NISM-Series-V-C:

Mutual Fund Distributors

(Level 2)
Certification Examination

Workbookfor
NISMSeriesVC:
MutualFundDistributors(Level2)
CertificationExamination

NationalInstituteofSecuritiesMarkets
www.nism.ac.in
ThisworkbookhasbeendevelopedtoassistcandidatesinpreparingfortheNationalInstitute
ofSecuritiesMarkets(NISM)NISMSeriesVC:MutualFundDistributors(Level2)Certification
Examination.

WorkbookVersion:March2015

Publishedby:
NationalInstituteofSecuritiesMarkets
NationalInstituteofSecuritiesMarkets,2015
NISMBhavan,Plot82,Sector17,Vashi
NaviMumbai400703,India

Allrightsreserved.Reproductionofthispublicationinanyformwithoutpriorpermissionof
thepublishersisstrictlyprohibited.

ii
 Disclaimer

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iii
AboutNISM

In pursuance of theannouncement made by the FinanceMinister inhis BudgetSpeech in

February 2005, Securities and Exchange Board of India (SEBI) has established theNational
InstituteofSecuritiesMarkets(NISM)inMumbai.

SEBI,byestablishingNISM,hasarticulatedthedesireexpressedbytheIndiangovernmentto
promotesecuritiesmarketeducationandresearch.

Towards accomplishing the desire of Government of India and vision of SEBI, NISM has
launchedanefforttodeliverfinancialandsecuritieseducationatvariouslevelsandacross
varioussegmentsinIndiaandabroad.Toimplementitsobjectives,NISMhasestablishedsix
distinct schools to cater the educational needs of various constituencies such as investor,
issuers,intermediaries,regulatorystaff,policymakers,academiaandfutureprofessionalsof
securitiesmarkets.

NISMbringsoutvariouspublicationsonsecuritiesmarketswithaviewtoenhanceknowledge
levelsofparticipantsinthesecuritiesindustry.

NISM is mandated to implement certification examinations for professionals employed in

varioussegmentsoftheIndiansecuritiesmarkets.

iv
Acknowledgement

ThisworkbookhasbeendevelopedbyNISMincooperationwiththeExaminationCommittee
for Mutual Fund Distributors (Level 2) Certification Examination consisting of industry
representatives.NISMgratefullyacknowledgesthecontributionofallcommitteemembers.

AbouttheAuthor

This workbook has been developed for NISM by Mr. Sundar Sankaran, Director, Finberry
Academy.

v
About the NISMSeriesVC: Mutual Fund Distributors (Level 2) Certification
Examination

NISMSeriesVA:MutualFundDistributorscertificationexamination(MFD,launchedonJune
1,2010)istherequisitestandardforpeoplewhosellmutualfundsshouldpossessandisthe
mandated examination for all distributors vide SEBI notification No. LADNRO/GN/2010
11/09/6422,datedMay31,2010.

NISMSeriesVB: Mutual Fund Foundation Certification Examination (MFF, launched in

January 2013) is the minimum knowledge benchmark for the new cadre of distributors as
definedinSEBIcircularCIR/IMD/DF/21/2012datedSeptember13,2012.

NISMSeriesVC:MutualFundDistributors(Level2)CertificationExamination(MFDL2)isa
voluntary examination and seeks to fulfil the aspiration of mutual fund advisers and
employees, who wish to assess themselves against higher standards of overall expertise
related to mutual funds sales, distribution and advisory functions. Through such certified
professionals,NISMhopestobenefitthemutualfundindustry.

Theexaminationisvoluntaryandisopentoall.Incaseofexamineeswhohavequalifiedin
theNISMSeriesVA:MutualFundDistributorsCertificationExamination(MFD)andarenow
appearing for the NISMSeriesVC: Mutual Fund Distributors (Level 2) Certification
Examination (MFDL2), performance in MFD examination already obtained, will not be
impacted.

CasestudiesusedinthisworkbookmaycoverapplicativeaspectsofcontentcoveredinMFD
workbook.Candidatesarethereforeadvisedtobefullyconversantwiththecurriculumofthe
MFDexamination,beforetheyattemptthisLevel2examination.

ExaminationObjectives
Theexaminationseekstocreateacommonknowledgebenchmarkforassociatedpersons,
i.e.,distributors,agentsoranypersonsemployedorengagedortobeemployedorengaged
inthesaleand/ordistributionofmutualfundproductsandadvisoryfunctions,inorderto
enableabetterunderstandingoffeaturesofadvancedmutualfundproducts,fundvaluation,
fundperformancemeasurements,investorserviceandrelatedregulations.

Onsuccessfulcompletionoftheexaminationthecandidateshould:
UnderstandthesalientfeaturesofFundofFunds,Exchange TradedFunds,RealEstate
MutualFunds,VentureCapitalFunds,PrivateEquityFundsandInternationalFunds
Know the legalities of real estate mutual funds, investment restrictions applicable to
mutualfundschemes,andtheprocessesformakingchangesinthestructureofamutual
fundoranyofitsschemes
Appreciatetheworkingofnewerchannelsofdistributionviz.stockexchangeandinternet

vi
 Get acquainted with the approaches fund managers take to manage investments and
associatedrisks
Understand how equities, debt, derivatives and real estate are valued in mutual fund
schemes
GetorientedtotheaccountingaspectsofNAVdetermination,investorstransactionswith
thefundandcorporateactionsbyinvesteecompanies
Knowhowtaxationaffectsmutualfundschemesandinvestors
UnderstandtheprocessesunderlyinginvestmentinNFO,openendschemes,closedend
schemesandETFaswellasnominationandpledgeprocessesrelatingtomutualfunds
Appreciatehowschemesareevaluated
Getahistoricalperspectiveonreturnsearnedindifferentassetclasses
Getacquaintedwiththeissuesinvolvedinsellingalternateinvestmentproducts
Getorientedtobasicsoffinancialplanning
Understandethicalrequirementsandmeasurestoprotectmutualfundinvestors

AssessmentStructure
Theexaminationconsistsof8caseletswith4multiplechoicequestionsof2markseachper
caseletand36onemarkmultiplechoicequestionsaddingupto100marks.Theexamination
shouldbecompletedin2hours.Thereisnegativemarkingof25%ofthemarksassignedtoa
question.Thepassingscorefortheexaminationis60marks.

Howtoregisterandtaketheexamination
Tofindoutmoreandregisterfortheexaminationpleasevisitwww.nism.ac.in

vii


THISPAGEHASBEENLEFTBLANK
INTENTIONALLY

viii
Contents

1. MUTUAL FUND STRUCTURES .......................................................................................... 1

1.1. FundofFunds.................................................................................................................................1
1.2. ExchangeTradedFunds..................................................................................................................2
1.3. RealEstateMutualFunds(REMF)&RealEstateInvestmentTrusts(REIT).........................................4
1.4. VentureCapitalFunds....................................................................................................................5
1.5. AngelFunds....................................................................................................................................8
1.6. PrivateEquityFunds.......................................................................................................................9
1.7. InternationalFunds........................................................................................................................9

2. LEGAL AND REGULATORY ENVIRONMENT OF MUTUAL FUNDS ......................... 13

2.1. RegulatoryFrameworkforRealEstateMutualFunds....................................................................13
2.2. RegulatoryFrameworkforRealEstateInvestmentTrusts..............................................................15
2.3. InvestmentNormsforMutualFunds.............................................................................................19
2.4. SEBINormsforMutualFundsInvestmentinDerivatives..............................................................26
2.5. SEBINormswithrespecttoChangesinControllingInterestofanAMC..........................................26
2.6. ChangesinMutualFundSchemes.................................................................................................28

3. FUND DISTRIBUTION AND SALES PRACTICES .......................................................... 33

3.1. InternetandMobileTechnologies................................................................................................34
3.2. StockExchanges...........................................................................................................................36

4. INVESTMENT AND RISK MANAGEMENT ..................................................................... 45

4.1. FundamentalAnalysis...................................................................................................................45
4.2. TechnicalAnalysis.........................................................................................................................47
4.3. QuantitativeAnalysis....................................................................................................................49
4.4. DebtInvestmentManagement.....................................................................................................50
4.5. IssuesforaDebtFundManager....................................................................................................54
4.6. Derivatives...................................................................................................................................54
4.7. ApplicationofDerivatives.............................................................................................................58

5. VALUATION OF SCHEMES ............................................................................................... 63

5.1. Equities........................................................................................................................................63
5.2. Debt.............................................................................................................................................65
5.3. NonPerformingAssets(NPA)andProvisioningforNPAs..............................................................66
5.4. Gold.............................................................................................................................................68
5.5. RealEstateMutualFunds.............................................................................................................68

6. ACCOUNTING ...................................................................................................................... 71
6.1. NetAssetValue............................................................................................................................71
6.2. InvestorTransactions....................................................................................................................73
6.3. DistributableReserves..................................................................................................................75
6.4. UniqueAspectsofRealEstateSchemesAccounting......................................................................75

7. TAXATION ........................................................................................................................... 79
7.1. TaxesforAMCs.............................................................................................................................79
7.2. TaxesforInvestors........................................................................................................................80

8. INVESTOR SERVICES ......................................................................................................... 85

8.1. NewFundOffer............................................................................................................................85
8.2. OpenendFund.............................................................................................................................85
ix
8.3. ClosedendFund...........................................................................................................................86
8.4. ExchangeTradedFund..................................................................................................................86
8.5. Nomination..................................................................................................................................87
8.6. Pledge..........................................................................................................................................88

9. SCHEME EVALUATION ..................................................................................................... 91

9.1. MeasuresofReturn......................................................................................................................91
9.2. MeasuresofRisk..........................................................................................................................95
9.3. BenchmarksandRelativeReturns.................................................................................................96
9.4. RiskadjustedReturns...................................................................................................................98
9.5. LimitationsofQuantitativeEvaluation.........................................................................................101

10. ASSET CLASSES AND ALTERNATE INVESTMENT PRODUCTS ............................ 103

10.1. HistoricalReturns........................................................................................................................103
10.2. PerspectivesonAssetClassReturns.............................................................................................105
10.3. AlternateInvestmentProducts....................................................................................................107

11. CASES IN FINANCIAL PLANNING ................................................................................ 115

Case1.......................................................................................................................................................115
Case2.......................................................................................................................................................117

12. ETHICS AND INVESTOR PROTECTION ..................................................................... 119
12.1. CodeofConduct..........................................................................................................................119
12.2. Misselling...................................................................................................................................120
12.3. SafeguardsinMutualFundStructure...........................................................................................121
12.4. RegulatoryStepsforProtectingInvestorsagainstFraud...............................................................122

x
 1. MutualFundStructures

LearningObjective
ThisChapterexplainstheworkingofschemesthataredifferentfromtheregularmutual
fund structures. You will understand the salient features of Fund of Funds, Exchange
TradedFunds,RealEstateMutualFunds,VentureCapitalFunds,PrivateEquityFundsand
InternationalFunds.

Chapter1oftheMFDWorkbookintroducedvarioustypesofmutualfundschemes.Mostof
theseareavailableforinvestmentinIndia,andarebeingsoldbymutualfunddistributors.
Here,wefocusonschemesthatoperatedifferentlyfromtheregularmutualfundstructures.

1.1. FundofFunds
Inthenormalstructure,investorsinvestinamutualfundscheme,whichinturninvestsin
equity,debtorgold,oramixoftheseassetclasses.Normalmutualfundschemesareneither
expected nor encouraged to invest in other mutual fund schemes. Therefore, the SEBI
(Mutual Funds) Regulations, 1996 [referred to as MF Regulations in the rest of this
Workbook]imposea5%limitoninterschemeinvestments.ThisiselaboratedinChapter2.

FundofFunds(FoF)investsinothermutualfundschemes,floatedbythesamemutualfund
orothermutualfunds.Sincetheirinvestmentobjectiveitselfistoinvestinothermutualfund
schemes,the5%limitmentionedaboveisnotapplicabletoFoF.

AsdiscussedintheMFDWorkbook,mutualfundsfloatdifferentkindsofschemestocaterto
differentinvestorneeds.Overaperiodoftime,therehasbeenaproliferationofmutualfund
schemes.Thisisnotonlyconfusingfortheinvestors,butalsocumbersometoadminister,for
themutualfunds.

SEBIhasbeensuggestingthatAssetManagementCompanies(AMCs)shouldmergeschemes
thathavesimilarinvestmentobjectives,sothatthemultiplicityofschemesisreduced.

As on December 31, 2014, the Indian mutual fund industry offered 1,861 mutual fund
schemes.Itisdifficultforinvestorstoevaluatesuchawiderangeofschemes.FoFismarketed
onthepremisethatitwillmaintainanoptimalportfolioofmutualfundschemesthatwould
helpinvestorsbenefitfromthemarket.

SomeFoFalsomadespecialarrangementswithspecificAMCsforentryloadtobewaivedon
theFoFsinvestmentintheAMCsschemes.AspercurrentMFRegulations,entryloadinany
casecannotbechargedforanynewinvestmentfromanyinvestor.

1
FoF that invests in mutual funds abroad offers investors the additional benefit of taking
international exposure by investing in Indian rupees, as will be seen in the section on
InternationalFundsinthisChapter.

UndertheMFRegulations,FoFissubjecttothefollowinginvestmentrestrictions:
(a)ItshallnotinvestinanyotherFoFscheme;
(b)Itshallnotinvestitsassetsotherthaninschemesofmutualfunds,excepttotheextentof
funds required for meeting the liquidity requirements for the purpose of repurchases or
redemptions,asdisclosedintheofferdocumentoftheFoFscheme.

Further,nomutualfundschemeispermittedtoinvestinaFoF.

FoFmayofferbenefitstotheinvestor.However,thepointtonoteisthattheFoFalsoaddsto
thecostbornebytheinvestor.Thereisacostchargedintheunderlyingmutualfundschemes
(wheretheFoFinvests);andthereisanadditionalcostintheFoFscheme(wheretheinvestor
invests).Aswithanymutualfundscheme,theinvestorshouldreadtheInvestmentPolicyin
theOfferDocumentoftheFoFbeforeinvesting.

AninvestorinaFoFshouldthereforeconsiderthecompositecostthathisinvestmentwould
incur.TheMutualFundRegulationshavelimitedthetotalexpensesofFoFschemes,including
theweightedaverageofchargesleviedbytheunderlyingschemes,at2.50percentofthe
averagedailynetassetsofthescheme.

1.2. ExchangeTradedFunds
Allinvestorswhoinvestinanopenendmutualfundschemeonasingledaygettheirunitsat
thesameNetAssetValue(NAV);similarlyallrepurchasesfromamutualfundschemeona
dayhappenatthesameNAV.Thisisofcoursesubjecttothecutofftimingsdiscussedin
Chapter7ofMFDWorkbook.

Aclosedendmutualfundschemeislistedinthestockexchange.Therefore,itspricemight
fluctuateduringtheday,inlinewiththeoverallmarketconditions.However,concernisthe
lack of liquidity for the investor, if the scheme does not sufficiently trade in the stock
exchange.

Liquidityisgenerallynotaconcernforinvestorsinanopenendscheme,becausethescheme
isopenforsaleandrepurchaseonanytradingday.However,theopenendschemeendsup
havingtoplanforthisliquiditybymaintainingsomefundsinliquidassets.Totheextentof
thoseliquidassets,theschemesassetsarenotinvestedintheassetclasswhereitwould
normallyhavebeeninvested.

Further, between the time funds are received from the investor, to the time these are
deployedinthemarket,themarketitselfmaymove.Ifthemarketmoveshigher,itwillhurt
alltheinvestorsinthescheme.

2
Similarly, there can be a time lag between the repurchase by the investors, and sale of
securitiesbytheschemetoprovidethefundsfortherepurchase.Ifthemarketmoveslower
during this time lag, it will hurt the investors who continue in the scheme (the exiting
investorsunitsbeingredeemedattheearlierhigherNAV).

The problems related to timelag can be quite severe if there are significant sale or re
purchasetransactionsinaday.

Thus,thefollowingareinherentweaknessesinthetraditionalmutualfundstructure:

Openendschemes

o Lackofadynamicpriceduringtheday
o Needtoprovideforliquidassets
o Timinglagsininvestmentandredemption

Closedendschemes

o Lackofliquidity(despitelistingintheexchange).

ExchangeTradedFunds(ETF)seektogetoveralltheseproblems,throughauniquestructure
asfollows:

AnETFacceptscashonlyduringtheNewFundOffer(NFO).
PostNFO,itonlyacceptssecurities(againstsaleofnewunits)orgivessecurities
(againstrepurchaseofexistingunits).Therefore,itdoesnotneedtomaintain
liquidassets,andisunaffectedbythetiminglags.
Suchtransactingthroughsecuritiesisfeasibleonlyforlargevaluetransactions.
Therefore,thispostNFOrouteofdirecttransactionswiththefundisessentially
forlargeinvestors.
PostNFO liquidity for retail investors is structured through market makers
appointed by the fund. The market makers are responsible to give twoway
quotes[bidprice(priceatwhichmarketmakerispreparedtobuyunitsfromthe
investor)andaskprice(priceatwhichmarketmakerispreparedtosellunitsto
theinvestor)].
The bidask prices can keep fluctuating during the day, depending on market
conditions.Thebidaskspread(thedifferencebetweenthetwoprices)isaprofit
forthemarketmaker.
Forexample,ifthemarketmakerquotes15.10,15.20,hewouldearn10paise
perunit,bybuyingaunitatRs15.10(fromaninvestor)andsellingtheunit(to
someotherinvestor)atRs15.20.
Professionalmarketmakersfinetunetheirquotesinsuchamannerthattheyare
abletobalancethebuyinginterestandsellinginterestinthemarket.However,
thisisnotalwayspossible,especiallyifthemarketisilliquid.

o Attheendoftheday,ifthemarketmakerfindsthathehasbought12,000
units and sold 12,500 units, he needs to deliver 500 additional units to
3
 investors who have paid for those units. Market makers retain a small
portfoliooftheunitstobeabletohandlesuchmismatches.
Intheeventofalargemismatchi.e.moreretailinvestorshaveboughtunits
(forwhichtheywouldhavepaidmoney),themarketmakerwillconvertthe
moneyintosecuritiesandtransferthemtotheETF(forittoissueunitsagainst
thesecurities).
o Similarly,ifthemarketmakerfindsthatmoreretailinvestorshavesoldunits
(forwhichtheywouldneedtobepaidmoney),themarketmakerwillofferthe
unitsforrepurchasetotheETF.TheETFwillreleasesecurities(byredeeming
thoseunits),whichthemarketmakerwillsell,inordertopaytheinvestors.

TheaboveexplanationwasforanETFbasedonsecurities.Similarly,ETFscanbebasedon
assetslikegold.

Inordertofacilitatetransactingthroughsecuritiesandenhancetransparency,ETFsarebased
onastandardisedportfoliostructure,likeanIndex;orastandardisedasset,likegold.Thisis
announced when the scheme is launched. Therefore, an investor knows that the
performanceoftheETFisexpectedtotracktheperformanceofitsunderlyingindexorasset.

The Offer Document of the ETF would provide details of how the ETF is constructed. The
maximumpermissiblecostforanETFis1.5%ofitsaveragenetassets.

1.3. RealEstateMutualFunds(REMF)&RealEstateInvestmentTrusts(REIT)
In April 2008, SEBI took a landmark step of adding real estate to the list of permitted
investments for mutual funds. Under the revised definition, mutual fund means a fund
establishedintheformofatrusttoraisemoniesthroughthesaleofunitstothepublicora
sectionofthepublicunderoneormoreschemesforinvestinginsecuritiesincludingmoney
market instruments or gold or gold related instruments or real estate assets. Real estate
mutualfundschememeansamutualfundschemethatinvestsdirectlyorindirectlyinreal
estateassetsorotherpermissibleassets.

Chapter VI A was added to the SEBI Regulations, to set the regulatory framework for real
estatemutualfunds.ThesearediscussedindetailinChapter2ofthisworkbook.
AnalternateformatforpoolinginvestormoneyintorealestateisprovidedinSecurities&
ExchangeBoardofIndia(RealEstateInvestmentTrusts)Regulations,2014(REITRegulations).
AsdiscussedinChapter2,thestructureofREITisquitedifferentfromREMF.REITsarefocused
oninvestinginrentalearningpropertiesandneedtodistribute90%oftheirincome.

Irrespectiveofstructure,aninvestorneedstobeawareofthefollowingfeaturesofrealestate
exposure:
Realestate,asanassetclass,behavesdifferentlyfromdebt,equityandgold.Therefore,
ithelpsinvestorsindiversifyingtheirportfolioandreducingtherisk.

4
 Realestateisalessvolatileassetthanequity.Ithasitscycles,butittendstofollowa
broadtrend,eitherupwardsordownwards.

Further,realestateisagrowthassetthatcanyieldhighandgrowingregularincomein
theformofrentals.

However,directinvestmentinrealestatehasthefollowinglimitations:
o Hightransactionvalue,whichlimitssuchinvestmentstohighnetworthinvestors
o Hightransactioncostsfordealinginrealestate
o Lowliquidity,ascomparedtoequityandgold
o Lackoftransparencyinpricingandproblemofunaccountedmoney
o Regulatory risk of ownership issues with property and other frauds related to
transacting
o Hasslesofadministeringtherealestateproperty,protectingfromencroachmentsetc.

The limitations in direct investment in real estate, make REMF and REIT an optimal
approachtotakingexposuretothisassetclass:
o TicketsizeforinvestmentinREMFcangodowntoRs1,000,orevenlower.Minimum
investment, on subscription to REIT is set at Rs 200,000; these can be traded at a
minimumvalueofRs100,000inthestockexchange.
o Professional investors like the managers of these pooled vehicles are in a better
positiontohandletheotherproblemsandrisks.

Yet,investorsneedtobeawareofthefollowingrisksinthesepooledvehicles:
o SEBIRegulationsbarmutualfundsfromindulgingincashtransactionsinrealestate.
However, cash transactions are a malaise of the real estate industry. The asset
managementcompanyneedstohaveastronginternalcontrolsystemandhighethical
standards,toensurefairnesstoinvestors.
o Sincethemarketisinherentlyilliquid,andrealestatevaluationishighlysubjective,
netassetvaluesmayormaynotreflectthetruerealisablevalue.
o In order to address this risk, SEBI has insisted on Independent valuation of the
propertiesoftheREMF/REIT.
o TheilliquidnatureoftheassethasalsoforcedSEBItoinsistonREMFbeingclosedend
andlisted.Further,investorsmaybepaidtheirmaturityduesinphases,linkedtosale
of the underlying real estate assets by the AMC. In the case of REIT too, listing is
mandatory.

A few schemes in the venture capital structure (discussed in the next section) have been
launchedasvehiclesforrealestateinvestment.Buttheseweremostlyprivatelyofferedto
largeinvestorswithhighinvestmentrequirement.

1.4. VentureCapitalFunds
Equity mutual fund schemes primarily invest in equity shares that are listed in the stock
exchanges.VentureCapitalFunds(VCF)investinsharesofunlistedcompanies.Theyinvestat

5
averyearlystageinacompany,andthus,takeaprojectriski.e.theriskthattheprojectmay
failandthecompanymayfoldup.Suchearlystagebusinesses,whereVCFinvest,arereferred
toasVentureCapitalUndertakings(VCU).

VCFarepreparedtohavealonginvestmenthorizonof3to5yearsormore.Inreturn,they
receivetheirsharesatanextremelylowvaluation.

Unlikemutualfunds,whicharegovernedbytheSEBI(MutualFunds)Regulations,1996,VCF
weregovernedbytheSEBI(VentureCapital)Regulations,1996(VCRegulations).OnMay21,
2012,SEBI(AlternateInvestmentFund)Regulations,2012(AIFRegulations)replacedtheVC
Regulations.However,theventurecapitalfunds/schemesthatwereinexistenceasonthat
date, continue to be regulated by the earlier VC Regulations till the funds / schemes are
woundup.

Under the AIF Regulations, venture capital fund means an Alternative Investment Fund
which invests primarily in unlisted securities of startups, emerging or earlystage venture
capitalundertakingsmainlyinvolvedinnewproducts,newservices,technologyorintellectual
propertyrightbasedactivitiesoranewbusinessmodel.Bydefinition,venturecapitalfunds
includeangelfunds,whicharediscussedinthenextsection.

AIFregulationsenvisagethreecategoriesoffunds:

CategoryIAlternativeInvestmentFundwhichinvestsinstartuporearlystage
venturesorsocialventuresorSMEsorinfrastructure orothersectorsorareas
which the government or regulators consider as socially or economically
desirable.Thiscategoryincludesventurecapitalfunds,SMEfunds,socialventure
funds,infrastructurefundsandsuchotheralternativeinvestmentfundsasmay
bespecifiedbySEBI.Angelfundsareasubcategoryofventurecapitalfundsthat
raisemoneysfromangelinvestorsandcomplywithspecifiednorms.
CategoryIIAlternativeInvestmentFundwhichdoesnotfallinCategoryIand
IIIandwhichdoesnotundertakeleverageorborrowingotherthantomeetday
todayoperationalrequirementsandaspermittedinregulations
Category III Alternative Investment Fund which employs diverse or complex
trading strategies and may employ leverage including through investment in
listedorunlistedderivatives

SalientfeaturesoftheAIFregulationsareasfollows:

Thefundcanbeconstitutedasatrustorcompany
Equitylinkedinstrumentsincludeinstrumentsconvertibleintoequitysharesor
sharewarrants,preferencesharesanddebenturesconvertibleintoequity.
A VCF may raise money from any investor Indian, Foreign or NonResident
Indian(NRI),byissuingunits.
TheminimuminvestmentamountforinvestorsinaVCFhasbeensetatRs1crore.
ThelimitisRs25lakhforemployeesordirectorswhoareassociatedwiththeVCF.

6
 ThefundcanreceivegrantsuptoRs25lakh.Thesecannotbeservicedintheform
ofinterest,dividendetc.
TheManagerorSponsorneedstohaveacontinuinginterestintheAIFofnotless
than2.5%ofthecorpusorRs.5crore,whicheverislower.
TheVCFhastomobilisemoneythroughprivateplacement.Noschemecanhave
morethan1,000investors.
If the fund is constituted as a company, then it needs to comply with the
requirements of Companies Act, 2013. In a private placement, as per the
CompaniesAct,2013,invitationcannotbemadetomorethan50investors[other
than Qualified Institutional Buyers (QIBs) and employees investing through
EmployeeStockOptionPlans(ESOPs)].
EveryfundorschemeshouldhaveaminimumcorpusofRs20crore.
ThefollowinginvestmentrelatedregulationsareapplicableforVCF:

o Atleasttwothirdsoftheinvestiblefundsshouldbeinvestedinunlistedequity
andequityrelatedinstrumentsofVCUorincompanieslistedorproposedto
belistedonaSMEexchangeorSMEsegmentofanexchange.
o Notmorethanonethirdoftheinvestiblefundscanbeinvestedin:

Subscription to Initial Public Offer (IPO) of a VCU whose shares are

proposedtobelisted.
DebtofaVCUwheretheVCFhasalreadyinvestedinequity
Preferentialallotment,includingqualifiedinstitutionalplacementofa
listedcompanysubjecttolockinperiodof1year
Equitysharesorequitylinkedinstrumentsoffinanciallyweakorsick
companies.
Special Purpose Vehicles (SPV) created by a VCF for facilitating or
promotinginvestments.

Itisclearthatinvestorsneedtobeextracautious,whileinvestinginaVCF.Therelativelyhigh
minimum investment keeps out the small investors. Other investors need to note the
followingrisks:

VCFs are not as closely monitored by the regulators, as mutual funds. Their
disclosurerequirementstoinvestorsarealsonotsostringentlyregulated.
TheprojectriskthattheVCFtakesisasignificantriskforinvestorsintheVCF.
TheassetprofileoftheVCFislargelyilliquid.Therefore,illiquidityisanotherlarge
riskthataninvestorintheVCFwillhavetobepreparedfor.Onclosureofthe
VCF,theinvestormayevenreceivetheilliquidsharesoftheVCUs,wheretheVCF
hasinvested.
Illiquidity affects transparency in pricing, and therefore the valuation of
investments.

7
1.5. AngelFunds
Asmentionedearlier,AngelFundsareacategoryofVCF.However,thefollowingdistinctive
provisionshavebeenmadeforangelfundsintheAIFregulations:
"Angelinvestor"meansanypersonwhoproposestoinvestinanangelfundandsatisfies
oneofthefollowingconditions,namely,
(a) an individual investor who has net tangible assets of at least two crore rupees
excludingvalueofhisprincipalresidence,andwho:
i. hasearlystageinvestmentexperience(i.e.priorexperienceininvestinginstart
uporemergingorearlystageventures),or
ii. hasexperienceasaserialentrepreneur(i.e.apersonwhohaspromotedorco
promotedmorethanonestartupventure),or
iii. isaseniormanagementprofessionalwithatleasttenyearsofexperience;
(b) abodycorporatewithanetworthofatleasttencrorerupees;or
(c) an Alternative Investment Fund registered under the AIF Regulations or a VCF
registeredundertheVCRegulations.

Angelfundscanonlyraisefundsthroughissueofunitstoangelinvestors.Thefundswill
beraisedbyprivateplacementthroughissueofInformationMemorandum/Placement
Memorandum.
AngelfundsneedtohaveaminimumcorpusofRs10crore.
Minimum investment from an angel investor is Rs 25 lakhs. It can have upto 3 years
maturity.
Noschemeoftheangelfundshallhavemorethanfortynineangelinvestors.
Angelfundsshallinvestonlyinventurecapitalundertakingswhich:
(a) have been incorporated during the preceding three years from the date of such
investment;
(b) haveaturnoveroflessthantwentyfivecrorerupees;
(c) are not promoted or sponsored by or related to an industrial group whose group
turnoverexceedsthreehundredcrorerupees;and
(d) are not companies withfamily connection with any of the angelinvestors who are
investinginthecompany.

Investmentbyanangelfundinanyventurecapitalundertakingshallnotbelessthanfifty
lakhrupeesandshallnotexceedfivecrorerupees.
Investmentbyanangelfundintheventurecapitalundertakingshallbelockedinfora
periodofthreeyears.
Angelfundsshallnotinvestinassociates.
Angelfundsshallnotinvestmorethantwentyfivepercentofthetotalinvestmentsunder
allitsschemesinoneVCU.Thepercentageistobedeterminedbythefundattheendof
itstenure.
Themanagerorsponsorshallhaveacontinuinginterestintheangelfundofnotlessthan
two and half percent of the corpus or fifty lakh rupees, whichever is lesser, and such
interestshallnotbethroughthewaiverofmanagementfees.
Unitsofangelfundsshallnotbelistedonanyrecognisedstockexchange.

