Mutual Fund as a Tool for Financial Planning

7/29/2019 Mutual Fund as a Tool for Financial Planning

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Mutual Funds as a Tool for Financial Planning

Executive Summary

India has been amongst the fastest growing markets for Mutual Fund since 2004, witnessing

CAGR of 29 percent in the five year period from 2004-2008 as against the global average of 4

percent. The Increase in revenue & profitability however has not been commensurate with the

AUM growth in the last five years.

Low customer awareness levels and financial literacy pose the biggest challenge to channelising

the household savings into mutual funds. Further fund houses have shown limited focus on

increasing retail penetration and building retail AUM. Most AMCs and distributors have a limited

focus beyond the top 20 cities that is manifested in limited distribution channels and investor

servicing. The Indian Mutual Fund Industry has largely been product led and not sufficiently

customer focus with limited focus being accorded by players to innovation and new product

development. Further there is limited flexibility in fees and pricing structures currently.

As we all are aware how mutual Fund Industry has become one of the most powerful & popular

tool for Investments across globe. It plays one of the vital roles in the economic factors of India.

They act as mirrors that reflect performance of the economy as a whole.

A Mutual Fund is a trust that pools the savings of a number of investors who share a common

financial goal. The money thus collected is invested by the fund manager in different types of

securities depending upon the objective of the scheme.

This project tries to bring out the existence of the Mutual Fund Industry in India, how popular they

became as one of the best mode of Investments for Individual as well as FII Investors, how one

has to do the planning of their investments, what are the risk involved etc.

Thus this project aims to give both a macro point of view of the importance of Mutual Fund and

their functionalities.

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INTRODUCTION

The mutual fund (MF) industry has been one of the fastest growing financial sectors; it has

been growing at a CAGR of 20-25 percent in the last ten years. As per AMFI chairman

A.R.Kurian, the asset base is expected to grow at an annual rate of about 30-35 percent over

the next few years as investors shift their assets from banks and other traditional avenues.

The Mutual Fund Industry came into existence with the setting up of UTI in 1964. UTI

continues to dominate the mutual fund industry with a corpus of 700bn (54% of the industry

assets), but the investors confidence is shaken by the recent crisis.

The mutual fund industry in India has completed 36 years and the ride through these years

has not been smooth. Investors have still to overcome their experience with mutual fund like

Morgan Stanley, Mastergain, Monthly Equity plans of SBI, UTI and Canara Bank.

The nationalized banks entered the mutual fund business in the early nineties and got off to a

good start because of the stock market boom. But these banks did not understand the mutual

fund business nor did they have the required skill, experience or the technology. As a result

they failed miserably.

Investors experience with Morgan Stanley, the first foreign mutual fund was also not too good.

The Morgan Stanley fund in its initial public offer (IPO) raised 10bn. The entire fund raising

exercise was centered on the hype that the fund was first of its kind, promoted by an

internationally acclaimed asset management company. It was marketed like any other public

issue. Investors rushed in hoping for superior returns without realizing that the functioning of a

mutual fund is different from investing in an equity fund IPO. Nor did they realize that the

scheme was a closed-ended scheme with lock in of 15 years. The equity market also did not

favor Morgan Stanley and investors lost heavily.

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As a result of all this, investors confidence in mutual funds was shaken up.

Though the experience of mutual fund investors in the past has not been good it does not

mean that all funds have performed badly. In fact, if one looks at income funds and recent

performance of equity funds, they have done quite well. Due to which investors are relooking

at mutual funds as a tool for investments. Most traditional avenues have become unattractive.

Investors are realizing the benefits of investing in the capital markets through mutual funds

rather than investing directly. The awareness about mutual funds is slowly but steadily

growing.

Investors are realizing that they need to look no further than mutual funds for their complete

set of investment needs. However like any other investment a disciplined approach is required

for investing in mutual funds.

A mutual fund is the ideal investment vehicle for todays complex and modern financial

scenario. Markets for equity shares, bonds and other fixed income instruments, real estate,

derivatives and other assets have become mature and information driven. Price changes in

these assets are driven by global events occurring in faraway places. A typical individual is

unlikely to have the knowledge, skills, inclination and time to keep track of events, understand

their implications and act speedily.

The industry is also having a profound impact on financial markets. Fund managers, by their

selection criteria for stocks have forced corporate governance on the industry. By rewarding

honest and transparent management with higher valuations, a system of risk-reward has been

created where the corporate sector is more transparent then before.

One thing is certain - that the mutual fund industry is here to stay.

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The study has been divided into two sections:

Section I, talks about the genesis of mutual fund, the evolution of mutual funds in India and the

mutual funds registered in India. It also explains the concept of a mutual fund, the benefits of

investing in a mutual fund, the types of mutual fund schemes. It talks about the regulatory

framework within which mutual funds in India operate. The concept of NAV and the tax

benefits have also been explained in detail.

The last chapter in this section covers the most important aspect of mutual fund, Investment

Management. This chapter covers the different styles of debt and equity management, the

securities in which debt and equity funds invest and the risks associated with these

investments.

Section II. Describes the different avenues available to the retail investor. There was a time

when Indian investors did not have many investment schemes to choose from. It was easy

then for the agents to simply point out the benefits of any currently available scheme to a

prospective investor. The investor then decided whether the schemes suited to his needs or

not. Now, the Indian mutual funds industry offers a wide choice of investment schemes, unlike

ever before. Different schemes are suited to different investor needs. In this scenario, an

investor not only has to choose from this variety of investment options available, but also

design a proper investment strategy that is suitable to his situation and needs. In this scenario

an investor should develop the right approach to investing, and avoid ad-hoc investment

decisions. All this has been covered in section II.

It explains in detail the concept of financial planning, the benefits and the steps in financial

planning. Asset Allocation, which is an important aspect of financial, planning, has also been

explained in detail.

The final chapter talks about choosing a mutual fund scheme and investing in it, keeping in

mind the costs involved and the risks associated with it.

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To summarize, as Jacobs puts it, mutual fund investing is not a get-rich-quick scheme.

Investors should have an Investment Program and ought to set their sights on long term

goals, in other words, investment decisions to be taken in terms of clear, long-term goals, not

on an ad-hoc basis.

Each investor should expect only realistic wealth accumulation goals, no dramatic result

overnight. For example, in the current Indian market conditions, investors can expect 20% plus

returns in equity investments, 11 or 12% returns in debt investments and 8 to 9% in money

market investment. These expectations can change over time. Specific investments or funds

can give greater return or less return, but higher returns will be in most cases achieved by

investors or their fund managers taking greater risks.

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The History of Mutual Funds

Mutual funds came into existence for the 1st time when three Boston securities executives

pooled their money together in 1924 to create the first mutual fund; they had no idea how

popular mutual funds would become.

The idea of pooling money together for investing purpose started in Europe in the mid-1800.

The first pooled fund in the U.S. was created in 1893 for the faculty and staff of Harvard

University. On March 21st, 1924 the first official mutual fund was born. It was called the

Massachusetts Investors Trust.

After one year, the Massachusetts Investors Trust grew from $50,000 in assets in 1924 to

$392,000 in assets (with around 200 shareholders). In contrast, there are over 10,000 mutual

funds in the U.S. today totaling around $7 trillion (with approximately 83 million individual

investors) according to the Investment Company Institute.

The stock market crash of 1929 slowed the growth of mutual funds. In response to the stock

market crash, Congress passed the Securities Act of 1933 and the Securities Exchange Act of

1934. These laws require that a fund be registered with the SEC and provide prospective

investors with a prospectus.

