Part-12

Mutual Funds
&
Pension Funds

1
Definition
 What is a mutual fund?
 It is a collection of assets like:
 Stocks
 Bonds
 Precious metals
 Real estate

2
Definition (Cont…)
 Who purchases these assets?
 A pool of investors
 Who manages these assets?
 A professional investment company

3
The Mechanics
 When an investor makes an investment
in a mutual fund, his money is pooled
with that of other investors who have
chosen to invest in the fund.
 Every investor will receive shares of the
fund, in proportion to the amount of
funds invested by him or her.

4
The Mechanics (Cont…)
 If the fund is just commencing
operations, the pooled resources
will be used to acquire a portfolio
of assets.
 Else if the fund is already in
operation the newly received funds
will be used to expand its portfolio.

5
Shares of a Fund
 Every share held by a mutual fund
investor represents a proportional
interest in the portfolio of
securities managed by the fund.
 When a fund is just commencing
operations, the issue of shares by
it is known as an Initial Public
Offering (IPO).
6
Shares of a Fund (Cont…)
 During an IPO, the shares will be
issued at par.
 Subsequent share issues will be
made at a price that is based on
the Net Asset Value (NAV) of the
fund.

7
Definition of NAV
 The NAV of a fund at any point in
time is:
 The total value of all the securities in
its portfolio, less any outstanding
liabilities
 Divided by the total number of shares
issued by the fund.

8
NAV (Cont…)
 The NAV will fluctuate from day to
day:
 Due to changes in the value of the
assets constituting the portfolio
 Due to income from the assets held
by the fund
 Due to expenses incurred by the fund

9
NAV (Cont…)
 On a given day, the NAV may be higher or
lower than what the shareholder paid to
acquire the shares of the fund.
 Thus just like shareholders of a company,
holders of mutual fund shares participate:
 In all profits and losses made by the fund, as
well as in its income and expenditure.

10
The U.S. Mutual Fund
Industry
 The industry is really big:
 In the 1990s money was pouring into
mutual funds at the rate of $1 billion
per day.
 By the end of the 1990s:
 There were 10,350 different funds in the
U.S
 Holding about $3.7 trillion in assets

11
Why Invest in a Mutual
Fund?
 Why should an investor invest in a
mutual fund, rather than invest
directly in securities?
 A mutual fund by definition has a
large corpus at its disposal.
 So the size of its typical
investment tends to be large.

12
Why Invest ?(Cont…)
 Consequently, its transactions costs
tend to be low.
 These benefits obviously get passed on
to the shareholders of the fund.
 This is particularly attractive from the
standpoint of an investor seeking to
acquire a diversified portfolio of assets.

13
Why Invest? (Cont…)
 The cost of building a diversified
portfolio using the limited funds at
one’s disposal can be prohibitive.
 However by investing in a mutual
fund one effectively ensures
diversification and that too at a
lower cost.

14
Why Invest? (Cont…)
 Mutual funds can afford to employ well
qualified and experienced professionals.
 These analysts can evaluate the merits of an
investment before committing funds.
 Individual investors lack such expertise.
 And nor can they afford to employ advisors
with such skills.

15
Why Invest? (Cont…)
 Mutual fund investments are often
more liquid than investments in
the underlying assets.
 Consequently shareholders can
dispose off their shares easily,
quickly, and at a fair price.

16
Any Disadvantages?
 Investing in a mutual fund is not all
about advantages, however.
 There are drawbacks.
 Firstly, the investor has no control
over the cost of investing.
 It is entirely in the hands of the
fund manager.

17
Disadvantages (Cont…)
 Moreover, as long as one is invested in
the fund, he has to pay the required
investment management fees.
 This is true even if the value of the
assets of the fund is showing a declining
trend.
 Second, mutual funds incur sales and
marketing expenditure , which get
passed on to the investor.

18
Disadvantages (Cont…)
 An individual investor will not
obviously incur such costs.
 Thirdly the choice of securities is
delegated to the fund manager.
 Thus the investor forsakes the option
to design his own kind of portfolio.
 This may not be satisfactory for a
High Net Worth (HNW) investor.

19
Disadvantages (Cont…)
 In practice fund managers attempt
to cater to different types of
investors, by offering funds with
different investment objectives.
 But the availability of such choice may
itself pose problems
 Because an investor may once again need
expert advice on which fund to choose.

20
Open-End versus Closed-
End Funds
 In the case of an open-end fund,
the investor can buy or sell shares
of the fund from/to the fund at any
point in time.
 The purchase/sale price of the
share at which an investor can
transact is called the Net Asset
Value (NAV).
21
NAV
 The NAV of a fund is defined as the
market value of all the assets of the
fund plus any accrued income, less the
liabilities of the fund, divided by the
total number of shares outstanding.
 The NAV of an open-end fund is
determined once a day at the close of
trading.

22
NAV (Cont…)
 All new investments into the fund
and withdrawals from the fund
during the course of a day, are
priced at the NAV that is computed
at the end of that day.
 As the prices of the assets of the
fund fluctuate, so will the NAV and
the total value of a fund.
23
Open-End Funds
 The number of shares outstanding
at any point in time may either go
up subsequently or go down.
 It would depend on whether
additional shares are issued or
existing shares repurchased.
 Thus the `unit capital’ of an open-
end fund is not fixed but variable.

24
Open-End Funds (Cont…)
 The investable corpus of the fund
will go up if the number of new
subscriptions by new/existing
investors exceeds the number of
redemptions by existing investors.
 The investable surplus will stand
reduced if redemptions exceed the
fresh subscriptions.
25
Open-End Funds (Cont…)
 Such funds always stand ready to
issue fresh shares.
 Many successful funds stop fresh
subscriptions after reaching a
target size.
 This could happen if they feel that
further growth will adversely
impact profitability.

26
Open-End Funds (Cont…)
 However they rarely deny
investors the freedom to redeem
shares.
 Every open-end fund will maintain
a Cash Reserve which is usually
about 5% of the total assets.
 This is done to cover redemption
requests from shareholders.
27
Open-End Funds (Cont…)
 However should additional funds
be required, the fund manager will
have no choice but to liquidate
some of the assets of the fund.

28
Closed-End Funds
 These funds make a onetime sale of
a fixed number of shares.
 Their `unit capital’ therefore remains
fixed.
 They do not allow investors to
buy/redeem units from/with them.
 But to provide liquidity to investors
they get listed on stock exchanges.
29
Closed-End Funds (Cont…)
 In the case of a listed closed-end fund,
investors can buy and sell shares through a
broker.
 The share price need not be equal to the
NAV.
 Depending on investors’ perceptions about
future performance and supply-demand
factors, the shares may trade at a premium
to or at a discount from the NAV.

30
Closed-End Funds (Cont…)
 Shares that trade below the NAV are
said to: `trade at a discount’
 Shares that trade above the NAV are
said to:
`trade at a premium’
 Shares of unlisted closed-end funds
can be traded over-the-counter.

31
Life-Boat Provisions
 The fund charters of closed-end funds
usually contain life-boat provisions.
 These require such funds to take action in
cases where the shares are trading at a
substantial discount to the NAV.
 The funds in such cases can either buy back
the shares via a tender offer, or else they
can convert it to an open-ended fund.

32
Life-Boat (Cont…)
 If the fund managers fail to
respond in an appropriate fashion,
dissident shareholders can buy
large blocks of shares and initiate
a proxy fight to either have the
fund liquidated or to make it open-
ended.

33
Regulation
 Under the U.S. Investment Company Act
of 1940, a closed-end fund is capitalized
only once.
 That is, once it makes an issue of shares
via an Initial Public Offering it cannot
issue further shares subsequently.
 Consequently many closed-end funds
choose to borrow when they wish to
increase the size of their investments.
34
Closed-End Funds (Cont…)
 Unlike open-end funds, these funds
are not listed in the mutual fund
tables printed in the financial
papers.
 Rather they are listed alphabetically
with stocks in the table of share
prices.

35
Unit Trusts
 Unit Trusts a.k.a Unit Investment
Trusts are similar to closed-end
funds in the sense that they are
capitalized only once.
 Consequently their `unit capital’
remains fixed.
 Most Unit Trusts invest in bonds.

36
Unit Trusts (Cont…)
 Unit Trusts differ from mutual funds in
one crucial respect.
 Once a portfolio of bonds is assembled
by a Unit Trust, it is held until the bonds
are redeemed by the issuer.
 Thus there is no trading in the assets
which comprise the portfolio.

