Introduction

Mutual fund industry and structure

Let’s begin with the mutual fund industry in India. Today, in March 2010, the Indian mutual fund
industry has 40 players. The number of public sector players has reduced from 11 to 5. The public sector
has gradually receded into the background, passing on a large chunk of market share to private sector
players.

The Association of Mutual Funds in India (AMFI) is the industry body set up to facilitate the growth

of the Indian mutual fund industry. It plays a pro-active role in identifying steps that need to be

taken to protect investors and promote the mutual fund sector. It is noteworthy that AMFI is not a

Self-Regulatory Organisation (SRO) and its recommendations are not binding on the industry

participants. By its very nature, AMFI has an advisor’s or a counsellor’s role in the mutual fund

industry. Its recommendations become mandatory if and only if the Securities and Exchange Board

of India (SEBI) incorporates them into the regulatory framework it stipulates for mutual funds.

The Indian mutual fund industry follows a 3-tier structure as shown below:

Let’s understand what each of these terms means and their roles in the mutual fund industry:

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Sponsors

They are the individuals who think of starting a mutual fund. The Sponsor approaches SEBI, the

market regulator and also the regulator for mutual funds. Not everyone can start a mutual fund.

SEBI will grant a permission to start a mutual fund only to a person of integrity, with significant

experience in the financial sector and a certain minimum net worth. These are just some of the

factors that come into play.

Trust

Once SEBI is satisfied with the credentials and eligibility of the proposed Sponsors, the Sponsors

then establish a Trust under the Indian Trust Act 1882. Trusts have no legal identity in India and

thus cannot enter into contracts. Hence the Trustees are the individuals authorized to act on

behalf of the Trust. Contracts are entered into in the name of the Trustees. Once the Trust is

created, it is registered with SEBI, after which point, this Trust is known as the mutual fund.

Asset Management Company (AMC)

The Trustees appoint the AMC, which is established as a legal entity, to manage the investor’s

(unit holder’s) money. In return for this money management on behalf of the mutual fund, the

AMC is paid a fee for the services provided. This fee is to be borne by the investors and is

deducted from the money collected from them.

The AMC has to be approved by SEBI and it functions under the supervision of its Board of Directors,

and also under the direction of the Trustees and the regulatory framework established by SEBI. It is

the AMC, which in the name of the Trust, that floats new schemes and manages these schemes by

buying and selling securities.

So broadly, so far, we have the Sponsors, the Trust and the AMC.

Apart from these parties, we also have the following:

1. Custodian

The Custodian maintains the custody of the securities in which the scheme invests. It also keeps

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a tab on corporate actions such as rights, bonus and dividends declared by the companies in

which the fund has invested. The Custodian is appointed by the Board of Trustees. The

Custodian also participates in a clearing and settlement system through approved depository

companies on behalf of mutual funds, in case of dematerialized securities.

2. Transfer Agents

Registrar and Transfer Agents (RTAs) maintain the investor’s (unit holder’s) records, reducing the

burden on the AMCs.

A comprehensive structure of a mutual fund appears as depicted in the chart below:

So in the diagram, we see the Sponsor, the Trustees, the AMC, the Mutual Fund, its Transfer Agent

and Custodian, and last but not least, the Unit Holders. All of these industry participants function

within the regulations laid down by the SEBI.

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What is a mutual fund?
A mutual fund is a legal vehicle that enables a collective group of individuals to:

i. Pool their surplus funds and collectively invest in instruments / assets for a common investment

objective.

ii. Optimize the knowledge and experience of a fund manager, a capacity that individually they may

not have

iii. Benefit from the economies of scale which size enables and is not available on an individual

basis.

Investing in a mutual fund is like an investment made by a collective. An individual as a single

investor is likely to have lesser amount of money at disposal than say, a group of friends put

together.

Now, let’s assume that this group of individuals is a novice in investing and so the group turns over

the pooled funds to an expert to make their money work for them. This is what a professional Asset

Management Company does for mutual funds. The AMC invests the investors’ money on their

behalf into various assets towards a common investment objective.

Hence, technically speaking, a mutual fund is an investment vehicle which pools investors’ money

and invests the same for and on behalf of investors, into stocks, bonds, money market instruments

and other assets. The money is received by the AMC with a promise that it will be invested in a

particular manner by a professional manager (commonly known as fund managers). The fund

managers are expected to honour this promise. The SEBI and the Board of Trustees ensure that this

actually happens.

The organisation that manages the investments is the Asset Management Company (AMC). The

AMC employs various employees in different roles who are responsible for servicing and managing

investments.

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Types of Mutual Fund
The AMC offers various products (schemes/funds), which are structured in a manner to benefit and

suit the requirement of investors’. Every scheme has a portfolio statement, revenue account and

balance sheet.

The chart below shows the typical classification of mutual fund schemes on various basis:

 Tenor
Tenor refers to the ‘time’. Mutual funds can be classified on the basis of time as under;

1. Open ended funds

These funds are available for subscription throughout the year. These funds do not have a fixed

maturity. Investors have the flexibility to buy or sell any part of their investment at any time, at

the prevailing price (Net Asset Value - NAV) at that time.

