CHAPTER

1110

MUTUAL FUNDS

LEARNING OUTCOMES
After going through the chapter student shall be able to understand
 Basics of Mutual Funds- Including its concepts and benefits etc.
 Evolution of the Indian Mutual Fund Industry
 Types of Mutual Funds
(1) Structural Classification (2) Portfolio Classification
 Evaluating performance of Mutual Funds
(1) Net Asset Value (NAV) (2) Costs incurred by Mutual Fund
(3) Holding Period Return (HPR)
 The criteria for evaluating the performance
(1) Sharpe Ratio (2) Treynor Ratio
(3) Jensen’s Alpha (4) Sortino Ratio
 Advantages and Disadvantages of Mutual Fund
 Factors influencing the selection of Mutual Funds
 Signals highlighting the exit of the investor from the Mutual Fund Scheme
 Money Market Mutual Funds (MMMFS)
 Exchange Traded Funds
 Side Pocketing
 Tracking Error
 Real Estate Investment Trusts (ReITs)
 Infrastructure Investment Trusts (InvITs)

©The Institute of Chartered Accountants of India

 10.2 FINANCIAL SERVICES AND CAPITAL MARKETS

CHAPTER OVERVIEW

Mutual Funds
Basics of Mutual
Funds

Meaning Evolution Organization

Sponsor

Trustee

Asset Management
Company

Types of Mutual Funds

On the basis of
Based on On the basis of
On the basis of clasification of
Investment Investment
Structure portfolio
objective Portfolio
Management

Open Close
Active Equity
Ended Ended

Passive Debt

Hybrid

Solution Oriented &

other Funds

Multi Asset Funds

Arbitrage Funds

©The Institute of Chartered Accountants of India

 MUTUAL FUNDS 10.3

Explanation of Importants Terms

Net Assets Value (NAV) and Indicative NAV

Performance Measurement

Jenson
Cost Point to Rolling Sharp & Alpha & Alpha &
Incurred Point Return Return Treynor ratio Sortino Benchmarking
Ratio

Advantages and Disadvantages

Factors Influencing the Selection of Mutual Funds

Signals Highlighting the Exit of the Investor from the Mutual Fund Scheme

Money Market Mutual Funds

Separation of Distribution and Advisory Functions in the MF Industry

Exchange Traded Funds

Side Pocketing

Tracking Error

Real Estate Investment Trusts (REITs) & Infrastructure Investment Trusts (INVITs)

©The Institute of Chartered Accountants of India

 10.4 FINANCIAL SERVICES AND CAPITAL MARKETS

1. MEANING
A Mutual Fund is a pool of funds from a diverse cross section of society, that imparts the benefits of
scale and professional management to the investors, which otherwise would not have been available
to them. The rationale for any pooling of service is two-fold: affordability and convenience. Office
commuters can go to the office by own vehicle or taxicab, which is the synonym for do-it-yourself in
the context of investments. The other way of doing the office commute is by public transport like bus
or train, which essentially is the pooling concept, bringing transport within the reach of those people
who cannot afford their own vehicle. The synonym here is the Mutual Fund. To be noted, it is not
just affordability due to which people may take to public transport; there could be reasons like saving
the hassles of maintaining and driving own vehicle. The other benefit in the mutual fund context is
professional management and tracking of investments.

The diagram above illustrates that a mutual fund is a common pool of investments of a cross section
of investors. To understand the concept better, please look at the following diagram:

©The Institute of Chartered Accountants of India

 MUTUAL FUNDS 10.5

A Mutual Fund is a pool of investment funds of several investors who have a common investment
objective. The asset management company that manages the day-to-day running of the fund invests
the money collected in securities like stocks, bonds etc. The investors, called unit holders as they
hold units in the pool proportionate to their investment, earn from the appreciation in the investments
and dividend / coupon received in the fund. Thus, a Mutual Fund is the most suitable investment for
the common man as well as HNIs since it offers an opportunity to invest in a diversified,
professionally managed basket of securities at a relatively low cost.

2. EVOLUTION
2.1 History of Mutual Funds (Global)
A mutual fund, as the term suggests, is a pooling of resources of many investors and is managed
by professionals. The concept of pooling money for investments has been there for a long time. It
began in the Netherlands in the 18th century; today it is a growing, international industry with fund
holdings accounting for trillions of dollars in the United States alone. The closed-end investment
companies launched in the Netherlands in 1822 by King William I is supposedly the first mutual
funds. Another theory says a Dutch merchant named Adriaan van Ketwich whose investment trust
created in 1774 may have given the king the idea. The concept spread to Great Britain and France,
and then to the United States in the 1890s.

©The Institute of Chartered Accountants of India

 10.6 FINANCIAL SERVICES AND CAPITAL MARKETS

2.2 Expansion
By the late 1920s, there were quite a few mutual funds in the USA. With the stock market crash of
1929, some funds were wiped out, particularly the leveraged ones. The creation of the Securities
and Exchange Commission (SEC), and the Securities Act of 1933 put certain safeguards for investor
protection.

Despite the global financial crisis of 2008-2009, the story of the mutual fund is far from over. In fact,
the industry is still growing. In the U.S. alone there are more than 10,000 mutual funds and fund
holdings are measured in the trillions of dollars.

2.3 History of Mutual Funds in India

The evolution of the mutual fund industry in India has been relatively more ‘administered’ i.e., there
have been quite a few administrative interventions. The history, as delineated by Association of
Mutual Funds of India (AMFI), is as follows:

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:

2.3.1 First Phase – 1964-87

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 ` 6,700 crore of assets under
management.

2.3.2 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

©The Institute of Chartered Accountants of India

 MUTUAL FUNDS 10.7

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 `47,004 crore.

2.3.3 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 the industry has witnessed several mergers and acquisitions. As at the end of
January 2003, there were 33 mutual funds with total assets of ` 1,21,805 crore. The Unit Trust of
India with `44,541 crore of assets under management was way ahead of other mutual funds.

2.3.4 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 ` 29,835 crore 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 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 `76,000 crore 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.
Growth in terms of quantum of funds managed.

©The Institute of Chartered Accountants of India

 10.8 FINANCIAL SERVICES AND CAPITAL MARKETS

[Source: Website of Association of Mutual Funds (AMFI)]

2.4 Mutual Fund Organization

©The Institute of Chartered Accountants of India

 MUTUAL FUNDS 10.9

There are various entities involved in the overall structure. They are explained as below:

Sponsor
Sponsor is the entity that creates a mutual fund. The rules are set by the Securities and Exchange
Board of India, in the Mutual Fund Regulations of 1996. Sponsor is defined under the SEBI
regulations as any person who, acting alone or in combination with another body corporate,
establishes a mutual fund. Sponsor is the promoter of the fund. A Sponsor could be a bank, a
corporate or a financial institution. Sponsors then form a Trust and appoint a Board of Trustees. The
sponsor also appoints Custodian.
As per SEBI regulations, a sponsor must contribute at least 40% of the net worth of the Asset
Management Committee (AMC) and possess a sound financial track record over five years prior to
registration. Sponsor signs the trust deed with the trustees. Sponsor creates the AMC and the trustee
company and appoints the board of directors of companies, with SEBI approval. Sponsor should
have at least a 5-year track record in the financial services business and should have made a profit
in at least 3 out of the 5 years. The AMC’s capital is contributed by the sponsor. Sponsor should
contribute at least 40% of the capital of the AMC.
Trust
The Mutual Fund is a trust under the Indian Trusts Act, 1882. The trust deed is registered under the
Indian Registration Act, 1908. The Trust oversees the safekeeping of the unit holders’ investments.
Trustee
The Board of Trustees i.e., the body of individuals, looks after safeguarding the interest of the unit
holders. At least 2/3rd of the Trustees is independent i.e. not associated with the Sponsor. A mutual
fund in India is form as Trust under Indian Trust Act, 1882. The trust-mf is managed by the Board of
Trustees. The Board of Directors i.e. Trustees do not manage the portfolio of securities directly
rather they supervise the work of AMC (Asset Management Company) and ensure that the fund is
managed by stated objectives and as per SEBI regulations.
Trusts always work for the interest of unit holders, and it is created through a document called Trust
Deed that is executed by sponsors in favor of Trustees. The Trustees being the primary guardians
of unit holder’s funds and assets, they must ensure that the investor’s interests are safeguarded and
that the AMC operations are as per regulation laid down by SEBI. SEBI mandates a minimum of
2/3rd independent directors on the board of the trustee company. Trustees are appointed by the
sponsor with SEBI approval. The trustees make sure that the funds are managed according to the
investor’s mandate.

©The Institute of Chartered Accountants of India

 10.10 FINANCIAL SERVICES AND CAPITAL MARKETS

Asset Management Company (AMC)

The AMC is that part of the mutual fund system that looks after the operations and investments of
the MF. Formation of the AMC requires approval by SEBI. The AMC needs to have a net worth of `
50 crore. The role of AMC is to act as investment manager of trust. The AMC (as appointed by
trust/sponsor) requires approval by SEBI.

The AMC is under the supervision of its own board of directors and the directors of trustees and
SEBI. The trustees are empowered to terminate the appointment of AMC and appoint a new AMC
with prior approval of SEBI and unit holders. The AMC, in the name of the Trust, manages different
investment schemes as per the investment management agreement with the trustees. A Director of
AMC should have complete professional experience in finance.
The AMC cannot act as a trustee of any other MF. The AMC always acts in the interest of unit
holders (investor). The AMC gets a fee for managing the funds, according to the mandate of the
investors. At least ½ of the AMC’s Board should be of independent members. An AMC cannot
engage in any business other than portfolio advisory and management. An AMC of one fund cannot
be Trustee of another fund. AMC should be registered with SEBI. Also, AMC signs an investment
management agreement with the trustees.

3. TYPES OF MUTUAL FUNDS

There are various types of mutual funds, classified primarily based on the underlying portfolio.

3.1 On the basis of Structure

3.1.1 Open Ended Funds
It is a commonly used term in the mutual fund industry; let us understand the term for the investor.
Most of the funds (or Schemes, technically) are open ended, ones that are available for purchase
from the AMC and redemption with the AMC on an on-going basis, round the year on all working
days, till it is wound up.
What it means for the investor is, there is liquidity round the year - can be purchased anytime and
can be sold (redeemed, technically) anytime i.e. the investor can enter and exit anytime. AMC issues
new units when investor enters/purchase units form AMC and redeem/sells the units back to AMC.
Listed open-ended funds can be sold at the Exchange as well, but in case of redemption with the
AMC, liquidity is assured. There is no additional cost for this liquidity as AMCs do not charge any
premium for redemption.

©The Institute of Chartered Accountants of India

 MUTUAL FUNDS 10.11

Sometimes there is an exit load in an open-ended fund. It means if the investor exits within that
period, there will be a penalty charged on the exit value, but liquidity is available nonetheless at the
cost of the exit load. It is a matter of discipline so that the investor comes in with the requisite horizon
in mind and if she exits within that period, she pays adequate compensation to the other investors
who are staying back.
The implications of open-ended funds for the AMC are fund (or Scheme) corpus size volatility; fund
size increases when investors purchase units from the AMC and fund size comes down when
investors redeem units.

An open-ended fund comes into existence through the New Fund Offer (NFO) process and the Fund
(or Scheme) parameters are decided by the NFO documents - Scheme Information Document (SID)
and Key Information Memorandum (KIM). There is another document called Scheme Additional
Information (SAI).
There is no defined maturity date for open-ended funds. If there is a single investor- the Scheme
continues to be in existence. There are limitations on maximum holding by a single investor: it is
referred to commonly as the 20/25 rule i.e., there must be a minimum 20 investors to float a Scheme
and maximum permissible holding per investor is 25%.

3.1.2 Close Ended Funds

Close ended funds are available for subscription only during the New Fund Offer (NFO) period and
not beyond that. The initial subscription amount is collected from investors and the fund is ‘closed’
after the NFO closure date i.e., no further purchase is allowed. There is no redemption possible with
the AMC. Hence from the AMC’s perspective, the fund (or Scheme) corpus size is stable and there
is no need to keep some portion in liquid or easily marketable securities to meet sudden redemption
pressure.
Close ended funds may have a defined maturity date e.g., fixed maturity plans (FMPs) that have a
maturity date. In an open-ended structure, it is practically not feasible to have a maturity date as it
is meant to be available for investment and redemption on an on-going basis. Closed ended funds
are listed at the Exchange but are not as liquid as open-ended funds as there is no defined liquidity
like redemption with the AMC.