The SEC (U.S. Securities and Exchange Commission) helped create the Investment Company

Act of 1940 which provides the guidelines that all funds must comply with today.

With renewed confidence in the stock market, mutual funds began to blossom. By the end of

the 1960's there were around 270 funds with $48 billion in assets.

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In 1976, John C. Bogle opened the first retail index fund called the First Index Investment

Trust. It is now called the Vanguard 500 Index fund and is the largest mutual fund with over

$100 billion in assets.

One of the largest contributors of mutual fund growth was the birth of the Individual Retirement

Account (IRA) in 1981. Mutual funds are now popular in employer-sponsored defined

contribution retirement plans (401k's for example), IRA's and Roth IRA's.

Mutual funds are very popular today, known for ease-of-use, liquidity, and unique

diversification capabilities.

Structure of the Indian mutual fund industry

The Indian mutual fund industry is dominated by the Unit Trust of India which has a total

corpus of Rs700bn collected from more than 20 million investors. The UTI has many schemes

in all categories i.e. equity, balanced, income etc with some being open-ended and some

being closed-ended. The Unit Scheme 1964 commonly referred to as US 64, which is a

balanced fund, is the biggest scheme with a corpus of about Rs200bn. UTI was floated by

financial institutions and is governed by a special act of Parliament. Most of its investors

believe that the UTI is government owned and controlled, which, while legally incorrect, is true

for all practical purposes.

The second largest category of mutual funds is the ones floated by the private sector and by

foreign asset management companies. The largest of these are Prudential ICICI AMC and

Birla Sun Life AMC. The aggregate corpus of assets managed by this category of AMCs is in

excess of Rs.250bn.

The third largest category of mutual funds is the ones floated by nationalized banks. Canbank

Asset Management floated by Canara Bank and SBI Funds Management floated by the State

Bank of India are the largest of these.

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Recent trends in mutual fund industry

The most important trend in the mutual fund industry has been the aggressive expansion of

the foreign owned mutual fund companies and the decline of the companies floated by

nationalized banks and smaller private sector players.

Many nationalized banks got into the mutual fund business in the early nineties and got off to a

good start due to the stock market boom prevailing then. These banks did not really

understand the mutual fund business and they just viewed it as another kind of banking

activity. Few hired specialized staff and generally chose to transfer staff from the parent

organizations. The performance of most of the schemes floated by these funds was not good.

Some schemes had offered guaranteed returns and their parent organizations had to bail out

these AMCs by paying large amounts of money as the difference between the guaranteed and

actual returns. The service levels were also very bad. Most of these AMCs have not been able

to retain staff, float new schemes etc. and it is doubtful whether, barring a few exceptions; they

have serious plans of continuing the activity in a major way.

The experience of some of the AMCs floated by private sector Indian companies was also very

similar. They quickly realized that the AMC business is a business, which makes money in the

long term and requires deep-pocketed support in the intermediate years. Some have sold out

to foreign owned companies; some have merged with others and their general restructuring

going on.

The foreign owned companies have deep pockets and have come in here with the expectation

of a long haul. They can be credited with introducing many new practices such as new product

innovation, sharp improvement in service standards and disclosure, usage of technology,

broker education and support etc. In fact, they have forced the industry to upgrade itself and

service levels of organizations like UTI have improved dramatically in the last few years in

response to the competition provided by these.

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Mutual Funds in India (1964-2000)

The end of millennium marks 36 years of existence of mutual funds in this country. The ride

through these 36 years is not been smooth. Investor opinion is still divided, while some are for

mutual funds others are against it.

UTI commenced its operations from July 1964 .The impetus for establishing a formal institution

came from the desire to increase the propensity of the middle and lower groups to save and to

invest. UTI came into existence during a period marked by great political and economic

uncertainty in India. With war on the borders and economic turmoil that depressed the financial

market, entrepreneurs were hesitant to enter capital market. The already existing companies

found it difficult to raise fresh capital, as investors did not respond adequately to new issues.

Earnest efforts were required to canalize savings of the community into productive uses in

order to speed up the process of industrial growth.

The then Finance Minister, T.T. Krishnamachari set up the idea of a unit trust that would be

"open to any person or institution to purchase the units offered by the trust. However, this

institution, is intended to cater to the needs of individual investors, and even among them as

far as possible, to those whose means are small."

Mr. T.T. Krishnamachari ideas took the form of the Unit Trust of India, an intermediary that

would help fulfill the twin objectives of mobilizing retail savings and investing those savings in

the capital market and passing on the benefits so accrued to the small investors.

UTI commenced its operations from July 1964 "with a view to encouraging savings and

investment and participation in the income, profits and gains accruing to the Corporation from

the acquisition, holding, management and disposal of securities." Different provisions of the

UTI Act laid down the structure of management, scope of business, powers and functions of

the Trust as well as accounting, disclosures and regulatory requirements for the Trust.

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One thing is certain the fund industry is here to stay. The industry was one-entity show till

1986 when the UTI monopoly was broken when SBI and Canbank mutual fund entered the

arena. This was followed by the entry of others like BOI, LIC, GIC, etc. sponsored by public

sector banks. Starting with an asset base of Rs0.25bn in 1964 the industry has grown at a

compounded average growth rate of 26.34% to its current size of Rs1130bn.

1999-2000 Year of the funds

Mutual funds have been around for a long period of time to be precise for 36 yrs. but the year

1999 saw immense future potential and developments in this sector. This year signaled the

year of resurgence of mutual funds and the regaining of investor confidence in these mutual

funds. This time around all the participants are involved in the revival of the funds ----- the

AMCs, the unit holders, the other related parties. However the sole factor that gave lift to the

revival of the funds was the Union Budget. The budget brought about a large number of

changes in one stroke.

It provided center stage to the mutual funds, made them more attractive and provides

acceptability among the investors. The Union Budget exempted mutual fund dividend given out

by equity-oriented schemes from tax, both at the hands of the investor as well as the mutual

fund. No longer were the mutual funds interested in selling the concept of mutual funds they

wanted to talk business which would mean to increase asset base, and to get asset base and

investor base they had to be fully armed with a whole lot of schemes for every investor. So

new schemes for new IPOs were inevitable. The quest to attract investors extended beyond

just new schemes. The funds started to regulate themselves and were all out on winning the

trust and confidence of the investors under the aegis of the Association of Mutual Funds of

India (AMFI)

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One can say that the industry is moving from infancy to adolescence, the industry is maturing

and the investors and funds are frankly and openly discussing difficulties, opportunities and

compulsions.

Future Scenario

The mutual fund (MF) industry has been one of the fastest growing financial sector, it has been

growing at a CAGR of 20- 25 per cent in the last ten years. As per AMFI chairman, Mr. A. P.

Kurian, the asset base is expected to grow at an annual rate of about 30 to 35 % over the

next few years as investors shift their assets from banks and other traditional avenues. The

market is expected to witness a flurry of new players entering the arena. Some big names like

Fidelity, Principal, and Old Mutual etc. are looking at Indian market seriously. One important

reason for it is that most major players already have presence here and hence these big

names would hardly like to get left behind.

The industry is also having a profound impact on financial markets. The new generations of

private funds which have gained substantial mass are now seen flexing their muscles. Fund

managers, by their selection criteria for stocks have forced corporate governance on the

industry. By rewarding honest and transparent management with higher valuations, a system

of risk-reward has been created where the corporate sector is more transparent then before.

Mutual funds are now also competing with commercial banks in the race for retail investors

savings and corporate float money. The power shift towards mutual funds has become

obvious. The coming few years will show that the traditional saving avenues are losing out in

the current scenario. Many investors are realizing that investments in savings accounts are as

good as locking up their deposits in a closet.

