Industry Profile

I. Introduction

The Indian mutual fund industry has witnessed significant growth in the past few years driven by
several favourable economic and demographic factors such as rising income levels, and the
increasing reach of Asset Management Companies and distributors. However, after several years of
relentless growth ,the industry witnessed a fall of 8% in the assets under management in the financial
year 2008-2009 that has impacted revenues and profitability. Whereas in 2009-10 the industry is on
the road of recovery.

II. History of Mutual Funds

Money Market Schemes: Money Market Schemes aim to provide easy liquidity, preservation of capital
and moderate income. These schemes generally invest in safer, short-term instruments, such as
treasury bills, certificates of deposit, commercial paper and inter-bank call money.

First Phase 1964-87

Unit Trust of India (UTI) was established on 1963 by an Act of Parliament. It was set up by the
Reserve Bank of India and functioned under the Regulatory and administrative control of the Reserve
Bank of India. In 1978 UTI was de-linked from the RBI and the Industrial Development Bank of
India (IDBI) took over the regulatory and administrative control in place of RBI. The first scheme
launched by UTI was Unit Scheme 1964. At the end of 1988 UTI had Rs.6, 700 Crores of assets
under management.

Second Phase 1987-1993 (Entry of Public Sector Funds)

1987 marked the entry of non- UTI, public sector mutual funds set up by public sector banks and Life
Insurance Corporation of India (LIC) and General Insurance Corporation of India (GIC). SBI Mutual
Fund was the first non- UTI Mutual Fund established in June 1987 followed by Canbank Mutual
Fund (Dec 87), Punjab National Bank Mutual Fund (Aug 89), Indian Bank Mutual Fund (Nov 89),
Bank of India (Jun 90), Bank of Baroda Mutual Fund (Oct 92). LIC established its mutual fund in
June 1989 while GIC had set up its mutual fund in December 1990.
At the end of 1993, the mutual fund industry had assets under management of Rs.47, 004 Crores.
Third Phase 1993-2003 (Entry of Private Sector Funds)
With the entry of private sector funds in 1993, a new era started in the Indian mutual fund industry,
giving the Indian investors a wider choice of fund families. Also, 1993 was the year in which the first
Mutual Fund Regulations came into being, under which all mutual funds, except UTI were to be
registered and governed. The erstwhile Kothari Pioneer (now merged with Franklin Templeton) was
the first private sector mutual fund registered in July 1993.
The 1993 SEBI (Mutual Fund) Regulations were substituted by a more comprehensive and revised
Mutual Fund Regulations in 1996. The industry now functions under the SEBI (Mutual Fund)
Regulations 1996.
The number of mutual fund houses went on increasing, with many foreign mutual funds setting up
funds in India and also the industry has witnessed several mergers and acquisitions. As at the end of
January 2003, there were 33 mutual funds with total assets of Rs. 1, 21,805 Crores. The Unit Trust of
India with Rs.44, 541 Crores of assets under management was way ahead of other mutual funds

Fourth Phase since February 2003

In February 2003, following the repeal of the Unit Trust of India Act 1963 UTI was bifurcated into
two separate entities. One is the Specified Undertaking of the Unit Trust of India with assets under
management of Rs.29, 835 crores as at the end of January 2003, representing broadly, the assets of

US 64 scheme, assured return and certain other schemes. The Specified Undertaking of Unit Trust of
India, functioning under an administrator and under the rules framed by Government of India and
does not come under the purview of the Mutual Fund Regulations.

The second is the UTI Mutual Fund Ltd, sponsored by SBI, PNB, BOB and LIC. It is registered with
SEBI and functions under the Mutual Fund Regulations. With the bifurcation of the erstwhile UTI
which had in March 2000 more than Rs.76,000 Crores of assets under management and with the
setting up of a UTI Mutual Fund, conforming to the SEBI Mutual Fund.
The graph indicates the growth of assets over the years:

Assets of the mutual fund industry touched an all-time high of Rs639,000 crore (approximately $136 billion)
in May, aided by the spike in the stock market by over 50 per cent in the last one month and fresh inflows in
liquid funds, data released by the Association of Mutual Funds in India (AMFI) shows yesterday.

