Concept and Role of Mutual Funds: A Complete Guide for NISM Series V-B

A mutual fund is a professionally managed investment vehicle designed to mobilize money from investors to invest in various securities in line with specific objectives. Technically, individuals do not invest in a mutual fund but rather invest through them to gain access to equities, bonds, and money market instruments that might otherwise be out of reach.

2.1 The Concept of a Mutual Fund

A mutual fund is established as a trust that pools money from numerous investors (unit-holders) to invest in a diversified portfolio of securities. This structure ensures a professional approach to investing, regulated oversight, and inherent diversification.

2.1.1 The Role of Mutual Funds

The primary role of a mutual fund is to assist investors in building wealth or earning income by participating in securities market opportunities. Beyond individual investor benefits, the industry plays a vital role in the broader economy:

• Economic Development: Funds raised are used by governments and companies to finance projects, which in turn creates employment and supports production.
• Corporate Governance: As large institutional investors, mutual funds can monitor the ethical standards and operations of the companies they invest in.
• Market Stabilization: They act as stabilizers by countering large-scale inflows or outflows from foreign investors.
• Employment: The industry provides livelihoods for employees of Asset Management Companies (AMCs), distributors, and various service providers.

2.1.2 Investment Objectives of Mutual Funds

Every mutual fund scheme operates with a pre-announced investment objective that reflects the needs of its target investors. These objectives typically center around a combination of safety, liquidity, and returns.

2.1.3 Investment Policy and Style

Once an objective is set, an AMC formulates an investment policy, including asset allocation (where to invest) and investment style (how to invest). For instance, an equity manager may choose a growth style, a value style, or a focused versus diversified approach.

2.1.4 Key Mutual Fund Operational Concepts

To understand how these funds work, investors must grasp several foundational terms:

• Units and Face Value: Investor contributions are converted into "Units," typically with a face value of Rs. 10 for accounting purposes.
• Unit Capital: This is the total number of units issued by a scheme multiplied by the face value.
• Recurring Expenses: These are ongoing fees (fund management, commissions) charged as a percentage of the Assets Under Management (AUM). Higher expenses lead to a lower Net Asset Value (NAV).
• Net Asset Value (NAV): The true worth of a single unit of a scheme. It is also the net realizable value if the scheme were liquidated.
• Assets Under Management (AUM): The total sum of all investments in a scheme. It fluctuates based on market performance and new investor contributions or redemptions.
• Mark to Market (MTM): The daily process of valuing every security in the portfolio at its current market price, which causes the NAV to fluctuate daily.

2.1.5 Advantages of Investing Through Mutual Funds

1. Professional Management: AMCs provide research-based investing and handle all administrative tasks like collecting dividends and interest.
2. Affordable Diversification: Investors can own a slice of a broad portfolio for as little as Rs. 500, reducing the risk of "all eggs in one basket".
3. Economies of Scale: Pooling money allows for lower transaction costs, professional research, and better negotiation with service providers.
4. Liquidity: Investors can generally recover the market value of their units from the fund itself or via stock exchanges.
5. Transparency: SEBI mandates regular disclosures via scheme documents (SID, SAI, KIM), portfolio disclosures, and daily NAV updates.
6. Tax Benefits: Options like Equity Linked Savings Schemes (ELSS) offer tax deductions under Section 80C, while other options allow for tax deferral.
7. Investment Discipline: Facilities like Systematic Investment Plans (SIP), Systematic Withdrawal Plans (SWP), and Systematic Transfer Plans (STP) promote long-term discipline.

2.1.6 Limitations of Mutual Funds

• Lack of Portfolio Customization: Unlike Portfolio Management Services (PMS), a mutual fund unit-holder cannot influence which specific securities the fund manager buys.
• Choice Overload: The sheer number of schemes can make it difficult for investors to choose without professional help.
• No Control Over Costs: All investors share the costs of the scheme proportionately, with no individual control over the expense ratio.
• No Guaranteed Returns: Mutual funds are "pass-through" vehicles; they pass both risk and return to the investor and cannot guarantee profits.

2.2 Classification of Mutual Funds

2.2.1 Classification by Structure

• Open-ended Funds: These allow investors to enter or exit at any time. New units are created upon purchase and cancelled upon redemption, meaning the unit capital changes constantly.
• Close-ended Funds: These have a fixed maturity date and units are only available from the fund during the New Fund Offer (NFO). Post-NFO, they must be listed on a stock exchange to provide liquidity. They often trade at a discount to their NAV.
• Interval Funds: These combine features of both. They are mostly close-ended but become open-ended for specified "transaction periods".
• Exchange Traded Funds (ETFs): These track an index and are traded on stock exchanges like individual stocks. Unlike traditional funds, ETFs offer multiple price points throughout the day.

