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AMFI Certification ExaminationTutorial
AMFI Certification ExaminationTutorial
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About the AMFI Examination
Candidates can take the computer based exam at the NSE centers
or the written exams conducted by UTIICM
The exam is now available in 2 languages : Hindi and English
– The computer based exam is only in English.
– The written exam is in English and Hindi
Registration on the NSE exams can be done on-line at
www.nseindia.com
Registration for written exams can be done by downloading the
application forms from www.iicm.com
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Question Paper Design
Each chapter has a weightage in the exams.
– Not disclosed by AMFI
– Indicated in the CIEL book
There are 72 questions
– 44 questions of 1 mark each ; 28 questions of 2 marks each
– 42 questions from part 1; 30 questions from part 2
The paper is generated by randomly choosing from the question
bank
– The question paper for each candidate is different
– In the written exam, there are 5 sets of papers in the hall3
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Attempting the paper
There are 2 hours to do the paper, most people do it in 1 hour
Written exam
– There is an answer sheet with boxes for each question. Color the
appropriate box with pencil.
– Valuation is done using an optical reader. Results are announced in 10
days.
NSE Online exam – Answers are chosen with the click of the mouse
– Results is known as soon as the paper is submitted
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Some Tips
It is not a great idea to read the paper fully, attempt questions as
you see them.
– Reading fatigue sets in.
Mark and keep aside questions for which you are not sure of the
answers, revert only to these questions.
– Revising all questions can create confusion.
– Do not revise and redo the questions that have been already attempted.
Negative marking
– 25% of the marks of a question is reduced for a wrong answer.
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Approximate Weighting
Concept, History & Type of Mutual Funds (10 Marks)
Fund Structure & Constituents (4 Marks)
Legal & Regulatory Framework (5 Marks)
Offer Document (9 Marks)
Mutual Fund Distribution & Sales Practices (6 Marks)
Accounting Valuation & Taxation (9 Marks)
Investor Services (3 Marks)
Investment Management (6 Marks)
Return, Risk, Performance & Fund Selection (8 Marks)
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Approximate Weighting -2
Financial Planning Concept & Process (4 Marks)
Life Cycles & Wealth Cycles (4 Marks)
Creating & Recommending a Model Portfolio (5 Marks)
Investment Strategies (5 Marks)
Investment Products (7 Marks)
Business Ethics for Mutual Fund (4 Marks)
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8
Chapter 1
Concept, History & Type of Mutual Funds
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What is a Mutual Fund?
A mutual fund is a pool of investors’ money
The money collected is invested based on pre-specified investmentobjectives
– HDFC Income Fund
– DSPML Top 100 Equity Fund
The investment objective of a fund determines its investment portfolio and
its risk and return.
The benefits from the pool is shared only by the investors who contributed
to it
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Proportionate Share
Contribution to the pool is not equal
– Hence the share is not equal, but proportionate
Investor A 10000 12000
Investor B 20000 24000
Investor C 30000 36000
Total 60000
Gain over time 12000
Current Value 72000
Current
Value of the
Investment
isproportionate
72000
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Nature of the Pool
The contribution to the pool depends upon the type of scheme
– In an open-ended scheme investors can invest and redeem at any
time
– In a closed-end fund, contribution to the fund happens only at the
time of creation of the pool and redemption at the time of maturity
Method to measure the contribution is standardized
Share of the pool is called “Unit”
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Units Vs. Shares
Shares Units
Investor in shares - Share holder Mutual fund investor - Unit holder
Holds the share of the company Holds the units of the fund
Share has a face value Unit has a face value
First time issue - IPO (InitialPublic Offering)
First time issue - NFO (NewFund Offer)
Subsequent transactions in
stock exchange
Subsequent transaction through
the fund (sometimes listed)
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Portfolio of a Fund
The money pooled is invested in a portfolio of marketablesecurities such as:
– Equity shares
– Bonds and debentures
– Money market instruments
– Derivatives
Securities are tradable and have a market price. The portfolio value changes with changes in the market price of
the underlying securities.
The value of the investor’s holding changes with a change in the
portfolio value.
If we divide the value of the portfolio by the number of units, weget the net asset value (NAV) per unit.
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Valuation of Portfolio - Example
Consider a pool of money contributed by different investors.
Investor A - Rs. 3000000
Investor B - Rs. 1000000
Investor C - Rs. 500000
Investor D - Rs. 400000Investor E - Rs. 56000
Total - Rs. 4956000
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Numericals not in the exam; only for understanding
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Valuation of Portfolio - 2
Day 1 Day 10Security No.
of
Shares
Market
Price
Market
Value
Market
Price
Market Value
L & T 1000 2700 2700000 2900 2900000
Finolex 2000 53 106000 57 1140000
Sun Pharma 1000 1400 1400000 1300 1300000
ICICI Bank 1000 750 750000 700 700000
Total 4956000 6040000
If the NAV of the fund was Rs.10 at the start, it would now be
Rs.12.18 at the end of 10 days, when the value of the portfolio
moved up.
Note: Numericals not in the exam; only for understanding
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Assets and Liabilities of the Fund
The total assets of a mutual fund refers to the current value of its
portfolio. – No other long-term assets are held in the balance sheet.
– Current assets and accrued income are added to the portfolio
value.
The assets are funded completely by the investors’ contribution
– No long-term liabilities in the balance sheet. – Current liabilities and accrued expenses are deducted from the
portfolio value.
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Net Assets
Net assets of the mutual fund
= Market value of the portfolio
+ (Accrued income and current assets)
- (Accrued expenses and current liabilities)
Net asset value of a unit (NAV)
= Net assets / Number of units
Net assets of the fund = NAV * Number of units
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Advantages of a Mutual Fund
Portfolio Diversification
– The portfolio is spread across industries, companies, issuers and
maturities.
Low Transaction Cost
– Benefits of economies of scale accrue to the investor since the
fund invests large sums of money in the market.
Professional Managers
– The fund managers have expertise in sector evaluation and
security selection.
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Advantages of Mutual Funds - 2
Reduction in Risk
– Portfolio diversification and professional management of the funds
leads to a reduction in risk for the investor.
Flexibility
– The choice of products and options allow investors to structure
their investment and returns in the way that suits them.
Liquidity – Mutual fund portfolios are managed to provide liquidity and easy
exit options to investors.
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Disadvantages of Mutual Funds
No Customization
– The selection of sectors and securities in the portfolio is according
to the view of the fund manager.
No control over fund management cost
– Investors do not directly control fund running expenses
– Upper limit on costs is prescribed by regulation
Too many options to choose from
– Fund selection can be difficult when there are too many of the
same kind.
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History of Mutual Funds
Phase I (1964 to 1987)
– UTI was set up and governed by Unit Trust of India Act ,1963
– First scheme was Unit Scheme 1964
– First diversified equity scheme was Master share launched in
1986
Phase II (1987 to 1993)
– Banks and insurance companies allowed to set up funds in 1987
– SBI mutual fund was the first bank-sponsored fund – SEBI was formed in 1988 and regulatory powers given in 1992
Phase III (1993 to 1996)
– Kothari Pioneer was the first private sector mutual fund in 1993
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History of Mutual Funds - 2
Phase IV (1996 to 1999)
– Three Tier structure of Sponsor - Trust – AMC was implemented.
– Dividends from mutual funds became exempt from tax in 1999.
Phase V (1999 to 2004)
– The UTI Act was repealed and UTI came into Sebi’s fold in 2003.
