MUTUAL FUND - A COMPENDIUM

All about Mutual Funds - Credit to Mr. KK Kapoor of CS Mysore


What is a mutual fund?
A mutual fund is a pool of money contributed by individuals who have similar financial goals. The money collected is then invested in various securities such as equities, debentures/bonds and/or money market instruments.
What is a fund house/family?
A group of funds managed under one umbrella. The most basic fund family would include a stock, bond and money market-portfolio, although many funds have variants like sector funds, balanced funds.
For instance, Zurich India Mutual Fund is a fund house with several funds under it.
What is the Net asset value (NAV)?
The price or value of one unit of a fund. It is calculated by summing the current market values of all securities held by the fund, adding in cash and any accrued income, then subtracting liabilities and dividing the result by the number of units outstanding. Most open-ended funds companies compute NAVs once a day based on closing market prices.
What are a fund�s net assets?
The total value of a fund's cash and securities less its liabilities or obligations.
What is a fund portfolio?
A group of securities held by the mutual fund. A portfolio could be a mixture of stocks, bonds and cash.
What is the portfolio turnover of a fund supposed to mean?
A measure of the amount of buying and selling activity in a fund.Turnover is defined as the lesser of securities sold or purchased during a year divided by the average of monthly net assets. A turnover of 100 percent, for example, implies positions are held on average for about a year.
How are mutual funds classified?
Mutual Funds can be classified into the following 3 broad categories:
1. Portfolio classification
2. Functional classification
3. Geographical classification
How are mutual funds classified based on their portfolios?
Portfolio classification of mutual funds is done on the following basis:
Growth Funds
Investment objective: Capital appreciation of equity shares
Investment avenue: Equity shares of companies with high growth potential
For e.g.. Morgan Stanley Growth Fund
Income Funds
Investment objective: Providing safety of investments and regular income
Investment avenue: Bonds, debentures and other debt related instruments as well as equity shares of companies with high dividend payouts.
There are 2 aspects of income funds viz. Low investment risk with constant income and high investment risk generating high income.
For e.g.. Templeton Income Fund
Balanced Funds
Investment objective: Modest risk of investment and reasonable rate of return Investment avenue: Judicious mix of equity shares, preference shares as well as bonds, debentures and other debt related instruments.
For e.g.. GIC Balanced Fund
Money Market Mutual Funds (MMMFs)
Investment objective: To take advantage of the volatility in interest rates in the money market Investment Avenue: Certificate of deposits (CDs), call money market, commercial papers. Investors can participate indirectly in the money market through MMMFs.
For e.g.. IDBI-PRINCIPAL Money Market Fund 1997
Specialised Funds
Investment Objective: To take advantage of conditions in a particular sector or a specific income producing security
Investment Avenue: Specialised investments in securities of companies in certain sectors or specific income producing securities
For e.g.. Kothari Pioneer's Internet Opportunities
Fund
Leveraged Funds
Investment objective: To increase the value of the portfolio and benefit the shareholders by gains exceeding the cost of borrowed funds
Investment avenue: Speculative and risky investments, like short sales to take advantage of declining market.
Not common in India
Index Funds
Investment Objective: To increase the value of the portfolio in line with the benchmark index (for e.g.. BSE Sensex, SP CNX 50)
Investment Avenue: Investments only in those shares that form a part of the benchmark index, in exactly the same proportion, so that the value of the index fund varies in proportion with the benchmark index.
For e.g. UTI Nifty Index Fund
Hedge Funds
Investment Objective: To hedge risks in order to increase the value of the portfolio
Investment Avenue: Employ speculative trading principles - buy rising shares and sell shares whose prices are likely to fall.
Not common in India
How are mutual funds classified functionally?
Functional classification of mutual funds is done on the following basis:
Open ended scheme
Investors under this scheme are free to join the fund or withdraw from the fund at any time after an initial lock-in period. Such funds announce sale and repurchase prices from time to time. In an open-ended scheme, investors can resell units in the fund to the issuing mutual fund at the net asset value (NAV) of the units. This is because open-ended schemes are permitted to buy/sell their own units. For e.g. Alliance Capital 1995 Fund
Close-ended scheme
Unlike the open-ended schemes, close-ended schemes do not issue units for repurchase redemption on a periodic basis. Its units can be redeemed only on termination of the scheme, or through dealings in the secondary market. In such schemes, the period of the scheme is specified at the outset. They have a definite target amount for the funds and cannot sell more after initial offering. For eg. UTI Mastergain 1986
How are mutual funds classified geographically?
Mutual funds can be classified geographically on the following basis:
Domestic funds
Domestic fund houses launch funds, which mobilise savings of the nationals within the country. These schemes could fall under any of the categories mentioned under portfolio classification and functional classification. Schemes launched by Indian MFs like GIC MF, UTI LIC MF, SBI MF, Canbank MF, Bank of Baroda MF, Bank of India MF, Morgan Stanley, Templeton, Alliance.
