NISM Series V-A MFD Certification Exam Workbook - August 2023 PDF

1  Workbook for NISM-Series-V-A: Mutual Fund Distributors Certification Examination National Institute of Securities Markets www.nism.ac.in 2 This...

1  Workbook for NISM-Series-V-A: Mutual Fund Distributors Certification Examination National Institute of Securities Markets www.nism.ac.in 2 This workbook has been developed to assist candidates in preparing for the National Institute of Securities Markets (NISM) Certification Examination for Mutual Fund Distributors. Workbook Version: August 20231 Published by: National Institute of Securities Markets © National Institute of Securities Markets, 2020 NISM Registered Office 5th floor, NCL Cooperative Society, Plot No. C-6, E-Block, Bandra Kurla Complex, Bandra East, Mumbai, 400051 National Institute of Securities Markets Patalganga Campus Plot IS-1 & IS-2, Patalganga Industrial Area Village Mohopada (Wasambe) Taluka-Khalapur District Raigad-410222 Website: www.nism.ac.in All rights reserved. Reproduction of this publication in any form without prior permission of the publishers is strictly prohibited. 1 This version of the workbook is for candidates appearing for NISM Series VA: Mutual Fund Distributors Certification Examination on or after 20th October 2023. 3  Foreword NISM is a leading provider of high-end professional education, certifications, training and research in financial markets. NISM engages in capacity building among stakeholders in the securities markets through professional education, financial literacy, enhancing governance standards and fostering policy research. NISM works closely with all financial sector regulators in the area of financial education. NISM Certification programs aim to enhance the quality and standards of professionals employed in various segments of the financial services sector. NISM’s School for Certification of Intermediaries (SCI) develops and conducts certification examinations and Continuing Professional Education (CPE) programs that aim to ensure that professionals meet the defined minimum common knowledge benchmark for various critical market functions. NISM certification examinations and educational programs cater to different segments of intermediaries focusing on varied product lines and functional areas. NISM Certifications have established knowledge benchmarks for various market products and functions such as Equities, Mutual Funds, Derivatives, Compliance, Operations, Advisory and Research. NISM certification examinations and training programs provide a structured learning plan and career path to students and job aspirants who wish to make a professional career in the Securities markets. Till March 2023, NISM has issued more than 17 lakh certificates through its Certification Examinations and CPE Programs. NISM supports candidates by providing lucid and focused workbooks that assist them in understanding the subject and preparing for NISM Examinations. The book covers all important topics to enhance the quality of sales, distribution and related support services in the mutual fund industry. It covers topics related to the basics of mutual funds, their role and structure, different kinds of mutual fund schemes and their features, accounting, valuation and taxation aspects underlying mutual funds and their distribution. The book also discusses the concept of scheme evaluation, services to investors and prospective investors. It will be immensely useful to all those who want to have a better understanding of Indian mutual fund industry. Dr. C.K.G. Nair Director 4 Disclaimer The contents of this publication do not necessarily constitute or imply its endorsement, recommendation, or favoring by the National Institute of Securities Markets (NISM) or the Securities and Exchange Board of India (SEBI). This publication is meant for general reading and educational purpose only. The statements/explanations/concepts are of general nature and may not have taken into account the particular objective/ move/ aim/ need/ circumstances of individual user/ reader/ organization/ institute. Thus, NISM and SEBI do not assume any responsibility for any wrong move or action taken based on the information available in this publication. Therefore, before acting on or following the steps suggested on any theme or before following any recommendation given in this publication user/reader should consider/seek professional advice. The publication contains information, statements, opinions, statistics and materials that have been obtained from sources believed to be reliable and the publishers of this title have made best efforts to avoid any errors. However, publishers of this material offer no guarantees and warranties of any kind to the readers/users of the information contained in this publication. Since the work and research is still going on in all these knowledge streams, NISM and SEBI do not warrant the totality and absolute accuracy, adequacy or completeness of this information and material and expressly disclaim any liability for errors or omissions in this information and material herein. NISM and SEBI do not accept any legal liability whatsoever based on any information contained herein. While the NISM Certification examination will be largely based on material in this workbook, NISM does not guarantee that all questions in the examination will be from material covered herein. Acknowledgement This workbook has been developed jointly by the Certification Team of National Institute of Securities Markets (NISM), NISM Resource Persons—Mr. Sundar Sankaran, Ms. Sunita Abraham, Mr. Amit Trivedi and reviewed by Mr. Joydeep Sen. NISM gratefully acknowledges the contribution of the Examination Committee for NISM-Series-V-A: Mutual Fund Distributors Certification Examination consisting of industry experts. 5 About NISM Certifications The School for Certification of Intermediaries (SCI) at NISM is engaged in developing and administering Certification Examinations and CPE Programs for professionals employed in various segments of the Indian securities markets. These Certifications and CPE Programs are being developed and administered by NISM as mandated under Securities and Exchange Board of India (Certification of Associated Persons in the Securities Markets) Regulations, 2007. The skills, expertise and ethics of professionals in the securities markets are crucial in providing effective intermediation to investors and in increasing the investor confidence in market systems and processes. The School for Certification of Intermediaries (SCI) seeks to ensure that market intermediaries meet defined minimum common benchmark of required functional knowledge through Certification Examinations and Continuing Professional Education Programmes on Mutual Funds, Equities, Derivatives Securities Operations, Compliance, Research Analysis, Investment Advice and many more. Certification creates quality market professionals and catalyzes greater investor participation in the markets. Certification also provides structured career paths to students and job aspirants in the securities markets. About the Certification Examination for Mutual Fund Distributors The examination seeks to create a common minimum knowledge benchmark for all persons involved in selling and distributing mutual funds including: Individual Mutual Fund Distributors Employees of organizations engaged in sales and distribution of Mutual Funds Employees of Asset Management Companies especially persons engaged in sales and distribution of Mutual Funds The certification aims to enhance the quality of sales, distribution and related support services in the mutual fund industry. Examination Objectives On successful completion of the examination, the candidate should: Know the basics of mutual funds, their role and structure, different kinds of mutual fund schemes and their features. Understand how mutual funds are distributed in the market-place, how schemes are to be evaluated, and how suitable products and services can be recommended to investors and prospective investors in the market. 6  Get oriented to the legalities, accounting, valuation and taxation aspects underlying mutual funds and their distribution. Assessment Structure The examination consists of 100 questions of 1 mark each and should be completed in 2 hours. The passing score for the examination is 50 percent. There shall be no negative marking. How to register and take the examination To find out more and register for the examination please visit www.nism.ac.in 7  CONTENTS Contents CHAPTER 1: INVESTMENT LANDSCAPE............................................................................................... 13 1.1 Investors and their Financial Goals....................................................................................................... 13 1.2 Savings or Investments?....................................................................................................................... 17 1.3 Different Asset Classes......................................................................................................................... 19 1.4 Investment Risks................................................................................................................................... 23 1.5 Risk Measures and Management Strategies........................................................................................ 27 1.6 Behavioural Biases in Investment Decision Making............................................................................. 28 1.7 Risk Profiling ……………………………………………………………………………………………………………………………………30 1.8 Understanding Asset Allocation........................................................................................................... 30 1.9 Do-it-yourself versus Taking Professional Help.................................................................................... 32 CHAPTER 2: CONCEPT AND ROLE OF A MUTUAL FUND....................................................................... 36 2.1 Concept of a Mutual fund..................................................................................................................... 36 2.2 Classification of Mutual Funds.............................................................................................................. 44 2.3 Growth of the mutual fund industry in India........................................................................................ 56 CHAPTER 3: LEGAL STRUCTURE OF MUTUAL FUNDS IN INDIA............................................................. 58 3.1 Structure of Mutual Funds in India....................................................................................................... 58 3.2 Key Constituents of a Mutual Fund...................................................................................................... 59 3.3 Organization Structure of Asset Management Company.................................................................... 64 3.4 Role and Support function of Service Providers.................................................................................... 66 3.5 Role and Function of AMFI................................................................................................................... 70 CHAPTER 4: LEGAL AND REGULATORY FRAMEWORK.......................................................................... 73 4.1 Role of Regulators in India.................................................................................................................... 73 4.2 Role of Securities and Exchange Board of India................................................................................... 73 4.3 Due Diligence Process by AMCs for Distributors of Mutual Funds....................................................... 