Mutual Fund

Definition
A mutual fund is a trust that pools together the resources of like-minded investors for
investment in capital market. By investing in the units of the mutual fund, the investor
becomes a part owner of the assets of the mutual fund.

Fund Players
SPONSOR COMPANY
Establishes a MUTUAL fund as a
Trust MF is Registered with SEBI

Mutual Managed by Board of Holds unit holder’s funds in

Fund Trustees (BOT) MF and ensures compliance
with SEBI Regulations

Board of Asset Management Manages the funds as per SEBI

Trustees Company (AMC) Guidelines, and as per AMC
agreement

Provides necessary
Appoint Custodian
Custodial
Board of Services
Trustees
Appoint Transfer
Agents, Register Provides Register services and Act
as Transfer Agents

Advantages of Mutual Fund

1) Professional Management
2) Diversification
3) Economies of Scale
4) Liquidity
5) Options aplenty
6) Easily available
Disadvantages of Mutual Fund
1) No guarantee of return
2) Loads of cost
3) Selection of right funds
4) Unethical practices

The World of Mutual Funds

Mutual fund schemes are close to 400 in number in India, as of 31 Aug 2003. It would be
necessary to classify them. The following are three different types of classification. Each
classification is mutually exclusive. A popular fund can be classified under each one of
the following classifications:

• Functional classification
• Portfolio classification
• Ownership classification

A. Functional classification

Under this classification, funds are split into:

• Open-ended funds
• Close-ended funds

Open-ended funds (OEF): In an OEF, an investor can join the scheme at any time and
exit out of the scheme also at any time. Consequently, the capital of the fund is unlimited
and the redemption period is indefinite.

Close-ended funds (CEF): In a CEF, an investor can buy into the scheme only during
the Initial Public Offering or from the stock market after the units have been listed. The
scheme has a limited life at the end of which the corpus is liquidated. The investor can
exit the scheme only:

• By selling in the stock market or

• During repurchase period at his choice or
• At the termination of the scheme

B. Portfolio classification

Based on the composition of portfolio, funds can be classified into:

 • Equity funds
• Debt funds
• Special funds

(i) Equity funds: Equity funds invest primarily in equity stocks. The following are types
of equity funds: -

Growth funds: Growth funds seek to provide long-term capital appreciation to the
investor. They are best suited for long term investors.

Aggressive funds: While growth funds look for reasonable returns, aggressive funds
look for extra-ordinary returns. They achieve this by investing in start-ups, IPOs and in
speculative shares they are best suited for those who are willing to take a risk.

Income funds: Income funds seek to maximize the present income of investors they
invest in safe stocks, which pay high cash dividends, and in high yield money market
instruments. These are best suited for those who seek current income.

Balanced funds: Balanced funds are a cross between growth funds and income funds.
Balanced funds buy shares for growth and bonds for income. This is good for investors
who want to strike the golden mean.

Fund of Funds
In simple terms, the fund of funds involves investors putting money into a mutual fund
and the mutual fund in turn invests its assets in other mutual fund schemes rather than
buying shares, debentures or other assets of its own.

In a normal fund (say, equity fund), one can get a good feel about the portfolio, or
change in the composition of portfolio of assets. Monitoring the portfolio in a fund of
funds is a different ball game altogether.

(ii) Debt funds

Bond funds: Bond funds or debt funds invest exclusively in fixed income securities like
government bonds, corporate debenture, convertible debentures, money market etc.
Investors who are looking for safe, steady income can buy into government bond funds or
high-grade corporate bonds. Investors seeking tax-free income can buy government bond
funds.

Gilt funds: A predominant portion of money is invested in Government securities, by

Gilt funds.

(iii) Special funds

Index funds: Every stock market has a stock index which in intended to measure the
upward and downward sentiment of the stock market. Two important indices in India are
the Sensex and Nifty. Index funds, simply mimic, the stock market. Index funds are low
cost funds. Whatever the market delivers-good, bad or ugly- that is, what you will
receive.

International funds: A mutual fund located in India might raise money in India to
invest abroad. Raise money locally to invest globally is their credo.

Offshore funds: A mutually fund located in India might raise money abroad to invest in
India. Raise money globally to invest locally is their credo.

Sector funds: A sector fund invests its entire money in a particular industry. Thus, a
Pharma fund, invests only in pharmaceutical industry and a Tech fund, invests only in
technology companies. A utility fund, invests in the utility industry like power, natural
gas and telephone companies.