India is at the first stage of a revolution that has already peaked in the U.S. The U.S. boasts of

an asset base of mutual funds that is much higher than its bank deposits. In India, mutual fund

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assets are not even 10% of the bank deposits, but this trend is beginning to change. Mutual

Funds are going to change the way banks do business in the future.

The first phase - 1964 and 1987, when the only player was the Unit Trust of India, had a total

asset of Rs. 6,700/- crores at the end of 1988.

The second phase - 1987 and 1993, during this period 8 funds were established (6 by banks

and one each by LIC and GIC). At the end of 1994, the total assets under management had

grown to Rs. 61,028/- crores and numbers of schemes were 167.

Currently there are 34 Mutual Fund organisations in India managing over Rs. 92,000/- crores.

The mutual funds registered in India are

A) Unit Trust of India

B) Bank sponsored

a. BOB Asset Management Co. Ltd.

b. Canbank Investment Management Services Ltd.

c. PNB Asset Management Co. Ltd.

d. SBI Funds Management Ltd.

C) Institutions

a. GIC Asset Management Co. Ltd.

b. IDBI Principal Asset Management Co. Ltd.

D) Private Sector

1. Indian

a. Benchmark Asset Management Co. Ltd.

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b. Kotak Mahindra Asset Management Co. Ltd.

c. Reliance Capital Asset Management Ltd.

d. J.M. Capital Management Ltd.

2. Joint Ventures - Predominantly Indian

a. Birla Sun Life Asset Management Pvt. Co. Ltd.

b. Cholamandalam Cazenove Asset Management Co. Ltd.

c. HDFC Asset Management Company Ltd.

d. Sundaram Newton Asset Management Company

e. Tata TD Waterhouse Asset Management Private Ltd.

3. Joint Ventures - Predominantly Foreign

a. IDFC Asset Mgmt Co. Pvt. Ltd.

b. ING Investment Management (India) Pvt. Ltd.

c. Prudential ICICI Management Co. Ltd.

d. Templeton Asset Management (India) Pvt. Ltd.

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Concept of a Mutual Fund

A Mutual Fund is a trust that pools the savings of a number of investors who share a common

financial goal. The money thus collected is invested by the fund manager in different types of

securities depending upon the objective of the scheme. These could range from shares to

debentures to money market instruments. The income earned through these investments and

the capital appreciations realized by the scheme are shared by its unit holders in proportion to

the number of units owned by them (pro rata). Thus a Mutual Fund is the most suitable

investment for the common man as it offers an opportunity to invest in a diversified,

professionally managed portfolio at a relatively low cost. Anybody with an investible surplus of

as little as a few thousand rupees can invest in Mutual Funds. Each Mutual Fund scheme has

a defined investment objective and strategy.

A mutual fund is the ideal investment vehicle for todays complex and modern financial

scenario. Markets for equity shares, bonds and other fixed income instruments, real estate,

derivatives and other assets have become mature and information driven. Price changes in

these assets are driven by global events occurring in faraway places. A typical individual is

unlikely to have the knowledge, skills, inclination and time to keep track of events, understand

their implications and act speedily. An individual also finds it difficult to keep track of ownership

of his assets, investments, brokerage dues and bank transactions etc.

A mutual fund is the answer to all these situations. It appoints professionally qualified and

experienced staff that manages each of these functions on a full time basis. The large pool of

money collected in the fund allows it to hire such staff at a very low cost to each investor. In

effect, the mutual fund vehicle exploits economies of scale in all three areas - research,

investments and transaction processing. While the concept of individuals coming together to

invest money collectively is not new, the mutual fund in its present form is a 20th century

phenomenon. In fact, mutual funds gained popularity only after the Second World War.

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Globally, there are thousands of firms offering tens of thousands of mutual funds with different

investment objectives. Today, mutual funds collectively manage almost as much as or more

money as compared to banks.

Benefits of Investing in Mutual Funds

If mutual funds are emerging as the favorite investment vehicle it is because of the many

advantages they have over other forms and avenues of investing. The following are the major

advantages offered by mutual funds to all investors.

Diversification

The first principle of mutual fund investing is broad diversification of securities. For nearly all

investors, cost alone generally recludes achieving adequate diversification without using

mutual funds.

For example, if an investor had Rs. 50,000 to invest and he was keen on acquiring stocks like

Bajaj Auto, Hindustan Lever or Infosys, he would be unable to purchase even 100 shares (the

market lot) of any of these companies. While investing through a mutual fund could make him

a part owner of all these stocks with an investment of as low as Rs 1,000.

Professional Management

A mutual fund is managed by skilled, experienced professionals who are judged by the total

returns they generate over time. As an individual investor, one may not be in a position to keep

track of the performance of various companies. A fund manager, on the other hand, has

access to extensive research inputs both from its own research analysts as well as reputed

broking firms.

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Liquidity

In many cases, mutual funds offer more liquidity than individual stocks or bonds. Large

amounts of money can be invested or redeemed at a price based on the funds net asset value

(NAV). Further, money can be efficiently switched between, say, a stock and a money market

fund at little or no cost.

Convenience

Mutual fund investment provides simplicity and convenience. On every purchase or

redemption, an investor receives an Account Statement similar to a bank statement. An

investor avails of features like reinvestment of dividends, tax reporting, switches, systematic

investment and withdrawal and cheque writing on money market funds. Moreover, an investor

is not required to physically take delivery of securities, so problems of bad delivery, theft or

loss in transit are minimized.

Tax Benefits

There are several tax benefits available for investors in a mutual fund. A detailed explanation

is provided in the ensuing report.

Structure of Mutual Funds in India

Like other countries, India has a legal framework within which mutual funds must be

constituted.

Unlike in the UK, where distinct trust and corporate/ approaches are followed with separate

regulation, in India, open and closed end funds operate under the same regulatory structure.

There is one unique structure as unit trusts. A mutual fund in India is allowed to issue open

end and closed end schemes under a common legal structure. The structure which is required

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to be followed by mutual funds in India is laid down under SEBI (Mutual Fund) Regulations,

1996.

The structure of each of the fund constituents is explained below,

The Fund Sponsor

Sponsor is defined under SEBI regulation as nay person who, acting alone or in combination

with another body corporate, establishes a mutual fund. The sponsor of a fund is akin to the

promoter of a company as he gets the fund registered with SEBI. The sponsor will form a Trust

and appoint a Board of Trustees. The sponsor will also generally appoint an Asset

Management Company as fund managers. The sponsor, either directly is acting through the

Trustees, will also appoint a Custodian to hold the fund assets. All these appointments are

made in accordance with SEBI Regulations.

Mutual Funds as Trusts

A mutual fund in India is constituted in the form of Public Trust created under the Indian Trusts

Act, 1882; The Fund Sponsor acts as the Settler of the Trust, Contributing to its initial capital

and appoints a Trustee to hold the assets of the Trust for the benefit of the unit-holders, who

are the beneficiaries of the Trust. The fund then invites investors to contribute their money in

the common pool, by subscribing to units issued by various schemes established by the trust

as evidence of their beneficial interest in the fund.

It should be understood that a mutual fund is just a pass-through, rather it is the Trustee or

Trustees who have the legal capacity and therefore all acts in relation to the trust are taken on

its behalf by the Trustees. The trustees hold the unit-holders money in a fiduciary capacity.

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Trustees

A mutual fund is governed by trustees. The trustees have oversight responsibility for the

management of the fund's business affairs and safeguarding the interest of the unit holders.

