing other related services such as preparation of transfer documents and updating records. Distributors AMC appoints the distributors who sell units on behalf of the fund. A sponsor or an associate can act as a distributor for the AMC with which he or she is associated. A distributor usually acts on behalf of several MF’s simultaneously and may have several subbrokers under him for the purpose of distribution of units. The distributor community includes brokers as also independent individuals. Brokers Engaged for transactions in the securities markets. Not more than 5% of the trade should be done with a related broker. Brokers also provide research reports to the AMCs. Fund Mergers and Scheme Takeovers A running fund constitution can change in the following possible ways 1. Trustees may decide to change the AMC and handover the scheme to a new AMC 2. The scheme may be merged with another scheme of the same AMC 3. The AMC is taken over by another set of sponsors 4. One AMC may merge with another AMC 5. Just the schemes may be taken over by another set of trustees Transaction Type AMC Takeover by new sponsor AMC Merger Trustees changing AMC Schemes taken over by another AMC Scheme Merger Trustee Approval Yes Yes Yes Yes Yes SEBI Approval Yes Yes Yes Yes Yes High Court Approval No Yes No No No Example of AMC Merger - HB & Taurus – Two MF companies in India which merged using the AMC merger route Example of AMC Takeover - Zurich acquired Threadneedle globally and bought out ITC Threadneedle’s India business. Zurich similarly acquired Kemper Twentieth Century Finance. In recent times Alliance was taken over by Birla. Example of Scheme Takeover – Zurich finally exited MF business in India and sold all its schemes in India to HDFC (technically the AMC was not sold but just the schemes) Quick Wit 1. A mutual fund is owned by a. The Govt. of India b. SEBI c. All its investors d. AMFI 2. The a. b. c. d. 3. The a. b. c. d. 4. The a. b. c. d. 5. The a. b. c. d. structure, which is required to be followed by mutual funds in India, is laid down by Financial Ministry Securities & Exchange Board of India (SEBI) Fund Sponsor Association of Mutual Funds of India (AMFI) RBI Board of Trustees of a mutual fund: Act as a protector of investor’s interests Directly manage the portfolio of securities Do not have the right to dismiss the AMC Cannot supervise and direct the working of the AMC trust that manages a mutual fund is appointed by The Finance Ministry RBI SEBI The sponsor of that mutual fund custodian of a mutual fund: Is appointed for safekeeping of securities Need not be an entity independent of the sponsors Not required to be registered with SEBI Does not give or receive deliveries of physical securities 6. Transfer Agents of a mutual fund are not responsible for a. Issuing and redeeming units of the mutual fund b. Updating investor records c. Preparing transfer documents d. Investing the funds in securities markets 7. The a. b. c. d. sponsor of a mutual fund may be compared to A director in a Company The Chief Executive of a Company Promoter of a Company An equity shareholder in a Company 8. Issuing and redeeming units of a mutual fund is the role a. The custodian b. The transfer agent c. The trustees d. The bankers 9. The fund sponsors should have a sound financial track record of a. 7 years b. 12 months c. 5 years d. 3 years 10. The net worth of an asset management company should be greater than a. Rs.100 Crores b. Can be decided by the Sponsor c. Should be at least Rs.10 Crores at all times d. Should be greater than Rs.10 Crores 11. The role of an AMC is to act as a. Promoter b. Investment Manager c. Distribution agent d. Regulator 12. As per SEBI’s principles, the AMC and the Board of Trustees of a fund should belong to the same Sponsors a. True b. False 13. Role of the custodian is a. managing the fund’s distribution channel b. making investments on behalf of the Fund Managers c. handling payment of investments with bankers d. safe keeping of securities or participating in the clearing system on behalf of the mutual fund 14. As per investment company institute, AMFI equivalent in the US, corporate bond funds have higher risk than: a. Money Market funds b. Index funds c. Aggressive funds d. Growth funds 15. In case of a fund take-over a. High court approval may not be necessary b. SEBI approval is a must c. All unit holders must be informed d. All of the above Answers 1. c 2. b 3. a 4. d 5. a 6. d 7. c 8. b 9. c 10. d 11. b 12. a 13. d 14. a 15. d CHAPTER 3 LEGAL AND REGULATORY FRAMEWORK Legal & Regulatory Environment SEBI - Securities and Exchange Board of India has been setup by an Act of Parliament in 1992. SEBI is the overall Capital Markets Regulator and regulates all MFs. RBI - Apex Banking Body Regulates the Banking System and Money Market. Mutual Funds are investors in Money Market and thus indirectly under RBI’s regulation. As the apex banking body, RBI regulates any bank assured return scheme. Thus if a bank sponsored AMC wants to offer assured return scheme, it will have to take RBIs approval as well. Ministry of Finance - Ministry of Finance ultimately supervises both RBI and SEBI. Securities Appellate Tribunal (SAT) - created in 2003 to provide the apex appeal mechanism for actions taken by SEBI. Company Law Board - is a body specially constituted by the central govt. for carrying out judicial proceedings with respect to company affairs Department of Company Affairs (DCA) - responsible for formulating and modifying regulations relating to companies. DCA has legal powers to prosecute company directors for failure to comply with any of the provision of companies Law, as also for non-payment of deposits or frauds and other offences. Registrar of Companies (RoC) - is the primary legal interface for all companies. All AMC accounts and records are filed with the RoC. The RoC monitors regulatory compliance by companies. Office of the Public Trustee - Board of Trustees of the Trustee Company is accountable to the office of the Public Trustee, which in turn reports to the Charity Commissioner. Self Regulatory Organizations (SROs) - is an association representing a group of market participants, which is specially empowered by the apex regulatory authority to exercise predefined authority over the regulation of their members. Stock Exchanges - These are SROs under the supervision of SEBI. Eg. BSE and NSE. Association of Mutual Funds in India (AMFI) - AMFI is simply an industry association, eventhough it performs certain self-regulatory functions, it does not have an SRO status yet. Its principle objectives are: To promote the interest of MFs and unit holders and interact with SEBI/RBI/Govt./ Regulators To set and maintain ethical, commercial and professional standards in the industry To increase public awareness and understanding of the concept and working of MFs in the country To develop a cadre of well trained distributors and to implement a program of training and certification for all intermediaries and others engaged in the industry Investor’s Rights and Obligations Investor’s Rights Right of Proportionate Beneficial Ownership of the scheme’s assets Right to Timely Service Unit holders are entitled to receive the dividend warrants within 30 days of the date of dividend declaration and redemptions proceeds within 10 days otherwise Unit holders have the right to payment of interest at a rate specified by SEBI Right to Information Unit-holders have the right to inspect major documents of the fund like o trust deed o investment management agreement o custodian service agreement o registrar and transfer agency agreement o memorandum and articles of association of the AMC o right to receive a copy of the annual financial statements o right to receive a complete statement of scheme portfolio before the expiry of one month from the close of each half year (that is 31st march and 30th September). Right to approve changes in fundamental attributes To carry out a change in fundamental attributes o All unit-holders have to be informed in writing o Advertisement in an English daily newspaper having nationwide circulation and in a newspaper in the regional language of MF head office o The unit-holders must be given an option to redeem their holdings in the fund without any exit load Right to wind up a scheme If 75% of the investors pass a resolution to this effect. Right to terminate the AMC The appointment of an AMC of a fund can be terminated by 75% of the unit-holders of the scheme with the prior approval of SEBI. Investors Obligations Study OD Provide PAN Monitor their investment Investors Complaints Redressal Mechanism Investor Grievances can be addressed to Trustee SEBI is the primary body to address MF complaints Investors cannot seek redressal under Companies Act since fund investors are neither share holders nor depositors in AMC Legal limitations to Investors’ rights Unit-holders (Investors) are not distinct from the trust and thus they cannot sue the trust A prospective investor does not enjoy any rights Quick Wit 1. Documents available to investors for inspection do not include a. Memorandum and Articles of Association of AMC b. Consent of auditors and legal advisors c. Investment management reports d. Reports based on which actual investments are made 2. AMFI is governed by a. RBI b. Ministry of Finance c. A board of directors elected from among members of AMFI d. SEBI 3. The a. b. c. d. 4. The a. b. c. d. 5. The a. b. c. d. highest authority among the following is the SEBI Company Law Board RBI Ministry of Finance entity that SEBI does not regulate is Share registrars Mutual funds Stock exchanges Non-banking finance companies accounts and all other records of an AMC are filed with AMFI Registrar of Companies Agent’s Association UTI 6. Fund merger involving 2 or more schemes of different AMCs requires consent of unit holders with X% voting rights. X is a. 50 b. 100 c. 51 d. 75 7. a. b. c. d. A close-ended scheme of a mutual fund is not governed by Exchange Rules of the stock exchange where it is listed Listing Agreement between the fund and the stock exchange Guidelines issued by the Ministry of Commerce Companies Act provisions relating to transactions in securities 8. Which of the following is a Self-Regulatory Organisation? a. Bombay Stock Exchange b. SEBI c. AMFI d. RBI 9. A Self-Regulatory Organisation can regulate a. All entities in the market b. Only it’s own members in a limited way c. Its own members with total jurisdiction d. No entity at all 10. Only one of the following is required to pass the AMFI examination a. trustees b. officers of SEBI working in the Mutual Fund department c. employees in a call center dealing with mutual fund investors d. fund managers 11. The amount of authority enjoyed by a Self-regulatory Organisation is defined by a. The apex regulatory authority b. Company law board c. It’s own members d. RBI 12. The role of AMFI in the mutual funds industry is not to a. Promote the interests of the unit holders b. Set a Code of Ethics c. Regulate mutual funds d. Increase public awareness of mutual funds in the county 13. Bank owned Mutual Funds are supervised by a. SEBI b. RBI c. Jointly by SEBI & RBI d. AMFI 14. Mutual fund units cannot be distributed by a. Trustees of the fund b. The AMC c. Non-banking finance companies d. Banks 15. An Investor invested in the UTI Money Market Mutual Fund. To see the relevant financial statements, she should read a. Financial statement of the schemes managed by UTI trustee b. Annual report of AMFI c. Annual report of SEBI d. Financial statement of the UTI AMC Answers 1. d 2. c 3. d 4. d 5. b 6. d 7. c 8. a 9. b 10. c 11. a 12. c 13. a 14. a 15. a CHAPTER 4 OFFER DOCUMENT Offer Document: contains the details of a scheme that the AMC prepares on behalf of the trustees and circulates to the prospective investor Contents of the OD Details of the sponsor and the AMC Description of the scheme and the