Mutual Funds

MUTUAL FUNDS

Mutual Fund is an investment company that pools money from shareholders / unitholders and invests in a variety of securities, such as stocks, bonds and money market instruments. Most open-end mutual funds stand ready to buy back (redeem) its shares at their current net asset value, which depends on the total market value of the fund's investment portfolio at the time of redemption. Most open-end mutual funds continuously offer new shares also to investors.

In Simple Words, Mutual fund is a mechanism for pooling the resources by issuing units to the investors and investing funds in securities in accordance with objectives as disclosed in offer document.

Investments in securities are spread across a wide cross-section of industries and sectors and thus the risk is reduced. Diversification reduces the risk because all stocks may not move in the same direction in the same proportion at the same time. Mutual fund issues units to the investors in accordance with quantum of money invested by them. Investors of mutual funds are known as unitholders.

The profits or losses are shared by the investors in proportion to their investments. The mutual funds normally come out with a number of schemes with different investment objectives which are launched from time to time. In India, a mutual fund is required to be registered with Securities and Exchange Board of India (SEBI), which regulates securities markets, before it can collect funds from the public.

In Short, a mutual fund is a common pool of money in to which investors with common investment objective place their contributions that are to be invested in accordance with the stated investment objective of the scheme. The investment manager would invest the money collected from the investor in to assets that are defined/ permitted by the stated objective of the scheme. For example, an equity fund would invest equity and equity related instruments and a debt fund would invest in bonds, debentures, gilts etc.

Sponsor:

A sponsor is an entity responsible for laying the foundation stone of a fund. In real sense, it puts in the seed money in fund’s set up. Any registered company, a scheduled bank or financial institution can act as sponsor. As per SEBI norms it must possess a prerequisite and good financial record in past. AMC and custodian are appointed by sponsor but once AMC is constituted, sponsor is just the stakeholder of fund and is not liable for making up any operational losses of the fund. For example, SBI is the sponsor of SBI Mutual Fund.

Board of trustees:

Mutual funds in India are constituted as trusts and have a board of trustees to run the fund. AMC is a third party appointed by trustees for managing the money but the real power lies with the trust that is accountable for investor’s money held in the fund. They can even sack the AMC if it is found doing unethical practices or underperforming.

Custodian:

It is an independent entity appointed for holding and safekeeping of the fund’s assets. As the portfolio of securities for a mutual fund is so big, they need a third party for receipt, delivery of securities and keeping an account of the same. Most of the funds use banks as their custodians but one bank can act as custodian of multiple funds. On a broader side, when instead of common public, bigger players like FIIs are the investors, the concept of domestic and global custodian comes into picture.

AMC:
Asset Management Company (AMC) can be considered as the heart of any fund. It manages the investments you have made. At the core are fund managers or portfolio managers taking investment decisions on your behalf. They have access to critical market data that helps them analyze the market conditions and explore investing opportunity to meet their financial objectives. In addition, it is responsible for maintaining a record of pricing and accounting data. It also calculates NAV of the fund that is mandated by SEBI to be disclosed publicly on daily basis. The fund charges investors a fee, called management fees for the services offered by AMC.

The ultimate aim of any fund is the benefit to investors and SEBI is keeping an eye on above entities to ensure compliance of rules and regulations set for the investor’s benefit. The fund regulations in India are considered the best in the world and one major strength lies in well coordinated structure with defined roles of sponsor, trustee, AMC that tend to protect investor’s from risk of default.

8.1 History of Mutual Funds in India

Unit Trust of India (UTI) was the first mutual fund set up in India in the year 1963. In early 1990s, Government allowed public sector banks and institutions to set up mutual funds.

In the year 1992, Securities and exchange Board of India (SEBI) Act was passed. The objectives of SEBI are – to protect the interest of investors in securities and to promote the development of and to regulate the securities market.

In 1995, the RBI permitted private sector institutions to set up Money Market Mutual Funds (MMMFs). They can invest in treasury bills, call and notice money, commercial paper, commercial bills accepted/co-accepted by banks, certificates of deposit and dated government securities having unexpired maturity of upto one year.

As far as mutual funds are concerned, SEBI formulates policies and regulates the mutual funds to protect the interest of the investors. SEBI notified regulations for the mutual funds in 1993. Thereafter, mutual funds sponsored by private sector entities were allowed to enter the capital market. The regulations were fully revised in 1996 and have been amended thereafter from time to time. SEBI issues guidelines to the mutual funds from time to time to protect the interests of investors.