The country's burgeoning mutual fund industry is expected to see its assets growing by 29% annually
in the next five years. The total assets under management in the Indian mutual funds industry are
estimated to grow at a compounded annual growth rate (CAGR) of 29 per cent in the next five years,"
the report by global consultancy Celent said. However, the profitability of the industry is expected to
remain at its present level mainly due to increasing cost incurred to develop distribution channels and
falling margins due to greater competition among fund houses, it said.

Regulatory Framework
Securities and Exchange Board of India (SEBI)
The Government of India constituted Securities and Exchange Board of India, by an Act of
Parliament in 1992, the apex regulator of all entities that either raise funds in the capital markets or
invest in capital market securities such as shares and debentures listed on stock exchanges. Mutual
funds have emerged as an important institutional investor in capital market securities. Hence they
come under the purview of SEBI. SEBI requires all mutual funds to be registered with them. It issues
guidelines for all mutual fund operations including where they can invest, what investment limits and
restrictions must be complied with, how they should account for income and expenses, how they
should make disclosures of information to the investors and generally act in the interest of investor
protection. To protect the interest of the investors, SEBI formulates policies and regulates the mutual
funds. MF either promoted by public or by private sector entities including one promoted by foreign
entities are governed by these Regulations. SEBI approved Asset Management Company (AMC)
manages the funds by making investments in various types of securities. Custodian, registered with
SEBI, holds the securities of various schemes of the fund in its custody. According to SEBI
Regulations, two thirds of the directors of Trustee Company or board of trustees must be
independent.
Association of Mutual Funds in India (AMFI)
With the increase in mutual fund players in India, a need for mutual fund association in India
was generated to function as a non-profit organisation. Association of Mutual Funds in India
(AMFI) was incorporated on 22nd August, 1995.

AMFI is an apex body of all Asset Management Companies (AMC) which has been registered with
SEBI. Till date all the AMCs are that have launched mutual fund schemes are its member. It
functions under the supervision and guidelines of its Board of Directors.

Association of Mutual Funds India has brought down the Indian Mutual Fund Industry to a
professional and healthy market with ethical line enhancing and maintaining standards. It follows the
principle of both protecting and promoting the interests of mutual funds as well as their unit holders.

The objectives of Association of Mutual Funds in India

The Association of Mutual Funds of India works with 30 registered AMCs of the country. It has
certain defined objectives which juxtaposes the guidelines of its Board of Directors. The objectives
are as follows:

This mutual fund association of India maintains high professional and ethical standards in all
areas of operation of the industry.

It also recommends and promotes the top class business practices and code of conduct which

is followed by members and related people engaged in the activities of mutual fund and asset
management. The agencies who are by any means connected or involved in the field of
capital markets and financial services also involved in this code of conduct of the association.

AMFI interacts with SEBI and works according to SEBIs guidelines in the mutual fund
industry.
Association of Mutual Fund of India do represent the Government of India, the Reserve Bank
of India and other related bodies on matters relating to the Mutual Fund Industry.

It develops a team of well qualified and trained Agent distributors. It implements a program of
training and certification for all intermediaries and other engaged in the mutual fund industry.

AMFI undertakes all India awareness program for investors in order to promote proper
understanding of the concept and working of mutual funds.

At last but not the least association of mutual fund of India also disseminate information on

Mutual Fund Industry and undertakes studies and research either directly or in association
with other bodies.

Concept of Mutual Fund

A Mutual Fund is a trust that pools the savings of a number of investors who share a common
financial goal. The money thus collected is then invested in capital market instruments such as
shares, debentures and other securities. The income earned through these investments and the
capital appreciations 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. The flow chart below describes the working of a mutual fund:

Mutual fund operation flow chart

Mutual funds are considered as one of the best available investments as compare to others. They
are very cost efficient and also easy to invest in, thus by pooling money together in a mutual fund,
investors can purchase stocks or bonds with much lower trading costs than if they tried to do it on

their own. But the biggest advantage to mutual funds is diversification, by minimizing risk &
maximizing returns.

