Chapter – 12 Mutual Funds

12.1 Introduction
Mutual funds are one of the most popular investment options these days. A mutual fund is
essentially a common pool of money in which investors put in their contribution. This collective
amount is then invested according to the investment objective of the fund. The money could be
invested in stocks, bonds, money market instruments, gold and other similar assets.
These funds are operated by money managers or fund managers, who by investing in line
with the specified investment objective attempt to create growth or appreciation of the
amount for investors.
For example, a debt fund will have its specified objective to invest in fixed income
instruments or products like bonds, government securities, debentures, etc. Similarly, an
equity fund will invest in stocks and other equity instruments.
A mutual fund is an investment vehicle formed when an asset management
company (AMC) or fund house pools investments from several individuals and
institutional investors with common investment objectives. A fund manager, who is a
finance professional, manages the pooled investment. He or she purchases securities such
as stocks and bonds that are in line with the investment mandate.
12.2 Definition of 'Mutual Fund'
Definition: A mutual fund is a professionally-managed investment scheme, usually run
by an asset management company that brings together a group of people and invests their
money in stocks, bonds and other securities.

As an investor, you can buy mutual fund 'units', which basically represent your share of
holdings in a particular scheme. These units can be purchased or redeemed as needed at
the fund's current net asset value (NAV). These NAVs keep fluctuating, according to the
fund's holdings. So, each investor participates proportionally in the gain or loss of the
fund.

Mutual funds are an excellent investment option for individual investors to get exposure
to expert managed portfolio. Mutual funds have advantages and disadvantages compared
to direct investing in individual securities. The advantages of mutual funds include
economies of scale, diversification, liquidity, and professional management. However,
these come with mutual fund fees and expenses. Also, one can diversify their portfolio by
investing in mutual funds as the asset allocation would cover several instruments.
Investors would be allocated with fund units based on the amount they spend. Each
investor would hence experience profits or losses that are proportional to their
investment. The main intention of the fund manager is to provide optimum returns to
investors by investing in securities that are in sync with the fund’s objectives.
The performance of mutual funds is dependent on the underlying assets.
12.3 Understanding Mutual Funds

Mutual funds pool money from the investing public and use that money to buy other
securities, usually stocks and bonds. The value of the mutual fund company depends on
the performance of the securities it decides to buy. So, when you buy a unit or share of a
mutual fund, you are buying the performance of its portfolio or, more precisely, a part of
the portfolio's value. Investing in a share of a mutual fund is different from investing in
shares of stock. Unlike stock, mutual fund shares do not give its holders any voting rights.
A share of a mutual fund represents investments in many different stocks (or other
securities) instead of just one holding.
That's why the price of a mutual fund share is referred to as the net asset value (NAV) per
share, sometimes expressed as NAVPS. A fund's NAV is derived by dividing the total value
of the securities in the portfolio by the total amount of shares outstanding. Outstanding
shares are those held by all shareholders, institutional investors, and company officers or
insiders. Mutual fund shares can typically be purchased or redeemed as needed at the
fund's current NAV, which—unlike a stock price—doesn't fluctuate during market hours,
but it is settled at the end of each trading day. Ergo, the price of a mutual fund is
also updated when the NAVPS is settled.
The average mutual fund holds over a hundred different securities, which means mutual
fund shareholders gain important diversification at a low price. Consider an investor who
buys only Google stock before the company has a bad quarter. He stands to lose a great
deal of value because all of his dollars are tied to one company. On the other hand, a
different investor may buy shares of a mutual fund that happens to own some Google
stock. When Google has a bad quarter, she loses significantly less because Google is just
a small part of the fund's portfolio.

12.4 How Mutual Funds Work?

The mutual fund collects money from you and other investors and allots units. This is
similar to buying shares of a company. Here, the price of each mutual fund unit is known
as the Net Asset Value. The assets are invested in a set of stocks or bonds that form the
portfolio of the fund. The fund manager, depending on the investment objective of the
scheme, decides the portfolio allocation.

Example of how mutual funds work:

Let's say HDFC Mutual Fund launches a new scheme called HDFC Top 20 Fund. For sake
of simplicity, let's assume the scheme collects Rs 1 crore from 100 investors who invested
Rs 1 lakh each. Given that the fund house issues the units at an NAV of Rs 10, it will allot
10,000 units (Investment/NAV) to each investor. Thus, the total number of units
allocated by the fund house is 10 lakh.
The fund house has an objective to invest over 20 stocks. The fund manager decides to
invest an equal amount in each stock. Since, the scheme has a corpus of Rs 1 crore, it will
invest Rs 5 lakh in each stock. In reality, the fund manager invests a high proportion in
stocks that are expected to deliver better returns over the long term.
After a month, there is no change in the portfolio holding or the number of investors. The
value of stocks in the portfolio grows to Rs 1.2 crore. Since the units of the fund remains
unchanged at 10,000 units, the NAV of each unit is now Rs 12.
For the investors, their investment would have grown to Rs 1.2 lakh (10000 units * Rs 12).

