NISM MF Distributors Certification

Duration 2 Days
 PROGRAM OBJECTIVES

At the end of the program you will be able to:

Explain the Concept, Role and Functioning of Mutual Funds

Appreciate the need for a sales person to act as a financial

planner for the client

Preparation for passing NISM Certification Test.

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Rules of NISM Certification Test

Duration of the test is 2 hours

The question paper consists of 100 questions of 1 mark each
Each question paper may be different
You will be given four options
Minimum pass marks is 50
There is negative marking for wrong answers, 25% marks
deducted for every wrong answer
You will have questions on numericals, use of calculator is
allowed
To register and take the examination please visit
www.nism.ac.in
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 Recommended Reading Material

Workbook for NISM Mutual Fund Distributors Certification

Examination(can be downloaded from www.nism.ac.in)

Reference Books:

Mutual Funds in India H. Sadhak

Indian Mutual Funds Handbook Sundar Sankaran

How Mutual Funds Work Fredman and Wiles

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Chapter 1

Concept and Role of a Mutual Fund

 Basic Mutual Fund Concepts
Collective Investment Vehicle
Pool of investors money invested according to pre-specified investment objectives
Range of products known as Mutual Fund Schemes

Mutuality in contribution and benefit

Profits or losses belong to the investors
Benefits accrue in the proportion to the share in the pool

Product is described by its Investment Objective

Fund managers invest as per investment objective
Investors match their objectives with the funds investment objectives
Investment objective defines the risk return profile of the fund

6
Mutual Fund Units

What shares is to equity, units is to mutual funds

Mutual fund investor is called a unit holder

Mutual funds are first offered to an investor in NFO (New Fund Offer)

Subsequently, mutual funds units may be bought and sold through the fund itself
Continuous transactions at fund offices or investor service centres
Purchase and redemptions
Some funds may be listed on stock exchange

Unit Capital is the corpus of the fund

Number of Units * Face Value
Changes depending upon the nature of the fund
Open-ended Fund - Investors come in and move out any time
Closed-ended Fund - Investors stay till maturity

7
Investment Portfolio
Portfolio is a collection of securities
equity shares, bonds, debentures, deposits, money market instruments, derivatives and the
like

Mutual funds can invest only in marketable securities

Value of the investment portfolio changes with a change in market price of the
securities

Marking to market
Process of using market price to value an investment portfolio is known as marking to
market

Unrealised gains or Unrealised losses

Gains or losses in values of the securities held in the portfolio, but not realized through a
sale

Total Assets
Market Value of all the securities held in the portfolio
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Net Assets

Assets Under Management (AUM)

Total Assets + Current Assets

Mutual Fund does not hold any long term assets or liabilities
Mutual funds are not permitted to borrow

Short-term liabilities
Fund running expenses
Net Assets = Total assets + Accrued income Current liabilities Accrued expenses

Net Asset Value

Value per unit at current market prices
Net assets divided by units outstanding

9
Changes in Net Assets

The net assets of a mutual fund may go up due to the following reasons:
Entry of new investors
Income from dividends or interest
Realised gains from sale of investments
Unrealised gain from increase in the value of the investments

The net assets may go down due to the following reasons:

Redemption by existing investors
Expenses to be paid
Realised losses from sale of investments
Unrealised losses from decrease in the value of the investments

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Investing through MFs

Advantages Disadvantages

1. Professional Management 1. Lack of Portfolio Customization

2. Portfolio Diversification 2. Choice Overload

3. Economies of Scale

4. Liquidity

5. Flexibility & Convenience

6. Regulatory Comfort

7. Tax Benefits

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 Types of Funds
Open-ended Funds
Does not have a fixed maturity date
Accept purchases and redemptions at any time
Purchase and redemption transactions happen on a continuous basis at fund offices and ISCs
Transactions are based on NAV of the fund
Unit capital is not fixed

Close-ended Funds
Run for a specific period
Closed-end funds are offered in an NFO but are closed for further purchases after the NFO
Compulsorily listed on a stock exchange to provide liquidity during the life of the fund
Unit capital of a closed-ended fund is kept constant

Interval Funds
Variant of closed-ended funds
Primarily closed-ended but become open-ended at specific intervals Specified Transaction
Period
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Fund Classification

Based on investment objective

Debt funds investing in short and long term debt instruments
Equity funds investing in equity securities
Hybrid funds investing in a combination of equity and debt
Other funds including international, commodity, and fund of funds.

Based on investment risk

Equity funds have a greater degree of risk as compared to a debt funds
Liquid funds are the least risky, as they invest in very short-term securities

Based on investment style

Actively Managed Funds
Passive Funds

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Fund Classification-2

Based on investment horizon

Equity funds are recommended for the long term (five years and above)
Balanced funds are recommended for three years and above
Income funds are recommended for medium term (one year and above)
Short term debt funds are recommended for the short term (up to one year)
Liquid funds are recommended for ultra-short periods (up to a month)

Based on investment categories

Equity funds invest in equity shares; Debt funds invest in debt securities;
Money market funds invest in money market securities; Commodity funds invest in
commodity-linked securities;
Real estate funds invest in property-linked securities; Gold funds invest in gold-linked
securities

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 Debt Funds - 1

Money Market or Liquid Funds

Very short term maturity
Invest in debt securities with less than 91 days to maturity
Treasury bills, commercial papers and certificate of deposits
Primary source of income is interest
No mark to market for securities less than 91 days to maturity
Low risk of NAV fluctuation
Safety of principal and superior liquidity
Used primarily by large corporate investors and institutional investors
Park their surplus funds for short periods of time

Floating Rate Funds

Invest largely in floating rate debt securities
Earn an interest income in line with the market interest rates
Lower mark to market risk
Attractive when the interest rates are rising

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Debt Funds - 2
Gilt Funds
invest in government securities of medium and long-term maturities
No risk of default
High interest rate risk, depending upon maturity profile
Diversified Debt Funds
invest in medium-term and long-term securities issued by the government, banks and
corporates
Benefit of higher coupon
Higher credit risk
High interest rate risk due to long term orientation

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Debt Funds - 3
High-yield Debt Funds
Seek higher interest income by investing in debt instruments that have lower credit ratings
Also known as junk bond funds
Fixed Maturity Plans
Closed-end funds that invest in debt instruments with maturities that match the term of the
scheme
Debt securities are redeemed on maturity and paid to investors
No interest rate risk
Issued in a series by a mutual fund
Issued for various time horizons

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 Equity Funds

Diversified Equity Funds

Invest in equity shares across various sectors, sizes and industries
Less risky
Thematic Equity Funds
Choose the equity shares and sectors they would hold in their portfolio based on a theme
Infrastructure, service industries, consumer spending, financial industry
Multiple sectors and stocks falling within a theme
Less diversified than a diversified equity fund
Sector Equity Funds
Invest in a given sector, such as technology, banking or pharma.
Concentrated funds and feature high risk
Sector performances tend to be cyclical
Mirror the performance of a sector

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Strategy-Based Equity Funds

Growth Funds
Invest in companies whose earnings are expected to grow at an above-average rate

Value Funds
Identify stocks of good quality companies that are currently undervalued by the
market

Mid-cap and Small-cap funds

Focus on smaller and emerging companies for their higher growth potential

Dividend Yield Funds

Income from dividends and invest in companies that have a high dividend yield
Also known as Equity Income Funds

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Equity-Linked Savings Scheme

Some equity schemes are designated as ELSS at the time of launch

Offer tax benefits u/s 80C

Investment up to Rs. 100,000 in a year in such funds can be deducted from taxable income
of individual investors

ELSS must hold atleast 80% of the portfolio in equity securities

Lock-in period of 3 years from the date of investment

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 Hybrid Funds
Monthly Income Plans
Smaller allocation to equity (5% to 25%)
Larger allocation to debt, pre-dominantly debt-oriented
Regular income from debt securities and equity for long-term growth
Periodic distribution of dividends, though there is no assurance
Balanced Funds
Equity-oriented hybrids that invest up to 65% in equity
The allocation to debt offers a cushion from the risk of an all equity portfolio
For investors who seek growth from equity but want protection from volatility
Asset Allocation Funds
Dynamic Funds that can change proportion between debt and equity depending upon market
outlook
Capital Protection-Oriented Funds
Debt securities with a derivative instrument or equity shares
Structured portfolio such that Amount invested + Interest = Investors principal
Investment in debt may be combined with debt and equity derivatives
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Other Types of Funds-1

Fund of Funds (FoF)

Invests in other funds
Funds may be of same fund house or various fund houses (Multi-manager)
Portfolio manager makes the choice of funds according to investment objective
Two levels of expenses- underlying level and FoF level

International Funds
Invest in securities issued in foreign markets
Invests in foreign securities or foreign funds
Host fund is the international fund
Feeder fund is the fund launched in India
Feeder fund ties up with the Host fund in an FoF structure

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Other Types of Funds - 2
Arbitrage Funds
Take equal and opposite exposure in different markets
Earn a return due to difference in price in the two markets
For example, equity in cash market and futures market
Low risk, return similar to the debt funds
Exchange Traded Funds (ETF)
Open-ended funds that track a market index
Units are listed like shares on the stock exchange
Purchase and sale transactions are executed on stock exchange
Demat accounts are used
Transactions at market prices, which may be different from the NAV
Commodity Funds
Invest in commodity ETFs, commodity stocks or in international commodity futures contracts
In India, direct investment in commodity futures is not allowed
Indian commodity funds usually invest in stocks of commodity companies
Gold Funds are structured as ETFs
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Role of Mutual Funds
To the investor
they offer products that enable access to various markets
a diversified investment opportunity at a low cost
To the issuers of various securities,
they are institutional investors seeking better return, lower risk
ability to monitor and evaluate investment options efficiently
Industry competitive and well-regulated
Mutual funds have grown from a single player (UTI) in 1964 to 40 players in 2010
There are about 850 mutual products in the market
Public sector mutual funds came in late 1980s and the private and foreign funds came since the
1990s
Most of the assets of the mutual fund industry are in short term debt funds (about 60%), which
are favoured by institutional investors
Several measures are being taken by regulators and the industry to increase the
participation of retail investors in mutual funds

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Chapter 2

Fund Structure and Constituents

Structure of Mutual Funds

Three-tier structure of Sponsor-Trust-Asset Management Company based on SEBI

(Mutual Funds) Regulations, 1996
Sponsor creates the mutual fund and sets up the AMC
Mutual fund is structured as a trust, overseen by a Board of Trustees
Trustees appoint the AMC to manage the funds
Sponsor
Promotes the mutual fund
Appoints the Board of Trustees and Board of Directors of the AMC
Seeks regulatory approval
Eligibility criteria
At least five years experience in the financial services industry
A good financial track record of at least three years prior to registration of the fund.
(Positive net worth is essential)
At least 40% contribution to the capital of the AMC