investment objective Terms of issue Historical statistics Investor’s rights and services Fee structure and expenses Information on income and expenses of existing schemes Front page of the offer document contains its date of publication, name & type of fund and its major objectives. Specifically the following: Name of Mutual Fund Name of Scheme Type of Scheme (Equity/Income/Balanced) Name of AMC Unit Price Opening, Closing & Earliest Closing date Name of Guarantor if the scheme is an assured return SEBI disclaimer Statement to the effect that it is important for a prospective investor to read it and retain for future reference Validity of the OD for new schemes For a new scheme – 6 months from the date of receipt by the AMC of the letter containing observations from SEBI. For existing open-ended funds – updated at least once every 2 years For closed ended funds – published only once during the lifetime at the time of NFO Investors right to Information on Material Changes in scheme Examples of such major changes include: Reconstruction of the AMC Imposing or enhancing of entry or exit load Change in the Key personnel of the AMC especially the fund manager Addition of new plans in the existing scheme Change in management/controlling interest of the AMC Other important information regarding OD Compliance Officer, an AMC employee, has to sign the due diligence certificate which states that Information in the OD is according to SEBI formats Information is verified and is true and fair representation of facts All constituents of the fund are SEBI registered. Risk factors, both standard and scheme-specific, have to be disclosed Factors common to all funds are called as standard risk factors. These include market risk, no assurances of return, etc. Factors specific to a scheme are scheme-specific risk factors in the - these include restrictions on liquidity such as lock-in period, risks of investing in the First scheme of a fund, etc. Fundamental attributes of a scheme include: Scheme type Objectives Investment pattern Fees and expenses Liquidity conditions Accounting and valuation Investment restrictions, if any For any change in fundamental attributes, investor approval is not needed. Trustees and SEBI should approve the change and investors should be informed. A scheme cannot make any guarantee of return, without stating the name of the guarantor and disclosing the net worth of the guarantor. Information on existing schemes and financial summary of existing schemes to be given for 3 years. Information on transactions with associate companies to be provided for the past 3 years. If any expense incurred is higher than what was stated in the OD, for past schemes, explanations should be given. There is no information on other mutual funds, their product or performance in the OD. Investors’ rights are stated in the OD. The borrowing restrictions on the mutual fund should be disclosed. This includes the purposes and the limits on borrowing. 3 years track record of investors’ complaints and redressal should be disclosed in the OD. Any pending cases or penalties against sponsors or AMC should be disclosed in the OD. Key information Memorandum (KIM) KIM is the abridged version of Offer document. It is distributed with all application forms. In fact, the Offer document does not have an application form with it but a Key Information Memorandum does. Quick Wit 1. a. b. c. d. 2. a. b. c. d. 3. a. b. c. d. Which of the following is true? KIM is abridged offer document OD is abridged shareholder agreement KIM is abridged Investment Management Agreement OD is abridged KIM The following is not required on the cover page of the OD Date on which approved by trustees Earliest closing date for New Fund Offer Date the NFO closes Date the NFO opens A due diligence certificate does not certify that The draft offer document forwarded to SEBI is in accordance with SEBI regulations All legal requirements connected with launching of the scheme have been complied with Disclosures made in the offer document are true, fair and adequate The AMC guarantees a good performance 4. For assured return schemes, information about the guarantor's net worth which justifies guarantor's ability to meet shortfalls in the returns assured under the scheme can be found in a. The offer document b. The key information memorandum c. Both (a) and (b) d. None of the above 5. In the offer document, funds are required to make disclosures summarising associate transactions and their impact on the performance of the scheme for the last a. One fiscal year b. 2 fiscal years c. 3 fiscal years d. 5 fiscal years 6. a. b. c. d. 7. a. b. c. d. 8. a. b. c. d. An open ended scheme can change its fundamental attributes by allowing unit holders to exit scheme after 6 months without exit load after obtaining prior approval from SEBI informing each unit holder individually and allowing exit without exit load both b and c above The front page of an offer document need not cover Opening, closing and earliest closing date of the offer Disclaimer clause Legal and regulatory compliance Price of units The OD should indicate the management of the fund. The management doesn’t include name of trustees name of the Fund Manager business experience of the key personnel of the AMC registration number of the custodian 9. OD must contain information about unit holder transaction expenses. Which of the following is not an item under this? a. Repurchase load b. Initial issue expenses c. Max sales load d. Switchover load Answers 1. 2. 3. 4. 5. 6. 7. 8. 9. a a d c c d c d b CHAPTER5 FUND DISTRIBUTION & SALES PRACTICES Who can invest in a Mutual Fund? Residents including – Resident Individuals / HUF – Partnership Firms – Insurance Companies – Financial Institutions – Provident Funds Non Residents – NRI’s & Persons of Indian Origin Foreign Entities – FII’s registered with SEBI Foreign citizens / entities cannot invest in MF – Indian companies – Indian Trusts / Charitable Institutions – Banks – NBFCs -- Mutual Funds Distribution Channels MF products can be distributed by individual distributors as well as large distribution companies. MFs tend to prefer large distribution companies as it tends to reduce their administrative burden of dealing with individuals and thus saves on costs. Min Qualification required to be an MF Distributor is Class 12th. However everyone has to pass the AMFI test before selling MFs. As of March 31, 2005, almost 50,000 candidates had passed the AMFI certification out of which 30,000 had registered themselves. Sales Practices Norms for Distributors Distributors are compensated by funds through commissions. There are no rules prescribing the minimum or maximum commission rates. Commission could be paid as either or both of o Upfront Commission – paid for sale i.e., for getting the investment o Trail Commission – paid for retention of investors in the fund Distributor’s Obligations There are no mandatory guidelines for mutual fund distributors’ role and services to investors. Distributors need to comply with AMFI’s Code of Ethics titled AMFI Guidelines & Norms for Intermediaries (AGNI) as well as Code of Conduct given by the AMC they are registered with. AGNI as well as SEBI prohibits distributors from rebating commission. AMFI recommends certain distributor practices like knowing important characteristics of the scheme, identifying clients, know your clients, understanding needs of clients and helping them choose an investment etc. Sales Practices for Mutual Funds SEBI has laid an advertising code for MFs as per which: Dividends should be mentioned in rupees along with FV of each unit of that scheme For schemes > 1 year old, only CAGR can be advertised for 1, 3, 5 years and since inception Performance is compared against benchmarks Quick Wit 1. An agent's appointment by a fund a. Requires SEBI's approval b. Is a lengthy and cumbersome process c. Is mandatorily preceded by an AMFI test d. Does not require any approval 2. The a. b. c. d. following are not termed as "sales practices" Agents commission Before-and after-sales service to investors Advertising of schemes Stock broking among the following are not eligible to invest in MF? Indian Companies Banks Non Banking Finance Companies Foreign Citizens among the following are not Institutional Investors? Banks Resident Individuals Provident Funds Non Banking Finance Companies 3. Who a. b. c. d. 4. Who a. b. c. d. 5. Generally, which category of investors needs advice for Investing in Mutual Funds? a. Non Banking Finance Companies b. Insurance Companies c. Foreign Institutional Investors d. Individuals 6. Agents are compensated by mutual funds a. Through salaries b. Through commissions c. Through an annual fee d. Not in cash but in kind 7. An NRI wishes to invest in a Mutual Fund. Which of the following is true? a. He cannot apply as he will be paying in Foreign Currency b. Need not take individual permission as RBI has granted general permission in this regard c. The investor has to apply to RBI seeking permission as he will be paying in foreign currency d. Cannot apply as it is open to Indian residents only 8. The cut-off time for redemption request kept by an AMC is 3:00 pm. An application for redemption received at 3:01pm a. redemption will be based on next day NAV but no exit load will be charged b. redemption will be based on next day NAV c. applicant will be asked to resubmit the request 10 am the next day d. the same day NAV will apply since the gap is less than 30 minutes from cut-off time 9."Sales Practices" cover the following areas a. Desirable marketing practices b. Agents responsibilities to the investor c. Ethical code of conduct d. All of the above Answers 1. 2. 3. 4. 5. 6. 7. 8. 9. c d d b d b b b d CHAPTER 6 ACCOUNTING VALUATION AND TAXATION Accounting policies to be followed by mutual funds are laid down in the SEBI (Mutual Fund) Regulations, 1996. Investor’s subscriptions to the mutual fund are accounted as unit capital, and not as liabilities or deposits. However unit capital is found on the liabilities side of the balance sheet and is maintained at face value. Assets of a mutual fund are the investments made by the fund. Other short-term assets in the fund balance sheet are called as current assets. Liabilities can be in the nature of short-term (Bridge) loans – max 6 months and max 20% of net assets (for dividend or redemption payment only) Net assets, in simple terms, refer to market value of investments less current liabilities. Net Assets are computed as: (Market value of investments + other assets + accrued income - current liabilities - accrued expenses) NAV is computed as Net Assets/No. of units outstanding All mutual funds have to disclose their NAV everyday, by posting it on the AMFI web site by 8.00 p.m. Open-ended funds have to compute and disclose NAVs everyday. Closed end funds can compute NAVs every week, but disclosures have to be made everyday. NAVs to be rounded off at least upto 4 decimal places for liquid/MMMFs and at least upto 2 decimal places for others. Sale Price – Price at which MF sells and investor buys (Subscribes) = NAV + Entry Load Repurchase Price – Price at which MF buys and investor sells (Redeems) = NAV – Exit Load !!!CAUTION!!! For Numerical, always do load calculations on NAV. Other accounting guidelines Changes in NAV due to the assumptions about accruals should not impact NAV by more than 1%. Changes in NAV attributable to non-recording of sale and repurchase of units or securities cannot be more than 2%, and these transactions should be recorded within 7 days. Initial issue expenses of a scheme cannot exceed 6% of funds mobilized. Any amounts above this have to be borne by Sponsor or AMC. For a closed end fund, initial issue expenses are charged over the life of the scheme, on a weekly basis. Open-end funds can no longer charge initial issue expenses to the scheme, any expenses towards launch have to be recovered from the entry