Mutual Funds (Advanced) Module

NCFM Module Examination Details

Allowable access to Candidate at
Sr. Module Name Test No. Of Maxi- Nega- Pass Test Centre
NO Dura- Ques- mum tive marks Normal Regular
tion (in tions Marks Mark- Open Distri- /Sci- Finan-
min- ing Office bution entific cial
utes) Spread Table Calcu- Calcu-
Sheet lator lator

FOUNDATION
1 Financial Markets: A Beginners’ Module 120 60 100 NO 50 NO NO YES NO
2 Mutual Funds : A Beginners' Module 120 60 100 NO 50 NO NO YES NO
3 Currency Derivatives: A Beginner’s Module 120 60 100 NO 50 NO NO YES NO
4 Equity Derivatives: A Beginner’s Module 120 60 100 NO 50 NO NO YES NO
5 Interest Rate Derivatives: A Beginner’s Module 120 60 100 NO 50 NO NO YES NO
6 Commercial Banking in India: A Beginner’s Module 120 60 100 NO 50 NO NO YES NO
7 FIMMDA-NSE Debt Market (Basic) Module 120 60 100 YES 60 YES NO YES NO
8 Securities Market (Basic) Module 120 60 100 YES 60 NO NO YES NO
9 Clearing Settlement and Risk Management Module 60 75 100 NO 60 YES NO YES NO
10 Banking Fundamental - International 90 48 48 YES 29 YES NO YES NO
11 Capital Markets Fundamental - International 90 40 50 YES 30 YES NO YES NO
INTERMEDIATE
1 Capital Market (Dealers) Module 105 60 100 YES 50 NO NO YES NO
2 Derivatives Market (Dealers) Module 120 60 100 YES 60 NO NO YES NO
3 Investment Analysis and Portfolio Management 120 60 100 YES 60 NO NO YES NO
4 Fundamental Analysis Module 120 60 100 YES 60 NO NO YES NO
5 Operation Risk Management Module 120 75 100 YES 60 NO NO YES NO
6 Options Trading Strategies Module 120 60 100 YES 60 NO NO YES NO
7 Banking Sector Module 120 60 100 YES 60 NO NO YES NO
8 Treasury Management Module 120 60 100 YES 60 YES NO YES NO
9 Insurance Module 120 60 100 YES 60 NO NO YES NO
10 Macroeconomics for Financial Markets Module 120 60 100 YES 60 NO NO YES NO
11 NSDL–Depository Operations Module # 75 60 100 YES 60 NO NO YES NO
12 Commodities Market Module 120 60 100 YES 50 NO NO YES NO
13 Surveillance in Stock Exchanges Module 120 50 100 YES 60 NO NO YES NO
14 Technical Analysis Module 120 60 100 YES 60 NO NO YES NO
15 Mergers and Acquisitions Module 120 60 100 YES 60 NO NO YES NO
16 Back Office Operations Module 120 60 100 YES 60 NO NO YES NO
17 Wealth Management Module 120 60 100 YES 60 NO NO YES NO
18 Project Finance Module 120 60 100 YES 60 NO NO YES NO
19 Venture Capital and Private Equity Module 120 70 100 YES 60 NO NO YES NO
20 Financial Services Foundation Module ### 120 45 100 YES 50 NO NO YES NO
21 NSE Certified Quality Analyst $ 120 60 100 YES 50 NO NO YES NO
22 NSE Certified Capital Market Professional (NCCMP) 120 60 100 NO 50 NO NO YES NO
23 US Securities Operation Module 90 41 50 YES 30 YES NO YES NO
ADVANCED
1 Algorithmic Trading Module 120 100 100 YES 60 YES NO YES NO
2 Financial Markets (Advanced) Module 120 60 100 YES 60 YES NO YES NO
3 Securities Markets (Advanced) Module 120 60 100 YES 60 YES NO YES NO
4 Derivatives (Advanced) Module 120 55 100 YES 60 YES YES YES NO
5 Mutual Funds (Advanced) Module 120 60 100 YES 60 YES NO YES NO
6 Options Trading (Advanced) Module 120 35 100 YES 60 YES YES YES YES
7 Retirement Analysis and Investment Planning 120 77 150 NO 50 YES NO YES YES
8 Retirement Planning and Employee Benefits ** 120 77 150 NO 50 YES NO YES YES
9 Tax Planning and Estate Planning ** 120 77 150 NO 50 YES NO YES YES
10 Investment Planning ** 120 77 150 NO 50 YES NO YES YES
11 Examination 5/Advanced Financial Planning ** 240 30 100 NO 50 YES NO YES YES
12 Equity Research Module ## 120 49 60 YES 60 YES NO YES NO
13 Financial Valuation and Modeling 120 100 100 YES 60 YES NO YES YES
14 Mutual Fund and Fixed Income Securities Module 120 100 60 YES 60 YES NO YES YES
15 Issue Management Module ## 120 55 70 YES 60 YES NO YES NO
16 Market Risk Module ## 120 40 65 YES 60 YES NO YES NO
17 Financial Modeling Module ### 120 30 100 YES 50 YES NO YES NO
18 Business Analytics Module ### 120 66 100 NO 50 YES NO YES NO

# Candidates securing 80% or more marks in NSDL-Depository Operations Module ONLY will be certified as ‘Trainers’.
### Module of IMS Proschool
## Modules of Finitiatives Learning India Pvt. Ltd. (FLIP)
** Financial Planning Standards Board India (Certified Financial Planner Certification) FPSB India Exam
$ SSA Business School
The curriculum for each of the modules (except Modules of Financial Planning Standards Board India, Finitiatives Learning
India Pvt. Ltd. and IMS Proschool) is available on our website: www.nseindia.com
Preface
About NSE Academy

NSE Academy is a subsidiary of National Stock Exchange of India. NSE Academy straddles
the entire spectrum of financial courses for students of standard VIII and right up to MBA
professionals. NSE Academy has tied up with premium educational institutes in order to
develop pool of human resources having right skills and expertise which are apt for the
financial market. Guided by our mission of spreading financial literacy for all, NSE Academy
has constantly innovated its education template, this has resulted in improving the financial
well-being of people at large in society. Our education courses have so far facilitated more
than 41.8 lakh individuals become financially smarter through various initiatives.

NSE Academy’s Certification in Financial Markets (NCFM)

NCFM is an online certification program aimed at upgrading skills and building competency. The

program has a widespread reach with testing centers present at more than 154+

locations across the country.

The NCFM offers certifications ranging from the Basic to Advanced.

One can register for the NCFM through:

• Online mode by creating an online login id through the link ‘Education’>‘Certifications’ >
‘Online Register / Enroll’ available on the website www.nseindia.com

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Once registered, a candidate is allotted a unique NCFM registration number along with an
online login id and can avail of facilities like SMS alerts, online payment, checking of test
schedules, online enrolment, profile update etc. through their login id.
Contents
CHAPTER 1 : MUTUAL FUNDS IN PERSPECTIVE ......................................................8
1.1 Mutual Funds...................................................................................................8
1.2 Portfolio Management Schemes (PMS)................................................................9
1.3 Hedge Funds.................................................................................................10
1.4 Venture Capital Funds & Private Equity Funds ...................................................11
1.5 Points to Remember ......................................................................................12

CHAPTER 2 : RESTRICTIONS ON INVESTMENTS BY MUTUAL FUND SCHEMES........ 13

2.1 General .......................................................................................................13
2.2 Equity...........................................................................................................13
2.3 Debt . ..........................................................................................................14
2.4 Derivatives ...................................................................................................15
2.5 Gold ............................................................................................................17
2.6 Real Estate . .................................................................................................17
2.7 Infrastructure Debt Fund Schemes...................................................................18
2.8 International Investments ..............................................................................19
2.9 Points to remember........................................................................................20

CHAPTER 3 – SID, SAI, KIM AND FACT SHEETS ....................................................21

3.1 Introduction .................................................................................................21
3.2 Scheme Information Document (SID) ..............................................................24
3.3 Statement of Additional Information (SAI).........................................................30
3.4 Key Information Memorandum (KIM) ...............................................................33
3.5 Fact Sheets ..................................................................................................37
3.6 Points to remember........................................................................................37
3.7 Ready Reckoner ............................................................................................38

CHAPTER 4 : NOVEL PORTFOLIO STRUCTURES IN MUTUAL FUND SCHEMES ......... 42

4.1 Index Funds .................................................................................................42
4.2 Exchange Traded Funds (ETFs).........................................................................44
4.3 Arbitrage Funds ............................................................................................46
4.4 Monthly Income Plans (MIP)............................................................................47
4.5 Fixed Maturity Plans (FMP) .............................................................................47
4.6 Points to remember .......................................................................................48

1
CHAPTER 5 : VALUATION OF INVESTMENTS BY MUTUAL FUND SCHEMES ............. 50
5.1 Equity .........................................................................................................50
5.1.1 Traded Securities ............................................................................... 50
5.1.2 Non-Traded / Thinly Traded / Unlisted Equities ....................................... 51
5.1.3 Warrants . ......................................................................................... 52
5.1.4 Rights . ............................................................................................. 52
5.2 Debt ........................................................................................................ 52
5.2.1 Money market and debt securities with residual maturity of upto 60 days ...... 53
5.2.2 Money market and debt securities with residual maturity of over 60 days ..... 53
5.2.3 Provisioning for Non-Performing Assets (NPA) ........................................54
5.2.4 Re-classification of Non-Performing Assets (NPA) . .................................. 56
5.2.5 Provisioning & Re-classification in case of Re-scheduling .......................... 56
5.3 Gold ............................................................................................................56
5.4 Real Estate . .................................................................................................57
5.5 Other Investments ........................................................................................58
5.6 Points to remember........................................................................................58

CHAPTER 6 : QUANTITATIVE EVALUATION OFMUTUAL FUND SCHEMES ............... 59

6.1 Returns .......................................................................................................59
6.1.1 XIRR ................................................................................................ 59
6.1.2 Dividend Re-investment (CAGR)............................................................61
6.1.3 Compounding of Periodic Returns .........................................................61
6.2 Risk ............................................................................................................63
6.2.1 Standard Deviation . ........................................................................... 63
6.2.2 Beta.................................................................................................. 63
6.2.3 Weighted Average Maturity . ................................................................65
6.2.4 Modified Duration ............................................................................... 65
6.3 Risk Adjusted Returns . ..................................................................................67
6.3.1 Sharpe Ratio ..................................................................................... 67
6.3.2 Sortino Ratio ..................................................................................... 67
6.3.3 Treynor Ratio .................................................................................... 68
6.3.4 Jensen’s Alpha.................................................................................... 68
6.4 Points to remember .......................................................................................69

CHAPTER 7 – CUT-OFF TIME REGULATIONS AND TIME STAMPING ....................... 70

7.1 Introduction .................................................................................................70

2
7.2 Cut-Off Timing...............................................................................................71
7.2.1 Liquid Schemes & Plans – Subscriptions ................................................71
7.2.2 Liquid Schemes & Plans – Re-Purchases ................................................72
7.2.3 Other than Liquid Schemes & Plans – Subscriptions................................. 72
7.2.4 Other than Liquid Schemes & Plans – Re-purchases................................. 73
7.2.5 At a Glance........................................................................................ 73
7.3 Official Points of Acceptance (PoA) . .................................................................73
7.4 Time Stamping Requirements..........................................................................74
7.5 Points to remember .......................................................................................74

CHAPTER 8 – INVESTMENTS IN MUTUAL FUND THROUGH NSE . ........................... 77

8.1 Introduction..................................................................................................77
8.1.1 Listed Schemes................................................................................... 77
8.1.2 Exchange Traded Funds (ETFs) ............................................................78
8.1.3 Mutual Fund Service System (MFSS) . ...................................................78
8.1.3.1 Subscription (Physical mode) ................................................80
8.1.3.2 Subscription (Demat mode) ..................................................81
8.1.3.3 Redemption (Physical Mode) .................................................83
8.1.3.4 Redemption (Demat Mode) ...................................................85
8.2. Points to remember .......................................................................................87

CHAPTER 9 – NON RESIDENT INVESTMENTS IN MUTUAL FUND SCHEMES ............ 88

9.1 Introduction..................................................................................................88
9.2 Investment by NRIs / PIOs..............................................................................88
9.2.1 Repatriable basis: .............................................................................. 88
9.2.2 Non-Repatriable basis.......................................................................... 88
9.3 Investment by Foreign Institutional Investors ...................................................89
9.4 Investment by Qualified Foreign Investors ........................................................89
9.4.1 Direct Route (Demat) ......................................................................... 93
9.4.2 Indirect Route (Unit Confirmation Receipts – UCR) . ................................ 94
9.5 Points to remember .......................................................................................97

CHAPTER 10 – I
 NVESTMENTS BY INDIANS IN INTERNATIONAL MUTUAL FUND
SCHEMES ......................................................................................99
10.1 Introduction .................................................................................................99
10.2 Foreign Direct Investment and Portfolio Investment ...........................................99
10.3 Investing in International Mutual Fund Schemes.................................................99

3
 10.3.1 Need to understand the international financial market ............................. 99
10.3.2 Need to understand regulations regarding permissible investment............. 99
10.3.3 Need to understand regulations regarding taxation ............................... 100
10.3.4 Need to understand regulations regarding repatriation........................... 100
10.3.5 Foreign currency risk ........................................................................ 100
10.4 Why invest abroad?...................................................................................... 101
10.5 International Fund of Funds ......................................................................... 101
10.6 Points to remember ..................................................................................... 102

CHAPTER 11 – MUTUAL FUND ACCOUNTING ...................................................... 103

11.1 Introduction ............................................................................................... 103
11.2 Accounting for Income, Gains & Losses from Investments . ............................... 103
11.3 Accounting for Expenses............................................................................... 104
11.4 Determining the NAV ................................................................................... 104
11.5 Accounting for Load . .................................................................................. 107
11.6 Distributable Reserves ................................................................................. 108
11.7 Points to remember..................................................................................... 109

CHAPTER 12 – MUTUAL FUND TAXATION ........................................................... 110

12.1 Introduction................................................................................................ 110
12.2 Mutual Fund Tax Provisions . ......................................................................... 110
12.2.1 Securities Transaction Tax (STT) ........................................................ 110
12.2.2 Capital Gains Tax ............................................................................. 110
12.2.3 Tax on Income Distributed ................................................................. 111
12.2.4 Tax Deducted at Source (TDS) / Withholding Tax .................................. 111
12.3 Compounding Wealth, Gross of Tax . .............................................................. 111
12.3.1 Bank Fixed Deposit ........................................................................... 112
12.3.2 Mutual Fund .................................................................................... 113
12.3.3 Dividend Payout and Growth Options within Schemes . .......................... 113
12.3.4 Double Indexation ............................................................................ 114
12.3.5 Setting Off & Carry Forward of Losses ................................................. 115
12.3.6 Dividend Stripping............................................................................. 116
12.4 Points to remember...................................................................................... 116
References........................................................................................................... 119

4
 Distribution of weights of the
Mutual Funds (Advanced) Module Curriculum

Chapter No. Title Weights (%)

1 Mutual Funds in Perspective 7

2 Investments by Mutual Fund Schemes 7

3 Valuation of Investments by Mutual Fund Schemes 8

4 Mutual Fund Accounting 8

5 Novel Portfolio Structures in Mutual Fund Schemes 10

6 Quantitative Evaluation of Mutual Fund Schemes 10

7 Cut-off Time Regulations & Time Stamping 8

8 Investment in Mutual Funds through Exchange 6

9 Non-Resident Investment in Indian MF Schemes 9

10 Investment by Indians in International MF Schemes 8

11 Mutual Fund Taxation 9

12 SID, SAI, KIM & Fact Sheets 10

Note: Candidates are advised to refer to NSE’s website: www.nseindia.com, click on

‘Education’ link and then go to ‘Updates & Announcements’ link, regarding revisions/
updations in NCFM modules or launch of new modules, if any.

Last Updated: 2018

Copyright © 2018 by National Stock Exchange of India Ltd. (NSE)

Exchange Plaza, Bandra Kurla Complex,
Bandra (East), Mumbai 400 051 INDIA

All content included in this book, such as text, graphics, logos, images, data compilation etc.
are the property of NSE. This book or any part thereof should not be copied,
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any form or by any means, electronic, mechanical, photocopying, recording or otherwise.

5
Acronyms

AD Authorised Dealer
ADR American Depository Receipt
AMC Asset Management Company
AMFI Association of Mutual Funds in India
AUM Assets Under Management
CAGR Compounded Annual Growth Rate
DDT Dividend Distribution Tax
DP Depository Participant
DTAA Double Taxation Avoidance Agreement
EC European Commission
ETF Exchange Traded Fund
FATF Financial Action Task Force
FCNR Foreign Currency Non-Resident account
FEDAI Foreign Exchange Dealers Association of India
FII Foreign Institutional Investor
FMP Fixed Maturity Plan
FoF Fund of Funds
GCC Gulf Co-operation Council
GDR Global Depository Receipt
IOSCO International Organization of Securities Commission
IPO Initial Public Offer
KIM Key Information Memorandum
KYC Know Your Client
LBMA London Bullion Market Association
MFSS Mutual Fund Service System
MIP Monthly Income Plan
MMOU Multilateral Memorandum of Understanding
MTM Marked to Market
NAV Net Asset Value
NFO New Fund Offering
NPA Non-Performing Assets
NRE Non-Resident External account
NRI Non-Resident Indian
NRO Non-Resident Ordinary account

6
NSE National Stock Exchange
PE Private Equity
PIO Person of Indian Origin
PIPE Private Investment in Public Equity
PMS Portfolio Management Scheme
PoA Power of Attorney
PoA Points of Acceptance
QFI Qualified Foreign Investor
REIT Real Estate Investment Trusts
RTA Registrar & Transfer Agent
SAI Statement of Additional Information
SEBI Securities & Exchange Board of India
SID Scheme Information Document
SIP Systematic Investment Plan
SPV Special Purpose Vehicle
STP Systematic Transfer Plan
STT Securities Transaction Tax
SWP Systematic Withdrawal Plan
TM Trading Member
UCR Unit Confirmation Receipt
VCF Venture Capital Funds

7
CHAPTER 1 : MUTUAL FUNDS IN PERSPECTIVE

1.1 Mutual Funds

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. The United States leads with the number
of mutual fund schemes. There are more than 8000 mutual fund schemes in the U.S.A.
Comparatively, India has around 1000 mutual fund schemes, but this number has grown
exponentially in the last few years. The Total Assets under Management in India of all Mutual
funds put together touched a peak of Rs. 8,07,546 Crores at the end of November 2009.

Mutual Fund Industry Statistics (India) - December 2016

Increase/ Change
Scheme Name Rs. crore
Decrease (%)

Asset Under Management (AUM) (YoY) 1,339,555 1339555 0% 

Asset Under Management (AUM) (MoM) 1,339,555 72 0.01% 

Source: http://nseindia.moneycontrol.com/mutualfundindia/tracker_home.php

There are various asset classes in which an investor can invest his savings depending on his
risk appetite and time horizon viz. real estate, bank deposits, post office deposits, shares,
debentures, bonds etc. While investing in these asset classes an individual would need to
study the risk and reward closely.

Example

Mr. Arun proposes to invest in shares of M/s. Linked Ltd.

This requires a detailed analysis of the

 performance of the company
 understanding the future business prospects of the company
 track record of the promoters and the dividend, bonus issue history of the company etc.

However, the above process is cumbersome and time consuming.

Alternatively an investor can utilize professional expertise to achieve superior returns at

acceptable risk. This is done by investing through mutual funds which offer various types of
schemes. The fund manager studies and analysis numerous stocks before selection for inclusion
in the mutual fund scheme. Therefore an individual investor benefits from professional fund
management. 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

8
and sectors. This diversification helps in reducing the overall risk of the portfolio.

Mutual fund schemes are offered to investors for the first time through a New Fund Offering
(NFO). Thereafter, close-ended schemes stop receiving money from investors, though these
can be bought on the stock exchange(s) where they are listed. Open-ended schemes sell and
re-purchase their units on an ongoing basis.

Know Your Client (KYC) process is centralised in the mutual fund industry. Therefore, the
investor needs to complete the formalities only once with the designated KYC service provider.
The KYC confirmation thus obtained is valid for investment with any mutual fund.

A feature of mutual fund schemes is the low minimum investment amount – as low as Rs.
1,000 for some schemes. This makes it possible for small investors to invest. The expense
ratio (which is not more than 2.5% in many schemes, especially liquid and index funds and
goes below 0.05% in some schemes)being low also helps in making mutual funds a good
instrument for building wealth over the long term.

Mutual funds are closely regulated by the Securities & Exchange Board of India (SEBI). The
applicable regulation is the SEBI (Mutual Fund) Regulations, 1996.

Under the regulations, the Board of Trustees perform an important role in protecting the
interests of investors in mutual fund schemes. Another protective feature is the checks and
balances in the mutual fund system. For instance, while the Asset Management Company
(AMC) handles the investment management activity, the actual custody of the investments is
with an independent custodian. Investor records are mostly maintained by the registrar and
transfer agents (RTAs), who offer their services to multiple mutual funds. In some cases, the
AMC itself maintains the investor records.

SEBI also regulates the investments that mutual fund schemes can make. For instance,
commodities other than gold are not permitted. Even within the permissible investments,
SEBI has prescribed limits for different kinds of schemes.

Rigorous standards of disclosure and transparency make sure that investors get a complete
view of their investments on a regular basis. Consolidated Account Statements, mandated
by SEBI, ensure that the investor’s investments across various mutual funds in the industry
are consolidated into a single monthly statement. Even those investors who do not transact,
receive their statement of accounts every 6 months.

1.2 Portfolio Management Schemes (PMS)

PMS is an investment facility offered by financial intermediaries generally to high networth
investors. There is no concept of a NFO. The PMS provider keeps receiving money from
investors. Unlike mutual funds, which maintain their investment portfolio at the scheme level,
the PMS provider maintains a separate portfolio for each investor.

An investor who chooses to operate multiple PMS accounts will need to go through a separate
KYC process with each intermediary. Each will provide a separate statement of the investor’s
account in their own format. The facility of Consolidated Account Statement is not available.

9
SEBI has set the minimum investment limits under PMS (Rs. 25 lakh presently). Many PMS
providers operate with much higher minimum investment requirements.

The cost structure for PMS, which is left to the PMS provider, can be quite high. Besides a
percentage on the assets under management, the investor may also have to share a part of
the gains on the PMS portfolio; the losses are however borne entirely by the investor.

PMS have an unconstrained range of investments to choose from. The limits, if any, would be
as mentioned in the PMS agreement executed between the provider and the client.

PMS are regulated by SEBI, under the SEBI (Portfolio Managers) Regulations, 1993. However,
since this investment avenue is meant only for the high networth investors, the mutual fund
type of rigorous standards of disclosure and transparency are not applicable. The protective
structures of board of trustees, custodian etc. is also not available. Investors therefore have
to take up a major share of the responsibility to protect their interests.

1.3 Hedge Funds

These are a more risky variant of mutual funds which have become quite popular internationally.
Like PMS, hedge funds too are aimed at high networth investors. They operate with high fee
structures and are less closely monitored by the regulatory authorities.

From a fund management perspective, the risk in hedge funds is higher on account of the
following features:

 Borrowings

Normal mutual funds accept money from unit-holders to fund their investments. Hedge
funds invest a mix of unit-holders’ funds (which are in the nature of capital) and borrowed
funds (loans).

Unlike capital, borrowed funds have a fixed capital servicing requirement. Even if the
investments are at a loss, loan has to be serviced. However, if investments earn a return
better than the cost of borrowed funds, the excess helps in boosting the returns for the
unit-holders. The following example illustrates how borrowing can be a double-edged
sword for the fund.

Scenarios-> A B C

a. Unit-holders’ Funds (Rs. Cr.) 1,000 100 100

b. Borrowings (Rs. Cr.) 0 900 900
c. Total Investment (Rs. Cr.) [a+b] 1,000 1,000 1,000
d. Return on Investment (%) 15% 15% 5%
e. Return on Invt. (Rs. Cr.) [c X d] 150 150 50
f. Interest on loan (%) 7% 7%
g. Interest on Loan (Rs. Cr.) [b X f] 0 63 63
h. Unit-holders’ Profits (Rs.Cr.) [e-g] 150 87 -13
i. Profit for Unit-holders (%) [h ÷ a] 15% 87% -13%

10
The 15% return in the market was boosted through leverage of 9 times to 87% return for
unit holders in a good market; in a bad market the same leverage dragged the unit-holders’
return down to -13%.

The borrowing is often in a currency that is different from the currency in which the
investments are denominated. If the borrowing currency becomes stronger, then that adds to
the losses in the fund.

 Risky investment styles

Hedge funds take extreme positions in the market, including short-selling of investments.

In a normal long position, the investor buys a share at say, Rs. 15. The worst case is that
the investor loses the entire amount invested. The maximum loss is Rs. 15 per share.

Suppose that the investor has short-sold a share at Rs. 15. There is a profit if the share
price goes down. However, if the share price goes up, to say, Rs. 20, the loss would be Rs.
5 per share. A higher share price of say, Rs. 50 would entail a higher loss of Rs. 35 per
share. Thus, higher the share price more would be the loss. Since there is no limit to how
high a share price can go, the losses in a short selling transaction are unlimited.

Under SEBI’s mutual fund regulations, mutual funds are not permitted to borrow to invest.
Borrowing is permitted only for investor servicing (dividend or re-purchases). Further, the
borrowing is limited to 20% of the net assets, and cannot be for more than 6 months at a
time. Similarly, mutual funds are not permitted to indulge in short-selling transactions.

Such stringent provisions have ensured that retail investors are protected from this risky
investment vehicle.

1.4 Venture Capital Funds & Private Equity Funds

These funds largely invest in unlisted companies. Venture capital funds invest at an earlier
stage in the investee companies’ life than the private equity funds. Thus, they take a higher
level of project risk and have a longer investment horizon (3 – 5 years).

Venture Capital Funds are governed by the SEBI (Venture Capital) Regulations, 1996. Under
these regulations, they can mobilise money only through a private placement. Investors can
be Indians, NRIs or foreigners. Every investor has to invest a minimum of Rs. 5 lakh in the
fund.

Unlike mutual funds, which accept money from investors upfront, venture capital funds and
private equity funds only accept firm commitments (a commitment to invest) initially. A part
of the firm commitment may be accepted in money. The balance moneys are called from the
investors, as and when the fund sees investment opportunities.

