Operational Concepts of Mutual Funds

What this chapter covers

Units 9 to 11 carry 25 marks between them — about 8 marks for this chapter.

LEARNING OBJECTIVES: After studying this chapter, you should know about: Concept of New Fund Offer — allotment, inception date and use of NFO proceeds · Continuous / On-going Offer · Computation of Net Asset Value (NAV) · Operating cycle of a mutual fund · Time stamping of transactions and Risk Controls · Cut-off timing for applicable NAV · Mutual fund investment through stock exchanges · Roles of RTAs in Tax Computation · Reporting Requirements to CBDT

11.1 New Fund Offer

The mutual fund units are offered to the public for the first time when the scheme is launched through new fund offer (NFO). A mutual fund product begins its life on the NFO start date... During the NFO period (open date to close date) the units are purchased at the NFO price.

The first sample question tests this — during the NFO, units are bought at the NFO price, not NAV.

The NFO for mutual funds (except ELSS) are open for a period not more than 15 days.

The mutual fund would need the all the applicants to be KYC complied with completed application form with the prescribed documentation and the requisite investment amount, to allot an investment folio in the name of the investor.

Applications in NFO can also be made using Application Supported by Blocked Amount (ASBA) facility. The Mutual Funds/AMCs have to compulsorily provide ASBA facility to the investors for all NFOs launched on or after October 1, 2010.

The eighth sample question tests this — the mechanism blocking funds in the investor's own bank account is ASBA.

Allotment

Once the NFO closes, there is a 'no transaction period' (usually 5 days). During this period, the investors' account folio details are created, cheques are banked, bounced cheques are returned, and the final list of unit holders who form the register of investors for the just closed NFO is created.

The mutual fund (except ELSS) should allot units and dispatch statements of accounts... within the stipulated time notified by SEBI — currently... within 5 business days from the NFO close date. In case of ELSS, the allotment must be done within 30 days.

Inception date

The fund begins to declare its NAV from the next day of allotment. The date of allotment is the inception date of the fund, when its NAV is set at face value. Transactions in an open ended fund can begin from the next day when the first NAV of the fund will be declared.

Schemes are required by regulation to open for transactions within 5 working days of allotment.

Use of NFO proceeds

The mutual fund shall make investments out of the NFO proceeds only on or after the closure of the NFO period.

11.2 On-going or continuous offer

On-going or continuous offer indicates that transactions are resumed in a fund after the allotment is over. Purchases and redemptions of units happen at NAV related prices during the on-going offer period.

The third sample question tests this — ongoing purchases and redemptions are based on Net Asset Value.

For liquid funds, NAV is calculated and declared every calendar day, whereas NAVs for other than liquid funds are calculated and declared every business day.

In case of open-ended mutual funds, fresh units can be purchased from the fund and allotted units can be redeemed to the fund at prices linked to the NAV on an on-going basis. No new purchases from the fund can happen in case of closed-end mutual funds... However, investors can transact in the dematerialised mode among themselves through stock exchange platform where units of the closed end mutual funds are listed.

Why NAV-based pricing is fair

An investor buys 1 unit in a scheme during NFO at Rs. 10. There is a 10 percent appreciation in portfolio after that. Therefore, NAV goes up to Rs. 11. What happens if a new investor is allowed to buy another unit at Rs. 10? The total assets of the fund will be Rs. 21, and NAV drops to 21/2 = Rs. 10.50 per unit.

The NAV has fallen to Rs. 10.50, because another unit was purchased at Rs. 10. If the new unit was purchased at Rs 11, total net assets would be Rs. 22 and the NAV remained unchanged at Rs. 11 per unit. To be fair to both investors, the price charged to investors for buying or selling units has to be based on NAV.

Selling below NAV takes value from existing unit holders.

The operating cycle

Investor transaction is accepted by Official Point of Acceptance i.e. RTA's ISCs/AMC offices.

Transaction is intimated to RTA back office along with the data and images.

Transactions also flow from various other sources directly to RTA from AMC websites/digital portals, Channel partners, MFU, Exchanges and other online platforms as their systems has been integrated with RTA system.

Units are added (purchase) post realisation of funds or reduced (redemption) in the folio of investors.

Inflow and outflow resulting from transactions is reported to the AMC Treasury.

Units issued and redeemed for the day are consolidated.

Unit capital is updated for increase/decrease from the transactions.

Unit capital is communicated to AMC fund accounts.

Portfolio is valued by fund accounts/custodian.