2.2.2 Classification by Management Style

• Actively Managed Funds: The fund manager has the flexibility to choose specific securities to outperform the market, typically resulting in higher costs.
• Passive Funds (Index Funds): These mirror a specific index (like the Nifty 50). They have lower running costs as the fund manager does not decide which securities to buy.
• Mutual Fund Lite (MF Lite): A simplified framework introduced by SEBI specifically for passively managed schemes like index funds and ETFs.

2.2.3 Classification by Investment Universe

Schemes are categorized based on where they invest, such as Equity Funds, Debt Funds, Gold Funds, or International Funds.

2.2.4 SEBI Scheme Categorization (2017 Regulation)

To ensure uniformity and help investors compare similar schemes, SEBI established five broad categories:

A. Equity Schemes (11 Sub-categories)

• Multi Cap: Minimum 75% in equity, with at least 25% each in large, mid, and small-cap stocks.
• Large Cap: Minimum 80% in large-cap stocks (1st-100th company by market cap).
• Mid Cap: Minimum 65% in mid-cap stocks (101st-250th company).
• Small Cap: Minimum 65% in small-cap stocks (251st company onwards).
• ELSS: Tax-saving schemes with a 3-year lock-in and minimum 80% in equity.
• Flexi Cap: Minimum 65% in equity with dynamic allocation across all market caps.

B. Debt Schemes (16 Sub-categories)

• Liquid Fund: Invests in debt/money market instruments with maturity up to 91 days.
• Overnight Fund: Invests in securities with a maturity of 1 day.
• Corporate Bond Fund: Minimum 80% in AA+ and above rated corporate bonds.
• Gilt Fund: Minimum 80% in government securities across maturities.
• Dynamic Bond: Invests across various durations based on interest rate views.

C. Hybrid Schemes (6 Sub-categories)

• Conservative Hybrid: 75-90% in debt; 10-25% in equity.
• Aggressive Hybrid: 65-80% in equity; 20-35% in debt.
• Arbitrage Fund: Minimum 65% in equity/equity-related instruments, focusing on arbitrage opportunities.

D. Solution Oriented & Other Schemes

• Retirement Fund: Has a lock-in of 5 years or until retirement age.
• Children’s Fund: Has a lock-in of at least 5 years or until the child reaches majority.
• Index Funds/ETFs: Replicate a specific index with minimum 95% investment in its constituents.
• Fund of Funds (FoF): Minimum 95% investment in an underlying fund.

2.2.5 Specialized and New Fund Types

• Fixed Maturity Plans (FMPs): Close-ended debt funds where the portfolio duration matches the scheme's maturity.
• Target Maturity Funds (TMF): Debt funds with a pre-defined maturity date, ideal for predictable returns.
• ESG Investing: A thematic equity sub-category focusing on Environmental, Social, and Governance criteria.
• Smart Beta Funds: Passive funds that use alternative weighting strategies (not just market cap) to improve returns or reduce risk.
• Quant Funds: Use predetermined mathematical models and machines to select securities, removing human bias.
• Specialized Investment Fund (SIF): A new product line requiring a minimum investment of Rs. 10 lakhs.

2.3 Growth of the Indian Mutual Fund Industry

The Indian mutual fund industry has experienced exponential growth. The total Assets Under Management (AUM) surged from Rs. 9.87 lakh crores in June 2014 to Rs. 68 lakh crore by November 2024.

Key Takeaways

• Professional Trust: A mutual fund is a trust that allows for professional, diversified, and regulated investment.
• NAV is Vital: The Net Asset Value represents the per-unit market value and is calculated daily using Mark to Market.
• Structure Matters: Choose between open-ended (continuous liquidity) and close-ended (fixed maturity) based on needs.
• Standardization: SEBI categorization ensures that "Large Cap" means the same thing across all fund houses, aiding objective comparison.
• Passive Rise: Index funds and ETFs are gaining popularity due to lower costs and the new MF Lite framework.

Important Terms to Remember

• AUM: Total investor money managed by the fund.
• MTM: Daily valuation of portfolio holdings.
• TER: Total Expense Ratio; includes all recurring costs.
• IDCW: Income Distribution cum Capital Withdrawal (the new name for the dividend option).
• Smart Beta: Passive strategies that don't rely solely on market capitalization.