12.5 Growth of Mutual Funds in India

The mutual fund industry in India started in 1963 with the formation of Unit Trust of
India, at the initiative of the Government of India and Reserve Bank of India. The history
of mutual funds in India can be broadly divided into four distinct phases
First Phase - 1964-1987
Unit Trust of India (UTI) was established in 1963 by an Act of Parliament. It was set up
by the Reserve Bank of India and functioned under the Regulatory and administrative
control of the Reserve Bank of India. In 1978 UTI was de-linked from the RBI and the
Industrial Development Bank of India (IDBI) took over the regulatory and administrative
control in place of RBI. The first scheme launched by UTI was Unit Scheme 1964. At the
end of 1988 UTI had Rs. 6,700 crores of assets under management.
Second Phase - 1987-1993 (Entry of Public Sector Funds)
1987 marked the entry of non-UTI, public sector mutual funds set up by public sector
banks and Life Insurance Corporation of India (LIC) and General Insurance Corporation
of India (GIC). SBI Mutual Fund was the first non-UTI Mutual Fund established in June
1987 followed by Canbank Mutual Fund (Dec 87), Punjab National Bank Mutual Fund
(Aug 89), Indian Bank Mutual Fund (Nov 89), Bank of India (Jun 90), Bank of Baroda
Mutual Fund (Oct 92). LIC established its mutual fund in June 1989 while GIC had set up
its mutual fund in December 1990.
At the end of 1993, the mutual fund industry had assets under management of Rs. 47,004
crores.
Third Phase - 1993-2003 (Entry of Private Sector Funds)
With the entry of private sector funds in 1993, a new era started in the Indian mutual fund
industry, giving the Indian investors a wider choice of fund families. Also, 1993 was the
year in which the first Mutual Fund Regulations came into being, under which all mutual
funds, except UTI were to be registered and governed. The erstwhile Kothari Pioneer (now
merged with Franklin Templeton) was the first private sector mutual fund registered in
July 1993.
The 1993 SEBI (Mutual Fund) Regulations were substituted by a more comprehensive
and revised Mutual Fund Regulations in 1996. The industry now functions under the SEBI
(Mutual Fund) Regulations 1996.
The number of mutual fund houses went on increasing, with many foreign mutual funds
setting up funds in India and also the industry has witnessed several mergers and
acquisitions. As at the end of January 2003, there were 33 mutual funds with total assets
of Rs. 1,21,805 crores. The Unit Trust of India with Rs. 44,541 crores of assets under
management was way ahead of other mutual funds.
Fourth Phase - since February 2003
In February 2003, following the repeal of the Unit Trust of India Act 1963 UTI was
bifurcated into two separate entities. One is the Specified Undertaking of the Unit Trust
of India with assets under management of Rs. 29,835 crores as at the end of January
2003, representing broadly, the assets of US 64 scheme, assured return and certain other
schemes. The Specified Undertaking of Unit Trust of India, functioning under an
administrator and under the rules framed by Government of India and does not come
under the purview of the Mutual Fund Regulations.
The second is the UTI Mutual Fund, sponsored by SBI, PNB, BOB and LIC. It is registered
with SEBI and functions under the Mutual Fund Regulations. With the bifurcation of the
erstwhile UTI which had in March 2000 more than Rs. 76,000 crores of assets under
management and with the setting up of a UTI Mutual Fund, conforming to the SEBI
Mutual Fund Regulations, and with recent mergers taking place among different private
sector funds, the mutual fund industry has entered its current phase of consolidation and
growth.
The graph indicates the growth of assets over the years.

Note:
Erstwhile UTI was bifurcated into UTI Mutual Fund and the Specified Undertaking of the
Unit Trust of India effective from February 2003. The Assets under management of the
Specified Undertaking of the Unit Trust of India has therefore been excluded from the
total assets of the industry as a whole from February 2003 onwards.

12.6 Organisation of Mutual Fund

The structure of Mutual Funds in India is a three-tier one. There are three distinct entities
involved in the process – the sponsor (who creates a Mutual Fund), trustees and the asset
management company (which oversees the fund management). The structure of Mutual
Funds has come into existence due to SEBI (Securities and Exchange Board of India)
Mutual Fund Regulations, 1996. Under these regulations, a Mutual Fund is created as a
Public Trust.

