Part 12

Part-12
Mutual Funds
&
Pension Funds
1
Definition
 What is a mutual fund?
 It is a collection of assets like:
 Stocks
 Bonds
 Precious metals
 Real estate
2
Definition (Cont…)
 Who purchases these assets?
 A pool of investors
 Who manages these assets?
 A professional investment company
3
The Mechanics
 When an investor makes an
investment in a mutual fund, his
money is pooled with that of other
investors who have chosen to
invest in the fund.
 Every investor will receive shares
of the fund, in proportion to the
amount of funds invested by him
or her. 4
The Mechanics (Cont…)
 If the fund is just commencing
operations, the pooled resources
will be used to acquire a portfolio
of assets.
 Else if the fund is already in
operation the newly received funds
will be used to expand its portfolio.
5
Shares of a Fund
 Every share held by a mutual fund
investor represents a proportional
interest in the portfolio of
securities managed by the fund.
 When a fund is just commencing
operations, the issue of shares by
it is known as an Initial Public
Offering (IPO).
6
Shares of a Fund (Cont…)
 During an IPO, the shares will be
issued at par.
 Subsequent share issues will be
made at a price that is based on
the Net Asset Value (NAV) of the
fund.
7
Definition of NAV
 The NAV of a fund at any point in
time is:
 The total value of all the securities in
its portfolio, less any outstanding
liabilities
 Divided by the total number of shares
issued by the fund.
8
NAV (Cont…)
 The NAV will fluctuate from day to
day:
 Due to changes in the value of the
assets constituting the portfolio
 Due to income from the assets held
by the fund
 Due to expenses incurred by the fund
9
NAV (Cont…)
 On a given day, the NAV may be
higher or lower than what the
shareholder paid to acquire the
shares of the fund.
 Thus just like shareholders of a
company, holders of mutual fund
shares participate:
 In all profits and losses made by the
fund, as well as in its income and 10
The U.S. Mutual Fund
Industry
 The industry is really big:
 In the 1990s money was pouring into
mutual funds at the rate of $1 billion
per day.
 By the end of the 1990s:

There were 10,350 different funds in the
U.S

Holding about $3.7 trillion in assets
11
Why Invest in a Mutual
Fund?
 Why should an investor invest in a
mutual fund, rather than invest
directly in securities?
 A mutual fund by definition has a
large corpus at its disposal.
 So the size of its typical
investment tends to be large.
12
Why Invest ?(Cont…)
 Consequently, its transactions
costs tend to be low.
 These benefits obviously get
passed on to the shareholders of
the fund.
 This is particularly attractive from
the standpoint of an investor
seeking to acquire a diversified
portfolio of assets. 13
Why Invest? (Cont…)
 The cost of building a diversified
portfolio using the limited funds at
one’s disposal can be prohibitive.
 However by investing in a mutual
fund one effectively ensures
diversification and that too at a
lower cost.
14
 Mutual funds can afford to employ
well qualified and experienced
professionals.
 These analysts can evaluate the
merits of an investment before
committing funds.
 Individual investors lack such
expertise.
 And nor can they afford to employ15
 Mutual fund investments are often
more liquid than investments in
the underlying assets.
 Consequently shareholders can
dispose off their shares easily,
quickly, and at a fair price.
16
Any Disadvantages?
 Investing in a mutual fund is not all
about advantages, however.
 There are drawbacks.
 Firstly, the investor has no control
over the cost of investing.
 It is entirely in the hands of the
fund manager.
17
Disadvantages (Cont…)
 Moreover, as long as one is
invested in the fund, he has to pay
the required investment
management fees.
 This is true even if the value of the
assets of the fund is showing a
declining trend.
 Second, mutual funds incur sales
and marketing expenditure , which
get passed on to the investor. 18
 An individual investor will not
obviously incur such costs.
 Thirdly the choice of securities is
delegated to the fund manager.
 Thus the investor forsakes the
option to design his own kind of
portfolio.
 This may not be satisfactory for a
High Net Worth (HNW) investor.
19
 In practice fund managers attempt
to cater to different types of
investors, by offering funds with
different investment objectives.
 But the availability of such choice
may itself pose problems