– Assets in 2001 were Rs1,50,000 crore.
Phase VI (2004 onwards)
– Marked by mergers, acquisitions and entry of international players.
– Currently there are 35 players managing nearly 600,000 crore in assets.
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Classification of Mutual Funds
Mutual fund products can be classified as follows:
Based on Life Span – Open and closed end funds
Based on Asset Class
– Equity, debt, money markets, gilts and the like
– Funds may also invest in a combination of asset classes
Based on Management Style
– Passive and active funds
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No fixed maturity date.
Offered during NFO for the first time. – Investors can buy redeem on a continuous basis
after the fund re-opens for transactions.
– On-going transactions are done at NAV-based
prices.
Unit capital is not fixed but changes with purchase
and redemption.
Transactions can be restricted by the fund under
special situations.
Open-ended Funds
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Closed End Funds
Specified maturity date
– Offered during the NFO for the first time
– Redeemed on maturity date
Closed for further purchase and redemption after NFO
– Some funds may offer redemption at NAV-based prices
Listed on Stock exchange
– Prices determined by liquidity in the market
– Can be at premium or discount to NAV
Unit capital does not change after NFO
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Equity Funds
Pre-dominantly invest in equity markets
– Diversified portfolio of equity shares
– Select set of equity shares based on selection criterion
Diversified equity funds
– ELSS is a special case with tax concessions
Growth funds & Value funds
Mid & small stock funds
Index funds
Specialty funds (sector and thematic funds)
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Debt Funds
Predominantly invest in the debt markets
– Diversified debt funds
– Select set based on some criterion
Income funds or diversified debt funds
Gilt funds – short and long term gilt fund
Liquid and money market funds
Serial plans or fixed maturity plans
Erstwhile assured return funds
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Hybrid Funds
Investment in more than one asset class
– Debt and equity in varying proportions
– Pre-dominantly debt with some exposure to equity
• MIPs
• Education plans and children’s plans
– Pre-dominantly equity with some exposure to debt
• Balanced funds
• Retirement plans
• Growth & Income funds
– Asset allocation funds
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Other Funds
Commodity funds
– Invest in commodity stocks and futures
Real estate funds
– Invest in real estate linked products and in property
International funds
– Invest in global ETFs, funds and securities
Fund of funds
– Invest in other funds
– Two layers of management fees
ETFs
– Passive funds linked to an index
– Bought and sold on the exchange29
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Basis for Classification
Risk
– Sector funds are most risky; money market funds are least risky
Tenor
– Equity funds require a long investment horizon; liquid funds are
for the short term liquidity needs
Investment objective
– Equity funds suit growth objectives; debt funds suit income
objectives
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Classification - Asset class
Fund type Securities held
Equity Funds - Shares
Income Funds - Bonds / Government securities
Money Market Funds(Liquid)
- Short maturity fixed incomeinstruments
Hybrid Funds - Shares & fixed income instruments
Commodity Funds - Gold, commodity stocks and futures
Real Estate Funds - Real estate
Fund of Funds - Other funds
Gilt Funds - Government securities
High Yield Debt Funds - Debt instruments with lower creditrating
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Classification - Asset class
- Sector, Diversified
- Country, Regional, Global
- Value, Growth, Combination
Equity
- Large cap, Mid cap, Small cap
- G-Sec, Gilt,
- High yield
Fixed Income
- Floating rate income
Hybrid - MIP, Balanced Fund, Asset Allocation Fund
- Children’s fund
- Pension Fund
Special purpose
- ELSS
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Classification - Management Style
Passive Funds
– No active call on stock or proportion
– Follows a chosen market index in terms of stocks and weightage in the
portfolio
– Index Funds, ETFs follow a passive style
Active Funds
– Actively managed by the fund manager
– Tries to deliver better returns than the market index
– A particular market index is chosen as benchmark
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Chapter 2Fund Structure and Constituents
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Mutual Fund Structures
Mutual funds may be structured as a company or as a trust
– In a company structure, investors hold shares.
– In a trust, investors are the beneficiaries.
– In the UK, closed-end funds are set up as companies and open-end
funds as unit trusts.
– In USA , funds are set up as investment companies.
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Mutual Fund Structure in India
In India, the structure to be followed by mutual funds is specified in
Sebi’s (Mutual Fund) Regulations of 1996. – Three-tier structure of Sponsor, Trust, AMC (Asset Management
Company)
Sponsor promotes the fund and sets up the AMC.
The mutual fund is the trust supervised by the trustees.
Trustees appoint the AMC to manage the funds.
Sebi’s regulations lays down the eligibility norms, role and
responsibilities of each constituent.
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Sponsor of a Mutual Fund
The sponsor is the promoter of the mutual fund
The role of the sponsor includes
– Setting up the trust & AMC and contribute capital
– Appointing the members of the Board of trustees and AMC
– Appointing the custodian
– Seeking regulatory approvals
A sponsor of a mutual fund can be
– An Indian company /Bank /Financial institution (Reliance)
– A Foreign entity (JPMorgan, Fidelity)
– A Joint venture (ICICI Prudential, Birla Sunlife)
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Regulatory Norms
Sebi’s regulations for mutual funds has laid down the eligibility
norms for a sponsor:
– At least 5 years experience in the financial services industry
– Good financial track record• Positive net worth in the immediately preceding three years
– At least 40% of the AMC’s capital to be contributed by the sponsor.
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Trustees of a Mutual Fund
The sponsor registers the mutual fund as a trust and appoints the
trustees with the approval of SEBI – The trustees can be constituted either as Board of Trustees or Trustee
Company
– Trustees have to meet at least 6 times in a year
– Trustees are paid a fee for their services
Trustees have fiduciary responsibility to protect the interest of the
investors
• The authority and responsibility of the trustees are laid down in
the trust deed
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Role of the Trustees
Registered ownership of investments is with the trust
•
At least two-thirds of the trustees should be independent of thesponsor
Trustees of one mutual fund cannot be trustee of another mutual
fund
– Independent trustee
– Board approval
Right to seek regular information and remedial action
All major decisions need trustee approval
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Asset Management Company (AMC)
The AMC is the investment manager of a mutual fund appointed by
the trustees:
– Set up by the sponsor as a public or private company through
contribution of capital.
– The investment management agreement lays down the role andresponsibilities of the AMC.
– The AMC reports to the trustees periodically and have to provide all
information when ever required.
The creation, marketing and management of mutual fund products is
the responsibility of the AMC.
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Regulatory Norms for AMC
The AMC has to be registered with Sebi which has laid down the
eligibility norms :
– An AMC must have a net worth of at least Rs. 10 crore at all times.
– 50% of the members of the board have to be independent.
– The AMC of one mutual fund cannot be the AMC/Trustee of another
mutual fund.
– An AMC cannot engage in any business other than investment
management.
– The AMC must make periodic statutory disclosures to SEBI.
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Outsourced Functions of AMC
The core function of the AMC is the management of the fund
portfolio.
