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These markets can be either primary markets or after markets.
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| A stock market is a market for the trading of publicly held company stock and associated financial instruments (including stock options, convertibles and stock index futures). Many years ago, worldwide, buyers and sellers were individual investors and businessmen. These days markets have generally become "institutionalized"; that is, buyers and sellers are largely institutions whether pension funds, insurance companies, mutual funds or banks. This rise of the institutional investor has brought growing professionalism to all aspects of the markets.
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| The money market is a subsection of the fixed income market. We generally think of the term "fixed income" as a synonym of bonds. In reality, a bond is just one type of fixed income security. The difference between the money market and the bond market is that the money market specializes in very short-term debt securities (debt that matures in less than one year). Money market investments are also called cash investments because of their short maturities. Money market securities are essentially IOUs (an abbreviation of the phrase "I owe you") issued by governments, financial institutions and large corporations. These instruments are very liquid and considered extraordinarily safe. Since they are extremely conservative, money market securities offer significantly lower returns than most of the other securities.
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The capital market framework consists of the following participants:
- Stock Exchanges
- Market intermediaries, such as stock-brokers and Mutual Funds
- Investors
- Regulatory institutions (e.g. SEBI)
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The following are the different types of financial instruments-
- Debentures
- Bonds
- Preference shares
- Equity shares
- Government securities
Debentures
A debenture is the most common form of long-term loan taken by a company. It is usually a loan repayable at a fixed date, although some debentures are irredeemable securities; these are sometimes called perpetual debentures. Most debentures also pay a fixed rate of interest, and this interest must be paid before a dividend is paid to shareholders.
Bonds
A bond is a debt investment with which the investor loans money to an entity (company or government) that borrows the funds for a defined period of time at a specified interest rate.
Preference shares
Preferential shareholders enjoy a preferential right over equity shareholders with regards to:
Receipt of dividend
Receipt of residual funds after liquidation
However, preferential shareholders do not have voting rights; they are entitled only to a fixed dividend.
Equity shares
Equity shares represent proportionate ownership in a company. Investors who own equity shares in a company are entitled to ownership rights, such as:
- Share in the profits of the company (in the form of dividends),
- Share in the residual funds after liquidation / winding up of the company,
- Selection of directors in the board, etc.
Government Securities
The Central Government and the State Governments issue securities periodically for the purpose of raising loans from the public. There are 2 main types of Government securities:
Dated Securities: have a maturity period of more than 1 year
Treasury Bills: have a maturity period of less than 1 year
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| One cannot buy directly from the market or stock exchange. A buyer has to buy stocks or equity through a Stock Broker, who is a registered authority to deal in equities of various companies. In effect a lot many intermediaries might come in between the buyer and seller, as brokers do their business through many sub-brokers and the like.
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| The general theory goes that the higher the profit, the greater the risk. Since there is scope for high profit in the Stock Market, investing in the Stock Market can be risky. In fact, more than 80% of the people who put money in the market lose it and a majority of the rest are barely able to protect themselves from losses. Only a minuscule minority of investors are able to garner any substantive profits.
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Basic human psychology. Men want profits- big and fast. Not many are deterred by the risks involved. The fact is that investment in the stock markets can give, potentially, the fastest ROI (Return On Investment), as the value of a stock can rise pretty fast, ensuring huge profit for investor. People buy shares in a company for either of two reasons:
- They have a stake in the company. They are concerned not only in the future growth in stock value but in the worth of the company itself. Their investments are long-term and they don't sell their shares in an impulse.
- They want quick profit and don't have any stake or interest in the company, but merely want some quick value addition. Most investors belong to this category. Their investments - both buying and selling - are impulsive. Mostly, they don't do any market research and don't follow any sector or company to gain proper knowledge before investing.
