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Knowledge Corner

Mutual Fund Investing-I

A mutual fund is a professionally managed type of collective investment scheme that pools money from many investors and invests it in stocks, bonds, short-term money market instruments and other securities. Mutual funds have a fund manager who invests the money on behalf of the investors by buying / selling stocks, bonds etc. Currently, the worldwide value of all mutual funds totals more than $US 26 trillion. There are various investment avenues available to an investor such as real estate, bank deposits, post office deposits, shares, debentures, bonds etc. A mutual fund is one more type of Investment Avenue available to investors. There are many reasons why investors prefer mutual funds.
Buying shares directly from the market is one way of investing. But this requires spending time to find out the performance of the company whose share is being purchased, understanding the future business prospects of the company, finding out the track record of the promoters and the dividend, bonus issue history of the company etc. An informed investor needs to do research before investing. However, many investors find it cumbersome and time consuming to pore over so much of information, get access to so much of details before investing in the shares. Investors therefore prefer the mutual fund route. They invest in a mutual fund scheme which in turn takes the responsibility of investing in stocks and shares after due analysis and research. The investor need not bother with researching hundreds of stocks. It leaves it to the mutual fund and it’s professional fund management team.
Another reason why investors prefer mutual funds is because mutual funds offer diversification. An investor’s money is invested by the mutual fund in a variety of shares, bonds and other securities thus diversifying the investor’s portfolio across different companies and sectors. This diversification helps in reducing the overall risk of the portfolio. It is also less expensive to invest in a mutual fund since the minimum investment amount in mutual fund units is fairly low (Rs. 500 or so). With Rs. 500 an investor may be able to buy only a few stocks and not get the desired diversification. These are some of the reasons why mutual funds have gained in popularity over the years. Indians have been traditionally savers and invested money in traditional savings instruments such as bank deposits. Against this background, if we look at approximately Rs. 7 lakh crores1 which Indian Mutual Funds are managing, then it is no mean an achievement. A country traditionally putting money in safe, risk-free investments like Bank FDs, Post Office and Life Insurance, has started to invest in stocks, bonds and shares – thanks to the mutual fund industry. However, there is still a lot to be done. The Rs. 7 Lakh crores stated above includes investments by the corporate sector as well. Going by various reports, not more than 5% of household savings are channelized into the markets, either directly or through the mutual fund route.
Not all parts of the country are contributing equally into the mutual fund corpus. 8 cities account for over 60% of the total assets under management in mutual funds. These are issues which need to be addressed jointly by all concerned with the mutual fund industry. Market dynamics are making industry players to look at smaller cities to increase penetration. Competition is ensuring that costs incurred in managing the funds are kept low and fund houses are trying to give more value for money by increasing operational efficiencies and cutting expenses. As of today there are around 40 Mutual Funds in the country. Together they offer around 1051 schemes2 to the investor.
Mutual Funds in India follow a 3-tier structure. There is a Sponsor (the First tier), who thinks of starting a mutual fund. The Sponsor approaches the Securities & Exchange Board of India (SEBI), which is the market regulator and also the regulator for mutual funds. Not everyone can start a mutual fund. SEBI checks whether the person is of integrity, whether he has enough experience in the financial sector, his networth etc. Once SEBI is convinced, the sponsor creates a Public Trust (the Second tier) as per the Indian Trusts Act, 1882. Trusts have no legal identity in India and cannot enter into contracts, hence the Trustees are the people authorized to act on behalf of the Trust. Contracts are entered into in the name of the Trustees. Once the Trust is created, it is registered with SEBI after which this trust is known as the mutual fund. It is important to understand the difference between the Sponsor and the Trust. They are two separate entities. Sponsor is not the Trust; i.e. Sponsor is not the Mutual Fund. It is the Trust which is the Mutual Fund. The Trustees role is not to manage the money. Their job is only to see, whether the money is being managed as per stated objectives. Trustees may be seen as the internal regulators of a mutual fund.
This is the role of the Asset Management Company (the Third tier). Trustees appoint the Asset Management Company (AMC), to manage investor’s money. The AMC in return charges a fee for the services provided and this fee is borne by the investors as it is deducted from the money collected from them. The AMC’s Board of Directors must have at least 50% of Directors who are independent directors. The AMC has to be approved by SEBI. The AMC functions under the supervision of it’s Board of Directors, and also under the direction of the Trustees and SEBI. It is the AMC, which in the name of the Trust, floats new schemes and manages these schemes by buying and selling securities. In order to do this the AMC needs to follow all rules and regulations prescribed by SEBI and as per the Investment Management Agreement it signs with the Trustees. If any fund manager, analyst intends to buy/ sell some securities, the permission of the Compliance Officer is a must.
A compliance Officer is one of the most important persons in the AMC. Whenever the fund intends to launch a new scheme, the AMC has to submit a Draft Offer Document to SEBI. This draft offer document, after getting SEBI approval becomes the offer document of the scheme. The Offer Document (OD) is a legal document and investors rely upon the information provided in the OD for investing in the mutual fund scheme. The Compliance Officer has to sign the Due Diligence Certificate in the OD. This certificate says that all the information provided inside the OD is true and correct. This ensures that there is accountability and somebody is responsible for the OD. In case there is no compliance officer, then senior executives like CEO, Chairman of the AMC has to sign the due diligence certificate. The certificate ensures that the AMC takes responsibility of the OD and its contents.
