Products for the New Cadre — the five simple and performing schemes

Where this chapter sits

Chapter 4 carries 6% of the paper. It matters more than its weight suggests, because this examination is the qualification for the new cadre — these are the only products you will be permitted to distribute.

Two things dominate the exam here: the list of five permitted scheme types, and the 91-day / 1-year distinction between liquid and money market funds.

4.1 Who the new cadre are, and what they may sell

This chapter deals with the specific products allowed to be distributed by the basic cadre of distributors.

As per the circular, the following may be considered to be empanelled as mutual fund distributors under the new cadre:

1. Postal agents
2. Retired government and semi-government officials (class III and above or equivalent) with a service of at least 10 years
3. Retired bank officers with a service of at least 10 years
4. Other similar persons (such as bank correspondents) as may be notified by AMFI/AMC from time to time

Note the two "at least 10 years" conditions, and that class III or above or equivalent qualifies for retired officials.

These new cadre distributors can sell only simple and performing schemes. Such products include:

1. Liquid / money market schemes
2. Index schemes
3. Diversified equity schemes
4. Retirement benefit schemes having tax benefits
5. Fixed Maturity Plans (FMPs)

And there is a performance condition attached to all of them: these products should have returns equal to or better than their scheme benchmark returns during each of the last three years.

Equal to or better than benchmark, in each of the last three years. Not an average — every year.

How a distributor knows which qualify: the Asset Management Companies (AMCs) are required to publish a list of such simple and performing schemes on their websites to enable the new cadre of distributors to distribute these schemes to their clients.

The distributor does not have to work it out. The AMC publishes the list.

4.2 Liquid and money market schemes

A Liquid Fund is an open-ended liquid scheme whose investment is into debt and money market securities with maturity of upto 91 days only.

A Money Market Fund is an open-ended debt scheme investing in money market instruments having maturity upto 1 year.

91 days for liquid; 1 year for money market. That pair is the most examined fact in the chapter.

Why both are low risk — two reasons.

Both the above categories of funds invest in debt and money market securities, with very short maturities... This means the interest rate risk is very low in both these funds.

Interest rate risk is the sensitivity of debt securities with respect to movement of interest rates within the economy. When the interest rates move up, prices of debt papers move down, and vice versa. Short maturities mean small price sensitivity.

And on credit: money market securities also have high credit rating, and hence the credit risk is very low.

Together: these funds are considered to be among the lowest risk funds within mutual funds.

What they are used for: low interest rate risk coupled with low credit risk makes these funds suitable for short term parking of surplus money. Many mutual fund distributors recommend these funds to their investors when the surplus is available for short, but uncertain periods.

And a second use worth knowing: many also use these funds for another purpose. They park the customer's surplus funds in liquid or money market funds, and then periodically transfer the same in equity funds on a regular basis – a process known as Systematic Transfer Plan (STP).

4.3 Index funds

An Index Fund is an open-ended scheme replicating/tracking a specific index. The minimum investment in securities of a particular index (which is being replicated/tracked) shall be 95 percent of total assets.

In other words, at least 95 percent of the assets of the scheme must be invested in the constituents of the index.

What an index is

A stock market index is created by selecting a group of stocks that are representative of the whole market or a specified sector or segment of the market. An Index is calculated with reference to a base period and a base index value.

An Index is used to give information about the price movements of products in the financial, commodities or any other markets. Financial indexes are constructed to measure price movements of stocks, bonds, T-bills and other forms of investments. Stock market indexes are meant to capture the overall behaviour of equity markets.

And the everyday use: it is also known as the barometer of the respective market. When the value of the index moves up, the market is considered to have moved up, and vice versa. Looking at it in another way, observers look at the index movement to check whether the market is up or down.

The indices the workbook names

Learn the numbers: 30, 50, 250, 3000, and more than 7 years.

Why an index fund is called passive

An index fund is also called a passive fund, since the fund manager need not actively manage the portfolio, which only mirrors the composition of the underlying index.

The role of the fund management team is only to manage the inflows into and outflows from the fund on account of purchases and redemptions; and ensure that the portfolio tracks the respective index.

In other words, the fund manager does not need to decide which securities to buy or sell and when to do so.

And the direct consequence for cost: due to a very limited role of the fund management team, the total expense ratio (TER) in case of index funds is very low. SEBI has also allowed a lower limit of the maximum expenses that could be charged.

Who they suit

• As already mentioned, it is the simplest way to take exposure to any market
• For those seeking wealth creation, but are not sure which schemes to choose, equity-oriented index funds could be an ideal choice
• For those seeking to invest overseas, but do not possess enough skills to conduct research on foreign stocks, an index fund tracking the respective foreign market is an excellent choice

And a transparency benefit: since the index fund tracks the underlying index, it becomes easy for an investor to understand and track the performance of the scheme.

The Indian position: currently in India, we have index funds available on equity indices, and majority of these are tracking the large-cap indices, viz., Nifty and Sensex.

4.4 Diversified equity schemes

Equity as an asset class has the potential to generate returns higher than inflation. When that happens, the purchasing power of one's money grows.

But the risks are real, and there are two of them.

