Basics of Mutual Funds

What this chapter covers

Chapter 5 carries 3 marks out of 100 — 3% of the paper.

LEARNING OBJECTIVES: After studying this chapter, you should know about the following: Collective Investment Vehicle with proportionate ownership · Mutual Funds · Advantages of Mutual Funds · Assets under Management (AUM) and Net Asset Value (NAV) · Role of RTAs related to NAV

5.1 Introduction to mutual funds

A mutual fund is an investment option, where investors contribute small amounts of money. These contributions are pooled together to make it a large sum. This sum is then invested in a portfolio of various securities.

Two words worth separating: when we say 'Mutual Fund' we are referring to the money contributed by the investors. When we say 'portfolio' we are referring to the securities in which the investments have been made.

The fund is the money; the portfolio is what it buys.

A mutual fund thus enables investors to participate in securities markets and invest in equity shares, bonds and other such instruments by pooling their money together.

And the objective comes first: a mutual fund will state its investment objective upfront. This indicates how the money will be invested and how the portfolio will be constructed. Investors choose a fund, which matches their own objectives.

The illustration: an equity fund may state that its objective is to invest in equity shares to generate long term growth. An investor, who likes to invest in a portfolio of equity shares, will buy the units of this fund. A liquid fund may state that its objective is to generate reasonable return with high liquidity from investing in money market instruments over the short term. Investors having a short term surplus may decide to invest in such a fund.

The first sample question turns on this — the securities a scheme invests in depend on its investment objective.

Collective investment vehicle

A mutual fund is a collective investment vehicle. Usually a mutual fund product is first described by its investment objective. Investors then invest their money in the product. The money is pooled together and is invested according to the stated objective.

Example 1: ABC Income Fund is a debt fund that invests pre-dominantly in debt instruments, with the objective of generating regular income for its investors. ABCC Top 100 Fund is a fund that seeks to generate capital appreciation from a portfolio of equity shares of the 100 largest listed companies.

Fund managers invest the pool of money into securities such as equity and debt, according to the stated investment objective of the fund. The risk and return of the fund depend on the investment portfolio of the fund.

And the name is explained: the benefits from the investment portfolio accrue to those that contribute to the pool. There is thus mutuality in the contribution and the benefit. Hence the name 'mutual' fund.

Proportionate share of benefits

When a mutual fund pools money from several investors, each investor does not contribute the same sum of money. Depending on their needs and preferences, investors put in money into the fund. Therefore, each investor's share in the pool of funds is not equal.

The benefits from the fund accrue to all investors in proportion to their share in the pool.

Example 2: Three investors invest Rs. 10,000, Rs. 20,000 and Rs. 30,000 respectively in a mutual fund. So the pooled sum is Rs. 60,000. The money is invested and gains Rs. 12000 over time. This means, the pool is now worth Rs. 72,000. The value of the investors' holding in the mutual fund also goes up proportionately (in the ratio of 1:2:3) to Rs. 12,000, Rs. 24,000 and Rs. 36,000 respectively.

Why a unit is needed at all: investors can contribute into a fund or redeem and take away their contributions, depending on the nature of the pool. In a closed end fund, investors tend to stay until maturity. If a fund is open-ended, investors can come in and move out at will. Therefore, there is the need to standardize the contributions of investors to be able to objectively measure their share in the fund.

Units of a mutual fund

When investors subscribe to a mutual fund, they buy a share in the pool of funds. This share is called a unit of the mutual fund scheme. The investment in a mutual fund by an investor is represented by the number of units held.

A mutual fund investor is called a unit holder just as an investor in equity shares is called a shareholder. The ownership of the fund is jointly held by all the unit holders.

Each unit has a face value. This is typically Rs. 10 per unit for most mutual funds.

How units first reach investors: equity shares are offered to investors for the first time through an initial public offering (IPO). Subsequently equity shares are bought and sold on the stock exchange. Likewise, mutual funds are offered for the first time to investors through a new fund offer (NFO).

Then the routes diverge by structure: open-ended mutual fund units can be bought and sold through the fund itself. Funds enable continuous transactions at their offices and at investor service centres. Closed-ended mutual funds are listed and can be bought and sold on the stock exchange.

Both the major stock exchanges, National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) have a separate segment for mutual fund trading. Certain types of funds called Exchange Traded Funds (ETFs) can only be bought and sold through the stock exchanges.

Unit capital

Unit capital of a mutual fund scheme denotes the total value of its corpus i.e. number of units outstanding multiplied by its face value.

Face value, not NAV — which is exactly what the fourth sample question tests, and the answer there is false.

Post NFO, unit capital does not change for closed-ended mutual funds, whereas the unit capital of an open-ended mutual fund varies.

How an investment becomes units: investments are made in rupee terms by the investor. But the fund will always record this investment in terms of number of units.

