Mutual Funds – Tool for Wealth Management By- Nilesh Sodhani CA (Final) Student

What is a Mutual Fund ? A Mutual Fund is a professionally managed collective investment scheme that pools money from many investors and invests it in stocks, bonds, short-term money market instruments, and/or other securities. The Mutual Fund will have a fund manager that trades the pooled money on a regular basis.

The Structure of Mutual Funds In India Mutual fund is the form of a Public Trust created under the Indian trust Act. 1882. In India, Mutual funds are organized as trusts. The trust is either managed by a Board of Trustees, or by a trustee company. The trustees hold the unit holders money in a fiduciary capacity.(Money belongs to unit holders) In legal sense, the investors are the beneficial owners of investments.

Shares of ownership in a public company. Basic Understanding of Stocks and Bonds Stocks : Shares of ownership in a public company. The most common owned investment Types of Stocks : Cyclical Stocks Growth Stocks Value Stocks

Bonds : The money which you lend to the government or a company, and in return you can receive interest on your invested amount, which is back over predetermined amounts of time. The most common lending investment traded on the market. Many other types of investments - annuities, real estate, and precious metals

Working of Mutual Funds Mutual funds can be either or both of open ended and closed ended investment companies depending on their fund management pattern. Mutual funds have diversified investments spread in calculated proportions amongst securities of various economic sectors. Mutual funds get their earnings in two ways: Dividend, the most organic way Redemption of their shares by investors at a discount to the current NAVs.

Concept of Mutual Funds Investors pool their money Investors get Mutual Fund Units on Proportionate basis The Money collected from investors is invested by the Fund Manager The Fund Manager realises gains or losses, and collects dividend or interest income Such gains are passed on to the investors in proportion of no. of units held by them

Open Ended Funds Purchase and sell units of the fund, at NAV related prices, at any time, directly from the fund. Open ended scheme are offered for sale at a pre- specified price, say Rs. 10, in the initial offer period. After a pre-specified period say 30 days, the fund is declared open for further sales and repurchases Investors receive account statements of their holdings, The number of outstanding units goes up and down The unit capital is not fixed but variable.

Closed ended Funds Open for sale to investors for a specified period, after which further sales are closed. Any further transactions happen in the secondary market where closed-end funds are listed. The price at which the units are sold or redeemed depends on the market prices, which are fundamentally linked to the NAV. The corpus of closed ended funds remains unchanged. The unit capital is fixed, one time sale.

Types of Mutual funds Types of Mutual Funds Stock Funds Taxable Bond Funds Municipal Bond Funds Stock and Bond Funds Money Market Funds

Common Stock Funds Most popular type of fund Wide variety with different objectives and levels of risk Growth Industry or sector funds Geographic areas International or Global Equity Index funds

Generally seek to generate current income with limited risk Taxable Bond Funds Generally seek to generate current income with limited risk Can vary by maturity Short-term, Intermediate-term, Long-term Can vary by type of bond Government Corporate Mortgage-backed International/Global Bond Index funds

Municipal Bond Funds Provide investors with income exempt from Federal taxation Often concentrate on single states to avoid state income taxation as well

Stock and Bond Funds Seek to provide a combination of income and value appreciation. Different names Balanced funds (60% equity+40% of debt securities) Goal: to conserve principal, by maintaining a balanced portfolio of both stocks and bonds Blended funds: Mutipurpose funds(e.g., balanced target maturity, convertible securities that invest in both stocks and bonds Flexible funds: Flexible income, flexible portfolio, global flexible and income funds, that invest in both stocks and bonds

Money Market Funds These debt funds invest only in instruments with maturities less than a year. Provide safe, current income with high liquidity Invest in money market securities T-bills, Bank CD’s, Commercial paper, etc. NAV stays at Re.1; income either paid out or reinvested daily Provide an alternative to bank deposits, but not FDIC insured

Key Information Mamorandum It’s attached with the Mutual Fund Form which contains : 1. Name of the fund. 2. Investment objective 3. Asset allocation pattern of the scheme. 4. Risk profile of the scheme 5. Plans & options 6. Minimum application amount/ no. of units 7. Benchmark index 8. Dividend policy 9. Name of the fund manager(s) 10 . Expenses of the scheme: load structure, recurring expenses 11. Performance of the scheme (scheme return v/s. benchmark return) 12. Year – wise return for the last 5 Financial Years