Broadly, open-ended funds are much more popular than closed ended as the mutual fund industry
is supposed to provide investment solutions along with liquidity that is available at any point of time.
Close Ended Funds are meant to fulfil a particular requirement.

©The Institute of Chartered Accountants of India

 10.12 FINANCIAL SERVICES AND CAPITAL MARKETS

Difference between Open Ended Funds and Close Ended Funds

Particulars Open-Ended Mutual Funds Close-ended Mutual Funds

Lock-In Period Such funds have no lock-in Close-ended mutual funds have
period. The units of open- a specific lock-in period.
ended funds can be bought
and sold at any point in time.

Redemption of the units of such

Sometimes the only exception
funds is only possible after the
to this is the Equity Linked
expiry of the said lock-in.
Savings Scheme. It is an open-
ended mutual fund that has a
3-year lock-in.
Liquidity Open-ended funds are highly Close-ended mutual funds have
liquid since the units can be no liquidity since they can only
bought and sold freely without be redeemed after the expiry of
any restrictions. the lock-in period.

For liquidity they have to be

liquidated by selling through
Markets where they trade.
Mutual Fund Units and There’s no limit on either the The number of units and the
Fund Size number of units in open-ended fund size in close-ended mutual
mutual funds or the fund size. funds is limited.

New units are created by the Investors cannot invest in such

fund house as and when funds once all the listed units
individuals invest money into have been subscribed.
the fund.
Investment Method Open-ended mutual funds Since you can only subscribe to
support both lump-sum the units of a close-ended fund
investments as well as during the New Fund Offer
Systematic Investment Plans (NFO) period, only lump-sum
(SIPs). investments are allowed.
Track Record of Since open-ended mutual Close-ended funds do not have
Performance funds are perpetual by nature, any track record of
track records of past performance.
performances are available

©The Institute of Chartered Accountants of India

 MUTUAL FUNDS 10.13

3.2 On the basis of Classification of Portfolio Management

Active Funds:

Active Funds are mutual funds where the fund manager plays an active role in deciding whether to
buy, sell or hold the investments. Active funds employ a variety of strategies to construct and
manage their portfolios. For example, to outperform the entire market and others acting as powerful
hedges against unforeseen market declines or corrections. In an Active Fund, the Fund Manager is
‘Active’ in deciding whether to Buy, Hold, or Sell the underlying securities and in stock selection.
Active funds adopt different strategies and styles to create and manage the portfolio.

The investing strategy and style are explicitly available in the Scheme Information document (offer
document). Active funds seek to outperform their benchmark index in terms of returns. Furthermore,
the fund strategy determines its risk and return characteristics. Active funds are expected to
generate better returns (alpha) than the benchmark index. The risk and return in the fund will depend
upon the strategy adopted. Active funds implement strategies to ‘select’ the stocks for the portfolio.
Passive Funds:

Passive funds are the index funds which track the market index and try to generate returns in line
with the index. Fund managers of the passive funds invest in the components of the underlying index
in the same proportion as the index. The objective of the passive funds is to generate market like
returns. Passive Equity funds are the index funds which follow equity indices like Nifty 50 index or
any of the sectoral indices.

If you are a beginner and find it challenging to choose the right equity investment for your portfolio,
passive equity funds are the ideal choice for you. These are simple, low cost and easy to track.
Passive Funds hold a portfolio that replicates a stated Index or Benchmark, for example, Index
Funds and Exchange Traded Funds (ETFs)

In a Passive Fund, the fund manager has a passive role, as the stock selection / Buy, Hold, Sell
decision is driven by the Benchmark Index and the fund manager / dealer merely needs to replicate
the same with minimal tracking error.
Difference Between Active and Passive Funds:
(i) Active Funds
• Rely on professional fund managers who manage investments.
• Aim to outperform Benchmark Index.

©The Institute of Chartered Accountants of India

 10.14 FINANCIAL SERVICES AND CAPITAL MARKETS

• Suited for investors who wish to take advantage of fund managers' potential for
generating higher income.

(ii) Passive Funds

• Investment holdings mirror and closely track a benchmark index, e.g., Index Funds or
Exchange Traded Funds (ETFs).

• Suited for investors who want to allocate exactly as per market index.
• Lower Expense ratio hence lower costs to investors and better liquidity.

3.3 Investment based on Investment Objective

Mutual funds offer products that cater to the different investment objectives of the investors such
as–
• Capital Appreciation (Growth)
• Capital Preservation

• Regular Income
• Liquidity
• Tax-Saving

Mutual funds also offer investment plans, such as Growth and Dividend options, to help tailor the
investment to the investors’ needs.
(Source: https://www.amfiindia.com/investor-corner/knowledge-center/types-of-mutual-fund-schemes.html)

3.4 On the Basis of Investment Portfolio

The Schemes would be broadly classified in the following groups:

a. Equity Schemes

Equity Schemes are those schemes which invest in Equity Shares. The target here is capital
appreciation and they are riskier due to equity component. Markets are considered to have
cycles thus these funds are considered better from the long-term perspective, as in the short
term, markets can be volatile.

©The Institute of Chartered Accountants of India

 MUTUAL FUNDS 10.15

b. Debt Schemes

Debt Schemes invest in fixed income securities thus target fixed income. The idea here is
diversification and they are safer than equity funds. But the quality of debt instrument in which
the fund is investing is always to be considered and selected. If the quality, i.e. safety of
investment, is more then obviously the returns will be lower and vice versa. Thus, there are
different types of debt funds which are differentiated based on safety and returns they offer.
“The more the credit risk, the greater the return and less the credit risk lessor the return”.

c. Hybrid Schemes

Hybrid funds Invest in a mix of equities and debt securities. SEBI has classified Hybrid funds
into 7 sub-categories as follows:
(i) Conservative Hybrid Fund - 10% to 25% investment in equity & equity related
instruments; and 75% to 90% in Debt instruments.
(ii) Balanced Hybrid Fund - 40% to 60% investment in equity & equity related
instruments; and 40% to 60% in Debt instruments.
(iii) Aggressive Hybrid Fund - 65% to 80% investment in equity & equity related
instruments; and 20% to 35% in Debt instruments.
(iv) Dynamic Asset Allocation or Balanced Advantage Fund -Investment in equity/ debt
that is managed dynamically (0% to 100% in equity & equity related instruments; and
0% to 100% in Debt instruments).

(v) Multi Asset Allocation Fund - Investment in at least 3 asset classes with a minimum
allocation of at least 10% in each asset class.
(vi) Arbitrage Fund - Scheme following arbitrage strategy, with minimum 65% investment
in equity & equity related instruments.
(vii) Equity Savings Fund - Equity and equity related instruments (min.65%); debt
instruments (min.10% and derivatives (min. for hedging to be specified in the SID).

d. Solution-oriented & Other funds

(i) Retirement Fund - Lock-in for at least 5 years or till retirement age whichever is
earlier.

(ii) Children’s Fund - Lock-in for at least 5 years or till the child attains age of majority
whichever is earlier.

©The Institute of Chartered Accountants of India

 10.16 FINANCIAL SERVICES AND CAPITAL MARKETS

(iii) Index Funds/ ETFs - Minimum 95% investment in securities of a particular index.

(iv) Fund of Funds (Overseas/ Domestic) - Minimum 95% investment in the underlying
fund(s).

(v) Hybrid funds - Invest in a mix of equities and debt securities. They seek to find a
‘balance’ between growth and income by investing in both equity and debt.

e. Multi Asset Funds

A multi-asset fund offers exposure to a broad number of asset classes, often offering a level
of diversification typically associated with institutional investing. Multi-asset funds may invest
in several traditional equity and fixed income strategies, index-tracking funds, financial
derivatives as well as commodities like gold. This diversity allows portfolio managers to
potentially balance risk with reward and deliver steady, long-term returns for investors,
particularly in volatile markets.

f. Arbitrage Funds

“Arbitrage” is the simultaneous purchase and sale of an asset to take advantage of the price
differential in the two markets and profit from price difference of the asset on different markets
or in different forms. An arbitrage fund buys a stock in the cash market and simultaneously
sells it in the Futures market at a higher price to generate returns from the difference in the
price of the security in the two markets. The fund takes equal but opposite positions in both
the markets, thereby locking in the difference.

The positions must be held until expiry of the derivative cycle and both positions need to be
closed at the same price to realize the difference. The cash market price converges with the
Futures market price at the end of the contract period. Thus, it delivers risk-free profit for the
investor/trader. Price movements do not affect the initial price differential because the profit
in one market is set off by the loss in the other market. Since mutual funds invest their own
funds, the difference is the return.

Hence, Arbitrage funds are a good choice for cautious investors who want to benefit from a
volatile market without taking on too much risk.

(Source:https://www.amfiindia.com/investor-corner/knowledge-center/types-of-mutual-
fund-schemes.html)

©The Institute of Chartered Accountants of India

 MUTUAL FUNDS 10.17

A. Equity Schemes:

Sl. Category of Scheme Characteristics Type of scheme

No. Schemes
(uniform description of
scheme)
1 Multi Cap Fund Minimum investment in equity Multi Cap Fund – An open-
& equity related instruments – ended equity scheme
65% of total assets investing across large cap,
mid cap, small cap stocks
2 Large Cap Fund Minimum investment in equity Large Cap Fund – An open-
& equity related instruments of ended equity scheme
large cap companies – 80% of predominantly investing in
total assets large cap stocks
3 Large & Mid Cap Minimum investment in equity Large & Mid Cap Fund – An
Fund & equity related instruments of open-ended equity scheme
large cap companies – 35% of investing in both large cap and
total assets mid cap stocks
Minimum investment in equity
& equity related instruments of
mid cap stocks – 35% of total
assets
4 Mid Cap Fund Minimum investment in equity Mid Cap Fund – An open-
& equity related instruments of ended equity scheme
mid cap companies – 65% of predominantly investing in mid
total assets cap stocks
5 Small Cap fund Minimum investment in equity Small Cap Fund – An open-
& equity related instruments of ended equity scheme
small cap companies – 65% of predominantly investing in
total assets small cap stocks
6 Dividend Yield Fund The scheme should An open-ended equity scheme
predominantly invest in predominantly investing in
dividend yielding stocks. dividend yielding stocks
Minimum investment in equity
– 65% of total assets
7 Value Fund Scheme should follow a value An open-ended equity scheme
investment strategy. following a value investment
strategy
Minimum investment in equity
& equity related instruments –
65% of total assets

©The Institute of Chartered Accountants of India

 10.18 FINANCIAL SERVICES AND CAPITAL MARKETS

8 Contra Fund The scheme should follow a An open-ended equity scheme

contrarian investment strategy. following contrarian
investment strategy
Minimum investment in equity
& equity related instruments –
65% of total assets
9 Focused Fund A scheme focused on the An open-ended equity scheme
number of stocks (maximum investing in maximum 30
30) stocks (mention where the
scheme intends to focus, viz;
Minimum investment in equity
multi cap, mid cap, small cap)
& equity related instruments –
65% of total assets
10 Sectoral / Thematic Minimum investment in equity An open-ended equity scheme
& equity related instruments of investing in - sector (mention
a particular sector/ particular the sector)
theme – 80% of total assets
An open-ended equity scheme
following – theme (mention the
theme)
11 ELSS Minimum investment in equity An open-ended equity linked
& equity related instruments – saving scheme with a statutory
80% of total assets (in lock in of 3 years and tax
accordance with Equity Linked benefit
Saving Scheme, 2005 notified
by Ministry of Finance)

For classification of companies as per market capitalization, the definition is as follows:

• Large Cap: 1st -100th company in terms of full market capitalization
• Mid Cap: 101st -250th company in terms of full market capitalization
• Small Cap: 251st company onwards in terms of full market capitalization
B. Debt Schemes:
Sr. Category of Scheme Characteristics Type of scheme
No. Schemes (uniform description of
scheme)
1 Overnight Fund Investment in overnight An open-ended debt
securities having maturity of 1 scheme investing in
day overnight securities

