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Sunday, March 16, 2008

Mutual funds concepts

Mutual Funds
A mutual fund is a common pool of money into which investors with common investment objectives place their contributions that are to be invested, in accordance with the stated objective of the scheme. The investment manager invests the money collected into assets that are defined by the stated objective of the scheme.
For example, an Equity fund would invest in Equity and Equity related instruments and a Debt fund would invest in Bonds, Debentures, Gilts etc.
What are Mutual Funds
Mutual Funds in India-Growing from very Modest BeginningsThe Indian Mutual fund industry has started opening up many exciting investment opportunities for Indian investors. We have started witnessing the phenomenon of savings now being entrusted to the funds rather than in banks alone.Mutual Funds now represent perhaps one of the most appropriate investment opportunities for most investors. As financial markets become more sophisticated and complex, investors need a financial intermediary who can provide the required knowledge and professional expertise on taking informed decisions.
The Indian Mutual fund industry has passed through three phases:The first phase was between 1964 and 1987 when Unit Trust of India was the only player. By the end of 1988, UTI had total assets worth Rs.6,700 crores.The second phase was between 1987 and 1993, during which period, 8 funds were established (6 by banks and one each by LIC and GIC).
The total number of schemes went up to 167 and Assets Under Management saw the figures improving to over 61,000 crores.The third phase was marked by the entry of private and foreign sectors in the Mutual fund industry in 1993. The first entrant was Kothari Pioneer Mutual fund, launched in association with a foreign fund.

The Securities and Exchange Board of India (SEBI) formulated the Mutual Fund Regulation in 1996, which for the first time established a comprehensive regulatory framework for the mutual fund industry. Since then several mutual funds have been set up by the private and joint sectors. Currently there are 34 Mutual Fund organizations in India. Today the AUM of the Mutual Fund Industry stands at over Rs.2 lakh crores, a growth of over 1 lakh crores since the last 5 years. Also the percentage of Equity assets in the overall AUM has increased from a shade under 5% to over 30% in the same period.

What are the types of Mutual Funds
(I) Mutual Funds Classification based on Investment Objective:
1.Equity Oriented
a. General Purpose
The investment objectives of general-purpose Equity schemes does not restrict these funds from investing only in specific industries or sectors. Hence these funds have a diversified portfolio of companies spread across a vast spectrum of industries. While these schemes are exposed to equity price risks, diversified general-purpose equity funds seek to reduce the sector or stock specific risks through diversification. They mainly have market risk exposure.
b. Sector Specific
These schemes restrict their investing to one or more pre-defined sectors, e.g. technology sector. Since they depend upon the performance of select sectors only, these schemes are inherently more risky than general-purpose schemes. They are best suited for informed investors who wish to take a view and risk on the concerned sector.
c. Special schemes
Index schemes
The primary purpose of an Index is to serve as a measure of the performance of the market as a whole, or a specific sector of the market. An Index also serves as a relevant benchmark to evaluate the performance of Mutual Funds. Some investors are interested in investing in the market in general rather than investing in any specific fund. Such investors are happy to receive the returns posted by the markets. As it is not practical to invest in each and every stock in the market in proportion to its size, these investors are comfortable investing in a fund that they believe is a good representative of the entire market. Index Funds are launched and managed for such investors.
Tax saving schemes
Investors (Individuals and Hindu Undivided Families ("HUFs") are now encouraged to invest in Equity markets through Equity Linked Savings Scheme (ELSS) by offering them a tax rebate. Units purchased cannot be assigned / transferred/ pledged / redeemed / switched - out until completion of 3 years from the date of allotment of the respective Units.The Scheme is subject to Securities & Exchange Board of India (Mutual Funds) Regulations, 1996 and the notifications issued by the Ministry of Finance (Department of Economic Affairs), Government of India regarding ELSS.Investments in ELSS schemes are eligible for deduction under Sec 80C.An example of ELSS scheme is the Kotak ELSS scheme.