8
1.6. PrivateEquityFunds
PrivateEquityFunds(PEFunds)donotinvestinearlystagebusinesses.Theypreferbusinesses
thathavecrossedtheprojectriskstage,andneedfundstoscaleup.Therefore,itissaidthat
angelsandVCsprovideseedcapital,whilePEsprovidegrowthcapital.

ThelateinvestmentreducestheriskthataninvestorinthePEFundtakes.Theconsequence
ofthelaterinvestmentisthatthePEFundmaygetitssharesatahighervaluationthanthe
VCF,thusreducingthereturnoninvestment.

PE Funds have a shorter investment horizon than VCF. Typically, they expect to exit their
investmentsin1to3years.TheyofteninvestjustbeforetheIPOoftheVCU.

Attimes,publiccompaniesdonotwanttogothroughthepublicissueprocesstoraisemore
equity.TheythenapproachthePEFundsforinvestment.SuchinvestmentsarecalledPrivate
InvestmentinPublicEquity(PIPE).

Besidestheinvestmentpattern,PEFunds(andVCF)aredifferentfrommutualfundsinthe
followingways:

Atthefirststage,theytakefirmcommitmentsnotmoney.Everyinvestorknows
thesizeatwhichthefundhasclosed,anditsshareinthesame.Inordertoensure
seriousnessofcommitment,apartofthecommitmentiscollectedupfront.
TheVCFkeepsevaluatinginvestmentproposalsfromVCUs.Wheneveritchooses
toinvest,therequirementforfundscomesup.Accordingly,itcallsformoney,in
proportiontoeachinvestorsshareintheVCF.Thatiswhentheinvestorsinvest.
TheinvestorsinvestmentsintheVCFhappeninphases,inlinewiththeVCFs
commitmenttoVCUs.
Similarly,theVCFreceivesmoneyasandwhenitsellsitsshareholdinginaVCU.
Thiswouldthengobacktotheinvestorsproportionately.Thus,investorsreceive
theirmoneyinphases.
Besidesafixedmanagementfee,investorsarealsochargedapercentageonthe
profitsearnedbythefund.

Althoughtheprojectriskislower,investmentinPEFundsisstillrisky.AswithVCF,PEFunds
arelesscloselyregulatedthanmutualfunds.

1.7. InternationalFunds
InternationalFundshelpinvestorstakeexposuresabroad.Besidesthenormalfactorslike
typeofsecurity,sector,etc.,thesefundsalsoentailacountryfactor,whichtranslatesintoan
exchangeraterisk.ThereturnofadomesticIndianinvestorinaninternationalfunddepends
notonlyontheperformanceoftheassetswherethefundinvests,butalsothemovementin
the exchange rate between the Indian rupee and the currency of the country / countries
wherethefundinvests.

9

LetusconsiderasimpleexampleofanIndianfundthatinvestsentirelyintheUS.Supposeit
investedRs450mnonDay1(mn=million).AssumingtheexchangeratewasRs45=1USD,
theinvestmentwouldamounttoRs450mnRs45perUSDi.e.USD10mn.

IfonDay2,thevalueoftheportfoliowastogouptoUSD11mn,theportfoliohaseffectively
yielded(1110)10i.e.10%return,inUSDterms.

Whatwasthereturninrupeeterms?Forthis,letusassumethattheexchangerateonDay2
isRs44=1USD.Atthisexchangerate,theportfoliowouldbevaluedatUSD11mnXRs44
perUSDi.e.Rs484mn.Thereturninrupeetermsworksoutto(484450)450i.e.,7.56%.

Theportfolioreturn,whichwas10%inUSDterms,isonly7.56%inrupeeterms.Thedecline
inreturninrupeetermsisbecausetherupeebecamestrongeri.e.theUSDbecameweaker.
OnDay1,thefundhadtopayRs45tobuy1USD.ButwhenitwasconvertingtheUSDinto
rupeesonDay2,sincetheexchangerateonDay2isRs44perUSD,itwillgetonlyRs44for
1USD.ThedeclineinthevalueoftheUSDbroughtdownthereturnsinrupeeterms.

As a general principle, an investor is better off, if the currency into which the portfolio is
invested(inthiscase,USD)weretostrengthen.Inthiscase,theUSDweakened.Therefore,
the10%USDreturngotdraggeddownto7.56%returninrupees.

A resident Indian can remit up to USD 125,000, per financial year under the Liberalised
RemittanceScheme(LRS),forpermittedtransactionsincludingpurchaseofsecurities.

It is, however, difficult for retail investors to invest small amounts of money abroad.
Therefore,fundsmakearrangementstoreceivemoneyinrupeesinaschemeinIndia.The
Indianschemeinturnwilleitherinvestdirectlyinsecuritiesabroad,ortieuptoinvestina
domesticfundofthecountrywhereitwantstoinvest.

Forexample,supposeaschemeisfloatedinIndiainrupeestogiveIndianinvestorsthebenefit
oftheUSmarket.ThefundwilltieupwithaschemethatwouldhavebeenfloatedintheUS,
whichwouldreceiveinvestmentsinUSD.Insuchacase,theschemefloatedinIndiaiscalled
a feeder scheme, while the scheme in the US is called the host scheme. Domestic Indian
investorswillinvestinthefeederscheme,whichwillconvertthecorpusintoUSDandinvest
inthehostscheme.ThefeederschemeisreallyaFoFthatisinvestinginthehostfund.

On maturity, the host scheme will redeem the units and give the proceeds in USD to the
feederscheme,whichwillconverttheUSDintorupeesandpaythedomesticIndianinvestors.

SuchanarrangementgivesdomesticIndianinvestorsthreebenefits:

TheydonotneedtospendtheirtimeinunderstandingtheUSmarket;thehostscheme
doesthatjob.
TheyareabletotakeexposuretotheUSmarketwithasmallinvestmentofRs5000.The
feederschemefacilitatesthis.
10
 ThisinvestmentstructurealsoleavestheUSD125,000LRSlimituntouched.Theinvestor
canusetheentireLRSlimitforotherinternationaltransactions.
Attimes,investorsgetexcitedaboutsomethingbecauseitisinternational.Itisusefulto
notethatifacountrytowhichexposureistakengoesintorecession,notonlywillthe
securitymarketsperformpoorly,butalsothecountryscurrencywillbecomeweaker.The
investorishurtbothways.Further,ifacountryrunsintoabalanceofpaymentscrisis,it
mayputrestrictionsonrepatriationofinternationalinvestments.Somefundsreducesuch
countryrisk,byinvestinginamixofcountries.

ThenatureofinvestmentsthatIndianfundscanmakeabroadisgovernedbySEBIregulations.
ThisisdiscussedinChapter2.

11
 Exercise
MultipleChoiceQuestions
1. AnIndianfundinvestedUSD15mninaforeignfund,whentheexchangeratewasRs46.67
=1USD.Overaperiodoftime,theportfolioappreciatedtoUSD18mn,whentheexchange
ratewasRs45=1USD.Whatistherupeeportfolioreturn?
a. 15.71%
b. 10%
c. 3.58%
d. 16.42%

2. FundofFundscaninvestinotherfundstotheextentof
a. Onethirdofthecorpus
b. Twothirdofthecorpus
c. Threefourthofthecorpus
d. Theentirecorpus

3. WhichofthefollowingisfalseofExchangeTradedFunds?
a. Combinefeaturesofopenendedandcloseended
b. Liquidityprovidedbymarketmaker
c. ReceivesubscriptionsinmoneyonlypostNFO
d. Canbeboughtthroughstockbrokers

4. Whichofthefollowingentailsthemaximumprojectrisk?
a. MutualFund
b. InternationalFund
c. PEFund
d. VCFund








Answers
1a,2d,3c*,4d
*DuringNFOitreceivessubscriptionincash

12
 2. LegalandRegulatoryEnvironmentofMutualFunds

LearningObjective
ThisChapterdiscussestheregulatoryframeworkforRealEstateMutualFundsandReal
Estate Investment Trusts. Further, it gets into details of investment norms for mutual
funds.Italsodiscussestheprocesstobefollowedformakingchangesinthestructureof
amutualfundoranyofitsschemes.

2.1. RegulatoryFrameworkforRealEstateMutualFunds
Asdiscussedinthepreviouschapter,SEBIhasprescribedtheregulatoryframeworkforreal
estate mutual funds. Here we discuss various SEBI regulations with respect to Real Estate
MutualFunds.

2.1.1. RealEstateAsset
Realestateassetmeansanidentifiableimmovableproperty
(i)whichislocatedwithinIndiainsuchcityasmaybespecifiedbySEBIfromtimetotimeor
inaSpecialEconomicZone(SEZ);
(ii)onwhichconstructioniscompleteandwhichisusable;
(iii)whichisevidencedbyvalidtitledocuments;
(iv)whichislegallytransferable;
(v)whichisfreefromallencumbrances;
(vi)whichisnotsubjectmatterofanylitigation.

But,itdoesnotinclude
I.aprojectunderconstruction;or
II.vacantland;or
III.desertedproperty;or
IV.landspecifiedforagriculturaluse;or
V.apropertywhichisreservedorattachedbyanyGovernmentorotherauthorityorpursuant
toordersofacourtoflawortheacquisitionofwhichisotherwiseprohibitedunderanylaw
forthetimebeinginforce.

2.1.2. Whocanpromote?
InMFDWorkbookthenormsbasedonwhichasponsorcanpromotemutualfundoperations
arelisted.Suchanexistingmutualfundmaylauncharealestatemutualfundschemeifithas
adequatenumberofkeypersonnelanddirectorshavingadequateexperienceinrealestate.

The regulations also provide for real estate companies to launch real estate mutual fund
schemes.Theeligibilitycriteriaare
13
(a) the sponsor should have a sound track record and general reputation of fairness and
integrityinallhisbusinesstransactions.
Explanation: For the purposes of this clause sound track record shall mean the sponsor
should
(i)becarryingonbusinessinrealestateforaperiodofnotlessthanfiveyears;and
(ii)thenetworthispositiveinalltheimmediatelyprecedingfiveyears;and
(iii)thenetworthintheimmediatelyprecedingyearismorethanthecapitalcontributionof
thesponsorintheassetmanagementcompany;and
(iv)thesponsorhasprofitsafterprovidingfordepreciation,interestandtaxinthreeoutof
theimmediatelyprecedingfiveyears,includingthefifthyear;

(b)theapplicantisafitandproperperson;

(c)inthecaseofanexistingmutualfund,suchfundisintheformofatrustandthetrustdeed
hasbeenapprovedbySEBI;

(d) the sponsor has contributed or contributes at least 40% to the net worth of the asset
managementcompany:
Anypersonwhoholds40%ormoreofthenetworthofanassetmanagementcompanyis
deemedtobeasponsorandwillberequiredtofulfiltheeligibilitycriteria;

(e)thesponsororanyofitsdirectorsortheprincipalofficertobeemployedbythemutual
fundshouldnothavebeenguiltyoffraudorhasnotbeenconvictedofanoffenceinvolving
moralturpitudeorhasnotbeenfoundguiltyofanyeconomicoffence;

(f)trusteesaretobeappointedforthemutualfund;

(g)assetmanagementcompanyistobeappointedtomanagethemutualfundandoperate
theschemes;

(h)custodianistobeappointedinordertokeepcustodyofthesecuritiesorotherassetsor
titledeedsofrealestateofthemutualfund,andprovidesuchothercustodialservicesasmay
beauthorisedbythetrustees.

2.1.3. SchemeFeatures
Everyrealestatemutualfundschemehastobecloseendedanditsunitsareto
belistedonarecognizedstockexchange.
Redemption of a real estate mutual fund scheme may be done in a staggered
manner.
Theunitsissuedbyarealestatemutualfundschemeshallnotconferanyrighton
theunitholderstousetherealestateassetsheldbythescheme.Anyprovision
tothecontraryinthetrustdeedorinthetermsofissueshallbevoid.
Thetitledeedspertainingtorealestateassetsheldbyarealestatemutualfund
schemehavetobekeptinsafecustodywiththecustodianofthemutualfund.
14
 Arealestatemutualfundschemecannotundertakelendingorhousingfinance
activities.
Allfinancialtransactionsofarealestatemutualfundschemearetoberouted
throughbankingchannels.Cashorunaccountedtransactionsarenotpermitted.
Thetrusteesareexpectedtoreviewthemarketpriceoftheunitsduringtheyear,
andrecommendproportionatebuybackofunitsfromunitholders,iftheunits
aretradedatsteepdiscounttothenetassetvalue.
Themagnitudeofdiscountwhichshallamounttosteepdiscountistobedisclosed
intheofferdocument.

2.1.4. ValuationandNAV
Therealestateassetsheldbyarealestatemutualfundschemearetobevalued

o atcostpriceonthedateofacquisition;and
o atfairpriceoneveryninetiethdayfromthedayofitspurchase.
DetailedvaluationnormshavebeenprescribedbySEBI.

Theassetmanagementcompany,itsdirectors,thetrusteesandtherealestate
valuerhavetoensurethatthevaluationofassetsheldbyarealestatemutual
fund scheme is done in good faith, in accordance with the norms specified.
Further,theaccountsoftheschemearetobepreparedinaccordancewiththe
accountingprinciplesspecified.
Thenetassetvalueofeveryrealestatemutualfundschemeistobecalculated
anddeclaredatthecloseofeachbusinessdayonthebasisofthemostcurrent
valuation of the real estate assets held by the scheme and accrued income
thereon,ifany.

2.1.5. UsageofRealEstateAssets
Theassetmanagementcompanymayletoutorleaseouttherealestateassets
heldbytherealestatemutualfundschemeifthetermofsuchleaseorletting
doesnotextendbeyondtheperiodofmaturityofthescheme.
Where real estate assets are let out or leased out, the asset management
companyhastodiligentlycollecttherentsorotherincomeinatimelymanner.
Realestateassetsheldbyarealestatemutualfundschememaybeletouttothe
sponsor,assetmanagementcompanyoranyoftheirassociates,atmarketprice
or otherwise on commercial terms. However, not more than 25% of the total
rentalincomeoftheschemeshallbederivedfromassetssoletout.

2.2. RegulatoryFrameworkforRealEstateInvestmentTrusts
TheREITRegulations,2014provideforthefollowing:

2.2.1. RealEstateAsset

15
RealestateassetmeanspropertiesownedbyREITwhetherdirectlyorthroughaspecial
purposevehicle.

Realestateorpropertymeanslandandanypermanentlyattachedimprovementstoit,
whetherleaseholdorfreeholdandincludesbuildings,sheds,garages,fences,fittings,fixtures,
warehouses,carparks,etc.andanyotherassetsincidentaltotheownershipofrealestate
butdoesnotincludemortgage.ItexcludesanyassetthatfallswithintheMinistryofFinances
definitionofinfrastructure.

"Specialpurposevehicle"or"SPV"meansanycompanyorLimitedLiabilityPartnership(LLP)
(i)inwhichtheREITholdsorproposestoholdcontrollinginterestandnotlessthanfiftyper
centoftheequitysharecapitalorinterest;
(ii)whichholdsnotlessthaneightypercentofitsassetsdirectlyinpropertiesanddoesnot
investinotherspecialpurposevehicles;and
(iii)whichisnotengagedinanyactivityotherthanholdinganddevelopingpropertyandany
otheractivityincidentaltosuchholdingordevelopment.

TheREITshallnotinvestinvacantlandoragriculturallandormortgagesotherthanmortgage
backedsecurities.However,thisdoesnotapplytoanylandwhichiscontiguousandextension
ofanexistingprojectbeingimplementedinstages.

2.2.2. Whocanpromote,manageandsupervise?
Thesponsor,managerandtrusteehavetobeseparateentities.

AnREITcanhaveamaximumofthreesponsors,eachholdingatleast5%ofthetotal
REITunits,posttheinitialoffertothepublic.Allofthemtogetherneedtoholdatleast
25%ofthepostinitialofferREITunits.
Theminimumunitholdingneedstobeheldforatleast3years.Thereafter,theyneed
toholdatleast15%ofthetotalREITunitsatalltimes.
Anyexcessovertheminimumunitholdinghastobeheldforatleast1yearfromthe
dateoflisting.
EachsponsorshouldhaveanetworthofatleastRs20crore,andallsponsorstogether
shouldhavenetworthofatleastRs100crore.
Thesponsororitsassociate(s)shouldhavenotlessthanfiveyearsofexperiencein
development of real estate or fund management in the real estate industry. A
developerdesirousofbeingpromotershouldhavecompletedatleasttwoprojects.

Manager,whoisacompanyorbodycorporate,shouldhaveanetworthofatleastRs
10crore.IfmanagerisLLP,itsnettangibleassetsneedtobeatleastworthRs10crore.
The manager or its associate needs not less than five years of experience in fund
managementoradvisoryservicesorpropertymanagementintherealestateindustry
orindevelopmentofrealestate.

16
 Themanagershouldhavenotlessthantwokeypersonnel,eachhavingnotlessthan
five years of experience in fund management or advisory services or property
managementintherealestateindustryorindevelopmentofrealestate.
Themanagershouldensure thatnotlessthanhalf,of itsdirectorsinthecaseofa
companyorofmembersofthegoverningBoardincaseofanLLP,areindependent
andnotdirectorsormembersofthegoverningBoardofanotherREIT.
The manager has to enter into an investment management agreement with the
trusteewhichprovidesfortheresponsibilitiesofthemanager.

The Trustee has to be registered with SEBI under SEBI (Debenture Trustees)
Regulations,1993andcannotbeanassociateofthesponsor(s)ormanager.Trustee
willneedtohavetherequisiteinfrastructure,personneletc.
The trustee and its associates shall not invest in units of the REIT in which it is
designatedasthetrustee.

2.2.3. Structure
Unlike mutual funds, REIT cannot promote multiple schemes. Each REIT is a
completeinvestmentunit.
Multipleclassesofunitsarenotallowed.
NounitholderoftheREITcanenjoypreferentialvotingoranyotherrightsover
anotherunitholder.
Initialofferofunitscanbemadethroughpublicissueonly.Thisneedstobedone
within3yearsofregistrationwithSEBI.Theperiodcanbeextendedby1yearin
specificsituations.
Atthestageofpublicissue,valueofalltheassetsownedbyREITshouldbenot
lessthanRs500crore.Offertothepublicshouldbeatleast25percentofthe
totalunitspostissue.Further,theoffersizetothepublicshouldbeatleastRs
250crore.
Subjecttoapplicableregulations,theREITmayinviteforsubscriptionsandallot
unitstoanyperson,whetherresidentorforeign.Underboththeinitialofferand
followonpublicoffer,theREITshallnotacceptsubscriptionofanamountless
thanRs2lakhfromanapplicant.
Investorscannotbeofferedanyguaranteedreturns.
Subscriptionamounthastobekeptinaseparatebankaccountinthenameofthe
REIT.Itcanonlybeutilizedforadjustmentagainstallotmentofunitsorrefundof
moneytotheapplicantstillthetimetheunitsarelisted.
Unitscanbeissuedindematerialisedformonly.
Within12daysofclosureofoffer,theunitshavetobemandatorilylisted.
MinimumtradinglotforsecondarymarkettradesisRs1lakh.
Atalltimes,theREITshouldhaveatleast200publicunitholders.
NotlessthanseventyfivepercentoftherevenuesoftheREITandtheSPV,other
thangainsarisingfromdisposalofproperties,shallbe,atalltimes,fromrental,
leasingandlettingrealestateassetsoranyotherincomeincidentaltotheleasing
ofsuchassets.

17
 TheaggregateconsolidatedborrowingsanddeferredpaymentsoftheREITnetof
cashandcashequivalentsshallneverexceedfortyninepercentofthevalueof
theREITassets.Thisexcludessecuritydepositsrefundabletotenants.
Distributions:

o NotlessthanninetypercentofnetdistributablecashflowsoftheSPVshallbe
distributed to the REIT in proportion of its holding in the SPV, subject to
applicable provisions in the Companies Act, 2013 or the Limited Liability
PartnershipAct,2008;
o Notlessthanninetypercent.ofnetdistributablecashflowsoftheREITshall
bedistributedtotheunitholders;
o Such distributions shall be declared and made not less than once every six
monthsineveryfinancialyearandshallbemadenotlaterthanfifteendays
fromthedateofsuchdeclaration.

Foranysaleofproperty,whetherbytheREITortheSPVorforsaleofsharesor
interestintheSPVbytheREITexceedingtenpercentofthevalueofREITassets
inafinancialyear,themanagershallobtainapprovalfromtheunitholders.
Theunitscanberedeemedthroughbuybackordelisting.

2.2.4. Valuation
A full valuation of the REIT assets shall be conducted by the valuer within 3
monthsoftheendofeveryfinancialyear.
AhalfyearlyvaluationoftheREITassetsshallbeconductedbythevaluerforthe
halfyear ending on September 30 for incorporating any key changes in the
previoussixmonths.Suchhalfyearlyvaluationreportshallbepreparedwithin
fortyfivedaysfromthedateofendofsuchhalfyear.
Thevaluershallnotbeanassociateofthesponsor(s)ormanagerortrusteeand
shallhavenotlessthanfiveyearsofexperienceinvaluationofrealestate.
With respect to purchase or sale of properties, from / to related parties, both
priortoandafterinitialoffer,twovaluationreportsfromtwodifferentvaluers,
independentofeachother,shallbeobtained.
Transactionsforpurchaseofsuchassetsshallbeatapricenotgreaterthan,and
transactionsforsaleofsuchassetsshallbeatapricenotlesserthan,theaverage
ofthetwoindependentvaluations.
Ifitisnotarelatedpartytransaction,afullvaluationofthespecificpropertyshall
beundertakenbythevaluer.Approvaloftheunitholdersistobeobtainedif
(1)incaseofapurchasetransaction,thepropertyisproposedtobepurchasedat
avaluegreaterthanonehundredandtenpercentofthevalueofthepropertyas
assessedbythevaluer;
(2)incaseofasaletransaction,thepropertyisproposedtobesoldatavalueless
thanninetypercentofthevalueofthepropertyasassessedbythevaluer.
Novaluershallundertakevaluationofthesamepropertyformorethanfouryears
consecutively.Itcanbereappointedafteraperiodofnotlessthantwoyearsfrom
thedateitceasestobethevalueroftheREIT.

18
 The valuer(s) and any of its employees involved in valuing of the assets of the
REIT,shallnot,
(i)investinunitsoftheREITorintheassetsbeingvalued;and
(ii)selltheassetsorunitsofREITsheldpriortobeingappointedasthevaluer,till
thetimesuchpersonisdesignatedasvaluerofsuchREITandnotlessthansix
monthsafterceasingtobevalueroftheREIT.

2.3. InvestmentNormsforMutualFunds
HerewediscussSEBInormsforinvestmentbymutualfundschemesinvarioussecurities.

2.3.1. Equity/DebtSchemes

A mutual fund scheme shall not invest more than 15% of its NAV in debt
instrumentsissuedbyasingleissuerthatareratednotbelowinvestmentgrade
byacreditratingagencyauthorisedtocarryoutsuchactivityundertheAct.
Theinvestmentlimitmaybeextendedto20%oftheNAVoftheschemewiththeprior
approvaloftheBoardofTrusteesandtheBoardoftheassetmanagementcompany.

o These limits are not applicable for investments in Government securities

issuedbyCentraland/orStateGovernmentoronitsbehalf,bytheRBI.
o Thelimitsare,however,applicabletoalldebtsecuritiesissuedbypublicbodies
or institutions such as electricity boards, municipal corporations, state
transportcorporationsetc.guaranteedbyeitherStateorCentralGovernment.

Amutualfundschemeshallnotinvestmorethan10%ofitsNAVinunrateddebt
instrumentsissuedbyasingleissuerandthetotalinvestmentinsuchinstruments
shallnotexceed25%oftheNAVofthescheme.

o All such investments shall be made with the prior approval of the Board of
TrusteesandtheBoardoftheassetmanagementcompany.
o Mutual Funds may, for the purpose of operational flexibility, constitute
committees to approve investment proposals in unrated instruments.
However, detailed parameters for investment in unrated debt instruments
havetobeapprovedbytheBoardoftheAMCandTrustees.
o Details of such investments shall be communicated by the AMCs to the
Trusteesintheirperiodicalreports,alongwithclearindicationastohowthe
parameterssetforinvestmentshavebeencompliedwith.
o PriorapprovaloftheBoardoftheAMCandTrusteesshallberequiredincase
investment is sought to be made in an unrated security falling outside the
prescribedparameters.

Nomutualfundschemeshallinvestmorethan30% ofitsnetassetsinmoney
marketinstrumentsofanissuer.

o ThislimitisnotapplicableforinvestmentsinGovernmentsecurities,treasury
billsandcollateralizedborrowingandlendingobligations.
19
 No mutual fund under all its schemes should own more than 10% of any
companyspaidupcapitalcarryingvotingrights.

Nomutualfundschemeshallmakeanyinvestmentin

o anyunlistedsecurityofanassociateorgroupcompanyofthesponsor;or
o any security issued by way of private placement by an associate or group
companyofthesponsor;or
o thelistedsecuritiesofgroupcompaniesofthesponsorwhichisinexcessof25
percentofthenetassets.

Nomutualfundschemeshallinvestmorethan10percentofitsNAVintheequity
sharesorequityrelatedinstrumentsofanycompany

o Thelimitisnotapplicableforinvestmentsincaseofindexfundorsectoror
industryspecificscheme.

Amutualfundschemeshallnotinvestmorethan5%ofitsNAVintheunlisted
equitysharesorequityrelatedinstrumentsincaseofopenendedschemeand
10%ofitsNAVincaseofcloseendedscheme.

Transfersofinvestmentsfromoneschemetoanotherschemeinthesamemutual
fundshallbeallowedonlyif,

o Suchtransfersaredoneattheprevailingmarketpriceforquotedinstruments
onspotbasis.
o The securities so transferred shall be in conformity with the investment
objectiveoftheschemetowhichsuchtransferhasbeenmade.

No scheme of a mutual fund shall make any investment in any fund of funds
scheme.

A scheme may invest in another scheme under the same asset management
company or any other mutual fund without charging any fees, provided that
aggregate interscheme investment made by all schemes under the same
management or in schemes under the management of any other asset
managementcompanyshallnotexceed5%ofthenetassetvalueofthemutual
fund.

o Thisclauseisnotapplicabletoanyfundoffundsscheme.
o It is also not applicable to investments in mutual funds in foreign countries
madeinaccordancewiththeseGuidelines.

Afundoffundsschemeissubjecttothefollowinginvestmentrestrictions:

o Afundoffundsschemeshallnotinvestinanyotherfundoffundsscheme;
o A fund of fundsscheme shall not invest its assets other than inschemes of
mutualfunds,excepttotheextentoffundsrequiredformeetingtheliquidity

20
 requirementsforthepurposeofrepurchasesorredemptions,asdisclosedin
theofferdocumentoffundoffundsscheme.

Everymutualfundshallbuyandsellsecuritiesonthebasisofdeliveriesandshall
inallcasesofpurchases,takedeliveryofrelevantsecuritiesandinallcasesof
sale,deliverthesecurities:

o Saleofgovernmentsecurityalreadycontractedforpurchaseispermitted.

A mutual fund may lend and borrow securities, or enter into short selling
transactionsonarecognisedstockexchange,inaccordancewiththeframework
relatingtoshortsellingandsecuritieslendingandborrowingspecifiedbySEBI.

TheSchemeInformationDocument(SID)needstomention:

o Intentiontolendsecuritiesbelongingtoaparticularmutualfundscheme
o Exposurelimitwithregardtosecuritieslending,bothfortheschemeaswellas
forasingleintermediary.
o Risksfactorssuchasloss,bankruptcyetc.associatedwithsuchtransactions.

The funds of a scheme shall not in any manner be used in carry forward
transactions.However,themutualfundmayenterintoderivativestransactions
onarecognizedstockexchange.

Schemes are permitted to invest in mortgagebacked securitised debt that is
ratednotbelowinvestmentgrade.

Themutualfundshavinganaggregateofsecurities,whichareworthRs10crore
ormore,asonthelatestbalancesheetdate,aretosettletheirtransactionsonly
throughdematerialisedsecurities.

Mutual funds are not permitted to borrow except to meet temporary liquidity
needsforrepurchase,redemptionofunitsorpaymentofinterestordividendto
theunitholders:
Further,theborrowingcannotbemorethan20percentofthenetassetofthe
scheme and the duration of such a borrowing cannot exceed a period of six
months.

Mutualfundscannotadvanceanyloansforanypurpose.

Mutualfundsmayenterintounderwritingagreementafterobtainingacertificate
of registration in terms of the Securities and Exchange Board of India
(Underwriters)RulesandSecuritiesandExchangeBoardofIndia(Underwriters)
Regulations,1993authorisingittocarryonactivitiesasunderwriters.

o Theunderwritingobligationwillbedeemedasifinvestmentsaremadeinsuch
securities.
21
 o Thecapitaladequacynormsforthepurposeofunderwritingshallbethenet
assetofthescheme.
o Theunderwritingobligationofamutualfundcannotatanytimeexceedthe
totalnetassetvalueofthescheme.

Pendingdeploymentoffundsofaschemeintermsofinvestmentobjectivesof
thescheme,amutualfundmayinvesttheminshorttermdepositsofscheduled
commercialbanks.

o ShortTermforparkingoffundsbyMutualFundsistreatedasaperiodnot
exceeding91days.
o Suchdepositsshallbeheldinthenameoftheconcernedscheme.
o MutualFundsshallnotparkmorethan15%oftheirnetassetsinshortterm
depositsofallscheduledcommercialbanksputtogether.
Thislimithowevermayberaisedto20%withpriorapprovaloftheTrustees.
Also, parking of funds in short term deposits of associate and sponsor
scheduled commercial banks together shall not exceed 20% of the total
deploymentbytheMutualFundinshorttermdeposits.
o MutualFundsshallnotparkmorethan10%ofthenetassetsinshortterm
depositswithanyonescheduledcommercialbankincludingitssubsidiaries.
o Trusteesshallensurethatfundsofaparticularschemearenotparkedinshort
termdepositofabankwhichhasinvestedinthatscheme.
o In case of liquid and debt oriented schemes, AMC(s) shall not charge any
investmentmanagementandadvisoryfeesforparkingoffundsinshortterm
depositsofscheduledcommercialbanks.
o HalfYearlyportfoliostatementsshalldiscloseallfundsparkedinshortterm
deposit(s) under a separate heading. Details shall also include name of the
bank,amountoffundsparked,percentageofNAV.
o Trusteesshall,intheHalfYearlyTrusteeReportscertifythatprovisionsofthe
MutualFundsRegulationspertainingtoparkingoffundsinshorttermdeposits
pendingdeploymentarecompliedwithatallpointsoftime.TheAMC(s)shall
alsocertifythesameinitsComplianceTestReports[CTR(s)].
o Investmentsmadeinshorttermdepositspendingdeploymentoffundsshall
be recorded and reported to the Trustees including the reasons for the
investment especially comparisons with interest rates offered by other
scheduledcommercialbanks.
o The above guidelines (other than the requirement of disclosure in the Half
YearlyPortfoliostatements)shallnotapplytotermdepositsplacedasmargins
for trading in cash and derivatives market. However, duration of such term
depositsshallbedisclosedintheHalfYearlyPortfolio.