Venture capital funds may invest in India or abroad. However, not more than 25% of the
corpus can be invested in a single undertaking. Venture capital funds are not permitted to
invest in Non-banking Financial Services, Gold Financing (other than for jewellery) and any
other industry not permitted under the industrial policy of the country. They can also not
invest in companies where the owners or managers of the fund have more than 15% stake.

11
Just as investors bring money into the fund in stages, the fund returns money to investors
in stages, as and when some investments are sold. On maturity of the fund, the unsold
investments may be distributed to the investors in the proportion of their stake in the fund.

Private equity funds typically have a shorter investment horizon of 1 – 3 years. While their
focus is on unlisted companies, they do invest in listed companies too. Such deals, called in
Private Investment in Public Equity (PIPE) are increasing in India.

1.5 Points to Remember

 Mutual Funds are a vehicle for retail investors to benefit from the capital market. They
offer different kinds of schemes to cater to various types of investors.

 Mutual fund schemes are offered to investors, for the first time, through a New Fund
Offering (NFO). Thereafter, close-ended schemes stop receiving money from investors.
Open-ended schemes offer to sell and re-purchase their units on an ongoing basis.

 Know Your Client (KYC) process is centralised.

 Mutual funds are closely regulated by the Securities & Exchange Board of India (SEBI).

 Portfolio Management Scheme (PMS) is an investment facility offered by financial

intermediaries generally to high networth investors.

 PMS are regulated by SEBI, under the SEBI (Portfolio Managers) Regulations, 1993.

 Hedge funds are a more risky variant of mutual funds which have become quite popular
internationally.

 Risk in a hedge fund is built through borrowings or risky investment styles, including
short-selling of securities.

 Venture Capital Funds (VCF) and Private Equity (PE) Funds largely invest in unlisted
companies. VCFs invest at an earlier stage in the investee companies’ life than the PE
funds.

 VCF are governed by the SEBI (Venture Capital) Regulations, 1996.

 Private equity funds typically have a shorter investment horizon of 1 – 3 years.

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CHAPTER 2 : R
 ESTRICTIONS ON INVESTMENTS BY
MUTUAL FUND SCHEMES

We know that mutual funds invest in different types of securities such as Equity, Debt,
Derivatives and so on. The fund manager holds the discretion of choosing the various securities
in which the fund invests. However, he must do so in line with the investment objective of
the fund and the limits set under the SEBI (Mutual Funds) Regulations, 1996 and the SEBI
Master Circular for Mutual Funds (as on September 14, 2016). Let us look at the important
restrictions on investments by Mutual Funds now.

2.1 General
 A mutual fund can not borrow money for investment. However, it can borrow upto 20% of
net asset of the scheme for a maximum tenor of six months, in order to meet temporary
liquidity needs of the mutual funds for the purpose of repurchase, redemption of units or
payment of interest or dividend to the unitholders

 Carry forward transactions are not permitted. But mutual funds can trade in derivatives.

 Mutual funds are permitted to lend securities in accordance with SEBI’s Stock Lending
Scheme.

 Mutual Funds may enter into underwriting agreements as per the SEBI (Underwriters)
Rules and SEBI (Underwriters) Regulations, 1993. However, the underwriting obligation
must not exceed net asset value of the scheme.

2.2 Equity
 A scheme cannot invest more than 10% of its assets in a single company’s shares or
share-related instruments. However, sector funds can have a higher investment in a single
company, as provided in their Scheme Information Document.

Index funds invest as per the index they track. In the index construction, a single company
may have a weightage higher than 10%. In such cases, the higher single company
investment limit would be applicable.

The 10% limit is applicable when the scheme invests. Breach of the limit on account of
subsequent market movements is permitted. For example, a scheme with net assets
of Rs. 100 crores may have invested Rs. 10 crores in a single company, XYZ. Later, on
account of market movements, the net assets of the scheme increase to Rs. 102 crores,
while the value of the investment in XYZ company goes up to Rs. 11 crores. XYZ company
now represents Rs. 11crores ÷ Rs. 102 crores i.e. 10.78%. The scheme is not obliged to
sell any shares of XYZ company to fall within the 10% limit. However, fresh purchases
of XYZ company’s shares would need to be suspended, until the investment value goes
below 10% of the scheme’s net assets.

13
 Mutual funds are meant to invest, primarily in listed securities. Therefore, investment in
unlisted shares is restricted as follows:

o Open-ended schemes: 5% of Net Assets

o Close-ended schemes: 10% of Net Assets

 Unlisted securities or securities issued through private placement by an associate or a

group company of the sponsor are not a permissible investment.

 Mutual fund schemes cannot invest more than 25% of their net assets in listed securities
of group companies of the sponsor of the Asset Management Company.

 All the schemes of a mutual fund put together cannot control more than 10% of the voting
rights of any company.

 Mutual fund schemes cannot charge management fees on their investment in other mutual
fund schemes (of the same asset management company or other asset management
companies). Such investment is also subject to a cap of 5% of the net assets of the fund.
This is not applicable to fund of funds schemes.

 Inter-scheme transfers of investments can only be at market value.

 If any scheme of a mutual fund has invested in a company or its associates, which
together hold more than 5% of the net assets of any mutual fund scheme of that asset
management company, then that needs to be disclosed.

 Investments and disinvestments are to be contracted directly in the name of the concerned
scheme. Transactions cannot be contracted in a general account and distributed across
schemes later.

 Fund of funds schemes can not invest in:

o Any other fund of funds scheme

o Any asset other than schemes of mutual funds, except for meeting liquidity
requirements, which must be disclosed in the offer document.

2.3 Debt
 Mutual fund schemes can invest in debt securities, but they cannot give loans.

 A scheme cannot invest more than 15% of its net assets in debt instruments issued by a
single issuer. If prior approval of the boards of the Asset Management Company and the
Trustees is taken, then the limit can go up to 20%. If the paper is unrated, or rated below
investment grade, then a lower limit of 10% is applicable.

These limits are exempted for money market securities and government securities.
However, the exemption is not available for debt securities that are issued by public
bodies / institutions such as electricity boards, municipal corporations, state transport
corporations, etc. guaranteed by either state or central government.

14
 Total exposure of debt schemes in a group must not exceed 20%. However, it may be
extended to 25% with prior approval of the board of trustees.

 Investment in unrated paper and paper below investment grade is subject to an overall
cap of 25% of net assets of the scheme.

 Liquid funds can only invest in money market securities of upto 91 days maturity.

 Close ended debt schemes can invest only in securities which mature on or before the
date of maturity of the scheme.

 Total exposure of debt schemes to a particular sector must not exceed 25% of net assets
of the scheme. An additional exposure of 10% may be allowed to the financial services
sector, only in the form of investment in Housing Finance Companies (HFCs), if these
securities are AA rated or above, and the HFCs are registered with the National Housing
Board (HFB)

 The following regulations are applicable for investment in short term deposits (upto 91
days):

o The deposits can only be placed in scheduled banks

o The deposits are to be held in the name of the specific scheme

o Not more than 15% of the net assets of the scheme can be placed in such short term
deposits having a maximum maturity of 91 days. With the permission of trustees, the
limit can go up to 20%

o Short term deposits with associate and sponsor scheduled commercial banks together
cannot exceed 20% of the total short term deposits placed the mutual fund

o Not more than 10% of the net assets are to be placed in short term deposits of any
one scheduled bank including its subsidiaries

o The funds are not to be placed with a bank that has invested in that scheme

o The Asset Management Company cannot charge investment management and advisory
fee on such deposits placed by liquid and debt funds

 Transactions in government securities are to be settled in demat form only

 Inter-scheme transfers in the same mutual fund can be done at market value only

 Unlisted securities or securities issued through private placement by an associate or a

group company of the sponsor are not a permissible investment.

 Mutual fund schemes cannot invest more than 25% of their net assets in listed securities
of group companies of the sponsor of the Asset Management Company.

2.4 Derivatives
Mutual Funds are permitted to invest in financial derivatives traded in the stock exchange,
subject to disclosures in the Scheme Information Document. The permitted derivatives include
stock futures, stock options, index futures, index options and interest rate futures.

15
They can also enter into forward rate agreements and interest rate swaps (for hedging) with
banks, primary dealers (PDs) and financial institutions (FIs). Exposure to a single counter-
party cannot however exceed 10% of net assets of the scheme.

Mutual funds can also invest in derivatives traded on exchanges abroad, for hedging and
portfolio balancing with the underlying as securities.

The following limits have been stipulated by SEBI:

 Gross exposure through debt, equity and derivatives cannot exceed 100% of the net
assets of the scheme.

 The exposure in derivative transactions is calculated as follows:

o Long Futures - Futures Price x Lot Size x Number of Contracts

o Short Futures - Futures Price x Lot Size x Number of Contracts

o Option Bought - Option Premium Paid x Lot Size x Number of Contracts

Mutual funds are not permitted to sell options or buy securities with embedded written options.

 In the exposure calculations, positions that are in the nature of a hedge are excluded.

o Hedging positions are the derivative positions that reduce possible losses on an
existing position in securities. These are excluded from the limits till the existing
position remains.

o Hedging positions taken for existing derivative positions are not excluded from the
limits.

o Any derivative instrument used to hedge should have the same underlying security as
the existing position being hedged.

o The quantity of underlying associated with the derivative position taken for hedging
purposes should not exceed the quantity of the existing position against which the
hedge has been taken.

 The total exposure related to option premium paid cannot exceed 20% of the net assets
of the scheme.

 Exposure to a single counterparty in case of plain vanilla interest rate swaps, which can
only be taken with a RBI recognized market maker, must not exceed 10% of net assets of
the scheme.

 Within the SEBI limits, the Board of Trustees can stipulate limits. The limits on investment
in derivatives need to be disclosed in the Scheme Information Document.

 The AMC has to put in place, adequate risk containment measures, as may be stipulated
by the Trustees.

16
2.5 Gold
Gold ETFs can invest only in gold and gold-related instruments. Gold-related instruments are
defined to mean instruments that have gold as the underlying, and specified by SEBI.

If the gold acquired by the gold exchange traded fund scheme is not in the form of standard
bars, it is to be assayed and converted into standard bars which comply with the good delivery
norms of the London Bullion Market Association (LBMA).

Until the funds are deployed in gold, the fund may invest in short term deposits with scheduled
commercial banks.

The fund may also maintain liquidity, as disclosed in the offer document, to meet re-purchase
/ redemption requirements.

2.6 Real Estate

Real estate mutual funds are permitted to invest in direct real estate assets, as well as real
estate securities.

While investing in real estate assets, the fund must ensure that construction is complete and
that the asset is usable. Project under construction is not a permitted investment. Similarly,
investment cannot be made in vacant land, agricultural land, deserted property or land
reserved or attached by the government or any authority.

The real estate asset should have valid title deeds, be legally transferable and free from
encumbrances, and not be the subject matter of any litigation.

The following SEBI limits are applicable:

 At least 75% of the net assets is to be invested in real estate assets, mortgage backed
securities and equity shares or debentures of companies engaged in dealing in real estate
assets or in undertaking real estate development projects.

 At least 35% has to be invested directly in real estate assets.

 The combined investment of all the schemes of a mutual fund:

o In a single city cannot exceed 30% of the net assets

o In a single real estate project cannot exceed 15% of the net assets

o Cannot exceed 25% of the issued capital of any unlisted company.

 No real estate mutual fund scheme can invest more than 15% of its net assets in equity
shares or debentures of any unlisted company.

 A real estate mutual fund scheme is not permitted to invest more than 25% of its net
assets in listed securities of its sponsor or associate or group company.

 Real estate mutual funds are not permitted to invest in:

o Unlisted security of its sponsor or associate or group company.

o Listed security by way of private placement by its sponsor or associate or group

company.

17
 Real estate mutual funds are not permitted to engage in lending or housing finance
activity.

 Real estate mutual funds cannot invest in real estate which was owned by its sponsor or
AMC or associates during last 5 years, or in which any of these parties enjoy tenancy or
lease rights.

 The lease or rental arrangement on the real estate assets cannot go beyond the maturity
of the scheme.

 Not more than 25% of the rental of a scheme can come from real estate assets let out to
its sponsor, or associates or group. The lease would need to be at market rates.

 Real estate assets cannot be transferred between schemes.

2.7 Infrastructure Debt Fund Schemes

Infrastructure debt fund schemes invest primarily in debt securities or securitized debt
instruments of infrastructure companies or projects.

 An infrastructure debt scheme must be launched either as a close-ended scheme maturing

after more than five years or interval scheme with lock-in of five years.

 Units of infrastructure debt schemes must be listed on a recognized stock exchange, after
the scheme is fully paid-up

 Every scheme must invest atleast 90% of its net assets in debt securities ir securitized
debt instruments of infrastructure companies, projects, special purpose vehicles created
for investment in infrastructure. Balance amount may be invested in equity, money market
instruments or bank deposits.

 Not more than 30% of net assets of a scheme can be invested in a single infrastructure
company or project or SPV.

 Also, The total exposure of a mutual fund to a single infrastructure company or project
or SPV must not exceed 30% of the net assets of all the schemes of a mutual fund put
together,

 Investment in ungraded or below investment grade securities of infrastructure companies

or projects or SPVs must not exceed 30% of the net assets of the scheme. However, this
limit may be increased to 50% with the prior approval of the trustees and board of the
AMC.

 No infrastructure debt fund scheme can invest in

o Any unlisted security of the sponsor or its associate or group company;

o Any listed security issued by way of preferential allotment by the sponsor or its
associate or group company;

 A scheme can invest upto 25% of the net assets of the scheme in a a listed security of
the sponsor or its associate or group company having completed and revenue generating

18
 infrastructure company or project or SPV, with the prior approval of the trustees of the
AMC and by making full disclosures to investors

2.8 International Investments

Indian mutual fund schemes are permitted to take exposure to the following international
investments:

 American Depository Receipts (ADRs) and Global Depository Receipts (GDRs) issued by
Indian or foreign companies

 Equity of overseas companies listed on recognized stock exchanges overseas

 Initial and follow on public offerings for listing at recognized stock exchanges overseas

 Government securities issued by countries that are rated not below investment grade

 Foreign debt securities (short term as well as long term with rating not below investment
grade by accredited/ registered credit rating agencies) in countries whose currencies are
fully convertible

 Money Market Instruments rated not below investment grade

 Repos in form of investment, where the counterparty is rated investment grade or above.
However, borrowing of funds through repos is not allowed

 Derivatives traded on recognized stock exchanges overseas only for hedging and portfolio
balancing with securities as the underlying

 Short term deposits with banks overseas where the issuer is rated not below investment
grade

 Units / securities issued by overseas mutual funds or unit trusts, registered with overseas
regulators, that invest in:

o The above securities; or

o Real estate investment trusts (REITs) listed on recognized stock exchanges overseas

o Unlisted overseas securities not more than 10% of the scheme’s net assets.

The mutual fund needs to appoint a dedicated Fund Manager for overseas investments (other
than for investment in units / mutual funds / unit trusts).

Aggregate ceiling for overseas investments is US $ 7 billion and within this overall limit,
Mutual Funds can make overseas investments subject to a maximum of US $ 300 million per
MutualFund.

The mutual fund industry is permitted to invest up to USD 1bn, in overseas ETFs that invest
in securities. A single mutual fund cannot invest more than USD 50mn.

19
2.9 Points to remember
Permissible Asset Conditions for Investment
Classes
Equity Not more than 10% in single company’s shares. For unlisted shares,
max exposure can be 5% of net assets for Open ended schemes
and 10% of net assets for Close ended schemes
Debt Can invest in debt securities, but they cannot give loans. Not more
than 155 of net assets in single issuers debt instruments
Liquid funds investment only in money market securities of 91-day
maturity
Derivatives Permitted to invest subject to disclosures in SID. Gross exposure
through debt, equity and derivatives cannot exceed 100% of the
net assets of the scheme
Gold ETFs Investment in gold and gold-related instruments
Real estate Can invest in direct real estate assets as well as real estate
securities. Not permitted to engage in lending or housing finance
activity.
International Can invest in ADRs, GDRs and Government securities issued by
Investments countries rated Investment grade and above.
Can invest in foreign debt securities in countries where currency is
fully convertible, International MFs and REITs

20
CHAPTER 3 – SID, SAI, KIM AND FACT SHEETS

3.1 Introduction
As per SEBI guidelines, New Fund Offers or NFOs other than ELSS can remain open for
a maximum of 15 days. Refund or Allotment must be done with 5 business days of scheme
closure. Open-ended schemes must re-open for sale/re-purchase within 5 business days of
allotment date.

The offer documents contain all details of the NFO. This is one of the most important sources
of information on the scheme. The offer documents are divided into two parts

a) Scheme Information Document or SID

b) Statement of Additional Information or SAI

In practice, SID and SAI are considered 2 separate documents. However, in legal terms, SAI
is considered a part of the SID.

The Scheme Information Document sets forth concisely the information about the scheme
that a prospective investor ought to know before investing. Before investing, investors should
also ascertain about any further changes to this Scheme Information Document after the date
of this Document from the Mutual Fund / Investor Service Centres / Website / Distributors or
Brokers.

The investors are advised to refer to the Statement of Additional Information (SAI) for details
of ________ Mutual Fund, Tax and Legal issues and general information on www.__________.
(Website address)

SAI is incorporated by reference - For a free copy of the current SAI, please contact your
nearest Investor Service Centre or log on to our website. The Scheme Information Document
should be read in conjunction with the SAI and not in isolation”.

Key Information Memorandum or KIM is a summary of the SID and SAI. It is widely
distributed in the market. As per SEBI regulations, every application form is to be accompanied
by the KIM.

Offer documents are vetted by SEBI, although no formal approval is given for the same. Every
offer document clearly states that:

“The particulars of the Scheme have been prepared in accordance with the Securities and
Exchange Board of India (Mutual Funds) Regulations 1996, (herein after referred to as ‘SEBI
(MF) Regulations’) as amended till date, and filed with SEBI, along with a Due Diligence
Certificate from the AMC. The units being offered for public subscription have not been
approved or recommended by SEBI nor has SEBI certified the accuracy or adequacy of the
Scheme Information Document.”

The drafts of all NFO documents can be obtained on the SEBI website at http://www.sebi.gov.
in/sebiweb/home/list/3/39/37/0/Draft. The screenshot looks like this:

21
The list of new fund offers is also available on the website of AMFI at: https://www.amfiindia.
com/new-fund-offer.

22
The screen shot looks like this:

A fund fact sheet is a document published by a fund house. It lists details of each of the
schemes managed by the fund house. Each scheme generally has just one page so it is not
too heavy and easy to read and understand.

Published on a monthly basis, here are some of the things a fund fact sheet covers:

1. The portfolio depicts how the money invested in a scheme has been deployed in various
securities

2. The performance of the scheme

3. The size and investment details of the scheme

Available on the website of the company, it is a vital document and is useful to ascertain
important information on the scheme. This helps keep track of the performance of the
investments.

In this chapter, these documents shall be covered in detail.

23
3.2 Scheme Information Document (SID)
The Scheme Information Document has all information specific to the scheme. It is to be
updated within 3 months of the end of every financial year. Only if the scheme is launched
in the second half of a financial year, the first update can happen within 3 months of the end
of the following financial year. Changes until an update are incorporated in an addenda, and
stapled to the SID. The changes are also advertised in an English newspaper and a newspaper
in the language of the state where the registered office of the mutual fund is located.

The Riskometer is the first item given in the cover page of an SID. This is a SEBI directive
to mutual funds. This carries the level of risk in a pictorial manner. The level of risk in mutual
fund schemes shall be five as under:

i. Low - principal at low risk

ii. Moderately Low - principal at moderately low risk

iii. Moderate - principal at moderate risk

iv. Moderately High -- principal at moderately high risk

v. High - principal at high risk

A scheme with moderate risk would be shown as under:

Riskometer

y Moderate Mo
el de
r at Hi rat
e
od ow gh ely
M L
Low

High

LOW HIGH
As per SEBI directive, mutual funds may ‘product label’ their schemes on the basis of the best
practice guidelines issued by Association of Mutual Funds in India (AMFI) in this regard.

The position of SID is clear from the following disclosures that are found in the cover page
of any SID:

 The Scheme Information Document sets out concisely the information about the scheme
that a prospective investor ought to know before investing. Investors should also ascertain
about any further changes to the Scheme Information Document after the date of this
document from the mutual fund / investor service centres / website / distributors or
brokers before investing in the scheme.

 The scheme particulars have been prepared in accordance with the Securities and
Exchange Board of India (Mutual Funds) Regulations, 1996, as amended till date, and

24
 filed with SEBI, along with Due Diligence Certificate from the AMC. The units being offered
for public subscription have not been approved or recommended by the Securities and
Exchange Board of India nor has Securities and Exchange Board of India certified the
accuracy or adequacy of the Scheme Information Document.

 The investors are advised to refer to the Statement of Additional Information (SAI) for
details of the mutual fund, tax and legal issues and general information on the website of
the mutual fund.

 SAI is incorporated by reference (is legally a part of the Scheme Information Document).
For a free copy of the current SAI, please contact your nearest Investor Service Centre or
log on to the mutual fund website.

 The Scheme Information Document should be read in conjunction with the SAI and not in
isolation.

 This Scheme Information Document is dated ________.

The Cover Page also has the following information:

 Name of the Scheme, type of Scheme (equity, balanced, income, debt, liquid, ETF,
etc.; open-end / close-ended / interval), name of the AMC, classes of units offered
for sale, price of the units, opening date, closing date and scheme re-opening date
(if applicable);.

 Names of mutual fund, AMC and trustee company, along with address and website details

 If the scheme is an assured returns scheme, then the name of the guarantor

The highlights section would have the following information:

 Investment objective

 Liquidity

 Benchmark

 Transparency / NAV Disclosure

 Loads

 Minimum Application Amount

The definitions section explains all the terms used in the SID that are not explained in the
regulations.

Risk factors, to be disclosed in legible fonts, are grouped into standard risk factors and
scheme specific risk factors. Some of these risk factors are as follows:

 Standard Risk Factors

o Investment in mutual fund units involves investment risks such as trading volumes,
settlement risk, liquidity risk, default risk including the possible loss of principal.

o As the price / value / interest rates of the securities in which the scheme invests

25
 fluctuates, the value of your investment in the scheme may go up or down (Mutual
funds may also provide factors affecting capital market in general and not limited to
the aforesaid).

o Past performance of the sponsor / AMC / mutual fund does not guarantee future
performance of the scheme.

o The name of the scheme does not in any manner indicate either the quality of the
scheme or its future prospects and returns.

o The sponsor is not responsible or liable for any loss resulting from the operation of
the scheme beyond the initial contribution of _____ made by it towards setting up the
fund.

o The present scheme is the first scheme being launched under its management. (This
would be mentioned, if the AMC has no previous experience in managing a Mutual
Fund).

o The present scheme is not a guaranteed or assured return scheme (This is mentioned
for all schemes except assured return schemes).

 Scheme-specific Risk Factors

o Arising from the investment objective, the investment strategy and the asset allocation
of the scheme

o Arising from non-diversification, if any

o Arising out of close-ended schemes, namely infrequent trading, discount to NAV etc.

o In the case of assured returns schemes, the net worth and liquidity position of the
guarantor and the source of the guarantee has to be disclosed.

o If the return is assured only for a specific period, then there needs to be a statement
to the effect that there is no guarantee that such return may be generated for the
remaining duration of the scheme.

The due diligence certificate mentioned in the cover page has to be signed by the compliance
officer, chief executive officer, managing director, whole time director, or executive director of
the AMC. The certificate, which is included verbatim in the SID, has the following confirmations:

 The draft Scheme Information Document forwarded to SEBI is in accordance with the
SEBI (Mutual Funds) Regulations, 1996 and the guidelines and directives issued by SEBI
from time to time.

 All legal requirements connected with the launch of the scheme as also the guidelines,
instructions, etc. issued by the government and any other competent authority in this
behalf, have been duly complied with.

 The disclosures made in the Scheme Information Document are true, fair and adequate
to enable the investors to make a well-informed decision regarding investment in the
proposed scheme.

26
 The intermediaries named in the Scheme Information Document and Statement of
Additional Information are registered with SEBI and such registration is valid, as on date.

An important section of the SID is the scheme details, where the following information
is included:

 Type of scheme, i.e. open / close / interval, equity / debt / income / liquid / balanced /
ETF, etc.

 Scheme’s investment objective and policies (including the types of securities in which it
will invest) is to be clearly and concisely stated

 Scheme’s proposed asset allocation, giving the broad classification of assets and indicative
exposure level in percentage terms specifying the risk profile, as follows:

Instrument Indicative Allocation (% of total assets) Risk Profile

Maximum Minimum High / Medium / Low

 The asset allocation should be consistent with the investment objective of the scheme.

 If the scheme’s name implies that it will invest primarily in a particular type of security,
or in a certain industry or industries, the scheme should have an investment policy which
requires that, under normal circumstances, at least 65 per cent of the value of its total
assets be invested in the indicated type of security or industry.

 Percentage of investment in foreign securities, derivatives, stock lending, securitized debt,

etc. is to be indicated.

 The types of instruments in which the scheme will invest and the concerned regulations
and limits applicable

 Various derivative products that the scheme will invest in, specifying (i) the instruments
to be used and (ii) the applicable limits

 The investment strategies of the scheme - Information about investment approach and
risk control should be included in simple terms.

 In case the scheme proposes to invest in derivatives, the various strategies to be adopted
by the fund manager are to be disclosed.

 Assured return schemes need to disclose:

o How many schemes have assured returns, their number and corpus size?

o The justification as to how the net worth and liquidity position of the guarantor would
be adequate to meet the shortfall in these schemes.

o Details of the schemes which did not pay assured returns in the past and how the
shortfall was met.

27
 The floors and ceilings within a range of 5% of the intended allocation (in %) against each
sub asset class / credit rating, as per the following sample matrix:

Instruments:Credit Rating-> AAA AA A BBB

Certificate of Deposits
Commercial Paper
Non-Convertible Debentures
Securitised Debt
Any other

 Portfolio turnover policy has to be disclosed, particularly by equity oriented schemes

 In discussing its investment strategies, the scheme has to briefly discuss the probable
effect of such strategies on the rate of the total portfolio turnover of the scheme, if such
effects are significant; and also other consequences which will result from the higher
portfolio turnover rate, e.g. higher brokerage and transaction cost.