37
Unit Trusts (Cont…)
 Usually the only time the trustee of
a Unit Trust can sell a bond held by
it, is if there has been a significant
decline in the credit quality.
 Because of the lack of active
trading the cost of operating a Unit
Trust is lower than the cost of
running a closed-end fund.
38
Unit Trusts (Cont…)
 Second, most unit trusts have a fixed
termination date.
 And finally, unlike investors of a mutual
fund who are constantly exposed to a
changing portfolio composition, unit
trust investors know the exact
composition of their portfolio from the
outset.
 Unit trusts are more common in Europe.

39
Calculating the NAV
 The net assets of a fund is defined as:
Net Assets = Market Value of all Investments
+ Receivables
+ Other Accrued Income
+ Other Assets
- Accrued Expenses
- Other Payables
- Other Liabilities

40
Calculating the NAV
(Cont…)
 The NAV is defined as:
NAV = Net Assets ÷ No. of Units
Outstanding

41
Factors Affecting the NAV
 The NAV is affected by four sets of
factors:
 Purchase and sale of investment
securities
 Valuation of the investment securities
 Other assets and liabilities
 Units sold or redeemed

42
Other Assets & Liabilities
 The term `other assets’ includes
any income due to the fund but not
received as on the valuation date,
like:
 Dividends announce by a company
whose shares are being held by the
firm but which have not yet been
received.

43
Other Assets & Liabilities
(Cont…)
 `Other liabilities’ include expenses
payable by the fund such as:
 Custodian fees
 Management fees payable to the Asset
Management Company
 All items of income and expenditure
have to be accrued and included while
computing the NAV.

44
Other Assets & Liabilities
(Cont…)
 In India SEBI requires that all income and
expenditure should be accrued up to the
valuation date and considered for NAV
computations.
 Major expenses like management fees
should be accrued on a day to day basis.
 Other expenses need not be accrued daily if
non-accrual will not affect the NAV by more
than 1%.

45
Expenses of a Fund
 The Asset Management Company will
have many funds under its
management.
 Some expenses would be specific to a
given scheme.
 Others may be common to all schemes.
 All expenses should be clearly
identified and allocated.

46
Expenses
 Expenses may be broadly
categorized as:
 Investment management and
advisory fees.
 Initial expenses of launching a
scheme
 Recurring expenses

47
Recurring Expenses
 This expenditure category includes:
 Marketing and selling expenses
 Brokerage and transactions costs
 Registrar services for transfer of units sold
or redeemed
 Fees and expenses of trustees
 Audit fees
 Custodian fees

48
Recurring Expenses
(Cont…)
 Costs related to investor communication
 Costs of fund transfers
 Costs of providing account statements and
dividend/redemption checks and warrants
 Insurance premiums
 Winding up costs if a fund or a scheme is
being terminated
 Statutory advertisements

49
Illustration of an NAV
Calculation
 A mutual fund in the U.S. has
acquired the following shares:
 IBM – 1,000
 Exxon – 2,000
 GM – 2,000
 It has issued 20,000 units to its
shareholders

50
Illustration (Cont…)
COMPANY # of PRICE VALUE
Shares
IBM 1,000 35 35,000

Exxon 2,000 80 160,000

GM 2,000 60 120,000

TOTAL 5,000 315,000

51
Illustration (Cont…)
 First day’s NAV:
315,000
_______ = 15.75
20,000

52
Illustration (Cont…)
The Next Day
COMPANY # Of PRICE VALUE
Shares
IBM 1,000 40 40,000

Exxon 2,000 90 180,000

GM 2,000 75 150,000

TOTAL 5,000 370,000

53
Illustration (Cont…)
 The next day’s NAV:
370,000
_______ = 18.50
20,000

54
Illustration (Cont…)
 So, the NAV will change when the
values of the securities bought by the
fund change.
 But the NAV may also change if the
fund issues additional shares.
 If the incoming funds are used to acquire
shares in the existing proportions, then
the NAV will not change.
 Else it will.

55
Illustration (Cont…)
Case-A
 Assume that the fund issues 2,000
additional shares at the end of the first day.
 At an NAV of 15.75 this will mean an inflow
of 31,500.
 Assume that 100 shares of IBM, 200 shares
of Exxon, and 200 shares of GM are bought.
 That is, the existing ratio of [Link] is maintained.

56
Illustration (Cont…)
COMPANY # of PRICE VALUE
Shares
IBM 1,100 40 44,000

Exxon 2,200 90 198,000

GM 2,200 75 165,000

TOTAL 5,500 407,000

57
Illustration (Cont…)
 The next day’s NAV:
407,000
_______ = 18.50
22,000

58
Illustration (Cont…)
Case-B
 The fund decides to acquire 300
shares of IBM, 150 shares of Exxon,
and 150 shares of GM.

59
Illustration (Cont…)
COMPANY # Of PRICE VALUE
Shares
IBM 1,300 40 52,000

Exxon 2,150 90 193,500

GM 2,150 75 161,250

TOTAL 5,600 406,750

60
Illustration (Cont…)
 The new NAV:
406,500
_______ = 18.4886
22,000

61
Expenses (Cont…)
 When a scheme is first launched, the
AMC will incur significant
expenditure, whose benefit will
accrue over many years.
 The entire expenditure cannot therefore
be charged in the first year itself.
 SEBI permits such expenses to be
amortized over a period of five years.

62
Expenses (Cont…)
 However issue expenses incurred during
the life of a scheme have to be charged
in the year of incurrence itself.
 The unamortized portion of the initial
issue expenses shall be included in the
NAV calculation and will be classified
under `Other Assets’.
 Investment advisory fees cannot be claimed
on such assets.

63
SEBI’s Accounting Policies
for Mutual Funds
 Dividends received by a fund from a
share should be recognized the day the
share goes ex-dividend and not on the
declaration date.
 While determining capital gains/losses
on the sale of securities, the average
cost method must be used to determine
the cost of purchase.

64
Example
 A mutual fund acquires 100 shares of
WIPRO for Rs 600 each on August 1.
 It buys another 200 shares at Rs 750
each on September 1.
 On 15 September it sells 100 shares
for Rs 800 each.
 What is the capital gain or loss?

65
Calculation of
Gains/Losses
 The average cost per share will be
determined as follows:
600 x 100 + 750 x 200
______________________ = Rs 700
300
 Total cost of shares sold = 100 x 700

= Rs 70,000

66
Calculation (Cont…)
 Sale proceeds = 100 x 800 = Rs
80,000
 Capital gains = Rs 10,000

67
Accounting Policies
(Cont…)
 Purchase/sale of investments
should be recognized on the trade
date and not on the settlement
date.
 Bonus/rights issues should be
recognized only when the shares
are traded on the exchange on a
ex-bonus/ex-rights basis.
68
Accounting Policies
(Cont…)
 Income receivable on investments,
which is accrued, but not received
for 12 months beyond the due
date, should be provided for, and
no further accrual should be made
for it.

69
Accounting for Major
Transactions
 Here is a detailed illustration on
how sales and redemptions of
shares of a mutual fund are
accounted for in its books of
accounts as per SEBI guidelines.

70
Illustration
 Day-1:
 An open-end fund issues 1,000 shares at a
face value of Rs 10 each.
 Thus unit capital will appear on the liabilities
side with a value of Rs 10,000.
 This amount will be invested in various
securities.
 Thus investments will appear as an asset
with a value of Rs 10,000.
 The NAV will obviously be Rs 10.

71
Illustration (Cont…)
 Day-2:
 The market value of the investments
rises to Rs 11,000.
 Thus there will be an unrealized capital
gain of Rs 1,000.

Unrealized capital gains have to be
recognized as income in the books of
account, but cannot be distributed to the
shareholders.

72
Illustration (Cont…)
 As far as the books are concerned,
Investments will be debited by Rs
1,000.
 Thus its value will go to Rs 11,000.
 The unit premium reserve will be credited
with Rs 1,000.
 The NAV will obviously be Rs 11.

73
Illustration (Cont…)
 Day-3:
 The market value of the investments
rises to Rs 12,000.
 10% of the original portfolio is sold.
 Thus shares worth bought for 1,000 are
sold for 1,200.
 Thus investments will be debited with
1,000 and credited with 1,200.
 The balance in the account will be 10,800.

