Mutual Funds

 

History The first mutual funds were established in Europe. One researcher credits a Dutch merchant with creating the first mutual fund in 1774. The first mutual fund outside the Netherlands was the oreign ! "olonial #o$ernment Trust% which was established in &ondon in 1'('. )t is now Trust and trades on the &ondon stoc* e+change. the oreign ! "olonial )n$estment Trust ,utual funds were introduced ,utual introduced into the -nited -nited tates tates in the 1'/0s. They became popular during the 1/0s. These early funds were generally of the closed2end type with a fi+ed number of shares which often traded at prices abo$e the $alue of the portfolio. The first open2end mutual fund with redeemable shares was established on ,arch 1% 1/4. This fund% the ,assachusetts )n$estors Trust% is now part of the , family of funds funds.. Howe$er% closed2end funds remained more popular than open2end funds throughout the 1/0s. 3y 1//% open2end funds accounted for only 5 of the industry6s 7 billion in total assets. 8fter the stoc* mar*et crash of 1//% 1// % "ongress passed "ongress passed a series of acts regulating the securities mar*ets in general and mutual funds in particular. The  The  ecurities 8ct of 1/99re:uires 1/99re:uires that all in$estments sold to the public% including mutual funds% be registered with the ecurities and E+chang E+c hangee "ommis "ommissio sion n and that that they they pro$id pro$idee prospe prospecti cti$e $e in$est in$estors ors with with a  prospectus  prospectus that  that discloses essential facts about the in$estment. The  The  ecurities and E+change 8ct of 1/94 re:uires 1/94  re:uires that issuers of securities% including mutual funds% report regularly to their in$estors; this act also created the ecurities and E+change "ommission% which is the principal regulator of mutual funds.. The  funds The <e$enue 8ct of 1/9( established 1/9( established guidelines for the ta+ation of mutual funds% while the )n$estment "ompany 8ct of 1/40  1/40  go$erns their structure. =hen confidence in the stoc* mar*et returned in the 1/0s% the mutual fund industry began to grow again. 3y 1/70% there were appro+imately 9(0 funds with 4' billion in assets. >10? The >10? The introduction of money mar*et funds in the high interest rate en$ironment of the late 1/70s fund%%  irst )nde+ )n$estment Trust%  boosted industry growth dramatically. The first retail inde+ fund wass form wa formed ed in 1/ 1/7( 7( by by  The @angu nguard ard #ro #roup up%% he head aded ed by by  Aoh Aohn n 3og 3ogle le;; it is no now w ca callled the @anguard 00 )nde+ und  und  and is one of the world6s largest mutual funds% with more than 100 billion in assets as of Aanuary 91% 011. und industry growth continued into the 1/'0s and 1//0s% as a result of three factorsB a   bull bull mar*et  for both stoc*s and bonds% new product introductions Cincluding ta+2e+empt bond% mar*et bond% sector% target et date date  funds funds and wider wider distri distribut bution ion of fund fund shares shares.. 8mong 8mong the new internation inter national al and targ distribution channels were retirement plans. ,utual funds are now the preferred in$estment option in certain types of fast2growing retirement plans% specifically in 401C*  401C* and other defined contribution plans  plans and in indi$idual retirement accounts accountsC)<8s% C)<8s% all of which surged in popularity in the 1/'0s. Total mutual fund assets fell in 00' as a result of the credit crisis of 00' 00'..

 

)n 009% the mutual fund industry was in$ol$ed in a  a  scandal scandal in$ol$ing  in$ol$ing une:ual treatment of fund shareholders. ome fund management companies allowed fa$ored in$estors to engage in late trading%% which is illegal% or mar*et timing% trading timing%  which is a practice prohibited by fund policy. The  and scandal was initially disco$ered by then2New or* tate 8ttorney #eneral  Eliot pitFer  and resulted in significantly increased regulation of the industry. 8t the end of 011% there were o$er 14%000 mutual funds in the -nited tates with combined assets of 19 trillion% according to the )n$estment "ompany )nstitute C)")% )nstitute C)")% a trade association of  in$estment companies in the -nited tates. The )") reports that worldwide mutual fund assets were 9.' trillion on the same date. ,utual funds play an important role in -.. household finances and retirement planning. 8t the end of 011% funds accounted for 95 of household financial assets. Their role in retirement  planning is particularly significant. <oughly half of assets in 401C* plans and indi$idual retirement accounts were in$ested in mutual funds.