Organization of a Mutual Fund

There are many entities involved and the diagram below illustrates the organizational set up of a
mutual fund

Types of Mutual Fund schemes in INDIA

Wide variety of Mutual Fund Schemes exists to cater to the needs such as financial position, risk
tolerance and return expectations.

Overview of existing schemes existed in mutual fund category: BY STRUCTURE

Close - Ended Schemes: 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. 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 Schemes: Interval Schemes are that scheme, which combines the features of open-ended and
close-ended schemes. The units may be traded on the stock exchange or may be open for sale or
redemption during pre-determined intervals at NAV related prices.
Overview of existing schemes existed in mutual fund category: BY NATURE
Equity fund: These funds invest a maximum part of their corpus into equities holdings. The structure
of the fund may vary different for different schemes and the fund managers outlook on different
stocks. The Equity Funds are sub-classified depending upon their investment objective, as follows:
-Diversified Equity Funds
-Mid-Cap Funds
-Sector Specific Funds
-Tax Savings Funds (ELSS)
Equity investments are meant for a longer time horizon, thus Equity funds rank high on the riskreturn matrix.

Debt funds: The objective of these Funds is to invest in debt papers. Government authorities, private
companies, banks and financial institutions are some of the major issuers of debt papers. By investing
in debt instruments, these funds ensure low risk and provide stable income to the investors.
Gilt Funds: Invest their corpus in securities issued by Government, popularly known as Government
of India debt papers. These Funds carry zero Default risk but are associated with Interest Rate risk.
These schemes are safer as they invest in papers backed by Government.
Income Funds: Invest a major portion into various debt instruments such as bonds, corporate
debentures and Government securities.
Monthly income plans ( MIPs): Invests maximum of their total corpus in debt instruments while they
take minimum exposure in equities. It gets benefit of both equity and debt market. These scheme
ranks slightly high on the risk-return matrix when compared with other debt schemes.
Short Term Plans (STPs): Meant for investment horizon for three to six months. These funds
primarily invest in short term papers like Certificate of Deposits (CDs) and Commercial Papers (CPs).
Some portion of the corpus is also invested in corporate debentures.
Liquid Funds: Also known as Money Market Schemes, These funds provides easy liquidity and
preservation of capital. These schemes invest in short-term instruments like Treasury Bills, inter-bank
call money market, CPs and CDs. These funds are meant for short-term cash management of
corporate houses and are meant for an investment horizon of 1day to 3 months. These schemes rank
low on risk-return matrix and are considered to be the safest amongst all categories of mutual funds.
Balanced funds: They invest in both equities and fixed income securities, which are in line with predefined investment objective of the scheme. These schemes aim to provide investors with the best of
both the worlds. Equity part provides growth and the debt part provides stability in returns.
Further the mutual funds can be broadly classified on the basis of investment parameter. It means
each category of funds is backed by an investment philosophy, which is pre-defined in the objectives
of the fund. The investor can align his own investment needs with the funds objective and can invest
accordingly

16

By investment objective:
Growth Schemes: Growth Schemes are also known as equity schemes. The aim of these schemes is to
provide capital appreciation over medium to long term. These schemes normally invest a major part
of their fund in equities and are willing to bear short-term decline in value for possible future
appreciation.
Income Schemes: Income Schemes are also known as debt schemes. The aim of these schemes is to
provide regular and steady income to investors. These schemes generally invest in fixed income
securities such as bonds and corporate debentures. Capital appreciation in such schemes may be
limited.
Balanced Schemes: Balanced Schemes aim to provide both growth and income by periodically
distributing a part of the income and capital gains they earn. These schemes invest in both shares and
fixed income securities, in the proportion indicated in their offer documents.

