Mutual Funds - Chapter 3

Mutual Funds - Chapter 3

Why are mutual funds important in any market? That is because not all investors have the ability, skills and the resources to invest directly in the stock market and create a diversified portfolio. Quite often, investors are averse to taking the risk directly or do not have the time for the same. That gap is filled by mutual funds.

Key Concepts Pertaining To Mutual Funds

  • Asset Management Company (AMC): is the specialist institution that manages the mutual fund on behalf of the investors. For example, HDFC AMC manages the funds with its team of fund managers for all the schemes of HDFC Mutual Fund.
  • Mutual fund Units: It is the total corpus subdivided by the face value. Normally, Mutual Fund NFOs are issued with face value of Rs.10, which was the case with the Kotak Pioneer Fund NFO. In that case an investment of Rs.5,000 would have resulted in 500 units of Rs.10 face value being allotted. Of course, the actual units will be lower as the issue expenses will be debited to the initial value of the fund.
  • Net Asset Value (NAV) is the most important concept and is the market value of corpus (adjusted for costs) and divided by the number of outstanding units. NAV is announced by the fund on a daily basis. NAV is calculated on MTM value.
  • Total Expense Ratio (TER): refers to all the administrative, transaction and legal charges to be debited to the cost. In case of Regular Plans, the TER includes the selling expenses and trail commission also.
  • Exit Loads: This is not included in the TER and is a kind of penalty that is charged to investors if they exit before 1 year in the case of equity funds.

Mutual Fund Categories

  • Open ended versus closed ended: Open ended funds allow fresh investment and redemption at any point of time. Closed ended funds open at NFO and end at the end of the tenure. After that, closed ended funds can be bought and sold in secondary market.
  • Equity funds versus Debt Funds: This is based on the asset mix of the fund. A fund is classified as an equity fund if the exposure to equity is more than 65%. Debt funds hold debt predominantly but long dated debt. A fund holding short dated debt is a liquid fund.
  • Active Funds versus passive funds: Active funds are those where fund managers make conscious decisions on what to buy and what to sell. Passive funds like index funds are just benchmarked to an index like Sensex or Nifty and calibrated accordingly.

Key Players In The Mutual Fund Set Up

A mutual fund does not run with investors and fund managers alone. Here are  other key players.

  • Custodian the institution that directly services the mutual fund. The custodian holds the investments on behalf of the mutual fund and does all the stock market settlement of funds and securities on behalf of the mutual fund. E.g. Deutsche, HDFC Custody etc.
  • Registrar & Transfer Agent maintains and services investor records. The R&T agent accounts for and processes the purchases, redemptions, switches, SIP, STP, SWP as well as the corporate actions pertaining to the fund. E.g. CAMS and Karvy Computershare.
  • Distributors play a very important role in creating new markets for the mutual fund products and also servicing these markets with appropriate services and products. Distributors are paid commissions by the fund and billed to regular plans of MFs.
  • Brokers are also referred to as the institutional brokers and they execute buy and sell transactions on behalf of the mutual fund. Such brokers charge a commission and also offer algorithm trading. Brokers also give research support to mutual funds.

Types of Mutual Fund Products

Mutual funds can be classified into 5 broad categories.

  1. Equity Funds: are predominantly into equity shares and are considered higher on the risk scale. Equity funds can be further subdivided into large cap funds, mid cap funds, small cap funds, multi-cap funds, sector funds, thematic funds etc.
  2. Debt Funds: Debt funds are predominantly invested in fixed income instruments and can either be liquid funds at the short end or income funds at the long end. Debt funds are further classified into G-Sec funds, income funds, credit opportunity funds, dynamic funds, floating rate funds etc.
  3. Hybrid Funds: Hybrid funds are a mix of equity and debt or a hybrid of equity and derivatives. Hybrid funds come in the form of equity balanced funds with a bigger share in equity, MIPs with a bigger share in debt and arbitrage funds that arbitrage the spread between equity and derivatives.
  4. Other Funds: This includes the miscellaneous fund categories like index funds, exchange traded funds (ETFs), gold funds, gold ETFs, fund of funds (FOF), REITs etc. These are normally passive in nature but gold and REITS can also be active.
  5. Goal based funds: These are a unique category of funds as per the SEBI classification and are directed towards specific goals like retirement, children’s education etc. These goal based funds are normally structured as fund of funds (FOFs). FOFs invest in a portfolio of mutual funds and are most commonly used by goal based funds.