NAV computation is done using the portfolio value and updated unit capital.

NAV is communicated to RTA for applying to investor transactions.

Eleven steps, beginning and ending at the RTA.

When investor transactions are received at the ISC during a business day, the applicable NAV of that transaction is not known. The AMC (or its custodian) computes the NAV at the end of the day, after the markets have closed.

In case of electronic transactions submitted to RTA various other online/digital sources, server at AMC/RTA end is considered as Official Point of Acceptance and hence NAV reaching the AMC/RTA server is considered for the NAV applicability.

11.3 Computation of NAV

The number in the denominator can be provided by the R&T agent, only after processing the purchase and sales transactions, for which they need the applicable NAV.

The second sample question tests this — the unit capital detail is supplied by the Registrar and Transfer Agent.

Therefore transactions can be processed only the next day based on NAV of previous day. After processing the transactions, the updated unit capital is communicated to the AMC.

NAV of Day T thus includes portfolio value of Day T (Numerator) and the number of outstanding units on day T-1 (Denominator).

Today's portfolio; yesterday's units.

Other things remaining constant, any increase in outstanding units in the denominator without a corresponding increase in the numerator representing the investment of funds received, will depress the NAV.

Example: Suppose the market value of the securities of a mutual fund scheme is Rs 500 lakh. The scheme expenses are Rs. 100 lakh. The mutual fund issues 10 lakh units of Rs 10 each to its investors. So, the NAV per unit of the fund is Rs (500 – 100)/10 = Rs 40.

RTA plays a crucial role in NAV calculation. In an open ended fund, the number of units changes daily based on purchase (increase in units) and redemption (decrease in units). This change of units is monitored by the RTA.

**And all transactions are captured by R&T agent by day-end for next day's reports to fund house for cash flow projection.

11.4 Applicable NAV

The NAV that is applicable to a transaction depends, among other things, on the day and time at which the transaction request was received at the official point of acceptance. It is therefore very critical to record the time at which a transaction was received and use this information to determine the applicable NAV for a transaction. SEBI has imposed electronic time stamping as a mandatory requirement for financial transactions related to mutual funds, for the same reason.

The sixth sample question tests exactly this — time stamping determines the applicable NAV for the transaction.

11.5 Time stamping and risk control

The time stamping guidelines defined by SEBI have to be complied with at all official points of acceptance of investor transactions. Mutual fund offices and designated investor service centres (ISCs) are official points of acceptance.

The time stamping machine captures the time of receipt of a transaction at the ISC... The location code, machine identifier, date, time (hh:mm) and running serial number are generated in every time stamp.

Five elements in every stamp.

As per the SEBI Regulations, a document evidencing purchase and its corresponding payment instrument should have the same time stamp serial number. That is, an application form and the accompanying cheque should have identical time stamping impressions.

Where the impressions go

In case of purchase transactions, the impressions are affixed on the face of the application form or transaction slip and on the back of the payment instrument.

In case of a purchase accompanied by an electronic fund transfer fax copy of the form and of the transfer instruction, are time-stamped. Transactions that are electronically enabled such as online transactions, are time stamped based on server timings.

Some transactions such as redemptions, switches and transfers are not accompanied by a payment instrument. For such transactions, impressions of the time stamp are affixed on the face of the application (transaction request) and on the investors' acknowledgement copy. If no acknowledgement is issued, then the application is stamped twice.

Non-financial transactions are not accompanied by a payment instrument. For such transactions all impressions of the time stamp are affixed on the transaction request itself.

Risk controls

The time stamp impression has to be affixed on a blank space in a document. Care has to be taken to ensure that the time stamping impression does not overwrite anything in the documents. Since the time stamp impression is used for determining applicable NAV, it has to be clear, legible and readable.

Since the AMC offices are official points of acceptance, they also receive transactions and timestamp them. The applicable NAV is based on the time stamp made at the AMC office. Therefore, for document control purposes the ISCs only time stamp the cover sheet received from the AMC.

Offices of distributors are not official points of acceptance. Therefore, they cannot time stamp the transactions received at their offices. Each transaction request received at the ISC in a bunch from distributors should be individually time stamped. The NAV on these transactions is applied as per the time stamp on each individual transaction request. This is irrespective of the time of receipt of the bunch.

Individually stamped, whatever time the bunch arrived.

Applications for fresh purchases or additional purchases should always be accompanied by a payment instrument.