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Mutual Fund as a Trust

Investors in the mutual fund are beneficiaries of the trust

Trustees are appointed by the Sponsor with SEBI approval
May be a set of individuals or a Trustee company
The sponsor will have to appoint at least 4 trustees.
Trustees must act on behalf of the investors
Guardians of unitholders funds and assets
Trust deed is executed by the Sponsor in favour of the trustees
Clauses laid down by SEBI
Board of Trustees
Oversee the working of the AMC and management of the mutual fund
Key decisions of the AMC require trustee approval
Must meet at least 6 times in a year
At least 2/3rds of the members have to be independent

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Asset Management Company

AMC is the investment manager of the mutual fund

Responsible for running of the day to day operations
Investment Management Agreement between the trustees and the AMC
Lays down rights and obligations of the AMC
AMC seeks approvals and supervision by the Trustees
Board of Trustees is the internal regulator
AMC is appointed by the trustees, with SEBI approval
AMCs should have a net worth of at least Rs10 crore at all times
At least 50% of members of the board of an AMC have to be independent.
The AMC of one mutual fund cannot be an AMC or trustee of another fund.
AMCs cannot engage in any business other than that of financial advisory and investment
management

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Other Fund Constituents

Mutual fund constituents (except custodians) are appointed by the AMC with the
approval of the trustees.
All mutual fund constituents have to be registered with SEBI
They are usually paid fees for their services

Constituent Role

Custodian Hold funds and securities

R&T Agent Keep and service investors records

Banks Enable collection and payment

Auditor Audit scheme accounts

Fund Accountants Performs the role of calculating the NAV

Distributors Distribute fund products to investors

Brokers Execute transactions in securities

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Custodian

Hold the securities of the mutual fund

Responsible for their safekeeping
Appointed by the Sponsor
Only constituent NOT directly appointed by the AMC
Must be independent of the Sponsor and its associates
Functions of the Custodian
Delivering and accepting securities and cash to complete portfolio transactions
Tracking and completing corporate actions and payouts on the securities held by the fund
Coordinating with the DPs who hold the securities account of the mutual fund schemes

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Registrars and Transfer Agents

Create and maintain investor records and service them

Accept and process investor transactions
Operate Investor Service Centres (ISCs)
R&T functions
Issuing and redeeming units and updating the unit capital account.
Enabling investor transactions such as purchase, redemption and switches.
Creating, maintaining and updating investor records.
Banking the payment instruments given by investors and notifying the AMC.
Processing payouts to investors in the form of dividends and redemptions.
Sending statutory and periodic information to investors

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Distributors

Appointed by the AMC in order to sell mutual fund units to investors on behalf of the
AMC
Enable the reach of mutual fund products across geographical locations
Commission is paid to distributors on sale of mutual fund units
Theres no exclusivity in mutual fund distribution
Sponsor and its associates may act as the distributors
Distributors may be individuals or institutions such as banks, NBFCs or broking and
distribution companies
Must pass the certification examination mandated by SEBI and conducted by the NISM
(NISM Series V A Mutual Fund Distributors Certification Exam)
Must obtain AMFI Registration Number (ARN) after clearing the examination, to empanel
as distributors with a mutual fund

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Brokers, Banks and Auditors

Brokers execute buy and sell transactions of the fund managers

Banks provide collection and payment services

Payment instruments are collected in mutual fund scheme accounts
Carry out redemption and dividend payments

Auditors audit the books of the mutual fund

Account of each mutual fund scheme is kept separately
Auditors of mutual fund are different from auditors of the AMC

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Chapter 3

Legal and Regulatory Environment

 SEBI as the Regulator

Indian mutual funds are supervised and regulated by the SEBI

SEBI (Mutual Funds) Regulations, 1996
Various amendments and circulars from time to time
SEBI was set up by the SEBI Act, 1992 and is supervised by Ministry of Finance
Regulation of Constituents
SEBI regulates registrars, custodians, brokers, collecting banks and the like
Distributors must clear the mandatory certification prescribed by SEBI
Constituents must be registered with SEBI
AMC and Trustee company are also governed by the Companies Act and Indian Trusts
Act respectively

35
RBI and Stock Exchanges

RBI regulates banks in India

Banks can act as sponsors, custodians, bankers and distributors of mutual funds
Mutual funds also invest in money market instruments and g-secs
Money and debt markets are regulated by RBI
Subject to regulations laid down by RBI

Closed-ended funds/ETFs are listed on stock exchanges

Listing agreement with stock exchanges
Subject to regulatory and disclosure requirements

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Association of Mutual Funds in India (AMFI)

AMFI is industry association of mutual fund industry

It is not a Self Regulating Organisation (SRO)
AMFIs functions
Recommends best business practices and code of conduct for members.
Represents the industry to regulators and policy makers in SEBI, RBI and the government
Conducts investor awareness programmes
Disseminates information
AMFI Registration Number (ARN)
Distributor is empanelled by a mutual fund ONLY after registration with AMFI
AMFI Code of Ethics (ACE) for AMCs
Dealing with investors, intermediaries and the public
Adapted as a supplement in the Fifth Schedule of the SEBI (Mutual Fund) Regulations
AMFI Guidelines and Norms for Intermediaries (AGNI)
SEBI has made it mandatory for distributors to follow the code
AMFI is authorised by SEBI to seek explanation, issue warnings, or cancel the registration

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Summary of Mandated Service Standards by SEBI

Transaction Turnaround Time

Allotment of units in a NFO (other than ELSS) 5 days from NFO closing date

Allotment of units in a ELSS NFO 30 days from NFO closing date

Dispatch of Statement of Account (on-going) 10 working days from transaction request

Dispatch of Statement of Account (Systematic

10 days from end of calendar quarter
transactions)

Dispatch of dividend warrants 30 days from date of dividend declaration

Dispatch of redemption proceeds 10 working days from transaction request

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Investor Rights for Service Standards

Delay in dispatching dividend warrants or redemption proceeds

AMC has to pay the unit-holder interest at the rate of 15% p.a

Systematic investors can make a special request for Statement of Account

Must receive their Statements of Account within 10 days

Dormant investor must receive a Statement of Account once a year

Soft copy of Statement of Account may be sent to investors every month

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Special Transactions

Change of Broker
Letter to the mutual fund indicating change of ARN
Nomination
Nominee appointed by the unitholder
Proceeds of the folio in the event of death will go to the nominee
Unit Certificate
May be provided upon request within 30 working days
No operational purpose
Demat holding
In order to transact units on stock exchange
AMC/MF to co-ordinate with DP to provide demat statement to unit holders

40
Investor Rights for Information Disclosure

NAV and Sale and Repurchase prices disclosed on AMFI website by 9pm every business
day .FoFs can publish their NAV by 10 am of the next business day
Detailed Portfolio disclosure in the prescribed format every 6 months
One English daily and one regional newspaper
Within 1 month of the close of half-year
Close-ended debt funds and Interval funds have to publish their portfolios on website
Within 3 working days of every month-end
Summarised portfolio disclosure to unit holders every month through Factsheet
Voluntary industry practice
Scheme-wise annual report to be mailed to all unit-holders
Within 4 months of financial year-end
Key documents may be inspected by investors
Detailed offer document, Key Information Memorandum, Annual Report
Trust Deed, Investment Management Agreement, Custodial Services Agreement, R&T Agent
Agreement and Memorandum & Articles of Association of the AMC

41
Rights With Respect to Fund Management

Change in Fundamental Attributes

Mutual fund to send a written communication to ALL unit holders about the proposed change
In one English daily and one regional newspaper
Option to exit for at least 30 days without exit load before the implementation of the change
Termination of AMC or winding up of a Scheme by unit holders
Resolution by unit holders holding at least 75% of assets in the scheme
Termination of AMC or winding up of a Scheme by Majority of Trustees
Seek the consent of unit holders
Change in Sponsor or the AMC
Unit holders have the right to be informed
Option to redeem without exit load
Structural Protection
The AMC or the sponsor do not directly hold the funds or securities belonging to the investors
Custodian is independent of the Sponsor

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Limits to Investor Rights

Cannot sue the Trust

Unit holders are not a separate entity different from the Trust
The Trust is only a notional entity
Principle of caveat emptor (let the buyer beware)
Unit holders cannot seek legal recourse on the grounds of not having read, understood or
noticed information disclosed
A prospective investor has no rights with respect to the fund, the AMC or intermediaries
Limits to redressal
Neither shareholders nor depositors
Investments cannot be protected
Offer document discloses all pending investor complaints

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Chapter 4

Offer Document
Role of the Offer Document (OD)

Legal representation of the offer of the mutual fund scheme to the investors
Contractual relationship between investor and the mutual fund based on OD
Source of information
Background information on the mutual fund and the scheme
Investors are expected to read and understand OD before investing
Format prescribed by SEBI
Offer Document for a new fund
AMC seeks trustee approval and files draft OD with SEBI for approval
OD is available on SEBI website for public viewing
SEBI approval usually comes within 21 days, subject to changes, if any
NFO must be made within 6 months of SEBI approval of the OD
SEBI only vets the OD to ensure that all required information is provided. It does not
approve or recommend the scheme being offered.(Disclaimer Clause)

45
New Fund Offer Process

Application forms contain abridged version of the OD, known as Key Information
Memorandum (KIM)
Complete OD available to investors on website
NFO period must be limited to 15 days, except for ELSS up to 30 days
Open-ended scheme opens for re-purchase and purchase after allotment
Close-ended scheme gets listed on stock exchange
Allotment must be completed and scheme open for transactions within 5 working days
of NFO closure
Components of Offer Document
Statement of Additional Information(SAI)
Information generic to all schemes of a mutual fund
Scheme Information Document(SID)
Information specific to a scheme

46
Statement of Additional Information(SAI)

Contains generic information of the mutual fund

Details of the sponsor and financial history
Names and addresses of the Board of Trustees
Details of AMC, key personnel and Board of Directors of AMC
Details of various fund constituents
Investor service officers details
Contains financial information of the mutual fund
Performance of existing schemes on yearly basis
Scheme expenses and loads applicable
Initial issue expenses
Lays down the rights of investor w.r.t information, services and redressal
Filed only once with SEBI in the prescribed format

47
Scheme Information Document(SID)

Filed with SEBI for approval before launch of a new scheme

Information specific to a certain scheme

Scheme type (open or closed end)
Investment objective
Asset allocation
Investment strategies
Terms with regard to liquidity
Fees and expenses
Benchmark for the scheme
Investment restrictions, if any
Mandatory disclosures and disclaimers

48
Fundamental Attributes and Risk Factors
Fundamental attributes are essential features of the scheme
Risk and return parameters are defined by the fundamental attributes
The fundamental attributes of a scheme may be changed provided:
The approval of the trustees and SEBI is taken.
Investors are informed about the proposed change and given the option to exit the scheme
without paying an exit load.
The AMC makes a public announcement of the change in at least two newspapers.