HISTORY OF INDIAN MUTUAL FUND INDUSTRY

The mutual fund industry in )ndia started in 1/(9 with the formation of -nit Trust of )ndia% at the initiati$e of the #o$ernment of )ndia and <eser$e 3an* of )ndia. The history of mutual funds in )ndia can be broadly di$ided into four distinct phases irst Ghase 2 1/(421/'7 -nit Trust of )ndia C-T) was established in 1/(9 by an 8ct of Garliament. )t was set up by the <eser$e 3an* of )ndia and functioned under the <egulatory and administrati$e control of the <eser$e 3an* of )ndia. )n 1/7' -T) was de2lin*ed from the <3) and the )ndustrial De$elopment 3an* of )ndia C)D3) too* o$er the regulatory and administrati$e control in place of <3). The first scheme launched by -T) was -nit cheme 1/(4. 8t the end of 1/'' -T) had <s. (%700 crores of assets under management. econd Ghase 2 1/'721//9 CEntry of Gublic ector unds 1/'7 mar*ed the entry of non2-T)% public sector mutual funds set up by public sector ban*s and &ife )nsurance "orporation of )ndia C&)" and #eneral )nsurance "orporation of )ndia C#)". 3) ,utual und was the first non2-T) ,utual und established in Aune 1/'7 followed by "anban* ,utual und CDec '7% Gunab National 3an* ,utual und C8ug '/% )ndian 3an*  ,utual und CNo$ '/% 3an* of )ndia CAun /0% 3an* of 3aroda ,utual und COct /. &)" established its mutual fund in Aune 1/'/ while #)" had set up its mutual fund in December  1//0. 8t the end of 1//9% the mutual fund industry had assets under management of <s. 47%004 crores.

 

Third Ghase 2 1//92009 CEntry of Gri$ate ector  ector unds =ith the entry of pri$ate sector funds in 1//9% a new era started in the )ndian mutual fund industry% gi$ing the )ndian in$estors a wider choice of fund families. 8lso% 1//9 was the year in which the first ,utual und <egulations came into being% under which all mutual funds% e+cept -T) were to be registered and go$erned. The erstwhile Iothari Gioneer Cnow merged with ran*lin Templeton Templeton was the first pri$ate sector mutual fund registered in Auly 1//9. The 1//9 E3) C,utual und <egulations were substituted by a more comprehensi$e and re$ised ,utual und <egulations in 1//(. The industry now functions under the E3) C,utual und <egulations 1//(. The number of mutual fund houses went on increasing% with many foreign mutual funds setting up funds in )ndia and also the industry has witnessed se$eral mergers and ac:uisitions. 8s at the end of Aanuary 009% there were 99 mutual funds with total assets of <s. 1% 1%'0 crores. The -nit Trust of )ndia with <s. 44%41 crores of assets under management was way ahead of other  mutual funds. ourth Ghase 2 since ebruary 009 )n ebruary 009% following the repeal of the -nit Trust of )ndia 8ct 1/(9 -T) was bifurcated into two separate entities. One is the pecified -nderta*ing of the -nit Trust of )ndia with assets under management of <s. /%'9 crores as at the end of Aanuary 009% representing broadly% the assets of - (4 scheme% assured return and certain other schemes. The pecified -nderta*ing of  -nit -n it Trust rust of )ndi )ndia% a% func functi tioni oning ng under under an admi admini nist strat rator or and and under under the the rule ruless fram framed ed by #o$ernment of )ndia and does not come under the pur$iew of the ,utual und <egulations. The second is the -T) ,utual und% sponsored by 3)% GN3% 3O3 and &)". )t is registered with E3) and functions under the ,utual und <egulations. =ith the bifurcation of the erstwhile -T) which had in ,arch 000 more than <s. 7(%000 crores of assets under management and with the setting up of a -T) ,utual und% conforming to the E3) ,utual und <egulations% and with recent mergers ta*ing place among different pri$ate sector funds% the mutual fund industry has entered its current phase of consolidation and growth. The graph indicates the growth of assets o$er the years.