74
Illustration (Cont…)
 The realized gain on the sale of
investments will be Rs 200.
 The unrealized capital gain will be Rs
1,800
 Since the shares are sold for 1,200,
cash or bank will be debited with Rs
1,200.
 The NAV will be 12 as can be
demonstrated.
75
Illustration (Cont…)
 Net Assets = Market Value of Investments
on Hand +
Cash Received from sale of Investments
= Rs 12,000
 Number of units outstanding = 1,000
 NAV = 12

76
Illustration (Cont…)
 The NAV consists of:
 Face value of Rs 10
 Realized gain of 0.20
 Unrealized gain of Rs 1.80

77
Illustration (Cont…)
 Day-4:
 There is no change in the market
value of the investments.
 The fund sells 100 units.
 It repurchases 75 units.
 Both transactions take place at the NAV
of 12.

78
Equalization Account
 An open-end fund will sell and redeem
shares at NAV.
 While creating/redeeming shares it is
important to ensure that the percentage
of income that is eligible for distribution
does not change.
 For this purpose SEBI requires the
creation of an Equalization Account.

79
Equalization Account
(Cont…)
 The first step is the computation of the
Distributable Reserves:
 Distributable Reserves = Income
+ Realized
Gains on
Investments
- Expenses
- Unrealized
Losses

80
Equalization Account
(Cont…)
 Note:
 Unrealized losses are recognized
 Unrealized gains are not recognized
 If the distributable reserves are
positive than the following ratio is
computed:
 Distributable Reserves ÷ No. of Units
Outstanding
81
Equalization Account
(Cont…)
 This ratio has to be multiplied by
the number of shares sold.
 If the shares are sold above par, then
the equalization account is credited
by this amount.
 If the shares are sold at below par,
then the equalization account is
debited by this amount.

82
Equalization Account
(Cont…)
 In the case of redemptions, the number
of units has to be multiplied by the
number of units redeemed.
 If the units are repurchased at above par, the
equalization account has to be debited.
 If the units are repurchased at below par the
equalization account has to be credited.

83
Equalization Account
(Cont…)
 The net balance in the equalization
account is transferred to the Profit &
Loss Account.

84
Illustration (Cont…)
 In our case, the distributable
reserves = realized capital gains =
Rs 200
 The ratio = 200 ÷ 1000 = 0.20
 When 100 units are sold at Rs 12,
the equalization account will be
credited with 0.20 x 100 = Rs 20.

85
Illustration (Cont…)
 Because of this transaction:
 Units outstanding will increase to 1,100
 The sale proceeds will be Rs 1,200
 The unit capital account will be credited
with Rs 1,000.
 The unit premium reserve will be
credited with Rs 180 which is the
unrealized capital gain.

86
Illustration (Cont…)
 When 75 units are redeemed at Rs 12:
 The equalization account is debited by Rs
15.
 The units outstanding will decrease to 1025
 The outflow of cash will be Rs 900.
 The unit capital will be debited by Rs 750.
 The unit premium reserve will be debited by
Rs 135.

87
Illustration (Cont…)
 The net amount of Rs 5 in the
equalization account will be
transferred to the Profit & Loss
account.
 This can be distributed to the
shareholders.
 The balance in the unit premium reserve
cannot however be distributed.

88
SEBI Guidelines on
Valuation
 Mutual funds have to report their
NAV on a daily basis.
 Thus their portfolios must be
marked to market on a daily basis.
 SEBI has prescribed certain
regulations for the valuation of
assets.

89
Valuation (Cont…)
 When a security is traded on a stock
exchange, it should be valued at the
last quoted price on the exchange
where it is principally traded.
 If the security is not traded on any
exchange on a given day, the value at
which it was traded on the earliest
previous day may be used
 Provided that this date is not more than 60
days prior to the valuation date.

90
Valuation (Cont…)
 If a security is not traded on any
stock exchange for 60 days prior to
the valuation date, it must be
treated as a non-traded scrip.

91
Valuation of Non-Traded
Scrips
 Equity shares are to be valued on the
basis of capitalization of earnings.
 The capitalization will be determined
with reference to the Price/Earnings
ratios of comparable traded securities
with an appropriate discount for lower
liquidity.

92
Example
 Assume that the fund is holding shares
of a company which is not publicly trade
but has an EPS of Rs 2.
 A similar company whose shares are
actively traded has a P/E ratio of 12.
 Using this ratio, the value of the non-
traded scrip should be Rs 24.

93
Example (Cont…)
 However since the non-traded
scrip is less liquid, we may use a
lower P/E ratio, say 10.
 If so, we would value our share at
20.

94
Non-traded Scrips (Cont…)
 For debt instruments we would
price it using the YTM of a
comparable traded debt security.
 To account for the lower liquidity we
would use a higher YTM.

95
Costs
 The costs incurred by an investor in a mutual fund
can be classified under two heads.
The first is called a sales charge or a shareholder
fee.
 This is a one time charge that is debited at the time
of a transaction – either at the time of purchase, or a
sale, or an exchange of shares of one scheme for
that of another.
 The amount would depend on the method used by
the fund for distributing its shares.

96
Costs (Cont…)
 The second category of costs is the annual
operating expense incurred by the fund,
called the expense ratio.
 The largest component of the expense ratio
is the management fee.
 This cost is independent of the method
adopted for distributing the shares.

97
Sales Charges
 Traditionally, two methods have
been adopted for distributing
shares of a mutual fund.
 They have been sold using a sales
force or a wholesale distributor, or
 They have been sold directly.

98
Sales Charges (Cont…)
 The first method requires an intermediary
like a an agent, a stockbroker, an insurance
agent, or other similar entity who is capable
of providing investment advice to the client,
and can also service the investment
subsequently.
 This is an active approach.
 In such cases, it is said that `the fund is sold
not bought’.

99
Sales Charges (Cont…)
 In the second case there is no
intermediary or salesman.
 No advice is provided at the time of
sale.
 The potential client is expected to
dial a toll-free number in response
to an advertisement or other source
of information.
100
Sales Charges (Cont…)
 This is a passive approach.
 It is said that `the fund is bought and not
sold’.
 The agent based system comes with an
attached cost – a sales charge which has
to be borne by the client.
 The charge is a compensation for the
services rendered by the agent.

101
Loads
 The sales charges levied by such
funds are referred to as loads.
 The traditional practice has been to
deduct the load upfront from the
investor’s initial contribution at the
time of entry, and pass it on to the
agent/distributor.
 The balance represents the
investable amount for the client.
102
Front-End Loads
 This method of charging is called
front-end loading.
 The corresponding loads are called
front-end or entry loads.
 Since the total amount paid by the
investor in such cases exceeds the
NAV, such funds are said to be:
`purchased above the NAV’.
103
No-Load Funds
 In the case of directly placed funds, there
is no need for a sales charge because an
intermediary is not present.
 Such fund are known as no-load funds.
 In these cases, the entire amount paid by
the investor is investable.
 Such fund are said to be: `purchased at
NAV’.

104
Load or No-Load?
 It was thought at one time that load funds
would become obsolete and that no-load
funds would come to dominate the market.
 After all why would any rational investor pay
a sales charge, if it is avoidable.
 It was felt that, individual investors, given
their increasing levels of sophistication,
would prefer to make their own decisions.

105
Load or No-Load ? (Cont…)
 However the trend has been to the
contrary.
 Load funds continue to be popular.
 There are two reasons for this.
 Firstly many investors continue to be
dependent on the counsel, service,
and the initiative of investment
agents.
106
Load or No-Load? (Cont…)
 Besides load funds have shown a lot of
ingenuity and flexibility in devising new
methods for imposing the load.
 The objective has been to compensate the
agent without appearing to be a burden on
the investors.
 These innovations have been in the form of
`back-end’ and `level’ loads.

107
Back-End Loads
 These are imposed at the time of
redemption of shares.
 Consequently they are known as
exit loads.
 The advantage is that the investor
pays the NAV at the time of entry,
and the entire amount is investable.

108
Level Loads
 In this case, a uniform sales charge is
imposed every year.
 Hence the reported NAVs will be lower
than what they would have been in the
absence of a sales charge.
 However, once again, the entire amount
paid at the outset will be investable.

109
Level Loads (Cont…)
 Level loads appeal to investors
who are more comfortable with the
concept of an annual fee rather
than commissions.
 Such investors are known as fee
based planners.