All mutual funds, whether promoted by public sector or private sector entities including those promoted by foreign entities, are governed by the same set of Regulations. There is no distinction in regulatory requirements for these mutual funds and all are subject to monitoring and inspections by SEBI. The risks associated with the schemes launched by the mutual funds sponsored by these entities are of similar type.

8.2 Types of Mutual Funds

a) Schemes according to Maturity Period:

A mutual fund scheme can be classified into open-ended scheme or close-ended scheme depending on its maturity period.

(i) Open-ended Fund

An open-ended Mutual fund is one that is available for subscription and repurchase on a continuous basis. These Funds do not have a fixed maturity period. Investors can conveniently buy and sell units at Net Asset Value (NAV) related prices which are declared on a daily basis. The key feature of open-end schemes is liquidity.

(ii) Close-ended Fund

A close-ended Mutual fund has a stipulated maturity period e.g. 5-7 years. The fund is open for subscription only during a specified period at the time of launch of the scheme. Investors can invest in the scheme at the time of the initial public issue and thereafter they can buy or sell the units of the scheme on the stock exchanges where the units are listed. In order to provide an exit route to the investors, some close-ended funds give an option of selling back the units to the mutual fund through periodic repurchase at NAV related prices. SEBI Regulations stipulate that at least one of the two exit routes is provided to the investor, i.e. either repurchase facility or through listing on stock exchanges. These mutual funds schemes disclose NAV generally on weekly basis.

b) Schemes according to Investment Objective:

A scheme can also be classified as growth fund, income fund, or balanced fund considering its investment objective. Such schemes may be open-ended or close-ended schemes as described earlier. Such schemes may be classified mainly as follows:

(i) Growth / Equity Oriented Scheme

The aim of growth funds is to provide capital appreciation over the medium to long- term. Such schemes normally invest a major part of their corpus in equities. Such funds have comparatively high risks. These schemes provide different options to the investors like dividend option, capital appreciation, etc. and the investors may choose an option depending on their preferences. The investors must indicate the option in the application form. The mutual funds also allow the investors to change the options at a later date. Growth schemes are good for investors having a long-term outlook seeking appreciation over a period of time.

(ii) Income / Debt Oriented Scheme

The aim of income funds is to provide regular and steady income to investors. Such schemes generally invest in fixed income securities such as bonds, corporate debentures, Government securities and money market instruments. Such funds are less risky compared to equity schemes. These funds are not affected because of fluctuations in equity markets. However, opportunities of capital appreciation are also limited in such funds. The NAVs of such funds are affected because of change in interest rates in the country. If the interest rates fall, NAVs of such funds are likely to increase in the short run and vice versa. However, long term investors may not bother about these fluctuations.

(iii) Balanced Fund

The aim of balanced funds is to provide both growth and regular income, as such schemes invest both in equities and fixed income securities in the proportion indicated in their offer documents. These are appropriate for investors looking for moderate growth. They generally invest 40-60% in equity and debt instruments. These funds are also affected because of fluctuations in share prices in the stock markets. However, NAVs of such funds are likely to be less volatile compared to pure equity funds.

(iv) Money Market or Liquid Fund

These funds are also income funds and their aim is to provide easy liquidity, preservation of capital and moderate income. These schemes invest exclusively in safer short-term instruments such as treasury bills, certificates of deposit, commercial paper and inter-bank call money, government securities, etc. Returns on these schemes fluctuate much less compared to other funds. These funds are appropriate for corporate and individual investors as a means to park their surplus funds for short periods.

(v) Gilt Fund

These funds invest exclusively in government securities. Government securities have negligible or nil default risk. NAVs of these schemes also fluctuate due to change in interest rates and other economic factors as is the case with income or debt oriented schemes.

c) Other schemes

(i) Index Funds

Index Funds replicate the portfolio of a particular index such as the BSE Sensitive index, S&P NSE 50 index (Nifty), etc. These schemes invest in the securities in the same weightage composition of an index. NAVs of such schemes would rise or fall in accordance with the rise or fall in the index, though not exactly by the same percentage due to some factors known as "tracking error" in technical terms. Necessary disclosures in this regard are made in the offer document of the mutual fund scheme. There are also exchange traded index funds launched by the mutual funds which are traded on the stock exchanges.

(ii) Tax Saving Schemes

In India, Tax Saving Schemes schemes offer tax rebates to the investors under specific provisions of the Income Tax Act, 1961 as the Government offers tax incentives for investment in specified avenues, for e.g. Equity Linked Savings Schemes (ELSS).