C. Ownership classification
Based on who the principal sponsor is, mutual funds can be classified into:

• Public sector mutual funds

• Private sector mutual funds
• Foreign mutual funds

Public sector mutual funds: Growth HDFC Growth fund

These are sponsored by a
Aggressive Franklin Internet Opportunities
Company belonging to the
Public sector. Income Templeton India Income Builder
Balanced Prudential India Child Care plan
Private sector mutual funds: Bond DSP Merry Lynch Bond fund
When a fund is sponsored by a
Company belonging to the private Index Birla Index fund
Sector, we refer to it as a private Sector Alliance Buy India fund
Sector fund. Open ended Reliance Income
Close ended Reliance Fixed Term
Foreign mutual funds: Public Sector SBI Mutual
These are funds, which are Private Sector Sundaram Mutual
Sponsored by foreign
Companies. These funds Foreign Morgan Stanley Mutual
Raise money in India, operate
From India and invest in India.

Computing Returns

Investors derive three types of income from owning mutual fund units:

Cash dividend
Capital gains disbursements
Changes in the fund’s NAV per unit (a k a unrealized gains)
For an investor who holds a mutual fund for one year, the one-year holding period return
is

Returns
D1+CG1+(NAV1-NAV0) *100 Formula 2
= NAV0 Dividend + Realized
Capital gains+

Unrealized capital gains

Returns= Base net asset value

Risk:

Risk refers to the variability of the return.

Risk can be computed either as total risk or as non-diversifiable risk.
Total risk is measured with the help of standard deviation.
Non-diversifiable risk is measured with the help of beta.

Model 1:

Developed by William Sharpe, this model measures reward (the risk premium) earned
per unit of total risk. Risk premium, is the return in excess of the risk free rate of return.
Since risk, under Sharpe model is total risk, it is computed as the standard deviation of
rates of return.

Formula 3
(Rp-Rf)/SD
Rp=Return on portfolio
Rf=Risk free rate
SD=Standard deviation
Of portfolio
Steps: The steps involved in arriving at the Sharpe index are:

Step 1: Compute return

Step 2: Compute risk
Step 3: Apply formula (denominator is standard deviation)

Interpretation of Result: The higher the Sharpe ratio, the better is the performance.
Advantage: Measures the volatility of the portfolio returns without directly lining it to a
benchmark.

Disadvantage: It considers total risk whereas the diversifiable portion of the total risk is
irrelevant since it can be eliminated through diversification. The only relevant risk is non-
diversifiable risk.

Model 2: Treynor Model

Developed by Jack Treynor, this model measures the reward (risk premium earned) per
unit of non-diversifiable risk. Risk, under the Treynor model, means only non-
diversifiable and is hence the beta of the rates of return.

Steps: The steps involved in arriving at the Treynor index are: Formula 4
(Rp-Rf)
Step 1: Compute return Beta
Step 2: Compute risk
Step 3: Apply formula (denominator is Beta)

Interpretation of Result: Higher the Treynor ratio, the better is the performance.

Advantage: Measures the volatility in terms of non-diversifiable risk, which is the only
relevant risk.

Disadvantage: Beta values are a function of the past and this approach is beset with
limitations.

Model 3: Jensen Model

Both the Sharpe and Treynor models were ratios. They do not give us any indication of
the excess return earned by the portfolio.

The Jensen’s and measure developed by Jensen deals with the return in excess of that
which is mandated by the capita asset-pricing model. We know that under CAPM the
expected return is Rf+Beta (Rm-Rf). If the actual return received is greater than the
CAPM return, it means that the fund has given a return, which is in excess of the return
that it should earn. Jensen’s measure is also known as Alpha.

Steps: The steps involved in arriving at the Jensen index are:

Step 1: Compute return on portfolio

Step 2: Compute return as per CAPM
Step 3: Apply formula
Interpretation of Result: Higher the Jensen measure, the better is the performance. If the
Alpha is positive, the fund is undervalued. If negative, the fund is overvalued.

Advantage: By linking to CAPM, Jensen offers a measure of excess return, which is

useful in assessing whether a Mutual Fund is undervalued or overvalued.

Disadvantage: Jensen’s Alpha holds good only across a reasonable time frame, say 1
year.

Selection of a Mutual Fund

1.Investment Objective
2.Past Performance
3.Equity Research
4.Global Linkages
5.Transparency in fund accounting
6.Investor services.