Investmentbyliquidschemesandplans

o Thesewillmakeinvestmentin/purchasedebtandmoneymarketsecurities
withmaturityofupto91daysonly.Allsecuritiesabove60daysofmaturity
needtobemarkedtomarketforvaluationpurposes.

22
 The maturity limit is also applicable in case of inter scheme transfer of
securities.
Incaseofsecuritieswheretheprincipalistoberepaidinasinglepayout,the
maturityofthesecuritiesshallmeanresidualmaturity.
Incasetheprincipalistoberepaidinmorethanonepayout,thematurityof
thesecuritiesshallbecalculatedonthebasisofweightedaveragematurityof
security.
Incaseofsecuritieswithputandcalloptions(dailyorotherwise)theresidual
maturityofthesecuritiesshallnotbegreaterthan91days
o Incasethematurityofthesecurityfallsonanonbusinessdaythensettlement
ofsecuritieswilltakeplaceonthenextbusinessday.

Investmentbyclosedenddebtschemes

o Closeendeddebtschemesshallinvestonlyinsuchsecuritieswhichmatureon
orbeforethedateofmaturityofthescheme.

Internationalinvestments

o A dedicated fund manager has to be appointed for making the overseas

investments.
o Thefollowinginvestmentsarepermitted:

ADR(s)and/orGDR(s)issuedbyIndianorforeigncompanies.
Equity of overseas companies listed on recognized Stock Exchanges
overseas.
Initial and Follow on Public Offerings for listing at recognized Stock
Exchangesoverseas.
Foreign debt securities in the countries with fully convertible
currencies,shorttermaswellaslongtermdebtinstrumentswithrating
not below investment grade by accredited/ registered credit rating
agencies.
MoneyMarketInstrumentsratednotbelowinvestmentgrade.
Reposintheformofinvestment,wherethecounterpartyisratednot
belowinvestmentgrade;reposhallnothoweverinvolveanyborrowing
offundsbyMutualFunds
Government securities where the countries are rated not below
investmentgrade.
Derivatives traded on recognized stock exchanges overseas only for
hedgingandportfoliobalancingwithunderlyingassecurities.
Shorttermdepositswithbanksoverseaswheretheissuerisratednot
belowinvestmentgrade.
Units / securities issued by overseas Mutual Funds or unit trusts
registeredwithoverseasregulatorsandinvestingin
AforesaidSecurities

23
 Real Estate Investment Trusts listed on recognized Stock
Exchangesoverseasor
Unlistedoverseassecurities,notexceeding10%oftheirnet
assets.

2.3.2. GoldSchemes
The funds of any such scheme are to be invested only in gold or gold related
instruments in accordance with its investment objective, except to the extent
necessary to meet the liquidity requirements for honouring repurchases or
redemptions,asdisclosedintheofferdocument;and
GoldDepositScheme(GDS)ofbanksisapermittedgoldrelatedinstrumentfor
investmentbyGoldETFs.However,GDSinvestmentcannotexceed20%ofthe
netassetsofthescheme.
Pendingdeploymentoffundsinaccordancewiththeabove,themutualfundmay
investitsfundsinshorttermdepositsofscheduledcommercialbanks.

2.3.3. RealEstateMutualFunds(REMF)
Everyrealstatemutualfundschemehastoinvestatleastthirtyfivepercentof
thenetassetsoftheschemedirectlyinrealestateassets.
Further,everyrealestatemutualfundschemehastoinvest

o atleast75%ofthenetassetsoftheschemein

realestateassets
mortgagebackedsecurities(butnotdirectlyinmortgages)
equitysharesordebenturesofcompaniesengagedindealinginreal
estate assets or in undertaking real estate development projects,
whetherlistedonarecognizedstockexchangeinIndiaornot

o thebalanceinothersecurities

Unlessotherwisedisclosedintheofferdocument,nomutualfundcan,underall
itsrealestatemutualfundschemes,investmorethanthirtypercentofitsnet
assetsinasinglecity.
Nomutualfundcan,underallitsrealestatemutualfundschemes,investmore
thanfifteenpercentofitsnetassetsintherealestateassetsofanysinglereal
estateproject.
Singlerealestateprojectmeansaprojectbyabuilderinasinglelocationwithina
city.
Nomutualfundcan,underallitsrealestatemutualfundschemes,investmore
thantwentyfivepercentofthetotalissuedcapitalofanyunlistedcompany.
Nomutualfundcaninvestmorethanfifteenpercentofthenetassetsofanyof
its real estate mutual fund schemes in the equity shares or debentures of any
unlistedcompany.
Realestatemutualfundschemescannotinvestin

o anyunlistedsecurityofthesponsororitsassociateorgroupcompany
24
 o anylistedsecurityissuedbywayofpreferentialallotmentbythesponsororits
associateorgroupcompany
o anylistedsecurityofthesponsororitsassociateorgroupcompany,inexcess
oftwentyfivepercentofthenetassetsofthescheme

Mutualfundisnotpermittedtotransferrealestateassetsamongstitsschemes.
Mutual fund cannot invest in any real estate asset which was owned by the
sponsorortheassetmanagement company oranyofitsassociatesduringthe
period of last five years or in which the sponsor or the asset management
companyoranyofitsassociatesholdtenancyorleaserights.

2.3.4. RealEstateInvestmentTrusts(REIT)
Atleast80percentoftheREITassetsneedstobeincompletedandrentgenerating
assets.

Notmorethan10percentoftheREITassetscanbeinincompleteprojectsorother
nonrentgeneratingassets.Suchincompleteornonrentgeneratingassetscannotbe
heldformorethan3yearsfromcompletion/purchase.

Notmorethan20percentoftheREITassetscanbeinvestedin:
(i) Incompleteornonrentgeneratingassets;
(ii) Listedorunlisteddebtofcompaniesorbodycorporateinrealestatesector.
ThisdoesnotincludeinvestmentindebtofSPVs;
(iii) Mortgagebackedsecurities;
(iv) Equity shares of companies listed on a recognized stock exchange in India
whichderivenotlessthanseventyfivepercentoftheiroperatingincomefrom
realestateactivityaspertheauditedaccountsofthepreviousfinancialyear;
(v) Governmentsecurities;
(vi) UnutilizedFSIofaprojectwhereithasalreadymadeinvestment;
(vii) TDRacquiredforthepurposeofutilizationwithrespecttoaprojectwhereit
hasalreadymadeinvestment;
(viii) Moneymarketinstrumentsorcashequivalents.

AREITshallholdatleasttwoprojects,directlyorthroughSPV.Notmorethansixty
percentofthevalueoftheassets,proportionatelyonaconsolidatedbasis,shallbein
asingleproject.

A REIT shall hold any completed and rent generating property, whether directly or
throughSPV,foraperiodofnotlessthanthreeyearsfromthedateofpurchaseof
suchpropertybytheREITorSPV.

REIT cannot invest in other REITs or give loans to any person. Investment in debt
securitiesisnottreatedasloan.

25


2.4. SEBINormsforMutualFundsInvestmentinDerivatives1
HerewediscussSEBInormsforinvestmentintoderivativeproductsbymutualfundschemes.
The cumulative gross exposure through equity, debt and derivative positions
shouldnotexceed100%ofthenetassetsofthescheme.
Mutual Funds shall not write options or purchase instruments with embedded
writtenoptions.
Thetotalexposurerelatedtooptionpremiumpaidmustnotexceed20%ofthe
netassetsofthescheme.
Eachpositiontakeninderivativesshallhaveanassociatedexposure,whichisthe
maximumpossiblelossthatmayoccuronaposition.However,certainderivative
positionsmaytheoreticallyhaveunlimitedpossibleloss.

Exposureinderivativepositionsiscomputedasfollows:
o LongFuture

FuturesPrice*LotSize*NumberofContracts

o ShortFuture

FuturesPrice*LotSize*NumberofContracts

o Optionbought

OptionPremiumPaid*LotSize*NumberofContracts.

Cash or cash equivalents with residual maturity of less than 91 days may be
treatedasnotcreatinganyexposure.
Mutual Funds may enter into plain vanilla interest rate swaps for hedging
purposes.

o The counter party in such transactions has to be an entity recognized as a

marketmakerbyRBI.
o Further,thevalueofthenotionalprincipalinsuchcasesmustnotexceedthe
valueofrespectiveexistingassetsbeinghedgedbythescheme.
o Exposuretoasinglecounterpartyinsuchtransactionsshouldnotexceed10%
ofthenetassetsofthescheme.

2.5. SEBINormswithrespecttoChangesinControllingInterestofanAMC
Here we discuss SEBI norms with respect to change in controlling interest of the Asset
ManagementCompany.

1The concept and application of derivatives are covered in Chapter 4.

26

Nochangeinthecontrollinginterestoftheassetmanagementcompanycanbe
madeunless,

o PriorapprovalofthetrusteesandtheBoard(i.e.SEBI)isobtained;
o A written communication about the proposed change is sent to each unit
holder,andanadvertisementisgiveninoneEnglishdailynewspaperhaving
nationwidecirculation,andinanewspaperpublishedinthelanguageofthe
regionwheretheHeadOfficeofthemutualfundissituated;and
o Theunitholdersaregiven30daystoexitontheprevailingNetAssetValue
withoutanyexitload.

Incasetheapplicantproposingtotakethecontrolofthemutualfundisnotan
existingmutualfundregisteredwithSEBI,itshouldapplytoSEBIforregistration
underSEBI(MutualFunds)Regulations,1996.
Incaseofnewsponsors,orincaseoftakingoveroftheschemesbyanexisting
mutualfund,undertakingsonthefollowinglinesarerequiredtobegiveninthe
interestofunitholders:

o Taking full responsibility of the management and the administration of the

schemesincludingthemattersrelatingtothereconciliationofaccounts(asif
theschemeshadbeenfloatedbythenewtrusteesonthedateoftakingover).
o Assumption of the trusteeship of the assets and liabilities of the schemes
includingunclaimeddividendsandunclaimedredemptions.
o Assuming all responsibilities and obligations relating to the investor
grievances,ifany,inrespectoftheschemestakenover,inaccordancewith
andpursuanttotheSEBI(MutualFunds)Regulations.

WhileseekingtheapprovalofSEBIforchangeinthecontrollinginterestofthe
asset management company, the mutual fund handing over the control to
anotherperson,shouldalsofilethedraftlettertobesenttotheunitholders.

Thedraftlettertotheunitholdersshouldincludethefollowinginformation

o Theactivitiesofthenewsponsoranditsfinancialperformanceasprescribed
inthestandardofferdocument;
o Incaseoftakingoveroftheschemes byanexistingmutualfundregistered
with SEBI, the draft letter should also include the condensed financial
informationofalltheschemesintheformatprescribedinthestandardoffer
document;
o Theamountofunclaimedredemptionanddividendandalsotheprocedurefor
claimingsuchamountbytheunitholders.

Theinformationgivenintheofferdocumentsofexistingschemesshallberevised
andupdatedpursuanttothechangeincontrollinginterestofthemutualfund.
SuchaddendumshallalsobefiledwithSEBI.

27
 In case of any other situation like change in indirect control of the asset
management company, or change in the promoters of the sponsor etc., the
mutual fund should provide full information to SEBI for advice on the further
courseofaction.

2.6. ChangesinMutualFundSchemes
2.6.1. ChangeinFundamentalAttributes
FundamentalAttributesincludes:

Typeofascheme
a.Openended/Closeended/Intervalscheme
b. Sectoral Fund/Equity Fund/Balanced Fund/Income Fund/Debt Fund/Index
Fund/AnyothertypeofFund
InvestmentObjective(s)
a.MainObjectiveGrowth/Income/Both.
b.InvestmentpatternThetentativeEquity/Debt/MoneyMarketportfoliobreakup
withminimumandmaximumassetallocation,whileretainingtheoptiontoalterthe
assetallocationforashorttermperiodondefensiveconsiderations.
TermsofIssue
a.Liquidityprovisionssuchaslisting,repurchase,redemption.
b.Aggregatefeesandexpenseschargedtothescheme.
c.Anysafetynetorguaranteeprovided.

The trustees have been made responsible in case there is a change in the fundamental
attributesofanyschemeorthetrustorfeesandexpensespayableoranyotherchangewhich
wouldmodifytheschemeandaffecttheinterestofunitholdersthatsuchchangescannotbe
carriedoutunless,
(i)awrittencommunicationabouttheproposedchangeissenttoeachunitholderandan
advertisementisgiveninoneEnglishdailynewspaperhavingnationwidecirculationaswell
asinanewspaperpublishedinthelanguageofregionwheretheHeadOfficeofthemutual
fundissituated;and
(ii)theunitholdersaregivenanoptiontoexitattheprevailingNetAssetValuewithoutany
exitload.
The Scheme Information Document (SID) is to be revised and updated immediately after
completionofthedurationoftheexitoption.

2.6.2. ConversionofClosedEndSchemetoOpenEndScheme
Incaseofaconversionofclosedendschemetoopenendscheme:
DisclosurescontainedintheSIDneedtoberevisedandupdated.Acopyofthe
draftSIDhastobefiledwithSEBI.
Adraftofthecommunicationtobesenttounitholdershastobesubmittedto
SEBI,whichwillincludethefollowing:

o Latestportfolioofthescheme(s)intheprescribedformat

28
 o Details of the financialperformance of the scheme(s) since inception in the
format prescribed in SID, along with comparisons with appropriate
benchmark(s).
o The addendum to the SID detailing the modifications (if any) made to the
scheme(s).

ThelettertounitholdersandrevisedSID(ifany)canbeissuedonlyafterthefinal
observationsascommunicatedbySEBIhavebeenincorporatedandfinalcopies
havebeenfiledwithSEBI.

Unitholdershavetobegivenatleast30daystoexerciseexitoption.Duringthis
period,theunitholderswhoopttoredeemtheirholdingsinpartorinfullshall
be allowed to exit at the NAV applicable for the day on which the request is
received,withoutchargingexitload.

2.6.3. ConsolidationofSchemes
AnyconsolidationormergerofMutualFundschemeswillnormallybetreatedasachangein
the fundamental attributes of the related schemes.Therefore, the Mutual Fundneeds to
complywiththerequirementsspecifiedinsection2.6.1.
Further,inordertoensurethatallimportantdisclosuresaremadetotheinvestorsofthe
schemes sought to be consolidated or merged and their interests are protected; Mutual
Fundshavetotakethefollowingsteps:

ApprovalbytheBoardoftheAMCandTrustee(s):
Theproposalandmodalitiesoftheconsolidationormergershallbeapprovedby
theBoardoftheAMCandTrustee(s),aftertheyensurethattheinterestofunit
holders under all the concerned schemes have been protected in the said
proposal.
SubsequenttoapprovalfromtheBoardoftheAMCandTrustee(s),MutualFunds
shallfiletheproposalwithSEBI,alongwiththedraftSID,requisitefees(ifanew
schemeemergesaftersuchconsolidationormerger)anddraftofthelettertobe
issuedtotheunitholdersofalltheconcernedschemes.
The letter addressed to the unit holders, giving them the option to exit at
prevailingNAVwithoutchargingexitload,shalldiscloseallrelevantinformation
enablingthemtotakewellinformeddecisions.Thisinformationwillinclude,inter
alia:

o Latestportfoliooftheconcernedschemes.
o Detailsofthefinancialperformanceoftheconcernedschemessinceinception
in the format prescribed in SID along with comparisons with appropriate
benchmarks.
o Information on the investment objective, asset allocation and the main
featuresofthenewconsolidatedscheme.
o Basisofallocationofnewunitsbywayofanumericalillustration

29
 o PercentageoftotalNPAsandpercentageoftotalilliquidassetstonetassets
ofeachindividualscheme(s)aswelltheconsolidatedscheme.
o Taximpactoftheconsolidationontheunitholders.
o AnyotherdisclosureasspecifiedbytheTrustees.
o AnyotherdisclosureasdirectedbySEBI.

Update of SID shall be as per the requirements for change in fundamental

attributeofthescheme.
MaintenanceofRecords:

o TheAMC(s)shallmaintainrecordsofdispatchoftheletterstotheunitholders
andtheresponsesreceivedfromthem.
o Areportgivinginformationontotalnumberofunitholdersintheschemesand
theirnetassets,numberofunitholderswhooptedtoexitandnetassetsheld
bythemandnumberofunitholdersandnetassetsintheconsolidatedscheme
shallbefiledwiththeBoardwithin21daysfromthedateofclosureoftheexit
option.

Mergerorconsolidationshallnotbeseenaschangeinfundamentalattributeof
thesurvivingschemeifthefollowingconditionsaremet:

o Fundamentalattributesofthesurvivingschemedonotchange.Thesurviving
schememeanstheschemewhichremainsinexistenceafterthemerger.
o MutualFundsareabletodemonstratethatthecircumstancesmeritmergeror
consolidationofschemesandtheinterestoftheunitholdersofthesurviving
schemeisnotadverselyaffected.
o AfterapprovalbytheBoardsofAMCsandTrustees,themutualfundsshallfile
such proposal with SEBI. SEBI would communicate its observations on the
proposalwithinthetimeperiodprescribed.
o The letter to unitholders is issued only after the final observations
communicatedbySEBIhavebeenincorporatedandfinalcopiesofthesame
havebeenfiledwithSEBI.

Example
SupposeNAVoftwoschemesAandBareRs12andRs16respectively.

SchemeAhasdecidedtomergeintoSchemeB.AninvestorYhas1,000unitsofSchemeA.
HowmanyunitsofSchemeBwillYreceiveonmerger?
Itcanbecalculatedas1,000XRs12/Rs16i.e.750.
InvestorYwillreceive750unitsofSchemeBinplaceoftheholdingof1,000unitsofScheme
A.

2.6.4. LaunchofAdditionalPlans
Additionalplanssoughttobelaunchedunderexistingopenendedschemeswhich
differsubstantiallyfromthatschemeintermsofportfolioorothercharacteristics
shall be launched as separate schemes in accordance with the regulatory
provisions.
30
 However,plan(s)whichareconsistentwiththecharacteristicsoftheschememay
be launched as additional plans as part of existing schemes by issuing an
addendum.
SuchproposalshouldbeapprovedbytheBoard(s)ofAMCandTrustees.
The addendum shall contain information pertaining to salient features like
applicableloads,expensesorsuchotherdetailswhichintheopinionoftheAMC/
Trusteesismaterial.
TheaddendumshallbefiledwithSEBI21daysinadvanceofopeningofplan(s).
AMC(s) shall publish an advertisement or issue a press release at the time of
launchofsuchadditionalplan(s).

2.6.5. OtherChanges
TheAMCisrequiredtoissueanaddendumanddisplayitonitswebsite.
The addendum has to be circulated to all the distributors/ brokers/ Investor
ServiceCentre(ISC)sothatthesamecanbeattachedtocopiesofSIDalreadyin
stock,tilltheSIDisupdated.
IncaseanyinformationinSIDisamendedmorethanonce,thelatestapplicable
addendumshallbeapartofSID.(Forexample,incaseofchangesinloadstructure
theaddendumcarryingthelatestapplicableloadstructureshallbeattachedto
allKeyInformationMemorandum(KIM)andSIDalreadyinstocktillitisupdated).
A public notice is to be given in respect of such changes in one English daily
newspaperhavingnationwidecirculationaswellasinanewspaperpublishedin
thelanguageofregionwheretheHeadOfficeoftheMutualFundissituated.
Theaccountstatementsissuedtoinvestorshavetoindicatetheapplicableload
structure.
AnymaterialchangesintheStatementofAdditionalInformation(SAI)shallbe
made on an ongoing basis by way of update on the Mutual Fund and AMFI
website.Theeffectivedateforsuchchangesshallbementionedintheupdated
SAI.
AsoftcopyoftheupdatedSID/SAIhastobefiledwithSEBIinPDFFormatalong
withprintedcopyofthesame.
AMCalsohastosubmitanundertakingtoSEBI,whilefilingthesoftcopy,that
informationcontainedinthesoftcopyofSID/SAItobeuploadedonSEBIwebsite
iscurrentandrelevantandmatchesexactlywiththecontentsofthehardcopy,
andthattheAMCisfullyresponsibleforthecontentsofthesoftcopyoftheSID
/SAI.

31
 Exercise
MultipleChoiceQuestions
1. WhichofthefollowingcanlaunchrealestatemutualfundsinIndia?
a. ExistingAMCs
b. RealEstateCompanies
c. Eitheroftheabove
d. Noneoftheabove

2. A mutual fund scheme shall not invest more than __% of its NAV in unrated debt
instrumentsissuedbyasingleissuer.
a. 5%
b. 10%
c. 15%
d. 20%

3. Mutualfundscannotgetintounderwritingcontracts.
a. True
b. False

4. Liquidschemesandplanscanmakeinvestmentin(i.e.,purchasedebtandmoneymarket
securities)withmaturityofupto182days.
a. True
b. False














Answers
1c,2b,3b,4b

32
 3. FundDistributionandSalesPractices

LearningObjective
ThisChapterseekstohelpthereaderunderstandtheworkingofnewerchannelsofMF
distributionsuchasinternetandstockexchanges.

Traditionally,transactionsinunitsofmutualfundschemeshavebeeneffectedasfollows:

NewFundOffer

Theinvestorsubmittedtheapplicationforpurchase,alongwithcheque/demanddraft,to
theAMCoranauthorisedbankeroftheAMCoradistributorortheregistrar&transferagent
(RTA).

PostNFOTransactionsinOpenendschemes

SaleorrepurchaserequestswouldbesubmittedtotheAMC,distributororRTA.Accordingly,
the AMC would issue new units to the investor (increase in unit capital) or repurchase
existingunitsoftheinvestor(decreaseinunitcapital).

PostNFOTransactionsinClosedendschemes

Theseschemesarelistedinanexchange.Therefore,investorswouldneedtogotoastock
brokertoselltheirunitsorbuymoreunits.Theunitswouldbetransactedbetweenaseller
andabuyerforthoseunitsthroughoneormorestockbrokersinthestockexchange.Theunit
capitaloftheschemewouldremainthesame.Theonlychangewouldbereplacementofthe
sellersdetailsbythenameandotherdetailsofthebuyerofthoseunits.
Investorswhodidnotknowastockbrokerwouldgotoadistributor,whowouldpassonthe
requesttoastockbroker.
Investorswhodidnotwanttotransactinastockexchange,wouldreceivetheproceedson
maturityorearlyredemptionoftheclosedendscheme.TheAMCwouldcanceltheunitsand
paythevalueoftheunitstotheinvestoronsuchmaturityorearlyredemptionoftheclosed
endscheme.

ExchangeTradedFund(ETF)

Asalreadydiscussedin Chapter1,ETFscombinethefeaturesof openendandclosedend

schemes.

NewerChannelsofMutualFundDistribution
Although the traditional approaches to transacting in units continue, several newer
developmentshavechangedthecomplexionofmutualfundtransactionsinthecountry.A
keyenablerhasbeendematerialisation.
33
As explained in the MFD Workbook, dematerialisation has eliminated the need for Unit
Certificatestobeissuedtotheinvestor.Instead,anelectronicrecordoftheunitholdingis
maintainedwithadepository.
SEBI has made it mandatory for AMCs to give unitholders the right to hold their units of
mutualfundschemesindematform.TheunitholdercanstatehispreferenceattheNFO
stageitself.Evenlater,theinvestorcanrequesttheconversionofphysicalunitsintodemat
form.
Dematerialisationhasmadeitpossibletotransactinunitsquickly,throughtheinternetand
stockexchanges.Evenpledgeofunits,assecurityforfinancingtransactions,ispossible.

3.1. InternetandMobileTechnologies
With the emergence of internet technology, it has become possible to transact in units
withouthavingtovisittheofficesoftheAMCordistributororRTA.Thefollowinginternet
channelsareavailable:

WebsitesofAMCs

AlmosteveryAMCoffersthefacilitytoexistingfolioholderstobuynewunitsoroffertheir
existingunitsforrepurchase,throughtheAMCwebsite.Onlyonce,fortheirfirsttransaction
withtheAMC(whenthefolioiscreated),theyneedtoestablishphysicalcontactwiththe
AMC, distributor or RTA, to sign the forms and hand them over. Thereafter, all future
transactionswiththeconcernedAMCcanhappenthroughtheinternet.
SomeAMCsofferinvestorsthefacilityofevenmakingthefirstinvestmentthroughthenet.
However,theunitsaremadeavailabletotheinvestoronlywhentheysignandsendaprint
oftheironlineapplication.
Recently,anAMChascompletelyremovedtherequirementofaphysicalsignature,evenfor
thefirstinvestment.UnitsareissuedonthebasisofonlineKYCcheckwiththerecordsofthe
registrar,andpaymentmadethroughanonlinebankingaccount.Thedigitalimageofthe
signature of the investor in the KYC records is used, so that the requirement of physical
signatureattheinvestmentapplicationstageiseliminated.
Inthecaseofrepurchase,themoneyswouldbedirectlytransferredtotheunitholdersbank
account.

Paymentforfreshpurchasescanbedonethroughanyofthefollowinginternetchannels:

The payment gateway on the website will lead to the login page of the unit
holdersbankaccount.Withtheusernameandpasswordofhisinternetenabled
bankaccount(providedbyhisbank),theunitholdercantransfermoneysfrom
hisbankaccounttothebankaccountoftheAMC.Abenefitofusingthisfacility
isthatintherecordsoftheAMC,theunitholdersapplicationandmoneytransfer
aredirectlylinked.
TheunitholdercanalsodoatransferdirectlyfromhisbankaccounttotheAMCs
bankaccountthroughNationalElectronicFundTransfer(NEFT)/RealTimeGross
Settlement(RTGS)/ImmediatePaymentService(IMPS)facilityprovidedbyhis
bank.Thelimitationsofthismodeoftransferare:
34
 o The unitholder will first need to check with the AMC or its website on the
detailsoftheAMCsbankaccountintowhichmoneyhastobetransferred.
o The unitholder will have to add the AMCs bank account as a registered
beneficiary in his bank account. Thereafter, the unitholder will have to
transfermoneystotheAMCsbankaccount.Somebanksallowtransfersonly
24hoursafterabeneficiaryisadded.
o Since the purchase request and money transfer happen as independent
transactions,theunitholdermayneedtoseparatelycoordinatewiththeAMC
toensurethattheunitsaremadeavailablewithoutdelay.Thisincreasesthe
processes at the AMC end too. For this reason, some of the AMCs do not
encouragethismodeoftransfer,especiallyforsmallinvestments.
o The unitholders bank may charge a fee for the NEFT / RTGS / IMPS
transaction. This may be avoided when the payment is made through the
AMCswebsite(throughtheirpaymentgateway).Further,theremaybelimits
onhowmuchtheunitholdersbankallowstobetransferredthroughthese
internetormobilebasedfacilitiesinasingleday.

Some AMCs also receive small value investment requests through credit card
payments.Theunitholdershouldcheckonthecosts,ifany,thatthecreditcard
issuerwillchargehimforthetransaction.

AlimitationisthateachAMCwebsiteallowstransactioninonlyitsschemes.Therefore,a
unitholderwhowantstotransactwithmultipleAMCswillhavetovisitmultiplewebsites.

WebsitesofDistributors

Manylargedistributorsofferthefacilityofbuyingandsellingunitsthroughtheirwebsite.The
transactions would be similar to the AMC websites, discussed earlier. One physical
interaction will be necessary at the outset, to comply with the KYC norms. Thereafter,
transactionscanhappenthroughtheInternet.

Abenefitoftransactingthroughthedistributorswebsiteisthatitwillallowtheunitholder
totransactinunitsofseveralAMCs,withwhomthedistributorhastiedup.Thus,theneed
tovisitmultipleAMCwebsitesissignificantlyavoided.

Aswithanytransactiononthenet,theunitholdershouldensurethatthewebsiteisgenuine.
Beforeenteringtheusernameandpassword,theunitholdershouldcheckforthepadlock
symbolintheaddressbar.Thesymbolisanindicationthatthewebsitehasbeenverifiedby
VeriSign(anindependentassuranceprovider)tobeagenuinesite,whoseconnectiontothe
serverisencryptedandtherefore,secure.

Unitholders can access the websites using smartphones. In that sense, even today, it is
possibletotransactinmutualfundunits,usingadvancedhandsets.

35
Besides,initialstepshavebeentakentoofferapplicationsthatcanbedownloadedonthe
smartphoneforeasyandsecuretransactions.UsingWirelessApplicationProtocol(WAP),
thetransactionscanbeeffectedevenwithoutaccessingthewebbrowser.

ApplicationofmanyofthenewertechnologiesisnascentinIndia.GivenIndiasgeographic
spread, and popularity of mobile phones, this can become an important medium for
transactinginmutualfundunits.

3.2. StockExchanges
ListedUnits

Itismandatoryforclosedendschemestobelistedinthestockexchange.ETFs,bydefinition,
arelistedinthestockexchange.Itisthereforepossibletotradeontheseunitsthroughthe
stockexchangetradingsystem.

Allthatisrequiredisanonlinetradingaccountanddemataccount.Onlydematunitscanbe
tradedintheexchange.Further,toensuretimelypayments,itisadvisablethattheinvestor
alsohaveaninternetenabledbankingaccount.

Further,theinvestorgrievancehandlingprocessisavailable.

TransactionEngines

Besides offering a platform for trading in listed units, BSE and NSE have also developed
transactionenginesformutualfunds.NSEsplatformiscalledNEATMFSS.BSEsplatformis
BSE StAR Mutual Funds Platform. Both depositories, CDSL and NSDL are linked to the
transactionengines.

These engines help stockbrokers in managing mutual fund applications (fresh purchases,
repeatpurchases,SIP,redemptions)ofinvestors.Theinvestorcantransactinphysicalunits
ordematunits.Inthelattercase,theinvestorsdemataccountneedstoberegisteredwith
thebroker.

The engines are available for transactions from 9 am to 3 pm on every working day. The
objectiveistousethestockexchangeinfrastructuretowidenthereachofmutualfundsin
thecountry.

AMCscantieupwitheitherorboththestockexchangestoenablemembers(brokers)ofthe
stockexchangetooffermutualfundservicestoinvestorsinthoseAMCs.Thebrokerneeds
tohaveanAMFIRegistrationNumbertoofferthemutualfundservices.Besides,heneedsto
beempanelledwiththeAMCwhoseschemeshewouldliketodealin.

36
Purchaseisallowedonlyinamount(Rs);saleisallowedonlyinnumberofunits.Theunits/
money are credited to the brokers pool account, from which the broker transfers to the
investorsDPaccount/bankaccount.