(iii) Sector Specific Schemes

These have caught the fancy of investors in the recent times. These schemes invest only in stocks of a particular sector alone, for example, Banking, Pharmaceuticals, Infrastructure etc.

8.3 What is NET ASSET VALUE ?

The Term Net Asset Value (NAV) is used by investment companies to measure net assets. It is calculated by subtracting liabilities from the value of a fund's securities and other items of value and dividing this by the number of outstanding shares. Net asset value is popularly used in newspaper mutual fund tables to designate the price per share for the fund.

The value of a collective investment fund based on the market price of securities held in its portfolio is first calculated. Units in open ended funds are valued using this measure. Closed ended investment trusts have a net asset value but have a separate market value (if listed on stock exchange). Such closed ended Schemes can trade at net asset value or their price can be at a premium or discount to NAV. NAV is calculated each day by taking the closing market value of all securities owned plus all other assets such as cash, subtracting all liabilities, then dividing the result (total net assets) by the total number of shares outstanding.

Calculating NAVs - Calculating mutual fund net asset values is easy. The current market value of the fund's net assets (securities held by the fund minus any liabilities) is found and then divided by the number of units outstanding. So if a fund had net assets of Rs.50 lakh and there are one lakh units of the fund, then the price per unit (or NAV) is Rs.50.00.

The NAV has significance, apart from knowing one’s value of investment at a particular time. The AMC fixes the sale and repurchase price of open-ended schemes at NAV (or around it, in case of entry / exit load is applicable).

Factoring

What is factoring?

Factoring is a service that covers the financing and collection of account receivables in domestic and international trade. It is a cash management tool for companies where long receivables are a part of business cycle. It is the conversion of credit sales into cash.

In factoring, a financial institution (factor) buys the accounts receivable of a company (Client) and pays up to 80% of the amount immediately on agreement. Factoring company pays the remaining amount (Balance 20%-finance cost-operating cost) to the client when the customer pays the debt. Collection of debt from the customer is done either by the factor or the client depending upon the type of factoring. The account receivable in factoring can either be for a product or service.

Examples are factoring against goods purchased, factoring for construction services (usually for government contracts), factoring against medical insurance etc. Let us see how factoring is done against an invoice of goods purchased.

Characteristics of factoring

1. Usually period for factoring is 90 to 150 days. Sometimes more than 150 days.
2. Costly source of finance compared to other sources of short term borrowings.
3. Credit worthiness is evaluated based on financial strength of customer (debtor). Therefore ideal for new and emerging firms without strong financials.
4. Bad debts are considered for factoring.
5. Credit rating is not mandatory. But factoring companies usually carries out credit risk analysis before entering into agreement.
6. Method of off balance sheet financing.
7. Cost of factoring=finance cost + operating cost. Factoring cost depends on transaction size, financial strength of the customer etc. varies from 1.5% to 3% per month depending upon the financial strength of client's customer.
8. Indian firms offer factoring for invoices as low as 1000Rs
9. For delayed payments beyond the approved credit period, penal charge of around 1-2% per month over and above normal cost is charged.

How is factoring different from a bank loan?

1. Credit decision in factoring is based on receivables rather than other factors like how long the company has been in business, working capital and personal credit score.

2. Factoring is not a loan; it is the purchase of financial asset.

3. Bank loan involves two parties whereas factoring involves three-buyer, exporter and factor.

**There is some misconception regarding factoring like people believe factors are a lender of last resort but that is not true because exporters seeking out factoring are often in the beginning stages of growth. At first glance, factoring appears to be expensive but does a lot more; in essence, factoring replaces the accounts receivables and credit department.

Advantages

• turns receivables instantly into cash
• provides credit protection for receivables
• helps meet increasing sales demand and expand
• Saves time as invoice financing company collects money itself

Disadvantages

• may lead to ruined relations with customers if factor engages in aggressive or unprofessional practices when collecting accounts.
• cost involved in factoring agreement may be more than cost of other methods of financing

Different types of Factoring

1. Disclosed and Undisclosed
2. Recourse and Non recourse

A single factoring company may not offer all these services.

Disclosed

o Client's customers are notified of factoring agreement. Can either be recourse or non recourse.

o factor may or may not be responsible for the collection of debts depending on whether it is recourse or non recourse.

Undisclosed

client's customers are not notified of the factoring arrangement. Sales ledger administration and collection of debts are undertaken by client himself. Client has to pay the amount to the factor irrespective of whether customer has paid or not.