Fig. 12.1 Structure of Mutual Funds in India

The Structure of Mutual Fund

The Fund Sponsor
The Fund Sponsor is the first layer in the three-tier structure of Mutual Funds in India.
SEBI regulations say that a fund sponsor is any person or any entity that can set up a
Mutual Fund to earn money by fund management. This fund management is done
through an associate company which manages the investment of the fund. A sponsor can
be seen as the promoter of the associate company. A sponsor has to approach SEBI to
seek permission for a setting up a Mutual Fund. Once SEBI agrees to the inception, a
Public Trust is formed under the Indian Trust Act, 1882 and is registered with SEBI.
Trustees are appointed to manage the trust and an asset management company is created
complying with the Companies Act, 1956.
Trust and Trustees
Trust and trustees form the second layer of the structure of Mutual Funds in India. A
trust is created by the fund sponsor in favour of the trustees, through a document called
a trust deed. The trust is managed by the trustees and they are answerable to investors.
They can be seen as primary guardians of fund and assets. Trustees can be formed by two
ways – a Trustee Company or a Board of Trustees. The trustees work to monitor the
activities of the Mutual Fund and check its compliance with SEBI (Mutual Fund)
regulations. They also monitor the systems, procedures, and overall working of the asset
management company. Without the trustees’ approval, AMC cannot float any scheme in
the market. The trustees have to report to SEBI every six months about the activities of
the AMC.
Asset Management Companies
Asset Management Companies are the third layer in the structure of Mutual Funds. The
asset management company acts as the fund manager or as an investment manager for
the trust. A small fee is paid to the AMC for managing the fund. The AMC is responsible
for all the fund-related activities. It initiates various schemes and launches the same. The
AMC is bound to manage funds and provide services to the investor. It solicits these
services with other elements like brokers, auditors, bankers, registrars, lawyers, etc. and
works with them. To ensure that there is no conflict between the AMCs, there are certain
restrictions imposed on the business activities of the companies.
Other Components in the Structure of Mutual Funds
Custodian
A custodian is responsible for the safekeeping of the securities of the Mutual Fund. They
manage the investment account of the Mutual Fund, ensure the delivery and transfer of
the securities. They also collect and track the dividends & interests received on the Mutual
Fund investment.
Registrar and Transfer Agents (RTAS)
These are the entities who provide services to Mutual Funds. RTAs are more like the
operational arm of Mutual Funds. Since the operations of all Mutual Fund companies are
similar, it is economical in scale and cost effective for all the 44 AMCs to seek the services
of RTAs. CAMS, Karvy, Sundaram, Principal, Templeton, etc are some of the well-known
RTAs in India. Their services include:
• Processing investors’ application
• Keeping a record of investors’ details
• Sending out account statements to the investors
• Sending out periodic reports
• Processing the payouts of the dividends
 • Updating the investor details i.e. adding new members and removing those who
have withdrawn from the fund..
Auditor
Auditors audit and scrutinise record books of accounts and annual reports of various
schemes. Each AMC hires an independent auditor to analyse the books so as to keep their
transparency and integrity intact.
Brokers
AMC uses the services of brokers to buy and sell securities on the stock market. The AMCs
uses research reports and recommendations from many brokers to plan their market
moves. The three-tier structure of the Mutual Funds is in place keeping the fiduciary
nature of the Mutual Funds in mind. It ensures that each element of the system works
independently and efficiently. This structure of Mutual Funds is in line with the
international standards and thus there is a proper separation of responsibilities and
functioning of each constituent of the structure.

12.7 Mutual Fund Concept

Net Asset Value:

The performance of a particular scheme of a mutual fund is denoted by Net Asset Value
(NAV). Mutual funds invest the money collected from investors in securities markets. In
simple words, NAV is the market value of the assets minus the liabilities on the day of
valuation. Since market value of securities changes every day, NAV of a scheme also varies
on day today basis.
The NAV per unit is the market value of securities of a scheme divided by the total
number of units of the scheme on any particular date. For example, if the market
value of securities of a mutual fund scheme is INR 200 lakh and the mutual fund has
issued 10 lakh units of INR 10 each to the investors, then the NAV per unit of the fund is
INR 20(i.e.200 lakh/10 lakh). NAV is required to be disclosed by the mutual funds on a
daily basis. The NAV per unit of all mutual fund schemes have to be updated on
AMFI‟s website and the Mutual Funds‟ website by 9 p.m. of the same day.

NAV=(Market price of securities + Other Assets-Total liabilities)/Units outstanding as at

the NAV date

Entry and Exit Load

Mutual fund companies collect an amount from investors when they join or leave a
scheme. This fee is generally referred to as a 'load'. Entry load can be said to be the
amount or fee charged from an investor while entering a scheme or joining the company
as an investor. Exit load is a fee or an amount charged from an investor for exiting or
leaving a scheme or the company as an investor.
Generally, an entry load is collected to cover costs of distribution by the company.
Different mutual funds house.