load and excess have to be borne by the AMC. A fund that does not charge any of the initial issue expenses is called a no-load fund. AMC can charge 1% higher investment management fee in case of a no-load scheme. The mutual fund can charge the following recurring expenses: o Investment management fees to the AMC o Custodian’s fees o Trustee Fees o Registrar and transfer agent fees o Marketing and distribution expenses o Operating expenses o Audit fees o Legal expenses o Costs of mandatory advertisements and communications to investors Regulatory Ceilings on Fees & Loads Fee Type Initial Issue Expenses (Charged on Corpus collected during NFO) Recurring Expenses (Charged on Weekly Average Net Assets) Open-End Cannot Charge Can Charge ClosedEnd Can Charge Maximum Limit Not to exceed 6% of initial resources Can Charge Up to 100Cr – 2.5% 100Cr-400Cr – 2.25% 400Cr-700Cr – 2.00% Above 700Cr – 1.75% Above limits are lower by 0.25% for debt funds For FOFs this is 0.75% flat Investment Management Fee (included in recurring expenses above) (Charged on Weekly Average Net Assets) Entry Load (Charged on NAV) Exit Load (Charged on NAV) Can Charge Can Charge Up to 100Cr – 1.25% Above 100Cr – 1.00% Higher by 1% for No-Load Schemes Can Charge Can Charge Cannot Charge Can Charge CDSC (Variable Exit Load) (Charged on NAV) Can Charge Can Charge For Open-end fund Entry + Exit Load <= 7% of NAV Also Repurchase price cannot be less than 93% of Sale Price For Closed-end fund Exit Load <= 5% of NAV Up to 12 months – 4% Up to 24 months – 3% Up to 36 months – 2% Up to 48 months – 1% Above 48 months - Nil Accounting Policies applicable to MFs Investments are marked to market using market prices Dividends should be recognized not on the date of declaration but on the day the share gets quoted ex-dividend. Same for Bonus & Rights shares To calculate gain or loss from sale, average cost method must be followed Purchase/Sale to be recognized on trade date and not on settlement date Distributable Reserves = Income + Realised Gain – Expenses – Unrealised losses Equalization a/c is created to ensure that regular sale and repurchase of units does not change the percentage of income distributed Non Performing Assets An asset is classified as NPA if interest or principal amount remained outstanding for one qtr from the day such installment has fallen due. Deep Discount Bonds (DDBs) are classified as NPAs if the grade falls to BB or below OR it is defaulting on other commitments OR in case of full Networth erosion of the borrower. Valuation of Scheme Portfolios Valuation of Equity Securities Traded Securities – Mark to Market – i.e., last quoted closing price on the stock exchange where it is ‘principally traded’ Thinly Traded Securities – Those securities which are traded for less than 5 lacs AND less than 50,000 shares – Complex valuation method is used if the security is not traded for more than 30days otherwise last traded price. Valuation of Debt Securities Traded Securities – as quoted in market upto last 15 days Thinly Traded Securities – those securities (except GoI securities) where there is no trade in marketable lot of Rs 5 Cr on valuation date Securities with maturity upto 182 days are valued on the basis of amortization cost + accrued interest Taxation In the hands of the funds – Income earned by all SEBI registered MFs is exempt from tax under Sec 10 (23D) of IT Act, 1961. In the hands of investors As per Income Tax all funds are classified as Equity Oriented (>=65% in Indian Equities) Debt Oriented (<65% in Indian Equities) Current tax-rates (FY 2007-08) are as follows: Income Type Dividend STCG LTCG Fund Type Equity Debt Equity Debt Equity Debt Tax Rate (in the hands of) MF Investors NIL NIL Pays DDT NIL NIL 10%* NIL Added to income* NIL NIL NIL 10% flat or 20% with indexation* * for NRI Investors, this is deducted at source by the MF. 20% in case of LTCG for Debt schemes DDT Rates Individuals & HUFs – 12.5% + Surcharge & Education Cess = Effective Rate of 14.1625% Other Investors – 20% + Surcharge & Education Cess = Effective Rate of 22.66% For liquid funds = DDT rate is 25% + Surcharge & Education Cess = Effective Rate of 28.325% irrespective of the category of investor Securities Transaction Tax – Levied at the time of sale/redemption of Equity Oriented Funds @ 0.25% MF units are not under Wealth Tax ambit FOFs are treated as debt schemes even though they may be investing in equity schemes Quick Wit 1. NAV a. b. c. d. means: (Market Value of Assets – Liabilities) / number of units outstanding (Book Value of Assets – Liabilities) / number of units outstanding unit capital / number of units outstanding net assets / initial number of units 2. A mutual fund may transfer investments from one scheme to another a. Not at all b. At current market rates c. At cost price d. At a fixed premium over market rate 3. In case of listed securities of group companies of the sponsor, mutual fund is not allowed to invest more than a. 25% of its net assets b. 10% of its net assets c. cannot invest at all d. >5% of net assets 4. In a a. b. c. d. mutual fund investor's subscriptions are accounted for as Liabilities Deposits Unit capital None of the above 5. Liabilities in the balance sheet of a mutual fund are a. In the form of long-term loans b. Strictly short term in nature c. Combination of long term and short term d. Not allowed as per regulations 6. Which of the below is a short-term capital asset? a. Unit of MF held for a period of not more than one year preceding the date of transfer b. Unit of MF held for a period of less than one year preceding the date of transfer c. Unit of MF held for a period of less than three years preceding the date of transfer d. Unit of MF held for a period of not more than three years preceding the date of transfer 7. For a scheme that has a load, the AMC can charge an investment management fee not exceeding a. 1.50% b. 2.00% c. 1.25% d. 0.50% 8. The a. b. c. d. maximum load that a fund can charge is determined by AMC SEBI AMFI Distribution agents based on demand for the fund 9. The a. b. c. d. "load" charged to an investor in a mutual fund is Entry fee Cost of the paper on which the unit certificates are printed The fee the agent charges to the investor The expenses incurred by fund managers for distributing a mutual fund scheme 10. NAVs of equity funds are not affected by a. Stock market movements b. Events affecting the industry/sector in which the fund has invested c. Happenings in the companies in which the fund has invested d. Real estate prices 11. All expenses and income accrued upto the valuation date shall be considered for valuation. Some minor expenses need not be so accrued, provided their affect on the NAV is not more than: a. 2.0% b. 1.5% c. 0.5% d. 1.0% 12. Net a. b. c. d. 13. For a. b. c. d. Asset Value (NAV) of a mutual fund scheme is defined as the scheme’s Assets minus liabilities Assets per unit Assets minus liabilities per unit None of the above an open-ended fund, the repurchase price should not be lower than NAV 95% of NAV 93% of NAV 97% of NAV 14. Contingent deferred sales charge (CDSC) a. Is higher for investors who stay invested in the scheme longer b. Is lower for investors who stay invested in the scheme longer c. Is the same for all investors irrespective of how long they stay invested d. Is not allowed to be charged to mutual fund investors in India 15. What would be the maximum initial issue expenses charged from the investors, if the amount mobilized from a mutual fund during the NFO is Rs. 50 crore? a. Rs. 5 crore b. Rs. 2 crore c. Rs. 3 crore d. Rs. 1 crore 16. The charge to an investor at the time of redemption of units from the fund is known as a. Recovery charge b. Repurchase load c. Redemption weight d. Exit load 17. The total net assets of a fund scheme increased from 100 cr to 120 cr. Of this, 5 cr was unrealized gain. The number of units is 10 cr. The maximum dividend per unit the scheme can declare is: a. Rs 2 b. Rs 1.50 c. Rs. 0.50 d. Rs. 1 18. Loads are recovered a. from agents and distributors b. as a fixed amount each year c. at the time of investor’s entry or exit d. none of the above Answers 1. a 2. b 3. a 4. c 5. b 6. a 7. c 8. b 9. d 10. d 11. d 12. c 13. c 14. b 15. c 16. d 17. b 18. c CHAPTER 7 INVESTOR SERVICES Investment Plans/Options and Services The term investment plan generally refers to the portfolio flexibility that the fund provides to investors offering different ways to invest or reinvest. Automatic Reinvestment Plans (ARP) - to reinvest the amount of dividends or other distributions made by the fund in the same fund. Systematic Investment Plans (SIP) - Invest a fixed sum periodically, through direct debit/PDCs to the investor’s bank account. Systematic Withdrawal Plan (SWP) - allow the investors to make systematic withdrawals from his fund investment account on a periodic basis. Systematic Transfer Plans (STP) - allow the investor to transfer on periodic basis a specified amount from one scheme to another within the same fund family (meaning two schemes managed by the same AMC and belonging to the same mutual fund). A transfer will be treated as redemption of units from the scheme from which the transfer is made and as investment in units of the scheme into which the transfer is made. Other Investors services Telephone/Internet transactions Investors may redeem or purchase units by calling a fund representative or registrar or investor service centre. Many distribution companies, banks and brokers accept investor’s instructions by telephone or through internet/e-mail. Cheque writing Some open end mutual funds allow the facility of cheques writing by providing the investor with a cheques book treating his fund account as the equivalent of a bank savings account for this purpose. The fund must have RBI approval in order to offer this service. RBI rules do not permit investors to issue cheques to third parties for other payments. Periodic Statement and Tax Information All mutual funds provide periodic statements to investors in the form of financial statements and performance reports. SEBI regulations require funds to send annual financial statements to unit holders within six months of the close of the accounting year. Loans against Units Several banks lend to the investors against mutual funds units held by them. The amount of loan is usually a percentage of the value of the investors holding in units. Quick Wit 1. What is the proof that the investor has invested in mutual fund units? a. The investors receive units commensurate with the investment made b. Investors get an account statement, showing their holdings and their price c. The receipt of money acts as the proof d. None of the above 2. Which of the following is true? a. SEBI does not allow the investor to pledge his mutual fund units in favor of a financial institution b. An investor cannot redeem his mutual fund holding in part c. The frequency of investment offered for SIP varies from one fund to another d. All of the above 3. Which of the following is TRUE of an automatic reinvestment (or growth) plan? a. The growth plan allows for the automatic reinvestment of all returns b. The major benefit of automatic reinvestment is compounding c. An investor who subscribes to the growth option under a scheme can later switch to a dividend option d. All of these 4. A Systematic Investment Plan a. Requires the investor to invest a fixed sum periodically b. Enforces saving in a disciplined and phased manner c. Provides the benefit of Rupee Cost Averaging d. All of these 5. A systematic withdrawal plan is ideal for a. Investors with growth as the main investment objective b. Investors who wish to benefit from market fluctuations c. Investors who prefer a regular income stream d. Investors who are not sure about themselves 6. Mutual fund in India do not offer a. Nomination and transfer facilities b. Redemption of units c. Loans against units d. Providing periodic statements to unit holders regarding their transactions Answers 1. 