Fundamental Attributes

o Type of Scheme

o Investment Objective (Main objective & Investment pattern)

o Terms of the issue

o Provision for liquidity (Listing, Re-purchase, Redemption)

o Aggregate fees and expenses

o Any safety net or guarantee

 Benchmark - The name and the justification (specific to the scheme objective) for the use
of benchmark index with which the performance of the scheme can be compared with.

 Name, age, qualification and experience of the fund manager to the scheme to be
disclosed. The experience of the fund manager should include last 10 years of experience
and also the name of any other schemes under his / her management.

 All the investment restrictions as contained in the Seventh Schedule to SEBI (Mutual
Funds) Regulations, 1996 and applicable to the scheme should be incorporated.

 Further, in case the fund follows any internal norms vis-à-vis limiting exposure to a
particular scrip or sector, etc. apart from the aforementioned investment restrictions, the
same need to be disclosed.

o In case of equity schemes only equity related investment restrictions need to be

disclosed, though the scheme would be investing a portion of the assets in bonds for
liquidity or for other purposes.

o In the case of a fixed income / debt schemes, only the investment restriction applicable
to bonds is to be disclosed.

28
 o In the case of balanced schemes, all investment restrictions are to be disclosed.

Past performance of the scheme, as shown in the following table:

[In case of a new scheme, this Compounded Scheme Benchmark

is not applicable. Hence give Annualised Returns Returns % Returns %
the statement-“This scheme is a
new scheme and does not have Returns for the last 1
any performance track record”] year
Or
Returns for the last 3
[In case of a scheme in existence, years
the return figures shall be given
for that scheme only. For a Returns for the last 5
scheme which is in existence for years
more than 1 year, the returns
given will be Compounded Returns since inception
Annualised Returns and for
scheme which is in existence Year-wise returns for the last 5 financial years
for less than 1 year, the returns Yearwise Returns for the last 5 financial years
would be absolute returns since 20

inception. Absolute returns for

15
10
Returns

each financial year for the last

5
0
-5
5 years shall be represented by 10
-15
means of a bar diagram as per -20
a-b b-c c-d d-e e-f
the adjacent format.] Last 5 Financial Years

Scheme Returns (%) Benchmark Returns (%)

The SID has the following details of the units and the offer, in general:

 New Fund Offer (NFO)

Opening date, Closing Date, Offering Price, Minimum Application Amount, Minimum Target
Amount, Maximum Amount to be raised (if any), Plans / Options offered, Dividend policy,
Allotment procedure, Refund procedure, Who can invest, Where to submit applications,
How to apply, Listing, Special facilities (e.g., SIP, SWP, STP), Restrictions on Transfer

 Ongoing Offer

Re-opening date, How sale and re-purchase price will be determined, Cut-off timing, Where
applications are to be submitted, Minimum amount for transactions, Minimum balance to
be maintained, Consequences of non-maintenance of minimum balance, Special facilities,
Procedures regarding account statement, dividend, redemption and consequences of
delay

 Periodic disclosures that will be made e.g. NAV

 Brief policies of the mutual fund with regard computation of NAV of the scheme in
accordance with SEBI (Mutual Funds) Regulations, 1996.

o Rounding off policy for NAV as per the applicable guidelines.

o Policy on computation of NAV in case of investment in foreign securities.

29
Fees, expenses and loads, which have a direct bearing on investors’ returns are detailed
as follows:

 Initial Issue Expenses

For the scheme proposed to be issued, the nature of the issue expenses to be incurred,
such as advertising expenses, commission to agents or brokers, registrar’s expenses,
printing and marketing expenses and postage and miscellaneous expenses need to be
described. The source for meeting these expenses may be disclosed.

 Annual Scheme Recurring Expenses (as a per cent of Average Weekly Net Assets)

Expenses chargeable to the scheme need to be quantified. This would include investment
management and advisory fee, trustee fee, custodian fee, registrar and transfer agent
fee, marketing and selling expenses, brokerage and transaction cost on distribution of
units, audit fee, investor communications cost, investor servicing cost, fund transfer cost,
insurance premium, winding up costs for termination, cost of statutory advertisement,
etc. Some of these expenses can be clubbed together.

 If there is more than one plan, then the expense is to be given separately for each plan.

 The mutual fund has to update the current expense ratios on the website within two
working days, mentioning the effective date of the change.

 The maximum limit for management fee and annual scheme running expense as per SEBI
regulations too are to be disclosed.

 Load Structure gives the details of Exit Load, CDSC

The SID also makes a reference to the investors’ rights that are detailed in the SAI.

Finally, the SID mentions penalties, pending litigation or proceedings, findings of inspections
or investigations for which action may have been taken or is in the process of being taken by
any regulatory authority against the mutual fund or AMC.

3.3 Statement of Additional Information (SAI)

The Statement of Additional Information features details that are common across
schemes, such as:

 Information about the Mutual Fund Sponsor, AMC and Trustee Companies

 Constitution of the Mutual Fund

ABC (the “Mutual Fund”) has been constituted as a trust on _______ in accordance with
the provisions of the Indian Trusts Act, 1882 (2 of 1882) with XYZ, as the Sponsor and
DEF as the Trustee. The Trust Deed has been registered under the Indian Registration Act,
1908. The Mutual Fund was registered with SEBI on ____________under Registration
Code MF

 Sponsor

ABC Mutual Fund is sponsored by XYZ. The Sponsor is the Settler of the Mutual Fund Trust.

30
 The Sponsor has entrusted a sum of ` _______ to the Trustee as the initial contribution
towards the corpus of the Mutual Fund.

 Financial Performance of the Sponsor (past three years) is as follows:

o Net Worth

o Total Income

o Profit after Tax

o Assets Under Management (if applicable).

 Trustees

DEF (the “Trustee”), through its Board of Directors, shall discharge its obligations as
trustee of the ABC Mutual Fund. The Trustee ensures that the transactions entered into
by the AMC are in accordance with the SEBI Regulations and will also review the activities
carried on by the AMC.

 Details of Trustee Directors as follows:

o Name, Age, Qualifications, Brief Experience

o Responsibilities and duties of the Trustee as well as the specific and general due
diligence.

 Asset Management Company

STP Ltd. is a private limited company incorporated under the Companies Act, 1956
on ________, having its Registered Office at _____________________. STP Ltd. has
been appointed as the Asset Management Company of the -----------Mutual Fund by
the Trustee vide Investment Management Agreement (IMA) dated ___________, and
executed between DEF and STP.

 Details of AMC Directors as follows:

Name, Age, Qualifications, Brief Experience

State the Duties and obligation of the AMC as specified in the SEBI Mutual Fund Regulations.

 Information on Key Personnel is as follows:

o Name, Age, Qualifications, Brief Experience of CEO, CIO, Operations Head, Compliance
Officer, Sales Head, Risk Manager, Investor Relations Officer.

o The AMC may decide on the key personnel it wants to mention in the SAI in addition
to the persons mentioned above.

 Service Providers

Details of Custodian, Transfer Agent, Statutory Auditor, Legal Counsel, Fund Accountant,
Collecting Bankers.

 Condensed Financial Information about Schemes

31
 Details to be given for all schemes launched by the mutual fund in last 3 fiscal years
(excluding redeemed schemes)

o NAV at beginning of year

o Dividend

o NAV at end of year

o Annualised Return

o Net Assets at end of period

o Ratio of Recurring Expenses to Net Assets.

 How to Apply?

 Procedures and KYC Requirements

 Rights of Unit-holders in Scheme

 Investment Valuation Norms for Securities and Other Assets

 Tax, Legal and General Information

o Applicable tax provisions for Mutual Fund and for investments in Mutual Fund scheme.

o Information on Nomination Facility, KYC Requirements, Requirements of Prevention

of Money Laundering Act, Transfer and transmission of units, Duration of the scheme/
Winding up, Procedure and manner of winding up, etc.

o Information on Underwriting, Securities Lending and Borrowing by the Mutual Funds,

Inter-scheme transfers, Associate Transactions, etc.

 Documents available for inspection:

The following documents will be available for inspection at the office of the Mutual Fund
at ________________________________ during business hours on any day (excluding
Saturdays, Sundays and public holidays):

o Memorandum and Articles of Association of the AMC.

o Investment Management Agreement.

o Trust Deed and amendments thereto, if any.

o Mutual Fund Registration Certificate.

o Agreement between the Mutual Fund and the Custodian.

o Agreement with Registrar and Share Transfer Agents.

o Consent of Auditors to act in the said capacity.

o Consent of Legal Advisors to act in the said capacity.

o Securities and Exchange Board of India (Mutual Funds) Regulations, 1996 and
amendments from time to time thereto.

32
 o Indian Trusts Act, 1882.

 Investor Grievances Redressal Mechanism

o Brief description of the investors’ complaints history for the last three fiscal years for
existing schemes, and the redressal mechanism thereof.

o The SAI should include data updated every two months on the number of complaints
received, redressed and pending with the Mutual Fund.

SAI is to be updated within 3 months of the end of each financial year.

3.4 Key Information Memorandum (KIM)

The Key Information Memorandum (KIM) is a summary of the SID and SAI. As per SEBI
regulations, every application form is to be accompanied by the KIM. Being brief, it is easier
to review. KIM is more commonly found in the market with distributors, investors etc.

The important contents of KIM are:

 Name of the AMC, mutual fund, Trustee, Fund Manager and scheme

 Dates of Issue Opening, Issue Closing & Re-opening for Sale and Re-purchase

 Plans and Options under the scheme

 Risk Profile of Scheme

 Price at which Units are being issued and minimum amount / units for initial purchase,
additional purchase and re-purchase

 Benchmark

 Dividend Policy

 Performance of scheme and benchmark over last 1 year, 3 years, 5 years and since
inception.

 Loads and expenses

 Contact information of Registrar for taking up investor grievances

KEY INFORMATION MEMORANDUM

Scheme
(________________________)
Offer for Units ofRs.10 Per Unit for cash during the
Initial Offer Period and at NAV based prices upon re-opening

Initial Offer Opens on:

Initial Offer Closes on:
Scheme Re-opens for continuous sale and
repurchase on:

33
This is followed by the riskometer.

This Key Information Memorandum (KIM) sets forth the information, which a prospective investor
ought to know before investing. For further details of the scheme/Mutual Fund, due diligence
certificate by the AMC, Key Personnel, investors’ rights & services, risk factors, penalties &
pending litigations, associate transactions etc. investors should, before investment, refer to the
Scheme Information Document and Statement of Additional Information available free of cost
at any of the Investor Service Centres or distributors or from the website www. ___________.

The Scheme particulars have been prepared in accordance with Securities and Exchange Board
of India (Mutual Funds) Regulations 1996, as amended till date, and filed with Securities and
Exchange Board of India (SEBI). The units being offered for public subscription have not been
approved or disapproved by SEBI, nor has SEBI certified the accuracy or adequacy of this KIM.

Investment Objective
Asset Allocation Pat- Types of Instruments Normal Allocation (% of Net Assets)
tern of the scheme Equity and Equity
Linked Instruments
Debt securities
Money market in-
struments
Risk Profile of the Mutual Fund Units involve investment risks including the pos-
Scheme sible loss of principal.
Please read the SID carefully for details on risk factors before
investment.
Scheme specific Risk Factors are summarized below:





Plans and Options
Applicable NAV (after
the scheme opens for
repurchase and sale)
Minimum Application Purchase Addition- Repurchase
Amount/ Number of al Pur-
Units chase
Despatch of Repur- Within 10 working days of the receipt of the redemption request
chase (Redemption) at the authorised centre of the ------- Fund.
Request
Benchmark Index
Dividend Policy

34
Name of the Fund Man-
ager
Investment Objective
Name of the Trustee
Company
[In case of a new scheme, Compounded Annu- Scheme Benchmark Returns
the statement should be alised Returns Returns %
given “This scheme does %
not have any performance Returns for the last 1
track record”] year
Or
Returns for the last 3
[In case of a scheme in
years
existence, the return fig-
ures shall be given for that Returns for the last 5
scheme only, as per the years
For a scheme which is in Returns since inception
existence for more than Year-wise returns for the last 5 financial years
1 year, the returns given Yearwise Returns for the last 5 financial years
will be Compounded An- 20
15

nualised Returns and for

10
Returns

5
0
scheme which is in exis- -5
10
-15
tence for less than 1 year, -20
a-b b-c c-d d-e e-f
the returns would be ab- Last 5 Financial Years
solute returns since incep- Scheme Returns (%) Benchmark Returns (%)

tion.
Absolute returns for each
financial year for the last 5
years shall be represented
by means of a bar diagram
as per the adjacent for-
mat.
Expenses of the New Fund Offer Period Continuous Offer
Scheme Entry load : ---- Entry load : ----
(i) Load Structure Exit load : ---- Exit load : ----
(ii) Recurring expenses CDSC (if any) : CDSC (if any) : __
First Rs. 100 crores : Actual expenses for the previous
Next Rs. 300 crores : financial year: ----
Next Rs. 300 crores : (Not Applicable in case of a new
Balance : scheme)
Tax treatment for the Investor are advised to refer to the details in the Statement of
Investors (Unitholders) Additional Information and also independently refer to his tax
advisor.

35
 Daily Net Asset Value The NAV will be declared on all ------- days and will be pub-
(NAV) Publication lished in 2 newspapers. NAV can also be viewed on www.___
and http://www.amfiindia.com/ [You can also telephone us at
------ (optional) ].
For Investor Grievanc- Name and Address of Name, address, telephone number, fax
es please contact Registrar number, e-mail id of ------Mutual Fund
Unitholders’ Informa- frequency and the policy of the fund house for the providing the
tion Accounts Statement, Annual Financial results and Half yearly
portfolio to the investors.

Date: N.B. Data and information shall be up-to-date but in no case older than 30 days from
the date of KIM

The fund account statement gives the following details of the investor:

o Name of investor, Folio Number, Account No.

o PAN No.

o Bank Mandate Details

o Scheme including option

o Number of units held at the beginning of the statement period, additional units purchased,
any units sold / redeemed and the closing balance of units held

o If investment has been made through a distributor, then the distributor’s name

o Cost of purchase, Dividends declared

Unit-holders are entitled to account statements of their holdings and transactions, on an

ongoing basis, as follows:

o If there are no transactions, then once every 6 months. The AMC may:

a) Send it along with the Portfolio Statement or Annual Report of the scheme

b) Send a soft copy, instead of hard copy, if investor has given such a mandate.

o In the case of SIP / SWP / STP:

a) The AMC shall send it once every quarter ending March, June, September and
December within 10 working days of the end of the respective quarter.

(However, the first account statement under SIP/STP/SWP has to be issued within 10
working days of the initial investment).

o The AMC has to provide it on Unit-holders’ request, within 5 working days, without any
charges.

o AMCs have to issue consolidated account statement (across all mutual funds) for
each calendar month, by the 10th of the following month, to investors in whose folios
transaction(s) has/have taken place during that month.

36
3.5 Fact Sheets
Although fact sheet is not mandated by SEBI, most AMCs come out with a monthly fact sheet.
Some also come out with an annual fact sheet.

The information commonly found in fact sheets is as follows:

 Market round up and view on future direction

 Scheme-wise details on:

o Name of scheme

o Investment objective

o Options

o Dividend frequency

o Load structure

o Minimum investment amount

o Corpus

o Key ratios such as portfolio turnover, Beta, standard deviation, alpha, Sharp ratio,
weighted average maturity, duration

o Benchmark

o Inception date

o Performance of the scheme as compared to the benchmark

Since inception

Yearwise for the last 5 years

o Current value of Rs. 10,000 invested in the scheme and in the benchmark

 Portfolio details – Composition of net assets with details of securities, credit rating, sector
etc.

Note:

Readers are advised to visit the website of AMCs to review samples of SID, SAI, KIM and
Fact Sheets. These are easily downloadable from the websites, free of cost. These can be
compared to the data given in this chapter and the various sections identified

3.6 Points to remember

 The Scheme Information Document has all information specific to the scheme. It is to be
updated within 3 months of the end of every financial year.

 SAI is incorporated by reference (is legally a part of the Scheme Information Document).

 Risk factors, to be disclosed in legible fonts in SID, are grouped into standard risk factors
and scheme specific risk factors.

37
 The due diligence certificate has to be signed by the compliance officer, chief executive
officer, managing director, whole time director, or executive director of the AMC.

 Assured return schemes need to disclose:

o How many schemes have assured returns, their number and corpus size?

o The justification as to how the net worth and liquidity position of the guarantor would
be adequate to meet the shortfall in these schemes.

o Details of the schemes which did not pay assured returns in the past and how the
shortfall was met.

 Statement of Additional Information features details that are common across schemes.
It is to be updated within 3 months of the end of each financial year.

 Key Information Memorandum is a summary of the SID and SAI. As per SEBI regulations,
the KIM is attached to the Application Form.

 If there are no transactions, unit-holders are entitled to account statements of their
holdings every 6 months.

 AMCs have to issue consolidated account statement (across all mutual funds) for
each calendar month, by the 10th of the following month, to investors in whose folios
transaction(s) has/have taken place during that month.

 Although fact sheet is not mandated by SEBI, most AMCs come out with a monthly fact
sheet. Some also come out with an annual fact sheet.

3.7 Ready Reckoner

Contents of the Offer Document

• Details of the sponsor and the AMC

• Description of the scheme and the investment objective

• Terms of issue

• Historical statistics

• Investor’s rights and services

• Fee structure and expenses

• Information on income and expenses of existing schemes

38
Front page of the offer document contains its date of publication, name & type of
fund and its major objectives. Specifically the following

• Name of Mutual Fund

• Name of Scheme

• Type of Scheme (Equity/Income/Balanced)

• Name of AMC

• Unit Price

• Opening, Closing & Earliest Closing date

• Name of Guarantor if the scheme is an assured return

• SEBI disclaimer

• Statement to the effect that it is important for a prospective investor to read it and
retain for future reference

• Abridged version of the OD is called as Key Information Memorandum (KIM)

• Investors are required to read and understand the offer document before investing
in mutual funds

• No recourse is available to investors for not reading the OD or KIM, as they sign the
form stating that they have read the OD

• OD is issued by the AMC on behalf of the Trustees

• KIM has to be compulsorily made available along with the application form.

• Closed end funds issue an offer document at the time of the NFO

• Trustees approve the contents of the OD and KIM

• The format and content of the OD has to be as per SEBI guidelines.

• The AMC prepares the OD and is responsible for the information contained in the
OD

• The Compliance Officer has to sign the due diligence certificate. He is usually an
AMC employee

• The due diligence certificate states that:

o Information in the OD is according to SEBI formats

o Information is verified and is a true and fair representation of facts

o All constituents of the fund are SEBI registered

39
• SEBI does not approve or certify the contents of the OD

• Factors common all funds are called as standard risk factors. These include market
risk, no assurances of return, etc.

• Factors specific to a scheme are scheme-specific risk factors in the Offer Document.

• These include restrictions on liquidity such as lock-in period, risks of investing in the
first scheme of a fund etc.

• Fundamental attributes of a scheme include its basic features

• For any change in the fundamental attributes, investor approval is not needed.
Trustees and SEBI should approve the change.

• Each investor should be informed through a communication and given the option to
exit without paying any exit load.

• A scheme can not make any guarantee or return, without stating the name of the
guarantor, and disclosing the net worth of the guarantor. The past performance of
the assured return schemes should also be given.

• Information on existing schemes and financial summary of existing schemes to be

given for 3 years

• Information on transaction with associate companies to be provided for past 3

years

• If any expense incurred is higher than what was stated in the OD, for past schemes,
explanation should be given.

• There is no information on other mutual funds, their product or performance in the

OD

• Investors’ rights are stated in the OD

• The borrowing instructions on the mutual fund should be disclosed. This includes
the purposes and the limits on borrowing

• Investors have the right to inspect a number of documents. These are:

o Trust deed

o Investment management agreement

o SEBI (MF) Regulations

o AMC annual reports

o Unabridged Offer Document

o Annual reports of existing schemes

o 3 years track records of investor’s complaints and redressal should be disclosed

in OD

40
• Any pending cases or penalties against sponsors or AMC should be disclosed in the
OD

• The offer document contains detailed information, while the KIM is a summary form
of the OD

• If any information is crucial to the investor, it will be found in both KIM and OD. For
example, the details of guarantee if the scheme is an assured return scheme.

• The name and addresses of the Trustees and AMC directors will be found in the KIM,
but the details of their role, responsibilities and duties will not be found in the KIM,
but only in the OD

• The OD and KIM are documents of a mutual fund and there will be no information
about other mutual funds in an OD. There will be no comparisons are data on
performance of other mutual funds.

• The OD and KIM will not contain names of securities in which the mutual fund plans
to invest. Only broad allocation will be given.

41
CHAPTER 4 : N
 OVEL PORTFOLIO STRUCTURES
IN MUTUAL FUND SCHEMES

The investor in any mutual fund scheme is buying into a portfolio of securities. The upsides
and downsides on that portfolio, and the expenses of running the scheme belong to the
investors.

In general, the fund manager holds the right to select securities for the scheme, subject to
limits that have been set in the scheme information document, and certain prudential limits
on holding of securities. These limits were discussed in the earlier Chapters. Based on the
type of investments they select, given these limits, we have seen that there are various types
of Schemes called Equity, Debt, Balanced and so on.

Sometimes, mutual funds come out with variations from the normal portfolio structure, to
cater to unique customer needs. In this Chapter, we will look at some common novel portfolio
structures.

4.1 Index Funds

An Index is an indicator of the market’s or a particular sector’s performance. Indices are used
as benchmarks against which a mutual fund schemes performance is measured.

Every mutual fund scheme has to disclose its benchmark. For instance, diversified equity
funds use Nifty 50 as a benchmark. Equity schemes that propose to go beyond large cap
companies can opt for NIFTY 500. Nifty Midcap 50 can be considered for equity schemes that
invest mainly in mid cap companies. Similarly, there are sectoral indices for sector funds and
debt indices for debt funds.

Fund managers who operate on the mandate of “beating the benchmark” are said to run
active schemes or managed schemes. They seek to perform better than the benchmark.
Comparision of mutual performance with that of its benchmark is called relative performance
of schemes. Parameters for such quantitative evaluation of schemes are discussed in
Chapter [6].

The danger with active management is that the fund manager can also get beaten by the
benchmark. The fund manager seeks to beat the benchmark through superior stock selection.
But if the investment portfolio fares poorly, as compared to the benchmark, then the relative
performance suffers.

Active management also calls for higher investment in stock analysis. This is passed on to the
actively managed schemes in the form of higher costs of investment.

Some investors are satisfied with the benchmark returns. However, buying all the shares
that go into the benchmark, in the same proportion as in the benchmark, requires large
investment. Retail investors may not be able to do this.

Alternatively, the investor can buy futures contracts on the benchmark. For instance, Nifty

42
Futures. But here again, the investment requirement is high. Further, futures are typically
short term products of upto 3 months maturity. A long term investor will need to keep rolling
over (close out the near month contract and buy the next month contract) the futures contract
at the end of its expiry.

Index schemes make it convenient for investors to take the benchmark exposure by investing
small amounts. For instance, the minimum investment amount is as low as Rs. 1,000 in some
schemes. With such a low investment outlay, the investor is effectively getting exposure to a
basket of 50 stocks that represent the Nifty 50.

 The index scheme maintains a portfolio that mirrors the index. That is how they ensure
that the performance of the index gets translated into the scheme. As will be seen in the
next chapter, index schemes have a Beta of 1. The features of index schemes are:They
are passive schemes, because the fund manager does not do stock selection.

 The stocks and their weightage in the scheme, depend on the composition of the index
that the scheme is replicating.

 This kind of investment behaviour is cheaper for the mutual fund scheme to administer.

 Investor in the passive scheme also benefits through lower investment advisory fees.

 The index scheme performance will not beat the performance of the underlying index.

Example: A Nifty 50 Index Fund invests in companies whose securities are included in Nifty
50 Index to achieve the returns of the above index as closely as possible. This fund does not
seek to outperform the Nifty 50, but merely replicate its behavior for investors looking for a
cheaper investment avenue having the same returns as the index.

The below image depicts the comparative returns of the Nifty 50 Index Fund with that of the
Nifty 50 Index for 2 years as on January 23, 2017

Fig 1: A Nifty 50 Index Fund returns v/s Nifty 50 (2yrs)

Source: Moneycontrol.com

43
4.2 Exchange Traded Funds (ETFs)
Despite its best efforts, the index scheme performance may not be perfectly in line with the
index. The gap in the performance between the index scheme and the index is called ‘tracking
error’. This is caused by several factors:

 Timing differences

The NAV at which investors are allotted units, depends on the time stamp on the investor’s
application and timing of receipt of funds. For example, an investor whose application is
received before 3 p.m. is allotted units at the closing NAV of the application date. Although
the units would have been allotted on the basis of the same day’s NAV, the scheme itself
will receive funds only after a couple of days. By the time the scheme receives funds
and invests, the market may have changed. If the market goes higher at the time of
investment, then the scheme performance suffers.

 Liquidity

The Nifty 50 only comprises 50 stocks. The scheme however invests in the 50 stocks,
plus money in the bank. The liquidity needs of the scheme determine the money it keeps
in the bank. This portfolio difference from the Nifty causes a gap between the scheme
performance and index performance.

 Costs

The index fund will charge investment advisory fees, though they are lower than in
actively managed schemes. Similarly, there are other costs like registrar fees, trustee
fees, brokerage etc.

Even if the mutual fund scheme somehow managed a perfect mirroring of the index, its
performance will be lower than the index on account of the cost and fees.

 Inability to Time the market

Another weakness of index schemes is that all the investors investing up to the cut-off
time will get units at the same NAV. There is no difference between a 10 am investor, a
12 noon investor or a 2 pm investor. The market however changes every micro second.
An investor, who is buying index schemes that are close-ended, may find its price in the
exchange changing in line with the market. But then, investors cannot be sure that they
will be able to trade. Liquidity is better for open-ended schemes, where investors can offer
their units for re-purchase or buy new units, any day, at NAV-based prices.

Exchange Traded Funds address some of the above issues with Index Funds. They are securities
that track a particular index or portfolio of securities and trade on the stock exchange like
common stock. They can be bought and sold throughout the day and all price variations are
reflected real-time in the ETF.