Offshore Funds
Offshore funds can invest in securities of foreign companies, after requisite permission from RBI. The objective behind launching offshore funds is to attract foreign capital for investment in the country of the issuing company. These funds facilitate cross border fund flow, which is a direct route for getting foreign currency. From the investment point of view, Offshore funds open up domestic capital markets to the international investors and global portfolio investments.
What are the different plans that mutual funds offer?
Mutual Funds in order to cater to a range of investors, have various investment plans. Some of the important investment plans include:
Growth Plan
Under the Growth Plan, the investor realises only the capital appreciation on the investment (by an increase in NAV) and does not get any income in the form of dividend.
Income Plan
Under the Income Plan, the investor realises income in the form of dividend. However his NAV will fall to the extent of the dividend.
Dividend Re-investment Plan
Here the dividend accrued on mutual funds is automatically re-invested in purchasing additional units in open-ended funds. In most cases mutual funds offer the investor an option of collecting dividends or re-investing the same.
Systematic Investment Plan (SIP)
Here the investor is given the option of preparing a pre-determined number of post-dated cheques in favour of the fund. He will get units on the date of the cheque at the existing NAV. For instance, if on 25th March, he has given a post-dated cheque for June 25th, he will get units on 25th June at existing NAV.
Systematic Withdrawal Plan
As opposed to the Systematic Investment Plan, the Systematic Withdrawal Plan allows the investor the facility to withdraw a pre-determined amount/units from his fund at a pre-determined interval. The investor�s units will be redeemed at the existing NAV as on that day.
Retirement Pension Plan
Some schemes are linked with retirement pension. Individuals participate in these plans for themselves, and corporates for their employees.
Insurance Plan
Some schemes launched by UTI and LIC offer insurance cover to investors.
What is a 401(k) plan?
A popular contribution program in the USA, available through many employers. Within these tax-sheltered plans, participants often can choose mutual funds as one or more of the investment choices.
This plan (or even a variant) is yet to be introduced in India.
What are the advantages of investing in a mutual fund?
Mutual funds are superior to other comparable investment avenues because of the following reasons:
Investors are exposed to reduced investment risk due to portfolio diversification, economies of scale in transaction cost and professional management.
Limited Risk
Investors are exposed to reduced investment risk due to portfolio diversification, economies of scale in transaction cost and professional management.
Diversified investment
Small investors can participate in larger basket of securities and share the benefits of efficiently managed portfolio by experts, and are freed from maintaining records of company share certificates, and tracking tax rules. Mutual fund investments are less risky due to portfolio diversification, which is possible mainly due to large funds available at their disposal. Small investors can never spread their risks across such a wide portfolio, as can mutual funds.
Freedom from tracking investments
Investors do not have to track their investments regularly, as the tracking is done by experts who buy and sell securities for them. Investors are only required to track the performance of the mutual fund.
Professional management
Mutual funds are run by professionals, with experience in portfolio management. Analysts employed by mutual funds analayse data and information available in a manner that cannot be matched by the lay investor.
Tax benefits
Income tax benefits are granted to investors in mutual funds, making it more tax efficient as compared to other comparable investment avenues.
Who is a custodian?
The custodian, an independent organisation, has the physical possession of all securities purchased by the mutual fund, and undertakes responsibility for its handling and safekeeping. For instance, the Stock Holding Corporation of India Ltd (SCHIL) is the custodian for most fund houses in the country.
What is an Asset Management Company (AMC)?
A highly regulated organisation that pools money from many people into a portfolio structured to achieve certain objectives. Hence it is termed as an Asset Management Company. Typically an AMC manages several funds - open-end /closed-end across several categories - growth, income, balanced. Every mutual fund has an AMC associated with it.
For instance, Alliance Capital Mutual Fund is associated with Alliance Capital Asset Management Company Ltd.
What is load?
It is a charge collected by a mutual fund when it sells units. It can be either front-end load (i.e., the charge is collected when an investor buys the units) or back-end load (i.e, the charge collected when the investor sells back the units). Some schemes do not charge any load and are called No Load Schemes
What is an ex-dividend date?
Normally, one business day after the record date. Investors purchasing unit on or after the ex-dividend date are not entitled to collect dividends or bonus units. The NAV falls by the amount of the dividend distributed and/or bonus issued. The terms ex-bonus and ex-dividend often are used synonymously.
For instance, if the record date for dividend is October 15th, then investors who don't have their names in the list of unitholders as on that day, will not receive dividend. This works very similar to dividend and bonus declarations in the case of stocks.
