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Introduction to personal finance, wealth management and mutual funds


This chapter gives a glimpse into the world of personal finance, investments and wealth management – this space is heavily regulated by SEBI regulations. Any financial intermediary interested in operating in this space is required to put in place a very sophisticated set of documentation - consultants and corporate law firms who help these intermediaries with such work are in great demand. 
Businessmen and entrepreneurs often seek counsel from various advisors about the ways in which they can manage personal finances, invest their money and make it grow. In fact, it is essential for any businessman to know the basics of how he should manage or invest his funds himself - this chapter should provide an introductory glance.


What can a businessman (or for that matter, anyone who has surplus funds) do with his money? If he does not spend it on consumer items or invest in property, he has two options – he can invest it in his own business, or invest / lend it to other businesses. In this chapter we will discuss about the options available if he is considering investing in other businesses.

An ‘angel investor’ typically invests his own money in other startups. Often, entrepreneurs who have made successful exits turn into angel investors (and invest the profit they made into other startups) to encourage other entrepreneurs. Angel investors can invest alone or collectively, e.g. several individual investors forming part of a group such as ‘Mumbai Angels’ may invest their own money in a startup.

High-net worth individuals and institutional investors can also pool in their money to make large investments into businesses (such money can be managed professionally) – the investment vehicle is typically a venture capital or a private equity fund. We discussed about venture capital in Module 4. Venture capital funds typically take in huge amounts from each investor into the fund pool. They also take certain ‘protective rights’ to safeguard their interest in the companies in which they invest (by entering into sophisticated shareholder agreements).

Investment in startups is extremely risky - what if you want to invest your money in relatively stable and established businesses?
Individuals who have large amount of capital but do not want to pool it with funds of other investors (e.g. high net-worth individuals or HNIs) can avail of portfolio management services (PMS) to manage their wealth – these are provided by professionals known as ‘portfolio managers’ who are registered with SEBI. They are empowered contractually to invest the funds of their clients depending on the returns desired by the clients and their risk appetite.

Their relationship with the client is governed by a portfolio management services agreement. If one desires the services of a portfolio manager, the minimum amount of funds that he must be allocated for managing is very high – SEBI regulations stipulate a minimum of INR 5 lakhs for any investor, and PMS providers are free to require a higher amount as the minimum funds for PMS services. Depending on the contract, they may have the discretion to make decisions for investment of the client’s money.

What options are available for ordinary investors who wish to invest in established companies?
Portfolio management services, venture capital and angel investments are tools for very rich investors. What opportunities are available to the ordinary investor? Investment in stock markets has been a very popular option with many people investing through online brokerages such as Sharekhan, India Infoline, etc. However, investing directly into the stock market requires undertaking a lot of research to identify which stocks can potentially grow in future (or you may have to subscribe to a service which provides you the requisite research and inputs so that you can make investment decisions).

Can retail investors ‘pool’ their funds with other investors and gain exposure to a wider portfolio?
Retail investors can pool large amounts of money, which is managed through a professional set of managers. Instead of investing individually in stock markets, they can invest through mutual funds. Unlike venture capital and private equity funds, mutual funds do not acquire any special rights in the businesses they invest in. Venture capital is typically used for investing in unlisted companies, and a mutual fund for investing primarily in listed companies. Mutual funds can also invest in commodities (e.g. gold) and indexes (apart from investing in companies), which enables investors to invest in a wide variety of instruments. 

Mutual funds and portfolio management services
Portfolio management services require a high contribution from their clients – hence their clients are typically wealthy persons and high net worth individuals. Ordinary retail investors cannot easily avail of their services for this reason. However, mutual funds are more accessible to retail investors as there is no minimum amount that must be contributed as per law. Further, investors do not necessarily need to subscribe at the time a scheme is launched - they can also purchase mutual fund units on a stock exchange from other unit holders.