2. 3. 4. 5. 6. b c d d c c AMFI Revision Kit/Ver. 2008.01 CHAPTER 8 INVESTMENT MANAGEMENT Investment or Portfolio Management is a “specialist” function. After collecting and investing an investor’s money effective portfolio management will have to give acceptable returns to the investor, in order to keep him satisfied and prevent him from moving to any other competitor fund. Equity Portfolio Management Types of Equity Instruments Ordinary shares – constitute ownership of the company and each share entitles the holder to ownership privileges such as dividend declared by the company and voting rights at meetings. Preference shares – do not constitute ownership. However holders have preference over ordinary shareholders in two instances a) in payment of dividend at fixed rates subject to availability of profits after tax, b) in payment of principal in case of winding up of the company. Equity Warrants - are long term rights that offer holders the right to purchase equity shares in a company at a fixed price on a future date (akin to a call option). Convertible Debentures - fixed rate debt instruments that are converted into equity shares at the end of a specified period. Equity Classes On the basis of Market Capitalisation Market Capitalisation or M-Cap is equivalent to the current value of a company i.e. No of shares outstanding * current market price. Every fund manager could categorise M-Cap differently An indicative figure is: Large Caps – Market Cap > Rs 5000 Cr Mid-Cap – Market Cap > Rs 1000 Cr but < Rs 5000Cr Small-Cap – Market Cap < Rs 1000 Cr Classification in Terms of Anticipated Earnings Price/earning ratio: Price of a share/Earnings per share (MPS/EPS) Dividend yield: Dividend per share/Current market price (DPS/MPS) Cyclical Stocks: are shares of companies whose earnings are correlated with the state of the economy. Their earnings tend to go up during upward economic cycles and vice versa. E.g. Cement & Steel stocks Growth Stocks: are shares of companies whose earnings are expected to increase at rates that exceed normal market levels. They tend to re-invest earnings and usually have high P/E ratio and low dividend yield. Value Stocks: are shares of companies in mature industries and are expected to yield growth in earnings. These companies may, however have assets whose values have not been recognized by investors in general and are thus underpriced /available cheap. AMFI Revision Kit/Ver. 2008.01 Approaches to Portfolio Management Passive – in which the fund manager’s objective is to seek a return equal to that of the index (the benchmark that it tracks) e.g. Index Funds Active – in which Fund Manager seeks to do better than the index it tracks Securities Research Fundamental Analysis – involves research into a company’s management, its operations, its competition and finances. Technical Analysis – involves predicting future price movement on the basis of historical stock price movement and trading volumes. Quantitative Analysis – uses mathematical models for equity valuation. Portfolio Management Organisation Structure Fund Managers are strategists who take overall decisions on asset allocation or industry exposures Security Analysts support the fund manager in tracking of sectors and companies Security Dealers execute the actual order by dealing with brokers and internal operating staff Debt Portfolio Management Classification of Debt Instruments Secured – backed by assets of the borrowers, generally in case of Corporate Debentures Unsecured – no asset backing of the borrower e.g. FI Bonds Interest Bearing – in which interest is paid Discounted – Instruments which are issued at a discount to face value, on maturity the face value is paid and no interest (coupon) payment in between, the difference being chargeable to tax as interest Fixed Rate – Interest rate is fixed Floating Rate or Floater – Interest rate varies with a certain benchmark (e.g. MIBOR etc.) Type of Debt Instruments Short-Term Certificate of Deposit are unsecured instruments issued by banks for 91days to 1 year at a discount to face value Commercial Paper are unsecured instruments issued by corporates for 3 months to a year at a discount to face value (generally used for working capital finance requirements) Treasury Bills are short term government obligations for 91days to 364 days, issued at a discount to face value Long-Term G-Secs/Corporate Debentures/ PSU Bonds/FI Bonds issued by the respective issuers Characteristics of Debt Instruments Par Value – Amount to be paid on maturity Coupon – Annual interest payment Maturity – Date on which issuer has to repay face value Call Option – Allows the issuer to redeem (call back the bond) before maturity; exercised in case interest rates fall in the economy Put Option – Allows the investor to redeem before maturity; would be beneficial to exercise in case interest rates rise in the economy AMFI Revision Kit/Ver. 2008.01 Measures of Bond Yields Current Yield = Annual Coupon Interest/Current Market Price Yield to Maturity = is a bond’s IRR = Prevailing interest rates Risks in Bond Investing Interest Rate Risk – Bond Prices and Interest rates move in opposite direction Reinvestment Risk – Risk of not being able to reinvest earnings into same rate instruments Call Risk – Risk of instrument getting redeemed before maturity leading to loss of interest Default Risk – Risk of borrower not being able to repay on time Inflation Risk – Higher inflation raises return expectation Liquidity Risk – Not being able to cash out when required Yield Spreads – It is a measure of default risk. It is the difference or additional yield in comparison to a benchmark which is usually a govt security. Higher the Credit rating, lower is the spread. Duration – is a measure of interest rate risk. It measures the percentage change in stock price for a 1% change in yield Investment Restrictions Minimum number of investors – 20, where no single investor should have more than 25% of corpus Investments in Equity Shares or equity related instruments of a single company cannot exceed 10% of NAV (except index and Sectoral funds, where the respective index limit applies) A Mutual Fund under all its schemes combined cannot own more than 10% of any company’s paid-up capital with voting rights Investments in ‘rated investment grade’ instrument of a single issuer cannot exceed 15%. This limit can be extended to 20% with prior approval of AMC board and Board of Trustees. For unrated instruments the limit is 10% for one issuer and 25% collectively in a scheme. Investment in unlisted shares is capped to 10% for closed-end and 5% for openend schemes. Mutual Funds can also invest in overseas listed companies upto USD 300 million per fund house and USD 4 billion as the industry combined. No lending. Prohibition from investing in unlisted companies of the sponsor. Only delivery based sale/purchase is allowed. Securities have to be bought in the name of the scheme. AMFI Revision Kit/Ver. 2008.01 Quick Wit 1. Calculate the current yield on a G. Sec with at par value of Rs. 1000, coupon of 11% and market price of Rs. 1010. 1. 11.20% 2. 10.89% 3. 11.21% 4. 12.20% 2. Cyclical stocks command, 1. Relatively lower P/E ratio, and have higher dividend payouts 2. Relatively higher P/E ratio, and have higher dividend payouts 3. Relatively higher P/E ratio, and have lower dividend payouts 4. Relatively lower P/E ratio, and have lower dividend payouts 3. Current yield relates interest on a security to a. Its current market price b. Its face value c. Its fair value d. The current price of T-Bills 4. Dividend yield for a stock is a. Dividend per share b. Dividend per face value c. Dividend per share to current market price d. None of the above 5. As compared to a fund with fluctuating total returns, a fund with stable positive earnings a. Gives higher returns b. Is less risky c. Gives lower returns d. Is more risky 6. As per SEBI, Non-Performing assets (NPA) of a mutual fund can be defined as a. An equity which is trading below its par value b. An equity share which is yet to be listed on the stock exchange c. A debt security on which either interest or the principle or both amounts are due but not received for one quarter after the due date d. None of these 7. Of the following, which type of the fund would have a higher P/E multiple in comparison to average market multiple a. A value fund b. A growth fund c. An index fund d. Could be any of the above three, one cannot generalise 8. The a. b. c. d. differentiating factor among debt funds of comparable maturity and quality is Gross yields Costs Fund age Tenure of the fund manager AMFI Revision Kit/Ver. 2008.01 9. Up to what extent unlisted equity shares can be held in an Equity fund? a. 10% in Closed Ended fund b. 5% in open ended fund c. Both a and b d. None of the above 10. An a. b. c. d. active style of portfolio management includes the following Application of ‘Systematic Transfer Plan’ in various schemes of a fund Undertake macroeconomic analysis to determine profitable investment trends Invest in companies with high market capitalization All of the above 11. When interest rate rises, bond price a. is not affected b. fluctuates up or down c. also rises d. falls 12. A growth fund manager would apply the following strategies a. Invest in those companies that would give more returns than the average returns in the industry. b. Invest in companies having a large equity base. c. Invest in companies coming out with new “Initial public offer’ d. All of the above 13. When interest rates for similar maturities bonds are 11.5%, bond with a 8% coupon rate will become a. More attractive b. Less attractive c. At par d. The price is unrelated to the interest rates for similar securities 14. Duration of a bond means the percent change in: a. price with change in yield b. price as a result of stock market fluctuations c. price with change in coupon rate d. none of the above AMFI Revision Kit/Ver. 2008.01 Answers 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. b a a c b c b b c b d a b a AMFI Revision Kit/Ver. 2008.01 CHAPTER 9 MEASURING AND EVALUATING FUND PERFORMANCE Methods of calculating return Change in NAV or Absolute Return Method This method is suitable for computing returns between two dates. This is simple to compute & easy to understand. (NAV at the end of Period-NAV at the beginning of Period)*100 NAV at the beginning of Period Simple Total Return method In this method, dividends distributed are added to change in NAV to compute total return. Thus the formula is (Change in NAV + Distribution)*100 NAV at the beginning of period Return on Investment or Total Return with Dividend Reinvested method In this method, dividends are assumed to be reinvested (purchase more units). The Formula is: (NAV at end*Units at end)-(NAV at beginning*Units at beginning)*100 NAV at beginning* Units at beginning Units at end = Units at Beginning + Additional Units purchased Additional Units purchased = Dividend Amount / Ex-Div NAV CAGR This is the simple compound interest formula solved for r. The formula is: n A = P (1+r) A= Amount at Maturity, P = Principal investment, r = Rate of Interest, n = no of year Solve the equation for r 1/n r = (A/P) - 1 For a fund that has not completed a year, only absolute return should be used. Less than one year return should not be annualized except for liquid funds. For a scheme that has completed a year, CAGR is used. Expense Ratio = Total Expenses/Net Average Assets – is an indicator of fund’s efficiency and cost effectiveness Income Ratio = Net Investment Income/Net Assets – usually for income oriented funds Portfolio Turnover Rate = Lower of assets purchased or sold/Net Assets. This indicates churn and transaction cost Evaluating Fund Performance Funds performance is measured against a benchmark, usually an index Index funds performance is also measured against the index it is designed to track, called the BASE index. Variation in actual return from index return is called tracking error Debt funds performance is tracked against an appropriate index similar to composition of the fund. FMPs are usually compared against Fixed deposits of similar maturity AMFI Revision Kit/Ver. 2008.01 Quick Wit 1. The NAV of an open-ended fund was Rs.16 at the beginning of the year and Rs.22 after 13 months. The annualised change in NAV is a. 6.0% b. 34.6% c. 40.6% d. 37.5% 2. A fund has a front load of 1% and back-end load of 0.5%. The investor enters at NAV of Rs.10 and exits at NAV of Rs.12. The return of investment earned by him is a. 20% b. 18.22% c. 18.5% d. None of these 3. What would be a suitable benchmark to evaluate a closed-end debt fund? a. BSE Sensex b. I-sec’s Si-bex c. Crisil Composite Bond Fund Index d. S & P CNX Nifty 4. An actively managed equity fund expects to a. Be able to beat the benchmarks b. Earn the same returns as the benchmark c. Have no benchmarks d. Underperform when compared with the benchmark 5. Turnover rates would be most relevant to analyze the performance of a. Equity funds b. Growth funds c. Debt funds d. Value funds 6. Which of the following is of no relevance in evaluating fund's performance? a. The performance of the stock market as a whole b. The performance of other mutual funds c. The returns given by other comparable financial products d. The change in wholesale price index 7. The a. b. c. d. difference between NAV change and total return as measures of fund performance is None Total return takes dividend into account while NAV change does not Total return does not take NAV into account Total return does not take the time period into account AMFI Revision Kit/Ver. 2008.01 Answers 1. 