How does one calculate the expense ratio for a fund?
The expense ratio for a fund is the annual expenses of a fund (at the end of the financial year), including the management fee, administrative costs, divided by the number of units on that day.
How relevant is the expense ratio?
As is evident from the definition, a lower expense ratio underlines the efficiency of a fund. This is a yardstick that investors need to apply to gauge the efficiency (or lack of it) between funds.
What is cheque-writing facility?
A service enabling investors to write cheques against their mutual fund account balances. Cheques usually must meet a certain minimum amount and the service is restricted to money-market funds.
What is a contingent deferred sales charge (or CDSC)?
A back-end load imposed on an investor if he exits from the fund before a pre-determined period (say 6 months). The charges decline the longer an investor stays invested with a fund.
What is a daily dividend fund?
A fund (money-market or bond) that calculates dividends daily, paying out or reinvesting the same.
What are derivatives?
Financial instruments based on some primary underlying asset or index such as a stock, bond, commodity, or a benchmark of stock prices. Derivative securities fluctuate up and down in tandem with the primary security. Derivatives often are leveraged, making them more volatile. They can be used to speculate as well as to reduce or control an unwanted risk. Options and futures are standardised derivatives. Others are customised to meet specific needs.
What is an Initial public offering (IPO)?
The sale of a company's shares or a fund house�s mutual fund to investors for the first time.
What is an asset management fee?
The fee charged by the asset management company (AMC) for portfolio management. The fee charged on an annual basis is calculated as percentage of net assets under management.
What is growth investing ?
A popular investment style whereby fund managers identify companies showing promise of above-average earnings. Stocks are held primarily for price appreciation as opposed to dividend income. Growth investors (or managers) are willing to pay a premium to acquire a stock if they feel it has the right prospects. Growth investing is an alternative to value investing.
For instance, buying an over-valued software stock would be the part of a growth manager�s investment strategy.
What is value investing?
As opposed to growth investors, value investors (or managers) focus on identifying under-priced stocks. Value investors look out for stocks selling at low prices, but which have the potential to give attractive returns in future.
What is hedging?
A general term used to describe any of several risk-reduction strategies. A fund manager might partially hedge against a market decline simply by moving a larger fraction of the portfolio into cash. Alternatively, the manager could sell stock-index futures contracts. If the market falls, the gains on the shorted futures would more or less offset the decline in the portfolio's value.
What is passive investing?
This is the investment style espoused by index fund managers who simply invest by benchmarking their portfolio to a common stockmarket index like the BSE-30 or the SP CNX-50. The fund manager only invests in stocks in the index in exactly the same proportion. There is no attempt to beat the benchmark index, but to simply replicate it, and therefore it is called as passive investing. The index fund will never outperform the benchmark index, nor does it attempt to.
FAQs on taxation
What tax benefits are available to those who invest in mutual funds? Please mention the tax benefits on equity-oriented and debt-oriented funds separately.
Dividends declared by debt-oriented mutual funds (i.e. mutual funds with less than 65% of assets in equities), are tax-free in the hands of the investor. However, a dividend distribution tax of 14.03% (including surcharge) is to be paid by the mutual fund on the dividends declared. Long-term debt funds, government securities funds (gsec/gilt funds), monthtly income plans (MIPs) are examples of debt-oriented funds.
Dividends declared by equity-oriented funds (i.e. mutual funds with more than 65% of assets in equities) are tax-free in the hands of investor. There is also no dividend distribution tax applicable on these funds. Diversified equity funds, sector funds, balanced funds (with more than 65% of net assets in equities) are examples of equity-oriented funds.
Amount invested in tax-saving funds (ELSS) would be eligible for deduction under Section 80C, however the aggregate amount deductible under the said section cannot exceed Rs 100,000.
How are equity-oriented funds defined?
A mutual fund must have at least 65% of its net assets in equities/stocks to qualify as an equity-oriented mutual fund
Do equity/balanced funds have to maintain a daily, minimum 65% equity allocation?
Not really, the equity allocation is calculated based on the weekly average net assets in equities. If this average is below 65%, the fund stands to forfeit its equity-oriented status.
Do balanced funds qualify as equity-oriented funds?
If balanced funds maintain a minimum (average) 65% equity allocation, they do qualify as equity-oriented funds.
Is a capital gain on sale/transfer of units of mutual fund liable to tax? If yes, at what rate?
Section 2(42A): Under Section 2(42A) of the Act, a unit of a mutual fund is treated as short-term capital asset if the same is held for less than 12 months. The units held for more than twelve months are treated as long-term capital asset.
Section 10(38): Under Section 10(38) of the Act, long term capital gains arising from transfer of a unit of mutual fund is exempt from tax if the said transaction is undertaken after October 1, 2004 and the securities transaction tax is paid to the appropriate authority. This makes long-term capital gains on equity-oriented funds exempt from tax from assessment year 2005-06.
