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Mutual Funds | Definition, Objectives, Types, Functions, Guidelines, Advantages & Disadvantages

Mutual Funds


What is Mutual Funds ?


A mutual fund is a pool of money representing the savings made by a number of investors. The funds so collected are managed by professionals by investing in equity as well as debt instruments like stocks, debentures, bonds, money market and other financial instruments. The job of the fund manager of a mutual fund, also known as the portfolio manager, includes making investments out of the funds entrusted by various investors to the mutual fund, booking capital gains/losses, periodically collecting interest/dividend income and payment of interest/dividend to investors, etc.
The profits earned by a mutual fund (net of all its expenses) are distributed among-st the individual investors, in the ratio of their level of investment (i.e. the shares/units held by each one of them). The valuation of one unit/share of a mutual fund, also referred to as the 'Net Asset Value (NAV)' is carried out on a day-to-day basis. The NAV is calculated by dividing the total value of the fund by the total number of outstanding units as on that day.

Definition of Mutual Funds


The Securities and Exchange Board of India (Mutual Funds) Regulations, 1993 defines Mutual Fund as :
"A fund established in the form of a Trust by a sponsor to raise monies by the trustees through the sale of units to the public under one or more schemes-for investing in securities in accordance with these regulations".

According to Weston J. Fred and Brigham, Eugene F., mutual funds are :
"Corporations which accept dollars from savers and then use these dollars. to buy stocks, long-term bonds, short-term debt instruments issued by business or government units, these corporations pool funds and thus reduce risk by diversification".

Functions of Mutual Funds 


The mutual funds of all the categories perform following essential functions or features :
  • Trading, i.e. buying and selling of various financial instruments on behalf of their clients, viz. Unit-holders.
  • Offering an opportunity to small investors to become a shareholder of a large and diversified portfolio of assets with minimum exposure to associated risks.
  • The savings, mobilized through various schemes launched by mutual funds, are channelized to create a portfolio of assorted securities, viz. equities, debentures, bonds, Government securities, etc. such portfolios are generally large in size, diversified and financially robust.
  • Investors of mutual funds are given a certificate with regard to their share of participation in the fund in the form of units.
  • Mutual funds are managed by highly professional and experienced personnel, which generally ensures higher returns on the amount invested.
  • They are helpful to small investors, who do not have the time, expertise, experience or resources to access capital market directly, in taking the benefits of such profitable avenue.

Objectives of Mutual Funds 


Most of the people, having surplus funds with them and willing to invest in various financial instruments available in the market, face the twin problems relating to (i) the shortage of time, and (ii) lack of a flair for research with a view to selecting individual equity/debt instruments to be included in their portfolio. 

Under such circumstances, mutual funds, with their professional expertise in the field, step in with the solution of the prospective investors' dilemma. They offer multiple choice of investments in funds, having specialization in diversified financial instruments like stocks, bonds, and other assets. A diversified portfolio ensures that a drop in the market value of one stock or bond does not impact the overall return in a considerable manner. Entrusting the job of selection of stocks and bonds, for purchase or sell at appropriate time to a mutual fund, gives enough time to an individual investor for pursuing any other chosen activity. A good number of mutual funds are in existence in the market with their varied offerings, which can cater to the needs of different categories of investors. Mutual funds serve the following objectives :

Objectives of Mutual Funds

1) Diversification : 
The significance of diversified investment lies in the old adage "do not put all the eggs in one basket". Diversification is an age old hedging instrument. High concentration of investment in one or two equities is likely to lead towards exposure of the portfolio to avoidable risks. If due to some reason, the market value of any one of such stocks decline sharply, the entire portfolio would be impacted negatively. Financial advisors, therefore, suggest the investors to keep minimum 15 stocks in their portfolio. Management of a portfolio of this size by an individual investor requires a lot of time and efforts. However, the mutual funds have the benefit of holding a huge number of stocks, which ensures diversification for individual investors, and also safeguards them from a negative market movement in respect of any of the stocks held by the funds.

2) Growth : 
One of the investor's categories is keen in a fast progression in their fund-value. The best option for them is 'stock route' of investment which have, if taken on a long-term basis, traditionally yielded a high rate of returns; although this route is fraught with the highest level of risk. Funds, which invest their client's money exclusively in highly rated and generally expensive stocks, are referred to as 'growth funds', whereas those funds, which invest their client's money in comparatively less-expensive. stocks, are termed as 'value funds'.

3) Income : 
Some other funds, commonly referred to as 'income mutual funds', cater to the needs of investors, who are more interested in getting a regular stream of income from their investments. Such funds invest in the bonds, common/preferred stocks, or even real estate investment trusts (REITs) of the blue-chip companies with a record of giving high dividend pay-outs. Such form of income received by the mutual fund is passed on to the investors at a regular periodicity (monthly or quarterly). Commonly a yield between 3% and 7% is paid by.such income-oriented mutual funds.

4) Low Fees : 
Investment in equities at individual level is an expensive affair, due to the element of brokerage involved therein. Investment in equities through a mutual fund is, therefore, a good option for individual investors, because their fees are reasonable; some of them in fact do not charge anything for the services provided by them (e.g. no load mutual funds), while the charges (operational fees) of many other MFs are below 1% per annum. Another category of low cost funds is 'Index Funds', fees of which are just 0.1% per annum. Portfolio of such funds are highly diversified, benefit of which is available to investors at a cheap price.