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The term "Derivative" indicates that it has no independent value, i.e. its value is entirely "derived" from the value of the underlying asset. The underlying asset can be securities, commodities, bullion, currency, live stock or anything else. In other words, Derivative means a forward, future, option or any other hybrid contract of pre determined fixed duration, linked for the purpose of contract fulfillment to the value of a specified real or financial asset or to an index of securities. With Securities Laws (Second Amendment) Act,1999, Derivatives has been included in the definition of Securities. The term Derivative has been defined in Securities Contracts (Regulations) Act, as:- A Derivative includes: -
a. a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security;
b. a contract which derives its value from the prices, or index of prices, of underlying securities;
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| Futures Contract means a legally binding agreement to buy or sell the underlying security on a future date. Future contracts are the organized/standardized contracts in terms of quantity, quality (in case of commodities), delivery time and place for settlement on any date in future. The contract expires on a pre-specified date which is called the expiry date of the contract. On expiry, futures can be settled by delivery of the underlying asset or cash. Cash settlement enables the settlement of obligations arising out of the future/option contract in cash. However so far delivery against future contracts have not been introduced and the future contract is settled by cash settlement only.
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Options Contract is a type of Derivatives Contract which gives the buyer/holder of the contract the right (but not the obligation) to buy/sell the underlying asset at a predetermined price within or at end of a specified period. The buyer / holder of the option purchases the right from the seller/writer for a consideration which is called the premium. The seller/writer of an option is obligated to settle the option as per the terms of the contract when the buyer/holder exercises his right. The underlying asset could include securities, an index of prices of securities etc. Under Securities Contracts (Regulations) Act,1956 options on securities has been defined as "option in securities" means a contract for the purchase or sale of a right to buy or sell, or a right to buy and sell, securities in future, and includes a teji, a mandi, a teji mandi, a galli, a put, a call or a put and call in securities;
An Option to buy is called Call option and option to sell is called Put option. Further, if an option that is exercisable on or before the expiry date is called American option and one that is exercisable only on expiry date, is called European option. The price at which the option is to be exercised is called Strike price or Exercise price.
Therefore, in the case of American options the buyer has the right to exercise the option at anytime on or before the expiry date. This request for exercise is submitted to the Exchange, which randomly assigns the exercise request to the sellers of the options, who are obligated to settle the terms of the contract within a specified time frame. As in the case of futures contracts, option contracts can also be settled by delivery of the underlying asset or cash. However, unlike futures cash settlement in option contract entails paying/receiving the difference between the strike price/exercise price and the price of the underlying asset either at the time of expiry of the contract or at the time of exercise / assignment of the option contract. However so far delivery against option contracts have not been introduced and the option contract, on exercise or expiry, is settled by cash settlement only.
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Futures contract based on an index i.e. the underlying asset is the index,are known as Index Futures Contracts. For example, futures contract on NIFTY Index and BSE-30 Index. These contracts derive their value from the value of the underlying index. Similarly, the options contracts, which are based on some index, are known as Index options contract. However, unlike Index Futures, the buyer of Index Option Contracts has only the right but not the obligation to buy / sell the underlying index on expiry. Index Option Contracts are generally European Style options i.e. they can be exercised / assigned only on the expiry date. An index, in turn derives its value from the prices of securities that constitute the index and is created to represent the sentiments of the market as a whole or of a particular sector of the economy. Indices that represent the whole market are broad based indices and those that represent a particular sector are sectoral indices.
In the beginning futures and options were permitted only on S&P Nifty and BSE Sensex. Subsequently, sectoral indices were also permitted for derivatives trading subject to fulfilling the eligibility criteria. Derivative contracts may be permitted on an index if 80% of the index constituents are individually eligible for derivatives trading. However, no single ineligible stock in the index shall have a weightage of more than 5% in the index. The index is required to fulfill the eligibility criteria even after derivatives trading on the index has begun. If the index does not fulfill the criteria for 3 consecutive months, then derivative contracts on such index would be discontinued. By its very nature, index cannot be delivered on maturity of the Index futures or Index option contracts therefore, these contracts are essentially cash settled on Expiry. Therefore index options are the European options while stock options are American options.
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| Derivative trading in India takes can place either on a separate and independent Derivative Exchange or on a separate segment of an existing Stock Exchange. Derivative Exchange/Segment function as a Self-Regulatory Organisation (SRO) and SEBI acts as the oversight regulator. The clearing & settlement of all trades on the Derivative Exchange/Segment would have to be through a Clearing Corporation/House, which is independent in governance and membership from the Derivative Exchange/Segment.
