Frequently Asked Questions

Why have mutual funds in India performed so poorly?

Most investors associate mutual funds with Master gain, Monthly Equity Plans of SBI Mutual Fund, UTI and Canbank Mutual Fund and of course Morgan Stanley Growth Fund. This is so because these funds truly had participation from masses, with a fund like Morgan Stanley having more than 1 million investors. Investors feel that after 5 years, Morgan Stanley Growth Fund units still trade below the original IPO price of Rs.10.

It is incorrect to think that all mutual funds have performed poorly. If one looks at some income funds, they have come with reasonable returns. It is only the performance of equity funds, which has been poor. Their poor performance has been amplified by the closed end discounts ie units of these funds quoting at sharp discounts to their NAV resulting in an even poorer return to the investor.

One must remember that a Mutual Fund does not provide assured returns and neither can it "manufacture" returns out of thin air. Returns provided by mutual funds are a function of the returns in the underlying asset class in which the fund invests. Good funds can beat returns in their asset class to some extent but that’s all. E.g. take the case of a sector specific fund like a pharma fund which invests only in shares of pharmaceutical companies. If the Govt. comes with new regulation that severely restricts the pricing freedom of these companies resulting in negative outlook for the sector, the prices of all stocks in the sector could fall substantially resulting in a severe erosion in the NAV of the fund. No one can do anything about it. A good fund manager would probably sell part of the fund before prices fall too much and wait for an opportune time to reinvest at lower levels once the dust has settled. In that case, the NAV of the fund would fall to a lesser extent – but fall it will. If the investor in the fund has invested in some stocks in the sector on his own, in all probability, his personal investments may have depreciated to a larger extent.

Let us extend this example to an analysis of the investment climate in the last 7 years. The stock markets have done very badly in the last seven years. The BSE Sensex crossed 3000 for the first time in early 1992. Since then it has gone up and come down several times but has remained in the same range. Effectively, for a seven-year investment period, the total return has been almost zero. The prices of many leading stocks of yesteryear have fallen by more than 50% in these seven years. If one considers the fact that the sensex has been changed several times, with all the weak stocks having been weeded out, the effective returns on the old sensex, existing in 1992, have been substantially negative. The following table gives some of the prices of stocks considered "blue chips" in 1992, in 1994 and the prices prevailing at present.

Price in Rupees

It is quite obvious that if a fund had invested in any of these shares in 1992 or subsequently in the 1994 boom, and if it remained invested in the share, then it would be confronting a huge fall in NAV. This is exactly what has happened.

A similar table for prices of shares of Public Sector Undertakings (PSUs) is given below.

Price in Rupees

Most mutual fund managers took some time to realize the changed circumstances wherein the open economy ushered in by the liberalization took the full impact of the global deflation in commodity prices. This problem was compounded further by the Asian crisis after which cheap imports from Asia caused severe pressure on profits.

To add to this, most funds had invested some part of their portfolio in medium sized "growth" companies. Many of these companies have performed even worse than bigger ones and quite a few have seen share prices dip more than 90% from their 1994 highs. More important, funds could not sell these shares because of complete lack of liquidity with, at best, few hundred shares being traded every day.

Meanwhile, shares of companies in sectors like consumer goods (FMCG) and software, were showing good growth and they went up rapidly in price. Most fund managers were unwilling to sell shares of erstwhile "blue chips" at low prices and buy shares of emerging "blue chips" at high prices. This resulted in poor performance and negative returns.

One more issue is that the fund managers in many funds were not "professionally qualified and experienced". This is especially true of some of the funds floated by nationalized banks. Some of these individuals were transferred from the parent organization and did not really know much about investment management.

Lastly, investors would do well to have a look at the investments, which they made on their own. In most cases, they would have done much worse than the mutual funds. We have received numerous requests for advice from individual investors on what to do about their own investments. If that were any indicator, investors would have done really badly.