©The Institute of Chartered Accountants of India

 MUTUAL FUNDS 10.19

2 Liquid Fund Investment in Debt and An open-ended liquid

money market securities with scheme
maturity of upto 91 days only
3 Ultra-Short Duration Investment in Debt & Money An open ended ultra –
Fund Market instruments such that short term debt scheme
the Macaulay duration of the investing in instruments
portfolio is between 3 months with Macaulay duration
– 6 months between 3 months and 6
months
4 Low Duration Fund Investment in Debt & Money An open-ended low
Market instruments such that duration debt scheme
the Macaulay duration of the investing in instruments
portfolio is between 6 months with Macaulay duration
– 12 months between 6 months and 12
months
5 Money market Fund Investment in Money Market An open-ended debt
instruments having maturity scheme investing in money
upto 1 year market instruments
6 Short Duration Fund Investment in Debt & Money An open-ended short-term
Market instruments such that debt scheme investing in
the Macaulay duration of the instruments with Macaulay
portfolio is between 1 year – duration between 1 year
3 years and 3 years
7 Medium Duration Fund Investment in Debt & Money An open-ended medium-
Market instruments such that term debt scheme
the Macaulay duration of the investing in instruments
portfolio is between 3 years – with Macaulay duration
4 years between 3 years and 4
years
8 Medium to Long Investment in Debt & Money An open-ended medium-
Duration Fund market instruments such that term debt scheme
the Macaulay duration of the investing in instruments
portfolio is between 4 – 7 with Macaulay duration
years between 4 years and 7
years
9 Long Duration Fund Investment in Debt & Money An open-ended debt
Market Instruments such that scheme investing in
the Macaulay duration of the instruments with Macaulay
portfolio is greater than 7 duration greater than 7
years years

©The Institute of Chartered Accountants of India

 10.20 FINANCIAL SERVICES AND CAPITAL MARKETS

10 Dynamic Bond Investment across duration An open-ended dynamic

debt scheme investing
across duration
11 Corporate Bond Fund Minimum investment in An open-ended debt
corporate bonds – 80% of scheme predominantly
total assets (only in highest investing in highest rated
rated instruments) corporate bonds
12 Credit Risk Fund Minimum investment in An open-ended debt
corporate bonds – 65% of scheme investing in below
total asset (investment in highest rated corporate
below highest rated bonds
instruments)
13 Banking and PSU Fund Minimum investment in Debt An open-ended debt
instrument of banks, Public scheme predominantly
Sector Undertakings, Public investing in Debt
Financial Institutions – 80% of instruments of banks,
total assets Public Sector
Undertakings, Public
Financial Institutions
14 Gilt Fund Minimum investment in An open-ended debt
Gsecs – 80% of total assets scheme investing in
(across maturity) government securities
across maturity
15 Gilt Fund with 10-year Minimum investment in G An open-ended debt
constant duration secs – 80% of total assets scheme investing in
such that the Macaulay government securities
duration of the portfolio is having a constant maturity
equal to 10 years of 10 years
16 Floater Fund Minimum investment in An open-ended debt
floating rate instruments – scheme predominantly
65% of total assets investing in floating rate
instruments

For debt funds, the classification is based on Macaulay Duration, and not based on Average Maturity
of Modified Duration.
The calculation of Macaulay Duration has been dealt with in the Chapter – Security Valuation in the
Advanced Financial Management Paper of CA Final Course.

©The Institute of Chartered Accountants of India

 MUTUAL FUNDS 10.21

C. Hybrid Schemes:
Sr. Category of Scheme Type of scheme
No. Schemes Characteristics (uniform description of scheme)
1 Conservative Investment in equity & An open-ended hybrid scheme
Hybrid Fund equity related investing predominantly in debt
instruments – between instruments
10% and 25 % of total
assets
Investment in Debt
instruments – between
75% and 90% of total
assets
2 Balanced Hybrid Equity & Equity related An open-ended balanced scheme
Fund instruments – between investing in equity and debt
40% and 60 % of total instruments
assets.
Debt instruments –
between 40% and 60% of
total assets
No arbitrage would be
permitted in this scheme
Aggressive Hybrid Equity & Equity related An open-ended hybrid scheme
Fund instruments – between investing predominantly in equity
65% and 80% of total and equity related instruments
assets;
Debt instruments –
between 20% and 35% of
total assets
3 Dynamic Asset Investment in equity / An open-ended dynamic assets
Allocation or debt that is managed allocation fund
Balanced dynamically
Advantage
4 Multi Assets Invests in at least three An open-ended scheme investing
Allocation asset classes with a in the three different asset classes
minimum allocation of at
least 10% each in all
three asset classes
5 Arbitrage Fund Scheme following An open-ended scheme investing
arbitrage strategy. in arbitrage opportunities
Minimum investment in

©The Institute of Chartered Accountants of India

 10.22 FINANCIAL SERVICES AND CAPITAL MARKETS

equity & equity related

instruments – 65% of
total assets
6 Equity Savings Minimum investment in An open-ended scheme investing
equity & equity related in equity, arbitrage and debt
instruments – 65% of
total assets and minimum
investment in debt – 10%
of total assets
Minimum hedged &
unhedged to be stated in
the SID

D. Solution Oriented Schemes:

Sr. No. Category of Scheme Type of scheme
Schemes Characteristics (Uniform description of scheme)
1 Retirement Fund Scheme having a lock – An open ended retirement solution
in for at least 5 years or oriented scheme having a lock – in
till retirement age of 5 years or till retirement age
whichever is earlier (whichever is earlier)
2 Children’s Fund Scheme having a lock – An open-ended fund for investment
in for at least 5 years or for children having a lock – in for at
till the child attains age of least 5 years or till the child attains
majority whichever is age of majority (whichever is
earlier earlier)
E. Other Schemes:
Sr. No. Category of Scheme Type of scheme
Schemes Characteristics (Uniform description of scheme)

1 Index Funds / Minimum investment in An open-ended scheme replicating

ETFs securities of a particular / tracking an index
index (which is being
replicated / tracked) –
95% of total assets
2 FOFs (Overseas / Minimum investment in An open-ended fund of fund
Domestic) the underlying fund – scheme investing in a particular
95% of total assets fund (mention the underlying fund)

©The Institute of Chartered Accountants of India

 MUTUAL FUNDS 10.23

3.5 SEBI Allowed Flexicap Plans in Relief to Fund Houses Facing Tight
Regulation
The Securities and Exchange Board of India introduced flexicap schemes under the broader equity
mutual fund category. The move came as a relief to fund houses which operated multicap schemes
after the capital markets regulator tightened investment norms for this category. The majority of the
large multicap schemes were shifted to the new flexicap category. Kotak Standard Multicap Fund,
the largest scheme in the category was renamed Kotak Standard Flexicap. The fund manager,
investment process and fund portfolio remained the same. The new category gave the fund manager
flexibility to invest in a mix of large, midcap and smallcap stocks. The scheme needs to invest at
least 65% of the corpus to equity, SEBI said in a circular.
The decision to introduce flexicap schemes followed protests from a section of the mutual fund
industry after the regulator on September 11, 2020, unexpectedly asked multicap funds to allocate
at least 25% of their portfolios to large-, mid- and smallcap stocks each. Till then, there were no
investment restrictions for this product, resulting in many of these schemes holding as much as 75%
of their portfolios in largecap stocks, resembling large and midcap schemes as per SEBI’s
classification. Multicap portfolios manage 20% of the industry's equity assets under management.
Motilal Oswal Multicap Fund, another large scheme in the category, was also being shifted to the
flexicap category. Most multicap funds got their schemes reclassified into the flexicap category.
Fund managers of large multicap funds were opposed to staying in this category under the new
investment rules, which would require them to shift a large chunk of their corpus in largecap stocks
to small and midcaps. They feared the rush to make obligatory purchases of illiquid smaller stocks
to meet the norms that would drive up these stocks and be detrimental to the multicap investor.

4. DIRECT PLAN AND REGULAR PLAN

One may invest in mutual funds directly i.e., without involving or routing the investment through any
distributor/agent in a ‘Direct Plan’. Or one may choose to invest in mutual funds with the help of a
Mutual Fund distributor/agent in what is termed as a ‘Regular Plan’. 'Direct Plan' and 'Regular Plan’
are both part of the same mutual fund scheme, have the same/common portfolio, and are managed
by the same fund manager, but have different expense ratios (recurring expenses that are incurred
by the mutual fund scheme).
The Direct Plan has a lower expense ratio than the Regular Plan, as there is no distributor/agent
involved, and hence there are savings in terms of distribution cost/commissions paid out to the
distributor/agent, which is added back to the returns of the scheme. Hence, a Direct Plan has a
separate NAV, which is higher than the “Regular” Plan’s NAV. In due course, the lower expense

©The Institute of Chartered Accountants of India

 10.24 FINANCIAL SERVICES AND CAPITAL MARKETS

ratio of the Direct Plan translates to higher returns on the investments which keep compounding
over the years. Thus, the investment in the Direct Plan would be worth more over a period, in
comparison to investment in the Regular Plan of the same scheme. It should be however borne in
mind that the difference between NAV of Direct Plan and Regular Plan tends to be marginal.
Direct Plans are for those who prefer to invest DIRECTLY in a mutual fund scheme without the help
of any distributor/agent. Investing in a Direct Plan is like buying a product from the manufacturer
directly, whereby the cost to the customer would be lower. Except that, investing in a mutual fund
scheme directly is not as simple as buying some item from a factory outlet, because choosing a
mutual fund scheme requires adequate knowledge and awareness of the mutual fund product,
especially the risks that are associated with the potential rewards. Choosing a Direct Plan means
making your own decisions about fund/scheme selection (and the related execution work) which not
everyone may be capable of.
In short, Direct Plan is suited for those who understand what kind of mutual funds are needed for
different kinds of investment needs, can research these independently, and are able to
identify/shortlist the funds to invest in, and then go through the process of investing without the help
of an intermediary. However, when the markets fall and investment values come under pressure,
independent advice from a professional advisor can help one stay the course. Thus, a Direct Plan
makes sense only if you have adequate knowledge and capability to select good funds yourself; or
are willing to seek professional advice from a registered investment adviser for a fee.
While the Direct Plan makes sense for knowledgeable, Do-it-Yourself (DIY) investors, it may not be
suited for all investors, especially new and inexperienced investors. So, if you are a new and
inexperienced investor or unsure of which scheme to invest in and need guidance/assistance in
investing, you may be better off seeking the help of a mutual fund distributor and investing in a
Regular Plan.

5. EXPLANATION OF IMPORTANT TERMS USED IN

MUTUAL FUNDS
New Fund Offer (NFO): A mutual fund house, also known as an asset management company, will
issue a New Fund Offer (NFO) when they choose to introduce a new mutual fund scheme. It's a mutual
fund scheme's initial offer that gives investors the chance to invest early and earn substantial profits.
A mutual fund house can raise the necessary funds through an NFO to buy stocks or debt
instruments. Customers can purchase units at INR 10 per unit NAV for a subscription duration
ranging from ten (10) to fifteen (15) days offered by AMCs. Investors receive units from AMCs
according to a first-come, first-served policy.

©The Institute of Chartered Accountants of India

 MUTUAL FUNDS 10.25

Expense Ratio: Under SEBI (Mutual Funds) Regulations, 1996, Mutual Funds are permitted to
charge certain operating expenses for managing a mutual fund scheme – such as sales & marketing/
advertising expenses, administrative expenses, transaction costs, investment management fees,
registrar fees, custodian fees, audit fees – as a percentage of the fund’s daily net assets.
All such costs for running and managing a mutual fund scheme are collectively referred to as ‘Total
Expense Ratio’ (TER). The TER is calculated as a percentage of the Scheme’s average Net Asset
Value (NAV). The daily NAV of a mutual fund is disclosed after deducting the expenses.
(Source: Amfi Website)
Scheme Information Document (SID):
Scheme Information Document contains basic information about the scheme which investors should
know about before investing. The scheme information document usually runs into several pages and
may seem too technical for novice investors. However, it has very useful scheme related information,
which can help investors make informed investment decisions. However, some key information
which investors should look for and read in the scheme information document are as follows:

• Fund management team details

• Risks factors
• Scheme details

• Other information
Statement of Additional Information (SAI):
This document is essentially an addendum to the SID. Information provided in the SAI includes the
following: -
(i) Constitution of the mutual fund i.e. the Asset Management Company of the scheme,
scheme sponsors and trustees. The sponsor is the promoter of the Asset Management
Company. The sponsor provides capital, creates a board of trustees and sets up the Asset
Management Company (AMC). The role of the trustees is to protect the interest of investors,
monitoring the AMC and ensuring compliance with regulations.

