Introduction

What are Mutual Funds?

A mutual fund is a form of collective investment that pools money from many investors and invests the money in stocks, bonds, short-term money-market instruments, and/or other securities. The portfolio manager trades the fund's underlying securities, realizing a gain or loss, and collects the dividend or interest income. The investment proceeds are then passed along to the individual investors. Mutual Fund is the investment vehicle that is gaining momentum in the Indian ma rket. Institutions known as Asset Management Companies regulate mutual funds in India. Money from the common man is pooled in and is diversified into other investment opportunities. Financial institutions or companies manage these mutual funds. Professionals are hired into these companies to evaluate the Balance Sheet and Profit and Loss accounts of companies to know which of them are perfor ming and will succeed in the near future. Thus bringing high r eturns to the investment. Apart from investments in equities, debentures which are directly linked to the bullish and bearish tr ends in the market, mutual funds are invested in more subtle companies that have a steady growth rate and thus are not much affected by the share market. This is the advantage of mutual funds over banks and other investment options, as they allow investors to invest in safe, low risk and high-risk companies. The investors can invest in different schemes of one fund or in different mutual funds altogether and build up their investment portfolio. The flow chart below describes broadly the working of a mutual fund:

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CONSTITUTION OF THE MUTU L FUND

Though there are many differences among various Mutual Funds, all Mutual Funds comprise of following four components. They are: Sponsor The sponsor initiates the idea to set up a mutual fund. It could be a registered company, scheduled bank or financial institution. A sponsor has to satisfy certain conditions, such as on capital, track record (at least five years' operation in financial services), default-free dealings and a general reputation of fairness, has to be ascertained. The sponsor appoints the trustees, AMC and custodian. Once the AMC is formed, the sponsor is just a stakeholder

Trust/Board of Trustees Trustees hold a fiduciary responsibility towards unit holders by protecting their interests. Sometimes, as with Canara Bank, the trustee and the sponsor are the same. For others, like SBI Funds Management, State Bank of India is the sponsor and SBI Capital Markets the trustee. Trustees float and market schemes; and also they secure necessary approvals. They check whether the investments of the AMC are within defined limits, whether the fund's assets are protected, and also whether the unit holders get their due returns.

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Fund Managers/AMC They are the ones who manage the investor s money. An AMC takes investment decisions, compensates investors through dividends, maintains proper accounting and information for pricing of units, calculates the NAV, and provides information on listed schemes and secondary market unit transactions. It also exercises due diligence on investments, and submits quarterly reports to the trustees. The fund manager is a very important person for the successful working of the various schemes of the fund. It is he who decides the portfolio of companies in which the money is to be invested. This portfolio is selected according to the investment objectives of the AMC as well as the investment strategies for that particular scheme.

Custodian It is often an independent organization, and it takes custody of securities and other assets of a mutual fund. Among public sector mutual funds, the sponsor or trustee generally also acts as the custodian.

Sponsors

Board of Trustees Asset Management Company

Custodians

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History and Development of Mutual Funds in India

The mutual fund industr y in India started in 1963 with the formation of Unit Trust of India, at the initiative of the Government of India and the Reserve Bank of India. The histor y of mutual funds in India can be broadly divided into four distinct phases.

The Evolution
The formation of Unit Trust of India marked the evolution of the Indian mutual fund industry in the year 1963. The primary objective at that time was to attract the small investors and it was made possible through the collective efforts of the Government of India and the Reserve Bank of India. The history of mutual fund industry in India can be better understood divided into following phases:

Phase I. Establishment and Growth of Unit Trust of India - 1964-87

Unit Trust of India enjoyed complete monopoly when it was established in the year 1963 by an act of Parliament. UTI was set up by the Reserve Bank of India and it continued to operate under the regulatory control of the RBI until the two were de-linked in 1978 and the entire control was transferred in the hands of Industrial Development Bank of India (IDBI). UTI launched its first scheme in 1964, named as Unit Scheme 1964 (US-64), which attracted the largest number of investors in any single investment scheme over the years.

UTI launched more innovative schemes in 1970s and 80s to suit the needs of different investors. It launched ULIP in 1971, six more schemes between 1981-84, Children's Gift Growth Fund and India Fund (India's first offshore fund) in 1986, Mastershare (India s first equity diversified scheme) in 1987 and Monthly Income Schemes (offering assured r eturns) during 1990s. By the end of 1987, UTI's assets under management grew ten times to Rs 6700 crores.