Performance Measurement Earnings can be either dividend or capital gains. Rate of Return = Income Earned *100/ Amount invested. Simple total return (STR) method includes the dividends paid to the investor STR = {NAV(end) – NAV ( begin)}+ Dividend paid *100 NAV at beginning Rule of 72 is a thumb rule used in finding doubling period. If Rate = 12%, then money will double in 72/12 = 6 years. Comparison with : Market Index Funds in the same group Other similar investible products

Performance Measurement Change in NAV= ( NAV at end – NAV at beg.)*100 NAV at the beginning Total Return = ( Change in NAV+ Dividend) *100 NAV at the beginning Return on investment or Total Return with dividend reinvested at NAV. Portfolio Turnover Rate – It is lesser of assets purchased or sold divided by the fund’s net assets. A 100% turnover implies that the manager replaced his entire portfolio during the period in question 200% means portfolio changed in 6 months A liquid fund has the highest portfolio turnover.

Numerical 1 : An open ended fund was purchased when its NAV was Rs. 22. One year later, its NAV was Rs. 24. The annualised percent NAV change is _ _ _ _ Answer % change in NAV = ( 24 -22) *100 = 9.09% 22

Numerical 2 : Purchase price Rs. 22 per Unit NAV at year end Rs. 23 per Unit Interim Div. Rs. 3 Ex.-Div. NAV Rs. 21 Total Return = _ _ _ _ _ Assume investment of Rs. 10000 Step 1: Initial Units alloted =10000/22=454.55 Step 2:Total Div.=454.55*3=1363.65 Step 3: Additional Units=1363.65/21=64.94 Step 4:Total Units=454.55+64.94=519.49 Step 5:Withdral Amt. =519.49*23=11947.17 Gain =11947.17-10000=1947.17 Gain of 1947.17 on the investment of Rs. 10000 So that on the investment of Rs. 100 gain is 19.47 Ans:19.47%

Measuring performance of mutual funds Comparison Portfolio Analysis Tools Comparison with : Market Index Funds in the same group Other similar investible products Standard Deviation Beta Analysis R-squared Sharpe Ratio Portfolio Turnover Ratio Total Expense Ratio

Stage Financial needs Investment preferences Accumulation stage Investing for long term identifed Growth options and long term   financial goals products.High risk appetite Transition Stage Near term needs for funds as Liquid and medium term investments. pre-specified needs draw closer Lower risk appetite Reaping Stage Higher liquidity requirements Preference for income and debt products Inter Generational Long term investment of inheritance Low liquidity needs. transfer Ability to take risk and invest for the long term Sudden wealth surge Medium to long term Wealth preservation. Preference for low risk products

Mutual Fund Expenses and Considerations Loads Commission to the broker to financial advisor who sold the fund to the investor For load funds, the offer price is the fund’s NAV plus the load (while no-load funds are sold at their NAV) Ex. 4% load with NAV Rs.96, buy at Rs.100 Load range from around 3% (low-load) to 8.5% 12b-1 Fees: pay to the distributor (.25%-.75% )+ .25% servicing charge in some cases) Fees deducted from the asset value of the fund to cover marketing expenses An alternative to loads

Mutual Fund Expenses (Contd…) Offering Price= NAV/(1-load %). Investing Rs.1,000 in a load MF with 7% and expected return of 10%, Rs.value=1000(1-.07)(1.10)=1023 (2.3% growth) Investing Rs.1,000 no load MF with 8% return and 2% redemption fee, Rs.value=1000(1-0)(1.08)(1-.02)= 1058.4 (5.84% growth) Rs.35.4 Difference

Mutual Fund Expenses (Contd…) Deferred Sales Loads Redemption charges when fund shares are sold (rather than when purchased) Often high (5-7%) if shares are sold within the first year, but then fall over time, perhaps even disappearing eventually Share Classes Many funds offer several different classes of shares (A-B-C) with different fee structures Best choice usually depends of investment horizon

Mutual Fund Expenses (Contd…) Management Fees Fees deducted from the fund’s asset value to compensate the fund managers Some adjust fees according to the fund’s performance Expense ratio Adding all fees and calculating expenses as a percentage of the fund’s asset

Investment Strategies Choose in funds consistent with your objectives, constraints, and tax situation. Consider index funds for a large portion of your fund portfolio. When possible, invest in no-load funds with below-average expense and turnover ratios. Invest at least 10-20% in international or global funds. Own funds in different asset classes and consider life-cycle investing.