Risk Factors may be standard or scheme-specific

Standard risk factors apply across mutual fund schemes irrespective of whether it is an
equity fund or a debt fund.
E.g. Mutual funds are subject to market risk
Scheme-specific risk factors apply to the specific scheme for which the OD has been
prepared
E..g First scheme of a mutual fund
E.g. Risk of concentration in a sector fund
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Other Information

Indicative asset allocation and type of securities that the fund will invest in
Borrowing policy of the fund period and limits on borrowing
Policy and regulations on inter-scheme transfers
Methodology of calculation of NAV, Sale and Purchase Price
Operational details:
Period of offer
Plans, options and loads
NFO price and basis for subsequent pricing
Application process
Minimum investment amount
Investment facilities such as SIPs, SWPs and switches
Investors eligible to invest
Date of commencing ongoing sale and purchase
Maturity date, if scheme is closed-ended
List of Official Points of Acceptance (OPAT)

50
Modifications to SAI and SID

Open-ended schemes SID must be valid at all times

Updated version to be available on website
Changes to SID
Material changes to be updated immediately
Changes to fundamental attributes
Changes to investment options
Changes in load structure
No material changes, SID to be updated every year, within 3 months of the end of the FY
Changes to SAI
Material changes to be updated immediately
Changes to Sponsor/AMC
Changes to key personnel
No material changes, SAI to be updated every year, with 3 months at the end of FY

51
Addendum

Appendix to the Offer Document

Mutual Funds issue an addendum to notify any change in the information provided till
such time they are incorporated in the SID or SAI every year

Addendums have to be approved by trustees and notified to SEBI

Addendum must be published in two newspapers

To be prominently displayed on the notice board at the official points of acceptance of

application forms

52
Key Information Memorandum

Seeks to provide key fund information to the investor before investing

Abridged and concise version of the offer document
A copy of the KIM must accompany every application form
KIM contains all information for on-going transactions
Format for KIM is prescribed by Sebi
Must be updated at least once a year
Contents of KIM:
Investment objective and asset allocation pattern of the scheme.
Scheme-specific operational details.
Names of the AMC and trustee company.
Performance history of the scheme and the benchmark for one, three and five years and
since inception.
Expenses and loads applicable to the scheme.
Investor services and rights.

53
Chapter 5
Fund Distribution and Channel Management
Practices
Individual and Institutional Distribution Channels

Individual distributors are known as Independent Financial Advisors (IFAs)

Agreement with AMC to act as distributor
Establish personal long term contacts across investment products

Institutional distributors can be distribution houses, banks, or non-banking finance

companies
Employees and Sub-brokers
Wide branch network and large client base
Greater geographical reach
Standardised process for acquiring, servicing and advising institutional distributors
AMCs have to deal with one entity rather than several individuals
AMCs channel managers service the institutional distributors
Provide in-house research and product recommendations to investors

55
Newer Channels of Mutual Fund Distribution

Online Mutual Fund Distribution

Websites allow investors to make investments online, view current holdings at latest NAV
and conduct sale/purchase transactions
Investor creates an account with mutual fund/distributor website
Account is password protected
Convenient and paper-less transactions
No cheque writing is required, payment can be made through credit card.
Distribution through Stock Exchanges
Sebi has allowed stock exchange brokers to conduct mutual fund transactions through
their trading platforms with the NSE and BSE
Brokers must clear NISM MFD Certification, obtain ARN and empanel as distributor with
AMC
NSEs NEAT MFSS and BSEs STAR Mutual Fund Platform
Open from 9am to 3 pm
Mutual funds tie up with the stock exchanges to offer their funds through trading platforms

56
Appointment of Distributor

AMCs appoint mutual fund distributors by entering into distribution agreements

A distributor has to be empanelled by a mutual fund before being able to distribute its
products to investors
Pre-requisites for being appointed as a distributor:
Individual distributors and employees or representatives of institutional distributors have to
clear the NISM Mutual Fund Distributor (MFD) certification examination
Need to obtain the AMFI Registration Number (ARN) before they can seek empanelment
with AMCs
Institutions in the distribution business also need to get registered with AMFI
The certification examination is valid for a period of three years, after which it has to be
revalidated by attending a Continuing Professional Education (CPE) training
Empanelment form must be filled up while seeking empanelment
Personal details, names of key people handling sales and operations, business details
Appointment / termination of distributor is the discretion of the AMC
Does not require SEBI approval

57
Distribution Agreement
Lists down the terms and conditions of the appointment of the distributors
AMC has the power to terminate agreement at any time, after due notice
Follow the Code of Ethics by the AMFI and Mutual funds
Clauses of the agreement:
Ensure that the KIM is given along with the application form to investors
Inform investors that there is no recourse to the distributor for any problems in the investment.
Offer units only at the public offering price currently in effect and not offer differential pricing.
Commit to keeping the transactional details confidential.
Commit to abide by instructions from the AMC and the statutory codes, guidelines and circulars.
Not issue advertisement or publicity material other than that provided or approved by the AMC.
Ensure that the risk factors are mentioned along with performance and other related
information.
Provide all the information that the AMC may ask for from time to time.
Ensure that all employees who are engaged in selling or marketing of mutual funds have an
ARN.
Undertake not to attract investors through temptation of rebate of commission or gifts.

58
Distributor Commissions

There are no SEBI rules on the minimum or maximum rate of commission

influenced by commissions paid by other competing funds and the type of scheme
Distributors are not allowed to charge commissions on their own investment
Initial Commission is paid up-front
Entry load charged from investors was used by mutual funds to pay commissions to brokers
Entry load has been banned since Aug 1, 2009
Investors have the power to decide the payment to advisors for their services
Distributors have to disclose the commissions they earn on comparable schemes when they
recommend a scheme to the investor
Trail commission is paid as long as the investor remains invested in the fund
Calculated on the current market value (units brought in by the distributor x current NAV of the
units)
Paid for the time period of which the investor remains with the fund
AMFI has imposed a ban on trail commission for transferred assets
Money saved by AMC is to be used for investor education
59
Sales Practices

Distributor actions must be in the interest of the unit holders

Distributors have to follow AMFI's code of ethics (ACE) as well as well as those
prescribed by the concerned AMC, AMFI and SEBI.
AMFI and fund houses have put in place a set of guidelines to be followed by the
distributors. These include the following:
A mutual fund is not accountable for the activities of the sub-brokers of a distributor.
Distributors must have complete knowledge of the product on offer.
Distributors must know their clients needs and profile.
The product chosen must meet the clients requirements.
Distributors must encourage good investment habits such as long-term and regular
investment.
Distributors must provide good and efficient after-sales service.

60
 SEBI Advertisement Code

SEBI has prescribed advertisement code for mutual funds which

is mandatory and is as under:
Standard measures to compare such as Annual Yield,
CAGR etc.
Annualised yields for at least one, three, five years &
since launch
For less than 1 year performance, Absolute Return without
annualisation
Past gains may not repeat in future
Risk factors prominently stated
Appropriate benchmark to be chosen
Any ranking of fund to be explained 61
Chapter 6

Accounting, Valuation and Taxation

 NAV Computation

Net Assets = Sum total of all Assets - Liabilities of the Fund

Assets = Market value of Investments +

Receivables + Accrued income +
Other Assets

Liabilities = Accrued expenses + Payables + Other Liabilities

Net Assets of the Scheme

NAV of a Unit = Number of Units Outstanding
Q: Can you calculate NAV if total assets and total No.of units are given?
63
 Exercise

Calculate NAV of Fund Unit in the following case:

No. of units: 10,000

Market value of investments in Govt. Securities : Rs. 1 lakh

Market Value of investments in Corporate Bonds:Rs. 1 lakh

Other Assets of the fund: Rs. 20,000/-

Liabilities of the fund: Rs. 25,000/-

Payables by the fund: Rs. 5,000-

64
Valuation Principles

Valuation day is every business day when NAV is calculated

Valuing the mutual fund portfolio using current market prices of the securities it holds,
is called marking to market
Net assets can go up when there is a realized income or an appreciation in the market
value of the schemes assets.
Net assets will go down when there is a realized loss or depreciation in the value of the
schemes assets.
Expenses and income are accrued every day
Accrued income may be dividends or interest receivable
Accrued expenses are usually the fund recurring expenses charged daily to the scheme
but paid monthly or annually.
NAV of mutual fund schemes have to be posted on the AMFI website every business
day, by 9 pm.
NAV is rounded off up to at least two decimal places for equity and balanced schemes
and to four decimal places for liquid, index and other debt schemes.

65
Purchase and Redemption Price

Purchase price to the investor is the sale price to the mutual fund; redemption price to the
investor is the re-purchase price to the mutual fund
Entry Load
Imposed on the NAV to arrive at purchase price
Investor pays a price that is more than the NAV
No entry loads can be charged to investors
Exit Load
Imposed on NAV to arrive at the redemption price
Reduces the redemption price
Exit load cannot be varied based on the type of investor; it has to apply uniformly to all
investors in a scheme
CDSC (Contingent Deferred Sales Charge)
Variable exit loads applied on the basis of the period for which the investor stays invested
Exit loads or CDSC charged to investors in excess of 1% has to be credited back to the
scheme.

66
Scheme Expenses

Expenses borne by the mutual fund scheme regulated by SEBI

Any expense that is not chargeable, or exceeding the limits, has to be borne by the
AMC
Initial Issue Expenses
Incurred to meet expenses on advertisement, commissions, and launch of the scheme
during an NFO
Expenses related to an NFO cannot be charged to the investor. They have to be borne by
the AMC
Fund Recurring Expenses
Incurred to manage the money mobilised from the investor
The heads of expenses that can be charged to the scheme.
The maximum expense, as percentage of net assets, that can be so charged
Accrual basis, and reduced from the assets of the scheme, before computing NAV

67
Chargeable and Non-Chargeable Expenses

Expenses, identified as being direct expenses incurred to manage the fund, can be
charged to the scheme
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 disclosure and advertisements
Expenses other than those listed above, cannot be charged to the scheme
Fines and penalties also cannot be charged to the scheme

68
 Maximum Recurring Expenses
Recurring Expenses cannot exceed the following regulatory limits

Average Weekly For Equity For Bond

Assets Funds Funds
For first Rs.100 crs 2.50% 2.25%
For next Rs.300 crs 2.25% 2.00%
For next Rs.300 crs 2.0% 1.75%
On Balance Average
1.75% 1.50%
Weekly Assets
Calculate max. Recurring Expenses that MF can charge if average
weekly net assets are Rs.1,000 Core in Equity / Debt scheme

69
Investment Management Fees

Most significant head of expenses charged to the scheme

The limits on AMC 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.
Liquid funds and debt funds cannot charge any investment management fees for funds
parked in short-term bank deposits
An index scheme is passively managed
The expense limits for Index schemes (including ETFs) is : Recurring expense limit
(including management fees) is 1.50% , Management Fees is 0.75%.
Fund of funds invest in other funds, and therefore cannot charge more than 0.75% as
fees.
Including the expenses of the fund in which it invests, the overall expense to the investor
in a fund of funds cannot exceed the expense limits prescribed.