5) International Exposure : 
International markets (e.g. US, UK, Japanese, or Chinese) are not easily accessible for individual investors. However, these markets can be accessed without any hurdle through international-focused mutual funds. Thus, individual investors, interested in investing in stocks of companies only in international markets, can do so through the international-focused mutual funds.

Advantages of Mutual Funds 


Mutual funds are beneficial to various categories of investors, especially the small investors to whom they offer a convenient route for participation in the capital market. 10 advantages of mutual funds are as follows :

1) Transparency : 
Operations of mutual funds are fully transparent, inasmuch as their portfolios are disclosed every month. Investors are in the know of things with regard to the deployment of their funds, and if the portfolio management does not come up to their expectations, they are free to move out of the funds after giving a short notice to this effect.

2) Diversification : 
Diversification is a good tool for risk-mitigation process. It is not possible for a small individual investor to afford diversification with limited amount, expertise and other resources. However, mutual funds have a large corpus and a big team of professionals, and as such are in a position to invest in companies belonging to different industries and sectors. thereby ensuring low level of risks.

3) Research : 
Mutual funds have a large set-up with plenty of funds and market research team. They have access to data which is required to take investment decisions on behalf of their unit-holders. It is not possible for an individual investor to do on his/her own, what a mutual fund can do on his/her behalf.

4) Professional Management : 
At individual level, a small investor is neither equipped with the requisite understanding of the market operations nor has the necessary resources to access the market for investment in a fruitful manner. It is, therefore, crucial to seek the help of an expert, who is neither easy to find, nor affordable by an average investor. Mutual funds come to the rescue of small investors in this regard, as they have a team of professionals having necessary expertise and experience in respect of research and analysis of companies' data with a view to evaluating their performance level. The investment strategies adopted by them generally do not go wrong. For a small investor, mutual funds are the best option to enter and take advantage of the capital market.

5) Convenience : 
Investment through a mutual fund is not only time and energy saver, it is a convenient way to enter the capital market.

6) Stability : 
Corpus held by most of the mutual funds is quite large and diversified, which provide them the benefit of 'economies of scale'. As a result, they are in a position to absorb any unexpected loss arising out of their operations in the market, and at the same time continue their investment strategies by remaining in the market.

7) Tax Benefits : 
Dividends distributed by mutual funds are exempted from capital gains tax in the hands of their investors. Further, some of the schemes floated by mutual funds like Equity. Linked Saving Scheme (ELSS), and Rajeev Gandhi Equity Saving Scheme (RGESS) also, provide tax relief to investors.

8) Flexibility : 
Some of the mutual funds offer a family (group) of schemes, wherein an investor is allowed to transfer the holdings from one scheme to another scheme within the same family.

9) Affordability : 
Due to the 'economies of scale' factor, investment by a small investor through a mutual fund is cost-effective as compared to the direct investment in the capital market. 

10) Liquidity : 
Selling of securities, at times, poses a major challenge, if it is held in individual capacity by an investor. However, if the investment has been made through a mutual fund, the encasement is hassle-free. They can be sold to the fund directly in the case of an open ended fund, whereas in the case of a close-ended fund, they can be sold in the secondary market. where they are traded frequently.

Disadvantages of Mutual Funds


Some of the shortcomings or limitations common to almost all the mutual funds are as follows :

1) Dilution : 
Diversification, although good for a fund and its investors as a risk management technique, has its own drawbacks, due to the dilution factor associated with it. This phenomenon may be best understood with the help of an example - in case one of the securities held in a fund's portfolio performs very well and its market value doubles in a short span of time, its impact would not be prominently felt on the fund's portfolio, as the security forms only a small part of the overall portfolio. Diversification leads a mutual fund to perform either remarkably good or bad.

2) No Insurance : 
Mutual fund industry as a whole is under regulation of various Government agencies (SEBI, RBI, etc.). However, no protection is available to it in the form of insurance against likely losses incurred by it, as available to banks against losses by: DICGC. Mutual funds have to put in place their own mechanisms like diversification, to: reduce the risks they are exposed to. As the nature of their business involves dealing with. capital market, which is highly volatile, they may incur some losses in certain cases, and in some exceptional cases their entire investment. may be wiped out.

3) Fees and Expenses : 
With a view to meeting management expenses, most of the mutual funds charge management' and 'operating' fees from their investors, which ranges between 1% and 1.5% per year for actively managed funds. Some mutual funds also charge 'sales commission' and "redemption fees, over and above the 'management' and 'operating' fees. As many of the funds are actively engaged in trading of shares, the transaction cost shoots up considerably. Some of these charges are made applicable on an on-going basis, as against the stock investments wherein commission is paid only at the time of buying or selling.

4) Poor Performance : 
Performance of mutual funds is entirely dependent on the movement of stock market, which is highly volatile. Therefore, there is no assurance to investors with regard to the returns on the amount invested by them. Historically, on an average almost 75% of the mutual funds have not been able to keep pace with the major market indices like 'Standard and Poor's 500 (S&P 500). Sometimes the capabilities of professional managers employed by funds are also placed under doubt by the critics; whether they are really better-off in carrying out their jobs than an ordinary investor.

5) Loss of Control : 
From an investor's point of view, once the money is invested in a mutual fund the control thereon is entirely passed on to the managers of the fund. Various decisions with regard to buying and selling of securities, their timings, etc. are entrusted to them. Their decisions may not always match with what an investor would have taken, had he For example, the tax implications of a decision taken by a fund. manager may not be necessarily suitable for some investors.

6) Trading Limitations : 
Mutual funds are normally considered to be liquid. However, some of them (e.g. open-ended funds) cannot be traded freely in the middle of trading day, as there are some restrictions on that. They can be bought and sold only at the end of the day at the current value of their holdings.