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With the amendment in the definition of 'securities' under SC(R)A (to include derivative contracts in the definition of securities), derivatives trading takes place under the provisions of the Securities Contracts (Regulation) Act, 1956 and the Securities and Exchange Board of India Act, 1992.
Dr. L.C Gupta Committee constituted by SEBI had laid down the regulatory framework for derivative trading in India. SEBI has also framed suggestive bye-law for Derivative Exchanges/Segments and their Clearing Corporation/House which lay's down the provisions for trading and settlement of derivative contracts. The Rules, Bye-laws & Regulations of the Derivative Segment of the Exchanges and their Clearing Corporation/House have to be framed in line with the suggestive Bye-laws. SEBI has also laid the eligibility conditions for Derivative Exchange/Segment and its Clearing Corporation/House. The eligibility conditions have been framed to ensure that Derivative Exchange/Segment & Clearing Corporation/House provide a transparent trading environment, safety & integrity and provide facilities for redressal of Investor Grievance. Some of the important eligibility conditions are-
- Derivative trading to take place through an on-line screen based Trading System.
- The Derivatives Exchange/Segment shall have on-line surveillance capability to monitor positions, prices, and volumes on a real time basis so as to deter market manipulation.
- The Derivatives Exchange/ Segment should have arrangements for dissemination of information about trades, quantities and quotes on a real time basis through atleast two information vending networks, which are easily accessible to investors across the country.
- The Derivatives Exchange/Segment should have arbitration and Investor Grievance redressal mechanism operative from all the four areas / regions of the country.
- The Derivatives Exchange/Segment should have satisfactory system of monitoring investor complaints and preventing irregularities in trading.
- The Derivative Segment of the Exchange would have a separate Investor Protection Fund.
- The Clearing Corporation/House shall perform full novation, i.e., the Clearing Corporation/House shall interpose itself between both legs of every trade, becoming the legal counterparty to both or alternatively should provide an unconditional guarantee for settlement of all trades.
- The Clearing Corporation/House shall have the capacity to monitor the overall position of Members across both derivatives market and the underlying securities market for those Members who are participating in both.
- The level of initial margin on Index Futures Contracts shall be related to the risk of loss on the position. The concept of value-at-risk shall be used in calculating required level of initial margins. The initial margins should be large enough to cover the one-day loss that can be encountered on the position on 99% of the days.
- The Clearing Corporation/House shall establish facilities for electronic funds transfer (EFT) for swift movement of margin payments.
- In the event of a Member defaulting in meeting its liabilities, the Clearing Corporation/House shall transfer client positions and assets to another solvent Member or close-out all open positions.
- The Clearing Corporation/House should have capabilities to segregate initial margins deposited by Clearing Members for trades on their own account and on account of his client. The Clearing Corporation/House shall hold the clients' margin money in trust for the client purposes only and should not allow its diversion for any other purpose.
- The Clearing Corporation/House shall have a separate Trade Guarantee Fund for the trades executed on Derivative Exchange / Segment.
Presently, SEBI has permitted Derivative Trading on the Derivative Segment of BSE and the F&O Segment of NSE.
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| Derivative products have been introduced in a phased manner starting with Index Futures Contracts in June 2000. Index Options and Stock Options were introduced in June 2001 and July 2001 followed by Stock Futures in November 2001. Sectoral indices were permitted for derivatives trading in December 2002. Interest Rate Futures on a notional bond and T-bill priced off ZCYC have been introduced in June 2003 and exchange traded interest rate futures on a notional bond priced off a basket of Government Securities were permitted for trading in January 2004.
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A stock on which stock option and single stock future contracts are proposed to be introduced is required to fulfill the following broad eligibility criteria:-
- The stock shall be chosen from amongst the top 500 stock in terms of average daily market capitalisation and average daily traded value in the previous six month on a rolling basis.
- The stock's median quarter-sigma order size over the last six months shall be not less than Rs.1 Lakh. A stock's quarter-sigma order size is the mean order size (in value terms) required to cause a change in the stock price equal to one-quarter of a standard deviation.