The trustees are expected to exercise sound business judgement and keep a watchful eye on

the functioning of the asset management company. As per the Securities and Exchange Board

of India (SEBI) regulations, at least half of the board of trustees shall consist of independent

persons, who are not affiliated with the asset management company or any of its affiliates.

The Asset Management Company

An AMC is involved in the daily administration of the mutual fund and also acts as investment

advisor for the fund. An Asset Management Company is promoted by a sponsor, which usually

is a, reputed corporate entity with sound track record of profitability.

An AMC typically has three departments:

A) Fund Management comprises of fund managers, research analysts and dealers

B) Sales & Marketing which is involved in generating sales through brokers, agents and

financial planners.

C) Operations & Accounting oversees back office and operational activities. It consists of fund

accountants and compliance officer.

The other fund constituents are

Custodians and Depositories

Mutual funds are required by law to protect their portfolio securities by placing them with an

independent third party as custodian, typically a bank or trust company. The custodian also

handles payments and receipts for the funds security transactions.

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Bankers

A funds activities involve dealing with money on a continuous basis primarily with respect to

buying and selling units, paying for investments made, receiving the proceed on sale of

investments and discharging its obligations towards operating expenses. A funds bankers

therefore play a crucial role with respect to its financial dealings by holding its bank accounts

and providing it with remittance services.

Transfer Agents

A share transfer agent is employed by the AMC on behalf of the mutual fund to conduct record

keeping and related functions. Share transfer agent maintains records of unit holder accounts,

prepares and mails account statements confirming transactions and account balances. It also

maintains customer service departments (termed as "Investor Service Centres" or ISCs) at

main cities and towns to facilitate daily purchases and redemptions by investors.

Distributors

Mutual fund operate as collective investment vehicles, on the principle of accumulating funds

from a large number of investors and then investing on a big scale. For a fund to sell units

across a wide retail base of individual investors an established network of distribution agents is

essential AMC, usually appoint Distributors or Brokers, who sell units on behalf of the fund.

A draft offer document is to be prepared at the time of launching the fund. Typically, it pre

specifies the investment objectives of the fund, the risk associated, the costs involved in the

process and the broad rules for entry into and exit from the fund and other areas of operation.

In India, as in most countries, these sponsors need approval from a regulator, SEBI (Securities

exchange Board of India) in our case. SEBI looks at track records of the sponsor and its

financial strength in granting approval to the fund for commencing operations.

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A sponsor then hires an asset management company to invest the funds according to the

investment objective. It also hires another entity to be the custodian of the assets of the fund

and perhaps a third one to handle the registrars work for the unit holders (subscribers) of the

fund.

Types of Mutual Funds

Mutual fund schemes may be classified on the basis of its structure and its investment

objective.

On the basis of its structure they are classified as open ended and close ended schemes.

Most schemes floated by AMCs are open-ended schemes as investors need liquidity and

these schemes allow investors to enter or exit any time.

Open-ended Funds

An open-end fund is one that is available for subscription all through the year. These do not

have a fixed maturity. Investors can conveniently buy and sell units at Net Asset Value ("NAV")

related prices. The key feature of open-end schemes is liquidity. In open-ended schemes

investors can enter and exit on any business day hence the corpus of the schemes is not fixed

and keeps fluctuating.

Closed-ended Funds

A closed-end fund has a stipulated maturity period which generally ranging from 3 to 15 years.

The fund is open for subscription only during a specified period. The corpus of the scheme is

fixed. Investors can invest in the scheme only 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 they are

listed.

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On the basis of investment objective they are classified as growth, income or balanced

schemes

Growth Funds

The aim of growth funds is to provide capital appreciation over the medium to long- term. Such

schemes normally invest majority of their corpus in equities. It has been proven that returns

from stocks, have outperformed most other kind of investments held over the long term.

Growth schemes are ideal for investors having a long-term outlook seeking growth over a

period of time.

Income Fund

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 and

Government securities. Income Funds are ideal for capital stability and regular income.

Balanced Funds

The aim of balanced funds is to provide both growth and regular income. Such schemes

periodically distribute a part of their earning and invest both in equities and fixed income

securities in the proportion indicated in their offer documents. These are ideal for investors

looking for a combination of income and moderate growth. The advantage of investing in these

schemes that when equities are performing well the fund manager can increase his exposure

in equities and in a falling market he can increase his exposure in debt. Such a fund is ideal for

investors who do not desire high volatility.

Money Market Funds

The aim of money market funds is to provide easy liquidity, preservation of capital and

moderate income. These schemes generally invest in safer short-term instruments such as

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treasury bills, certificates of deposit, commercial paper and inter-bank call money. Returns on

these schemes may fluctuate depending upon the interest rates prevailing in the market.

These are ideal for corporate and individual investors as a means to park their surplus funds

for short periods.

Apart from the types of schemes mentioned above mutual fund schemes can be further

classified as follows,

Load Funds & No load Funds

Load Funds

Marketing of a mutual fund scheme involves initial expenses. These expenses may be

recovered from investors by the mutual fund in the form of load. The load is used to cover

expenses incurred on distribution, sales and marketing. Three ways in which load is charged is

Entry Load: This is charged at the time the investor enters into the fund by deducting a

specified amount from his initial contribution. However with the recent SEBI circular no load will

be charged to the distributor.

Exit Load: This is charged at the time the investor redeems from the fund by deducting a

specified amount from his redemption proceeds.

No-Load Funds

A No-Load Fund is one that does not charge a commission for entry or exit. That is, no charge

is payable on purchase or sale of units in the fund. The advantage of a no load fund is that the

entire corpus is put to work.

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Tax Saving Schemes

These schemes offer tax rebates to the investors under specific provisions of the Indian

Income Tax laws as the Government offers tax incentives for investment in specified avenues.

Investments made in Equity Linked Savings Schemes (ELSS) and Pension Schemes are

allowed as deduction u/s 88 of the Income Tax Act, 1961. The Act also provided opportunities

to investors to save capital gains u/s 54EA and 54EB by investing in Mutual Funds, provided

the capital asset had been sold prior to April 1, 2000 and the amount was invested before

September 30, 2000.

Special Schemes

Industry Specific Schemes

Industry Specific Schemes invest only in the industries specified in the offer document. The

investment of these funds is limited to specific industries like InfoTech, FMCG, and

Pharmaceuticals etc.

Index Schemes

Index Funds attempt to replicate the performance of a particular index such as the BSE

Sensex or the NSE 50.

Sectoral Schemes

Sectoral Funds are those, which invest exclusively in a specified industry or a group of

industries or various segments such as 'A' Group shares or initial public offerings.

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The Regulatory framework of Mutual Funds in India

SEBI The Capital Markets Regulator

The Government of India constituted Securities and Exchange Board of India, by an act of

Parliament in 1992, as the apex regulator of all entities that either raise funds in the capital

markets or invest in capital market securities such as shares and debentures listed on stock

exchanges. It was formed to protect the interests of investors in securities and to promote the

development of, and to regulate the securities market and for matters connected therewith or

incidental thereto.

Mutual funds have emerged as an important institutional investor in capital markets securities.

Hence they come under the purview of SEBI. SEBI requires all mutual funds to be registered

with them. It issues guidelines for all mutual fund operations, including where they can invest,

what investment limits and restrictions must be complied with, how they should account for

income and expenses, how they should make disclosures of information to the investors and

generally acts in the interest of investor protection.