88 4.4 Investor Grievance Redress Mechanism............................................................................................... 88 4.5 AMFI Code of Conduct for Intermediaries............................................................................................ 89 CHAPTER 5: SCHEME RELATED INFORMATION................................................................................... 92 5.1 Mandatory Documents......................................................................................................................... 92 5.2 Non-Mandatory Disclosures............................................................................................................... 109 8 CHAPTER 6: FUND DISTRIBUTION AND CHANNEL MANAGEMENT PRACTICES................................... 112 6.1 The role and importance of mutual fund distributors........................................................................ 112 6.2 Different kinds of mutual fund distributors........................................................................................ 113 6.3 Modes of distribution......................................................................................................................... 115 6.4 Pre-requisites to become Distributor of a Mutual Fund..................................................................... 118 6.5 Revenue for a mutual fund distributor............................................................................................... 121 6.6 Commission Disclosure mandated by SEBI......................................................................................... 128 6.7 Due Diligence Process by AMCs for Distributors of Mutual Funds..................................................... 128 6.8 Difference between distributors and Investment Advisors................................................................ 129 6.9 Nomination facilities to Agents/Distributors and Payment of Commission to Nominee................... 131 6.10 Change of distributor.......................................................................................................................... 133 CHAPTER 7: NET ASSET VALUE, TOTAL EXPENSE RATIO AND PRICING OF UNITS................................ 136 7.1 Fair Valuation Principles..................................................................................................................... 136 7.2 Computation of Net Assets of Mutual Fund Scheme and NAV........................................................... 140 7.3 Dividends & Distributable Reserves.................................................................................................... 149 7.4 Concept of Entry and Exit Load and its impact on NAV...................................................................... 150 7.5 Key Accounting and Reporting Requirements.................................................................................... 151 7.6 NAV, Total expense ratio and pricing of units for the Segregated Portfolio...................................... 152 CHAPTER :8 TAXATION.................................................................................................................... 154 8.1 Applicability of taxes in respect of mutual funds................................................................................ 154 8.2 Capital Gains...................................................................................................................................... 155 8.3 Dividend income (IDCW option)......................................................................................................... 160 8.4 Stamp Duty on Mutual Fund Units..................................................................................................... 161 8.5 Setting off of Capital Gains and Losses under Income Tax Act........................................................... 162 8.6 Securities Transaction Tax.................................................................................................................. 162 8.7 Tax benefit under Section 80C of the Income Tax Act........................................................................ 163 8.8 Tax Deducted at Source...................................................................................................................... 164 8.9 Applicability of GST............................................................................................................................. 164 CHAPTER 9: INVESTOR SERVICES...................................................................................................... 166 9.1 The NFO process................................................................................................................................. 166 9.2 New Fund Offer Price/On-going Offer Price for subscription.............................................................. 167 9.3 Investment Plans and Services........................................................................................................... 168 9 9.4 Allotment of Units to the Investor...................................................................................................... 172 9.5 Account statements for investments.................................................................................................. 173 9.6 Mutual Fund Investors........................................................................................................................ 174 9.7 Filling the Application Form for Mutual Funds................................................................................... 176 9.8 Financial Transactions with Mutual Funds......................................................................................... 181 9.9 Cut-off Time and Time Stamping........................................................................................................ 192 9.10 KYC Requirements for Mutual Fund Investors.................................................................................... 195 9.11 Systematic Transactions..................................................................................................................... 203 9.12 Operational aspects of Systematic Transactions................................................................................ 207 9.13 Non-Financial Transactions in Mutual Funds..................................................................................... 210 9.14 Change in Status of Special Investor Categories................................................................................. 216 9.15 Investor transactions – turnaround times.......................................................................................... 219 CHAPTER 10: RISK, RETURN AND PERFORMANCE OF FUNDS............................................................ 223 10.1 General and Specific Risk Factors....................................................................................................... 223 10.2 Factors that affect mutual fund performance.................................................................................... 235 10.3 Drivers of Returns and Risk in a Scheme............................................................................................ 237 10.4 Measures of Returns........................................................................................................................... 246 10.5 SEBI Norms regarding Representation of Returns by Mutual Funds in India.................................... 251 10.6 Risks in fund investing with a focus on investors................................................................................ 251 10.7 Measures of Risk................................................................................................................................. 254 10.8 Certain Provisions with respect to Credit risk..................................................................................... 258 CHAPTER 11: MUTUAL FUND SCHEME PERFORMANCE..................................................................... 266 11.1 Benchmarks and Performance........................................................................................................... 266 11.2 Price Return Index or Total Return Index........................................................................................... 267 11.3 Basis of Choosing an appropriate performance benchmark.............................................................. 267 11.4 Benchmarks for equity schemes......................................................................................................... 268 11.5 Benchmarks for Debt Schemes........................................................................................................... 269 11.6 Benchmarks for Other Schemes.......................................................................................................... 270 11.7 Quantitative Measures of Fund Manager Performance.................................................................... 272 11.8 Tracking Error..................................................................................................................................... 274 11.9 Scheme Performance Disclosure......................................................................................................... 275 CHAPTER 12: MUTUAL FUND SCHEME SELECTION............................................................................ 280 10 12.1 Scheme Selection based on Investor needs, preferences and risk-profile........................................... 280 12.2 Risk levels in mutual fund schemes.................................................................................................... 282 12.3 Scheme Selection based on investment strategy of mutual funds..................................................... 286 12.4 Selection of Mutual Fund scheme offered by different AMCs or within the scheme category.......... 293 12.5 Selecting options in mutual fund schemes......................................................................................... 297 12.6 Do’s and Don’ts while selecting mutual fund schemes....................................................................... 297 Appendix 1: Fifth Schedule of Securities and Exchange Board of India (Mutual Funds)Regulations, 1996 [Regulations 18(22), 25(16), 68(h)]............................................................................... 300 Appendix 2: AMFI Code of Ethics.............................................................................................................. 302 Appendix 3: AMFI’s Code of Conduct for Intermediaries of Mutual Funds.............................................. 307 Appendix 4: Format of Scheme Information Document (SID).................................................................. 314 Appendix 5: Format of Statement of Additional Information (SAI)........................................................... 332 Appendix 6: Format of Key Information Memorandum........................................................................... 340 Appendix 7: KYC Form for Individual......................................................................................................... 344 Appendix 8: KYC Form for Non-Individuals............................................................................................... 348 Appendix 9: KYC Details Change Form for Individuals.............................................................................. 352 Appendix 10: KYC Details Change Form for Non-Individuals.................................................................... 