If at the time of carrying out basic checks, a document is found to be incomplete the transaction request should not be time stamped. It should be returned over the counter for corrections. If an error is found in a transaction request that has been accepted and time-stamped, it should not be returned (even if the transaction is found unacceptable).

Not yet stamped — return it. Already stamped — keep it.

Machine maintenance

In order to ensure that all the machines at the ISC are in workable condition, they have to be tested every day as per a laid down process.

The machine should remain locked at all times except when replacement of ribbon or ink cartridge is required. The key should be kept in the custody of the ISC head.

A machine log should be maintained at a branch level. The log should be used to record instances of the machine having been opened.

Every morning, the first time stamp serial number should be verified with that of the last time stamp serial number of the previous day, to ensure that it is continuous.

Daily control reports are generated by all official points of acceptance, indicating the first, last and the time stamp serial number at cut-off time, for transactions received during the day.

11.6 Cut-off time

The applicable NAV for a mutual fund transaction will depend upon: The day of the transaction · The time of the transaction · The type of scheme · The availability of clear funds for utilization by the mutual funds.

Four factors.

**The day matters because markets and mutual funds do not work every day, and if it is not a business day for the fund, there would be no NAV on that date. However, Liquid funds publish NAV every calendar day, as the change in NAV is only made up of interest accrual.

A business day does not include a day on which the money markets are closed or otherwise not accessible.

Liquid fund remittances may be made electronically and deployed on the same day. Therefore, they have an earlier cut-off time.

Table 11.1 — applicable NAV

The seventh sample question tests the liquid fund purchase rule — application and funds both before cut-off gives the previous day's closing NAV.

Instant Access Facility: for liquid fund redemptions through Instant Access Facility (IAF) upto the cut off time, the lower of... (a) NAV of previous calendar day; and (b) NAV of calendar day on which application is received; after cut-off, the lower of the calendar day on which such application is received and the next calendar day. Mutual Funds/ AMCs can offer Instant Access Facility (IAF) only in Overnight and Liquid schemes.

Mutual Funds shall calculate NAV for each calendar day for their liquid fund schemes and plans.

The above cut-off timings are not applicable to: New Fund Offers (NFOs) · International Schemes · Transactions in Mutual Fund units undertaken on a recognized Stock Exchange

The worked week

Assume that in a particular week, Monday, Wednesday, Thursday and Friday are business days, whereas all the other days are non-business days.

1. An investor submits an application on Monday to buy units of an equity mutual fund scheme for Rs. 3,00,000. If application is made on Monday and fund gets realized on Wednesday by 2 pm, it will be Wednesday's NAV.

2. An investor makes an application to purchase units of a liquid fund. If application is made on Monday and fund gets realized by 1 p.m. on Monday, it will be Sunday's NAV. If it gets realized by 3 pm on Monday, it will be Tuesday's NAV. If it gets realized by 10 am on Wednesday, it will be Tuesday's NAV.

3. An investor makes an application for redemption of units of equity fund on Monday. If the application is submitted before the cut-off time, the redemption would be processed at Monday's NAV. However, if the application is submitted after the cut-off time, the applicable NAV would be of Wednesday.

4. Redemption from liquid fund, application submitted on Monday. If the application is submitted before the cut-off time, the redemption would be processed at Tuesday's NAV. However, if the application is submitted after the cut-off time, the applicable NAV would be of Wednesday.

11.7 Segregated portfolios

Segregated Portfolio (popularly referred to as side pocket) is allowed by SEBI in case of debt/ money market instruments facing default or downgrade of part of its portfolio. The concept of segregated portfolio means to separate / segregate the debt/ money market instruments facing a "credit event" from the main portfolio. This ensures liquidity and fair treatment for all investors.

Creation of segregated portfolio is based on issuer-level credit events and are implemented at the ISIN-level. Credit event is defined as downgrade of a debt instrument below investment grade by SEBI registered Credit Rating Agency (CRA).

The Scheme Information Document (SID) must have a specific provision allowing for creation of a segregated portfolio and such actions must be approved by the Trustees.

The fifth sample question tests this — the SID must have the enabling provision.

For unrated instruments: SEBI permitted segregation of unrated debt or money market instruments... of an issuer that does not have any outstanding rated debt or money market instruments... only in case of actual default of either the interest or the principal amount.

Rated instruments — a credit event. Unrated instruments — actual default.

The rules that follow

Segregated portfolio will be effective from the day of credit event.

An email or SMS to be sent to all unitholders of the concerned scheme.

NAV of both the segregated portfolio and main portfolio to be declared daily.