2. 3. 4. 5. 6. 7. b b b a a d b AMFI Revision Kit/Ver. 2008.01 CHAPTER 10 HELPING INVESTORS WITH FINANCIAL PLANNING Financial planning is an exercise aimed at identifying all financial needs of an individual, translating the needs into monetarily measurable goals at different times in the future, and planning the financial investments that will allow the individual to provide for and satisfy his future financial needs and achieve his/her life’s goals. Benefits of becoming a financial planner include: ability to establish long term relationships ability to build a profitable business A financial planner’s role is discussion of client’s goals and asset allocation and then help client select an appropriate scheme and fund manager. The fund manager’s role is analysis of markets and choice of individual securities. Asset allocation refers to allocation of a client’s investments at a broad level across various asset classes, including real assets (real estate, jewellery etc.) and financial assets. Risk tolerance of a client refers to the extent of loss that a client can tolerate and for how long they can withstand such declines in value. Portfolio rebalancing refers to the process of making changes to asset allocation and specific investments to ensure that the strategy remains current with changes in the client needs, financial situations and market conditions. Client Financial Planner Fund Manager Portfolio Investments Discussion Of Goals & Asset Allocation Choice of Schemes & Fund Manager Market Analysis & Choice of Securities Financial Planning process was first formalized by the Certified Financial Planner – Board of Standards (USA) and consists of six steps: I. establish and define client-planner relationship II. gathering client data, defining client goals III. analyzing and evaluating a client’s financial status IV. developing and presenting financial planning recommendations and/or options V. implementing the financial planning recommendations VI. monitoring the financial planning recommendations Indian Financial Planner should use the process as follows: Step 1: Establish and define the relationship with the client Step 2: Define the client’s goals Step 3: Gather & analyze data, assess current resource & future income potential of client Step 4: Determine and shape the risk tolerance level of the client Step 5: Ascertain the client’s tax situation Step 6: Recommend the appropriate asset allocation and specific investments Step 7: Execute the plan and make the client invest Step 8: Review progress and rebalance portfolio AMFI Revision Kit/Ver. 2008.01 Measurable financial goals must be set. Financial planning is not the same as investing, it comes before investing. A client must understand the effect of each financial decision on other areas of life. Once every 3 to 6 months, the planner should meet the client to review progress and perform an active, ongoing evaluation of results. The client must play an active role in decision-making, ask questions and stay ‘in charge’. Basis of Financial Planning Life Cycle and Wealth Cycle Stages The life cycle of an individual can be sub-divided into: o Childhood stage o Young unmarried stage o Young Married stage o Young Married with children stage o Married with Older Children stage o Post-family/pre-retirement stage o Retirement Stage During childhood stage, the main need for children may be to invest cash gifts to provide lump sum when they are adults. During young unmarried stage, there may be urgent short term needs such as saving up to marry and establish a home. During young married stage, it is important to create an emergency fund before committing to long-term plans. The need for life insurance is higher in case only one partner is working. During the young married with children stage, the need for adequate life cover is higher and must be met first. During married with older children stage, provision to provide retirement income is crucial. During post-family/pre-retirement stage, protection from disability and health problems is important as well as the need to maximize investment into pension products. At retirement stage, need for fixed income and capital protection is crucial. A supplementary approach to life stage guide is the wealth cycle guide. The wealth cycle approach is more comprehensive and relevant than grouping investor merely by age or ‘life stage’. The wealth stages of a client are: a. accumulation stage – the financial goals are quite some time away and investments can be made for the long-term; clients are looking to build wealth b. transition stage – one or more of the goals are approaching and clearly in sight; c. reaping stage – the cashing out stage when the goal has arrived; a client about to retire or just retired d. intergenerational wealth transfer stage – older investors who need to start thinking about how to share their wealth e. sudden wealth stage – significant events such as a sale of shares or business, inheritance or winning from a contest/lottery making the client wealthy. An effective mode of investing is ‘goal oriented investing’ where a specific and separate asset allocation and investment strategy is evolved to meet each individual goal. goal-oriented investing works well for all types of investors. affluent investors is a category of wealthy individuals who do not need financial planning to take care of the normal goals such as retirement income, children education/marriage etc affluent investors are categorized as: wealth creating – those who are willing to take risk to make their net worth grow wealth preserving – those who are looking to primarily conserve the wealth that they already have AMFI Revision Kit/Ver. 2008.01 Quick Wit 1. Financial planning is: a. investing funds to receive the highest rate of return possible b. resorting to tax planning to keep taxes as low as possible c. planning for retirement with the maximum income possible d. process of solving financial problems and reaching goals 2. Investment strategy need not be refined if a. The client’s future needs or current resources change b. The investment climate and financial markets change c. The client’s personal situation, on account of a personal or financial event, change d. The stock market moves up drastically 3. A couple in mid 40s who have children approaching the age of higher education or marriage are in a. accumulation stage b. transition stage c. reaping stage d. distribution phase 4. A client whose goal of buying a house or funding a child’s education is close at hand is in the: a. accumulation stage b. transition stage c. reaping stage d. distribution stage 5. A grandfather wants to make an investment for a newborn grandson. Which is the most suitable investment? a. Index funds b. Income funds c. Money market funds d. Gilt funds 6. The a. b. c. d. basis of genuine investment advice should be The current market situation The agent commissions paid by different funds Financial planning to suit the investor's situation Planning to complete the agent's annual targets 7. Financial planners and their clients should focus on a. Allocating funds to asset classes b. Allocating funds to individual securities c. Tracking stocks, which they feel have potential d. None of the above 8. Financial Planning comprises a. Defining a client's profile and goals b. Recommending appropriate asset allocation c. Monitoring financial planning recommendations d. All of the above AMFI Revision Kit/Ver. 2008.01 9. Where would you place a 53 years old executive planning to retire at age 60? a. Sudden wealth stage b. Reaping stage c. Accumulation stage d. Transition stage 10. During the reaping phase the investor looks to: a. building wealth b. cashing out c. transferring wealth d. all of the above 11. A client’s financial plan need not be reviewed when a. the client has just retired b. the client has just been divorced at age 40 c. the client feels he has attained his financial goals d. the client’s mutual fund portfolio shows appreciation AMFI Revision Kit/Ver. 2008.01 Answers 1. d 2. d 3. b 4. b 5. a 6. c 7. a 8. d 9. d 10. b 11. d AMFI Revision Kit/Ver. 2008.01 CHAPTER 11 RECOMMENDING FINANCIAL PLANNING STRATEGIES TO INVESTORS Investing is a life-long activity, not an ad-hoc process. Investing for the long term provides the benefit of power of compounding. The more frequent the compounding, greater the growth in capital; six-monthly compounding of 100 rupees for 10 years would yield Rs. 321 instead of Rs. 311 with annual compounding. The ‘growth’ option offered in mutual fund schemes has the same power of compounding Different investing strategies suit different investors. Different strategies are: o Buy and hold: most common strategy and the most common mistake made by investors; falling in love with investments means sometimes holding on to non-performers and losing the power of compounding o Rupee Cost Averaging: investing in a disciplined manner; investing the same amount each month or at regular intervals will average our the cost of purchase, with per unit price being ‘always’ less than if you try and guess market highs and lows and invest irregularly Disadvantage: it does not tell you when to buy or sell a fund or to switch from loosing to winning funds o Value Averaging: keeping a target value of investment constant by investing the amount by which the investment value has come down or by cashing the increased value of his investment or doing nothing if the value is unchanged o Jacob’s recommendation of a combined approach: combine RCA and VA by using an aggressive growth fund and a money market fund of the same family Some key aspects that the client should keep in mind on when to invest and when to cash out: o invest whenever they have money o when to cash out needs more thought and skill o in case of stock – sell out as the price rises beyond reason or when fundamentals start to deteriorate o in case of mutual funds – redeem when the goals have arrived and clients need the money of if the market appears ‘overvalued’ in terms of fundamentals and historic valuations o buy and hold may not be a good strategy with stocks but is good in case of a