Expense Ratio
It is the ration of expense incurred by a mutual fund for managing a fund to net assets of
the fund. It represents the annual fund operating expenses of a scheme, expressed
as a percentage of the fund’s daily net assets. Operating expenses of a scheme are
administration, management, advertising related expenses, etc.
An expense ratio of 1% per annum means that each year 1% of the fund’s total assets will
be used to cover expenses. Information on expense ratio that may be applicable to
a scheme is mentioned in the offer document. Currently, in India, the expense ratio is
fungible, i.e., there is no limit on any particular type of allowed expense as long as the
total expense ratio is within the prescribed limit. For limits on expense ratio, refer to
regulation 52 of the SEBI (Mutual Funds) Regulations, 1996.

12.8 Advantages of Mutual Funds

Investing in mutual funds provides several advantages for investors. The flexibility and
expert management of money make mutual funds a lucrative investment option.

I. Investment Handled by Experts

Fund managers manage the investments pooled by the asset management companies
(AMCs) or fund houses. They are finance professionals with an excellent track record of
managing investment portfolios. Furthermore, fund managers are supported by a team
of analysts and experts who pick the best-performing stocks and assets that have the
potential to provide excellent returns for investors.
II. No Lock-in Period
Most mutual funds come with no lock-in period. In investments, the lock-in period is a
timeframe over which the investments once made cannot be withdrawn. Some
investments allow premature withdrawals within the lock-in period in exchange for a
penalty. Most mutual funds are open-ended, and they come with no exit load. ELSS is the
most popular mutual funds plan which has a lock-in period of three years.
III. Low Cost
Investing in mutual funds comes at a low cost, and thereby making it suitable for small
investors. Fund houses or asset management companies (AMCs) levy a small amount
referred to as the expense ratio on investors to manage their investments. It generally
ranges between 0.5% to 1.5% of the total amount invested. The Securities and Exchange
Board of India (SEB) has mandated expense ratio to be under 2.5%.
IV. Systematic Investment Plan
The most significant advantage of investing in mutual funds is that you can spend a small
amount regularly via a systematic investment plan (SIP). The frequency of your SIP can
 be monthly, quarterly, or bi-annually, as per your comfort. Also, you can decide the ticket
size of your SIP. However, it cannot be less than the minimum investible amount. You
can initiate or terminate a SIP as and when you need.
V. Switch Fund Option
If you would like to move your investments to a different fund of the same fund house,
then you have an option to switch your investments to that fund from your existing fund.
A good investor knows when to enter and exit a particular fund. In case you see another
fund having the potential to outperform the market or your investment objective changes
and is in line with that of the new fund, then you can initiate the switch option.
VI. Goal-Based Funds
Individuals invest their hard-earned money with the view of meeting financial goals.
Mutual funds provide fund plans that help investors meet all their financial goals, be it
short-term or long-term. There are mutual fund schemes that suit every individual’s risk
profile, investment horizon, and style of investments. Therefore, investors need to assess
their profile carefully so that they pick the most suitable fund plan.
VII. Diversification
Unlike stocks, mutual funds invest in various assets and shares of several companies,
thereby providing the benefit of diversification. Also, this alleviates the risk of
concentration. If one asset class fails to perform up to the expectations, then the other
asset classes would make up for the losses. Therefore, investors need not worry about
market volatility as the diversified portfolio would provide some stability.
VIII. Flexibility
Mutual funds are buzzing these days because they provide the much-needed flexibility to
the investors. The combination of investing via a SIP and no lock-in period has made
mutual funds an even more lucrative investment option. Also, you can enter and exit a
mutual fund plan at any time, which may not be the case with most other investment
options. It is for this reason that millennials are preferring mutual funds.
IX. Liquidity
As most mutual funds do not have a lock-in period, it provides investors with high
liquidity. This makes it easier for the investor to fall back on their mutual fund investment
at times of financial crisis. The redemption requests are processed quickly, unlike other
investment options. On placing the redemption request, the fund house or the asset
management company would credit your money in just 3-7 days.
X. Seamless Process
Investing in mutual funds is a relatively simple process. Buying, selling of the fund units
are all made at the current net asset value (NAV)of the mutual fund plan. As the fund
manager and his or her team of experts and analysts are tasked with choosing shares and
assets, investors only need to invest, and the rest would be taken care of by the fund
manager.
 XI. Regulated
All mutual fund houses and mutual fund plans are always under the purview of the
Securities and Exchange Board of India (SEBI) and Reserve Bank of India(RBI). Apart
from that, the Association of Mutual Funds in India (AMFI), a self-regulatory body
formed by all fund houses in the country, also governs fund plans. Therefore, investors
need not worry about the safety of their mutual fund investments as they are safe.
XII. Ease of Tracking
One of the most significant advantages of investing in mutual funds is that tracking
investments are easy and straightforward. Fund houses understand that it is hard for
investors to take some time out of their busy schedules to track their finances, and hence,
they provide regular statements of their investments. This makes it a lot easier for them
to track their investments and make decisions accordingly.