Portfolio management services offer more flexibility and customization. Mutual funds have a standard ‘scheme’ document as per which they will invest funds – hence an investor can only invest in one of several straitjacketed ‘schemes’. On the other hand, a portfolio management service will allow for tremendous personalization as per every client’s needs and objectives.
The SEBI (Portfolio Managers) Regulations, 1993, SEBI (Venture Capital Funds) Regulations 1996 and SEBI (Mutual Funds) Regulations 1996 are accessible on the following link: 
Understanding Mutual Funds

Mutual funds are an alternative to investing directly in the stock market. They are professionally managed and invest money pooled from various investors. Hence, the corpus of the fund is much larger than that of a single investor, as the total funds are the aggregate of the amount contributed by multiple investors. Pooling also enables money to be invested into different types of securities, which reduces risk and helps in achieving diversification for investors. Investors are able to gain ‘exposure’ to a wider portfolio. By pooling money together in a mutual fund, investors who do not necessarily have large amounts of capital can gain exposure to a very diverse set of securities, which would have otherwise required them to invest huge amounts of capital.

Investing in mutual funds may be beneficial for an investor who is not very hands-on with market dynamics or familiar with stock market, as mutual funds have professional managers who systematically conduct detailed research on various stocks and sectors. For sophisticated investors mutual funds may not turn out to be optimal investment tools as the management charges and fees for the fund correspondingly reduce the effective returns generated by it.

Thus, a mutual fund is a connecting bridge or a financial intermediary which allows a group of investors to pool their money and invest in specific instruments with a predetermined investment objective. Mutual fund units are listed on stock exchanges – hence after they are issued by the trustee company, they can be purchased and sold in the same manner as shares.

When you invest in a mutual fund, you are buying units or portions of the mutual fund and thus on investing one becomes a shareholder or unit holder of the fund. The mutual fund will have a fund manager who is responsible for investing the money into specific securities (stocks or bonds).
In this chapter, we will explain the types of mutual funds, structure of a mutual fund and the legal framework governing mutual funds.
  1. Types of mutual funds and their schemes
Mutual funds are classified depending on their investment objectives (e.g. whether it is a scheme focusing on appreciation of capital or merely earning a steady stream of income) and the securities they invest in. They may have schemes which invest only in equity shares, which are called ‘growth schemes’, or those which invest in ‘debt securities’ (bonds or debentures) which are called income schemes. Funds which invest only in government debt securities are called ‘gilt-edged funds’.

One of the major objectives while investing in equity is appreciation of capital, while in case of debt the key incentive is to earn interest. Since there is a legal obligation by the company to pay interest on debt securities (i.e. bonds and debentures), they are also known as ‘fixed income securities’. Debt funds have a much lower risk compared to equity funds.

When a fund invests money, the aggregate amount is pooled together and divided into ‘units’ (units of a fund are like shares of a company). The gamut of securities in which a mutual fund scheme has invested its entire capital is known as its ‘portfolio. The composition of the portfolio may differ depending upon the type of fund, for example, an equity oriented fund may invest primarily in equity shares of a company, an infrastructure debt fund may only invest in debt instruments of infrastructure companies, etc.


A mutual fund scheme could have contributed 80% of its funds into large cap companies and 20% in early stage companies or penny stocks. Or it may have contributed 60% of its funds into equity securities and 40% of into debt securities. A single investor cannot trace which securities his money has been invested. Therefore, mutual funds issue their own ‘units’. The value of a single unit is linked to the total value of the portfolio, and is known as called the ‘net asset value’ or NAV.


Open / closed ended schemes and entry / exit loads
Fund schemes may be open ended, that is, the scheme has no particular maturity period and an investor can purchase and sell units at any time. The investor will earn returns based on the returns made by the fund – by way of dividend or interest, or by selling the securities in its portfolio. They may, alternately, be closed ended, that is, they have a fixed maturity period and are open to subscription at a fixed time, after which subscription is not permitted. Returns may be provided to investors periodically or upon maturity, and investors may be restricted from exit.