Theprocessisbroadlysimilarinbothexchanges.ThefollowingextractsfromtheUserManual
ofBSEStARareillustrative.

(Inthecharts,MFIreferstoMutualFundIntermediaryi.e.thestockbroker;ICCLrefersto
IndianClearingCorporationLimited,whichisBSEsclearinghouse.)

37


38
Thefollowingarevarioustimetablesfor:

SubscriptionActivities

39
 RedemptionActivities

40
ForLiquidSchemesinL0Category(HistoricalNAV)andDebt/EquitySchemesinL1Category,
thecutofftimeforsubscriptionandfundsis1:00p.m.toavailthebenefitofHistoricalNAV
(L0Category)andTdayNAV(L1Category).InLiquidSchemesinL0Category,unitsareallotted
ontheTday.

41


42
Transactions in demat units are conveniently conducted through the net. For physical
transactions,therelatedpaperswillneedtobehandedovertothestockbrokerintimefor
themtobepassedontotheAMC/RTAby4pmthesameday.

Thetransactionslipgeneratedbythesoftware,alsoincludesthetimestamp.Thisservesthe
purposeofanacknowledgementfortheinvestor.

IncaseofDebtSchemes,transactionsforsubscriptionofRs1croreandabovearenotallowed
intransactionengine.

Since the stock exchange is only a facilitator, while the AMC is the counterparty for the
investorstransactions,thetransactionsarenotprotectedbythesettlementguaranteefund.
However, the investor grievance handling mechanism is available for applicationrelated
issues.TheissuesrelatedtoallotmentneedtobetakenupwiththeRTA/AMCconcerned.

43
Exercise
MultipleChoiceQuestions
1. Whichofthefollowingistrue?
a. Allmutualfundunitsneedtobeinphysicalform
b. Allmutualfundunitsneedtobeindematform
c. Investorhastheoptionofchoosingbetweenphysicalanddematform
d. Transactioninstockexchangeonlyhappensinphysicalunits

2. AninvestorwantstotransactinunitsofmultipleAMCs.Whichislikelytobethemost
convenientwebsitetodothetransactions?
a. WebsiteofanyAMC
b. Websiteoflargedistributor
c. AMFIWebsite
d. SEBIWebsite

3. Forapurchasethroughthetransactionengineofastockexchange,thenewunitswillbe
firstcreditedto__________.
a. Demataccountofinvestor
b. Poolaccountofthestockbroker
c. Either(a)or(b)attheoptionofinvestor
d. Either(a)or(b)attheoptionofthestockbroker

4. WhichofthefollowingisrequiredforonlinetradinginUnitsinastockexchange
a. Onlinetradingaccount
b. Demataccount
c. Both(a)and(b)
d. (a),(b)andinternetenabledbankaccount








Answers
1c,2b,3b,4c

44
 4. InvestmentandRiskManagement

LearningObjective
This Chapter discusses some of the approaches taken by fund managers to managing
investmentsandrelatedrisks.

4.1. FundamentalAnalysis
4.1.1. Introduction
Morethan1,300companiesarelistedintheNationalStockExchange.ThenumberinBombay
StockExchangeisinexcessof5000.

One approach to evaluating these equity shares and managing the investment in them is
fundamentalanalysis.Here,theanalystevaluatesthefundamentalsofthecompanyviz.the
companys management, competitive position in its industry, growth prospects, financial
statements,regulatoryenvironmentetc.Accordingly,decisionsaretakentobuy,holdorsell
theinvestments.

4.1.2. Topdownv/sBottomupApproach
Inatopdownapproach,theportfoliomanagerstartswithaneconomicanalysis.Different
economiesandsectorsareevaluated,toidentifyattractivepocketsofinvestment.Basedon
this,capitalallocationbetweendifferentcountriesand/orsectorsisdecided.Thereafter,
individualstocksareselectedforinvestment.

Inabottomupapproach,theportfoliomanagerlooksforgoodstockstopick,irrespectiveof
thesectorstheybelongto.Thus,sectoralallocationintheportfolioisnotaconsciouscall,
butaconsequenceofthestockspicked.

4.1.3. Ratios
Afundamentalanalystreliesheavilyonfinancialratios.Theworkingofsomeofthecommonly
usedratiosisexplainedbelow:

Price/EarningsRatio(P/ERatio)

Suppose,theProfitafterTax(PAT)ofTataSteelfor201011isRs6,000crore,andthecompany
hasissued100croreshares.
TheEarningsperShare(EPS)wouldbe:PATNo.ofequityshares
i.e., Rs6,000crore100crore
i.e.,Rs60
IfthesharesofthecompanyarebeingtradedatRs480(marketprice),thentheP/ERatiocan
becalculatedas
MarketPriceEPS
i.e., Rs480Rs60 i.e.,8times
45
Since the P/E Ratio has been calculated based on past profits, it is called trailing P/E or
historicalP/E.MarketstendtotradebasedonforwardP/Ei.e.projectedprofits.InJuly2011,
iftheanalystestimatesTataSteelsPATfor201112togouptoRs8,000crore,andassuming
thecapitalstructuretobethesame,theprojectedEPSfor201112wouldbeRs8,000crore
100crorei.e.Rs80.Accordingly,theforwardP/EratiowouldbeRs480Rs80i.e.6times.

Afundamentalanalystwillcomparethiswithothersteelcompanies,suchasSAIL.Onthis
basis,hewilldecidethesteelcompanywhoseshareshewouldliketobuy,ifheisbullishon
thesteelsector.

In practice, P/E ratios too would change over time, in line with the industry prospects,
competitive position, management quality etc. In the above case, let us say, the analyst
believesthatTataSteelsP/Eratio,basedontheoverallmarketconditionandtheP/Eratio
ofothersteelcompaniesis10times.Inthatcasehewouldsetatargetpriceasfollows:
TargetPrice=ProjectedEPSXProjectedP/ERatio
i.e.Rs80X10
i.e.Rs800.
Onthisbasis,hewouldsuggestabuy,atthecurrentmarketpriceofRs480.Hewould
estimatetheupsidepotentialtobe(Rs800Rs480)Rs480i.e.67%.

MarginofSafety

ProjectingEPSaswellasP/Eratiosisasubjectiveexercise.Otherapproachestodetermine
theintrinsicvalueofashare,too,havetheirshareofsubjectivity.
Therefore, legendary investors like Benjamin Graham and Warren Buffett rely heavily on
marginofsafety.
Marginofsafetycanbecalculatedas1(MarketPriceIntrinsicValue).Intheabovecase,
(MarketPriceIntrinsicValue)isRs480Rs800i.e.60%.

Marginofsafetywouldbe(160%)i.e.40%.
The implication is that the estimate of intrinsic value can be wrong by 40%, and still the
investorwillnotlosemoney.Rs800less40%isRs480,thecurrentmarketprice.

MarginofSafetyisthusthemarginavailablefortheanalysttogowrong.Higherthemargin
ofsafety,saferwouldbetheinvestment.

PricetoBookValueRatio

BookValueofanycompanyssharecanbecalculatedasitsNetWorthNumberofshares.
The net worth is nothing but the companys share capital plus reserves less accumulated
losses.

SupposethenetworthofBankofBarodaisRs20,000crore,andithasissued40croreequity
shares.ThebookvalueofBankofBarodasequitysharescanbecalculatedasRs20,000crore
40crorei.e.Rs500.
IftheequitysharesaretradinginthemarketatRs900,thePricetoBookValueratiocanbe
calculatedtobeRs900Rs500i.e.1.8times.
46

As with Price / Earnings Ratio, Price to Book Value ratio of a companys equity shares is
comparedwiththatofothercompaniesinthesamesector,todecideonthesharetobuy/
hold/sell.Ahighpricetobookvalueratiomightbeanindicationthatthecompanysshares
areovervalued.Basedonthis,ananalystmaysuggestthatthesharesbesold.

4.1.4. RatiosinPerspective
Threegenericratioswerediscussedabove.Analystsdevisesectorspecificratios too. For
instance,AverageRevenueperUser(ARPU)isassociatedwithtelecomstocks.Retailstocks
arecomparedontheirRevenueperStockKeepingUnit(SKU).

Investmentdecisionscannotbetakenbasedonratiosblindly.AhighP/Eratiocouldbeeither
becausethecompanyhasexcellentprospects(suggestingthatthesharesbebought)orthe
companyssharesareovervalued(suggestingthatthesharesbesold).Theexpertiseofan
analystisrequiredfortakingsuchjudgementcalls.

Fundamentalanalyststypicallyfocusononeorafewsectors.Theresearchdivisioninalarge
brokinghousewould,therefore,haveseveralfundamentalanalysts,eachfocusingonafew
sectors.Theykeepmeetingcompaniesmanagementandtrackotherdevelopmentsinthe
sector,tofinetunetheirearningsestimatesandP/Eprojections.

4.2. TechnicalAnalysis
4.2.1. Introduction
TechnicalAnalysisisastudyofpastpricebehaviourofthemarketsandindividualstocks,to
predict their future direction. The following are key assumptions underlying technical
analysis.

Market price of a stock depends only on its supply and demand. The various
factorsdrivingthestockpricearecapturedinthesupplyanddemand.
Stockpricesandmarketsingeneralfollowatrendthatpersistsforareasonable
periodoftime.
Themarketgivesenoughindicationofchangesinthetrend,toguidethetechnical
analystininvestmentdecisions.

Atechnicalanalystbasesinvestmentdecisionsonsharepricesandtradingvolumes,which
arebelievedtocaptureandpredicthumanbehaviour.Thebeliefisthattheentiremarket
knowsmoreaboutanystockthananindividualanalyst.Thisknowledgeoftheentiremarket
iscapturedinthepriceandvolumesinthemarket.Sincetechnicalanalystsusechartstoread
themarket,theyarealsocalledchartists.

4.2.2. Tools
AccordingtoCharlesDow,theAmericanjournalistwhocofoundedDowJones&Company
andTheWallStreetJournal,stockpricemovementsaregovernedbythreecyclicaltrends:

47
 o Primarytrend,whichisthelongerrangecycle
o Secondarytrend,whichisthemediumrangecycle,lastingafewweekstoafew
months.Thismovementmaybeinadirectionoppositetotheprimarytrend.
o Minortrendisthedaytodayfluctuations,whicharebelievedtohavelowanalytic
andpredictivevalue.

Thehighinapricetrendiscalledapeak;thelowinthetrendiscalledatrough.Inabullish
market, each successive peak in the share price would be higher than the previous peak.
Similarly,eachsuccessivetroughwouldbehigherthantheprevioustrough.Thepositionis
reversedinabearishmarket.

Besidestheprice,DowTheoryalsoconsidersthevolume.Inabullishmarket,astheprice
increases,thevolumetooincreases;butwhenpricedecreases,volumesarelow.Onceagain,
inabearishmarketthepositionisreverse.

Duringamarketbottom,volumesgoup;volumesdeclinebeforeamajordeclineinprice.

Asastockpricedeclines,itislikelytostabiliseatitssupportlevel,wheredemandforthestock
increases.Whenthestockpricegoesup,itshouldbesoldclosertoitsresistancelevel,where
supplyofthestockincreases.

TechnicalanalystsrelyheavilyonMovingAverageofthestockpricestointerprettheprice
trends.Ina5daymovingaverage,theDay5valuewouldbetheaverageofthestockprices
forthe5daysfromDay1toDay5;Day6valuewouldbetheaverageofthestockpricesfor
the5daysfromDay2toDay6.Thus,everyday,theoldestdataisdropped,andthelatest
dataisaddedfortheaverage.

Movingaveragesforshortperiods,suchas5daysor7days,helpinunderstandingtheshort
termtrend.200daymovingaverageofthestockpricehelpsinreadingthelongtermtrend.

TheJapanesehaveanapproachtotechnicalanalysis,calledCandleStick.Here,theopening
andclosingpriceforeverytradingperiodisshownintheformofabox.Upwardmovement
ofpriceisshownasawhitebox,whileablackboxdenotesthattheclosingpricewaslower
thantheopening.Thehighandlowduringthetradingperiodaredenotedbyaverticalline.
Thepatternformedbytheseboxesandlinesisstudiedtogaugethelikelydirectionofthe
stock.

RNElliottbelievedintheElliottWaveTheorythatstockmarketmovesinwavesthatfollow
theFibonacciseries(1,2,3,5,8,13,21,34).Everynumberintheseriesisthesummation
oftheprevioustwonumbers.Thus,1+2=3;2+3=5;3+5=8andsoon.

AccordingtotheElliottWaveTheory,themarketmovesinfivedistinctwavesontheupside,
and three distinct waves on the downside. Elliott gave different names to different wave
trajectories.

Layinvestors,attimes,getenamouredwithtechnicalanalysis,becauseitdoesnotcallfor
readingofvoluminousfinancialinformation.Theylearnafewtechnicaltoolsfrombooks,

48
websitesorshorttermtrainingprograms,applyitonsharepriceinformationthatisreadily
availableinwebsites,andtradeonthatbasis.

Technicalanalysisisanartthatcallsforexperience.Untilonehasacquireddeepknowledge
andtherequisiteexperience,itwouldbebettertotakeasecondopinionfromanexpert,or
limittheexposurethatonetakes.

4.2.3. Fundamentalv/sTechnicalAnalysis
Both streams of analysts are strongly committed to their approach to stock analysis.
Fundamentalanalystsoftendecrythetechnicalanalysts,whodonotseemtoconsiderthe
business,earningsormanagementofthecompaniestoinvestin.

Technicalanalysts,ontheotherhand,arehappyaboutthefrequencyofdatatheyworkwith
onanytradingdaythereisacontinuousstreamofpriceandvolumedata.Fundamental
analystsreceiveearningsinformationeveryquarter;companiesmayalsosharesomesales
informationeverymonth.

Itisgenerallyacceptedthatfundamentalanalysisaidsdecisionsonbuy/sell/hold.Oncethe
decisionistaken,timingoftheimplementationcanbeguidedbytechnicalanalysis.

Daytradingandothershorterterminvestmentapproachesdependontechnicalcalls.

4.3. QuantitativeAnalysis
The analysis of stocks discussed so far did involve an element of quantitative analysis.
However, the term quantitative analysis is used to describe the newer approaches to
investment,describedbelow.

Investmentpractitionersarealwayslookingfornewerinvestmentframeworksthatwillhelp
themearnbetterreturnsatalowerrisk.Thisquesthasledmathematicallyorientedanalysts
toapplyadvancedmathematicsandstatistics,usingcomputersoftwareonmarketdata.High
end computers and software are used to quickly simulate different economic and market
scenario,andthelikelystockpricesinthosescenariosordifferencesinvaluebetweenpairs
of securities. Probability distributions are becoming an important driver of investment
decisions.Basedonsuchanalyses,optimalinvestmentportfoliosareconstructed.Algorithms
basedonsuchanalysesareusedfortradinganapproachthatiscalledalgotrading.

Derivatives have thrown open an entirely new gamut of investment avenues. Arbitrage
between the derivatives and the underlying cash market; and also between the same
instrumentsindifferentexchangeshasbecomeautomated.
BlackMonday(October19,1987),whentheDowJonesindexfellby22%,wasattributedto
automatedtrading.Suchtradinghasledtosomeextrememovesinthestockmarketinthe
lastfewyears.Anewtermhasbeencoinedforthisflashtrading.

49
Algo, automated, flash all boil down to the same approach of quick trading driven by
computerbased investment models that use advanced mathematics and statistics. The
professionalswhoworkonsuchinvestmentmodelsaregenerallyemployedinhedgefunds.
Blindfaithinsuchmodelscanbedangerous.Thesemodelstendtoignoretheroleofblack
swanevents,discussedinChapter9.

4.4. DebtInvestmentManagement
4.4.1. RoleofDebt
Whileequityisviewedasagrowthasset,debtismoreofanincomeasset.Thepredominant
returnonenormallyexpectsoutofdebtisinterest,althoughdebtalsoyieldscapitalgains,as
willbediscussedinthisChapter.

Debt performs the role of a defensive asset in the portfolio. As highlighted in the MFD
Workbook,amixofdebtandequityintheportfolioassetallocationisaprudentapproach
toinvestmentmanagement.

4.4.2. Interest&Yield
Theinterestthatanissuerpromisestopayonadebtinstrumentisalsocalledcoupon.Itmay
beafixedrate,orafloatingratei.e.linkedtosomeotherinterestrateinthemarket,suchas
theinterestonPublicProvidentFund.

Floatingrateinterestisdefinedintermsofitsbaseandspread.PPF+2%wouldsignifythat
interestpayableontheinstrumentwouldbe2%overthePPFRate. IfPPFRateis8%,an
investorintheinstrumentisentitledtointerestattherateof8%+2%i.e.10%.ThePPFRate,
here,isthebase(whichwillfluctuatefromtimetotime)and2%isthespread(whichwill
remainconstantduringthetenoroftheinstrument).

Aninvestorisbetteroff,ifthesameannualcouponrateispaidmorefrequentlyduringthe
year. The interest that is received during the year can be reinvested to earn additional
income.Therefore,forthesamecouponof10%p.a.,aninvestorisbetteroffwithhalfyearly
interestpayments(i.e.5%everyhalfyear)ascomparedtoannualinterestpayment(i.e.10%
for the whole year). Similarly, quarterly interest of 2.5% would be better than halfyearly
interestof5%.

Differentinstrumentsofferinginterestatvariousfrequenciescanbeeasilycomparedthrough
theirannualisedyield.Itiscalculatedas(1+couponperperiod)Numberofperiods1,asshown
inthefollowingtable.

Coupon Formula AnnualisedYield

10%p.a.,annual (1+10.00%)11 10.00%

10%p.a.,semiannual (1+5.00%)21 10.25%

10%p.a.,quarterly (1+2.50%)41 10.38%

50
Annualisedyieldcanbeeasilycalculatedfromthecoupon,basedonitsfrequency.Thereturn
earnedbyadebtinvestor,asalreadyseen,isinterest+capitalgains.Ifaninvestorbuysthe
debtsecurityofferingcouponof10%p.a.payablesemiannuallyatRs99,whenitsmaturity
value is Rs 100, then a capital gain of Re 1 is expected. The annualised yield of 10.25%,
mentionedintheabovetable,doesnotcapturethiselementofreturnarisingonaccountof
capitalgain.

Totalreturnuntilmaturityofthedebtsecurity(includinginterestandcapitalgain/loss)is
calledyieldtomaturity(YTM).ItcanbeeasilycalculatedwithMSExcel,bylistingthecash
flowsandtheirrespectivedates,andusingtheXIRRfunction.

Forthecashflowsfromaninvestorsperspective,theoriginalinvestmentcanbeshownasa
negative value, while interest and maturity receipts can be shown as positive values, as
detailedinthetableabove.

Theannualisedyieldof10.25%togetherwiththecapitalgainofRs1hascontributedtothe
YTMto10.51%.

4.4.3. RisksinDebt
InterestRisk/PriceRisk

This is the primary risk in debt investment. An investor ina debenture that yieldsa fixed
interestfindsthatitlosesvalueinthemarket,ifoverallinterestratesinthemarketwereto
goupsubsequently.However,ifoverallinterestratesinthemarketweretogodown,then

51
theinvestorisinthehappypositionofseeingthevalueofthefixedinterestratedebenture
gaininvalue.

Such increases and decreases in value of fixed interest rate debt securities, in line with
decreases and increases in overall interest rates in the market (although the coupon and
maturityvalueofthefixedinterestratesecuritydoesnotchange)areasourceofcapitalgains
andcapitallossesindebtinvestment.

Broadly,itcanbesaidthattheextentoffluctuationinvalueofthefixedratedebtsecurityis
afunctionofitstimetomaturity(balancetenor).Longerthebalancetenor,higherwouldbe
the fluctuation in value of the fixed rate debt security arising out of the same change in
interestratesinthemarket.

Thishasledtotheconceptofweightedaveragematurityindebtschemes.Ifaschemehas
70%ofitsportfolioina4yearsecurity,andbalance30%ina1yearsecurity,theweighted
averagematuritycanbecalculatedtobe(70%X4years)+(30%X1year)i.e.3.1years.The
NAVofsuchaschemecanbeexpectedtofluctuatemorethananotherdebtschemewitha
weightedaveragematuritycloserto1.5years.

Amorescientificmeasureofsensitivityofafixedratedebtinstrumenttointerestratesisits
modifiedduration.ThiscanbeeasilycalculatedusingtheMDURATIONfunctioninMSExcel.

Suppose State Bank of India issues a 5year debenture, with an interest rate of 8% p.a.,
payablehalfyearly.Whatisitsmodifiedduration?

TheparametersthatMSExcelneedsforthecalculationsareasfollows:

SettlementDatei.e.thedatethesecurityispurchased,say,07072011
MaturityDatei.e.5yearslater,07072016
Coupon,whichis8%
Yield,whichcanbecalculatedas(1+4%)21i.e.8.16%
FrequencyoftheCoupon(numberofpaymentsinayear),whichis2.Itwouldbe
1forannualpayments,4forquarterlypaymentsetc.
The syntax for the function is =mduration(settlement date, maturity date,
coupon,yield,frequency).

Onenteringthisfunction,themodifieddurationwouldbecalculatedtobe4.05.
Thismeansthatifyieldsinthemarketforsimilardebtsecuritiesweretochangeby1%,the
valueofthisSBIDebentureinthemarketwouldchangeby4.05%.

Ifyieldsinthemarketweretoincreaseby0.25%,theSBIdebenturewilllosevaluetothe
extentof4.05X0.25%i.e.1.01%.Thus,thedebenturesthatearliertradedatRs100,would
now trade at Rs 98.99. Such fluctuations are a feature of any fixed rate debenture. The
interestinafloatingratedebenturekeepsgettingresetinlinewithchangesinyieldinthe
market.Therefore,thefluctuationsinvalueareminimisedinsuchsecurities.

52
 CreditRisk

Aninvestorinasecurityissuedbythegovernment(Sovereignsecurity)drawscomfortthat
thegovernmentwillnotdefault.Therefore,sovereignsecuritiesaresaidtobefreeofcredit
risk. This feature ensures that yields in the market are typically lowest for sovereign
securities.
Theyieldavailableinthemarketfordifferenttenorsofgovernmentsecuritiesiscapturedin
theSovereignYieldCurve.

Sinceeverynonsovereignsecurityentailsacreditrisk,theyieldneedstobeahigherthanthe
sovereign yield for the same maturity. This difference between sovereign yield and non
sovereignyieldisalsocalledspread.

Betterthecreditratingofanissuer,lowerwouldbethespread.Issuerswithapoorcredit
ratingneedtoofferhigheryieldstoattractinvestors.Therefore,thespreadonsuchsecurities
wouldbehigher.

Creditratingtoochangesovertime.AsecuritythatwasratedAAA,cangetdowngradedto
say, AA.Inthatcase,theyieldexpectationsfrom thesecuritywouldgo up,leading to a
declineinitsvalueinthemarket.Thus,ashrewdinvestorwhoanticipatesanimprovement
increditratingonaninstrumentcanbenefitfromtheincreaseinitsvaluethatwouldfollow.

ReinvestmentRisk

TheXIRRfunctionusedfortheyieldcalculationsearlier,presumesthattheinvestorwouldbe
abletoreinvestallthecashflowsreceivedduringthetenorofthesecurity,atthesameXIRR
yield.

Inreality,whentheinvestorreceivesinterest,hemayfindthatinterestratesinthemarket
havegonedown.Thiswouldbringdownthereinvestmentrate,andthereforetheoverall
returnoftheinvestor.Iftheinterestratesweretogoup,theinvestorwouldobviouslybenefit
intermsofreinvestmentrateontheinterestreceived(althoughthedebtsecurityitselfwill
losevalue).

Somesecuritiesareissuedoncumulativebasis.Acumulativedebentureof8%couponp.a.
payablehalfyearlymeansthattheinterestwillbecalculatedforeveryinterestperiod,butit
wouldnotbepaidtotheinvestor;itwillbeaddedtotheprincipal,onwhichinterestforthe
nextperiodwouldbecalculated.Thus,thebaseonwhichthe8%couponiscalculatedkeeps
goingupuntilmaturity.Sincetheinvestordoesnotreceiveanyinteresttoreinvestduring
thetenorofthesecurity,thereisnoreinvestmentrisk.Thisriskistakenupbytheissuerof
thecumulativedebenture.

Aslightlydifferentstructuretoavoidreinvestmentriskisazerocoupondebenture.Here,
theissuerdoesnotannounceacoupon.However,thedebentureisissuedatadiscountto
itsfacevalue.

53
Suppose,adebentureoffacevalueRs100isissuedatRs80.TheinvestorwillinvestRs80,but
receive Rs100 on maturity. The difference of Rs20 is effectively interest income for the
investor.YTMcanbecalculatedusingtheXIRRfunction,asshownearlier.

ForeignCurrencyRisk

Investments that are denominated in foreign currency entail this risk. As with equity
(explained in Chapter 1), the investor benefits if the currency in which the investment is
denominated,becomesstronger.

4.5. IssuesforaDebtFundManager
Whywouldaninvestorinvestinalongertenordebtsecurity,ifitentailstheriskofahigher
loss,ifinterestratesweretogoup?

Oneanswerislogical.Theexpectationisthatinterestrateswouldgodown.Alonger
tenordebtsecuritywouldappreciatemore,iftheinterestrateexpectationcomestrue.
Interestratesareaconsequenceofcomplexfactors.InIndia,thechallengeofinterest
rateforecastsisgreaterbecausethereliabilityofsomeofthemacroeconomicnumbers
isnotsohigh.Therefore,debtfundmanagersneedanexcellentgripontheeconomy.
Thesovereignyieldcurveisupwardsloping.Thismeansthattheinherentinterestyield
in the debt security would go up with the tenor. A 5year debt security would offer a
higheryieldthana1yeardebtsecurityofthesameissuer.

Thedebtfundmanager,thus,hastobalancethedesiretoearnahigherinterestbasedyield,
withtheprospectoftheportfoliosufferingahighercapitalloss.Similarly,itisthejobofthe
managertobalancetheotherrisks,toearnareasonablereturnfortheinvestors.

4.6. Derivatives
Theinvestmentrelateddiscussionssofarfocusedonwhatiscalledthecashmarketi.e.the
equityordebtsecuritiesdirectly.Itisalsopossibletohavethesameexposurethroughan
indirectroute.

Suppose,PartyAentersintoacontracttobuyfromPartyB,3monthsfromtoday,10litresof
petrolatapricethatisdecidedtoday.PartyAwillbenefitifthepriceofpetrolgoesupitis
said to have a long position in petrol. If the price of petrol goes down, Party B benefits;
conversely,ithastobearalossifthepetrolpricesweretomoveup.PartyBthereforehasa
shortpositioninpetrol.

Sincetheprofitsorlossesonthecontractdependonpetrolprices,thecontractisaderivative
withpetrolbeingtheunderlying.Derivativecontractsareconstructedwithvariousunderlying
suchasequityshares,equityindices,debtsecurities/interestrate,debtindices,gold,other
commodities,rainfalletc.

Forthesameunderlying,derivativecontractscanbestructuredinvariousways,depending
onthetypeofpositionenvisaged.Forwards,Futures,OptionsandSwapsarethecommonly
tradedcontractformats.

54
4.6.1. Forwards
Thepetrolcontractmentionedaboveisinthenatureofaforward.Thefeaturesofaforward
are:

Thereisanunderlyingviz.petrol
Bothpartiestothecontractarecommitted.
Onepartysgainistheotherpartysloss.Itisazerosumgame.Suchcontracts
aresaidtobesymmetric.
Variouspairsofpartiesmayenterintoalternatecontractstructuresforthesame
underlying.Forexample,4monthsinsteadof3monthsor7litresinsteadof3
litresorthecontractsmaybefordifferentgradesofpetrol.Suchcontractsare
notstandardised.
Thecontractsarenottradedinanexchange.Therefore,thereisnotransparency
ontheprevailingpriceinthemarketforsuchacontract.
If either party wants to get out of the position, it can only do so with the
concurrenceoftheotherparty.Itcannot,forinstance,sellitspositiontosome
thirdparty,unlessthecounterpartyagreestothearrangement.
Eachpartyhastoevaluatethecounterpartyriskthatisinherenttothecontract.
Ifapartyisunableorunwillingtofulfilitsobligation,theotherpartyloses.
Thereisnoformalriskmanagementframeworktoprotectthepartiesfromthe
counterpartyrisk.

4.6.2. Futures
Futuresareanalternateformatoftakingpositionsonthesameunderlying.Thesimilarities
betweenforwardsandfuturesare:

Thereisanunderlyingviz.petrol
Bothpartiestothecontractarecommitted.
Thecontractstructureissymmetric.

Futures,however,addresssomeweaknessesofforwards:
Thecontractsaretradedinastockexchange.
Inordertoenabletradingwithadequateliquidity,thecontractsarestandardised.
Forinstance,inIndia,futuresonequitysharesarecommonlytradedfor1month
(nearmonth),2month(nextmonth)and3month(farmonth)duration.Eventhe
datewheneachcontractwouldmatureisstandardisedviz.thelastThursdayof
everymonth.
Thetradingensurestransparency.Atanystage,anyonecanchecktheprevailing
marketpriceforsuchacontract.
A party that wants to exit its position can sell the contract at any time to any
buyer,whoisavailableinthemarket.
Although two independent parties do the trade in the Stock Exchange, the
clearing corporation associated with the exchange introduces itself into the
contract, between the two parties, through a legal process called novation.

55
 Therefore, for both the parties, the counterparty is the clearing corporation,
which will fulfil the obligation to the other party, even if one of the parties
defaults.Onaccountofthisfeature,thepartiesdonotneedtogothroughthe
processofassessingthecounterpartyriskforeachtransaction.
Inordertoprotectitself,theclearingcorporationimposesmarginrequirements
ontheparties.Themarginsaresetatalevelwhereitfullycoversthelosssuffered
byanyparty.Thislossisassessedcontinuously,anddependingonneeds,more
marginscanbecollected.Arobustriskmanagementframeworkensuresthatthe
positions taken by parties are covered by margins, andsafety of the market is
ensured.

Let us take the example of the SBI Futures Contracts that are available for trading in the
NationalStockExchange(NSE)[Itisalsoavailableinotherexchanges.Asanillustration,the
NSEContractisdiscussed]:

The clearing corporation associated with NSE is National Securities Clearing

CorporationLimited.
NSE has set the market lot at 125 for SBI Futures. Thus, each contract would
represent125underlyingshares.
IfthefuturesistradedatRs2,500,theneachcontractleadstoanexposureofRs
2,500X125i.e.Rs312,500.
Theinvestor,however,paysonlyapartofthisamount,initially.Ifthemarginis
15%,theinitialmarginwouldamounttoRs312,500X15%i.e.Rs46,875.
After the initial margin, the investor keeps receiving (if the underlying i.e., SBI
share moves in his favour) or paying (if the underlying moves against him) a
variablemargin,everyday.
If on settlement, the market price of the underlying SBI share is Rs 3,000, an
investorwouldhaveearnedaprofitofRs3,000Rs2,500i.e.Rs500pershare.
This translates into a gain of Rs 500 X 125 i.e. Rs 62,500 on the contract for
someonewhohasgonelongi.e.boughtthecontract.
Theinvestordoesnotneedtoholdthecontractuntilsettlementdate.Itcanbe
sold any time before the settlement date. Depending on how the prices have
moved,aninvestorwhohasgonelongwillgainorlosemoney.