mutual fund, provided the investor is willing to wait out a full market cycle o start planning and investing early o have realistic expectations o invest regularly Asset Allocation – the strategic tool Besides how much and for how long to invest, the important question is where to invest or which asset classes to invest in. Asset allocation means determining the percentage of investments to be held in equities, bonds and money market/cash instruments. Over 94% of returns on a managed portfolio come from the right level of asset allocation between stocks and bonds/cash. Benjamin Graham suggested a 50/50 split between equities and bonds. AMFI Revision Kit/Ver. 2008.01 Graham suggested different combinations Portfolio Type Basic managed Portfolio Portfolio mix 50% diversified equity ‘value’ fund 25% Govt Securities fund 25% High grade corporate bond fund 50% total stock market/index fund 50% total bond market portfolio 85% Balanced 60/40 fund 15% Medium term bond fund 20% diversified equity fund 20% aggressive growth fund 10% specialty fund 100% Single Index fund with 60/40 equity/bond holding Basic Indexed Portfolio Simple Managed Portfolio Complex Managed Portfolio Readymade Portfolio Graham’s 50/50 is the basic asset allocation. Bogle suggested variation to percentages based on age, financial circumstances and objectives. Bogle’s recommended strategic allocations are: Younger Investor 80E/20D 60E/40D Older Investor 70E/30D 50E/50D Accumulation Stage Distribution Stage E – Equity D – Debt Bogle’s thumb rule for asset allocation is that the debt portion of an investor’s portfolio should be equal to her age. So a 30-year investor can make a 70/30 asset allocation and at age 50 she could balance it out. Fixed asset allocation means liquidating a part of position in the asset class with higher return and reinvesting in the other asset with lower return. This is a disciplined approach and lets an investor book profits in rising market and increasing holding in falling markets Flexible asset allocation means no rebalancing and letting the profits run. If stocks continue to return more than bonds, then a fixed ratio is better than flexible ratio, e.g, in bull markets If bond returns are close to equity market returns, the flexible ratio may work better Tactical asset allocation refers to making changes in asset allocation within the overall percentage holding with the objective of yielding extra return e.g. investing in small company more than large-company shares or prefer value stocks over growth stocks A fund that earns a higher return than another can still give lower net returns, if its expense ratio or loads are higher – investors must watch out for such ‘cost penalty’ while selecting funds AMFI Revision Kit/Ver. 2008.01 Quick Wit 1. A criticism of Rupee Cost Averaging is: a. investment is for the same amount at regular intervals b. over a period of time, average per share price will be more than guessing highs and lows c. it does not tell you when to buy, sell or switch from one scheme to another d. rupee cost averaging has no serious shortcomings 2. Value averaging means a. Keeping the target value of investment constant by investing the amount by which the investment value has gone down b. Investing the same amount of funds regularly c. Investing in one lump sum amount d. None of these 3. Which of the following strategies is an example of the combined approach of RCA and Value Averaging? a. b. c. d. When the investor sets a target value for his investments in an Equity fund When the investor invests a fixed sum each month in a Liquid Fund When the investor invests regularly in a Liquid Fund When the investor invests regularly in a Liquid Fund , sets a target for an Equity Fund, then invests more in Equity Fund if its value declines and books profits when its value exceeds the target value 4. Which of the following is the best investment option for the purpose of getting the maximum benefits of compounding? a. 12% interest paid yearly b. 6% interest paid every 6 months c. 3% interest paid every quarter d. 1% interest paid monthly 5. As a financial planner, which of the following would you suggest for a person who can take a moderate risk? a. Aggressive growth fund b. Aggressive equity fund c. Diversified equity fund d. Sectoral fund 6. Financial planning involves the achievement of following objectives: a. Buying a home b. Purchase of a new car c. Planning for retirement d. All of the above 7. What is Bogle’s suggestion regarding the ‘rule of thumb’ for asset allocation? a. 50% equity and 50% debt b. 60% equity and 40% debt c. An investor’s allocation to debt should be equal to his age. d. Investor should not do any re-balancing of his/her portfolio 8. What should be the recommended portfolio for an investor who is risk averse in his transition phase? a. Higher allocation to equity funds AMFI Revision Kit/Ver. 2008.01 b. Higher allocation to debt instruments c. Investments only in equity d. He should not invest anywhere 9. Investors who follow the fixed allocation approach a. Maintain balance in their portfolio by liquidating a part of the position in the class, which has given higher return, and reinvesting in the other asset class, which has lower return b. Are not disciplined c. Increase their equity position when equity prices tend to climb d. None of the above 10. Which of the following lets an investor book profits in rising market and increase holdings in a falling market? a. Fixed Rates of Asset Allocation b. Flexible Ratio of Asset Allocation c. Investment without any asset allocation plan d. Buy and hold Strategy 11. A Flexible Ratio of Asset Allocation means a. Continuously changing the ratio of various assets in the portfolio b. Not doing any re-balancing and letting the profits run c. Active switching d. None of the above 12. Deciding on strategies such as long-term compounding, cost averaging, value averaging, active switching, all depend on the a. Stock market situation on date b. Amount of money to be invested c. Investor's risk tolerance d. Phase through which the economy is passing AMFI Revision Kit/Ver. 2008.01 Answers 1. c 2. a 3. d 4. d 5. c 6. d 7. c 8. b 9. a 10. a 11. b 12. c AMFI Revision Kit/Ver. 2008.01 CHAPTER 12 SELECTING THE RIGHT INVESTMENT PRODUCT FOR INVESTORS Products available Gold and real estate are physical assets available for investing. Investment in Gold is not subject to erosion on account of rupee depreciation. Historically, Gold is seen as a hedge against inflation or a means of security in bad times. Gold ETFs are now available which make investing in gold easier and make it a financial instrument. Financial assets with guaranteed or fixed returns have been popular e.g. bank deposits, company deposits, government saving instruments such as PPF, Indira Vikas Patra and NSC. Financial assets also include capital market securities such as equity/preference shares, bonds/debentures issued by companies or Financial Institutions, money market instruments such as commercial paper or certificate of deposits. Individual investors can buy capital market instruments but have no direct access to money market instruments. Mutual funds represent indirect investment through an intermediary – the fund. Investments in mutual funds, unlike bank deposits or governments saving instruments, are not guaranteed for return or capital. Issuer Bank Corporate Product Fixed Deposits Shares Bonds, Debentures Fixed Deposits Govt. Securities PPF Other personal investments Bonds Insurance policies Available to Investor, MFs Investor, MFs Investor, MFs Investor, MFs Investor, MFs Investor Investor Investor, MFs Investor Government FIs Insurers Bank deposits are favoured investment option due to safety and liquidity. Yield on bank deposits is negligible after accounting for inflation and tax. Corporate securities include equity instruments, debt instruments and quasi debt-quasi equity instruments. Equity instruments are in the form of shares issued either privately and unlisted, or issued publicly and listed on a stock exchange. Shares can be bought either at the time of Initial Public Offer (IPO) or subsequently or through the Stock Exchange where it is listed. Benefit of equity investing is the high growth potential and high degree of liquidity due to the listing on an exchange. Historically, equity investing has yielded the highest return. Challenge in equity investing is to identify the shares that are likely to appreciate. Corporate also issue debentures paying fixed rates of interest. In India, Debentures are generally secured by the assets of the borrower. Companies also issue unsecured bonds, like FIs. Company Fixed Deposit is another avenue available in the market. Company FDs are unsecured and generally carry a higher rate of interest compared to bank deposits and are taxable. Credit rating of the borrower is given by a rating agency. Borrowers with lower rating need to pay higher interest. Credit Rating is only an opinion expressed by an independent agency based on review of the issuer’s business. AMFI Revision Kit/Ver. 2008.01 Credit rating is assigned by agencies such as ICRA, CRISIL and CARE. Earlier financial institutions such as ICICI and IDBI issued bonds, general purpose or for infrastructure financing, usually unsecured in nature. FI bonds generally have 2 options – periodic interest or deep discount basis. Both options qualify for deduction under 80C of Income Tax Act. Deduction of Interest income under 80L is not applicable. Public Provident Fund (PPF) is a govt. obligation, risk-free, statutory scheme. PPF carries tax-free interest of 8% p.a. compounded annually and contribution up to Rs. 70,000 is eligible for deduction under Section 80C (F.Y. 2007-08). Only one account per individual is allowed. The scheme requires annual contribution between Rs. 500 and Rs. 70,000 to be made over 16 years, with the option to withdraw 50% of 4th year balance in the 7th year. Restriction on withdrawal reduces liquidity for the investor. Indira and Kisan Vikas Patra were introduced as post office schemes to tap rural savings, but also became popular with urban investors. Indira Vikas Patra is now no longer issued. RBI Bonds pay 8% p.a. (F.Y. 2007-08) and are fully taxable and has a maturity of 6 years. Government Securities are government paper issued for terms ranging from 1-30 years and define the yield curve to a great extent. Primary Dealers appointed for this purpose deal in G-Secs. Direct investing in G-Secs is possible, though amounts required may be large, hence best accessible through mutual funds. Life Insurance is available from LIC as well as private players. Term Insurance is a ‘Without Profit’ policy that provides a certain sum of money (Sum Assured) to the nominee of the life assured in the event of death within a specified term and nothing in case of survival. An endowment policy is generally a ‘with profit’ policy and provides the sum assured in the event of death or maturity (whichever is earlier) of policy term and also bonuses as declared from year to year. Most policies require the individual to pay a fixed premium on a yearly basis. If the individual decides to discontinue the policy during its tenure, he would be entitled to receive the policy’s surrender value, which is a percentage of premiums paid till date. Traditionally, life insurance has been viewed as an investment avenue and for its tax benefits. Premium paid on life insurance qualifies for deduction under Section 80C and proceeds at the time of death or maturity are exempt from tax under section 10(10D). Life insurance should not be viewed as an investment, but mainly to provide for dependants in case of untimely death viz. protection. A ‘convergence’ between mutual funds and life insurance is the advent of ULIPs which offer investors choice of investment plans with different asset allocation and life cover at the same time. Comparison of Investment Products