Real Estate Funds
Specialized real estate funds would invest in real estates directly, or may fund real estate developers or lend to them directly or buy shares of housing finance companies or may even buy their securitized assets.
2. Debt Based
These schemes, (also commonly referred to as Income Schemes), invest in debt securities such as corporate bonds, debentures and government securities. The prices of these schemes tend to be more stable as compared to Equity schemes. Most of the returns to the investors are generated through dividends or steady capital appreciation in these schemes. These schemes are ideal for conservative investors or those not in a position to take higher Equity risks, such as retired individuals. However, when compared to the money market schemes they do have a higher price fluctuation risk.
a. Income Schemes
These schemes invest in money markets, bonds and debentures of corporates with medium and long-term maturities. These schemes primarily target current income instead of capital appreciation. Hence they distribute a substantial part of their distributable surplus to the investor by way of dividend distribution. Such schemes usually declare quarterly dividends and are suitable for conservative investors who have medium to long-term investment horizon and are looking for regular income through dividend or steady capital appreciation.
b. Liquid Income Schemes
Liquid Income Schemes are similar to the Income schemes but have a shorter maturity period.
c. Money Market Schemes
These schemes invest in short term instruments such as commercial paper ("CP"), certificates of deposit ("CD"), treasury bills ("T-Bill") and overnight money ("Call"). The schemes are the least volatile of all the types of schemes because of their investments in money market instruments with short-term maturities. These schemes have become popular with institutional investors and high net worth individuals having short-term surplus funds.
d. Gilt Funds
These schemes primarily invest in Government securities. Hence the investor usually does not have to worry about credit risk since Government Debt is generally credit risk free.
3. Hybrid Scheme
These schemes are commonly known as balanced schemes and invest in both equities as well as debt. By investing in a mix of this nature, balanced schemes seek to attain the objective of income and moderate capital appreciation and are ideal for investors with a conservative, long-term orientation.
(II) Mutual Fund Investment Based on Constitution:
1. Open-ended schemes
Open-ended schemes do not have a fixed maturity period. Investors can buy or sell units at NAV-related prices from and to the mutual fund, on any business day. These schemes have unlimited capitalization, do not have a fixed maturity date, there is no cap on the amount you can buy from the fund and the unit capital can keep growing. These funds are not generally listed on any exchange.
Open-ended schemes are preferred for their liquidity. Such funds can issue and redeem units any time during the life of a scheme. Hence, unit capital of open-ended funds can fluctuate on a daily basis. The advantages of open-ended funds over close-ended are as follows:

Ø An any time exit option, the issuing company directly takes the responsibility of providing an entry and an exit. This provides ready liquidity to the investors and avoids reliance on transfer deeds, signature verifications and bad deliveries.
Ø An any time entry option, an open-ended fund allows one to enter the fund at any time and even to invest at regular intervals.
2. Close-ended schemes
Close-ended schemes have fixed maturity periods. Investors can buy into these funds during the period when these funds are open in the initial issue. After that, such schemes cannot issue new units except in case of bonus or rights issue. However, after the initial issue, you can buy or sell units of the scheme on the stock exchanges where they are listed. The market price of the units could vary from the NAV of the scheme due to demand and supply factors, investors' expectations and other market factors.

3. Interval schemes
These schemes combine the features of open-ended and closed-ended schemes. They may be traded on the stock exchange or may be open for sale or redemption during pre-determined intervals at NAV based prices.
Who can invest in Mutual Funds
Mutual Funds in India are open to investment by
1. Residents including
a. Resident Indian Individuals
b. Indian Companies
c. Indian Trusts / Charitable Institutions
d. Banks
e. Non-Banking Finance Companies
f. Insurance Companies
g. Provident Funds
2. Non-Residents including
a. Non-resident Indians, and
b. Other Corporate Bodies
3. Foreign entities, viz.
a. Foreign Institutional Investors (FIIs) registered with SEBI.

However some category of investors are not allowed to invest in particular schemes of certain funds. Besides the investors who are eligible to invest may still need to follow different procedures.