7) Size : 
Corpus size of some mutual funds is so enormous that it is difficult to find good investments of choice. especially the funds which concentrate on shares of small companies. This problem is aggravated in view of the strict rules pertaining to single company/group of companies' exposure limits applicable to mutual funds. As a result of such a scenario, mutual funds are compelled to compromise while selecting companies for investment purpose.

8) Inefficiency in Cash management : 
With a view to providing enough liquidity for the likely redemption cases, some categories of mutual funds are required to maintain heavy amount of cash on an on-going basis. The other side of this is loss of opportunity cost, i.e. part of a fund's corpus, which could have been invested in some profitable avenue, becomes idle in the form of hard cash. This impacts the profitability of a mutual fund, and the ultimate sufferers are investors with reduced returns in their hands.

Types of Mutual Funds


On the basis of their investment pattern and other characteristics, mutual funds can be classified into two broad categories, which are further sub categorized as depicted below. Classification of mutual funds explained as follows :

Classification of Mutual Funds

General Classification 


Mutual funds under this category are classified into various sub-categories as indicated above. Individual sub-category has been discussed below in detail :

1) Open-Ended Schemes : 
Under the open-ended schemes, mutual funds make their units available on an on-going basis (on-tap) at the Net Asset Value (NAV) based rates. They are not listed on. any of the stock exchanges. Such schemes do not have any lock-in period', and they offer repurchase facilities immediately after the allotment. 'US-64 scheme' of Unit Trust of India is typical example of open-ended scheme. Other salient features of open-ended schemes launched by MFs are as under : 

  • During the life-span of an open-ended scheme of a fund, the investors are free to enter or come out of such scheme at any point of time. 
  • Corpus of an open-ended scheme is not fixed its level keep on increasing or decreasing with the entry/exit of investors.
  • Such schemes do not have a fixed redemption/maturity period. Redemption price of units, in the form of NAV, is always on offer by the fund, at which an investor can get his/her units redeemed and exit out of the fund.
  • An investor desirous of re-entering the scheme, can do so by purchasing units at the prevailing NAV rates, sale and purchase price are notified by such funds at periodical intervals.
  • Liquidity is the biggest advantage to an investor for having invested in such schemes. The unit-holders can sell/repurchase units as and when they desire to do so.
  • Open-ended schemes are generally launched by a mutual fund as a family of schemes (numerous schemes). An investor has the choice to transfer the investment from one scheme to another scheme of the same family.

2) Close-Ended Schemes : 
Close-ended schemes do not provide redemption of their unit on an on going basis. The Close-Ended Schemes characterized by the following features :
  • The corpus of a close-ended scheme is fixed, and their maturity period is between two and five years.
  • Investors have the option to invest in such schemes only during the time of their launch, when they remain open for subscription for a limited period (generally 45 days).
  • Once the limited offer period is over, investors cannot buy the units under a close ended scheme directly from the fund. However, as the units are listed in the stock exchanges, they can be traded (bought and sold) in the secondary market.
  • Some of the close-ended schemes give an. opportunity to the unit holders for selling their units directly to the fund from time to time at the prices linked to their NAV.
  • Investors directly receive dividends, bonuses, etc. periodically from the fund.
  • Units sold by a unit holder directly to the fund cannot be repurchased from the fund by him. He may, however, do so from the secondary market at the prevailing market rates.
  • Close-ended scheme of a fund and open ended scheme of the same fund are not inter convertible, i.e. a close-ended scheme cannot be converted into an open-ended scheme, and vice-versa.
  • If the majority unit holders desire to roll over the units, it can be done by passing a resolution to that effect by them.

3) Interval Schemes : 
They are hybrid schemes having some characteristics of open-ended schemes, and some characteristics of close-ended schemes. They give an option to their existing unit-holders for redemption of their units at NAV-based prices at predetermined periodicity.

4) Load Funds : 
There are certain common overheads incurred by almost all the mutual funds, e.g. marketing, distribution, advertising, portfolio churning, fund manager's salary, etc. Such expenses are recovered by many mutual funds from their investors in the form of various loads, e.g. entry load, exit load, etc. Such funds are termed as 'Load Funds'. Various kinds of loads are levied on the investors, which are as follows :

i) Entry Load or Front-end Load : 
Charges under this load are imposed on an investor right at the time, when he/she joins the scheme. The amount of entry load,is subtracted from the amount of contribution to the fund by the investor.

ii) Exit Load or Back-end Load : 
Charges under this load are levied on an investor at the time of his/her exit from the scheme by way of redemption of units held by him/her. The amount of exit load is recovered from the redemption proceeds payable to such unit holders.

iii) Deferred Load : 
Deferred load represents the charges recovered during the period spread over a wide range of time.

iv) Contingent Deferred Sales Charge (CDSC) : 
Some schemes envisage reduction in the percentage of exit load in proportion of the investor's length of stay with the fund (longer the stay, less the percentage of exit load). Such kind of load is referred to as the *Contingent Deferred Sales Charge' (CDSC).

5) No-Load Funds : 
Mutual funds, which do not charge any of the above loads, are aptly termed as 'No-load Funds'.

6) Tax-Exempt Funds : 
Mutual Funds investing their corpus in such financial instruments, which are exempted from the payment of tax, are termed as Tax-exempt Funds. All the equity oriented funds, which are open-ended, are exempted from the payment of distribution tax (distribution tax is a tax levied on income distributed to investors). Other examples of tax exempt category are long-term capital gains and dividend income (in the hands of investors).