2. Close Ended funds

These funds begin with a fixed corpus and operate for a fixed duration. These funds are open for

subscription only during a specified period. When the period terminates, investors can redeem

their units at the prevailing NAV.

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 Asset classes
1. Equity funds

These funds invest in shares. These funds may invest money in growth stocks, momentum

stocks, value stocks or income stocks depending on the investment objective of the fund.

2. Debt funds or Income funds

These funds invest money in bonds and money market instruments. These funds may invest into

long-term and/or short-term maturity bonds.

3. Hybrid funds

These funds invest in a mix of both equity and debt. In order to retain their equity status for tax

purposes, they generally invest at least 65% of their assets in equities and roughly 35% in debt

instruments, failing which they will be classified as debt oriented schemes and be taxed

accordingly. (Please see our Tax Section on Page 39 for more information.) Monthly Income

Plans (MIPs) fall within the category of hybrid funds. MIPs invest up to 25% into equities and the

balance into debt.

4. Real asset funds

These funds invest in physical assets such as gold, platinum, silver, oil, commodities and real

estate. Gold Exchange Traded Funds (ETFs) and Real Estate Investment Trusts (REITs) fall within

the category of real asset funds.

 Investment Philosophy
1. Diversified Equity Funds

These funds diversify the equity component of their Asset Under Management (AUM), across

various sectors. Such funds avoid taking sectoral bets i.e. investing more of their assets towards

a particular sector such as oil & gas, construction, metals etc. Thus, they use the diversification

strategy to reduce their overall portfolio risk.

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2. Sector Funds

These funds are expected to invest predominantly in a specific sector. For instance, a banking

fund will invest only in banking stocks. Generally, such funds invest 65% of their total assets in a

respective sector.

3. Index Funds

These funds seek to have a position which replicates the index, say BSE Sensex or NSE Nifty.

They maintain an investment portfolio that replicates the composition of the chosen index, thus

following a passive style of investing.

4. Exchange Traded Funds (ETFs)

These funds are open-ended funds which are traded on the exchange (BSE / NSE). These funds

are benchmarked against the stock exchange index. For example, funds traded on the NSE are

benchmarked against the Nifty. The Benchmark Nifty BeES is an example of an ETF which links to

the stocks in the Nifty. Unlike an index fund where the units are traded at the day’s NAV, in ETFs

(since they are traded on the exchange) the price keeps on changing during the trading hours of

the exchange. If you as an investor want to buy or sell ETF units, you can do so by placing orders

with your broker, who will in-turn offer a two-way real time quote at all times. The AMC does

not offer sale and re-purchase for the units. Today, ETFs are available for pre-specified indices.

We also have Gold ETFs. Silver ETFs are not yet available.

5. Fund of Funds (FOF)

These funds invest their money in other funds of the same mutual fund house or other mutual

fund houses. They are not allowed to invest in any other FOF and they are not entitled to invest

their assets other than in mutual fund schemes/funds, except to such an extent where the fund

requires liquidity to meet its redemption requirements, as disclosed in the offer document of

the FOF scheme.

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6. Fixed Maturity Plan (FMP)

These funds are basically income/debt schemes like Bonds, Debentures and Money market

instruments. They give a fixed return over a period of time. FMPs are similar to close ended

schemes which are open only for a fixed period of time during the initial offer. However, unlike

closed ended schemes where your money is locked for a particular period, FMPs give you an

option to exit. Remember though, that this is subject to an exit load as per the funds regulations.

FMPs, if listed on the exchange, provide you with an opportunity to liquidate by selling your

units at the prevailing price on the exchange. FMPs are launched in the form of series, having

different maturity profiles. The maturity period varies from 3 months to one year.

 Geographic Regions
1. Country or Region Funds

These funds invest in securities (equity and/or debt) of a specific country or region with an

underlying belief that the chosen country or region is expected to deliver superior performance,

which in turn will be favourable for the securities of that country. The returns on country fund

are affected not only by the performance of the market where they are invested, but also by

changes in the currency exchange rates.

2. Offshore Funds

These funds mobilise money from investors for the purpose of investment within as well as

outside their home country.

So we have seen that funds can be categorised based on tenor, investment philosophy, asset

class, or geographic region. Now, let’s get down to simplifying some jargon with the help of a

few definitions, before getting into understanding the nitty-gritty of investing in mutual funds.

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DEFINITIONS
 Net Asset Value (NAV)
NAV is the sum total of all the assets of the mutual fund (at market price) less the liabilities (fund

manager fees, audit fees, registration fees among others); divide this by the number of units and

you arrive at the NAV per unit of the mutual fund.

Simply put, this is the price at which you can buy / sell units in a mutual fund.

 Standard Deviation (SD)

SD is the measure of risk taken by, or volatility borne by, the mutual fund. Mathematically

speaking, SD tells us how much the values have deviated from the mean (average) of the values.

SD measures by how much the investor could diverge from the average return either upwards or

downwards. It highlights the element of risk associated with the fund. The SD is calculated by

using returns of the scheme i.e. Net Asset Value (NAV).