- The market wide position limit in the stock shall not be less than Rs.50 crores.
- A stock can be included for derivatives trading as soon as it becomes eligible. However, if the stock does not fulfill the eligibility criteria for 3 consecutive months after being admitted to derivatives trading, then derivative contracts on such a stock would be discontinued.
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| The Standing Committee on Finance, a Parliamentary Committee, at the time of recommending amendment to Securities Contract (Regulation) Act, 1956 had recommended that the minimum contract size of derivative contracts traded in the Indian Markets should be pegged not below Rs. 2 Lakhs. Based on this recommendation SEBI has specified that the value of a derivative contract should not be less than Rs. 2 Lakh at the time of introducing the contract in the market. In February 2004, the Exchanges were advised to re-align the contracts sizes of existing derivative contracts to Rs. 2 Lakhs. Subsequently, the Exchanges were authorized to align the contracts sizes as and when required in line with the methodology prescribed by SEBI.
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| Lot size refers to number of underlying securities in one contract. The lot size is determined keeping in mind the minimum contract size requirement at the time of introduction of derivative contracts on a particular underlying. For example, if shares of XYZ Ltd are quoted at Rs.1000 each and the minimum contract size is Rs.2 lacs, then the lot size for that particular scrips stands to be 200000/1000 = 200 shares i.e. one contract in XYZ Ltd. covers 200 shares.
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The basis for any adjustment for corporate action is such that the value of the position of the market participant on cum and ex-date for corporate action continues to remain the same as far as possible. This will facilitate in retaining the relative status of positions viz. in-the-money, at-the-money and out-of-the-money. Any adjustment for corporate actions is carried out on the last day on which a security is traded on a cum basis in the underlying cash market. Adjustments mean modifications to positions and/or contract specifications as listed below:
- Strike price
- Position
- Market/Lot/ Multiplier
The adjustments are carried out on any or all of the above based on the nature of the corporate action. The adjustments for corporate action are carried out on all open, exercised as well as assigned positions. The corporate actions are broadly classified under stock benefits and cash benefits. The various stock benefits declared by the issuer of capital are:
- Bonus
- Rights
- Merger/ demerger
- Amalgamation
- Splits
- Consolidations
- Hive-off
- Warrants, and
- Secured Premium Notes (SPNs) among others.
The cash benefit declared by the issuer of capital is cash dividend.
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Two type of margins have been specified -
- Initial Margin - Based on 99% VaR and worst case loss over a specified horizon, which depends on the time in which Mark to Market margin is collected.
- Mark to Market Margin (MTM) - collected in cash for all Futures contracts and adjusted against the available Liquid Networth for option positions. In the case of Futures Contracts MTM may be considered as Mark to Market Settlement.
Dr. L.C Gupta Committee had recommended that the level of initial margin required on a position should be related to the risk of loss on the position. The concept of value-at-risk should be used in calculating required level of initial margins. The initial margins should be large enough to cover the one day loss that can be encountered on the position on 99% of the days. The recommendations of the Dr. L.C Gupta Committee have been a guiding principle for SEBI in prescribing the margin computation & collection methodology to the Exchanges. With the introduction of various derivative products in the Indian securities Markets, the margin computation methodology, especially for initial margin, has been modified to address the specific risk characteristics of the product. The margining methodology specified is consistent with the margining system used in developed financial & commodity derivative markets worldwide. The exchanges were given the freedom to either develop their own margin computation system or adapt the systems available internationally to the requirements of SEBI. A portfolio based margining approach which takes an integrated view of the risk involved in the portfolio of each individual client comprising of his positions in all Derivative Contracts i.e. Index Futures, Index Option, Stock Options and Single Stock Futures, has been prescribed. The initial margin requirements are required to be based on the worst case loss of a portfolio of an individual client to cover 99% VaR over a specified time horizon.
