Basics of Mutual Funds

What this chapter covers

Units 6 to 8 carry 25 marks between them — about 8 marks for this chapter.

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) · Total Expense Ratio (TER) and its implication Direct and Regular Plans · Concepts of T30 and B30 · Role of RTAs related to NAV and TER

8.1 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.

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.

Two different things — the money and the securities.

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

For example, an equity fund may state that its objective is to invest in equity shares to generate long term growth... 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.

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.

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. 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... 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.

A 20% gain on every rupee, whoever put it in.

Units

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.

Equity shares are offered to investors for the first time through an initial public offering (IPO)... Likewise, mutual funds are offered for the first time to investors through a new fund offer (NFO). 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 compulsorily 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 (FV). Post NFO, unit capital does not change for closed-ended mutual funds, whereas the unit capital of an open-ended mutual fund varies.

Investments are made in rupee terms by the investor. But the fund will always record this investment in terms of number of units.

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 as a fractional value also.

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

The third sample question runs this backwards — unit capital Rs. 10 lakh at a face value of Rs. 10 gives 1,00,000 units. The NAV of Rs. 50 is a distractor; outstanding units come from unit capital ÷ face value, never from NAV.

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.

8.2 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... A minimum level of diversification in a mutual fund portfolio is ensured by SEBI's regulations that mandate maximum exposure to a security/issuer.

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...

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

Nine advantages.

8.3 Open ended and close ended funds

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... 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.

Table 8.1

A recent overhaul: 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, aimed at ensuring funds remain "true-to-label." The revised framework takes effect immediately, with existing schemes required to align within six months.

8.4 Assets under Management

A portfolio is a collection of securities... Mutual funds can invest only in marketable securities, or securities that can be traded in a market and therefore have a market price.

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.

Example 6

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.

And it falls as easily: if the value of the portfolio falls from Rs. 47,50,000 to Rs. 45,00,000... this will lead to the NAV per unit falling from Rs. 10 to Rs. 9.47 (i.e. 45,00,000 / 4,75,000).

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.

8.5 Redefining the Total Expense Ratio

As per the SEBI circular, from April 1, 2026, TER will represent the total cost borne by the investors and will have a clear internal break-up of the costs.

TER will now consist of: Base Expense Ratio (BER) or the AMC-controlled expenses · External charges including, brokerage, exchange and regulatory fees and statutory levies such as GST, STT, CTT and stamp duty

The sixth sample question tests this — the total of BER, brokerage and statutory levies is the Total Expense Ratio (TER).

This development ensures that the investors can clearly see what the fund house controls and what expenses arise due to regulation, taxation or market activity.

The activities associated with portfolio management involve costs and fees. These expenses are charged to the mutual fund scheme. Regulations cover what kind of costs can be charged to the scheme and also prescribe limits on these expenses.

The second and fourth sample questions turn on that sentence — the type of expenses and their limits are decided by SEBI, and expenses charged to a scheme are limited by regulation.

What BER includes

Investment and advisory fees · marketing and selling expenses including fees, commission and charges towards distribution of mutual fund schemes, if any · brokerage cost incurred towards execution of trades · registrar services for transfer of units sold or redeemed · fees and expenses of trustees · audit fees · custodian fees · costs related to investor communication · costs of fund transfer from location to location · costs of providing account statements and Income Distribution cum Capital Withdrawal payout/redemption cheques and warrants · insurance premium paid by the fund · winding up costs for terminating a scheme · costs of statutory advertisements · expenses towards storage and handling of underlying goods due to physical settlement of any commodity derivative contract or cost towards storage and handling of gold and silver · listing fees, in case of schemes listed on a recognised stock exchange

Note that registrar services for transfer of units sold or redeemed is on the list — the RTA's own fee is a scheme expense.