Exchange Traded Funds started as passive funds (investing as per an index), though active
ETFs have been launched abroad. In India, we only have passive ETFs. When the scheme is
launched, its connection with the index is announced. For instance, 500 ETF units = 1 unit of
CNX Nifty.

44
ETFs are open-ended funds that can be bought at prices, which vary during the day, and
operate with low tracking error. They achieve this combination of features through their unique
structure as follows:

 ETFs receive funds from investors only during the NFO. These are invested by the date the
scheme goes opens and declares its NAV. Post-NFO, the scheme does not receive funds
from investors, thus avoiding the investment timing problems normally associated with
index funds.

 Being open-ended, they need to sell new units on a daily basis. Post-NFO, the ETF only
sells units against securities. Therefore, an investor who wants to buy ETF units after the
NFO needs to offer the requisite Nifty securities, in the same proportion as the index.

 Similarly, the scheme fulfils the need of daily re-purchase of its units, by releasing the
requisite Nifty securities. An investor who offers his units for re-purchase will receive Nifty
securities in the same proportion as the index - not funds. Therefore, the scheme does not
need to maintain liquid funds. This eliminates another reason for the tracking error found
in index schemes.

Smaller investors do not have the transaction size to receive and give the requisite
Nifty securities. The mutual fund lists the ETF units in the stock exchange, and appoints
identified brokers as ‘market makers’ to facilitate the transactions of small investors.

The market maker gives a two-way quote for the ETF units. Thus, investors know at what
price they can buy or sell the ETF units. As with any securities transaction in the stock
exchange, the ETF units are bought and sold by the market maker against funds. The
broker will also charge a brokerage for the transaction.

Such market makers’ transactions with the investors do not go through the books of the
scheme, the scheme does not run into the timing differences and liquidity needs that
normal open-ended index funds face. Also, ETFs have lower transaction costs than an
actively managed fund, which makes it attractive for smaller retail investors.

In order to trade in the above manner, the investor needs to have a demat account and
trading account with the broker.

Since the ratio between each unit and the index is frozen, the units are expected to trade
in the exchange on the basis of that intrinsic value. There are however occasions when,
on account of ignorance or lack of liquidity, ETFs are traded at prices that are significantly
different from their intrinsic value. Buying ETF units at higher than their intrinsic worth is
not advisable.

Example:

This Exchange Traded Fund is an open ended, index linked, exchange traded fund. The
investment objective of the scheme is to provide returns that closely correspond to the total
returns of securities as represented by Nifty 50. The below chart shows the performance of
the ETF over a 2 year horizon as on January 23, 2017

45
Fig 2: The ETF 2-yr performance

Source: Moneycontrol.com

4.3 Arbitrage Funds

In an arbitrage, the investor takes opposite positions in two transactions. The net effect is
that no new position is created, but a spread is earned on the difference between the two
transactions.

For instance, shares of a company may be bought in the cash market, and futures (with
underlying as the same number of shares on the same company) are sold. The cash and
futures positions balance each other.

Normally, the futures price would be higher than the cash price. The difference in prices is the
riskless profit earned from the arbitrage. The difference tends to capture the cost of funds for
the period of the contract, though at times it may be higher or lower than the funding cost.
In periods of extreme volatility, the futures price can be much higher than the cash price for
the same underlying.

Arbitrage funds focus on such arbitrage transactions. The returns are closer to liquid funds,
which capture the short term funding cost in the market. It can be higher in volatile market
conditions.

As will be seen in Chapter 11, equity funds are more tax efficient than debt funds. The
interesting aspect of arbitrage funds is that the return profile is closer to a debt fund. On
account of the compensating positions taken, the market risk is negligible – lesser than in
a normal debt fund. Yet, they offer the tax efficiency of equity funds, because the positions
taken are in the equity market.

The investment objective of an Arbitrage Advantage Fund is ‘to seek to generate reasonable
returns by predominantly investing in arbitrage opportunities in the cash and derivatives
segments of the equity markets and by investing balance in debt and money market
instruments’.

46
4.4 Monthly Income Plans (MIP)
Monthly Income Plans maintain a portfolio that is debt-oriented. Equity component is as low as
15-20%. The high debt component, with its daily interest accrual, balances the volatility risks
on the low equity component. The nature of equity and debt investments made is also safer
in MIP. With such a portfolio structure, the MIP hopes to pay a monthly income to investors.

Mutual fund schemes offer income to investors through declaration of dividend. As discussed
in the previous chapter, dividend can only be declared if the scheme has distributable reserves.
There are occasions where on account of significant decreases in MTM valuation, the scheme
will not have the distributable reserves to distribute a dividend. Portfolio losses may be higher
than the income accrual. In such cases, the scheme cannot declare a dividend. Therefore,
investor needs to be clear that there is no guarantee regarding the monthly income.

The MIP portfolio, with low allocation to equity, is appropriate for most risk averse investors.
They need to take exposure to equity to protect themselves against inflation. The MIP portfolio
with its relatively low NAV volatility is appropriate for such investors.

However, MIP is not appropriate for investors who depend on the monthly income to meet
their regular expenses. Such investors should rely on safer investments (like Post Office
Monthly Income Scheme) that assure a monthly income to meet their monthly expenses.
Example: A Monthly Income Plan seeks to generate reasonable returns through investments
in Debt and Money Market Instruments The secondary objective of the scheme is to invest in
equity and equity related instruments to seek capital appreciation. As on October 28, 2016,
its holdings included:

Equity 24.01%

Debt 67.48%

Cash / Call 8.51%

4.5 Fixed Maturity Plans (FMP)

A major risk in debt investments is the price risk arising out of changes in yields in the
market. As discussed in the next chapter, Weighted Average Maturity and Modified Duration
are measures of this risk.

This price risk is a market phenomenon. Until maturity, debt securities trade in the market
at prices that fluctuate with interest rates. However, on maturity, the issuer redeems the
instrument at the agreed value. The redemption amount, which is paid by the issuer, is not a
function of the market. The only uncertainty is the one created by credit risk. Will the issuer
be able to pay the redemption amount?

Thus, on maturity of a debt instrument, the market risk is no longer a factor. A scheme that
invests all its moneys for the same maturity as the scheme’s own maturity will thus be able to
eliminate the market risk on maturity. FMPs are structured in this manner.

FMPs are close-ended scheme. Their Scheme Information Document will not only mention the
maturity of the scheme, but also the credit rating of the instruments it will invest in.

47
Suppose, an FMP is offered for 3 years, and it proposes to invest in only AAA securities. If
AAA companies are paying 9% on 3-year securities, and the expense ratio of the scheme is
indicated to be 0.5%, then the investor can expect a return of 9% minus 0.5% i.e. 8.5% from
the 3-year FMP. This is not a guaranteed return, but an indicative return that the investor can
expect.

The point to note is that until maturity, the scheme has a market risk. Therefore its NAV can
fluctuate. An FMP investor selling the units before maturity can earn a return higher or lower
than the indicative return. However, it is sometimes difficult to redeem FMPs before maturity
as the market is not liquid.

Example: A Fixed Maturity Plan - 1919D is a 1919 Day FMP. The investment objective of the
Plan is to generate income through investments in Debt / Money Market Instruments and
Government Securities maturing on or before the maturity date of the Plan.

6 Capital Protection Oriented Schemes

Like MIPs and other hybrid funds, Capital Protection Oriented Schemes too, invest in a mix of
debt and equity securities. However, the investment philosophy here is different. The portfolio
of capital protection oriented schemes is structured to ensure that the investor at least gets
back the capital invested.

These schemes are offered as close-ended schemes. Suppose a capital protection oriented
scheme of 7 years is offered to investors. If yields on government securities of the same
maturity are 8%, then Rs. 58.35 invested today in government securities will grow to Rs. 100
in 7 years.

The mutual fund scheme will therefore allocate 58.35% of the amount collected from investors,
to government securities. Sovereign securities do not have a credit risk – and market risk
too is eliminated by matching the scheme’s maturity with its investment maturity. Thus, the
scheme is in a position to assure investors that they will at least get their capital back at the
end of 7 years.

The remaining 41.65% of the investor’s moneys is invested in risky investments like equity. In
the worst case, these investments lose their entire value. In such an eventuality, the investor
will get only the capital back (through redemption of underlying government securities).

Realistically, the risky investments too will have some realisable value. Thus, the investor gets
the capital back, with some additional return.

Such schemes are suitable for investors who want to take some exposure to equity, but
without any risk of losing the principal invested.

Example: A Capital Protection Oriented fund seeks capital protection on maturity by investing
in fixed income securities maturing on or before the tenure of the scheme and capital
appreciation by investing in equity and equity related instruments.

Points to remember

 Every mutual fund scheme has to disclose its benchmark

48
 Fund managers who operate on the mandate of “beating the benchmark” are said to run
active schemes or managed schemes.

 Comparision of mutual performance with that of its benchmark is called relative

performance of schemes.

 The index scheme mirror the index. Index schemes have a Beta of 1.

 Exchange Traded Funds started as passive funds (investing as per an index), though
active ETFs have been launched abroad. In India, we only have passive ETFs.

 ETFs are open-ended funds that can be bought at prices, which vary during the day, and
operate with low tracking error.

 The returns in a arbitrage fund are closer to liquid funds, which capture the short term
funding cost in the market. It can be higher in volatile market conditions.

 Monthly Income Plans maintain a portfolio that is debt-oriented. Equity component is as

low as 15-20%.

 FMP invests all its moneys for the same maturity as the scheme’s own maturity. Thus,
price risk is eliminated on maturity.

 FMP is a close-ended scheme. Return is not guaranteed, but investor can operate with an
indicative yield based on yields in the market and the expense ratio of the scheme.

 Capital Protection Oriented Schemes invest in a mix of debt and equity securities. They
are offered as close-ended schemes.

49
CHAPTER 5 : V
 ALUATION OF INVESTMENTS BY
MUTUAL FUND SCHEMES

We know that the value of any Mutual Fund Scheme is given by the Net Asset Value or NAV.
This value is derived from the value of the investments made by the scheme, and it reflects
timely changes in the prices of investments. Hence, all investments of mutual fund schemes
need to be marked to market (MTM) in order to determine the realistic value of each unit
of the scheme. The method for carrying out MTM valuation differs based on the nature of
investments. SEBI has laid down detailed rules regarding MTM valuation of the investment
portfolio of schemes. Let us look at these below.

5.1 Equity

5.1.1 Traded Securities

The securities are valued at the last quoted closing price on the stock exchange.

 When the securities (scrips) are traded on more than one recognised stock exchange, the
securities are valued at the last quoted closing price on the stock exchange where the
security is principally traded. The asset management company selects the appropriate
stock exchange, but the reasons for the selection should be recorded in writing.

It is permissible for all scrips being valued at the prices quoted on the stock exchange
where a majority in value of the investments are principally traded.

Once a stock exchange has been selected for valuation of a particular security, reasons
for change of the exchange have to be recorded in writing by the asset management
company.

 When on a particular valuation day, a security has not been traded on the selected stock
exchange, the value at which it is traded on another stock exchange can be used. For
instance, if you are valuing the security of ABC traded on the BSE on January 27, 2017. If
it has not been traded on BSE on January 27, 2017, you can consider the last traded price
of ABC on the NSE instead.

 When a security is not traded on any stock exchange on a particular valuation day, the
value at which it was traded on the selected stock exchange or any other stock exchange,
on the earliest previous day can be used, provided the last traded date is not more than
30 days prior to the valuation date. For eg: If the security ABC was last traded on January
20, 2017, and you are trying to value your fund on January 27, 2017, and if there have
been no trades of ABC between January 20 and January 27, then you have to consider
the last traded price on January 20th. If it has not been traded for 30 days, it will be
considered as a non-traded security and valued as per rules given below.

50
Example

Portfolio of Mr. Patel comprises of stocks ABC, DEF and XYZ. He wants to know the value of his
portfolio as on January 20, 2017. The prices of these stocks are as follows:

Scrip Last traded date LTP on NSE LTP on BSE

ABC 17.01.2017 – 200
DEF 20.01.2017 230 231
XYZ 11.01.2017 157 156

The value of ABC, will be taken as of 17.01.2017 on the BSE even though NSE is the principal
stock exchange as on 20th it was not traded anywhere, and the last trade was on the BSE on
17th January 2017. So the price of ABC will be Rs. 200

The price of DEF will be Rs. 230 as it was traded on the same day on the NSE.

The price of XYZ will be Rs. 157 as it was last traded on 11th January on both the NSE and the
BSE, but the NSE is the principal stock exchange.

5.1.2 Non-Traded / Thinly Traded / Unlisted Equities

If a security is not traded on any stock exchange for a period of 30 days prior to the valuation
date, the scrip is treated as ‘non-traded’ scrip.

An equity share, convertible debenture, equity warrant, etc. is considered as thinly traded
if, across all stock exchanges, it trades less than Rs. 5 lakh in value and 50,000 shares in
volume, during the preceding calendar month. For example, if the volume of trade is 1,00,000
and value is Rs.4,00,000, the shares do not qualify as thinly traded. Also if the volume traded
is 40,000, but the value of trades is Rs.6, 00,000, the shares do not qualify as thinly traded

Non-traded and thinly traded securities are valued “in-good faith” by the asset management
company as per appropriate valuation methods based on the principles approved by the Board
of the asset management company. The formula for such valuation in good-faith is as follows:

 Calculate the Net Worth per share of the company, based on latest available balance sheet.

Net Worth per share = [Share Capital+ Reserves (excluding Revaluation Reserves) –
Miscellaneous expenditure and Debit Balance in Profit and Loss Account] / Number of Paid
up Shares.

 Calculate the Earnings per share of the company as per the latest audited annual accounts.

 Assess the average capitalization rate (P/E ratio) for the industry based upon either BSE
or NSE data. This is to be consistently followed.

The industry average P/E ratio has to be discounted by 75 per cent i.e. only 25 per cent
of the industry average P/E is to be considered for the valuation of the company’s share.
Earnings per Share (EPS) of the latest audited annual report must be considered.

The EPS of the company multiplied by the discounted industry average P/E is the capitalised
earning value per share of the company.

 Calculate the average of Net Worth per share and Capitalised earning value per share of
the company. This has to be further discounted by 10 per cent for illiquidity so as to arrive
at the fair value per share.

51
 If the EPS is negative, EPS value for that year is taken as zero for arriving at capitalised
earning.

 If the latest Balance Sheet of the company is not available within nine months from the
close of the year, unless the accounting year is changed, the shares of such companies
have to be valued at zero.

 If an individual security accounts for more than 5 per cent of the total assets of the
scheme, an independent valuer has to be appointed for the valuation of the said security.

 If trading in an equity security is suspended up to thirty days, then the last traded price
will be considered for valuation of that security

Unlisted equities are valued in good faith on the basis of a similar formula. However, the
discount for illiquidity is 15%. Further, with the approval of trustees, the unlisted equities may
be valued lower than the formula-based value.

Aggregate value of “illiquid securities” under a scheme, which are defined as non-traded,
thinly traded and unlisted equity shares, cannot exceed 15 per cent of the total assets of the
scheme. Illiquid securities held above 15 per cent of the total assets have to be assigned zero
value.

5.1.3 Warrants

Warrants to subscribe for shares attached to instruments, are valued at the value of the share
which would be obtained on exercise of the warrant as reduced by the amount which would
be payable on exercise of the warrant.

5.1.4 Rights

Until they are traded, the value of “rights” shares are calculated as:

Vr = n/m x (PXR - PRP)

Where

Vr = Value of rights

n = No. of rights offered

m = No. of original shares held

PXR = Ex-rights price

PRP = Rights Offer Price

If the rights are not treated paripassu with the existing shares, suitable adjustment has to be
made to the value of rights.

Where it is decided not to subscribe for the rights but to renounce them and renunciations are
being traded, the rights can be valued at the renunciation value.

5.2 Debt
Debt instruments are valued on a Yield to Maturity (YTM) basis.

52
5.2.1 Money market and debt securities with residual maturity of upto 60 days

Such securities, including floating rate securities, are to be valued at the weighted average
price at which they are traded on the particular valuation day.

When these securities are not traded on a particular valuation day they are to be valued on
amortization basis.

Floating rate securities with floor and caps on coupon rate, and residual maturity of upto 60
days are valued on amortization basis taking the coupon rate as floor.

5.2.2 Money market and debt securities with residual maturity of over 60 days

Such securities, including floating rate securities, are to be valued at the weighted average
price at which they are traded on the particular valuation day.

When these securities are not traded on a particular valuation day they are to be valued on
Yield to Maturity (YTM) basis. This is done at benchmark yield/ matrix of spread over risk free
benchmark yield obtained from agency(ies) entrusted for the said purpose by AMFI.

The applicable YTM is determined as follows:

 Based on yield on government securities, risk-free benchmark yields are calculated.

Government securities are grouped into “duration buckets” of 0.25-0.5 year, 0.5-1 year,
1-2 years, 2-3 years, 3-4 years, 4-5 years, 5-6 years, and 6 years and above for this
purpose. Thereafter, volume-weighted yield is calculated for each bucket.

 The risk-free benchmark yield is to be set at least every week. If there is any significant
movement in prices of Government Securities on account of any event impacting interest
rated on any day such as a change in the Reserve Bank of India (RBI) policies, the
benchmark has to be reset to reflect the change in market conditions.

 Credit spreads are to be calculated based on trades (minimum trade value Rs. 1 crore) of
corporate debentures/bonds of different ratings. Credit spread is the Corporate YTM for
each credit rating, minus the risk-free yield.

 All trades in the stock exchange during the fortnight prior to the benchmark date are to be
used in building the volume-weighted corporate YTM and spread matrices (for the same
duration buckets for various credit ratings). The most conservative publicly available credit
rating is to be used.

 Where there are no secondary trades on the stock exchange in a particular rating category
and no primary market issuances during the fortnight under consideration, then trades
on the stock exchange during the 30 day period prior to the benchmark date can be
considered for computing the average YTM for such rating category.

 In each rating category, all outliers are removed for smoothening the YTM matrix.

 In the event of lack of trades in the secondary market and the primary market the gaps
in the matrix are filled by extrapolation. If the spreads cannot be extrapolated for the
reason of practicality, the gaps in the matrix are filled by carrying the spreads from the
last matrix.

53
 The benchmark risk free yield plus the applicable credit spread would be the YTM used for
valuing the non-traded rated corporate paper. The Yields calculated would be marked-up/
marked-down to account for the illiquidity risk, promoter background, finance company
risk and the issuer class risk. As the level of illiquidity risk would be higher for non rated
securities the marking processfor rated and non rated securities would be differentiated
as follows:

Category Discretionary Mark up /

Mark down
+ –
Rated instruments with duration upto 2 years 100bps 50bos
Rated instruments with duration over 2 years 75bps 25bps

 The fund manager has to give an internal credit rating for paper that does not have a
public external credit rating. Since un-rated instruments tend to be more illiquid than
rated securities, the yields would be marked up by adding discretionary discount as under:

Category Discretionary Discount

Unrated instruments with duration upto 2 Discretionary discount of upto +50 bps over
years and above mandatory discount of +50 bps
Unrated instruments with duration over 2 Discretionary discount of upto +50 bps over
years and above mandatory discount of +25 bps

 Securities embedded with call option are valued at the lower of the value as obtained by
valuing the security to final maturity and valuing the security to call option. In case there
are multiple call options, the lowest value obtained by valuing to the various call dates and
valuing to the maturity date is to be taken as the value of the instrument.

 Securities with put option are valued at the higher of the value as obtained by valuing the
security to final maturity and valuing the security to put option. In case there are multiple
put options, the highest value obtained by valuing to the various put dates and valuing to
the maturity date is to be taken as the value of the instruments.

 Securities with both Put and Call option on the same day are deemed to mature on the
Put/Call day and valued accordingly.

 Government securities are valued at prices for government securities released by an

agency suggested by AMFI.

5.2.3 Provisioning for Non-Performing Assets (NPA)

An ‘asset’ is classified as NPA if the interest and/or principal amount have not been received
or remained outstanding for one quarter from the day such income and/or instalment was
due. If the due date for interest is 30.06.2011 and it is not received upto 30.09.2011, it will
be classified as NPA from 01.10.2011.

After the expiry of the 1st quarter from the date the income was due, interest accrual on the

54
asset has to be stopped. In the earlier example, accrual will continue till 30.09.2011. From
01.10.2011, the scheme has to stop accruing interest.

On classification of the asset as NPA, interest accrued and recognized in the books of accounts,
but due for more than a quarter, has to be provided for. In the example, interest accrued upto
30.06.2011 and outstanding on 30.09.2011 has to be fully provided for on 01.10.2011.

Besides the value of the asset has to be provided for as per the following schedule (or earlier,
but not later):

 10 percent of the book value of the asset has to be provided for after 6 months past
due date of interest i.e. 3 months form the date of classification of the asset as NPA i.e.
01.01.2012.

 20 percent of the book value of the asset has to be provided for after 9 months past
due date of interest i.e. 6 months form the date of classification of the asset as NPA i.e.
01.04.2012.

 20 percent of the book value of the asset has to be provided for after 12 months past
due date of interest i.e. 9 months form the date of classification of the asset as NPA i.e.
01.07.2012.

 25 percent of the book value of the asset has to be provided for after 15 months past
due date of interest i.e. 12 months form the date of classification of the asset as NPA i.e.
01.10.2012.

 25 percent of the book value of the asset has to be provided for after 18 months past
due date of interest i.e. 15 months form the date of classification of the asset as NPA i.e.
01.01.2013.

Thus, 18 months past the due date of income or 15 months from the date of classification of
the ‘asset’ as an NPA, the asset will be fully provided for.

If any instalment is due during the period of interest default, the amount of provision will be
the instalment amount or the above provision amount, whichever is higher.

Deep Discount Bonds

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

 If the rating of the Bond comes down to Grade ‘BB’ (or its equivalent) or below.

 If the company is defaulting in its commitments in respect of other assets, if available.

 Net worth is fully eroded.

Provision should be made as per the earlier mentioned norms as soon as the asset is classified
as NPA. Full provision is to be made if the rating comes down to Grade ‘D’ (or its equivalent).

The provisioning norms are applicable for both secured and unsecured debt instruments.

In the case of close-ended schemes, faster provisioning has to be done, so that the asset is
fully written off before the closure of the scheme.

55
5.2.4 Re-classification of Non-Performing Assets (NPA)

 If the company has fully cleared all the arrears of interest, the interest provisions can be
written back in full.

 The asset will be reclassified as performing on clearance of all interest arrears and if the
debt is regularly serviced over the next two quarters.

 In case the company has fully cleared all the arrears of interest, the interest not credited
on accrual basis can be credited at the time of receipt.

 The provision made for the principal amount can be written back as follows:

o 100% of the asset provided for in the books will be written back at the end of the 2nd
quarter, if the provision of principal was made due to default in interest only.

o 50% of the asset provided for in the books will be written back at the end of the
2nd quarter and 25% after every subsequent quarter, if both instalment and interest
payment were in default earlier.

 An asset is reclassified as ‘standard asset’ only when both, the overdue interest and
overdue instalments are paid in full and there is satisfactory performance for a subsequent
period of 6 months.

5.2.5 Provisioning & Re-classification in case of Re-scheduling

If a company defaults in payment of either interest or principal amount, and the mutual fund
has accepted a rescheduling of the obligations, the following norms are applicable:

 If it is a first rescheduling, and only payment of interest is in default, the classification of
the asset as NPA will be continued and existing provisions shall not be written back. After
two quarters of regular servicing of the debt, it can be classified as ‘performing asset’ and
the interest provided can be written back.

 If the rescheduling is done due to default in interest and principal amount, the asset will
continue as NPA for a period of 4 quarters. If the asset is regularly serviced during these
4 quarters, the asset can be classified as ‘performing asset’. Thereafter, all the interest
provided till such date can be written back.

 If the rescheduling is done for a second / third time or thereafter, the characteristics of
NPA will be continued until it is regularly serviced for eight quarters. Thereafter, it can be
reclassified as ‘performing asset’ and interest provided for can be written back.

5.3 Gold
The gold held by a gold exchange traded fund scheme has to be valued at the AM fixing price
of LBMA in US dollars per troy ounce for gold having a fineness of 995.0 parts per thousand.
Where the gold held by a gold exchange traded fund scheme has a greater fineness, the
relevant LBMA prices of AM fixing is taken as the reference price.

The following adjustments are made for the valuation:

 Conversion to metric measure as per standard conversion rates

 Conversion of US dollars into Indian rupees as per the RBI reference rate declared by the
Foreign Exchange Dealers Association of India (FEDAI)

56
 Addition of transportation and other charges that may be normally incurred in transporting
the gold from London to the place where it is actually stored on behalf of the mutual fund

 Addition of notional customs duty and other applicable taxes and levies that may be
normally incurred in transporting the gold from London to the place where it is actually
stored on behalf of the mutual fund

The adjustment for transportation and customs duty can be made on the basis of a notional
premium that is usually charged for delivery of gold to the place where it is stored on behalf
of the mutual fund.

5.4 Real Estate

The real estate assets held by a real estate mutual fund scheme are to be valued –

(a) at cost price on the date of their acquisition; and

(b) at fair price on every ninetieth day from the day of their purchase.

“Cost” includes purchase price and any other directly attributable expenditure such as
professional fees for legal services, registration expenses and asset transfer taxes.

If the payment for a real estate asset is deferred, its cost is the cash price equivalent. A real
estate mutual fund scheme has to recognise the difference between this amount and the total
payments, as interest expense over the period of credit.

A real estate mutual fund scheme is required to use the services of two independent and
approved valuers having recent experience in the category of real estate asset being valued
and use the lower of the two valuations.

“Fair value” means the amount for which an asset can be exchanged between knowledgeable
parties in an arm’s length transaction and certified by the real estate valuer.

“Real estate valuer” means a qualified valuer of real estate assets who has been accredited
by a credit rating agency registered with SEBI.

“Knowledgeable” means that both the buyer and the seller are reasonably informed about the
nature and characteristics of the real estate asset, its actual and potential uses, and market
conditions at the balance sheet date.

The net asset value of every real estate mutual fund scheme is to be calculated and declared
at the close of each business day on the basis of the most current valuation of the real estate
assets held by the scheme and accrued income thereon, if any.

Where a portion of the real estate asset is held to earn rentals or for capital appreciation, and
if the portions can be sold or leased separately, the real estate mutual fund scheme has to
account for the portions separately.