354 Appendix 11: Process for Aadhaar e-KYC of investors (resident) in the securities markets.................... 356 Appendix 12: Procedure for Transmission of Units on Death of a Unitholder......................................... 358 Appendix 13: Easy guide for New Distributors.......................................................................................... 364 Appendix 14: Indian and Global mutual fund industry............................................................................. 365 Appendix 15: Additional knowledge resources......................................................................................... 366 11  Syllabus Outline with Weightages Unit No. Unit Name Weightage Unit 1 Investment Landscape 8 Unit 2 Concept & Role of a Mutual Fund 6 Unit 3 Legal Structure of Mutual Funds in India 4 Unit 4 Legal and Regulatory Framework 10 Unit 5 Scheme Related Information 10 Unit 6 Fund Distribution and Channel Management Practices 6 Unit 7 Net Asset Value, Total Expense Ratio and Pricing of units 8 Unit 8 Taxation 4 Unit 9 Investor Services 15 Unit 10 Risk, Return and Performance of Funds 7 Unit 11 Mutual Fund Scheme Performance 7 Unit 12 Mutual Fund Scheme Selection 15 12 CHAPTER 1: INVESTMENT LANDSCAPE Learning Objectives: After studying this chapter, you should understand about: Investors and their financial goals Saving or investment Different asset classes Investment risks Risk measures and management strategies Behavioral biases in investment decision making Risk profiling Understanding asset allocation Do-it-yourself v/s taking professional help 1.1 Investors and their Financial Goals “Please suggest some good investments.” “Which mutual fund schemes should one buy this year?” “Which is the best mutual fund scheme?” “Which is the best investment?” “Should I invest in stocks or real estate?” “What is your view of the stock market?” “Are my investments proper? Or should I make some changes?” One hears these and many similar questions, very regularly. There is an issue with these questions. These are about the investments and not the investor. The investor’s needs are not even discussed, and probably not even considered important. As leadership guru and bestselling author Simon Sinek says, “Start with Why”. The discussion of investments must start with “why” – the purpose of investment. “Why is one investing?” 1.1.1 Why Investments? Let us take a look at some examples: Shalini, an eight-year-old girl, lives in a mid-size town in North India with her parents. She is highly inspired by watching the recent success of India’s space programs, in which some women scientists played a huge role. She wants to become a space scientist. Her parents, Mrs. And Mr. Gupta want to support her pursue her dream. Rabindra, 45 years old, is working as an engineer in a large multinational firm. His wife is a homemaker. Since the company does not provide any pension plan, he is worried about how they would be able to live a comfortable life once he retires from the job. Surinder Singh has recently moved to a large city from his hometown, as he got a promotion 13 and a transfer in the company where he works. While his job is very good,he is facing trouble in settling down with a house. He is tired of going house-hunting every now and then and is thinking of buying his own house in the near future. Mrs. D’Souza has recently retired from her job. She received a large sum as retirement benefits. She intends to invest the same in order to receive regular income to live a comfortable life. 1.1.2 Financial Goals The above are some examples of common situations we see regularly in our own life or the lives of people around us. Though there is no explicit mention of money in these examples, we intuitively know that money would be involved in each of these situations, whether Shalini has to be educated well, or Surinder Singh has to buy a house, or Mrs. D’Souza or Rabindra have to fund their lives in retirement. In the investment world, the requirements of these four are known as financial objectives. When we assign amounts and timelines to these objectives, we convert these into financial goals. There are numerous examples of such financial goals. Among the most common are funding a child’s education, the cost of the marriage of one’s son or daughter, funding the lifestyle in retirement, buying a vehicle, buying or renovating one’s house, taking a big vacation. At the same time, there could be some not-so-common ones like starting one’s own business or taking a sabbatical from work and fund one’s higher education. Goal setting is a very important exercise while planning for investments. As seen above, all the financial goals are about the need for money that cannot be fulfilled through the inflow at that time. While the expenses for the goal may be high or low, the income (from salary, professional fees, etc.) may be less than the amount required to fund the goal. This is where money needs to be withdrawn from the investments – in other words, this is why one needs to invest the money. The first step in goal setting is to identify these events in life. Some of these are desirable and can be planned, whereas some others, which may be undesirable, may spring up as surprises. Those events with a potential negative outcome would be undesirable. Some of the examples of the same are the death of a family member, hospitalization, accident, theft, fire,etc. One cannot plan to fund the expenses associated with such events through investments,though we can create an emergency fund using some savings and investment products. Apart from the emergency fund, one may buy insurance policies to cover the risks of such events. After identifying the events, one needs to assign priorities–which of these are more important than the others. Retirement or children’s education fall into the responsibility’s category, whereas a grand vacation may be a good-to-have goal. Having said that, it is only the individual and the family that can decide which is which. A financial advisor may only guide and help one take an appropriate decision. At the same time, the role of such an intermediary would be very important. 14 After that, one needs to assign a timeline as well as the amount of funding required at the time of such events. Take for example, if someone is planning to buy a house, one needs to decide the type of house one wants, as well as the location. These inputs would help arrive at approximate cost. After that one needs to decide by when one would like to buy this. Both the timeline and amount are critical for one to be able to plan to achieve the goal. Such an exercise allows one to classify the goals in terms of the timeline – are the goals in the near term, or far in the future? 1.1.3 Short term needs versus Long Term Goals Take a relook at the examples at the beginning of the chapter. Shalini’s higher education is roughly ten years away, whereas Rabindra may work for another fifteen years. On the other hand, Surinder Singh may need to buy a house in the next couple of years. Mrs. D’Souza’s case is interesting since she has a need for income from investments in the immediate term, but the same must also continue for a long and uncertain period, as the income is required for life. Rabindra would also enter a similar situation on retirement. The retirement goal can be broken into two parts – accumulating a sum for retirement and then taking income out of the corpus thus accumulated. Another look at the two approaches to classify the goals indicates that the goals can be placed in the following matrix: Critically important Dreams Good-to-have (responsibilities orneeds) Immediate term Near term Medium term Long term This looks very similar to the urgent v/s important matrix that Stephen Covey discussed in his bestseller “The Seven Habits of Highly Effective People”. The matrix is referred to in the context of time management, and it classifies various tasks one undertakes during the day, as well as over a period. Let us take a look at the matrix: The Time Management Matrix Urgent Not Urgent Important I II Not Important III IV (Source: The Seven Habits of Highly Effective People, by Stephen R Covey) In the book, Covey says that as long as you keep focusing on Quadrant I, it keeps getting bigger 15 and bigger and then starts to dominate you. This quadrant referred to by Covey is “urgent and important”. When that happens, the ‘important but not-so-urgent’ tasks are not plannedfor in time until they also enter the quadrant 1, becoming urgent. The same principle appliesto financial goals, too. A large number of people struggle with their finances since they do not plan for the important and not urgent events in life. Wisdom suggests that if one plans well for those important and not urgent tasks (and goals), life changes for the better. In order to achieve this, it is important to first classify the financial goals – those events in life in terms of timeline and importance in one’s life. 1.1.4 Financial Goals, Time Horizon for their achievement and Inflation The next step would be to assign amounts to the financial goals. In the process of planning, this is an important question: How much would it cost? Shalini, the eight-year-old, wants to be a space scientist, for which she needs good quality education. How much would such education cost? Well, this question must be answered in terms of the amount needed when Shalini reaches college. And that is roughly a decade from now. In such a case, the costs are quite likely to move up. Such a rise in the cost of the goals is called inflation. It applies to many other areas of personal finance. This is known as inflation with respect to the goal value. Inflation adjustment for the goal values is critical, without which the entire planning can go haywire. The cost of education has been going up at a very fast pace over the last few decades. Similar is the case of the cost of healthcare, which can have a big impact on the expenses during the retirement years. 1.1.5 The Pool Approach Some people have a pool of savings / investment and meet their financial requirements from the pool. It is possible to manage that way. However, the lacuna is, you are not sure of the horizon for the investments. As we will see going ahead, knowing your horizon is important for investment decisions. Case Study: In case of Shalini’s higher education. Assume that the cost of her higher education is Rs. 50 lacs (in today’s price), whereas Shalini would go to college 10 years later. If the inflation in college fees is expected to be 8 percent p.a., her parents need to provide for Rs. 1,07,94,625 in 10 years, approximately.2 There are too many assumptions involved here–the course Shalini would pursue, the cost of the education, and the inflation. However, one needs to start with some assumptions to plan properly. Else, the parents may plan to accumulate Rs. 50 lacs, which would be grossly insufficient. 2Note: Inflation numbers are taken based on random assumptions, and only for illustration purposes. 16 Inflation has a long-term impact, and hence while planning for funding all the long-term goals, one must consider inflation in the cost of the goal. On the other hand, the immediate term and near-term goals may not have a big impact due to changes in price. As mentioned earlier, inflation is the rise in prices of various products, and services consumed. If the inflation is 6 percent p.a., the household expenses would be higher a year later in comparison to today’s cost of living. If a family’s monthly expenses are Rs. 30,000 currently, they would be spending Rs. 31,800 next year if the inflation is 6 percent. This does not look like much, but if the inflation stays at the same level, this family’s monthly expenses would be roughly Rs. 53,725 after 10 years; and Rs. 96,214 after 20 years. There is one thing common in all these financial goals: a mismatch of cash flows. Either the expenses are far higher than the income at that point in time, or there is no income at the time of funding these goals. Since these are future goals, an investor may have time to accumulate one’s savings; and grow them through appropriate investment avenues. 