7) Non-Tax-Exempt Funds : 
Mutual Funds investing their corpus in such financial securities, which attract payment of tax, are termed as 'Non-Tax-exempt Funds'. In our country, all mutual funds, other than the 'open-ended equity. oriented funds' are required to pay distribution tax. Any profit made by an investor on account of sale of units, within twelve months of their purchase, falls under the category of short-term capital gains, and is taxable. Similarly, in the case of an 'equity-oriented fund', sale of its units attracts Securities Transaction Tax (STT). The amount of STT is recovered from the redemption proceeds payable to an investor.

Broad Classification


Various sub-categories of the broad classification of mutual funds are as follows :

1) Equity Funds : 
Equity funds are those funds which invest their corpus exclusively in the equity market. They are, for the obvious reasons, considered the most risky funds as compared to other categories of funds; at the same time they are the most rewarding funds for the investors, as their dividend pay-out ratio is also very high. However, it is worthwhile and sensible for an investor, putting their money in an equity fund, to remain invested therein for a longer period, i.e. more than three years. Equity funds may be categorized in different groups depending upon the level of risk an individual fund is exposed to. Following is the list of such categories, which are arranged in the descending order of the risks they are associated with. Equity funds are categorized as follows :

i) Aggressive Growth Funds : 
Aggressive Growth Funds are characterized by their preference for maximum capital appreciation within minimum time-frame, for which they resort to speculation by investing in the equities having 'high risks and high returns without proper analysis and research. As a result, these funds tend to be volatile in nature and their exposure to risks is higher as compared other equity funds.

ii) Growth Funds : 
The objective of Growth Funds is also capital appreciation in the long term perspective of three to five years. However, their investment strategy differ from that of these funds, in as much as they prefer to invest in equities of the companies. with better future prospects in terms of better average earnings, after proper analysis and t research, and they avoid (although not completely refrain from) speculative investments.

iii) Equity Income or Dividend Yield Funds :
The objective of Equity Income, also rightly referred to as Dividend Yield Equity Funds, is to invest in equities of such companies, which are recognized for higher dividend payments to their investors. This ensures a steady flow of recurring income along with stable capital appreciation for their investors. Historically, the power or utility companies are known to show comparatively less volatility in their share prices. Equity Income Funds are generally associated with a lower risk level.

iv) Diversified Equity Funds : 
Diversified equity funds have a policy of investing their entire corpus, excepting an insignificant part thereof, in different sectors, without emphasis on any specific sector. By adopting this strategy of diversified investments, such funds are able to manage risks which specific to certain sector/companies. Nevertheless, they are required to manage equity market risks, which they are exposed to like any other fund. Equity Linked Saving Scheme (ELSS) is classic example of diversified equity fund. 
Under this scheme the funds are required to invest minimum 90% of their corpus in equities on a continuous basis. Investors are encouraged by the Government of India to invest in ELSS, by providing them tax benefits in the form of making them eligible to claim deduction from taxable income up to Rs.1.50 lakh. ELSS has lock-in period of three years, before which the units cannot be redeemed the normal course. However, in certain exceptional circumstances, an investor may be allowed redemption before the expiry of the lock-in period on the condition that they pay income tax on such income for which tax exemption was allowed in the past.

v) Equity Index Funds : 
Equity Index Funds are designed with the objective of keeping in alignment with the performance of a particular stock market index. This is achieved by achieved developing a portfolio comprising the equities of the same companies in the same ratio, which formed that specific index. In this connection, it is noteworthy that equity index funds, which follow broad indices (like S & P, CNX, Nifty, Sensex etc.) are exposed to lower level of risk as compared to the equity index funds, which follow narrow indices (like BSE, BANKEX or CNX etc.). Narrow indices are considered more risky due to the fact that their diversification status is at a low level.

vi) Value Funds : 
Value Funds have the policy of investing in the companies with strong fundamentals, but due to certain specific reasons their stocks are, for the time being. under-valued and as such they are available in the market at a low Price. Various vital ratios, viz. Price to Earning Ratio (PER) (Market Price per Share/Earning per Share) and Market to Book Value (Fundamental Value) Ratio, etc. of such stocks are rather at a lower level for the time being. As the value funds prefer stocks of blue-chip companies from various sectors and avoid concentration of investment in a few sectors only, their exposure to risks is limited as compared to other funds like growth funds or specialty funds. 
The sectors, in which the value funds prefer to invest, are cement, steel, sugar, and other cyclical industries. Stocks from cyclical industries have the characteristics of being volatile in the short-term. However, such volatility and the inherent risks associated therewith tends to move further off with the passage of time. This is precisely the reason behind the advice of professionals to have a long-term horizon in mind, while investing in value funds.