Is it true that globally mutual funds under perform benchmark indices? Why are smart money managers unable to do as well as the market? Or is it that they are not smart at all? What are the limitations of mutual funds?

It is 100% true that globally, most mutual fund managers under perform the asset class that they are investing in. It is not true that the fund managers are dumb; this under performance is largely the result of limitations inherent in the concept of mutual funds. These limitations are as follows:

Entry and exit costs: Mutual funds are a victim of their own success. When a large body like a fund invests in shares, the concentrated buying or selling often results in adverse price movements ie at the time of buying, the fund ends up paying a higher price and while selling it realizes a lower price. This problem is especially severe in emerging markets like India, where, excluding a few stocks, even the stocks in the Sensex are not liquid, let alone stocks in the NSE 50 or the CRISIL 500. So, there is simply no way that a fund can beat the Sensex or any other index, if it blindly invests in the same stocks as those in the Sensex and in the same proportion. For obvious reasons, this problem is even more severe for funds investing in small capitalization stocks. However, given the large size of the debt market, excluding UTI, most debt funds do not face this problem

Wait time before investment: It takes time for a mutual fund to invest money. Unfortunately, most mutual funds receive money when markets are in a boom phase and investors are willing to try out mutual funds. Since it is difficult to invest all funds in one day, there is some money waiting to be invested. Further, there may be a time lag before investment opportunities are identified. This ensures that the fund under performs the index. For open-ended funds, there is the added problem of perpetually keeping some money in liquid assets to meet redemptions.

Fund management costs: The costs of the fund management process are deducted from the fund. This includes marketing and initial costs deducted at the time of entry itself, called "load". Then there is the annual asset management fee and expenses, together called the expense ratio. Usually, the former is not counted while measuring performance, while the latter is. A standard 2% expense ratio means that, everything else being equal, the fund manager under performs the benchmark index by an equal amount.

Cost of churn: The portfolio of a fund does not remain constant. The extent to which the portfolio changes is a function of the style of the individual fund manager ie whether he is a buy and hold type of manager or one who aggressively churns the fund. It is also dependent on the volatility of the fund size ie whether the fund constantly receives fresh subscriptions and redemptions. Such portfolio changes have associated costs of brokerage, custody fees, registration fees etc. which lowers the portfolio return commensurately.

Change of index composition: World over, the indices keep changing to reflect changing market conditions. There is an inherent survivorship bias in this process, with the bad stocks weeded out and replaced by emerging blue chips. This is a severe problem in India with the Sensex having been changed twice in the last 5 years, with each change being quite substantial. Another reason for change index composition is Mergers & Acquisitions. The weightage of the shares of a particular company in the index changes if it acquires a large company not a part of the index.

Tendency to take conformist decisions: From the above points, it is quite clear that the only way a fund can beat the index is through investment of some part of its portfolio in some shares where it gets excellent returns, much more than the index. This will pull up the overall average return. In order to obtain such exceptional returns, the fund manager has to take a strong view and invest in some uncommon or unfancied investment options. Most people are unwilling to do that. They follow the principle "No fund manager ever got fired for investing in Hindustan Lever" i.e. if something goes wrong with an unusual investment, the fund manager will be questioned but if anything goes wrong with the blue chip, then you can always blame it on the "environment" or "uncontrollable factors" knowing fully well that there are many other fund managers who have made the same decision. Unfortunately, if the fund manager does the same thing as several others of his class, chances are that he will produce average results. This does not mean that if a fund manager takes "active" views and invests in heavily researched "uncommon" ideas, the fund will necessarily outperform the index. If the idea does not work, it will result in poor fund performance. But if no such view is taken, there is absolutely no chance that the fund will outperform the index.

Should an investor invest in a mutual fund despite its limitations or no?

Yes. Investor should invest some part or their investment portfolio in mutual funds. In fact some investors may be better off by putting their entire portfolio in mutual funds. This is on account of the following reasons:

On their own, uninformed investors could perform much worse than mutual funds.