Futuresthathaveashareastheunderlyingarecalledstockfutures;whentheunderlyingis
anindex,itisanindexfuture;commoditiesaretheunderlyingforcommodityfutures;futures
that are constructed on debt securities are called interest rate futures; futures on foreign
currencyarecalledcurrencyfutures.AlltheseareavailableforinvestmentinIndia.

4.6.3. Options
In the petrol contract discussed earlier, both the parties were committed. Party A was
committedtobuy,justasPartyBwascommittedtosell.Suchastructuremadeitasymmetric
contract.Ifpetrolpriceswentup,PartyAwouldgain,butPartyBwouldlose,andviceversa.
Itwasazerosumgame.

56
ThecontractstructurecanbemodifiedtomakePartyBcommitted,butnotPartyAi.e.Party
Acanhavetheright(butnottheobligation)tobuy10litresofpetrolfromPartyBataprice
whichisdecidedtoday.IfPartyAchoosestoexercisethisright,PartyBisobligedtosell10
litresofpetrolattheagreedprice.Suchacontractiscalledanoption.

SincethecontractistoBUYpetrol,itisacalloption.
SincePartyAhastheright,butnottheobligation,ithasboughtthecalloption
PartyBisobligedtoselltheunderlying,ifPartyAexercisesitsright.PartyBhas
soldthecalloption(orwrittenthecalloption).
Ifpetrolpricesweretogoup,PartyAwillexercisetheoptionandbookaprofit
(thecorrespondinglosswouldbetotheaccountofPartyB).Ifpetrolpricesdo
notgoup,PartyAwillnotexercisetheoptioni.e.itwilllettheoptionlapse.
Thus,PartyBwillnotbenefitfromanydeclineintheprices,althoughitwillsufferfrom
anyappreciationintheprices.Therefore,thecontractissaidtobeasymmetric.
ForenteringintosuchanasymmetriccontractPartyAwillpayanoptionpremium
toPartyBwhichistakingtherisksunderthecontract.Thisoptionpremiumisan
incomeforPartyB(expenseforPartyA),irrespectiveofwhetherornotPartyA
exercisesitsoption.

Anoptioncontractcanalsoconferarighttosellsomething.SupposePartyCacquiresthe
righttosell10litresofdieseltoPartyDatapriceagreedupontoday.

SinceitisarighttoSELLdiesel,itisaputoption.
Theright,butnottheobligation,iswithPartyC.Therefore,ithasboughttheput
option.
PartyD,whichisobliged,hassoldtheputoption(orwrittentheputoption).
Party C will pay Party D an option premium for entering into the asymmetric
contract.
Sinceitisarighttosell,PartyCwillbenefitifdieselpricesweretofall.Butif
dieselpricesincrease,PartyCwilllettheoptionlapse.
IfPartyCexercisesitsoption(whichwouldhappenifdieselpricesdecline),Party
Dwillsufferaloss.Buttheoptionpremiumwouldbeitsincome.

AmericanOptionscanbeexercisedanytimeuptomaturityofthecontract;EuropeanOptions
canbeexercisedonlyonthedateofexpiryofthecontract.
Optionshavesomesimilaritieswithfutures:

Theyaretradedinastockexchange.Thisensurestransparencyofprices.
Theyareavailableforstocksandindices,withreasonableliquidity,for1month
(near month), 2month (next month) and 3month (far month) duration, and
settledonthelastThursdayofeachmonth.
Theclearingcorporationbecomesthecounterpartyforallcontractsthroughthe
processofnovation.
The clearing corporation implements a risk management system, including
margins.However,sinceonlytheselleroftheoptioncanincuraloss,onlyhehas
topayamargin.(thebuyeroftheoptionwillpaythepremium).

57
Aswithfutures,optionscanbeconstructedonstocks(stockoptions),indices(indexoptions),
commodities (commodity options) or debt securities (interest rate options) or foreign
currency (currency options.) In India, we currently have index options, stock options and
currencyoptions.

4.6.4. Swaps
Supposeabankhasborrowedmoneyatafixedrateofinterest (say, 7%).Itnow expects
interest rates to go down. Based on this view, switching to a floating rate of interest is
advisable.Butthelendermaynotagreetotheswitch.

Thebankwouldthenlookaroundinthemarket,forsomeotherpartythathasacontraryview
oninterestrates.Iftheotherparty(say,PartyY),expectsinterestratestogoup,itwouldbe
happytogetintoanarrangementwhereitwouldpayafixedrateofinterest(say,7%),in
return for a floating rate of interest (say, 5year Government Security yield +1%). Let us
assumethattheyieldis6%initially.

ThebankandPartyYwouldthenenterintoaswapagreement.Thetermswouldincludea
notionalprincipal(sayRs1crore),whichdoesnotgetexchangedinaninterestrateswap,but
isusedasthebasisforcalculatingtheinterestpayments.

Ifonthefirstinterestpaymentdate,theGovernmentSecurityYieldhasgoneup
from 6% to 6.5%, the bank is expected to pay Party Y 6.5% + 1% i.e. 7.5% of
Rs1crore. In return, it is expected to receive 7% of Rs1crore. Thus, the bank
wouldincuranetcostof0.5%ofRs1crorei.e.Rs50,000onaccountoftheswap.
If on the next interest payment date, the Government Security Yield has gone
downto5%,thebankhastopayfloatinginterestof5%+1%i.e.6%ofRs1crore.
Inreturn,itisexpectedtoreceive7%ofRs1crore.Thus,thebankwouldgain1%
ofRs1crorei.e.Rs100,000onaccountoftheswap.

Itisclearfromtheexamplethatwhentheexpectedinterestview(declineininterestrate)
doesnotmaterialise,thebanklosesmoney.Butwhenitsinterestviewisvalidated,itgains.
Forsimplicity,theexamplepresumesthattheinterestarrangementisannual.Normally,itis
semiannual.

Theabovewasanexampleofaninterestrateswapbetweenfixedandfloatinginterestrates.
Similarly,swapscanbeconstructedbetweentwodifferentkinds offloatinginterestrates.
Forexample,theswapcouldbebetweenGovernmentSecurityYieldandMumbaiInterBank
OfferedRate(MIBOR).Ifforeigncurrencyisinvolved,theswapcangobeyondinterestto
covertheprincipalalso.

Likefuturesandoptions,swapstoocanbetraded.Butswaptradingisnotsoprevalentin
India. Bank treasuries do intermediate in the swap market and earn the spread between
differentpartiestoswapcontracts.

4.7. ApplicationofDerivatives
58
TheSBIFuturesexampleshowedhowitispossibletotakeapositionworthRs312,500by
investingamereRs46,875.ThisamountstoaleverageofRs312,500Rs46,875i.e.6.7
times.ThismeansthatapersonwhohasRs312,500toinvestcan

TakeapositionofRs312,500inthecashmarket.
TakeapositionofRs312,500X6.7i.e.Rs20,83,333inthefuturesmarket.

Suchleveragingisfoundattractivebyinvestors.Theyneedtohoweverconsiderthefactthat
besidestheinitialmargin,theymayalsohavetopaydailymargins,ifthemarketpricesturn
adversetotheirposition.

Leveragingisariskyapproachtoinvestment.Derivativescanalsobeusedasaprudentrisk
managementtool,asillustratedbelow.

4.7.1. EquityMarket
PurchaseofaPutOption

Supposeafundmanagerisapprehensivethatthemarketwouldgodown.Hedoesnotneed
toselltheinvestmentportfolio.Instead,hecanpaytheoptionpremiumandbuyaputoption
onthestocksheldorontheindex.

o Ifthemarketdoesgodown,theinvestmentportfoliowilllosevalue.However,theput
option will appreciate in value, thus offering protection to the schemes Net Asset
Value.
o Ifthemarketgoesup,theinvestmentportfoliowillappreciate.Theoptionpremium
expensewoulddragdowntheNAVtoanextent.Butthatisthecostofprotection.

SellingaStockFuture

SupposeafundmanagerwantstoprotecttheNAVduringatemporaryperiodofweaknessin
themarket.Heonlyneedstosellastockfuture(forprotectingastockthatisintheportfolio)
oranindexfuture(forprotectingtheoverallportfolio).Whenthemarketturnsweak,the
investment(share)portfoliowilllosevalue.However,thefundmanagercancovertheearlier
soldstockfuture,bybuyingitatalowerprice,i.e.,thefuturespositioncanbesquaredto
bookaprofit.Thisprofitcanmakeupforanylossintheinvestment(share)portfolio.

Arbitrage

SupposeastockistradingatRs2,463,whilefuturesonthesamestock,withtimetomaturity
of8days,aretradingatRs2,467.Thefundmanagercanbuythestockandsellfuturesonthe
samestock.Sincethepositionsneutraliseeachother,thefundmanagerearnsarisklessprofit
of(Rs2,467Rs2,463)Rs2,463X(3658)i.e.7.41%.

Onmaturity,boththe positionswould be reversed.Therealprofitfor theschemewould

needtoincludetheinterestcostonmarginpayments,profit/lossbookedonthereversal
transactions, and the transaction costs related to the original pair of transactions and the
reversaltransactions.

59

Portfoliosofarbitrageschemesareconstructedinsuchamannertoearnrisklessprofits.

4.7.2. DebtMarket
Itispossiblefordebtfundmanagerstomanagetheirdebtexposuresthroughinterestrate
futures,asillustratedbelow:

SellinganInterestRateFuturetoProtectPortfolio

Wheninterestratesintheeconomygoup,debtsecuritiesthatyieldafixedcoupondepreciate
invalue.ThiswillbringdowntheNAVofthescheme.

Adebtportfoliomanagercansellaninterestratefuture,inanticipationofincreaseininterest
rates.Wheninterestratesdogoup,theinterestratefutureswilllosevalue.Atthatstage,
the futures position can be reversed at a profit. This will cushion the decline in NAV on
accountofdecreaseinthevalueoftheportfolio.

CalendarSpreadTrading

Theyieldsinthemarketvarydependingonthenatureoftheissuerandwhenthesecurityis
duetomature.Debtportfoliomanagersmonitortheyieldsconstantly.Attimes,theycan
identifymispricingofsecuritiesi.e.yieldforsomematurityisunusuallyhigh,whiletheyield
forsomeothermaturityisunusuallylow.

Insituationsofmispricing,debtportfoliomanagersdocalendarspreadtradingi.e.theygo
longonasecurityforonematurity,andgoshortonasecurityofthesameissuerforanother
maturity.Sincebothsecuritiesarefromthesameissuer,thecreditriskisneutralised,while
aspreadisearned.Itisaformofarbitragetradingtoearnrisklessprofits.

Technically, doing the calendar spread trade through interest rate futures is superior to
trading with the underlying securities themselves. Thus, the fund manager can buy an
interest rate future for one maturity, and sell another interest rate future for a different
maturity,tolockinaspreadprofit.

Arbitrage

Insteadoftradingonthecalendarspreadbetweentwofuturescontract,thefundmanager
canalsoarbitragebetweenthecashmarketandthefuturesmarket,toearnarisklessprofit.
Thisiscalledcashandfuturesarbitrage.

DurationTargeting

Attimes,thefundmanagerwouldliketochangethedurationoftheinvestmentportfolio.
Thiscanbeachievedbytradingtheunderlyingsecurities.Analternatewouldbetobuyand
selltheinterestratefuturesofdifferentmaturitiestoachievethetargetduration.Calculators
areavailablefordeterminingthevalueoffuturestotrade.

4.7.3. ForeignCurrency

60
In India, currency futures are available against the rupee for USD (US Dollar), Euro, GBP
(BritishPound)andJPY(JapaneseYen).

SupposethefundmanagerispositiveaboutUSequities,butnegativeabouttheUSDcurrency.

PureinvestmentinUSequitieswouldexposetheportfoliototheUSDrisktoo.Asseenin
Chapter1,theUSequityportfoliomightappreciate;butwhenitistranslatedintorupees,it
mightdepreciateonaccountofaweakUSD.

Thefundmanagercanprotecttheportfoliofromsucharisk,bysellingUSDfutures.When
theUSDweakens,thefundmanagercansquareofftheUSDfuturesataprofit.Thiswillmake
upthelossintheinvestmentportfolioonaccountofUSDweakness.

Thus,futurescanbeusedtoimmuniseinternationalportfoliosfromforeigncurrencyrisk.

61
 Exercise
MultipleChoiceQuestions
1. Whichofthefollowingdoesafundamentalanalyststudy?
a. Companysfinancials
b. Companysmanagement
c. Competitivepositioninindustry
d. Alltheabove

2. ThefundamentalanalysthasestimatedthetheoreticalpriceofastocktobeRs20.Itis
nowtradingatRs12.Whatisthemarginofsafety?
a. 60%
b. 40%
c. 75%
d. Noneoftheabove

3. Atechnicalanalyststudies___________.
a. Sharepricetrends
b. Sharetradingvolumes
c. Boththeabove
d. Humanbehaviour

4. Whichofthefollowingis/areexample/sofcomputerbasedtrading?
a. AlgoTrading
b. FlashTrading
c. AutomatedTrading
d. Alltheabove










Answers
1d,2b,3c,4d

62
 5. ValuationofSchemes

LearningObjective
ThisChapterhelpsinunderstandinghowequities,debt,derivativesandrealestateare
valuedinmutualfundschemes.Thediscussionondebtalsocoversregulationsonwhen
aninvestmentistoberecognisedasanonperformingasset,andhowaprovisionistobe
madeforthepotentialloss.

Thevaluationofindividualsecuritiesdeterminesthetotalportfoliovaluation,whichisakey
factordrivingtheNAVofanyscheme.

TheAMChastoconstituteaninhouseValuationCommittee,whichwouldincludeemployees
fromaccounts,fundmanagementandcompliancedepartments.Thecommitteeisexpected
toregularlyreviewthesystemsandpracticesofvaluationofsecurities.Similarsecuritiesin
variousschemesoftheAMCaretobevaluedconsistently.

Incasesecuritiespurchasedbyamutualfunddonotfallwithinthecurrentframeworkofthe
valuationofsecurities,thenthemutualfundhastoreportimmediatelytoAMFIregardingthe
same. Further, at the time of investment, the AMC is expected to ensure that the total
exposureinsuchsecuritiesdoesnotexceed5%ofthetotalAUMofthescheme.AMFIisto
ensurethatvaluationagencies coversuchsecuritiesintheirvaluationframeworkwithin6
weeks.Untilthen,thesecuritiesmaybevaluedaspertheAMCsproprietaryvaluationmodel.

5.1. Equities
Ifitistradedinastockexchangeonthedateofvaluation,theclosingvaluationinthestock
exchangeistobeused.Preferenceshouldbeforthestockexchangewherethesecurityis
principallytraded.Allthesecuritiescanbevaluedonthebasisofpricesquotedinastock
exchangewheremajorityinvalueoftheinvestmentsareprincipallytraded.

Once an exchange is selected for the valuation of a security, this has to be consistently
followed.Intheeventofanychange,reasonsneedtoberecordedinwriting.

Ifasecurityisnottradedonthedateofvaluation,thevalueofthesecurityonanyexchange
onthelatestpreviousdaymaybeused,solongasitiswithin30dayspriortothevaluation
date.

Itistreatedasnontraded,ifitisnottradedinanystockexchangefor30dayspriortothe
valuationdate.

Equitysharesandequityrelatedsecurities(convertibledebentures,equitywarrants,etc.)are
consideredtobethinlytraded,iftradinginamonth(allrecognisedstockexchangesinIndia
together)islessthanRs5lakh,andvolumetradedislessthan50,000shares.
63

Nontradedandthinlytradedequitiesaretobevaluedasfollows:

Calculatethenetworthpershare
NetWorthpershare=
[ShareCapital+Reserves(excludingRevaluationReserves)Miscellaneousexpenditureand
DebitBalanceinProfitandLossAccount]
NumberofPaidupShares
SupposetheNetWorthpershareisRs30.

CalculatetheindustrysPrice/EarningsRatio,basedonlatestBSE/NSEdataandlatest
auditedEPSofthecompany.Reducethisby75%i.e.only25%shouldbeconsidered.
Supposeitis40less75%i.e.10times

DeterminetheEPSofthecompanybasedonlatestauditedaccounts.Ifitisnegative,itis
tobetakenaszero.
SupposetheEPSisRs5

CapitalEarningValueofthesharewillbetakenasIndustryP/E(25%,asexplainedabove)
XCompanysEPS
Basedontheaboveassumptions,CapitalEarningvaluewouldbe10XRs5i.e.Rs50

TheaverageoftheBookValueofthecompanysshareanditsCapitalEarningValueisto
bereducedby10%forilliquidity.Thiswillbethefairvalueoftheshare,tobeusedfor
portfoliovaluation.
Forthenumbersgivenearlier,itwouldbecalculatedas:
[(Rs30+Rs50)2]less10%
i.e.Rs40less10%
i.e.Rs36

IfthelatestBalanceSheetofthecompanyisnotavailablewithinninemonthsfromthe
closeoftheyear,unlesstheaccountingyearischanged,thesharesofthecompanyareto
bevaluedatzero.

Valuation of unlisted equities is similar to valuation of thinlytraded and nontraded

equities,exceptforthefollowingdifferences:

Thenetworthpershareistobecalculatedontwobasis

o Thefirstbasisisthesameasdiscussedearlier.
o Inthesecondbasis,adjustmentistobemadeforoutstandingwarrantsandoptions.
Theamountreceivableagainsttheoutstandingwarrantsandoptionsisaddedtothe
numerator, while the number of new shares that would be issued is added to the
denominator.Onthisbasis,thenetworthisrecalculated.

Thelowerofthetwobaseswouldbeconsideredasthenetworthforfurthercalculation.

64
 Theadjustmentforilliquiditywouldbe15%,(insteadof10%inthecaseofthinlytraded
andnontradedequities).

If on the above basis, an individual security that is unlisted or nottraded or thinly traded
accountsformorethan5%ofthenetassetsofascheme,thenanindependentvaluerhasto
beappointedforitsvaluation.

Aggregate value of illiquid securities under a scheme (i.e. nontraded, thinly traded and
unlistedequityshares),cannotexceed15percentofthetotalassetsofthescheme.Any
illiquidsecuritiesheldabove15percentofthetotalassetsneedtobeassignedzerovalue.

Valuation of convertible debentures is done separately for the convertible and non
convertible portions the former is valued like equity; the latter is valued like debt. A
discountfactorcanbeappliedontheequity,becauseofnontradabilityoftheinstrument
untilconversion.

Warrantstosubscribeforsharesattachedtoinstrumentsarebevaluedatthevalueofthe
sharewhichwouldbeobtainedonexerciseofthewarrant,asreducedbytheamountwhich
would be payable on exercise of the warrant. Here again a discount for illiquidity can be
applieduntilthewarrantisexercised.

Untilrightssharesgettraded,theyarevaluedasperthefollowingformula:
VR=n/mx(PXRPOF)
Where
VR=Valueofrights
n/m=No.ofrightssharesentitled
[n=No.ofsharesheld;m=No.ofsharesthatwouldyield1rightsshare]
PXR=Exrightsprice
POF=RightsOfferPrice

Suppose,theschemeholds150equityshares.TheExRightspriceisRs25,andtherightsoffer
is1:3atRs15.

Therightswillbepricedat(1503)X(Rs25Rs15)i.e.Rs500.

Whereitisdecidednottosubscribefortherightsbuttorenouncethemandrenunciations
arebeingtraded,therightscanbevaluedattherenunciationvalue.

5.2. Debt

Moneymarketanddebtsecurities,includingfloatingratesecuritieshavetobevaluedatthe
valuation given by agencies entrusted for this purpose by AMFI. They are valued on
amortisationbasisiftheresidualmaturityisupto60days.

65
5.3. NonPerformingAssets(NPA)andProvisioningforNPAs
Assetsthathavelosttheirvalue,whollyorpartly,needtobewrittendownintheaccountsof
thescheme.ThisensuresthattheNAVprovidesarealisticassessmentoftheworthofeach
unitofthescheme.

SEBI has framed detailed regulations on recognition of assets as nonperforming, and

provisionforthoselossesintheaccountsofthescheme.

5.3.1. NPARecognition
Iftheinterestand/orprincipalamountisnotreceivedorremainsoutstandingforonequarter
fromthedaysuchincomeand/orinstalmentwasdue,thentheassetistoberecognisedas
NPA. The definition is to be applied one quarter after the due date of interest. Further,
interestaccrualwillstopaftertheexpiryofonequarterfromtheduedateofthedefaulted
interest.

Forexample,ifaninterestwasdueonJune30,2011,andremainsoutstanding,theassetwill
beclassifiedasNPAonOctober1,2011.InterestincomewillbeaccrueduptoSeptember30,
2011.Thereafter,theschemewillstopaccruingtheinterestincome.

5.3.2. ProvisionforLosses
Intheabovecase,onOctober1,2011fullprovisionneedstobemadefortheinterestthat
wasaccruedonJune30,2011thatremainsoutstanding.OnJanuary1,2012,fullprovision
would be made for interest that was accrued on September 30, 2011 and remains
outstanding.

Apartfromtheprovisioningforinterestincomethatwasdueandrecognisedasincomeinthe
accounts,thepotentiallossofprincipalamounttooistobeprovidedfor,eventhoughthe
amountmaynotbedue.Theprovisioningschedulehasbeenprescribedasfollows:

% of book Prescribedtimeperiod In the above
value to example
writeoff
10% 6monthsafterduedateofinterest January1,2012

20% 9monthsafterduedateofinterest April1,2012

20% 12monthsafterduedateofinterest July1,2012

25% 15monthsafterduedateofinterest October1,2012

25% 18monthsafterduedateofinterest January1,2013

66
Ifanyinstalmentisdueduringtheprovisioningperiod,thentheprovisioningwouldbeasper
theabovetable,orfortheentireinstalmentdue,whicheverishigher.

Inthecaseofcloseendedscheme,theaboveprovisioningistheminimum.Theschemewill
havetoprovidefortheentirebookvalueoftheasset,priortoclosureofthescheme.

Theprovisioningnormsarethesameforsecuredandunsecureddebtsecurities.

Deep Discount Bonds are classified as NPAs, if any two of the following conditions are
satisfied:

IftheratingoftheBondcomesdowntoGradeBB(oritsequivalent)orbelow.
Ifthecompanyisdefaultingintheircommitmentsinrespectofotherassets.
Networthisfullyeroded.

Provisioning schedule for principal in the case of deep discount bonds is the same as for
regularbonds.

IfthecreditratingfallstoD(i.e.default)thentheentirebookvalueistobeprovidedfor.

5.3.3. ReclassificationofAssetsandProvisionWriteback
NPAwillbereclassifiedasaperformingassetasfollows:

Whenthecompanyclearsallthearrearsofinterest,theinterestprovisionscan
bewrittenbackinfull.Further,theinterestthatwasnotaccruedearliercanbe
recognisedasincomebasedonreceipt.
Theassetwillbereclassifiedasperformingonclearanceofallinterestarrears,
andifthedebtisregularlyservicedoverthenexttwoquarters.
Theprovisionmadefortheprincipalamountcanbewrittenbackasfollows:

%ofprovisiontowrite Prescribedtimeperiod
back
100% End of 2nd calendar quarter, if only interest was in
default

Ifbothprincipal&interestwasindefault:

50% Endof2ndcalendarquarter

25% Endofeverysubsequentquarter

Itcanbereclassifiedas'standardasset'onlywhenboth,theoverdueinterestand
overdueinstalmentsarepaidinfullandthereissatisfactoryperformancefora
subsequentperiodof6months.

5.3.4. Disclosures
67
 Inthehalfyearlyportfoliostatement,NPAistobedisclosedsecuritywise.
The total amount of provisions made against the NPAs has to be disclosed in
additiontothetotalquantumofNPAsandtheirproportiontotheassetsofthe
MutualFundscheme.
Where the date of redemption of an investment has lapsed, the amount not
redeemedisshownasSundryDebtorsandnotinvestment.However,wherean
investmentisredeemablebyinstalments,itwillbeshownasaninvestmentuntil
allinstalmentshavebecomeoverdue.

5.4. Gold
GoldheldbyagoldexchangetradedfundschemeisvaluedattheAMfixingpriceofLondon
BullionMarketAssociation(LBMA)inUSdollarspertroyounceforgoldhavingafinenessof
995.0partsperthousand.Thisissubjecttothefollowing:

Adjustmentforconversiontometricmeasureasperstandardconversionrates;
Adjustment for conversion of US dollars into Indian rupees as per the RBI
reference rate declared by the Foreign Exchange Dealers Association of India
(FEDAI);and
Additionof

o Transportationandotherchargesthatmaybenormallyincurredinbringing
suchgoldfromLondontotheplacewhereitisactuallystoredonbehalfofthe
mutualfund;and
o Notional customs duty and other applicable taxes and levies that may be
normallyincurredtobringthegoldfromtheLondontotheplacewhereitis
actuallystoredonbehalfofthemutualfund;

Wherethegoldheldbyagoldexchangetradedfundschemehasagreaterfineness,
therelevantLBMApricesofAMfixingistakenasthereferenceprice.
Ifthegoldacquiredbythegoldexchangetradedfundschemeisnotintheformof
standardbars,ithastobeassayedandconvertedintostandardbarswhichcomply
withthegooddeliverynormsoftheLBMAandthereaftervalued.

5.5. RealEstateMutualFunds
AsdiscussedinChapter2,therealestateassetsheldbyamutualfundaretobevaluedat
costpriceonthedateofacquisition.Thiscomprisespurchasepriceandanyotherdirectly
attributable expenditure such as professional fees for legal services, registration expenses
andassettransfertaxes.

Ifthepaymentforarealestateassetisdeferred,itscostwouldbethecashpriceequivalent.
Theschemehastorecognisethedifferencebetweenthisamountandthetotalpaymentsas
interestexpenseovertheperiodofcredit.

Oneveryninetiethdayfromthedayofitspurchase,ithastobevaluedatitsfairprice.
68
Fair value means the amount for which an asset could be exchanged between
knowledgeablepartiesinanarmslengthtransactionandcertifiedbytherealestatevaluer.

Knowledgeablemeansthatboththebuyerandthesellerarereasonablyinformedaboutthe
natureandcharacteristicsoftherealestateasset,itsactualandpotentialuses,andmarket
conditionsatthebalancesheetdate.

Fair value specifically excludes an estimated price inflated or deflated by special terms or
circumstances such as atypical financing, sale and leaseback arrangement, special
considerationsorconcessionsgrantedbyanyoneassociatedwiththesale.

Whereaportionoftherealestateassetisheldtoearnrentalsorforcapitalappreciation,and
iftheportionscanbesoldorleasedseparately,therealestatemutualfundschemehasto
accountfortheportionsseparately.

69
 Exercise
MultipleChoiceQuestions
1. Equitysharesandequityrelatedsecurities(convertibledebentures,equitywarrantsetc.)
areconsideredtobethinlytraded,if______________.
a. iftradinginamonth(allrecognisedstockexchangesinIndiatogether)islessthanRs
5lakh
b. volumetradedislessthan50,000shares
c. Boththeabove
d. Neither(a)nor(b)

2. Illiquidsecuritiesheldabove15percentoftotalassetsneedtobeassignedzerovalue.
a. True
b. False

3. Moneymarketanddebtsecurities,includingfloatingratesecuritiesarevaluedinmutual
fundschemesonamortisationbasisiftheresidualmaturityisupto_______days.
a. 30
b. 45
c. 60
d. 90

4. Mutualfundsvaluedebtsecuritiesatvaluesgivenbyagenciesauthorisedforthepurpose
byAMFI.
a. True
b. False










Answers
1c,2a,3c,4a

70
 6. Accounting

LearningObjective
This Chapter explains how the net asset value (NAV) of a scheme is calculated, and the
variousaccountingrequirementsthathaveabearingonthesame.Italsodiscusseshow
unitholderstransactionsareaccountedinthescheme,aswellastheimpactofcorporate
actionsincompanieswheretheschemehasinvested.

6.1. NetAssetValue
AsdiscussedintheMFDWorkbook,NAVofaschemeisthevalueofeachunitofthescheme.
Everyschemehasabalancesheetviz.statementofassetsandliabilities,basedonwhichNAV
iscalculated.

The previous chapter explained how investments are valued in the scheme. Besides
investment,thebalancesheetofaschemeincludesvariousotheritems,suchas:

Liabilities

o UnitCapitalviz.NumberofunitsissuedbytheschemeXFacevalueofeach
unit(typicallyRs10).
o Reserves(RevenueReserve,UnrealisedAppreciationReserve,UnitPremium
Reserve& Income Equalisation Reserve) These capture the schemes
accumulated profits / losses, gains / losses in the schemes investment
portfolio, and the difference between the face value and price at which
investorstransacttheirunitswiththescheme.Thisisexplainedinthenext
section.
o Currentliabilities,whichwouldincludesundrycreditors(theamountpayable
oninvestmentspurchased),andexpensessuchascustodialfees,registrar&
transferfees,auditorsfees,trusteefees&managementfeesthathavebeen
accruedasanexpense,butnotyetpaid.

Assets

o Cashandmoneyinbank
o Currentassets,whichwouldincludesundrydebtors(theamountreceivableon
investmentssold),andincomesuchasdividendandinterestthathavebeen
accrued,butarenotyetreceived.
o Inthepast,schemeswerepermittedtoaccounttheinitialissueexpensesas
anexpense,overaperiodoftime.Thispractice,calleddeferredloadisno
longer permitted. However, some old schemes may continue to charge
deferredload.Initialissueexpensesthathavealreadybeenspent,butareyet
to be treated as an expense, are shown in the asset side as Expenses not
writtenoff.

71
Thetotalassetswouldequalthetotalliabilitiesofthescheme.Letusconsiderthefollowing
simplifiedexampleofaschemesbalancesheet:

Description Amount
(Rsincrore)

Liabilities

UnitCapital[100croreunitsofRs10each] 1,000

Reserves 500

Currentliabilities 50

TotalLiabilities 1,550

Assets
Investments(atmarketvalue) 1,490

Cash&Bank 20

CurrentAssets 40

TotalAssets 1,550

TheunitholdersfundsintheschemeareeffectivelytheUnitCapital&Reservesviz.Rs1,000
+Rs500i.e.Rs1,500crore.Thisvalue,dividedbythe100croreunitsgivestheNAVasRs15.

