Part 3 : Mutual

Funds and Financial

Planning Essentials
Chapter 1 : Introduction to Mutual Funds
Chapter 2 : Criteria for selection of Mutual Funds
Chapter 3 : Financial Planning, Life Cycle and Personal Budget
 Part 3 : Mutual
Funds and Financial
Planning Essentials
Chapter 1 : Introduction to
Mutual Funds
Introduction
• In the earlier modules we understood the concepts of banking, basic
economic terms, investment products and risk-return analysis.
• We also look at the basics of financial planning and how investor risk
profile plays a role in selection of the investment avenue.
• We also saw that some of the investment instruments carried higher
risk and some of them were near risk-free investments. In the
chapter, we will learn all about the mutual fund. We will try to
understand the meaning, nature of mutual funds, their advantages
and disadvantages, key scheme types and the concept of NAV
Introduction
• The Association of Mutual Funds in India (AMFI) is dedicated to develop-
ing the Indian Mutual Fund Industry on professional, healthy and ethical
lines and to enhance and maintain standards in all areas with a view to
protecting and promoting the interests of mutual funds and their unit
holders.
• AMFI, the association of SEBI registered mutual funds in India of all the
registered Asset Management Companies, was incorporated on August
22, 1995, as a non-profit organisation.
• As of now, all the 42 Asset Management Companies that are registered
with SEBI, are its members.
• Website: https://www.amfiindia.com
ABOUT MUTUAL FUNDS
• A Mutual Fund is an avenue of investment in the form of a trust where money
mobilised from various investors who share a common investment objective
is pooled and invested in securities like bonds, equity, and short-term debt.
• A key feature of a mutual fund is that it is managed by an asset management
company and is overseen by a professional fund manager.
• The key advantage of this form of investment is that an investor is able to
invest in the financial market under the supervision of a qualified portfolio
manager while also having access to a wider range of investment options than
would be typically accessible to an individual investor.
• Mutual Funds serve various functions within the financial economy at both
the micro and macro level.
Micro Level
• At the micro level they provide a relatively risk-free investment avenue to individual
investors and help them earn income or build wealth, by facilitating participating in the
financial markets through investment in equity or debt.
• The major feature and advantage of mutual funds is that because they are managed by
professional fund managers, individual investors gain access to their expertise and are also
freed from the need to manage their investments on an individual level.
• Moreover, mutual funds can be structured differently for different kinds of investment
objectives, and so offer versatility and make it possible to build a large corpus of money
from various investors with diverse objectives.
• In the industry, the words "fund' and 'scheme' are used inter-changeably. Various
categories of schemes are called "funds". To ensure consistency with what is experienced
in the market, this workbook goes by the industry practice. However, wher ever a
difference is required to be drawn, the scheme offering entity is referred to as "mutual
fund" or "the fund".
Macro Level
• At the macro level, money raised from investors ultimately benefits governments, companies,
and other entities, directly or indirectly, by providing funding for various projects or paying for
various expenses.
• Projects that are facilitated through such financing, offer employment to people; the income
they earn helps employees buy goods and services offered by other companies, thus
supporting projects of these goods and services companies.
• Thus, money flow in the economy is sustained and overall economic development is supported.
• Moreover, being large investors, mutual funds can keep a check on the operations of the
investee company and their corporate governance and ethical standards. The mutual fund
industry itself also offers employment to a large number of employees of mutual funds,
distributors, registrars and various other service providers. Higher employment, income and
output in the economy boosts the revenue collection of the government through taxes and
other means. When these are spent prudently, it promotes further economic development and
nation building.
• Mutual funds can also act as market stabilizers in countering large inflows or outflows from
foreign investors. Mutual funds are therefore thought to be a key participant in the capital
market of any economy.
Advantages of mutual funds
• Affordable and accessible.