(ii) Key information about the AMC i.e. Key personnel of the AMC, key associates of the AMC
like Bankers, Custodians, Registrars, Auditors and Legal Counsel, Financial and legal issues
etc.

©The Institute of Chartered Accountants of India

 10.26 FINANCIAL SERVICES AND CAPITAL MARKETS

Key Information Memorandum (KIM):

KIM is Key Information Memorandum. As the name suggests, it has key scheme related information.
The KIM is essentially a concise version of the SID. The KIM is available with all mutual fund scheme
application forms. It is recommended to read the KIM carefully before investing, especially if you
have not gone through the SID.
(Source : https://www.miraeassetmf.co.in/quiz-module-list/topic-2/intermediate-level/investor-rights-
obligations/sid-sai-kim-before-investing
Systematic Investing Plan (SIP):
It is designed to aid you in achieving your financial objectives over time. It offers a straightforward
way to regularly invest a predetermined sum in your chosen mutual funds. SIP, with its promise to
make investing accessible to everybody, has become a major change in financial planning and asset
management. But besides understanding the meaning of SIP, it is also important to understand how
it works and how it can play a huge role in the success of your wealth-building journey. Let's discuss
SIP in detail.
How does SIP work?
SIP offers a convenient method for investing in mutual funds, allowing you to determine your desired
regular investment amount easily. This amount is automatically deducted from your bank account to
buy mutual fund units. Over time, these investments grow due to compounding. There are two
principles on which the SIP works. They are as follows:
(i) Regular Investing

SIPs offer a strategic shield against the unpredictable tides of the financial markets. By adhering to
consistent investments, SIPs ensure that the average purchase cost remains stable over the long
term.
In practical terms, when market conditions are buoyant, you acquire fewer units of your chosen
investment, and during market downturns, you secure more units for your investment. This key
difference between SIP and mutual fund investing can provide investors with a risk-mitigation
strategy and potentially higher returns over time.
(ii) Power of Compounding
The power of compounding in SIP refers to reinvesting the returns generated by your mutual fund
investments back into the same fund. Over time, this process leads to exponential growth as your
returns earn additional returns.

©The Institute of Chartered Accountants of India

 MUTUAL FUNDS 10.27

The longer you stay invested, the more significant the compounding effect becomes, potentially
resulting in substantial wealth accumulation, making SIP an effective strategy for long-term financial
goals.
Let's consider two friends, Alice and Bob. Alice started investing `10,000 annually in an SIP at 25,
with an expected SIP return rate of 10% per annum. Over 30 years, she has made a total contribution
of ` 3,00,000. On the other hand, Bob started his investments at the age of 35 and invested ` 10,000
annually, expecting a 10% annual return. Over 20 years, Bob's total investment amounted to
` 2,00,000.

(Source: https://www.kotak.com/en/stories-in-focus/mutual-funds/what-is-sip.html)
(iii) Law of averages:
If NAV of the units comes down SIP helps in averaging, as investor is investing the same amount of
money every month (period) the no. of units he/she can buy with that amount is more as the NAV
has come down, which will reduce the overall cost of the portfolio of mutual fund. When the NAV
starts recovering again the breakeven point arrives early because of law of averages.
Lump Sum Investment:
In a lump sum, it means a single, bulk amount invested a one-time mutual fund investment. It is just
like FD. It is different than SIP where the money was pumped in periodically. In Lump sum money is
invested in one shot and without the intention to repeat it periodically.
The Systematic Transfer Plan (STP): It eliminates the additional burden involved in moving or
transferring funds between mutual fund schemes. When you have a large quantity of money to invest
in one go, this is the option you should pick. It does assist you in distributing your money over time
to lessen the effects of dealing with the market at its highest point. It is preferable to go from equity
plans to debt schemes and vice versa when you want to be risk-adverse with a plan.
Systematic Withdrawal Plan (SWP): One can periodically take out a predetermined amount of
money from one’s assets by using a systematic withdrawal plan. Retirees benefit most from this plan
because they may require a consistent income stream most of the time. But they also use this
technique to invest in new schemes or adjust their existing investments.

6. NET ASSET VALUE (NAV)

There is a valuation of the fund done at the end of every business day, so that the investor knows
the value of his/her investments as on that date. The term ‘value’ here refers to the market value

©The Institute of Chartered Accountants of India

 10.28 FINANCIAL SERVICES AND CAPITAL MARKETS

i.e., if hypothetically the entire portfolio were to be liquidated, how much would be realized. Since
each investor holds units in the pool of funds, the valuation is published in terms of per unit, so that
the value of one’s holdings can be computed. The formula for computation of NAV is:
Market Value of Investments heldby the Fund+ Value of Current Assets -
Value of Current Liabilities andProvisions
NAV=
No.of Units on the valuation date before redemption
or creation on units

From the above formula, it can be observed that from the market value of the investments as on that
day, we must add the cash equivalents or other current assets and need to deduct any expenses
that have accrued but not paid out, so that the NAV represents a true and fair picture. That is the
reason it is called ‘net’ asset value i.e., it is net of liabilities, expenses, etc.
Example
From the following information in respect of a mutual fund, calculate the NAV per unit:

`
Cash and Bank Balance 6,00,000
Bonds and Debenture (unlisted) 7,50,000

Equities (current market value) 13,00,000

Quoted Government Securities 10,50,000
Accrued Expenses 1,25,000
Number of outstanding units 2,50,000
Solution
Cash and Bank Balance 6,00,000

Bonds and Debenture (unlisted) 7,50,000

Equities (current market value) 13,00,000
Quoted Government Securities 10,50,000

Total Assets (Realizable Value) 37,00,000

Less: Accrued Expenses 1,25,000
Net Assets 35,75,000

©The Institute of Chartered Accountants of India

 MUTUAL FUNDS 10.29

Number of outstanding units 2,50,000

Net Assets Value (NAV)/unit 14.30
NAV is published on every business day for all funds; for Liquid Funds, NAV is published on Sundays
as well. In equity funds, returns come mostly from price movement. Hence the differential in NAV
between two dates is mostly the difference in market value of the investments. In debt funds, returns
come mostly from interest accrual. Hence the differential in NAV between two dates is mostly the
accrual, provided the period is sufficiently long to absorb short term volatilities.

7. INDICATIVE NET ASSET VALUE

A measurement of an investment's intraday net asset value (NAV) is called indicative net asset value
(iNAV). Approximately every 15 seconds, INAV is reported. It provides investors with a gauge of the
investment's worth throughout the day.
(i) Key characteristics
 Indicative net asset value (iNAV) is a measurement of an investment's intraday net
asset value (NAV).
 An agent that calculates indicative net asset value (iNAV)—typically the exchange
where the investment is traded—reports it roughly every 15 seconds.

 Both exchange-traded funds and closed-end mutual funds can publish indicative net
asset value (iNAV) (ETFs).
 The calculation agent will utilise the established prices of all securities in the portfolio to
get the overall asset value, which is then reduced by the fund's liabilities and divided by
the number of shares to determine the indicative net asset value (iNAV).
(ii) Comparing net asset value and indicative net asset value (NAV)

The iNAV is a tool that aids in preserving trading of assets close to par value. It provides a
glimpse of a fund's worth that is almost real-time thanks to iNAV reports that are sent out every
15 seconds. A fund may be able to avoid considerable premium and discount trading by reporting
an iNAV.
Because they fall under the Investment Company Act of 1940's definition of a mutual fund
investment, closed-end funds, and ETFs compute net asset values. The funds trade like stocks
on the open market, with transactions taking place at the market price, while they determine a
daily net asset value.

©The Institute of Chartered Accountants of India

 10.30 FINANCIAL SERVICES AND CAPITAL MARKETS

8. PERFORMANCE MEASUREMENT
It comes as a statutory warning that “mutual fund investments are subject to market risks . . . past
performance is not an indication of future performance”. Very few people read it or understand the
importance of the statement. The implication of the statement is that the performance we are looking
at today is the result of certain investment decisions taken by the fund manager in the past. The
fund manager is ultimately a human being, and future decisions may or may not be as effective and
hence future returns from that fund may or may not be as good.
Even though past performance may not be repeated in future, there is no logic to go for a Fund that
has been an underperformer, because that fund manager could not prove himself / herself efficient
over the period under consideration. The outperformer has something going for himself / herself.
Hence, let us look at past performance also as a hygiene factor.
What should be avoided is,
• looking at past performance over a short period of time
• looking at returns only till a particular date and comparing the numbers.
• basing a decision on a ranking system, ranked only by returns till a particular date.
Let us now understand why the above practices should be avoided.

A short period of time is not adequate to judge the performance of a fund manager, just like the runs
scored or wickets taken by a cricketer in 5 matches is not enough to judge his class - at best it shows
his current form. Similarly, if a bond fund is outperforming the peer group over a period of say 1 or
2 months, it may be that the calls (investment decisions) taken by the fund manager over 1 or 2
months have proved better than other fund managers and that’s it. Fund managers who have proven
herself over a long period of time should be preferred.
As discussed earlier, a Fund may have done well over say a 1-year period which makes it eligible
for ‘5 stars’ (performance ranking done by some agencies / websites) as against another Fund which
is say ‘4 stars’ or ‘3 stars’ and you take the decision to invest in the 5-star rated Fund, it may not be
an entirely correct decision. Nothing wrong about a fund doing well, more so if the performance-
based ranking is over an adequate period and it is done on a ‘Risk-Adjusted Basis’ i.e., adjusted for
volatility in returns.
The point is, there are certain ‘hygiene factors’ which should be considered. Lay investors would be
attracted by the ‘5 stars’ and would not be aware that a 5-star rated Fund may be low on the hygiene
factors. For example, a Fund with a corpus of `1,000 crore from a leading AMC / sponsor with 4-

©The Institute of Chartered Accountants of India

 MUTUAL FUNDS 10.31

star performance should be preferred over a 5-star rated Fund with a corpus of `20 crore which is
from an AMC that ranks among the bottom 5 in terms of corpus / their sponsor is not so well known
or if the credit quality of the Fund is relatively poor.

8.1 Performance Measures

There are various ways of measuring performance; what is most used is looking at point to point
returns (i.e., returns from one date to today’s date) over various time periods e.g., 1 month, 3 month,
6 months, 1 year, 2 years, etc.
As a matter of regulation, returns from fixed income funds for a period of less than 1 year should be
annualized on a simple basis and for a period of more than 1 year, it should be annualized on a
compounded basis. There are more refined methods of looking at point to point returns, which are
• looking at risk-adjusted (i.e., adjusted for volatility) returns.
• looking at various statistical ratios e.g., Sharpe Ratio, Alpha Ratio, Treynor Ratio, etc.

8.1.1 Costs incurred by Mutual Fund

Costs, when high, reduce the returns of an investor. High Costs are the cause of below par performance
of some mutual funds. Costs carry two components: (1) Initial Expenses attributable to establishing a
scheme under a Fund and (2) Ongoing recurring expenses (Management Expense Ratio) which is made
up of (a) Cost of employing technically sound investment analysts (b) Administrative Costs (c)
Advertisement Costs involving promotion and maintenance of Scheme funds. The Management Expense
Ratio is measured as a % of average value of assets during the relevant period.
Expense Ratio = Expense / Average value of Portfolio

If Expenses are expressed per unit, then Expense Ratio = Expenses incurred per unit /
Average Net Value of Assets.
For example, a mutual fund has paid annual expenses of Rs. 20 lakhs. The assets under
management in the beginning and at the end of year were Rs. 200 lakhs and Rs. 400 lakhs
respectively.
Rs.20 lakhs
Expense Ratio = x100 = 6.67%
(Rs.200 + Rs. 400 lakhs) / 2

The Expense Ratio relates to the extent of assets used to run the Mutual Fund. It is inclusive of
travel costs, management consultancy and advisory fees. It, however, excludes brokerage expenses
for trading as purchase is recorded with brokerage while sales are recorded without brokerage.