CHOOSING THE RIGHT MUTUAL FUND: is your one-stop investment destination, offering you investment opportunities in a host of financial instruments; with products like Easy IPO, Easy Derivatives, Easy Equity, Easy Mutual Fund. Further more, our offerings are customized to suit your investment profile, hence you can meet your investment objectives.Added to this our , extensive research and wide range of products would cater to your needs and objectives.
1. Past performance
While past performance is not an indicator of the future it does throw some light on the investment philosophies of the fund, how it has performed in the past and the kind of returns it is offering to the investor over a period of time. It would also make sense to check out the two-year and one-year returns for consistency. Statistics such as how 'these funds had performed in the bull and bear markets of the immediate past?' would shed light on the strength of a fund. Tracking the fund's performance in the bear market is particularly important because the true test of a portfolio is often revealed in how little it falls during a bearish phase.
2. Know your fund manager
The success of a fund to a great extent, depends on the fund manager. Some of the most successful Funds are run by the same fund managers. It would be sensible to always ask about the fund manager before investing, knowing about changes in the Fund Manager's strategy or any other significant developments that an AMC may have undergone. For instance, if the portfolio manager who generated the fund's successful performance is No longer managing that particular fund, one would do well to look into the implications and analyze what the pros and cons of investing in that fund.
3. Does the scheme suit your risk profile?
Certain sector-specific schemes come with a high-risk high-return tag. Such plans are suspect to crashes in case the industry/sector loses the market's fancy. If the investor is totally risk averse, he can opt for pure debt schemes with little or no risk. Most investors prefer the balanced schemes, which invest in a combination of equities and debts. Growth and pure equity plans give greater returns than pure debt plans, but their risks are higher.

4. Read the prospectus
The prospectus says a lot about the fund. Reading the fund's prospectus is a must to learn about its investment strategy and the risk that it is prone to. Funds with higher rates of return may carry a higher element of risk. Hence, it is of utmost importance that an investor always chooses a particular scheme after considering his financial goals and weighs them against the risk that a Mutual Fund may take while investing in a particular sector. However, all funds carry some level of risk. Just because a fund invests in Government or Corporate bonds does not mean that it does not have significant risk.

5. Fund Diversification
While choosing a mutual fund, one should always consider factors like the extent of diversification that a Mutual Fund offers. Maintaining a diversified and balanced portfolio is a key to maintaining an acceptable level of risk. Generally the more diversified a fund; the lesser is its susceptibility to get affected by one particular sector/industry's fall.
6. Costs
A fund with high costs must perform better than a low-cost fund to generate the same returns for you. Even small differences in fees can translate into large differences in returns over a period of time. Finally, an investor must be careful not to pick a fund simply because it has shown a spurt in value in the current rally. It would be advisable to ferret out information regarding a fund for at least three years. The one thing to remember while investing in Equity funds is that it makes no sense to get in and out of a fund with each turn of the market. Like stocks, the right Equity Mutual Fund will pay off big -- if you have the patience. Similarly, it makes little sense to hold on to a fund that lags behind the total market year after year.
What is NAV
Net Asset Value (NAV) denotes the performance of a particular scheme of a mutual fund.Mutual funds invest the money collected from the investors in the securities markets. In simple words, Net Asset Value is the market value of the securities held by the scheme. Since market value of securities changes every day, NAV of a scheme also varies on day-to-day basis.
NAV= The market value of securities of a scheme / Total number of units of the scheme on any particular date.
For example, if the market value of securities of a Mutual Fund scheme is Rs.200 lakhs and it has issued 10 lakh units of Rs.10 each, to the investors, then the NAV per unit of the fund is Rs.20. NAV is required to be disclosed by the Mutual Funds on a regular basis - daily or weekly - depending on the type of scheme.
Tax Aspects of Mutual funds
Tax Implications of Dividend Income
Equity Schemes
Equity Schemes are schemes, which have more than 50 per cent investments in Equity shares of domestic companies.As far as Equity Schemes are concerned, no Distribution Tax is payable on dividend. In the hands of the investors, dividend is tax-free.
Other Schemes
For schemes other than Equity, in the hands of the investors, dividend is tax-free.However, Distribution Tax on dividend @ 12.81% is to be paid by Mutual Funds.
Tax Implications of Capital Gains
The difference between the sale consideration (selling price) and the cost of acquisition (purchase price) of the asset is called capital gain. If the investor sells his units and earns capital gains, he is liable to pay capital gains tax.Capital gains are of two types: Short Term and Long Term Capital Gains.
Short Term Capital Gains
If the holding period of the Mutual Fund units is less than or equal to 12 months from the date of allotment of units, then short term capital gains is applicable.On Short Term capital gains, no Indexation benefit is applicable.
Tax and TDS Rate (excluding surcharge)
Resident Indians and Domestic Companies
The Gain will be added to the total income of the Investor and taxed at the marginal rate of tax. No TDS.
For NRIs: 10% TDS from the gain for equity schemes and 30% for debt schemes.
Long Term Capital Gains
The holding period of Mutual Fund units is more than 12 months, from the date of allotment of units.On Long Term capital gains Indexation benefit is applicable.
Tax and TDS Rate (excluding surcharge)
Resident Indians and Domestic Companies
The Gain will be taxed
A) At 20% with indexation benefit for debt funds
At 10% without indexation benefit, whichever is lower for debt funds. This does not include TDS.