Because an investor may once again
need expert advice on which fund to
choose.
20
Open-End versus Closed-
End Funds
 In the case of an open-end fund,
the investor can buy or sell shares
of the fund from/to the fund at any
point in time.
 The purchase/sale price of the
share at which an investor can
transact is called the Net Asset
Value (NAV).
21
NAV
 The NAV of a fund is defined as the
market value of all the assets of
the fund plus any accrued income,
less the liabilities of the fund,
divided by the total number of
shares outstanding.
 The NAV of an open-end fund is
determined once a day at the close
of trading. 22
NAV (Cont…)
 All new investments into the fund
and withdrawals from the fund
during the course of a day, are
priced at the NAV that is computed
at the end of that day.
 As the prices of the assets of the
fund fluctuate, so will the NAV and
the total value of a fund.
23
Open-End Funds
 The number of shares outstanding
at any point in time may either go
up subsequently or go down.
 It would depend on whether
additional shares are issued or
existing shares repurchased.
 Thus the ùnit capital’ of an open-
end fund is not fixed but variable.
24
Open-End Funds (Cont…)
 The investable corpus of the fund
will go up if the number of new
subscriptions by new/existing
investors exceeds the number of
redemptions by existing investors.
 The investable surplus will stand
reduced if redemptions exceed the
fresh subscriptions.
25
 Such funds always stand ready to
issue fresh shares.
 Many successful funds stop fresh
subscriptions after reaching a
target size.
 This could happen if they feel that
further growth will adversely
impact profitability.
26
 However they rarely deny
investors the freedom to redeem
shares.
 Every open-end fund will maintain
a Cash Reserve which is usually
about 5% of the total assets.
 This is done to cover redemption
requests from shareholders.
27
 However should additional funds
be required, the fund manager will
have no choice but to liquidate
some of the assets of the fund.
28
Closed-End Funds
 These funds make a onetime sale
of a fixed number of shares.
 Their ùnit capital’ therefore
remains fixed.
 They do not allow investors to
buy/redeem units from/with them.
 But to provide liquidity to investors
they get listed on stock exchanges.
29
Closed-End Funds (Cont…)
 In the case of a listed closed-end fund,
investors can buy and sell shares
through a broker.
 The share price need not be equal to
the NAV.
 Depending on investors’ perceptions
about future performance and supply-
demand factors, the shares may trade
at a premium to or at a discount from
the NAV.
30
 Shares that trade below the NAV
are said to: `trade at a discount’
 Shares that trade above the NAV
are said to:
`trade at a premium’
 Shares of unlisted closed-end
funds can be traded over-the-
counter.
31
Life-Boat Provisions
 The fund charters of closed-end
funds usually contain life-boat
provisions.
 These require such funds to take
action in cases where the shares
are trading at a substantial
discount to the NAV.
 The funds in such cases can either
buy back the shares via a tender
offer, or else they can convert it to32
Life-Boat (Cont…)
 If the fund managers fail to
respond in an appropriate fashion,
dissident shareholders can buy
large blocks of shares and initiate
a proxy fight to either have the
fund liquidated or to make it open-
ended.
33
Regulation
 Under the U.S. Investment Company Act
of 1940, a closed-end fund is capitalized
only once.
 That is, once it makes an issue of shares
via an Initial Public Offering it cannot
issue further shares subsequently.
 Consequently many closed-end funds
choose to borrow when they wish to
increase the size of their investments.
34
 Unlike open-end funds, these funds
are not listed in the mutual fund
tables printed in the financial
papers.
 Rather they are listed alphabetically
with stocks in the table of share
prices.
35
Unit Trusts
 Unit Trusts a.k.a Unit Investment
Trusts are similar to closed-end
funds in the sense that they are
capitalized only once.
 Consequently their ùnit capital’
remains fixed.
 Most Unit Trusts invest in bonds.
36
Unit Trusts (Cont…)
 Unit Trusts differ from mutual
funds in one crucial respect.
 Once a portfolio of bonds is
assembled by a Unit Trust, it is
held until the bonds are redeemed
by the issuer.
 Thus there is no trading in the
assets which comprise the
portfolio. 37
 Usually the only time the trustee of
a Unit Trust can sell a bond held by
it, is if there has been a significant
decline in the credit quality.
 Because of the lack of active
trading the cost of operating a Unit
Trust is lower than the cost of
running a closed-end fund.
38
 Second, most unit trusts have a
fixed termination date.
 And finally, unlike investors of a
mutual fund who are constantly
exposed to a changing portfolio
composition, unit trust investors
know the exact composition of
their portfolio from the outset.
 Unit trusts are more common in
Europe. 39
Calculating the NAV
 The net assets of a fund is defined
as:
Net Assets = Market Value of all
Investments
+ Receivables
+ Other Accrued Income
+ Other Assets
- Accrued Expenses
- Other Payables
- Other Liabilities 40
Calculating the NAV
(Cont…)
 The NAV is defined as:
NAV = Net Assets ÷ No. of Units
Outstanding
41
Factors Affecting the NAV
 The NAV is affected by four sets of
factors:
 Purchase and sale of investment
securities
 Valuation of the investment securities
 Other assets and liabilities
 Units sold or redeemed
42
Other Assets & Liabilities
 The term òther assets’ includes
any income due to the fund but not
received as on the valuation date,
like:
 Dividends announce by a company
whose shares are being held by the
firm but which have not yet been
received.
43
(Cont…)
 Òther liabilities’ include expenses
payable by the fund such as:
 Custodian fees
 Management fees payable to the
Asset Management Company
 All items of income and
expenditure have to be accrued
and included while computing the
NAV. 44
(Cont…)
 In India SEBI requires that all income
and expenditure should be accrued up
to the valuation date and considered for
NAV computations.
 Major expenses like management fees
should be accrued on a day to day
basis.
 Other expenses need not be accrued daily if
non-accrual will not affect the NAV by more
than 1%.
45
Expenses of a Fund
 The Asset Management Company
will have many funds under its
management.
 Some expenses would be specific to a
given scheme.
 Others may be common to all
schemes.
 All expenses should be clearly
identified and allocated.
46
Expenses
 Expenses may be broadly
categorized as:
 Investment management and
advisory fees.
 Initial expenses of launching a
scheme
 Recurring expenses
47
Recurring Expenses
 This expenditure category
includes:
 Marketing and selling expenses
 Brokerage and transactions costs
 Registrar services for transfer of units
sold or redeemed
 Fees and expenses of trustees
 Audit fees
 Custodian fees 48
Recurring Expenses
(Cont…)
 Costs related to investor
communication
 Costs of fund transfers
 Costs of providing account
statements and dividend/redemption
checks and warrants
 Insurance premiums
 Winding up costs if a fund or a
scheme is being terminated
 Statutory advertisements 49
Illustration of an NAV
Calculation
 A mutual fund in the U.S. has
acquired the following shares:
 IBM – 1,000
 Exxon – 2,000
 GM – 2,000
 It has issued 20,000 units to its
shareholders
50
Illustration (Cont…)
COMPAN # of PRICE VALUE
Y Shares
IBM 1,000 35 35,000
Exxon 2,000 80 160,000
GM 2,000 60 120,000
TOTAL 5,000 315,000
51
 First day’s NAV:
315,000
_______ = 15.75
20,000
52
The Next Day
COMPAN # Of PRICE VALUE
Y Shares
IBM 1,000 40 40,000
Exxon 2,000 90 180,000
GM 2,000 75 150,000
TOTAL 5,000 370,000
53
 The next day’s NAV:
370,000
_______ = 18.50
20,000
54
 So, the NAV will change when the
values of the securities bought by
the fund change.
 But the NAV may also change if
the fund issues additional shares.
 If the incoming funds are used to
acquire shares in the existing
proportions, then the NAV will not
change.
 Else it will.
55
Case-A
 Assume that the fund issues 2,000
additional shares at the end of the first
day.
 At an NAV of 15.75 this will mean an
inflow of 31,500.
 Assume that 100 shares of IBM, 200
shares of Exxon, and 200 shares of GM
are bought.
 That is, the existing ratio of 1:2:2 is
maintained.
56
COMPAN # of PRICE VALUE
Y Shares
IBM 1,100 40 44,000
Exxon 2,200 90 198,000
GM 2,200 75 165,000
TOTAL 5,500 407,000
57
 The next day’s NAV:
407,000
_______ = 18.50
22,000
58
Case-B
 The fund decides to acquire 300
shares of IBM, 150 shares of Exxon,
and 150 shares of GM.
59
COMPAN # Of PRICE VALUE
Y Shares
IBM 1,300 40 52,000
Exxon 2,150 90 193,500
GM 2,150 75 161,250
TOTAL 5,600 406,750
60
 The new NAV:
406,500
_______ = 18.4886
22,000
61
Expenses (Cont…)
 When a scheme is first launched,
the AMC will incur significant
expenditure, whose benefit will
accrue over many years.
 The entire expenditure cannot
therefore be charged in the first year
itself.
 SEBI permits such expenses to be
amortized over a period of five years.
62
Expenses (Cont…)
 However issue expenses incurred
during the life of a scheme have to be
charged in the year of incurrence
itself.
 The unamortized portion of the initial
issue expenses shall be included in
the NAV calculation and will be
classified under Òther Assets’.
 Investment advisory fees cannot be
claimed on such assets.
63
SEBI’s Accounting Policies
for Mutual Funds
 Dividends received by a fund from
a share should be recognized the
day the share goes ex-dividend
and not on the declaration date.
 While determining capital
gains/losses on the sale of
securities, the average cost
method must be used to determine
the cost of purchase. 64
Example
 A mutual fund acquires 100 shares
of WIPRO for Rs 600 each on
August 1.
 It buys another 200 shares at Rs
750 each on September 1.
 On 15 September it sells 100
shares for Rs 800 each.
 What is the capital gain or loss?
65
Calculation of
Gains/Losses
 The average cost per share will be
determined as follows:
600 x 100 + 750 x 200
______________________ = Rs 700
300
 Total cost of shares sold = 100 x
700
= Rs 70,000
66
Calculation (Cont…)
 Sale proceeds = 100 x 800 = Rs
80,000
 Capital gains = Rs 10,000
67
Accounting Policies
(Cont…)
 Purchase/sale of investments
should be recognized on the trade
date and not on the settlement
date.
 Bonus/rights issues should be
recognized only when the shares
are traded on the exchange on a
ex-bonus/ex-rights basis.
68
Accounting Policies
(Cont…)
 Income receivable on investments,
which is accrued, but not received
for 12 months beyond the due
date, should be provided for, and
no further accrual should be made
for it.
69
Accounting for Major
Transactions
 Here is a detailed illustration on
how sales and redemptions of
shares of a mutual fund are
accounted for in its books of
accounts as per SEBI guidelines.
70
Illustration
 Day-1:
 An open-end fund issues 1,000 shares at a
face value of Rs 10 each.
 Thus unit capital will appear on the liabilities
side with a value of Rs 10,000.
 This amount will be invested in various
securities.
 Thus investments will appear as an asset
with a value of Rs 10,000.
 The NAV will obviously be Rs 10.
71
 Day-2:
 The market value of the investments
rises to Rs 11,000.
 Thus there will be an unrealized capital
gain of Rs 1,000.
 Unrealized capital gains have to be
recognized as income in the books of
account, but cannot be distributed to the
shareholders.
72
 As far as the books are concerned,
Investments will be debited by Rs
1,000.