110
Contingent Deferred Sales
Charge
 This is the most common form of exit
load.
 This approach imposes a load on
withdrawal, which is a function of the
number of years that the investor has
spent with the fund.
 The longer an investor stays with a fund,
the lower will be the load on
redemption.
111
Illustration
 Consider a 3,3,2,2,1,1,0 contingent deferred
sales charge.
 It means that the load is 3% if the shares are
redeemed within two years, 2% if they are
redeemed after 2 years but within 4 years,
and 1% if the redemption takes place after 4
years but within 6 years.
 There is no load if the redemption takes
place after 6 years.

112
Multiple Share Classes
 Many mutual fund families offer their funds with a
choice of loading mechanisms.
 The client can pick the method of his choice.
 Shares subject to front-end loading are called class
`A shares’.
 Those subject to back-end loading are called class
`B shares’.
 This with a level load are called class `C shares’.

113
Loads (Cont…)
 According to the National
Association of Securities Dealers
(NASD), the maximum allowable
sales charge is 8.5%.
 Most funds impose lower charges in
practice.
 The sales charge is often lower for
investments beyond a specified
level.
114
Loads (Cont…)
 In the case of front-end load funds and
back-end load funds, the declared NAV
will not include the load.
 In the case of funds with a front-end
load, the investor must add the load
amount per share to the NAV in order
to calculate the purchase price.

115
Loads (Cont…)
 In the case of funds with back-end
loads, the investor has to deduct
the load amount per share from
the NAV in order to get the net
sale proceeds.
 We will illustrate these cases using
a numerical example.

116
Illustration
 A fund has declared a NAV of 19.30.
The front-end load is 2.5%.
 So the price payable by the investor is
19.30
-------- = 19.7949.
.975
 This can be understood better as follows.

117
Illustration (Cont…)
 In the absence of a load, an investment of
$1000 would fetch the investor
 1000
 ------- = 51.81 units.
 19.30
 However because of the load it will fetch
only: 1000 x .975/19.30 = 50.5181 units.

118
Illustration (Cont…)
 Now assume that the fund charges an
exit load of 2.5% instead of an entry load.
 Instead of receiving 19.30 per unit, the
investor will receive only
 19.30 x .975 = 18.82 per unit.
 Thus a sale of 100 units which would
have fetched $1930 in the absence of a
load, will now fetch only $ 1882.

119
Loads (Cont…)
 Loads can be imposed by both open-ended as
well as closed-ended funds.
 Loads represent issue expenses which are
just one of the many expenses incurred by a
mutual fund.
 Other expenses like the fund manager’s fees
have to be charged on an ongoing basis.
 The impact of such charges will be a
reduction in the reported NAV.

120
Expense Ratio
 The operating expense is debited
annually from the investor’s balance
by the sponsor of the fund.
 There are three main categories of
such expenses:
 Management Fee
 Distribution Fee
 Other Expenses

121
Management Fee
 It is also known as the Investment
Advisory Fee.
 It is the fee charged by the investment
advisor for managing the fund’s portfolio.
 The fees charged would depend on the
nature of the fund.
 The greater the required levels of efforts
and skills, the higher will be the fees.

122
12b-1 Fee
 In 1980 the SEC approved the imposition
of a fixed annual fee called the 12b-1
fee.
 It is intended to cover distribution costs
including continuing agent
compensation, and the fund’s marketing
and advertising expenses.
 By law it cannot exceed 1% of the fund’s
assets in a given year.

123
12b-1 Fee (Cont…)
 The 12b-1 fee may include a fee of up to
0.25% of the assets to compensate sales
professionals for providing services or for
maintaining shareholders accounts.
 This is intended to provide the sales agent with an
incentive to continue to service the account, even
after having received a transaction based fee such
as a load.

124
12b-1 Fee (Cont…)
 This component of the fee is applicable
only for sales-force-sold load funds and
not for directly sold no-load funds.
 The balance of the 12b-1 fee accrues to
the sponsor and is intended to provide
an incentive to continue advertising
and marketing efforts.

125
Other Expenses
 These are incurred on account of the
following.
 Custody related costs have to be paid in
connection with the holding of cash and
securities.
 Transfer agents have to be paid when
securities are transferred from existing to
new shareholders; and when income from
investments is distributed to existing
shareholders.
126
Other Expenses (Cont…)
 Fees have to be paid to public
accountants who have been entrusted
with the task of scrutinizing the books of
account of the fund.
 Directors fees have to be paid.
 The sum total of all this expenditure is
called the Expense Ratio.

127
 Illustration
Expense FUND
Type
Fidelity Vanguard American
Magellan S&P500 Index Income Fund
of America-A
Management 0.57% 0.16% 0.28%
Fee
Distribution 0 0 0.24%
(12b-1) fee
Other 0.18% 0.02% 0.07%
Expenses
TOTAL 0.75% 0.18% 0.59%

128
Analysis
 The first two funds are directly sold.
 Hence the 12b-1 distribution fee is zero.
 The American Income Fund is sold via a sales
force and hence there is a 12b-1 fee.
 A fund which tracks an established market index
is relatively easy to manage as compared to a
fund which requires active portfolio rebalancing.

129
Analysis (Cont…)
 So the Vanguard S&P500 Index
fund has the lowest management
fee.
 The Fidelity Magellan Fund is an
actively managed pure stock fund
and has the highest management
fee.

130
Switching Fees
 For many years there was no charge
for switching from one mutual fund to
another within the same family.
 But of late some funds have started
charging a flat fee.
 They argue that such charges are being
levied to discourage frequent switching.

131
Switching Fees (Cont…)
 They may have a point because
frequent switching increases the
administrative costs involved in
keeping track of customer accounts.
 Switching charges are recovered
directly from the shareholder and do
not impact the NAV.

132
Categorization of Funds
 One way to categorize funds is on the
basis of the investments made by them.
 Consequently we have:
 Equity Funds
 Bond Funds
 Money Market Funds
 Precious Metal Funds
 Real Estate Funds
133
Categorization (Cont…)
 Another way to categorize is on the
basis of investment objectives.
 Growth Funds; These funds target
capital appreciation in the medium to
long term.
 Income Funds: They focus on earning
regular income, and are less concerned
with capital appreciation.

134
Categorization (Cont…)
 Value Funds invest in undervalued
securities in the hope of a
subsequent rise in price.
 Funds can also be categorized on
the basis of their risk profiles.
 Equity Funds have a greater risk of
capital loss than Debt Funds.

135
Categorization (Cont…)
 Money Market Funds have an even lower risk of
capital loss as compared to Debt Funds.
 Fund Managers can design funds with specific
risk-return characteristics in order to cater to
different types of investors.
 For instance Equity Income Funds invest in
securities which may not show much capital
appreciation, but which pay steady dividends.

136
Categorization (Cont…)
 Balanced Funds seek to reduce risk
by mixing equity investments with
investments in fixed-income
securities.
 They also attempt to strike a
balance between the need for
capital appreciation and the need
for steady income.
137
Money Market Funds
 They invest in securities with one
year or less to maturity.
 Typical investments are:
 Treasury Bills
 Certificates of Deposit
 Commercial Paper
 These investments are very liquid
and carry low credit risk.
138
Money Market Funds
(Cont…)
 There are also tax-free money
market funds which invest only in
municipal securities.
 The earnings of these funds are
exempt from Federal income taxes,
and in some cases from state taxes
as well.

139
Money Market Funds
(Cont…)
 The SEC has recently issued regulations
to improve the safety, liquidity, and
diversity of all money market funds.
 They should invest a minimum of 95% in top
rated securities.
 No more than 1% may be invested in the
securities on an investor who is not top
rated.
 The maximum maturity of an investment
should not exceed 90 days.

140
Money Market Funds
(Cont…)
 These funds are ideal for investors
seeking:
 Stability of principal
 High liquidity
 Check writing facilities

141
MMMFs versus Bank CDs
 The earnings from an MMMF are as
high or higher than those from
bank CDs.
 And unlike CDs, MMMFs do not
carry any early withdrawal
penalties.

142
Gilt Funds
 Gilt securities are debt instruments
issue by the government with a
maturity in excess of one year.
 In the U.S such securities are known
as T-bonds and T-notes.
 These securities carry little default
risk.
 But they are not risk-less either.
143
Gilt Funds (Cont…)
 For they are vulnerable to interest
rate risk or market risk.
 That is, changes in the interest
rate structure in the economy can
lead to substantial volatility in
bond prices.

144
Debt Funds
 These are also known as Income Funds.
 They invest in fixed-income securities
issued by governments, private
companies, banks and financial
institutions, infrastructure companies,
and public utilities.
 They carry lower risk as compared to
equities and provide stable income.

