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January 23, 2011

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.


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.


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.

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).

1 comment:

  1. Nice posting, thanks for sharing with us. Your blog is great and helped me feel better knowing about the Closed End Mutual Funds Scheme. Thanks again!


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