Until 1980s, bank deposits were the primary investment option. US-64, the only mutual fund scheme, was managed as a fixed return investment, as safe as banks, and paying comparable though slightly higher dividends. Equity investing was introduced subsequently, but these were not perceived to be high-risk because of under pricing of primary share issues. After crisis of 1992 and free pricing of shares, risk of direct investing was known to investors. Professional management and lower of risk through diversification was now sought by investors. AMFI Revision Kit/Ver. 2008.01 Comparison of various financial products Convenience Equity FI Bonds Corp Debentures Company FDs Bank Deposits PPF Life Insurance (Traditional) Life Insurance (ULIPs) Gold Real Estate Mutual Funds Moderate High Low Moderate High High High Return High Moderate Moderate Moderate Low Moderate Low Safety Low High Moderate Low High High High Volatility High Moderate Moderate Low Low Low Low Liquidity High-Low Moderate Low Low High LowModerate Low High High High Moderate High Moderate High ModerateHigh LowModerate Moderate Low High Low Low High Moderate High High High Moderate High Comparison between direct equity investing and mutual fund investing Identifying stocks is a difficult and specialized process requiring research and monitoring the market Diversification, implied by the term ‘don’t put all your eggs in one basket’ is available to a mutual fund that pools the resources of many investors Professional management of funds ensures that the best avenues are tapped based on comprehensive information and detailed research, full utilization of market opportunities and tight control over costs Mutual funds focus on investment activities based on investment objectives such as income, growth or tax savings, thus providing a vehicle to attain objectives in a planned manner Mutual Funds offer liquidity through repurchase options and through listing on stock exchanges as against direct equity, where several stocks are often not traded for long periods Direct equity investing involves a high level of transaction costs per rupee invested in the form of brokerage, commission, stamp duty etc. In terms of convenience, mutual funds score over direct equity investing due to flexibility such as switch between schemes, cheque writing facilities etc. Equity investing is better in case the investor has a truly large portfolio and the time, knowledge and resources required for direct investing Comparison between bank deposits and Debt funds A bank deposit is guaranteed by the bank for repayment of principal and interest In a mutual fund, unlike the bank, there is no contractual guarantee for repayment of principal or interest to the investor In a mutual fund, the expected returns will be commensurate with the level of risk assumed by the fund A bank depositor does not directly hold a portfolio of investments, as he does in case of a fund AMFI Revision Kit/Ver. 2008.01 The Investor Perspective Investment Objective Capital Appreciation Income Income Income Income Income Risk Cover Risk Cover, Capital Growth, Income Inflation hedge Capital Growth, Income Capital Growth, Income Risk Tolerance High Low High-Moderate-Low High-Moderate-Low Low Low Low High-Moderate-Low Low Low-Moderate High-Moderate-Low Investment Horizon Long Term Medium-Long Term Medium-Long Term Medium Short-MediumLong Term Long Term Long Term Medium-Long Term Medium-Long Term Long Term Short-MediumLong Term Equity FI Bonds Corp Debentures Company FDs Bank Deposits PPF Life Insurance (Traditional) Life Insurance (ULIPs) Gold Real Estate Mutual Funds Mutual Funds offer higher flexibility as compared to other investment options. Mutual funds combine advantages of all other forms, while doing away with the disadvantages. AMFI Revision Kit/Ver. 2008.01 Quick Wit 1. Direct investment in stock markets can be a better option over investing through mutual funds if: a. the investor wants better returns than those offered by mutual funds b. the investor has large capital, knowledge and resources for research c. the investor has identified a bullish phase in the stock market d. the investor wants to invest for the long term 2. A small investor can build a diversified portfolio by a. Buying one share each of all listed companies b. Investing in a mutual fund c. Borrowing enough money to buy shares of well-managed companies d. None of the above 3. The a. b. c. d. difference between debenture and bond is: Bonds are issued by corporations and debentures are issued by PSUs Bonds are unsecured and debentures are secured. Bonds are backed by loans and debentures are backed by assets None of the above 4. An income fund scheme invests in debenture of a company. What is the relationship of MF investor with that company? a. Debenture holder b. Creditor c. Shareholder d. No relationship 5. An investor in need of regular income should not select: a. a bank deposit b. a debt fund c. an equity growth fund d. PPF 6. Which of the following has the highest level of liquidity? a. equity b. PPF c. Company Fixed Deposits d. Mutual Funds 7. The a. b. c. d. most important factor to look for when investing in a corporate fixed deposit is the Yield Rate of interest Credit rating of the deposit None of the above 8. Which of the following should not be viewed primarily as an investment option? a. Mutual Funds b. Equity shares c. Life Insurance d. None of the above AMFI Revision Kit/Ver. 2008.01 9. How would you convince a first-time investor who is risk-averse to invest in mutual funds in comparison to a bank deposit? a. Mutual funds is the right choice to grow your wealth at a fast pace b. Mutual fund has the likelihood of giving more growth than the bank deposit as the investment is in a diversified portfolio of securities. c. Investment in Mutual fund doubles your money in 3 years d. All of the above 10. An investor can assess the performance of his mutual fund by comparing it with the performance of a. Other mutual fund of the same type b. The stock market c. Other financial products d. All of the above 11. If an investor needs income, he should select funds with: a. low expense ratio b. high expense ratio c. low current yield d. high current yield 12. What makes mutual fund the single most important financial instrument as a financial planner? a. Mutual Funds help in portfolio diversification and risk reduction b. Mutual Funds help in doubling investment c. Both the above d. None of the above 13. An investor claims that the PPF is a superior instrument to Mutual Funds. An argument to defend investment in a Mutual Fund over PPF is: a. Mutual Fund will surely yield a better return than PPF b. A mutual fund offers the potential for higher income and capital appreciation c. The capital investment is safer in a Mutual Fund d. A Mutual Fund investment is less volatile 14. The liquidity needs of an investor are met through a. Equity funds b. Index funds c. Money market funds d. Sector funds 15. There is no contractual guarantee for repayment of principal or interest to an investor in a. Bank deposit b. Debt fund c. Secured debentures d. All of the above 16. Listing of shares at a stock exchange ensures a. Guaranteed returns b. Long term capital appreciation c. Low risk d. High liquidity AMFI Revision Kit/Ver. 2008.01 Answers 1. b 2. b 3. b 4. d 5. d 6. d 7. c 8. c 9. b 10. d 11. d 12. a 13. b 14. c 15. b 16. d AMFI Revision Kit/Ver. 2008.01 CHAPTER 13 HELPING INVESTORS UNDERSTAND RISK IN FUND INVESTING Defining Risk ‘Risk’ is equated with volatility of earnings. Risk can also be termed as deviation (both positive & negative) from expected earnings. The risk of MF investing can be built into the investment planning in two ways: o By defining the risk appetite of the investor and aligning the investment objectives to the investor’s risk tolerance. o by evaluating and measuring the risks of MF portfolio created for the investor so that risks assumed are kept in line with the investor’s risk appetite. The right level of risk tolerance of any investor depends upon his age, the amount of investable funds available, and his financial circumstances including income level, job security, family size etc. From Asset Allocation to Fund Category Selection Asset allocation is about allocating money between equity, debt and money market segments. Jacob’s recommendation of portfolio sub-allocations: Low-Risk (Conservative) portfolio 50% G Secs + 50% MMMF Moderate Risk (Cautiously Aggressive) portfolio 40% in Growth & Income + 30% Govt Bonds + 20% Growth Funds + 10% Index Funds High Risk (Aggressive) Portfolio 25% Aggressive Growth Funds + 25% International Funds + 25% Sector Funds + 15% High Yield Bond Funds + 10% Gold Funds Types of Risks in Equity Funds Company Specific Sector Specific Market Risk Company and Sector risk can be reduced with diversification but market risk cannot be diversified Measures of Risk (Statistical) Standard Deviation (Measure of Volatility) – is considered the best measure if risk. It measures fluctuation of a fund’s returns around mean level. Standard deviation is a measure of Total Risk. Lower the better. Beta Co-efficient (Measure of Sensitivity) – Relates a fund’s returns with the market index and measures the sensitivity of the fund’s returns to market index. Beta is a measure of Market Risk. A beta of 1 means that the fund moves with the market. A beta of 2 would mean that the fund’s volatility is double than that of the market. Higher beta funds do well in a rising market, lower beta funds do better in a falling market. AMFI Revision Kit/Ver. 2008.01 Bogle’s Ex-Marks or R-Squared (Measure of Sympathy) – It measures the correlation between the fund’s performance and the index. It thus helps in spotting questionable betas. The quality of beta depends on the Ex-marks (higher the Ex-marks, more reliable the beta). **Index Funds should have a Beta as well as R-Squared of 1** Measures of Risk Adjusted Return Sharpe Ratio S.D. Treynor Ratio Beta R = Fund return Rf = Risk-free return AMFI Revision Kit/Ver. 2008.01 Quick Wit 1. If beta is higher than 1, the fund is a. Less volatile than market b. More volatile than market c. Equally volatile than market d. No relation 2. An investor asks you in what order he should list the following schemes, going from the scheme with the least risk to the one with the highest risk – 1. Balanced Fund 2. A Stock Index Fund 3. A Liquid Fund 4. An IT Sector Fund. Suggest the right order. a. 1,2,3,4 b. 1,3,4,2 c. 3,1,2,4 d. 2,3,1,4 3. The a. b. c. d. ratio which divides risk premium by Standard Deviation is Sharpe Ratio Treynor Ratio Bogle Ratio Jensen Ratio 4. An ex-mark of 100% is possible for a. A growth fund b. An aggressive growth fund c. An index fund d. A balanced fund 5. The a. b. c. d. best equity fund, relative to others would have Higher ex marks, lower beta and higher gross dividend yield Higher ex marks, higher beta and higher gross dividend yield Lower ex marks, lower beta and lower gross dividend yield Lower ex marks, higher beta and higher gross dividend yield 6. A fund with a high beta coefficient gives greater returns in a rising market, and is more risky in a falling market a. True b. False 7. Which of the following is a disadvantage of standard deviation as a measure of risk? a. Standard deviation measures total risk, not just market risk b. It is based on past returns, which does not necessarily indicate further performance c. It is an independent number d. All types of fund can be measured with standard deviation AMFI Revision Kit/Ver. 2008.01 Answers 1. 2. 3. 4. 5. 6. 