Money Market Schemes: Money Market Schemes aim to provide easy liquidity, preservation of
capital and moderate income. These schemes generally invest in safer, short-term instruments, such
as treasury bills, certificates of deposit, commercial paper and inter-bank call money.

Other schemes
Tax Saving Schemes:
Tax-saving schemes offer tax rebates to the investors under tax laws prescribed from time to time.
Under Sec.80C of the Income Tax Act, contributions made to any Equity Linked Savings Scheme
(ELSS) are eligible for rebate.

17

Index Schemes:
Index schemes attempt to replicate the performance of a particular index such as the BSE Sensex or the
Nifty 50. The portfolio of these schemes will consist of only those stocks that constitute the index. The
percentage of each stock to the total holding will be identical to the stocks index weightage. And hence,
the returns from such schemes would be more or less equivalent to those of the Index.

Sector Specific Schemes:

These are the funds/schemes which invest in the securities of only those sectors or industries as
specified in the offer documents. Ex- Pharmaceuticals, Software, Fast Moving Consumer Goods
(FMCG), Petroleum stocks, etc. The returns in these funds are dependent on the performance of the
respective sectors/industries. While these funds may give higher returns, they are more risky
compared to diversified funds. Investors need to keep a watch on the performance of those
sectors/industries and must exit at an appropriate time.

VI. Advantages of Mutual Funds

Diversification It can help an investor diversify their portfolio with a minimum investment.
Spreading investments across a range of securities can help to reduce risk. A stock mutual fund, for
example, invests in many stocks .This minimizes the risk attributed to a concentrated position. If a
few securities in the mutual fund lose value or become worthless, the loss maybe offset by other
securities that appreciate in value. Further diversification can be achieved by investing in multiple
funds which invest in different sectors.
Professional Management- Mutual funds are managed and supervised by investment professional.
These managers decide what securities the fund will buy and sell. This eliminates the investor of the
difficult task of trying to time the market.
Well regulated- Mutual funds are subject to many government regulations that protect investors from
fraud.

Liquidity- It's easy to get money out of a mutual fund.

Convenience- we can buy mutual fund shares by mail, phone, or over the Internet.
Low cost- Mutual fund expenses are often no more than 1.5 percent of our investment. Expenses for
Index Funds are less than that, because index funds are not actively managed. Instead, they
automatically buy stock in companies that are listed on a specific index
Transparency- The mutual fund offer document provides all the information about the fund and the
scheme. This document is also called as the prospectus or the fund offer document, and is very detailed
and contains most of the relevant information that an investor would need.
Choice of schemes there are different schemes which an investor can choose from according to his
investment goals and risk appetite.
Tax benefits An investor can get a tax benefit in schemes like ELSS (equity linked saving scheme)

DISADVANTAGES OF INVESTING IN MUTUAL FUNDS

There are certainly some benefits to mutual fund investing, but you should also be aware of the
drawbacks associated with mutual funds.
1 No Insurance: Mutual funds, although regulated by the government, are not insured against losses. The
Federal Deposit Insurance Corporation (FDIC) only insures against certain losses at banks, credit
unions, and savings and loans, not mutual funds. That means that despite the risk-reducing
diversification benefits provided by mutual funds, losses can occur, and it is possible (although
extremely unlikely) that you could even lose your entire investment.
2 Dilution: Although diversification reduces the amount of risk involved in investing in mutual funds, it
can also be a disadvantage due to dilution. For example, if a single security held by a mutual fund
doubles in value, the mutual fund itself would not double in value because that security is only
one small part of the funds holdings. By holding a large number of different investments, mutual
funds tend to do neither exceptionally well nor exceptionally poorly.
3 Fees and Expenses: Most mutual funds charge management and operating fees that pay for the funds
management expenses (usually around 1.0% to 1.5% per year for actively managed funds). In
addition, some mutual funds charge high sales commissions, 12b-1 fees, and redemption fees.
And some funds buy and trade shares so often that the transaction costs add up significantly.
Some of these expenses are charged on an ongoing basis, unlike stock investments, for which a
commission is paid only when you buy and sell .
4 Poor Performance: Returns on a mutual fund are by no means guaranteed. In fact, on average, around
75% of all mutual funds fail to beat the major market indexes, like the S&P 500, and a growing
number of critics now question whether or not professional money managers have better stockpicking capabilities than the average investor.
5 Loss of Control: The managers of mutual funds make all of the decisions about which securities to buy
and sell and when to do so. This can make it difficult for you when trying to manage your