• Variety of investment structures
• Tax benefits and deferrals
• Expertise of fund managers
• Ability to make regular and systematic investments
• Well-regulated and controlled
• Liquidity
• Wealth creation
Limitations of mutual funds
• Lack of portfolio control and choice
• Choice overload
• Lack of cost control
Mutual Fund & SEBI:
• SEBI supervises and controls the securities market, but most
importantly, it protects your interests as an investor by enforcing firm
rules and regulations.
• To protect financial transactions SEBI mandates that every investor
must comply with KYC norms.
• Legally speaking, a mutual fund comprises 5 entities - Sponsor,
Trustee, AMC, Custodian and RTA.
• Securities and Exchange Board of India (SEBI) is a legal body that
regulates the Indian capital markets including mutual funds.
KEY PARTICIPANTS IN THE MUTUAL FUND INDUSTRY
Sponsor: A sponsor is a person or an entity that sets up a mutual fund. The sponsor or
sponsors are like the promoters of a company. They set up a trust for the management
of the fund.
Trustee: The trustees of the mutual fund hold the property of the fund for the benefit
of the unit holders. The trustees hold general power of superintendence and
direction over the AMC and monitor its performance and compliance with SEBI
Regulations. SEBI Regulations require that at least two thirds of the directors of
trustee company or board of trustees must be independent and not affiliated with the
sponsors.
Asset Management Company: An Asset Management Company or AMC manages the
funds by making investments in various types of securities. This must be approved by
SEBI. SEBI also required that 50% of the directors of AMC must be independent.
Custodian: The Custodian holds the securities of the various schemes of the fund in its
custody. The custodian must be registered with SEBi
 Subscribers: Are the investors who commit to investing in a financial instrument
before the actual closing of the purchase.
KEY PARTICIPANTS IN THE MUTUAL FUND
INDUSTRY

Registrar & Transfer Agents: A registrar and transfer agent (RTA) acts as
a mediator or agent between investors and mutual fund houses.
Fund Manager: A fund manager is a person who oversees the activities
of the mutual fund. In other words, the fund manager is responsible for
implementing a fund's investment strategy and managing its trading
activities. They also manage analysts, conduct research, and make
investment decisions.
Fund Accountant: A fund accountant is responsible the day-to-day
aspects of accounting for one or more assigned mutual funds. They also
prepare Net Assets Values, yields, distributions, and other fund
accounting outputs for sub- sequent review.
History of Mutual Funds in India
Phase 1 (1964-1987) – Establishment
Phase 2 (1987-1993) – Launch of Public Sector Mutual Funds
Phase 3 (1993-2003) – Launch of Private Sector Mutual Funds
Phase 4 (2003-2014) – Consolidation and slowdown
Phase 5 (since 2014) – Rejuvenation and consistent growth
MAJOR FUND HOUSES IN INDIA

Axis AMC
 Aditya Birla SunLife AMC
Franklin Templeton Asset Management (India)
HDFC AMC
Invesco Asset Management (India)
Kotak Mahindra AMC
LIC Mutual Fund AMC
Motilal Oswal AMC
 Nippon Life India Asset Management
 SBI Funds AMC
UTI AMC
(Please note the list is not exhaustive)
MUTUAL FUND SCHEMES
There is a wide range of mutual fund structures for different investor goals.
Mutual funds can be broadly classified based on the following criteria:
• Organisation Structure -Open ended, Close ended, Interval
• Portfolio management strategy - Active or Passive
• Investment Objective - Growth, Income, Liquidity
• Underlying Portfolio - Equity, Debt, Hybrid, Money market instruments,
Multi Asset
• Sector specific funds – Real Estate, Hospital, FMCG
• Thematic/solution oriented -Tax saving, Retirement benefit, Child welfare,
Arbitrage
• Exchange Traded Funds
• Fund of funds
NET ASSET VALUE
• Net Asset value or NAV refers to the value of each unit of the scheme.
NAV is one of the most important concept to understand in a mutual
fund.
