Chapter 6: Mutual Funds
6.1 Concept, Working, and Three-Tier Legal Structure of Mutual Funds
Conceptual Framework of Collective Investment
A Mutual Fund is a collective investment vehicle that mobilizes financial resources from multiple retail and institutional investors sharing a common financial objective. The pooled capital is invested in a diversified portfolio of capital market instruments—such as listed equities, corporate debentures, government bonds, money market instruments, or gold—in strict conformity with the stated investment mandate of the scheme.
Individual Investors Pooled Capital ---> Mutual Fund Scheme Pool ---> Asset Management Company (AMC)
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Unitholders Receive Units <--- Net Profits / Capital Appreciation <--- Diversified Capital Market Portfolio
Economic Benefits of Mutual Funds
- Professional Portfolio Management: Qualified fund managers and research analysts continuously monitor corporate fundamentals, macroeconomic indicators, and valuations to make informed capital allocation decisions.
- Instant Diversification: By pooling resources, even an investor committing ₹500 via a Systematic Investment Plan (SIP) achieves fractional exposure to a portfolio of 40–60 blue-chip companies, reducing idiosyncratic business risk.
- Economies of Scale: Massive pooled volumes significantly lower execution brokerage, custodial charges, and research overheads compared to individual retail trading accounts.
- Liquidity and Convenience: Open-ended mutual funds provide continuous redemption liquidity at prevailing Net Asset Value (NAV)-linked prices directly with the fund house on any business day.
- Stringent Regulatory Oversight: Regulated under the SEBI (Mutual Funds) Regulations, 1996, mutual funds adhere to strict portfolio disclosure rules, valuation norms, and prudential investment caps.
The Three-Tier Legal Governance Structure in India
To protect unitholders' interests and prevent conflicts of interest between fund promoters and client capital, SEBI mandates a strict three-tier legal architecture structured as an Indian Trust under the Indian Trusts Act, 1882:
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| THREE-TIER MUTUAL FUND GOVERNANCE STRUCTURE |
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| SPONSOR |
| - The promoter establishing the Mutual Fund (like a promoter in a company) |
| - Must satisfy SEBI fit and proper criteria, track record of 5 years profitability, 40% AMC equity|
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| Appoints & Settles Trust
v
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| BOARD OF TRUSTEES |
| - Legal custodian of investor wealth under the Indian Trusts Act, 1882 |
| - Minimum 50% independent trustees; owes strict fiduciary duty to unitholders |
| - Approves all schemes, oversees AMC operations, prevents promoter conflict |
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Appoints AMC | Appoints Custodian
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v v
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| ASSET MANAGEMENT COMPANY (AMC) | | CUSTODIAN |
| - Manages the investment portfolio| | - Holds physical securities and demat assets in custody |
| - Net worth minimum ₹50 Crore | | - Independent of AMC; settles securities & corporate actions|
| - Minimum 50% independent board | +-----------------------------------------------------------+
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Roles and Fiduciary Duties of Key Entities
- Sponsor: Initiates the mutual fund trust. Under SEBI regulations, the sponsor must have a sound track record of carrying on business in financial services for at least 5 years, possess positive net worth in all preceding 5 years, and contribute at least 40% of the AMC's net worth.
- Board of Trustees / Trustee Company: Holds the trust property in fiduciary trust for the exclusive benefit of unitholders. Trustees enter into an Investment Management Agreement (IMA) with the AMC, monitor scheme compliance with statutory investment limits, ensure error-free NAV computations, and submit quarterly compliance reports directly to SEBI.
- Asset Management Company (AMC): The operational engine approved by SEBI that manages the investment schemes. The AMC employs the Chief Investment Officer (CIO), portfolio managers, analysts, and dealers. The AMC's net worth must not be less than ₹50 Crore.
- Custodian: An independent institution registered with SEBI (e.g., HDFC Bank, SBI, ICICI Bank, Deutsche Bank) responsible for the safekeeping of portfolio securities, tracking dividend receipts, and handling delivery vs. payment (DvP) trade settlements.