B) No Long-term Capital Gain tax on equity funds.
A) 20% TDS from the Gain only for debt funds.
B) No tax on Long-term Capital Gains for equity funds
Surcharge applicable
Resident Indians: If the Gain exceeds Rs.8.5 lakhs, surcharge is payable by investors @ 10%. Domestic Companies: Payable by the investor @ 2.5%.
NRIs: If the Gain from the Fund exceeds Rs 8.5 lakhs, surcharge is deducted at source @ 2.5%

Risk Vs Reward
Having understood the basics of Mutual Funds, the next step is to build a successful investment portfolio. Before one begins to build a portfolio, one should understand some other elements of Mutual Fund investing and how they can affect the potential value of investments over the years. The first thing that has to be kept in mind while investing, is that there is no guarantee that one will end up with more money while withdrawing. In other words, the potential of loss is always there. The loss of value in investments, is what is considered risk in investing.

At the cornerstone of investing is the basic principal that the greater the risk you take, the greater the potential reward.
Risk then, refers to the volatility - the up and down activity in the markets and individual issues that occur constantly over a period of time. This volatility can be caused by a number of factors - interest rate changes, inflation or general economic conditions. It is this variability, uncertainty and potential for loss, that causes investors to worry. We all fear the possibility that a stock we invest in will fall substantially. But it is this very volatility that earns higher long-term returns from these investments, than from a savings account.

Different types of mutual funds have different levels of volatility or potential price, and those with the greater chance of losing value are also the funds that can produce the greater returns for you over time. So risk has two sides: it causes the value of your investments to fluctuate, but it is precisely the reason you can expect to earn higher returns.

One might find it helpful to remember that all financial investments will fluctuate. There are very few perfectly safe havens and those simply don't pay enough to beat inflation over the long run.
Types of risks
All investments involve some form of risk. Mentioned below are the common types of risks. An investor would do well to evaluate them against potential rewards while selecting an investment. Market Risk
At times, the prices or yields of all the securities in a particular market rise or fall due to broad outside influences. When this happens, the stock prices of both an outstanding, highly profitable company and a fledgling corporation may be affected. This change in price is due to "market risk". It is also known as systematic risk.
Inflation Risk
Sometimes referred to as "loss of purchasing power." Whenever inflation rises forward faster than the earnings on your investment, one runs the risk of actually being able to buy less, not more. Inflation risk also occurs when prices rise faster than returns.
Credit Risk
In short, how stable is the company or entity to which one lends his/her money while investing? How certain are you that it will be able to pay the interest you are promised, or repay your principal when the investment matures?
Interest Rate Risk
Changing interest rates affect both Equities and bonds in many ways. Investors are reminded that "predicting" which way rates will go, is rarely successful. A diversified portfolio can help in offsetting these changes.
Exchange risk
A number of companies generate revenues in foreign currencies and may have investments or expenses also denominated in foreign currencies. Changes in exchange rates may, therefore, have a positive or negative impact on companies which in turn would have an effect on the investment of the fund.
Investment Risks
In sectoral fund schemes, investments will be predominantly in Equities of select companies in the particular sectors. Accordingly, the NAV of the schemes are linked to the equity performance of such companies and may be more volatile than a more diversified portfolio of Equities.

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