145
Debt Funds (Cont…)
 They have higher credit risk as compared
with Gilt Funds.
 As compared with Money Market Funds,
they have greater market risk as well as
credit risk.
 Their focus is primarily on earning
income and not on capital appreciation.
 They distribute substantial income to
shareholders on a regular basis.
146
Sub-Classification of Debt
Funds
 Diversified Debt Funds: It is a fund that invests in
virtually all types of debt issues, cutting across
all sectors and industries.
 Investments in debt carries less risk as compared
to an equity investment but there is nevertheless
exposure to credit risk or the risk of default.
 The advantage of a diversified fund is that
idiosyncratic credit risk gets diversified away.

147
Sub-Classification (Cont…)
 Focused Debt Funds: They invest only in
debt securities issued by a specific sector
or industry.
 Some invest only in corporate bonds and
debentures.
 Others in only Infrastructure Bonds or
Municipal Bonds.
 Still others invest only in Mortgage
Backed Securities.
148
Sub-Classification (Cont…)
 High Yield Debt Funds: They invest
in non-investment grade bonds or
Junk bonds.
 There is a far greater degree of
risk in this case.
 But the expected returns are also
very high.

149
Equity Funds
 Such funds invest a major portion if not all of
their corpus in equity shares.
 Such shares may be acquired by subscribing
to an IPO or via the secondary market.
 Equity shares are by definition more risky
than debt.
 This is because they constitute a residual
claim rather than a contractual claim.

150
Types of Equity Funds
 Aggressive Growth Funds: They target high
capital appreciation and usually take
substantial risks in the process.
 They tend to invest in less researched and
highly speculative stocks.
 High returns are more likely but the returns
tend to be very volatile.

151
Equity Funds (Cont…)
 Growth Funds: They also target
companies with a high perceived
potential for growth.
 But they tend to invest in sunrise
industries – Information Technology,
Bio Technology, Pharmaceuticals.
 The difference as compared to an
aggressive growth funds is that the
stocks tend to be less speculative.
152
Equity Funds (Cont…)
 Specialty Funds: They have a narrow focus.
 Tend to invest only in companies which
satisfy certain pre-defined criteria.
 For instance some funds will not invest in
Tobacco or Liquor companies.
 Others tend to focus on companies from
specific regions – Latin America or the
ASEAN.

153
Equity Funds (Cont…)
 Some equity funds tend to be highly
diversified while others hold concentrated
investments in a few chosen securities.
 The latter are obviously more volatile.
 Sector Funds: They invest only in a chosen
sector or industry like – Software, Pharma, or
FMCG.
 As compared to a diversified fund, the risk
level is higher.

154
Equity Funds (Cont…)
 Offshore Funds: They invest in
equities of companies located in
foreign countries.
 International diversification offers
even grater scope for risk reduction
than domestic diversification.
 But it exposes investors to foreign
exchange risk.
155
Equity Funds (Cont…)
 This is the risk that the domestic
currency may have appreciated by
the time the returns are
repatriated to the home country.
 These funds may be well
diversified or else may choose to
remain concentrated in a few
countries.
156
Equity Funds (Cont…)
 Small Cap Funds: They invest in
companies with a low market
capitalization as compared to large Blue
Chip companies.
 The shares of these companies are less
liquid, and consequently prices tend to
be volatile.
 Some of these funds target aggressive
growth while others aim at a steady
growth.
157
Equity Funds (Cont…)
 What is the definition of a small cap fund.
 Market capitalization is defined as the price
of a share times the number of shares issued.
 The definition of small, medium, and large
cap companies is subjective.
 Fabozzi has suggested the following
classification for U.S. companies.

158
Market Capitalization
Firm Type Market
Capitalization
Small Cap < 2 billion USD

Mid Cap 2 ≤ M-Cap < 12

159
Equity Funds (Cont…)
 Option Income Funds: These funds write
options on stocks held by them.
 Conservative option funds invest in large
dividend paying companies, and then sell
options against their stock positions.
 Thus they have two sources of income –
dividends and option premiums

160
Equity Funds (Cont…)
 Diversified Equity Funds: These funds
diversify their investments across
companies.
 Extensive diversification ensures that the
level of risk is low.
 Equity Index Funds: They track the
performance of a stock market index, such
as the Dow Jones Industrial Average or the
Standard & Poor’s 500 Index.

161
Equity Funds (Cont…)
 These funds will invest only in stocks
which constitute the target index, and in
exactly the same proportions as such
stocks are present in the index.
 These funds can be thought of as
`Mimicking Funds’.
 If the index being represented is well
diversified, then the corresponding
index fund will have low risk.
162
Equity Funds (Cont…)
 Value Funds: Growth funds focus on
companies with good or improving prospects
for future profits.
 Their primary aim is capital appreciation.
 Value Funds too seek capital appreciation.
 But their focus is on fundamentally sound
firms which are perceived to be undervalued.

163
Equity Funds (Cont…)
 As compared to Growth Funds,
Value Funds are less risky.
 Many of them tend to invest in a
large number of sectors and are
therefore well diversified.
 Equity Income Funds: They invest in
companies which give high dividend
yields.
164
Equity Funds (Cont…)
 Their target is high current income,
and steady not spectacular capital
appreciation.
 Such funds invest heavily in equity
stocks.
 The prices of such firms do not
fluctuate much.
 But they provide steady dividends.
165
Hybrid Funds
 These funds have a dual debt/equity focus.
 There are various forms of hybrid funds.
 Balanced Funds: They hold portfolios consisting
of debt instruments, convertible securities,
preference shares, and equity shares.
 They hold almost equal proportions in
debt/money market assets and equities.

166
Hybrid Funds (Cont…)
 Their objective is steady income
accompanied by moderate capital
appreciation.
 They are primarily intended for
conservative and long-term investors.
 Asset-Allocation Funds: Traditionally
mutual funds have invested in a pre-
defined asset class.

167
Hybrid Funds (Cont…)
 For instance some invest in debt
while others invest in equities.
 There are funds which invest in
more than one asset class, for
instance Balanced Funds.
 But even in this case, the relative
proportions invested in equity and
debt will generally not vary much.

168
Hybrid Funds (Cont…)
 Asset Allocation Funds however
follow a variable allocation policy.
 They will move in and out of various
asset classes.
 The choice of an asset class at any
point in time would depend on the
fund manager’s current view on the
market.
169
Commodity Funds
 They invest in commodity markets.
 The investments may be made by
buying the physical commodities or
by buying the shares of commodity
firms, or by using commodity futures
contracts.
 Specialized commodity funds tend to
focus on a specific commodity or
commodity group – like edible oils.
170
Commodity Funds (Cont…)
 Diversified Commodity Funds invest
in a cross-section of commodities.
 Common examples are the following:
 Gold Funds
 Silver Funds
 Platinum Funds

171
Real-Estate Funds
 These funds either invest directly
in real estate or else fund real
estate developers.
 Some of these funds invest in
housing finance companies.
 While others invest in mortgage-
backed securities.

172
Tax Free Funds
 Such funds invest in securities, the
income from which is exempt from
income tax.
 In the U.S. municipal bonds yield
tax-free income.
 However income earned from
corporate bonds is taxable.

173
The Largest Funds in the
U.S.
NAME Objective Total Assets NAV
Fidelity Growth 92588MM 119.30
Magellan
Vanguard Growth/ 89393 121.86
Index 500 Income
Janus Fund Capital 40081 33.29
Appreciation
Fidelity Blue Growth 26721 51.53
Chip
Vanguard: Balanced 22524 28.21
Wellington
Putnam: Extra Growth 21328 23.30
Voyageur 174
The Prospectus
 What is a prospectus?
 It is a formal printed document
offering to sell a security.
 The Securities Act of 1933 requires
the delivery of a prospectus prior to,
or with, any solicitation for an order
for mutual funds.

175
The Prospectus (Cont…)
 It is required to disclose important
information about the security.
 At the minimum it must disclose:
 The fund’s financial history
 Its investment objectives
 Information about the management.

176
The Prospectus (Cont…)
 The front page will show:
 The date of publication
 The name of the fund
 The type of fund
 Major objectives
 The first page will have the Table
of Contents.