12.9 Disadvantages of Mutual Funds

The downsides of mutual funds include:
• Investment risk: Stocks, bonds, and the mutual funds that invest in them all
involve some level of risk, which is the possibility of a decline in value, or, in a
worst-case scenario, the total loss of principal—your initial investment. Different
mutual funds come with different types of risk. For example, stock funds are riskier
in general than bond funds and come with a high degree of market risk in
particular, referring to the potential for wild upswings and downswings in stock
prices. Bond funds are perceived as riskier than money-market funds and often
come with credit risk, which is the risk that the companies that make up your fund
will default on their debts. Before you invest, determine your risk tolerance and
invest accordingly.
• Fees: From sales charges to management fees, a mutual fund can become an
expensive proposition if you're not careful about which one you buy. These fees can
eat into your investment returns, so look for funds with no sales charges or
transaction fees and an expense ratio (operational expenses divided by average net
assets) that's at or below the average (45% in 2019) to maximize your returns.7
• Less control: A mutual fund doesn't grant investors as much control over the
underlying securities they hold as they would if they were to buy securities
individually.
• Tax inefficiency: If you hold mutual funds in a taxable investment account such
as a brokerage account, you could be on the hook to pay taxes on investment
earnings (for example, dividends from an income fund). A simple way to overcome
this is to keep mutual funds in tax-advantaged accounts like IRA accounts.
12.10 Different types of Mutual Fund Schemes

The mutual fund industry in India is growing at an exponential pace. The Indian
mutual fund industry recorded an Average Assets Under Management (AAUM) of Rs.
23.16 trillion as on February 28, 2019. The AUM of the industry stood Rs. 5.09 trillion
on February 28, 2009, which means the Indian mutual fund industry has registered a
more than 4 ½ fold increase in a period of 10 years.
There are as many as 44 AMFI (Association of Mutual Funds in India) registered fund
houses in India which together offer more than 2,500 mutual fund schemes. The wide
array of funds often makes it a little difficult for investors to choose the best scheme
for them. These schemes cater to investors needs, financial position, risk tolerance and
return expectations. The mutual fund can be classified primarily on the basis of:

1. Based on Asset Class

a. Equity Funds
Equity funds primarily invest in stocks, and hence go by the name of stock funds as
well. They invest the money pooled in from various investors from diverse
backgrounds into shares/stocks of different companies. The gains and losses
associated with these funds depend solely on how the invested shares perform (price-
hikes or price-drops) in the stock market. Also, equity funds have the potential to
generate significant returns over a period. Hence, the risk associated with these funds
also tends to be comparatively higher.
b. Debt Funds
Debt funds invest primarily in fixed-income securities such as bonds, securities and
treasury bills. They invest in various fixed income instruments such as Fixed Maturity
Plans (FMPs), Gilt Funds, Liquid Funds, Short-Term Plans, Long-Term Bonds and
Monthly Income Plans, among others. Since the investments come with a fixed
interest rate and maturity date, it can be a great option for passive investors looking
for regular income (interest and capital appreciation) with minimal risks.
c. Money Market Funds
Investors trade stocks in the stock market. In the same way, investors also invest in
the money market, also known as capital market or cash market. The government runs
it in association with banks, financial institutions and other corporations by issuing
money market securities like bonds, T-bills, dated securities and certificates of
deposits, among others. The fund manager invests your money and disburses regular
dividends in return. Opting for a short-term plan (not more than 13 months) can lower
the risk of investment considerably on such funds.
d. Hybrid Funds
As the name suggests, hybrid funds (Balanced Funds) is an optimum mix of bonds and
stocks, thereby bridging the gap between equity funds and debt funds. The ratio can
either be variable or fixed. In short, it takes the best of two mutual funds by
distributing, say, 60% of assets in stocks and the rest in bonds or vice versa. Hybrid
funds are suitable for investors looking to take more risks for ‘debt plus returns’
benefit rather than sticking to lower but steady income schemes.
2. Based on Structure
Mutual funds are also categorised based on different attributes (like risk profile, asset
class, etc.). The structural classification – open-ended funds, close-ended funds, and
interval funds – is quite broad, and the differentiation primarily depends on the
flexibility to purchase and sell the individual mutual fund units.
a. Open-Ended Funds
Open-ended funds do not have any particular constraint such as a specific period or
the number of units which can be traded. These funds allow investors to trade funds
at their convenience and exit when required at the prevailing NAV (Net Asset Value).
This is the sole reason why the unit capital continually changes with new entries and
exits. An open-ended fund can also decide to stop taking in new investors if they do
not want to (or cannot manage significant funds).
b. Closed-Ended Funds
In closed-ended funds, the unit capital to invest is pre-defined. Meaning the fund
company cannot sell more than the pre-agreed number of units. Some funds also come
with a New Fund Offer (NFO) period; wherein there is a deadline to buy units. NFOs
comes with a pre-defined maturity tenure with fund managers open to any fund size.
Hence, SEBI has mandated that investors be given the option to either repurchase
option or list the funds on stock exchanges to exit the schemes.
c. Interval Funds
Interval funds have traits of both open-ended and closed-ended funds. These funds
are open for purchase or redemption only during specific intervals (decided by the
fund house) and closed the rest of the time. Also, no transactions will be permitted for
at least two years. These funds are suitable for investors looking to save a lump sum
amount for a short-term financial goal, say, in 3-12 months.
3. Based on Investment Goals
a. Growth Funds
Growth funds usually allocate a considerable portion in shares and growth sectors,
suitable for investors (mostly Millennials) who have a surplus of idle money to be
distributed in riskier plans (albeit with possibly high returns) or are positive about the
scheme.
b. Income Funds
Income funds belong to the family of debt mutual funds that distribute their money in
a mix of bonds, certificate of deposits and securities among others. Helmed by skilled
fund managers who keep the portfolio in tandem with the rate fluctuations without
compromising on the portfolio’s creditworthiness, income funds have historically
earned investors better returns than deposits. They are best suited for risk-averse
investors with a 2-3 years perspective.
c. Liquid Funds
Like income funds, liquid funds also belong to the debt fund category as they invest in
debt instruments and money market with a tenure of up to 91 days. The maximum
sum allowed to invest is Rs 10 lakh. A highlighting feature that differentiates liquid
funds from other debt funds is the way the Net Asset Value is calculated. The NAV of
liquid funds is calculated for 365 days (including Sundays) while for others, only
business days are considered.
d. Tax-Saving Funds
ELSS or Equity Linked Saving Scheme, over the years, have climbed up the ranks
among all categories of investors. Not only do they offer the benefit of wealth
maximisation while allowing you to save on taxes, but they also come with the lowest
lock-in period of only three years. Investing predominantly in equity (and related
products), they are known to generate non-taxed returns in the range 14-16%. These
funds are best-suited for salaried investors with a long-term investment horizon.
e. Aggressive Growth Funds
Slightly on the riskier side when choosing where to invest in, the Aggressive Growth
Fund is designed to make steep monetary gains. Though susceptible to market
volatility, one can decide on the fund as per the beta (the tool to gauge the fund’s
movement in comparison with the market). Example, if the market shows a beta of 1,
an aggressive growth fund will reflect a higher beta, say, 1.10 or above.
f. Capital Protection Funds
If protecting the principal is the priority, Capital Protection Funds serves the purpose
while earning relatively smaller returns (12% at best). The fund manager invests a
portion of the money in bonds or Certificates of Deposits and the rest towards equities.
Though the probability of incurring any loss is quite low, it is advised to stay invested
for at least three years (closed-ended) to safeguard your money, and also the returns
are taxable.
g. Fixed Maturity Funds
Many investors choose to invest towards the of the FY ends to take advantage of triple
indexation, thereby bringing down tax burden. If uncomfortable with the debt market
trends and related risks, Fixed Maturity Plans (FMP) – which invest in bonds,
securities, money market etc. – present a great opportunity. As a close-ended plan,
FMP functions on a fixed maturity period, which could range from one month to five
years (like FDs). The fund manager ensures that the money is allocated to an