 Sharpe Ratio (SR)

SR is a measure developed to calculate risk-adjusted returns. It measures how much return you

can expect over and above a certain risk-free rate (for example, the bank deposit rate), for every

unit of risk (i.e. Standard Deviation) of the scheme. Statistically, the Sharpe Ratio is the

difference between the annualised return (Ri) and the risk-free return (Rf) divided by the

Standard Deviation (SD) during the specified period. Sharpe Ratio = (Ri-Rf)/SD. Higher the

magnitude of the Sharpe Ratio, higher is the performance rating of the scheme.

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 Compounded Annual Growth Rate (CAGR)
It means the year-over-year growth rate of an investment over a specified period of time.

Mathematically it is calculated as under:

 Absolute Returns
These are the simple returns, i.e. the returns that an asset achieves, from the day of its purchase

to the day of its sale, regardless of how much time has elapsed in between. This measure looks

at the appreciation or depreciation that an asset - usually a stock or a mutual fund - achieves

over the given period of time. Mathematically it is calculated as under:

Generally returns for a period less than 1 year are expressed in an absolute form.

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Why should we invest in mutual funds?
While everyone fantasizes about investing in the stock markets and is passionate about investing in

stocks, what’s more important is; how smartly are these investments done. One can invest in the stock

markets either through the direct route i.e. stocks or through the indirect route i.e. mutual funds.

Both have their own pros and cons, and so it’s important for us to understand both routes before

embarking on an investment spree.

If an investor has a profound insight into stocks and investments with the requisite time and skill to

analyze companies, then he can surely begin independent stock-picking. However, if an investor

lacks any one or all these pre-requisites, then he’s better off investing in stocks through the indirect

route i.e. through mutual funds. Mutual funds offer several important advantages over direct stock-

picking.

1. Diversification

Investing in stocks directly has one serious drawback - lack of diversification. By putting your

money into just a few stocks, you can subject yourself to considerable risk. Decline in a single

stock can have an adverse impact on your investments, damaging the returns of your portfolio.

A mutual fund, by investing in several stocks, tries to overcome the risk of investing in just 3-4

stocks. By holding say, 15 stocks, the fund avoids the danger of one rotten apple spoiling the

whole portfolio. Funds own anywhere from a couple of dozen to more than a hundred stocks. A

diversified portfolio may thus fall to a lesser extent, even if a few stocks fall dramatically. Also, a

mutual fund’s NAV may certainly drop, but mutual funds tend to not fall as freely or as easily as

stocks. The legal structure and stringent regulations that bind a mutual fund do a very good job

of safeguarding investor interest.

2. Professional management

Active portfolio management requires not only sound investment sense, but also considerable

time and skill.

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By investing in a mutual fund, you as an investor do not have to track the prospects and

potential of the companies in the mutual fund portfolio. This is already being done for you, by

skilled research professionals appointed by the mutual fund houses, professionals whose job it is

to continuously research and monitor these companies.

3. Lower entry level

There are very few quality stocks today that investors can buy with Rs. 5,000 in hand. This is

especially true when valuations are expensive. Sometimes, with as much as Rs 5,000 you can buy

just a single stock.

In the case of mutual funds, the minimum investment amount requirement is as low as Rs. 500.

This is especially encouraging for investors who start small and at the same time take exposure

to the fund’s portfolio of 20-30 stocks.

4. Economies of scale

By buying a handful of stocks, the stock investors lose out on economies of scale. This directly

impacts the profitability of portfolio. If investors buy or sell actively, the impact on profitability

would be that much higher.

On the other hand, in case of mutual funds, frequent voluminous purchases/sales results in

proportionately lower trading costs than individuals thus translating into significantly better

investment performance.

5. Innovative plans/services for investors

By investing in the stock market directly, investors deprive themselves of various innovative

plans offered by fund houses.

For example, mutual funds offer automatic re-investment plans, systematic investment plans

(SIPs), systematic withdrawal plans (SWPs), asset allocation plans, triggers etc., tools that enable

you to efficiently manage your portfolio from a financial planning perspective too.

These features allow you to enter/exit funds, or switch from one fund to another, seamlessly -

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something that will probably never be possible in case of stocks.

6. Liquidity

A stock investor may not always find the liquidity in a stock to the extent they may want.

There could be days when the stock is hitting an upper/lower circuit, thus curtailing

buying/selling. Further, if an investor is invested in a penny stock, he may find it difficult to get

out of it.

On the other hand, mutual funds offer some much required liquidity while investing. In case of

an open-ended fund, you can buy/sell at that day's NAV by simply approaching the fund house

directly, or by approaching your mutual fund distributor or even by transacting online.

As highlighted above, investing in mutual funds has some unique benefits that may not be

available to stock investors. However by no means are we insinuating that mutual fund investing

is the only way of clocking growth. This can also be done even by investing directly into the right

stocks. However, mutual funds offer the investor a relatively safer and surer way of picking

growth minus the hassle and stress that has become synonymous with stocks over the years.