70
Accounting Policies

Accounts of each mutual fund scheme have to be maintained separately

SEBI regulations indicate the specific accounting treatment of various items in a
mutual fund schemes account
Distributable surplus for the purpose of paying dividend includes realized gains,
accrued income and unrealized losses but does not include unrealized gains
Mutual funds can distribute dividends only out of realized profits
Unrealised gains cannot be distributed as dividends
Unrealised losses must be reduced from the distributable surplus
Unit Premium Reserve is not available for dividend distribution
Average cost should be used to determine the holding cost of the securities
Investments should be accounted on the transaction date, not on the settlement date
Dividends, bonus and rights received by a mutual fund scheme should be recognized
on the ex-date

71
Valuation Norms

Valuation of the mutual fund portfolio is done on every business day

Business day is a day when the securities markets in which the fund has invested is open
Equity shares are valued at the last traded price on the valuation day
If no traded price available, the closing price of the previous trading day (not more than 30 days
before) can be taken
In case of thinly traded share, SEBI-approved valuation methodology is adopted to arrive at the
fair value
Debt securities are valued either at market prices if traded, or as per SEBI norms for
valuation
Securities with residual maturity < 91 days
to be valued at weighted average price if traded on the valuation date
Non-traded debt securities will be valued on amortization basis
Securities with residual maturity > 91 days
to be valued at weighted average price if traded on valuation date
If no traded price available, valuation based on yield matrix
Crisil provides Crisil Yield Matrix used across the industry

72
Tax Aspects for Mutual Funds

A mutual fund is recognized as a pass-through structure and is exempted from income tax
Dividends, interest and capital gains earned by the mutual fund scheme itself is fully exempt
from tax
Dividends are exempt from tax in the hands of the investor
Dividends are subject to dividend distribution tax (DDT) depending on the type of scheme
and investor
To be paid directly by the fund, before distribution of the dividend
Equity-oriented Fund
Scheme that has more than 65% of its net assets in equity securities
Not subject to DDT
Non-equity oriented funds are subject to DDT
Liquid funds - 25% for all categories of investors
Non-equity oriented, non-liquid funds - 12.5% by individuals and HUFs
20% by all other categories of investors
Surcharge and cess as applicable would be added

73
Capital Gains and Securities Transaction Tax

Short term capital gain (STCG) / Short term capital loss (STCL)
Capital gain or loss realised by sale of units within a period of 12 months
Long term capital gain (LTCG) / Long term capital loss (LTCL)
Gain or loss from sale after a holding period of one year
Indexation
Adjusting the purchase price for inflation for purposes of determining capital gains
The cost of inflation index to be used for indexation is published every year by the CBDT
(Central Board of Direct Taxes)
Mutual funds are not subject to Wealth Tax in the hands of the investor
Securities Transaction Tax
Applicable only for equity-oriented funds and equity and derivative securities
Payable by the mutual fund on purchase and sale transactions on the stock exchanges
at 0.125% for equity and 0.017% for derivatives
Payable by the investor at 0.125% on listed equity-oriented schemes and at 0.25% on
redemption of equity-oriented fund

74
 Calculating Capital Gain Tax - An Example

Mr. Arun invests Rs.2 lacs in MF units during FY 97-98

In F.Y. 2007-08, he sells units and gets Rs.3,36,930
CII 2007-08 : 551, CII 97-98 : 331
Indexed purchase cost (2,00,000 x 551 / 331) = Rs.3,32,930
Capital Gains : Rs.3,36,930 3,32,930 = Rs. 4,000
Long Term Capital Gain Tax is Rs.4,000* 20%=Rs.800 or 10% of
Rs.1,36,930/- i.e. Rs.13,693/-
Obviously he will select the option of paying Rs. 800/- and not
Rs.13,693 as long term capital gain tax.

75
Tax Provisions

Fund Type DDT STCG LTCG STT

Equity oriented On redemptions

NA 15% Exempt
funds @0.25%

10% without
Marginal rate
Liquid funds 25% indexation or 20% Not applicable
of taxation
after indexation

12.5% (individuals 10% without

Other non-equity Marginal rate
and HUFs) 20% indexation or 20% Not applicable
oriented funds of taxation
(others) after indexation

76
Chapter 7

Investor Services
Investors in Mutual Funds
Investors Eligible to Invest in Mutual funds
Individuals & Hindu undivided families (HUFs)
Companies & partnership firms
Trusts & charitable institutions
Banks & financial institutions
Non-banking finance companies (NBFCs)
Insurance companies
Provident funds
Mutual funds
Foreign institutional investors (FIIs)
Non resident Indians (NRIs)
Persons of Indian origin (PIOs)
Resident individual investors are the largest segment
Retail and HNI
HUFs can invest through Karta
Overseas Corporate Bodies and foreign citizens (except PIOs) are not eligible
78
Retail and Institutional Investors

The Who Can Invest section of the offer document of a scheme specifies the categories of
investors eligible to invest in a mutual fund scheme

The individual investor category includes retail investors, HNIs, minors and NRIs
Retail investors may depend upon the distributor to provide the information and analysis
HNIs may demand a better quality of service.
Minors can invest through a guardian

Institutional investors invest as per their charter and internal processes

Approval of management committees and board of directors
Boards resolution and charter of the institution are required
Authorised signatories are individuals authorised to sign document

79
Know Your Customer (KYC)

The identity of those entering into financial transactions must be known and verified
Proof of identity of the customer, proof of residence, Permanent Account Number and
photograph are verified to comply with KYC norms
Identified service provider: CSDL Ventures Ltd
Designated acceptance points: Points of Service (PoS)
KYC once completed, is valid across mutual funds
Investors have to submit a photocopy of the KYC acknowledgement along with application
forms
KYC compliance is mandatory for all joint investors in a folio, for purchase transactions
of Rs.50,000 or above
KYC for investment by a minor
Compliance by guardian
KYC for investment by Power of Attorney
Compliance by the investor and the holder of attorney

80
PAN and Micro-SIP

PAN is mandatory for all investors in a mutual fund, irrespective of invested amount
(Exception: Micro SIP)
Micro-SIP are exempted from requirement of PAN card
Annual investment does not exceed Rs.50,000 made by individuals, NRIs, minors and
sole-proprietary firms
Exemption not available for HUFs and PIOs or non-individual investors
Alternate valid photo identification documents must be provided instead
Investor is also required to provide an undertaking that their total micro-SIP
investments in a year do not exceed Rs.50,000

81
Purchase Transactions

Fresh purchases are made by investors by submitting an application form complete in

all respects
Open a new folio
Minimum investment amount
During an NFO or after the scheme opens for purchases
Additional Purchases are subsequent purchases after fresh purchase
Can be made under the existing folio
Can be made using a transaction slip
Minimum additional investment amount
Transaction Slip
Folio number to identify the investor
Used for redemptions, additional purchases, switches and even non-financial transactions
such as change of address or change of bank details
Has to be signed according to the mode of holding of the folio, to be valid

82
Payment Instruments
Payment is usually made by cheque
Local cheques accounts in same city but different banks
Outstation cheques accounts in different banks in different cities
At-par cheques work like local cheques
Demand drafts are accepted from locations where an ISC is not available
Mutual funds do not accept cash, outstation cheques, money orders, stale cheques or post
dated cheques (except for SIPs)
Electronic Payment Instruments
Schemes account details are essential
Proof of transfer must be appended along with the application
EFT, RTGS, ECS, Direct transfer, SWIFT
Widely used for making liquid fund purchases by institutional investors
ASBA (Application Supported by Blocked Amount)
Sebi has allowed for NFO applications
Money goes out of the investors bank account only on allotment

83
Payment Instruments NRIs and FIIs

Non-resident external (NRE)

Foreign currency accounts
Funds can be repatriated on redemption
Non-resident ordinary (NRO)
Indian rupee accounts
Funds cannot be repatriated on redemption
Foreign currency non-resident (FCNR)
Payment remitted from abroad
Foreign Inward Remittance Certificate (FIRC) is a proof that an individual has received a
payment in foreign currency from outside the country
Source of funds determines repatriability of funds on redemption
Redemptions to NRIs are subject to TDS on the capital gains made in the transaction
Redemptions to NRIs are in Indian rupees
FIIs use non-resident rupee accounts for investments in India
Funds fully repatriable on redemption

84
Redemption Transactions

Redemption may be specified in terms of units or rupees

The repurchase price is the applicable NAV minus exit load
Redemption request has to be filed by joint holders as per mode of holding
In case of corporate investors, authorised signatories have to sign the redemption request
If a redemption request reduces the balance to below minimum limit, then all the units
standing to the credit of the folio will be redeemed and the folio closed
Redemptions are either made directly into the bank account, or by cheques on which
the bank account details are pre-printed
Mutual funds are required to service redemption requests within 10 working days
Failing this, AMCs have to pay a penal interest of 15% per annum to the unit holders

85
Applicable NAV

Cut-off time determines the NAV applicable for the transaction

NAV applied to a transaction depends upon the time when the transaction request was
received by the mutual fund and the type of scheme

NAV is computed on business days for all schemes

Except liquid funds, for which NAV is computed every calendar day

Cut-off time varies for liquid fund purchases

Historical NAV is possible

For all non-liquid funds, the applicable NAV is prospective

86
Cut-off Time and Applicable NAV

Transaction Cut-off time Applicable NAV

NAV of the day prior to the day on which clear

Liquid fund purchases 12.00 noon
funds are available

Liquid fund redemptions 3.00 pm NAV of transaction day

Non-Liquid fund purchases 3.00 pm NAV of transaction day

Non-Liquid fund redemptions 3.00 pm NAV of transaction day

87
Time Stamping

Record the time at which a transaction was received at an OPAT

OPATs - Mutual fund offices and designated investor service centres (ISCs)
The time stamp is mandatory to determine the applicable NAV for a financial
transaction
Electronic time stamping requirement for all mutual fund purchase and redemption
transactions
The time stamping machine captures the time of receipt of a transaction
The location code, machine identifier, date, time (hh:mm) and running serial number
are generated in every time stamp
The time stamping machine records three impressions for purchase:
the application form or transaction slip,
the back of the payment instrument, and
the acknowledgement.
For redemption transactions all three impressions are on the redemption request

88
Statement of Account (SoA)

Proof of investment
SoAs are despatched by the R&T agent, after every transaction
Within 10 business days of the transaction
In case of NFO, SoA must be despatched within 5 business days of allotment
In case of SIP, SoA is sent every quarter
Fresh purchase SoA
Amount, price, and units are mentioned
Subsequent transaction SoA
Amount, price, balance units, current market value are mentioned
Received through post, courier, email

89
Transactions Through Stock Exchange Brokers

Transactions are placed like orders to the brokers

Contract note generated with an electronic time stamp
Receipt of purchase requests and redemption requests is handled by brokers
Allotment of units against purchase and release of funds on redemption, is handled by
the R&T agents
Folio details are sent to R&T agents by brokers
Settlement is not guaranteed by the stock exchange or clearing corporation
Responsibility of settlement lies with the AMC and R&T agents
May be in physical form or through demat account
Demat statement is considered as the SoA to the investor
Demat transactions are settled through credit and debit instructions to the depository
Physical transactions are settled through R&T Agent