©The Institute of Chartered Accountants of India

 10.32 FINANCIAL SERVICES AND CAPITAL MARKETS

8.1.2 Point to Point Returns

Point to point simply measures returns from a past date to the current date, by taking the NAV at
these two dates. For measurement of returns, the growth option NAV should be taken and not the
dividend option as there would be complications of adding back dividend. As an example, the return
over one year from 31 December 2017 to 31 December 2018 is the increment in the growth option
NAV divided by the NAV as on 31 Dec 2017.
Similarly, returns over three months from 30 September 2018 to 31 December 2018 is the increment
in the growth option NAV divided by the NAV as on 31 December 2017. The return over three years
from 31 December 2015 to 31 December 2018 is the increment in the growth option NAV divided by
the NAV as on 31 December 2015. To be noted, returns from equity funds over a period of less than
one year is expressed as absolute and for more than one year, it is annualized on a compounded
basis. Further, fixed income funds for a period of less than one year should be annualized on a
simple basis and for a period of more than one year, it should be annualized on a compounded
basis.
Point to point return explained.
Example: Yash Vardhan Large Cap Equity Investment began on January 2, 2015. Initial investment
amount is ` 10,00,000. NAV at the start of the fund Rs 100.54. Ending on January 2, 2017 - Closing
NAV ` 172.95. If you were requested to find out the returns, you probably could without much trouble.
Let's calculate -
Solution – By dividing `10,00,000 by `100.54, you get 9946.290 units. The final investment value
is equal to 9946.290 units x ` 172.95 (or `17,20,210.86).
The CAGR method can be used to determine the growth of this lump sum investment over a two-
year period: = [Ending Value/Beginning Value] ^ (1/2) - 1 = [17,20,210.86/10,00,000] ^ (1/2) - 1
= 31.16%. It would be considered as a tremendous growth rate.

8.1.3 Rolling Returns

The method to iron out the possible skew in point-to-point returns which may result from
outperformance / underperformance in the recent past, is to look at rolling returns. Measurement of
rolling returns works like this - For a period under consideration, it takes many short periods of fixed
frequency, measures the return from the Fund over these shorter time periods and take the average
of all the data over the entire period.

©The Institute of Chartered Accountants of India

 MUTUAL FUNDS 10.33

Performance of a Liquid Fund over a 3-month period:

• Point-to-point: Simply measure the performance of the growth option NAV from the start
date to today’s date, annualized.
• Rolling return of daily frequency: Measure the return from the start date to next date, from
next date to next-to-next date and so on and take the average of all these observations.

• Rolling return of weekly frequency: Measure the return from the start date to next week,
from next week to next-to-next week and so on and take the average of all these observations.
Performance of an Equity / Bond Fund over a 3-year period:

• Point-to-point: Simply measure the performance of the growth option NAV from the start
date to today’s date, annualized on a compounded basis.
• Rolling return of monthly frequency: Measure the return from the start date to one-month-
later date, from next month to next-to-next month and so on and take the average of all these
observations.
• Rolling return of quarterly frequency: Measure the return from the start date to three-
month-later date, from next quarter to next-to-next quarter and so on and take the average of
all these observations.
The superiority of rolling return as a performance measurement over simple point-to-point return is
that it irons out the various smaller pockets of outperformance and underperformance against the
peer group and throws up a more dependable (smoothened out) data.
Rolling Returns explained
The objective is to find the fund's 2-year rolling return. So, let us start in 2015 to do this.
Firstly, calculate the return between the NAV on January 2, 2015, and the NAV on January 2, 2013,
which is two years ago. Secondly, shift the date by one day, i.e., between January 3, 2015, and
January 3, 2013, and then compute the return between these dates using the NAV for these two
dates. Once again change the date to January 4th, 2013, or 2015, and compute the return.
So, the purpose is to keep on going in this manner until a time series with a 2-year return is arrived
at.
Let's figure out the initial rolling return:
NAV as of January 2nd, 2013, was 100.54.

NAV on January 2nd, 2015, was 172.95.

©The Institute of Chartered Accountants of India

 10.34 FINANCIAL SERVICES AND CAPITAL MARKETS

Since the period is two years, we use CAGR: [172.95/100.54] ^ (1/2)-1 = 31.16%.

NAV on January 3, 2013, would be the second rolling return in this series, at 101.75.

NAV on January 3, 2015, was 173.65; So, the CAGR in this situation = [173.65/101.75] ^ (1/2)-1 =
30.64.
Next, it will be calculated from January 4, 2013, to January 4, 2015, and so on.

8.2 Statistical Ratios

8.2.1 Sharpe Ratio (Reward to Variability)
The Sharpe ratio evaluates the relationship between an investment's return and risk. The idea that
excess returns over time may indicate greater volatility and risk rather than investment expertise is
expressed mathematically in this way.
As a result of his work on the capital asset pricing model (CAPM), economist William F. Sharpe
proposed the Sharpe ratio in 1966 under the name reward-to-variability ratio.
The numerator of the Sharpe ratio is the difference over time between realised or predicted returns
and a benchmark, such as the performance of a certain investment category or the risk-free rate of
return. The standard deviation of returns over the same period, which serves as a gauge of volatility
and risk, serves as its denominator.
Furthermore, investors prefer stocks or portfolios with relatively less risk or less volatility. But how
do we evaluate portfolios with different returns and different levels of risk? Let us take an example.

Portfolio A Portfolio B Benchmark

Annualized return 7.9% 6.9% 7.5%
Annualized risk 5.5% 3.2% 4.5%

©The Institute of Chartered Accountants of India

 MUTUAL FUNDS 10.35

Sharpe ratio
(Risk-free rate = 2%) 7.9% - 2.0% 6.9% - 2.0% 7.5% - 2.0%
rP - rF 5.5% 3.2% 4.5%
SR =
σP = 1.07 = 1.53 = 1.22

rP is the portfolio return

rF is the risk-free rate
σP is the SD of the portfolio

SR = Sharpe Ratio
As we see in the table above, though the return of portfolio A (7.9%) is higher than portfolio B (6.9%)
and Benchmark (7.5%), variability also is higher. The Sharpe Ratio of portfolio A (1.07) is much
lower than portfolio B (1.53) and lower than benchmark portfolio (1.22).
The higher the Sharpe ratio, the better because the portfolio has given that much higher return to
compensate for the higher variability. The Sharpe ratio is a very popular method for measuring risk-
adjusted return.

8.2.2. Treynor Ratio

The output of Treynor ratio is like Sharpe Ratio, the difference being that in the denominator, instead
of taking standard deviation, it takes beta of the portfolio i.e., systematic risk.

rP - rF
Treynor Ratio (TR) =
βP

βP = Beta of the portfolio

The Treynor ratio measures excess return generated per unit of risk in the portfolio i.e. excess return

©The Institute of Chartered Accountants of India

 10.36 FINANCIAL SERVICES AND CAPITAL MARKETS

earned above the risk-free investment. Treasury bills are usually taken as the proxy for risk-free
return as it is issued by the Government and duration is not very long. Risk refers to the portfolio
beta i.e. the extent to which the portfolio performance varies along with the relevant market.
Let's consider the following example to understand Treynor Ratio:

Portfolio Return: 10%

Risk-Free Rate: 6%

Portfolio Beta: 1.2

Treynor Ratio = (10% - 6%) / 1.2 = 3.33%

In this example, the portfolio generated a Treynor Ratio of 3.33%, which shows its performance in
comparison to its exposure to systematic risk.

8.2.3 Jensen’s Alpha

This is the difference between a fund’s actual return and those that could have been made on a
benchmark portfolio with the same risk- i.e., beta. It measures the ability of active management to
increase returns above those that are purely a reward for bearing market risk. Caveats apply
however since it will only produce meaningful results if it is used to compare two portfolios which
have similar betas.

Assume Two Portfolios

A B Market Return
Return 12 14 12
Beta 0.7 1.2 1.0

Risk Free Rate = 9%

The return expected = Risk Free Return + Beta portfolio (Return of Market - Risk Free Return)

Using Portfolio A, the expected return = 0 .09 + 0.7 (0.12 - 0.09) = 0.09 + 0.021 = 0.111
Jensen Alpha = Return of Portfolio- Expected Return= 0.12 - 0.111 = 0.009
If “apples are compared to apples”- in other words a computer sector fund A is compared with
computer sector fund B - it is a viable number. But if taken out of context, it loses meaning. Alphas
are found in many rating services but are not always developed the same way- so you can’t compare

©The Institute of Chartered Accountants of India

 MUTUAL FUNDS 10.37

an alpha from one service to another. However, we have usually found that their relative position in
the rating service is to be viable. Short-term alphas are not valid. A minimum time frame of one to
three years is preferable.

8.2.4 Sortino Ratio

Sortino ratio is a variation of the concept of Sharpe or Treynor ratios; instead of measuring it against
any type of risk, Sortino measures it against only downside risk in the portfolio.

rP - rF
SR =
σD

Here,
σD is the standard deviation on the downside i.e., not just the entire deviations in the portfolio but
the downside deviations only.
Sortino ratio penalizes only returns below a specified rate. Sharpe and Sortino measure risk-
adjusted return, but they are different. Sortino ratio differentiates negative volatility from entire
volatility by taking the standard deviation of negative returns, called downside, rather than total
standard deviation.

For example, assume Mutual Fund A has an annualized return of 14% and a downside deviation of
10%. Mutual Fund B has an annualized return of 12% and a downside deviation of 7%. The risk-free
rate is 5.5%. The Sortino ratios for both funds would be calculated as:
14% - 5.5%
Mutual Fund A Sortino = 10% = 0.85
12% - 5.5%
Mutual Fund B Sortino = 7% = 0.93

©The Institute of Chartered Accountants of India

 10.38 FINANCIAL SERVICES AND CAPITAL MARKETS

Even though Mutual Fund A is returning 2% more on an annualized basis, it is not earning that return
as efficiently as Mutual Fund B, given their downside deviations. Based on this metric, Mutual Fund
B is the better investment choice.

8.2.5 Portfolio or Fund Alpha

The Alpha is the excess return over broad market, represented by the benchmark. Beta is the
systematic return or return along with the market whereas Alpha is the return over and above the
market generated by active fund management and by taking risks i.e., unsystematic risks. To gauge
the excess return over the market, the index or benchmark is taken to represent the market return
and the excess return over the index / benchmark is the Alpha. Alpha may be positive or negative
i.e., active portfolio calls or portfolio churning can go either way.

8.2.6 Benchmarking
For any performance evaluation, benchmarking is very important. However, the question is, what is
the correct benchmark? In most literature on mutual funds and on communications from AMCs, the
standard / official benchmark is mentioned. For example, for a large cap equity fund, the Nifty 50
Index can be used or if it is a Short-Term Bond Fund, the CRISIL index for Short Term Bond Funds
(STBex) would be mentioned.

9. ADVANTAGES AND DISADVANTAGES OF MUTUAL

FUND
9.1 Advantages
(i) Professional expertise: Except for some large corporate investors with dedicated treasury
departments, it is not possible for an investor to replicate the expertise and professional fund
management skills of MFs. The market is dynamic and portfolio reshuffling calls must be
taken as and when required. Active tracking of portfolio is not the job of the archetype
investor.

(ii) Risk Diversification — Buying shares in a mutual fund is an easy way to diversify your
investments across many securities and asset categories such as equity, debt, and gold,
which helps in spreading the risk - so you won't have all your eggs in one basket. This proves
to be beneficial when the underlying security of a given mutual fund scheme experiences
market headwinds.

©The Institute of Chartered Accountants of India

 MUTUAL FUNDS 10.39

With diversification, the risk associated with one asset class is countered by the others. Even
if one investment in the portfolio decreases in value, other investments may not be impacted
and may even increase in value. In other words, you don’t lose out on the entire value of your
investment if a particular component of your portfolio goes through a turbulent period. Thus,
risk diversification is one of the most prominent advantages of investing in mutual funds.