On account of the aforementioned advantages which mutual funds offer, they (mutual funds)

have emerged as immensely popular asset class, especially for retail investor, and for the

investor looking for growth with lower risks.

We can consider placing the tax snippet here as an advantage and bring in DTC mention as a

potential advantage lost.

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Debunking MF investing myths
Very often, we see that mutual fund investors are surrounded by myths based on widely held, yet

incorrect beliefs and also based on flawed information. Both these kinds of myths can consequently lead

investors to make incorrect investment decisions. We’d like to take this opportunity to debunk some

common mutual fund myths:

Myths based on Incorrect Beliefs

When asked why the avid investor of stocks/shares does not take to mutual funds with the same

passion and enthusiasm, the likely response is that mutual funds investments are dull and boring.

They lack the thrill that one gets by investing in stocks. Bringing us to Myth # 1:

1. Mutual funds lack excitement

“Who wants to invest in a staid investment like a mutual fund that probably grows half as fast

as some ‘exciting’ stocks like Infosys, ONGC or BHEL during a bull run? The poser is relevant.

Underperformance almost always gets the thumbs down, no matter what the reason. After all,

every investor wants his money to work for him and if a stock does that better, why invest in a

mutual fund?”

Yes, stocks can be exciting. And mutual funds may lack the excitement of a stock, but it’s the kind

of excitement that investors can do without for their long-term wealth as well as health. Mutual

funds may not give an impetus to the investor’s portfolio in a bull run like some ‘exciting’ stocks.

But, you can be sure that they won’t burn a huge crater in the investor’s portfolio either.

Something that could be inevitable, should individual stocks be crashing by say 40%.

2. Mutual funds are too diversified

“Mutual funds own too many stocks to be of any serious benefit. A focused portfolio of 8-10

stocks will generate a more attractive return than a mutual fund portfolio comprising 30-40

stocks.”

We are not sure if there is any theory to prove or disprove that concentrated portfolios (8-10

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stocks) do better than diversified portfolios (30-40 stocks) in the Indian context. Of course, Mr.

Warren Buffet has successfully managed a small portfolio over a long period of time. But, not too

many investors can claim to have his investment discipline, insight and experience. In the absence

of these important traits, it would be incorrect to expect a concentrated portfolio to outperform

a diversified portfolio, at least over the long-term (3-5 years).

Remember, fund managers are experienced money managers and their mandate is to

outperform the benchmark index of the fund. And if these experienced managers have chosen

the diversification route, that tells us a little about how to go about making money in the stock

markets.

3. Mutual funds are too expensive

“Mutual funds aren’t cheap. On an average, the recurring expenses for a diversified equity fund

ranges from 2.25% to 2.50% of net assets.”

The 2.50% (maximum) recurring expenses charged by the mutual fund go towards meeting the

brokerage costs, custodial costs and fund management cost. These are expenses that stock

investors incur as well (barring the fund manager’s salary). Consider this, when you have a

competent fund manager who combines his time, effort and expertise to research stocks and

sectors to pick his best 30-40 stocks and also buys and sells them for you, you have someone who

is doing a lot of work for you and is charging only a maximum of 2.50% of your investments. Of

course we agree that this must be followed by sheer out performance of the benchmark index

and even peers. You don’t want to pay for underperformance.

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The good news is that quite a few diversified equity funds have managed to put in what can be

termed as ‘a very good performance’ over 3-5 years vis-à-vis the benchmark index and peers.

Which are these funds, you ask?

TOP 10 DIVERSIFIED EQUITY FUNDS

In sum, we’d like to say that investing your money is serious business, which is best done with a

methodical approach. Mutual funds allow for that, and investors must try to benefit from them.

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Myths based on Incorrect Facts
1. Equity funds invest up to 35% in debt

Equity funds are commonly known to take on the investment mandate (mentioned in the fund scheme

offer document) to invest up to 35% of their assets in debt and money market instruments. This in turn,

leads investors to believe that the fund manager intends to use asset allocation as a strategy for

delivering growth i.e. investors expect the fund to capitalise on opportunities from both the equity and

debt markets. However in reality, most equity funds rarely use the mandate to invest in debt. In other

words, the intention is to be a ‘true blue’ equity fund that is almost entirely invested in equity

instruments at all times.

2. Funds with more stars/higher rankings make better buys

Often, investors make their investment decisions based on the fund’s ranking or the number of

stars allotted to it. Fund rankings and ratings have gained popularity over the years; a higher

ranking/rating is construed as a sign of the fund being a good investment avenue.

Sadly, what investors fail to realise is that often rankings/ratings are based only on the past

performance on the net asset value (NAV) appreciation front. Very few rankings/ratings in the

market consider factors such as volatility and risk-adjusted performance. So the fund’s NAV

might have grown over the years, but with a very high risk factor.

3. Once a fund house makes the grade, so do all its funds

“One swallow does not a summer make” goes the proverb. Similarly, just because a fund house

makes the grade, it doesn’t necessarily mean that all its funds are worth investing in. Typically,

for a fund house to make the grade, it should be governed by a process-driven investment

approach. Also, it must have a track record of delivering and safeguarding investors’ interests at

all times.