SEBI (MUTUAL FUNDS) REGULATIONS, 1996

A comprehensive set of regulations for all mutual funds has been accomplished with SEBI

(Mutual Fund) regulations 1996. These regulations set uniform standards for all funds and will

eventually be applied in full to Unit Trust of India as well, even though UTI is governed by its

own UTI Act. The regulation governing Mutual funds are as follows,

Registration of the Fund

The regulations lay down the procedure of registration for the Fund with the SEBI board. For

the purpose of grant of a certificate of registration, the applicant has to fulfil the following,

namely: -

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The sponsor should have a sound track record and general reputation of fairness and

integrity in all his business transactions;

In the case of an existing mutual fund, such fund is in the form of as trust and the trust

deed has been approved by the Board;

The sponsor has contributed or contributes atleast 40% to the networth of the asset

management company.

The sponsor or any of its directors or the principle officer to be employed by the mutual

fund should not have been guilty of fraud or has not been convicted of an offence involving

moral turpitude or has not been found guilty of any economic offence:

Appointment of trustees to act as trustees for the mutual fund in accordance with the

provisions of the regulations;

Appointment of asset management company to manage the mutual fund and operate the

scheme of such funds in accordance with the provisions of these regulations;

Appointment of a custodian in order to keep custody of the securities and carry out the

custodian activities as may be authorised by the trustees.

Constitution and Management of Mutual Fund and Operation of Trustees

A mutual fund is constituted in the form of a trust and the instrument of trust is a deed, the

same has to be registered under the provision of the Indian Registration Act. It lays down the

contents of the trust deed. The trust deed shall contain such clauses as are necessary for

safeguarding the interests of the unit holders. A mutual fund shall appoint trustees in

accordance with these regulations. An asset management company or any of its officers or

employees shall not be eligible to act as a trustee of any mutual fund.

Rights & Obligations of Trustees

The trustees and the asset management company shall with the prior approval of the

Board enter into an investment management agreement.

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The trustees shall have a right to obtain from the asset management company such

information as is considered necessary by the trustee.

The trustees shall ensure before the launch of any scheme that the asset management

company has;-

a) systems in place for its back office, dealing room and accounting;

b) appointed all key personnel including fund manager (s) for the scheme(s) and

submitted their bio-data which shall contain the educational qualifications, past experience in

the securities market with the trustee, 15 days of their appointment;

c) appointed auditors to audit its accounts;

d) appointed compliance officer to comply with regulatory requirement and to redress

investor grievances;

e) appointed registrars and laid down parameters for their supervision;

f) prepared compliance manual and designed internal control mechanisms including

internal audit systems;

g) Specified norms for empanelment of brokers and marketing agents.

Asset Management Company and its obligations:

The asset management company shall take all reasonable steps and exercise due

diligence to ensure that the investment of funds pertaining of these regulations and the trust

deed.

The asset management company shall exercise due diligence and care in all its investment

decision as would be exercised by other persons engaged in the same business.

The asset management company shall submit to the trustees quarterly reports of each

year on its activities and the compliance with these regulations.

In case the asset management company enters into any securities transactions with any of

its associates a report to that effect shall immediately be sent to the trustees.

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The asset management company shall not appoint any person as key personnel who has

been found guilty of any economic offence or involved in violation of securities laws.

The asset management company shall appoint registrars and share transfer agents who

are registered with the Board.

The asset management company shall abide by the Code of Conduct as specified in the

Fifth Schedule.

Investment Objectives and Valuation Policies

Investment objective:

The moneys collected under any scheme of a mutual fund shall be invested only in

transferable securities in the money market or in the capital market or in privately placed

debentures or securities debts.

The mutual fund shall not borrow except to meet temporary liquidity needs of the mutual

funds for the purpose of repurchase or redemption of units or payment of interest or dividend

to the unit holders.

The mutual fund shall not advance any loans for any purpose or for options trading.

Method of valuation of investments:

Every mutual fund shall compute and carry out valuation of its investments in its portfolio

and published the same in accordance with the valuation norms.

General Obligations

To maintain proper books of accounts and records, etc.

Limitation on fees and expenses on issue of schemes and annual charges.

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Advertisement Code

An advertisement shall be truthful, fair and clear and shall not contain a statement, promise

or forecast which is untrue or misleading.

The advertisement shall not be so designed in content and format or in print as to be likely

to be misunderstood, or likely to disguise the significance of any statement. Advertisements

shall not contain statements, which directly or by implication or by omission may mislead the

investor.

Advertisements shall not be so framed as to exploit the lack of experience or knowledge of

the investors. As the investors may not be sophisticated in legal or financial matters, care

should be taken that the advertisement is set forth in a clear, concise, and understandable

manner. Extensive use of technical or legal terminology or complex language and the inclusion

of excessive details, which may detract the investors, should be avoided.

Code of Conduct

Mutual fund schemes should not be organised, operated, managed or the portfolio of

securities selected, in the interest of sponsors, directors of asset management companies,

members of Board of trustees or directors of trustee company, associated person or in the

interest of special class of unit holders rather than in the interest of all classes of unit holders

of the scheme.

Trustees and asset management companies must ensure the dissemination to all unit

holders of adequate, accurate, explicit and timely information fairly presented in a simple

language about the investment policies, investment objectives, financial position and general

affairs of the scheme.

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Trustees and asset management companies should excessive concentration of business

with broking firms, affiliates and also excessive holding of units in a scheme among a few

investors.

Trustees and asset management companies must avoid conflicts of interest in managing

the affairs of the scheme and keep the interest of all unit holders paramount in all matters.

Trustees and asset management companies must ensure scheme wise segregation of

cash and securities accounts.

Trustees and asset management companies shall carry out the business and invest in

accordance with the investment objectives stated in the offer documents and take investment

decision solely in the interest of unit holders.

Trustees and asset management companies must not use any unethical means to sell

market or induce any investor to buy their schemes.

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Valuation and Taxation

Net Asset Value

Net Asset Value refers to the price at which a mutual fund investor purchases or redeems units

of a scheme.

Mutual Funds value their investments on a mark to mark basis with reference to the date on

which they are valued i.e. valuation date. For e.g. if the fund announces its NAV every day, it

will have to value its portfolio daily. The norms of valuation are laid down in SEBI (Mutual

Fund) Regulations 1996.

The most important part of the NAV calculation is the valuation of the assets owned by the

fund. Once it is calculated, the NAV is simply the net value of assets divided by the number of

units outstanding.

Taxation

Mutual funds of all types serve as an important savings tool in two ways: directly, by investing

in them, and indirectly, by offering you various tax benefits.

These tax advantages provided by investing in a mutual fund also give it an edge over certain

comparable investments.

The following is a general description of the tax laws in effect as of the date. Tax laws may

change in the future and the applicability of these laws may vary from person to person,

depending on each particular circumstance.

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Tax benefits to the Mutual Fund

Under Section 10(23D), Income including Capital Gains earned by Mutual Funds is exempt

from tax.

Tax benefits to the investors

Under Section 10(33), Dividends declared by Mutual Funds are tax-free in the hands of the

investor. Schemes investing 50% or more in equities are exempt from distribution tax. Other

schemes are liable to 20% dividend distribution tax plus surcharge.

Under Section 2(42A), a unit of a mutual fund is treated as a long term capital asset if held

for more than one year.

Under Section 112, capital gains chargeable on transfer of long term capital assets are will

be taxed @ 20% after indexation or @ 10% of capital gains, whichever is lower.

Under Section 194K & 196A, No Tax is deducted at source for income distributed by

mutual funds.

Under Section 88, subscriptions upto Rs. 10,000/- made in an equity linked saving scheme

of a mutual fund will be eligible for 20% rebate.

Short term / Long term Capital Gains and losses can be offset against each other.