(iii) Operational / Transaction ease: The process of buying and selling an instrument in the
secondary market is quite cumbersome as compared to the process of investing / redeeming
in MFs. For a similar / comparable return, the investor would rather settle for an easier
process.

(iv) Affordability & Convenience (Invest Small Amounts) — For many investors, it could be
more costly to directly purchase all the individual securities held by a single mutual fund. By
contrast, the minimum initial investments for most mutual funds are more affordable.

(v) Accessibility: Mutual Funds are easy to access, through distributors, online, acceptance
centers etc.

(vi) Ticket Size: All ticket sizes are available, from as small as `5000 to multiples of crores.

(vii) Liquidity: In mutual funds, liquidity is just a redemption away. Nowadays, it can be done
online, and the money gets credited to your bank account. The time for getting the credit
depends on the nature and terms of the fund; it may be T+1 day to T+3 days.

(viii) Option of multiple funds: There are multiple categories of funds discussed earlier, there is
one to suit your requirement, managed by professionals. That is not the case with direct
investment in equity stocks / bonds.

(ix) Well-Regulated: Mutual Funds are regulated by the capital markets regulator, Securities and
Exchange Board of India (SEBI) under SEBI (Mutual Funds) Regulations, 1996. SEBI has
laid down stringent rules and regulations keeping investor protection, transparency with
appropriate risk mitigation framework and fair valuation principles.

(x) Tax Benefits: Investment in ELSS upto `1,50,000 qualifies for tax benefit under section 80C
of the Income Tax Act, 1961. Mutual Fund investments when held for a longer term are tax
efficient.

©The Institute of Chartered Accountants of India

 10.40 FINANCIAL SERVICES AND CAPITAL MARKETS

9.2 Disadvantages of Mutual Fund

(i) If you are running your own portfolio, you can run your own strategies. In mutual funds, you
are following the fund manager thus, dependent on him.

(ii) In developed markets like the USA, there is a shift towards passively managed funds i.e., ETFs
(discussed below) as there is not much alpha generated over the broad market. ETFs run at a
much lower cost than actively managed funds. While ETFs also are mutual funds, the point is, the
alpha is missing in developed markets due to better information and efficiency in markets.

10. FACTORS INFLUENCING THE SELECTION OF MUTUAL

FUNDS
(1) Past Performance – The Net Asset Value is the yardstick for evaluating a Mutual Fund. The
higher the NAV, the better it is. Performance is based on the growth of NAV during the referral
period after taking into consideration Dividend paid.
Growth = (NAV1 – NAV0) + D1 / NAV0.
Where,
NAV1 = Closing NAV

NAV0 = Opening NAV

D1 = Dividend paid by the Mutual Fund

Example:

NAV at the beginning ` 80

NAV at the end ` 100
Dividend per unit ` 1.50
Growth = (NAV1 – NAV0) + D1 / NAV0
= (100 – 80) + 1.50/80 x 100 = 26.875%
(2) Timing – The timing when the mutual fund is raising money from the market is vital. In a
bullish market, investment in mutual funds falls significantly in value whereas in a bearish
market, it is the other way round where it registers growth. The turns in the market need to
be observed.

©The Institute of Chartered Accountants of India

 MUTUAL FUNDS 10.41

(3) Size of Fund– Managing a small sized fund and managing a large sized fund is not the same
as it is not dependent on the product of numbers. Purchasing through large sized fund may
by itself push prices up while sale may push prices down, as large funds get squeezed both
ways. So, it is better to remain with medium-sized funds.

(4) Age of Fund– Longevity of the fund in business needs to be determined and its performance
in rising, falling and steady markets must be checked. Pedigree does not always matter as
also success strategies in foreign markets.

(5) Largest Holding – It is important to note where the largest holdings in mutual fund have been
invested.

(6) Fund Manager– One should have an idea of the person handling the fund management. A
person of repute gives confidence to the investors.

(7) Expense Ratio– SEBI has laid down the upper ceiling for Expense Ratio. A lower Expense
Ratio will give a higher return which is better for an investor.

(8) PE Ratio– The ratio indicates the weighted average PE Ratio of the stocks that constitute the
fund portfolio with weights being given to the market value of holdings. It helps to identify the
risk levels in which the mutual fund operates.

(9) Portfolio Turnover – The fund manager decides as to when he should enter or quit the
market. A very low portfolio turnover indicates that he is neither entering nor quitting the
market very frequently. A high ratio, on the other hand, may suggest that excessively frequent
moves have led the fund manager to miss out on the next big wave of investments. A simple
average of the portfolio turnover ratio of peer group updated by mutual fund tracking agencies
may serve as a benchmark.

11. SIGNALS HIGHLIGHTING THE EXIT OF THE INVESTOR

FROM THE MUTUAL FUND SCHEME
(1) When the mutual fund consistently under performs the broad-based index, it is high time that
the investor should get out of the scheme. It would be better to invest in the index itself either
by investing in the constituents of the index or by buying into an index fund.

©The Institute of Chartered Accountants of India

 10.42 FINANCIAL SERVICES AND CAPITAL MARKETS

(2) When the mutual fund consistently under performs its peer group instead of it being at the top. In
such a case, the investor would have to pay to get out of the scheme and then invest in the winning
schemes.
(3) When the mutual fund changes its objectives e.g., instead of providing a regular income to
the investor, the composition of the portfolio has changed to a growth fund mode which is not
in tune with the investor’s risk preferences.
(4) When the investor changes his objective of investing in a mutual fund which no longer is
beneficial to him.
(5) When the fund manager, handling the mutual fund schemes, has been replaced by a new
entrant whose image is not known.

12. MONEY MARKET MUTUAL FUNDS (MMMFs)

The Government of India thought of introducing Money Market Mutual Funds (MMMFs) on Indian
financial canvass in 1992. The aim of the Government was to develop the money market and to
enable individual investors to gain from money market instruments since it is practically impossible
for individuals to invest in instruments like Commercial Papers (CPs), Certificate of deposits (CDs)
and Treasury bills (TBs) which require huge investments. The Government constituted a Task Force
on MMMFs under the chairmanship of Shri D. Basu.
Money market funds are generally the safest and most secure of mutual fund investments because
the period is short term and the visibility is clear, thus probability of default is not present there. The
goal of a money-market fund is to preserve principal while yielding a modest return. Money-market
mutual fund is akin to a high-yield bank account but is not entirely risk free. When investing in a
money-market fund, attention should be paid to the interest rate that is being offered.

13. SEPARATION OF DISTRIBUTION AND ADVISORY

FUNCTIONS IN THE MUTUAL FUND INDUSTRY
The industry association of Mutual Funds in India (AMFI) prohibited distributors from using
nomenclature that includes references to advisors, therefore some mutual fund (MF) distributors
may need to rename themselves. The move follows the decision taken by markets regulator
Securities and Exchange Board of India (SEBI) to separate distribution and advisory functions in the
MF industry.

©The Institute of Chartered Accountants of India

 MUTUAL FUNDS 10.43

“Pursuant to the regulatory amendment, MF distributors whose registered name has terms such as
adviser / advisor / financial adviser/ investment adviser/ wealth adviser/wealth manager etc., are
required get their registered name changed,” AMFI said in a circular.
AMFI issued a non-exhaustive list of names that are permitted and prohibited for distributors.
“The name of an MF distributor should reflect the registration held by the entity and should not in
any way create an impression of performing a role for which the entity is not registered. Thus, every
MF distributor, while dealing in distribution of securities, should clearly specify that he /she is acting
as an MF distributor,” AMFI has said.
The industry body also prescribed font size for MF distributors to be used in all forms of
communication such as websites, mobile apps, business cards and signboards.

14. EXCHANGE TRADED FUNDS (ETFS)

14.1 Introduction
An exchange-traded fund (ETF) is a Mutual Fund Scheme that is traded on stock exchanges, much
like stocks. If the ETF represents a portfolio, it being listed as an ETF means the entire portfolio is
being traded as one unit at the Stock Exchange. ETFs can be diverse; the portfolio may comprise
stocks, bonds, commodities, index, etc. It usually trades close to its intrinsic value or market value
of the underlying assets, but it is nothing hard and fast.

14.2 Advantages of ETFs

Fund management expenses are lower in ETFs than actively managed funds, as these are passively
managed funds, investing in assets like gold or equity index.

• ETFs offer intra-day purchase and sale on the Exchange, which suits active traders. This is
not possible with conventional funds.

• Close-ended funds have a fixed corpus. ETFs also have a given corpus, but that may change
as per demand. Authorized Participants can create new units or redeem existing units with
the AMC. This makes the ETF price realistic i.e., it moves with the movement in the underlying
market.

©The Institute of Chartered Accountants of India

 10.44 FINANCIAL SERVICES AND CAPITAL MARKETS

Equity ETFs listed on NSE

Issuer Name Name Underlying Launch Date
Edelweiss AMC Edelweiss Exchange Traded NIFTY 50 Index 08-May-2015
Scheme - NIFTY
ICICI Prudential AMC ICICI Prudential NIFTY ETF NIFTY 50 Index 20-Mar-2013
Kotak AMC Kotak NIFTY ETF NIFTY 50 Index 02-Feb-2010
MotilalOswal AMC MOSt Shares M50 NIFTY 50 Index 28-Jul-2010
Quantum AMC Quantum Index Fund - NIFTY 50 Index 10-Jul-2008
Growth
Religare AMC Religare Invesco NIFTY ETF NIFTY 50 Index 13-Jun-2011
SBI AMC SBI ETF NIFTY NIFTY 50 Index 23-Jul-2015
UTI AMC UTI NIFTY ETF NIFTY 50 Index 03-Sep-2015
Birla Sun Life AMC Birla Sun Life NIFTY ETF NIFTY 50 Index 21-Jul-2011
ICICI Prudential AMC ICICI Prudential CNX 100 NIFTY 100 20-Aug-2013
ETF
Kotak AMC Kotak Banking ETF NIFTY Bank 04-Dec-2014
SBI AMC SBI ETF Banking NIFTY Bank 20-Mar-2015

©The Institute of Chartered Accountants of India

 MUTUAL FUNDS 10.45

MotilalOswal AMC MOSt Shares M100 NIFTY Midcap 100 31-Jan-2011

SBI AMC SBI ETF NIFTY Junior NIFTY Next 50 20-Mar-2015
Kotak AMC Kotak PSU Bank ETF NIFTY PSU BANK 08-Nov-2007
ICICI Prudential AMC ICICI Prudential Sensex ETF S&P BSE Sensex 10-Jan-2003
UTI AMC UTI Sensex ETF S&P BSE Sensex 03-Sep-2015
Reliance Nippon Life Reliance ETF NIFTY BeES NIFTY 50 Index 28-Dec-2001
Asset Management
Limited Reliance ETF NIFTY 100 NIFTY 100 22-Mar-2013
Reliance ETF Bank BeES NIFTY Bank 27-May-04
CPSE ETF NIFTY CPSE Index 28-Mar-14
Reliance ETF Dividend NIFTY Dividend 15-Apr-14
Opportunities Opportunities 50
Reliance ETF Consumption NIFTY India 03-Apr-14
Consumption
Reliance ETF Infra BeES NIFTY 29-Sep-10
Infrastructure
Reliance ETF Junior BeES NIFTY Next 50 21-Feb-03
Reliance ETF PSU Bank NIFTY PSU BANK 25-Oct-07
BeES
ICICI Prudential AMC BHARAT 22 ETF S&P BSE BHARAT 28-Nov-17
22 index

15. SIDE POCKETING

What Does Mutual Fund Side Pocketing Mean?
A strategy to protect investors in instruments with exposure to risky assets is called side pocketing.
It is essentially an accounting technique used to distinguish between liquid and high-quality
investments and illiquid investments in a loan portfolio.
How does it function?
The fund houses move the illiquid asset into a side pocket whenever a bond owned by the fund has
its rating downgraded, and the current holders receive a pro rata allocation in it.

©The Institute of Chartered Accountants of India

 10.46 FINANCIAL SERVICES AND CAPITAL MARKETS

What Effect Does Side Pocketing Have on NAV?

The fund's NAV only represents the value of liquid assets when side pocketing is used; illiquid assets
are placed into a separate pocket and have a different NAV determined by an estimate of the
realisable value of investors.
Does it Protect Investing?