1.2 Savings or Investments? Before taking a look at various investment options available for an investor, some important questions need to be tackled. Do the two words “saving” and “investment” mean the same thing? Or are they different words? If these are different things, which is better – saving or investing? Such clarification is warranted since many individuals use the two terms interchangeably. The word “saving” originates from the same root as “safe”. The safety of money is of critical importance here. Whereas, when one invests money, the primary objective typically is to earn profits. The important point to note here is that there is a trade-off between risk and return. The other difference is evident from the dictionary definition of “saving”– reduction in the amount of money used. This definition refers to reducing consumption so that some money is saved. It is this saved money that can be invested. In other words, saving and investing are not to be considered as two completely different things, but two steps of the same process – in order to invest money, one needs to save first. Thus, saving precedes investing. 1.2.1 Factors to evaluate investments The three most important factors to evaluate investments are safety, liquidity, and returns. In addition to these, there are few more parameters such as convenience, ticket size (or the minimum investment required), taxability of earnings, tax deduction, etc. These factors have been discussed below: Safety: This begins with the safety of capital invested. However, one could stretch that to also include the degree of surety of income from investment. In order to understand the safety of an investment, it is important to understand the risks involved. 17 Liquidity: How easily can one liquidate the investment and convert it to cash? The degree of ease is different across different categories, and even within the categories, the same could be different across products. Sometimes, the nature of the product could be such that selling it is difficult, whereas sometimes there could be some operational features, e.g., a lock-in for a certain period, after which one may be able to liquidate the investment; or a penalty for an early exit. While such a penalty does not hamper liquidity, it only lowers the investment returns. Another aspect that one may also want to look at is divisibility. Is it possible to liquidate part of the investment or is it necessary to sell the whole thing? Returns: As seen earlier in the definition of investments, the major purpose is to get some returns from investment. Such returns may be in the form of regular (or periodic) income, also known as current income; and capital appreciation, or capital gains. The current income is receivable periodically, without having to sell the investment, whereas the capital gains can be realized only when one sells the investment. The exit charges or penalty would bring down the returns, as seen earlier. Hence, whenever there are any such charges for early withdrawals, the same must be considered as a trade-off between liquidity and returns. Convenience: Any investment must be evaluated in terms of convenience with respect to investing, taking the money out–fully or partially, as well as the investor’s ability to conveniently check the value of the investment, as well as to receive the income. Ticket size: What is the minimum amount required for investment? There are some avenues where an investor can start investing amounts as small as Rs. 50 or Rs. 100, whereas some require more than Rs. 1 lakh, and sometimes more than Rs. 1 crore. This becomes an important factor while taking a decision about the selection of investment options. At the same time, this must not be the only factor. Some investors (though a very small number) have started considering certain investments (requiring large amounts), only because they could afford the same, without checking whether they needed it, or if that was appropriate for their situation and goals. Taxability of income: What one retains after taxes is what matters, and hence, taxation of the earnings is another important factor that one must consider. While looking at the taxability of income, it is critical to evaluate various other factors, too, and not look at taxation in isolation. For example, some products may offer lower tax on investment returns, but the safety also may be low. At the same time, there could be some products that may offer low tax on investment returns, only if the investor stays invested for a certain term, or till the maturity of the product. In other words, if the investor sells the investment before maturity (or a certain minimum period), the investment returns may be taxable. Tax deduction: A related matter is the tax deduction that may be available in case of certain products. Such a deduction effectively increases the return on investment, since the same is 18 calculated after factoring the net amount invested. However, where a deduction is available, the product may have a lock-in period of certain years. Once again, this is a trade-off between liquidity and tax deduction. The above discussion offers a good framework for the evaluation of investment products. However, as mentioned earlier, no factor should be seen in isolation. One also must consider the investor’s situation while evaluating the avenues. 1.3 Different Asset Classes Various investment avenues can be grouped in various categories, called asset classes. An asset class is a grouping of investments that exhibit similar characteristics. There are four broad asset categories or asset classes, and then there are various subcategories, within each of these. The four broad categories—Real estate, Commodities, Equity and Fixed income. 1.3.1 Real Estate Real estate is considered as the most important and popular among all the asset classes. However, the popularity of this asset category is large because of a reason not related to investment. For those who have bought their own houses, it is the largest expense in life. The word used here is “expense”, and not “investment”. This would be elaborated later, but it is pertinent to mention here that in majority of cases, individuals purchase real estate for self- occupation. This should not be considered as an investment, since selling the same may have a negative impact on one’s lifestyle. Real estate could be further classified into various categories, viz., residential real estate, land, commercial real estate, etc. As an asset category, real estate exhibits certain traits, some of which are listed as under: Location is the most important factor impacting the performance of an investment in real estate Real estate is illiquid It is not a divisible asset One can invest in physical real estate, as well as in the financial form Apart from capital appreciation, it can also generate current income in form of rents In case of real estate, the transaction costs, e.g., brokerage charges, registration charges, etc. are quite high. This would bring down the return on investment. The cost of maintenance of the property, as well as any taxes payable must be adjusted before calculating the return on investment, something that many individual investors do not. These expenses are also quite high, and cannot be ignored. The investments acquired or sold shall be accounted at transaction price excluding all transaction costs such as brokerage, stamp charges and any charge customarily included in the broker’s contract note that are attributable to acquisition/sale of investments. 19 1.3.2 Commodities This is another asset category that people at large are familiar with in various ways. On a regular basis, people consume many commodities, e.g., agricultural commodities like spices; petroleum products such as petrol and diesel; or metals like gold and silver. However, it is not possible to invest in most of these, as many of these are either perishable and hence cannot be stored for long, or storage of the same could take a lot of space, creating a different kind of difficulties. Though there are commodities derivatives available on many commodities, it may not be wise to call these “investments” for two reasons, (1) these are leveraged contracts, i.e., one can take large exposure with a small of money making it highly risky and (2) these are normally short-term contracts, whereas the investors’ needs may be for longer periods. On the other hand, there are at least two commodities that many investors are quite familiar with as investment avenues, viz., gold, and silver. When someone invests in these commodities, the prices are almost in sync across the world. It is easy to understand the prices of gold and silver across countries by simply looking at the foreign exchange rate between the two countries’ currencies, and making adjustments for various costs and restrictions imposed by any of the countries. In this manner, these two are globally accepted assets. Both these commodities have been used as investments or storage of value for long. In fact, the history of currency would be incomplete without mention of these two. Gold has also been considered by many as a safe haven asset. In case of failure of an economy, or a currency, gold is considered to be the final shelter. However, the opposite camp also comes with very strong arguments. Many currencies across the world were pegged to the gold reserves available with the central bank of the country for long. However, this so-called gold standard has been done away with a few decades ago. And still, most of the central banks hold gold in their reserves. An investor in these commodities would have to count only on capital appreciation since these do not generate any current income. Gold and silver come in varying degrees of purity. Each one can be bought at different prices from the market. However, for a large majority of investors, it is almost impossible to make out the level of purity. If we opt for a purity certificate, the cost goes up and without one, the risk of getting lower quality metal is high. 1.3.3 Fixed Income When someone borrows money, one has to return the principal borrowed to the lender in the future. There could also be some interest payable on the amount borrowed. There are 20 various forms of borrowing, some of which are through marketable instruments like bonds and debentures3. There are many issuers of such papers, e.g., Companies, Union Government, State Governments, Municipal Corporations, banks, financial institutions, public sector enterprises, etc. Many bonds pay regular interest; thus, the investors can expect current income. At the same time, if someone has invested at the time of issuance of the bond and hold the same till maturity, in almost all cases, there would be no capital gains. On the other hand, a transaction through secondary market – whether at the time of buying or at the time of selling, or both – may result into capital gains or losses. Bonds are generally considered to be safer than equity. However, these are not totally free from risks. These risks will be discussed in detail later in the chapter. Bonds can be classified into subcategories on the basis of issuer type i.e., issued by the government or corporates or on the basis of the maturity date: short term bonds (ideal for liquidity needs), medium term bonds, and long-term bonds (income generation needs). 