Price fluctuation: equity is a risky asset in that the share prices fluctuate a lot. Due to such fluctuations, there is a high possibility that one may end up buying at high prices or selling at low prices or both.

Company failure: when an investor invests in a company's share, there is a possibility that the company does very well, and the share price moves up over the years. At the same time, if the company struggles or incurs losses or fails altogether, the shareholder loses. The loss could be as much as the entire capital invested.

The two mitigations

The risks highlighted above can be mitigated through two things:

• By investing in a diversified portfolio made up of stocks of good quality companies in sound businesses, and
• By staying invested for long term through ups and downs of the markets

And how each is achieved: the first can be easily achieved through investing in a diversified equity mutual fund, and once that is done, one only needs to stay invested in the mutual fund scheme, or to keep adding to the investment periodically as and when one's savings permit. For a large number of investors, SIP (Systematic Investment Plan) helps here.

Diversification answers the company-failure risk; staying invested answers the fluctuation risk.

What the fund is

A diversified equity fund is a simple type of mutual fund that invests across a wide spectrum of companies representing a number of industrial sectors. Such diversification reduces the risk of owning one company's share or the risk of owning shares of companies from one industry.

Note the two risks diversification addresses — single company, and single industry.

The distributor's duty of care

Care must be taken by the distributor to see the segment of the market that such a fund is investing in – is it investing in stocks of large companies, or mid-sized companies, or small companies, or a combination of these?

The large companies are generally less risky in comparison to their smaller counterparts. At the same time, these small companies also offer higher return potential. Care must be taken to understand this while selecting the schemes for the investors.

"Diversified equity" is not one thing. A large-cap fund and a small-cap fund are both diversified, and they carry quite different risk.

4.5 Life cycle funds

An open-ended scheme with a target maturity date ranging from 5 to 30 years.

There is a glide path for investing in a mix of asset classes i.e. Equity, Debt, Gold ETFs, etc.

The "glide path" is the defining feature. As the fund moves toward its target maturity, the allocation shifts — equity component moves down, debt component goes up. The portfolio becomes progressively more conservative as the goal approaches, which is exactly what a person nearing a fixed date needs.

How many can be open at once: life cycle fund may be launched for tenure in multiple of 5 years and a maximum of 6 funds by a mutual Fund can be active for subscription at any point in time.

Tenure in multiples of 5 years; maximum 6 funds active for subscription.

The exit load is graded: 3% for first one year, 2% for first two years and 1% for exit within first three years. There is no exit load beyond three years of investment in the fund.

The load falls 3 → 2 → 1 → nil. It is designed to discourage early exit from what is meant to be a long-horizon product.

4.6 Fixed Maturity Plans

Fixed maturity plans are a kind of close-ended debt fund where the duration of the investment portfolio is closely aligned to the maturity of the scheme.

How they are built: AMCs tend to structure the scheme around pre-identified investments. Further, being close-ended schemes, they do not accept money post-NFO. Therefore, the fund manager has little ongoing role in deciding on the investment options.

The benefit that follows: such a portfolio construction gives more clarity to investors on the likely returns if they stay invested in the scheme until its maturity (though there can be no guarantee or assurance of such returns). This helps them compare the risk and returns of the scheme with alternative investments.

Note the parenthesis carefully — clarity is not a guarantee. There can be no guarantee or assurance of such returns.

The big benefit: it is relatively easy to estimate the returns expected from such schemes.

The cost of that benefit: these are close-ended funds and hence no redemption is allowed before the scheme's maturity. On maturity of the scheme, the investors' money is returned.

The partial remedy: in order to provide liquidity to the investors, listing of the units of such schemes on recognized stock exchanges is compulsory.

And the honest caveat: however, such listing does not guarantee liquidity, as the trading volumes in these units may be very low, or there may be no trading at all.

Compulsory listing, but no guaranteed liquidity. That pair is examinable.

Drivers of returns

In the liquid and money market funds, the major driver of the scheme returns would be the yield earned from the debt instruments. Similarly, in case of FMPs too, the returns would come from the yield on the debt securities.

The diversified equity funds and the index funds would derive the returns from the returns generated by the portfolio of stocks the scheme has invested in.

The returns from the life cycle funds would depend on how the money is allocated between equity and debt.

Three drivers for five products: yield for the three debt products, the stock portfolio for the two equity ones, and the allocation for the life cycle fund.

Target Maturity Funds

Target Maturity Funds (TMFs) are a type of debt mutual fund in India that offer a unique investment strategy. These funds are designed to mature on a specific date, typically ranging from 3 to 14 years, allowing investors to plan their financial goals accordingly.

How they work: TMFs invest in bonds with matching maturities, minimizing reinvestment risk and providing predictable returns.

Who they suit: they are ideal for investors seeking low-risk, income-generating investments with a defined horizon, such as retirement planning or children's education.

And on liquidity: additionally, TMFs provide liquidity through listing on stock exchanges, allowing investors to exit before the maturity date if needed.

Keep the three maturity ranges apart: liquid — 91 days · money market — 1 year · TMF — 3 to 14 years · life cycle fund — 5 to 30 years.