Phase II. Entry of Public Sector Funds - 1987-1993

The Indian mutual fund industry witnessed a number of public sector players entering the market in the year 1987. In November 1987, SBI Mutual Fund from the State Bank of India became the

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first non-UTI mutual fund in India. SBI Mutual Fund was later followed by Canbank Mutual Fund, LIC Mutual Fund, Indian Bank Mutual Fund, Bank of India Mutual Fund, GIC Mutual Fund and PNB Mutual Fund. By 1993, the assets under management of the industry increased seven times to Rs. 47,004 cror es. However, UTI remained to be the leader with about 80% market share.

Phase III. Emergence of Private Sector Funds - 1993-96

The permission given to private sector funds including foreign fund management companies (most of them entering through joint ventures with Indian promoters) to enter the mutual fund industry in 1993, provided a wide range of choice to investors and more competition in the industry. Private funds introduced innovative products, investment techniques and investorservicing technology. By 1994-95, about 11 private sector funds had launched their schemes.

Phase IV. Growth and SEBI Regulation - 1996-2004

The mutual fund industry witnessed robust growth and stricter regulation from the SEBI after the year 1996. The mobilization of funds and the number of players operating in the industry reached new heights as investors started showing more interest in mutual funds.

Investor s' interests were safeguarded by SEBI and the Government offered tax benefits to the investors in order to encourage them. SEBI (Mutual Funds) Regulations, 1996 was introduced by SEBI that set uniform standards for all mutual funds in India. The Union Budget in 1999 exempted all dividend incomes in the hands of investors from income tax. Various Investor Awareness Progr ams were launched during this phase, both by SEBI and AMFI, with an objective to educate investors and make them informed about the mutual fund industry.

In February 2003, the UTI Act was repealed and UTI was stripped of its Special legal status as a trust formed by an Act of Parliament. The primary objective behind this was to bring all mutal fund players on the same level. UTI was re-organized into two parts: 1. The Specified Undertaking, 2. The UTI Mutual Fund

Presently Unit Trust of India operates under the name of UTI Mutual Fund and its past schemes
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(like US-64, Assured Return Schemes) are being gradually wound up. However, UTI Mutual Fund is still the largest player in the industry. In 1999, there was a significant growth in mobilization of funds from investors and assets under management.

Phase V. Growth and Consolidation - 2004 Onwards

The industry has also witnessed several mergers and acquisitions recently, examples of which ar e acquisition of schemes of Alliance Mutual Fund by Birla Sun Life, Sun F&C Mutual Fund and PNB Mutual Fund by Principal Mutual Fund. Simultaneously, more international mutual fund players have entered India like Fidelity, Franklin Templeton Mutual Fund etc. There were 29 funds as at the end of March 2006. This is a continuing phase of growth of the industry through consolidation and entry of new international and private sector players.

Key Events
1963 UTI, India s first mutual fund, launched 1964 UTI launches US-64 1986 UTI Mastershare, India s first true mutual fund scheme, launched 1987 PSU banks and insurers allowed to float mutual funds; State Bank of India (SBI) first off the Block. 1992 Harshad Mehta-fuelled bull market arouses middle-class interest in shares and mutual funds 1993 Private sector and foreign players allowed; Kothari Pioneer first private fund house to start operations; SEBI set up to regulate industr y 1994 Morgan Stanley is the first foreign player 1996 SEBI s mutual fund rules and regulations, which form the basis of most current laws, come into force 1998 Master Index Fund is India s first index fund
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1999 The takeover of 20th Century AMC by Zurich Mutual Fund is the first acquisition in the industry 2000 The industr y s Assets Under Management (AUM) cross Rs. 1,00,000 crore 2001 US-64 scam leads to UTI overhaul 2002 UTI bifurcated, comes under SEBI purview; mutual fund distributors banned from giving commissions to investors; floating rate funds and foreign debt funds debut 2003 AMFI certification made compulsory for new agents 2004 Long-term capital gains exempt from tax for equity funds. Securities transaction tax introduced 2005 The industry s AUM crosses Rs. 2,00,000 crore Section 80C introduced, which allows up to Rs. 1 lakh in Equity-Linked Savings Schemes (ELSS) for deduction from total taxable income 2006 AUM crosses Rs. 3,00,000 crore in October 2007 Mutual funds launch Gold ETFs and schemes that will invest in overseas securities 2008 PAN card becomes mandatory to invest in mutual funds 2009 AMFI committee on introducing different classes of shares in mutual funds

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Types of Mutual Funds

Mutual funds usually invest in stocks, bonds, and depending on the conservativeness of the fund's goal, may also utilize investments like certificates of deposit, money market accounts, and so on.