Suppose the investments were purchased at Rs 1,200crore. The Unrealised Appreciation

ReservewouldbeRs1,490Rs1,200i.e.Rs290crore.Assumetheotherreservescomprise
RevenueReservesRs175croreandUnitPremiumReserveofRs35crore.

If the next day, investments were to appreciate from Rs 1,490crore to Rs 1,530crore, an

additionalamountofRs40crorewouldgointoUnrealisedAppreciationReserve,takingitto
Rs290+Rs40i.e.Rs330crore.

Theunitholdersfundsinthe schemewillalsogoupbyRs40croretoRs1,540crore.This
value, divided by the 100crore unitsgives theNAV as Rs 15.40. Thus, theappreciation in
investmenttranslatesintoanincreaseintheNAV,althoughtheinvestmentshavenotbeen
sold.

Ifthefollowingday,investmentsweretoloseRs20croreinvalue,thenthemarketvalueof
investmentsandunrealisedappreciationreservewouldgodowntothesameextent.The
correspondingdeclineinunitholdersfundswilldragdowntheNAVtoRs15.20.
72

RevisionoftheinvestmentvalueinlinewithchangesinthemarketiscalledMarktoMarket
(MTM).OnaccountofMTM,theNAVcapturesthecurrentvalueofinvestmentsheldbythe
scheme.

6.2. InvestorTransactions
Inthepreviousexample,whereNAVwasRs15.00,theUnrealisedCapitalAppreciationwas
Rs290crore,whichamountstoRs0.29perunit.Theparvalueofeachunit,whichisincluded
intheUnitCapitalisRs10.ThebalanceportionoftheNAVviz.Rs15.00Rs10.00Rs0.29
i.e.Rs4.71canbesaidtorepresentincomethatisrealised.

6.2.1. SaleofNewUnits
Supposeaninvestorbought100unitsfromtheschemeatRs15.00perunit.Thetransaction
isaccountedasfollows:

BankaccountoftheschemewouldgoupbyRs15.00perunitX100unitsi.e.Rs
1,500.
UnitcapitalwillgoupbyRs10perunitX100unitsi.e.Rs1,000.
IncomeEqualisationReservewouldincreasebyRs4.71perunitX100unitsi.e.Rs
471.
UnitPremiumReservewouldincreasebyRs0.29perunitX100unitsi.e.Rs29.

TheincreaseinunitholdersfundsbyRs1,000+Rs471+Rs29i.e.Rs1,500,andissue
ofadditional100units,willkeeptheNAVatRs15.00.

Inthepast,schemescouldissueunitsatapricehigherthantheNAV.Thedifferencewas
calledentryload.Forinstance,iftheunitsweresoldatRs15.60theexcessoverNAVviz.Rs
0.60,istheentryload.Thiswouldgointoaseparateaccount,fromwhichtheAMCcould
meetsellingexpenses.Mutualfundsarecurrentlynotpermittedtochargeentryload.

6.2.2. RepurchaseofExistingUnits
Suppose an existing investor offers 50 units for repurchase at Rs 15.00 per unit. The
transactionisaccountedasfollows:

BankaccountoftheschemewouldgodownbyRs15.00perunitX50unitsi.e.
Rs750.
UnitcapitalwillgodownbyRs10X50unitsi.e.Rs500.
IncomeEqualisationReservewoulddecreasebyRs4.71perunitX50unitsi.e.Rs
235.50.
UnitPremiumReservewoulddecreasebyRs0.29perunitX50unitsi.e.Rs14.50.

ThedecreaseinunitholdersfundsbyRs500+Rs235.50+Rs14.50i.e.Rs750,andreduction
of50units,willkeeptheNAVatRs15.00.

73
Ifexitloadof1%isapplicable,thentheinvestorwillreceiveonlyRs15.00less1%viz.Rs14.85.
Earlier,thebalanceamountviz.Rs0.15perunitX50unitsi.e.Rs7.50wouldgointoaseparate
account,fromwhichtheAMCcouldmeetsellingexpenses.AspercurrentSEBIrequirements,
theexitloadamountneedstobewrittenbacktothescheme,thusbenefitingtheinvestors
whocontinueinthescheme.

Attheendoftheyear,thebalanceintheIncomeEqualisationReserveistransferredtothe
RevenueAccount.Itwouldbeshownseparatelyfromthenetincomefortheperiod(Income
onaccountofinterest,dividend,capitalgainsetc.lesstheschemeexpenses).Balanceinthe
Revenue Account after declaration of dividend becomes part of Revenue Reserves of the
scheme.

6.2.3. OtherAccountingPolicies
Dividendincomeearnedbyaschemeshouldberecognised,notonthedatethe
dividendisdeclared,butonthedatetheshareisquotedonanexdividendbasis.

Onlyforinvestmentsthatarenotquotedonthestockexchange,dividendincome
mustberecognisedonthedateofdeclaration.

Inrespectofallinterestbearinginvestments,incomemustbeaccruedonaday
todaybasisasitisearned.Theincomethatisaccruedbutnotyetreceivedwill
beshownasInterestRecoverableintheassetsideofthebalancesheet.

Whensuchinvestmentsarepurchased,interestpaidfortheperiodfromthelast
interest due date upto the date of purchase must not be treated as a cost of
purchase,butmustbedebitedtoInterestRecoverableAccount.

Similarlyinterestreceivedatthetimeofsale,fortheperiodfromthelastinterest
duedateuptothedateofsale,mustnotbetreatedasanadditiontosalevalue
butmustbecreditedtoInterestRecoverableAccount.

Transactionsforpurchaseorsaleofinvestmentsarerecognisedasofthetrade
dateandnotasofthesettlementdate.

In the case of purchase, it will be added to the investment portfolio, and the
amountpayablewouldappearinthebalancesheetunderSundryCreditors.

In the case of sale, the corresponding investment would be taken off the
portfolio,andtheamountrecoverablewouldbereflectedinthebalancesheet
underSundryDebtors.

Where investment transactions take place outside the stock market (e.g.
acquisitions through private placement or purchases or sales through private
treaty),thetransactionshouldberecordedintheeventofapurchase,asofthe
dateonwhichtheschemeobtainsanenforceablerighttoreceivethesecurity
purchasedandanenforceableobligationtopaytheprice.Intheeventofasale,

74
 it is recorded when the scheme obtains an enforceable right to collect the
proceedsofsaleandanenforceableobligationtodelivertheinstrumentssold.
Thecostofinvestmentsacquiredorpurchasedshouldincludebrokerage,stamp
chargesandanychargecustomarilyincludedinthebrokerscontractnote.
In respect of privately placed debt instruments any frontend discount offered
shouldbereducedfromthecostoftheinvestment.
Underwritingcommissionshouldberecognisedasrevenueonlywhenthereisno
devolvementonthescheme.Wherethereisdevolvementonthescheme,thefull
underwritingcommissionreceivedandnotmerelytheportionapplicabletothe
devolvementshouldbereducedfromthecostoftheinvestment.
Holding cost of investments for determining the capital gains / losses is to be
calculatedonaveragecostbasis.
Bonussharestowhichtheschemebecomesentitledshouldberecognisedonly
whentheoriginalsharesonwhichthebonusentitlementaccruesaretradedon
thestockexchangeonanexbonusbasis.
Rightsentitlementsshouldberecognisedonlywhentheoriginalsharesonwhich
therightentitlementaccruesaretradedonthestockexchangeonanexrights
basis.

6.3. DistributableReserves
Mutualfundschemesarepermittedtodeclareadividendoutofrealisedprofitsonly.Thus,
RevenueReserveandIncomeEqualisationReserveareavailablefordistributionasdividend.
However, dividend cannot be distributed from Unit Premium Reserve and Unrealised
AppreciationReserve.

6.4. UniqueAspectsofRealEstateSchemesAccounting
The following are a few unique aspects of accounting related to real estate mutual fund
schemes:

Therealestateassetshallberecognizedonthedateofcompletionoftheprocess
of transfer of ownership i.e. the date on which the real estate mutual fund
schemeobtainsanenforceablerightincludingallsignificantrisksandrewardsof
ownership.
Arealestatemutualfundschemeshallnotrecogniseinthecarryingamountofa
realestateasset,thecostsofthedaytodayservicingofsuchanasset.These
costsaretoberecognisedintherevenueaccountasanexpense.
Arealestatemutualfundschememayacquirepartsofrealestateassetsthrough
replacement. For example, the interior walls may be replacements of original
walls.

Therealestatemutualfundschemeshallrecogniseinthecarryingamountofareal
estateasset,thecostofreplacingpartofanexistingrealestateassetatthetimethat
costisincurred.Further,thecarryingamountofthosepartsthatarereplacedareto
beeliminatedfromtheassetsandshownintherevenueaccount.

75
 Rental income is accrued on a daily basis, till the currency of the lease
agreements.
Againorlossarisingfromachangeinthefairvalueoftherealestateassetisto
berecognisedintheRevenueAccountfortheperiodinwhichitarises.Thegain
thatarisesfromtheappreciationinthevalueofrealestateassetisanunrealised
gain,whichcannotbedistributedasdividend.
Ifpaymentforarealestateassetsoldisdeferred,theconsiderationreceivedis
recognized, initially at the cash price equivalent. The difference between the
nominal amount of the consideration and the cash price equivalent should be
recognisedasinterestrevenueovertheperiodofcredit.

76
 Exercise
MultipleChoiceQuestions
1. Whichofthefollowingareapartofunitholdersfundsinthescheme?
a. UnitCapital
b. UnitCapital&UnitPremium
c. UnitCapital&IncomeEqualisationReserve
d. UnitCapital,UnitPremium&IncomeEqualisationReserve

2. Dividendshouldberecognisedinthebooksoftheschemeon______________.
a. Exdividenddate
b. Bookclosuredate
c. Datedividendispaid
d. Datedividendisannounced

3. Frontenddiscountinaprivatelyplaceddebentureshouldberecognisedbytheschemeas
_________________.
a. Income,atthetimeofinvestment
b. Income,atthetimeofallotment
c. Income,spreadequallyovertenoroftheinstrument
d. Reductionfromthecostofinvestment

4. Rentalincomehastoberecognisedinamutualfundschemeon_______________.
a. Dateithasaccruedandbecomedue
b. Dateithasaccrued,evenifnotdue
c. Dateitisreceivedbythescheme
d. Datethelesseeconfirmspayment










Answers
1d,2a,3d,4b

77


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78
 7. Taxation

LearningObjective
This Chapter helps in understanding how taxation affects mutual fund schemes and
investorsinthoseschemes.

UndertheIncomeTaxAct,1961mutualfundsareexemptfromtax.However,theAMChas
topayataxonitsincome(managementfeesearnedfromtheschemeslessexpenseslikerent
andsalariesincurredinrunningtheoperations),likeanyothercompany.Thetaxframework
applicableformutualfundschemesandinvestorsisgivenbelow.

7.1. TaxesforAMCs
7.1.1. SecuritiesTransactionTax(STT)
Schemes pay thistaxontheirtransactionsinequityandequityrelated instrumentsinthe
market.Thetaxispayableatthefollowingrates:

Purchaseofequitysharesinarecognizedstock 0.1%ofvalueofsharesbought
exchange
Sale of equity shares in a recognized stock 0.1%ofvalueofsharessold
exchange
Sale of Derivatives (Futures) in a recognized 0.01%oftradevalue
stockexchange
Sale of Derivatives (Options) in a recognized 0.017%oftheoptionpremium
stockexchange
Iftheoptionisexercised 0.125%ofvalueofsharesbought

Sale of units of equity oriented fund by the 0.001% of repurchase price or sale
scheme that has invested in it to the mutual price
fundorinarecognisedstockexchange

7.1.2. IncomeDistributionTax
Debt Schemes need to pay this tax on the dividend they distribute to unitholders. The
applicableratesareasfollows:

Investors other than individuals 30% plus 12% surcharge plus 2%

andHinduUndividedFamily(HUF) Education Cess plus 1% Secondary &
HigherEducationCessi.e.34.608%

Investors who are Individuals & 25% plus 12% surcharge plus 2%
HUF Education Cess plus 1% Secondary &
HigherEducationCessi.e.28.84%

79
The income distribution tax does not vary with the marginal rate of taxation. Therefore,
individualsandHUFsinthehighertaxslabsmightfinditbettertoreceivetheirincomeas
dividend,onwhichtheeffectivetaxratewouldbelower.

Incomedistributiontaxisalsoapplicableoninvestmentsindebtschemesbyinvestors,who
arenototherwiseliabletotax.Suchinvestorsmightfindittaxefficienttoinvestinthegrowth
optionofdebtschemes.Theycanmeettheircashflowneedsbyofferingtheirunitsforre
purchase.Incomedistributiontaxisnotapplicableonrepurchases.

7.2. TaxesforInvestors
7.2.1. SecuritiesTransactionTax
Likeschemes,investorstoobearSTTontheirequityandequityrelatedinvestmentsatthe
ratesoutlinedinsection7.1.1.

7.2.2. Dividends
Dividendreceivedinthehandsofinvestorsisexemptfromtax.Dividendfromdebtschemes
entailsincomedistributiontax,asalreadyexplained.

SupposethattheNAVofanequityschemegoesupfromRs10toRs11.Iftheschemepays
outRe1asdividend,thenNAVoftheschemewouldgodowntoRs11Re1i.e.Rs10.The
NAVafterthedividenddistributioniscalledexdividendNAV.

InthesamesituationofNAVgoinguptoRs11,thedebtschemewillnotbeabletodeclare
Re1asdividend,becauseitalsoneedstoprovideforincomedistributiontax.

7.2.3. CapitalGains
Thedifferencebetweenthepriceatwhichtheinvestoracquiredtheunits,andthepriceat
whichtheyweresoldistaxedasacapitalgain.Iftheunitshavebeenheldformorethana
year(3yearsfornonequityschemes),itqualifiestobealongtermcapitalgain.Unitssold
afteraholdingperiodofuptoayear(3yearsfornonequityschemes)aretaxableasshort
termcapitalgain.

Thetaxtreatmentofsuchlongtermandshorttermcapitalgainsisdifferentforequityand
debtschemes:

EquitySchemes,wheretheinvestorhasborneSTTonthesaletransaction:

o Longtermcapitalgainsareexemptfromtax.
o Short term capital gains are taxable at 15% plus 5% surcharge plus 2%
EducationCessplus1%Secondary&HigherEducationCessi.e.16.2225%.

TheIncomeTaxAct,1961definesequityschemetobeaschemethatinvestsatleast65%of
itscorpusindomesticequities.Schemesthatdonotmeetthisrequirementwouldnotenjoy
thebenefitofnil/15%capitalgainstaxrate.
80
 Otherschemes(includingdebtschemes,ETFGoldSchemes)

o Theinvestorcantakethebenefitofindexation,inthecaseoflongtermcapital
gains.Thecostofacquisitionisadjustedforinflationbetweenthefinancial
yearinwhichtheunitswereacquired,andthefinancialyearinwhichtheyare
sold.Thesellingpriceminustheindexedcostofacquisitionistakenasthe
longtermcapitalgain,onwhichtaxwouldbepayableat20%(plussurcharge
andeducationcess).

Supposethattheinvestorbought100unitsatRs10onOctober1,2014.These
aresoldatRs13onOctober5,2017.ThegovernmenthasdeclaredtheCost
InflationIndextobe1024forfinancialyear201415.Supposeitis1300for
financialyear201718.

Sincetheholdingisformorethanayear,itwouldqualifyasalongtermcapital
gain.Taxcalculationsareasshowninthefollowingtable:

81




Iftheunitsarepurchasedondifferentdatesatdifferentprices,thenthecost
ofacquisitionfortheunitssoldisdeterminedonFirstinfirstout(FIFO)basis.

o Short term capitalgainsare added to the income of the investorand taxed
accordingly.Thus,taxationwoulddependonthetaxslaboftheinvestor.
Aninvestorwhodoesnothaveanyotherincomemayfindthattheshortterm
capitalgainsareexemptfromtax.Ontheotherhand,aninvestorinthehigher
taxslabmaypaytaxoncapitalgainsat30%plussurchargeandeducationcess.

7.2.4. SetoffandCarryForwardofLosses
Thediscussionsofarfocussedoncapitalgains.Theinvestormightalsobookaloss,which
maybelongtermorshortterm.Subjecttoconditions,thelosscanbesetoffagainstgains;
inthatcase,thetaxthatwouldotherwisehavebeenpayableonthegaincanbeavoided.If
thelossinafinancialyearismorethanthegaininthatyear,itcanbecarriedforwardforset
offagainstgainsinfutureyears.Thus,thelossinafinancialyearmayhelpinminimisingthe
capitalgainstaxinafuturefinancialyear.Thesetoffispermittedasfollows:

Capitallosscannotbesetoffagainstanyotherkindofincome.
Speculationlosscanonlybesetoffagainstspeculationprofit.Itcanbecarried
forwardfor4financialyears.
Shorttermcapitallosscanbesetoffagainstanycapitalgain,longtermorshort
term.Itcanbecarriedforwardfor8financialyears.
Longtermcapitallossistobesetoffonlyagainstlongtermcapitalgain.Itcan
becarriedforwardfor8financialyears.
Longtermcapitallossarisingoutofsaleofequityorequityorientedmutualfund
units (where STT has been paid) is not available for set off against any other
capitalgains.

7.2.5. DividendStripping
Supposeaninvestorbuysunitswithin3monthspriortotherecorddateforadividend,and
sellsthoseunitswithin9monthsaftertherecorddate.Ifthereisacapitalloss,thenthat
wouldnotbeallowedtobesetoffagainstothercapitalgainoftheinvestor,uptothevalue
ofthedividendincomeexempted.

7.2.6. BonusStripping
Supposeaninvestorbuysunitswithin3monthspriortotherecorddateforabonusissue,
andsellsthoseunitswithin9monthsaftertherecorddate.Ifthereisacapitallossonthe
saleoftheoriginalunits,thenthatwouldnotbeallowedtobesetoffagainstothercapital
gainoftheinvestor.Instead,suchcapitallosswouldbetreatedasthecostofacquisitionof
thebonusunits.

82
 Exercise
MultipleChoiceQuestions
1. SecuritiesTransactionTaxisapplicableon
a. EquitySchemes
b. EquitySchemes&Debtschemesotherthanliquidschemes
c. DebtSchemes
d. EquityandDebtschemes

2. Dividenddistributiontaxisapplicableat___%oninvestorsotherthanindividualsandHUFs
a. 12.5%
b. 25%
c. 30%
d. 20%

3. TheminimumholdingperiodforcapitalgainstoqualifyaslongterminthecaseofETF
Goldschemeis
a. 1year
b. 2years
c. 3years
d. 24monthsand1day

4. Longtermcapitallosscanbesetoffagainst
a. Longtermcapitalgain
b. Shorttermcapitalgain
c. Anyotherheadofincome,exceptspeculationgain
d. Alltheabove









Answers
1a,2c,3a,4a

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84
 8. InvestorServices

LearningObjective
This Chapter helps understand the processes underlying investment in NFO, openend
schemes,closedendschemesandETF.Italsodiscussesnominationandpledge.

8.1. NewFundOffer
In an NFO, besides the Official Points of Acceptance viz. offices of the AMC and RTA,
applicationsarealsoreceivedbycollectionbankersappointedbytheAMC.

DifferentpaymentoptionswerediscussedintheMFDWorkbook.Allpaymentinstruments,
includingthosereceivedbytheAMCandRTAarebankedwiththecollectionbankers.

The bankers certify the collections information. This is reconciled with the RTAs records.
AccordinglytheAMCproceedswiththeallotmentofunits.Theseactivitiesareconducted
duringthenotransactionperiodwhichisusuallyaperiodof5daysfromclosureoftheNFO.

Allotment formalities need to be completed and Statement of Accounts despatched to

investorswithin5daysfromNFOClosure.Extendedtimeframeisavailableforallotmentin
thecaseofELSSandRGESSschemes.

Thedateofallotmentiscalledinceptiondate.TheschemestartsdeclaringitsNAVfromthe
following day, which is also the day when openend schemes are opened for ongoing
transactions.

8.2. OpenendFund
The period when ongoing transactions are permitted in an open end scheme is called
continuousofferperiod.Itstartsfromthedayaftertheinceptiondate.

Duringthecontinuousofferperiod,saleandrepurchasetransactionshappenatNAVbased
prices.SinceintradaycutofftiminghasbeenspecifiedtodeterminetheapplicableNAV,
transactionrequests(forsaleorrepurchase)canonlybesubmittedattheOfficialPointsof
Acceptanceviz.officesoftheAMCandRTA.

Theofficesofbrokerswhomeetspecificconditions,qualifyasOfficialPointsofAcceptance.
Thetimeprintedinthecontractnotefromthestockexchangesystemistreatedasthetime
stamp.

Transactionslipssent along with the Statement of Accounts have the folio number of the
investorpreprinted.InvestorscanalsouseblanktransactionslipsavailableinofficesofAMC,
RTAanddistributors.

85
Basedonthetransactionrequests,thefollowingstepsareinitiated:

The Treasury department of the AMC is informed of the sale and repurchase
volume,sothattheycanplantheirinvestmentsordisinvestments.
The AMCs Fund Accounting department calculates the NAV, after considering
dayendportfoliovaluesandthedayssale/repurchasetransactions.Theday
endNAViscommunicatedtotheRTA.
BasedontheNAVinformation,theRTAproceedswiththecreditingofthenew
units(forsaletransaction)ordeductingtherepurchasedunitsfromthefolioof
theinvestor.

8.3. ClosedendFund
Closedend funds are listed in the stock exchange. Therefore, the investor will have to
approachabrokertotransactinthoseunits.Asrequiredbythestockexchangesystem,the
investorneedstohaveademataccountwhosedetailsareregisteredwiththebroker.

Iftheinvestorhasanonlinetradingaccountwiththebroker,thenhecanissuethebuy/sell
instructionthroughtheinternet.Inothercases,thebrokerwillenterthedetailsonbehalfof
theinvestor.Theinvestorcaneitherspecifyalimitpriceforthetransaction,orleaveitatthe
marketprice.

Thestockexchangetradingsystemwillmatchthebuy(orsell)orderswithsell(orbuy)orders
in the system. Wherever there is a match, the order execution information is sent to the
terminalsofthebrokerrepresentingthebuyerandthebrokerrepresentingtheseller.

Ifalimitpriceisgiven,theorderwillbeexecutedatapricebetterthanorequaltothelimit
pricei.e.,buytransactionwillbeexecutedatpriceslowerthanorequaltothelimitprice.Sale
orderswillbeexecutedatpriceshigherthanorequaltothelimitprice.Ordersthatremain
unexecutedattheendofthedaywilllapse.

Iftheorderisplacedwithoutalimitpricei.e.atthemarket,thenithasagreaterchanceof
beingexecutedi.e.theorderwouldnotlapseattheendoftheday.

Theinvestorwouldneedtomakepaymentforpurchasesorensurethattheunitsareavailable
inthedemataccountforthesales,asperthestockexchangesettlementsystem.Whenthe
stockexchangecompletesthepayout,investorswhohavesoldwillhavetheirmoneyand
investorswhohaveboughtwillhavetheirunitsintheirdemataccounts.

8.4. ExchangeTradedFund
TheETFtransactionsofinvestorswithbrokerswouldbesimilartowhathasbeenmentioned
earlierfortradinginclosedendschemes.ETFalsoreceiveandgivesecurities,postNFO,in
thecaseoflargeinvestors.Accordingly,newunitsareissuedorexistingunitsredeemed.The
stepsinvolvedinthiswerediscussedinChapter1.

86


8.5. Nomination
Theunitholderhasarighttonominateoneormorepersons(uptothree)inwhomtheunits
shallvestintheeventofhisdeath.

Wheretheunitsareheldbymorethanonepersonjointly,thenominationneedstobedone
bythejointunitholderstogether.

Thenominationcanbemadeonlybyindividuals applyingfor/holdingunitson theirown

behalfsinglyorjointly.Nonindividualsincludingsociety,trust,bodycorporate,partnership
firm,KartaofHinduUndividedfamily,holderofPowerofAttorneycannotnominate.
If the nominee is a minor, the name, address and signature of the guardian of the minor
nominee(s)istobeprovidedbytheunitholder.

Nomination can also be in favour of the Central Government, State Government, a local
authority,anypersondesignatedbyvirtueofhisofficeorareligiousorcharitabletrust.
TheNominee shallnotbeatrust (otherthanareligiousorcharitabletrust),society,body
corporate,partnershipfirm,KartaofHinduUndividedFamilyoraPowerofAttorneyholder.
AnonresidentIndiancanbeanomineesubjecttotheexchangecontrolregulationinforce,
fromtimetotime.

Nominationinrespectoftheunitsstandsrescindeduponthetransferofunits.

In case of multiple nominees, the percentage of allocation/share in favour of each of the

nominees should be indicated against their name and such allocation/share should be in
wholenumberswithoutanydecimalsmakingatotalof100percent.

Iftheaggregateislessthan100%,thenthebalancewillberebalancedtothefirstunitholder.
Iftheaggregateisgreaterthan100%thennominationwouldberejected.

Intheeventoftheunitholdersnotindicatingthepercentageofallocation/shareforeachof
thenominees,theMutualFund/AssetManagementCompanyshallsettletheclaimequally
amongstallthenominees.

Transfer of units in favour of Nominee(s) is a valid discharge by the Asset Management

Companyagainstthelegalheir.

Thecancellationofnominationcanbemadeonlybythoseindividualswhoholdunitsontheir
behalfsinglyorjointlyandwhomadetheoriginalnomination.

On cancellation of the nomination, the nomination shall stand rescinded and the ssset
managementcompanyshallnotbeunderanyobligationtotransfertheunitsinfavourofthe
Nominee(s).

87

TheformatofthenominationformisgiveninAnnexure8.1.

8.6. Pledge
Investorscanborrowmoneyagainstpledgeoftheirmutualfundunits.Thedocumentation
forborrowingvariesbetweendifferentlenders.

In order to mark the lien / pledge / hypothecation / charge on his mutual fund units, the
investorwillhavetosubmitarequesttothemutualfund,specifyinghisfolionumber,scheme
name,numberofunitstobecharged,andthepersoninwhosefavourthechargeistobe
created.Basedonthis,theRTAwillmarkthechargeinitsrecords.

Oncethechargeiscreated,theinvestorwillnotbeabletosellthoseunitsorofferthemfor
repurchase,thoughhecancontinuereceivingthedividend.

Inordertoreleasethecharge,thepersoninwhosebenefitthechargehasbeencreatedwill
havetoconfirm.Thereafter,theunitsareavailableforsale/repurchasebytheinvestor.

88
Annexure8.1

FORMFORNOMINATION/CANCELLATIONOFNOMINATION
(tobefilledinbyindividual(s)applyingsinglyorjointly)

NameoftheMutualFund:Date:DD/MM/YYYY

I/We,___________________,_____________________and__________________________
*doherebynominatetheperson(s)moreparticularlydescribedhereunder/and/cancelthe
nominationmadebyme/usonthe_______________dayof_______________inrespect
ofunitsheldbyme/usunderApplication/FolioNo.______________.(*Strikeoutwhichever
isnotapplicable)

Name Date Name Signature Proportion

and of and of (%)
Address Birth Address Guardian
of of
Nominee Guardian
(to be furnished in case
nomineeisminor)

Name and Address of SignatureofApplicant(s)
Applicant(s)

89
 Exercise
MultipleChoiceQuestions
1. InanNFO,applicationsarereceivedat___________.
a. OfficesofAMC
b. OfficesofAMCandRTA
c. BranchesofCollectionBanks
d. Alltheabove

2. Allotmentformalitiesneedtobefinalisedwithin___daysofclosureofNFO.
a. 10
b. 7
c. 5
d. 3

3. Inceptiondateis___________.
a. Dateissueislaunched
b. Dateofallotment
c. DateNAVbasedtransactionsstart
d. Datepriortodateofallotment

4. Unitholdercannominateupto___nominee(s).
a. 1
b. 2
c. 3
d. 5











Answers
1d,2c,3b,4c

90
 9. SchemeEvaluation

LearningObjective
ThisChapterdiscussesthequantitativeapproachestoevaluatingmutualfundschemes.

TheMFDWorkbookcoveredvariousqualitativeaspectsthatgointoevaluatingmutualfund
schemes, and recommending them to investors. The quantitative techniques to scheme
evaluationrevolvearoundmeasurementofriskandreturn,andtheircombinationaspartof
variousriskadjustedreturnframeworks.

9.1. MeasuresofReturn
Schemereturnscanbecalculatedinvariousways.Inordertoensurefairnessinthemarket,
SEBIhasissuedguidelinesonhowtheyshouldbedeterminedinvariousscenarios.

9.1.1. SimpleReturn
SupposetheNAVofaschemehasgoneupfromRs10toRs10.50,andithasnotdeclareda
dividend,thentheschemehasgeneratedareturnof{(Rs10.50Rs10)Rs10}X100i.e.5%.
Thisisthesimplereturn.

IftheschemehaddeclaredadividendofRs0.30perunit,thenthataspectofthereturnisnot
capturedintheabovecalculation.Withoutthedividendpayment,theNAVmighthavebeen
Rs10.80,insteadofRs10.50.Inthatcase,thesimplereturnwouldhavebeen{(Rs10.80Rs
10)Rs10}X100i.e.8%.Thissimplisticapproachofaddingbackthedividendcomponentin
theschemereturniscalledtotalreturn.

Mostschemeshaveagrowthoption,wheredividendisnotdeclared.Calculatingthesimple
returnbasedonNAVofthegrowthoptionofaschemeisasuperiorapproachascompared
tothetotalreturncalculationforthedividendoptionofthesamescheme.

While announcing their returns for periods shorter than a year, schemes are required to
disclosethesimplereturn.

9.1.2. AnnualisedReturn
Theaboveexampleof5%returnisgoodifitwasearnedduringa2monthperiod;butnotso,
ifitwasearnedoveranentireyear.Thiscontextoftimeperiodisintroducedinsimplereturn
calculationthroughannualisationviz.convertingthereturnintoitsannualequivalent.

If5%returnwasearnedover2months,thentheannualisedreturnwouldbe(5%2)X12
i.e.30%.Thesame5%returnearnedover6monthstranslatesintoanannualisedreturnof
(5%6)X12i.e.10%.

91
Whileannouncingtheirreturnsforperiodsshorterthanayear,liquidschemesarepermitted
to use annualised return, so long as the annualisation does not reflect an unrealistic or
misleadingpictureoftheperformanceorfutureperformanceofthescheme.

Thisflexibilityforliquidschemesisavailableifaperformancefigureisavailableforatleast7
days,15daysand30days.Inallothercasesofperiodsshorterthanayear,themutualfund
addsanasteriskafterthereturn,andthendisclosestheperiodtowhichthereturnpertains.