• All subscriptions into the fund and all redemptions out of the fund are
based on the NAV of the units on the date of
subscription/redemption.
• The fund houses are directed to publish the NAV of each fund on a
daily basis.
• These NAVs are made available on the respective websites of the
AMCs as well as on the AMFI website.
 How is NAV calculated?
• This is calculated as follows:
NAV = Unit holders' Funds in the Scheme (a.k.a. Net Assets) /No. of
outstanding Units
For example, if unit-holders' funds in the scheme are taken as Rs 365 crore and
the number of outstanding units are 42 crore, then the NAV will be:
Rs 365 crore / 42 crore = Rs. 8.69 per unit
Alternate formula for calculating NAV:
NAV (Total Assets -Liabilities/Expenses other than to Unit holders) / No. of
outstanding Units
This calculation shows that:
• The higher the interest, dividend and capital gains earned by the
scheme, the higher would be the NAV.
• The higher the appreciation in the investment portfolio, the higher
would be the NAV
• The lower the expenses, the higher would be the NAV.
The summation of these three parameters gives us the profitability
metric as being equal to:
(A) Interest income
(B) + Dividend income
(C) +Realized capital gains
(D) + Valuation gains
(E) - Realized capital losses
(F) -Valuation losses
(G) -Scheme expenses
 Part 3 : Mutual
Funds and Financial
Planning Essentials
Chapter 2 : Criteria for
selection of Mutual Funds
INTRODUCTION
• In the earlier chapter, we understood a few concepts of mutual funds, various
schemes of mutual funds, advantages and disadvantages of mutual funds and
the concept of Net Asset Value (NAV)
• While the industry of mutual funds is vast expanding with a variety of new
scheme offerings, it is important to understand how these returns of mutual
funds are tracked.
• When fund manager creates portfolio of stocks/debt instruments, they need to
evaluate the fund performance. But, what are these fund performance metrics?
• Mutual fund schemes invest in the market for the benefit of Unit-holders. How
well did a scheme perform? An approach to assess the performance is to pre-
define a comparable -- a benchmark - against which the scheme can be
compared.
Six levels of Risk for Mutual Fund
Schemes
• Securities and Exchange Board of India (SEBI), being the capital market regulator, has issued a
circular in October 2020 advising the Mutual Fund industry intermediaries on the use of Risk-o-
meter.
• SEBI, based on the recommendation of Mutual Fund Advisory Committee (MPAC), has reviewed
the guidelines for product labelling in mutual funds and decided that the Risk level of a scheme
be depicted by "Risk-o-meter“
• Risk-o-meter has following six levels of risk for mutual fund schemes:
i. Low Risk
ii. Low to Moderate Risk
iii. Moderate Risk
iv. Moderately High Risk
v. High Risk and
vi. Very High Risk
MUTUAL FUND RETURNS
Drivers of Returns and Risk in a Scheme
• The portfolio is the main driver of returns in a mutual fund scheme.
• The asset class in which the fund invests, the segment sectors of the
market in which the fund will focus on, the styles adopted to select
securities for the portfolio and the strategies adopted to manage the
portfolio will all determine the risk and return in a mutual fund
scheme.
• The underlying facts are different for each asset class.
MUTUAL FUND RETURNS
Measures of Returns
• The returns from an investment is calculated by comparing the cost paid
to acquire the asset (outflow) or the starting value of the investment to
what is earned from it (inflows) and computing the rate of return.
• The inflows can be from periodic pay- outs such as interest from fixed
income securities and dividends from equity investments and gains or
losses from a change in the value of the investment.
• The calculation of return for a period will take both the income earned
and gains/loss into consideration, even if the gains/loss have not been
realized.
MUTUAL FUND RETURNS
Simple Return
((Later value-Initial value) x 100)/Initial Value
Example:
Suppose you invested in a scheme at a NAV of Rs. 15. Later,
you found that the NAV has grown to Rs. 20. How much is your
return?