Short term capital gains on equity-oriented funds is chargeable to tax @10% (plus education cess, applicable surcharge). However, such securities transaction tax will be allowed as rebate under Section 88E of the Act, if the transaction constitutes business income.
Long-term capital gains on debt-oriented funds are subject to tax @20% of capital gain after allowing indexation benefit or at 10% flat without indexation benefit, whichever is less.
Short-term capital gains on debt-oriented funds are subject to tax at the tax bracket applicable (marginal tax rate) to the investor.
Section 112: Under Section 112 of the Act, capital gains, not covered by the exemption under Section 10(38), chargeable on transfer of long-term capital assets are subject to following rates of tax:
Resident Individual & HUF - 20% plus surcharge, education cess.
Partnership Firms & Indian Companies - 20% plus surcharge.
Foreign Companies - 20% (no surcharge)
Capital gains will be computed after taking into account the cost of acquisition as adjusted by Cost Inflation Index, notified by the Central Government.
"Units" are included in the proviso to the sub-section (1) to Section 112 of the Act and hence, unit holders can opt for being taxed at 10% (plus applicable surcharge, education cess) without the cost inflation index benefit or 20% (plus applicable surcharge) with the cost inflation index benefit, whichever is beneficial.
Under Section 115AB of the Income Tax Act, 1961, long term capital gains in respect of units, purchased in foreign currency by an overseas financial, held for a period of more than 12 months, will be chargeable at the rate of 10%. Such gains will be calculated without indexation of cost of acquisition. No surcharge is applicable for taxes under section 115AB, in respect of corporate bodies.
Is it possible to offset the capital loss on a mutual fund investment after a dividend declaration?
This is a practice that is popularly referred to as 'dividend stripping'. The capital loss from a dividend declaration can be offset if you have remained invested in the mutual fund 3 months before and 9 months after the dividend declaration. If you haven't adhered to this guideline then you cannot offset the capital loss arising from a dividend declaration.
What is the tax implication of a bonus/rights issue on mutual fund units?
Under Section 55(2) (AA), bonus on mutual fund units has a zero (nil) cost of acquisition. The holding period is calculated from the date of allotment of mutual fund units. The net sales proceeds are treated as the capital gain. The period of holding of such issue is reckoned from the date of the allotment of such issue.
The cost of acquisition of the rights issue on mutual fund units is the amount actually paid for acquiring such right, according to Section 55(2) (AA) (iii). The holding period is reckoned from the date of allotment.
Where there is a transfer of these rights, the cost of acquisition of such rights is to be taken as 'Nil' according to Section 55(2) (AA) (ii). Sale price of such transferred rights will be taken as capital gain.
The period of holding in the hands of the transferor is computed from the date of offer, made by the company to the date of renouncement.
What are the tax benefits for the foreign investors?
Section 115E: Under Section 115E of the Act, capital gains, chargeable on transfer of long-term capital assets of an Non-Resident Indians (NRIs) are subject to following rates of tax:
Investment income:
20%
Long term capital gains:
10%
Subject to surcharge and education cess.
Section 10(23D): Under provisions of section 10(23D) of the Act, any income received by the Mutual Fund is exempt from tax.
Section 115R: Under Section 115R, the Income distributed to a unit holder of a Mutual Fund shall be charged to following rates of tax to be payable by the Mutual Fund.
Amounts distributed to individual or HUF:
12.5% + SC, EC
Amounts distributed to others:
20.0% + SC, EC
However, the above distribution tax will be exempted for an open-ended Equity-Oriented Funds (funds, investing more than 50% in equity or equity related instruments).
Is wealth tax applicable to mutual fund investments?
No. Units, held under the Scheme of the Fund, are not treated as assets within the meaning of Section 2(EA) of the Wealth Tax Act, 1957 and are, therefore, not liable to Wealth-Tax.
Is gift tax applicable to mutual funds investments?
No. Units of the mutual fund may be given as a gift and no gift tax will be payable, either by the donor or the donee.
How can I avoid payment of capital gains on mutual fund investments?
The capital gain, which is not exempt from tax as explained above, can be invested in the specified asset, mentioned below, within 6 months of the sale.
Specified asset means any bond redeemable after 3 years:
Issued on or after April 1, 2000 by NABARD (National Bank for Agriculture and Rural Development or NHA (National Highways Authority of India
Issued on or after April 1, 2001 by the Rural Electrification Corporation Ltd.
Issued on or after April 1, 2002 by the National Housing Bank or by the Small Industries Development Bank of India.
Such capital gains can also be invested in any residential house property in accordance with Section 54F of the Act and one can claim exemption from capital gains.