Forexample:
5%*
*Returnrelatesto2months

9.1.3. CompoundingofPeriodicReturns
Inordertocapturethefluctuationsinperformance,simplereturnsarecalculatedforaseries
of short, constant time periods (periodic returns). For instance, weekly returns may be
calculatedforayear.Theseperiodicreturnsarethenaveragedtoarriveatanaverageperiodic
return,whichinturniscompoundedtoarriveatanannualreturn.Thecompoundingisdone,
usingtheformula:
{(1+PeriodicReturn)No.ofPeriodsequivalenttoayear}1.

While working with weekly returns, 52 weeks will be equivalent to a year; in the case of
monthlyreturns,12monthswouldbeequivalenttoayear.

SupposetheclosingNAVon5consecutiveweeksisRs10.00,Rs10.05,Rs10.02,Rs10.15&Rs
10.20.Thecalculationswouldbeasshowninthefollowingtable:

92
9.1.4. CompoundedAnnualisedGrowthRate(CAGR)
This is the SEBIprescribed method of disclosing returns, by all schemes for time periods
longerthanayear.Here,thedividendsdeclaredduringtheperiodarepresumedtohave
beenreinvestedinthesameschemeattheexdividendNAV.Basedonthispresumption,
theclosingnumberofunitsiscalculated.Compoundedannualgrowthinwealthduringthe
period is calculated, using the compound interest formula viz. (Closing Wealth Opening
Wealth)(1/n)1,wherenisthetimeperiodinyears.

Supposeaninvestorbought120unitsinaschemeonJanuary1,2011atRs10perunit.On
April1,2011,theschemedeclareddividendofRs1perunit,afterwhichtheexdividendNAV
wasRs12perunit.OnApril6,2012,theschemedeclaredanotherdividendofRs1perunit,
afterwhichtheexdividendNAVwasRs13perunit.WhatistheCAGRfromJanuary1,2011
toApril6,2012?

Thecalculationsareshowninthefollowingtable:

OnApril1,2011,dividendofRe1perunitwouldhaveyieldedRs120onthe120unitsheld.
ReinvestingattheexdividendNAVofRs12wouldgiveRs120Rs12i.e.10additionalunits.
Thustheunitholdingwouldgoupto130.

OnApril6,2012,dividendofRs1perunitwouldhaveyieldedRs130onthe130unitsheld.
ReinvestingattheexdividendNAVofRs13wouldgiveRs130Rs13i.e.10additionalunits.
Thustheunitholdingwouldgoupto140.AttheexdividendNAVofRs13,theclosingwealth
wouldbe140XRs13i.e.Rs1,820.

n,thetimeperiodbetweenJanuary1,2011andApril6,2012,is461daysi.e.461365
years.Sincetheformulausestheterm1n,theactualtermappliedintheformulais(365
461).

TheCAGRduringtheperiodis(1,8201,200)(365461)1i.e.39.07%.

93
Aswithsimplereturn,thecalculationsgetsimplerifthegrowthoptionoftheschemeistaken
asthebase.Sincenodividendisdeclared,alltheintermediatecalculationscanbeavoided.

9.1.5. LoadAdjustedReturn
Ifexitloadof1%wasapplicable,theinvestorwouldgetonlyRs13less1%i.e.Rs12.87onre
purchase.Therealisationon140unitswouldbeRs1,802.TheCAGRfortheinvestorwould
be(1,8021,200)(365461)1i.e.37.96%.

The scheme announces its CAGR on the basis of NAV. However, the investor may have
investedathigherthanNAV(iftherewasanentryload).Similarly,investormayrecoverless
thanNAV(ifthereisanexitloadorContingentDeferredSalesCharge).Theinvestorsactual
returnwouldbeloweronaccountofsuchloads.

9.1.6. XIRR
TheCAGRapproachtocalculatingreturns,thoughtechnicallysound,cangetcumbersome
whendividendsaretobeconsidered.Theassumptionthateachdividendisreinvestedat
theexdividendNAVmakesitessentialtoknownotonlythedividendsdeclared,butalsothe
exdividendNAVaftereachsuchdividend.

AnalternateapproachisXIRRafunctionthatcanbeusedinMSExcel.Thesyntaxis=XIRR
(rangeofcellswherethecashflowsarelisted,rangeofcellswheretherespectivedatesare
listed).Outflows(investment)fromtheinvestorhavetobeshownasnegativecashflows,
whileinflows(dividend,repurchase)andclosingvaluefortheinvestorhavetobeshownas
positivecashflows.

Fortheearliercase,whereCAGRwascalculatedas39.07%,theXIRRcalculationsareshown
inthefollowingsnapshotoftheMSExcelspreadsheet.Thenumberofunitsremainsthe
samebecausedividendsarenotpresumedtobereinvested.

TheXIRRfunctionpresumesthatallthedividendswouldbereinvestedatthesameXIRRrate.
Since the reinvestment assumption is different, the calculated return too is different
(40.87%).

94
OfficialdocumentsoftheschemedisclosetheCAGR,becausethatismandatedbySEBI.The
markethoweverusesXIRRmorecommonly,becauseitiseasiertocalculate.

9.2. MeasuresofRisk
Two measures of risk are used in various riskadjusted return frameworks standard
deviationandbeta.Itwouldbetechnicallycorrecttousebetaonlyinthecaseofdiversified
equityschemes.Standarddeviationcanhoweverbeusedforallschemetypes.

9.2.1. StandardDeviation
The NAV of any scheme would keep fluctuating in line with changes in the valuation of
securitiesinitsportfolio.ThechangeinNAVofthegrowthoptionofaschemecapturesthe
schemesreturn,asalreadydiscussed.Thereturncanthusbecalculatedatdifferentpoints
oftime,keepingthetimeperiodconstant.

Intheexampleearlierusedforcompoundingofperiodicreturns,thestandarddeviationof
theperiodicreturnscanbecalculated,usingthe=stdevfunctioninMSExcel,asfollows:

Standarddeviationisastatisticalmeasureofhowmuchtheschemesreturnvariesbasedon
its own past standard. It is a measure of total risk in the scheme. Higher the standard
deviation,moreriskytheschemeis.

The standard deviation has been calculated above, based on weekly returns. 52 weeks
represent a year. Therefore, the standard deviation can be annualised by multiplying the
weeklynumberbythesquarerootof52[writteninexcelassqrt(52)].

Theannualisedstandarddeviationwouldthereforebe0.65Xsqrt(52)i.e.4.70%(rounded).

Whileworkingwithmonthlyreturns,thestandarddeviationwouldbemultipliedbysqrt(12);
inthecaseofdailyreturns,itwouldbemultipliedbysqrt(252),becausethereare252trading
daysinayear,afterkeepingoutthenontradingdays(Saturdays,Sundays,holidays).

9.2.2. Beta

95
Analternativeapproachtoviewingriskistoconsider,basedonpastdata,howsensitivethe
schemes returns are, to changes in returns on a benchmark i.e. for every 1% change in
benchmarkreturns,howmuchisthechangeintheschemesreturns?

Thisisdonebypickinguptheclosingvalueofthebenchmarkforthesame5weeksasabove,
andcalculatingtheweeklybenchmarkreturnsforWeeks2to5.Betacanbeeasilycalculated,
using the slope function in MS Excel, as shown in the following table with Sensex as the
benchmark:

Thismeansthatbasedonpastdata,theschemesreturnstendtochangeat1.22timesthe
changeintheSensexreturns.Thus,itismoreriskythantheSensex.

ApplicationofBetainthemarketsisbasedontheCapitalAssetsPricingModel,whichstates
thatsomerisks(nonsystematicrisk)canbediversifiedaway.Betaisameasureoftherisks
thatcannotbediversifiedaway(systematicrisk).

AschemethatislessriskythanthebenchmarkwouldbecharacterisedbyBetabeinglessthan
1.Sinceanindexfundmirrorstheportfolioofthebenchmarkittracks,indexfundshavea
Betacloserto1.

TheconceptofBetahasbeenexplainedusingweeklydata,thattooforonly5weeks.Betais
normally calculated using daily data for long time periods, even going up to 3 years.
Dependingonthetimeperiodandfrequencyofdata,differentpublicationssharedifferent
valuesofBetaforthesameschemeorstock.Interschemeevaluationshouldbebasedon
datathatisconsistentbetweenschemes.

9.3. BenchmarksandRelativeReturns
ThevariouskindsofreturnsdiscussedinPara9.1,focusedonthescheme.Thesearecalled
absolutereturns.Schemereturnscanalsobecomparedwithexternalbenchmarkssuchas
thebestschemeinthecategory,oraveragereturnsfortheschemecategory,oranindexthat
isrepresentativeoftheschemesportfolio.Suchcomparisonofaschemesreturns,relative
toitsbenchmark,iscalledrelativereturns.

96
BSEsSensexandNSEsNIFTYaregoodbenchmarksfordiversifiedequityportfolios,especially
thosethatfocusonlargecompanies.Midcapandsmallcapindicesoftheseexchangesare
suitableforschemeswhoseinvestmentstrategyistoinvestinmediumsizeandsmallsize
companies,respectively.Besides,severalsectoralindicesareavailableforsectorfunds.

ICICISecuritiesIBex,whichisbasedonthemostliquidgovernmentsecurities,isanindex
thatcanbeabenchmarkfordebtschemes.Dependingonthenatureofportfolio,schemes
canselectSiBex(13years),MiBex(37years)orLiBex(over7years).

CRISIL too has created various indices such as Liquid Fund Index, Balanced Fund Index,
CompositeBondFundIndex,MIPBlendedIndex&ShortTermBondFundIndex.Thesecan
bebenchmarksfordebtandhybridfunds.

Whenschemesarelaunched,theydisclosethebenchmarkthatisappropriate.
Whentheschemehasbeeninexistenceformorethan3years:

Performanceinformationistobeprovidedsinceinceptionandforasmanytwelve
monthperiodsaspossibleforthelast3years,suchperiodsbeingcountedfrom
thelastdayofthecalendarquarterprecedingthedateofadvertisement,along
withbenchmarkindexperformanceforthesameperiods.
PointtopointreturnsonastandardinvestmentofRs10,000isalsotobeshown
inadditiontoCAGRforaschemeinordertoprovideeaseofunderstandingto
retailinvestors.

Whenaschemesreturnisbetterthanthatofitsbenchmark,itissaidtohaveoutperformed
itsbenchmark.

Wheretheschemehasbeeninexistenceformorethanoneyearbutlessthanthreeyears,
performanceinformationistobeprovidedforasmanyastwelvemonthperiodsaspossible,
suchperiodsbeingcountedfromthelastdayofthecalendarquarterprecedingthedateof
advertisement,alongwithbenchmarkindexperformanceforthesameperiods.

Wheretheschemehasbeeninexistenceforlessthanoneyear,pastperformanceshouldnot
beprovided.

Forthesakeofstandardization,asimilarreturninINRandbywayofCAGRhastobeshown
forthefollowingapartfromtheschemebenchmarks:

EquitySchemes:SensexorNifty
Longtermdebtscheme:10yearGoISecurity
Shorttermdebtfund:1yearTBill

Whentheperformanceofaparticularmutualfundschemeisadvertised,theadvertisement
shall also include the performance data of all the other schemes managed by the fund
managerofthatparticularscheme.

97
Incasethenumberofschemesmanagedbyafundmanagerismorethansix,thentheAMC
maydisclosethetotalnumberofschemesmanagedby thatfundmanageralongwiththe
performancedataoftop3andbottom3schemes(inadditiontotheperformancedataofthe
scheme forwhich the advertisement is being made) managed by thatfund manager in all
performancerelatedadvertisement.However,insuchcasesAMCsshallensurethattrueand
fairviewoftheperformanceofthefundmanageriscommunicatedbyprovidingadditional
disclosures,ifrequired.

9.4. RiskadjustedReturns
Investorsneedtoconsiderbothriskandreturnintheirinvestmentdecisions.Thefollowing
examplesofriskadjustedreturnframeworksarebased,totheextentpossible,ontheearlier
examplewhereNAVfor5weekswasconsidered.Inreality,theevaluationisdonebasedon
dataoverlongtimeperiodsof1to5years.

9.4.1. SharpeRatio
SharpeRatiomeasurestheexcessreturnsthataschemehasearned,perunitofrisktaken.
Fortheexcessreturns,thebaseistakenasriskfreereturnviz.thereturnthatcanbeearned
byinvestingingovernment.ThereturnbasedonaTreasuryBillindexisoftenusedforthe
purpose.

Supposetheriskfreereturnis7%.Intheearlierexample,thecompoundedreturnonthe
schemewas29.47%,whiletheannualisedstandarddeviationwas4.70%.

SharpeRatiocanbecalculatedas(29.47%7%)4.70%,whichis4.78.ThisSharpeRatiohas
tobecomparedwiththeSharpeRatioforotherschemesofthesametype.Theschemewith
thehighestSharpeRatiohasgiventhebestreturnperunitofrisk(standarddeviation).

9.4.2. SortinoRatio
Theunderlyingprinciplehereisthatreturnsthatarebetterthanthestandardaregood,and
shouldnotbeviewedasarisk.Therefore,onlytheannualiseddownsidedeviationbased
onperiodswhentheschemereturnhasgonebelowtheminimumacceptablereturnistobe
considered.

Thus,SortinoRatio=(SchemeReturnRiskfreeReturn)DownsideDeviation.

AswithSharpeRatio,ahigherSortinoRatiomeansthattheschemeoffersabetterreturnper
unitofrisk.

9.4.3. TreynorRatio
Thistoomeasurestheexcessreturnperunitofrisk.UnlikeSharpeRatio,whichusesstandard
deviation,TreynorratiousesBetatomeasurerisk.

ThusTreynorRatio=(SchemeReturnRiskfreeReturn)Beta.

98
Intheearlierexample,Betawascalculatedtobe1.22.Thus,theTreynorRatiois(29.47%
7%)1.22,whichis0.18

Amongschemesofthesametype,theonewiththehighestTreynorRatioissuperior.
Since Beta measures only systematic risk, Treynor Ratio would be more appropriate for
diversifiedequityportfolios,wherethenonsystematicriskshavebeendiversifiedaway.

9.4.4. JensensAlpha
This is a measure of outperformance. It compares the actual scheme performance, with
what it ought to have been, given the risk in the scheme. This is calculated by using the
=interceptfunctioninMSExcel,asshownbelow:

Here,thefundmanagerhasoutperformedtotheextentof0.24%.Ifalphavalueisnegative,
itmeansthatthefundmanagerunderperformedi.e.earnedareturnlesserthanwhatshould
havebeenearned,giventherisktakeninthescheme.

JensensAlphatooshouldideallybeused,onlyforevaluatingdiversifiedequityportfolios.
Further, the reliability of the measure should be established through a statistical measure
calledRsquare.HighertheRsquarevalue,morereliableistheAlphameasure.

9.4.5. AppraisalRatio
SinceJensenAlphaconsidersonlysystematicrisk,itisdividedbythestatisticalmeasureof
nonsystemicrisktoarriveattheAppraisalRatio.
TheinclusionofnonsystematicriskinthedenominatormakesitpossibletouseAppraisal
Ratioforalltypesofmutualfundschemes.Highertheratio,betteristhescheme.

9.4.6. EugeneFama
Conceptually, it is like Jensen Alpha, with standard deviation as the measure of risk. It
measuresoutperformancebycomparingtheactualschemereturns,withthereturnsthat
oughttohavebeenearned,giventhestandarddeviationrisk.
99

Thereturnthatoughttohavebeenearnedcanbetakentobeequalto
RiskFreeReturn+
{(StandardDeviationofSchemeStandardDeviationofMarket)X(MarketReturnRiskFree
Return)}

Therelevantdatafromtheearlierexampleisreproducedbelow:

Substitutingthevaluesintheformula,thereturnoughttohavebeen
7%+{(4.70%2.62%)X(11.42%7%)}
i.e.14.92%.

Theschemereturnwas29.47%.TheEugeneFamais29.47%14.92%i.e.14.55%.
The positive number indicates outperformance. Higher the positive number, better the
scheme.

SinceEugeneFamausesstandarddeviation,whichisameasureoftotalrisk,itcanalsobe
usedforportfoliosotherthandiversifiedequityportfolios.

9.4.7. Modigliani&Modigliani(M2)
Inthisapproach,theschemereturnisadjustedtoreflectthedifferenceinstandarddeviation
betweentheschemeandthemarket.ThisM2valueoftheschemecanbedirectlycompared
tothemarketreturn.IftheM2valueisbetterthanthemarketreturn,thentheschemehas
outperformed.

TheM2valueisgivenbytheformula:

RiskFreeReturn+
100
{(SchemeReturnRiskFreeReturn)X
(StandardDeviationofMarketStandardDeviationofScheme)}

Substitutingthevaluesintheexample:
M2=7%+(29.47%7%)X(2.62%4.70%)
i.e.19.54%

Sincethisishigherthanthemarketreturnof11.42%,theschemehasdonebetterthanthe
market.

9.5. LimitationsofQuantitativeEvaluation
Quantitativeevaluationsarelargelybasedonhistoricaldata.Thepastmayormaynotrepeat
itself.Inparticular,thingswhichhaveneverhappenedearliercanhappen.AsNicholasTaleb
reasonsinTheBlackSwan,justbecausesomeonehasnotseenablackswan,itdoesnot
meanthatallswansarewhite.

Taleb argues thatsome of these highly improbableeventshave fat tails i.e. when these
eventshappen,thelossescanbeveryhigh.

Investingbasedonquantitativeevaluation,ignoringtheimprobableeventsthathavefattails,
canspelldisaster.Itisthereforeimportanttokeepaneyeonrisksthatarenonquantifiable
too,andconsidervarioussubjectivefactorswhiletakinginvestmentdecisions.

1Nassim Nicholas Taleb, The Black Swan: The Impact of the Highly Improbable, Penguin Books (2007)

101
 Exercise
MultipleChoiceQuestions
1. Whichofthefollowingisasoundmeasureforreturnsoverlongperiodsoftime?
a. Simplereturn
b. TotalReturn
c. AnnualisedReturn
d. CAGR

2. Over18months,thegrowthoptionofaschemehasgoneupfromRs10toRs16.How
muchistheCAGR?
a. 60%
b. 40%
c. [(1610)(1812)]1
d. [(1610)(1218)]1

3. AppraisalRatiocanonlybeusedinthecaseofdiversifiedequityschemes.
a. True
b. False

4. ___isasinglenumberforthescheme,whichcanbecomparedwiththemarketreturn.
a. SharpeRatio
b. TreynorRatio
c. EugeneFama
d. M2













Answers
1d,2d,3b,4d

102
 10. AssetClassesandAlternateInvestmentProducts

LearningObjective
ThisChapterprovidesahistoricalperspectiveonreturnandriskinequity,debtandgold.It
alsogetsintotypicalissuesthatgointosellingalternateinvestmentproducts.

10.1. HistoricalReturns
10.1.1. Equity
Equityisconsideredtobeagrowthasseti.e.mostofthereturnsareintheformofcapital
gainsandsignificantcapitallossesarealsopossible.

ThefollowingchartusestheBSESensexasabenchmarktomeasureequityreturns.Aswas
discussedintheMFDWorkbook,theBSESensexiscalculatedonthebasisofequitysharesof
30large,profitableandliquidcompaniesbelongingtoadiverserangeofsectors.Thus,the
returnsontheBSESensexareanindicatoroftheprofitabilityofthecreamofIndiancorporate
sector.

The graph shows the absolute returns for each year, as well as the compounded annual
growthratesinceJanuary1,1998.Outofthe15years,theabsolutereturnsarenegativein
5years.In2009,thereturnwasdown51%,butitrecoveredthefollowingyearby76%.In
2001and2004again,returnswereinexcessof70%.

103
Althoughtheannualreturnsareveryvolatile,thefluctuationintheCAGRismuchlesser.After
theinitial4years,theCAGRsinceJanuary1,1998ispositiveevenduringtheyearswhenthe
annualreturnsarenegative.Itisforthisreasonthatinvestmentinequitiesisadvisableonly
iftheinvestorhasalongtimehorizon.

10.1.2. Gold
Likeequity,goldisviewedasagrowthasset.TheannualreturnsandCAGRsinceJanuary2,
1979aredepictedinthefollowingchart.

GoldwasatapeakonJanuary1,1980.Thisexplainsthehighreturnof134%forthatyear.
Duringthe35years,evengoldhasearnednegativereturnsin7years,includingafallof22%
in1982and18%in2014.Ascomparedwithequity,theCAGRreturnsarelessvolatile,and
haveremainedat9%orhigherduringtheperiod.TheCAGRduringthelast35yearsis8.6%.

10.1.3. Debt
Debtisconsideredanincomeasset,becausealargepartofthereturnsindebtcomesoutof
interestincome.

However, like equity, debt too is traded in the market. Depending on the price of debt
securities in the market, there can be capital gains, or even capital losses. As already
discussed,theelementofcapitalgainorlossislowerinshortertermdebtsecurities.Thegain
orlossincreaseforlongertermdebtsecurities.

Theinterestratesthatbanksandothercompaniesofferontheirfixeddepositstoochanges
inlinewithmarketconditions.ThefollowingchartdepictstheannualreturnsandCAGRsince
197576,iftheinvestorinvestedin1yearfixeddepositswithbanks.

104
Sincefixeddepositreceiptsdonotgettradedinthemarket,depositorsdonotexperience
fluctuationinvalueoftheirfixeddeposits.Therefore,thegraphdoesnotshowanyinstances
of negativereturns.Yet, if they were toseek premature return of their deposit, they will
receiveareturnthatislowerthanwhatwascommittedwhentheyinitiatedthedeposit.

In199192and199596,thefixeddepositratehasgoneupto12%.Ithasalsogonedownto
4%in200304.

10.2. PerspectivesonAssetClassReturns
Investorsneedamixofassetsintheirportfolio.Thisiscalledassetallocation,a
topicthatisdiscussedinthenextChapter.
Themixofassetsshouldincludegrowthassetslikeequity,goldandrealestate,
aswellasincomeassetslikedebt.
Equityisanextremelyvolatileassetclass,andshouldbeconsideredonlyforlong
terminvestments.

The asset class returns discussed earlier in this chapter were based on annual returns,
consideringtheSensexvaluesatthebeginningofeachyear.Itispossibletotakeamuch
closerlookatchangeinequityvaluesduringtheyear,andassessthereturnsoverdifferent
timehorizons.Thefollowingchartpresentssuchaprofileofreturns,basedondailyvaluesof
theSensexsinceApril1,1991.

105

Clearly the maximum returns tapers down, as the holding period increases. The minimum
returns go up with the holding period, i.e. the downside risk is lower for longer holding
periods.Thecorridorbetweenthemaximumandminimumtherangegetsnarroweras
theholdingperiodincreases2.

Duringtheperiod,therewere4,830instancesof1yearrollingreturns.Thereturnsforsuch
1yearholdingperiodsvariedbetween56%and+263%.

Attheotherextreme,therewere247instancesof20yearrollingreturnsduringtheperiod
analysed.Thereturnsforsuch20yearholdingperiodswerewithinanarrowcorridorof7%
to15%.

ThesereturnsarebasedoninvestmentintheSensexviz.passiveinvestments.Itispossible
toearnhigherreturnsbasedonactiveinvestment.Somefactorstoconsiderinsuchactive
investmentwerediscussedinChapter4.

Afewaspectsofassetclassestonote:

Goldislessvolatilethanequity.Itdoeswellinsituationsofpoliticaloreconomicturmoil.
Thus,itisaneffectivehedgeagainstsituationswhenfinancialmarketsperformpoorly.

2SundarSankaran, Wealth Engine, Vision Books (2012)

106
 Realestateagainislessvolatile.Ittendstomovemoregradually,upordown,depending
on the economic cycles. A benefit of real estate is that it is possible to earn a rental
income,whichwillgoupastherealestatevaluesappreciate.Thus,itcanbebothagrowth
assetandanincomeasset.
Debtisanincomeassetadefensiveassettohaveinonesportfolio.

Attheturnofthecentury,fixeddepositinvestorswereworried.Thefixeddepositinterest
ratesweregoingdown.Asalreadydiscussed,wheninterestratesgodown,thevalueofdebt
securitiesgoup.Thisbenefitofcapitalappreciationhelpedevensomeofthegiltschemes
reportreturnsinexcessof20%,insomeoftheyears.

Thereisanimportantlessonfromthisexperience.Wheninterestratesaregoingdown,debt
investorsarebetteroffinvestinginsuitabledebtmutualfundschemes.Thisprotectsthem
fromaphenomenonwherefixeddepositinvestmentsyieldlowerandlowerinterestrates.

10.3. AlternateInvestmentProducts
Investors have a range of nontraditional investment options too. Some of these are
discussedinchapter1andsomearediscussedbelow.

10.3.1. CapitalProtectionOrientedSchemes
The MFD Workbook featured an introduction to these schemes. Such schemes are close
ended, and structured to ensure that the investors capital is protected. The capital
protectionisensuredthroughanyofthefollowingstructures:

Constant Proportion Portfolio Insurance (CPPI) The following example from the MFD
Workbookexplainstheconcept.

SupposeaninvestorinvestedRs10,000inacapitalprotectionorientedschemeof5years.If
5yeargovernmentsecuritiesyield7%atthattime,thenanamountofRs7,129.86investedin
5yearzerocoupongovernmentsecuritieswouldmaturetoRs10,000in5years.Thus,by
investingRs7,129.86in the 5yearzerocoupongovernmentsecurity,thescheme ensures
thatitwillhaveRs10,000torepaytotheinvestorin5years.

Afterinvestinginthegovernmentsecurity,Rs2,870.14isleftover(Rs10,000investedbythe
investor,lessRs7129.86investedingovernmentsecurities).Thisamountisinvestedinriskier
securitieslikeequities.Eveniftheriskyinvestmentbecomescompletelyworthless(arare
possibility),theinvestorisassuredofgettingbacktheprincipalinvested,outofthematurity
moneysreceivedonthegovernmentsecurity.

OptionBasedPortfolioInsurance(OPBI)

AswithCPPI,thecapitalprotectionisbasedoninvestmentinadebtsecurity.Thescheme
canusethebalanceamounttobuyoptionsonequities.

107
AsalreadyexplainedinChapter4,thebuyerofanoptionbearstheoptionpremiumexpense,
butdoesnothavetobearanylossarisingoutofanunfavourablemovementinthemarket.
Thus,theequityexposuredoesnotbearanylosses,beyondtheoptionpremium,whichisan
expensethatisknownwhentheoptionisbought.

Complex option trading strategies can also be used to hedge the equity portfolio on a
continuingbasis.

Investorsshouldunderstandthesourceofcapitalprotection.Attimes,thesearestructured
on the basis of investment in nongovernment securities. The credit risk involved in non
sovereignsecuritieswasdiscussedinChapter4.Schemeswherecapitalprotectionisbased
oninvestmentingovernmentsecuritiesarepreferableforinvestorswhoarelookingforthe
safety.

10.3.2. PortfolioManagementSchemes(PMS)
MutualFundsofferstandardisedschemestoinvestorsatlarge.Aninvestorinaschemeis
effectively buying into the schemes portfolio. He does not get a customised portfolio.
MutualfundschemesoperateunderthestrictregulationofSEBI.

PMSseektoofferacustomisedportfoliotoeveryinvestor.Theseareofferedintwoformats
discretionaryandnondiscretionary.

In a discretionary PMS, the fund manager individually and independently

managesthefundsofeachclientinaccordancewiththeneedsoftheclient.
Ontheotherhand,inanondiscretionaryPMS,theportfoliomanagermanages
thefundsinaccordancewiththedirectionsoftheclient.

PortfolioManagersofferingPMSneedtoregisterwithSEBI.Theyalsoneedtoexecutean
agreement,inwriting,witheachclient,clearlydefiningtheinterserelationshipandsetting
out their mutual rights, liabilities and obligations relating to the management of funds or
portfolioofsecurities.TheagreementhastocontainthedetailsasspecifiedinScheduleIV
oftheSEBI(PortfolioManagers)Regulations,1993.

SEBIhasprescribedaminimuminvestment(notjustaninvestmentcommitment)ofRs25
lakhforeachinvestorinaPMS.ManyPMSprovidersinsistonamuchhigherinvestment,
goinguptoafewcroresofrupeesinmanycases.

ThefeeschargeablebythePMSmanagercanbebasedonportfoliomanagedorthereturns
generated.Thestrictexpenselimitsprescribedformutualfundschemesarenotapplicable
forPMS.

AlthoughPMSarealsoregulatedbySEBI,theydonotoperateunderthestrictnormsthatare
applicableformutualfunds,asregardsportfolioconstruction,costs,disclosure,transparency,
governance etc. Therefore, the investor has a greater responsibility to ensure adequate
safeguardofhisinterests.

108
10.3.3. StructuredProductsandEquityLinkedDebentures
Chapter4featuredadiscussiononinvestmentandriskmanagementinthecontextofequity,
debtandderivatives.Thesecanbemixedinvariousformstocreatenewinstrumentsthat
arecalledstructuredproducts.

Forinstance,aninstrumentthatoffersareturnthatisequivalentto6%plusthedifference
(%)betweentheBrentOilPriceandtheNymexOilPrice,isacombinationofadebtinstrument
andanoilderivative.

Manyoftheseareinternationalproducts,whichareincreasinglybeingofferedinIndiatohigh
networthinvestors.Theminimuminvestmentrequirementisalsohigh.Sincetheseofferings
are not vetted by SEBI (and may not be required to be so vetted, if privately placed), the
investorneedstobeextracareful.Beforeinvesting,heneedstounderstandtheriskreturn
frameworkunderlyingtheinstrument,andthecapabilityoftheissuertofulfilcommitments
acrossallkindsofmarketsituations.

Inthelastfewyears,suchproductsarealsobeingissuedbyIndianNonBanking
Finance Companies, linked to Indian equity indices like the Nifty. A typical
structurewouldbea23yearzerocouponnote,wherethereturnislinkedtoa
diversifiedequityindex.TheseareotherwisecalledEquityLinkedDebenturesor
MarketLinkedDebentures.TheapplicableSEBIrequirementsareasfollows:
TheissuershouldhaveaminimumnetworthofRs100crore.
MinimuminvestmentlimitforanyinvestorisRs10lakh.
TheliberalSEBIregulationsforissueandlistingofdebtsecuritiesareapplicable
onlyiftheprincipalisguaranteed,
TheinstrumentneedstobecreditratedbyanyregisteredCreditRatingAgency.
It has to bear a prefix PPMLD denoting Principal Protected Market Linked
Debentures, followed by the standardized rating symbols for long/short term
debt.
TheOfferDocumentshouldincludeadetailedscenarioanalysis/valuationmatrix
showingvalue ofthesecurityunderdifferentmarketconditionssuchasrising,
stableandfallingmarketconditions.
A risk factor is to be prominently displayed that such securities are subject to
modelrisk,i.e.,thesecuritiesarecreatedonthebasisofcomplexmathematical
modelsinvolvingmultiplederivativeexposureswhichmayormaynotbehedged
andtheactualbehaviourofthesecuritiesselectedforhedgingmaysignificantly
differfromthereturnspredictedbythemathematicalmodels.
Similarly, a risk factor is to be prominently displayed stating that in case of
Principal/CapitalProtectedMarketLinkedDebentures,theprincipalamountis
subject to the credit risk of the issuer whereby the investor may or may not
recoverallorpartofthefundsincaseofdefaultbytheissuer.
The issuer has to ensure that the intermediary selling the instrument to retail
investorsisSEBIregulated.