Simple Return = ((20 - 15) * 100) / 15 = 33.33%
MUTUAL FUND RETURNS
Annualised Return
Annualization helps us compare the returns of two different time periods.
Annualized Return = Simple Return x 12/ Period of Simple return in months
Example:
Annualised returns:
Two investment options have indicated that their returns since inception as 9% and 4%
respectively.
If the first investment was existence for 9 months and the second for 3 months, then the
two returns are obviously not comparable without using this method
Investment 1 ------------------ 9 percent * 12/9 =12% p.a
Investment 2------------------ 4 percent x 12/3 = 16% p.a.
SEBI Norms regarding
Representation of Returns by
Mutual Funds in India
• Mutual funds are not permitted to promise any returns, unless it is an
assured returns scheme. Assured returns schemes call for a guarantor
who is named in the offer document.
• The guarantor will need to write out a cheque, if the scheme is
otherwise not able to pay the assured return.
• Advertisement Code and guidelines for disclosing performance
related information of mutual fund schemes are prescribed by SEBI.
Alpha
• The difference between a scheme's actual return and its optimal return is its Alpha - a
measure of the fund manager's performance. Alpha, therefore, measures the
performance of the investment in comparison to a suitable market index.
• Positive alpha is indicative of out-performance by the fund manager; negative alpha
might indicate under-performance.
• Since the concept of Beta is more relevant for diversified equity schemes, Alpha should
ideally be evaluated only for such schemes.
• These quantitative measures are based on historical performance, which may or may
not be replicated.
• Such quantitative measures are useful pointers. However, blind belief in these
measures, without an understanding of the underlying factors, is dangerous. While the
calculations are arithmetic - they can be done by a novice; scheme evaluation is an art-
the job of an expert.
Beta
• Beta is based on the Capital Asset Pricing Model (CAPM), which states that there are two
kinds of risk in investing in equities-systematic risk and non-systematic risk.
• Systematic risk is integral to investing in the market; it cannot be avoided. For example,
risks arising out of inflation, interest rates, political risks etc. This arises primarily from
macro-economic and political factors. This risk cannot be diversified away.
• Non-systematic risk is unique to a company; the non-systematic risk in an equity portfolio
can be minimized by diversification across companies. For example, risk arising out of
change in management, product obsolescence etc.
• Since non-systematic risk can be diversified away, investors need to be compensated only
for systematic risk, according to CAPM. This systematic risk is measured by its Beta
• Beta measures the fluctuation in periodic returns in a scheme, as compared to fluctuation
in periodic returns of a diversified stock index (representing the market) over the same
period.
• The diversified stock index, by definition, has a Beta of 1. Companies or schemes, whose
beta is more than 1, are seen as more risky than the market. Beta less than 1 is indicative of
a company or scheme that is less risky than the market.
QUANTITATIVE MEASURES OF FUND MANAGER
PERFORMANCE ABSOLUTE & RELATIVE
RETURNS
• Using the concept of benchmarks, one can do relative comparison viz.
how did a scheme perform vis-à-vis its benchmark or peer group. Such
comparisons are called relative return comparisons.
• A credible benchmark should meet the following requirements:
It should be in sync with
(a) the investment objective of the scheme (i.e. the securities or variables
that go into the calculation of the benchmark should be representative of
the kind of portfolio implicit in the scheme's investment objective);
(b) asset allocation pattern; and
(c) investment strategy of the scheme.
QUANTITATIVE MEASURES OF FUND MANAGER
PERFORMANCE ABSOLUTE & RELATIVE
RETURNS
If a comparison of relative returns indicates that a scheme earned a
higher return than the benchmark, then that would be indicative of
outperformance by the fund manager.
In the reverse case, the initial premise would be that the fund manager
under-performed. Such premises of outperformance or under-
performance need to be validated through deeper performance
reviews.
MCs and trustees are expected to conduct such periodic reviews of
relative returns, as per the SEBI Guidelines.