Number of units = Invested amount / price per unit

Example 3: If the value of a unit is Rs. 10, and 2000 units have been sold at Rs. 10 each, the value of the pool is 10 x 2000 = Rs. 20,000.

Example 4: If the price of 1 unit is Rs 10.225, and the amount invested is Rs 20,000, the number of units issued against this investment is 20,000/10.225 = 1955.99 units.

Units can thus be denoted also as a fractional value.

Example 5: If a fund has issued 10,000 units so far, its unit capital is 10,000 x 10 (Face Value) = Rs. 1,00,000.

And each scheme stands alone: according to the SEBI Regulations, each mutual fund scheme has to have a separate account. Therefore, the unit capital of each scheme is maintained to reflect its current corpus.

5.2 Advantages of mutual funds

Portfolio diversification from securities spread over various companies, industries, issuers and maturities. The portfolio will not be affected by the bad performance of one or few of the securities.

Low transaction cost from economies of scale. Since the fund invests large sums of money, the transaction cost comes down. Small amounts invested by investors get benefits of the large pool.

Professional managers who are employed by mutual funds offer their expertise in managing the investors' funds, given their knowledge of markets and securities, according to the investment objective of the scheme.

Portfolio diversification and the professional management of funds offer reduction in risk for the investor. The investment is always in a managed portfolio and not a single stock or sector. A minimum level of diversification in a mutual fund portfolio is ensured by SEBI's regulations that mandate maximum exposure to a security/issuer.

That sentence answers the third sample question — risk is reduced by portfolio diversification and professional management.

Investors can choose their investment to suit their particular needs and preferences.

Minimum investment required is low for most funds.

Mutual fund transactions are flexible and easy to conduct.

Open-ended mutual funds structure the portfolio in such a way that they are able to provide liquidity to the investor. Investors can withdraw their money from the scheme as per their requirements.

Close-ended mutual funds are mandatorily listed on stock exchanges to provide liquidity to its investors.

Note which structure is mandatorily listed — close-ended, not open-ended. The fifth sample question tests this and the answer is false.

And a recent facility: Mutual Fund Investors has an additional advantage of opting for voluntary lock-in/debit freeze the folios through MF Central platform via RTAs, applicable only for KYC complied (Registered / Validated) investors having valid Email ID and Mobile number (both mandatory).

Note that it runs through the RTAs — one of several places in this chapter where the R&T agent appears.

5.3 Open ended and close ended funds

Units of mutual funds are first issued to investors when the scheme is launched. Subsequently, the investors' purchase and sale transactions with the fund depend upon the structure of the mutual fund.

In an open ended fund, the number of units is not constant and changes based on daily purchase and redemptions by the unitholders. The open ended structure is highly liquid as unitholders can buy additional units or sell their existing units from the fund itself. As more investments are made in a fund, the number of units increases. Similarly, when more investors choose to exit the fund and redeem their units, the number of units decreases. Purchase and redemption transactions are done at NAV-linked prices.

In a closed ended fund, the number of units is fixed after the NFO. Purchase and redemption transactions from the fund are not allowed post NFO. To ensure liquidity, listing of closed ended funds is compulsory. Units are bought and sold in the stock exchanges at market price, based on demand and supply.

Two different sources of liquidity — the fund itself, or the exchange.

The comparison table

A recent development: SEBI has unveiled a sweeping overhaul of mutual fund categorisation, introducing Life Cycle Funds as a new category and rolling out a detailed framework for Fund of Funds (FoFs) with multiple underlying schemes. SEBI superseded earlier provisions on scheme classification and consolidated a revised structure aimed at ensuring funds remain "true-to-label," while accommodating new asset classes and strategies. The revised framework takes effect immediately, with existing schemes required to align within six months.

5.4 Assets under Management

A portfolio is a collection of securities. These securities can be equity shares, bonds, debentures, deposits, money market instruments, derivatives and the like. Mutual funds can invest only in marketable securities, or securities that can be traded in a market and therefore have a market price.

Only marketable securities — because the portfolio must be valued every day.

The value of the fund's portfolio changes with changes in market value of the securities that have been bought. The portfolio is updated every day, to represent its current market value. This process is called 'marking to market'.

The market value of the portfolio is known as the assets under management (AUM) of the fund.

The worked illustration

As the market price of the shares changes, the value of the portfolio has changed from Rs. 47.50 lakh to Rs. 48.06 lakh. Therefore, if the units had been issued at Rs. 10 each (face value), there would be 4,75,000 outstanding units (i.e. 47,50,000/10). Their market value will now be 48,06,000 / 4,75,000, which is Rs. 10.12 per unit.

Note that two securities rose and two fell, and the fund still gained — that is diversification working.

The value of the investors' unit holdings also changes along with the market value of the portfolio. The current market value per unit is called the net asset value (NAV). NAV can move up or down, depending upon whether the value of the portfolio has moved up or down.