– Functions other than core activities are outsourced to constituents
The constituents of a mutual fund are appointed to take care of
specific activities:
– Appointed by the AMC
• Custodians are an exception and are appointed by the sponsor directly
– Should be registered with SEBI & approved by Trustees
– Paid a service fee
– Governed by the agreement entered into with the AMC and Sebi’s
regulations43
R l f O h C i
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Role of Other Constituents
Different constituents and their roles are:
• Custodian s Hold funds & securities
• R & T Agents Keep records & service investor needs
• Banks Handle collection & payment
• Auditors Audit scheme accounts
• Distributors Distribute fund products to investors
• Brokers Execute security transactions
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C t di
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Custodians
Custodians hold the cash and securities of the mutual fund and are
responsible for the safekeeping of the assets
The custodian must be an entity independent of the sponsor
The functions of the custodian include:
– Complete the transactions, deliver & accept cash & securities
– Track and complete corporate actions & payouts
• Rights, bonus, dividends, & interests
• Sale & buy back offers, redemptions
– Coordination with depository participants (DP)
– Some custodians may offer fund accounting & valuation services
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R & T Agents
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R & T Agents
The R&T agents are the record keepers of a mutual fund
They operate Investor Service Centers (ISCs) that are official points to
accept and process transactions
They are primarily responsible to provide investor services and are paid a
fee for their services
– Issue & redeem units, update unit capital
– Enable investor transactions
– Create, maintain and update investor records
– Bank the payment instruments & notify AMC
– Process redemption and dividend payouts
– Send periodic statutory information to investors
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Other Constituents
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Other Constituents
Banks
– Provide collection services
– Investor cheques / DDs are collected into scheme accounts
Auditors
– Audit the books of mutual funds
– Separate auditors for AMC accounts
Brokers – Execute buying & selling stocks as instructed by the fund managers
– Give research reports on securities to the AMC
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Distributors
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Distributors
AMCs appoint non-exclusive distributors to sell mutual fund units
A distributor can appoint multiple sub-brokers
A distributor can be
– An individual (IFA - Independent Financial Advisor)
– Institutions such as banks
– Non-banking finance companies (NBFC)
– Broking & distribution companies
IFAs & employees of corporate distributors have to
– Clear AMFI Certification Exam
– Empanel with a mutual fund
– Take refresher course once in five years 48
Take-over and Merger
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Take over and Merger
– Scheme Take-over
• Schemes of one fund are taken-over by another fund.
– AMC Take-over
• Sponsor of one AMC sells their equity holding to another sponsor.
– AMC Merger• Two AMCs merge their operations
• Structure of AMC and holdings of the sponsors change.
– AMC Change
• Trustees may terminate one AMC and appoint another.
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Unit holders & Merger Take-over
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Unit holders & Merger, Take over
Re-organization requires the approval of trustees and SEBI
AMC merger/ take-over requires the approval of high court
Investors of open-ended schemes
– Need not approve the merger / take over
– Need to be informed – advertisements & individual communication
– Need to given the option to exit without paying exit load
75% of voting rights must approve the reorganization in case of a
close-end scheme
– Approval sought through postal ballot
– No response is deemed to be an approval
Key documents are amended after the change
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Chapter 3Legal and Regulatory Framework
SEBI - Primary Regulator
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SEBI - Primary Regulator
All activities of mutual funds are defined and regulated by SEBI
Investor complaints redressal is done by trustees, AMC & SEBI
UTI came under SEBI’s regulation in 2003
– Now all the UTI schemes are managed by UTI AMC
– UTI’s Assured returns scheme are under a special undertaking
Role of RBI
Bank sponsored mutual funds are regulated by both SEBI & RBI
RBI also regulates money markets and gilt markets
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Other Regulators
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Other Regulators
The ministry of finance is the apex supervisor
– SEBI and RBI are governed by Acts of Parliament
• (SEBI Act 1992, RBI Act 1949)
– Appeals against SEBI are made to the Securities Appellate Tribunal
The Company Law Board (CLB) is the regulator under the
Company’s Act 1956
– AMC & trustee company are formed as companies
– Complaints against directors are escalated to CLB
– Dept of company affairs can prosecute the company directors
– The Registrar of companies ensures compliance
53
Other Regulators -2
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Other Regulators 2
Indian Trust Act
– Mutual funds are set up as trusts
– Governed by Indian Trust Act,1882
– Office of the Public Trustee and Charity Commissioner supervise theBoard of trustee company
Stock Exchange
– Listing regulations govern the schemes listed on the stock exchange
54
Self- Regulatory Organizations
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g y g
Self-regulatory organizations (SROs) are the second tier in the
regulatory structure
– Formed as an industry association & registered with regulatory body
– Granted SRO status by the regulator
– Given limited powers by the regulator
AMFI is not a Self Regulatory Organization
– AMFI is an association of mutual funds
– It provides guidelines to mutual funds
– Regulations are issued by SEBI – AMFI board is appointed by AMCs and made up of AMC
representatives
55
Rights of Unit holders
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Unit holders of a mutual fund have certain rights
– Timely service
– Receive information that may affect their investments
Units holders with 75% or more of unit capital
– Can terminate an AMC
– Can wind up a scheme
There are limits to investors’ rights:
– No legal recourse to the mutual fund itself
– No recourse for failure to read the offer document
– Investors are not shareholders in the AMC
– Investments are not protected under Companies Act56
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Chapter 4Offer Document
Source of Information
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The offer document (OD)provides all information that an investor
needs to evaluate a mutual fund
– The OD is first prepared at the time of an NFO
– It is a legal document
– Investors are required to read the OD before investing
The AMC prepares the OD with the approval of the trustees
– The format is prescribed by Sebi
– Has to be filed with Sebi for approval
– Sebi can ask for changes
58
Due Diligence Certificate
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The AMC is responsible for the accuracy of information in the OD
The Due diligence certificate is signed by the compliance officer ofthe AMC
– It is part of the offer document
The due diligence certificate states that
– The OD is prepared as per Sebi’s regulations
– Information in the OD is accurate
– All the constituents associated with the mutual fund are registered with
Sebi
59
Updating the OD
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The OD must have relevant information to help make appropriate
investment decisions
The OD prepared at the time of the NFO will have to be updated for
changes
Sebi prescribes the frequency with which the OD has to be revised
– OD of open ended schemes are revised every two years
– OD of closed-end schemes do not require revision
(The format and revision rules have been changed by Sebi with
effect from June 1, 2008)
60
Addendum to OD
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The changes in the material information in the offer document is
intimated through an addendum
– Attached as an appendix to the OD
– Approved by trustees and notified to Sebi
– Has to be published in two news papers and displayed in all OPoAs
The information in the addendum is included in the OD when the OD
is revised
Change in material information includes
– Change in sponsor, AMC
– Change in fundamental attributes, loads, options in the scheme61
Contents of the OD - Risks
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The risk in a mutual fund scheme may be standard or scheme
specific risks
Standard risks are common to all mutual fund schemes
– All schemes are subject to market risks
– Past performance is not indicative of future performance
Scheme specific risks depend upon the investment objective, asset
allocation and strategy of a fund
– A sector fund has risk of concentration
– The first scheme of a fund house has the risk of no past history
62
Contents of the OD- Constituents
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The OD gives background information about the constituents of the
mutual fund.
Information about the sponsor in the OD includes:
– Name and financial history of the past three years
– Liability of the sponsor for assured return scheme, if any
Information about the trustees includes:
– Name and address of the trustees
– Details of independent trustees
– Summary of trust deed provision
Contents of the OD- Constituents
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Information about the AMC includes:
– Details of the directors
– Information of the key personnel
Information is provided of other constituents such as custodian, R&T
agent and auditor
The offer document gives information for the preceding three years
Information in the OD is limited to the schemes of the fund house.