1.3.4 Equity This is the owner’s capital in a business. Someone who buys shares in a company becomes a part-owner in the business. In that sense, this is risk capital, since the owner’s earnings from the business are linked to the fortunes, and hence the risks, of the business. When one buys the shares of a company through the secondary market, the share price could be high or low in comparison to the fair price. Historically, equity investing has generated returns in excess of inflation, which means the purchasing power of one’s money has increased over the years. It has also delivered higher returns than other investment avenues, most of the time, if one considers long investment periods. Since the base year of 1979, Sensex has grown from a level of 100 to around 66000 i.e., July 2023. This is an appreciation of around 16 percent p.a., compounded annually.4 Apart from long term capital appreciation, equity share owners may also receive dividends from the company. Such dividends are shared out of the profit that the company has generated from its business operations. If the company does really well, the dividends tend to grow over the years. To sum up, equity share prices generally fluctuate a lot, often without regard to the business fundamentals. However, over long periods of time, the share prices follow the fortunes of the 3We would use the two words bonds and debentures interchangeably in this discussion. 4Sensex is BSE’s benchmark index representing shares of 30 large-sized companies. It is also considered to be one of the bellwether indices, a barometer of what is happening in the stock market in India. 21 firm. If the profits of the company continue to grow over the years, the share price follows. There are similarities and differences between the various asset categories. Investments in equity and bonds can be done only in financial form, whereas one can buy the other two assets, viz., real estate and commodities either in financial or in physical form. It is this physical form that gives a feeling of safety to many. Anything that is tangible is perceived to be safer than something intangible. Real estate and commodities differ from equity and bonds in another way, too. These could be bought as an investment or for consumption purposes. For example, one may invest in residential property and give it on rent to generate income. This is an investment. At the same time, one may also buy a flat to live in–for residential purposes. Such a self-occupied house may not be an investment. A similar logic may be applied to gold and silver by checking whether one has invested in the metal or bought the same for personal use. When someone invests in equity shares, part of the profits made by the company may be shared with the investor. With a careful analysis of various equity shares, it is possible to receive a periodic income (though without any guarantee about how much would one receive, and whether one receives anything at all). Similarly, real estate could be given on rent to generate intermittent cash flow. Bonds pay interest income. It is the commodities where such intermittent cash flow is not generated. An investor in equity, real estate and commodities is an owner of the asset, whereas an investor in bonds has lent money to someone. In such a case, the lender’s receipts—be its interest payments or return of principal amount invested – are agreed at the time of the issue of such instruments. In all the other three cases, the investor’s cash flows (or receipts) are unknown. To that extent, the future returns from these assets, which may also be called ownership assets, would be highly uncertain in comparison to the lending assets like bonds or fixed deposits. While the above discussion was about the characteristics of various asset classes and certain differences across the asset categories, the same must be seen from another perspective, too. While one may buy equity shares listed in India in Indian Rupees, one can also invest in shares of various companies listed outside India. This provides exposure to another currency. For example, an investor buying the shares of a company listed on the London Stock Exchange is exposed to the fortunes of the company, as well as the change in the exchange rate between the British Pound and the Indian Rupee. Similarly, one could also invest in bonds denominated in various currencies other than Indian Rupee, and one could also buy real estate abroad. These are called international assets. However, one must understand the basic nature of the asset class as discussed earlier, and then try to assess the impact of currency fluctuation on these investments. 22 Different investment avenues can be categorized into different asset category as can be seen from the illustration in Table 1.1: Table 1.1 Investment avenues classified under different asset categories Equity Fixed Income Blue-chip Companies Fixed deposit with a bank Mid-sized companies Recurring deposit with a bank Small-sized companies Endowment Policies Unlisted Companies Money back Policies Foreign Stocks Public Provident Fund Equity Mutual Funds Sukanya Samruddhi Yojana (SSY) Exchange Traded Funds Senior Citizens’ Savings Scheme (SCSS) Index Funds Post office Monthly Income Scheme Recurring deposit with a post office Company fixed deposit Debentures/bonds Debt Mutual Funds Real Estate/Infrastructure Commodities Physical Asset Gold Residential/ Commercial Silver Financial Asset Gold Funds Real Estate Mutual Funds (REMF) Commodity ETFs Real Estate Investment Trusts (ReIT) Infrastructure Investment Trust (InvIT) Hybrid asset classes Others Hybrid Mutual funds or Multi Asset Fund Rare coins Art Rare stamps 1.4 Investment Risks To obtain a better understanding of the investment avenues, it is essential to understand the different types of risks involved. 1.4.1 Inflation Risk Inflation or price inflation is the general rise in the prices of various commodities, products, and services that we consume. Inflation erodes the purchasing power of money. The following table explains what inflation can do to the purchasing power of our money. How much money would you need to buy the goods you can If inflation is assumed buy with Rs. 10,000 today at 8% p.a.5 5 The numbers are arrived at by using the future value equation, i.e., A = P * (1 + r) ^ n, where A is the future value (the values in the right-side column); P is the present value (Rs. 10,000 in the example); r is the rate of inflation (8% p.a. in the example); n is the number of years (the periods in the first column in this table). 23  After 5 years Rs. 14,693 After 10 years Rs. 21,589 After 20 years Rs. 46,610 After 30 years Rs. 1,00,627 The above table shows how fast the purchasing power of the money goes down. This risk hits hard over long periods. If this is not properly accounted for in the investment plan, one may fall short of the target when the need arises. One may also look at the impact of inflation in another way. If one could buy 100 units of something with Rs. 10,000 today, assuming inflation of 8 percent p.a., one would be able to buy only 68 units of the same thing after 5 years, and only 46 units after 10 years. This clearly shows the loss of purchasing power. In this context, it is pertinent to take a look at whether the investments are able to protect purchasing power or not. In order to protect the purchasing power, the investment return should be at least as much as inflation. If the same is higher than inflation, the purchasing power increases, whereas if one earns lower returns than inflation, the purchasing power drops. Incidentally, when one seeks the total safety of invested capital, along with anytime liquidity, the investment returns are usually lower than inflation. Take for example, if you earn an interest rate of 7 per cent p.a. on your fixed deposit when the inflation is at 8 per cent p.a., it is obvious that the investment grows at a slower pace than the rise in prices. The returns on investment without factoring inflation is known as the “nominal rate”. However, when this number is adjusted for inflation, one gets the “real rate of return”. If the investment returns are higher than inflation, the investor is earning a positive real rate, and vice versa. 1.4.2 Liquidity Risk Investments in fixed income assets are usually considered less risky than equity. Even within that, government securities are considered the safest. In order to avail the full benefits of the investments, or to earn the promised returns, there is a condition attached. The investment must be held till maturity. In case if one needs liquidity, there could be some charges or such an option may not be available at all. Here is an example. Assume that an investor has invested one’s money in a safe investment option, a bank deposit for a goal that is due five years from now. For such a goal, one chose to invest in a five-year fixed deposit. As is clear, the term of the deposit is five years, and the promised returns would accrue to the investor only if the money is kept in the deposit for the entire period. In case, for some reason the investor needs the money before maturity, there could be some deduction in the interest, which reduces the investment return. Some other products like PPF (Public Provident Fund) may offer no liquidity for a certain period, and even after that, there may be only partial liquidity. 24 This risk is also very closely associated with real estate, where liquidity is very low, and often it takes weeks or months to sell the investment. Some investment options offer instant access to funds, but the value of the investment may be subject to fluctuations. Equity shares, listed on stock exchanges are an example of this. While it is easy to sell shares to get cash in case of a large number of listed shares, the equity prices go up and down periodically. Such investments are not appropriate for funding short term liquidity needs. 1.4.3 Credit Risk When someone lends money to a borrower, the borrower commits to repay the principal as well as pay the interest as per the agreed schedule. The same applies in the case of a debenture or a bond or a fixed deposit. In the case of these instruments, the issuer of the instruments is the borrower, whereas the investor is the lender. The issuer agrees to pay the interest and repay the principal as per an agreed schedule. There are three possibilities in such arrangements: (1) the issuer honours all commitments in time, (2) the issuer pays the dues, but with some delay, and (3) the issuer does not pay principal and the interest at all. While the first is the desirable situation, the latter two are not. Credit risk is all about the possibility that the second or the third situation may arise. Any delay or default in the repayment of principal or payment of interest may arise due to a problem with one or both of the two reasons: (1) the ability of the borrower, or (2) the intention of the borrower. While the ability of the borrower, if the same happens to be a company, is a function of the business stability and profitability of the company. Stable companies, which may be market leaders in their respective segments, may pose a lower risk, in comparison to a new company, or a small-sized company in the same industry. Some industries may also exhibit higher stability in comparison to some other. A lender tries to assess both before lending the money or expects enough compensation in case the ability appears to be low. In the case of debentures or bonds, the investor would expect higher interest from bonds with low safety. In this context, the bonds issued by the government of their own country would be considered to be the safest for investors. Such bonds normally offer the lowest interest rates for the citizens of the country, due to the high (highest) safety of capital. All the other bonds/ debentures available in the country would offer a higher rate of interest. 