Diversification of risks which is difficult for an investor to achieve with the small amount of funds at his disposal

Possibility of investing in small amounts as and when the investor has funds to invest

Unquestioned service of transaction processing, tracking of investments, collecting dividends/interest warrants etc.

Debt funds in India offer exposure to a diversified portfolio of bonds/debentures, which is possible, only if the investor is investing millions of rupees. Further, they offer easy liquidity and tax benefits. Debt funds thus offer a great proposition that is impossible for ordinary investors to replicate on their own. This proposition compares favorably against competing investments like small savings.

Investors require analytical capability and access to research and information and need to spend an enormous amount of time to make investment decisions and keep monitoring them. Some people have the inclination and the time to make better decisions than fund managers do, but the vast majority does not. Those who can are advised to invest some part of their money into funds, especially debt funds, to diversify their risk. They may also note that one of the objectives of this site is to help them improve the odds in their favor.

Are mutual funds safe? Are returns on mutual funds guaranteed by Government of India, or Reserve Bank or any other government body?

Any mutual fund is as safe or unsafe as the assets that it invests in. There are two basic categories of mutual funds with others being variations or mixtures of these. Firstly, there are those that invest purely in equity shares (called equity funds or " growth funds") and secondly, there are those that invest purely in bonds, debentures and other interest bearing instruments called "income" or "debt" funds. The NAV of growth funds fluctuates in line with the fluctuation of the shares held by them. They can also witness face substantial erosion in value, which could be permanent in some cases. On the other hand, prices of debt instruments fluctuate to a much lesser degree and an income fund is extremely unlikely to face erosion in value – especially of the permanent kind.

Most mutual funds have qualified and experienced personnel, who understand the risks of investing. But, nobody is immune from making mistakes. However, funds diversify the investment portfolio substantially so that default in any single investment (in the case of an income fund) will not affect the overall performance of a fund in a significant manner. In the event of default of a part of the portfolio, an income fund is extremely unlikely to face erosion in face value.

Generally, mutual funds are not guaranteed by anybody. However, in the Indian context, some of the mutual funds have floated "guaranteed" or "assured" return schemes which guarantee a certain annual return or guarantee a buyback at a specified price after some time. Examples of these include funds floated by the UTI, Canbank Mutual Fund, SBI Mutual Fund, LIC Mutual Fund etc. Many of these funds have not earned returns that they promised and the asset management companies of the respective mutual funds or their sponsors have made good their promises. The biggest case pertains to the US 64, which never guaranteed any returns but is being bailed out by the Government due to the millions of individuals who have invested in it.

Can the foreign mutual funds operating in India take investors money outside the country?

A mutual fund and the company that manages it are 2 entirely different companies. Legally speaking, a mutual fund is a trust formed and registered under the Indian Trust Act. The sponsor asset management company is formally appointed by the trustees of the trust to manage money on their behalf e.g. DSP Merrill Lynch equity fund is a mutual benefit trust registered under the Indian Trust Act. The trustees have appointed DSP Merrill Lynch Asset Management Company Pvt. Ltd. to manage the funds in the trust and the company cannot touch one rupee from the trust except to the extent of the fees that it receives for managing the funds.

Repatriation of money outside India comes under the purview of the Foreign Exchange Regulation Act, 1973 which specifies the situations in which money can be remitted outside India. Under the act, banks that repatriate money on behalf of their clients have to ensure compliance with various legal formalities and ensure that the entity, which remits money, is entitled to do so. Any failure or violation leads to serious consequences for both the remitter and the bank. Money collected by a mutual fund domestically is not allowed to be remitted outside India.

Is mutual funds out performance always good?

Mutual fund performance of index may not always be a positive indicator. In several cases one notices that the funds performance is very lop sided and is driven by few scrips. In other words the fund manager has taken significantly higher risks and in the game of probability he would have made more money. But it is very likely that if his call had not been right, he would have under performed and lost badly. From an investor’s point of view, when he is looking at such out-performances in the past, he cannot derive confidence and comfort in the fund managers' ability to repeat the performance in future. As markets are not rational, there is no methodology in the world to scientifically predict stock prices. Therefore it is not possible for anyone to beat the market on a consistent basis and hence there is no guarantee that the fund manager would perform well all the while.