Investors often make the mistake of confusing the fund for its fund house i.e. they assume that

simply because a fund belongs to a given fund house, it’s worth investing in. Such an investment

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approach is far from correct. It is not uncommon to find funds (from quality fund houses) that

have either lost focus on account of persistent change in positioning or have fallen out of favour

with the fund house itself, on account of their lacklustre investment themes.

4. A fund invests in the same stocks as its benchmark index

A number of investors believe that a mutual fund always invests in the same stocks that

constitute its benchmark index. For example, if the BSE Sensex is the benchmark index for a

fund, then it is expected to invest in the same 30 stocks that form the BSE Sensex. This is true

only in the case of index funds i.e. passively-managed funds that attempt to mirror the

performance of a chosen index. In all other cases, i.e. in actively managed funds, the fund

manager is free to invest in stocks from within the index and without.

The benchmark index only serves the stated purpose i.e. benchmarking. It offers investors the

opportunity to evaluate the fund’s performance. Generally, a fund’s success is measured in its

ability to outperform its benchmark index. Secondly, the benchmark index also aids in 'broadly'

understanding the kind of investments the fund will make. For example, a fund benchmarked

with BSE Sensex or BSE 100 would typically be a large cap-oriented fund, while one

benchmarked with S&P CNX Midcap is likely to be a mid cap-oriented fund.

5. The dividend option is better

While investing in a mutual fund, investors can choose between the growth and the dividend

options; furthermore, within the dividend option, they can select either the dividend payout

(wherein the dividend is paid to the investor) or the dividend reinvestment (wherein the

dividend is used to buy further units in the fund, thereby increasing the number of units held by

the investor) options. But, our experience says that investors usually opt in for the dividend

payout option.

A common misconception is that opting for the dividend option is better, since it provides better

returns on account of dividends declared. This is so because investors feel that they fetch better

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dividend adjusted returns, as compared to the returns in the growth option.

But is this true? Given below is a table which explains that if an investor invests Rs 10,000 in the

HDFC Top 200 Fund on Feb 16, 2000 in the dividend and the growth option each, at an NAV of Rs

27.29 & Rs 25.65 respectively, and stays invested for a period of 10 years; his returns on his

investments would be only 16.0% under the dividend option and 20.9% under the growth

option.

This thus indicates that opting for a dividend option does not always give better returns, when

compared to growth option. It also noteworthy that the rate of dividend declared by the fund house is

calculated on the face value of the units. For example when a 25% dividend is declared by the fund, it

means the investor will get Rs. 2.50 [Rs 10 (F.V.) x 25%] per unit.

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Net Asset Value
Invest in the mutual fund, not its NAV

NFOs (New Fund Offers) launched at an issue price of Rs 10 are perceived to be a good investment

opportunity by a large section of mutual fund investors. Similarly, existing mutual funds with a lower

NAV (Net Asset Value) often appeal more to investors. We believe that that neither of the

approaches to selecting a mutual fund is right. In this note, we revisit our views on investing based

on the NAV.

Mathematically NAV is expressed as:

An illustration should help to understand better how the NAV is calculated:

So, when an investor invests in a mutual fund, he invests at its existing NAV. The investor buys the

units at a price (i.e. NAV), the calculation of which is based on the current market price of all the

assets that the mutual fund owns. In other words, the NAV represents the fund’s intrinsic worth.
www.Personal FN.com 30

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In case of the stock market investing however, the stock price of a company is usually different from

its intrinsic worth, or what is called the book value of the share. The stock price could be higher

(premium) or lower (discount) as compared to the book value of the company. A relatively lower

share price would, other things being positive, make it an attractive purchase (as the share seems

undervalued).

The reason for such a ‘mis-pricing’ could be that investors evaluate the company’s future

profitability and suitably pay a higher or lower price as compared to its book value. This does not

hold true for open-ended mutual funds – they always, always, trade at their book value; so investors

never buy them cheap or expensive in that sense.

The following illustration will clearly establish the irrelevance of NAV while making an investment

decision.

HDFC Equity Fund, with an NAV of Rs 221.56 (third highest NAV in our sample) has topped on the 1-

Yr return front, by clocking a return of 111.7%. On the other hand, Reliance Growth Fund which

tops on the NAV front (Rs 418.89) has clocked a return of 106.9%.

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Systematic Investment Plan
Very often, investors tend to time the market. You know it’s true. We all want to buy at the lows

and sell at the highs. And yes, ideally one should enter the market when it is at lower levels and exit

when it is at higher levels.

But, to do so is almost impossible. No one can predict where the markets are heading tomorrow.

Nonetheless, when individuals get news or tips from brokers/friends/relatives or such other

‘informed’ sources, investments are made.

Tips and news can be the resort for the short-term investor. But, for serious investors, who are

investing for a longer duration (3-5 years) for a broader financial planning objective (like planning

for your child’s education, retirement planning), a “tip” is not the way to go.