 

tructure )n the -% a mutual fund is registered with the ecurities and E+change "ommission "ommission CE".  CE". Open Op en2e 2end nd and cl clos osed ed2e 2end nd fund fundss are are o$ers o$ersee een n by a  board of directors directors  Cif Cif orga organiF niFed ed as a corporation or  board  board of trustees Cif trustees Cif organiFed as a trust. The board is charged with ensuring that the fund is managed in the best interests of the fund6s in$estors and with hiring the fund manager  and other ser$ice pro$iders to the fund.

trades Cbuys The fund manager % also *nown as the fund sponsor or fund management company% trades Cbuys and sells the fund6s in$estments in accordance with the fund6s in$estment obecti$e. 8 fund in$estment ment ad$is ad$isor  or .  unds that are managed by the same fund manager must be a registered registered in$est manager and that ha$e the same brand name are *nown as a fund family or fund comple+. ,utual funds are not ta+ed on their income and profits as long as they comply with re:uirements esta establ blis ishe hed d in th thee -. -.. . )n )nte tern rnal al <e$e <e$enue nue "ode "ode.. p pec ecif ific ical ally ly%% they they must must di$e di$ers rsif ify y thei their  r  in$estments% limit ownership of $oting securities% distribute a high percentage of their income and capital gains Cnet of capital losses to their in$estors annually% and earn most of the income  by in$esting in securities and currencies.

 

,utual funds pass ta+able income on to their in$estors by paying out di$idends and capital gains at least annually. The characteriFation of that income is unchanged as it passes through to the shareh sha reholde olders. rs. or e+ample e+ample%% mutual mutual fund fund distr distribu ibutio tions ns of di$ide di$idend nd income income are report reported ed as di$idend income by the in$estor. There is an e+ceptionB net losses incurred by a mutual fund are not distributed or passed through to fund in$estors but are retained by the fund to be able to offset future gains. ,utual funds may in$est in many *inds of  securities. securities. The types of securities that a particular  fund may in$est in$est in are set forth in the fund6s prospectus% prospectus% which describes describes the fund6s fund6s in$estment in$estment obecti$e% obect i$e% in$estment in$estment approach and permitted permitted in$estment in$estments. s. The in$estment in$estment obecti$e obecti$e describes describes the type of income that the fund see*s. or e+ample% a capital appreciation fund generally loo*s to earn most of its returns from increases in the prices of the securities it holds% rather than from di$ide di$ idend nd or int intere erest st income income.. The in$est in$estmen mentt approa approach ch descri describes bes the criter criteria ia that that the fund fund manager uses to select in$estments for the fund. fund6s portfolio manager  or   or  8 mutual fund6s in$estment portfolio in$estment portfolio  is continually monitored by the fund6s portfolio managers. Hedge funds are funds are not considered a type of Cunregistered mutual fund. =hile they are another type of collecti$e in$estment $ehicle% they are not go$erned by the )n$estment "ompany 8ct of 1/40 and are not re:uired to register with the ecurities and E+change "ommission Cthough hedge fund managers must register as in$estment ad$isers.

Advantages and disadvantages ,utual funds ,utual funds ha$e ha$e ad$anta ad$antages ges compar compared ed to direct direct in$est in$esting ing in indi$id indi$idual ual securi securiti ties. es. These These includeB 

)ncrea )nc reased sed di$ers di$ersifi ificat cation ionBB 8 fund fund normal normally ly holds holds many securi securitie ties. s. Di$ers Di$ersif ificat ication ion decreases ris*.

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Daily li:uidityB hareholders of open2end funds and unit in$estment trusts may sell their  holdings bac* to the fund at the close of e$ery trading day at a price e:ual to the closing net asset $alue of the fund6s holdings. Howe$er% there may be fees and restrictions as stated in the fund prospectus.

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Grofessional Grofes sional in$estment in$estment managementB managementB Open2end and closed2end closed2end funds hire portfolio portfolio managers to super$ise the fund6s in$estments.