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Investment Management

One foundation on which a mutual fund is built is the portfolio management skills. The

performance of the fund, the returns produced for the investor are accounted for largely by

success in the portfolio management function.

Equity Portfolio Management

A Review of the Indian Equity Market

Mutual fund managers generally invest only in market-traded stocks. Even then, the Indian

fund manager has a vast universe of shares available to him for investment. As of 1999 year-

end, major Indian stock exchanges had over 6400 shares listed. The market capitalization of

all listed stocks now exceeds Rs. 700,000 crores and often approaches Rs. 10 lakh crores.

There are a large number of indices also available, from BSE 30-share index to S&P CNX 500

index. The number of industries or sectors represented in various indices or in the listed

category exceeds 50. Of course, the number of actively traded stocks is smaller, but still

exceeds 1500. BSE has 140 scrips in its Specified Group a list, which are basically large-

capitalization stocks. B 1 Group includes over 1100 stocks, many of which are mid-cap

companies. The rest of the B 2 Group includes over 4500 shares, largely low-capitalization.

NSE has a special mid-cap index that includes selected 50 companies. A fund manger must

review all these candidates to choose from.

Indian economy is going through a period of both rapid growth and rapid transformation. Thus,

the industries with growth prospects or the blue chip shares of yesterday are no longer certain

to continue to be in that category tomorrow. New sectors such as software or technology

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stocks have emerged recently. In this process of rapid economic change, the stock selection

task of an active fund manager in India is by no means simple of limited.

An equity portfolio managers task consists of two major steps:

Constructing a portfolio of equity shares or equity linked instruments that is consistent with

the investment objective of the fund and

Managing or constantly rebalancing the portfolio to produce capital appreciation and

earnings that would reward the investors with superior returns.

Stock Selection

The equity portfolio manager has available to him a whole universe of equity shares and other

instruments such as preference shares warrants or convertible debentures issued by many

companies. Event within each category of equity instruments, shares of one company may be

very different in terms of their potential than shares of other companies. So, how does the fund

manager go about choosing from the different types of stocks, in order to construct his

portfolio? The general answer is that his choice of shares to be included in a funds portfolio

must reflect the investment objective of the fund. However, more specifically, the equity

portfolio manager will choose from a universe of investible shares in accordance with

The nature of the equity instrument, or a particular stocks unique characteristics, and

A Certain investment style or philosophy in the process of choosing.

Thus, you may see a mutual funds equity portfolio include shares of diverse companies.

However, in reality, the group of stocks selected will have certain unique characteristics,

chosen in accordance with the preferred investment style, such that the portfolio as a whole is

consistent with the schemes objectives. We will now, therefore, review how different stocks

are classified according to their characteristics. Later, we will explain two major investment

styles. But first a short review of the size of the Indian stock markets.

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Types of Equity Instruments

Ordinary Shares

Ordinary shareholders are the owners of a company, and each share entitles the holder to

ownership privileges such as dividends declared by the company and voting rights at

meetings. Losses as well as profits are shared by the equity shareholders. Without any

guaranteed income or security, equity shares are as risk investment, bringing with them the

potential for capital appreciation in return for the additional risk that the investor undertakes in

comparison to debt instruments with guaranteed income.

Preference Shares

Unlike equity shares, preference shares entitle the holder to dividends at fixed rates subject to

availability of profits after tax. If preference shares are cumulative, unpaid dividends for years

of inadequate profits are paid in subsequent years. Preference shares do not entitle the holder

to ownership privileges such as voting rights at meetings.

Equity Warrants

These are long term rights that offer holders the right to purchase equity shares in a company

at a fixed price (usually higher that the current market price) within a specified period. Warrants

are in the nature of options on stocks.

Equity Classes

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Equity shares are generally classified on the basis of either the market capitalization or the

anticipated movement of company earnings. It is imperative for a fund manager to understand

these elements of stocks before he select them for inclusion in the portfolio.

INVESTMENT PRODUCTS

Mutual Fund Investment viz. a viz. other products

Physical and Financial Assets

The ranges of investment options available in India cover both physical assets and financial

assets Real estate and Gold are examples of physical assets. Traditionally, gold has been a

favorite asset for many Indians.

In the financial assets category, Indian investors have generally had guaranteed or fixed return

products such as bank deposits, company deposits and Government Savings instruments

such as Public Provident Fund, Indira Vikas Patra and National Savings Certificates.

Financial assets also include capital market securities such as equity/preference shares, and

bonds/debentures issued by companies or financial institutions, money market instruments

such as commercial paper or certificates of deposit. Individual investors can buy capital market

instruments but do not have any direct access to money markets instruments.

Guaranteed and Non-Guaranteed Investments

Quite distinct from the above-described investment instruments are the mutual fund units.

Unlike capital market or money market instruments, where the investor lends directly to the

borrower/ issuer of securities, mutual fund units represent indirect investments through an

intermediary the fund. However, unlike the bank deposits or government savings

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instruments, where the intermediary or the borrower guarantees the capital protection and

interest rates, investment in a mutual fund is not guaranteed for returns or capital.

The salient features of the investment products available in India are given below.

Physical Assets: Gold and Real Estate

Indians are the largest investors in Gold in its various forms. Investment in Gold is not subject

to erosion on account of rupee depreciation, which is perhaps its biggest advantage.

Historically, Gold has been perceived as a hedge against inflation or as a means of security in

bad times. Hence, investors do not always look for returns while investing in gold. Recently,

the government has deregulated the import of Gold significantly. Nevertheless, it is the

average Indians obsession with Gold that has maintained its place as a key investment option.

An interesting development recently has been the permission by the government for banks to

issue Gold Bonds. These bonds represent securitization of gold. Investors can hold these

bonds and earn some returns, instead of holding the metal and incur costs and risks

associated with storage. The instrument is till in its infancy.

Real estate the also been a preferred investment alternative with the Indian investor. However

the capital required is often beyond the means of the small individual investor. Also, the real

estate market has been in a recession for the past few years, and even during and upswing, it

is not easy to liquidate holdings quickly at an appropriate price. Even high net worth individuals

have tended to keep away from real estate purely as a form of investment.

Once again, for those investors who like investing in real estate, an attractive option may

emerge soon with some Mutual Funds planning to offer Real Estate Mutual Funds an indirect

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form of investing that still offers to the investors the benefits of both real estate investing and

mutual fund investing.

Financial Assets

Products by Issuer

Issuer Product Available To

Banks Fixed Deposits Investor

Corporate - Shares

- Bonds, Debentures

- Fixed Deposits

- Investor, MFs

- Investor, MFs

- Investor, MFsGovernment - Govt. Securities

-PPF

-

- Investor, MFs

-Investor

FIs - Bonds - Investor, MFs

Insurance Cos - Insurance Policies - Investor

Banks

Bank deposits have been a favored investment option with the India investor, mainly because

of the liquidity and safety benefits they offer. Most Indian banks are promoted either by the

government or by leading financial institutions. The liquidity and safety offered by banks does

however come at a price. Yield on bank deposits is negligible after accounting for inflation and

tax. While the bank guarantees the return of the capital, deposit is not a secured investment,

its perceived safety coming from the soundness of the bank management or ownership.

Investors should be advised to park only a part of the savings in bank deposits

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Corporate Papers

Securities available in the capital market include equity instruments, debt instruments and

quasi debt-quasi equity instruments issued by companies.