1.4.4 Market Risk and Price Risk When securities are traded in an open market, people can buy or sell the same based on their opinions. It does not matter whether these opinions are based on facts, or otherwise. Since 25 the opinions may change very fast, the prices may fluctuate more in comparison to the change in facts related to security. Such fluctuations are also referred to as volatility. There are two types of risks to a security—market risk and price risk. Let us understand this through an example. When there is a possibility of a country getting into a warlike situation, there is a widespread fear that this may impact the economy and the companies within it. Due to such a fear, it is quite possible that the prices of all stocks (or at least a large number of stocks) in the market may witness a fall. This is a market-wide fall. On the other hand, when the sales of a company’s products fall, due to technological changes, or the arrival of a better product, the company’s share price falls. During such times, there could be many other companies, whose share prices may rise. This is an example of a company specific risk. As is evident from the discussion, the stability of the company’s business and the profitability of the firm play a major role with respect to company specific risk factors. Between the general, market-wide factors and firm-specific factors, there could be some industry-specific factors, which would impact all the firms within the same industry. For example, if the Government policy changes with respect to a particular industry, all the firms may get impacted. Similarly, if a new and better technology becomes available, all the firms within the same industry that use the old technology may get impacted. This happened when mobile phones started becoming popular, the pager industry vanished in less than a couple of decades. The risk specific to the security can be reduced through diversification across unrelated securities, but the one that is market-wide cannot be reduced through diversification. 1.4.5 Interest Rate Risk Interest rate risk is the risk that an investment's value will change as a result of a change in interest rates. This risk affects the value of bonds/debt instruments more directly than stocks. Any reduction in interest rates will increase the value of the instrument and vice versa. While most investors are familiar with the concept of debentures, they normally buy and hold these bonds till maturity. On maturity of the bond, they get the maturity amount, since it is part of the bond agreement (assuming the company does not default on the commitment). On the other hand, if an investor sells the bond in the secondary market, one would have to do the transaction at the current market price. This price depends on many factors, but chief among these is the change in the interest rates in the economy. The relationship between interest rates and bond prices is inverse. When the interest rates in the economy increase, the prices of existing bonds decrease, since they continue to offer the old interest rates. Assume that a bond was issued at Rs. 1000 for one year, and it offered an interest rate of 8 percent. Immediately after the bond was issued, the interest rates in the economy increased, and new bonds are now offering 8.5 percent interest. 26 In such a case, the earlier bond becomes less attractive. If the investor who invested in that bond wants to sell, it can only be done at a discount. The reverse is also true. If in the above example, had the interest rate moved down, the price of the bond would have moved up. The interest rate risk varies for bonds with different maturities. Those with longer maturity would witness higher price fluctuations in comparison to those with shorter maturities. Such movements in bond prices on account of changes in interest are referred to as “interest rate risk”. This is a market-wide factor affecting the prices of all bonds. 1.5 Risk Measures and Management Strategies Many of the risks cannot be eliminated, and the investor must take some of those, in order to earn decent returns on one’s investment portfolio. However, one needs to manage the risks that one is taking. One may consider the following strategies for management of the investment risks: Avoid One may avoid certain investment products if one does not want to take the respective risk. However, this may also mean giving up the opportunity to benefit out of the said investment. Many experts recommend that one should avoid the investment avenues that one does not understand. Take a position to benefit from some event/development An investor can also take an investment position in anticipation of some developments in the market. Let us take an example here: a bond investor expects the interest rates to go down. In such a case, one may sell the short maturity bonds and invest in long maturity bonds. If the interest rates move down, the investor’s judgment would be rewarded handsomely. At the same time, if the judgment is wrong, there could be losses, too. This is an example of managing the interest rate risk. Similarly, some investors manage their investment portfolios using such strategies across multiple asset categories. In order to take and dynamically change such positions, the investor must have superior knowledge than a large number of investors in the market. This is difficult and hence risky. Due to the amount of skill required, and the risks involved, such strategies are not recommended for a large number of investors. Diversify While the previous strategy is possible when one has superior knowledge, not everyone would possess the same. For a lay investor a prudent approach would be to diversify across various investment options. This spreads the risk of loss and thus the probability of losing everything can be significantly reduced through diversification. Before managing the risks, the risks have to be measured. Measurement of credit risk is 27 undertaken through credit rating and credit spreads. Risks related to volatility in prices, primarily the fluctuations that happen in investment returns are measured through variance, standard deviation, beta, modified duration which will be discussed in Chapter 10. 1.6 Behavioural Biases in Investment Decision Making Before discussing asset allocation, it is important to take a detour and discuss behavioural biases in investment decision making. This is also one of the risks the investors must understand. However, this risk is not related to the investments, but the role of emotions in decision making, or in other words the irrational behaviour of investors towards management of money. Investors are driven by emotions and biases. The most dominant emotions are fear, greed and hope. Some important biases are discussed below: Availability Heuristic Most people rely on examples or experiences that come to mind immediately while analyzing any data, information, or options to choose from. In the investing world, this means that enough research is not undertaken for evaluating investment options. This leads to missing out on critical information, especially pertaining to various investment risks. Confirmation Bias Investors also suffer from confirmation bias. This is the tendency to look for additional information that confirms their already held beliefs or views. It also means interpreting new information to confirm the views. In other words, investors decide first and then look for data to support their views. The downside is very similar to the previous one – investors tend to miss out on many risks. Familiarity Bias An individual tends to prefer the familiar over the novel, as the popular proverb goes, “A known devil is better than an unknown angel.” This leads an investor to concentrate the investments in what is familiar, which at times prevents one from exploring better opportunities, as well as from a meaningful diversification. Herd Mentality “Man is a social animal” – Human beings love to be part of a group. While this behaviour has helped our ancestors survive in hostile situations and against powerful animals, this often works against investors interests in the financial markets. There are numerous examples, where simply being against the herd has been the most profitable strategy. Loss Aversion Loss aversion explains people's tendency to prefer avoiding losses to acquiring equivalent gains: it is better not to lose Rs. 5,000 than to gain Rs. 5,000. Such behaviour often leads people to stay away from profitable opportunities, due to the perception of high risks, even 28 when the risk could be very low. This was first identified by Psychologists Daniel Kahneman and Amos Tversky. Kahneman went on to win Nobel Prize in Economics, later on. Overconfidence This bias refers to a person’s overconfidence in one’s abilities or judgment. This leads one to believe that one is far better than others at something, whereas the reality may be quite different. Under the spell of such a bias, one tends to lower the guards and take on risks without proper assessment. Recency bias The impact of recent events on decision making can be very strong. This applies equally to positive and negative experiences. Investors tend to extrapolate the event into the future and expect a repeat. A bear market or a financial crisis leads people to prefer safe assets. Similarly, a bull market makes people allocate more than what is advised for risky assets. The recent experience overrides analysis in decision making. For example, a rise in prices of equities will make people think only about a further rise which would lead to more investment being made in equities. This increases the risk. On the other hand, a fall in prices in an asset would make people stay away thinking it would fall further which could lead to loss of opportunities. Behaviour patterns There are different types of people and the factors that influence their lives also impact the manner in which they save or invest. The drive to save more or be regular in investing often come from these personal factors. Behavioural tests are very useful in determining and knowing the kind of personality a person has and this would include whether they are spenders or savers or investors. Knowing this can help in making the right efforts to get the individual to perform the desired ac-on. Interest of the investors Many times, the financial and investment decisions are not guided by the fact as to whether this investment is suitable for a person or not but by the interest of the investor. This can lead to the construction of portfolios which are not suitable for specific people. For example, someone working in the Information Technology industry might just have technology stocks in their portfolio. This leads to a concentration of risk and is something that has to be avoided. Ethical standards The presence of ethical principles in the dealing of individuals also has an impact as far as their investment behaviour is concerned. Those following ethical standards are more likely to pay attention to their investments and be disciplined because they tend to follow the norms. This is a big help when it comes to building long term wealth. Trying to take shortcuts might derail the entire investment process and set back the existing efforts. These are only some of the biases. This is not an exhaustive list. The negative effect of these 29 biases is that the investor does not gather enough information to be able to identify more opportunities or to evaluate various risks related to investment avenues. It is only prudent for an investor to do a detailed analysis as is possible, without taking such shortcuts. It is important to avoid behavioral biases in investment decisions. To detach emotions from investments, it is better to take the opinion of a third person i.e. Registered Investment Advisor (RIA) or Mutual Fund Distributor (MFD). 