Additionally, and unfortunately, many long-term investors before investing in equity funds wait for

the markets to decline in order to invest at lower levels.

We believe that you should invest regularly for the purpose of meeting your long-term investment

objectives. An effective and a hassle-free way of investing regularly is through the SIP (Systematic

Investment Plan) route.

With SIPs, you don’t have to worry about timing the market since you are investing a fixed amount

at regular intervals (like a month or quarter, for instance). If markets correct, the option to invest

any surplus funds to get a lower average cost is always available.

4 good reasons for investing regularly through SIPs:

1. Light on the wallet

Given that the average annual per capita income of an Indian citizen is approximately only Rs.

25,000 (i.e. monthly income of Rs 2,083), a Rs 5,000 one-time entry in a mutual fund may still

appear high (2.4 times the monthly income!). So, if an investor cannot invest Rs 5,000 in one shot, that’s

not a huge stumbling block, the investor can simply take the SIP route and trigger the mutual

fund investment with as low as Rs 250 per month.

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2. Makes market timing irrelevant

If market lows give you the jitters and make you wish you had never invested in equity, then SIPs

can help. Plenty of retail investors are not experts on stocks and are even more out-of-sorts with

stock market oscillations.

3. Power of compounding

The early bird gets the worm is not just jungle folklore. The same stands true for the ‘early’

investor, who gets the lion’s share of the investment booty vis-à-vis the investor who comes in

later (see table below). This is mainly due to a thumb rule of finance called ‘compounding’.

So as we see, Vijay starts at age 25, and invests Rs. 7,000 per month until retirement (age 60).

His corpus at retirement is approximately Rs. 2.65 crore. Ajay starts at age 30, a mere 5 years

after Vijay, and invests the same amount until retirement (also at age 60). His corpus comes to

approximately Rs. 1.58 crore, note the difference between the 2 corpuses here.

And lastly, we have Sanjay, the latest bloomer of the lot. He begins investing at age 35, the same

amount monthly as Vijay and Ajay, and invests up to his retirement (also at age 60). His corpus

is, in comparison, a meagre Rs. 92 lakhs.

So the earlier you begin your SIPs, the better off you are thanks to compounding.

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4. Lowers the average cost

SIPs work better as opposed to one-time investing. This is because of rupee-cost averaging.

Under rupee-cost averaging, an investor typically buys more of a mutual fund unit when prices

are low.

On the other hand, he will buy fewer mutual fund units when prices are high. This is a good

discipline since it forces the investor to commit cash at market lows, when other investors

around him are wary and exiting the market. Investors who kept their SIPs going while the

Sensex fell from 21,000 to 8,000 in 2008 and sitting on some significant profits now, because

they kept up their investing discipline.

The above table explains the absolute returns generated by SIPs in the respective time frame.

For investment in some large cap funds, SIPs on an average have delivered absolute returns of

53.2%, 35.0% and 20.2% over 1-yr, 2-yr and 3-yr periods.

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Taxation on your mutual fund investments
One key point to keep in mind when investing, is how that investment is going to be taxed. Given

below are the facts you need to know regarding taxation of mutual funds:

Equity Funds
 As an investor if you have opted for the dividend option, for the reason that you want cash

inflows to be managed through dividends, then the dividends which you received under the

scheme is completely exempt from tax under section 10(35) of the Income Tax Act, 1961.

 If you are caught in the wrong habit of short-term (period of less than 12 months) trading, then

you better be ready to forgo your profits/capital gains, if any, in the form of Short Term Capital

Gains (STCG) tax. STCG are subject to taxation @ 15% plus a 3% education cess.

 If an investor deploys his money for long-term (over a period of 12 months) and thus subscribe

to a good habit of long-term investing, then there is no tax liability towards any Long Term

Capital Gain (LTCG)

 If an investor deploys his money in an Equity Linked Saving Scheme (ELSS), then he enjoys a tax

deduction under section 80C of the Income Tax Act, which enables him to reduce his Gross

Total Income (GTI). However, this benefit can be availed by investors upto a maximum sum of Rs

1,00,000. Also at the time of exiting (after 3 years of lock-in) from the fund the investor will not

be liable to any LTCG tax

 Investors will also have to bear a Securities Transaction Tax (STT) @ 0. 25%; this is levied at the

time of redemption of mutual fund units.

Debt Funds
 Similarly, in a debt funds too, if investors have opted for the dividend option, to manage your

cash inflows, then the dividend which the scheme declares will be subject to an additional tax on

income distributed. Hence, in such a case investors are actually paying the tax indirectly.

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 Unlike equity funds, in debt funds, investors are liable to pay a tax on their Long Term Capital

Gains (LTCG), which is 10% without the benefit of indexation and 20% with the benefit of

indexation.

 Similarly, in case of Short Term Capital Gains (STCG), the individual assesses will be taxed at the

rate, in accordance to the tax slabs

Unlike in case of equity mutual funds, investors will not have pay any Securities Transaction Tax

(STT)

So now that we know what to watch out for and the basic Do’s and Don’ts, we come to how to

actually select a winning mutual fund.