64
Fundamental Attributes of a Scheme
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The fundamental attributes of a scheme define the risk and return
characteristics of a scheme
– Type of scheme
– Investment objective
– Investment Pattern
– Terms with regard to liquidity
– Fes and expenses
– Accounting and valuation and investment norms
The suitability of a scheme for an investor’s needs depends on its
fundamental attributes
Change in Fundamental Attributes
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The fundamental attributes of a scheme may change
– Approval of the trustees and Sebi is required
– Investors need to be informed of the change and given the option to exit
without paying exit load
– Details have to be published in at least two national papers
The OD of a scheme has to be revised
The investment by the investor may require review for continued
suitability
66
Financial Information in the OD
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The OD provides information of the performance of existing
schemes for the last three years
– Financial summary of existing schemes
– Investor complaints and redressal for existing schemes
The OD provides the details of expenses of existing schemes
– Expenses as a percentage of weekly average net assets
– Variation between estimates and actuals
– Loads and initial expenses
Information on Investor Services
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The offer document will give information on the services and
information that an investor can expect
– Process for addressing investor grievance
– Information that is given and their periodicity
Investors can ask to inspect documents related to the fund
– Investment management agreement and Trust deed
– Annual reports of AMC and schemes
– Agreements entered into with R&T agent, custodian and other
constituents
Information on Investments
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Information on the investment pattern and strategy of the fund
– Allocation to asset classes and types of securities
– No information on specific securities the fund may invest in
Details of the borrowing policy of the fund
Details of the investment in the sponsor group companies
Policy on inter-scheme transfers and valuation of securities
Information on the method of calculating NAV, sale and redemptionprice
69
Operational Details of the Scheme
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The OD gives information that is essential for the investor to
complete the investment process
– The period of NFO
– The NFO price for subsequent transactions
– Minimum initial and subsequent investment
– Plans ,options and loads
– Availability of forms, payment instruments and submission
– Investors eligible to invest
– Facilities such as switch and SIPs
– Date of commencement of on-going purchase and sale
Key Information Memorandum (KIM)
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KIM is the abridged version of the OD
– Must accompany every application form
– Is updated regularly
– Key information is available both in the OD and KIM
A first time investor should refer to the OD for information. An
existing investor can use the KIM for continuing transactions
The format of the KIM is prescribed by Sebi
Information in the KIM
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• The KIM contains the crucial information required by an investor
Investment objective, asset allocation
Scheme specific operational details
Expenses and loads
Details of key constituents
Performance history of the scheme and its benchmark
Investor rights and services
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Chapter 5Mutual Fund Distribution & Sales Practices
Types of Investors
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Offer document clearly specifies the investors eligible to invest in themutual fund scheme
– Some schemes may have restrictions
Some categories of investors are: – Individuals & Hindu undivided Families (HUF)
– Companies & Partnership firms
– Trusts & charitable institutions
– Banks & Financial institutions
– Non-banking finance companies (NBFC)
– Insurance companies
– Provident funds – Mutual funds
– Foreign Institutional Investors (FII)
– Non resident Indians (NRI) & Persons of Indian Origin (PIO)
74
Features of Investor Categories
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Resident investor is the largest segment of investors
Institutional investors
– Are smaller in number, larger in ticket size
– They need to have specific internal approval for investing
FIIS need to register with SEBI before investing
Foreign citizens and overseas corporate bodies are not allowed to invest in
mutual funds
NRIs and PIOs can invest without separate approval from RBI
75
Individual Investors
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Individual investors require advice to make their investments
– Retail or HNI
The documents
– PAN mandatory for all investors including NRI
– KYC norms to be fulfilled for all investments above Rs.50,000
Upto three joint holders are allowed
– Complete address to be provided for first holder
– All communication goes to the first holder
Bank details have to be provided mandatorily
76
Institutional Investors
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Have specific needs and investment profile
– Prudential guidelines
Need Board approval before investment
– Approval, Trust Deed, RoC, MoA to be submitted for investment
List of Authorized signatories is mandatory
May not require investment advise
May not go through intermediaries
– Direct sales channels
77
Intermediaries
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Mutual funds may employ distributors to reach their products
(channels)
There are non-exclusive individual and institutional channels
Individual distributors
– Establish personal long term relationship with investors
– Hand-hold the investor through the process
– Have evolved as financial planners providing personalized service
Institutional channels
– Have large depositor / client base
– Client acquisition process is standardized 78
Features of distribution channels
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Individual distributors (IFA)
– Agreement with AMC
– Non-exclusive
– Have sub-brokers
– Limited research information to clients
Institutional
– Have many employees and sub-brokers
– Large foot print in terms of branches
– AMC deals with single entity instead of large number of investors
– Have established client base & offer multiple products
– Able to give research based advice 79
Appointment of Distributors
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AMC appoints the distributor
– SEBI approval is not required
– The sponsor can be a distributor
– Employees cannot be distributors
The distributor enters into an agreement with the AMC
– Terms of appointment
– Periodicity of commission payment
The distributor is the investor’s contact with the mutual fund
– Copy of KIM to be given along with application to the investor
– Information to investor that there is no recourse to distributor
– Units will be allotted to the investor at Public Offer Price80
Commission to Distributors
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Primary form of remuneration for the distributor is commission
– Commission is split as up-front and trail
– Commission is paid at the discretion of the fund
– No maximum / minimum limit prescribed by SEBI
– Commission is influenced by market practice
– Equity schemes have higher commission than debt schemes
– No commission for own investment
Distributors tend to pass the commission to the investor (rebating)
– This practice is banned by SEBI
81
Guidelines on Selling Practices
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Product to be sold keeping the interest of the investor in mind
– No specific regulation on investor servicing
AMFI guidelines are:
– Mutual funds are not accountable for the sub-broker’s activities
– Distributors should have complete knowledge of offered products
– They should know the clients’ need and profile
– Chosen product must meet the clients’ requirements
– They should encourage good long-term investment habits
– They should provide good & efficient service
Mutual funds should follow SEBI guidelines for marketing
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Chapter 6Accounting, Valuation, and Taxation
Unit Capital and Portfolio Value
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Number of outstanding units multiplied by face value per unit is theunit capital.
– This is shown on the liability side of the balance sheet.
– This is also called the corpus of the scheme.
The investment portfolio, along with any accrued income andreceivables represents the assets of the scheme.
A scheme has some short-term liabilities, payables and accruedexpenses.
Nets assets of a scheme are computed as assets minus liabilities.
Net asset value (NAV) is a per unit representation of a scheme’s net
assets and is computed as
– Net assets/Number of units outstanding
84
NAV Computation and Posting
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NAV is calculated every business day, also called as valuation day,
for all mutual fund schemes.
NAV has to be posted on the AMFI website every business day by 9
pm.
NAV is impacted by the following factors:
– Purchase and sale of investments by fund managers
– Valuation of investments held in the portfolio
– Valuation of other assets and liabilities of the scheme
– Sale and purchase of units by investors
85
NAV Representation
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Expense and income are accrued on a daily basis.
Calculation of NAV includes all incomes and expenses accrued untilthe valuation date.
Any transaction that impacts the NAV by more than 1% should notbe excluded in computation.
– Any errors to computation to be rectified in 7 business days.
NAV is rounded off to 4 decimal points for liquid funds, and twodecimal points for other schemes.
NAV is published in the newspapers for investor information.
86
Applicable NAV
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The price at which investors can buy or sell their units depends
on the NAV after adjustment for the load.
Applicable NAV depends on the cut-off time for the transaction.
– For all non-liquid schemes, the cut-off time for both purchase and
redemption is 3 pm.
– The cut-off time for liquid fund purchases is 12 noon
NAV is computed on business days for all schemes.