The fair value of real estate asset should not reflect future capital expenditure that will improve
or enhance the asset. Similarly, it cannot reflect the related future benefits from the future
expenditure.

57
5.5 Other Investments
If any security purchased by a mutual fund does not fall within the current framework of
valuation of securities, it has to report immediately to AMFI regarding the same. Further, at
the time of investment, it has to ensure that the total exposure in such securities does not
exceed 5% of the total AUM of the scheme.

AMFI is to ensure that valuation agencies cover such securities in the valuation framework
within six weeks from the date of receipt of such intimation from the mutual fund. Until then,
the mutual fund can value such securities using their proprietary model which has been
approved by their independent trustees and the statutory auditors.

AMCs have to ensure that similar securities held under its various schemes are valued
consistently.

5.6 Points to remember

Invested security Valuation
Traded securities Last quoted closing price on stock exchange
Non-traded and thinly Valued in good faith by AMC as per appropriate valuation
traded securities methods approved by Board of the AMC
Unlisted equities Valued in good faith, discounted for illiquidity @15%
Warrants Value of share that would be obtained – amount payable on
exercise of warrant
Rights renounced Renunciation value
Money market and short- Weighted average price traded on the valuation day. If not
term debt securities traded, to be valued on amortization basis.
(maturity <91 days)
Money market and short- Weighted average price traded on valuation day. If not traded,
term debt securities to be valued on YTM basis
(maturity > 91days)
Securities with call Lower of the value as obtained by valuing the security to final
option maturity and valuing the security to call option.
Securities with put Higher of the value as obtained by valuing the security to final
option maturity and valuing the security to put option.
Government securities Prices released by agency suggested by AMFI
Assets classified as NPA Provisioning to be done for value of assets
Gold held by Gold ETF AM fixing price of LBMA in USD per troy ounce fr gold having a
fineness of 995.0 ppt
Real estate assets Cost price on date of acquisition and fair price every 90th day
held by real estate MF from day of purchase
scheme

58
CHAPTER 6 : Q
 UANTITATIVE EVALUATION OF
MUTUAL FUND SCHEMES

Any mutual fund scheme is as good as the returns it provides for a certain amount of risk that
the investor takes. These risks and returns can be quantified using certain measures. This
chapter takes a more detailed view into the quantitative evaluation of mutual fund schemes.
The various measures can be depicted as follows:

XIRR

Return CAGR

Compounding
Periodic returns
Quantitative
Evaluation Standard
Deviation

Beta
Risk
Weighted average
maturity

Modified duration

In the first half of the chapter we will look at measures for Returns from the scheme and in
the second half we will look at measures to assess Risk in a scheme.

6.1 Returns

6.1.1 XIRR

Dividend payments in a scheme depend on profits. Some debt schemes do declare dividend
daily or weekly. These are exceptions to the general rule that unlike debt, mutual funds
cannot work with pre-specified dividend payment dates.

Calculating returns with irregular dividend payment dates becomes easier using the XIRR
function in Spreadsheet (in MS Excel, Open Office etc.).

Calcuation of return using XIRR Function

Suppose an investor bought 1,000 units in the dividend payout option of a scheme, on January
15, 2011, when the NAV was Rs. 14 per unit. On July 1, 2011 the scheme distributed a

59
dividend of Rs. 2 per unit. Another dividend of Rs. 1.50 per unit was distributed on December
10, 2011. The investor exited the scheme on February 1, 2012, when the NAV was Rs. 15 per
unit. The applicable exit load was 1%.

The re-purchase price is Rs. 15 minus 1% i.e. Rs. 14.85 per unit. Having bought the units at
Rs. 14 per unit, a capital gain of Rs. 0.85 per unit is earned. The investor has also received
dividend twice during the investment holding period. The cash flows and compounded return
can be calculated as shown in Table 6.1:

(The cash flows are shown from the investor’s point of view. Therefore, purchase is shown as
negative cash flow; dividend and re-purchase are positive cash flows)

Table 6.1: XIRR Calculation for first purchase

Calculation of Return with Additional Purchase using XIRR Function

Suppose the investor bought another 500 units on September 15, 2011 at Rs. 13 per unit.
The investor sold only 1,000 units on February 1, 2012. The revised calculation is shown in
Table 6.2.

(The second dividend is earned on 1,500 units. The balance 500 units that the investor holds
on February 1, 2012 is also shown at its realisable value, net of exit load)

Table 6.2: XIRR on additional purchase

60
6.1.2 Dividend Re-investment (CAGR)

XIRR is an easy approach to calculating returns. Indeed, it is widely used in the market. A
weakness of the XIRR function is that it assumes that the dividend receipts would have been
re-invested at the same XIRR rate. This is a questionable assumption.

SEBI has therefore stipulated that returns should be calculated assuming that the dividends
have been re-invested in the same scheme at the Ex-dividend NAV i.e. the NAV after every
dividend payment. As will be appreciated, after every dividend payment, the NAV goes down.

The calculation therefore calls for the ex-dividend NAV after each dividend distribution.

Illustration:

Suppose it was Rs. 12.50 per unit on July 1, 2011 and Rs. 13.594 per unit on December 10,
2011.

On the original 1,000 units, the investor received dividend of Rs. 2 per unit i.e. Rs. 2,000 on
July 1, 2011.

Based on re-investment of dividend, the additional units the investor would have on July 1,
2011 would be Rs. 2,000 ÷ Rs. 12.50 i.e. 160 units.

The second dividend would therefore be received on the original 1,000 units plus the additional
160 units i.e. 1,160 units. At Rs. 1.50 per unit, the total dividend amounts to Rs. 1,740.

The dividend re-investment would yield Rs. 1,740 ÷ Rs. 13.594 i.e. 128 new units.

The total units thus becomes 1,160 + 128 i.e. 1,288. At Rs. 14.85 per unit, this would be
valued at Rs. 19,127 on February 1, 2012, as compared to the original investment of Rs.
14,000 on January 15, 2011. The investment holding period is 382 days.

The compounded annual growth rate (CAGR) can be calculated as follows:

CAGR = 100 X {(I2 ÷ I1) (1÷r)}-1

i.e. 100 X {(19,127 ÷ 14,000)(365÷382} - 1

i.e. 34.74%
The detailed cash flows are shown in Table 6.3

Table 6.3 Calculation of Return using CAGR

61
The requirement of finding out the dividend rate and the ex-dividend NAV after each
dividend and accordingly determining the additional units make the calculation cumbersome.
Therefore, the CAGR calculation is more commonly used in statutory communication, such as
Scheme Information Document, Performance advertisements etc. In other situations, market
intermediaries use the XIRR.

Another variation is to apply the CAGR on the growth option of the scheme. Since no dividend
is declared in the growth option, the cumbersome dividend re-investment calculations are
avoided.

6.1.3 Compounding of Periodic Returns

The above calculations cover a period of more than a year, but the NAV of only 4 days have
been used. Intermediate NAVs have been ignored. Researchers often work with NAVs at
periodic intervals – daily, weekly, monthly etc. The periodic returns are then averaged and
compounded, as shown in in the below table.

Illustration

The periodic return from January 15, 2011 to February 15, 2011 is 100 X (Rs. 13.75 –
Rs. 13.50) ÷ Rs. 13.50 i.e. 1.85%. Similarly, periodic returns have been calculated for the
following months.

The average of the periodic returns is 1.05%. Since each period is of 1 month, this average
too is a monthly return. This can be compounded using the formula (1+monthly return)12- 1
to give the annual return of 13.36%.

Table 6.4 Calculation of Compounded Return from Monthly Returns

62
The formula for compounding of periodic returns varies depending on the period.
For instance, while working with weekly returns, the compounding formula would be
(1 + Weekly Return)52 – 1, since there are 52 weeks in the year.

6.2 Risk

6.2.1 Standard Deviation

Standard deviation measures the extent to which the scheme returns deviate from its
own past standards. This can be easily calculated using the Spreadsheet function ‘STDEV’
as shown in Table 6.5. The standard deviation, based on monthly returns is 2.53%. This
needs to be compounded to its annual equivalent, by multiplying it by the square root of
12. (If the periodic returns were weekly, the multiplication factor would be square root
of 52).

Thus, the annualised standard deviation is 8.78%.

Table 6.5 Calculation of Standard Deviation

This is to be compared with other schemes of the same type e.g. diversified equity funds,
liquid funds etc.

A high standard deviation would mean that the scheme deviates more from its past standard
i.e it is more risky.

6.2.2 Beta

An alternate approach to measure equity risk is based on Capital Assets Pricing Model (CAPM),

63
discussed in NCFM’s workbook titled Securities Market (Advanced) Module. We saw that there
are two risks in investing in equity:

 Systematic risk (β) is inherent to equity investments e.g. the risk arising out of political
turbulence, inflation etc. It would affect all equities, and therefore cannot be avoided.

 Non-systematic risk is unique to a company e.g. risk that a key pharma compound will not
be approved, or the risk that a high performing CEO leaves the company. Non-systematic
risk can be minimized by holding a diversified portfolio of investments.

Since investors can diversify away their non-systematic risks, they have to be compensated
only for systematic risk.

Calculation of beta calls for information on the value of the market index on each of the days
for which the NAV information is used. A diversified index like CNX Nifty has to be used.

Based on the value of Nifty on each of those days, the periodic returns can be calculated, as
was done for the scheme returns. Thereafter, the ‘slope’ function can be used in Spreadsheet.
The details are shown in Table 6.6.

Table 6.6 Calculation of Beta

The Beta is 0.98 is close to 1. This means that the scheme returns are closely aligned with
that of the Nifty.

If the beta is more than 1, it means that the scheme is more risky than the market. A value
of beta that is less than 1 would mean that the scheme is less risky than the market.

Since index schemes mirror the portfolio of their benchmark index, their risks are expected

64
to be similar. Therefore, beta of an index scheme would be close to 1, as seen in the above
example.

6.2.3 Weighted Average Maturity

Fixed rate debt instruments have a price risk. When interest rates in the market go up, the
debt instruments already issued, based on the erstwhile lower interest rates, lose value.
Similarly, when interest rates in the market go down fixed rate debt instruments gain value.

The extent of such depreciation or appreciation of fixed rate debt instruments in response to
changes in yields in the market, is influenced by the tenor of the instruments. Instruments
that have a longer maturity are more volatile than those with shorter maturity.

Therefore, the weighted average maturity of the portfolio of a mutual fund scheme becomes
an indicater of the scheme’s price risk. Higher the weighted average maturity, more the
scheme’s NAV is likely to fluctuate in response to changes in market yields.

The calculation of weighted average maturity is illustrated in Table 6.7 for a scheme with debt
portfolio of Rs. 255 crore. The weighted column is calculated as Tenor X Proportion for each
row.

Table 6.7 Calculation of Weighted Average Maturity

A liquid fund would have its investments in securities of upto 91 days. Therefore, its weighted
average maturity would be less than 0.25 years.

6.2.4 Modified Duration

While maturity influences the price risk in a debt security, a more scientific approach would be
to consider its modified duration.

Suppose the modified duration is to be calculated as of January 15, 2012, for a security that
offers a coupon of 11% p.a., payable half-yearly, until it matures on January 25, 2014. The
security is currently traded in the market at an yield of 11.5%.

The modified duration can be calculated using the MDURATION function in Spreadsheet. This
is shown in Table 6.8.

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Table 6.8 Calculation of Modified Duration of a Debt Security

The implication is that if the yields in the market were to change by 1%, this debt security is
likely to change in value by 1.68%.

If the coupon payments were quarterly, the frequency would be shown as 4; annual coupon
payment would mean frequency of 1.

In this manner, the modified duration can be calculated for every debt security in the scheme’s
portfolio. Thereafter, the modified duration for the scheme can be calculated, as shown in
Table 6.9.

Table 6.9 Calculation of Modified Duration for Scheme

Higher the modified duration, more sensitive the NAV of a scheme is, to changes in yields in
the market.

66
6.3 Risk Adjusted Returns
Having determined the risk and return, there are various frameworks through which a
combined view of the two can be taken for better investment decisions. Some of these are:

6.3.1 Sharpe Ratio

In the example considered in Table 6.4, the compounded return was 13.36%. The annualised
standard deviation was calculated to be 8.78% in Table 6.5. Let us say that a risk-free return
of 7% would have been possible, if the same money was invested in government bonds.

Thus, by investing in the scheme, the investor earned a return that was higher by 13.36%
minus 7% i.e. 6.36%. This is his risk premium, a premium earned for the risk taken.

If the risk premium of 6.36% is divided by the standard deviation of 8.78%, we get a value
of 0.72, which is the Sharpe Ratio (Table 6.10)

This indicates that for every unit of risk taken (as measured by standard deviation), the
investor earned a return of 0.72%. This is the Sharpe Ratio.

Table 6.10 Calculation of Sharpe Ratio for Scheme

In a comparision of two schemes of the same type, the one with the higher Sharpe Ratio is
considered to have delivered superior risk-adjusted returns.

Sharpe Ratio can be used for debt schemes as well as equity schemes.

6.3.2 Sortino Ratio

Standard deviation is calculated on the basis that both positive and negative moves are a
risk. A view can be taken that only the negative returns are a risk. Accordingly, the downside
deviation can be calculated as the standard deviation of only the negative returns in Table
6.5. This works out to 1.03%. Multiplied by the square root of 12, the annualised downward
deviation is calculated to be 3.57%.

The Sortino Ratio is the Risk Premium calculated earlier, divided by the annualised downward
deviation i.e. 6.36% ÷ 3.57% = 1.78.

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Within a category of schemes (applicable for both debt and equity schemes), the scheme with
the higher Sortino Ratio is viewed as offering a better risk-adjusted return.

6.3.3 Treynor Ratio

The Treynor Ratio is the Risk Premium calculated earlier, divided by the Beta, which was
calculated to be 0.98 in Table 6.6. It thus works out to 6.36% ÷ 0.98 = 6.47%.

As in the case of the previous ratios, a higher Treynor Ratio is indicative of better risk-adjusted
return. However, this ratio should ideally be used only for diversified equity portfolios.

6.3.4 Jensen’s Alpha

Alpha is a measure of the fund manager’s performance.

In the process of managing a non-index scheme, the fund manager may take a risk (as
measured by beta) that is different from the market risk; the scheme returns too are likely to
be different from the market.

Logically, if the fund manager took a higher risk than the market, he ought to deliver a
return that is higher than the market. Alpha compares the return which ought to have been
generated (for the risk taken) by the scheme with the return that was actually generated.
The difference between the two is out-performance (if actual return is higher) or under-
performance (if actual return is lower).

Alpha can be positive or negative. It is calculated using the INTERCEPT function in Spreadsheet,
as shown in Table 6.11.

Between two fund managers of competing diversified equity schemes, the one with higher
alpha is considered to have delivered better risk adjusted returns.

Table 6.11 Calculation of Jensen’s Alpha for Scheme

The fund manager of this scheme has demonstrated a minor out-performance of 0.03%.

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6.4 Points to remember

XIRR

Return CAGR

Compounding
Periodic returns
Quantitative
Evaluation Standard
Deviation

Beta
Risk
Weighted average
maturity

Modified duration

69
CHAPTER 7 – C
 UT-OFF TIME REGULATIONS
AND TIME STAMPING

7.1 Introduction
When an investor buys or sells shares in the secondary market, there is no financial implication
on the company whose shares are being traded or its other shareholders. However, subscription
to and re-purchase of units of a mutual fund scheme, affect the financials of the scheme;
these transactions therefore affect the scheme’s other investors.

 If investors are permitted to subscribe to new units of a scheme at a price lower than their
intrinsic value, then the prior investors lose out.

 Similarly, if investors are able to offer their units for re-purchase at a price higher than
their intrinsic value, the investors who continue in the scheme lose out.

 If investors subscribe to or re-purchase units at their intrinsic value, then neither the prior
investors nor the continuing investors are adversely affected.

The intrinsic value of the units of a scheme, is its NAV. The NAV however keeps changing. The
schemes declare their NAV every day.

 Allowing an investor to invest at yesterday’s NAV, if the market has gone up today, is
again unfair.

 Similarly, it would be unfair to allow an investor to offer his units for re-purchase at
yesterday’s NAV, after the investor has seen a decline in the market today.

Therefore, the day whose NAV the investor gets – the day of the transaction, or a preceding
or succeeding day – too is important and material to the transaction. A few operational factors
compound the problem:

 The scheme may receive a cheque for subscription to new units on Day T. But the money
will be received in the scheme’s bank accounts only on Day T+1 or Day T+2. By then, the
market may change.

 Banks may credit the money into the account as of a “value date”. But the funds may be
available for investment by the scheme, only on the following day.

 Unscrupulous investors may stop payment of their subscription cheque if they see the
market going down after the application for subscription has been sent.

Considering all these dynamics, SEBI has mandated detailed regulations on the applicable
NAV for investors’ transactions with various types of schemes in different situations. The
applicable NAV depends on whether or not the investor’s application for subscription / re-
purchase was received before the specified “cut-off” timing. This is applicable to all mutual
funds. It is to be uniformly applied to all investors. The only exceptions are:

 International funds

 Transactions in Mutual Fund units undertaken on a recognized Stock Exchange

70
Mutual Funds have to ensure that each payment instrument for subscription or purchase of
units is deposited in a bank expeditiously by utilization of the appropriate banking facility.
AMCs have to compensate any loss occasioned to any investor or to the scheme and/or plan
on account of non-compliance.

Mutual Funds need to calculate NAV for each calendar day for their liquid fund schemes and
plans.

7.2 Cut-Off Timing

7.2.1 Liquid Schemes & Plans - Subscriptions

The following NAVs are to be applied:

 Where the application is received upto 2.00 p.m. on a day and funds are available for
utilization before the cut-off time without availing any credit facility, whether, intra-day
or otherwise – the closing NAV of the day immediately preceding the day of receipt of
application;

 Where the application is received after 2.00 p.m. on a day and funds are available for
utilization on the same day without availing any credit facility, whether, intra-day or
otherwise – the closing NAV of the day immediately preceding the next business day;
meaning the closing NAV of the day of receipt of application; and

 Irrespective of the time of receipt of application, where the funds are not available for
utilization before the cut-off time without availing any credit facility, whether, intra-day or
otherwise – the closing NAV of the day immediately preceding the day on which the funds
are available for utilization.

“Business Day” does not include a day on which the money markets are closed or otherwise
not accessible.

For allotment of units in respect of purchase in liquid schemes, it has to be ensured that:

 Application is received before the applicable cut-off time.

 Funds for the entire amount of subscription/purchase as per the application are credited
to the bank account of the respective liquid schemes before the cut-off time.

 The funds are available for utilization before the cut-off time without availing any credit
facility whether intra-day or otherwise, by the respective liquid schemes.

For allotment of units in respect of switch-in to liquid schemes from other schemes, it has
to be ensured that:

 Application for switch-in is received before the applicable cut-off time.

 Funds for the entire amount of subscription/purchase as per the switch-in request are credited
to the bank account of the respective switch-in liquid schemes before the cut-off time.

 The funds are available for utilization before the cut-off time without availing any credit
facility whether intra-day or otherwise, by the respective switch-in schemes.

71
7.2.2 Liquid Schemes & Plans – Re-Purchases

The following NAVs are to be applied:

 Where the application is received up to 3.00 pm – the closing NAV of day immediately
preceding the next business day; which means the closing NAV of the same day; and

 Where the application is received after 3.00 pm – the closing NAV of the next business
day.

7.2.3 Other than Liquid Schemes & Plans - Subscriptions

The following NAVs are to be applied:

 Where the application is received up to 3.00 pm with a local cheque or demand draft
payable at par at the place where it is received – closing NAV of the day on which the
application is received;

 Where the application is received after 3.00 pm with a local cheque or demand draft
payable at par at the place where it is received – closing NAV of the next business day;
and

 Where the application is received with an outstation cheque or demand draft which is not
payable on par at the place where it is received – closing NAV of day on which the cheque
or demand draft is credited.

In respect of purchase of units in Income/ Debt oriented schemes (other than liquid fund
schemes and plans) with amount equal to or more than Rs. 1 crore, irrespective of the time
of receipt of application, the closing NAV of the day on which the funds are available for
utilization is applicable.

For allotment of units in respect of purchase in income/debt oriented mutual fund schemes/
plans other than liquid schemes, it has to be ensured that:

 Application is received before the applicable cut-off time (3 pm).

 Funds for the entire amount of subscription/purchase as per the application are
credited to the bank account of the respective schemes before the cut-off time
(3 pm).

 The funds are available for utilization before the cut-off time (3 pm) without availing any
credit facility whether intra-day or otherwise, by the respective scheme.

For allotment of units in respect of switch-in to income/debt oriented mutual fund schemes/
plans other than liquid schemes from other schemes, it has to be ensured that:

 Application for switch-in is received before the applicable cut-off time.

 Funds for the entire amount of subscription/purchase as per the switch-in request are
credited to the bank account of the respective switch-in income/debt oriented mutual
fund schemes/plans before the cut-off time.

 The funds are available for utilization before the cut-off time without availing any credit

72
facility whether intra-day or otherwise, by the respective switch-in income/debt oriented
mutual fund schemes/plans.

7.2.4 Other than Liquid Schemes & Plans – Re-purchases

The following NAVs are to be applied:

 Where the application is received up to 3.00 pm – closing NAV of the day on which the
application is received; and

 An application received after 3.00 pm – closing NAV of the next business day.

7.2.5 At a Glance

Liquid Schemes - Subscriptions

Application with funds available before 2.00 pm Closing NAV of previous day
Application with funds available after 2.00 pm Closing NAV of same day
Application with funds available later, irrespective Closing NAV of previous day of funds
of time availability

Liquid Schemes - Repurchases

Application received before 3.00 pm Closing NAV of same day

Application received after 3.00 pm Closing NAV of next day

Other than Liquid Schemes - Subscriptions

Application received before 3 pm with local cheque

or demand draft Closing NAV of same day
Application received after 3 pm with local cheque
or demand draft Closing NAV of next day
Application received with outstation cheque or Closing NAV of the day funds are
demand draft realised

Other than Liquid Schemes - Repurchases

Application received before 3 pm Closing NAV of same day

Application received after 3 pm Closing NAV of next day

7.3 Official Points of Acceptance (PoA)

In order to ensure transparency in capturing the timing, SEBI has mandated official points of
acceptance for receipt of these applications. Application from investors are to be received by

73
mutual funds only at the official points of acceptance, addresses of which have to be disclosed
in the SID and on Mutual Funds’ websites.

The Official PoA are typically offices of the AMC and RTA. Offices of the DP can also be an
Official PoA for re-purchase transactions. Offices of stock exchange brokers can be Official PoA
for transactions routed through the stock exchange.

7.4 Time Stamping Requirements

 For every machine, running serial number has to be stamped from the first number to the
last number as per its capacity before repetition of the cycle.

 Every application for purchase is to be stamped on the face and the corresponding payment
instrument is to be stamped on the back indicating the date and time of receipt and the
running serial number. The application and payment instrument should contain the same
serial number.

 Every application for redemption has to be stamped on the face and on the investor’s
acknowledgment copy (or twice on the application if no acknowledgment is issued)
indicating the date and time of receipt and running serial number.

 Different applications cannot be bunched together with the same serial number.

 Blank papers should not be time stamped. Genuine errors, if any, are to be recorded with
reasons and the corresponding applications requests are to be preserved.

 The time stamping machine should have a tamper proof seal and the ability to open the
seal for maintenance or repairs must be limited to vendors or nominated persons of the
mutual fund, to be entered in a proper record.

 Breakage of seal and/or breakdown of the time stamping process has to be duly recorded
and reported to the Trustees.

 Every effort should be made to ensure uninterrupted functioning of the time stamping
machine. In case of breakdown, the mutual funds have to take prompt action to rectify
the situation. During the breakdown period, mutual funds need to adopt an alternative
time stamping method that has already been approved by the Board of the AMC and the
Trustee(s). An audit trail should be available to check and ensure the accuracy of the time
stamping process during the said period.

 Any alternate mode of application that does not have any physical or electronic trail needs
to be converted into a physical piece of information and time stamped in accordance with
the time stamping guidelines.

 Mutual Funds need to maintain and preserve all applications/ requests, duly time stamped,
at least for a period of eight years. They should be able to produce them as and when
required by SEBI or auditors appointed by SEBI.

7.5 Points to remember

 If investors are permitted to subscribe to new units of a scheme at a price lower than their
intrinsic value, then the prior investors lose out.

74
 Similarly, if investors are able to offer their units for re-purchase at a price higher than
their intrinsic value, the investors who continue in the scheme are cheated.

 If investors subscribe to or re-purchase units at their intrinsic value, then neither the prior
investors nor the continuing investors are adversely affected.

 The applicable NAV for a transaction depends on whether or not the investor’s application
for subscription / re-purchase was received before the specified “cut-off” timing. This
is applicable to all mutual funds. It is to be uniformly applied to all investors. The only
exceptions are:

o International funds

o Transactions in mutual fund units undertaken on a recognized Stock Exchange

 Where the application is received in a liquid scheme by 2.00 p.m. and funds are available
for utilization before the cut-off time on the same day, units will be allotted based on the
closing NAV of the day immediately preceding the day of receipt of application.

 Where the application is received in a liquid scheme after 2.00 p.m. and funds are available
for utilization on the same day units are allotted based on the closing NAV of the day
immediately preceding the next business day.

 Irrespective of the time of receipt of application in a liquid scheme, where the funds are
not available for utilization before the cut-off time, units are allotted at the closing NAV of
the day immediately preceding the day on which the funds are available for utilization.

 Where re-purchase application is received up to 3.00 pm, it is effected at the closing NAV
of day immediately preceding the next business day.

 Where re-purchase application is received after 3.00 pm, it is effected at the closing NAV
of the next business day.

 Where the application is received in a non-liquid scheme up to 3.00 pm with a local

cheque or demand draft payable at par at the place where it is received, units are allotted
at the closing NAV of the day on which the application is received.

 Where the application is received in a non-liquid scheme after 3.00 pm with a local cheque
or demand draft payable at par at the place where it is received, units are allotted at the
closing NAV of the next business day.

 In respect of purchase of units in Income/ Debt oriented schemes (other than liquid fund
schemes and plans) with amount equal to or more than Rs. 1 crore, irrespective of the
time of receipt of application, units are allotted at the closing NAV of the day on which the
funds are available for utilization.

 Where re-purchase application is received for a non-liquid scheme up to 3.00 pm, it is

effected at the closing NAV of the day on which the application is received.