Risky bets can be separated from safer and more liquid investments with the use of side pocketing
so that they are not affected by changes in the risky assets' credit profiles. Here, attempts are taken
to maintain the scheme's net asset value so that small investors' ability to redeem their investment
won't be harmed by any abrupt withdrawals by large investors.
Additionally, side pocketing makes sure that investors who held the investment at the time of the
write-off will benefit if the bond is ever recovered. As allotment and redemption are carried out on
liquid assets, the side pocketing process assures that investors owning units of the core plan do not
experience a liquidity crunch.
New Development

Debt mutual funds are now able to use the "side pocket" idea, thanks to the market regulator
Securities and Exchange Board of India (SEBI). In the past, the regulator opposed side-pocketing
and prohibited mutual fund companies from segregating their problematic investments.

The Association of Mutual Funds of India (AMFI) approached SEBI in 2016 to request the creation
of regulations governing side-pockets when the market experiences a credit event after JP Morgan
Asset Management (India investments)'s in Amtek Auto defaulted and the fund house turned to the
side pocket. SEBI, however, turned down the suggestion at the time.
The NAV of numerous debt schemes fell precipitously in 2018. Following these schemes, credit
ratings were lowered for investments in Infrastructure Leasing & Financial Services Ltd (IL&FS) and
certain of its subsidiaries. The rule on debt funds was changed because of this catastrophe.
Will side-pocketing entice investment firms to take on more credit risk?
Ajay Tyagi, Chairman of SEBI, was quoted as saying, "SEBI would take sufficient measures and
implement safeguards to guarantee that this provision is not abused. These protections will be
included in the final guidelines. Segregated or hazardous investments will be closed to new
subscriptions after the investment segregation process is complete. Investors can still subscribe to
the portion made up of liquid assets or safer assets, nevertheless.
Institutional investors typically have the first right of redemption in times of crises. Retail investors
become trapped in hazardous or segregated assets because of this process. Because other holdings

©The Institute of Chartered Accountants of India

 MUTUAL FUNDS 10.47

are unaffected, side-pocketing is implemented in this situation to help fund companies manage
redemption pressures better. Let's use an example to better understand the procedure now:
Example
Let's say a fund has a corpus of ` 5000 crores. Of this, a firm that is in default on its debt holds `
250 crores. An institutional investor wishes to redeem the entire investment in this scenario. To pay
substantial investors, this redemption pushes the fund manager to sell good bonds. Toxic assets
that are still present at the end of the accounting year account for a significant amount of the corpus.
Thus, the process influences retail investors. Side pocketing will be used to protect each investor;
250 crores will be set aside, and 4750 crores will serve as the safer corpus. Following that, units will
be distributed to investors (both institutional and retail).
Are there drawbacks to side pocketing?
Side pocketing is a technique that needs to be applied with caution. Illiquid investment value is also
a sensitive topic. The illiquid asset's NAV will therefore continue to be of concern. Investors will also
find it challenging to track two NAVs—one for each of the liquid and illiquid assets. Finally, the
availability of side pockets will provide fund houses more leverage. Therefore, it is the fund
manager's responsibility to apply the method carefully and logically.

16. TRACKING ERROR

16.1 Concept of Tracking Error and its distinction with Tracking Difference
Passive funds don't actively choose their stocks; instead, they invest according to rules. They
purchase all equities with the same weight as in the index to copy the performance of an index (such
as the Nifty 50 or Nifty 500). The fund may deviate somewhat from the benchmark's return during
the replication process due to several practical difficulties.
The tracking difference (TD) and tracking error (TE) are metrics used to describe these variations in
the returns. TD represents the discrepancy between benchmark return and fund return. Assume that
over the course of a year, the benchmark Nifty 50 Index returned 12% while the Nifty 50 Index Fund
generated 11% in returns. The 1% deviation in returns represents the tracking difference.

TD is usually negative because of the total expense ratio (TER) and other costs. Avoid any fund with
a greater TD that is either positive or negative. Higher TD may indicate less effective fund
management. The fact that TD examines point-to-point data to assess the effectiveness of fund
management is one of its shortcomings.

©The Institute of Chartered Accountants of India

 10.48 FINANCIAL SERVICES AND CAPITAL MARKETS

TE is used to observe how the fund is run during the period. Higher TE is brought on by continuous
movements in the daily monitoring difference over time. It is the daily tracking difference's variability
(or volatility), which can be called as the tracking difference’s standard deviation. If an investor wants
to compare index funds that track the same index without using technical terms, he can use the
following rule of thumb: the lower the TE, the more well a fund tracks the index. When we mix TD
and TE, things become fascinating. Both should ideally be lower and considered together when
assessing the fund’s performance.
Investors should choose the fund with the lowest tracking error and tracking difference after
comparing the performance of various schemes tracking the same index. It's crucial to keep in mind,
though, that a fund may have a high tracking error and still beat its peers. Investors should evaluate
both characteristics to make an informed decision when choosing an efficiently managed fund rather
than relying primarily on one when making their decision. A fund with a higher tracking error doesn't
necessarily suggest inefficient index tracking, and vice versa, therefore concentrating solely on
tracking error or tracking difference can be deceptive.

16.2 Reasons for Deviation Between a Scheme’s Return and the Benchmark
(Index) Return
What causes the fund to depart from benchmark returns, though? The same returns as the index
are essentially impossible for a fund manager to attain. A fund manager encounters several real-
world obstacles that cause the scheme return to differ from the benchmark return, which are follows:
(i) Total Expense Ratio (TER): It is charged by passive funds to cover management and
operating costs related to running the fund. The returns on the funds are directly impacted by
a higher or lower TER.
(ii) Cash holdings: To honor investor redemptions, passive funds also keep a specific portion
of their Assets Under Management (AUM) in cash and cash equivalents, which are often
liquid securities. Since this money isn't invested, rising or falling markets may cause it to add
to or detract from the fund's returns.
(iii) Securities lending: In addition to receiving returns from the index, passive funds may also
generate income. For a fee, they can lend securities they own to other market players for a
short time. The increased income aids in cost-cutting and betters tracking accuracy.
(iv) Timing of execution: Several stocks are added or withdrawn when the index is rebalanced.
Although the index calculates returns using closing day prices, in practice fund managers
might not be able to execute trades precisely at the closing prices. Due to this, the execution

©The Institute of Chartered Accountants of India

 MUTUAL FUNDS 10.49

price has a minor discrepancy, which results in tracking difference. This also applies to
managing the cash flow of investors daily.

(v) Dividend receipt is delayed, which could increase the tracking difference. When a fund gets
dividends from the underlying securities, there is a timing gap between when the payout is
made and when the benchmark index takes those payments into account.

(vi) Other costs: Passive funds also incur other expenses like goods and services tax on
management fees, brokerage fees for buy and sell transactions, exit load expenses, etc.,
which also impact fund returns. Apart from these, several factors such as corporate actions
(stock splits, mergers and acquisitions, spinoffs, etc.) also cause tracking differences.

16.3 Calculation of Tracking Error

∑ (d - d )
2

TE =
n-1
d = Return of Portfolio
d = Return of Benchmark

n = No. of observation
Example
The following data is available for the yearly returns for both Fund PQR and the Nifty:
Year Fund PQR Nifty
2022 15.54% 20.73%
2021 13.34% 10.96
2020 3.50% 1.38%
2019 10.00% 12.79%
2018 34.69% 31.49%

Calculate the tracking error. Also suggest the course of action for the investor.

( Return of a portfolio – Return of a benchmark )

2

Tracking Error =
(n -1)

©The Institute of Chartered Accountants of India

 10.50 FINANCIAL SERVICES AND CAPITAL MARKETS

=  (15.54% - 20.73) + (13.34% -10.96) + (3.50% -1.38%) + (10.00% -12.79%) + (34.69% - 31.49%) 
2 2 2 2 2

 (5 -1) 

= 0.037
The small tracking error in the question shows that Fund PQR does not considerably exceed the
benchmark. As a result, the investor can think about taking his money out of the fund and investing
it in a different, more promising investment options. Alternatively, he can be content with the fact
that his portfolio is gaining ground on the market.

17. REAL ESTATE INVESTMENT TRUSTS (REITs)

17.1 Introduction
A Real Estate Investment Trust (ReIT) is a form of investing in real estate, where the operator, the
REIT, owns, and operates the real estate. ReITs may own commercial real estate like warehouses,
offices, etc. ReITs can be publicly traded or private. The unitholders of a REIT earn their income
from real estate without directly owning it. As a regulation, REITs must pay out at least 90% of their
income to unitholders.

Type of ReIT Holdings

Equity Own and operate income-producing real estate
Mortgage Provide mortgages on real property
Hybrid Own properties and make mortgages

17.2 Indian Context

SEBI notified regulations for investment trusts in September 26, 2014: specifically, real estate
investment trusts (REITs) and infrastructure investment trusts (InvITs) – which was subsequently
amended in September 23, 2016. REITs and InVITs allow sponsors to monetize revenue-generating
real estate and infrastructure assets while enabling investors or unit holders to invest in these assets
without owning them. REITs and InVITs enjoy favourable tax treatment, including exemption from
dividend distribution tax and relaxation of capital gains tax.

17.3 Structure of investment trust

Investment trusts to hold assets either directly or through SPV. Investment trusts can invest in two-
level SPV structure through Holding Company (Holdco), subject to sufficient shareholding in the

©The Institute of Chartered Accountants of India

 MUTUAL FUNDS 10.51

Holdco and the underlying SPV and other safeguards including the following:

a. Investment trusts to have right to appoint majority directors in the SPV(s),

b. Holdco to distribute 100% cash flows realized from underlying SPVs and at least 90% of the
remaining cash flows.

Mandatory sponsor holding shall not less than 25% of the total units of the REIT after initial offer on
a post-issue basis (the minimum sponsor holding specified in this clause shall be held for a period
of at least three years from the date of listing of such units). The sponsor shall always hold not less
than 15% of the outstanding units of the listed REIT. In the case of InvIT, mandatory sponsor holding
is 15%. There is no limit on the number of sponsors both in the case of REIT and InvIT. REITs can
invest up to 20% in under-construction assets, while InvITs (through public issue) can invest up to
10% in under-construction assets.

Investment trusts shall hold controlling interest and not less than 50% equity share capital or interest
in the SPVs (except in the case of public private partnership projects where such holding is
disallowed by the government or regulatory provisions).

Furthur, SPVs shall hold not less than 80% of assets (90% in case of InvITs) directly in properties
(infrastructure projects for InvITs) and not invest in other SPVs.

Lastly, SPVs should not engage in any activity other than those pertaining and incidental to the
underlying projects.

17.4 Stipulations to ensure transparency

Trustee to hold assets for the benefit of unit holders, oversee activities, and ensure compliance with
respect to reporting and disclosure requirements.
A full valuation shall be conducted by an independent valuer not less than once in every financial
year; a half yearly valuation of the assets shall be conducted by the valuer for the half-year ending
September 30 for incorporating any key changes in the previous six months.
All related-party transactions should be on an arm’s-length basis.

©The Institute of Chartered Accountants of India

 10.52 FINANCIAL SERVICES AND CAPITAL MARKETS

Source: Google to https://commercialobserver.com/2013/03/reit-so-sweet-investors-reconsider-

real-estate-investment-trusts/
ReITs recently took off in India; the first IPO of REIT has been Embassy Office Parks REIT, backed
by Blackstone Group, raised about `4,750 crore in India’s first real estate investment trust listing.
The REIT, which includes Embassy Group properties, offered 158.6 million units at `299 to `300 a
piece. It started taking orders from anchor investors before moving on to a public offering. A
successful listing of the REIT has opened a fundraising avenue for India’s cash-starved property
companies. The nation’s real estate developers are struggling with sluggish sales and price declines.
The trust’s portfolio comprises about 33 million square feet of office space across four Indian cities,
Bengaluru, Pune, Mumbai, and Noida, as per Offer Document filed with SEBI. Its Express Towers
property, located in Mumbai’s central business district, counts Wells Fargo & Co., Warburg Pincus
as well as Blackstone as tenants.
The following chart illustrates the relationship between the Embassy REIT, the Trustee, the
Manager, and the Unitholders (which include the Sponsors) on the Listing Date.