Mutual funds are categorized by their goal: while some funds are designed to take risks in order to achieve the greatest potential growth, others are designed to maintain value while yet others

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invest heavily into dividend-yielding stocks in order to provide a source of income for mutual fund participants. While the individual investor must ultimately decide what his or her investment profile is, it is generally advised that younger investors take greater risks in order to attempt more dramatic growth, while older investors should invest more conservatively in order to protect their assets. Aggressive growth mutual funds are thus more popular with younger generations, and have a high level of risk with the potential for higher rates of growth. Asset allocation funds are designed to be as diverse as possible, having holdings in different asset classes and in different types of securities. Due to their diversity, asset allocation funds are usually lower-risk. Money market funds invest only in money markets, such as Treasury bills, certificates of deposit, and commercial paper. Money market funds ar e also low-risk, unlike capital appreciation funds which seek maximum growth by taking on ver y high levels of risk. Yet other types of mutual funds are balanced funds, bond funds, international funds, growth funds, stock funds, sector funds, regional funds, and income funds. Each of these types of funds has a different goal and a different investment style, and any mutual fund manager will be able to explain the differences and advise investors on which most closely meets their needs. Every scheme is bound by the investment objectives outlined by it in its prospectus, which determine the classes of securities it can invest in. Based on the asset classes, the different Mutual Funds that operate in Indian can be categorized as follows:

Mutual Funds by portfolio classification

Equity funds
These are the highest rung on the mutual fund risk ladder; such funds invest only in stocks. Most equity funds are general in nature, and can invest in the entire basket of stocks available in the market. There are also specialized equity funds, such as index funds and sector funds, which invest only in specific categories of stocks. At First Global we have Equity schemes offered by SBI Mutual Fund Reliance, DSP Merrill Lynch, ING Vysya, Sundar am BNP Paribas, HDFC and many others. With share prices fluctuating daily, such funds show volatile performance, even losses. However, these funds can yield great capital appreciation as, historically, equities have
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outperformed all asset classes. At present, there are four types of equity funds available in the market. In the increasing order of risk, these are: Index funds These funds track a key stock market index, like the BSE (Bombay Stock Exchange) Sensex or the NSE (National Stock Exchange) S&P CNX Nifty. Hence, their portf olio mirrors the index they track, both in terms of composition and the individual stock weight ages. For instance, an index fund like Magnum Index Fund of SBI MF that tracks the Sensex will invest only in the Sensex stocks. The idea is to replicate the performance of the benchmarked index to near accuracy. Index funds don t need fund managers, as there is no stock selection involved. Investing through index funds is a passive investment strategy, as a fund s performance will invariably mimic the index concerned, barring a minor "tracking error". Usually, there s a difference between the total returns given by a stock index and those given by index funds benchmarked to it. Termed as tracking error, it arises because the index fund charges management fees, marketing expenses and transaction costs (impact cost and brokerage) to its unit holders. Therefore, if the Sensex appreciates 10 per cent during a particular period while an index fund mirroring the Sensex rises 9 per cent, the fund is said to have a tracking error of 1 per cent. To illustrate with an example, assume you invested Rs 1,000 in an index fund based on the Sensex on 1 April 1978, when the index was launched (base: 100). In August, when the Sensex was at 3.457, your investment would be worth Rs 34,570, which works out to an annualized return of 17.2 per cent. A tracking error of 1 per cent would bring down your annualized return to 16.2 per cent. Obviously, the lower the tracking error, the better the Index Fund. Diversified funds Such funds have the mandate to invest in the entire universe of stocks, example Magnum Multicap Fund of SBIMF. Although by definition, such funds are meant to have a diversified portfolio (spread across industries and companies), the stock selection is entirely the prerogative of the fund manager. This discretionary power in the hands of the fund manager can work both ways for an equity fund. On the one hand, astute stock-picking by a fund manager can enable the fund to deliver market-beating returns; on the other hand, if the fund manager s picks languish, the returns will be far lower. The crux of the matter is that the returns from a diversified fund depend a lot on the fund manager s capabilities to make the right investment decisions.