And the downside case: if the value of the portfolio falls from Rs. 47,50,000 to Rs. 45,00,000, when the price of the shares held in the portfolio fall, this will lead to the NAV per unit falling from Rs. 10 to Rs. 9.47 (i.e. 45,00,000 / 4,75,000).

As new investors join the scheme the number of units will increase. These units will be issued at prevailing NAV. Similarly, if existing investors exit a scheme, the number of units will decrease. Existing holders will exit the scheme at prevailing NAV.

The distinction to hold firmly: AUM represents the total value of the portfolio and NAV represents the value of an individual unit. NAV and AUM data are reported on a daily basis and are publicly available. Such reporting of data has to be done within strict timelines prescribed by SEBI.

The RTA's role

RTAs play an important role in calculating the inflows and outflows of a mutual fund scheme. RTAs are responsible to maintain records of all the transactions done by the mutual fund investors on a daily basis to ascertain the quantum of inflows and outflows of the scheme. As the inflows to the scheme increases, the AUM of the scheme also goes up and vice-versa.

Daily records of every transaction — which is why the AUM figure depends on the R&T agent's work.

5.5 Net assets

Net assets refer to the net value of the portfolio, after charging the expenses. When we divide the net assets of a fund by the number of outstanding units issued, we get the net asset value (NAV) per unit. Net assets of a mutual fund may change with the change in the market value of the portfolio or change in the expenses charged to the fund.

Two things move net assets — the market, and the expenses charged.

NAV is calculated as: (Total Assets – Liabilities) / No. of units outstanding

The decimals: investors make investments in round figures or in multiples of one rupee. The NAV is calculated upto 2 decimal places for equity oriented mutual funds and upto 4 decimal places for index funds and all types of debt/ liquid/ money market funds.

Two decimals for equity; four for index, debt, liquid and money market funds.

Thus the number of units allotted to an investor will include fraction units. The issue of fraction units indicates proportionate ownership and ensures that the entire amount paid by the investor is invested.

Fractional units exist so that no part of the investor's money is left idle.

Disclosure of NAV

Mutual funds declare the NAV of all their schemes on every business day. The NAV of all mutual fund schemes have to be uploaded on AMFI's website (www.amfiindia.com) and also on the Mutual Funds' website by the time as per applicable guidelines.

Most schemes must report the same day, by 11 p.m. Only the overseas and commodity derivative schemes get to the next morning, and of those the ETCD schemes are earlier.

For an investor, NAV is the most important data point to evaluate the performance of their investments. RTAs ensure timely communication of latest NAVs to the unitholders.

Assets and liabilities of a fund

When we refer to total assets, we are referring to the market value of the mutual fund portfolio. A mutual fund rarely holds any other long-term asset in its balance sheet. There may be few receivables and accrued income, which are current assets. These are added to the portfolio value to get the total assets of the fund.

Similarly, on the liability side, a mutual fund does not have long-term liabilities. The assets are fully funded by the unit capital contributed by the investors.

One permitted borrowing-like arrangement: short term deposits not exceeding 20 percent of the net assets of the scheme and for a period not exceeding 91 days may be made for the purpose of redemption of units or paying dividends to the unit holders.

Twenty per cent, ninety-one days, and only for redemptions or dividends.

Therefore, when we refer to liabilities, we are referring to current liabilities, in terms of payables that may be due.

The expenses associated with managing the portfolio are accrued as current liabilities and are paid as they become due. Therefore, net assets of a fund refer to the market value of the portfolio, plus accrued incomes, less any current liabilities and accrued expenses. Net asset value (NAV) is a 'per unit' representation of the net assets of a fund.

The three worked examples

Example 6: The market value of a fund's portfolio is Rs. 700 crore. If the current liabilities are Rs. 5 crore, what are the net assets? Net assets = Portfolio value less liabilities = 700 – 5 = Rs. 695 crore.

Example 7: Assume that the net assets of a fund are Rs. 750 crore. The unit capital (face value Rs. 10) is Rs. 250 crore. What is the NAV? Number of units = Unit capital/Face value per unit = 250/10 = 25 crore units. NAV = Net asset /number of units = 750/25 = Rs. 30 per unit.

Note the step that matters in Example 7 — unit capital must first be converted into a number of units by dividing by face value. It is not itself the number of units.

Example 8: If a fund's NAV was Rs. 15 and the number of units was 100 crore, what are its net assets? Net Assets = NAV x Number of units = 15 x 100 = Rs. 1500 crore.

The sample questions confirm that the securities a scheme invests in depend on its investment objective; that the type of expenses chargeable and their limit is decided by the Securities and Exchange Board of India; that mutual funds carry lower risk because of portfolio diversification and professional management; that it is false that unit capital is units multiplied by NAV; and that it is false that open-ended funds are mandatorily listed.