Recourse

client undertakes to collect debts from customer. If customer dosent pay amount on maturity, factor will recover it from client. Offered at lower interest rate since risk by factor is low. Balance amount is paid to client when customer pays factor.

Non recourse

factor undertakes to collect debts from customer. Balance amount is paid to client at the end of credit period or when the customer pays factor whichever comes first. advantage is that continuous factoring will eliminate need for credit and collection departments.

Factoring companies in India

· Canbank Factors Limited

· SBI Factors and Commercial Services Pvt. Ltd

· The Hongkong and Shanghai Banking Corporation Ltd

· Foremost Factors Limited

· Global Trade Finance Limited

· Export Credit Guarantee Corporation of India Ltd

· Citibank NA, India

· Small Industries Development Bank of India (SIDBI)

· Standard Chartered Bank

What is forfeiting?

The forfeiting owes its origin to a French term ‘a forfait’ which means to forfeit (or surrender) ones’ rights on something to someone else. It is a mechanism of financing exports:

a. by discounting export receivables

b. evidenced by bills of exchanges or promissory notes

c. without recourse to seller (viz; exporter)

d. carrying medium to long-term maturities

e. on a fixed rate basis upto 100% of contract value.

In other words, it is trade finance extended by a forfaiter to an exporter seller for an export/sale transaction involving deferred payment terms over a long period at a firm rate of discount. Forfaiting is generally extended for export of capital goods, commodities and services where importer insists on supplies on credit terms. Recourse to forfaiting usually takes place where the credit is for long date maturities and there is no prohibition for extending the facility where the credits are maturing in periods less than one year.

Parties to Forfaiting

There are five parties in a transaction of forfaiting.

i. Exporter

ii. Importer

iii. Exporter’s bank

iv. Importer’s bank

v. The forfaiter.

Mechanism

1. exporter and importer negotiate proposed export sale contract. Then exporter approaches forfaiter to ascertain terms of forfaiting.

forfaiter collects details about importer, supply and credit terms, documentation etc.

· ascertains country and credit risk involved.

· quotes discount rate.

5. exporter then quotes a contract price to overseas buyer by loading discount rate, commitment fee etc. On the sale price of goods to be exported.

6. exporter and forfaiter sign a contract.

7. Export takes place against documents guaranteed by importer’s bank.

8. exporter discounts bill with forfaiter and latter presents the same to importer for payment on due date or even sell it in secondary market.

Documentation

1. Forfaiting transaction is usually covered either by a promissory note or bills of exchange & are guaranteed by a bank.

3. Bills of exchange may be ‘availed by’ importer’s bank. ‘Aval’ is an endorsement made on bills of exchange or promissory note by the guaranteeing bank by writing ‘per aval’ on these documents under proper authentication.

Costs of forfaiting

1. Commitment fee, payable by exporter to forfeiter ‘for latter’s’ commitment to execute a specific forfeiting transaction at a firm discount rate with in a specified time.

2. Discount fee, interest payable by exporter for entire period of credit involved and deducted by forfaiter from amount paid to exporter against availised promissory notes or bills of exchange.

3. Documentation fee.

Benefits of forfaiting

1. frees exporter from political or commercial risks from abroad.

2. offers ‘without recourse’ finance to an exporter. does not effect exporter’s borrowing limits/capacity.

3. relieves exporter from botheration of credit administration and collection problems.

4. Forfaiting is specific to a transaction. It does not require long term banking relationship with forfaiter.

5. Exporter saves money on insurance costs because forfeiting eliminates need for export credit insurance.

Advantages

· Firms resorting to factoring have added attraction of ready source of short-term funds. This improves cash flow and is invaluable as it leads to a higher level of activity resulting in increased profitability.

· By offloading the sales accounting and administration, management has more time for planning, running and improving the business, and exploiting opportunities, The reduction in overheads brought about by factor’s administration of sales ledger result in interest savings and contribute towards cost savings.

Disadvantages

· costlier to in-house management of receivables, specially for large firms which have access to similar sources of funds as the factors themselves and which on account of their size have well organised credit and receivable management.

· perceived as an expensive form of financing and also as finance of the last resort. This tends to have a deleterious effect on the creditworthiness of the company in the market.

Major players in India

The first factoring company was started by the SBI in 1991 namely Factors and Commercial Ltd. (SBI FACS) followed by Canara Bank and PNB, setting the subsidiaries for the purpose. While the SBI would provide such services in the Western region, the RBI has permitted the Canara Bank and PNB to concentrate on the Southern and Northern regions of the country, for providing such services for the customers. The major players since 1991 are Canbank Factors, SBI Factors and later Foremost Factors. The new entrants in the market include ICICI, HSBC and Global Trade Finance. Canback Factors leads in the domestic market with about 65%-70% of the share.