177
The Prospectus (Cont…)
 Description of the  How to redeem
fund shares
 Objectives of the fund  Shareholder services
 Management of the  Distributions and
fund taxes
 Performance history  Yield information
 Operating expenses  Schedule of
 Schedule of fees investments
 How to buy shares  Financial statements
 General information

178
The Prospectus (Cont…)
 Neither an investment company nor a
broker may legally offer a mutual fund
for sale unless a prospectus has been
provided to the investor.
 It is provided free of charge.
 It will include an application and a
postage paid return envelope to forward
the check and the completed
application.
179
The Prospectus (Cont…)
 It can be obtained from:
 The broker
 However brokers handle only load funds
 It can be obtained by writing to the
investment company
 Or by dialing the fund’s toll-free
number.

180
Taxation Issues
 In the U.S., a mutual fund must distribute at
least 90% of its net investment income earned,
exclusive of realized capital gains or losses, to
the shareholders, in order to be considered as a
Regulated Investment Company (RIC).
 Such companies are not required to pay taxes
at the fund level, prior to the distribution of
income to the shareholders.

181
Taxation (Cont…)
 At the hands of the shareholders,
however, any income that is received is
taxable.
 Capital gains made by the fund are
required to be distributed annually.
 They may be construed as short-term or
long-term in nature depending on
whether the fund has held the securities
in questions for less than a year or
more.
182
Taxation (Cont…)
 Investors have no control over the size
of distributions from the fund.
 Consequently the timing and amount of
taxes payable on their fund holdings is
out of their control.
 For instance, if a block of investors were
to sell their shares, it could trigger off a
sale of securities by the fund.

183
Taxation (Cont…)
 This could cause a capital gain to be realized and will
lead to a tax liability for investors who choose to
retain their holdings in the fund.
 A new investor may assume a tax liability even
though he may have no gains.
 This is because a shareholder as of the date of record
will receive a full year’s worth of dividends and capital
gains, even though he may have held the shares for
just a day.

184
Taxation (Cont…)
 This lack of control over capital gains taxes is one
of the major limitations of a mutual fund.
 In addition to being liable to pay taxes on gains
realized by the fund, a shareholder will have to
incur capital gains when he redeems his shares.
 The applicable tax rate would depend on whether
the gains are short-term or long-term in nature.

185
Mutual Fund Structure
 The structure of a fund may be depicted
as follows.
 At the top are the shareholders, who are
represented by a Board of Directors.
 The board governs the mutual fund
which is an entity constituted under the
Investment Company Act of 1940.

186
Fund Structure (Cont…)
 The Directors may be `inside’ or
`interested’ Directors which means that
they are affiliated with the fund, or they
could be `outside’ or `independent’
Directors.
 The portfolio of the fund is managed by
an Investment Advisor or a
Management Company.

187
Fund Structure (Cont…)
 The advisor can be an affiliate of a
brokerage firm, an insurance company,
a bank, an investment management
firm, or an independent entity.
 Many funds also engage the services of
broker-dealers to sell the shares to the
public, either directly or through other
firms.

188
Fund Structure (Cont…)
 The funds are also affiliated to
three external service providers:
 Custodian
 Transfer Agent
 Independent Public Accountant

189
Role of the External
Agents
 The role of the custodian is to hold the
assets of the fund and ensure that they
are segregated from the accounts of
others.
 Transfer agents perform the task of
processing orders at the time of
purchase and redemption and
transferring securities and cash to
concerned parties.
190
External Agents (Cont…)
 Transfer agents also distribute income paid by the
fund to the shareholders.
 The job of the public accountant is to audit the
financial statements of the firm.
 In addition every fund has internal departments to
comply with legal and procedural requirements,
and for marketing.

191
 Depiction of a Typical
Mutual Fund Structure

Shareholders

Board

Mutual Fund

Investment Advisor Distributor Accountant Custodian Transfer Agent

192
Services Offered by Mutual
Funds
 Automatic Reinvestment Plan
 Most funds offer the option of
automatically reinvesting all income
and capital gains.

It offers a systematic way of
accumulating additional shares.
 It is always a voluntary option.
 Distributions may be taken in cash, but
the benefits of compounding will be lost.

193
Services (Cont…)
 Whether taken in the form of cash or
reinvested, distributions are subject
to tax liabilities.
 However reinvested dividends and
capital gains are not subject to loads.

194
Services (Cont…)
 Contractual Accumulation Plan
 The investor can commit to
purchasing a pre-determined fixed
dollar amount on a regular basis for a
specified period.
 The choice of the amount, the
frequency, and the length of time is
made by the investor.

195
Services (Cont…)
 Voluntary Accumulation Plan
 Here the shareholder voluntarily
purchases additional units at periodic
intervals.
 Each purchase must meet the fund’s
minimum requirements.
 For regular accounts, the minimum amount
is $100.
 The investor can change the amount that he
invests each time, the frequency of
investment, and the duration of the plan.

196
Services (Cont…)
 Retirement Plans
 These include IRAs, Keogh Plans
(meant for the self-employed), 401(k)
and 403(b) plans.
 401(k) plans are set up by the employer
and the employee and are available to
most companies.
 403(b) plans are open to employees of
tax-exempt organizations such as schools
and hospitals.

197
Services (Cont…)
 IRA and Keogh plans are established by the
investors themselves and are subject to
certain government regulations.
 Both types of plans are meant for individuals.
 An IRA offers tax advantages for setting aside
money for one’s retirement.
 In order to qualify one must receive taxable
compensation and be below 70 ½ years of
age.
 Keogh plans are similar to IRAs.

198
Services (Cont…)
 Roth IRAs
 In a traditional IRA one qualifies for a tax
deduction while making a contribution.
 But taxes must be paid when the money
is taken out.
 Roth IRAs are different.
 No tax deduction can be claimed on the
money that is put in.

199
Services (Cont…)
 But the balance can be withdrawn
tax-free on retirement, provided:
 The account has been open for at least 5
years
 The investor is at least 59 ½ years old.
 Each individual can invest a maximum of
$2000 per year.

But the amount cannot exceed his annual
compensation.

200
Services (Cont…)

But if the investor is married and the spouse is
working he/she can contribute even if he/she is
not getting compensation.

The maximum contribution for a married couple
is $4,000 per annum.

201
Services (Cont…)
 Check Writing
 Many mutual funds, and all money
market funds, offer free check writing
facilities.
 This option is not available for
retirement accounts.
 There is no restriction on how many
checks can be written each month
provided the account balance does not
dip below a minimum.
202
Services (Cont…)
 Each check should be for an amount
greater than or equal to a specified
minimum.
 This is usually $500 for most funds.
 Of late many funds have reduced this to
$250.

203
Services (Cont…)
 Switching
 Most investment companies permit
switching from one fund to another
within the same family.
 Usually all that is required is a phone call.
 This is a free service.
 Investors use this service to take
advantage of cyclical swings in the
stock market.

204
Services (Cont…)
 They will keep their money in stock
funds when the market is bullish
 And switch to money market funds
when the market turns bearish.
 The question is, how does one decide
when to switch?
 There are many sources of advice.

205
Switching Advice
 Newsletters
 Donoghue’s Moneyletter
 Fabian Telephone Switch Newsletter
 InvesTech Market Letter
 Professional Timing Service
 Time Your Switch

206
Services (Cont…)
 Voluntary Withdrawal Plans
 Shareholders may redeem their
shares whenever funds are required.
 They can also establish a plan
whereby the fund will redeem a pre-
arranged dollar amount and wire it to
his bank at regular intervals.
 The usual minimum redemption is $50.

207
Investment Techniques
 Dollar Cost Averaging
 With this technique one must invest the
same amount of dollars at regular intervals.
 Your dollars will buy more when the NAV is
low and less when the NAV is high.
 Over a period, the average price will be less
than the price paid under a strategy where
one tries to guess the highs and the lows.
 The disadvantage is the strategy does not
tell when to buy, sell or switch.

208
Illustration
 An investor plans to invest $10,000
during the course of the year in
four equal quarterly installments.
 The NAVs at the beginning of each
quarter are 10, 8, 12.5, and 16
respectively.
 The plan would work as follows.

209
Illustration (Cont…)
DATE AMOUNT NAV # of
Shares
Jan 1 2,500 10 250
Apr 1 2,500 8 312.50
Jul 1 2,500 12.5 200
Oct 1 2,500 16 156.25
TOTAL 918.75
210
Value Averaging
 It is more sophisticated than dollar
cost averaging and is yet simple to
use.
 Assume that you want your
investment to increase in value by
$250 every month.
 In this strategy you will consider
your portfolio’s value at the end of
every month.
211
Value Averaging (Cont…)
 If the balance has increased by
exactly $250 do nothing.
 If the increase is less than $250
invest an amount that is adequate to
increase the account balance by
$250.
 If the increase is more than $250,
withdraw the excess balance.