How does one see through the marketing hype given out by mutual funds ? It is amazing how fund marketers can come up with statistics to show how their particular fund has done extremely well. Standard techniques include the following:

Defined period returns: Some period is depicted in which the particular fund outperformed others or some benchmark. One should look very carefully at start and end dates – they can always be chosen in a way that shows the fund in a favorable light

Out performance vs. performance: Sustained periods of low absolute performance are a cause for concern. It is all right to look at relative returns with respect to benchmark indices; but there is no sense if a particular fund produces absolute returns less than the deposit interest rates, even after a few years of existence.

Promise of long term performance: Lack of performance is often explained away as temporary with promises of good performance in the long term. Few define what this "long term" is – 1 or 2 or 5 or 10 years. Do not forget that the longer the period, the longer is the uncertainty in between – in other words, would you want to wait for 10 years to get an uncertain 2% higher returns as compared to the certain returns that you get in say the Public Provident Fund.

Rupee cost averaging: This is a term that has found its way into the marketing literature of all mutual funds. What it means is that if you put in a fixed amount of money every month in a fund, then, in months when the NAV is low, the investor gets more units which benefits him when the NAV rises. Do not forget the implicit assumption behind this – that the NAV will rise eventually. If it does not, you are no better off than by not buying.

Equities are the best bet in the long run: Ask this to any investor who put money in the Sensex in 1992. After a long run of 7 years, the investor is down on his investment by 50%. He would have been better off by investing in other investment.

What went wrong with US64 ?

Basically, for a period of 2-3 years, the UTI distributed more dividend to the unit holders of US 64 than the return earned from the investments in the scheme. This reduced the value of the residual investments in the scheme. This problem was compounded by the persistent fall in the prices of shares, especially the shares of companies in basic commodity industries like cement, steel, manmade fibers etc. and shares of public sector units. Throughout this period, when the NAV of US 64 was going down, UTI kept increasing the sale and repurchase prices of US 64 units. The stock market collapse after the Pokhran II nuclear tests was the last straw, which resulted in the erosion of the scheme’s book reserves and a wide difference between the actual NAV and the sale/repurchase price.

When this became known, it set a panic amongst investors of US 64. Many people felt that if there were large-scale redemptions, UTI would not be able to meet them without support of outside bodies like the RBI. Further, theoretically, if all investors wanted to redeem their US 64 units on the same day, the US 64 simply did not have the money to meet the redemptions on its own (due to the difference between NAV and the repurchase price).

What went wrong with Morgan Stanley ?

Morgan Stanley raised large corpus (more than Rs.10bn) in around early 1994. The entire exercise in fund raising was centered on the hype of the fund being was the first fund promoted by an internationally acclaimed asset management company. It was marketed like any other public issue and fund investors rushed to invest in the scheme hoping to get superior returns. No one bothered to explain to them that Morgan Stanley AMC was a service provider - providing them the service of investment advice and management. No one explained to them that they were not investing in a share of a company – in fact the artificial gray market premium served to perpetrate this feeling.

The IPO was a great success. It ensured that the name "Morgan Stanley" was now a part of the dreams of more than 1 million Indians.

The fund raising exercise, unfortunately, coincided with the peak of stock market boom. Indian stock markets lack depth and are quite illiquid. The fund managers were compelled to invest in equities in a big hurry as a number of Foreign Institutional Investors were investing huge sums of money in the country resulting in a mad rush for equity stocks. The fund’s managers invested a considerable amount of money in smaller companies with low floating stock and low market capitalization, either through the secondary market or through private placements. These companies had experienced the highest appreciation in prices in the immediate past.