No redemption and subscription are allowed in the segregated portfolio. However, in order to facilitate exit to unitholders in segregated portfolio, AMC shall enable listing of units of segregated portfolio on the recognized stock exchange within 10 working days of creation of segregated portfolio and also enable transfer of such units on receipt of transfer requests.

AMCs cannot charge investment and advisory fees on the segregated portfolio. However, TER (excluding the investment and advisory fees) can be charged, on a pro-rata basis only upon recovery of the investments in segregated portfolio.

Upon recovery of money, (partial or full), it shall be immediately distributed to the investors in proportion to their holding in the segregated portfolio.

Periodic Review of Action Taken to recover the investments of segregated portfolio.

Adequate disclosure of the segregated portfolio shall appear in all scheme-related documents.

Capital gains / loss to be calculated from date of original investment and not from date of segregation.

And a warning: existence of the provisions for segregated portfolio should not encourage the AMCs to take undue credit risk in the scheme portfolio. Any mis-use of the provisions of segregated portfolio, would be considered serious and stringent action may be taken.

The RTA's responsibilities

The segregated portfolio is in effect a close-ended fund carved out of the main fund. The RTA has responsibilities to: Calculate NAV · Inform investors of NAV · Issue account statements for the segregated fund · Distribute any money recovered · Ensure compliances for TER and reporting · Ensure smooth operation of the main portfolio with no restrictions on purchase and redemption

Six responsibilities.

11.8 Investing through stock exchanges

The terminals of stock exchanges can be used for transacting in mutual fund units. The brokers, who intend to offer the facility, must comply with the empanelment requirement and abide by the code of conduct and applicable SEBI guidelines for mutual fund distributors.

Folio details for transactions done are sent by brokers to the R&T agent who allot units for purchases and release funds for redemption requests. Such Mutual Fund Distributors do not handle pay-out and pay-in of funds as well as units on behalf of investors. The pay-in is directly received by the Clearing Corporation and pay-out is directly made to investor's account. In the same manner, units are credited and debited directly from the demat account of the investors by the Clearing Corporation.

SEBI has notified that pooling of funds/ units by stock brokers/ clearing members are discontinued for mutual fund transactions.

The online platforms offered by stock exchanges such as NSE Mutual Fund Platform (NMF II) and BSE StAr Mutual Fund are available to SEBI Registered Investment Advisors (RIAs)... including direct plans, and SEBI has allowed investors to directly access infrastructure of the recognised stock exchanges to purchase and redeem mutual fund units directly from Mutual Fund/ Asset Management Companies.

The advantages: independent view of customer's entire portfolio at one place · reduction of paperwork and ensuing errors · reduction of redundancy in process and data duplication at RTA and Distributor levels · de-risking mutual fund settlement processes by using superior Delivery v/s Payment (DVP) process provided by Stock Exchanges · extending present convenience available to Secondary market investors to mutual fund investors.

11.9 Holding units in dematerialised form

Mutual fund investors can choose to hold units in dematerialized form. The choice to hold units in demat mode is provided in the subscription form and the ISIN for each option of each scheme is quoted in the statement of account sent to the investors.

Once the units are held in demat mode, for redemption and all profile changes such as nomination, bank account, contact details etc. the investor is required to contact his DP. The RTA/AMC will use the details available in the DP account of the investor.

All schemes of Alternative Investment Funds (AIF) are mandated to hold their investments in dematerialized form w.e.f. October 1, 2024.

11.10 The RTA's role in tax computation

TDS on capital gains for NRIs

TDS is applicable for redemptions by NRIs. An RTA will check the residential status of each redemption application and flag the NRI applications for TDS. After the NRI application is flagged, capital gains are determined. The tax liability is determined based on holding period (long term or short term capital gains) and type of scheme (debt or equity).

TDS on dividend

The Finance Act 2020 has mandated that Dividends (IDCW) from Mutual Funds to be taxed in the hands of the investors. Earlier, dividends were tax free in the hands of the investor and Dividend Distribution Tax (DDT) was applicable.

For resident Indians, TDS is applicable at 10 percent for all dividends, both in equity and debt schemes. Dividend income (in respect of units of a mutual fund) below Rs. 5,000 in a financial year is exempt from TDS. In case, PAN is not available or is not submitted, the TDS rate shall be 20 percent.

For non-resident Indians (NRIs), TDS shall be at 20 percent of the dividend (IDCW) amount.