investment with the same tenure, to reap accrual interest at the time of FMP maturity.
h. Pension Funds
Putting away a portion of your income in a chosen pension fund to accrue over a long
period to secure you and your family’s financial future after retiring from regular
employment can take care of most contingencies (like a medical emergency or
children’s wedding). Relying solely on savings to get through your golden years is not
recommended as savings (no matter how big) get used up. EPF is an example, but
there are many lucrative schemes offered by banks, insurance firms etc.
4. Based on Risk
a. Very Low-Risk Funds
Liquid funds and ultra-short-term funds (one month to one year) are known for its
low risk, and understandably their returns are also low (6% at best). Investors choose
this to fulfil their short-term financial goals and to keep their money safe through
these funds.
b. Low-Risk Funds
In the event of rupee depreciation or unexpected national crisis, investors are unsure
about investing in riskier funds. In such cases, fund managers recommend putting
money in either one or a combination of liquid, ultra short-term or arbitrage funds.
Returns could be 6-8%, but the investors are free to switch when valuations become
more stable.
c. Medium-risk Funds
Here, the risk factor is of medium level as the fund manager invests a portion in debt
and the rest in equity funds. The NAV is not that volatile, and the average returns could
be 9-12%.
d. High-Risk Funds
Suitable for investors with no risk aversion and aiming for huge returns in the form of
interest and dividends, high-risk mutual funds need active fund management. Regular
performance reviews are mandatory as they are susceptible to market volatility. You
can expect 15% returns, though most high-risk funds generally provide up to 20%
returns.
5. Specialized Mutual Funds
a. Sector Funds
Sector funds invest solely in one specific sector, theme-based mutual funds. As these
funds invest only in specific sectors with only a few stocks, the risk factor is on the
higher side. Investors are advised to keep track of the various sector-related
trends. Sector funds also deliver great returns. Some areas of banking, IT and pharma
have witnessed huge and consistent growth in the recent past and are predicted to be
promising in future as well.
b. Index Funds
Suited best for passive investors, index funds put money in an index. A fund manager
does not manage it. An index fund identifies stocks and their corresponding ratio in
the market index and put the money in similar proportion in similar stocks. Even if
they cannot outdo the market (which is the reason why they are not popular in India),
they play it safe by mimicking the index performance.
c. Funds of Funds
A diversified mutual fund investment portfolio offers a slew of benefits, and ‘Funds of
Funds’ also known as multi-manager mutual funds are made to exploit this to the tilt
– by putting their money in diverse fund categories. In short, buying one fund that
invests in many funds rather than investing in several achieves diversification while
keeping the cost down at the same time.
d. Emerging market Funds
To invest in developing markets is considered a risky bet, and it has undergone
negative returns too. India, in itself, is a dynamic and emerging market where
investors earn high returns from the domestic stock market. Like all markets, they are
also prone to market fluctuations. Also, from a longer-term perspective, emerging
economies are expected to contribute to the majority of global growth in the following
decades.
e. International/ Foreign Funds
Favoured by investors looking to spread their investment to other countries, foreign
mutual funds can get investors good returns even when the Indian Stock Markets
perform well. An investor can employ a hybrid approach (say, 60% in domestic
equities and the rest in overseas funds) or a feeder approach (getting local funds to
place them in foreign stocks) or a theme-based allocation (e.g., gold mining).
f. Global Funds
Aside from the same lexical meaning, global funds are quite different from
International Funds. While a global fund chiefly invests in markets worldwide, it also
includes investment in your home country. The International Funds concentrate
solely on foreign markets. Diverse and universal in approach, global funds can be quite
risky to owing to different policies, market and currency variations, though it does
work as a break against inflation and long-term returns have been historically high.
g. Real Estate Funds
Despite the real estate boom in India, many investors are still hesitant to invest in such
projects due to its multiple risks. Real estate fund can be a perfect alternative as the
investor will be an indirect participant by putting their money in established real
estate companies/trusts rather than projects. A long-term investment negates risks
and legal hassles when it comes to purchasing a property as well as provide liquidity
to some extent.
h. Commodity-focused Stock Funds
These funds are ideal for investors with sufficient risk-appetite and looking to diversify
their portfolio. Commodity-focused stock funds give a chance to dabble in multiple
and diverse trades. Returns, however, may not be periodic and are either based on the
performance of the stock company or the commodity itself. Gold is the only
commodity in which mutual funds can invest directly in India. The rest purchase fund
units or shares from commodity businesses.
i. Market Neutral Funds
For investors seeking protection from unfavorable market tendencies while sustaining
good returns, market-neutral funds meet the purpose (like a hedge fund). With better
risk-adaptability, these funds give high returns where even small investors can
outstrip the market without stretching the portfolio limits.
j. Inverse/Leveraged Funds
While a regular index fund moves in tandem with the benchmark index, the returns
of an inverse index fund shift in the opposite direction. It is nothing but selling your
shares when the stock goes down, only to repurchase them at an even lesser cost (to
hold until the price goes up again).
k. Asset Allocation Funds
Combining debt, equity and even gold in an optimum ratio, this is a greatly flexible
fund. Based on a pre-set formula or fund manager’s inferences based on the current
market trends, asset allocation funds can regulate the equity-debt distribution. It is
almost like hybrid funds but requires great expertise in choosing and allocation of the
bonds and stocks from the fund manager.
l. Gift Funds
Yes, you can also gift a mutual fund or a SIP to your loved ones to secure their financial
future.
m. Exchange-traded Funds
It belongs to the index funds family and is bought and sold on exchanges. Exchange-
traded Funds have unlocked a new world of investment prospects, enabling investors
to gain extensive exposure to stock markets abroad as well as specialised sectors. An
ETF is like a mutual fund that can be traded in real-time at a price that may rise or fall
many times in a day.