Thus its value will go to Rs 11,000.
 The unit premium reserve will be credited
with Rs 1,000.
 The NAV will obviously be Rs 11.
73
 Day-3:
 The market value of the investments
rises to Rs 12,000.
 10% of the original portfolio is sold.
 Thus shares worth bought for 1,000 are
sold for 1,200.
 Thus investments will be debited with
1,000 and credited with 1,200.
 The balance in the account will be
10,800.
74
 The realized gain on the sale of
investments will be Rs 200.
 The unrealized capital gain will be Rs
1,800
 Since the shares are sold for 1,200,
cash or bank will be debited with Rs
1,200.
 The NAV will be 12 as can be
demonstrated.
75
 Net Assets = Market Value of
Investments on
Hand +
Cash Received from
sale of
Investments
= Rs 12,000
 Number of units outstanding =
1,000 76
 The NAV consists of:
 Face value of Rs 10
 Realized gain of 0.20
 Unrealized gain of Rs 1.80
77
 Day-4:
 There is no change in the market
value of the investments.
 The fund sells 100 units.
 It repurchases 75 units.
 Both transactions take place at the NAV
of 12.
78
Equalization Account
 An open-end fund will sell and
redeem shares at NAV.
 While creating/redeeming shares it
is important to ensure that the
percentage of income that is
eligible for distribution does not
change.
 For this purpose SEBI requires the
creation of an Equalization
Account. 79
(Cont…)
 The first step is the computation of the
Distributable Reserves:
 Distributable Reserves = Income
+ Realized
Gains on
Investments
- Expenses
- Unrealized
Losses
80
(Cont…)
 Note:
 Unrealized losses are recognized
 Unrealized gains are not recognized
 If the distributable reserves are
positive than the following ratio is
computed:
 Distributable Reserves ÷ No. of Units
Outstanding 81
(Cont…)
 This ratio has to be multiplied by
the number of shares sold.
 If the shares are sold above par, then
the equalization account is credited
by this amount.
 If the shares are sold at below par,
then the equalization account is
debited by this amount.
82
(Cont…)
 In the case of redemptions, the
number of units has to be
multiplied by the number of units
redeemed.
 If the units are repurchased at above
par, the equalization account has to
be debited.
 If the units are repurchased at below
par the equalization account has to
be credited. 83
(Cont…)
 The net balance in the equalization
account is transferred to the Profit &
Loss Account.
84
 In our case, the distributable
reserves = realized capital gains =
Rs 200
 The ratio = 200 ÷ 1000 = 0.20
 When 100 units are sold at Rs 12,
the equalization account will be
credited with 0.20 x 100 = Rs 20.
85
 Because of this transaction:
 Units outstanding will increase to
1,100
 The sale proceeds will be Rs 1,200
 The unit capital account will be
credited with Rs 1,000.
 The unit premium reserve will be
credited with Rs 180 which is the
unrealized capital gain.
86
 When 75 units are redeemed at Rs
12:
 The equalization account is debited
by Rs 15.
 The units outstanding will decrease to
1025
 The outflow of cash will be Rs 900.
 The unit capital will be debited by Rs
750.
 The unit premium reserve will be
debited by Rs 135. 87
 The net amount of Rs 5 in the
equalization account will be
transferred to the Profit & Loss
account.
 This can be distributed to the
shareholders.
 The balance in the unit premium
reserve cannot however be
distributed.
88
SEBI Guidelines on
Valuation
 Mutual funds have to report their
NAV on a daily basis.
 Thus their portfolios must be
marked to market on a daily basis.
 SEBI has prescribed certain
regulations for the valuation of
assets.
89
Valuation (Cont…)
 When a security is traded on a stock
exchange, it should be valued at the
last quoted price on the exchange
where it is principally traded.
 If the security is not traded on any
exchange on a given day, the value at
which it was traded on the earliest
previous day may be used
 Provided that this date is not more than 60
days prior to the valuation date.
90
Valuation (Cont…)
 If a security is not traded on any
stock exchange for 60 days prior to
the valuation date, it must be
treated as a non-traded scrip.
91
Valuation of Non-Traded
Scrips
 Equity shares are to be valued on
the basis of capitalization of
earnings.
 The capitalization will be
determined with reference to the
Price/Earnings ratios of
comparable traded securities with
an appropriate discount for lower
liquidity. 92
Example
 Assume that the fund is holding
shares of a company which is not
publicly trade but has an EPS of Rs
2.
 A similar company whose shares
are actively traded has a P/E ratio
of 12.
 Using this ratio, the value of the
non-traded scrip should be Rs 24. 93
Example (Cont…)
 However since the non-traded
scrip is less liquid, we may use a
lower P/E ratio, say 10.
 If so, we would value our share at
20.
94
Non-traded Scrips (Cont…)
 For debt instruments we would
price it using the YTM of a
comparable traded debt security.
 To account for the lower liquidity we
would use a higher YTM.
95
Costs
 The costs incurred by an investor in a
mutual fund can be classified under two
heads.
The first is called a sales charge or a
shareholder fee.
 This is a one time charge that is debited
at the time of a transaction – either at
the time of purchase, or a sale, or an
exchange of shares of one scheme for
that of another.
 The amount would depend on the
method used by the fund for distributing 96
Costs (Cont…)
 The second category of costs is the
annual operating expense incurred
by the fund, called the expense
ratio.
 The largest component of the
expense ratio is the management
fee.
 This cost is independent of the
method adopted for distributing 97
Sales Charges
 Traditionally, two methods have
been adopted for distributing
shares of a mutual fund.
 They have been sold using a sales
force or a wholesale distributor, or
 They have been sold directly.
98
Sales Charges (Cont…)
 The first method requires an
intermediary like a an agent, a
stockbroker, an insurance agent, or
other similar entity who is capable of
providing investment advice to the
client, and can also service the
investment subsequently.
 This is an active approach.
 In such cases, it is said that `the fund is
sold not bought’.
99
 In the second case there is no
intermediary or salesman.
 No advice is provided at the time
of sale.
 The potential client is expected to
dial a toll-free number in response
to an advertisement or other
source of information.
100
 This is a passive approach.
 It is said that `the fund is bought
and not sold’.
 The agent based system comes
with an attached cost – a sales
charge which has to be borne by
the client.
 The charge is a compensation for
the services rendered by the
agent. 101
Loads
 The sales charges levied by such
funds are referred to as loads.
 The traditional practice has been
to deduct the load upfront from the
investor’s initial contribution at the
time of entry, and pass it on to the
agent/distributor.
 The balance represents the
investable amount for the client.
102
Front-End Loads
 This method of charging is called
front-end loading.
 The corresponding loads are called
front-end or entry loads.
 Since the total amount paid by the
investor in such cases exceeds the
NAV, such funds are said to be:
`purchased above the NAV’.
103
No-Load Funds
 In the case of directly placed
funds, there is no need for a sales
charge because an intermediary is
not present.
 Such fund are known as no-load
funds.
 In these cases, the entire amount
paid by the investor is investable.
 Such fund are said to be:
`purchased at NAV’. 104
Load or No-Load?
 It was thought at one time that
load funds would become obsolete
and that no-load funds would come
to dominate the market.
 After all why would any rational
investor pay a sales charge, if it is
avoidable.
 It was felt that, individual
investors, given their increasing
levels of sophistication, would 105
Load or No-Load ? (Cont…)
 However the trend has been to the
contrary.
 Load funds continue to be popular.
 There are two reasons for this.
 Firstly many investors continue to
be dependent on the counsel,
service, and the initiative of
investment agents.
106
Load or No-Load? (Cont…)
 Besides load funds have shown a
lot of ingenuity and flexibility in
devising new methods for
imposing the load.
 The objective has been to
compensate the agent without
appearing to be a burden on the
investors.
 These innovations have been in
the form of `back-end’ and `level’107
Back-End Loads
 These are imposed at the time of
redemption of shares.
 Consequently they are known as
exit loads.
 The advantage is that the investor
pays the NAV at the time of entry,
and the entire amount is
investable.
108
Level Loads
 In this case, a uniform sales charge
is imposed every year.
 Hence the reported NAVs will be
lower than what they would have
been in the absence of a sales
charge.
 However, once again, the entire
amount paid at the outset will be
investable. 109
Level Loads (Cont…)
 Level loads appeal to investors
who are more comfortable with the
concept of an annual fee rather
than commissions.
 Such investors are known as fee
based planners.
110
Contingent Deferred Sales
Charge
 This is the most common form of
exit load.
 This approach imposes a load on
withdrawal, which is a function of
the number of years that the
investor has spent with the fund.
 The longer an investor stays with a
fund, the lower will be the load on
redemption. 111
Illustration
 Consider a 3,3,2,2,1,1,0 contingent
deferred sales charge.
 It means that the load is 3% if the
shares are redeemed within two years,
2% if they are redeemed after 2 years
but within 4 years, and 1% if the
redemption takes place after 4 years
but within 6 years.
 There is no load if the redemption takes
place after 6 years.
112
Multiple Share Classes
 Many mutual fund families offer their
funds with a choice of loading
mechanisms.
 The client can pick the method of his
choice.
 Shares subject to front-end loading are
called class À shares’.
 Those subject to back-end loading are
called class `B shares’.
 This with a level load are called class `C
113
Loads (Cont…)
 According to the National
Association of Securities Dealers
(NASD), the maximum allowable
sales charge is 8.5%.
 Most funds impose lower charges
in practice.
 The sales charge is often lower for
investments beyond a specified
level.
114
Loads (Cont…)
 In the case of front-end load funds
and back-end load funds, the
declared NAV will not include the
load.
 In the case of funds with a front-
end load, the investor must add
the load amount per share to the
NAV in order to calculate the
purchase price. 115
Loads (Cont…)
 In the case of funds with back-end
loads, the investor has to deduct
the load amount per share from
the NAV in order to get the net
sale proceeds.
 We will illustrate these cases using
a numerical example.
116
Illustration
 A fund has declared a NAV of
19.30.
The front-end load is 2.5%.
 So the price payable by the
investor is
19.30
-------- = 19.7949.
.975
117