The factoring service has not developed to any significant extent in India.

Bill Discounting

Bill discounting as a fund-based activity emerged as a profitable business in the early nineties – However post scam its importance has declined (restrictions by RBI)

DEF

Bank takes the bill drawn by borrower on his(borrower's) customer and pay him immediately deducting some amount as discount/commission. The Bank then presents the Bill to the borrower's customer on the due date of the Bill and collect the total amount. If the bill is delayed, the borrower or his customer pay the Bank a pre-determined interest depending upon the terms of transaction.

TYPES OF BILLS

Demand Bill: Payable immediately “at sight” or “on presentment” to the drawee. Bill on which no “due date” is specified is also termed as a demand bill.

Usance Bill: (time Bill) - Bill of exchange drawn on a term governed by the usage in that trade. Usance refers to the time period recognized by custom or usage for payment of bills.

Documentary Bills: B/Es that are accompanied by documents that confirm that a trade has taken place. documents include the invoices and other documents of title such as railway receipts, lorry receipts and bills of lading.

Further classified as:

(i) Documents against acceptance (D/A) bills - documentary evidence accompanying B/E is deliverable against acceptance by drawee.

(ii) Documents against payment (D/P) bills - In case a bill is a “documents against payment” bill and has been accepted by the drawee, documents of title will be held by bank till maturity of B/E.

Clean Bills: not accompanied by any documents that show that a trade has taken place. Thus interest rate charged on such bills is higher than rate charged on documentary bills.

CREATION OF A B/E:

Suppose a seller sells goods to a buyer. In most cases, the seller would like to purchase on credit. To solve this problem, the seller draws a B/E of a given maturity on the buyer.

Seller (creditor) ---Drawer of bill

Buyer(debtor)----Drawee.

seller then sends the bill to the buyer who acknowledges his responsibility for the payment of the amount by writing his acceptance on the bill.

DISCOUNTING OF A B/E:

The seller, who is the holder of an accepted B/E has two options:

1. Hold on to the B/E till maturity and then take the payment from the buyer.

2. Discount the B/E with a discounting agency. (more attractive)

The seller can take over the accepted B/E to a discounting agency and obtain ready cash.

(known as discounting the B/E)

The margin between the ready money paid and the face value of the bill is called the discount and is calculated at a rate percentage per annum on the maturity value.

The maturity a B/E is defined as the date on which payment will fall due.

TYPES OF BILL DISCOUNTING:

Bills discounting is of two types

1. Purchase bills discounting - investor discounts the purchase bill of the company and pays the company, who in turn pay their supplier. investor gets his money back from the company at the end of the discounting period.

2. Sales bill discounting - investor discounts the sales bill of the company and pays directly to the company. The investor gets his return from the company at the end of the discounting period.

Procedure

Broker will contact you with proposals to discount bills of different companies at different rates. better companies command discounting rates of 13% to 15%,while lesser known have to pay discounting rates of 17% - 28%.

On agreement of particular bill discounting transaction company gives to the investor the following:

ü The original copies of bills to be discounted;

ü hundi / promissory note; Post dated cheque.

The investor simply has to issue a cheque - amount arrived at after deducting the discount rate.

EX. Company A wants to discount its purchase bill of Rs200,000 for three months. Investor P agrees to do so at a discount rate of 21%.

Investor will issue a cheque of Rs189, 500. (200,000 x 21% x 3/12)

company on its part will issue a post-dated cheque of Rs200,000 for three months period.

He gets the interest element at the first day of issuing the cheque. i.e. he does not include that part in his cheque amount. Thus he can earn interest on this interest for a three-month period. Even a simple bank fixed deposit on it will earn @5% p.a. By investing Rs189,500 for three months, the investor earns Rs10,500 on it. A return of 22.16%.

Discount Rates The rates depend on the following factors:

Broker - His relations with the company and the investor do make a difference of a couple of percentage point in discounting rates.

Liquidity - Liquidity crunch in the market tends to hike up the rates even in the best of the companies.

Volume/Value of Discounting - When the volume/value of discounting done by the investor is high, he is looking at security more than returns. The company on its part is looking at savings by way of reduced legal paper work and a higher amount of dedicated funds .

Frequency - regular bills discounter may get upto 1% to1.5% points higher interest rates than a new investor. investor trying out with a new company and will agree to a lesser rate to ensure safety.