What BER excludes: the Base Expense Ratio (BER) shall represent the core investment management and recurring expenses of the scheme and shall not include any statutory levies or regulatory fees. Furthermore, transaction costs incurred for trade execution—comprising regulatory levies and expenses charged by stock exchanges, clearing corporations, or clearing houses shall remain excluded from the BER.

BER limits

SEBI guidelines states maximum BER as percent of daily net assets, for equity oriented scheme(s) it is 1.00 per cent and for other than equity oriented scheme(s) it is 0.80 per cent.

For a fund of funds scheme:

(i) Investing in liquid schemes, index fund scheme and exchange traded funds — not exceeding .90 per cent of daily net assets, including the weighted average TER of underlying schemes.

(ii) Investing a minimum of sixty-five per cent of assets under management in equity-oriented schemes — not exceeding 2.10 percent.

(iii) Investing in schemes other than as specified above — not exceeding 1.85 per cent.

For an index fund scheme or exchange traded fund: the base expense ratio of the scheme including the investment and advisory fees shall not exceed 0.90 per cent of the daily net assets.

For other open ended schemes:

Bigger funds charge less — the slabs fall as assets rise.

Brokerage on top: a mutual fund scheme may charge expense incurred towards brokerage, for the purpose of execution of trade, over and above the base expense ratio subject to a maximum of 0.06 per cent of trade value in case of cash market transactions and 0.02 per cent of trade value in case of derivatives transactions. Expense charged towards brokerage, over and above the specified limit, shall be part of the base expense ratio limit.

The BER limits specified above for the schemes include the investment management and advisory fee, but excludes the issue or redemption expenses.

Direct and regular plans

Mutual fund offers two types of plans: Direct Plan and Regular Plan. In direct plans, mutual funds provide the option to investment in the schemes without the involvement of any distributor, BER for this plan includes only the core investment management, advisory fees, and recurring expenses; whereas, in regular plans, investments are routed through a distributor, the BER for this plan includes the core AMC fees plus the distributor commission.

Since there is no distributors involved in a direct plan and no commission is payable, the BER of such plans are lower compared to regular plans where commissions need to be paid to the distributors involved.

Direct is cheaper — by exactly the commission.

T-30 and B-30

SEBI has classified cities as 'Top 30' (T-30) and 'Beyond top 30' (B-30) cities. T-30 refers to the top 30 geographical locations in India from where the mutual fund investments are made; whereas, B-30 refers to the locations beyond top 30 cities. The Top 30 cities mean the top 30 cities based on Association of Mutual Funds in India (AMFI) data on 'AUM by Geography – Consolidated Data for Mutual Fund Industry' as at the end of the previous financial year. The T-30 locations account for more than 80 percent of the industry AUM.

More than 80 per cent from thirty cities.

SEBI, with an objective to increase penetration of mutual funds in B-30 cities, has allowed mutual funds to charge additional expenses which can be used for distribution related expenses, including distributor commission... the incentive structure for onboarding of new investors from B-30 cities and women investors from both T-30 and B-30 cities has been revised. This means that the distributors mobilizing funds from investors located in B-30 locations... would earn higher commission.

The fifth sample question tests this — distributors mobilising from B-30 locations earn higher commissions.

The additional TER shall be charged based on inflows from retail investors from beyond top 30 cities (B-30 cities). Accordingly, it has been decided by SEBI that inflows of amount up to Rs. 2,00,000 per transaction, by individual investors shall be considered as inflows from "retail investor".

Retail means up to Rs. 2,00,000 per transaction, by an individual.

The RTA's tagging procedure

RTAs play an important role in tagging inflows to T-30 and B-30 locations. AMFI's standard procedure came into effect from April 1, 2019.

1. The report on AUM by Geography as well as tagging T-30/ B-30 transactions should be based on investors' PIN code in the folio.

The eighth sample question tests this — the report is generated on the investor's PIN code.

2. RTAs will have to use the city wise PIN code file for top 200 cities provided by AMFI to tag all purchase transactions (including switches, SIP/ STP, and IDCW reinvestments).