 In the absence of a load, an
investment of $1000 would fetch
the investor
 1000
 ------- = 51.81 units.
 19.30
 However because of the load it will
fetch only: 1000 x .975/19.30 =
50.5181 units. 118
 Now assume that the fund charges
an exit load of 2.5% instead of an
entry load.
 Instead of receiving 19.30 per unit,
the investor will receive only
 19.30 x .975 = 18.82 per unit.
 Thus a sale of 100 units which
would have fetched $1930 in the
absence of a load, will now fetch
only $ 1882. 119
Loads (Cont…)
 Loads can be imposed by both open-
ended as well as closed-ended funds.
 Loads represent issue expenses which
are just one of the many expenses
incurred by a mutual fund.
 Other expenses like the fund manager’s
fees have to be charged on an ongoing
basis.
 The impact of such charges will be a
reduction in the reported NAV. 120
Expense Ratio
 The operating expense is debited
annually from the investor’s
balance by the sponsor of the
fund.
 There are three main categories of
such expenses:
 Management Fee
 Distribution Fee
 Other Expenses
121
Management Fee
 It is also known as the Investment
Advisory Fee.
 It is the fee charged by the
investment advisor for managing
the fund’s portfolio.
 The fees charged would depend on
the nature of the fund.
 The greater the required levels of
efforts and skills, the higher will be
the fees. 122
12b-1 Fee
 In 1980 the SEC approved the
imposition of a fixed annual fee
called the 12b-1 fee.
 It is intended to cover distribution
costs including continuing agent
compensation, and the fund’s
marketing and advertising
expenses.
 By law it cannot exceed 1% of the
fund’s assets in a given year. 123
12b-1 Fee (Cont…)
 The 12b-1 fee may include a fee of
up to 0.25% of the assets to
compensate sales professionals for
providing services or for
maintaining shareholders
accounts.
 This is intended to provide the sales
agent with an incentive to continue to
service the account, even after having
received a transaction based fee such 124
12b-1 Fee (Cont…)
 This component of the fee is
applicable only for sales-force-sold
load funds and not for directly sold
no-load funds.
 The balance of the 12b-1 fee
accrues to the sponsor and is
intended to provide an incentive to
continue advertising and
marketing efforts. 125
Other Expenses
 These are incurred on account of the
following.
 Custody related costs have to be paid in
connection with the holding of cash and
securities.
 Transfer agents have to be paid when
securities are transferred from existing
to new shareholders; and when income
from investments is distributed to
existing shareholders.
126
Other Expenses (Cont…)
 Fees have to be paid to public
accountants who have been
entrusted with the task of
scrutinizing the books of account
of the fund.
 Directors fees have to be paid.
 The sum total of all this
expenditure is called the Expense
Ratio. 127
Illustration
Expense FUND
Type
Fidelity Vanguard American
Magellan S&P500 Income Fund
Index of America-A
Management 0.57% 0.16% 0.28%
Fee
Distribution 0 0 0.24%
(12b-1) fee
Other 0.18% 0.02% 0.07%
Expenses
TOTAL 0.75% 0.18% 0.59%
128
Analysis
 The first two funds are directly
sold.
 Hence the 12b-1 distribution fee is
zero.
 The American Income Fund is sold
via a sales force and hence there is
a 12b-1 fee.
 A fund which tracks an established
market index is relatively easy to
manage as compared to a fund 129
Analysis (Cont…)
 So the Vanguard S&P500 Index
fund has the lowest management
fee.
 The Fidelity Magellan Fund is an
actively managed pure stock fund
and has the highest management
fee.
130
Switching Fees
 For many years there was no
charge for switching from one
mutual fund to another within the
same family.
 But of late some funds have
started charging a flat fee.
 They argue that such charges are
being levied to discourage frequent
switching.
131
Switching Fees (Cont…)
 They may have a point because
frequent switching increases the
administrative costs involved in
keeping track of customer accounts.
 Switching charges are recovered
directly from the shareholder and do
not impact the NAV.
132
Categorization of Funds
 One way to categorize funds is on the
basis of the investments made by them.
 Consequently we have:
 Equity Funds
 Bond Funds
 Money Market Funds
 Precious Metal Funds
 Real Estate Funds
133
Categorization (Cont…)
 Another way to categorize is on
the basis of investment objectives.
 Growth Funds; These funds target
capital appreciation in the medium
to long term.
 Income Funds: They focus on
earning regular income, and are
less concerned with capital
appreciation. 134
 Value Funds invest in undervalued
securities in the hope of a
subsequent rise in price.
 Funds can also be categorized on
the basis of their risk profiles.
 Equity Funds have a greater risk of
capital loss than Debt Funds.
135
 Money Market Funds have an even
lower risk of capital loss as compared to
Debt Funds.
 Fund Managers can design funds with
specific risk-return characteristics in
order to cater to different types of
investors.
 For instance Equity Income Funds invest
in securities which may not show much
capital appreciation, but which pay
136
 Balanced Funds seek to reduce risk
by mixing equity investments with
investments in fixed-income
securities.
 They also attempt to strike a
balance between the need for
capital appreciation and the need
for steady income.
137
Money Market Funds
 They invest in securities with one
year or less to maturity.
 Typical investments are:
 Treasury Bills
 Certificates of Deposit
 Commercial Paper
 These investments are very liquid
and carry low credit risk.
138
Money Market Funds
(Cont…)
 There are also tax-free money
market funds which invest only in
municipal securities.
 The earnings of these funds are
exempt from Federal income taxes,
and in some cases from state taxes
as well.
139
Money Market Funds
(Cont…)
 The SEC has recently issued regulations
to improve the safety, liquidity, and
diversity of all money market funds.
 They should invest a minimum of 95% in top
rated securities.
 No more than 1% may be invested in the
securities on an investor who is not top
rated.
 The maximum maturity of an investment
should not exceed 90 days.
140
Money Market Funds
(Cont…)
 These funds are ideal for investors
seeking:
 Stability of principal
 High liquidity
 Check writing facilities
141
MMMFs versus Bank CDs
 The earnings from an MMMF are as
high or higher than those from
bank CDs.
 And unlike CDs, MMMFs do not
carry any early withdrawal
penalties.
142
Gilt Funds
 Gilt securities are debt instruments
issue by the government with a
maturity in excess of one year.
 In the U.S such securities are
known as T-bonds and T-notes.
 These securities carry little default
risk.
 But they are not risk-less either.
143
Gilt Funds (Cont…)
 For they are vulnerable to interest
rate risk or market risk.
 That is, changes in the interest
rate structure in the economy can
lead to substantial volatility in
bond prices.
144
Debt Funds
 These are also known as Income
Funds.
 They invest in fixed-income
securities issued by governments,
private companies, banks and
financial institutions, infrastructure
companies, and public utilities.
 They carry lower risk as compared
to equities and provide stable
income. 145
Debt Funds (Cont…)
 They have higher credit risk as
compared with Gilt Funds.
 As compared with Money Market Funds,
they have greater market risk as well as
credit risk.
 Their focus is primarily on earning
income and not on capital appreciation.
 They distribute substantial income to
shareholders on a regular basis.
146
Sub-Classification of Debt
Funds
 Diversified Debt Funds: It is a fund that
invests in virtually all types of debt
issues, cutting across all sectors and
industries.
 Investments in debt carries less risk as
compared to an equity investment but
there is nevertheless exposure to credit
risk or the risk of default.
 The advantage of a diversified fund is
that idiosyncratic credit risk gets
147
Sub-Classification (Cont…)
 Focused Debt Funds: They invest only in
debt securities issued by a specific
sector or industry.
 Some invest only in corporate bonds
and debentures.
 Others in only Infrastructure Bonds or
Municipal Bonds.
 Still others invest only in Mortgage
Backed Securities.
148
Sub-Classification (Cont…)
 High Yield Debt Funds: They invest
in non-investment grade bonds or
Junk bonds.
 There is a far greater degree of
risk in this case.
 But the expected returns are also
very high.
149
Equity Funds
 Such funds invest a major portion
if not all of their corpus in equity
shares.
 Such shares may be acquired by
subscribing to an IPO or via the
secondary market.
 Equity shares are by definition
more risky than debt.
 This is because they constitute a
residual claim rather than a 150
Types of Equity Funds
 Aggressive Growth Funds: They
target high capital appreciation
and usually take substantial risks
in the process.
 They tend to invest in less
researched and highly speculative
stocks.
 High returns are more likely but
the returns tend to be very 151
Equity Funds (Cont…)
 Growth Funds: They also target
companies with a high perceived
potential for growth.
 But they tend to invest in sunrise
industries – Information
Technology, Bio Technology,
Pharmaceuticals.
 The difference as compared to an
aggressive growth funds is that the
stocks tend to be less speculative.152
 Specialty Funds: They have a
narrow focus.
 Tend to invest only in companies
which satisfy certain pre-defined
criteria.
 For instance some funds will not
invest in Tobacco or Liquor
companies.
 Others tend to focus on companies
from specific regions – Latin 153
 Some equity funds tend to be highly
diversified while others hold
concentrated investments in a few
chosen securities.
 The latter are obviously more volatile.
 Sector Funds: They invest only in a
chosen sector or industry like –
Software, Pharma, or FMCG.
 As compared to a diversified fund, the
risk level is higher. 154
 Offshore Funds: They invest in
equities of companies located in
foreign countries.
 International diversification offers
even grater scope for risk
reduction than domestic
diversification.
 But it exposes investors to foreign
exchange risk. 155
 This is the risk that the domestic
currency may have appreciated by
the time the returns are
repatriated to the home country.
 These funds may be well
diversified or else may choose to
remain concentrated in a few
countries.
156
 Small Cap Funds: They invest in
companies with a low market
capitalization as compared to large
Blue Chip companies.
 The shares of these companies are
less liquid, and consequently
prices tend to be volatile.
 Some of these funds target
aggressive growth while others
aim at a steady growth. 157
 What is the definition of a small
cap fund.
 Market capitalization is defined as
the price of a share times the
number of shares issued.
 The definition of small, medium,
and large cap companies is
subjective.
 Fabozzi has suggested the
following classification for U.S. 158
Market Capitalization
Firm Type Market
Capitalization
Small Cap < 2 billion USD
Mid Cap 2 ≤ M-Cap < 12