 

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8bility to participate in in$estments that may be a$ailable only to larger in$estorsB or  e+ample% indi$idual in$estors often find it difficult to in$est directly in foreign mar*ets.

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er$ice and con$enienceB unds often pro$ide ser$ices such as chec* writing.

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#o$ernm #o$e rnment ent o$ersi o$ersight ghtBB ,utual ,utual funds funds are regula regulated ted by the ecuri ecuritie tiess and E+chang E+changee "ommission.

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Ease of comparisonB 8ll mutual funds are re:uired to report the same information to in$estors% which ma*es them easy to compare.

,utual funds ha$e disad$antages as well% which includeB 

ees

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&ess control o$er timing of recognition of gains

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&ess predictable income  No opportunity to customiFe

 T  Types ypes

TYPES

There are 9 principal types of mutual funds in the -nited tatesB open2end funds% funds% unit in$estment trusts C-)Ts; trusts  C-)Ts; and closed2end funds funds.. E+change2traded funds funds CETs  CETs are generally open2end funds or unit in$estment trusts that trade on an e+change; they ha$e gained in popularity recently.

 

=hile the term Jmutual fundJ may refer to all three types of registered in$estment companies% it is more commonly used to refer e+clusi$ely to the open2end and closed2end types.

Open-end funds 

Open2end mutual funds must be willing Open2end willing to buy bac* their shares shares from their in$estors at the end of e$ery business day at the net asset $alue computed that day. ,ost open2end funds also sell shares to the public e$ery business day; these shares are also priced at net asset $alue. 8  professional in$estment manager o$ersees the portfolio% buying and selling securities as appr approp opri riat ate. e. The The to tota tall in in$e $est stme ment nt in th thee fu fund nd wi will ll $ary $ary ba base sed d on sh shar aree purc purcha hase ses% s% sh shar aree redemptions and fluctuation in mar*et $aluation. There is no legal limit on the number of shares that can be issued. Open2end funds are the most common type of mutual fund. 8t the end of 011% there were 7%'1 open2end mutual funds in the -nited tates with combined assets of 11.( trillion.

Closed-end funds   "losed2end funds generally issue "losed2end issue shares shares to the public only once% when they are created through offering.. Their shares are then listed for trading on a  stoc* e+change e+change.. )n$estors an  an initial public offering who no longer wish to in$est in the fund cannot sell their shares bac* to the fund Cas they can with an open2end fund. )nstead% they must sell their shares to another in$estor in the mar*et; the  price they recei$e may ma y be significantly different from net asset $alue. )t may be at a JpremiumJ to net asset $alue Cmeaning that it is higher than net asset $alue or% more commonly% at a JdiscountJ to net asset $alue Cmeaning that it is lower than net asset $alue. 8 professional in$estment manager o$ersees the portfolio% buying and selling securities as appropriate. 8t the end of 011% there were (94 closed2end funds in the -nited tates with combined assets of  9/ billion.

Unit investment trusts   -nit in$estment trusts or -)Ts issue shares to the public only once% when they are created. -)Ts generally general ly ha$e a limited limited life span% established established at creation. creation. )n$estors )n$estors can redeem shares directly

 

with the fund at any time Cas with an open2end fund or wait to redeem upon termination of the trust. &ess commonly% they they can sell their shares in the open mar*et. -nit in$est -nit in$estmen mentt tr trust ustss do not ha$e a profes professio sional nal in$est in$estmen mentt manager manager.. Their Their portfo portfolio lio of  securities is established at the creation of the -)T and does not no t change. 8t the end of 011% there were (%0 -)Ts in the -nited tates with combined assets of (0  billion.

Exchange-traded funds  8 relati$ely recent inno$ation% the e+change2traded fund or ET is often structured as an open2 end in$est in$estmen mentt company company%% though though ETs ETs may also also be str structu uctured red as unit unit in$ in$est estmen mentt trusts trusts%% note. . ,ost ETs  partnerships% in$estments trust% grantor trusts or bonds Cas an e+change2traded note are inde+ funds that combine characteristics of both closed2end funds and open2end funds. )deally% ETs are traded throughout the day on a stoc* e+change at a price that is close to net asset $alue of the ET holdings. ET shares may be created or li:uidated during the trading day  by the fund manager wor*ing with an institution *nown as an authoriFed participant. ETs ha$e been gaining in popularity. 8s of ,arch 014% there were o$er 1%00 ETs in the -nited tates with combined assets of in e+cess of .7 trillion.