– for liquid funds, NAV is computed every calendar day.
87
Loads
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The price at which an investor purchases or redeems a mutual fund
unit is based on the NAV, adjusted for load.
Load refers to expenses incurred on marketing and distribution of a
scheme that can be recovered from the price.
Loads are of two types: Entry load applies for purchases; exit load
applies for redemptions.
Entry load means the investor pays a purchase price that is more
than the NAV, by the amount of load.
Exit load means the investor receives a redemtpion price that is less
than the NAV, by the amount of load. 88
Entry Load
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An investor wants to invest Rs 5000 in XYZ Growth Fund which has
an NAV of Rs 45. The investor also has to pay an entry load of
2.25%.
The price at which the units will be allotted is
– NAV + Load = Rs 45+ 2.25% of Rs 45
– = Rs 45+ Rs 1.0125
– = Rs 46.0125
– The investor will be allotted 108.666 units.
– (5000 / 46.0125).
89
SEBI Regulations
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SEBI regulations impose a limit on the maximum load that a
fund can charge.
An open ended fund can charge a maximum load of 7%.
A closed end fund can charge a maximum load of 5%.
The redemption price cannot be less than 93% of the purchase
price.
– If the NAV is Rs 10, the maximum purchase price can be Rs10.70.
– The minimum redemption price can be Rs 9.30.
90
Expenses
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Only scheme-specific expenses can be charged to the fund. These
expenses are:
– Investment management fees
– Marketing and selling expenses
– Fees of custodians
– Fees of registrar and transfer agents
– Audit fees
– Trustee fees
– Costs relating to investor communication
– Costs of statutory advertisements
Expenses incurred on AMC offices, staff salaries and technology
are borne by AMC and not charged to the scheme.91
Limits to Expenses
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The limits for expenses charged to the fund are as per the following
slabs:
– 2.5% on the first Rs100 crore of net assets – 2.25% on the next Rs300 crore of net assets
– 2% on the next Rs300 crore of net assets
– 1.75% on the balance net assets
The net assets in the above limit are taken as weekly average net
assets.
Debt funds are required to charge 0.25% lower in each of the aboveslabs.
Fund of funds can charge a maximum of 0.75% only as recurring
expenses. 92
Investment Management Fees
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The limits on investment management fees are as follows:
– 1.25% on the first Rs. 100 crore of net assets
– 1% on the remaining net assets over and above Rs.100 crore.
Example
A fund has net assets of Rs 800 crore. What is the limit on the
investment management fees that the AMC can charge to the fund?
– For the first 100cr @ 1.25% = 1.25 crore
– On the balance 700cr @ 1% = 7 crore
– Total fees that the AMC can charge = 8.25 crore
93
Accounting Policies
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Mutual funds can distribute dividends only out of realized profits.
Dividends, bonus and rights should be recognized on the ex-date.
Average cost must be used to determine the holding cost of the
securities.
Investments must be accounted on the transaction date, not on
the settlement date.
Scheme-wise annual reports have to be drawn according to SEBI
approved format
94
Valuation Policies
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Uniform policies of valuation are set by AMFI and approved by
SEBI.
Valuation policies to be disclosed to investors in the offer document.
The fair value of a security is the closing price at the markets on the
valuation date, in case of liquid securities.
In the case of illiquid securities, a valuation methodology is adopted
to arrive at the fair value.
Valuation of the mutual fund portfolio is done on every business
day.
95
Valuation of Equity Shares
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Equity shares are valued at the last traded price on the stock
exchange where they are principally traded.
If not traded, the closing price of the previous trading date can betaken.
– Not be more than 30 days before the valuation date.
A thinly traded share is defined as one where, in the preceding 30
days:
– The traded value is less than Rs 5 lakh, and
– The traded volume is less than 50,000 shares Thinly traded shares can be valued at the last traded price or at fair
valuation approved by the trustees.
96
Valuation of Debt Securities
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Closing price can be taken if it is not over 15 days old.
A debt security is thinly traded, if its traded value in the previous
one month is less than Rs.5 crore. Fair valuation for debt securities is done based on the yield provided
by Crisil and used uniformly across the industry.
– Government securities are valued using the Crisil gilt valuer. – Corporate securities are valued using the Crisil bond valuer.
If a corporate security is not of investment grade (credit rating below
BBB) it is valued at a discount of 25% on its face value. Money market securities with days to maturity not exceeding one
year, are not marked to market.
97
Illiquid Securities
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An illiquid security is defined as one that is thinly traded, non-tradedor unlisted.
If a security is illiquid, it cannot be accurately valued.
Such securities cannot exceed:
– 15% of net assets in an open-ended scheme.
– 20% of net assets in a closed end scheme.
Mutual funds cannot – transfer illiquid securities between schemes
– purchase illiquid securities from sponsors or associate companies.
Mutual funds disclose on a half-yearly basis:
– the holding of illiquid securities, scheme-wise
– in amount and as a percentage of net assets.
98
Taxation
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A mutual fund is exempted from income tax under Section 10(23D)
of the Income Tax Act.
Mutual funds distribute income as dividend, or allow the appreciation
to accumulate.
– They offer dividend and growth options to investors.
Mutual fund dividends are exempt from tax, in the hands of
the investors as per Section 10(35) of the IT Act.
– There is no tax deduction at source (TDS) on mutual fund dividends.
99
Taxation of Dividends
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Dividends are subject to dividend distribution tax (DDT)
– for equity-oriented schemes holding less than 65% in equity
DDT is payable at the rate of
– 12.5% for investments by individuals and Hindu undivided families
(HUFs)
– 20% for investments by all other categories
– 25% for all categories in a liquid scheme
DDT has to be paid directly by the fund, before distribution of
the dividend to the investor.
100
Taxation of Capital Gains
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Capital gain or loss realised:
– Within 12 months is called short-term capital gain or loss.
– After 12 months is called long-term capital gain or loss.
For an equity oriented fund,
– STCG is taxable at 15%
– LTCG is exempted from tax
For non-equity oriented funds
– STCG is taxable at the marginal rate of tax of the investor and LTCG is
taxable at 10% without indexation or 20% with indexation.
Securities transactions tax (STT) is payable at 0.25% by investors
on redeeming units of an equity-oriented fund.
