Concept and Role of a Mutual Fund — what you are actually selling

The correction that the exam actually tests

Everybody says "I have invested in a mutual fund."

Technically, that is wrong. One does not invest in a mutual fund — one invests through a mutual fund. The workbook says plainly that as a mutual fund distributor, it is critical to understand the difference between the two concepts.

Here is why it matters. When someone says they invested "in" a mutual fund scheme, the scheme is perceived to be competing with equity shares, debentures and bonds. It is not. One invests in those instruments through a mutual fund scheme. The fund buys the shares and the bonds for you.

The difference lies in three things: the professional way of investing, portfolio diversification, and a regulated vehicle.

The formal definition — learn this wording

Note the word trust. Not a company, not a partnership. That legal form is the whole subject of Chapter 3.

Through a mutual fund an investor gets access to equities, bonds, money market instruments and other securities that may otherwise be unavailable to them, plus professional fund management from an asset management company.

What mutual funds do for the country

The primary role is to help investors earn an income or build wealth by investing in opportunities in the securities markets. But the workbook lists a wider role, and the exam asks about it:

• Money raised ultimately benefits governments, companies and other entities, funding projects and expenses.
• Those projects offer employment; the income earned buys goods and services from other companies, supporting their projects too. Overall economic development is promoted.
• As a large investor, a mutual fund can keep a check on the operations of the investee company, and their corporate governance and ethical standards. One retail investor with 50 shares cannot. A fund holding a meaningful stake can.
• The industry itself offers livelihood to employees of mutual funds, distributors, registrars and service providers.
• Higher employment, income and output boosts the government's revenue collection through taxes, funding further development and nation-building.
• Mutual funds act as a market stabiliser, countering large inflows or outflows from foreign investors. They are therefore a key participant in the capital market of any economy.

A note on vocabulary: in the industry the words "fund" and "scheme" are used interchangeably, and various categories of schemes are called "funds". Where a distinction is needed, the scheme-offering entity is "the mutual fund" or "the fund".

Investment objective, then investment policy

Each pool of money mobilised is a scheme, and every scheme has a pre-announced investment objective. Investors pick the scheme whose objective reflects their own needs.

Objectives always come back to three basic needs: safety, liquidity and returns. The workbook's own examples, lifted from real SIDs:

Schemes are classified by investment objective (what they aim to achieve) and by investment universe (where they invest), and the two are closely related — a scheme seeking liquidity invests in money market securities; one seeking capital appreciation invests in equity.

Once the objective is fixed, the investment policy follows. The investment policy discloses exactly two aspects — asset allocation and investment style. Asset allocation is disclosed in the Scheme Information Document (SID). Style covers growth or value, and focused or diversified.

Remember the number two. The exam asks what the investment policy discloses.

Who keeps the profits?

Profits or losses belong to the investors — the unitholders. No other entity involved in the mutual fund, in any capacity, participates in the scheme's profits or losses. Everyone else — AMC, trustees, registrar, distributor — is paid a fee or commission for their contribution, whether the scheme gains or loses.

The vocabulary you will use every day

Units. An investor's investment is translated into a certain number of units of the scheme.

Face Value. Typically ₹10 per unit. The face value is relevant from an accounting perspective — nothing more. A new fund at ₹10 is not "cheaper" than an old one at ₹450.

Unit Capital. Number of units issued × face value (₹10).

Recurring Expenses. Fees and commissions paid to the various constituents, charged as a percentage of the scheme's AUM and deducted while calculating the NAV. So: the higher the expenses, the lower the NAV, and hence the lower the investor returns. SEBI has imposed strict limits on what may be charged.

Net Asset Value (NAV). The true worth of a unit. It rises when investment activity is profitable and falls when there are losses. It is also the net realisable value per unit if the scheme were liquidated — how much money could be generated if every holding were sold and converted into cash.

Assets Under Management (AUM). The scheme's total size. Also obtained by multiplying the current NAV by the total units outstanding. The relative size of AMCs is assessed by their AUM. At launch, AUM is the amount mobilised. Thereafter it rises with good performance and with post-NFO contributions, and falls when the scheme pays money out — as IDCW, or as consideration for repurchase and redemption.

Mark to Market (MTM). Valuing each security in the portfolio at its current market value. It is done daily to calculate the daily NAV, which is why the NAVs of all schemes fluctuate daily.

IDCW. The dividend option is now called Income Distribution cum Capital Withdrawal.

The advantages — with the catch in each

Professional management. Investing in line with the objective, adequate research, and prudent investment processes. Direct investing needs a broking account, a demat account and other relationships; a mutual fund simplifies that. And the fund manager's job extends beyond picking securities to administrative tasks — collecting interest payments, dividends, rights issues and buybacks, or following up on them. Because NAV is calculated and published daily, the accounting of the entire portfolio is done every day — an effort no individual would realistically match. All of this comes at very low cost and is available even for the smallest investments.