1.7 Risk Profiling The risk profilers try to ascertain the risk appetite of the investor so that one does not sell mutual fund schemes that carry a higher risk than what the investor can handle. In order to ascertain the risk appetite, the following must be evaluated: The need to take risks The ability to take risks, and The willingness to take risks Out of the above, the need to take risks arises when the investor needs higher returns to reach one’s goals. The ability to take risk refers to the financial ability, and the investment horizon, whereas the willingness is linked to the psychological capacity to handle risk. The distributor has to evaluate these three, and strike a balance between them, whenever there is a conflict. There are various approaches to creating the risk profile of the investor. The distributor is free to choose from these options. Alternately, one can also design one’s own method or tools for the same, based on the brief discussion mentioned above. 1.8 Understanding Asset Allocation The basic meaning of asset allocation is to allocate an investor’s money across asset categories in order to achieve some objective. In reality, most investors’ portfolios would have the money allocated across various asset categories. However, in many such cases, the same may be done without any process or rationale behind it. Asset Allocation is a process of allocating money across various asset categories in line with a stated objective. The underlined words are very important. First, it is a “process”, which always involves several steps, and those steps should not be ignored or skipped. Second, the whole idea behind asset allocation is to achieve some objective. Whichever approach one selects, one must go through the steps of the process in order to achieve the objective. There are two popular approaches to asset allocation6. Strategic asset allocation 6Note: In order to keep the discussion simple, and to understand the concept of asset allocation well, we will use a two- asset portfolio, consisting equity and debt, as example in the discussion under this topic. 30 Strategic Asset Allocation is allocation aligned to the financial goals of the individual. It considers the returns required from the portfolio to achieve the goals, given the time horizon available for the corpus to be created and the risk profile of the individual. In other words, it is an approach to maintain a target allocation across various asset categories. Such a target asset allocation across the asset categories is decided based on the analysis of the needs and risk appetite of the investor. Such an analysis would help a mutual fund distributor to arrive at allocation between various asset categories in percentage terms. This percentage target is also called the “strategic asset allocation”. Tactical asset allocation As opposed to the strategic asset allocation, one may choose to dynamically change the allocation between the asset categories. The purpose of such an approach may be to take advantage of the opportunities presented by various markets at different points in time, but the primary reason for doing so is to improve the risk-adjusted return of the portfolio. In other words, the attempt is to either reduce the portfolio risk without compromising the returns or to enhance portfolio returns without increasing the risk. Tactical asset allocation is also referred to as dynamic asset allocation. Tactical asset allocation is typically suitable for seasoned investors operating with a large investible surplus. As an illustration, if the appropriate allocation to equity and debt in a portfolio is say 60:40 and equity valuations are attractive, it may be increased to say 65:35 or 70:30. If equity valuation is stretched, it may be reduced somewhat. Rebalancing An investor may select any of the asset allocation approaches, however, there may be a need to make modifications in the asset allocations. Let us first start with the strategic allocation. In that case, the asset allocation is likely to change periodically, since the different assets may not move together in the same direction and may not move equally, even when the direction is the same. In such a case, it is quite possible that the current asset allocation may be different from the target allocation. What should one do in such a scenario? Well, many practitioners advocate that the portfolio should be rebalanced to restore the target asset allocation. Their argument is that the asset allocation was decided by an analysis of the needs and risk appetite of the investor. We need to reduce the allocation to the risky asset if that has gone up. On the other hand, if the allocation has gone down in the asset that has the potential to generate higher returns, we need to correct that as well. Such a rebalancing offers a huge benefit – it makes the investor buy low and sell high. Let us 31 understand this through an example: Assume that the target asset allocation for an investor is 50:50 between asset categories A and B. A year later, asset category A went up by 20 percent, whereas asset B went down by 5 percent. In such a case, the allocation has deviated from the target. If we started investment of Rs. 1,000 each in both the cases, the value in both the cases would stand at Rs. 1,200 in asset A and Rs. 950 in asset B, with the total portfolio value at Rs. 2,150. The current allocation stands at 55.81 percent in asset A and 44.19 percent in asset B. This needs to be restored to 50:50. That means selling some part of the investment in asset A (worth Rs. 125) and buying some in asset B. As we can see here the asset A, which has gone up, is sold; and asset B, which has gone down, is bought. This happens automatically, without the investor having to take a view on the direction of the markets. The rebalancing approach can work very well over the years when the various asset categories go through many market cycles of ups and downs. On the other hand, one may also need to do a rebalancing of the asset allocation, when the investor’s situation changes and thus the needs or the risk appetite might have changed. Rebalancing is required in the case of strategic asset allocation as well as tactical asset allocation. With the purpose to ensure uniformity across mutual funds, SEBI has provided the timelines for rebalancing of schemes. In the event of deviation from mandated asset allocation mentioned in the Scheme Information Document (SID) due to passive breaches (occurrence of instances not arising out of omission and commission of AMCs), mandated rebalancing period for all schemes other than Index Funds and Exchange Traded Funds is 30 business days. However, the mandated rebalancing period is not applicable to the Overnight Funds. 1.9 Do-it-yourself versus Taking Professional Help As discussed earlier, investors need to invest money from time to time. These investments can be made in various financial instruments ranging from Government sponsored schemes to bank fixed deposits to company debentures to shares of companies or real estate properties of even precious metals like gold or silver. One option is to manage the investments oneself. That would involve finding the right investments and carrying out the related research and administration work. The other option is to outsource the entire job to a professional or a company engaged in such a business. A mutual fund is that second option – it is managed by a team of professionals, known as the asset management company. This is what really needs to be understood. By choosing to 32 invest through mutual funds, one is not investing in alternative investment options, but only changing the way of investing money. The entire job of investing is outsourced to a professional firm. So, the next logical question is: “Which of the two choices is better – investing oneself or taking professional help to manage my investments?” This question should be broken down into three components: 1. Can one do the job oneself? 2. Does one want to do it? 3. Can one afford to outsource? Can one do the job oneself? This is the question about ability. In order to do a good job, there are a few requirements, viz., ability to do the job and the availability of time required for the same. There are tasks where one may not have the skills and knowledge, e.g., a history teacher may not be able to help her daughter to study Mathematics in the higher classes. At the same time, one may not have enough time required for the job. In either case, one is unable to do manage money oneself and should consider outsourcing it. Does one want to do it? Even when one has the required skills and knowledge to manage one’s money, it is very likely that one may not enjoy money management–either the research and analysis or administration or accounting. At the same time, one may want to spend time on one’s main profession or on certain other activities, e.g., spending time with family and friends, pursuing hobbies, etc. That also means that one needs help in managing investments. Can one afford to outsource? There is some cost associated with mutual funds since the agencies involved need to be paid their professional fees. While we will cover the costs associated with managing mutual funds in a later chapter, it is important to mention here that SEBI (the securities markets regulator) has issued guidelines on the maximum amount that can be charged to the fund. Most people make the mistake of comparing these fees with zero cost of managing one’s own money oneself. By this comparison, the cost of a mutual fund always looks higher between the two options. What is missed out in this comparison is the hidden costs of doing the investment management job on one’s own. This hidden cost comes in the form of one’s time and the 33 potential mistakes that an individual investor is likely to make. First, let us look at the cost of one’s time. Let us assume that a person generates the same investment returns as what a fund manager would have generated before the costs. Let us also assume that the cost of fund management is 2 percent p.a. This means if one is able to generate 12 percent p.a. by investing oneself, the mutual fund scheme would return 10 percent p.a. net of the fund management charges. On a portfolio of Rs. 10 lakhs, this amounts to a saving of roughly Rs. 20,000 for the year. Is it worth spending the amount of time one is required to spend for this saving? Please consider the amount of research one has to put in as well as the administration and accounting work. Someone may start thinking that this means investors with smaller portfolios should invest through mutual funds, but the bigger ones should not. This is where the concept of the value of time should be looked at. The value of time may be higher in the case of people with more wealth. The second hidden cost comes in the form of the mistakes one is likely to make given the emotional attachment with one’s own finances. For most investors, a mutual fund would turn out to be a better option than to build the portfolio oneself. The next chapter discusses what mutual funds are and their role in an investor’s portfolio. 