The Initial Margin is Higher of (Worst Scenario Loss +Calendar Spread Charges) Or Short Option Minimum Charge
The worst scenario loss are required to be computed for a portfolio of a client and is calculated by valuing the portfolio under 16 scenarios of probable changes in the value and the volatility of the Index/ Individual Stocks. The options and futures positions in a client's portfolio are required to be valued by predicting the price and the volatility of the underlying over a specified horizon so that 99% of times the price and volatility so predicted does not exceed the maximum and minimum price or volatility scenario. In this manner initial margin of 99% VaR is achieved. The specified horizon is dependent on the time of collection of mark to market margin by the exchange. The probable change in the price of the underlying over the specified horizon i.e. 'price scan range', in the case of Index futures and Index option contracts are based on three standard deviation (3s ) where 's ' is the volatility estimate of the Index. The volatility estimate 's ', is computed as per the Exponentially Weighted Moving Average methodology. This methodology has been prescribed by SEBI. In case of option and futures on individual stocks the price scan range is based on three and a half standard deviation (3.5 s) where 's' is the daily volatility estimate of individual stock. If the mean value (taking order book snapshots for past six months) of the impact cost, for an order size of Rs. 0.5 million, exceeds 1%, the price scan range would be scaled up by square root three times to cover the close out risk. This means that stocks with impact cost greater than 1% would now have a price scan range of - Sqrt (3) * 3.5s or approx. 6.06s. For stocks with impact cost of 1% or less, the price scan range would remain at 3.5s.
For Index Futures and Stock futures it is specified that a minimum margin of 5% and 7.5% would be charged. This means if for stock futures the 3.5 s value falls below 7.5% then a minimum of 7.5% should be charged. This could be achieved by adjusting the price scan range.
The probable change in the volatility of the underlying i.e. 'volatility scan range' is fixed at 4% for Index options and is fixed at 10% for options on Individual stocks. The volatility scan range is applicable only for option products.
Calendar spreads are offsetting positions in two contracts in the same underlying across different expiry. In a portfolio based margining approach all calendar-spread positions automatically get a margin offset. However, risk arising due to difference in cost of carry or the 'basis risk' needs to be addressed. It is therefore specified that a calendar spread charge would be added to the worst scenario loss for arriving at the initial margin. For computing calendar spread charge, the system first identifies spread positions and then the spread charge which is 0.5% per month on the far leg of the spread with a minimum of 1% and maximum of 3%. Further, in the last three days of the expiry of the near leg of spread, both the legs of the calendar spread would be treated as separate individual positions. In a portfolio of futures and options, the non-linear nature of options make short option positions most risky. Especially, short deep out of the money options, which are highly susceptible to, changes in prices of the underlying. Therefore a short option minimum charge has been specified. The short option minimum charge is 3% and 7.5 % of the notional value of all short Index option and stock option contracts respectively. The short option minimum charge is the initial margin if the sum of the worst -scenario loss and calendar spread charge is lower than the short option minimum charge. To calculate volatility estimates the exchange are required to uses the methodology specified in the Prof J.R Varma Committee Report on Risk Containment Measures for Index Futures. Further, to calculate the option value the exchanges can use standard option pricing models - Black-Scholes, Binomial, Merton, Adesi-Whaley.
The initial margin is required to be computed on a real time basis and has two components:-
- The first is creation of risk arrays taking prices at discreet times taking latest prices and volatility estimates at the discreet times, which have been specified.
- The second is the application of the risk arrays on the actual portfolio positions to compute the portfolio values and the initial margin on a real time basis.
The initial margin so computed is deducted from the available Liquid Networth on a real time basis.At the end of the day NSE sends a client wise file to all the brokers and this margin is debited to clients. Next day the broker is supposed to report the collection of margin. If the margin is short, a penalty is levied and the outstanding position is liable to be squared up at the cost of the investor. What are Market wide position limits for single stock futures and stock option Contracts
Market wide position limits on Single Stock Derivative Contracts are as follows
The market wide limit of open position (in terms of the number of underlying stock) on futures and option contracts on a particular underlying stock is
lower of-
- 30 times the average number of shares traded daily, during the previous calendar month, in the relevant underlying security in the underlying segment,
Or
- 20% of the number of shares held by non-promoters in the relevant underlying security i.e. free-float holding.