 If re-purchase application is received for a non-liquid scheme after 3.00 pm, it is effected
at the closing NAV of the next business day.

75
 In order to ensure transparency in capturing the timing, SEBI has mandated official points
of acceptance for receipt of these applications.

 The Official PoA are typically offices of the AMC and RTA. Offices of the DP can also be an
Official PoA for re-purchase transactions. Offices of stock exchange brokers can be Official
PoA for transactions routed through the stock exchange.

 Mutual Funds need to maintain and preserve all applications/ requests, duly time stamped,
at least for a period of eight years.

76
CHAPTER 8 – I
 NVESTMENTS IN MUTUAL FUND
THROUGH NSE

8.1 Introduction
National Stock Exchange (NSE) offers a low-cost distribution reach across the country.
Therefore, the role of brokers in mutual fund distribution has been increasing. The involvement
of NSE brokers in different contexts is discussed below.

8.1.1 Listed Schemes

Under SEBI regulations, close-ended schemes are to be mandatorily listed. This is equally
applicable for debt and equity schemes. The only exception is Equity Linked Savings Schemes
(ELSS) schemes, which are not listed during the first three years after NFO. This is because
investors in ELSS are not permitted to sell their units for three years.

The difference in transactions between open-end and close-ended schemes is important to

understand:

 Acquisition of Units by the Unit-holder

o In an open-end scheme, the units are newly created by the scheme. This is called a
“sale” transaction. It happens at the NAV.

o In a close-ended scheme, the pre-existing units change hands. It happens at a price
that is discovered in the stock exchange.

 Extinguishment of Unit-holding

o In an open-end scheme, the unit-holder offers his units for “re-purchase”. This is
effected at the NAV less Exit Load (if applicable). On re-purchase, the units are
cancelled.

The exit load, in percentage terms, is frozen when the unit-holder acquires the units. It may
be different for different investors. For the same investor, the percentage may be different for
various unit holdings in the same scheme, depending on when they were acquired.

Suppose an investor acquired 100 units of a scheme at Rs. 12 per unit on January 1, 2010
when the applicable exit load was 1%. 50 units were redeemed on June 6, 2011, when NAV
was Rs. 15; balance was redeemed on October 5, 2011, when NAV was Rs. 17.

 The redemption price on June 6, 2011 for this investor would be Rs. 15 less 1% i.e. Rs.
14.85 per unit. The exit load is Rs. 0.15 per unit.

The redemption price on October 5, 2011 for the same investor for the units (that were
bought on the same day as the previous lot of units) would be Rs. 17 less 1% i.e. Rs. 16.83
per unit. The exit load is Rs. 0.17 per unit. To clarify, the exit load is frozen in percentage
terms, and is applied on the NAV on the re-purchase date.

 On the same day, another investor may have offered units for re-purchase. Suppose these

77
 units were acquired on a date other than January 1, 2010. On the acquisition date, the
applicable exit load was 0.20%. The re-purchase price for this investor would be Rs. 17
less 0.20% i.e. Rs. 16.966 per unit.

o In a close-ended scheme, the unit-holder sells the units to some counter-party at a
price that is determined in the stock exchange. The units continue to exist. Only the
name of the unit-holder changes in the scheme records.

Listed schemes (typically, close-ended) are traded through NSE’s trading system, like any other
securities. Buyers and sellers enter their orders through their respective Trading Members
(TM). The system matches orders based on price and time priority. If a match is found, a trade
is generated. The TM earns a brokerage as per the terms of the contract with the client.

NSE’s Mutual Fund Service System (MFSS, discussed below) facilitates order collection (sale
and re-purchase) for open-end schemes.

8.1.2 Exchange Traded Funds (ETFs)

Like any share or close-ended scheme, ETFs are listed on the exchange. Therefore, Trading
Members at the NSE can help clients buy and sell ETFs as part of their normal services.

Besides, market makers in ETF can benefit from two other streams of income:

 The buy-sell spread arising out the market making operations. If the market maker buys
units from investors at Rs. 50.00 per unit, and sells units to investors at Rs. 50.60 per
unit, a spread of Rs. 0.60 is earned for every unit so traded.

 Large investors subscribing to the ETF directly with the scheme, or offering their units
for re-purchase to the scheme, will need to give or receive index securities in the same
proportion as the index. There is scope to earn a brokerage, when these investors buy or
sell index securities as part of the subscription or re-purchase.

Each ETF unit is defined to be equivalent to a certain proportion of the underlying index. For
example, 100 ETF Units = 1 Nifty. In that case, if the Nifty is at 6,000, then the intrinsic value
of each ETF Unit is Rs. 60.

Since large investors may choose to transact directly with the scheme, the trading volumes in
the exchange can get low in the case of some ETFs. Low liquidity disrupts the price discovery
mechanism, on account of which the ETF units may trade at a price that is not in synch with
its intrinsic value. The risk involved in buying ETF units at prices higher than its intrinsic worth
needs to be recognised; so also, selling ETF units at prices lower than its intrinsic worth may
lead to opportunity loss.

8.1.3 Mutual Fund Service System (MFSS)

NSE launched India’s first Mutual Fund Service System (MFSS) on November 30, 2009. Using
this, an investor can subscribe or redeem units of a mutual fund scheme, through trading
members of NSE.

Trading members of NSE who are ARN holders, and who have passed the Mutual Fund

78
Distributor certification examination of National Institute of Securities Market are eligible to
participate in NMF II Online Mutual Fund Platform. They are called participants.

It is now called the NMF II Online Mutual Fund Platform. It is open for trading between 9 a.m.
and 3 p.m. on all business days of the capital market segment. Participants can make the
service available for their registered clients.

Participants need to open a separate Bank account with any of the Clearing Banks identified
by the Clearing Corporation. This will be the designated bank account for transactions under
NMF II. Pay-in of funds for subscription is to be done through the designated bank accounts
on T+1 basis, as per time lines specified by the Clearing Corporation.

Participants can choose between Physical mode and depository mode while capturing
subscription / redemption requests on the MFSS. Securities settlement is effected through
the RTA (if physical mode) or through the Depository (if Demat mode).

79
The steps in the transactions are as follows:

8.1.3.1 Subscription (Physical mode)

 T-Day activities

 Investor has to submit the following documents/details along with clear funds to the
Participant:

Completed and Signed respective scheme Application Form

Copy of PAN Card of first holder

Copy of PAN Card of each additional holder in case of joint investment /either or
survivor basis

Copy of KYC acknowledgement of all holders

Copy of Guardian’s PAN Card in case investment is on behalf of minor

Folio No. in case the subscription is an additional purchase.

 The Participant verifies the application for mandatory details including PAN details and
KYC compliant acknowledgment issued by CVL.

 After completing the verification, Participant enters the subscription order on the
MFSS front-end system with the option of ‘Physical’ settlement.

The folio No (if available) is captured on the NMF II front-end.

The NMF II identifies each scheme uniquely in terms of Symbol & Series.

Subscription orders are created in terms of Amount.

Once the order is created, system generates a unique confirmation No. for the order.

 The investor receives a confirmation slip from the Participant. It contains unique
confirmation number and date and time stamp of order entry generated from the
MFSS system. Till the Participant provides allotment details to the investor, the order
confirmation slip is proof of the transaction.

On allotment, the investor will receive Statement of Account from the RTA directly.

 The Participant writes the unique confirmation number on the physical documents and
delivers the same at any of the RTA /AMC offices as may be intimated from time to
time.

 Exchange validates the transactions on T day evening with the RTA, and any discrepancy
in the transaction details is informed to the Participant on the same day evening.

 The Clearing Corporation provides the Participants with funds obligation report end of
day for all the valid transactions.

 T+1 Day activities

 The Clearing Corporation of the Exchange debits the designated clearing bank account
of the Participants for the required funds obligation on T+1 morning.

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  In case of shortage, the concerned Participant is provided an opportunity to identify
transactions and provide details of the transactions for which payments have been
received and transactions for which payments have not been received.

 The fund collected from the bank account of the Participant is compared with the
details provided by the Participant on the payment received status.

If the funds collected from the bank account of the Participant covers the details of the
payments received as provided by the Participant, the same is further processed.

Wherever the funds collected from the bank account falls short of the amount indicated
in the details provided by the Participant, the details are considered defective and are
not further processed. In such cases, the funds collected, if any, are returned to the
designated bank account of the Participant.

The Exchange / Clearing Corporation takes appropriate action including penalty on

participants who fail to fulfil their funds obligation as required.

The Exchange notifies RTA for all such defective transactions and rejections due to
non-payment of funds.

The RTA reverses such transactions for respective Participants. Transactions for other
Participants who have fulfilled their funds obligations are processed by the RTA.

 The RTA intimates the allotment details for accepted transactions including folio
numbers.

 Allotment information is provided to the Participants so that they can provide allotment
details to the investor.

8.1.3.2 Subscription (Demat mode)

 T-Day activities

 The order is placed like a normal secondary market activity. The investor provides the
depository account details along with PAN details to the Participant. KYC performed
by DP is considered compliance with applicable requirements.

 Participant enters the subscription order on the NMF II front-end system with the
option of ‘Depository’ settlement.

The system identifies each scheme uniquely in terms of Symbol & Series.

Subscription orders are created in terms of Amount.

Once the order is created, system generates a unique confirmation number for the
order.

 The investor receives a confirmation slip from the Participant. It contains unique
confirmation number and date and time stamp of order entry, generated from the
system. Till the Participant provides allotment details to the investor, the order
confirmation slip is proof of the transaction.

81
 Demat statement given by depository participant is deemed to be adequate compliance
of the requirement of Statement of Account.

 Exchange validates the transactions on T day evening with the RTA as well as the
depository. Any discrepancy in the transaction details is informed to the Participant on
the same day evening.

 The Clearing Corporation provides the Participants with funds obligation report end of
day for all valid transactions.

 T+1 Day activities

 The Clearing Corporation of the Exchange debits the designated clearing bank account
of the Participants for the required funds obligation on T+1 morning.

 In case of shortage, the concerned Participant is provided an opportunity to identify

transactions and provide details of the transactions for which payments have been
received and transactions for which payments have not been received.

 The fund collected from the bank account of the Participant is compared with the
details provided by the Participant on the payment received status.

If the funds collected from the bank account of the Participant covers the details of the
payments received as provided by the Participant, the same is further processed.

Wherever the funds collected from the bank account falls short of the amount indicated
in the details provided by the Participant, the details are considered defective and are
not further processed. In such cases, the funds collected, if any, are returned to the
designated bank account of the Participant.

The Exchange / Clearing Corporation takes appropriate action including penalty on

participants who fail to fulfil their funds obligation as required.

The Exchange notifies RTA for all such defective transactions and rejections due to
non-payment of funds.

The RTA reverses such transactions for respective Participants. Transactions for other
Participants who have fulfilled their funds obligations are processed by the RTA.

 The RTA intimates the allotment details for the accepted transactions including folio
numbers.

 Allotment information is provided to the Participants so that they can provide allotment
details to the investor.

 RTA credits the units to the pool account of the Participant, who will credit the
depository account of the investor if payment has been received.

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8.1.3.3 Redemption (Physical Mode)

 T-Day activities

 Investor has to submit the following documents/details to the Participant:

Completed and Signed redemption request, stating the folio number.

Copy of PAN Card of first holder

Copy of PAN Card of each additional holder in case of joint investment

Copy or allotment statement / holding statement/ SOA displaying the scheme holdings
to be redeemed

Copy of Guardians PAN Card in case investment is on behalf of minor

 The Participant verifies the application for mandatory details, investor identity and
verifies the signature on the application against the PAN signature of the signatory

 After completing the application verification, the Participant enters the redemption
order on the NMF II system with the option of ‘Physical’ settlement.

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 The system identifies each scheme uniquely in terms of Symbol & Series.

For physical orders the folio No is captured on the system front-end.

Redemption orders are created either in terms of Amount or Quantity for physical
settlement.

Once the order is created system generates a unique confirmation No. for the order.

 The investor receives a confirmation slip from the Participant. It contains unique
confirmation number generated from the MFSS front-end system. This is proof of
the transaction for the investor till the redemption proceeds are received from the
registrar.

 The Participant writes the unique confirmation number on the physical documents and
delivers the same at any of the RTA /AMC offices as may be intimated from time to
time.

 Exchange validates the transactions on T day evening with the RTA and any discrepancy
in the transaction details in terms of folio number etc. is informed to the Participant
on the same day evening.

 T+1 Day activities

 RTA carries out the redemption processing at its end and provides final redemption
information to the Exchange on T+1.

The file contains information about valid and rejected redemption orders.

For successful redemptions, the file contains the redemption NAV, units redeemed,
redemption amount, STT (if any).

 Redemption information is provided to the Participants through files so that they can
provide Redemption details to the investor.

 The redemption proceeds are directly sent by RTA through appropriate payment mode
such as direct credit, NEFT or cheque as decided by AMC from time to time, as per the
bank account details recorded with the RTA.

 It is the primary responsibility of the Participant to ensure completeness of the

documents including filling up of the all Key fields by the investor before accepting the
same for processing.

 It is also the responsibility of the Participant to ensure identity and authentication
of signature affixed based on the original PAN shown at the time of accepting the
redemption application form. In case of joint holding, this is to be ensured by the
Participant for all holders.

 In case the subscription application form has not reached to the RTA, the redemption
request for such subscription will not be taken by the RTA and shall be rejected.

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8.1.3.4 Redemption (Demat Mode)

 T-Day activities

 Investor places order for redemption as currently followed for secondary market
activities. The investor provides their depository account details along with PAN
details to the Participant. The investor also provides their Depository Participant with
Depository instruction slip (a copy of which is to be provided to the participant at the
time of placing the redemption request) with relevant units to be credited to Clearing
Corporation pool account same day before 4.30 p.m.

 The Participant enters the redemption order on the NMF II system with the option of
‘Demat’ settlement.

The MFSS identifies each scheme uniquely in terms of Symbol & Series.

Redemption orders are created only in quantity.

Once the order is created system generates a unique confirmation No. for the order.

 The investor receives a confirmation slip from the Participant. It contains unique
confirmation number generated from the NMF II front-end system. This is proof of
the transaction for the investor till the redemption proceeds are received from the
registrar.

 Exchange validates the transactions on T day evening with the RTA and any discrepancy
in the transaction details in terms of DP Id etc.is informed to the Participant on the
same day evening.

 Subsequent to the validation, Clearing Corporation will provide valid orders to

depository to validate the delivery instructions (DIS) received from the investor and
accept units received if they are equal to the valid transactions. The units thus received
will be credited to the beneficiary account of the AMC(s) by the Clearing Corporation.

 For all units received through the depository system as above, the Exchange will
inform the RTA same day with details of the addresses and bank mandate as captured
on the depository system.

 T+1 Day activities

 RTA carries out the redemption processing at its end and provides final redemption
information to the Exchange on T+1.

The file contains information about valid and rejected redemption orders.

For successful redemptions, the file contains the redemption NAV, units redeemed,
redemption amount, STT (if any).

 Redemption information is provided to the Participants through files so that they can
provide Redemption details to the investor.

 The redemption proceeds are directly sent by RTA through appropriate payment mode
such as direct credit, NEFT or cheque as decided by AMC from time to time, as per the
bank account details recorded with the depository.

 The units will be extinguished by the RTA from the beneficiary account of the AMC(s)

85
a) The typical NMF II calendar is as follows:

Activity Timings
T day
Order capture for subscription and redemption on the 9.00 a.m. - 3.00 p.m
MFSS
Subscription and redemption Order status report and 5.30 p.m.
Final funds obligation statement
T+1 day
Pay-in of funds 8.30 a.m.
Payment received and payment not received indication by 9.30 a.m.
Participants to Clearing Corporation
Allotment and redemption information from RTA 2.00 p.m.
Credit in the depository account of the investor End of day process at Depository
Redemption credit in the investor bank account/cheque As per the current Mutual fund
dispatch time lines adhered to by the
RTA

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In case of any dispute between the Participant and the investor arising out of the MFSS, the
Exchange provides support for speedy redressal of the dispute through the Investor Grievance
Cell.

8.2. Points to remember

 Under SEBI regulations, close-ended schemes are to be mandatorily listed. This is equally
applicable for debt and equity schemes. The only exception is ELSS schemes, which are
not listed during the first three years after NFO.

 In an open-end scheme, the units are newly created by the scheme. This is called a “sale”
transaction. It happens at the NAV.

 In a close-ended scheme, the pre-existing units change hands. It happens at a price that
is discovered in the stock exchange.

 In an open-end scheme, the unit-holder offers his units for “re-purchase”. This is effected
at the NAV less Exit Load (if applicable). On re-purchase, the units are cancelled.

 In a close-ended scheme, the unit-holder sells the units to some counter-party at a price
that is determined in the stock exchange. The units continue to exist. Only the name of
the unit-holder changes in the scheme records.

 Listed schemes (typically, close-ended) are traded through NSE’s trading system (National
Exchange for Automated Trading), like any share. Buyers and sellers enter their orders
through their respective Trading Members (TM). The system matches orders based on
price and time priority. If a match is found, a trade is generated. The TM earns a brokerage
as per the terms of the contract with the client.

 NSE’s NMF II Mutual Fund System facilitates order collection (sale and re-purchase) for
open-end schemes.

 Like any share or close-ended scheme, ETFs are listed in the exchange. Therefore, Trading
members in the NSE can help clients buy and sell ETFs as part of their normal services.

 Trading members of NSE who are ARN holders, and who have passed the Mutual Fund
Distributor certification examination of National Institute of Securities Market are eligible
to participate in NMF II MFS.

 NMF II MFS is open for trading between 9 a.m. and 3 p.m. on all business days of the
capital market segment. Securities settlement is effected through the RTA (if physical
mode) or through the Depository (if Demat mode).

 In case of any dispute between the Participant and the investor arising out of the MFSS,
the Exchange provides support for speedy redressal of the dispute through the Investor
Grievance Cell.

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CHAPTER 9 – N
 ON RESIDENT INVESTMENTS IN
MUTUAL FUND SCHEMES

9.1 Introduction
Non-Resident Indians (NRI) and Persons of Indian Origin (PIO) had been allowed to invest in
Indian mutual fund schemes for long. Foreign Institutional Investors (FIIs) registered with
SEBI too were also permitted to invest. The FIIs can open a sub-account to facilitate investment
by other non-residents. In 2011, the opening of mutual fund investments to foreign investors
through the portfolio investment route was undertaken. The operating guide lines were laid
down by SEBI in consultation with RBI in August 2011. The provisions regarding investment
operations by different kinds of non-residents are discussed here.

9.2 Investment by NRIs / PIOs

Mutual funds have general permission to offer units of Indian mutual fund schemes to NRIs
/ PIOs.

NRI is an Indian citizen or a foreign citizen of Indian origin (other than a citizen of Pakistan
or Bangladesh) who stays abroad for employment, or for carrying on business or vocation or
under circumstances indicating an intention to stay abroad for an uncertain duration.

A person is deemed to be of Indian origin if he/she or either of his/her parents or any of his /
her grandparents were born in undivided India.

NRI PIO

He/she or either of his/her parents or any of

Indian Citizen or Foreign Citizen of Indian
his / her grandparents were born in undivided
Origin not resident in India
India

No special permissions are required from RBI for NRIs / PIOs to invest or redeem the
investments. However, the investor would need to comply with the KYC requirements. KYC
compliant NRIs / PIOs may invest through either of the following routes:

9.2.1 Repatriable basis:

The investment needs to be in convertible currency. The NRI / PIO can invest through an
inward remittance through normal banking channels, or by debit to Non-Resident External
(NRE) or Foreign Currency Non-Resident account of the investor.

The re-purchase proceeds as well as dividends can be repatriated abroad.

9.2.2 Non-Repatriable basis

The investment does not need to be in convertible currency. Normally, the investment happens
through debit to Non-Resident Ordinary (NRO) account of the investor. The re-purchase
proceeds cannot be repatriated. However, dividends can be repatriated abroad.

88
The non-resident can execute a power of attorney (PoA) in favour of a resident, to make
it convenient to handle the paper work. The PoA would need to be notarized. Further, the
granter (the non-resident granting the power) and the attorney (the resident to whom the
power is being given) need to comply with KYC requirements.

Most mutual funds also provide the facility of investing online. To avail of this, the investor will
need an internet-enabled bank account.

Repatriable Non-Repatriable
Investment in convertible currency Convertible currency not required
Re-purchase proceeds can be repatriated abrod Cannot be repatriated abroad
Dividends can be repatriated abroad Dividends cannot be repatriated abroad
Inward remittance through normal banking channels Can give Power of Attorney to Resident

9.3 Investment by Foreign Institutional Investors

FII means an institution established or incorporated outside India, which proposes to make
investments in Indian securities and is registered with SEBI.

Pension Funds, Mutual Funds, Investment Trusts, Insurance or reinsurance companies, Banks,
Endowments, University Funds, Foundations, Charitable Trusts or Charitable Societies based
abroad are permitted to register as FIIs with SEBI.

Asset Management Companies, Institutional Portfolio Managers, Trustees and Power of Attorney
Holders proposing to invest on behalf of broad-based funds too are eligible to register as FII.

Broad Based Fund means a fund established or incorporated outside India, which has at least
twenty investors with no single individual investor holding more than 10% shares or units of
the fund.

The institution has to apply for FII registration with SEBI, which will forward one copy of the
application to RBI. On receipt of RBI consent, and subject to SEBI-registration, the FII can
open a foreign currency denominated as well as rupee denominated bank account in India. It
will also have to tie up with a domestic custodian.

SEBI-registered FIIs are permitted to invest, on repatriable basis, in units of mutual funds,
securities in primary and secondary markets including shares, debentures and warrants of
companies, dated Government Securities, derivatives traded on a recognized stock exchange
and Commercial Papers.

9.4 Investment by Qualified Foreign Investors

Foreign investors other than NRIs / PIOs and FIIs, who fulfil the norms for direct investment in
Indian mutual fund schemes, are termed Qualified Foreign Investors (QFIs). They are allowed
to invest in both debt and equity schemes.

QFI is defined to mean a person (not resident in India), who is resident in a country that
is compliant with Financial Action Task Force (FATF) standards, and that is a signatory to

89
International Organization of Securities Commission’s (IOSCO’s) Multilateral Memorandum of
Understanding (MMOU).

“Person” under Section 2(31) of the Income Tax Act, 1961 includes:

(i) an individual,

(ii) a Hindu undivided family,

(iii) a company,

(iv) a firm,

(v) an association of persons or a body of individuals, whether incorporated or not,

(vi) a local authority, and

(vii) every artificial juridical person, not falling within any of the preceding sub-clauses.

Under the Income Tax Act, 1961 an individual is said to be “resident in India” for any previous
year if he:

(a) is in India in that year for a period or periods amounting in all to one hundred and eighty-
two days or more; or

(b) having within the four years preceding that year been in India for a period or periods
amounting in all to three hundred and sixty-five days or more, is in India for a period or
periods amounting in all to sixty days or more in that year.

He is in India in the previous year for a period of

Condition - 1 182 days or more

Or

He is in India for a period of 60 days or more

Condition - 2 during the previous year

And

Also he resides in India for 365 days or more

during 4 years immediately preceding the
previous year

A company is said to be resident in India in any previous year, if-

(i) it is an Indian company; or

(ii) during that year, the control and management of its affairs is situated wholly in India.

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 Control and management of its affairs is wholly or partly situated in India

YES NO

Resident Non Resident

A Hindu undivided family, firm or other association of persons is said to be resident in India in
any previous year in every case except where during that year the control and management
of its affairs is situated wholly outside India.

“Resident” in a country, other than India, means resident as per the direct tax laws of that
country.

The FATF (www.fatf-gafi.org) is an inter-governmental body whose purpose is the development

and promotion of national and international policies to combat money laundering and terrorist
financing. It is a ‘policy-making body’ that works to generate the necessary political will to
bring about legislative and regulatory reforms in these areas.

The FATF has 35 members, including 2 regional organisations – European Commission (EC)
and Gulf Co-operation Council (GCC). The full list of members is as follows:

Argentina Greece Portugal

Australia Gulf Co-operation Council Republic of Korea

Austria Hong Kong, China Russian Federation

Belgium Iceland Singapore

Brazil India South Africa

Canada Ireland Spain

China Italy Sweden

Denmark Japan Switzerland

European Commission Kingdom of Netherlands Turkey

Finland Luxembourg United Kingdom

France New Zealand United States

Germany Norway

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The IOSCO’s objectives are:

 to cooperate in developing, implementing and promoting adherence to internationally

recognised and consistent standards of regulation, oversight and enforcement in order to
protect investors, maintain fair, efficient and transparent markets, and seek to address
systemic risks;

 to enhance investor protection and promote investor confidence in the integrity of securities
markets, through strengthened information exchange and cooperation in enforcement
against misconduct and in supervision of markets and market intermediaries; and

 to exchange information at both global and regional levels on their respective experiences
in order to assist the development of markets, strengthen market infrastructure and
implement appropriate regulation.

IOSCO’s website (www.iosco.org) features gives the following details as on October 2016:
There are three categories of members: ordinary, associate and affiliate. In general, the
ordinary members (126) are the national securities commissions in their respective
jurisdictions. Associate members (23) are usually agencies or branches of Government,
other than the principal national securities regulator in their respective jurisdictions that
have some regulatory competence over securities markets or intergovernmental international
organizations and other international standard-setting bodies, such as the IMF and the World
Bank, with a mission related to either the development or the regulation of securities markets.
Affiliate members (65) are self-regulatory organizations, stock exchanges, financial market
infrastructures, investor protection funds and compensation funds, and other bodies with an
appropriate interest in securities regulation.

MFs have to ensure that QFIs meet the KYC requirements as per the FATF standards, Prevention
of Money Laundering Act, 2002(PMLA) rules and regulations made there under, and SEBI
circulars issued in this regard before accepting subscriptions from QFIs. They also have to
deduct tax, as applicable, from the redemption proceeds of QFIs.

The investment ceiling applicable is as follows:

 Total overall ceiling of US $10 billion for investment by QFIs in equity schemes

 Total overall ceiling of US $3 billion (within the existing ceiling of USD 25 billion for FII
investment in corporate bonds issued by infrastructure companies) for investments by
QFIs in debt schemes which invest in infrastructure debt of minimum residual maturity of
5 years.