billion USD
Large Cap ≥ 12 billion USD
159
 Option Income Funds: These funds
write options on stocks held by
them.
 Conservative option funds invest in
large dividend paying companies,
and then sell options against their
stock positions.
 Thus they have two sources of
income – dividends and option 160
 Diversified Equity Funds: These funds
diversify their investments across
companies.
 Extensive diversification ensures that
the level of risk is low.
 Equity Index Funds: They track the
performance of a stock market index,
such as the Dow Jones Industrial
Average or the Standard & Poor’s 500
Index.
161
 These funds will invest only in stocks
which constitute the target index, and in
exactly the same proportions as such
stocks are present in the index.
 These funds can be thought of as
`Mimicking Funds’.
 If the index being represented is well
diversified, then the corresponding
index fund will have low risk.
162
 Value Funds: Growth funds focus
on companies with good or
improving prospects for future
profits.
 Their primary aim is capital
appreciation.
 Value Funds too seek capital
appreciation.
 But their focus is on fundamentally
sound firms which are perceived to163
 As compared to Growth Funds,
Value Funds are less risky.
 Many of them tend to invest in a
large number of sectors and are
therefore well diversified.
 Equity Income Funds: They invest
in companies which give high
dividend yields.
164
 Their target is high current income,
and steady not spectacular capital
appreciation.
 Such funds invest heavily in equity
stocks.
 The prices of such firms do not
fluctuate much.
 But they provide steady dividends.
165
Hybrid Funds
 These funds have a dual
debt/equity focus.
 There are various forms of hybrid
funds.
 Balanced Funds: They hold
portfolios consisting of debt
instruments, convertible securities,
preference shares, and equity
shares.
 They hold almost equal proportions166
Hybrid Funds (Cont…)
 Their objective is steady income
accompanied by moderate capital
appreciation.
 They are primarily intended for
conservative and long-term
investors.
 Asset-Allocation Funds:
Traditionally mutual funds have
invested in a pre-defined asset
class. 167
 For instance some invest in debt
while others invest in equities.
 There are funds which invest in
more than one asset class, for
instance Balanced Funds.
 But even in this case, the relative
proportions invested in equity and
debt will generally not vary much.
168
 Asset Allocation Funds however
follow a variable allocation policy.
 They will move in and out of
various asset classes.
 The choice of an asset class at any
point in time would depend on the
fund manager’s current view on
the market.
169
Commodity Funds
 They invest in commodity markets.
 The investments may be made by
buying the physical commodities
or by buying the shares of
commodity firms, or by using
commodity futures contracts.
 Specialized commodity funds tend
to focus on a specific commodity
or commodity group – like edible
oils. 170
Commodity Funds (Cont…)
 Diversified Commodity Funds
invest in a cross-section of
commodities.
 Common examples are the
following:
 Gold Funds
 Silver Funds
 Platinum Funds
171
Real-Estate Funds
 These funds either invest directly
in real estate or else fund real
estate developers.
 Some of these funds invest in
housing finance companies.
 While others invest in mortgage-
backed securities.
172
Tax Free Funds
 Such funds invest in securities, the
income from which is exempt from
income tax.
 In the U.S. municipal bonds yield
tax-free income.
 However income earned from
corporate bonds is taxable.
173
The Largest Funds in the
U.S.
NAME Objective Total Assets NAV
Fidelity Growth 92588MM 119.30
Magellan
Vanguard Growth/ 89393 121.86
Index 500 Income
Janus Fund Capital 40081 33.29
Appreciation
Fidelity Blue Growth 26721 51.53
Chip
Vanguard: Balanced 22524 28.21
Wellington
Putnam: Extra Growth 21328 23.30
Voyageur 174
The Prospectus
 What is a prospectus?
 It is a formal printed document
offering to sell a security.
 The Securities Act of 1933 requires
the delivery of a prospectus prior to,
or with, any solicitation for an order
for mutual funds.
175
The Prospectus (Cont…)
 It is required to disclose important
information about the security.
 At the minimum it must disclose:
 The fund’s financial history
 Its investment objectives
 Information about the management.
176
 The front page will show:
 The date of publication
 The name of the fund
 The type of fund
 Major objectives
 The first page will have the Table
of Contents.
177
 Description of the  How to redeem
fund shares
 Objectives of the  Shareholder services
fund  Distributions and
 Management of the taxes
fund  Yield information
 Performance history  Schedule of
 Operating expenses investments
 Schedule of fees  Financial statements
 How to buy shares  General information
178
 Neither an investment company nor a
broker may legally offer a mutual fund
for sale unless a prospectus has been
provided to the investor.
 It is provided free of charge.
 It will include an application and a
postage paid return envelope to forward
the check and the completed
application.
179
 It can be obtained from:
 The broker
 However brokers handle only load funds
 It can be obtained by writing to the
investment company
 Or by dialing the fund’s toll-free
number.
180
Taxation Issues
 In the U.S., a mutual fund must
distribute at least 90% of its net
investment income earned, exclusive of
realized capital gains or losses, to the
shareholders, in order to be considered
as a Regulated Investment Company
(RIC).
 Such companies are not required to pay
taxes at the fund level, prior to the
distribution of income to the
shareholders. 181
Taxation (Cont…)
 At the hands of the shareholders,
however, any income that is
received is taxable.
 Capital gains made by the fund are
required to be distributed annually.
 They may be construed as short-
term or long-term in nature
depending on whether the fund
has held the securities in questions
for less than a year or more. 182
Taxation (Cont…)
 Investors have no control over the
size of distributions from the fund.
 Consequently the timing and
amount of taxes payable on their
fund holdings is out of their
control.
 For instance, if a block of investors
were to sell their shares, it could
trigger off a sale of securities by
the fund. 183
Taxation (Cont…)
 This could cause a capital gain to be
realized and will lead to a tax liability for
investors who choose to retain their
holdings in the fund.
 A new investor may assume a tax
liability even though he may have no
gains.
 This is because a shareholder as of the
date of record will receive a full year’s
worth of dividends and capital gains,
184
Taxation (Cont…)
 This lack of control over capital gains
taxes is one of the major limitations of a
mutual fund.
 In addition to being liable to pay taxes
on gains realized by the fund, a
shareholder will have to incur capital
gains when he redeems his shares.
 The applicable tax rate would depend
on whether the gains are short-term or
long-term in nature.
185
Mutual Fund Structure
 The structure of a fund may be
depicted as follows.
 At the top are the shareholders,
who are represented by a Board of
Directors.
 The board governs the mutual fund
which is an entity constituted
under the Investment Company
Act of 1940. 186
Fund Structure (Cont…)
 The Directors may be ìnside’ or
ìnterested’ Directors which means
that they are affiliated with the
fund, or they could be òutside’ or
ìndependent’ Directors.
 The portfolio of the fund is
managed by an Investment
Advisor or a Management
Company. 187
 The advisor can be an affiliate of a
brokerage firm, an insurance
company, a bank, an investment
management firm, or an
independent entity.
 Many funds also engage the
services of broker-dealers to sell
the shares to the public, either
directly or through other firms. 188
 The funds are also affiliated to
three external service providers:
 Custodian
 Transfer Agent
 Independent Public Accountant
189
Role of the External
Agents
 The role of the custodian is to hold
the assets of the fund and ensure
that they are segregated from the
accounts of others.
 Transfer agents perform the task
of processing orders at the time of
purchase and redemption and
transferring securities and cash to
concerned parties. 190
External Agents (Cont…)
 Transfer agents also distribute
income paid by the fund to the
shareholders.
 The job of the public accountant is
to audit the financial statements of
the firm.
 In addition every fund has internal
departments to comply with legal
and procedural requirements, and191
Depiction of a Typical
Mutual Fund Structure
Shareholders
Board
Mutual Fund
Investment Advisor Distributor Accountant Custodian Transfer Agent
192
Services Offered by Mutual
Funds
 Automatic Reinvestment Plan
 Most funds offer the option of
automatically reinvesting all income
and capital gains.
 It offers a systematic way of
accumulating additional shares.
 It is always a voluntary option.