2) Debt/Income Funds : 
Debt funds or income funds are the funds with the policy of investing their corpus in the debt papers having medium or long-term tenure, issued by the companies belonging to diverse sectors like banking, financial institutions, infrastructure, Government companies, etc. Risk exposure of such funds is at a low level, and their endeavor is to ensure a stable stream of current income, rather than capital appreciation for their investors. 
With a view to achieve the above target, a major chunk of the available surplus is distributed among-st the investors. Even though the debt securities, which form the main constituent of debt-funds' portfolio, are in general much less risky as compared to the equities, they are exposed to the specific risk of default in the payment of interest and/or principal (credit default) by the issuer. As part of risk-mitigating/risk-management exercise, debt funds make their investments in the securities/issuers with better 'investment ratings' by credit rating agencies, like CRISIL CARE Ratings, ONICRA Credit Rating Agency, Fitch Ratings, ICRA, Moody's Investors Service, etc. Debt funds looking for higher returns should be ready to be exposed to higher risks. Debt funds may be classified into the following categories on the basis of their investment objectives :

i) Diversified Debt Funds : 
Debt funds, which invest in the debt instruments issued by various sectors of the economy, are termed as diversified debt funds.

ii) Focused Debt Funds : 
Focused debt funds belong to a category altogether different from the diversified debt funds. Such funds investment strategy focuses and invests and investing in carefully chosen debt instruments issued by companies belonging to the particular sector of the economy. They are very selective in their investment decisions.

iii) High Yield Debt Funds : 
The investment objective of high yield debt funds is to maximize their earnings, for which they are prepared to take the highest level of risks. Their choice of investment may include even the debt instruments rated by rating agencies as "below investment grade". They are willing to go to any extent in order to achieve their objective of higher returns. As a result, they tend to be more volatile in nature, and are exposed to higher default risks.

3) Liquid Funds/Money Market Funds : 
Liquid funds, also termed as money market funds, have the policy to invest exclusively in money market debt instruments, which are characterized by their high liquidity and short-term maturity period (within 12 months). The only risk they are exposed to is interest rate risk; other risks are at the minimal, i.e. they belong to the lowest risk bearing category of instruments, and as such are considered safest among-st other categories of mutual funds. Money market instruments of choice for a typical liquid fund are Government of India Treasury Bills of different maturities, Commercial papers issued by companies, Certificates of Deposit issued by banks, etc.

4) Hybrid Funds :
Hybrid funds invest in different financial instruments like equities, debts and various money market securities. Their portfolio is, thus, an assortment of diversified financial papers. The ratio of debt and equity in a hybrid fund's portfolio is generally 50:50, which may be fixed or variable.
According to their investment pattern, hybrid funds may be classified into 3 categories. Types of Hybrid Funds are as follows :

i) Balanced Funds : 
As the nomenclature itself indicates, balanced funds have a balanced portfolio, i.e. their portfolio include financial instruments of various classes, e.g. debt securities, convertible securities, equities, preference shares, etc., which are held in almost balanced/equal ratio. The biggest advantage of having a balanced portfolio is that the possibility of capital erosion is minimized. The investors of balanced funds are kept satisfied with a regular stream of income and adequate level of capital appreciation. Such funds meet the requirements of traditional investors with a long-term investment perspective.

ii) Growth-and-Income Funds : 
'Growth and Income Funds' are characterized by some features of 'growth funds' and some features of 'income funds'. They invest their corpus in the companies (i) with better prospects for capital appreciation and (ii) are recognized for distributing higher level of dividends to their investors. These funds are exposed to the level of risks, which is considered below than that of 'growth funds', but is above than that of 'income funds'.

iii) Asset Allocation Funds : 
In principle, mutual funds are free to frame their policies with regard to investment of the corpus in any class of assets, viz. financial (e.g. equity, debt, money market instruments, etc.) or non-financial (e.g. commodities, real estates, etc.). In accordance with their policy, they actually invest in any of the above mentioned asset class. However, 'asset allocation funds'. have policy of variable asset allocation, under which their fund managers are authorized to shift the fund's investment from one asset class to another at any point of time, keeping in view the better future prospects of a specific asset class.

5) Sector Funds :
Sector Funds are those funds which restrict their investments in a particular sector or interlinked sectors (e.g. energy, power, technology, infrastructure, etc.) of the economy. Such funds are variable in a significant manner as far as market capitalization, investment objective (i.e., growth and/or income) and class of securities within the portfolio are concerned. They are known for their volatile nature and moderate dividend distribution.
As the investment portfolio of sector funds generally consists of one specific sector (or two three closely linked sectors), their success is entirely dependent upon the future of those sectors. They are, therefore, considered the riskiest funds out of all the mutual funds. During their initial offering itself, they are required to disclose the name/s of the sector in which they plan to invest, and they have to abide the disclosure by restricting their investment in that particular sector. The success of such funds is linked with the successful performance of that particular sector. If it performs well, then the returns may be much more than that of equity diversified fund or an index fund. However, if that particular sector under performs, the returns would be adversely affected.
Sector funds, by their very characteristics, are meant for special category of investors; the investors who are well-informed, have a high level of risk-appetite, keep themselves side by side of all the market movements, monitor their portfolio and take a decision regarding their exit at an appropriate moment should enter such funds.

6) Technology Funds : 
Technology funds may be considered as one of the sector funds, as they have a strategy to invest exclusively in technology sector, which comprises of hardware and software companies, viz. manufacturers of computers and other electronic items, as well as developers of information technology related applications.
A technology mutual fund may be defined as a mutual fund, which invests in the companies engaged in the business of designing, creating and distributing technology-driven products and services. Such funds are characterized by the diversification of highest level. Certain classes of technology funds viewed by market are participants to be so distinctive that they need to be kept in a separate category.

7) Exchange Traded Funds (ETF) : 
Exchange Traded Funds are known for being traded as a single stock on stock exchanges at a price linked with the indices of those stock exchanges. Their investors get the benefits of both - close-ended as well as open-ended mutual funds. Other advantages offered by such funds include diversification coupled with the benefits of holding a single share, which can be traded at index-linked prices. Exchange traded funds are of recent origin in our country, and they have gained popularity within a short span of time, even in global market.