This limit would be applicable on all open positions in all futures and option contracts on a particular underlying stock.
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The measures specified by SEBI include:
- Investor's money has to be kept separate at all levels and is permitted to be used only against the liability of the Investor and is not available to the trading member or clearing member or even any other investor.
- The Trading Member is required to provide every investor with a risk disclosure document which will disclose the risks associated with the derivatives trading so that investors can take a conscious decision to trade in derivatives.
- Investor would get the contract note duly time stamped for receipt of the order and execution of the order. The order will be executed with the identity of the client and without client ID order will not be accepted by the system. The investor could also demand the trade confirmation slip with his ID in support of the contract note. This will protect him from the risk of price favour, if any, extended by the Member.
- In the derivative markets all money paid by the Investor towards margins on all open positions is kept in trust with the Clearing House/Clearing corporation and in the event of default of the Trading or Clearing Member the amounts paid by the client towards margins are segregated and not utilised towards the default of the member. However, in the event of a default of a member, losses suffered by the Investor, if any, on settled / closed out position are compensated from the Investor Protection Fund, as per the rules, bye-laws and regulations of the derivative segment of the exchanges.
- In the derivative markets all money paid by the Investor towards margins on all open positions is kept in trust with the Clearing House/Clearing corporation and in the event of default of the Trading or Clearing Member the amounts paid by the client towards margins are segregated and not utilised towards the default of the member. However, in the event of a default of a member, losses suffered by the Investor, if any, on settled / closed out position are compensated from the Investor Protection Fund, as per the rules, bye-laws and regulations of the derivative segment of the exchanges.
- The Exchanges are required to set up arbitration and Investor Grievance redressal mechanism operative from all the four areas / regions of the country.
Remember, Derivatives are tools which can be used for hedging, speculation as well as trading. It is always advisable to take positions in derivatives with caution. Since the trader is required to give only margin, there is a tendency of overtrading which must be avoided. Overtrading may result in failure to pay margin call &/or MTM the outstanding position is liable to be squared up. Before trading it is necessary that the investor should go through the risk disclosure document carefully so that he is aware of the precautions to be taken in derivatives trading.
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| An initial public offering, or IPO, is the first sale of stock by a company to the public. A company can raise money by issuing either debt or equity. If the company has never issued equity to the public, it's known as an IPO. Companies fall into two broad categories, private and public. A privately held company has fewer shareholders and its owners don't have to disclose much information about the company. Anybody can go out and incorporate a company, just put in some money, files the right legal documents and follows the reporting rules of your jurisdiction. Most small businesses are privately held. But large companies can be private too. It usually isn't possible to buy shares in a private company. You can approach the owners about investing, but they're not obligated to sell you anything. Public companies, on the other hand, have sold at least a portion of themselves to the public and trade on a stock exchange. This is why doing an IPO is also referred to as "going public." Public companies have thousands of shareholders and are subject to strict rules and regulations. They must have a board of directors and they must report financial information every quarter. From an investor's standpoint, the most exciting thing about a public company is that the stock is traded in the open market, like any other commodity. If you have the cash, you can invest.
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Going public raises cash, and usually a lot of it. Being publicly traded also opens many financial doors:
- Because of the increased scrutiny, public companies can usually get better rates when they issue debt.
- As long as there is market demand, a public company can always issue more stock. Thus, mergers and acquisitions are easier to do because stock can be issued as part of the deal.
- Trading in the open markets means liquidity. This makes it possible to implement things like employee stock ownership plans, which help to attract top talent.
Being on a major stock exchange carries a considerable amount of prestige. In the past, only private companies with strong fundamentals could qualify for an IPO and it wasn't easy to get listed.