Distributions may be taken in cash, but
the benefits of compounding will be lost.
193
Services (Cont…)
 Whether taken in the form of cash or
reinvested, distributions are subject
to tax liabilities.
 However reinvested dividends and
capital gains are not subject to loads.
194
Services (Cont…)
 Contractual Accumulation Plan
 The investor can commit to
purchasing a pre-determined fixed
dollar amount on a regular basis for a
specified period.
 The choice of the amount, the
frequency, and the length of time is
made by the investor.
195
Services (Cont…)
 Voluntary Accumulation Plan
 Here the shareholder voluntarily
purchases additional units at periodic
intervals.
 Each purchase must meet the fund’s
minimum requirements.
 For regular accounts, the minimum
amount is $100.
 The investor can change the amount that
he invests each time, the frequency of
investment, and the duration of the plan.
196
Services (Cont…)
 Retirement Plans
 These include IRAs, Keogh Plans
(meant for the self-employed), 401(k)
and 403(b) plans.
 401(k) plans are set up by the employer
and the employee and are available to
most companies.

403(b) plans are open to employees of
tax-exempt organizations such as schools
and hospitals.
197
Services (Cont…)
 IRA and Keogh plans are established by
the investors themselves and are subject
to certain government regulations.
 Both types of plans are meant for
individuals.

An IRA offers tax advantages for setting
aside money for one’s retirement.
 In order to qualify one must receive
taxable compensation and be below 70 ½
years of age.
 Keogh plans are similar to IRAs.
198
Services (Cont…)
 Roth IRAs
 In a traditional IRA one qualifies for a
tax deduction while making a
contribution.
 But taxes must be paid when the
money is taken out.
 Roth IRAs are different.
 No tax deduction can be claimed on
the money that is put in.
199
Services (Cont…)
 But the balance can be withdrawn
tax-free on retirement, provided:

The account has been open for at least 5
years
 The investor is at least 59 ½ years old.
 Each individual can invest a maximum of
$2000 per year.
 But the amount cannot exceed his annual
compensation.
200
Services (Cont…)

But if the investor is married and the spouse is
working he/she can contribute even if he/she is
not getting compensation.
 The maximum contribution for a married couple
is $4,000 per annum.
201
Services (Cont…)
 Check Writing
 Many mutual funds, and all money
market funds, offer free check writing
facilities.
 This option is not available for
retirement accounts.
 There is no restriction on how many
checks can be written each month
provided the account balance does
not dip below a minimum.
202
Services (Cont…)
 Each check should be for an amount
greater than or equal to a specified
minimum.

This is usually $500 for most funds.
 Of late many funds have reduced this to
$250.
203
Services (Cont…)
 Switching
 Most investment companies permit
switching from one fund to another
within the same family.
 Usually all that is required is a phone call.
 This is a free service.
 Investors use this service to take
advantage of cyclical swings in the
stock market.
204
Services (Cont…)
 They will keep their money in stock
funds when the market is bullish
 And switch to money market funds
when the market turns bearish.
 The question is, how does one decide
when to switch?
 There are many sources of advice.
205
Switching Advice
 Newsletters
 Donoghue’s Moneyletter
 Fabian Telephone Switch Newsletter
 InvesTech Market Letter
 Professional Timing Service
 Time Your Switch
206
Services (Cont…)
 Voluntary Withdrawal Plans
 Shareholders may redeem their
shares whenever funds are required.
 They can also establish a plan
whereby the fund will redeem a pre-
arranged dollar amount and wire it to
his bank at regular intervals.

The usual minimum redemption is $50.
207
Investment Techniques
 Dollar Cost Averaging
 With this technique one must invest the
same amount of dollars at regular intervals.
 Your dollars will buy more when the NAV is
low and less when the NAV is high.
 Over a period, the average price will be less
than the price paid under a strategy where
one tries to guess the highs and the lows.
 The disadvantage is the strategy does not
tell when to buy, sell or switch.
208
Illustration
 An investor plans to invest $10,000
during the course of the year in
four equal quarterly installments.
 The NAVs at the beginning of each
quarter are 10, 8, 12.5, and 16
respectively.
 The plan would work as follows.
209
DATE AMOUNT NAV # of
Shares
Jan 1 2,500 10 250
Apr 1 2,500 8 312.50
Jul 1 2,500 12.5 200
Oct 1 2,500 16 156.25
TOTAL 918.75
210
Value Averaging
 It is more sophisticated than dollar
cost averaging and is yet simple to
use.
 Assume that you want your
investment to increase in value by
$250 every month.
 In this strategy you will consider
your portfolio’s value at the end of
every month.
211
Value Averaging (Cont…)
 If the balance has increased by
exactly $250 do nothing.
 If the increase is less than $250
invest an amount that is adequate to
increase the account balance by
$250.
 If the increase is more than $250,
withdraw the excess balance.
212
Date Amt. NAV # of Shrs. Bal. Add. Invt. Add.
Shrs.
Jan 1 10000 10 1000 10000 - -
Mar 31 8 1000 8000 - -
Apr 1 2250 8 1531.25 10250 2250 531.25
Jun 30 12.50 1531.25 19140.62 - -