The market position started changing from late 1994. The boom in the market made it possible for many companies to raise equity capital and literally hundreds of public/rights issues opened for subscriptions every week, many of them at high issue prices. There were also massive private placements of equity shares and GDR issues at huge premiums. There were very few companies which did not wash their hands in this great gravy train. This deluge of paper soaked up money and reduced the amount available for fresh investment both from resident Indians, domestic mutual funds and from foreign institutional investors.

At this time, the RBI commenced on its tight money policy in a bid to control inflation from raising its head. Money supply tightened and bond yields started increasing dramatically. High industrial growth and tight money created a shortage for credit and rates started going sky high. Many corporates and banks started redeeming their holdings in the Unit Trust of India and other mutual funds. This put major pressure on the market, which was already showing signs of weakness. What followed was the great crash.

And in this crash, the biggest losers were the smaller capitalization stocks. Many of these stocks lost more than 90% of their peak prices.

Morgan Stanley AMC restructured the funds portfolio at big losses.

As the NAV went below par, investors’ confidence was shattered. Being a closed-ended scheme the Morgan Stanley’s mutual fund unit is also listed on the stock markets. Crisis of confidence led to its price on the stock exchange crashing and it started quoting at a steep discount to its NAV. The fund started buying back units in order to reduce the discount and also to boost the NAV (buying back units at prices below the NAV results in a profit, which will reduce the NAV). Given its large corpus size no amount of buy back or otherwise support could help boost the investor confidence.

Since then the equity markets have gone nowhere with the index still below the level at which the fund was invested. Most of the stocks in the Sensex have performed poorly with markets punishing commodity companies and companies with non-transparent Indian managements. To top it, many erstwhile bluechips have reported disastrous financial performances.

Consequently, the NAV of MSGF mirrors this gory saga of the Indian markets. In fact, the fund invested considerable amount of money in FMCG, pharmaceutical and software companies at the right time which improved the NAV from 1998 onwards.

How important is an AMC (Asset Management Company) behind a mutual fund? AMC controls the operations and functioning of a mutual fund. It is very critical to the performance of a mutual fund as it decides on the style of functioning, people who are going to manage the funds, the commitment to service quality and overall supervision.

The financial strength and the commitment of the AMC sponsors to the business are very key issues. This is because most AMCs lose money in the first few years of operations. In most cases, these losses are much more than the capital requirements stipulated by SEBI. Hence, a sponsor which is financially weak or which cannot capital to the business either because of its inability or unwillingness will result in an unhealthy operation. There will be a tendency to cut corners and unwillingness to spend money to expand operations. This is the last place where high quality persons would want to remain and work. The AMC then remains stunted and the sponsors lose interest. The worst affected are the investors. This is exactly what has happened with some AMCs promoted by Indian business houses.

This is also a problem that has afflicted some of the AMCs floated by nationalized banks. In these organizations, the traditional thinking is prevalent which can be summarized as "money is power". Since mutual fund business did not have access to too much money, a posting in the AMC became punishment postings for some personnel who were not doing well in the parent organization or who lost out in the organizational politics. The management of the banks also did not allow these AMCs to become independent viable businesses. The CEO’s of the AMCs did not have any clue of the mutual fund business and neither were they interested in it – the entire effort was spent in getting a posting back in the parent. The fund managers had no experience in the activity making a mockery of "professional management". The sad results are there to see. Some of the parents had to provide funds to bridge the gap in "assured return schemes". It looks extremely likely that some of these AMCs will no longer exist in a few years.

How and against what should you benchmark the performance of a mutual fund ? All mutual funds have different objectives and therefore their performance would vary. A mutual funds performance should be benchmarked against mutual funds of similar type or India Infoline mutual fund index for a particular type. e.g. equity fund index, income fund index or balanced fund index or liquid fund index. One can also benchmark the fund against the Sensex or any other broad based index for the particular asset class.

