Financial Markets
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Investing Money
Investment Cycle
The investment cycle has three stages:
1. Financial Planning: This is to understand the nature of the investor in terms of his/her appetite for risk. A
successful financial planner needs to know the following:
a) Understanding of portfolio management principles i.e. risk-return framework and
b) Reading of people and their comfort zones i.e. risk profiling
2. Investment Decision: It is also called asset allocation. Asset allocation refers to the strategy of dividing the
client’s total investment portfolio among various asset classes.
3. Portfolio Monitoring: It is important to conduct periodic portfolio reviews. As values of instruments in the
portfolio change, the proportion of debt/equity will change from the original requirement (say 50:50). Hence
rebalancing of the portfolio must be regularly done.
Rebalancing is the process of selling portions of the portfolio that have increased significantly, and using those funds
to purchase additional units of assets that have declined slightly or increased at a lesser rate.
This completes the investment cycle.
Role of Asset Management Companies (AMCs)
The role of an AMC is to make the decision process easier for investors. Many investment companies create a series
of model portfolios, each comprising different proportions of asset classes. These model portfolios range from
conservative to very aggressive.
In a conservative portfolio, a higher proportion of money is invested in fixed income or debt securities. In a very
aggressive portfolio, most of the money is invested in the higher risk class of equities.
Funds: Mutual Funds
Funds are a mode of investing money indirectly into stocks and bonds. A mutual fund is a type of fund that is
available to small (retail) investors.
The structure of mutual funds is:
1. Asset Management Company: Funds are managed by an an Asset Management Company. An AMC
raises money from investors and invests in a defined group of assets.
2. Sponsors: The sponsor initiates the idea to set up a mutual fund. It could be a registered company,
scheduled bank or financial institution.
3. Trustees: A trustee means a member of the Board or a Director of the Trustee company; his role is to
protect investors’ interests.
Some benefits of investing through mutual funds include diversification and professional money management.
The funds may charge fees which is known as “load”. This could be
1. Front-end or Entry Load: Fees charged when you are entering or purchasing units from the fund.
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Financial Markets
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2. Back-end or Exit Load: Fees charged when you are exiting or selling units to the fund.
Categorization of Mutual Funds
On the basis of liquidity mutual funds are categorized as
1. Open-ended Funds: Funds where investors can purchase the shares (units) of the fund from the fund
company, and sell them back to the company, at any time. There is no limit on the number of investors and
the funds have no fixed maturity.
2. Close-ended Funds: Units of closed ended funds, can be purchased from the fund company only during
the initial offer period and there is a limit on the total amount (corpus) that will be invested in the fund.
Close-ended funds typically have a fixed maturity.
On the basis of investment objective mutual funds are classified as:
1. Equity Funds: These are funds which invest primarily in equity.
2. Income Funds: Funds which invest primarily in debt instruments.
3. Balanced Funds: Balanced funds invest in both debt and equity, typically in equal amounts.
4. Money Market Fund: Funds investing in money market instruments such as CPs, CDs, T-bills.
5. Sectoral Funds: Funds which invest in equity of companies in specific sectors. An IT sector fund is one
example, which invests only in the shares of IT companies.
Each of the above could be open-ended or closed-ended.
On the basis of their investment plan mutual funds are classified as:
1. Growth Plans: These automatically reinvest the returns made by the investor, back into the fund.
2. Dividend Plan: Here, the returns are distributed in the form of dividend back to the investor at regular
intervals.
3. Systematic Investment Plan (SIP): Under this plan the investment is made in regular installments over
a fixed period: e.g. Rs. 5000 per month for six months, thereby averaging the cost of investment over a
period of time.
Net Asset Value (NAV)
The funds publish the value of their units daily. This value is known as the ‘Net Asset Value’ or NAV.
NAV = (Market Value of the fund investments (incl. cash) + Income Receivable
- Expenses Payable)/Number of outstanding units
The Investment Decision
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Financial Markets
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Finally, as companies need to decide how to raise money (debt or equity), investors also need to make an informed
decision on their options. The investment choice will depend on the trade-off made between the parameters of
returns, liquidity and safety.
Example questions on NAV:
For a Mutual Fund, the market value of all investments plus cash was INR 72.3 Crore, outstanding liabilities were
INR 5.5 Cr, the dividend and interest income already received was together INR 1 Crore, and expenses already paid
totaled INR 6.7 Crore. What is the NAV of each unit if the number of units outstanding are 1 Crore?
Ans: Use the above formula to calculate. The answer should be INR 66.8. Note that expenses have already been paid
and income is already received. Hence these items will already be reflected in cash and should not be considered
again. Just deduct the liabilities to be paid from the market value plus cash.
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