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Tax-saving funds Also known as ELSS or equity-linked savings schemes, these funds offer benefits under Section 88 of the Income-Tax Act. So, on an investment of up to Rs 10,000 a year in an ELSS, one can claim a tax exemption of 20 per cent from his/her taxable income, as in Magnum Tax gain Scheme of SBI MF. One can invest more than Rs 10,000, but won t get the Section 88 benefits for the amount in excess of Rs 10,000. The only drawback to ELSS is that the investor is locked into the scheme for three years. In terms of investment profile, tax-saving funds are like diversified funds. The one difference is that because of the three year lock-in clause, tax-saving funds get more time to reap the benefits from their stock picks, unlike plain diversified funds, whose portfolios sometimes tend to get dictated by redemption compulsions.

Sector funds The riskiest among equity funds, sector funds invest only in stocks of a specific industry, say IT or FMCG like Magnum Contra fund, Magnum FMCG Fund, Magnum IT Fund. A sector fund s NAV will zoom if the sector performs well; however, if the sector languishes, the scheme s NAV too will stay depressed. Barring a few defensive, evergreen sectors like FMCG and Pharma most other industries alternate between periods of strong growth and bouts of slowdowns. The way to make money from sector funds is to catch these cyclesget in when the sector is poised for an upswing and exit before it slips back. Therefore, unless one understands a sector well enough to make such calls, and get them right, sector funds should be avoided.

Debt funds
Such funds invest only in debt instruments, and are a good option for investors averse to taking on the risk associated with equities. Here too, there are specialized schemes, namely liquid funds and gilt funds. While the former invests predominantly in money market instruments such as certificates of deposit (CD), commercial paper (CP) and call money, gilt funds do so in securities issued by the central and state governments. Debt funds are of three types. They are: Income funds By definition, such funds can invest in the entire range of debt instruments. Most income funds park a major part of their corpus in corporate bonds and debentures, as the returns there are the
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higher than those available on government-backed paper. But there is also the risk of defaulta company could fail to service its debt obligations. Example, Magnum Income Fund offered by SBI Mutual Fund. Gilt funds They invest only in government securities and T-billsinstruments on which repayment of principal and periodic payment of interest is assured by the government. So, unlike income funds, they don t face the specter of default on their investments. This element of safety is why, in normal market conditions, gilt funds tend to give marginally lower returns than income funds, Example, Magnum Gilt Fund as offered by SBIMF. Liquid funds They invest in money market instruments (duration of up to one year) such as treasury bills, call money, CPs and CDs. Among debt funds, liquid funds are the least volatile. They are ideal for investors seeking low-risk investment avenues to park their short-term surpluses, Example, Magnum Floating rate plan offered by SBIMF.

Balanced funds
Lastly, there are balanced funds, whose investment portfolio includes both debt and equity. They invest in a pre-determined proportion in equity and debtnormally 60:40 in favor of equity. As a result, on the risk ladder, they fall somewhere between equity and debt funds depending on the fund s debt-equity spiltthe higher the equity holding, the higher the risk. Balanced funds ar e the ideal mutual funds vehicle for investors who prefer spreading their risk across various instruments. For example, Hybrid Schemes offered by SBIMF. Some of the popular schemes are Magnum Balanced Fund, Magnum Children s Benefit plan and Magnum Monthly Income plan.