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How to select a mutual fund?
The increased number of New Fund Offerings (NFOs) lately has led also to an increased dilemma in the

mind of investors. Investors often get confused when it comes to selecting the right fund from the

plethora of funds available. Many investors also feel that 'any' mutual fund can help them achieve their

desired goals. But the fact is, not all mutual funds are same. There are various aspects within a fund

that an investor must carefully consider before short-listing it for making investments. These aspects

which were briefly covered in the Path to Knowledge section, are given in a little more detail below:

 Performance
The past performance of a fund is important in analysing a mutual fund. But, as learnt earlier past

performance is not everything. It just indicates the fund’s ability to clock returns across market

conditions. And, if the fund has a well-established track record, the likelihood of it performing well

in the future is higher than a fund which has not performed well.

Under the performance criteria, we must make a note of the following:

1. Comparisons: A fund’s performance in isolation does not indicate anything. Hence, it becomes

crucial to compare the fund with its benchmark index and its peers, so as to deduce a

meaningful inference. Again, one must be careful while selecting the peers for comparison. For

instance, it doesn’t make sense comparing the performance of a mid-cap fund to that of a large-

cap. Remember: Don’t compare apples with oranges.

2. Time period: It’s very important that investors have a long term (atleast 3-5 years) horizon if

they wish to invest in equity oriented funds. So, it becomes important for them to evaluate the

long term performance of the funds. However this does not imply that the short term

performance should be ignored. Besides, it is equally important to evaluate how a fund has performed

over different market cycles (especially during the downturn). During a rally it is easy

for a fund to deliver above-average returns; but the true measure of its performance is when it

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posts higher returns than its benchmark and peers during the downturn. Remember: Choose a

fund like you choose a spouse – one that will stand by you in sickness and in health.

3. Returns: Returns are obviously one of the important parameters that one must look at while

evaluating a fund. But remember, although it is one of the most important, it is not the only

parameter. Many investors simply invest in a fund because it has given higher returns. In our

opinion, such an approach for making investments is incomplete. In addition to the returns,

investors must also look at the risk parameters, which explain how much risk the fund has taken

to clock higher returns.

4. Risk: We have seen in our Definitions section and on our Path to Knowledge, that risk is normally

measured by Standard Deviation (SD). SD signifies the degree of risk the fund has exposed its

investors to. From an investor’s perspective, evaluating a fund on risk parameters is important

because it will help to check whether the fund’s risk profile is in line with their risk profile or not.

For example, if two funds have delivered similar returns, then a prudent investor will invest in

the fund which has taken less risk i.e. the fund that has a lower SD.

5. Risk-adjusted return: This is normally measured by Sharpe Ratio. It signifies how much return a

fund has delivered vis-à-vis the risk taken. Higher the Sharpe Ratio, better is the fund’s

performance. From an investor’s perspective, it is important because they should choose a fund

which has delivered higher risk-adjusted returns. In fact, this ratio tells us whether the high

returns of a fund are attributed to good investment decisions, or to higher risk.

6. Portfolio Concentration: Funds that have a high concentration in particular stocks or sectors

tend to be very risky and volatile. Hence, investors should invest in these funds only if they have

a high risk appetite. Ideally, a well diversified fund should hold no more than 40% of its assets in its top

10 stock holdings. Remember: Make sure your fund does not put all its eggs in one basket.

7. Portfolio Turnover: The portfolio turnover rate measures the frequency with which stocks are

bought and sold. Higher the turnover rate, higher the volatility. The fund might not be able to

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compensate the investors adequately for the higher risk taken. Remember: Invest in funds with

a low turnover rate if you want lower volatility.

 Fund Management
The performance of a mutual fund scheme is largely linked to the fund manager and his team.

Hence, it’s important that the team managing the fund should have considerable experience in

dealing with market ups and downs. As mentioned earlier, investors should avoid fund’s that owe

their performance to a ‘star’ fund manager. Simply because if the fund manager is present today, he

might quit tomorrow, and hence the fund will be unable to deliver its ‘star’ performance without its

‘star’ fund manager. Therefore, the focus should be on the fund houses that are strong in their

systems and processes. Remember: Fund houses should be process-driven and not 'star' fund-

manager driven.

 Costs
If two funds are similar in most contexts, it might not be worth buying the high cost fund if it is only

marginally better than the other. Simply put, there is no reason for an AMC to incur higher costs,

other than its desire to have higher margins.

The two main costs incurred are:

1. Expense Ratio: Annual expenses involved in running the mutual fund include administrative

costs, management salary, overheads etc. Expense Ratio is the percentage of assets that go

towards these expenses. Every time the fund manager churns his portfolio, he pays a brokerage

fee, which is ultimately borne by investors in the form of an Expense Ratio. Remember: Higher

churning not only leads to higher risk, but also higher cost to the investor.

2. Exit Load: Due to SEBI’s recent ban on entry loads, investors now have only exit loads to worry

about. An exit load is charged to investors when they sell units of a mutual fund within a

particular tenure; most funds charge if the units are sold within a year from date of purchase. As

exit load is a fraction of the NAV, it eats into your investment value. Remember: Invest in a fund

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with a low expense ratio and stay invested in it for a longer duration.