8) Commodity Funds : 
Commodity funds, as the nomenclature itself suggests, have the policy of investing their corpus in various commodities (like metals, agricultural products, crude oils, etc.) directly or indirectly (through commodity companies or commodity future contracts). Typical examples of commodity funds are 'precious metals fund' and 'gold funds, which are known to invest their corpus in gold, gold futures, and/or shares of gold mines. Commodity funds may be classified as 'specialized funds (investing their corpus exclusively in a single commodity or a single group of commodities). and 'diversified funds' (investing their corpus in various commodities available in the market). The specialized funds risk exposure is. for obvious reasons, at a higher level as compared to that of diversified funds.

9) Fund of Funds (FOFs) : 
A mutual fund that invests in the units of other mutual funds/hedge funds, instead of investing directly in different financial instruments (equity or debt) available in the market, is known as 'Fund of Funds' (FOFs). FOF is also referred to as multi-manager investment. On the basis of their investment pattern, Fund of Funds may be categorized in the following two groups :

i) Mutual Fund FOFs : 
Mutual Fund FOF invests its corpus in the units of other mutual funds. Its portfolio comprises of units of various mutual funds and not the financial securities, as in the case with other mutual funds,

ii) Hedge Fund FOFs : 
The investment strategy of a hedge fund FOF is to exclusively invest in various hedge funds. An exposure to hedge fund industry ensures diversification of risks involved in a single investment fund.

10) Real Estate Funds : 
Real estate funds are those funds, which have the policy of investing their corpus exclusively in real estate developers directly or indirectly (i.e. through the shares/securitized assets of housing finance companies). They constitute a highly specialized category of mutual funds having the objective of generating regular flow of income and/or capital appreciation for their investors. Advantages & Disadvantages of Real Estate Funds are as follows :

Real estate funds may either be growth-oriented or income-oriented or both. However, an investor may reap the benefits of regular income in the form of dividends during the period of holding the units of such funds, and book capital gain from the sale of those units.

As compared to the diversified growth funds or income funds, the real estate funds are inherently more volatile in nature. It is therefore, suggested by experts to invest in such funds with a long term horizon in view, and remain invested therein. In the event of any adverse development, the real estate market tends to decline sharply, and investors of real estate funds are likely to suffer financially.

Guidelines for Mutual Funds 


The basic regulatory structure for mutual funds working in India are as follows :

Guidelines for Mutual Fund

UTI Guidelines for Mutual Funds 


1) Constitution and Management :

i) Trust : 
The mutual fund consists of trust, investors and the beneficiary. The basic structure of the trust consists of the three elements which are the trustees, the fund manager and the beneficiary. The trustee can be the sponsor bank and the mutual fund should be able to work in the business of investment and management of securities.

ii) Board of Trustees : 
The Board of trustee should have minimum 6 members and maximum 10 members. The working of mutual fund should invest in the board of trustee. It checks the daily working of the company.

iii) Sponsor : 
The sponsor should give 75 crore to the corpus fund as non-transferable capital. 

iv) Approval : 
The Ministry of Finance approves UTI for its mutual fund.

2) Investment Objectives and Policies  :

i) Areas of Investment : 
The mutual fund should invest in activities like holding or disposing of securities, collecting and discounting of bills of exchange, purchasing and selling of participation certificates according to any loan or advances given by any public financial institution or scheduled bank, make deposits with companies, invest in securities floated by the central government formulate schemes in association with LIC or GIC, acquire immovable properties, provide investment advisory and portfolio management service and working in any other business which the Ministry of Finance had approved.

ii) Granting Advance : 
Mutual funds give advances to the companies and cooperative societies which are working in the industrial activities. The investment should not be more than 20% of the funds in any type of scheme. The purchase of mutual fund can be on any margin of security. The trading is done over the counter when the fund scheme is listed.

iii) Borrowings : 
The mutual fund should not borrow in place of paying dividend or for meeting the temporary conditions which should not be more than 10% of NAV of the fund.

iv) Schemes : 
The UT'I can work in both the open and close ended schemes.

3) Schemes of Mutual Funds :

i) Approval : 
The various schemes made by the AMC require the approval of the trustees and copies of offer documents of such schemes should be given to SEBI.

ii) Disclosure : 
The offer documents should co the proper announcement for helping the investors to take better decisions. 

iii) Advertisements : 
The advertisement of the schemes should be according to the SEBI guidelines of the advertisement code.

iv) Listing : 
The listing of close-ended schemes is mandatory, and every close-ended scheme should be listed in a recognized stock exchange within 6 months from the closure. of subscription'. The listing of the schemes which will give the periodic repurchase facilities to all unit holders is not important. But if the scheme gives the monthly income or be made for any specific part of society then the listing is very important.

v) Redemption : 
The units of a close-ended scheme should be opened for sale or redemption at the pre-determined and fixed interval.

vi) Subscription Open : 
Only the unit-linked scheme can be opened for more than 45 days of subscription. The AMC will give the specific offer documents, the minimum subscription will increase under this scheme and if there over-subscription then the time period of subscription can be increased and for all the applicants who will apply up to 5,000 units will be given the full allotment.

vii) Re-Purchase of Close-Ended Schemes : 
The AMC according to its wish can repurchase or re-issue the units of a close ended scheme. The units of close-ended schemes can be opened for sale or can redeemed at the fixed predetermined intervals without listing and the maximum and minimum amount of sale or redemption of the and time period of such sale and redemption should be given in the offer document.