portfolio. For example, the tax consequences of a decision by the manager to buy or sell an asset
at a certain time might not be optimal for you. You also should remember that you are trusting
someone else with your money when you invest in a mutual fund.
6 Trading Limitations: Although mutual funds are highly liquid in general, most mutual funds (called
open-ended funds) cannot be bought or sold in the middle of the trading day. You can only buy
and sell them at the end of the day, after theyve calculated the current value of their holdings.
7 Size: Some mutual funds are too big to find enough good investments. This is especially true of funds
that focus on small companies, given that there are strict rules about how much of a single
company a fund may own. If a mutual fund has $5 billion to invest and is only able to invest an
average of $50 million in each, then it needs to find at least 100 such companies to invest in; as a
result, the fund might be forced to lower its standards when selecting companies to invest in.
8 Inefficiency of Cash Reserves: Mutual funds usually maintain large cash reserves as protection against
a large number of simultaneous withdrawals. Although this provides investors with liquidity, it
means that some of the funds money is invested in cash instead of assets, which tends to lower
the investors potential return.
Too Many Choices: The advantages and disadvantages listed above apply to mutual funds in general.
However, there are over 10,000 mutual funds in operation, and these funds vary greatly according to
investment objective, size, strategy, and style. Mutual funds are available for virtually every
investment strategy (e.g. value, growth), every sector (e.g. biotech, internet), and every country or
region of the world. So even the process of selecting a fund can be tedious.

VII. Terms used in Mutual Fund

Asset Management Company (AMC)
An AMC is the legal entity formed by the sponsor to run a mutual fund. The AMC is usually a
private limited company in which the sponsors and their associates or joint venture partners are the
shareholders. The trustees sign an investment agreement with the AMC, which spells out the
functions of the AMC. It is the AMC that employs fund managers and analysts, and other personnel.
It is the AMC that handles all operational matters of a mutual fund from launching schemes to
managing them to interacting with investors.

Fund Offer document

The mutual fund is required to file with SEBI a detailed information memorandum, in a prescribed
format that provides all the information about the fund and the scheme. This document is also called
as the prospectus or the fund offer document, and is very detailed and contains most of the relevant
information that an investor would need

Trust
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. The Trust
appoints the Trustees who are responsible to the investors of the fund.

Trustees
Trustees are like internal regulators in a mutual fund, and their job is to protect the interests of the
unit holders. Trustees are appointed by the sponsors, and can be either individuals or corporate
bodies. In order to ensure they are impartial and fair, SEBI rules mandate that at least two -thirds of
the trustees be independent, i.e., not have any association with the sponsor.
Trustees appoint the AMC, which subsequently, seeks their approval for the work it does, and reports
periodically to them on how the business being run.
Custodian
To determine the style of a mutual fund, consult the prospectus as well as other sources that review
mutual funds. Don't be surprised if the information conflicts. Although a prospectus may state a
specific fund style, the style may change. Value stocks held in the portfolio over a period of time may
become growth stocks and vice versa. Other research may give a more current and accurate account
of the style of the fund.
NAV
Net Asset Value is the market value of the assets of the scheme minus its liabilities. The per unit
NAV is the net asset value of the scheme divided by the number of units outstanding on the
Valuation Date.The NAV is usually calculated on a daily basis. In terms of corporate valuations, the
book values of assets less liability.