3. All NRI transactions (where tax status code is NRI, OCI, PIO, FIIs, QFI) should be tagged as T-30 and shown in the AUM by Geography report separately.

4. In respect of the transactions where country name is available in the application form or in KRA/ CKYC database, and the country name stated is other than 'India', the same to be tagged as T-30.

5. Where investor PIN code is available and matches with T-30 PIN code file provided by AMFI, the transaction shall be tagged as T-30.

6. If the investor PIN code is available and valid as per All India PIN Code master of Department of Posts, but does not match with the T-30 PIN code file — then a. If the city name is available in the KYC city field and matches with T-30 city list or is a foreign city, the same to be tagged as T-30; else, the same to be tagged as B-30 b. If the city name is not available in the KYC city field, the same to be tagged as B-30.

7. Where PIN code is invalid or not available, then a. If the city name can be positively identified as B-30, it is to be tagged as B-30 b. If the city name cannot be positively identified as B-30, it is to be tagged as T-30.

Note the default in rule 7 — when nothing can be established, the transaction is tagged T-30, so no incentive is paid on doubt.

8. Wherever, fresh purchase application is accompanied with KYC form, PIN code/ investor city name as per KYC application to be considered.

9. Re-tagging needs to be done at T+15 business days if the original tagging was done based on the fresh purchase application form and KRA/ CKYC download indicates a change requirement. The date of tagging/ re-tagging of transactions will be stored in the database for audit trail purpose.

10. PIN code or investor address received through stock exchange (non-demat)/ channel partners' feed for transactions, other than fresh purchase may be ignored and RTAs should go by the address as per KYC.

11. The PIN code Master and T-30/ Foreign City Master will be reviewed by AMFI for any changes or corrections in coordination with the RTAs once every year.

12. If any AMC/ RTA discovers that any PIN code should be included in the T-30/ B-30 city list, they shall report the same to AMFI. After due review, AMFI will provide a revised T-30/ B-30 list. All revisions will be applied prospectively.

8.6 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.

The seventh sample question tests the meaning — NAV is the market value per unit after charges and liabilities.

Investors make investments in round figures or in multiples of one rupee. The NAV is calculated up to 2 decimal places for equity oriented mutual funds and up to 4 decimal places for index funds and all types of debt/ liquid/ 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.

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

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. All mutual fund schemes (except for fund of fund schemes) shall update their latest NAVs by 11 p.m. of the same day and Fund of Fund schemes shall update the latest NAVs by 10 a.m. the following business day.

11 p.m. same day; 10 a.m. next business day for FoFs.

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

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. 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 (IDCW) to the unit holders. Therefore, when we refer to liabilities, we are referring to current liabilities, in terms of payables that may be due.

20 per cent of net assets; 91 days.

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.

The three worked examples

Example 7: The market value of a fund's portfolio is Rs. 700 crores. If the current liabilities are Rs. 5 crores, what are the net assets? Net assets = Portfolio value less liabilities = 700 – 5 = Rs. 695 crores.

Example 8: Assume that the net assets of a fund are Rs. 750 crores. The unit capital (face value Rs. 10) is Rs. 250 crores. 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.

Example 9: If a fund's NAV was Rs. 15 and the number of units was 100 crores, what are its net assets? Net Assets = NAV x Number of units = 15 x 100 = Rs. 1500 crore.

The chapter's sample questions confirm that the securities a scheme invests in depend on its investment objective; that the type of expenses chargeable and their limits are decided by SEBI; that unit capital of Rs. 10 lakh at a face value of Rs. 10 means 1,00,000 outstanding units; that expenses charged to a scheme are limited by regulation; that distributors mobilising from B-30 locations earn higher commissions; that BER plus brokerage plus statutory levies is the Total Expense Ratio; that NAV is the market value per unit after charges and liabilities; and that the AUM by geography report is generated on the investor's PIN code.