Affordable portfolio diversification. A unit-holder gets exposure to the whole portfolio in proportion to their holding — proportionate ownership in a diversified investment portfolio even for a small investment of ₹500. "All the eggs are not in the same basket," so the investor is less likely to lose money on all investments at the same time. To reach the same diversification directly, an investor would need several lakhs of rupees; through a scheme it takes less than a thousand rupees.

Economies of scale. Pooling makes professional management affordable for people who could never engage a manager alone. Costs of investment research and office space get spread across investors, and higher transaction volume makes it possible to negotiate better terms with brokers, bankers and other service providers.

Transparency. Three essential places to look, and you should know all three: scheme related documents (SID, SAI and KIM), portfolio disclosures, and the NAV of the scheme. Even a prospective investor can access all of it.

Liquidity. Illiquid investments — where the investor cannot easily find a buyer, or sometimes cannot even find the company — can cause real losses. A unit-holder in a mutual fund can recover the market value from the mutual fund itself: at any time, or during specific intervals, or only on closure, depending on the structure. Schemes where money can be recovered only on closure are compulsorily listed on a stock exchange. And if a "material" development occurs, the information is made available on time, so an investor can act — this combination of transparency and liquidity enhances safety.

Tax deferral. Mutual funds are not liable to pay tax on the income they earn. If the investor earned that income directly, tax might be payable in the same financial year. By choosing an option that lets money grow inside the scheme for years, the investor can defer the tax liability and legally build wealth faster.

Tax benefits. ELSS gives a deduction of the amount subscribed, up to ₹1,50,000 in a financial year under Section 80C of the old tax regime.

Convenient options, investment comfort (further purchases need very little documentation), regulatory comfort (SEBI's strict checks and balances), and a systematic approach — SIP to invest regularly, SWP to withdraw regularly, STP to move money between schemes.

The limitations — say these honestly to clients

The workbook lists four.

Lack of portfolio customisation. Portfolio Management Services (PMS) give a large investor better control over what securities are bought and sold, and a customised portfolio. A unit-holder in a mutual fund is just one of several thousand investors and cannot influence what securities the scheme invests in.

Choice overload. Too many houses, too many schemes, too many options within schemes. Greater dissemination of industry information and the availability of professional advisers or distributors helps. SEBI's answer was the categorisation of mutual funds — forcing uniformity in the characteristics of similar schemes across houses so that investors can compare.

No control over costs. All money is pooled and costs are shared in proportion to units held, so no individual controls them. SEBI caps expenses — and helpfully, market forces also push costs down, and many schemes operate at expenses much lower than the regulatory limits.

No guaranteed returns. A mutual fund is a pass-through vehicle that passes on the risk and return to the investors. It is not a guaranteed return product. Three factors decide returns: the movement of the specific market invested in, the performance of individual securities held, and the skills of the investment management team. Of these, the fund manager can work towards improving only his own skills; the other factors are out of his control.

How every Indian scheme is classified

By structure

• Open-ended — perpetual, open for purchase and repurchase after the NFO. New money creates units; exits cancel units; so unit capital keeps changing on a regular basis.
• Close-ended — fixed maturity. Units can be bought from the fund only during the NFO. At maturity the scheme is wound up, units cancelled and money returned. Every close-ended scheme other than an ELSS must be listed on a recognised stock exchange. Post-NFO trades happen between two investors on the exchange — the fund is not involved — so the unit capital remains fixed.
• Interval — largely close-ended, becoming open-ended at pre-specified intervals, for example 1–15 January and 1–15 July each year. Units must be compulsorily listed so investors have an exit route in between. No redemption or repurchase is allowed except during the transaction period.

Why close-ended units usually trade at a discount to NAV. The transaction price depends on demand and supply and is likely to be different from the NAV — and experience suggests that most of the time the units trade at a discount. The reasoning is elegant: the buyer has money and hence many options to choose from, whereas the seller has the units. This puts the buyer in a better bargaining position.

Interval fund timings — memorise these exactly as V-B states them: the periods when the scheme is open are transaction periods; the gap between them is the interval period. Minimum duration of the transaction period is 2 days, and maximum duration of the interval period is 15 days.

ETFs address the poor liquidity of listed close-ended and interval units, and their market price also tracks the NAV very closely. An ETF trades on a stock exchange just like any other stock, usually tracking an index, so they are passive in nature. Where an open-ended fund has a single NAV at the end of the day, an ETF is traded for the entire day and gives multiple opportunities and prices to enter or exit. The downside: prices might fluctuate quite a bit and there might be a big gap with the NAV, so investors must watch the price they transact at. Investors need a demat account. Both Gold ETFs and, more recently, Silver ETFs — schemes investing primarily in silver or silver related instruments — have been introduced.