viii) Conversion into Open-Ended Schemes : 
When the offer document of such a scheme discloses the option and the period of conversion then the units of close-ended scheme can be changed into open-ended scheme. Till, 12 January 1998, the approval of the majority of the unit holder is required for the conversion. Now, the unit holders which do not give the written consent for the conversion will be given the chance to redeem the full holdings at the price of NAV.

ix) Roll-Over : 
The close-ended scheme will be fully redeemable by the end of maturity period till the large number of unit holders agrees for the roll-over through passing a resolution. The unit holder which does not choose for the roll-over will be allowed for redeeming the holdings in the scheme at NAV base price.

x) Offering Period : 
The offering period of mutual fund will not be of more than 45 days excluding the equity linked savings scheme.

xi) Refund : 
The application money received from the mutual fund and asset management company will be refunded if the minimum subscription is not received and also in over subscription. It will be returned within 6 weeks from the date of closure or 15% interest per annum will be paid.

xii) Transfer of Units : 
The unit certificate will be freely transferable by both the parties and operation of law if not prohibited under some restricted or scheme. The guidelines of SEBI (depositories and participants) Regulations, 1996 will be transferred if the units are of depository.

xiii) Guaranteed Returns : 
A unit scheme will be given guaranteed return if such return is not fully guaranteed by the sponsor or the asset management company. The statement in offer document should show the name and the manner of the person who will guarantee the return will be stated in the offer document.

4) Investment Objectives and Valuation Policies :

i) Debt Instrument : 
The investments in debt instruments will be done only in the rated debt instrument. It should not be less than the investment grade but should be rated by the credit rating agency. The permission of Board of AMC is required if the debt instrument is not rated.

ii) Ownership : 
The ownership mutual fund cannot exceed 10% of the paid-up capital for the particular scheme. The maximum investment in the shares of the company by a mutual fund will be more than 10% of the paid-up capital of the company.

iii) Investment : 
The money collected in this scheme will be invested in the transferable money market securities, capital market securities and privately placed debentures of securitised debt. It is according to the investment guidelines given in the regulation of 1996.

iv) No Advance : 
Mutual funds cannot advance loans for any work and the funds will be given in option trading, short-selling and carry-forwarded transaction.

v) Underwriting : 
The undertaking activity by mutual funds is started after getting the certificate of registration from SEBI. The capital adequacy will be the net asset of the scheme for the purpose of underwriting. Thus, the underwriting obligation will not be more than the total NAV of the scheme.

vi) Borrowings : 
The mutual fund car borrow till the 20% of the net assets of the scheme till 6 months for meeting the temporary liquidity requirement of re-purchase. redemption of units, payment of interest or dividend to unit holders.

vii) Valuation : 
The mutual fund will calculate and do the valuation of its investment portfolio and publish at interval which will not be more than one week. The mutual fund will not be more than the re-purchase price which is less than 93% and the sale price is not more than 107% of the NAV.

viii) Publicity : 
The mutual fund will publish regularly the sale and re-purchase units for at least once in a week in the daily newspaper with all India movement and the difference between the re-purchase and sale price will not be more than 7% of the sale price.

5) Fees and Expenses :
  • The offer document should have full disclosure of the investment and advisory fee charged by AMC.
  • The AMC can charge 1.25% of the weekly average assets remaining in every accounting year for the concerned scheme till the net assets will not be more than 100 crore. If there are no-load schemes then the AMC can charge an extra 1% of weekly average net asset outstanding in each financial year.
  • The AMC will ask for primary expenses of introducing a scheme, recurring expense for marketing, agents commission brokerage and registrar services, fees and expenses for auditors, custodian, trustees and other costs permitted by the board. The initial expense will not be more than 6% of the initial resources issued from the scheme.
  • The total cost of the scheme will include the investment management and advisory fee. It excludes issue or redemption expenses.
  • The schemes in which the investment in bonds like recurring expenses will be reduced by at least 0.25% of the weekly average net assets.
  • The mutual fund and AMC will provide the periodic statements to SEBI.

6) Inspection and Audit : 
The regulations will have the inspection and audit procedures. The SEBI can check the books of accounts, records, documents, infrastructure system and procedure or investigate the affairs of the mutual fund, trustees and AMC.

RBI Guidelines for Mutual Funds


1) Constitution and Management Guidelines :

i) Trustees : 
The mutual fund will make a trust under the Indian Trust Act and the sponsoring bank will appoint a board of trustees for managing it. The board of trustee would appoint the two outside trustees which are not connected to the sponsoring bank and are trustworthy person and have the capability to work in the various kinds of problem relating to the protection of investment and investor. The regular management of schemes under the mutual fund is according to the way given by board of trustee which will be helpful for full-time executive trustee who will not simultaneously give their responsibility to the other bank.

ii) Sponsor : 
The contribution of the sponsor bank is as per the specification of RBI which should have minimum capital of 2 crore or the higher amount. The corpus would be changed at a later date into a subscription to any of the schemes of the fund with the permit of board of trustees of the fund. There is no further contribution made by sponsor bank without the approval of RBI to the corpus. Also with the contribution to the corpus, the sponsor bank should also contribute and control the share in each of the fund schemes which is equal to 1% of the total amount outstanding. It will not appeal to the special schemes in which the sponsor bank cannot participate.

iii) Mutual Fund Banks : 
The banks must require permission from the RBI before. declaring any scheme of mutual fund without considering whether they are identical or not to any earlier schemes approved by RBI.

