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CHAPTER - 1 CONCEPT & ROLE OF A MUTUAL FUND

CONTENT OUTLINE AND OBJECTIVES

Basic Mutual Fund Concepts

§ Define a mutual fund as a pool of investor funds
§ Explain investment objectives as the basis for differentiating and
choosing a fund
§ Explain the concept of marking to market as a feature of mutual
funds
§ Define and distinguish the terms unit capital, assets under
management and net asset value
§ List the advantages and limitations of a mutual fund

Mutual Fund Products

§ Compare and contrast closed-end funds, open-ended funds and
interval funds
§ Explain the features and types of liquid and debt funds
§ Explain the features and types of equity funds
§ Explain the features and types of hybrid funds
§ Explain the features of international funds, exchange traded funds,
fund of funds and arbitrage funds
§ Differentiate various fund types in terms of their investment
objective, risk and investing horizon

History and Role of Mutual Funds in India

§ Explain in brief the growth and status of the mutual fund industry
in India.

Marks weightage: 6 marks

Basic mutual fund conceps

Pool of Money
A mutual fund is a collective investment vehicle. It is a pool of investors’
money invested according to pre-specified investment [Link]
benefits from the investment of the pooled money accrue to those that
contribute to the pool. There is thus mutuality in the contribution and
the benefit. Hence the name ‘mutual’ fund.

When a mutual fund pools money from several investors, each investor
does not contribute the same sum of money. Therefore each investor’s
share in the fund is not equal. The benefits from the fund accrue to all
investors in proportion to their share in the pool.
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Example
§ Three investors invest Rs 10,000, Rs 20,000 and Rs 30,000 respectively in a mutual fund.
So the pooled sum is Rs 60,000.
§ The money is invested and gains Rs 12,000 over time. This means, the pool is now worth
Rs 72,000.
§ The value of the investors’ holding in the mutual fund also goes up proportionately (in the
ratio of [Link]) to Rs 12,000, Rs 24,000 and Rs 36,000 respectively.

Profits or losses in a mutual fund belong to the investors, in proportion

to their share in the pool of money.

Investment Objective
Mutual funds create a range of products, called as mutual fund schemes, to cater to varying
needs and preferences of investors. The term ‘fund’ may be used to denote the mutual fund
itself, or any of its schemes. Mutual fund products also use terms like plan or option, to
differentiate their product features. We will learn more about these aspects in a later chapter.
Usually a mutual fund product is first described by its investment objective. Investors choose
mutual funds based on the match of the fund to their own objectives. Fund managers invest in
securities such as equity and debt, according to the stated investment objective of the fund.

A mutual fund is a pool of investors’ money, invested in a portfolio of

securities as per the stated investment objective.

Example
§ HDFC Income Fund is a debt fund that invests pre-dominantly in debt instruments, with the
objective of generating regular income for its investors.
§ DSP Blackrock Top 100 Equity Fund is a fund that seeks to generate capital appreciation
from a portfolio of equity shares chosen primarily from the 100 largest listed equity
shares.

The risk and return of the fund also depends on its investment objectives.

Mutual Fund Units

The investment in a mutual fund is represented to the investor in units. Just as investors in
equity jointly hold shares of a company, mutual fund investors jointly hold units of the fund.
A mutual fund investor is called a unit holder just as an investor in equity shares is called a
share holder.

The ownership of the fund is jointly held by all the unit holders. Each unit
has a face value, typically Rs 10 per unit.
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Equity shares are offered to investors for the first time in an IPO (Initial public offering). Mutual
funds are offered for the first time to investors in an NFO (New fund offer). Subsequently equity
shares are bought and sold on the stock exchange. Mutual fund units can usually be bought
and sold through the fund itself. Funds enable continuous transactions at their offices and at
investor service centers.

Some mutual funds are listed and can be bought and sold on the stock exchange. When an
investor transacts with a mutual fund, units are allotted for purchase transactions, and units
are redeemed for redemption transactions.

Unit capital is also called the corpus of the fund. It is calculated as the
number of units in a fund multiplied by the face value per unit.

Investors can contribute into a fund or redeem and take away their contributions, depending
on the nature of the fund. In a closed-end fund, investors tend to stay until maturity. If a fund
is open-ended, investors can come in and move out at any time. The unit capital of an open-
ended mutual fund scheme thus changes depending on the type of fund and the nature of
investor transactions.

Investment Portfolio
A portfolio is a collection of securities. These securities can be equity shares, bonds, debentures,
deposits, money market instruments, derivatives and the like. Mutual funds can invest only
in marketable securities, or securities that can be traded in a market and therefore have a
market price.

The value of the investment portfolio of a mutual fund changes every time there is a change in
market price of the securities it holds.

The process of using market price to value an investment portfolio is

known as ‘marking to market’.

The value of the investment portfolio of a fund changes in value dynamically. Gains or losses
in values of the securities held in the portfolio, but not realised through a sale, are called
unrealised gains or unrealised losses.

Net Assets
Total assets of a mutual fund refer to the market value of the securities held in the portfolio.
A mutual fund does not hold any other long-term asset in its balance sheet. There may be few
receivables and accrued income, which are current assets. These are added to the portfolio
value to get the total assets under management (AUM) of the fund.

On the liability side, a mutual fund does not have long-term liabilities. The assets are fully
funded by the unit capital contributed by the investors. Mutual funds are not permitted to
borrow funds to invest them in their portfolio. Liabilities of a fund are expenses associated with
138 | Understanding Mutual Funds

State True or False:

1- True, 2- False, 3- False, 4- True, 5- False, 6- False, 7- True, 8- False, 9- True, 10- True,
11- True, 12- True, 13- True, 14- True, 15- True.

Chapter 2

Fill in the Blanks

1. Mutual funds in India are structured as _______.
2. The custodian of a mutual fund is appointed by ________.
3. The AMC of a mutual fund must have a minimum capital of _______.
4. A sponsor or its subsidiary cannot be a ________ of a mutual fund.
5. The document which lays down the rights and obligations of the AMC is called _______.
6. The responsibility of the trustees towards the investors is laid down in___________.
7. At least _________ of the members of the board of an AMC must be independent.
8. The board of trustees of a mutual fund must meet at least _________times in a year.
9. The trustees execute the investment management agreement with the ___________ .
10. The settlement of securities transactions is done by _____________.
11. Collection of funds in an IPO is done by____________
12. The auditors of a mutual fund cannot be auditors of ________
13. Mutual fund schemes are managed by AMCs under the supervision of __________.
14. The sponsors of a mutual fund invest in the capital of _________
15. All constituents except custodians are appointed by ________ with the approval of
___________.

State True or False

1. The AMC of a mutual fund can be dismissed by a majority of the trustees.
2. The AMC of a mutual fund cannot be dismissed by the unit holders.
3. The auditors of the schemes of a mutual fund and that of the AMC are usually the same
entity.
4. The trustees of a mutual manage the money invested by unit holders.
5. The functions of an R&T agent can be done in-house by the AMC.
6. Custodian holds the fund’s securities and investment bank accounts.
7. The sponsor must contribute at least 40% of the trust’s assets
8. An AMC can invest in its own schemes provided it discloses the same in the offer
document.
9. To empanel as a distributor one has to complete the KYD process.
10. Fund accountants and auditors do not need Sebi registration.
11. KYC completed with KRAs is valid across Sebi-registered entities.
12. KYC has to be completed for each mutual fund separately
13. To be a mutual fund distributor one has to obtain an ARN.
14. Distributors are appointed by AMFI.
15. AMC investment in their own schemes will not get them any fees.