 

Investments and classication Investment and classsification

,utual funds ,utual funds are normal normally ly classi classifie fied d by their their princi principal pal in$est in$estmen ments% ts% as descri described bed in the  prospectus and in$estment obecti$e. The four main categories of funds are money mar*et funds%  bond or fi+ed income funds% stoc* or e:uity funds and hybrid funds. =ithin =ithin these categories% funds may be sub classified by in$estment obecti$e% in$estment approach or specific focus. The E" re:uires that mutual fund names not be inconsistent with a fund6s in$estments. or e+ample% the J83" New Aersey Ta+2E+empt 3ond undJ would generally ha$e to in$est% under normal circumstances% at least '05 of its assets in bonds that are e+empt from federal income ta+% from the alternati$e minimum ta+ and from ta+es in the state of New Aersey. 3ond% stoc* and hybrid funds may be classified as either inde+ Cpassi$ely managed funds or  acti$ely managed funds.

Money maret funds  ,oney mar*et funds in$est in money mar*et instruments% which are fi+ed income securities with a $ery short time to maturity and high credit :uality. )n$estors often use money mar*et funds as a substitute for ban* sa$ings accounts% though money mar*et funds are not go$ernment insured% unli*e ban* sa$ings accounts. ,oney mar*et funds stri$e to maintain a 1.00 per share net asset $alue% meaning that in$estors earn interest income from the fund but do not e+perience capital gains or losses. )f a fund fails to maintain that 1.00 per share because its securities ha$e declined in $alue% it is said to Jbrea* the  buc*J. Only two money mar*et funds ha$e e$er bro*en the buc*B "ommunity 3an*er6s -.. #o$ernment ,oney ,ar*et und in 1//4 and the <eser$e Grimary und in 00'. 8t the end of 011% money mar*et funds accounted for 95 of open2end fund assets.

!ond funds   3ond funds in$est in fi+ed income or debt securities. 3ond funds can be sub classified according bonds%% in$estment in$estment2grad 2gradee to the specific types of bonds owned Csuch as high2yield or  un* bonds corporate bonds% go$ernment bonds or municipal bonds or by the maturity of the bonds held Cshort Csh ort2% 2% interm intermedi ediate ate22 or long2t long2term erm. . 3ond 3ond funds funds may in$est in$est in prima primaril rily y -. -... securi securitie tiess

 

Cdomestic or -.. funds% in both -.. and foreign securities Cglobal or world funds% or primarily foreign securities Cinternational funds. 8t the end of 011% bond funds accounted for 5 of open2end fund assets .>19?

"toc or e#uity funds   toc* or e:uity funds in$est in common stoc*s which represent an ownership share Cor e:uity in corporations. toc* funds may in$est in primarily -.. securities Cdomestic or -.. funds% in  both -.. and foreign securities Cglobal or world funds% or primarily foreign securities Cinternational funds. They may focus on a specific industry or sector. 8 stoc* fund may be sub classified along two dimensionsB C1 mar*et capitaliFation and C in$estment style Ci.e.% growth $s. blendKcore $s. $alue. The two dimensions are often displayed in a grid *nown as a Jstyle bo+J. ,ar*et capitaliFation CJcapJ indicates the siFe of the companies in which a fund in$ests% based on the $alue of the company6s stoc*. Each company6s mar*et capitaliFation e:uals the number of  shares outstanding times the mar*et price of the stoc*. ,ar*et capitaliFations are typically di$ided into the following categoriesB 

,icro cap

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mall cap



,id cap



&arge cap

=hile the specific definitions of each category $ary with mar*et conditions% large cap stoc*s generally ha$e mar*et capitaliFations of at least 10 billion% small cap stoc*s ha$e mar*et capitaliFations below  billion% and micro cap stoc*s ha$e mar*et capitaliFations below 900 million. unds are also classified in these categories based on the mar*et caps of the stoc*s that it holds. toc* funds are also subclassified according to their in$estment styleB growth% $alue or blend Cor  core. #rowth funds see* to in$est in stoc*s of fast2growing companies. @alue funds see* to in$est in stoc*s that appear cheaply priced. 3lend funds are not biased toward either growth or  $alue.