90
Investment Options
The underlying portfolios for all options are the same, only post-tax returns are different
Growth option
Gains made in the portfolio from income and appreciation are retained and gains are reflected
in NAV
Investor must redeem units to realise gains
Realised profit/loss is treated as capital gains or loss
Dividend Pay-out
Fund declares dividend from realised profits after trustee approval
Amount and frequency varies and depends upon distributable surplus
Ex-dividend NAV: NAV after the dividend is declared and paid out
Cum-dividend NAV: NAV after dividend has been declared but not paid out
NAV falls after dividend payout to the extent of dividend paid
Dividend Re-investment
Dividend is re-invested in the same scheme by buying additional units at the ex-dividend NAV

91
Investment Options An Illustration

Growth Dividend Payout Dividend Re-investment

NAV at the beginning Rs.10 Rs.10 Rs.10

Number of Units 100 100 100

NAV after 1 year Rs.12 Rs.12 Rs.12

Dividend of 10%
No Yes Yes
declared

Dividend Amount Nil Rs.100 Rs.100

NAV post dividend Rs.12 1100/100 = Rs.11 1100/100 = Rs.11

100+(100/11)
Number of units held 100 100
=109.09

Value of investment 100x12=1200 100x11=1100 109.09 x 11=1200

Pre-tax return on Rs.200 capital Rs.100 dividend+ Rs.100 dividend+ Rs.100

investment gain Rs.100 capital gain capital gain*

92
Systematic Investment Plans

Investors invest a sum periodically into a mutual fund scheme

Applicable NAV is the NAV on the date of the instalment
Rupee cost averaging
Buying more units when the market is low and less units when the market is high
Period of commitment of SIP can vary e.g. 6 months, 1 year, 3 years, 5 years
Specific intervals at which investment must be made e.g. monthly, quarterly, half-yearly
Investment is made on specific dates e.g. 1st, 5th, 10th, 15th of every month
Can be initiated along with NFO
First instalment is upon allotment
Second instalment comes after the fund opens for subscription
Payment modes Post dated cheques, electronic clearing service, standing instruction
for direct transfer

93
SWP and STP

Systematic Withdrawal Plan

Periodic redemptions at the prevailing NAV (less exit load as applicable)
Investors periodically book profits and generate regular income
Investor must specify the date of withdrawal, the period of withdrawal
May be specified in terms of number of units or amount, or as the periodic appreciation in
the scheme

Systematic Transfer Plan

Periodically transfer a specified sum from one scheme to another within the same fund
house
Helps in re-balancing portfolio
Redemption from source scheme
Investment of redemption proceeds into the destination scheme
SWP from source scheme and SIP into destination scheme

Capital gains apply, STCG/LTCG

94
Switches and Triggers

Switches
Redemption and purchase transaction rolled into one
Redeeming scheme is called source scheme switch out leg
Purchasing scheme is called target scheme switch in leg
Can also be done from one option to another
Saves time and effort in moving funds from one scheme/option to another
R&T carried out the transactions in the investors records
Exit loads not charged for switch within options
Exit loads charged as applicable for inter-scheme switch

Triggers
Automated purchase, redemption, switch or dividend decisions based on pre-defined
events
Pre-defined event may be Sensex levels, return targets etc.

95
Other Transactions

Service requirements or Non-financial transactions

Change in personal information such as name, bank account details, joint holder details,
signatories, status etc
Based on documents provided as proof
Mutual fund units can be pledged with banks and finance companies to borrow funds
The amount of loan depends on the value of units on the date of borrowing and the margin
Units pledged are marked under lien in the folio and cannot be redeemed
Investors can nominate the person to whom the units can be transferred in the event of their
death
Nominations can be changed
Nomination has to be signed by all joint holders
Nominee can be a minor
Nominee rights are subservient to that of the joint holders

96
Chapter 8

Risk, Return and Performance of Funds

 Drivers of Returns in a Scheme

The portfolio is the main driver of returns in a

mutual fund scheme.
The underlying factors are different for each asset
class.

98
 Equity Schemes - Fundamental and Technical Analysis

There are two disciplines of securities analysis : Fundamental & Technical

Fundamental Analysis
Entails review of the companys fundamentals viz. financial statements, quality of management,
etc
The analyst sets price targets, based on financial parameters like EPS, P/E Ratio
Judge whether the stock is undervalued or overvalued
Stock evaluated in the context of industry and macro factors
Technical analysis
Study of stock prices and volumes, plotted as charts
Identify patterns that may indicate whether there is a dominance of buying or selling interest in
stocks
Portfolio Building Approach Top down and Bottom up
Top down approach starts with macro, then industry and then company
Bottom up approach starts with company, then industry and then macro
Top-down is for sector selection; Bottom up is for stock selection

99
Earnings and Book Value Per Share

Earnings per share (EPS)

Profit after tax per share
Market price /Earnings per share to arrive at Price-Earning (PE) ratio
indicates how much the market is willing to pay per rupee of earning of a stock
Historical PE computed using past earnings
Forward PE computed using future earnings
Low PE means undervalued and high PE means overvalued

Book Value Per share

Net worth (share capital plus reserves and surpluses) of the company divided by the
number of shares
Market price/Book value per share to arrive at Price-Book Value (PBV) ratio
A PBV less than one, indicates that the share is selling at a price lower than its book
value, and may therefore be undervalued

100
Debt Securities
Debt securities represent an underlying loan
Borrower is the issuer; Lender is the buyer
Debt instruments have a face or par value, are issued for a specific period.
Debt instruments mature on a specific date called the maturity date.
Tenor is the distance in time to maturity.
Coupon rate is the annual rate of interest paid on the par value of the bond
Issued by the government, public limited companies, banks and financial institutions
Government securities are also called gilts and have no credit risk
Issued for a tenor from 2 to 30 years
Money market securities are issued for a tenor of less than 1 year
Treasury bills, commercial papers and certificates of deposit
Floating rate securities
Interest payable periodically is reset with reference to the benchmark or base rate
A spread is added to the benchmark rate to arrive at the coupon
Zero coupon bonds are issued at a discount and redeemed at par

101
Total Return in Debt Portfolios

Consists of accrual income that comes from interest received on the portfolio and
capital gains (losses) from changes in the value of the portfolio
Price of a bond responds to changes in market interest rates in an inverse relationship
An increase in interest rates leads to a fall in price of existing bonds
A fall in interest rates leads to gains in the price of existing bonds
The debt portfolio would show a mark-to-market gain if interest rates fall
The debt portfolio would show a mark-to-market loss if interest rates gain
The change in price of floating rate bond is limited due to interest rate changes
Coupon is linked to the market benchmark
Changes in interest rates reflected in the coupon itself

102
Implementing the Interest Rate View

A security of longer maturity would fluctuate a lot more, as compared to short tenor
securities
Debt analysts work with a related concept called modified duration
Modified Duration is a technical measure of bonds sensitivity to changes in interest
rates
Higher the modified duration of a bond, higher the interest rate sensitivity of a bond
Average maturity and modified duration are directly related

Fund manager alters strategy based on interest rate view

If interest rates are expected to increase, the fund manager will hold buy bonds of shorter
tenor, so that the capital losses are reduced
If interest rates are expected to fall, bonds of longer tenor will be bought, to enhance the
capital gains

103
Yield Spread and Credit Spread

Yield curve shows the relationship between the interest rates and the tenor, on a given day
It is drawn for g-secs, which do not have any credit risk
Yield curve usually slopes upward indicating that the interest rate for a longer tenor is higher
than that of the shorter tenor
A longer tenor bond may feature a higher rate compared to a lower tenor bond
Yield spread is the difference in yield across tenors, for the same credit quality

Difference between the rate for a bond with credit risk and the government bond for the
same tenor is called credit spread
Interest rates of all non-govt bonds are higher and depend on their credit rating
Higher the credit rating of a bond, higher is the perceived safety and lower the credit spread.
Bonds with higher credit rating are issued at lower rates; and vice versa

104
Investment in Gold and Real Estate

Gold as an investment class

Investors prefer to hold gold when their risk aversion goes up
Gold is a growth asset and generates no income
The returns from gold tend to be affected by the strength of the US Dollar, in which its price
is denominated
In rupee terms, the return from gold tends to increase when the rupee depreciates and
decrease when the rupee appreciates

Real Estate as an investment class

Does well in times of economic boom
Return from real estate is cyclical
Sensitive to interest rates
It is a long-term investment and oriented to capital appreciation rather than income
Rent is a source of income but the yield may be low
Liquidity is very low and getting out of an investment may be long-drawn and expensive

105
 Measures of Returns on Investment
Simple Return
Converting to a percentage
By comparing the NAV over two points in time we can estimate the return that fund has
earned over the period
Return can be positive or negative, depending on whether the end NAV is higher or lower
than the start NAV
Simple Return = (NAV at the end) - (NAV at the start) X 100
(NAV at the start)
SEBI prescribes simple absolute returns as the return representation for periods less than
one year for all funds except liquid funds
Example: The NAV of a fund was Rs 23.45 on January 31, 2009 and Rs 27.65 on March 31, 2010.
The absolute return earned by the investor who invested at the start of the period and is evaluating
his investment at the end of the period, would be:
= ((27.65 23.45)/23.45) x 100
= 17.91%

106
 Annualised Return

Returns can be standardized as if they were held for a one year period
Simple Return is multiplied by annualising factor 365/n or 12/n for holding period in
days and months respectively
Annualization of returns from Liquid funds, for periods less than a year, is allowed by
SEBI
Example:
An investor bought a unit at Rs 10.50 on Jan 1, 2010 and sold it for Rs 11.50 on April 30, 2010.
The Simple Return to the investor is:
(11.50 -10.50)/10.50 = 1/10.50 = 9.52%
However, this is the return earned over the period Jan 1, 2010 to 30 April, 2010. If we were to
ask, what would be the return per annum, we would annualise the return as follows:
= 9.52% x 365/120
= 28.96% p.a

107
 Compounded Annual Growth Rate(CAGR)
Compounded rate at which the investment has grown from one point to another
Compounding means return has been earned not just on the invested principal, but also on
the returns generated periodically
CAGR refers to the rate of return arrived at after allowing for returns to be reinvested
r = (V1/V0)1/n - 1
V0 is the value at the start;
V1 is the value at the end;
n is the holding period in years; and
r is the CAGR.
Return and performance data published by mutual funds use the CAGR method for periods
greater than one year
Example:
An investor purchased mutual fund units at Rs.12 each and redeemed them after three years for
Rs.26 each. What is his CAGR?
CAGR = (26/12)^(1/3) 1 = 29.4%

108
 CAGR for Dividend Reinvestment

In the case of a dividend option, we can compute the CAGR by assuming that the
dividends were reinvested at the ex-dividend NAV
Example:
An investor bought 100 units of a fund at Rs 10.50 each. He received a dividend of Rs 2 per
unit, which he reinvested at the ex-dividend NAV of Rs 10 each. If he sold his holdings at
Rs 11 per unit, what is the total return to A?
Begin value = 100 units x Rs 10.50 = Rs 1050
Dividends = 100 units x Rs 2 = Rs 200
No of units reinvested = 200/10 = 20 units
End value = 120 units x Rs 11 = Rs 1320
Total return = ((1320-1050)/1050) x 100
= 25.71%