Risk-adjusted Returns
• A risk-adjusted return is a calculation of the profit or potential profit
from an investment that takes into account the degree of risk that
must be accepted in order to achieve it.
• It enables the investor to make comparison between the high-risk and
the low-risk return investment.
Absolute Return
• Absolute return is simply whatever an asset or portfolio returned over
a certain period.
• Absolute performance is the return of the portfolio itself on a year-
over-year basis.
• Absolute return investing can beat average market returns with less
risk and volatility over time.
Relative Return
• Relative return is the return an asset achieves over a period of time compared to a benchmark. The
relative return is the difference between the asset's return and the return of the benchmark. Relative
return can also be known as alpha in the context of active portfolio management.
• Relative performance is the comparison of the returns of your portfolio to that of some benchmark
index.
• Relative return is important because it is a way to measure the performance of actively managed
funds, which should earn a return greater than the market. Specifically, the relative return is a way to
gauge a fund manager's performance.
Relative returns comparison is one approach towards evaluating the performance of the fund manager
of a scheme.
• A weakness of this approach is that it does not differentiate between two schemes that have assumed
different levels of risk in pursuit of the same investment objective.
• Therefore, although the two schemes share the benchmark, their risk levels are different.
• Evaluating performance, purely based on relative returns, may be unfair towards the fund manager
who has taken lower risk but generated the same return as a peer.
Measures of risk-adjusted
returns
Sharpe ratio is a very commonly used measure of risk-adjusted returns.
An investor can invest with the government and earn a risk-free rate of return
(Rf). T-Bill index is a good measure
Through investment in a scheme, a risk is taken, and a return is earned (Rs)
The difference between the two returns i.e. Rs - Rf is called risk premium.
It is like a premium that the investor has earned for the risk taken, as compared
to government's rid-free return This risk premium is to be compared with the
risk taken.
Sharpe Ratio uses Standard Deviation as a measure of risk It is calculated as:
Sharpe Ratio = (Rs – Rf) / Standard Deviation
Example: Let's say that the risk free return is 4.25% and the scheme has a standard
deviation of 0.35%. The return earned by the scheme is taken at 8%. Calculate the
Sharpe Ratio.

Rf = 4.25
Rs = 8%
Standard Deviation = 0.35%
Sharpe Ratio = (Rs – Rf) / Standard Deviation
Sharpe Ratio = (8-4.25) / 0.35 = 10.71
Sharpe Ratio is effectively the risk premium generated by assuming per unit of risk.
Higher the Sharpe Ratio, better the scheme is considered to be.
Sharpe Ratio comparisons can be undertaken only for comparable schemes.
or example, Sharpe Ratio of an equity scheme cannot be compared with the
Sharpe Ratio of Debt scheme.
 Treynor Ratio
Like Sharpe Ratio, Treynor Ratio too is a risk premium per unit of risk.
Computation of risk premium is the same as was done for the Sharpe Ratio. However, for risk, Treynor
Ratio uses Beta.
Treynor Ratio = (Rs - Rf) / Beta
Example:
Let's say that the risk free return is 4.25% and the scheme has a Beta of 1.2. The return earned by the
scheme is taken at 7.5%. Calculate the Treynor Ratio.
Beta = 1.2
Rf =4.25%
Rs =7.5%
Treynor Ratio = (Rs - Rf) / Beta
Treynor Ratio = (7.5 - 4.25) / 1.2 = 2.71
Higher the Treynor Ratio, better the scheme is considered to be. Since the concept of Beta is more relevant
for diversified equity schemes, Treynor Ratio comparisons should ideally be restricted to such schemes
Tracking Error
• The difference between an index fund's return and the market
return is the tracking error.
• Tracking error is a measure of the consistency of the out-performance
of the fund manager relative to the benchmark.
• It is not enough if the fund is able to generate a high excess return, it
must do so consistently.