One has to be very careful about choosing the comparison period. Ideally, one should compare the performance of equity or an index fund over a 1-2 year horizon. Any comparison over a shorter period would be distorted by short term, volatile price movements. Comparisons over a longer period need to be interpreted carefully by looking at other factors such as change in individuals managing the fund, one time investment successes etc. Similarly, the ideal comparison period for a debt fund would be 6-12 months while that for a liquid/money market fund would be 1-3 months. Apart from the entire period, one should also compare the performance in smaller intervals within the same period say intervals of one month duration.

To make comparison meaningful, one has to compare the average annual compounded rate of return. This adjusts for comparisons of differing period and also facilitates comparison across different classes. The return also incorporates dividend payouts. Thus, for example, one can say that ABC income fund has given a compounded annual growth rate (CAGR) of 13% p.a. including dividends in the last 2 years while XYZ income fund has given a CAGR of 13.2% p.a. over the last 3 years.

Apart from NAV, what other parameters can be compared across different funds of the same category?

Apart from plain numerical comparison of NAV’s, several other things can be checked, e.g. correlation of changes in NAV with changes in portfolio composition and appreciation/depreciation in valuation of individual items, increase in the size of the corpus etc. In debt funds, it is useful to compare the extent to which the growth in NAV comes from interest income and from changes in valuation of illiquid assets like bonds and debentures. It is also useful to compare expense ratios of funds e.g. Birla Income Plus has an expense ratio of 1.7% which is one of the lowest expense ratios of all income funds in the industry – this means that, everything else being equal, the performance of that fund will be higher by 0.55% than other funds, which have an expense ratio of 2.25%. Last, but not the least, one has to compare the risk profile of two funds. For income funds, this could mean credit quality of the portfolio and the fluctuations in the NAV with periodic changes in the interest rate environment. For equity funds, it could mean the volatility of the NAV with the ups and downs in the market or the percentage exposure to smaller company shares etc.

How different are styles of different mutual funds?

Different mutual funds have very different investing styles. These styles are a function of the individuals managing the fund with the overall investment objectives and policies of the organization acting as a constraint. These are manifest in things like

Portfolio turnover – Buy and hold strategy versus frequent investment changes

Kind of investments made – small versus large companies, multi baggers (investments which yield high gains) versus percentage players (investing in shares which will give small gains in line with the market), high quality – low yield bonds versus low quality – high yield bonds

Asset allocations – Varying percentage of cash depending on aggressive views on markets

The following examples serve to illustrate a few styles of equity fund managers

Some fund managers are passive value seekers and some are value creators. The former type buys undervalued assets and patiently waits for the market to discover the value. The latter aggressively promote the undervalued stocks that they have bought.

Some fund managers restrict themselves to liquid stocks while some thrive on illiquid stocks which offer themselves easily to large price changes.

Some fund managers are masters of the momentum game and seek to buy stocks that are in market fancy. They attach lesser importance to fundamentals and believe that a rising stock price and favorable momentum indicators imply that fundamentals are changing. In effect, they are following the philosophy, " The trend is my friend". Other fund managers go more by deep fundamental analysis completely ignoring price movements. They do not mind price going down and are in fact happy to buy more.

Some fund managers are growth investors i.e. they buy stocks with a high P/E using the forecasted growth to justify the high valuation. Others are value investors who buy shares with low P/E or P/BV multiples - typically companies rich with undervalued assets.

When you buy a mutual fund unit what exactly do you buy?

When you buy a mutual fund unit you are buying a part of the equity or debt portfolio owned by the mutual fund. In other words you are buying a part ownership of various companies and when you buy a debt mutual fund you are buying a part right to title to debt securities. In other words you step into the shoes of owners or lenders indirectly. The value of your part of the assets will fluctuate in line with the value of the individual components of the portfolio on the stock or the bond market.