**And if PAN is not linked with Aadhaar, higher TDS will get attracted.

Securities Transaction Tax

Securities Transaction Tax (STT) refers to the tax that has to be paid at the time of redemption or switch to other schemes or sale of units of equity oriented mutual funds, whether sold on stock exchange or otherwise. Concessional (lower) rate of tax is paid on Equity Mutual Funds since they are subject to Securities Transaction Tax (STT). STT is not applicable on purchase of units of an equity scheme. It is also not applicable to transactions in debt and liquid funds.

The fourth sample question tests all three of those propositions — and all are true.

The STT amount must be shown separately in the Statement of Account issued to the investor.

The RTA shall ensure correct deduction of STT applicable for the defined set of schemes and for the applicable transactions. RTA, then share the STT registers to the respective MF/ AMCs for onward remittance to the relevant government authorities.

Stamp duty

Stamp duty is payable at the rate of 0.005% (Rs 5 per lakh) is applicable to all mutual fund transactions since July 2020. This includes any new investments made in mutual fund schemes, whether they are equity, debt funds, or exchange-traded funds, and regardless of the mode of investment, be it SIPs or STPs. It's important to note that this duty is only imposed on the purchase of new mutual fund units and does not apply when selling or redeeming existing units.

The RTA will ensure that the stamp duty amount is shown separately in the account statement and also ensure collection of the same from investors and deposit to Government.

Note the mirror image — STT is on the sale side and only for equity; stamp duty is on the purchase side and applies to everything.

11.11 Reporting to the CBDT

FATCA

The Foreign Account Tax Compliance Act (FATCA) is a US law that aims to combat tax evasion by US persons opening accounts offshore. It enhances due diligence and information reporting requirements for both individual and entity accounts. On July 9, 2015, India signed Inter-Governmental Agreement (IGA) with the USA for implementation of FATCA i.e. the Indian financial institutions will provide the necessary information to Indian tax authorities, which will then be transmitted to USA automatically. Investors are required to provide FATCA declaration and inform Fund House whenever the status changes.

CRS

The G20 and Organisation of Economic Development (OECD) countries have together developed a Common Reporting Standard (CRS) on Automatic Exchange of Information (AEOI). The CRS on AEOI requires the financial institutions of the "source" jurisdiction to collect and report information to their tax authorities about account holders "resident" in other countries, such information having to be transmitted "automatically" annually.

In India, the Central Board of Direct Taxes (CBDT) is the nodal agency for all tax related compliances and exchange of information between governments. The RTA shall provide all relevant information in the necessary format to CBDT and flag any non-compliant investor folios for necessary action.

RTA facilitates the data after identification of reportable accounts, reports the same to AMC in unloadable format in CBDT Reporting portal. In any DQR (Data Quality Report) raised by CBDT, AMC will download and share with RTA for necessary. RTA will review and support AMC in submission of revised statements as may be required.

Statement of Financial Transactions

As per section 285BA of the Income Tax Act, specified entities are required to furnish a statement of financial transaction or reportable account in respect of specified financial transactions... to the income-tax authority.

A trustee of a Mutual Fund or such other person managing the affairs of the Mutual Fund are required to report details of receipt from any person of an amount aggregating to Rs. 10 lakh or more in a financial year for acquiring units of one or more schemes of a Mutual Fund (other than the amount received on account of transfer from one scheme to another scheme of that Mutual Fund) to the Income Tax authority. RTA, on behalf of the AMC, facilitates the data in the reportable format for upload into CBDT reporting portal.

Rs. 10 lakh or more in a financial year, excluding inter-scheme transfers.

Independently, MFRTAs are mandated to submit Statement of Financial Transactions (SFT-081) which encompasses transactions attracting capital gains to CBDT through the defined mechanism.

Centralisation of certifications

SEBI has mandated that intermediaries who are Reporting Financial Institutions (RFI), shall upload the FATCA CRA certifications obtained from clients onto the system of KRAs w.e.f. July 1, 2024. Further, existing certifications obtained prior to July 1, 2024 shall be uploaded within 90 days from July 1, 2024.

The chapter's sample questions confirm that NFO units are bought at the NFO price; that unit capital detail for NAV comes from the Registrar and Transfer Agent; that ongoing purchases and redemptions are based on Net Asset Value; that all three STT propositions are true; that a segregated portfolio needs a provision in the SID; that time stamping determines the applicable NAV; that a liquid fund purchase with application and funds before cut-off gets the previous day's closing NAV; and that the NFO mechanism blocking funds until allotment is ASBA.