Getting In On An IPO
Getting a piece of a hot IPO is very difficult, if not impossible. To understand why, we need to know how an IPO is done, a process known as underwriting. When a company wants to go public, the first thing it does is hire an investment bank. A company could theoretically sell its shares on its own, but realistically, an investment bank is required. Underwriting is the process of raising money by either debt or equity (in this case we are referring to equity). You can think of underwriters as middlemen between companies and the investing public. The company and the investment bank will first meet to negotiate the deal. Items usually discussed include the amount of money a company will raise, the type of securities to be issued and all the details in the underwriting agreement. The deal can be structured in a variety of ways. For example, in a firm commitment, the underwriter guarantees that a certain amount will be raised by buying the entire offer and then reselling to the public. In a best efforts agreement, however, the underwriter sells securities for the company but doesn't guarantee the amount raised. Also, investment banks are hesitant to shoulder all the risk of an offering. Instead, they form a syndicate of underwriters. One underwriter leads the syndicate and the others sell a part of the issue. Once all sides agree to a deal, the investment bank puts together a registration statement to be filed with the SEBI. This document contains information about the offering as well as company info such as financial statements, management background, any legal problems, where the money is to be used and insider holdings. Once SEBI approves the offering, a date (the effective date) is set when the stock will be offered to the public. During the cooling off period the underwriter puts together what is known as the red herring. This is an initial prospectus containing all the information about the company except for the offer price and the effective date, which aren't known at that time. With the red herring in hand, the underwriter and company attempt to hype and build up interest for the issue. As the effective date approaches, the underwriter and company sit down and decide on the price. This isn't an easy decision it depends on the company and most importantly current market conditions. Of course, it's in both parties' interest to get as much as possible. Finally, the securities are sold on the stock market and the money is collected from investors.
Don't Just Jump In
Let's say you do get in on an IPO. Here are a few things to look out for.
No History
It's hard enough to analyze the stock of an established company. An IPO company is even trickier to analyze since there won't be a lot of historical information. Your main source of data is the red herring, so make sure you examine this document carefully. Look for the usual information, but also pay special attention to the management team and how they plan to use the funds generated from the IPO. And what about the underwriters? Successful IPOs are typically supported by bigger brokerages that have the ability to promote a new issue well. Be more wary of smaller investment banks because they may be willing to underwrite any company.
The Lock-Up Period
If you look at the charts following many IPOs, you'll notice that after a few months the stock takes a steep downturn. This is often because of the lock-up period. When a company goes public, the underwriters make promoters and employees in case ESOP to sign a lock-up agreement. Lock-up agreements are legally binding contracts between the underwriters and insiders of the company, prohibiting them from selling any shares of stock for a specified period of time. The problem is, when lockups expire all the insiders are permitted to sell their stock. The result is a rush of people trying to sell their stock to realize their profit. This excess supply can put severe downward pressure on the stock price.
IPO Basics: Conclusion
Let's review the basics of an IPO:
- An initial public offering (IPO) is the first sale of stock by a company to the public.
- Broadly speaking, companies are either private or public. Going public means a company is switching from private ownership to public ownership
- Going public raises cash and provides many benefits for a company
- Getting in on a hot IPO is very difficult, if not impossible.
- The process of underwriting involves raising money from investors by issuing new securities.
- Companies hire investment banks to underwrite an IPO.
- An IPO company is difficult to analyze because there isn't a lot of historical info.
- Lock-up periods prevent insiders from selling their shares for a certain period of time. The end of the lockup period can put strong downward pressure on a stock.
- Flipping may get you blacklisted from future offerings.
- Road shows and red herrings are marketing events meant to get as much attention as possible. Don't get sucked in by the hype.
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| There are many theories and techniques about how to choose a winner, how to separate the wheat from the chaff. Some are homegrown, others are technically sophisticated. But beyond the jargon, there are three basic factors to look for while picking a stock: The company itself Its external environment The behaviour of its stock
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| There are several advantages mutual funds have over stocks. The key advantage funds have over stocks is diversification. Any fund normally invests in a diverse basket of securities, which may include stocks. Consider, one of the market favourites, Birla Advanatge Fund, a growth scheme with 26.43% of its portfolio in Infosys, 14.75% in VisualSoft and another 8.22% in SSI. With an investment of Rs.50,000 in the scheme you could own Rs.13,215 worth of Infosys, Rs.7375 of VisualSoft and Rs.4110 of SSI. Likewise you would own 27 other stocks that the scheme has put its money in. Hmmm, is that more satisfying than purchasing seven stocks of Infosys on your own with the same money. Hence, funds make it possible for individual investors to achieve more diversification and with less of their effort than compared to investing in individual stocks. Funds are also professionally managed and backed by an investment research team. The team looks at the performance of companies and then makes investments in them to achieve the objectives of the scheme. Compared to investing in stocks, your experience with fund investing will show you that you save a lot of paperwork as well as time. Under normal functioning, fund investment also does away with common problems associated with stocks like bad deliveries, delayed payments and the frequent visits to brokers and companies.