101
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Chapter 7Investor Services
Investor Information
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The investor provides information to the mutual fund at the time of
investment
– Mandatory information to be provided as required by Sebi
The application form is used to buy units
– Available along with the KIM
– Instructions for filling up application is available in the KIM & Offer
Document
The completed application from has to be submitted at the AMC’s
office or ISC
– Distributors assist in filling up and submitting application forms103
Documents for Investing
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The Offer document and KIM describes the investment process to
be followed by each category of investors
Individual investors have to provide PAN details with the
applications
– Maximum of three joint holders are allowed in a mutual fund
Institutional investors must be permitted by their charter to invest in
mutual funds
– Approval of the governing body must accompany the application form
signed by the authorized signatories
NRIs and FIIs have been given blanket permission to invest by RBI104
Payment Instruments
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The application form for buying units of a mutual fund must be
accompanied by a payment instrument
– Minimum investment in a scheme
The accepted payment instruments are mentioned in the offer
document/KIM of the scheme – Cheques and Demand drafts
– Instruments not accepted as valid
Source of investment for NRI/FII investment is important
– NRO, NRE, FCNR accounts & FIRC
– Repatriation of redemption proceeds 105
Investor Folio and Account Statement
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The information provided in the application form is captured under a
folio created
– Consolidation of holdings
– Creation of multiple folios
– Use of transaction slips for additional purchase
The proof of investment in a mutual fund is the account statement
– Gives details of financial and non-financial transactions
Mutual funds allow investors to use a common application form to
invest in different schemes of the fund house
106
Redemption of Investment
Investors can specify their redemption request in units or amount
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Investors can specify their redemption request in units or amount
– Partial redemption and full redemption
The redemption request has to signed by the holders according totheir mode of holding
– Authorized signatories to sign for institutional investors
The redemption proceeds are paid into the bank account of the firstholder
– Mandatory to provide bank account details in the application form
– Repatriation of NRI redemption will depend upon source of funds – The redemption proceeds have to be paid within 10 working days
107
Investment Options-I
I i h l i i d
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Investment options help investors invest and structure returns
according to their specific requirements
Automatic Reinvestment Plans
– Dividend re-invested and not paid-out
– Gives compounding benefits
Systematic Investment Plans
– Periodic investment of fixed amounts
– Allows rupee cost averaging
108
Investment Options-II
S t ti T f Pl
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Systematic Transfer Plans
– Allows periodic transfer of funds between schemes
– Transaction is done at applicable NAV
– Loads and taxes apply
Systematic Withdrawal Plans – Is used by investors who want regular income
– Reduces the units standing to the credit of the investor
– Loads and taxes apply
109
Facilities Offered by Mutual Funds
On line transactions ith the m t al f nds
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On-line transactions with the mutual funds
Cheque- writing facility
– Third party cheques cannot be written
Pledging of units
– Units under lien cannot be redeemed
Nomination facility
– Can be modified by the investor
Periodic information to the investor on performance, portfolio and
markets
110
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Chapter 8Investment management
I
Investment Portfolio of a Mutual Fund
The portfolio of a mutual fund is a collection of securities and
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The portfolio of a mutual fund is a collection of securities and
financial instruments
– Selection of securities depends upon the investment objective of the
fund
Equity and debt are the two broad categories of securities used to
create a fund portfolio
– Dynamics of the markets and strategies used by fund managers
– Types of instruments
– Sebi’s regulations govern the investments made by a fund
112
Types of Equity Instruments
Ordinary Equity Shares
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Ordinary Equity Shares
– Implies ownership
– No guarantee of principal or income
– Capital appreciation is the primary attraction
Preference Shares – Dividend paid at fixed rates
– May be cumulative and participating
– No voting rights
Equity Warrants
113
Categorization of Equity Instruments- I
Based on market capitalization
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Based on market capitalization
– Number of shares X Current market price
– Large, mid and small cap shares
– Varying risk return profile of and suitability of each category
– The objective of the fund would decide the selection of stocks
– Separate indices track each category
114
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Categorization of Equity Instruments- III
Growth stocks
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Growth stocks
– Earnings grow at faster than average rates and are ploughed back
– Have high P/E ratios and low dividend yields
Value stocks
– Undervalued shares with low P/E and high dividend yields
– Potential to earn profits when such shares find favor with markets
Cyclical stocks
– Earnings are linked to economic cycles
– Have low P/E and high dividend yield
116
Equity Fund Management Strategies
Passive fund management style
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Passive fund management style
– Strategy of investing in an index’s shares in the same proportion
– No stock selection or portfolio rebalancing except when the index
changes
– Costs of investments is kept low
Active fund management style
– Aims at bettering the index return through active stock selection and
portfolio rebalancing
– Higher fund management cost
117
Equity Fund Management Tools
Fundamental analysis
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u da e ta a a ys s
– Research into qualitative and quantitative factors that affect the
performance of the company
– Economy-industry-company analysis
Technical analysis
– Use of price data to identify future price movement patterns
Quantitative analysis
– Use of mathematical decision making models for fund management
118
Equity Fund Management Functions
Fund Managers
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g
– Take decisions on style, allocation and stock selection
Security Analysts
– Track companies in which the fund has invested and potential
opportunities
– Use fund management tools like fundamental and technical analysis
Security Dealers
– Members of the stock exchange
– Execute buy and sell orders for the fund
119
Features of Debt Instruments
Debt instruments represent a loan
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p
– Can be bought from issuer or in the secondary markets
Par value is the principal amount borrowed which is repaid on
redemption
Coupon is the rate of interest payable on the par value
Maturity is the term of borrowing
– Call and put option modify the maturity
120
Classification of Debt Instruments
Based on issuer
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– Differ in terms of credit quality
Based on tenor
– Instruments with less than one year to maturity are called money market
instruments
– Long-term borrowings are issued for up to 30 years
Based on interest payments
– Fixed and floating rates of interest
– Zero coupon and deep discount bonds
121
Money Market Instruments
Certificate of Deposits
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– Unsecured borrowings of banks
Commercial papers
– Credit rated paper to meet working capital requirements of companies
Treasury bills – Issued by the government for tenors of 91,182 and 364 days
Call and Notice markets & Repos
– Borrowings for overnight to 14 days
– CBLOs are securitized repos with liquidity
122
Long-Term Debt Instruments
Corporate Debentures are secured credit rated instruments
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– Listed on stock exchanges if publicly issued
– Usually privately placed
– May be fixed or floating rate bonds
– May be issued as convertible debentures
Government securities are issued by RBI through auctions
– Issued for maturities between 1 to 30 years
Bonds issued by FIs are unsecured borrowings
– May have tax concessions
123
Debt Fund Portfolio
A debt fund’s portfolio depends upon its investment objective
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– Liquid funds invest in money market securities
– Income funds invest in a combination of long-term debt securities
– Gilt funds invest only in government securities
– Dynamic bond funds actively manage the maturity of the portfolio
– FMPs invest in securities with maturities that match the tenor of the fund
Mutual funds do not give loans
124
Bond Yield Measures
Current yield of a bond is the coupon as a percentage of current
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market price
If we bought a 8% bond at Rs. 110, the current yield is
= (8/110)*100
= 7.27% The YTM is the rate at which present value of future cash flows
equals the current market price
Given price, YTM can be calculated through iteration
Given YTM, price can be computed, using the YTM rate to discountthe future cash flows.