©The Institute of Chartered Accountants of India

 MUTUAL FUNDS 10.53

Unitholders (including
Sponsors and Sponsor
Group)

Units Distributions

Holds the REIT assets in trust for the

REIT Management benefit of the Unitholders
Service

Manager Trustee
REIT Management FEE Embassy Trustee Fee
REIT
Property Management
Property Management

Shareholder Debt/Equity /Equity

Net Distributable Cash Flows

Services

Fee

Linked Instruments

Assets
SPVs

(Source: Embassy REIT Offer Document)

18. INFRASTRUCTURE INVESTMENT TRUSTS (INVITS)

An InvITs is a pool of money for investing in infrastructure projects and distribution of the earnings
to the unit holders. An InvIT issues units that are listed on the Stock Exchange. In that sense, InvITs
are like Exchange Traded Funds (ETFs) of Mutual Funds. The difference is, in a Mutual Fund, the
underlying portfolio of shares or bonds change in value every day and there is an NAV declared
every day. An InvIT invests in the projects which are identified as Special Purpose Vehicles (SPVs)
that are not valued everyday but once in six months for publicly offered InvITs. Both InvITs and
Mutual Funds are regulated by SEBI.

©The Institute of Chartered Accountants of India

 10.54 FINANCIAL SERVICES AND CAPITAL MARKETS

InvITs are set up as a trust and registered with SEBI. An InvIT involves four entities: Trustee,
Sponsor, Investment Manager and Project Manager. The trustee, who oversees the role of an
InvIT, is a SEBI registered debenture trustee and he cannot be an associate of the Sponsor or
Manager. ‘Sponsor’ means promoters and refers to any company or body corporate with a net worth
of ` 100 crore which sets up the InvIT and is designated as such while applying to SEBI. Promoters
or Sponsors, collectively, must hold at least 15% in the InvIT for a minimum of 3 years. The value of
the assets owned/proposed to be owned by InvIT shall be at least `500 crore. The minimum issue
size for an initial offer is ` 250 crore. InvITs are allowed to add projects in the same vehicle in future
so that investors can benefit from diversification as well as growth in their portfolio.
Given the challenging phase of infrastructure in the country today, InvITs may provide an alternate
source of funds. Several existing infrastructure projects which are under development in India are
delayed and ‘stressed’ on account of varied reasons like increasing debt finance costs, lack of
international finance flowing to Indian infrastructure projects, project implementation delays caused
by various factors like global economic slowdown, cost overruns, etc. InvITs may offer a source of
long-term re-finance for existing infrastructure projects. InvITs may help in attracting international
finance into Indian infrastructure sector. These would also enable the investors to hold a diversified
portfolio of infrastructure assets. Among Asian markets, Singapore is a success story for listed
Trusts. In Singapore, there are 39 listings with a market capitalization of approx $70 billion, but the
bias is on REITs than on InvITs.
There is a debate on whether an InvIT, by nature of investment, is equity or debt as it has features
of both. It is somewhere in between; loosely, debt-plus or equity-minus in terms of risk return profile.
It has equity-like features such as the units are listed, can change hands like equity stocks, there is
periodic valuation of the projects akin to periodic results of companies and economic factors like
higher GDP growth or higher inflation would lead to expectation of higher revenue and hence higher
price of the units at the Exchange. Its debt-like features are - there is periodic pay-out of the earnings
of the InvIT from the underlying SPVs, which is not exactly like contractual coupon pay-out on bonds
but somewhat comparable as the valuation gives a perspective on how much to expect. It is a hybrid
instrument with a somewhat predictable cash flow yield (akin to debt) and potential appreciation with
growth of the economy (akin to equity).

Taxation wise, an InvITs is a pass-through vehicle. There is a mandate to distribute at least 90% of
net-distributable cash flows. Interest component of income distributed by trust to the unit holders
would attract withholding tax @ 10% for resident unit holders. Interest income is taxable in the hands
of the unit holder. Dividend income is exempt in the hands of the unit holder and there is no dividend
distribution tax.

©The Institute of Chartered Accountants of India

 MUTUAL FUNDS 10.55

At this point of time, InvIT is not a retail product, the minimum primary application amount being
` 10 lakh and the minimum secondary transaction amount being ` 5 lakh. The restriction is imposed
because there is no track record and lack of awareness. There is a liquidity risk as well, in the
secondary market, the units may not be traded every day as the investor base is not wide at this
point of time. May be over a period, with the development of this market, SEBI would look to ease
the threshold amount for REITs and InvITs. As of now, investors should keep it on the radar and
participate through the mutual fund route who have a better understanding of the risk factors and
can handle secondary market liquidity issues.

SEBI allows unlisted InvITs to raise funds via right issues

The Securities and Exchange Board of India has allowed unlisted infrastructure investment trusts
(InvITs) to raise funds through rights issue of their units.

The regulator has come up with detailed guidelines on conditions for issuance of units, pricing,
timelines, and allotments. SEBI said InvITs can make a rights issue of units provided it fulfil the
conditions, including none of the respective promoters or partners or directors of the sponsor or
investment manager or trustee is a fugitive economic offender, nor are they barred from the
accessing the securities market.

If the InvIT wants to have the issue underwritten, it can appoint underwriters, SEBI said.

The regulator said the minimum allotment to any investor will be Rs 1 crore. Besides, the rights issue
should open within three months from the record date and kept open for at least three working days
but not more than 15 days.

The InvIT shall not make any further issue of units in any manner during the period between the date
of filing the letter of offer with the Board and the allotment of the units offered through the letter of
offer. The InvIT shall file an allotment report with the Board providing details of the allottees and
allotment made within 15 days of the issue closing date,” SEBI said in a circular.

©The Institute of Chartered Accountants of India

 10.56 FINANCIAL SERVICES AND CAPITAL MARKETS

TEST YOUR KNOWLEDGE

Multiple Choice Questions (MCQs)

1. The funds which allows to issue and redeem units any time during the life of the scheme and
new investors can join the scheme any time by directly applying to the mutual fund and can
redeem their units any time by surrendering the units to the Mutual Fund are called: -
(a) Balanced Funds
(b) Liquid Funds
(c) Close Ended Funds
(d) Open Ended Funds
2. Mr. Rahul is 25 years old. He has just started his career by taking a job in a well-known Steel
Company. He wants to grow his money and wants to generate wealth in long term by investing
in Mutual funds. He should invest in which type of mutual funds: -
(a) Debt Fund
(b) Liquid fund

(c) Equity fund

(d) Gold ETF
3. Market Value of Total Assets of the Mutual Fund is at ` 15 cr. and Total Liabilities is at 3 cr.
It has 1 cr. outstanding Units issued. Calculate the N.A.V. per unit of the Mutual Fund: -
(a) ` 17
(b) ` 10

(c) ` 12
(d) ` 15
4. Which type of fund is more volatile?
(a) Large-cap funds
(b) Mid-cap funds

©The Institute of Chartered Accountants of India

 MUTUAL FUNDS 10.57

(c) Small-cap funds

(d) Hybrid Funds
5. ____________ are an important link between fund managers and investors.
(a) Trustees
(b) Asset Management Companies
(c) Custodians
(d) Registrar And Transfer Agents
6. What is an open-ended mutual fund?
(a) It is the one that has an option to invest in any kind of security
(b) It has units always available for sale and repurchase.
(c) It has an upper limit on its NAV
(d) It has a fixed fund size
7. ________ is a method of investing in mutual funds wherein an investor chooses a mutual
fund scheme and invests the fixed amount of his choice at fixed intervals.
(a) Systematic Transfer Plan
(b) Systematic Withdrawal Plan
(c) Systematic Investment Plan
(d) Systematic Innovative Plan
8. Which among the following is not one of the ways of measuring performance of mutual funds?
(a) Sharpe Ratio

(b) Treynor Ratio

(c) Liquidity Ratio
(d) Sortino Ratio

9. Which among the following is true in case of rolling returns?

(a) It simply measures the performance of the growth option NAV from the start date to
today’s date, annualized.

©The Institute of Chartered Accountants of India

 10.58 FINANCIAL SERVICES AND CAPITAL MARKETS

(b) Measure the return from the start date to next date, from next date to next-to-next date
and so on and take the average of all these observations.

(c) measure the return from the start date to next week, from next week to next-to-next
week and so on and take the average of all these observations.
(d) All of the above
10. The CEO, Sumesh Kumar Nahta wants to know from the CFO, CA Aakash Mehta that if the
equity fund is redeemed at ` 20 and the exit load is 2.50%, what will be the NAV of the equity
fund?

(a) 19.50
(b) 20.50
(c) 19.975

(d) 20.00
11. Front end load is also called ………...
(a) Entry Load

(b) Exit Load

(c) Both Entry and Exit Load
(d) Trail Commission

Theoretical Questions
1. Briefly describe the organization of Mutual Funds.
2. Explain Mutual Funds based on Classification of Portfolio Management.
3. What is a Net Assets Value? Explain with the help of an example.
4. As a performance measurement, what is the difference between Point-to-Point Returns and
Rolling Returns?
5. Explain the significance of Side Pocketing in protecting mutual fund investors. What effect
does side pocketing have on NAV? Are there any drawbacks to side pocketing?

©The Institute of Chartered Accountants of India

 MUTUAL FUNDS 10.59

Practical Questions
1. Mr. Shreyas wants to invest in Ready Mutual Fund Scheme for which the following information
is available:

Asset Value at the beginning of the month ` 80

Annualized return 15 %
Distributions made in Income & Capital gain (per unit respectively). ` 0.80 and ` 0.60

Calculate the month end net asset value of the mutual fund scheme.
2. An investor purchased 400 units of a Mutual Fund at ` 12.25 per unit on 31st December 2021.
As on 31st December 2022 he has received ` 1.50 as dividend and ` 1.00 as capital gains
distribution per unit.
Required:
(i) The return on the investment if the NAV as of 31st December 2022 is ` 13.25.

(ii) The return on the investment as on 31st December 2022 if all dividends and capital
gains distributions are reinvested into additional units of the fund at ` 12.50 per unit.

ANSWERS/SOLUTIONS
Answers to the MCQ based Questions.
1. (d) 2. (c) 3. (c) 4. (c) 5. (a)
6. (b) 7. (c) 8. (c) 9 (d) 10 (b)
11. (a)

Explanations to the practical Questions in the MCQs

3. Net Assets Value = Value of Assets – Value of Liabilities/Total Number Outstanding Units
= ` 15 crore – ` 3 crore/` 1 crore = ` 12 crores
10. Redemption Price = NAV/ (1 + Exit Load)
Or, 20 = NAV/ (1 + 0.025) So, NAV = ` 20.5

Answers to the Theoretical Questions

1. Please refer to paragraph 2.4

©The Institute of Chartered Accountants of India

 10.60 FINANCIAL SERVICES AND CAPITAL MARKETS

2. Please refer to paragraph 3.2

3. Please refer to paragraph 6
4. Please refer to paragraph 8.1
5. Please refer to paragraph 15

Answers to the Practical Questions

1. Calculation of NAV at the end of month:
Given Annual Return = 15%
Hence Monthly Return (r) = 1.25%
(Closing NAV - Opening NAV) + Dividend + CapitalGain
r =
Opening NAV

0.0125 =
( Closing NAV − ` 80 ) + ` 0.80 + ` 0.60
` 80
1 = Closing NAV - `78.60

Closing NAV = ` 79.60

(Closing NAV - Opening NAV) + Dividend + CapitalGain

2. (i) Return on Investment =
Opening NAV
(13.25 - 12.25) + 1.5 + 1
= x100 = 28.57%
12.25
(ii) If all dividends and capital gain are reinvested into additional units ` 12.5 per unit, the
position would be as follows:
Total amount reinvested = ` 2.5 x 40 Units = ` 1000
1000
Additional units added = = 80 units
12.5
Value of now 480 (400 + 80) units as on 31/12/2022 = 480 units x ` 13.25 = ` 6360

Price paid for 400 units as on 31/12/2021 = 400 units x ` 12.25 = ` 4900
6360 - 4900
Return = x100 = 29.80%
4900

©The Institute of Chartered Accountants of India