12.11 Role of Mutual Funds

Mutual funds perform different roles for the different constituents that participate in
it.
Their primary role is to assist investors in earning an income or building their
wealth, by participating in the opportunities available in various securities and
markets. It is possible for mutual funds to structure a scheme for different kinds of
investment objectives. Thus, the mutual fund structure, through its various schemes,
makes it possible to tap a large corpus of money from investors with diverse
goals/objectives.
Therefore, mutual funds offer different kinds of schemes to cater to the need of diverse
investors. In the industry, the words ‘fund’ and ‘scheme’ are used inter-changeably.
Various categories of schemes are called “funds”. In order to ensure consistency with
what is experienced in the market, this workbook goes by the industry practice.
However, wherever a difference is required to be drawn, the scheme offering entity is
referred to as “mutual fund” or “the fund”.
The money that is raised from investors, ultimately benefits governments,
companies and other entities, directly or indirectly, to raise money for investing in
various projects or paying for various expenses.
The projects that are facilitated through such financing, offer employment to people;
the income they earn helps the employees buy goods and services offered by other
companies, thus supporting projects of these goods and services companies. Thus,
overall economic development is promoted.
As a large investor, the mutual funds can keep a check on the operations of the investee
company, and their corporate governance and ethical standards.
The mutual fund industry itself, offers livelihood to a large number of employees of
mutual funds, distributors, registrars and various other service providers.
Higher employment, income and output in the economy boosts the revenue collection
of the government through taxes and other means. When these are spent prudently, it
promotes further economic development and nation building.
Mutual funds can also act as a market stabilizer, in countering large inflows or
outflows from foreign investors. Mutual funds are therefore viewed as a key
participant in the capital market of any economy.

12.12 Mutual Fund Risks

Risk arises in mutual funds owing to the reason that mutual funds invest in a variety
of financial instruments such as equities, debt, corporate bonds, government
securities and many more. The price of these instruments keeps fluctuating owing to
a lot of factors which may result in losses. Hence, it is essential to identify the risk
profile and invest in the most appropriate fund.

Due to price fluctuation or volatility, a person’s Net Asset Value comes down, resulting
in a loss. In simple terms, NAV is the market value of all the schemes a person has
invested in per unit after negating the liabilities.

Hence, it becomes essential to identify the risk profile and invest in the most
appropriate fund.

2. Types of risks associated with mutual funds

a. Market Risk
We all would have seen that one-liner in all advertisements that mutual funds are
subject to market risk.

Market risk is a risk which may result in losses for any investor due to the poor
performance of the market. There are a lot of factors that affect the market. A few
examples are a natural disaster, inflation, recession, political unrest, fluctuation of
interest rates, and so on. Market risk is also known as systematic risk. Diversifying a
person’s portfolio won’t help in these scenarios. The only thing that an investor can do
is to wait for the things to fall in place.
b. Concentration Risk
Concentration generally means focusing on just one thing. Concentrating a
considerable amount of a person’s investment in one particular scheme is never a good
option. Profits will be huge if lucky, but the losses will be pronounced at times. The
best way to minimise this risk is by diversifying your portfolio. Concentrating and
investing heavily in one sector is also risky. The more diverse the portfolio, the lesser
the risk is.

c. Interest Rate Risk

Interest rate changes depending on the credit available with lenders and the demand
from borrowers. They are inversely related to each other. Increase in the interest rates
during the investment period may result in a reduction of the price of securities.
For example, an individual decides to invest Rs.100 with a rate of 5% for a period of x
years. If the interest rate changes for some reason and it becomes 6%, the individual
will no longer be able to get back the Rs.100 he invested because the rate is fixed. The
only option here is reducing the market value of the bond. If the interest rate reduces
to 4% on the other hand, the investor can sell it at a price above the invested amount.

d. Liquidity Risk
Liquidity risk refers to the difficulty to redeem an investment without incurring a loss
in the value of the instrument. It can also occur when a seller is unable to find a buyer
for the security.

In mutual funds, like ELSS, the lock-in period may result in liquidity risk. Nothing can
be done during the lock-in period. In yet another case, exchange-traded funds (ETFs)
might suffer from liquidity risk. As you may know, ETFs can be bought and sold on
the stock exchanges like shares.

Sometimes due to lack of buyers in the market, you might be unable to redeem your
investments when you need them the most. The best way to avoid this is to have a very
diverse portfolio and to select the fund diligently.

e. Credit Risk
Credit risk means that the issuer of the scheme is unable to pay what was promised as
interest. Usually, agencies which handle investments are rated by rating agencies on
these criteria. So, a person will always see that a firm with a high rating will pay less
and vice-versa.
Mutual Funds, particularly debt funds, also suffer from credit risk. In debt funds, the
fund manager has to incorporate only investment-grade securities. But sometimes it
might happen that to earn higher returns, the fund manager may include lower credit-
rated securities.
This would increase the credit risk of the portfolio. Before investing in a debt fund,
have a look at the credit ratings of the portfolio composition.