Mutual Funds by Structure Open-ended Funds

An open-end fund is one that is available for subscription all through the year. These do not have a fixed maturity. Investors can conveniently buy and sell units at Net Asset Value ("NAV") related prices. The key feature of open-end schemes is liquidity. It implies that the capitalization
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of the fund is constantly changing as investors sell or buy their shares. Further, the shares or units are normally not traded on the stock exchange but are repurchased by the fund at announced rates. Open-ended schemes have comparatively better liquidity despite the fact that these are not listed. The reason is that investor can approach mutual fund for sale of such units, at any time. No intermediaries are required. Moreover, the realizable amount is certain, since repurchase is at a price, based on declared net asset value (NAV). The portfolio mix of such schemes has to be investments, which are actively traded in the market. Otherwise, it will not be possible to calculate NAV. This is the reason that generally open-ended schemes are equity based. Moreover, desiring frequently traded securities, openended schemes hardly have in their portfolio shares of comparatively new and smaller companies since these are not generally tr aded. In such funds, option to reinvest its dividend is also available. Since there is always a possibility of withdrawals, the management of such funds becomes more tedious as managers have to work from crisis to crisis. Crisis may be on two fronts, one is, that unexpected withdrawals r equire funds to maintain a high level of cash available every time implying thereby idle cash. Fund managers have to face questions like what to sell . He could ver y well have to sell his most liquid assets. Second, by virtue of this situation such funds may fail to grab favorable opportunities. Further, to match quick cash payments, funds cannot have matching realization from their portfolio due to intricacies of the stock market. Thus, success of the open-ended schemes to a gr eat extent depends on the efficiency of the capital market. As a matter of fact all the schemes that SBI mutual funds offer are open ended in nature.

Closed-ended Funds
A closed-end fund has a stipulated maturity period which generally ranging from 3 to 15 years. The fund is open for subscription only during a specified period. Investors can invest in the scheme at the time of the initial public issue and thereafter they can buy or sell the units of the scheme on the stock exchanges where they are listed. Their price is determined on the basis of demand and supply in the market. Their liquidity depends on the efficiency and understanding of the broker entrusted with. Their price is free to deviate from NAV, i.e., there is every possibility that the market price may be above or below its NAV. If one takes into account the issue expenses, conceptually close ended fund units cannot be traded at a premium or over NAV
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because the price of a package of investments, i.e., cannot exceed the sum of the prices of the investments constituting the package. Whatever premium exists that may exist only on account of speculative activities. In order to provide an exit route to the investors, some close-ended funds give an option of selling back the units to the Mutual Fund through periodic repurchase at NAV related prices. SEBI Regulations stipulate that at least one of the two exit routes is provided to the investor.

Interval Funds
Interval funds combine the features of open-ended and close-ended schemes. They are open for sale or redemption during pr e-determined intervals at NAV related prices.

Mutual funds: The dvantages

If we are talking about the rapid growth of the Mutual funds industry and the competition it is giving to the other investment opportunities, we need to analyze the advantages of Mutual fund investments. Some of the advantages have been discussed in this section.

Professional management
It is very difficult for a new investor to analyze equities. Most of us have neither the skill to find good stocks that suit our risk and returns profile nor the time to track our investmentsbut still want the returns that can be had from equities. That is where mutual f unds come in. When investments are made in mutual funds, the fund manager takes care of the investments. A fund manager is an investment specialist, who brings to the table an in-depth understanding of the financial markets. By virtue of being in the market, the fund manager is ideally placed to research various investment options, and invest accordingly for the investor.

Small investments
Today, if we want to buy government securities, we would have to invest a minimum amount of Rs 25,000. Much the same is the case if we want to build a decent-sized portfolio of shares of blue-chips. Now, that might be too large an amount for many small investors. A mutual fund,
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however, gives us an ownership of the same investment pie at an outlay of Rs 1,000-5,000. That is because a mutual fund pools the monies of several investors, and invests the resultant large sum in a number of securities. Therefore, on a small outlay, we get to participate in the investment prospects of a number of securities.

Diversified portfolio
One of the most-mentioned tenets of portfolio management is: diversify. In other words, don t put all your eggs in one basket. The rationale for this is that even if one pick in the portfolio turns bad, the others can check the erosion in the portfolio value. For example Say, an investor has Rs 10,000 invested in one stock, Reliance. Now, for some reason, the stock drops 50 per cent. The value of the investment will halve to Rs 5,000. Now, say if he had invested the same amount in a mutual fund, which had parked 10 per cent of its corpus in the Reliance stock. Assuming prices of other stocks in its portfolio stay the same, the depreciation in the fund s portfolio and hence, the investmentwill be 5 per cent. That s one of the greatest merits of diversification.