109
 Investor Return vs. Represented Return

The investors investment may not have been made on the dates used to calculate
represented return
Investors may make additional investments or withdraw funds at different times.
Funds represent pre-tax returns.
Actual post tax returns may be different depending on the tax status of the investor and
the taxability of the return
The published return is for the growth option. An investor choosing a dividend option
may have a different holding period return
Investors may have a lower return if they pay an exit load, which makes their
redemption price lower than the NAV . In this case return has to be computed using the
redemption price, not the NAV.
Mutual funds cannot promise or assure returns to investors

110
Market Risks
Market risk is a standard risk in mutual fund products
Investment portfolio mark-to-market every business day
Returns would vary with variations in the market values
Market risk in equity arises from changes in prices due to changes in underlying
fundamental and technical factors
In debt instruments, changes in macro economic factors, that change the market
expectations for interest rates
Interest rate risk
Mutual funds manage market risks through diversification
Equity shares in a single stock cannot exceed 10% of the net assets.
Debt securities of a single borrower cannot normally exceed 15% of net assets; with trustee
approval maximum of 20% of net assets.
The holdings of a mutual fund across all its schemes cannot be over 10% of the paid up capital
of a single company
The average maturity of liquid and very short term debt funds is too low for market risks to
be significant
111
Liquidity Risks
Liquidity risks may not enable buying or selling easily as may be required
Small and mid-cap funds find it difficult to exit such stocks without impacting the price
Fund managers are wary of a large portfolio size
Secondary markets in corporate bonds of lower credit quality are not very liquid
Money market securities help in ensuring sufficient liquidity
May impact portfolio returns negatively
Right to temporarily stop redemptions if they perceive higher illiquidity in the markets
Illiquid and thinly traded securities cannot be more than 5% of net assets in a closed end
fund; and not over 10% of net assets in an open ended fund
Every scheme shall have at least 20 investors and that a single investor shall not hold over
25% of the unit capital of the scheme
No leveraging is allowed in Indian mutual funds
May borrow for 6 months (max) to meet short term liquidity requirements
Not exceeding 20% of net assets

112
Credit Risk

Default in payment of interest or principal, or both, by an issuer of debt securities

Deterioration of the credit quality will result in falling prices and net asset values
Credit risk is assessed from the credit rating
A high credit rating indicates a low degree of default risk.
Invest in instruments that are credit rated by agencies registered with SEBI.
Investment in unrated debt securities of one company cannot exceed 10% of the net
assets of a scheme.
Not more than 25% of net assets of a scheme can be in such unrated securities across
issuers
Mutual funds carry out their own internal credit research as well

113
Measuring Risk
Risk is defined as the variance of actual returns from expected returns
Standard deviation is the square root of variance
MS Excel function =stdev(range containing the return time series)
A higher standard deviation means greater volatility in return and greater risk
Market risk may be systematic or unsystematic
Systematic risk is not diversifiable, as it is caused by market-wide factors that may impact the
performance of a range of stocks.
Unsystematic risk is company specific and can be reduced by diversification
Beta is a measure of the systematic risk in an equity portfolio
Measures the sensitivity of the fund's returns to changes in the market index
A beta of 1 means the fund is likely to move along with the market.
Funds with beta > 1 are likely be more risky than the market and are aggressive funds
Funds with beta < 1 tend to be less risky compared to the market and are defensive funds
Modified duration measures risk in debt fund w.r.t. market factors
Higher the modified duration greater the market risk of the fund and vice versa
Higher the average maturity, higher the risk

114
Relative Return

Performance of mutual funds is measured on a relative basis

Absolute returns are meaningless
Underperformance or Outperformance vis--vis the market benchmark
There is no assurance of return
Invests in a set of marketable securities
Performance of a fund must be measured w.r.t.
The market that it operates in
Investment objectives
Every mutual fund product is mandatorily required to specify the benchmark to which
its performance could be compared

115
Benchmarks

Portfolio that generates an independent level of return, representing an asset class or

investment style
Market index is typically used to benchmark performance
Choice of a benchmark for a fund depends on its objectives and the asset classes in which it
invests
Commonly used benchmarks:
Market benchmark return
Peer group return
Return on other comparable financial products
Mutual funds have to indicate market benchmarks while filing the OD at the time of launch
May be changed only with trustees approval
Market benchmarks are independent portfolios that are not managed
Computed independently by exchanges, publications, research agencies
Benchmark return has to be presented when they advertise the schemes performance

116
Equity and Debt Fund Benchmarks
Equity fund benchmarks
Investment objectives and asset allocation in the portfolio are the basis for determining the
appropriate benchmark
E.g. Small and mid-cap funds benchmark BSE 500, Diversified funds benchmark BSE 100
Large cap funds benchmark BSE Sensex/Nifty, Banking sector funds benchmark BSE
Bankex
Debt fund benchmarks
Appropriate index would be one whose composition reflects the composition of the debt fund
portfolio in terms of tenor and composition
ICICI Securities Si-Bex, Mi-Bex, Li-Bex
Crisils LiquiFEX, STBEX, Gilt Bond Index, AAA Corporate Bond Index
Hybrid fund benchmarks
Asset allocation and composition of the benchmark should be similar to that of the fund
Crisil Mipex, Crisil Balancex
Gold ETFs are benchmarked against the price of gold
Real estate funds against real estate indices
Funds that invest in markets other than India, use appropriate indices of that market
117
Peer Group Benchmarks

Relative benchmarking with the peer group

Performance of a fund in comparison to other funds in the same category
A fund that has performed better than the average of its peer group is said to be an
outperformer
The funds being compared should invest in the same asset class
An equity fund cannot be compared with a debt or balanced fund.
The funds should have a similar investment pattern
A diversified equity fund cannot be compared with small cap or a mid cap fund.
The investment objective of the funds should be similar
An equity fund that focuses on the capital goods sector cannot be compared with a banking
sector fund.
A gilt fund cannot be compared with an income fund.
Research agencies providing ratings and rankings enable peer group comparison

118
Other Financial Products as Comparable Benchmarks

Absolute benchmarks are useful for a broader understanding of the product

Other products of similar nature
Debt fund return vis--vis the return on a bank deposit
MIP return vis--vis the return on PO Monthly Income Scheme

While comparing mutual funds with other products of a similar nature the effect of
taxes and costs must be considered

Mutual funds cannot provide absolute returns

They perform as per the asset classes they invest in and the market returns for these
asset classes

119
Risk-Adjusted Return
Risk-adjusted return is used to evaluate consistency of returns
Consistent return means return comes with a lower risk
Return generated relative to the risk taken by the fund to generate the return
Sharpe Ratio
Compares the return of a fund with its risk
Return is measured as the excess return over a risk free rate (Return of the fund risk free
rate)
It is common to use the 91-day Treasury bill rate as the indicator of the risk free rate
Sharpe ratio = Excess return / Standard Deviation
For the Sharpe ratio to be high, a fund needs to post a higher return for the same risk, or
lower risk for the same return
Example:
An equity fund posted a return of 25% with a standard deviation of 16%. The benchmark posted a
return of 22% with a standard deviation of 12%. If the risk free rate was 6%, the risk adjusted return
measured by the Sharpe ratio would be as follows:
For the fund: (25-6)/16 = 1.1875
For the benchmark: (22-6)/18 = 1.3333
120
Treynor Ratio

Compares the excess return over the risk free rate of a fund with its risk, measured by
beta
Excess return = Return of the fund risk free rate of return
Beta measures only systematic risk, Standard deviation measures total risk
Treynor Ratio = Excess return/Beta
Higher the Treynor ratio, better the fund performance
Example:
An equity fund posted a return of 25% with a beta 1.2. The benchmark posted a return of 22%
with a beta of 1. If the risk free rate was 6%, the risk adjusted return measured by the
Treynor ratio would be as follows:
For the fund: (25-6)/1.2 = 15.83
For the benchmark: (22-6)/1 = 16

121
Managers Alpha

Use the Treynor measure to ask if the manager posted an excess return over the
benchmark, after adjusting for market risk

Example:
An equity fund posted a return of 30% with a beta 1.2. The benchmark posted a return of
22% with a beta of 1. If the risk free rate was 6%, the risk adjusted return measured by
the Managers alpha would be as follows:
Excess return of 30% 6% (risk free rate) = 24%. Given its beta of 1.2, its excess return
should have been 19.2%. Therefore the alpha of the fund is 4.8%.

122
Tracking Error

A consistent performer is a fund which is able to give better returns than the
benchmark across time periods on a risk-adjusted basis
Tracking error measures the consistency in returns
The standard deviation of excess return is called the tracking error
Lower the tracking error, higher the consistency in performance

If the excess returns come with higher risk, they may not be consistent
Time series of excess returns and compute standard deviation of such excess returns
If the standard deviation is high, the returns may not be consistent

Tracking error of an index fund will have to be zero

123
Chapter 9

Scheme Selection
RISK LEVEL DEBT FUNDS HYBRID FUNDS EQUITY FUNDS
HIGH Sector Funds

Balanced Funds based

on Flexible Asset
Allocation
Growth Funds

High Yield Debt Funds

Diversified Equity Funds

Index Funds

Value Funds

Equity Income
Funds/Dividend Yield
Funds
Balanced Funds based
on Fixed Asset Allocation
Monthly Income Plans

Capital Protection
Oriented Funds
Diversified Debt Funds

Gilt Funds

LOW Money Market

Funds/Liquid Schemes 125
Performance and Cash Levels of Equity Funds

Mutual fund products differ primarily in terms of return, risk and desirable investing horizon
Consistent Performance
Consistently generate better returns than the benchmark over different market situations and
longer time periods
Ability of the fund to protect downside risk in time of market downturn
Longer term performance over 3, 5, 7 or 10 should be used to select equity funds
Cash Levels
Cash holdings in an equity fund should not be over 10% of the net assets
A high level of cash may imply that the fund manager is trying to time the market
Holding cash is a defensive stance, hoping to protect the from a steep fall in stock prices
The fund managers cash call may turn out to be right or wrong, implying a risk for the investor

126
Concentration and Market Cap of Equity Funds

Portfolio Concentration
Level of diversification based on portfolio objective
If the top 10 stocks in the portfolio account for more than 40% of the net assets, a fund
may be concentrated and can have a higher risk
If the top three sectors in a diversified equity fund account for over 40% of the net assets
the fund may be concentrated
A thematic or sector fund will have a higher sector concentration
Thematic and sector funds are chosen tactically

Market Capitalisation
Should be in line with the objectives of the portfolio
Large cap fund should be predominantly large cap
Large cap fund has lower risk of liquidity and earning shocks
Diversified fund having too much exposure to small caps is risky
Small/mid cap funds are suited for aggressive investors

127
Portfolio Turnover and Liquidity of Equity Funds

Portfolio turnover ratio = total sales or purchases of a fund (w.e. is lower) divided by the
average net assets of the fund
Higher the ratio, greater the frequency of trading, and lower the average holding period
High turnover means the stocks held in a portfolio are changed very frequently
Low turnover indicates that the fund manager has high conviction in the stocks selected
High ratio indicates market timing and momentum trading
Frequent trading increases transaction costs of the scheme