125
Risks in Debt Securities
Interest rate risk is the increase or decrease in the price of bonds
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with a change in rates
Credit risk is the risk of default in meeting obligations of interest and
repayment
– Government securities are not credit rated
– The credit risk of other bonds are measured by credit rating
– Credit spread is the excess interest paid by other borrowers over what
the government is paying for the same tenor
– Higher the credit rating, lower is the spread
126
Risks in Debt Securities
Reinvestment risk
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– The risk of reinvestment of interest income at lower rates
– Affects total income
Liquidity risk
– The risk of not being able to sell the bond close to its value
Inflation Risk
– The reduction in the value of fixed payments
Call risk
– The redemption by the issuer of a high interest debt prior to maturity
127
Managing Interest Rate Risk
The sensitivity of the price of a bond to changes in interest rates is
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measured by a number called duration
– Interest rate risk is different across bonds
– Duration is not equal to the tenor of the bond
If duration is 3 years, and interest changes by 1%, price of the bond
will change in the opposite direction, by 3%
128
Debt Fund Management Strategies
Buy and hold
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– Portfolio exposed to interest rate risk
Duration management
– increase duration if rates are expected to fall
– decrease duration if rates are expected to rise
Credit selection
– invest in low grade bonds that are likely to be upgraded
129
Investment in Derivatives
Derivatives derive their value from an underlying security
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– Futures
– Options
– Swaps
Derivatives are used to rebalance or hedge their portfolios
Sebi’s regulations require mutual funds to inform the investors
before using derivatives
– Explain the benefits in the offer document with simple examples
130
Investment Regulations
A mutual fund’s investment is governed by Sebi’s regulations which
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aim at
– A minimum level of diversification
– Protecting the investor’s interests
A mutual fund can
– Invest only in marketable securities
– Investment only on delivery basis
– Mutual funds can borrow up to 20% of net assets for a period not
exceeding 6 months
131
Investment Restrictions
A mutual fund under all its schemes, cannot hold more than 10% of
the paid-up capital of a company
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the paid up capital of a company
Not more than 10% of its NAV in a single company
– Exceptions: Index Funds and Sectoral funds
Debt instruments with investment grade rating of a single issuer
cannot exceed 15% of the net assets
– Can be extended to 20%, with the approval of the trustees
Investment in unlisted shares cannot exceed
– 5% of net assets for an open-ended scheme
– 10% of net assets for a close-ended scheme
132
Investment in Group Companies
A mutual fund scheme cannot invest in unlisted securities of the
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sponsor or an associate or group company of the sponsor
A mutual fund scheme cannot invest in privately placed securities of
the sponsor or its associates
Investment by a scheme in listed securities of the sponsor orassociate companies cannot exceed 25% of the net assets of the
scheme
133
Inter-Scheme Transfers
Inter-scheme transfers happen on a delivery basis, at market prices
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Such transfers should not result in significantly altering the
investment objectives of the schemes involved
Such transfer should not be of illiquid securities, as defined in the
valuation norms One scheme can invest in another scheme, up to 5% of its net
assets
– No management fee is payable on these investments
134
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Chapter 9Return, Risk, Performance and Fund Selection
Returns From Mutual Funds
The components of the returns from a mutual fund investment are
Di id d
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– Dividends
– Capital Gains
Dividends are paid out to investors who choose the dividend option
Capital gains is the difference between the acquisition price andsale price of units
– Realized when units are sold
136
Methods of Return Calculation
The methods of calculating returns from mutual funds are
Ch i NAV th d
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– Change in NAV method
– Total Return Method
– Return on Investment method
– Compounded annual growth rate method (CAGR)
The suitable method of calculating returns depends on the
investment objective of the investor
The performance data published by mutual funds use the CAGR
method for the growth option of a scheme
137
Change in NAV Method
Calculates the return between two dates
E l
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Example:
– NAV of a fund was Rs. 23.45 at the beginning of a year
– NAV of the fund was Rs. 27.65 at the end of the year
Percentage change in NAV= (27.65 – 23.45)/23.45 *100
= 17.91%
This method considers only the change in NAV between two dates
– Dividend paid, if any, is not considered
138
Total Return Method
Calculates the return by considering both dividend and capital
appreciation.
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Example
– Investor bought units of a mutual fund scheme at a price of Rs.12.45
per unit
– He redeems the investment a year later, at Rs. 15.475 per unit
– During the year, he also receives dividend at 7%
The rate of return on his investment can be computed as
= ((15.475 – 12.45) + 0.70)/12.45 x 100
= (3.725/12.45) x 100 = 29.92%
Does not consider the re-investment of dividend
139
Return on Investment (RoI) Method
The RoI is calculated using the formula
(Value of holdings at the end of the period value of holdings at the
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– (Value of holdings at the end of the period - value of holdings at the
beginning of the period)/ value of holdings at the beginning of the period
x 100
– Value of holdings at the beginning of the period = number of units at the
beginning x begin NAV
– Value of holdings end of the period = (number of units held at the
beginning + number of units re-invested) x end NAV
– Number of units re-invested = dividends/ex dividend NAV
140
RoI Method - Example
An investor buys 100 units of a fund at Rs. 10.5 on January 1, 2007.
On June 30 2007 he receives dividends at the rate of 10% The
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On June 30, 2007, he receives dividends at the rate of 10%. The
ex-dividend NAV was Rs. 10.25. On December 31, 2007, the fund’s
NAV was Rs. 12.25.
– The begin period value of the investment is = 10.5 x 100 = Rs. 1050
– Number of units reinvested = 100/10.25 = 9.756 units
– End period value of investment = 109.756 x 12.25 = Rs. 1344.51
– The return on investment =(1344.51-1050)/1050 x 100
= 28.05%
141
Compounded Annual Growth Rate
CAGR is the rate at which investment has grown from begin point to
the end point on an annual compounding basis
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the end point, on an annual compounding basis
– V0(1+r)n = V1
– r =((V1 /V0)1/n)-1
Where
– V0 is the value at the start
– V` is the value at the end
– n is the holding period in years
– r is the CAGR
142
Expense and Income Ratios
Expense ratio is calculated as
– Total expenses/Average net assets X 100
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Total expenses/Average net assets X 100
– It is a measure of efficiency of the fund
– Important in the evaluation of debt and liquid funds
– Fund size and account size has an impact on the expense ratios
Income ratio is calculated as
– Net investment income/Average net assets
– Useful for evaluating income-oriented funds
143
Turnover Ratio
Portfolio turnover ratio is calculated as
– Value of assets purchased or sold/Net Assets x 100
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Value of assets purchased or sold/Net Assets x 100
– Measures the trading activity in the portfolio
– A turnover rate of 200% means the portfolio was turned over twice
A high portfolio turnover ration implies higher transaction costs
– All costs related to trading are called transaction costs
Transaction costs have to evaluated in the light of the type of
scheme and investment objective
144
Portfolio Characteristics
Size of the fund
– A larger fund enjoys benefits of scale, a smaller fund is more agile
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A larger fund enjoys benefits of scale, a smaller fund is more agile
Cash holdings of a fund
– A high cash holding may impair performance in a rising market but
protect downside in a falling market
Funds hold some cash for redemption needs
– Deploying funds collected in an NFO may take time
145
Comparison of Mutual Fund Performance
The performance of mutual is compared to
– A benchmark
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– Peer group average
– Other financial products
The market index is used as a benchmark
– Choice depends on the investment objective of the fund
The performance of a fund has to be compared with other similar
funds to be relevant
146
Benchmark Comparison
Market benchmarks are independent portfolios that are not
managed by any fund manager
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g y y g
A fund’s chosen benchmark has to be mentioned in the offer
document
– Has to reflect the portfolio and investment objective of the fund
– Can be changed with approval of the trustees
Mutual fund performance is measured relative to the benchmark
– Investors look for absolute returns
147
Peer Group Comparison
The factors to be considered while selecting funds for peer group
comparison are:
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– They should invest in the same asset class
– Investment pattern must be similar
– The funds must have comparable investment objective
– The size and quality of assets must be comparable
Funds are ranked by grouping similar funds
148
Regulations for Return Computation
Returns should be calculated using the NAV of the growth option
– Load should not be included
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Returns have to be computed for 1,3,5,10 years and since inception
Returns for periods less than one year have to be absolute returns
– Liquid fund returns alone can be annualized for periods of less than 1 yr
Returns for periods more than on year has to calculated usingCAGR
Returns have to be disclosed for the fund and benchmark
149
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Chapter 9Return, Risk, Performance and Fund Selection
Returns From Mutual Funds
The components of the returns from a mutual fund investment are
– Dividends
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– Capital Gains
Dividends are paid out to investors who choose the dividend option
Capital gains is the difference between the acquisition price and
sale price of units
– Realized when units are sold
151
Methods of Return Calculation
The methods of calculating returns from mutual funds are
– Change in NAV method
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– Total return Method
– Return on investment method
– Compounded annual growth rate method (CAGR)
The suitable method of calculating returns depends on the
investment objective of the investor
The performance data published by mutual funds use the CAGR
method for the growth option of a scheme
152
Change in NAV Method
Calculates the return between two dates
Example:
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– NAV of a fund was Rs. 23.45 at the beginning of a year
– NAV of the fund was Rs. 27.65 at the end of the year
Percentage change in NAV
= (27.65 – 23.45)/23.45 *100
= 17.91%
This method considers only the change in NAV between two dates
– Dividend paid, if any, is not considered
153
Total Return Method
Calculates the return by considering both dividend and capital
appreciation.