Equity instruments are in the form of shares in companies either issued privately and unlisted,

or issued publicly and listed on a stock exchange(s). The investor may acquire such shares,

either at the time of the initial public offering by the company or subsequently, though the stock

exchanges at which they are listed. The benefit of investing in equities is the high growth

potential that this avenue offers. Also, the listing at stock exchanges ensures a high degree of

liquidity. Historically, equities have yielded the highest return as compared to other investment

options. However, for the individual investor, it is challenge to identify shares which are likely to

appreciate in value, and even if the succeeds in doing so, he may be unable to raise capital

that is required to develop a diversified portfolio. Besides, a risk-averse investor should be

advised to refrain from investing heavily in the equity market.

The corporate borrowers- companies- also issue debentures paying fixed rates of interest. In

India, these debentures are generally secured by the assets of the borrower. However, credit

standing of the borrower has to be determined with the help of the credit rating that a particular

debentures issue is given by a rating agency. Companies pay different rates of interest

depending upon how strong their rating or their market acceptance is. Borrowers with lower

rating need to pay higher interest. Companies can also issue unsecured bonds, like Financial

Institutions, though the instrument will not be called a debenture.

Both bonds and debentures may be subscribed to either in a private placement or in a public

issue. Many companies privately issue debt securities with less than 18 months maturity; as

such issues are exempt from the requirement of credit rating. Investors need to be extremely

careful about such investment and need to be sure that the issuing company is really

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creditworthy. Public issues and other private issues have to be rated, so some guidance is

available to the investor to judge the risk of default by the borrower.

Investing in company fixed deposits is yet another avenue available in the market. While

company fixed deposits may carry a higher rate of interest as compared to bank deposits, they

are also an unsecured investment. Each companys deposits must be evaluated with reference

to the risk rating assigned to them by credit rating agencies such as Crisil, ICRA and CARE.

Also, the tax effect could make the net returns on these instruments less attractive than other

debt instruments.

Financial Institutions

In recent times, financial institutions such as ICICI and IDBI have issued bonds on a regular

basis. Sometimes, these are general-purpose bonds issued to augment their resources.

Sometimes, they are issued with the intent of financing infrastructure development in the

country. These bonds are available for investment in the form of alternate options. One option

allows the investor to receive periodic interest payments (monthly, quarterly, and annually)

over the term of the instrument. The deep discount option does not pay interest on a periodic

basis. Instead, it yields a redemption value, which is higher than the issue price, the difference

being chargeable to tax as interest. Both options qualify for tax rebate under Section 88 of the

Income Tax Act. Deduction of interest income under Section 80L is not applicable. The Third

option gives interest at periodic interval and qualifies as investment specified under Section

54EA/EB of the Income Tax Act. Institution bond schemes usually have 3, 5, 10 and 15- year

maturities with annualized compounded returns ranging between 11% and 12.5%. A savvy

investment approach can make these bonds a very attractive investment option. It must be

noted that these bonds are unsecured.

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Government

Public Provident Fund

Public Provident Fund is a government obligation, hence virtually risk-free. Besides, tax-free

interest of 12% p.a. and contributions up to Rs.60000/- eligible for tax rebate under Section 88,

make the Public Provident Fund (PPF) one of the best options available to the investor. An

individual is allowed only one account in his name. The scheme requires annual contributions

(between Rs.100 and Rs.60000) to be made over 16 years, with the option to withdraw 50% of

the 4th year balance in the 7th year. Assured tax-free interest, which can be compounded over

16 years, makes this scheme a truly attractive option. There are restrictions on withdrawals,

which does reduce liquidity for the investor.

Indira and Kisan Vikas Patra

These were originally introduced as post office schemes in order to tap savings in rural India,

but also became popular with urban investors. However, their current yield (12.25% over 6

years, fully taxable) has made them unattractive. Nevertheless, Indira Vikas Patra continues

to appeal to investors with unaccounted income because the post office does not record the

identity of the investor. Consequently, they are easily transferable and liquid.

Other Scheme from National Savings Organization.

Besides PPF and Indira Vikas Patra, the NSO offers schemes such as post office accounts,

recurring deposits, relief bonds and the scheme for retiring government employees. However

these schemes have ceased to be attractive after the advent of PPF and institutional bonds.

Government Securities.

This is government paper normally issued on a long-term basis and defines the yield curve to

a great extent. Only primary dealers specially appointed for this purpose deal in government

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securities. From the individual investors perspective, government securities are not a direct

investment and are accessible through mutual funds.

Life Insurance

Life insurance in India was monopoly of the Life Insurance Corporation of India (LIC), till

government decided to privatize the Life Insurance.

LIC offers two types of policies- without profits and with profits. A without profits policy

purchased by an individual promises to pay a certain sum of money (the sum assured) to his

survivor nominated by him in the event of his death within a specified period (the term of the

Policy). If the individual services the term of the policy, he does not receive anything. A with

profits policy not only pays the sum assured in the event of death during the policy term, but

also pays a bonus as declared by LIC from year to year. If the individual services the term of

the policy, he receives the sum assured plus bonus accrued. Most policies require the

individual to pay a fixed premium on a yearly basis. If the individual decides to discontinue the

policy during its tenure, he would be entitled to the policys surrender value, which is a percent

of premium paid till date.

In India, life insurance is viewed more as an investment option than as a vehicle for risk

protection. In fact, very few individuals evaluate the need for insurance. Instead, they tend to

opt for it on account of tax benefits. Premium paid on life insurance qualifies for tax rebate

under Section 88 and proceeds at the time of death or maturity are exempt from tax. Certain

investors prefer life insurance because it acts as a forced saving (the policy would lapse if

annual premium is not paid to LIC). However, a careful evaluation of life insurance reveals

that the opportunity cost is significant when compared to other secure investment such as

PPF. It is important for an individual to evaluate the need for insurance with respect to his

earning potential and the financial impact on his dependents in the event of his untimely death.

Proceeds in the event of his surviving the term of the policy do not make insurance a

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worthwhile investment. Surrender values paid by LIC are not attractive leading to lengthy

lock-in period. LICs plans also offer very little flexibility and are not attractive due to a lengthy

lock-in period. LICs plans also offer very little flexibility. Therefore, an investor would be well

advised to buy insurance, not just as an investment, but mainly to provide for his dependants

in case of his untimely death.

The table below compares the investment options discussed above under the broad heads viz.

return, safety, volatility, liquidity and convenience.

Products Return Safety Volatility Liquidity Convenience

Equity High Low High High or

Low

Moderate

FI Bonds Moderate High Moderate Moderate High

Corporate

Debenture

Moderate Moderate Moderate Low Low

Company Fixed

Deposits

Moderate Low Low Low Moderate

Bank Deposits Low High Low High HighPPF Moderate High Low Moderate HighLife Insurance Low High Low Low ModerateGold Moderate High Moderate Moderate LowReal Estate High Moderate High Low LowMutual Funds High High Moderate High High

Although the table provides a qualitative evaluation of various financial products, the

comparison serves as a useful guide towards determining the best option.

It is clear from the above that equity investing in general has good potential in terms of return,

liquidity and convenience. However, individual stocks can give varied performance, one stock

being more liquid than another or one stock giving lower return than another. For this reason,

equity investing is fraught with risk and is not ideal for every individual investor. It is

recommended only for investors who are willing to invest the time required for research in

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stock selection (or have access to sound financial advice) and possess the capacity to bear

the inherent risk.

Bonds issued by institutions are an attractive option, particularly now with the liquidity that

accompanies their listing on stock exchanges. Bonds are a stable option in terms of fixed

returns, and are recommended for the risk-averse investor. However, bonds can lose value

when general interest rates go up. Bonds are also subject to credit risk or risk of default by the

borrower. In case of corporate bonds, the risk must be assessed in terms of the strength of

the borrower as indicated by the credit rating assigned to the bonds. In the absence of credit

rating, it is extremely difficult for the investor to decide on the quality of the bonds or

debentures. The secondary market in corporate bonds in India is also very thin, leading to

lack of liquidity for the investors who wish to sell.