2) Investment Objectives and Policies :

i) Trust Deed : 
The trust deed should have the investment objectives and policies of mutual fund. The various schemes made under the fund should be according to the main goals and plans, rules and regulations. The better knowledge of the investment objective of funds and the investment policies and also the terms and conditions of the scheme should be given while making offer for public subscription.

ii) Funds Deployment : 
The subscription payment received by mutual funds should be invested in the capital market instrument like government and other trustee securities, share/debentures of public limited companies, bonds of public sector undertakings, etc.

iii) No Lending : 
The mutual funds should not perform the banking and merchant banking function like direct or indirect lending. portfolio/funds management, underwriting, bills discounting, money market operations, etc.

iv) Inter-Scheme : 
The mutual funds should invest in schemes like other money market instruments, re-discounting of bills or bank deposits for periods not exceeding six months and temporary surplus funds of similar instrument which should be of not more than 25% of the investible funds. These short-term investments are allowed only in the agreement of the fund.

v) Delivery : 
The mutual funds should always take delivery of the purchased scrips and also of the scrips sold and given for the delivery to the purchaser. The scrips which are purchased is transferred in the name of the fund.

vi) Prohibited Avenues : 
The mutual funds will not invest in the short-term purchase and sale of securities over the transaction from one settlement to the next settlement and also in the other unit trust, mutual fund or similar collective investment schemes. It should not invest in share of investment companies and corporations.

3) Prudential Exposure Ceiling Limits : 
The mutual funds in any of the schemes should not have more than 5% of issued share capital or debenture stock of any company. If the mutual funds are investing in more than one scheme then the total of all the schemes should not be more than 15% of paid capital or debenture stock of a company and specified industries like cotton, textiles, tea, tires, etc. It will not be applicable to those schemes which are floated for investment in one or more specific industries and the declaration are made.

4) Pricing : 
The maximum range of the purchase and selling prices of units and shares of any schemes will not be more than 5%.

5) Cost : 
The total cost of controlling any kind of scheme in a fund should include management fees and other administrative costs which should be ranged to 5% of the total income of the scheme.

6) Income Distribution : 
The income distribution by the dividend and capitalization of gains method which should not be according to the revaluation of the stock holdings or unrealized capital appreciation.

7) Provisions : 
The provision for bad or doubtful debt and depreciation on investment should be given for satisfying the auditor prior to declare any dividend. The fund should make the dividend equalization fund for every scheme by taking a portion of its surplus income.

8) Statement of Accounts and Disclosures :

i) Separate Accounts : 
The mutual funds should keep the separate accounts for every kind of scheme launched and the assets should be separated under each scheme. The transferring of assets should be between the schemes taking place excluding the prior approval of board of trustees and the present market rates.

ii) Annual Statement : 
The board of trustees of mutual funds should make the annual statement of accounts for every scheme providing the information about the statements of assets and liabilities, income and expenditure accounts, duly audited by qualified auditors. In addition to this shortening, the type of annual accounts along with the reports of the auditors and the Board of Trustee may be published for the information of subscribers.

iii) NAV : 
The board of trustee of mutual funds will show the NAV of every scheme and the way of value the benefit of the subscribers.

iv) Reports by Sponsor : 
The RBI should be provided with the duplicate of the following report by the sponsor bank :
  • The half-yearly report showing the working of mutual fund along with the schemes of it.
  • The audited annual statement of accounts with the reports of auditors and the Board of Trustee.
  • The scheme-wise information about the investment portfolio of the funds like the cost of the investment, change in portfolio and also the past annual report and industry wise exposure.

SEBI Guidelines for Mutual Funds 


The basic guidelines and SEBI (Mutual Fund Regulations) are as follows :
  1. The mutual fund will be made according to the trusts given in the Indian Trust Act and will be controlled by individually formed Asset Management Company.
  2. The money market mutual fund will be controlled by RBI and SEBI controls the other mutual funds. 
  3. The independent directors are 50% of the members of the board of AMC and will have no relation with sponsoring organisation. 
  4. The experience of the directors in the area of portfolio management, financial administration, etc. should be of at least 10 years.
  5. The minimum net worth of AMC is 10 crore. 
  6. If the AMC fails to work for the interest of investors then the SEBI has the right to withdraw the approval of AMC. It does not include the banks which sponsors the mutual funds.
  7. One AMC cannot be the AMC for another mutual fund.
  8. The AMC can do other fund based business like providing investment management services to offshore funds, other mutual funds, venture. capital funds and insurance companies.
  9. The minimum amount of the closed-end scheme will be 20 crore and for the open-ended scheme Rs.50 crore. 
  10. The various scheme of the mutual fund is to registered with SEBI prior to floating in the market.
  11. The closed-ended scheme will be open for more than 45 days for the subscription and in open ended scheme the first 45 days will be kept for defining the target figure.
  12. The minimum amount or 60% of the target amount will not be raised and the whole subscription will be given to the investors.
  13. There would be separate fund manager for each and every scheme.
  14. The mutual fund cannot invest more than 10% of NAV of a scheme in shares or share related instruments of a single company as per the guidelines of SEBI, 1999.
  15. The maximum investment limit for MFs in listed companies ranges from 5 to 10% of NAV according to the open-ended funds.
  16. The initial cost of the issue will not be more than 6% of the funds will be collected from each scheme.
  17. The mutual funds would distribute 90% of the profits every year.
  18. The mutual fund will be required to send the audited annual statements of accounts and six months unaudited of net assets for every scheme to SEBI.
  19. The SEBI will show the same advertising code for all mutual funds which are to be followed.
  20. The SEBI after the proper monitoring will charge. the penalty on the mutual funds for not following the guidelines.

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