Among the factors listed above, while few can be easily gauged by investors, there are others on

which information is not widely available in public domain. This makes analysis of a fund difficult for

investors and this is where the importance of a mutual fund advisor comes into play.

10 pointers to investing in mutual funds

1. A fund sponsor with integrity
2. An experienced fund manager
3. A suitable investment philosophy
4. The correct fund by nature
5. The correct fund category
6. Fees and charges
7. The load
8. The tax implications
9. Investor service and transparency
10. Fund performance

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So how does one invest in mutual funds?
Mutual funds as an investment product were traditionally sold by mutual fund distributors for

commission (which is embedded in the entry load) which was received by them from the mutual fund

houses. However, after the abolition of entry load in August 2009, many distributors have stopped

selling mutual funds on account of a lack of incentive.

SEBI has recently proposed the fee based model to be adopted by mutual fund distributors. Under this

model, a distributor would be paid directly by his clients for the advice provided by him and/or the

service. This model is now incorporated, with the intention of making distributors more responsible and

accountable.

Investors can transact in mutual funds either through:

 Their mutual fund distributor

 Directly by approaching the AMC

 Through an online mutual fund trading platform

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Are you protected as a mutual fund investor?
Yes, a mutual fund investor’s interest is very much protected by SEBI. SEBI, the market regulator

under the SEBI (Mutual Fund Regulation) Act, 1996 carefully dictates the guidelines for mutual funds

in India. For an organisation to start a mutual fund business, requires the approval of SEBI. Thus

there is quality and credibility check on everyone who enters the mutual fund business.

Some of the Rights and Obligations of investors are:

 In case of dividend declaration, investors have a right to receive the dividend within 30 days of

declaration. In case the investor fails to claim the redemption proceeds immediately, then the

applicable NAV depends upon when the investor claims the redemption proceeds.

 On redemption request by investors, the AMC must dispatch the redemption proceeds within 10

working days of the request. In case the AMC fails to do so, it has to pay an interest @ 15%. This

rate may change from time to time subject to regulations.

 Investors can obtain relevant information from the trustees and inspect documents like trust

deed, investment management agreement, annual reports, offer documents, etc. They must

receive audited annual reports within 6 months from the financial year end.

 Investors can wind up a scheme or even terminate the AMC if unit holders representing 75% of

scheme’s assets pass a resolution to that respect.

 Investors have a right to be informed about changes in the fundamental attributes of a scheme.

Fundamental attributes include type of scheme, investment objectives and policies and terms of

issue.

 Lastly, investors can approach the investor relations officer for grievance redressal. In case the

investor does not get an appropriate solution, he can approach the investor grievance cell of

SEBI. The investor can also sue the trustees

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In the year 2009 SEBI brought in some sweeping reforms in the mutual fund industry, which we

believe are pro-investor. Some of the reforms were:

 SEBI ordered mutual funds not to disclose the indicative portfolio or indicative yield of their

newly launched Fixed Maturity Plans (FMPs), since this was pro-actively used as a tool to miss-

sell the product to the investors

 Abolition of entry load – making mutual fund investing cost effective. However, the mutual fund

houses felt a contrarian impact of this ruling, primarily due to the abolition of the commission

oriented sales culture. Many distributors too abandoned the selling of mutual funds and started

focusing on distribution of insurance products or other fixed deposit products which earned

them a higher commission for every sale.

 SEBI also stepped in to provide mutual fund investors transparency, by making distributors

disclose commissions (upfront and trail) to the investor. This enabled investors to judge the

quality of advice and the service provided by the distributor, and accordingly pay the distributor

for the advice and service rendered.

 Online mutual fund trading platform was launched by the exchanges (BSE and NSE), making

transacting in mutual funds easy and convenient for distributors.

 SEBI allowed mutual fund investors to change their mutual fund distributors without obtaining

a No Objection Certificate (NOC) from their earlier distributor, thus facilitating investors to shift

their distributor without any hassle.

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Conclusion
The year 2010, we believe, would continue to bring in reforms in the mutual fund industry, making

every initiative pro-investor. Also, many new players are likely to enter the mutual fund space, thus

leading to an increase in the product offering to mutual fund investors. The potential for growth will

come from inherent strengths and sustained interest by foreign and domestic funds as well as the

common investor.

However, the challenges will come from maintaining the interest of the all the participants in the

market. Increasing Assets Under Management (AUM) will also be a major challenge, since there is

no incentive for the distributors to promote mutual funds. Also after April 1, 2011, when the Direct

Tax Code (DTC), come into effect, mutual fund companies and investors would be very watchful on

the tax implications of various mutual funds.

But we believe that the overall long term economic outlook for India seems bullish and therefore;

investors should consider mutual fund investing for wealth creation.

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Bibliography
1. Mutual Fund Guidance 2010

2. NCFM Mutual Fund Module

3. Mutual Fund Advisory Services- Personal Finance

4. www. Sebi.gov.in.

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