34 Chapter 1: Sample Questions 1. Which among the following investment avenues does not offer income on a regular basis? a. Real estate b. Physical Gold c. Stocks d. Debentures 2. Which amongst the following asset categories can also be purchased for consumption purposes apart from an investment? a. Real estate b. Stocks c. Bonds d. Debentures 3. The purchasing power of currency changes on account of which of the following? a. Asset allocation b. Compound interest c. Inflation d. Diversification 4. What is the real rate of return? a. Return that the investor gets after payment of all expenses b. Return that the investor gets after taxes c. Return that the investor gets after adjusting the risks d. Return that the investor gets after adjusting inflation 5. When the interest rate in the economy increases, the price of existing bonds. a. Increases b. Fluctuate c. Decreases 35 CHAPTER 2: CONCEPT AND ROLE OF A MUTUAL FUND Learning Objectives: After studying this chapter, you should know about: Concept and Role of mutual funds Classification of mutual funds Growth of mutual fund industry in India 2.1 Concept of a Mutual fund A mutual fund is a professionally managed investment vehicle. Practically, one does not invest in mutual fund but invests through mutual funds. However, we hear of “investing in mutual funds” or “investing in mutual fund schemes”. While that is fine for the purpose of discussions, technically it is not correct. As a mutual fund distributor, it is critical to understand the difference between the two concepts. When someone says that one has invested in a mutual fund scheme, often, the scheme is perceived to be competing with the traditional instruments of investment, viz. equity shares, debentures, bonds, etc. The reality is that one invests in these instruments through a mutual fund scheme. In other words, through investment in a mutual fund, an investor can get access to equities, bonds, money market instruments and/or other securities, that may otherwise be unavailable to them and avail of the professional fund management services offered by an asset management company. Thus, an investor does not get a different product, but gets a different way of investing. The difference lies in the professional way of investing, portfolio diversification, and a regulated vehicle. Mutual fund is a vehicle (in the form of a “trust”) to mobilize money from investors, to invest in different markets and securities, in line with stated investment objectives. In other words, through investment in a mutual fund, an investor can get access to equities, bonds, money market instruments and/or other securities, that may otherwise be unavailable to them and avail of the professional fund management services offered by an asset management company. 2.1.1 Role of Mutual Funds The primary role of mutual funds is to help investors in earning an income or building their wealth, by investing in the opportunities available in securities markets. It is possible for mutual funds to structure a scheme for different kinds of investment objectives. 36 Mutual funds offer different kinds of schemes to cater to the need of diverse investors. In the industry, the words ‘fund’ and ‘scheme’ are used interchangeably. Various categories of schemes are called “funds”. In order to ensure consistency with what is experienced in the market, this workbook goes by the industry practice. However, wherever a difference is required to be drawn, the scheme offering entity is referred to as “mutual fund” or “the fund”. The money that is raised from investors, ultimately benefits governments, companies and other entities, directly or indirectly, for funding of various projects or paying for various expenses. The projects that are facilitated through such financing, offer employment to people; the income they earn helps them buy goods and services offered by other companies, thus supporting projects of these goods and services companies. Thus, overall economic development is promoted. As a large investor, the mutual funds can keep a check on the operations of the investee company, and their corporate governance and ethical standards. The mutual fund industry itself offers livelihood to a large number of employees of mutual funds, distributors, registrars and various other service providers. Higher employment, income and output in the economy boosts the revenue collection of the government through taxes and other means. When these are spent prudently, it promotes further economic development and nation-building. Mutual funds can also act as a market stabilizer, in countering large inflows or outflows from foreign investors. Mutual funds are therefore viewed as a key participant in the capital market of any economy. In 2022, when foreign portfolio investors (FPIs) sold heavily in the equity market, Mutual Fund industry provided a counterforce in the form of demand for equity stocks by virtue of fresh inflows into schemes / funds. 2.1.2 Investment Objectives of Mutual Funds Mutual funds seek to mobilize money from all possible investors. Various investors have different investment preferences and needs. In order to accommodate these preferences, mutual funds mobilize different pools of money. Each such pool of money is called a mutual fund scheme. Every scheme has a pre-announced investment objective. Investors invest in a mutual fund scheme whose investment objective reflects their own needs and preference. The primary objective of various schemes stems from the basic needs of an investor, viz., safety, liquidity, and returns. Let us look at some examples of investment objectives (Table 2.1), as taken from the scheme information documents of certain mutual fund schemes. 37 Table 2.1: Examples of Investment Objectives Investment Objectives Type of mutual fund scheme The scheme intends to provide reasonable income along with high Overnight fund liquidity by investing in overnight securities having a maturity of one business day. To generate capital appreciation/income from a portfolio, Equity fund predominantly invested in equity and equity related instruments The primary objective of the scheme is to generate long term capital Hybrid fund appreciation by investing predominantly in equity and equity related securities of companies across the market capitalization spectrum. The fund also invests in debt and money market instruments with a view to generate regular income. The primary objective of the scheme is to generate a steady stream Long Duration of income through investment in fixed income securities. fund As can be seen from the above examples, the investment objectives are a combination of safety, liquidity, and returns (be it regular income or long-term capital appreciation). It is in line with these objectives that the scheme would decide the investment universe i.e., the types of securities to invest in. As discussed in the previous chapter, different asset classes serve different purposes. Exactly, in the same way, the schemes that seek liquidity invest in money market securities, and those seeking capital appreciation invest in equity. Mutual fund schemes are often classified in terms of the investment objectives, and often in terms of the investment universe, i.e., where they invest. As can be seen from the discussion above, there is a very close relation between the two types of classifications. The money mobilized from investors is invested by the mutual fund scheme in a portfolio of securities as per the stated investment objective. Profits or losses, as the case might be, belong to the investors or unitholders. No other entity involved in the mutual fund in any capacity participates in the scheme’s profits or losses. They are all paid a fee or commission for the contributions they make to launching and operating the schemes. 2.1.3 Investment Policy of Mutual Funds Each mutual fund scheme starts with an investment objective. Since mutual funds are investment vehicles that invest in different asset categories, the mutual fund scheme returns would depend on the returns generated from these underlying investments. Hence, once the investment objective is finalised, the mutual fund scheme’s investment policy is arrived at. 38 This is to achieve the investment objective. The investment policy includes the scheme’s asset allocation and investment style. A mutual fund scheme with the objective of providing liquidity would invest in money market instruments or in debt papers of very short-term maturity. At the same time, a mutual fund scheme that aims to generate capital appreciation over long periods would invest in equity shares. This would reflect in the scheme’s asset allocation, which would be disclosed in the Scheme Information Document (SID). However, even within the same asset category, the fund manager may adopt different styles, e.g., growth style or value style; or different levels of portfolio concentration e.g., focused fund or diversified fund. The scheme’s investment policy would disclose two aspects–asset allocation and investment style. 2.1.4 Important Concepts in Mutual Funds Units The investment that an investor makes in a scheme is translated into a certain number of ‘Units’ in the scheme. Thus, an investor in a scheme is issued units of the scheme. Face Value Typically, every unit has a face value of Rs. 10. The face value is relevant from an accounting perspective. Unit Capital The number of units issued by a scheme multiplied by its face value (Rs. 10) is the capital of the scheme–its Unit Capital. Recurring Expenses The fees or commissions paid to various mutual fund constituents come out of the expenses charged to the mutual fund scheme. These are known as recurring expenses. These expenses are charged as a percentage to the scheme’s assets under management (AUM). The scheme expenses are deducted while calculating the NAV. This means that higher the expenses, lower the NAV, and hence lower the investor returns. Given this, SEBI has imposed strict limits on how many expenses could be charged to the scheme. For running the scheme of mutual funds, operating expenses are also incurred. Net Asset Value The true worth of a unit of the mutual fund scheme is otherwise called Net Asset Value (NAV) of the scheme. When the investment activity is profitable, the true worth of a unit increases. When there are losses, the true worth of a unit decreases. The NAV is also the net realizable 39 value per unit in case the scheme is to be liquidated–how much money could be generated if all the holdings of the scheme are sold and converted into cash. Assets Under Management The sum of all investments made by investors in the mutual fund scheme is the entire mutual fund scheme’s size, which is also known as the scheme’s Assets Under Management (AUM). This can also be obtained by multiplying the current NAV with the total units outstanding. The relative size of mutual fund companies/asset management companies is assessed by their assets under management (AUM). When a scheme is first launched, assets under management is the amount mobilized from investors. Thereafter, if the scheme performs well and is marketed well, its AUM goes up and vice versa. Further, if the scheme is open to receiving money from investors even post-NFO, then such contributions from investors boost the AUM. Conversely, if the scheme pays any money to the investors, either as a dividend or as consideration for buying back the units of investors, the AUM falls. Dividend option of schemes is now called Income Distribution Cum Capital Withdrawal (IDCW) option. Mark to Market The process of valuing each security in the investment portfolio of the scheme at its current market value is called Mark to Market (MTM). The mark-to-market valuation is done on a daily basis for the calculation of daily NAV of a mutual fund scheme. This results in daily fluctuations in the NAVs of all schemes