212
Illustration (Cont…)
Date Amt. NAV # of Shrs. Bal. Add. Invt. Add.
Shrs.
Jan 1 10000 10 1000 10000 - -

Mar 31 8 1000 8000 - -

Apr 1 2250 8 1531.25 10250 2250 531.25

Jun 30 12.50 1531.25 19140.625 - -

Jul 1 -8640.625 12.50 840 10500 -8540.625 -691.25

Sep 30 16 840 13440 - -

Oct 1 -2690 16 671.875 10750 -2690 -168.125

213
The Combined Method
 It is a combination of dollar cost
averaging and value averaging.
 Assume that you start with $1250
in a money market fund and $1250
in a stock fund on January 1.
 So the investment for the quarter is
$2500.

214
The Combined Method
(Cont…)
 On 31 March the value of the stock fund
will be $1000.
 We would require a balance of 2,750.
 So we should deposit $750 in a money
market fund and 1750 in the stock fund.
 The investment for the quarter is $2500.

215
The Combined Method
(Cont…)
 On June 30 the balance in the stock fund will
be $4,296.875.
 We would require a balance of $4250.
 So invest $2500 in the money market fund
and transfer $46.875 from the stock fund to
the money market fund.
 The investment for the quarter is $2500.

216
The Combined Method
(Cont…)
 On September 30 the value of the
stock fund will be 5440.
 We would require a balance of
$5,750.
 So invest 310 in the stock fund and
2190 in the money market fund.
 The investment for the quarter is
$2,500.
217
Exchange Traded Funds
 Mutual Funds have two serious
shortcomings.
 Firstly, the shares are priced at, and
can therefore be transacted only at,
the NAV as calculated at the end of
the day.
 Thus transactions at intra day
prices are ruled out.
218
ETFs (Cont…)
 Secondly investors have little control
over tax liabilities.
 In particular a big redemption of
shares can trigger of capital gains
taxes for investors who choose to
remain invested.
 In response to these shortcomings,
Exchange Traded Funds (ETFs) were
introduced in the 1990s.
219
ETFs (Cont…)
 These funds are open-ended in structure but
are traded on exchanges just like
conventional stocks.
 They are similar to closed-end funds in the
sense that their quoted prices are at a small
premium/ discount to/from their NAV.
 However these deviations from NAV are
limited in practice.

220
ETFs (Cont…)
 The deviations are limited because
of the potential for arbitrage.
 Most ETFs are based on popular
stock indices and follow a passive
investment strategy.
 But funds which actively manage
portfolios have started to appear.

221
ETFs (Cont…)
 Unlike in the case of an open-end fund,
ETF shares cannot be bought from or
sold to the fund sponsor.
 However the sponsor will exchange
large blocks of shares in kind for the
securities constituting the underlying
index plus cash representing the
accumulated dividends of the fund.

222
ETFs (Cont…)
 The large block of ETF shares which is
exchangeable with the fund is called a
Creation Unit.
 One creation unit is typically set equal
to 50000 ETF shares.
 Broker-dealers will usually purchase
creation units from the fund and break
them into individual shares which will
then be offered on the exchange.
223
ETFs (Cont…)
 Dealers and institutions can also
redeem ETF shares by assembling
creation units, and exchanging
them for a basket of underlying
securities plus cash.
 If the price of an ETF share were to
diverge significantly from the NAV,
then arbitrageurs would step in.
224
Arbitrage
 Assume that the ETF shares are overpriced.
If so, arbitrageurs will short sell ETF shares and
buy creation units from the sponsor to fulfill
their delivery obligations.
 On the other hand, if the shares are under-
priced, then arbitrageurs will buy ETF shares,
assemble them into creation units, and sell
them to the sponsor.

225
Advantages of Exchange
Trading
 Exchange trading offers many
advantages to the investors.
 These facilities are not available in the
case of open-end funds.
 Traders have the flexibility to place
orders like Limit Orders and Stop Loss
Orders.
They have the freedom to engage in
Short Sales and undertake trades on the
Margin.
226
Advantages (Cont…)
 ETFs also offer an advantage to
the shareholders from the
standpoint of taxation.
 A large scale redemption of shares
need not trigger of a capital gain.
 This is because an ETF can redeem
a large block of shares by offering
the underlying securities in return.

227
Advantages (Cont…)
 This will not constitute a taxable event
for the existing shareholders.
 Thus investors in ETFs are usually
subject to capital gains taxes only when
they sell their shares in the secondary
market at prices which are higher than
what they paid at the outset.

228
Advantages (Cont…)
 In practice, however, a limited
amount of realized capital gains
does get passed on to the
investors, and is therefore taxable.
 In addition, any cash dividends
distributed by ETFs is also taxable.

229
Popular ETFs
ETF Index Inception Net Assets
Tracked in MM of
USD

S&P500 S&P500 Jan-93 21,703

231
Segregated Accounts
 Many High Net Worth individuals
dislike mutual funds because of :
 Their inability to control tax
liabilities
 Their inability to influence
investment choices
 The lack of `special’ service

232
Segregated Accounts
(Cont…)
 Money managers therefore offer
the facility of separately managed
investment accounts for such
investors.
 They are more expensive for the
investor than investing in a mutual
fund, but offer several advantages.

233
Mutual Funds in the U.K.
 In the U.K. mutual funds take on
one of three forms:
 Unit Trusts
 Open Ended Investment
Companies (OEICs)
 Investment Trusts

234
Unit Trusts & OEICs
 In the case of a unit trust the assets are
held in the form of a trust and each owner
gets a beneficial ownership in the form of
`units’.
 An OEIC is similar in principle to a unit trust
except that the funds are formed with a
corporate structure and the investors are
issued shares.

235
Unit Trusts & OEICs
(Cont…)
 Investment Trusts are similar to
closed-end funds and trade on the
London Stock Exchange.
 In the case of Unit Trusts and
OEICs the funds are managed by a
professional fund manager.

236
Unit Trusts & OEICs
(Cont…)
 There is also an independent trustee who is
entrusted with the task of holding the assets
on behalf of the investor and monitoring the
decisions and investments made by the fund
manager.
 In the case of OEICs there is a single price for the
sale and redemption of shares, and other charges
are shown separately.

237
Unit Trusts & OEICs
(Cont…)
 Unit Trusts however follow a dual
pricing system with built-in charges.

238
The German System
 Mutual Funds in Germany take on
two general forms:
 Public or Retail Funds
 Non-public Funds – Reserved for
Institutional Investors
 There are also numerous closed-
end funds.

239
Germany (Cont…)
 The institutional fund are known as
Spezialfonds.
 The retail funds fall into two broad
categories:
 Bond Funds – Rentenfonds
 Stock Funds - Aktienfonds

240
Germany (Cont…)
 The structure of mutual funds is as follows.
 A Kapitalanlagegesellschaft or Management
Company is given a contractual arrangement
to manage a pool of assets on behalf of
investors who own shares in the pool.
 A custody bank – Depotbank – which by law
has to be German – supervise the activities
of the management company.

241
Germany (Cont…)
 The management company is
usually organized as a limited
liability company:
 Gesellschaft mit besschrankter
Haftung (GmbH)

242
Pension Plans
 A pension plan is a fund that is
established for the eventual payment of
retirement benefits.
 Corporate or Private plans are
sponsored by a private business entity
acting on behalf of its employees.
 Public Plans are set up by federal, state
and local governments acting on behalf
of their employees.

243
Pension Plans (Cont…)
 Taft Hartley plans are set up by
unions on behalf of their members.
 Individual plans are established by
investors themselves.

244
Pension Plans (Cont…)
 Pension plans in the U.S. are essentially financed
by contributions by the employer.
 In some cases, the employer’s contribution is
matched to some extent by a contribution from
the employees.
 The employer’s contribution, a specified amount
of the employee’s contribution, and the earnings
of the fund, are tax-exempt provided the fund
complies with certain regulations.

245
Pension Plans (Cont…)
 Plans which are given tax
exemption are called Qualified
Pension Plans.
 In essence, a pension is a form of
employee remuneration for which
the employee is not taxed until the
funds are withdrawn.

246
Types of Plans
 There are two basic types of plans:
 Defined Benefit Plans
 Defined Contribution Plans
 There is also a hybrid variety
called a Cash Balance Plan.