5
Jul 1 -8640.625 12.50 840 10500 -8540.625 -691.25
Sep 30 16 840 13440 - -
Oct 1 -2690 16 671.875 10750 -2690 -168.125
213
The Combined Method
 It is a combination of dollar cost
averaging and value averaging.
 Assume that you start with $1250
in a money market fund and $1250
in a stock fund on January 1.
 So the investment for the quarter is
$2500.
214
The Combined Method
(Cont…)
 On 31 March the value of the stock
fund will be $1000.
 We would require a balance of
2,750.
 So we should deposit $750 in a
money market fund and 1750 in
the stock fund.
 The investment for the quarter is
$2500. 215
The Combined Method
(Cont…)
 On June 30 the balance in the
stock fund will be $4,296.875.
$4250.
 So invest $2500 in the money
market fund and transfer $46.875
from the stock fund to the money
market fund.
 The investment for the quarter is 216
The Combined Method
(Cont…)
 On September 30 the value of the
stock fund will be 5440.
$5,750.
 So invest 310 in the stock fund and
2190 in the money market fund.
 The investment for the quarter is
$2,500.
217
Exchange Traded Funds
 Mutual Funds have two serious
shortcomings.
 Firstly, the shares are priced at,
and can therefore be transacted
only at, the NAV as calculated at
the end of the day.
 Thus transactions at intra day
prices are ruled out.
218
ETFs (Cont…)
 Secondly investors have little
control over tax liabilities.
 In particular a big redemption of
shares can trigger of capital gains
taxes for investors who choose to
remain invested.
 In response to these shortcomings,
Exchange Traded Funds (ETFs)
were introduced in the 1990s.
219
ETFs (Cont…)
 These funds are open-ended in
structure but are traded on
exchanges just like conventional
stocks.
 They are similar to closed-end
funds in the sense that their
quoted prices are at a small
premium/ discount to/from their
NAV.
 However these deviations from 220
ETFs (Cont…)
 The deviations are limited because
of the potential for arbitrage.
 Most ETFs are based on popular
stock indices and follow a passive
investment strategy.
 But funds which actively manage
portfolios have started to appear.
221
ETFs (Cont…)
 Unlike in the case of an open-end
fund, ETF shares cannot be bought
from or sold to the fund sponsor.
 However the sponsor will exchange
large blocks of shares in kind for
the securities constituting the
underlying index plus cash
representing the accumulated
dividends of the fund. 222
ETFs (Cont…)
 The large block of ETF shares which is
exchangeable with the fund is called a
Creation Unit.
 One creation unit is typically set equal
to 50000 ETF shares.
 Broker-dealers will usually purchase
creation units from the fund and break
them into individual shares which will
then be offered on the exchange.
223
ETFs (Cont…)
 Dealers and institutions can also
redeem ETF shares by assembling
creation units, and exchanging
them for a basket of underlying
securities plus cash.
 If the price of an ETF share were to
diverge significantly from the NAV,
then arbitrageurs would step in.
224
Arbitrage
 Assume that the ETF shares are
overpriced.
If so, arbitrageurs will short sell ETF
shares and buy creation units from the
sponsor to fulfill their delivery
obligations.
 On the other hand, if the shares are
under-priced, then arbitrageurs will buy
ETF shares, assemble them into
creation units, and sell them to the
sponsor. 225
Advantages of Exchange
Trading
 Exchange trading offers many
advantages to the investors.
 These facilities are not available in
the case of open-end funds.
 Traders have the flexibility to place
orders like Limit Orders and Stop
Loss Orders.
They have the freedom to engage
in Short Sales and undertake
trades on the Margin. 226
Advantages (Cont…)
 ETFs also offer an advantage to
the shareholders from the
standpoint of taxation.
 A large scale redemption of shares
need not trigger of a capital gain.
 This is because an ETF can redeem
a large block of shares by offering
the underlying securities in return.
227
 This will not constitute a taxable
event for the existing
shareholders.
 Thus investors in ETFs are usually
subject to capital gains taxes only
when they sell their shares in the
secondary market at prices which
are higher than what they paid at
the outset. 228
 In practice, however, a limited
amount of realized capital gains
does get passed on to the
investors, and is therefore taxable.
 In addition, any cash dividends
distributed by ETFs is also taxable.
229
Popular ETFs
ETF Index Inception Net
Tracked Assets in
MM of
S&P500 S&P500 Jan-93 USD
21,703
SPDR
S&P500 i S&P500 May-00 1,153
shares
DJIA DJIA Jan-98 2,050
Diamonds
NASDAQ- NASDAQ Mar-99 12,436
100(Qubes 100
230
)
ETFs (Cont…)
 SPDRs (pronounced as Spiders) is
an acronym for Standard & Poor’s
Depository Receipts.
 i shares are provided by Barclays
Global Investors.
231
Segregated Accounts
 Many High Net Worth individuals
dislike mutual funds because of :
 Their inability to control tax
liabilities
 Their inability to influence
investment choices
 The lack of `special’ service
232
Segregated Accounts
(Cont…)
 Money managers therefore offer
the facility of separately managed
investment accounts for such
investors.
 They are more expensive for the
investor than investing in a mutual
fund, but offer several advantages.
233
Mutual Funds in the U.K.
 In the U.K. mutual funds take on
one of three forms:
 Unit Trusts
 Open Ended Investment
Companies (OEICs)
 Investment Trusts
234
Unit Trusts & OEICs
 In the case of a unit trust the
assets are held in the form of a
trust and each owner gets a
beneficial ownership in the form of
ùnits’.
 An OEIC is similar in principle to a
unit trust except that the funds are
formed with a corporate structure
and the investors are issued 235
Unit Trusts & OEICs
(Cont…)
 Investment Trusts are similar to
closed-end funds and trade on the
London Stock Exchange.
 In the case of Unit Trusts and
OEICs the funds are managed by a
professional fund manager.
236
Unit Trusts & OEICs
(Cont…)
 There is also an independent
trustee who is entrusted with the
task of holding the assets on
behalf of the investor and
monitoring the decisions and
investments made by the fund
manager.
 In the case of OEICs there is a single
price for the sale and redemption of
shares, and other charges are shown 237
Unit Trusts & OEICs
(Cont…)
 Unit Trusts however follow a dual
pricing system with built-in charges.
238
The German System
 Mutual Funds in Germany take on
two general forms:
 Public or Retail Funds
 Non-public Funds – Reserved for
Institutional Investors
 There are also numerous closed-
end funds.
239
Germany (Cont…)
 The institutional fund are known as
Spezialfonds.
 The retail funds fall into two broad
categories:
 Bond Funds – Rentenfonds
 Stock Funds - Aktienfonds
240
Germany (Cont…)
 The structure of mutual funds is as
follows.
 A Kapitalanlagegesellschaft or
Management Company is given a
contractual arrangement to manage a
pool of assets on behalf of investors
who own shares in the pool.
 A custody bank – Depotbank – which by
law has to be German – supervise the
activities of the management company.
241
Germany (Cont…)
 The management company is
usually organized as a limited
liability company:
 Gesellschaft mit besschrankter
Haftung (GmbH)
242
Pension Plans
 A pension plan is a fund that is
established for the eventual payment of
retirement benefits.
 Corporate or Private plans are
sponsored by a private business entity
acting on behalf of its employees.
 Public Plans are set up by federal, state
and local governments acting on behalf
of their employees.
243
Pension Plans (Cont…)
 Taft Hartley plans are set up by
unions on behalf of their members.
 Individual plans are established by
investors themselves.
244
 Pension plans in the U.S. are essentially
financed by contributions by the
employer.
 In some cases, the employer’s
contribution is matched to some extent
by a contribution from the employees.
 The employer’s contribution, a specified
amount of the employee’s contribution,
and the earnings of the fund, are tax-
exempt provided the fund complies with
245
 Plans which are given tax
exemption are called Qualified
Pension Plans.
 In essence, a pension is a form of
employee remuneration for which
the employee is not taxed until the
funds are withdrawn.
246
Types of Plans
 There are two basic types of plans:
 Defined Benefit Plans
 Defined Contribution Plans
 There is also a hybrid variety
called a Cash Balance Plan.
247
Defined Benefit Plans
 In such cases the sponsor agrees
to make specified payments to
qualifying employees beginning at
retirement.
 In the case of death before
retirement, some payments are
made to nominated beneficiaries.
 The payments are typically made
on a monthly basis.
248
(Cont…)
 The quantum of payments is
determined by a formula that usually
takes into account the length of service
of an employee and his earnings.