Example
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Example
– Investor bought units of a mutual fund scheme at a price of Rs.12.45
per unit
– He redeems the investment a year later, at Rs. 15.475 per unit
– During the year, he also receives dividend at 7%
The rate of return on his investment can be computed as
= ((15.475 – 12.45) + 0.70)/12.45 x 100
= (3.725/12.45) x 100 = 29.92%
Does not consider the re-investment of dividend
154
Return on Investment (RoI) Method
The RoI is calculated using the formula
– (Value of holdings at the end of the period - value of holdings at the
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beginning of the period)/ value of holdings at the beginning of the periodx 100
– Value of holdings at the beginning of the period = number of units at the
beginning x begin NAV
– Value of holdings end of the period = (number of units held at the
beginning + number of units re-invested) x end NAV
– Number of units re-invested = dividends/ex dividend NAV
155
RoI Method - Example
An investor buys 100 units of a fund at Rs. 10.5 on January 1, 2007.
On June 30, 2007, he receives dividends at the rate of 10%. The
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ex-dividend NAV was Rs. 10.25. On December 31, 2007, the fund’s
NAV was Rs. 12.25.
– The begin period value of the investment is = 10.5 x 100 = Rs. 1050
– Number of units reinvested = 100/10.25 = 9.756 units
– End period value of investment = 109.756 x 12.25 = Rs. 1344.51
– The return on investment =(1344.51-1050)/1050 x 100
= 28.05%
156
Compounded Annual Growth Rate
CAGR is the rate at which investment has grown from begin point to
the end point, on an annual compounding basis
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– V0(1+r)n = V1
– r =((V1 /V0)1/n)-1
Where
– V0 is the value at the start
– V` is the value at the end
– n is the holding period in years
– r is the CAGR
157
Expense and Income Ratios
Expense ratio is calculated as
– Total expenses/Average net assets x 100
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– It is a measure of efficiency of the fund
– Important in the evaluation of debt and liquid funds
– Fund size and account size has an impact on the expense ratios
Income ratio is calculated as
– Net investment income/Average net assets
– Useful for evaluating income-oriented funds
158
Turnover Ratio
Portfolio turnover ratio is calculated as
– Value of assets purchased or sold/Net Assets x 100
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– Measures the trading activity in the portfolio
– A turnover rate of 200% means the portfolio was turned over twice
A high portfolio turnover ratio implies higher transaction costs
– All costs related to trading are called transaction costs
Transaction costs have to be evaluated in the light of the type of
scheme and investment objective
159
Portfolio Characteristics
Size of the fund
– A larger fund enjoys benefits of scale, a smaller fund is more agile
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Cash holdings of a fund
– A high cash holding may impair performance in a rising market but
protect downside in a falling market
Funds hold some cash for redemption needs
– Deploying funds collected in an NFO may take time
160
Comparison of Mutual Fund Performance
The performance of mutual is compared to
– A benchmark
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– Peer group average
– Other financial products
The market index is used as a benchmark
– Choice depends on the investment objective of the fund
The performance of a fund has to be compared with other similar
funds to be relevant
161
Benchmark Comparison
Market benchmarks are independent portfolios that are not
managed by any fund manager
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A fund’s chosen benchmark has to be mentioned in the offer
document
– Has to reflect the portfolio and investment objective of the fund
– Can be changed with approval of the trustees
Mutual fund performance is measured relative to the benchmark
– Investors look for absolute returns
162
Peer Group Comparison
The factors to be considered while selecting funds for peer group
comparison are:
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– They should invest in the same asset class
– Investment pattern must be similar
– The funds must have comparable investment objective
– The size and quality of assets must be comparable
Funds are ranked by grouping similar funds
163
Regulations for Return Computation
Returns should be calculated using the NAV of the growth option
– Load should not be included
Returns have to be computed for 1,3,5,10 years and since inception
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p y p
Returns for periods less than one year have to be absolute returns
– Liquid fund returns alone can be annualized for periods of less than one
year
Returns for periods more than one year has to calculated using
CAGR
Returns have to be disclosed for the fund and benchmark
164
Risk in Mutual Fund Investment
Risk arises when actual returns are different from expected returns
– Historical average is a good proxy for expected return
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Risk in equity funds depends upon the portfolio characteristics,
strategy and fund manager’s ability
– Maybe company specific or market risk
– Equity investing is profitable over the long-term
Risk in debt funds arises due to interest rate and credit risks
165
Measures of Risk
Standard deviation measures the fluctuation of actual return around
the mean
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– Preferred because it is a measure of total return
– Drawback is that it uses past performance data
Beta measures the sensitivity of a fund’s return to changes in the
market index
– Funds with high beta are more volatile
– Measures only market risk
Ex-marks or R-squared measures the extent to which the
fluctuation in returns can be explained by market movements166
Other Measures of Risk
Risk Adjusted Return considers risk premium in relation to the risk of
the fund
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– Sharpe ratio & Treynor ratio
Alpha is the excess return generated by a fund over what is justified
by its risk measured by beta
The P/E ratio of a fund can be used to gauge its risk
Interest rate risk and credit risk are the main risks in a debt fund
– Average maturity and duration measures interest rate risk
– Credit rating and NPAs measure credit risk
167
Equity Fund Selection
Fund category
– Suitability to investor objective
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Investment style
– Growth vs Value
Age of the fund
– Experience and consistency preferred to new fund
Fund management experience
Size of the fund
– Larger funds have lower costs
Performance and risk
168
Equity Fund Portfolio Evaluation
Percentage holding in cash
Concentration in portfolio
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Market capitalisation of the fund
Portfolio turnover
Risk Statistics – Beta
– Ex-Marks
– Gross dividend yield
– Funds with low beta, high ex-marks and high gross dividend yield is
preferable 169
Selection of Debt Funds
Total return rather than YTM is important
Expense very important
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– High expense ratios lead to yield sacrifice
Credit quality
– Better the rating of the holdings, safer the fund
Average maturity
– Higher average maturity means higher duration and interest rate risk
Tax implication have to be considered while selecting options
170
Selection of Liquid Funds
Relative yield of the fund is important
– Trade-off between yield and credit quality
P i f i i l i d
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Protection of principal invested
– NAV fluctuation limited due to low duration and low levels of interest
rate risk.
Credit quality of portfolio
Low expense ratio
Investor composition and size of the fund
171
Selection of Balanced Funds
Evaluation and selection criteria would depend upon the fund’s
equity or debt orientation
R t i k t ill d d thi i t ti
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– Returns ,risk , cost will depend on this orientation
Portfolio will have lower ex-marks and beta
– Average maturity of the debt component indicates the risk
Portfolio balance should be maintained in line with investment
objectives
– Tax status will depend upon the portfolio composition
172