The NAV is usually below the market price because the current value of the funds assets is higher
than the historical financial statements used in the NAV calculation.

20

Market Value of the Assets in the Scheme + Receivables + Accrued Income

- Liabilities - Accrued Expenses
NAV = -----------------------------------------------------------------------------------------------No. of units outstanding

Where,

Receivables: Whatever the Profit is earned out of sold stocks by the Mutual fund is called
Receivables.
Accrued Income: Income received from the investment made by the Mutual Fund.
Liabilities: Whatever they have to pay to other companies are called liabilities.

Accrued Expenses: Day to day expenses such as postal expenses, Printing, Advertisement Expenses
etc.

Calculation of NAV
Scheme ABN
Scheme Size Rs. 5, 00, 00,000 (Five Crores)
Face Value of Units Rs.10/Scheme Size

5, 00, 00,000

---------------------------=

-------------------= 50, 00,000

Face value of units

10

The fund will offer 50, 00,000 units to Public.

Investments: Equity shares of Various Companies.

Market Value of Shares is Rs.10, 00, 00,000 (Ten Crores)

Rs. 10, 00, 00,000

NAV

= --------------------------

= Rs.20/-

50, 00,000 units

21

Thus each unit of Rs. 10/- is Worth Rs.20/It states that the value of the money has appreciated since it is more than the face value.

Sale price
Is the price we pay when we invest in a scheme. Also called Offer Price. It may include a sales load.

Repurchase price
Is the price at which units under open-ended schemes are repurchased by the Mutual Fund. Such
prices are NAV related

Redemption Price
Is the price at which close-ended schemes redeem their units on maturity. Such prices are NAV
related

Sales load
Is a charge collected by a scheme when it sells the units. Also called, Front-end load. Schemes that
do not charge a load are called No Load schemes.

Repurchase or Back-end Load

Is a charge collected by a scheme when it buys back the units from the unit holders

22

CAGR (compounded annual growth rate)

The year-over-year growth rate of an investment over a specified period of time. The compound
annual growth rate is calculated by taking the nth root of the total percentage growth rate, where n is
the number of years in the period being considered.

VIII. Fund Management

Actively managed funds:
Mutual Fund managers are professionals. They are considered professionals because of their
knowledge and experience. Managers are hired to actively manage mutual fund portfolios. Instead of
seeking to track market performance, active fund management tries to beat it. To do this, fund
managers "actively" buy and sell individual securities. For an actively managed fund, the
corresponding index can be used as a performance benchmark.
Is an active fund a better investment because it is trying to outperform the market? Not necessarily.
While there is the potential for higher returns with active funds, they are more unpredictable and
more risky. From 1990 through 1999, on average, 76% of large cap actively managed stock funds
actually underperformed the S&P 500. (Source - Schwab Center for Investment Research)

23

Actively managed fund styles:

Some active fund managers follow an investing "style" to try and maximize fund performance while
meeting the investment objectives of the fund. Fund styles usually fall within the following three
categories.
Fund Styles:

Value: The manager invests in stocks believed to be currently undervalued by the market.

Growth: The manager selects stocks they believe have a strong potential for beating the
market.

Blend: The manager looks for a combination of both growth and value stocks.

To determine the style of a mutual fund, consult the prospectus as well as other sources that review
mutual funds. Don't be surprised if the information conflicts. Although a prospectus may state a
specific fund style, the style may change. Value stocks held in the portfolio over a period of time may
become growth stocks and vice versa. Other research may give a more current and accurate account
of the style of the fund.

Passively Managed Funds:

Passively managed mutual funds are an easily understood, relatively safe approach to investing in
broad segments of the market. They are used by less experienced investors as well as sophisticated
institutional investors with large portfolios. Indexing has been called investing on autopilot. The
metaphor is an appropriate one as managed funds can be viewed as having a pilot at the controls.
When it comes to flying an airplane, both approaches are widely used.
a high percentage of investment professionals, find index investing compelling for the following
reasons:

Simplicity. Broad-based market index funds make asset allocation and diversification easy.