 The benefit formula is often based on a
fixed percentage of the ending salary
for each year of service.
 From the employer’s point of view the
pension obligation is essentially a debt
obligation.
249
(Cont…)
 The employer needs to make a
prediction of the future benefits, to
determine the amount of the
contribution.
 The calculation of the current
contributions required to support the
promised future payments is made by
discounting the projected future cash
flows.
250
(Cont…)
 The entire investment risk is borne
by the employer.
 That is, since the benefits are
assured, the employer faces the
risk that returns on contributions
to the plan may not be adequate
to make the promised payments.
251
(Cont…)
 Actuaries are asked to provide
estimates of current pension
expenses and the liability of the
employer.
 The following factors are taken into
account.
 Of course all estimates involve
discretion.
252
Factors
 Age and sex of the employee
 Number of years of service
 Employee’s salary
 Anticipated salary increases
 Anticipated turnover rates
 Anticipated earnings rates on plan
assets
 Appropriate discount rate
253
(Cont…)
 These plans provide an incentive
for the employees to stay with the
firm until retirement or at least
until the benefits get vested.
 They also provide an incentive for
performance.
 Because the defined benefit is a
function of the last salary drawn.
254
(Cont…)
 The funding status of the plan depends
on the difference between the Plan
Assets and the Projected Benefit
Obligation.
 If the assets exceed the obligation the plan
is overfunded.
 Else it is underfunded.
 In the case of underfunded plans employees may
lose earned benefits if the company were to go
bankrupt.
255
(Cont…)
 A plan sponsor can use the
payments made into the pension
fund to purchase an annuity policy
from an insurance company.
256
(Cont…)
 Defined benefit plans which are
guaranteed by life insurance
companies are called ìnsured
benefit plans’.
 These are not necessarily safer
than uninsured plans.
 Because they depend on the
creditworthiness of the insurance
companies.
257
(Cont…)
 Benefits become vested when the
employees reach a certain age and
complete enough years of service,
so that they meet the minimum
requirements for receiving benefits
upon retirement.
 The payment of benefits is not
contingent upon a participant’s
continuation with the employer or
union. 258
(Cont…)
 Employees are generally
encouraged from quitting, since
until the plan is vested, they could
lose at least the accumulation
resulting from the employer’s
contribution.
259
Defined Contribution Plans
 In the case of these plans, the
sponsor is responsible only for
making specified contributions into
the plan on behalf of qualifying
employees.
 He is not responsible for making a
guaranteed payment to the
employee upon retirement.
260
(Cont…)
 The amount that is contributed is
typically either a percentage of the
employee’s salary and/or a
percentage of the employer’s
profits.
 The payments that are made to
qualifying participants upon
retirement are a function of how
the assets of the plan have grown261
(Cont…)
 Thus the retirement benefits are
critically dependent on the
investment performance of the
plan.
 The plan sponsors usually give the
participants various options as to
the investment vehicles in which
the contributions are to be
invested. 262
(Cont…)
 The fastest growing of such plans
are the 401(k) plans.
 Its equivalents are:
 403(b) plans in the non-profit
sector
 457 plans in the public sectors
263
(Cont…)
 To the employers these plans offer
relatively lower costs of
administration.
 Employees too find these plans to
be attractive because they have
some control over how their
money is invested.
 In many cases the employees are
given an option to invest in one or
more of a family of mutual funds. 264
Cash Balance Plans
 These plans combine features of
both defined benefit as well as
defined contribution plans.
 They are like defined benefit plans
in the sense that future benefits
are assured.
 The benefits are based on a fixed-
amount annual employer
contribution and a guaranteed
annual investment return. 265
Cash Balance Plans
(Cont…)
 Every employee has an account
that is periodically credited with a
fixed dollar amount.
 The account is also credited with
interest which is linked to some
fixed or variable index such as the
Consumer Price Index (CPI).
266
Cash Balance Plans
(Cont…)
 Interest is credited at a rate
specified in the plan, and is not
related to the actual investment
earnings of the employer’s pension
trust.
 Any gains or losses on the
investment accrue to/are borne by
the employer.
267
Cash Balance Plans
(Cont…)
 The similarity with a defined
contribution plan is that many cash
balance plans allow the employee
to take a lump sum payment of
vested benefits when terminating
their employment with a particular
employer.
 This amount can then be rolled
over into an IRA or the new
employer’s plan. 268
 Qualified pension funds are
exempt from federal income taxes.
 Pension funds therefore do not
usually invest in assets which are
largely or completely tax free.
 Pension plans are regulated by the
Employee Retirement Income
Security Act of 1974 (ERISA).
269
ERISA
 ERISA established minimum
funding standards for defined
benefit plans by requiring the
sponsor to make the minimum
contributions necessary to satisfy
the actuarially projected payment
benefits.
 Prior to this, many employers were
following a `pay as you go’ policy.270
ERISA (Cont…)
 That is, at the time of an employee’s
retirement the sponsor would pay the
necessary retirement benefits out of his
current cash flows.
 ERISA put a stop to this by requiring all
programs to be `funded’.
 Regular funding is intended to ensure
that contributions plus earnings are
adequate to cover the retirement
benefits.
271
ERISA (Cont…)
 ERISA also established fiduciary
standards for pension fund
trustees, managers, and advisors.
 All parties responsible for the
management of a pension fund are
expected to act `prudently’.
272
ERISA (Cont…)
 ERISA also specified minimum
vesting standards.
 For instance, by law, after five
years of employment, a plan
participant is entitled to 25% of the
accrued pension benefits.
 The percentage of entitlement
increases to 100% after 10 years.
273
ERISA (Cont…)
 ERISA also created the Pension
Benefit Guaranty Corporation
(PBGC) to insure the vested
pension benefits.
 The insurance program is funded
from the annual premiums that
must be paid by the plan sponsors.
274
Management of Pension
Plans
 A plan sponsor can choose the
following options for managing a
defined benefit plan.
 - he can employ in-house staff to
manage the assets.
 - he can entrust the task to one or
more money managers.
 - he can use a combination of
methods 275
Management (Cont…)
 Defined contribution plans allow the
participants to allocate their
contributions among mutual funds.
 Managers of the assets of a pension
fund obtain their income in the form of
fees.
 The annual fees range from 0.75% of
the funds under management to as low
as 0.01%.
 Sometimes the fees are linked to the
fund’s performance. 276
Advisors
 In addition to fund managers,
sponsors of pension funds also
engage the services of advisors
called Plan Sponsor Consultants.
 They provide the following
services:
 - Develop investment policies and
formulate asset allocation plans.
 - Provide actuarial service –
modeling liabilities and 277
Advisors (Cont…)
 - They design benchmarks to
measure the performance of
money managers.
 - They help measure and monitor
the performance of money
managers.
 - They help search for, and
recommend money managers.
 - They provide specialized 278
Major Managers of Defined
Benefit Funds
NAME AMOUNT in MM of USD
State Street Global 538,576
Barclays Global 490,400
Fidelity Investments 396,100
TIAA-CREF 285,447
Northern Trust 200,864
Deutsche Asset 192,748
Vanguard Group 176,732
PIMCO 163,613
J.P. Morgan 143,669
Prudential 132,550
279
Major Managers of Defined
Contribution Funds
NAME TOTAL 401(k) 457 403(b) Other
ASSETS Plans Plans Plans Plans
Fidelity 357,900 276,000 12,200 40,200 29,500
Investm
ents
TIAA- 284,853 0 0 284,853 0
CREF
CitiStree 195,950 173,431 3,066 58 19,395
t
Barclays 101,200 10,900 1,900 0 88,400
Global
Vanguar 89,831 77,219 3,640 3,120 5,852
d Group
280

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Exxon 2,000 80 160,000

TOTAL 5,000 315,000

Exxon 2,000 90 180,000

TOTAL 5,000 370,000

Exxon 2,200 90 198,000

TOTAL 5,500 407,000

Exxon 2,150 90 193,500

TOTAL 5,600 406,750

Mid Cap 2 ≤ M-Cap < 12

Investment Advisor Distributor Accountant Custodian Transfer Agent

Mar 31 8 1000 8000 - -

Apr 1 2250 8 1531.25 10250 2250 531.25

Jun 30 12.50 1531.25 19140.62 - -

Sep 30 16 840 13440 - -

Oct 1 -2690 16 671.875 10750 -2690 -168.125

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