Company fixed deposits fall short on several counts and are recommended only if the issuing

company and the deposits on offer are rated highly by credit rating agencies.

The major advantage of bank deposits relative to other products is the liquidity they offer.

Banks are usually willing to give loans against fixed deposits at a nominal charge over the

interest rate applicable to the deposits. Deposits rates offered by banks vary as per RBI

directives and the interest rate scenario in the economy. Bank deposits score high on safety,

as the return of capital is guaranteed to the depositor by the bank. However, the financial

soundness of the bank is important to look at.

PPF combines stability with a respectable return. Its tax-exempt status makes it an attractive

mechanism for the small investor to build his savings portfolio. However the lock in period

involved in PPF means that the investor loses out in terms of liquidity, particularly during the

early years of the scheme. Being a government supported investment, PPF scores very high

on safety, compared even to bank deposits.

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Insurance could become a serious investment vehicle once the insurance market in India is

opened to private players. In todays scenario the opportunity cost in terms of return is too high

for insurance to be compared on even terms with the other option. Its liquidity is also

extremely low, though safety is considered high at present for the government-owned LIC as

the only insurer.

Direct Equity Investment versus Mutual Fund Investing.

As mentioned earlier, investors have the option to invest directly in equities through the stock

market instead of investing through mutual funds. However, a practical evaluation reveals that

mutual funds are indeed a more recommended option for the individual investor. A

comparison between the two options is given below:

Identifying stocks that have growth potential is a difficult process involving detailed

research and monitoring of the market. Mutual Funds specialize in this area and possess the

requisite resources to carry out research and continuous market monitoring. This is clearly

beyond the capability of most individual investors.

Another critical element towards successful equity investing is diversification. A

diversified portfolio serves to minimize risk by ensuring that a downtrend in some

securities/sectors is offset by an upswing in the others. Clearly, diversification requires

substantial investment that may be beyond the means of most individual investors. Mutual

funds pool the resources of many investors and thus have the funds necessary to build a

diversified portfolio, and by investing even a small amount in a mutual fund, an investor can,

through his proportionate share, reap the benefit of diversification.

Mutual funds specialize in the business of investment management, and therefore

employ professional management for carrying out their activities. Professional management

ensures that the best investment avenues are tapped with the aid of comprehensive

information and detailed research. It also ensures that expenses are kept under tight control

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and market opportunities are fully utilized. An investor who opts for direct equity investing

loses out on these benefits.

Mutual funds focus their investment activities based on investment objectives such as

income, growth or tax savings. An investor can choose a fund that has investment objectives

in line with his objectives. Therefore, funds provide the investor with a vehicle to attain his

objectives in a planned manner.

Mutual funds offer liquidity through listing on stock exchange (for closed-end funds) and

repurchase options (for open-end funds). This is in contrast to direct equity investing where

several stocks are often not traded for long periods

Direct equity investing involves a high level of transaction costs per rupee invested in

the form of brokerage, commissions, stamp duty, etc. While mutual funds charge a

management fee, they succeed in keeping transaction costs under control because of the

economies of scale they enjoy.

In terms of convenience, mutual funds score over direct equity investing. Funds serve

investors not only through their investor services networks, but also through associates such

as banks and other distributors. Many funds allow investors the flexibility to switch between

schemes within a family of funds. They also offer facilities such as check writing and

accumulation plans. These benefits are not matched by direct equity investing.

It is clear that investing through mutual funds is far superior to direct investing except

perhaps for the investor who has truly large portfolio and the time, knowledge and resources

required for direct investing.

Bank Deposits versus Debt Funds

It needs to be understood that bank deposits cater to a segment of the investor class that

looks for safety and accepts a relatively lower return. Equity Funds cannot clearly be

compared with the bank deposits, as investors can expect higher returns from equity funds

only at the risk of losing part of the capital also. Given the risks, Indian investors are currently

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investing heavily in debt funds. However, before a bank depositor considers shifting his funds

to debt funds, he should compare the two in a meaningful manner.

A bank deposit is guaranteed by the bank for repayment of principal and interest. Any risks

associated with investment of the investors funds have to be borne by the bank. The depositor

has a contractual commitment from the bank to pay. A mutual fund, on the other hand, invests

at the risk of the investor. Hence, there is no contractual guarantee for repayment of principal

or interest to the investor.

The bank depositor does not directly hold the bank portfolio of investment, as he does in case

of a fund. The investor needs to assess the risk in terms of the credit rating of the bank, which

provides an indication of the financial soundness of the bank. However, a debt fund is not

rated by any agency. The investor has to assess the risk on the portfolio held by the fund. The

investor needs to know whether the fund invests in high quality assets or lower rated debt.

Unlike in case of bank deposits, therefore, the investor needs to know his own investment

objective and risk appetite before investing in a debt fund. The expected returns will be

commensurate with the level of risk assumed by the fund.

It can be seen that the bank deposits are not totally free from risk, while generally giving lower

returns. A conservative debt fund can give higher returns than a bank deposit, even if there is

no contractual guarantee as in a deposit. Investors seeking higher returns form the capital

market securities, a diversified debt portfolio while still investing small amounts and a portfolio

that matches his objective and risk appetite is well advised to consider part of his investment in

debt funds.

The Investor Perspective: Funds vs. Other Products

Product Investment Objective Risk

Tolerance

Investment

HorizonEquity Capital Appreciation High Long Term

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FI Bonds Income Low Medium to

Long TermCorporate Debentures Income H-M-Low The Same

Company Fixed Deposits Income The Same MediumBank Deposits Income Generally

Low

Flexible

All TermsPPF Income Low Long Term

Life Insurance Risk Cover Low Long Term

Gold Inflation Hedge Low Long Term

Real Estate Inflation Hedge Low Long Term

Mutual Funds Capital Growth,

Income

H-M- Low Flexible

All Terms

The comparison above highlights the flexibility offered by mutual funds from the investors

perspective. An investor can choose form a wide variety of funds to suit his risk tolerance,

investment horizon and investment objective. Bank deposits offer similar flexibility in

investment horizon and risk level, but only a fixed income. An investor looking for capital

growth has to potential, but a high risk and without the benefit of diversification and

professional management offered by mutual funds. Gold and real estate are attractive only in

high inflation economies. Other options are largely for the risk-averse, income-oriented

investor. Mutual funds present the widest choice to the investors.

Mutual Funds the best Investment Option

From the comparative analysis provided above, it emerges that each investment alternative

has its strengths and weakness. Some options seek to achieve superior returns (e.g. equity),

but with correspondingly higher risk. Others provide safety (such as PPF), but at the expense

of liquidity and growth. Options such as bank deposits offer safety and liquidity, but at the cost

of return. Mutual funds seek to combine the advantages of investing, in each of these

alternatives, while dispensing with the shortcomings. Clearly, it is in the investors interest to

focus his investment on mutual funds.

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However, a note of caution is in order. While the mutual funds are one of the best options for

the individual small investor, there are many mutual funds already available for the investor to

choose from. It must be realized that the performance of different funds varies form time to

time. Also, the Indian mutual fund sector has been in an evolving phase over the past five

years during which time several investors have encountered some poorly performing funds,

while others have been fortunate to be with good performers. Besid

Documents

Mutual Fund as a Tool for Financial Planning