Liquidity
There is a freedom to take the money out of open-ended mutual funds whenever one wants, no questions asked. Most open-ended funds mail the redemption proceeds, which are linked to the fund s prevailing NAV (net asset value), within three to five working days of putting in the request to withdraw.

Low Costs
Mutual Funds are a relatively less expensive way to invest compared to directly investing in the capital markets because the benefits of scale in brokerage, custodial and other fees tr anslate into lower costs for investors.

Transparency
The investor gets regular information on the value of the investment made in addition to disclosure on the specific investments made under the scheme, the proportion invested in each class of assets and the fund manager's investment strategy and outlook.

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Flexibility
Through features such as regular investment plans, regular withdr awal plans and dividend reinvestment plans, one can systematically invest or withdraw funds according to the needs and convenience.

Well Regulated
All Mutual Funds are r egistered with SEBI and they function within the provisions of strict regulations designed to protect the interests of investors. The operations of Mutual Funds are regularly monitored by SEBI.

Tax breaks
Last but not the least, mutual funds offer significant tax advantages. Dividends distributed by them are tax-free in the hands of the investor. They also give the advantages of capital gains taxation. For holding units beyond one year, one gets the benefits of indexation. Simply put, indexation benefits increase the purchase cost by a certain portion, depending upon the yearly cost-inflation index (which is calculated to account for rising inflation), thereby reducing the gap between the actual purchase cost and selling price. This reduces tax liability. What s more, taxsaving schemes and pension schemes give added advantage of benefits under Section 88. One can avail of a 20 per cent tax exemption on an investment of up to Rs 10,000 in the scheme in a year.

Disadvantages of Mutual Funds

Mutual funds are good investment vehicles to navigate the complex and unpredictable world of investments. However, even mutual funds have some inherent drawbacks.

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No assured returns and no protection of capital

Mutual funds do not offer assured returns and carry risk. For instance, unlike bank deposits, your investment in a mutual fund can fall in value. In addition, mutual funds are not insured or guaranteed by any government body (unlike a bank deposit, where up to Rs 1 lakh per bank is insured by the Deposit and Credit Insurance Corporation, a subsidiary of the Reserve Bank of India). There are strict norms for any fund that assures returns and it is now compulsory for funds to establish that they have resources to back such assurances. This is because most closedend funds that assured returns in the early-nineties failed to stick to their assurances made at the time of launch, resulting in losses to investors.

Restrictive gains
Diversification helps, if risk minimization is the objective. However, the lack of investment focus also means that we gain less than if we had invested directly in a single security. In the earlier example, say, Reliance appreciated 50 per cent. A direct investment in the stock would appreciate by 50 per cent. But the investment in the mutual fund, which had invested 10 per cent of its corpus in Reliance, will see only a 5 per cent appreciation

Fees and Commissions

All funds charge administrative fees to cover their day-to-day expenses. Some funds also charge sales commissions or "loads" to compensate brokers, financial consultants, or financial planners. Even if you don't use a broker or other financial adviser, you will pay a sales commission if you buy shares in a Load Fund. The loads are of two types:

Entry Load- Commission paid while purchasing Units of a particular fund. Exit Load- Commission paid while selling back the Units.

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Taxes
During a typical year, most actively managed mutual funds sell anywhere from 20 to 70 percent of the securities in their portfolios. If a fund makes a profit on its sales, one who has invested in it will pay taxes on the income he/she receives, even if he/she reinvests the money he has made.

Management Risk
When one invests in a mutual fund, he/she depends on the fund's manager to make the right decisions regarding the fund's portfolio. If the manager does not perform as well as he had hoped, investor might not make as much money on his investment as he had expected. Of course, if one had invested in Index Funds, he/she foregoes management risk, because these funds do not employ managers.

Regulation of Mutual Funds in India

Securities and Excha nge Board of India (SEBI)

As far as mutual funds are concerned, SEBI formulates policies and regulates the mutual funds to protect the interest of the investors. SEBI notified regulations for the mutual funds in 1993. Thereafter, mutual funds sponsored by private sector entities were allowed to enter the capital market. The regulations were fully revised in 1996 and have been amended thereafter from time to time. SEBI has also issued guidelines to the mutual funds from time to time to protect the interests of investors.

Every mutual fund must be registered with SEBI and registration is granted only where SEBI is satisfied with the background of the fund

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