Understanding KYC In Mutual Funds

Completing your know-your-client (KYC) formalities is mandatory before you invest in mutual funds. KYC can be done at SEBI authorized centres and requires the following documents.

  • Proof of Identity (passport, license, Aadhar card, Voter card etc)
  • Proof of address (passport, Aadhar, electricity bill, land line bill, water bill etc)
  • Copy of the PAN card
  • Copy of cancelled cheque

The investor can self-attest the above documents and submit for KYC. However, they must carry originals with them for verification with originals.  It is also possible to invest in mutual funds using E-Aadhar based KYC authentication but the online process has to be followed by in person verification (IPV). However, investments up to Rs.50,000 can be done without PAN.

Purchase / Redemption / Switch Transactions

There are 3 types of transactions that investors and fund holders conduct with mutual funds and can be summarized as under:

Purchase transactions

This entails an application to purchase units of a mutual fund either through the new fund offering (NFO) or through the secondary purchase from the MF. Application for purchase can be made in terms of number of units or in terms of purchase amount.

Redemption transactions

Redemption refers to withdrawing the investment made in a mutual fund by selling the units back to the mutual fund. While closed ended funds can be sold in the exchange, open ended funds can be redeemed with the fund at a price based on NAV.

Switch transactions

Switch refers to a rule based switch from one fund to another (equity to debt) or from one options to another (growth to dividend) or from one plan to another (regular to direct). Such switch transactions are treated as normal buy and sell transactions only.

Systematic Transacting In Mutual Funds: SIP, SWP AND STP

Transactions with mutual funds that can automated in a time bound manner are known as systematic transactions. Broadly, there are 3 kinds of systematic transactions that you can do with a mutual fund.

Systematic Investment Plans (SIP)

SIPs enable investors to invest a fixed sum periodically into a mutual fund scheme on a fixed date. This is normally done each month. SIPs have the advantage of syncing your outflows with income. They also offer rupee cost averaging which reduces your acquisition cost.

Systematic Withdrawal Plans (SWP)

SWPs allow investors to make periodic redemptions from their existing mutual fund investments at the prevailing NAV related price. This is a better choice than making dividend payouts as they are more tax efficient. SWPs are normally structured on debt funds.

Systematic Transfer Plans (STP)

STPs permit investors to periodically transfer a specified sum from one scheme to another within the same fund house. STP is very useful when you receive a lump sum. Instead of investing in an equity fund as a whole, you can invest the money in a liquid fund and then do periodic STP into an equity fund. This gives the added benefit of rupee cost averaging.

 Taxation of Mutual Fund Investments

For the tax purpose mutual funds are classified as equity funds and non-equity funds. Equity funds are those funds that have a greater than 65% exposure to equities. The rest of the funds are classified as non-equity funds. Let us look at tax implications.

Equity Funds

  • Dividends received on equity funds are tax free in the hands of the investor. However, they are subject to 10% dividend distribution tax (DDT) imposed on the fund
  • Short term capital gain (STCG) arises when equity funds are held for less than 1 year. Such gains are taxed at a concessional rate of 15%
  • Long term capital gains (LTCG) gains arise when equity funds are held for more than 1 year. From April 2018, such gains are taxed at a flat rate of 10% (without indexation) above annual LTCG threshold of Rs.1 lakh.

Non-Equity Funds

  • Dividends on non-equity funds are tax free in the hands of the investor. However, they are subject to 25% dividend distribution tax (DDT) plus cess and surcharge.
  • Short term capital gain (STCG) arises when non-equity funds are held for less than 3 years. Such gains are taxed at the normal peak rate applicable to the investor.
  • Long term capital gains (LTCG) gains arise when non-equity funds are held for more than 3 years. Such funds are taxed at 20% on their gains but with the benefit of indexation.

Salient Features of Mutual Fund Regulation In India

Here are a few areas that are outlined in SEBI guidelines.

  1. Investor’s money is held independently and not in the AMC’s balance sheet. The trust guidelines for protecting the money are laid out in the SEBI guidelines.
  2. SEBI clearly stipulates pre-conditions in terms of track record, promoter qualifications and capital adequacy. The roles and the responsibilities of the promoting AMCs and the trustees are also clearly laid out by SEBI.
  3. All Mutual fund schemes require the prior approval of the trustees and SEBI. The format and details of disclosures required in offer documents is defined in SEBI regulations
  4. Investment portfolio must adhere to scheme objectives be well diversified. Regulations specify limits on investments by company, by sector and by business group.
  5. Valuation of securities in a portfolio and accounting for income and expenses are defined by SEBI’s regulations including the fees that can be charged.