Liquidity is the option to exit the fund

An open-ended fund enables investors to exit the fund, when they choose to
Closed end funds or ELSS should be chosen only if the investor is sure of a longer
holding period

128
Size, Age and Style of Equity Funds

Size of the fund influences the performance

It is more difficult to liquidate, rebalance or significantly alter the composition of very large
portfolios
Finding suitable stocks to invest in may also become a challenge as the size increases
especially for mid-cap and small cap funds and sector funds
Longer age of the fund presents a longer track record for evaluation
An existing fund has a track record for evaluation, while the new fund has none
Ability to judge performance over a longer period of time
Style of fund performance defines risk-return profile
An actively managed fund may be riskier than a passive fund
Dividend yield funds that focus on value and are less risky, compared to growth-oriented
funds
Large cap funds may be larger in size and less volatile; small cap funds may be smaller in
size and more volatile
In a bullish market, growth funds may outperform value funds; in a bearish market, value
funds outperform growth funds
129
Average Maturity and Yield of Debt Funds

Debt funds are differentiated by the segment of the debt market they invest in
Fund managers construct portfolios including securities whose tenor is linked to the
objectives
Investing horizon of the investor may be matched to the average maturity
Average maturity indicates the extent of interest rate risk in the portfolio
Higher the average maturity of a debt fund, greater the interest rate risk of the fund
Yield of a debt fund portfolio indicates the return on the portfolio
Funds with shorter tenors may feature a lower yield compared to funds with higher
average maturity
Higher the proportion of securities to be valued every day on mark-to-market basis, and
higher the average maturity, higher the interest rate risk in the portfolio
In a falling interest rate scenario, debt funds with higher average maturity offer higher returns
from capital gains

130
Expense Ratio, Credit Quality and Special
Structures of Debt Funds
Expense ratio is very important in debt funds
Higher expense will directly reduce the return of the fund
A debt fund with lower expense ratio should be preferred to those with higher expense ratios
Institutional plans with lower expense ratios for large investors

Credit rating of instruments in the portfolio indicates the extent of credit risk
Extent of papers with low credit quality in the portfolio
Funds may compromise credit quality for a higher yield than peer group average
Gilt funds do not carry credit risk

Special Structures
Floating rate funds have a low interest rate risk and are a good investment option when interest
rates are rising
FMPs hold securities that have the same tenor as the fund and are held to maturity They are
not affected by interest rate risk
Liquid funds invest in securities with maturity <91 days. They have lowest interest rate risk

131
Performance and Portfolio Features of Debt Funds

Performance of debt funds need not be evaluated over long periods of time
Performance of debt funds is typically evaluated for periods from three months to one year
Funds with stable returns and regular dividends are preferred
Debt fund performances, within a given peer group does not vary too much

Portfolio Features
Large holding of cash and equivalents such as CBLO will reduce the returns
Funds with low credit quality may be giving a high return
A debt fund portfolio with a large number of securities is more liquid and more flexible
Large-sized debt funds can manage inflows and outflows, expenses and liquidity, better
than smaller funds

132
Selection of Hybrid Funds

Hybrid funds can have an equity or debt-orientation

Each component must be evaluated using the various parameters for each one
Hybrid funds provide an indicative allocation to equity and debt, usually within a range
Performance of a hybrid fund depends on the allocation to asset classes and changes to
this allocation
It may be difficult to compare hybrid funds with varying allocations
The securities held within the portfolio, under each asset class, will impact
performance
The regularity of the dividend and the predictability of the amount of dividend are
factors used in selection of funds

133
Selection of Other Fund Types
Gold Funds
Value of gold ETFs will be in line with the price of gold
Funds that invest in gold-linked company stocks may behave more like equity funds than
commodity funds
Arbitrage Funds
Seek to benefit from simultaneous exposure in equity and equity derivative markets
performance of these funds should be comparable to that of short term debt funds
Limited liquidity
Fund of Funds
A multi-manager fund of funds may be a better choice
Chosen based on investment objective
Evaluated based on their ability to select and manage a portfolio of funds
International Funds
Risk, return and performance may vary depending on strategy they adopt to invest in
international markets

134
Sources of Information on Mutual Funds

Monthly factsheets of fund houses

Information founds on investment-oriented websites
Websites of Amfi and Sebi and respective mutual funds
Agencies that use mutual fund data to create comparisons and reports for product
comparison and selection
Rankings and ratings of funds after classification of funds into a peer group
Information providers for mutual funds:
Value Research at www.valueresearchonline.com
Icra online at www.mutualfundsindia.com
CRISIL at www.crisilfundservices.com
Morning Star at www.morningstar.co.in
Lipper at www.lipperweb.com

135
Chapter 10
Selecting the Right Investment Products for
Investors
Physical Assets and Financial Assets

Physical assets have a physical and material form

E.g., gold and real estate
Return is usually in the form of appreciation over time
Physical assets are typically preferred by investors due their tangible nature
Exposed to hazards such as fire, theft or floods, which may erode their value
Financial assets involve investing money for some cash flows in the future
Underlying claim or entitlement to interest, dividends or principal invested does not have a
tangible form
E.g., Bank deposits, company deposits, equity shares, government saving instruments,
bonds and debentures
Protected from physical harm
Help in financing the economic activity
Encouraged by government over physical assets

137
Guaranteed and Non-Guaranteed Investments

Guaranteed Investments
Principal or interest or both are assured by an agency like the government
E.g. Government saving schemes

Non-Guaranteed Investments
Investments that do not provide any guarantee for periodic payouts or return of capital
E.g. equity shares, debentures and mutual funds

138
Gold as an Investment
Hedge against inflation
Holding gold in the physical form
Gold bonds, Gold coins and bars
Holding gold in the financial form
Buying gold in the commodity futures market
Traded in commodity exchanges like the NCDEX and MCX with prices linked to gold prices
Buying gold-linked funds
Buying gold exchange traded funds (ETFs)
Indian Mutual Funds Gold-linked funds
Gold ETFs
International gold funds
Securities of gold mining companies
Advantages of holding gold in financial form
Gold-based mutual fund schemes and ETFs are exempted from wealth tax
Investments in gold mutual funds are long-term capital assets after a holding period of one year
Mutual fund schemes offer nomination facility to investors, not available in physical gold
139
Real Estate as an Investment

Real Estate holding in physical form

Preferred by investors
Is beyond the means of small investors
capital required is large
transaction costs may be high
Not easy to quickly liquidate investments in real estate at an appropriate price
Risk of concentration is high
Not easy to diversify
Real Estate Mutual Funds (REMFs)
Enable investors to receive benefits of investing in real estate with a small investment
Direct investment in real estate, debt instruments issued by developers, or securitised
loans

140
Bank Deposits

Preferred form of investment with small investors

Facility to access funds anytime
Familiarity with their bank
Considered safe investment option
Limitations of bank deposits
Penalty for premature withdrawal
Yield on bank deposits is quite low
Effect of inflation on returns
Investors cannot benefit from changes in interest rates
No possibility to benefit from capital gains in a falling interest rate scenario
Interest income from bank deposits is taxable
Post-tax returns from bank deposits can be lower as compared to debt mutual funds for
an investor in a high tax bracket
DDT is lower than the investors marginal tax rates

141
Equity Shares

Popular among urban investors

Represents part ownership in the company
Investment in equity shares offers:
Growth potential and appreciation of capital invested
Liquidity from listing on stock exchanges
Higher long-term returns as compared to other investment options
Not easy for retail investors
Need research support, as well as expertise to select the right stocks
Need a large amount of capital to create a diversified portfolio of equity shares
Mutual funds offer the advantage of diversified and professionally managed equity
portfolio to retail investors, even with a small outlay

142
Debentures / Bonds and Company Deposits

Debentures/bonds represent borrowings of companies

Pay a floating or fixed rate of interest
Privately placed to institutional investors
Debentures offered to retail investors have to be secured by the assets of the borrower and
are listed on the stock exchanges
Liquidity of debentures is quite low and investors may end up holding them to maturity
Investors must be wary of instruments offering a high rate of interest, as they can have a low
credit quality
Company deposits are unsecured deposits to investors
Pay regular interest on the deposit and return the principal on maturity
Compulsorily credit rated
Rate of interest is usually higher than that of bank deposits because the credit risk is higher
Interest on company deposits is taxable
Liquidity is low and investors have to hold them to maturity
Investors in company deposits must be wary of default risk

143
Institutional Bonds

Financial institutions such as IFCI, NABARD and NHB issue bonds

Listed on stock exchanges
Usually offered with two options:
Periodic interest payments (monthly, quarterly or annual)
Deep discount option that pays no interest but has a redemption value which is higher
than the issue price.
Unsecured and have to be compulsorily credit rated.
Infrastructure bonds for tax saving
Infrastructure bonds are eligible for tax benefits under Section 80C of the Income Tax Act
(deduction up to Rs 1.20 lakh on amount invested)
Infrastructure bonds for saving capital gains
Investment of capital gains within 6 months, in such notified bonds, exempts the investor
from paying capital gains tax on the amount invested (Section 54 EC)
Notified bonds are bonds issued by NABARD, NHB and NHAI

144
Public Provident Fund (PPF)

Risk-free deposit that is made with the government

Can be opened by individual investors
An individual can have only one PPF account in his or her name
Annual contribution (deposit by the investor into the PPF account) can be between Rs 500
to Rs 70000
Compulsory to make deposits every year
Penalties are levied
Contributions up to Rs 70000 per annum are eligible for tax deduction under Section 80C
of the Income Tax Act.
Contributions have to be made for 15 years
Tax-free interest rate fixed by the government, currently at 8% per annum
Interest is compounded
Interest rates have fallen from 12% to 8% p.a.
Limited liquidity
Interest and the redemption proceeds at maturity are exempt from tax

145
Small Saving Schemes

Run by National Small Savings Organisation through the state governments

National Savings Certificate (NSC), Kisan Vikas Patra (KVP), Senior Citizens Savings
Scheme and post office saving schemes
Preferred by small investors
Guarantee on principal and interest
Offer a fixed, but low rate of interest and are bought for their safety than for their return
Have to be held until maturity
Very limited liquidity
Interest rates are fixed by the government, and revisions are not done very frequently
Last revision was in 2002

146
Insurance
Life insurance
Protection against loss of income due to unexpected death or disability of an earning member
Sum assured is the obligation of policy holder
Require the payment of regular premium by the policyholder
Surrender value is paid out in case of termination of policy
Types of life insurance policies
Pure term policy, where the sum assured is paid to the nominee on the policyholder's death.
Endowment policy, where the sum assured, along with accumulated bonuses, is paid to the
nominee in case of the death of the policyholder or to the policyholder on the maturity
Investors seek insurance both for protection and as an avenue for savings and investment
Compulsory saving e.g. ULIP
Tax benefits u/s 80C
Insurance is primarily as a protection product and not an investment or tax saving product
Term policies do not offer any return
Investors tend to over-commit premium
Many policies offer limited flexibility