For this purpose, the definition of infrastructure under the RBI’s ECB guidelines would be
applicable.

 Once the QFI investment reaches US$ 8 billion in equity schemes and US$2.5 billion in
debt schemes, the remaining limit is proposed to be auctioned by SEBI through a bidding
process.

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QFI investment is permitted through two routes as follows:

9.4.1 Direct Route (Demat)

 Three parties are envisaged in this route – the QFI, qualified DP and the MF.

 A SEBI-registered DP has to fulfill the following conditions to become a qualified DP:

o Net worth of Rs.50 crore or more

o Be either a clearing bank or clearing member of any of the clearing corporations

o Have appropriate arrangements for receipt and remittance of money with a designated
Authorised Dealer (AD) Category - I bank

o Demonstrate that it has systems and procedures to comply with the FATF Standards,
PMLA and SEBI circulars issued from time to time

o Obtain prior approval of SEBI before commencing the activities relating to accepting
MF subscription from QFIs

List of qualified DPs can be received from the website: http://www.sebi.gov.in/cms/sebi_

data/attachdocs/1370594911159.pdf

 Qualified DP shall open a demat account for the QFI only after ensuring compliance with
all the requirements as per the PMLA, FATF standards and SEBI circulars.

 A QFI is permitted to open only one demat account with any one of the qualified DPs. It
shall subscribe and redeem through that DP only.

 For the purpose of account opening, MF can rely on the KYC done by DPs. It has to obtain
the relevant records of KYC/ other documents from the DP. Further, the MF has to comply
with PMLA, FATF standards and SEBI circulars issued in this regard from time to time on
an ongoing basis.

 The qualified DP needs to open a separate single rupee pool bank account with a designated
AD Category -I bank, exclusively for the purpose of investments by QFIs in India.

 The subscription process is as follows:

o The QFI places the order, mentioning the name of the scheme/MF, with its DP and
remits foreign inward remittance through normal banking channel in any permitted
currency (freely convertible), directly to the single rupee pool bank account of the DP
maintained with a designated AD category - I bank.

o The DP in turn forwards the order to the concerned MF, and remits the money to the
MF’s scheme account on the same day as the receipt of funds from the QFI. In case
of receipt of money after business hours, DP has to remit the funds to the MF scheme
account by the next business day.

o In the event of a delay, the DP has to immediately return the money to the designated
overseas bank account of the QFI.

o MF processes the order and credits the units into the demat account of the QFI.

93
 o If, for any reason, the units are not allotted, MF / DP has to ensure that the money
is remitted back to the QFI’s designated overseas bank account within 3 working
days from the date of receipt of subscription of money in the single rupee pool bank
account of the DP maintained with a designated AD category I bank.

 The redemption process is as follows:

o The QFI can redeem, either through Delivery Instruction (physical/ electronic) or any
another mode prescribed by the Depositories.

o On receipt of instruction from QFIs, DP processes the same and forwards the
redemption instructions to the MF.

o Upon receipt of instruction from DP, MF processes the same and credits the single
rupee pool bank account of the DP with the redemption proceeds.

o The DP can make fresh purchase of units of equity and debt schemes of MF (if so
instructed by the QFI) out of the redemption proceeds received, provided that payment
is made towards such purchase within two working days of receipt of money from MF
in the pooled bank account.

o In case no purchase is made within the said period, the money has to be remitted by
the DP to the designated bank overseas account of the QFI, within two working days
from the date of receipt of money from the MF in the pooled bank account.

o In case of dividend payout, the MF credits the single rupee pool bank account of the
DP with the dividend amount. The DP in turn will remit the same to the designated
bank overseas account of the QFI within two working days from the date of receipt of
money from the MF in the DP’s rupee pooled bank account.

Subscription Process Redemption Proces

Either through delivery instruction or other

QFI Places order with its DP
mode
Remits foreign inward remittance to DP DP forwards redemtpion request to MF
MF processes request and credits DP account
DP Informs MF and forwards the funds
with proceeds
MF processes order DP remits funds within 2 working days to QFI

Credits units in Demat Account of QFI

Else money to be refunded within 3
working days

9.4.2 Indirect Route (Unit Confirmation Receipts – UCR)

 There are four parties involved –the QFI, UCR issuer (based overseas), SEBI registered
Custodian (based in India) and the MF.

 MF appoints one or more UCR issuing agents overseas, and one SEBI registered custodian
in India. UCR issuer appointed by MF acts as agent of the MF.

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 Entities fulfilling the following conditions can be appointed as UCR issuer:

o The entity is able to demonstrate that it has proven track record, expertise and
technology in the business of issuance of global depository receipts/ global custody
agency.

o The entity is registered with an overseas securities market / banking regulator.

 MF has to seek no objection from SEBI before appointing any UCR issuer, and furnish the
details and information sought by SEBI about the UCR issuer. SEBI reserves the right
to seek additional information / clarification and direct specific action, including non-
appointment / revocation of appointment of that UCR Issuing Agent.

 QFIs can subscribe / redeem only through the UCR Issuer.

 The MF mandates the UCR issuer regarding the requirements for KYC, customer due
diligence process and documents and information to be collected from the QFIs.

 MF has to obtain the relevant records of KYC/ other documents from the UCR issuer in
order to comply with FATF standards, PMLA and SEBI circulars.

 The units of the MF, denominated in rupees, are held as underlying by the custodian in
India in demat mode, against which the UCR issuer would issue UCR to the QFIs.

 MF has to ensure that for every UCR issued by the UCR issuer, Custodian in India holds
corresponding number of units against it i.e., there will be one unit of MF scheme for every
unit of UCR.

 MF will receive money from UCR issuer, either in a foreign country by opening bank
account overseas (in accordance with the relevant FEMA regulations), or in Indian rupees
in the respective MF scheme account held in India.

 Units purchased and redeemed through a UCR issuer are to be settled on gross basis.
Under no circumstances can they be netted against other investors of the UCR issuer.

 If the MF opens a bank account abroad, the investor transactions are as follows:

o UCR issuer forwards the purchase / subscription order of the QFI to the MF/Custodian.
Upon receipt and transfer of funds to India, the MF issues units to the custodian. The
custodian in turn confirms to the UCR Issuer to issue UCR to the QFIs.

o In case of redemption, the UCR issuer confirms receipt of redemption request to the
MF and the Custodian. Upon receipt of instruction, the MF processes the same and
transfers the redemption proceeds to the MF’s overseas bank account for making
payment to the designated overseas bank account of the QFI.

o In case of dividend payout, the MF transfers the dividend amounts to the MF’s overseas
bank account for making payment to the designated overseas bank account of the
QFI.

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 MF has bank account abroad
Subscription Redemption
UCR forwards purchase instruction to UCR confirms receipt of request to custodian
Custodian and MF
On receipt and transfer of funds to India,
MF processes the same
MF issues units to custodian
Transfers redemption proceeds to MF's foreign
Custodian confirms the same to UCR
bank account
Amount is transferred to QFI account

 If the MF does not open a bank account abroad, the transactions would flow as follows:

o UCR issuer forwards the purchase order to the MF and Custodian, and remits the
funds into MF scheme account (in rupee terms). Upon receipt of funds; the MF issues
units to the custodian. The custodian in turn confirms to the UCR Issuer to issue UCR
to the QFI.

o In case of redemption, the UCR issuer confirms receipt of redemption request to the
MF & Custodian. Upon receipt of instruction, the MF processes the request and remits
the redemption proceeds to the UCR issuer, which in turn remits the redemption
proceeds to the designated bank account of the QFI.

o In case of dividend payout, the MF remits the dividend amount to the UCR issuer,
which in turn remits the dividend amount to the designated bank account of the QFI.

MF Does not Have Bank account Abroad

Subscription Redemption
UCR forwards purchase order to MF and UCR issuer confirsm receipt of redemption
Custodian request to MF and custodian
Remits funds to MF scheme account in MF processes request and remits redemption
rupees proceeds to UCR issuer
MF issues units to custodian UCR issuer remints redemption amount to QFI
Custodian confirms to UCR issuer to
issue UCR to QFI

In case of subscription, the MF has to allot units based on the NAV of the day on which funds
are realized in the MF’s scheme bank account in India. In case of redemption, units are to be
redeemed on the day on which transaction slip/instruction is received and time stamped by
the MF, as per the applicable cut off time.

The demat / UCR holding by QFIs is non-transferable and non-tradeable. Systematic

Investments/ transfer/ withdrawals and switches too are not permitted for QFIs.

The MF/ DP has to:

 Capture the bank account details of the QFIs designated overseas bank account, and
ensure that all subscriptions are received from that overseas account and redemption
proceeds are also transferred into the same overseas account.

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 Ensure that the overseas bank account which QFIs has designated for the purpose is
based in countries which are compliant with FATF standards and are signatory to MMOU
of IOSCO.

 Ensure that units/ UCRs held by QFIs are free from all encumbrances i.e. pledge or lien
cannot be created for such units.

 Get QFIs to submit necessary information for the purpose of obtaining PAN.

 Ensure compliance with laws (rules and regulations) of the jurisdictions where the QFIs
are based.

 Ensure that the interests of existing unit holders of the MF schemes are not adversely
affected due to the issuance of UCRs/ demat units to the QFIs.

9.5 Points to remember

 Non-Resident Indians, Persons of Indian Origin, Foreign Institutional Investors and
Qualified Foreign Investors are permitted to invest in Indian mutual fund schemes.

 NRI / PIO can invest on repatriable basis through an inward remittance through normal
banking channels, or by debit to Non-Resident External (NRE) or Foreign Currency Non-
Resident account of the investor.

 NRI / PIO can also invest on non-repatriable basis. The investment does not need to be
in convertible currency. Normally, the investment happens through debit to Non-Resident
Ordinary (NRO) account of the investor. The re-purchase proceeds cannot be repatriated.
However, dividends can be repatriated abroad.

 Non-residents can execute a power of attorney (PoA) in favour of a resident, to make it

convenient to handle the paper work. The PoA would need to be notarized. Further, the
granter (the non-resident granting the power) and the attorney (the resident to whom the
power is being given) need to comply with KYC requirements.

 FII means an institution established or incorporated outside India, which proposes to

make investments in Indian securities and is registered with SEBI. SEBI-registered FIIs
are permitted to invest, on repatriable basis, in Units of mutual funds

 Foreign investors other than NRIs / PIOs and FIIs, who fulfil the norms for direct investment
in Indian mutual fund schemes, are termed Qualified Foreign Investors (QFIs). They are
allowed to invest in both debt and equity schemes.

 QFI needs to be resident in a country that is compliant with Financial Action Task Force
(FATF) standards, and that is a signatory to International Organization of Securities
Commission’s (IOSCO’s) Multilateral Memorandum of Understanding (MMOU).

 MFs have to ensure that QFIs meet the KYC requirements as per the FATF standards,
Prevention of Money Laundering Act, 2002 (PMLA) rules and regulations made there
under, and SEBI circulars issued in this regard before accepting subscriptions from QFIs.
They also have to deduct tax, as applicable, from the redemption proceeds of QFIs.

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 QFI investment is permitted through direct route (demat) and indirect route (UCR – Unit
Confirmation Receipt).

 Three parties are envisaged in the direct route - the QFI, qualified DP and the MF. Qualified
DP shall open a demat account for the QFI only after ensuring compliance with all the
requirements as per the PMLA, FATF standards and SEBI circulars.

 There are four parties involved in the indirect route - the QFI, UCR issuer (based overseas),
SEBI registered Custodian (based in India) and the MF.

 In case of subscription, the MF has to allot units based on the NAV of the day on which
funds are realized in the MF’s scheme bank account in India. In case of redemption, units
are to be redeemed on the day on which transaction slip/ instruction is received and time
stamped by the MF, as per the applicable cut off time.

 The demat / UCR holding by QFIs is non-transferable and non-tradeable. Systematic

Investments/ transfer/ withdrawals and switches too are not permitted for QFIs.

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CHAPTER 10 – I
 NVESTMENTS BY INDIANS
IN INTERNATIONAL MUTUAL
FUND SCHEMES

10.1 Introduction
In the globalised world of investments, capital flows significantly and quickly between countries.
Traditionally, India viewed itself as a capital-scarce and foreign currency-scarce country.
Therefore, while investments from abroad into the country were welcomed, investments
abroad by Indian residents were highly restricted.

Post-liberalisation many of these restrictions have been eased. The policy framework and
issues arising out of international investment are discussed here.

10.2 Foreign Direct Investment and Portfolio Investment

When someone invests directly in a project abroad, it is called foreign direct investment. The
investor normally takes an active interest in running or managing the business, appointing
directors and key managerial personnel etc. Foreign direct investment creates real value
in the physical economy in terms of output, employment etc. and tends to be long term.
Therefore, governments encourage such investment.

Portfolio investors trade in securities with a view to benefit from changes in their value, rather
than to create value through projects. The liquidity and foreign currency they bring in, and the
consequent valuation gains in the market can help the economy. However, since the investor
may not be committed to the project – the money itself may go to some other investor in the
company, rather than the company itself – portfolio investment holding period is often shorter
than what is seen with foreign direct investment.

Investments in mutual fund schemes are in the nature of portfolio investment.

10.3 Investing in International Mutual Fund Schemes

The tools and techniques for investing in local mutual fund schemes are equally applicable
while investing in international mutual fund schemes. Some additional issues to consider are
as follows:

10.3.1 Need to understand the international financial market

It is important to understand the market where money is being invested. Thus, an investor
in a mutual fund scheme that proposes to invest in Thailand needs to be sure that the Thai
market is an attractive investment destination.

10.3.2 Need to understand regulations regarding permissible investment

The regulations of both, India and the investee country need to be understood. In the earlier
example, the Thai regulations should permit investment by the Indian investor. With most

99
countries, foreign investment in financial markets is more liberalised than foreign investment
in real estate.

Besides, the investment should be permissible under Indian regulations. Indian residents
are presently permitted to remit upto USD 250,000 in every financial year for investments
and other specified purposes. Since the limit is per individual, families can transfer higher
amounts every year.

10.3.3 Need to understand regulations regarding taxation

The objective underlying investments is to earn a post-tax return. Therefore, tax implications
of the investment need to be understood. Besides a tax withheld in the investee country, the
income may be liable to an assessment-based tax in India and / or the investee country. India
has signed Double Taxation Avoidance Agreements (DTAA) with some countries. The investor
needs to check if any benefits are available under such agreements. The details of countries
and the taxation agreements can be seen from this website - http://www.incometaxindia.gov.
in/Pages/international-taxation/dtaa.aspx.

10.3.4 Need to understand regulations regarding repatriation

For an Indian investing abroad, the investment cycle is complete when money is brought back
to India. Some countries are easier to invest in, but not so easy to repatriate the money back.

The possibility of change in regulations in future too, needs to be factored. The investment
may be repatriable at the time of investment; but if the country runs into economic trouble,
it may limit the repatriability for foreign investors.

10.3.5 Foreign currency risk

An investor investing abroad is exposed to foreign currency risk. It is not adequate for the
financial market abroad to gain value; the exchange rate of the country too is to be considered.
Read the following example below to understand. These are not the current exchange rates or
current S&P value. These are just used for giving and example as these are changing all the
time. Kindly do not take these as current values.

For example, suppose an Indian invested in the US when the S&P was at 1,200. Later, the S&P
went up to 1,500 – a gain of 25%.

Suppose an investor invested USD 120,000, by buying USD from his Indian rupee bank
account, when the USD was equal to Rs. 50.00. He would have drawn down his bank account
by USD 120,000 X Rs. 50 per USD i.e. Rs. 60 lakh, for buying the requisite USD to make the
investment.

The investment would have grown to USD 150,000 – a gain of 25% in USD terms, in line with
the market there.

If the investor were to sell the investment, and at that stage each USD had strengthened to
Rs. 60.00 per USD, then he would have USD 150,000 X Rs. 60 per USD i.e., Rs. 90 lakh. This
represents a gain of 50% on the original investment of Rs. 60 lakh. The gain was 25% in USD
terms, but because the USD strengthened, the return in Indian rupees was 50%.

100
On the other hand, if the rupee had strengthened (i.e. USD became weak) to Rs. 40 per
USD, the investor would only receive USD 150,000 X Rs. 40 per USD i.e. Rs. 48 lakh. This
represents a loss of 20% on the original investment of Rs. 60 lakh. The gain was 25% in USD
terms, but because the USD weakened, there was a loss of 20% in Indian rupees.

Any taxes on the transaction or profits would pull down the post-tax returns further.

10.3.6 Transaction costs

The authorised dealer adds a margin at the time of buying or selling foreign currency. This
foreign currency transaction cost needs to be borne by the investor.

Besides, there is the cost of any permissions for investing abroad, brokerage cost, demat cost
etc.

All these transaction costs reduce the investor’s returns.

10.4 Why invest abroad?

Considering the issues mentioned earlier, direct investment in mutual fund schemes abroad is
meaningful only for large investors. Many of them prefer to keep some of their moneys abroad
for the following reasons:

 Asset allocation

Allocating assets across different countries reduces the dependence on any single country’s
economic performance. However, in a globalised environment with free capital flows,
markets across countries can move in tandem in the same direction. This can affect the
benefits of asset allocation.

 Country risk

As has been seen in the past, specific countries or regions can run into trouble. For
example, Ireland and Greece in the recent past; south-east Asia in the late 1990s. Besides
economic issues, war or internal strife can wreak havoc on markets, including real estate.
Investors can hedge their portfolio against such scenarios by investing in other countries.

10.5 International Fund of Funds

Investments abroad can be facilitated through a fund of funds structure as follows:

 A feeder fund can receive money in India in Indian rupees.

 A host fund abroad can be the target for the feeder fund to invest in.

In such a structure, the feeder fund operates like a fund of funds. Investors in the fund
of funds will earn a return that is linked to the return that the host fund generates, as
also the movement in currency exchange rate. The return profile is thus similar to direct
investment in the fund abroad. Benefits of such a structure are:

 Since the feeder fund receives money in Indian rupees, it becomes possible for even small
investors to get exposure to international markets.

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 The Indian investor does not need to worry too much about the regulations and market
structure abroad.

 The feeder fund being based in India, would be subject to SEBI regulations.

 The investment being in Indian rupees, the investor’s USD 250,000 foreign remittance
limit is available for other purposes.

10.6 Points to remember

 When someone invests directly in a project abroad, it is called foreign direct investment.
On the other hand, a portfolio investor may not be committed to a project. The money
itself may go to some other investor in the company, rather than the company itself.
Portfolio investment holding period is often shorter than what is seen with foreign direct
investment. Investments in mutual fund schemes are in the nature of portfolio investment.

 Indian residents are permitted to remit upto USD 250,000 in every financial year for
investments and other specified purposes. Since the limit is per individual, families can
transfer higher amounts every year.

 Before investing abroad, investors should understand the international financial markets,
foreign currency risk and regulations regarding permissible investments, repatriation and
tax.

 International investments help in asset allocation and diversifying country risk.

 Investments abroad can be facilitated through a fund of funds structure as follows:

o A feeder fund can receive money in India in Indian rupees.

o A host fund abroad can be the target for the feeder fund to invest in.

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CHAPTER 11 – MUTUAL FUND ACCOUNTING

11.1 Introduction
Returns to the investors depend on the performance of the scheme. NAV is a measure of
performance that investors track closely.

Besides affecting the price at which close-ended schemes’ units trade on the stock exchange,
NAV is the basis on which open-end schemes sell units to investors and re-purchase units
from investors on an ongoing basis.

If NAV is inflated (through excessively aggressive accounting), and knowledgeable investors

re-purchase their units at such higher price, the investors who continue in the scheme lose
out. Examples of aggressive accounting are:

 Valuing investments higher than their realisable value

 Not providing for expenses (or losses) that have been incurred in the scheme

 Recognising income (or profits) that do not really belong to the scheme.

On the other hand, if NAV is deflated [through excessively conservative accounting practices
such as under-valuing investments, making excessive provisions for expenses (or losses) or
under-reporting income or profits], investors who re-purchase their units get a raw deal, while
the investors who continue get undue benefits.

Considering these dynamics, SEBI has imposed strict norms regarding valuation of securities
and provisioning for NPA. These were discussed earlier. Some other aspects of accounting that
affect the NAV, or the price at which investors transact with the scheme, are discussed in this
Chapter.

11.2 Accounting for Income, Gains & Losses from Investments

 Interest income is accrued on debt securities every day. The scheme may have invested in
a 12% debenture where interest is payable semi-annually on June 30th and December 31st
each year. Although interest would be received in the scheme twice a year, the scheme
will keep accruing one day’s interest income each day, including on Sundays and holidays.
Such regular accretion of interest income ensures a gradual change in the NAV during the
year.

 There is a time lag between the day a company declares a dividend on its equity shares,
and the time when it is actually received in the scheme. Between the announcement of
dividend and the actual receipt of dividend, the stock exchange specifies an ex-dividend
date. All investors who buy their shares before that date are entitled to receive dividend
on those shares. From the ex-dividend date, any investor who buys shares of the company
will not be entitled to that dividend.

Under SEBI regulations, a scheme is to recognise the dividend as its income on the day
the shares become ex-dividend on the stock exchange.

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 On account of the MTM valuation discussed earlier, the scheme will keep showing capital
gains (if the market goes up) or capital losses (if the market goes down), for every
day when the NAV is calculated. Although the gains or losses are realised only when
the scheme sells these investments, MTM valuation ensures that the NAV reflects the
realisable value of those investments. Daily gains push up the NAV, while the daily losses
pull down the NAV.

11.3 Accounting for Expenses

 Under the existing norms, the maximum expense that an equity scheme can charge to
an investor is 2.5% (2.25% for debt funds). The rate is applicable in slabs and an AMC
is allowed to charge 2.5% for the first Rs.100 crore in weekly average net assets of a
scheme. For the next Rs.300 crore, a total expense ratio of 2.25% can be charged, while
AMCs can only charge a TER of 1.75% for anything beyond that. Within this, they can
charge any percentage under any head.

Expenses (and losses) bring down the NAV. Income (and profit) pushes up the NAV.
Explaining this with an example here. Suppose a scheme had net assets of Rs. 100 crore
on a day, and the scheme information document mentions management fees of 1.25%.

Consider a situation, where the scheme charges the entire 1.25% management fee at the
end of the year, based on average net assets during the year. With such accounting, the
NAV will be inflated all through the year (on account of under provision of expenses), and
suddenly on one day, the NAV will be pulled down by 1.25%.

In order to avoid such anomalies, SEBI has stipulated that the expense needs to be
accrued proportionately, every day or week when the NAV is calculated. In the above
example, 1.25% on Rs. 100 crores translates to annual management fee of Rs. 1.25
crore, which is equivalent to Rs. 34,247 per day. A provision for management fees for
that day will be made for this amount, thus ensuring that the NAV is not inflated. Daily
provision of such management fees, based on the net assets each day, ensures that there
is no sudden decline in NAV on this account.

Although the provision may be made every day, the actual payment of the management
fee by the scheme to the Asset Management Scheme will happen at frequencies mutually
agreed upon and mentioned in the contract.

 Similarly, other recurring expenses would be provided for regularly, through a separate
expense provision account. Actual expenses will be charged to the account as per bills
received from various service providers.

11.4 Determining the NAV

Net assets represent the unit-holders’ funds in the scheme. If all the scheme’s assets are
realised, and the scheme’s dues other than to unit-holders are paid out, what remains is the
net assets of the scheme. This amount, divided by the number of units, is the Net Asset Value
(NAV) per unit.

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The concept can be easily understood, considering the balance sheet of a scheme viz. listing
of its assets and liabilities.

Suppose a close-ended scheme mobilised Rs. 100 crore during its NFO. It would have issued
10 crore units of Rs. 10 each. The money would be in the bank. The scheme’s balance sheet
would read as follows:

Liabilities Rs. Cr. Assets Rs. Cr.

Unit Capital
100.00 Balance in Bank 100.00
(10 crore units of Rs. 10 each)
Total Liabilities 100.00 Total Assets 100.00

NAV of the scheme at this stage would be Rs. 100 crore ÷ 10 crore units i.e. Rs. 10 per unit.

The scheme invests Rs. 80 crore in equity shares. The market value of the investments is Rs.
80.25 crore at the end of the day. The idle funds of the scheme have been kept in the bank to
earn interest at 8% p.a. As per the Scheme Information Document, investment advisory fee
is chargeable at 1.25% p.a.; other recurring expense limit is 1.25% p.a.

Let us build the scheme’s profit & loss account.

Rs. Cr.
Income
Interest accrued on bank deposit 0.022
[Rs. 100 cr X 8% X 1 day ÷ 365 days]
Expenses
Recurring Expenses 0.003
[Rs. 100 cr X 1.25% X 1 day ÷ 365 days]*
Investment Advisory Fees 0.003
[Rs. 100 cr X 1.25% X 1 day ÷ 365 days]*
Profit before Unrealised Gains 0.016
[Income minus Expenses]
Unrealised Gains 0.250
[Rs. 80.25 crore minus Rs. 80.00 crore]
Profits of the Scheme 0.266

* Technically, these would be calculated on the closing value of net assets. For simplicity, the
numbers are worked out on the basis of the previous day’s closing value of net assets.

The balance sheet of the scheme would read as follows:

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 Liabilities Rs. Cr. Assets Rs. Cr.
Unit Capital 100.000 Balance in Bank 20.000
(10 crore units of Rs. 10 each) [Rs. 100 crore minus Rs. 80
crore]
Profit before Unrealised Gains 0.016 Interest accrued in bank 0.022
Unrealised Gains 0.250 Investments at market price 80.250
Sundry Creditors:
Investment Advisory Fees 0.003
payable
Other expenses payable 0.003
Total Liabilities 100.272 Total Assets 100.272

Net assets of the scheme are Total Assets minus Dues to outsiders (Sundry creditors) i.e. Rs.
100.272 crore minus Rs. 0.006 crore = Rs. 100.266 crore.

The NAV of the scheme is Rs. 100.266 crore ÷ 10 crore units i.e. Rs. 10.0266 per unit. This
comprises 3 elements:

 Par value of Rs. 10.0000

 Realised profit (profit before unrealised gain) of Rs. 0.0016

 Unrealised gains of Rs. 0.0250

Suppose the scheme had sold for Rs. 10.10 crore, investments that cost Rs. 10 crore. The
realised profit is now higher by Rs. 0.10 crore. It will go up to Rs. 0.116 crore.