 

8t the end of 011% stoc* funds accounted for 4(5 of the assets in all -.. mutual funds.

$y%rid funds  Hybrid funds in$est in both bonds and stoc*s or in con$ertible securities. securities. 3alanced funds% asset allocation funds% target date or target ris* funds and lifecycle or lifestyle funds are all types of  hybrid funds. Hybrid funds may be structured as funds of funds% meaning that they in$est by buying shares in other mutual funds that in$est in securities. ,ost fund of funds in$est in affiliated funds Cmeaning mutual funds managed by the same fund sponsor% although some in$est in unaffiliated funds Cmeaning those managed by b y other fund sponsors or in a combination of the two. 8t the end of 011% hybrid funds accounted for 75 of the assets in all -.. mutual funds.

Index &passively managed' versus actively managed   8n inde+ fund or passi$ely managed fund see*s to match the performance of a mar*et inde+% an  acti$ely managed fund see*s fund see*s to outperform a rele$ant inde+ such as the !G 00 inde+% 00 inde+% while an  through superior security selection.

 

Expenses EXPENSES

)n$estors in a mutual fund pay the fund6s e+penses. These e+penses fall into fi$e categoriesB distribution charges Csales loads and 1b21 fees% the management fee% other fund e+penses% shareholder share holder transaction transaction fees and securities transaction transaction fees. ome of these e+penses e+penses reduce the $alue of an in$estor6s account; others are paid by the fund and reduce net asset $alue. $alue. <ecurring fees and e+pensesLspecifically the 1b21 fee% the management fee and other fund e+pensesLare included in a fund6s total e+pense ratio% or simply the Je+pense ratioJ. 3ecause all funds must compute an e+pense ratio using the same method% it allows in$estors to compare costs across funds.

(istri%ution charges   Distribution charges pay for mar*eting% distribution of the fund6s shares as well as ser$ices to in$estors.

 

Front-end load or sales charge 8 front2end load or load or sales charge is charge is a commission commission paid  paid to a bro*er  a bro*er  by  by a mutual fund when shares are purchased. )t is e+pressed as a percentage of the total amount in$ested or the Jpublic offering  priceJ% which e:uals the net asset $alue plus the front2end load per share. The front2end load often declines as the amount in$ested increases% through brea*points. The front2end load is paid  by the shareholder; it is deducted from the amount in$ested.

Back-end load ome funds ha$e a bac*2end a bac*2end load% load% which is paid by the in$estor when shares are redeemed. )f the  bac*2end load declines the longer the in$estor holds shares% it is called a contingent deferred sales charges Cor "D". &i*e the front2end load% the bac*2end load is paid by the shareholder; it is deducted from the redemption proceeds.

12b-1 fees ome funds charge an annual fee to compensate the distributor of fund shares for pro$iding ongoing ser$ices to fund shareholders. This fee is called a 1b21 fee% after the E" rule authoriFing it. The 1b21 fee is paid by b y the fund and reduces n net et asset $alue.

No-load funds 8 no2load fund does fund does not charge a front2end load under any circumstances does not charge a  bac*2end load under any circumstances and does not charge a 1b21 fee greater than 0.5 of  fund assets. 8n e+ample of this type of fund is a <eal estate fund. fund.>1(?

Management fee The management fee is paid to the fund manager or sponsor who organiFes the fund% pro$ides the  portfolio management or in$estment ad$isory ser$ices and normally lends its brand name to the fund. The fund manager may also pro$ide other administrati$e ser$ices. The management fee often has brea*points% which means that it declines as assets Cin either the specific fund or in the fund family as a whole increase. The management fee is paid by the fund and is included in the e+pense ratio. The fund6s board of directors re$iews the management fee annually. und shareholders must $ote on any proposed increase in the management. Howe$er% the fund manager or sponsor may agree to wai$e all or a portion of the management fee in order to lower the fund6s e+pense ratio