147
New Pension Scheme

Launched in May 2009 is regulated by PFRDA

Save for a retirement corpus
Contributions made by the individual are managed by professional portfolio managers
No guarantee of returns
The minimum investment is Rs.500 a month or Rs.6000 annually, with no upper limit on
investment
Managed according to the investment mix selected by the contributor. The options available are
equity (E), credit risk bearing debt instruments (C) and government securities (G)
Investor can invest the entire corpus in C or G, investment in E is capped at 50%
Auto choice option where the exposure to equity keeps reducing as the age of the contributor
increases
Open an NPS account through identified Points of Presence
Tier I (Pension account). The amount invested cannot be withdrawn before the end of the term.
Tier-II (Savings account). The amount invested can be withdrawn to meet any financial
contingencies.
Permanent Retirement Account Number (PRAN) will be allotted

148
Chapter 11

Helping Investors with Financial Planning

 Financial Needs and Financial Goals

Financial Needs
Financial needs occur at various stages in ones life to meet life goals
Financial needs can be classified as investment needs and protection needs
Wanting to protect a familys income from any unforeseen risk is a protection need. This
is met by insurance
Need for funds to meet the expense on the college education a child is an investment
need. This is met through saving and investment.
Financial Goals
Financial need can be described in terms of the amount of money that may be required to
fulfil the need and the time when the money would be required
Assessment of financial goals begins with the estimate of future expenses for every
milestone event

150
Estimating Financial Goals
Future value of goals can be estimated based on current cost, time to goal and the expected
rate of inflation
The formula can be simplified as: [FV=current cost*{1+rate of inflation}^time]
Use the FV function in MS Excel
Example: It costs Rs.8 lakh to put a child through formal college education today. If a family
likes to estimate what this cost will be when their child, who is now 6 years old, is ready for
college education at 16 years of age?
= 8 x (1.07)^ 10 = 15.7 lakh

Calculating the target rate of return

Investor has defined the amount to invest as well as the value of future goal
Example: Suppose the investor indicates that an amount of Rs.5 lakh has been saved already
for this goal, and he likes to know what is the rate at which it should be invested to meet the
goal:
((Estimated future value/invested amount)^investment horizon ) 1
= ((15.7/5)^(1/10)) -1 = 12.12%
Use the RATE function in MS Excel
151
 Estimating the Investment Amount

Calculating the amount to be invested today

Example: For an estimated expense of Rs.15.7 lakh after 10 years, the investor chooses to
invest in a diversified equity portfolio, expected to earn an average return of 14% p.a. The
amount to be invested today can be computed as:
Future value of goal/(1+expected return)^investment horizon
=15.7/((1+14%)^10) = 4.23 lakh
Use the PV function in MS Excel

Estimating the amount of periodic investment

Instead of investing Rs.15.7 lakh in a lumpsum, the investor may choose SIP
Use the PMT function in MS Excel
The amount to be invested today in SIP:
PMT(rate of return, number of periods, PV (blank), FV)
= PMT(14/12, 10*12, , 15.7 lakh)=Rs.6060

152
Financial Planning and its Objectives

Financial Planning
Reviewing the portfolio and revising the asset allocation, if required
Define and implement the action plan for meeting financial goals
Proposed asset allocation has to match the investors risk profile
Creating an investment plan and asset allocation strategy to meet financial goals
Considers the overall situation of the investor

Objectives of Financial Planning

Creates a road map in terms what has to be done to achieve the goals
Ensure that the financial goals of the investor are met by the right combination of savings
and investment
The current and expected income and expenses and the ability to save and invest is
reviewed
Forces them to see which goals are realistic and what may have to be postponed,
modified or even given up

153
Need for Financial Planners

Financial planners advise investors on managing their finances such that goals are
achieved.
Identify the needs and financial situation of an investor
Translate the needs into measurable financial goals
Analyse risk profile of the investor
Plan investments so that these goals can be achieved
Suggest appropriate asset allocation
Have a good understanding of investment options available and their suitability
Work with clients on their overall financial situation and not just one or two aspects
Reviewed periodically so that it continues to be relevant to the investors needs and
situation

154
Steps in Financial Planning

Establish the client relationship.

Ascertain the clients needs and define with them, their financial goals
Gather data about the clients financial status. Analyse the data to prepare a current
financial position statement.
Understand how much of loss clients can withstand and for what period
Adjust choice of products to their risk preferences
Understand and explain the tax situation to the clients.
Try to optimise post-tax return on investments.
Suggest allocation to asset classes and specific schemes
Execute the plan by making the specified investments
Review and suggest changes in asset allocation

155
Life Cycle Approach in Financial Planning - 1
Younger investors do not seek income from investments, can take a long-term view and are
willing to take risks.
Older investors may be unwilling to take risks, given their limited investing horizon and
dependence on investment income.
Childhood Stage
Dependence on parents to meet expenses
Gifts received may be invested for the future
Young Adult Stage
start of the earning phase
Investing in equity must begin in this stage preferably through Equity SIPs
Life insurance may be necessary to protect income from disability or illness
Individual is partially dependent
Young married stage
Need to provide for emergencies and protect income from death, injuries or loss is high
Couple has joint responsibility to create and adhere to budgets and to control expenses
Need for term insurance is high
156
Life Cycle Approach in Financial Planning-2

Married with Children Stage

Higher expenses and less money is available for investment
Health and life insurance is important as protection needs are more important than
investment needs at this stage
Saving for childrens education
Married with Older Children Stage
Higher ability to save and invest because income levels are higher
Investment needs take precedence over protection needs
Focus on repayment of loans and saving for retirement
Pre-retirement Stage
Start setting aside increased amounts to protect their life style, post-retirement
Pension products and health insurance are preferred choices for investors
Retirement Stage
Investors have to pre-dominantly live off their investments
Require at least 2/3rd of their last income
Focus on income generation and protect wealth from the effects of inflation
157
Wealth Cycle Approach to Financial Planning

Accumulation Phase
Accumulate and save for the long-term
Choose growth-oriented investments
Have a long-term investing horizon and can allocate savings to equity
e.g. saving for childs education
Transition Phase
Withdrawal of funds for some financial goals while accumulating for retirement
Middle-aged investors
Have both equity and debt in their portfolio, as they have a medium-term horizon
e.g. withdraw from savings to meet the immediate education expenses of a child while at the
same time saving for retirement
Distribution Phase
Reaping stage
Depend on investment income
Retired investors
Income-oriented, preferring debt to equity

158
Inter-generational Wealth Transfer and Sudden
Wealth Surge

Inter-generational Wealth Transfer

Stage at which clients plan to pass on their wealth to the next generation or to organisations
and trusts
Focus on the goals of the beneficiaries
e.g. if the wealth is being transferred to grown-up children, the assets could be invested in
a balanced combination of equity and debt funds
If the recipients are young, the wealth could be invested in long-term growth funds
Advice on creating trusts and wills and planning for their estate
Sudden Wealth Surge
Investor experiences a sudden surge in wealth from unexpected flow of funds
e.g. lottery, sudden appreciation in shares, inheritance of wealth
Evaluate tax implications
Funds should be invested in low-risk products like a liquid fund till such time a proper
financial plan is drawn
Money received unexpectedly should be invested based on financial goals and risk
preference
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Financial Planning for Wealthy Investors

High net-worth investors

Have adequate wealth to take care of typical financial goals such as education, house etc
Do not need goal based financial planning but need planning to manage their wealth

Wealth-creating investors
Willing to take risks, investing in equity and risky assets
Comfort of accumulated wealth
Any short-term loss will not seriously impair their financial position

Wealth-preserving investors
Wealthy investors may not always be risk-taking equity investors
Cautious about the wealth they have accumulated and focus on preserving its value
Choose conservative investments, such debt and government securities
Focus on regular income from accumulated wealth

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Chapter 12
Recommending Model Portfolios and Financial
Plans
Model Portfolios and Risk Profiling
Model Portfolio
Creating an investment portfolio after considering the goals, investment horizon and
required return
Created for a given combination of risk, return and investing horizon
Ascertain the risk preferences of investors using risk profiling

Risk Profiling
Willingness of the investor to assume risk and to bear the possible loss in the
portfolio in order to ascertain appropriate asset allocation
Risk appetite is influenced by their personal and financial situation

Risk Profiling Tools are used to generate risk appetite scores for investors
Surveys, questionnaires and proprietary risk profiling tools
Scenario analysis
Past history of the actual transactions of the investors

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Risk Appetite and Asset Allocation
Age: Older investors may have lower risk
appetite than younger investors
Accumulated capital: The higher the accumulated capital,
higher is the risk appetite
Stability of income: Individuals with regular income tend
to have a higher risk appetite
Job security: Individuals with higher job security
may be willing to assume higher risk
Dependents: Risk appetite decreases as the
number of dependents increases
Earning members: Risk appetite increases as the
number of earning members
increases
Attitude: Individuals willing to experiment may
have a higher risk appetite

Asset allocation
Decision about the proportions in which investments would be divided between asset
classes such as equity, debt, cash and others
A model portfolio is indicative of the ideal asset allocation based on investor risk profile and
goals
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Strategic and Tactical Asset Allocation

Strategic Asset Allocation

Allocating the available resources between asset classes within the appropriate risk and
return framework
Model portfolio is an example
Asset allocation is driven completely by his need for return and risk profile
The investor and the financial planner agree to adhere to the strategic allocation most of the
time
For example, an investor desiring a return of 14% over 10 years, with a moderate appetite
for risk, may choose to have 60% of his investments in equity (expected return of
18%) and 40% in debt (expected return of 8%)
Tactical Asset Allocation
Active management of the proportions in various asset classes based on the expectation of
the performance of different asset classes
To defend the portfolio or earn additional returns
For example, if the advisor expects the equity markets to correct and he may tactically
reducing the allocation to equity and increasing the allocation to debt
Carried out by fund managers, expert advisors and experienced investors
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Fixed and Flexible Asset Allocation

Fixed Asset Allocation

Choose a strategic asset allocation and decide to rebalance periodically to the same ratio
Portfolio has an allocation of 60% in equity and 40% in debt and that equity markets are
doing well
Value of equity portfolio goes upto 70%
Investor will sell part of the equity holdings and bring it down to 60% of the portfolio value
and invest in debt and restore the proportion to 40%

Flexible Asset Allocation

Choose an asset allocation and let it move along with the market without rebalancing
If equity does well and the allocation increases, they allow it to run, without rebalancing to
a fixed ratio

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Revision and Re-balancing

Model portfolios are indicative

Asset allocations may have to be revised and rebalanced based on investor needs,
from time to time
Review of performance of the suggested asset allocation
Changes in investor preferences and needs
Examples:
Proportion to equity for an investor may change as he moves away from accumulation
phase into transition phase
Allocation to riskier assets reduces as life stage changes from young adult to married with
children stage
Allocation to income-oriented assets increases are investor approaches retirement
A retired investor whose retirement income is well taken care of and is looking to generate
a corpus for a grandchild may be willing to take a greater exposure to equity as he ages

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