In effect, you are buying a bundle of services as follows:

Investment management – which means investment advice and execution rolled into one

Diversification of investment risk – buying a larger basket of securities reduces the overall risk of investment

Asset custody – which means registration and physical custody of assets, ensuring corporate actions like payment of dividend and interest, bonus, rights entitlements etc

Portfolio information – which means calculating and disseminating ownership information like NAV, assets owned, etc on a periodic basis

Liquidity – Ability to speedily disinvest assets and obtain disinvestments proceeds

The mutual fund exploits economies of scale in research, execution and transaction processing to provide the first three services at low costs. The pooling of money makes it possible to offer the fourth service (since all investors are unlikely to exit at the same time). In addition, one also gets benefits like special tax concessions.

What you do not get is a guaranteed way of making money. There is no way that a mutual fund can insulate the investor from the vagaries of the market place and ensure that he always makes money. In addition, one is implicitly taking the risk of bad service quality in any of the four elements above including investment management.

What are load and no-load funds? Why are loads charged?

Some asset management companies (AMCs) levy service charges for allowing subscribers entry into/exit from mutual fund schemes. The service charge is termed as entry/exit load and such schemes are called "load" schemes. In contrast, funds for which no entry/exit charge is levied are called no-load funds.

The load is levied to cover the up-front cost incurred by the AMC in the process of marketing and selling the fund and other one-time transaction processing costs.

Why is the buy and sell price different for some mutual fund units and same for others?

Buying and selling prices are different for those mutual funds which have up front sales charges or entry loads. Usually, the selling price is the NAV while the buying price incorporates the service charge or the load. In case the fund is a no-load fund, there is no difference between the buying and selling prices. We have a detailed section on the characteristics of all mutual fund schemes, which tells you the exact load charged by respective funds.

Where can one obtain information on the market price of specific mutual fund units?

Buying and selling prices for units of open-ended mutual funds are declared every day. You can obtain this information on our website. Check out the section on mutual funds.

Most closed-ended mutual funds are listed on the stock exchanges. The trading volume in some of the widely held mutual fund units is considerable. The latest NAV and market price information of closed-ended mutual funds is available on our website.

All the above information is also available on the stock market page of popular newspapers.

The returns differ from year to year on account of the following reasons:

An income fund invests in instruments from which it earns two kinds of returns – The first comes from interest income. The second comes from any increase in the market price of invested instruments. The second component could also be negative when there is a fall in the market value of the invested instruments. The rise and fall in market prices of debt instruments is a function of the prevailing interest rates. Thus changes in interest rate environment cause fluctuations in returns.

Secondly, income mutual funds invest in an array of instruments with different maturity. Whenever any debt instrument in which the fund has invested is redeemed, the redemption proceeds have to be reinvested in a fresh instruments. This fresh investment would earn a rate of return depending on the prevailing interest rate which could be higher or lower than that prevailing in the earlier period. Accordingly, the overall return of the portfolio will change.

A third reason can be active view taking by the fund manager e.g. a fund manager can take a view that interest rates are expected to rise. Accordingly, he would disinvest a large part of his holdings and convert them into cash so as to avoid loss in the value of his holdings. If this view is wrong, he may end up having a low return on a large part of his portfolio, since cash is invested in low yielding money market avenues. On the other hand, if the view is right, the cash can be deployed in higher yielding instruments after interest rates rise, thus improving the overall return and more important avoiding the loss.

There is a fourth reason, which is relevant only for open-ended income funds. Such funds have a fluctuating level of idle cash (depending on the level of fresh collections) which is typically invested in low yielding money market instruments. This causes change in the rate of return.

Lastly, there is always the possibility of a credit loss for any income mutual fund ie losses arising out of default in any of the instruments in which the fund has invested. The fund will declare a low return in the period in which such losses show up.

What are the risks associated in investing in income mutual funds and how should one find out about these?

Income funds invest in a diversified portfolio of debt instruments which provide interest income. There is a possibility that some of these instruments are of low credit quality and the issuers of these instruments default in the payment of interest or principal. Such losses, called "credit losses", constitute an area of risk for income funds. The process of diversification mitigates this risk i.e. by the fund investing in a number of debt instruments. However, it should be noted that the funds returns could be eroded considerably if even 10% of the investments have credit quality problems. Also, the problem can be accentuated for investors who are investing for a short period if the losses show up in a particular period resulting in a short term decline in NAV. Investors can check the credit quality of the investment portfolio, which is published by most funds on a quarterly basis.