6.2 Categorization of Schemes, Offer Documents, NAV, and Total Expense Ratio
SEBI Scheme Categorization and Rationalization Mandate
To ensure standardization, avoid misleading scheme nomenclature, and facilitate meaningful peer comparisons for investors, SEBI established a comprehensive scheme categorization framework dividing mutual fund schemes into five distinct asset classes:
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| Category Group | Scheme Sub-Types | Regulatory Asset Allocation Mandate |
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| Equity Schemes | Large Cap Fund | Min 80% in top 1-100 listed stocks |
| | Mid Cap Fund | Min 65% in 101-250 listed stocks |
| | Small Cap Fund | Min 65% in 251st company onwards |
| | Multi Cap Fund | Min 25% Large, 25% Mid, 25% Small Cap |
| | Flexi Cap Fund | Min 65% in equity dynamically allocated |
| | ELSS (Tax Saving) | Min 80% equity; 3-year statutory lock-in |
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| Debt Schemes | Overnight Fund | Maturity of securities is 1 day |
| | Liquid Fund | Maturity of securities up to 91 days |
| | Ultra Short Duration Fund | Macaulay duration between 3 to 6 months |
| | Short Duration Fund | Macaulay duration between 1 to 3 years |
| | Corporate Bond Fund | Min 80% in AA+ and above rated debt |
| | Credit Risk Fund | Min 65% in AA and below rated bonds |
| | Gilt Fund | Min 80% in Government Securities |
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| Hybrid Schemes | Aggressive Hybrid Fund | 65%–80% Equity; 20%–35% Debt |
| | Conservative Hybrid Fund | 10%–25% Equity; 75%–90% Debt |
| | Balanced Advantage (Dynamic Asset)| 0%–100% Equity / Debt managed dynamically |
| | Arbitrage Fund | Min 65% fully hedged equity arbitrage |
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| Solution-Oriented | Retirement Fund / Children's Fund | Minimum 5-year lock-in period |
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| Other Schemes | Index Funds / ETFs | Min 95% replicating underlying index |
| | Fund of Funds (FoF) | Min 95% in underlying mutual fund schemes |
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Scheme Offer Documents: SID, SAI, and KIM
Every mutual fund scheme is launched via formal legal disclosure documentation vetted by SEBI:
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| SCHEME OFFER DOCUMENT STRUCTURE |
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| Scheme Information Document (SID) | - Specific scheme mandate, investment universe, asset mix |
| | - Riskometer rating, benchmark index, fund manager profile |
| | - Fee structure, redemption exit loads, past performance |
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| Statement of Additional | - Statutory background of the Sponsor, Trustees, and AMC |
| Information (SAI) | - Detailed financial statements, legal policies, custodians |
| | - Common disclosures applicable across all fund house schemes |
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| Key Information Memorandum (KIM) | - Abridged summary of the SID and SAI |
| | - Must be attached to every physical or digital application form|
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Computation of Net Asset Value (NAV)
The Net Asset Value (NAV) represents the fair market worth of one single unit of a mutual fund scheme on any valuation date:
$$\text{NAV} = \frac{\text{Market Value of Investments} + \text{Receivables} + \text{Accrued Income} + \text{Cash} - \text{Accrued Expenses} - \text{Liabilities}}{\text{Total Number of Outstanding Scheme Units}}$$
SEBI mandates daily end-of-day NAV calculation and dissemination on the AMFI (Association of Mutual Funds in India) portal and fund house websites by 11:00 PM for all mutual fund schemes (9:00 AM next day for Fund of Funds investing overseas).
Total Expense Ratio (TER) Framework
The Total Expense Ratio (TER) represents the annual operating expenses charged to the scheme as a percentage of daily net assets. SEBI Regulation 52 establishes tiered statutory caps on TER under the base slabs:
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| Daily Net Asset Slabs (Equity Schemes)| Maximum Allowable TER |
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| First ₹500 Crores | 2.25% |
| Next ₹250 Crores | 2.00% |
| Next ₹1,250 Crores | 1.75% |
| Next ₹3,000 Crores | 1.60% |
| Next ₹5,000 Crores | 1.50% |
| Slabs between ₹10,000 to ₹50,000 Cr | Progressive reduction |
| On balance over ₹50,000 Crores | 1.05% |
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- Direct Plans vs. Regular Plans: Direct plans have a lower TER than Regular plans because they eliminate distributor commission payments (trail fees). Consequently, the NAV of a Direct Plan is systematically higher than the NAV of its corresponding Regular Plan.