7. b c a c a a b AMFI Revision Kit/Ver. 2008.01 CHAPTER 14 RECOMMENDING MODEL PORTFOLIOS AND SELECTING THE RIGHT FUNDS Jacob’s 4 step program to developing a model portfolio Step I: Work with Investors to develop Long-term goals Step II: Determine the Asset Allocation Step III: Determine the Sector Distribution Step IV: Select specific fund manager and their schemes Jacob’s Model Portfolios Investor Young, Unmarried Professional Recommended Model Portfolio 50% in Aggressive Equity Funds 25% in High Yield Bond Funds and Growth and Income Funds 25% in Conservative Money Market Funds 10% in Money Market 30% in Aggressive Equity Funds 25% in High Yield Bond Funds 35% in Municipal Bond Funds 30% in Short-term municipal Funds 35% in long-term Municipal Funds 25% in moderately aggressive equity 10% in emerging growth equity 35% in conservative Equity funds 25% in moderately Aggressive Equity 40% in Money Market Funds Young Couple with two Incomes and two Children Older Couple Single Income Recently retired couple Jacob’s recommended Investment Strategies Investors in Accumulation Phase Equity, Sectoral & Balanced – 65% to 80% Income & Gilt Funds – 15% to 30% Liquid Funds – 5% Investors in Distribution Phase Equity & Balanced – 15% to 30% Income funds – 65% to 80% Liquid Funds – 5% Planning for Affluent Investors Wealth Creating Individuals: These are aggressive and tend to invest more in equity, maybe even 70% to 80% Wealth Preserving Individuals: Conservative and thus tend to invest majority into income, gilt and liquid funds AMFI Revision Kit/Ver. 2008.01 Fund Selection - Bogle’s Approach Equity Classify the funds – between Diversified, Sectoral, Index etc Chose a strategy – between Growth and Value Evaluate Past Returns – Compare with benchmark and with funds in same category over same timeframes Review Fund Size, Age, Costs, Manager’s experience – Bigger Size, Longer Age, Lower Costs and Higher Fund Manager’s experience are better Characteristics – Lower Cash Position, Low Concentration, Lower portfolio turnover are generally better. Higher Cap assumes less risk Risk Statistics – Low Beta, High Ex-Marks with the index, High Div yield are generally better Debt Type – Differentiate between Income/Gilt/Liquid etc Fund Age & Size – Bigger the Size and longer the age, better it is. Costs – Lower the better Loads – Should be low to none Average Maturity – Higher average maturity means higher interest rate risk. Credit Quality – More AAA rated securities, more secure the fund. MMMF Costs – Lower the better Quality – Extremely important for Liquid Funds that this is very high Yields – Higher the better Balanced Portfolio Balance – Should match investor’s objective Debt Portfolio Quality – Should be high Costs – Lower the better Portfolio Statistics – Just like equity funds AMFI Revision Kit/Ver. 2008.01 Quick Wit 1. A young couple has 2 incomes and 2 children. Jacob’s recommendation to them would be: a. 100% equity funds b. 10% money market, 50-60% aggressive equity and 30-40% conservative bond funds c. 25% debt 75% equity growth funds d. 80% debt and 20% equity funds 2. Which of the following is recommended by Jacob for a Low Risk portfolio? a. b. c. d. 50 % Growth and Income fund + 50% Money Market fund 50% Growth funds + 50% index fund 50% Government Securities fund + 50% Money Market fund 50% Sector Funds + 50 % Money Market fund 3. For which of the following would you consider “average maturity” as an important factor in selecting the right one for the investor? a. A debt fund b. A balanced fund c. A money market or liquid fund d. Both a and b above 4. A very high proportion of investment in all types of equity funds is advisable for investors a. In distribution phase b. In accumulation phase c. In transition phase d. Who are wealth preserving affluent individuals 5. For older investors who want to transfer their wealth a. b. c. d. No financial planning is required The right investment strategy depends upon who the beneficiaries are The right investment strategy depends upon the state of the stock market All the funds can be invested in aggressive equity funds AMFI Revision Kit/Ver. 2008.01 Answers 1. 2. 3. 4. 5. b c d b b AMFI Revision Kit/Ver. 2008.01 CHAPTER 15 BUSINESS ETHICS FOR MUTUAL FUNDS Business Ethics refers to rules of acceptable and good conduct in business. All those persons who are engaged in business should comply with rules of good conduct. These rules may be set by those who own and manage the business, or by those agencies that have the right to regulate the business. In many countries, laws such as consumer or investor protection act exist. Need of Business Ethics These are required to have honest and fair business practices. These are required to insure that the business is not done dishonestly and false promises are not made to the investors. From social angle, business ethics are required to protect the consumers’ interest. From the angle of business itself, good ethics means good business. Honest and fair practices will insure that the customer remain satisfied, will not feel cheated and the loyalty will increase. They are also required to have transparency in business dealings and insuring that both the existing as well as potential clients and consumers are treated at par. Need of business Ethics in Mutual Funds Mutual funds are vehicles of collective investment managed by asset managed companies. AMC manages this money to earn a fee. In this process the AMC take the help of many other entities including distributors and individual financial advisors. All these need to be abide by the rules of good conduct. In this process, the following points are important: o Trustees and directors of AMC set the rules for distribution and employees o AMFI has also set rules of good conduct for AMC’s , its employees and distributors Objective of Business Ethics The major objective is to have honest and transparent dealing with existing and potential consumers Another objective is protection of consumers or clients from being cheated or exploited We also require business ethics to ensure level playing field among all the business participants Business ethics also help in ensuring healthy competition for the benefit of all consumers Business Ethics and Fund Regulation in India Regulator’s Responsibilities Both the Govt. and SEBI are concerned with the protection of investor interest. SEBI has incorporated the rules of good conduct in MF regulations. SEBI has also issued guidelines to AMFI and MFs to develop code of conduct for fund distributors, fund managers and all employees and associates of AMC and Trustee Company. Regulatory objectives SEBI mandates the funds would have always conduct all their activities in the best interest of the investors. Three areas are particularly monitored by SEBI o Fund structure and Governance o Exercise of voting rights by funds o Fund operations AMFI Revision Kit/Ver. 2008.01 Fund structure – a Fiduciary responsibility for MFs A fund holds the investors money in trust. The money always continues to belong to investors. Fund managers only manage it. Such an arrangement of funds being held in trust places what is called a fiduciary responsibility on the trustees and fund managers. Naturally, ethical and honest behavior on the part of the fund trustees and managers is far more important for the MF industry than any other industry. The structure of the fund industry has been designed to protect the investor through a system of checks and balances on the observance of ethical standards by all the industry constituents. Fund Governance Regulators prime concern is investor protection. The entire legal structure prescribed for MF in India has been conceived to protect the investor through a system of independent controls or check and balances overall participants in the business Fund operations Insider trading Insider trading refers to buying and selling securities on the basis of privileged information available to the funds by person who are seen as insider to the company. Fund managers are not insiders but they can collude with other insiders to gain access to private information, and use that information to trade on their personal account. This would run against the interests of the investors. Preferential treatment to selected investors MFs are vehicle of collective investments where all investors in a scheme are to be treated equally. One group of investors cannot receive preferential treatment over another. The regulators keep a watch on AMCs to prevent any unethical practices in this regard. Personal trading by fund managers and employees Personal trading by fund employees who also buy and sell securities on behalf of the scheme can create situations of conflict of interest. Fund managers buy and sell securities from the markets for the MFs portfolio. They have access to information not necessarily available to others. The purpose is to ensure that the fund manager do not use any non-public information for personal gains. Compliance officer SEBI has made it mandatory for every AMC to have a compliance officer who would be responsible for implementation of all laws, guidelines and voluntary codes of conduct. Compliance officer not only reviews but can also give approval to personal trading and investment transactions. Code of Conduct for Distributors All the distributors and agents have to follow the code of conduct laid down in the 5th schedule of the SEBI MF Regulations (1996) as well as AGNI. Mutual funds have to monitor and report any violation of these guidelines to SEBI and AMFI. AMFI Revision Kit/Ver. 2008.01 Quick Wit 1. The a. b. c. d. code of conduct may be put in place by AMFI Board of Trustees Directors of AMC All of the above 2. Insider trading means a. personal trading transactions done by anyone associated with a Mutual Fund b. personal transaction done by anyone with knowledge of the fund decision in the security c. personal trading transaction without prior approval of the AMC d. personal trading transaction done by an insider of an AMC/Fund 3. Select which of the following is an example of unethical behaviour? a. Fund distributor buying shares that he knows are part of the fund portfolio recommended to investors b. Fund employee buying shares that he knows the fund has decided to buy c. Fund trustee owning a share portfolio of his own d. Fund manager buying shares in his own name 4. The a. b. c. d. 5. The a. b. c. d. code of ethics for mutual funds published by AMFI Is mandatory Is in the form of recommended practices Is unfavourable to investors Does not cover distribution and selling practices AMFI code of ethics does not cover the following prescriptions Adequate disclosures should be made to the investors Funds should be managed in accordance with stated investment objectives Conflict of interest should be avoided in dealings with directors or employees Investors should approve each investment decision 6. Code of ethics should be followed by distributors as a. It is required by AMFI b. It is required by AMC c. Business increases d. All of the above 7. What is insider trading? a. Buying and selling securities ahead of doing the same transaction for the fund b. Buying and selling securities on the basis of privileged information available to the fund by persons who are insiders to the company c. Both of the above d. None of the above 8. Mutual funds in India are required by SEBI to a. prohibit their employees from personal trading in secondary markets b. allow all employees to trade freely in secondary markets without restrictions c. establish a code of conduct and allow employees to do personal trading that conforms to SEBI guidelines d. allow employees to carry on personal trading as long as they abide by SEBI regulations AMFI Revision Kit/Ver. 2008.01 9. The detailed version of SEBI circular regarding code of conduct for distributors, given by AMFI is known as a. Ethics code b. AGNI c. Front running d. None of the Above 10. The regulation of Personal trading is applicable to a. Key Personnel of the AMC b. The directors of the trustee company c. Sponsor of the fund d. Only a and b AMFI Revision Kit/Ver. 2008.01 Answers 1. d 2. b 3. b 4. b 5. d 6. d 7. c 8. c 9. b 10. d AMFI Revision Kit/Ver. 2008.01
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