The second area of risks comes from the fluctuations in the prices of the underlying instruments in which the fund invests. Any rise in interest rates will result in a fall in the value of the investments causing a dip in the NAV. The fall in value is maximum for longer dated instruments and negligible for short dated instruments. Hence, the risk is higher in a fund that has an investment portfolio with a higher average maturity. This can again be checked from the investment portfolio, which is published by the funds.

Even if interest rates rise by 2-3%, the fall in NAV for most mutual funds is unlikely to exceed 5%. Similarly, a portfolio with as high as 10% of poor quality instruments will result in a fall in NAV by 10%. Regular interest income will take care of the losses in a few months. Thus, there is unlikely to be permanent erosion of capital in most reasonable circumstances. Hence, debt or income funds have a much lower risk than equity funds, which can have permanent erosion in value.

Today’s environment is characterized by a deep industrial recession and consequent high level of defaults on loans provided by banking sector to industry. In such a scenario, it may be prudent to look at the credit quality aspect very carefully before investing in an income mutual fund.

What are the tax benefits available for investing in mutual funds?

The tax benefits for investing in mutual funds are as follows:

Twenty percent of the amount invested in specified mutual funds (called equity linked savings schemes or ELSS and loosely referred to as "tax savings schemes") is deductible from the tax payable by the investor in a particular year subject to a maximum of Rs.2000 per investor. This benefit is available under section 88 of the I.T. Act.

Investment of the entire proceeds obtained from the sale of capital assets for a period of three years or investment of only the profits for a period of 7 years, exempts the asset holder from paying capital gains tax. This benefit is available under section 54EA and 54EB of the I.T. Act.

The mutual fund is completely exempt from paying taxes on dividends/interest/capital gains earned by it. While this is a benefit to the fund, it is the indirect benefit of unit holders as well. This benefit is available to the mutual fund under section 10 (23D) of the I.T. Act.

A mutual fund has to pay a withholding tax of 10% on the dividends distributed by it under the revised provisions of the I.T. Act putting them on par with corporates. However, if a mutual fund has invested more than 50% of its assets into equity shares, then it is exempt from paying any tax on the dividend distributed by it, for a period of three years, by an overriding provision. This benefit is available under section 115R of the I.T. Act.

The investor in a mutual fund is exempt from paying any tax on the dividend received by him from the mutual fund, irrespective of the type of the mutual fund. This benefit is available under section 10(33) of the I.T. Act.

The units of mutual funds are treated as capital assets and the investor has to pay capital gains tax on the sale proceeds of mutual fund units sold by him. For investments held for less than one year the tax is equal to 30% of the capital gain. For investments held for more than one year, the tax is equal to 10% of the capital gains. The investor is entitled to indexation benefit while computing capital gains tax. Thus if a typical growth scheme of an income fund shows a rise of 12% in the NAV after one year and the investor sells it, he will pay a 10% tax on the selling price less cost price and indexation component. This reduces the incidence of tax considerably. This concession is available under section 48 of the I.T. Act. The following calculations show this in more detail:

Purchase NAV = Rs.10

Sale NAV = Rs.11.2

Indexation component = 8%

Capital gains = 11.2 – 10(1.08)

= 11.2 – 10.8

= 0.4

Capital gains tax = 0.4*0.1 = 0.04.

If an investor buys a fresh unit in the closing days of March and sells it in the first week of April of the following year, he is entitled to indexation benefit for two financial years which close in the two March ending periods. This is termed as double indexation and lowers the tax even further especially for income funds. In the above example, the calculation would be as follows:

Capital gains = 11.2 – 10(1.08)(1.08)

= 11.2 – 11.7

= -0.5

Thus there would be no capital gains tax.