6.3 Scheme Factsheets, Pricing of Units, and Performance Evaluation Metrics
Mutual Fund Scheme Factsheets
The monthly factsheet published by an AMC is the primary analytical document providing investors and portfolio managers with complete transparency regarding a scheme's portfolio composition and performance:
- Portfolio Holdings: Line-by-line inventory of every security held, its market value, credit rating, and percentage allocation to scheme NAV.
- Sector Concentration: Sectoral distribution (e.g., Financial Services 32%, IT 14%, Capital Goods 9%) benchmarked against index weights.
- Fund Manager Details: Name, tenure with the fund, total assets managed, and historical performance of other schemes managed by the same individual.
- Portfolio Characteristics:
- For Equity Funds: Weighted Average Market Capitalization, Price-to-Earnings ($P/E$) ratio, Price-to-Book ($P/B$) ratio, and Portfolio Turnover Ratio (PTR).
- For Debt Funds: Yield to Maturity (YTM), Modified Duration, Macaulay Duration, and Average Maturity.
- The Product Riskometer: A visual dial rating the scheme's risk profile from Low, Low to Moderate, Moderate, Moderately High, High, to Very High, updated on a monthly basis based on portfolio composition.
Pricing of Units and Cut-off Timings
Mutual fund transactions are processed based on statutory cut-off timings stipulated by SEBI to ensure fair treatment between incoming and exiting unitholders:
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| Scheme Category | Transaction Type | Applicable NAV Rule |
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| Liquid & Overnight | Purchase / Subs | Historical closing NAV of the day immediately |
| Funds (Cut-off 1:30 PM)| | preceding the receipt of realization of funds |
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| Other Equity & Debt | Purchase / Subs | Closing NAV of the day when funds are credited |
| Funds (Cut-off 3:00 PM)| | to the scheme account before 3:00 PM |
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| All Schemes | Redemption | Same day closing NAV if application logged |
| (Cut-off 3:00 PM) | | before 3:00 PM; next day NAV if logged later |
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Key Performance Evaluation Metrics
To assess whether a fund manager generates skill-based excess returns or merely captures market beta, analysts deploy several quantitative metrics:
1. Compounded Annual Growth Rate (CAGR) vs. Absolute Return
For investment tenors exceeding one year, point-to-point performance must be reported as annualized CAGR: $$\text{CAGR} = \left( \frac{\text{NAV}{\text{end}}}{\text{NAV}{\text{start}}} \right)^{\frac{1}{n}} - 1$$ Where $n$ is the number of elapsed years. For periods under one year, simple annualized or absolute returns are presented.
2. Sharpe Ratio
Measures the excess return generated per unit of total risk (standard deviation $\sigma_p$): $$\text{Sharpe Ratio} = \frac{R_p - R_f}{\sigma_p}$$ A higher Sharpe ratio indicates superior risk-adjusted return efficiency.
3. Treynor Ratio
Evaluates excess return generated per unit of systematic market risk (Beta $\beta_p$): $$\text{Treynor Ratio} = \frac{R_p - R_f}{\beta_p}$$ This metric is particularly relevant when evaluating a well-diversified mutual fund scheme holding minimal unsystematic risk.
4. Jensen's Alpha ($\alpha$)
Derived from the Capital Asset Pricing Model (CAPM), Jensen's Alpha quantifies the abnormal excess return generated by the fund manager relative to the theoretical expected return: $$\alpha_p = R_p - [R_f + \beta_p (R_m - R_f)]$$
- $\alpha_p > 0$: The fund manager generated positive value-added return above market risk exposure.
- $\alpha_p = 0$: Returns exactly matched market risk expectations.
- $\alpha_p < 0$: The fund manager underperformed relative to the portfolio's risk profile.