The revised value of investments at market price would be Rs. 80.25 minus Rs. 10.10 crore
i.e. Rs. 70.15 crore.

The cost of these investments is Rs. 80 crore minus Rs. 10 crore i.e. Rs. 70 crore. Thus, the
unrealised gains is Rs. 70.15 crore minus Rs. 70 crore i.e. 0.15 crore.

If there were no other transactions / accruals / changes in market, the revised balance sheet
would be as follows:

Liabilities Rs. Cr. Assets Rs. Cr.

Unit Capital 100.000 Balance in Bank 20.000
(10 crore units of Rs. 10 each)
Realised Profit 0.116 Interest accrued in bank 0.022
Unrealised Gains 0.150 Investments at market price 70.150
Sundry Creditors: Sundry debtors (recoverable 10.100
on sale of investments)
Investment Advisory Fees payable 0.003
Other expenses payable 0.003
Total Liabilities 100.272 Total Assets 100.272

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Net assets of the scheme continue to be Rs. 100.272 crore minus Rs. 0.006 crore =
Rs. 100.266 crore.

The NAV of the scheme continues at Rs. 100.266 crore ÷ 10 crore units i.e. Rs. 10.0266 per
unit.

Since appreciation in the value of the investments sold was already booked as an unrealised
gain earlier, the sale of investments did not change the NAV. However, the composition of that
NAV changed as follows:

 Par value of Rs. 10.0000

 Realised profit (profit before unrealised gain) of Rs. 0.0116

 Unrealised gains of Rs. 0.0150

At a per unit level, unrealised gains reduced and realised gains increased by Rs. 0.01 each.

11.5 Accounting for Load

 In a close-ended scheme, investors buy or sell units in the stock exchange. The investors
will incur brokerage and other transaction costs. These are payable to the broker /
exchange / tax authorities. But nothing is payable to the scheme, as load or otherwise. As
far as the scheme is concerned, the units change hands – the unit-holder’s name changes
– but the transaction does not affect the balance sheet of the scheme or the NAV.

 An open-ended scheme sells its units to investors through a “sale” transaction; they
take back the units through a “re-purchase” transaction. These transactions are routed
through the bank account of the scheme. Therefore, the balance sheet of the scheme is
affected.

Suppose the scheme discussed earlier was an open-end scheme. If unit-holders bought
10,00,000 new units at the NAV viz. Rs. 10.0266, they would have paid Rs. 100,26,600 to the
scheme. This would go into the scheme.

Out of this amount, Rs. 1 crore (10,00,000 new units X par value of Rs. 10 each) would go
into the unit capital.

Part of the balance amount, that represents realised profit (10,00,000 new units X Rs. 0.0116
i.e. Rs. 0.001) would go into an account called Equalisation Reserve.

The balance amount, which represents unrealised gains (10,00,000 new units X Rs. 0.0150
i.e. Rs. 0.0015 – rounded below to Rs. 0.002), would go into an account called Unit Premium
Reserve.

The revised balance sheet, holding all other aspects constant, is as follows:

Liabilities Rs. Cr. Assets Rs. Cr.

Unit Capital 101.000 Balance in Bank 21.003
(10.1 crore units of Rs. 10 each)
Unit Premium Reserve 0.002 Interest accrued in bank 0.022
Equalisation Reserve 0.001
Realised Profit 0.116 Investments at market price 70.150

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Unrealised Gains 0.150 Sundry debtors (recoverable on 10.100
sale of investments)
Sundry Creditors:
Investment Advisory Fees 0.003
payable
Other expenses payable 0.003
Total Liabilities 101.275 Total Assets 101.275

Net assets of the scheme are Rs. 101.275 crore minus Rs. 0.006 crore = Rs. 101.269 crore.

The NAV of the scheme is Rs. 101.269 crore ÷ 10.1 crore units. It continues to be Rs. 10.0266
per unit.

The sale of new units at NAV changes the balance sheet of the scheme, but it does not affect
the NAV. Similarly, it can be seen that re-purchase of units at NAV changes the balance sheet
of the scheme, but not the NAV.

 When units are re-purchased from investors at below NAV, the difference is called exit
load. In the above example, if units were re-purchased with an exit load of 1%, then the
re-purchase price would be Rs. 10.0266 minus 1% i.e. Rs. 9.9263. The exit load of Rs.
0.1003 again goes into a separate account, from which the asset management company
can meet various selling expenses for the scheme. It does not affect the unit premium
reserve or equalisation reserve. Therefore, NAV of the scheme remains at Rs. 10.0266 per
unit.

Exit load is permitted by SEBI. It has however mandated that any exit load above 1%
would not be available for the asset management company to meet expenses. It has to be
written back to the scheme for the benefit of investors. To that extent, NAV can increase,
if the scheme levies an exit load higher than 1%.

11.6 Distributable Reserves

Distributable reserves represent the amount that is available for schemes to declare a dividend.

The earlier example illustrates how appreciation in the market can push up NAV, although the
scheme may not have sold any investments. Therefore, part of the NAV, which is represented
by unrealised gains, is a paper profit. It will become real, only when investments are sold.
Distributing such paper profits as dividend would not be appropriate. Therefore, SEBI has
stipulated that unrealised gains are not available for distribution as dividend.

The earlier example also illustrates how the amount in unit premium reserve, is recovered
from the investors when new units are sold to them. It is not a direct consequence of the
investment activity of the scheme. Therefore, SEBI has clarified that unit premium reserve
too is not available for distribution as dividend.

Thus, the amount that is available for dividend distribution (distributable reserve) is restricted
to the amounts lying in realised profits and equalisation reserve. Normally, towards the end
of every financial year, the scheme transfers the realised profits to the equalisation reserve.

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11.7 Points to remember
 Besides affecting the price at which close-ended schemes’ units trade in the stock
exchange, NAV is the basis on which open-end schemes sell units to investors and re-
purchase units from investors on an ongoing basis.

 If NAV is inflated (through excessively aggressive accounting), and knowledgeable

investors re-purchase their units at such higher price, the investors who continue in the
scheme lose out.

 If NAV is deflated [through excessively conservative accounting practices such as under-
valuing investments, making excessive provisions for expenses (or losses) or under-
reporting income or profits], investors who re-purchase their units get a raw deal, while
the investors who continue get undue benefits.

 Interest income is accrued on debt securities every day.

 Mutual fund schemes have to recognise the dividend as income on the day the shares
become ex-dividend in the stock exchange.

 Although the gains or losses are realised only when the scheme sells these investments,
MTM valuation ensures that the NAV reflects the realisable value of those investments.

 Expenses (and losses) bring down the NAV. Income (and profit) pushes up the NAV.

 SEBI has stipulated that the expense needs to be accrued proportionately, every day or
week when the NAV is calculated.

 Net assets represent the unit-holders’ funds in the scheme. This amount, divided by the
number of units, is the Net Asset Value (NAV) per unit.

 An open-ended scheme sells its units to investors through a “sale” transaction; they take
back the units through a “re-purchase” transaction.

 When an open-ended scheme sells new units, part of the sale price that represents realised
profit would go into an account called Equalisation Reserve. The part that represents
unrealised gains, would go into an account called Unit Premium Reserve.

 The sale / re-purchase of units by open-ended schemes change the balance sheet of the
scheme, but do not affect the scheme’s NAV.

 When units are re-purchased from investors at below NAV, the difference is called exit
load. Exit load is permitted by SEBI. It has however mandated that any exit load above
1% would not be available for the asset management company to meet expenses. It has
to be written back to the scheme for the benefit of investors.

 Distributable reserves represent the amount that is available for schemes to declare a
dividend.

 SEBI has stipulated that unit premium reserve and unrealised gains are not available for
distribution as dividend.

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CHAPTER 12 – MUTUAL FUND TAXATION

12.1 Introduction
In NCFM’s Workbook titled Securities Market (Advanced) Module, taxation of mutual fund
schemes was introduced. This chapter gets into the applicative aspects of the same.

12.2 Mutual Fund Tax Provisions

The mutual fund trust (and therefore the mutual fund schemes) is exempt from tax. However,
the trustee company and AMC pay tax, like any other company.

Despite the exemption to the mutual fund trust, investors in mutual fund schemes are
impacted by income tax as follows:

12.2.1 Securities Transaction Tax (STT)

This is applicable to equities and equity-oriented funds, but not to debt and debt-oriented
funds.

An equity-oriented fund is a fund that invests at least 65% of its corpus in equities of domestic
companies. Thus, international funds, gold funds and balanced funds with less than 65%
allocation to equity do not qualify.

Applicable rates are:

o STT on equity-oriented schemes of mutual funds

On scheme’s purchase of equity shares in the stock exchange 0.1%

On scheme’s sale of equity shares in stock exchange 0.1%
On scheme’s sale of futures & options in stock exchange 0.017%

o STT on investors in equity oriented schemes of mutual fund

On investor’s purchase of the units in stock exchange 0.125%

On investor’s sale of the units in stock exchange 0.125%
On re-purchase of investor’s units by the AMC 0.25%

12.2.2 Capital Gains Tax

The difference between the selling price (of sale in the stock exchange or as re-purchase of
units by the scheme) and buying price of an investment is treated as a capital gain (or capital
loss, if the selling price is lower).

Since the mutual fund is exempt from tax, the scheme does not pay a tax on its capital gains.
However, investors in mutual fund schemes are liable to be taxed on their capital gains. The
nature of capital gain viz. long term or short term, makes a difference. If the investment (any
type of mutual fund scheme) is held for more than 1 year, it qualifies to be a long term capital
gain. Else, it is a short term capital gain.

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Capital gains are taxed as follows:

 Equity-oriented schemes

o Long Term Capital Gains 10% above Rs, 1 Lakh + surcharge + education cess

o Short Term Capital Gains 15% + Surcharge +Education Cess

 Other Schemes

o Long Term Capital Gains

 The maximum tax rate is 10% + Surcharge + Education Cess.

 Investor can bring down the taxation by taking the benefit of indexation. Cost
of acquisition can be increased to the extent of inflation. Selling price being
held constant, the adjusted capital gains would be lower. Tax would need to
be calculated at 20% + Surcharge + Education Cess on the adjusted capital
gains.

o Short Term Capital Gains

 The income is added to the income of the assessee. Thus, it would be taxed
at Nil / 5%/ 10% / 20% / 30%, depending on the applicable tax slab. Further,
surcharge and education cess would be applicable.

12.2.3 Tax on Income Distributed

This is applicable only on dividend distributed by debt-oriented schemes. The applicable rate
is:

 Individuals & Hindu Undivided Families

o 25% plus surcharge plus education cess, for liquid schemes

o 25% plus surcharge plus education cess, for other debt schemes

o 10% plus surcharge plus education cess, for equity schemes

 Other investors

20% plus surcharge plus education cess for all debt schemes

12.2.4 Tax Deducted at Source (TDS) / Withholding Tax

There is no TDS on dividend or re-purchase amount for resident investors.

Non-resident investors might have to bear withholding tax, which will reduce the amount they
receive from the scheme as dividend or re-purchase amounts. They can however take the
benefit of Double Taxation Avoidance Agreements, if India has signed such an agreement with
the country of their residence.

12.3 Compounding Wealth, Gross of Tax

Let us compare taxation of mutual funds with bank deposits, where people tend to keep
significant amounts invested.

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12.3.1 Bank Fixed Deposit

Interest on bank fixed deposits is added to the income of the assessee. Thus, it would be
taxed at Nil / 5%/ 10% / 20% / 30%, depending on the applicable tax slab. Further, surcharge
and education cess would be applicable. This is similar to taxation of short term capital gains
on non-equity mutual fund schemes.

In every financial year, upto Rs. 10,000 of interest income is exempt from TDS. Beyond that
amount, tax would be deducted at 10%. Resident individuals can file Forms 15G or 15H to
claim exemption from TDS in specific situations.

An investor who is in the highest tax bracket, while filing the income tax return, is likely to
find that the applicable tax on the bank interest income is 30% plus surcharge plus education
cess. Accordingly, additional amount will have to be deposited with the income tax authorities
on self-assessment basis.

Consider the case of a normal investor who is subject to TDS. If Rs. 100,000 has been invested
in a bank fixed deposit yielding 10%, the amount that would be available for re-investment at
the end of Year 1 varies as shown in Table 1.1.

Table 1.1

Taxation applicable on Bank Fixed Deposits

Tax Slab-> Nil 10% 20% 30%

Fixed Deposit (Rs.) 100,000 100,000 100,000 100,000
Interest on Fixed Deposit (Rs.) 10,000 10,000 10,000 10,000
TDS (Rs.) Nil @ 1,000 1,000 1,000
Net FD Interest Received (Rs.) 10,000 9,000 9,000 9,000
Additional Self Assessment Tax* Nil Nil 1,000 2,000
Net Interest Income for Year * 10,000 9,000 8,000 7,000
(available for re-investment in next year)

@ Depositer may have filed 15G / 15H

* Surcharge & education cess are applicable, but have been ignored in this calculation

The growth in the wealth of an investor in the 30% tax bracket would be as shown in
Table 1.2.

Table 1.2

Growth in Wealth (Bank Fixed Deposits)

Year-> 1 2 3 Total
Fixed Deposit (Rs.) 100,000 107,000 114,490
Interest on Fixed Deposit (Rs.) 10,000 10,700 11,449 32,149
TDS (Rs.) 1,000 1,070 1,145 3,215

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 Net FD Interest Received (Rs.) 9,000 9,630 10,304 28,934
Additional Self-Assessment Tax (Rs.) * 2,000 2,140 2,290 6,430
Net Interest Income for Year (Rs) * 7,000 7,490 8,014 22,504
(available for re-investment in next year)
Value of Fixed Deposit after re-investment 107,000 114,490 122,504
(Rs.)

12.3.2 Mutual Fund

The mutual fund scheme does not pay a tax on its income every year. Taxation only comes in
the specific situations discussed earlier in this chapter.

Suppose, the investor had invested in a scheme, which in turn invested in a bank fixed deposit
that earned the same rate of interest of 10%. So long as the investor keeps the money
invested in the scheme, taxation is avoided. Growth in wealth of investor (irrespective of tax
slab) would be as shown in Table 1.3.

Table 1.3

Growth in Wealth (Mutual Fund Scheme)

Year-> 1 2 3 Total
Mutual Fund Investment (Rs.) 100,000 110,000 121,000
Interest earned by scheme (Rs.) 10,000 11,000 12,100 33,100
TDS (Rs.) Nil Nil Nil Nil
Net Interest Received (Rs.) 10,000 11,000 12,100 33,100
Additional Self-Assessment Tax (Rs.) Nil Nil Nil Nil
Net Interest Income for Year (Rs) 10,000 11,000 12,100 33,100
(available for re-investment in next year)
Value of Mutual Fund Investment post-interest 110,000 121,000 133,100
(Rs.)

In the mutual fund investment, wealth of the investor is growing on gross basis i.e. without
tax deduction each year. Thus, the investor’s wealth is 8.65% higher than in the case of bank
fixed deposit (Rs. 133,100 as compared to Rs. 122,504). The difference of 8.65% is a steep
86.5% of the 10% interest rate.

12.3.3 Dividend Payout and Growth Options within Schemes

Suppose the Rs. 100,000 was invested by an individual / HUF in a liquid scheme. Further, let
us assume that the dividend payout option of that scheme pays off all its income as dividend.
The comparative position of the investor between the dividend payout and growth options is
shown in Table 1.4.

A few points to note, from the table:

 Although the quoted rate for dividend distribution tax is 25% for individuals / HUF investing

113
 in liquid schemes, the tax is applied on the income distributed (Rs. 8,000). The tax of
Rs. 2,000 is only 20% on the Rs. 10,000 earned by the scheme. Thus, the effective rate
of dividend distribution tax is 20% (plus surcharge plus education cess), although the
quoted rate is 25%.

 Similarly, for individuals and HUFs investing in other debt schemes, the quoted dividend
distribution tax rate is 12.5%, but the effective rate is only 11.11% (plus surcharge plus
education cess).

 For investors other than individuals / HUFs investing in debt schemes, the quoted dividend
distribution tax rate of 20% translates to an effective rate of 13.08% (plus surcharge plus
education cess).

 The dividend distribution tax is applicable to all investors in debt mutual fund schemes,
irrespective of their tax slab. Even a loss making investor, who would otherwise not pay a
tax, bears dividend distribution tax (the scheme pays it when the dividend is distributed).

 It stands to reason that for most investors in debt schemes, it is better to opt for growth
option instead of dividend payout option.

Table 1.4

Dividend Payout v/s Growth (Individual / HUF in Liquid Scheme)

Dividend Growth
Payout Option Option

Investment by mutual fund scheme (Rs.) 100,000 100,000

Interest earned by mutual fund scheme (Rs.) 10,000 10,000
Dividend Distributed by Scheme 8,000 Nil
Dividend Distribution Tax at 25% on dividend distributed * 2,000 Nil
Net assets after the dividend 100,000 110,000
Wealth of Investor (Net assets + Dividend 108,000 110,000

* Surcharge & education cess are applicable, but have been ignored in this calculation

If the investor in the growth option were to redeem the investment, there will be no TDS on
the capital gain for resident investors. The ultimate taxation would not be more than 10%,
if it is a long term capital gain. Only if the holding period is less than a year (leading to a
short term capital gain) investors in the higher tax brackets might prefer the dividend payout
option, where the effective dividend distribution tax rate would be lower than their tax slab
rate.

12.3.4 Double Indexation

In the above example, if the investor invested in the growth option on March 30, 2009 and
redeemed the investment on April 2, 2010.

The investment happened in financial year 2008-09, for which the government has declared
cost inflation index of 582.

114
The investor redeemed the investment in financial year in 2010-11, for which the cost inflation
index is 711.

The capital gains is Rs. 110,000 minus Rs. 100,000 i.e. Rs. 10,000.

The holding period is 367 days, which is more than 1 year. Therefore, it is a long term capital
gain.

The maximum tax the investor has to bear is 10% (plus surcharge plus education cess) on
the capital gain of Rs. 10,000. Thus, the maximum tax payable would be Rs. 1,000 (plus
surcharge plus education cess).

Investor can benefit from indexation. The indexed cost of acquisition is Rs. 100,000 X 711 ÷
582 i.e. Rs. 122,165. This is higher than the selling price of Rs. 110,000. Thus, the investor
ends up with a long term capital loss of Rs. 12, 165. This can be set off against long term
capital gains, as discussed in the next section.

Another point to note is that although the investor held the investment for slightly more than
a year, the investor gets the benefit of indexation for two years viz. 2009-10 and 2010-11.
Hence the name “double indexation” for such structures.

Mutual funds tend to come out with fixed maturity plans towards the end of every financial
year to help them benefit from such double indexation.

12.3.5 Setting Off & Carry Forward of Losses

The income tax act provides for five heads of income:

 Salaries

 Income from House Property

 Profits and Gains of Business or Profession

 Capital Gains

 Income from other sources

Setting off losses in source of income against income in some other source of income is
governed by the following conditions:

 Loss under any source within any head of income, other than capital gains, is to be
set off against income from any other source under the same head of income in the
same assessment year.

 Loss under any source within any head of income, other than capital gains, is to be
set off against income from any other source under any other head of income in the
same assessment year.

 Loss under the head Profits & Gains of Business or Profession cannot be set off against
income from salaries.

 Unabsorbed business losses in a previous year can be carried forward and set off
against future Profits and Gains of Business or Profession, for 8 assessment years.

115
  Losses from speculative business can only be set off against profits from speculative
business.

 Unabsorbed speculative losses in a previous year can be carried forward and set off
against future speculative profit, for 4 assessment years.

 Loss under the head Capital Gain, cannot be set off against any other head of income.

 Short term capital loss is to be set off against long term capital gain or short term
capital gain.

 Long term capital loss is to be set off only against long term capital gain.

 Unabsorbed losses (long term or short term) can be carried forward for set off against
future capital gains for 8 assessment years.

12.3.6 Dividend Stripping

Dividend received in the hands of the investor is tax-free for all mutual fund schemes.

Suppose an investor buys units within 3 months prior to the record date for a dividend, and
sells those units within 9 months after the record date, and incurs a capital loss.

The capital loss will not be available for set-off against other capital gains to the extent of the
dividend that was exempted from tax.

Suppose, the record date for a dividend of Re. 1 per unit is April 1, 2011. Investor buys the
units at Rs. 15 and sells them at Rs.12.

The dividend of Rs.1 would be exempt from tax in the hands of the investor.

There is also a capital loss of Rs. 15 minus Rs. 12 i.e. Rs. 3 per unit. If the investor wants to
set off this loss against other capital gains, then, either the units should have been bought
before January 1, 2011, or they should have been sold after December 31, 2011.

If the investor buys the units during the 3 month period of January 1, 2011 to March 31, 2011;
and sells the units during the 9 month period of April 1, 2011 to December 31, 2011, then
out of the Rs. 3 capital loss, Rs. 1 will be disallowed because that is the amount the investor
received as tax-free dividend. The balance capital loss of Rs. 2 will however be available for
setting off against other capital gains.

12.4 Points to remember

 STT is applicable to equities and equity-oriented funds, but not to debt and debt-oriented
funds.

 An equity-oriented fund is a fund that invests at least 65% of its corpus in equities of
domestic companies. Thus, international funds, gold funds and balanced funds with less
than 65% allocation to equity do not qualify.

 STT on equity-oriented schemes of mutual funds is applicable as follows:

o On scheme’s purchase of equity shares in the stock exchange at 0.125%

116
 o On scheme’s sale of equity shares in stock exchange at 0.125%

o On scheme’s sale of futures & options in stock exchange at 0.017%

 STT on investors in equity oriented schemes of mutual fund is applicable as follows:

o On investor’s purchase of the units in stock exchange at 0.125%

o On investor’s sale of the units in stock exchange at 0.125%

o On re-purchase of investor’s units by the AMC at 0.250%

 The difference between the selling price (of sale in the stock exchange or as re-purchase
of units by the scheme) and buying price of an investment is treated as a capital gain (or
capital loss, if the selling price is lower).

 Since the mutual fund is exempt from tax, the scheme does not pay a tax on its capital
gains. However, investors in mutual fund schemes are liable to be taxed on their capital
gains.

 If the investment (in any type of mutual fund scheme) is held for more than 1 year, it
qualifies to be a long term capital gain. Else, it is a short term capital gain.

 Long term capital gains from equity mutual fund schemes are exempt from tax upto Rs.
1 lakh. After that, the taxation is 10% plus surcharge plus education cess.

 Short term capital gains from equity mutual fund schemes are taxed at 15% plus surcharge
plus education cess.

 The maximum tax rate on long term capital gains from non-equity mutual fund schemes
is 10% + Surcharge + Education Cess.

Investor can bring down the taxation by taking the benefit of indexation. Cost of acquisition
can be increased to the extent of inflation.

Selling price being held constant, the adjusted capital gains would be lower. Tax would need
to be calculated at 20% + Surcharge + Education Cess on the adjusted capital gains.

 Short Term Capital Gains from non-equity mutual fund schemes is added to the income of
the assessee. Thus, it would be taxed at Nil / 5%/ 10% / 20% / 30%, depending on the
applicable tax slab. Further, surcharge and education cess would be applicable.

 Tax on Income Distributed is applicable only on dividend distributed by debt-oriented

schemes. The applicable rate is:

o Individuals & Hindu Undivided Families

o 25% plus surcharge plus education cess, for liquid schemes

o 12.5% plus surcharge plus education cess, for other debt schemes

o Other investors

o 20% plus surcharge plus education cess for all debt schemes

The effective rate of tax on dividend distribution is lower than these quoted rates.

117
 There is no TDS on dividend or re-purchase amount for resident investors.

 Non-resident investors might have to bear withholding tax, which will reduce the amount
they receive from the scheme as dividend or re-purchase amounts. They can however
take the benefit of Double Taxation Avoidance Agreements, if India has signed such an
agreement with the country of their residence.

 Wealth build up in a bank fixed deposit happens net of tax. Mutual funds offer the benefit
of growing wealth on gross basis. The possibility of double indexation also exists. Thus,
investor’s wealth can grow faster through mutual funds.

 The dividend distribution tax is applicable to all investors in debt mutual fund schemes,
irrespective of their tax slab. Even a loss making investor, who would otherwise not pay a
tax, bears dividend distribution tax (the scheme pays it when the dividend is distributed).

It stands to reason that for most investors in debt schemes, it is better to opt for growth
option instead of dividend payout option.

 The income tax act provides for five heads of income:

o Salaries

o Income from House Property

o Profits and Gains of Business or Profession

o Capital Gains

o Income from other sources

 Loss under any source within any head of income, other than capital gains, is to be set
off against income from any other source under the same head of income in the same
assessment year.

 Loss under any source within any head of income, other than capital gains, is to be set
off against income from any other source under any other head of income in the same
assessment year.

 Loss under the head Profits & Gains of Business or Profession cannot be set off against
income from salaries.

 Unabsorbed business losses in a previous year can be carried forward and set off against
future Profits and Gains of Business or Profession, for 8 assessment years.

 Losses from speculative business can only be set off against profits from speculative
business.

 Unabsorbed speculative losses in a previous year can be carried forward and set off
against future speculative profit, for 4 assessment years.

 Loss under the head Capital Gain, cannot be set off against any other head of income.

 Short term capital loss is to be set off against long term capital gain or short term capital
gain.

118
 Long term capital loss is to be set off only against long term capital gain.

 Unabsorbed losses (long term or short term) can be carried forward for set off against
future capital gains for 8 assessment years.

 Dividend received in the hands of the investor is tax-free for all mutual fund schemes.

 Suppose an investor buys units within 3 months prior to the record date for a dividend,
and sells those units within 9 months after the record date, and incurs a capital loss.

The capital loss will not be available for set-off against other capital gains to the extent of the
dividend that was exempted from tax.

References
 AMFI

 SEBI

 Bogle, John C., Common Sense on Mutual Funds, (John Wiley & Sons, Inc., 1999)

 Hall, Alvin D., Getting Started in Mutual Funds, (John Wiley & Sons, Inc., 2000)

 Sadhak, H., Mutual Funds in India — Marketing Strategies and Investment Practices,
(Response Books 1997).

 Sankaran,Sundar, Indian Mutual Funds Handbook, [Vision Books (2003, 2007, 2011)]

 Sankaran,Sundar, NISM Series VA: MFD Certification Workbook, [National Institute of

Securities Market (2010)]

119
NOTES

120