Management quality. The passive nature of indexing eliminates any concerns about human
error or management tenure.

24

Low portfolio turnover. Less buying and selling of securities means lower costs and fewer tax
consequences.

Low operational expenses. Indexing is considerably less expensive than active fund
management.

Asset bloat. Portfolio size is not a concern with index funds.

Performance. It is a matter of record that index funds have outperformed the majority of
managed funds over a variety of time periods.

You make money from your mutual fund investment when:

The fund earns income on its investments, and distributes it to you in the form of dividends.

The fund produces capital gains by selling securities at a profit, and distributes those gains to
you.

You sell your shares of the fund at a higher price than you paid for them

IX. Risk
Every type of investment, including mutual funds, involves risk. Risk refers to the possibility that you
will lose money (both principal and any earnings) or fail to make money on an investment. A fund's
investment objective and its holdings are influential factors in determining how risky a fund is.
Reading the prospectus will help you to understand the risk associated with that particular fund.
Generally speaking, risk and potential return are related. This is the risk/return trade-off. Higher risks
are usually taken with the expectation of higher returns at the cost of increased volatility. While a
fund with higher risk has the potential for higher return, it also has the greater potential for losses or
negative returns. The school of thought when investing in mutual funds suggests that the longer your
investment time horizon is the less affected you should be by short-term volatility. Therefore, the
shorter your investment time horizon, the more concerned you should be with short-term volatility
and higher risk.

25

Defining Mutual fund risk

Different mutual fund categories as previously defined have inherently different risk characteristics
and should not be compared side by side. A bond fund with below-average risk, for example, should
not be compared to a stock fund with below average risk. Even though both funds have low risk for
their respective categories, stock funds overall have a higher risk/return potential than bond funds.
Of all the asset classes, cash investments (i.e. money markets) offer the greatest price stability but
have yielded the lowest long-term returns. Bonds typically experience more short-term price swings,
and in turn have generated higher long-term returns. However, stocks historically have been subject
to the greatest short-term price fluctuationsand have provided the highest long-term returns.
Investors looking for a fund which incorporates all asset classes may consider a balanced or hybrid
mutual fund. These funds can be very conservative or very aggressive. Asset allocation portfolios are
mutual funds that invest in other mutual funds with different asset classes. At the discretion of the
manager(s), securities are bought, sold, and shifted between funds with different asset classes
according to market conditions.
Mutual funds face risks based on the investments they hold. For example, a bond fund faces interest
rate risk and income risk. Bond values are inversely related to interest rates. If interest rates go up,
bond values will go down and vice versa. Bond income is also affected by the change in interest rates.
Bond yields are directly related to interest rates falling as interest rates fall and rising as interest rise.
Income risk is greater for a short-term bond fund than for a long-term bond fund.
Similarly, a sector stock fund (which invests in a single industry, such as telecommunications) is at
risk that its price will decline due to developments in its industry. A stock fund that invests across
many industries is more sheltered from this risk defined as industry risk.
Following is a glossary of some risks to consider when investing in mutual funds.

Call Risk. The possibility that falling interest rates will cause a bond issuer to redeemor
callits high-yielding bond before the bond's maturity date

26

Country Risk. The possibility that political events (a war, national

elections), financial problems (rising inflation, government default), or
natural disasters (an earthquake, a poor harvest) will weaken a country's

economy and cause investments in that country to decline.

Credit Risk. The possibility that a bond issuer will fail to repay interest and
principal in a timely manner. Also called default risk.

Currency Risk. The possibility that returns could be reduced for Americans
investing in foreign securities because of a rise in the value of the U.S. dollar

against foreign currencies. Also called exchange-rate risk.

Income Risk. The possibility that a fixed-income fund's dividends will

decline as a result of falling overall interest rates.

Industry Risk. The possibility that a group of stocks in a single industry will
decline in price due to developments in that industry.