247
Defined Benefit Plans
 In such cases the sponsor agrees to
make specified payments to
qualifying employees beginning at
retirement.
 In the case of death before
retirement, some payments are
made to nominated beneficiaries.
 The payments are typically made on
a monthly basis.
248
Defined Benefit Plans
(Cont…)
 The quantum of payments is
determined by a formula that usually
takes into account the length of service
of an employee and his earnings.
 The benefit formula is often based on a
fixed percentage of the ending salary
for each year of service.
 From the employer’s point of view the
pension obligation is essentially a debt
obligation.
249
Defined Benefit Plans
(Cont…)
 The employer needs to make a
prediction of the future benefits, to
determine the amount of the
contribution.
 The calculation of the current
contributions required to support the
promised future payments is made by
discounting the projected future cash
flows.
250
Defined Benefit Plans
(Cont…)
 The entire investment risk is borne
by the employer.
 That is, since the benefits are
assured, the employer faces the
risk that returns on contributions
to the plan may not be adequate
to make the promised payments.

251
Defined Benefit Plans
(Cont…)
 Actuaries are asked to provide
estimates of current pension
expenses and the liability of the
employer.
 The following factors are taken into
account.
 Of course all estimates involve
discretion.
252
Factors
 Age and sex of the employee
 Number of years of service
 Employee’s salary
 Anticipated salary increases
 Anticipated turnover rates
 Anticipated earnings rates on plan
assets
 Appropriate discount rate
253
Defined Benefit Plans
(Cont…)
 These plans provide an incentive
for the employees to stay with the
firm until retirement or at least
until the benefits get vested.
 They also provide an incentive for
performance.
 Because the defined benefit is a
function of the last salary drawn.
254
Defined Benefit Plans
(Cont…)
 The funding status of the plan depends
on the difference between the Plan
Assets and the Projected Benefit
Obligation.
 If the assets exceed the obligation the plan
is overfunded.
 Else it is underfunded.

In the case of underfunded plans employees may
lose earned benefits if the company were to go
bankrupt.

255
Defined Benefit Plans
(Cont…)
 A plan sponsor can use the
payments made into the pension
fund to purchase an annuity policy
from an insurance company.

256
Defined Benefit Plans
(Cont…)
 Defined benefit plans which are
guaranteed by life insurance
companies are called `insured
benefit plans’.
 These are not necessarily safer than
uninsured plans.
 Because they depend on the
creditworthiness of the insurance
companies.
257
Defined Benefit Plans
(Cont…)
 Benefits become vested when the
employees reach a certain age and
complete enough years of service, so
that they meet the minimum
requirements for receiving benefits
upon retirement.
 The payment of benefits is not contingent
upon a participant’s continuation with the
employer or union.
258
Defined Benefit Plans
(Cont…)
 Employees are generally
encouraged from quitting, since
until the plan is vested, they could
lose at least the accumulation
resulting from the employer’s
contribution.

259
Defined Contribution Plans
 In the case of these plans, the
sponsor is responsible only for
making specified contributions into
the plan on behalf of qualifying
employees.
 He is not responsible for making a
guaranteed payment to the
employee upon retirement.
260
Defined Contribution Plans
(Cont…)
 The amount that is contributed is typically
either a percentage of the employee’s
salary and/or a percentage of the
employer’s profits.
 The payments that are made to qualifying
participants upon retirement are a function
of how the assets of the plan have grown
over time.

261
Defined Contribution Plans
(Cont…)
 Thus the retirement benefits are
critically dependent on the investment
performance of the plan.
 The plan sponsors usually give the
participants various options as to the
investment vehicles in which the
contributions are to be invested.

262
Defined Contribution Plans
(Cont…)
 The fastest growing of such plans
are the 401(k) plans.
 Its equivalents are:
 403(b) plans in the non-profit
sector
 457 plans in the public sectors

263
Defined Contribution Plans
(Cont…)
 To the employers these plans offer
relatively lower costs of administration.
 Employees too find these plans to be
attractive because they have some
control over how their money is
invested.
 In many cases the employees are given
an option to invest in one or more of a
family of mutual funds.

264
Cash Balance Plans
 These plans combine features of both
defined benefit as well as defined
contribution plans.
 They are like defined benefit plans in the
sense that future benefits are assured.
 The benefits are based on a fixed-
amount annual employer contribution
and a guaranteed annual investment
return.

265
Cash Balance Plans
(Cont…)
 Every employee has an account
that is periodically credited with a
fixed dollar amount.
 The account is also credited with
interest which is linked to some
fixed or variable index such as the
Consumer Price Index (CPI).

266
Cash Balance Plans
(Cont…)
 Interest is credited at a rate
specified in the plan, and is not
related to the actual investment
earnings of the employer’s pension
trust.
 Any gains or losses on the
investment accrue to/are borne by
the employer.
267
Cash Balance Plans
(Cont…)
 The similarity with a defined contribution
plan is that many cash balance plans allow
the employee to take a lump sum payment
of vested benefits when terminating their
employment with a particular employer.
 This amount can then be rolled over into an
IRA or the new employer’s plan.
 Thus these plans are portable.

268
Pension Plans (Cont…)
 Qualified pension funds are
exempt from federal income taxes.
 Pension funds therefore do not
usually invest in assets which are
largely or completely tax free.
 Pension plans are regulated by the
Employee Retirement Income
Security Act of 1974 (ERISA).

269
ERISA
 ERISA established minimum funding
standards for defined benefit plans by
requiring the sponsor to make the
minimum contributions necessary to
satisfy the actuarially projected
payment benefits.
 Prior to this, many employers were
following a `pay as you go’ policy.

270
ERISA (Cont…)
 That is, at the time of an employee’s
retirement the sponsor would pay the
necessary retirement benefits out of his
current cash flows.
 ERISA put a stop to this by requiring all
programs to be `funded’.
 Regular funding is intended to ensure that
contributions plus earnings are adequate to
cover the retirement benefits.

271
ERISA (Cont…)
 ERISA also established fiduciary
standards for pension fund
trustees, managers, and advisors.
 All parties responsible for the
management of a pension fund are
expected to act `prudently’.

272
ERISA (Cont…)
 ERISA also specified minimum
vesting standards.
 For instance, by law, after five
years of employment, a plan
participant is entitled to 25% of the
accrued pension benefits.
 The percentage of entitlement
increases to 100% after 10 years.
273
ERISA (Cont…)
 ERISA also created the Pension
Benefit Guaranty Corporation
(PBGC) to insure the vested
pension benefits.
 The insurance program is funded
from the annual premiums that
must be paid by the plan sponsors.

274
Management of Pension
Plans
 A plan sponsor can choose the following
options for managing a defined benefit
plan.
 - he can employ in-house staff to manage
the assets.
 - he can entrust the task to one or more
money managers.
 - he can use a combination of methods

275
Management (Cont…)
 Defined contribution plans allow the
participants to allocate their
contributions among mutual funds.
 Managers of the assets of a pension fund
obtain their income in the form of fees.
 The annual fees range from 0.75% of the
funds under management to as low as
0.01%.
 Sometimes the fees are linked to the
fund’s performance.
276
Advisors
 In addition to fund managers, sponsors of
pension funds also engage the services of
advisors called Plan Sponsor Consultants.
 They provide the following services:
 - Develop investment policies and formulate
asset allocation plans.
 - Provide actuarial service – modeling
liabilities and forecasting.

277
Advisors (Cont…)
 - They design benchmarks to measure the
performance of money managers.
 - They help measure and monitor the
performance of money managers.
 - They help search for, and recommend
money managers.
 - They provide specialized research.

278
Major Managers of Defined
Benefit Funds
NAME AMOUNT in MM of USD
State Street Global 538,576
Barclays Global 490,400
Fidelity Investments 396,100
TIAA-CREF 285,447
Northern Trust 200,864
Deutsche Asset 192,748
Vanguard Group 176,732
PIMCO 163,613
J.P. Morgan 143,669
Prudential 132,550
279
 Major Managers of Defined
Contribution Funds
NAME TOTAL 401(k) 457 403(b) Other
ASSETS Plans Plans Plans Plans
Fidelity 357,900 276,000 12,200 40,200 29,500
Investme
nts
TIAA- 284,853 0 0 284,853 0
CREF
CitiStreet 195,950 173,431 3,066 58 19,395

Barclays 101,200 10,900 1,900 0 88,400