By management of the portfolio

• Actively managed — the manager chooses the portfolio within the objective. Higher expenses, because the manager's role is larger. Investors expect them to perform better than the market.
• Passive — invests on the basis of a specified index, holding the same shares in the same weights. Performance mirrors the index. They are not designed to perform better than the market. The manager has no role in deciding investments, so running costs are low. Also called index schemes.

MF Lite framework. SEBI introduced Mutual Fund Lite for passively managed schemes. An MF Lite is a mutual fund having only index funds, exchange traded funds, fund of funds or other schemes SEBI specifies.

By investment universe — equity, fixed income, money market, gold, international funds. This narrows further: within equity, large-cap and mid-cap funds; within debt, Government Securities funds and corporate debt funds.

SEBI's five categories

To standardise classification and ensure schemes are clearly distinct from one another, SEBI issued a circular on Categorization and Rationalization of Mutual Fund Schemes. The purpose is uniformity in the characteristics of similar schemes launched by different fund houses, so an investor can objectively evaluate them.

A. Equity — 13 sub-categories. B. Debt — 17. C. Hybrid — 7. D. Life Cycle Funds. E. Other — 2.

The market-cap definitions everything else depends on:

Equity sub-categories and their minimums:

For sectoral and thematic schemes, no more than 50% of the portfolio may overlap with other sectoral/thematic schemes and other equity categories except large cap. And funds may launch them only in accordance with the list of sectors and themes specified by AMFI, in consultation with SEBI, on a half-yearly basis.

Debt categories, defined mostly by Macaulay duration:

Corporate Bond versus Credit Risk is the trap. Corporate Bond = safer, AA+ and above, 80%. Credit Risk = riskier, AA and below excluding AA+, 65%. SEBI also directed that words or phrases highlighting only the return aspect must not be used in a scheme's name — no "credit opportunities fund", no "high yield fund", no "credit advantage".

Hybrid, by equity content:

Life Cycle Funds have a target date maturity following a glide path across equity, debt, InvITs, ETCDs, Gold and Silver ETFs. Minimum tenure 5 years, maximum 30 years, launched in multiples of 5 years, with a maximum of 6 such funds active for subscription at any point in time.

Other: Index Funds / ETFs — 95% in the securities of the index being tracked. Fund of Funds (Overseas or Domestic) — 95% in the underlying fund.

One scheme per category, with three exceptions: index funds and ETFs replicating different indices, fund of funds with different underlying schemes, and sector and thematic funds investing in different sectors or themes.

Also worth knowing: Fixed Maturity Plans — close-ended debt funds whose portfolio duration is closely aligned to the scheme's maturity, giving more clarity on likely returns (though there can be no guarantee or assurance). Target Maturity Funds — designed to mature on a specific date, typically 2 to 14 years away, holding bonds with matching maturities to minimise reinvestment risk. Infrastructure Debt Funds — set up either as a Trust or as a Company; a trust-based IDF is normally a mutual fund regulated by SEBI, a company-based IDF normally an NBFC regulated by the RBI. Real Estate Mutual Funds invest directly or indirectly in real estate assets — and are yet to be launched in India.

REITs and InvITs are trusts registered with SEBI — but they are NOT mutual fund schemes. REITs invest in commercial real estate assets; InvITs invest in the infrastructure sector.

ESG is a separate sub-category under the thematic category of equity schemes, launchable with one of six strategies: exclusion, integration, best-in-class and positive screening, impact investing, sustainable objectives, and transition or transition related investments.

New types of funds

Smart Beta Funds extend index funds and ETFs by changing the basis of exposure using alternative strategies. A plain index fund weights by market capitalisation; smart beta relies less on market cap — equal weighting, or exposure based on additional parameters. The aim is to improve returns, increase diversification and reduce risk.

Quant Funds rely on data analysis and numbers, usually undertaken by machines. Pre-determined models built from past data run through emerging data to select holdings and decide buys and sells. This takes out the human element in decision making.

International REITs funds invest in REITs abroad, giving exposure to both international funds and the commercial real estate sector.

Specialized Investment Fund (SIF). A new product line introduced by amendment to the SEBI (Mutual Funds) Regulations. The minimum required investment is ₹10 lakhs from an investor across all investment strategies of the same AMC.

How big has this become?

Roughly ₹32,000 crore arriving every month from ordinary households, on autopilot. That steady domestic flow is precisely what lets mutual funds act as the market stabiliser described earlier.