Concept of Mutual Fund
The flow chart below describes broadly the working of a mutual fund:
How does a Mutual fund work?
A Mutual Fund is a trust that pools the savings of a number of investors who share common financial goal, investments may be in shares, debt securities, money market securities or a combination of these. Those securities are professionally managed on behalf of the unit-holders, and each investor holds a pro-rata share of the portfolio i.e. entitled to any profits when the securities are sold, but subject to any losses in value as well.
The income earned through these investments and the capital appreciation realized are shared by its unit holders in proportion to the number of units owned by them. Thus a Mutual Fund is the most suitable investment for the common man as it offers an opportunity to invest in a diversified, professionally managed basket of securities at a relatively low cost.
Mutual Funds in India are governed by the SEBI (Mutual Fund) Regulations 1996 as amended from time to time. For further details please visit the SEBI website http://www.sebi.gov.in
Organization of Mutual Fund:
The structure consists of:
Sponsor is the person who acting alone or in combination with another body corporate establishes a mutual fund. Sponsor must contribute at least 40% of the net worth of the Investment Managed and meet the eligibility criteria prescribed under the Securities and Exchange Board of India (Mutual Funds) Regulations, 1996.The Sponsor is not responsible or liable for any loss or shortfall resulting from the operation of the Schemes beyond the initial contribution made by it towards setting up of the Mutual Fund.
The Mutual Fund is constituted as a trust in accordance with the provisions of the Indian Trusts Act, 1882 by the Sponsor. The trust deed is registered under the Indian Registration Act, 1908.
Trustee is usually a company (corporate body) or a Board of Trustees (body of individuals). The main responsibility of the Trustee is to safeguard the interest of the unit holders and inter alias ensure that the AMC functions in the interest of investors and in accordance with the Securities and Exchange Board of India (Mutual Funds) Regulations, 1996, the provisions of the Trust Deed and the offer documents of the respective Schemes. At least 2/3rd directors of the Trustee are independent directors who are not associated with the sponsor in any manner.
Asset Management Company (AMC):
The Trustee as the Investment Manager of the Mutual Fund appoints the AMC. The AMC is required to be approved by the Securities and Exchange Board of India (SEBI) to act as an asset management company of the Mutual Fund. At least 50% of the directors of the AMC are independent directors who are not associated with the Sponsor in any manner. The AMC must have a net worth of at least 50 crores at all times.
Registrar and Transfer Agent:
The AMC if so authorized by the Trust Deed appoints the Registrar and Transfer Agent to the Mutual Fund. The Registrar processes the application form; redemption requests and dispatches account statements to the unit holders. The Registrar and Transfer agent also handles communications with investors and updates investor records.
Types of Mutual Fund:
Definition of Large, Mid & Small Cap Stocks as per SEBI Guidelines:
Large Cap Stocks – 1 to 100 by Market Capitalization
Mid Cap Stocks – 101 to 250 by Market Capitalization
Small Cap Stocks – 251 onwards by Market Capitalization
Equity funds invest at least 65% of their corpus in equity and equity-related securities. These funds may invest in a wide range of industries/sectors or focus on one or more sectors.
A Multi-Cap Fund is a type of equity mutual fund that invests in shares of large-cap, mid-cap, and small-cap companies. The fund allocates a minimum of 65% of the total corpus in equity & equity-related instruments.Multi-cap funds can have a lower risk as compared to individual mid or small-cap focused funds because they are the most diversified equity funds.
Large Cap Fund:
A minimum of 80% of the value of the portfolio of large-cap mutual funds consists of equity & equity related instruments of large-cap companies.Large-cap mutual funds have the lowest risk among equity mutual funds because the large-cap companies have stable businesses.
Large & Mid Cap Fund:
Large & mid-cap mutual funds have a minimum 35% investment in stocks of large-cap and mid-cap companies each. The fund relies on the stability offered by the large-cap stocks and earns returns from the mid-cap stocks.
Mid Cap Fund:
A minimum of 65% of the total corpus of the mid-cap mutual fund schemes is invested in shares of mid-cap companies.Mid-cap mutual funds are riskier than large-cap mutual funds.
Small Cap Fund:
A small-cap fund invests a major portion (more than 65% of the total assets) in small-cap stocks. Thus, small-cap mutual funds have the highest risk but also have the potential to generate the highest returns.
Value funds follow a value investment strategy that relies on long-term wealth creation by investing in stocks of companies that meet the value investing criterion.
The contra fund capitalizes on the changing market conditions. The Contra fund follows a contrarian investment strategy that involves buying and selling in contra (opposite) to the present market sentiments.
Index funds are attached to a particular index such as the BSE SENSEX or the S&P CNX NIFTY. Their performance is linked to the results of that index. Here, the portfolio comprises stocks that represent an index and the weightage assigned to each stock is in line with the identified index. Hence, the returns will be more or less similar to those generated by the Index.
Sector-specific funds invest in the securities of a specific sector or industry such as FMCG, Pharmaceuticals, IT, etc. The returns on these funds are directed by the performance of the respective sector/industries.Sector funds allow an investor to diversify funds across multiple companies within an industry. These funds tend to be riskier as the performance is directly linked to that of the overall sector.
Tax Saving (Equity Linked Savings Schemes/ELSS) Funds:
The Income Tax Act offers tax deduction under specific provisions of the Income Tax Act, 1961. Designed to generate capital growth, ELSS mutual funds invest primarily in equities and largely suit investors with a higher risk appetite for capital appreciation. Spread over medium to long-term, tax saving funds comes with a lock-in period of 3 years
With an aim to provide stability of returns and capital appreciation, balanced mutual funds invest in both equities and fixed income instruments. These funds generally tend to invest around 65% in equity and 35% in debt instruments such as bonds and debentures.
Following a simpler approach, debt/income funds usually invest 65% of the amount in fixed income securities such as bonds, corporate debentures, government securities (gilts) and money market instruments. These funds are likely to be less volatile than equity funds.
Money Market/Liquid Funds:
If you are looking for a fund that offers liquidity and capital preservation with moderate income, then this is a suitable choice. Money market/liquid funds invest in safer short-term instruments such as Treasury Bills, Certificates of Deposit and Commercial Paper for less than 91 days. These funds are ideal to invest in if you are a corporate or an individual investor and wish to earn moderate returns on surplus funds.
Gilt mutual funds invest exclusively in government securities. The Gilt funds do not carry a credit risk - where the issuer of the security can default. However, it comes with an interest rate risk i.e. risk due to the rise or fall in interest rates.
Arbitrage funds work on the mispricing of equity shares in the spot and futures market. Mostly, it takes advantage of the price differences between current and future securities to generate maximum returns. The fund manager simultaneously buys shares in the cash market and sells it in futures or derivatives markets. The difference in the cost price and the selling price is the return you earn.
Fund of Funds:
A scheme that invests primarily in other schemes of the same mutual fund or other mutual funds is known as a FoF scheme. A FoF scheme enables investors to achieve greater diversification through one scheme. It spreads risks across a greater universe.
Global funds are quite distinct from International Funds. While a global fund invests primarily in markets around the world, it invests in securities in India. On the other hand, international funds focus exclusively on foreign markets. Global funds can be diverse and universal in strategy due to the distinct policy, market and currency differences across the world. It works as a break against inflation. The long-term returns from these funds have been historically high.