Investment Strategies (Contd….) If you actively manage your portfolio, consider the past year’s “hot funds.” Do not attempt to time the market; timing strategies add little except costs and risk. Use dollar cost averaging by investing a set dollar amount each month. Avoid investing money shortly before the capital gain distribution dates (prospectus). Do not own too many funds. You will get average returns with high expenses.

Advantages of Mutual Funds Simplicity Diversification Professional Management Liquidity Economies of Scale

PROFESSIONAL MANAGEMENT ADVANTAGES DISADVANTAGES LIQUIDITY ECONOMIES OF SCALE DIVERSIFICATION PROFESSIONAL MANAGEMENT TAXES DILUTION COSTS

LIQUID & MONEY MARKET FUNDS Risk Consideration High level of Return High level of Risk EQUITY FUNDS Returns comparatively less risky DEBT FUNDS Provide stable but low level of return LIQUID & MONEY MARKET FUNDS

Risk – Return Relationship

DOs in Selecting the Best Mutal Fund Draw down your Investment Objective Collect necessary information Pick out companies consistently performing above average Get a clear picture of fees & associated costs, taxes etc. Risk Analysis with the help of Sharpe Ratio & Beta Analysis Selecting one with a low minimum initial investment

Tax Implication in Mutual Funds The dividends are tax free in the hands of unitholders by it is liable to dividend distribution tax in case of closed ended fund and debt funds( equity <50%) No TDS on any income distribution by MF The earning on selling units is known as Capital Gain If units are held for less than 12 months--- STCG Else the earnings is known as LTCG.

Capital Gain Taxation The difference between sale and purchase price is known as capital gain / loss. The sale and purchase of units in equity oriented scheme of MF is subject to STT at the prescribed rate Under Section 111 A of the IT ACT, STCG on sale of equity oriented scheme is taxed at the rate specified by the govt. ( currently10%). LTCG LTCG if equity oriented scheme of MF is exempt from tax. Tax on other scheme is 10% for LTCG ( without indexation) and 20% with indexation.

Other Points in Taxation Section 80 C – Individual and HUF are entitled to deduction upto Rs. 1 lakh in respect of payment out of taxable income towards certain instruments which includes ELSS of Mutual funds. Dividend Stripping – ( Section 94(7) – If investor buy units within 3 months prior to record date of dividend and sells those units within 3 months of record date, then the loss if any, shall be ignored. Units are not considered under wealth tax Section 195 – 20% TDS for LTCG and 30% TDS on STCG if unit holder is a NRI. 48% TDS if unit holder is foreign company.

Buying Mutual Funds At the time of Initial Public Offerings made by Mutual Fund Companies From Stock Exchanges ( Closed End Funds ) Buying Open End Funds perpetually from the Company

What are Large-cap and Small-cap Shares ? The size of a company in the equity markets is determined by market capitalisation (no. of shares issued * market price/share) LARGE CAP SMALL CAP Market Capitalisation High Greater Liquidity Comparatively Smaller Returns Cost of Transaction Low Market Capitalisation Low Poor Liquidity Comparatively Higher Returns Cost of Transaction High

Computation of NAV For investors, the performance of their investment depends on what happens to the fund’s per share value, or net asset value (NAV). NAV= Market Value of Assets – Liabilities Number of Shares Outstanding NAV1=NAV0+All Incomes-All Distributed Example: NAV0=Rs.100, Distributed 1) Net Realized Gains=Rs.2 and 2) Net Investment Income=Re.1. NAV1= Rs.100-Rs.2-Re.1=Rs.97

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