• Tracking error is calculated as the standard deviation of the excess
returns generated by the fund.
• The tracking error has to be low for a consistently out- performing
fund.
 Part 3 : Mutual
Funds and Financial
Planning Essentials
Chapter 3 : Financial Planning,
Life Cycle and Personal Budget
Introduction
• In the earlier modules, we have learnt at length about the various
concepts of savings & investments, returns, investment vehicles, etc.
We have also touched based on the very basic of financial planning.
• In the chapter, we will try to learn some more about financial
planning, the steps involved, and the other aspects associated with
investments and sourcing of finances.
Steps Involved in Financial
Planning
Process undertaken by financial advisors for their client’s financial
planning
1) Establish and define the client-planner relationship
2) Gather client data, including goals
3) Analyze and evaluate financial status
4) Develop and present financial planning recommendations
5) Implement the financial planning recommendations
6) Monitor the financial planning recommendations
Understanding Financial Life
Cycle
The Ten Financial Stages of Life Experts have divided life into ten typical
financial stages. There are specific wealth building strategies for each
stage and financial ratios that mark the transition from one stage to the
next. The most unreliable indicator on the Financial Life Cycle is the age
range.
 Understanding Financial Life
Cycle
Life Stages Financial Stages
Stages
1&2 TODDLER AND • Parents teach – Accumulation (Piggy bank),
CHILDHOOD • Convertibility (spend some of our allowance to buy things)
• Relative Value (rupee and paisa)

3 TEENAGE YEARS • Budgeting

• Earned Income (selling stuffs, tutions)
• How money makes money
4 BUILDING THE • 20s – Building the foundation Stage
FOUNDATION • Critical years where we establish the financial habits that will
determine our financial future
• Three basic ways to acquire money:
 Affiliation
 Earn it by the sweat of your brow
 Have your own money, make money for you
 Understanding Financial Life
Cycle
Life Stages Financial Stages
Stages
5 EARLY ACCUMULATION • Between 30 and 40, our net worth exceeds our annual income
• Investment begins and diversification is made

6 RAPID ACCUMULATION • 40-55 years

• Compounding begins
• Due to increase in wealth
• Due to an increase in income and wealth, net worth is typically 3-7
times annual income.
• Discussions with our financial planning team begin to shift focus to
retirement planning.
• However, other aspects such as insurance and estate planning will
be significant as well.
 Understanding Financial Life
Cycle
Life Stages Financial Stages
Stages
7 FINANCIAL • Age 55 – 69
INDEPENDENCE • Options to change jobs, semi-retire, mid-life crisis
• At this point, net worth is typically 7-10 times annual living expenses.
• Meet with our financial planning team to ensure your retirement
projections are on the right track.
8 CONSERVATION YEARS • During the conservation years, risk usually decreases in order to
maintain and preserve your retirement income
• Although age can vary, typically when your portfolio reaches 10-15
times annual living expenses you have reached the conservation
years.
 Understanding Financial Life
Cycle
Life Stages Financial Stages
Stages
9 DISTRIBUTION YEARS • AGES 65+
• A main reason for conservation is to ensure the funds are available
for distributions throughout retirement. As your portfolio reaches
more than 15 times your annual living expenses, distributions will
occur.
• Those distributions vary based upon your personal goals such
as charitable giving or providing for the future generations of your
family.
10 SUNSET • The sunset stage comes when we have less than 12 months to live
and we try to provide orderly distribution of the bulk of our assets
Personal Budget
• One of the essential elements of financial planning is to identify the
financial gap. A budget can help in keep in check the possible expenses
and to plan for saving/investing the uncommitted income. If you want
to control your spending and work toward your financial goals, you
need a budget.
• A personal or household budget is a summary that compares and tracks
your income and expenses for a defined period, typically one month.
While the word "budget" is often associated with restricted spending, a
budget does not have to be restrictive to be effective.
• A budget works if you are honest about both your income and
expenses