Entry and exit from a mutual fund scheme may be permitted by the fund upon payment of a charge – this is known as entry load in case of subscribing to a fund and exit load in case of drawing out the investment. SEBI regulates the entry and exit loads on open and closed ended schemes.

Index Funds
Mutual funds may invest in a particular sector – e.g. software, alternative energy, etc. or in an index such as the NIFTY or BSE Sensex. In case of investment in an index, the proportion in which it invests in different stocks will mirror the weightage of the stock in the index. If 3 companies constitute a hypothetical index in the ratio of 3:2:1, the fund will invest its money in their stocks in the same ratio.

Index funds are chosen for investors who do not want their funds to be ‘actively’ managed by the fund managers – in an index fund, the money is simply pooled to mirror the composition of an index, hence investors don’t have to bear heavy management charges, as in the case of actively managed mutual funds.
  1. Ways of making returns through mutual funds
Investors can make returns through mutual fund investments in the following ways:
  • Sale of units by the unit holder on the stock exchange: An investor can sell individual units of the mutual fund on the stock market and make a profit due to increase in the value of the unit. This is very similar to selling shares on the stock market. Such gains are considered capital gains under tax law.
  • Sale of underlying securities by the fund: If the fund sells securities that have appreciated, the fund has a capital gain. A fund may also pass on these gains to investors in a distribution.
  • Buy-back by the fund: If the value of the underlying securities increases, an investor may also have the option to sell back the unit to the fund – he can make a huge profit through this process. An investor may also have the option to reinvest the gains made by selling the units back into the fund’s corpus.
  • Income from portfolio companies: The companies into which the fund has invested may pay out a dividend (if the investment is into shares) or interest (if the investment is into debentures or bonds). This income can be distributed by the fund to the holders of the mutual fund units.
  • Gain at the end of the scheme’s term: When the fund winds up after completion of its term, the investor is returned his original capital and any gains or losses made by the fund.
Costs of investing in a mutual fund vs. costs of investing directly into the stock market
Investing in mutual funds has its downside as well – fund managers charge management fees (usually a percentage charge on the basis of the total corpus contributed by all the investors and the profits made by the fund). The fund may also levy an entry or exit loads on a new investor or someone seeking to exit from the fund pending the completion of its term. The effect of extreme gains from a particular may be averaged out because of a diversified pool.
  1. Structure of a mutual fund
Mutual funds are governed by the SEBI (Mutual Funds) Regulations, 1996[1]. A mutual fund is constituted in the form of a trust governed by the Indian Trusts Act, 1882 and registered as per the Indian Registration Act, 1908.

In addition, the fund has a sponsor, trustees, asset management company (“AMC”) and a custodian. The trust is actually established by a sponsor (there can be multiple sponsors too) who is akin to the promoter of a company.
The trustees of the mutual fund hold its property for the benefit of the unit-holders. They have power of superintendence and direction over AMC. They monitor performance and compliance of SEBI Regulations by the mutual fund.  According to SEBI Regulations, two-thirds of the directors of trustee company or the board of trustees must be independent.

The AMC (which requires SEBI approval), manages the funds by making investments in various types of securities. The sponsor of the fund must have a minimum 40 percent contribution to the networth of the AMC. The AMC’s directors must have adequate professional experience in financial services.

The relationship between the fund (administered by the trustees) and the AMC is governed by an ‘Investment Management Agreement’, which must mandatorily address issues mentioned in the Mutual Funds Regulations.
The custodian, who is registered with SEBI, holds the securities of various schemes of the fund. The relationship between the fund and the custodian is governed by a ‘Custodian Agreement’.
If a mutual fund intends to invites funds from the public, it can do so by issuing an ‘offer document’ or a ‘scheme information document’.

In addition to regulation by SEBI, mutual funds have constituted a self-regulatory body called the Association of Mutual Funds in India (AMFI) to increase public awareness of the mutual fund industry, for upgrading professional standards and in promoting industry best practices.
Click here to download a graphical representation of a typical mutual fund structure.

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