109
 Theintermediaryhastoensurethatinvestorunderstandstherisksinvolved,is
capableoftakingtheriskposedbysuchsecuritiesanditshallsatisfyitselfthat
securitiesaresuitabletotheriskprofileoftheinvestor.
The intermediary has to provide anOffer Document to the investoreven if he
doesnotaskforit.
Theintermediaryhastoprovideassistancetotheinvestoronobtainingvaluation
information and provide guidance on exit loads, exit options, liquidity support
providedbytheissuerorthroughtheexchangeetc.

10.3.4. HedgeFunds
Aswouldbeclearfromthediscussionssofar,variousinvestmentoptionshavetheirunique
riskandreturncharacteristics.Mutualfundschemesmobilisemoneyfrominvestorsatlarge,
andinvesttheminsomeoftheseinvestmentoptions.Theinvestmentphilosophyofmutual
fundsschemesandthenatureofinvestmentstheymake,determinetheirunderlyingrisk.

Hedgefundsareahighriskvariantofmutualfundschemes.Theymobilisetheircapitalfrom
high networth investors. The risk is built into the scheme through one or more of the
followingfeatures:

Leveraging

Therole ofderivatives in building leveraged positions was covered inChapter 4. Another

formofleveragingisloans.

Supposeafundearns8%onitsinvestmentportfolio.Iftheexpenseratiois1%,thenthe
schemewouldreportaperformanceof8%less1%i.e.7%.

Now,considerasituationwhereaschemethathasunitcapitalofRs40,hasalsoborrowed
Rs60ataninterestrateof5%.Thereturnthattheschemehasearnedinexcessoftheinterest
cost on borrowed funds would go to those who have invested in the unit capital of the
scheme.Thishelpstheschemeboostitsperformance,asseenbelow:

110
 Case Case
1 2

Portfolio(Rs) 100 100

PortfolioReturn 8% 8%

ExpenseRatio 1% 1%

NetPortfolioReturn 7% 7%

NetPortfolioReturn(Rs) 7 7

UnitCapital(Rs) 100 40

Loan(Rs) 0 60

InterestonLoanat5% 0 3

SchemeReturn(Rs) 7 4

SchemeReturn 7% 10%
(%ofUnitCapital)
Thus,borrowing1.5timestheunitcapitalat5%interestratehashelpedtheschemeimprove
itsperformanceby3percentagepoints(whichis37X100i.e.43%higherthan7%).

Throughhigherleveraging,itispossibletoboosttheschemeperformanceevenmore.The
downside is that if the portfolio return is below the interest cost a distinct possibility in
bearishmarketsinterestpaymentswilldraintheunitcapital.Therefore,leveragingisahigh
riskapproachtoinvestments.

AsexplainedintheMFDWorkbook,mutualfundsinIndiaoperateunderstrictregulationson
theirborrowings.Therefore,wedonotseethiskindofstructureamongIndianmutualfund
schemes.But,someintermediariesofferhedgefundsonprivateplacementbasis,outside
themutualfundregulatoryframework.

ForeignCurrencyRisk

InternationalhedgefundsborrowfromlowinterestratecountrieslikeUSandJapan,toinvest
in the developing economies. This introduces foreign currency risk in the scheme. The
implicationsofsuchariskwerediscussedinChapter1.

Shortselling

Whenaninvestorhasboughtasecurity,heissaidtohavegonelongonthesecurity.The
maximumlosstheinvestorfacesisthepriceatwhichhehasboughtthesecurity.Shortselling
isanapproachwheretheinvestorsellsthesecurity,withthehopeofbuyingitbacklaterata
lowerprice.IfthesecurityissoldatRs100andboughtbackatRs80,theinvestorearnsRs
20pershare.
111

Theriskinshortsellingcomesoutofthepossibilityofthemarketgoingupafterthesecurity
has been sold. In the above example, if the investor is forced to buy back thesecurity at
Rs120,heendsuplosingRs20pershare.Higherthepriceatwhichthesecurityisbought
back,greaterwouldbetheloss.Thepotentiallossisinfinite.Thismakesshortselling,arisky
proposition.

Hedgefundsthatareprivatelyplacedwithhighnetworthinvestorsarebeyondthemutual
fundregulatoryframework.Theirstructuretooaddstotheriskelement.Therefore,investors
needtotakeextraprecautionsbeforetheyinvestinhedgefunds.

112
 Exercise
MultipleChoiceQuestions
1. Whichofthefollowingis/aregrowthassets?
a. Equity
b. Gold
c. RealEstate
d. Alltheabove

2. CapitalProtectionOrientedSchemesarealways______________.
a. Openended
b. Closeended
c. Intervalfunds
d. Exchangetradedfunds

3. Marketlinkeddebenturessufferfrommodelriskandcreditrisk.
a. True
b. False

4. Hedgefundsare_________.
a. Arbitragefunds
b. Lowriskfunds
c. Moderateriskfunds
d. Highriskfunds














Answers
1d,2b,3a,4d
113


THISPAGEHASBEENLEFTBLANK
INTENTIONALLY

114
 11. CasesinFinancialPlanning

LearningObjective
ThisChapterhelpsingainingexpertiseonpracticalaspectsoffinancialplanning.

FinancialPlanningwasdiscussedindetailinChapters11and12oftheMFDWorkbook.The
followingcaseswillgetyouacquaintedwiththeapplicationofsomeofthoseconceptsand
approaches. The cases given in this chapter are only indicative, to make candidates
comfortablewiththeformat.Thecasesinthefinalexaminationmayrelatetoanycontentin
theWorkbook.Somequestionsinthecaseswillrequirethecandidatetobeawareofpractical
aspectscoveredintheMFDWorkbooktoo.

Case1
TheXYfamilyhasinvestmentsofRs30lakhindebtandRs20lakhinequity.Recentlymarried,
soonaftertheygraduatedtogether,theysavedaftertax,Rs15lakhlastyear.Withattractive
salarythatbothearn,theyexpecttheirannualsavingstogoup20%everyyear.Theyplanto
investinthesamedebtequityratio.Thefinancialplannerexpectsaposttaxyieldof7%on
debtand15%onequity.Thefamilywouldliketogooffonaworldtourin4years.They
reckonthecurrentcostofthetourtobeUSD50,000(Rs50=1USD).Therupeeisexpected
togetweakerby3%p.a.,whileholidaycostsmayappreciate5%p.a.Theyalsowanttobuy
ahousein7years.ThecurrentcostoftheirpreferredhouseisRs1crore,whichisexpected
togoup10%p.a.(Assumeallsavingsareinvestedattheendoftheyear)

Q1WhatistheweightedaverageyieldexpectationfortheXYfamilyontheirportfolio?

a. 11%b.10.2%c.11.5%d.10.5%

Q2Ifthereturnexpectationsmaterialise,whatwouldbethevalueoftheircurrentportfolio
in4years?

a. Rs39lakhb.Rs35lakhc.Rs74lakhd.Rs82lakh

Q3Howmuchistheexpectedoutlayinfutureontheworldtour?

a. Rs34lakhb.Rs30lakhc.Rs28lakhd.Rs37lakh

Q4Ifnewsavingsarecompletelyusedfortheworldtourandotherluxuries,howequippedis
thecurrentinvestmentportfolioformeetingthecostofthehousein7years?

a. Completely inadequate b. Marginally inadequate c. Just about adequate d.

Comfortablycovered

115
Q5 How equipped is the investment portfolio created from existing and new savings, for
meetingthecostofthehousein7years?

a. Completely inadequate b. Marginally inadequate c. Just about adequate d.

Comfortablycovered

Q6Whatwouldbethevalueoftheportfoliocreatedfromnewsavings,attheendof3years,
iftheseareinvestedinthesamedebtequityratioandthereturnexpectationsmaterialise?

a. Rs41.4lakhb.Rs71.6lakhc.Rs110lakhd.Rs75.2lakh

Q7WhatshouldtheFPrecommendtotheXYfamilyregardingtheirassetallocationinthe
nextfewyears?

a. Maintain b. Consider increasing debt component c. Consider increasing the equity

componentd.cantsay

Q8WhatwouldaprudentFPsuggesttotheXYfamilyontheirfuturegoals?

a. Go on world tour immediately because costs will go up in future b. Consider

prioritisingthehousepurchasec.Avoidbuyingthehousebecauseitisanilliquidasset
d.Spendmorebecauseitwillboosttheeconomy

WorkingSpace

116
Case2
Aninvestorboughtunitsofaschemeasfollows:Feb5,2014500units@Rs12;Aug7,2014
600units@Rs13.Hesold600unitsatRs14onMarch2,2015.CostInflationIndexnumbers
are 201213 852; 201314 939; 201415 1024; 201516 1075 (assumption). Assume the
investorisin20%taxbracket.IgnoreSTT,Surcharge&EducationCess.

Q1Howmuchlongtermcapitalgaindidtheinvestorbookonthesale,iftheunitsrelatedto
equityscheme?

a. Rs1,000b.Rs100c.Rs200d.Rs500

Q2Howmuchshorttermcapitalgaindidtheinvestorbookonthesale,iftheunitsrelatedto
equityscheme?

a. Rs1,000b.Rs100c.Rs200d.Rs500

Q3Howmuchlongtermcapitalgaindidtheinvestorbookonthesale,iftheunitsrelatedto
debtscheme?

a. Nilb.Rs100c.Rs200d.Rs500

Q4Howmuchlongtermcapitalgaintaxwilltheinvestorhavetopay,iftheunitsrelatedto
equityscheme?

a. Rs150b.Rs100c.Rs200d.Nil

Q5Howmuchlongtermcapitalgaintaxwilltheinvestorhavetopay,iftheunitsrelatedto
debtscheme?

a. Rs150b.Rs100c.Rs50d.Nil

Q6Howmuchshorttermcapitalgaintaxwilltheinvestorhavetopay,iftheunitsrelatedto
equityscheme?

a. Rs15b.Rs10c.Rs20d.Nil

Q7Howmuchshorttermcapitalgaintaxwilltheinvestorhavetopay,iftheunitsrelatedto
debtscheme?

b. Rs15b.Rs10c.Rs220d.Nil

Q8FinancialPlannershouldadviseinvestortoselltheequityunitsonlyafter1monthsothat
taxisminimised.

a. Trueb.False

117
WorkingSpace

Answers:

Case1:

1b,2c,3a,4a,5d,6b,7c,8b

Case2:

1a,2b,3a,4d,5d,6a,7c,8b(marketcanmoveadverselyduringthemonth)

118
 12. EthicsandInvestorProtection

LearningObjective
ThisChapterhelpsincreatingawarenessaboutvariousformsofmissellingofmutualfunds
andsystemicsafeguardsbuiltfortheirprevention.Italsofacilitatesunderstandingofthe
roleofmutualfundsinprotectionagainstfraudsandscams.

Ethicsisimportantforanyrelationshiptosurviveandbusinesstoflourish.Itisforthisreason
thatSEBIandAMFIhavetakenvariousstepstoensureethicalconductinthemutualfund
industry.

12.1. CodeofConduct
The MFD Workbook discussed this. Given the importance, the same is reiterated in this
section.

12.1.1. AMFICodeofEthics(ACE)
TheAMFICodeofEthicssetsoutthestandardsofgoodpracticestobefollowedbytheAsset
Management Companies in their operations and in their dealings with investors,
intermediariesandthepublic.

SEBI (Mutual Funds) Regulation, 1996 requires all Asset Management Companies and
TrusteestoabidebytheCodeofConductasspecifiedintheFifthScheduletotheRegulation.
The AMFI Code has been drawn up to supplement that schedule, to encourage standards
higherthanthoseprescribedbytheRegulationsforthebenefitofinvestorsinthemutual
fundindustry.Annexure3.1oftheMFDWorkbookhasthedetails.

WhiletheSEBICodeofConductlaysdownbroadprinciples,theAMFIcodeofethics(ACE)
setsmoreexplicitstandardsforAMCsandTrustees.

12.1.2. AMFIsCodeofConductforIntermediariesofMutualFunds
AMFIhasalsoframedasetofguidelinesandcodeofconductforintermediaries,consisting
ofindividualagents,brokers,distributionhousesandbanksengagedinsellingofmutualfund
products.TheCodeofConductisdetailedinAnnexure3.2oftheMFDWorkbook.SEBIhas
madeitmandatoryforintermediariestofollowtheCodeofConduct.

IntheeventofbreachoftheCodeofConductbyanintermediary,thefollowingsequenceof
stepsisprovidedfor:

Write to the intermediary (enclosing copies of the complaint and other

documentaryevidence)andaskforanexplanationwithin3weeks.

119
 In case explanation is not receivedwithin 3 weeks, or if the explanation is not
satisfactory, AMFI will issue a warning letter indicating that any subsequent
violationwillresultincancellationofAMFIregistration.
Ifthereisaprovedsecondviolationbytheintermediary,theregistrationwillbe
cancelled,andintimationsenttoallAMCs.Theintermediaryhasarightofappeal
toAMFI.

12.1.3. GuidelinesforCirculationofUnauthenticatedNews
SEBI has issued guidelines to all market intermediaries relating to circulation of
unauthenticated news through various modes of communication. Following are the
guidelinesstipulatedbySEBI:
Proper internal code of conduct and controls should be put in place by market
intermediariesregisteredwithSEBI.Employees/temporarystaff/voluntaryworkers
etc.employed/workingintheofficesofmarketintermediariesshouldnotencourage
or circulate rumours or unverified information obtained from client, industry, any
tradeoranyothersourceswithoutverification.
AccesstoBlogs/Chatforums/Messengersitesetc.shouldeitherberestrictedunder
supervisionoraccessshouldnotbeallowed.
Logs for any usage of such Blogs/ Chat forums/ Messenger sites (called by any
nomenclature)havetobetreatedasrecordsandthesameshouldbemaintainedas
specifiedbytherespectiveRegulationswhichgoverntheconcernedintermediary.
Employeesshouldbedirectedthatanymarketrelatednewsreceivedbythemeither
intheirofficialmail/personalmail/blogorinanyothermanner,shouldbeforwarded
only after the same has been seen and approved by the concerned Intermediary's
Compliance Officer. If an employee fails to do so, he/she shall be deemed to have
violatedthevariousprovisionscontainedinSEBIAct/Rules/Regulationsetc.andshall
beliableforaction.TheComplianceOfficershallalsobeheldliableforbreachofduty
inthisregard.

12.2. Misselling
Misselling is not defined in the Act. However, every instance where an investor is told
somethingthatisnottrue,withtheintentionofinfluencinghimtobuytheproductwould
qualifyasmisselling.Similarly,convincinganinvestortobuyaproductthatisnotappropriate
forthepersonsriskprofileisacaseofmisselling.

Thefinancialplanningapproachisthebestsafeguardfortheinvestor.Whenproductsare
soldbasedonriskprofileoftheinvestorandhisassetallocation,heavoidsbuyingproducts
thatarenotsuitableforhim.

SEBIhascomeoutwithvariousstepstocontrolmisselling.Forinstance,itwasfoundthat
investorsweregettinginfluencedtochurntheirinvestmentportfoliofrequently.Investors
wouldoftenexittheirinvestmentsinexistingschemes,toinvestinNFOs.Whiletheinvestor
wouldbeartheload,intermediariesearnedattractivecommission,paidoutoftheseloads.
SEBIthereforeputanendtothepracticeofcharginganentryload.Thislimitedtheselling
commissions,andchurnininvestorsportfolios.
120

SEBIhasalsoprescribeddetailedguidelinesoninformationdisclosure.Forinstance,ascheme
cannotdemonstratea2%returnin1week,andonthatbasisclaimthattheannualisedreturn
isover100%.Howreturnistobecalculatedfordifferentkindsofschemesanddifferenttime
periodshavebeenspecified.ThiswascoveredintheMFDWorkbook.

Investmentpolicy,assetallocation,returns,risketc.areexplainedintheOfferDocumentsof
schemes.Investorsshouldreadthesamebeforeinvesting.

By separating the Scheme Information Document (SID) from the Statement of Additional
Information(SAI),SEBIhasmadeiteasierforinvestorstoaccessandunderstandthesalient
featuresofeachscheme.Awellinformedinvestorisinabetterpositiontoprotecthimself.
CutofftimingshavebeenprescribedfordeterminingtheNAVthatwouldbeapplicableon
investmentsandredemptionsduringtheday.Thisprotectslayinvestorsfromanymischief
createdbyunethicalinvestors,seekingtobreakthesystem.

Attimes,investorsgetswayedbyrebatingviz.commissionpassedbacktotheinvestors.They
investdependingonthecommissionpassedon,ratherthanthequalityoftheinvestmentand
itssuitability.Therefore,intermediariesweretoldtostopthepracticeofrebating.

When schemes were missold as a shortterm tool to benefit from a planned dividend
distribution,SEBIclampeddownonthepractice.TheCentralGovernmenttoochangedthe
taxlaws.Theyspecifiedaminimuminvestmentholdingperiodforinvestorstosetofftheir
capital loss against other capital gains. Dividend stripping provisions were discussed in
Chapter7.

Asdiscussedinthenextsection,soundlegalstructurewithchecksandbalancesisaneffective
safeguardforinvestorprotection.

Intermediariesneedtoensurethatclientsinterestandsuitabilitytotheirfinancialneedsis
paramount,andthatextracommissionorincentiveearnedshouldneverformthebasisfor
recommendingaschemetotheclient.

12.3. SafeguardsinMutualFundStructure
Besides the measures mentioned earlier to prevent misselling and protect investors, the
mutualfundstructure,withitsinbuiltchecksandbalancesareasourceofimmensecomfort
forinvestors.ThelegalstructurewasdiscussedindetailintheMFDWorkbook.Thefollowing
safeguardsmaybenoted:

While the day to day activities are handled by the AMC, the trustees are
responsible for exercising control over the AMC. This is an additional layer of
control,beyondtheoverallregulationbySEBI.
TheCustodianisanentityindependentoftheAMC.Ithandlesthereceiptand
deliveryoftheschemesinvestmentsandkeepsataboncorporateactionssuch
asbonusanddividend.
121
 Theinvestmentsareheldinthenameoftheindividualschemes.Thisensures
thatinvestorsintheschemeearnthereturnsthatareduetothem.
Transfers of investments between schemes need to be at market value. This
prevents any mischief of transferring profits or losses from one scheme to
another.

12.4. RegulatoryStepsforProtectingInvestorsagainstFraud
SEBIandAMFIhavetakenseveralstepstoprotectinvestorsagainstfraud.Thefollowingare
somemeasurestakentoaddresstherisksininvestorserviceprocesses:

12.4.1. ThirdPartyPayments
MutualFundshavebeenaskedtoensurethatpaymentforinvestmentsismadeoutofthe
bankaccountofoneofthepersonswhoismentionedasanapplicantforthoseunits.Third
partypaymentsareacceptedonlyinexceptionalcases.Forinstance,paymentbyparents/
grandparents/ related Persons on behalf of a minor in consideration of natural love and
affectionorasgiftforavaluenotexceedingRs50,000/foreachregularpurchaseorperSIP
instalment. Related Person means any person investing on behalf of a minor in
consideration of natural love and affection or as a gift. In such cases persons who make
paymentshouldbeKYCCompliantandsignThirdPartyDeclarationForm.Similarly,employer
makingpaymentsonbehalfofemployeethroughpayrolldeductions,andcustodianonbehalf
ofFIIsarepermittedthirdpartypayments.AMCsarerequiredtoputchecksandbalancesin
placetoverifysuchtransactions.Thisensuresthatchequesdonotgetmisappropriatedby
anyoneinthesystem.

12.4.2. BankMandates
Investors, who are individuals, can register upto 5 bank accounts with the AMC, and also
indicate one of them as a default bank account. Dividend and redemption payments are
directlycreditedtotheinvestorsdefaultbankaccount.Thisisnotonlyfasterandconvenient
fortheinvestor,butalsoeliminatestheriskofstolencheques.Wheredirectcreditisnot
possible,dividendandredemptionchequeshavetomentionthedefaultbankaccount.This
preventsfraudulentencashmentofcheques.

Theinvestorcaneasilychangethedefaultbankaccounttooneoftheotherregisteredbank
accounts.Ifanewbankaccountistoberegistered,theinvestorhasprovidecompletedetails,
includingbankname,branchname,MICR(whereapplicable),IFSCcode(whereapplicable),
account number and type of account. The investor has to also submit a cancelled blank
chequetoenableverificationofthebankdetails.

12.4.3. ThirdPartyRedemptions
Redemptionrequestsneedtobesignedaspertheaccountoperatinginstructionsregistered
withtheAMC.ThisensuresthatredemptionrequestsarenotfraudulentlymadetotheAMC
orRTA.

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Redemption moneys are paid through direct credit to the registered bank account, or by
chequesthatmentionthedefaultbankaccountnumber.

12.4.4. KYC
TheKYCrequirementswerediscussedintheMFDWorkbook.Thisnotonlypreventsmoney
laundering, but also ensures that investors are not cheated through any fraudulent
investmentfollowedbyredemption.

The SEBI initiative for Centralised KYC Registration Agencies has made the KYC process
convenient for financial market investors, while ensuring proper recording of investor
informationandinpersonverificationofinvestors.

12.4.5. ChangeofAddress
ThisisdonethroughaKYCUpdateFormthathastobesubmittedtoCVLalongwithrequisite
documents.CVLinturninformstheRTA.Thisaddressestheriskofafraudstersiphoningthe
moneyoftheinvestorbychangingtheaddressrecordsforthefolio.

12.4.6. PowerofAttorney
Incasetransactionsaretobedoneunderapowerofattorney,theneithertheoriginalpower
ofattorneyoranotarisedcopyhastobefiledwiththeAMC.Ithastocontainthesignature
ofboththeinvestorandtheattorney.

12.4.7. KYD
TheregulatorshavealsobroughtinKnowYourDistributor(KYD)requirements.Thus,allthe
detailsofthedistributor,includingfingerprintisavailableatacentralplace.
The unique features of mutual fund structure and processes have ensured the highest
standardsofprotectionformutualfundinvestors.

12.4.8. DueDiligenceofDistributors
AMCsareexpected toperform due diligenceof distributors who fulfil one or more of the
followingcriteria:

Multiplepointpresence(Morethan20locations)
AUMraisedoverRs100Croreacrossindustryinthenoninstitutionalcategorybut
includinghighnetworthindividuals(HNIs)
CommissionreceivedofoverRs1crorep.a.acrossindustry
CommissionreceivedofoverRs50LakhfromasingleMutualFund

At the time of empanelling distributors and during the period i.e. review process, Mutual
Funds/AMCshavetoundertakeaduediligenceprocesstosatisfyfitandpropercriteriathat
incorporate,amongstothers,thefollowingfactors:

Businessmodel,experienceandproficiencyinthebusiness.

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 Recordofregulatory/statutorylevies,finesandpenalties,legalsuits,customer
compensationsmade;causesfortheseandresultantcorrectiveactionstaken.
Reviewofassociatesandsubsidiariesonabovefactors.
Organizationalcontrolstoensurethatthefollowingprocessesaredelinkedfrom
salesandrelationshipmanagementprocessesandpersonnel:

i)Customerrisk/investmentobjectiveevaluation.
ii) MF scheme evaluation and defining its appropriateness to variouscustomer risk
categories
iii)Inthisrespect,customerrelationshipandtransactionsaretobecategorizedas:

Advisorywhereadistributorrepresentstoofferadvicewhiledistributing
theproduct,itissubjecttotheprincipleofappropriatenessofproductsto
that customer category. Appropriateness is defined as selling only that
productcategorizationthatisidentifiedasbestsuitedforinvestorswithina
definedupperceilingofriskappetite.Noexceptioncanbemade.
ExecutionOnlyincaseoftransactionsthatarenotbookedasadvisory,it
stillrequires:
i)Ifthedistributorhasinformationtobelievethatthetransactionisnot
appropriateforthecustomer,awrittencommunicationistobemadeto
the investor regarding the unsuitability of the product. The
communicationhastobedulyacknowledgedandacceptedbyinvestor.

ii) A customer confirmation to the effect that the transaction is

executiononlynotwithstandingtheadviceofinappropriatenessfrom
that distributor is to be obtained prior to the execution of the
transaction.

iii)Onallsuchexecutiononlytransactions,thecustomerisnotrequired
to pay the distributor anything other than a standard flat transaction
charge.

Nothirdcategorizationofcustomerrelationship/transactionispermitted.

While selling Mutual Fund products of the distributors
group/affiliate/associates, the distributor has to make disclosure to the
customerregardingtheconflictofinterestarisingfromthedistributorselling
suchproducts.

12.4.9. ComplianceandRiskManagementFunctionsofDistributors
Thefollowingdefinedmanagementprocessesaretobereviewed:

Thecriteriatobeusedinreviewofproductsandtheperiodicityofsuchreview.
Thefactorstobeincludedindeterminingtheriskappetiteofthecustomerand
theinvestmentcategorizationandperiodicityofsuchreview.
Review of transactions, exceptions identification, escalation and resolution
processbyinternalaudit.

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 Recruitment, training, certification and performance review of all personnel
engagedinthisbusiness.
Customeronboardingandrelationshipmanagementprocess,servicingstandards,
enquiry/grievancehandlingmechanism.
Internal/externalauditprocesses,theircomments/observationsasitrelatesto
MFdistributionbusiness.
Findingsofongoingreviewfromsamplesurveyofinvestors

Thus, SEBI has taken various measures to ensure that mutual funds are a secure form of
investmentforinvestors.

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 Exercise
MultipleChoiceQuestions
1. AMFICodeofEthicsismeantfor
a. AMCs
b. Distributors
c. Investorsinmutualfunds
d. Alltheabove

2. Rebatingisthepracticeof
a. Sellingduplicateunitcertificates
b. SellingunitsatadiscounttoNAV
c. Sellingunitsthroughthenet
d. Passingondistributorcommissiontoinvestors

3. ChangeofAddressrequestisrequiredtobesubmittedto
a. AMC
b. Distributor
c. RTA
d. CVL

4. Individualscanregisterupto___bankaccountswiththeAMC.
a. 2
b. 3
c. 4
d. 5











Answers
1a,2d,3d,4d

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127
ListofAbbreviations

A/A ArticlesofAssociation
ACE AMFICodeofEthics
AMC AssetManagementCompany
AMFI AssociationofMutualFundsinIndia
AML AntiMoneyLaundering
ARN AMFIRegistrationNumber
ASBA ApplicationSupportedbyBlockedAmount
CAGR CompoundedAnnualGrowthRate
CDSC ContingentDeferredSalesCharge
CFT CombatingFinancingofTerrorism
CVL CDSLVenturesLtd
DD DemandDraft
DDT DividendDistributionTax(AdditionalTaxonIncomeDistribution)
DP DepositoryParticipant
ECS ElectronicClearingService
F&O Futures&Options
FCNR ForeignCurrencyNonResidentaccount
FEMA ForeignExchangeManagementAct,1999
FII ForeignInstitutionalInvestor
FIRC ForeignInwardRemittanceCertificate
FMP FixedMaturityPlan
HUF HinduUndividedFamily
ISC InvestorServiceCentre
KIM KeyInformationMemorandum
KYC KnowYourCustomer
MBanking MobileBanking
MF MutualFund
MicroSIP SIPwithannualaggregateinvestmentlessthanRs50,000
NAV NetAssetValue
NBFC NonBankingFinanceCompany
NEFT NationalElectronicFundsTransfer
NFO NewFundOffer
NOC NoObjectionCertificate
NPA NonPerformingAsset
NRE NonResidentExternalaccount
NRI NonResidentIndian
NRO NonResidentOrdinaryaccount
PAN PermanentAccountNumber
PDC PostDatedCheques
PFM PensionFundManager
PFRDA PensionFundRegulatory&DevelopmentAuthority
128
 PIO PersonofIndianOrigin
PMLA PreventionofMoneyLaunderingAct
PoA PowerofAttorney/ PointsofAcceptance,dependingoncontext
POP PointsofPresence
RBI ReserveBankofIndia
RTA Registrars&TransferAgents
RTGS RealTimeGrossSettlement
SAI StatementofAdditionalInformation
SEBI Securities&ExchangeBoardofIndia
SID SchemeInformationDocument
SIP SystematicInvestmentPlan
SRO SelfRegulatoryOrganisation
STP SystematicTransferPlan
STT SecuritiesTransactionTax
SWP SystematicWithdrawalPlan
SWIFT SocietyforWorldwideInterbankFinancialTelecommunication
VCF VentureCapitalFund
VCU VentureCapitalUndertaking

129
ReadingList

BogleJohnC,"BogleonMutualFunds",DellPublishing
BogleJohnC,"CommonSenseonMutualFunds",JohnWiley&Sons
Fredman&Wiles,"HowMutualFundsWork",PrenticeHall
GibsonRogerC,AssetAllocationBalancingFinancialRisk,TataMcGrawHill
IncomeTaxReadyReckoner(Latest)
JacobsBruce,"AllaboutMutualFunds",ProbusPublishing
MutualFundsGuide2012,ValueResearch
PozenRobertC,"TheMutualFundBusiness",TheMITPress
RowlandMary,"TheNewCommonsenseGuidetoMutualFunds",VisionBooks
SadhakH,"MutualFundsinIndia",ResponseBooks/SagePublications
SEBI,InvestorGrievancesRights&Remedies
ScottDavidL,HowtoManageYourInvestmentRisksandReturns,VisionBooks
SundarSankaran,"IndianMutualFundsHandbook",VisionBooks(2012)
SundarSankaran,WealthEngine:IndianFinancialPlanning&WealthManagement
Handbook,VisionBooks(2012)

BrowsingList
AMFI(www.amfiindia.com)
BSE(www.bseindia.com)
CredenceAnalytics(www.credenceanalytics.com)
CRISIL(www.crisil.com)
Lipper(www.lipperweb.com)
MorningStar(www.morningstar.com)
NSE(www.nseindia.com)
RBI(www.rbi.org.in)
SEBI(www.sebi.gov.in)MutualFundsSection
ValueResearch(www.valueresearchonline.com)

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