A custodian’s role is safe keeping of physical securities and also keeping a tab on the corporate actions like rights, bonus and dividends declared by the companies in which the fund has invested. The Custodian is appointed by the Board of Trustees. The custodian also participates in a clearing and settlement system through approved depository companies on behalf of mutual funds, in case of dematerialized securities. In India today, securities (and units of mutual funds) are no longer held in physical form but mostly in dematerialized form with the Depositories. The holdings are held in the Depository through Depository Participants (DPs). Only the physical securities are held by the Custodian. The deliveries and receipt of units of a mutual fund are done by the custodian or a depository participant at the instruction of the AMC and under the overall direction and responsibility of the Trustees. Regulations provide that the Sponsor and the Custodian must be separate entities.
The role of the AMC is to manage investor’s money on a day to day basis. Thus it is imperative that people with the highest integrity are involved with this activity. The AMC cannot deal with a single broker beyond a certain limit of transactions. The AMC cannot act as a Trustee for some other Mutual Fund. The responsibility of preparing the OD lies with the AMC. Appointments of intermediaries like independent financial advisors (IFAs), national and regional distributors, banks, etc. is also done by the AMC. Finally, it is the AMC which is responsible for the acts of its employees and service providers. As can be seen, it is the AMC that does all the operations. All activities by the AMC are done under the name of the Trust, i.e. the mutual fund. The AMC charges a fee for providing its services. SEBI has prescribed limits for this. This fee is borne by the investor as the fee is charged to the scheme, in fact, the fee is charged as a percentage of the scheme’s net assets. An important point to note here is that this fee is included in the overall expenses permitted by SEBI. There is a maximum limit to the amount that can be charged as expense to the scheme, and this fee has to be within that limit. Thus regulations ensure that beyond a certain limit, investor’s money is not used for meeting expenses.
Once the three tier structure is in place, the AMC launches new schemes, under the name of the Trust, after getting approval from the Trustees and SEBI. The launch of a new scheme is known as a New Fund Offer (NFO). We see NFOs hitting markets regularly. It is like an invitation to the investors to put their money into the mutual fund scheme by subscribing to its units. When a scheme is launched, the distributors talk to potential investors and collect money from them by way of cheques or demand drafts. Mutual funds cannot accept cash. (Mutual funds units can also be purchased on-line through a number of intermediaries who offer on-line purchase / redemption facilities). Before investing, it is expected that the investor reads the Offer Document (OD) carefully to understand the risks associated with the scheme.
Registrars and Transfer Agents (RTAs) perform the important role of maintaining investor records. All the New Fund Offer (NFO) forms, redemption forms (i.e. when an investor wants to exit from a scheme, it requests for redemption) go to the RTA’s office where the information is converted from physical to electronic form. How many units will the investor get, at what price, what is the applicable NAV, how much money will he get in case of redemption, exit loads, folio number, etc. is all taken care of by the RTA.
The investor has to fill a form, which is available with the distributor. The investor must read the Offer Document (OD) before investing in a mutual fund scheme. In case the investor does not read the OD, he must read the Key Information Memorandum (KIM), which is available with the application form. Investors have the right to ask for the KIM/ OD from the distributor. Once the form is filled and the cheque is given to the distributor, he forwards both these documents to the RTA. The RTA after capturing all the information from the application form into the system sends the form to a location where all the forms are stored and the cheque is sent to the bank where the mutual fund has an account. After the cheque is cleared, the RTA then creates units for the investor. The same process is followed in case an investor intends to invest in a scheme, whose units are available for subscription on an on-going basis, even after the NFO period is over.
Some of the Rights and Obligations of investors are:-
Investors are mutual, beneficial and proportional owners of the scheme’s assets. The investments are held by the trust in fiduciary capacity (The fiduciary duty is a legal relationship of confidence or trust between two or more parties). ¨ In case of dividend declaration, investors have a right to receive the dividend within 30 days of declaration.
  • On redemption request by investors, the AMC must dispatch the redemption proceeds within 10 working days of the request. In case the AMC fails to do so, it has to pay an interest @ 15%. This rate may change from time to time subject to regulations.
  • In case the investor fails to claim the redemption proceeds immediately, then the applicable NAV depends upon when the investor claims the redemption proceeds.
  • Investors can obtain relevant information from the trustees and inspect documents like trust deed, investment management agreement, annual reports, offer documents, etc. They must receive audited annual reports within 6 months from the financial year end.
  • Investors can wind up a scheme or even terminate the AMC if unit holders representing 75% of scheme’s assets pass a resolution to that respect.
  • Investors have a right to be informed about changes in the fundamental attributes of a scheme. Fundamental attributes include type of scheme, investment objectives and policies and terms of issue.
  • Investors can approach the investor relations officer for grievance redressal. In case the investor does not get appropriate solution, he can approach the investor grievance cell of SEBI. The investor can also sue the trustees. The offer document is a legal document and it is the investor’s obligation to read the OD carefully before investing.
The OD contains all the material information that the investor would require to make an informed decision. It contains the risk factors, dividend policy, investment objective, expenses expected to be incurred by the proposed scheme, fund manager’s experience, historical performance of other schemes of the fund and a lot of other vital information. It is not mandatory for the fund house to distribute the OD with each application form but if the investor asks for it, the fund house has to give it to the investor. However, an abridged version of the OD, known as the Key Information Memorandum (KIM) has to be provided with the application form.
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