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| Historically equity did give better returns than bonds, golds and other assets. But if the long term horizon is assumed to be 7 years, then in the Indian context, the equities have practically given near zero returns.
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| Beside investing in Government of India securities and money market instruments, they are slightly more overweighed on corporate India. Approximately 50-60% of the portfolio would consist of fixed income instruments issued by corporate India. They therefore provide a higher return typically between 11-12% per annum. Ideally suited for investors looking beyond a period of 1 year.
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| MIP is a variant of income scheme that provides investors an option to get monthly returns in the form of dividends. UTI is the only fund house giving out assured returns on MIP (distributed as post-dated cheques). Private sector mutual funds are not allowed to give assured returns on MIPs. Usually, the returns from such schemes are between 10.5 –11.5%
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| Balanced schemes invest both in equity shares and in income-bearing instruments. They aim to reduce the risks of investing in stocks by having a stake in both the equity and the debt markets. These schemes adopt some flexibility in changing the asset composition between equity and debt. The fund managers exploit market conditions to buy the best class of assets at each point in time. By mixing stocks and bonds (and sometimes other types of assets as well, like call money or commercial paper), a balanced scheme is likely to give a return somewhere in between those of stocks and bonds. Bonds add stability during market downturns and volatile periods, while stocks provide growth. Since the return on different types of assets rise and fall at different times, the risk is usually lower in balanced schemes than in pure growth or income schemes.
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| The part of mutual fund assets that gets removed each year for expenses (which includes management fees, annual operating costs, administrative expenses and all other costs incurred by the fund) expressed, as a percentage is the expense ratio. It provides a quick check of efficiently the fund manager is handling the fund.
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Look for one thing in the fine print: the scheme's expenses. One such expense is the bomb of a salary paid to the investment experts who manage the fund. Apart from management fee there is also the money the fund spends on advertising and marketing a scheme. There is a host of operating expenses from buying stationery to maintaining the fund house's staff. Should it matter to you if the fund house purchases a new computer?
It does. In whatever way the fund spends the money, the net expenses are all billed in one way or the other to the unitholder. The expenses of a scheme does not include brokerage commissions.
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| They are slightly volatile because 95% of the traded volume of fixed income instruments in India comprise of gilt schemes and therefore pricing of such schemes is done daily.
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Getting back to cuisine talk. Do you stop frequenting the Udupi joint round the corner just because a new cook cooked your favourite appam even if it was to your liking?
Similarly, there is not much reason to opt out of a fund just because it has a new manager. Managers usually work to the fund house's objective set for a scheme. However, do keep track what the new manager is upto. Is the manager handling the portfolio in a way that it reflects the fund's objectives?
If the new manager churns the portfolio upside down, it might mean more capital gains distributions, and hence more taxes. Obviously then, (and before appams start tasting like idlis) time you looked for another fund.
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| NAV is the net realizable value of each unit of the scheme. After netting off liabilities from the asset value and dividing by the total number of units outstanding we arrive at the NAV.
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| No, you may not actually get that much when you redeem your units. That is because of the charges levied by some mutual funds. Though NAV is a good enough figure to tell you what the price of each unit is, it is not an exact one. Funds charge fee for managing your money called the annual expense fee. Some funds also charge a fee when you buy or sell units called the entry and exit load.
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| In India majority of mutual funds are open-ended. Fund that float open ended schemes can sell as many units as investors demand. These do not have a fixed maturity period. Investors can buy or sell units at NAV-related prices from and to the mutual fund on any business day. Most people prefer open-ended mutual funds because they offer liquidity. Such funds can issue and redeem units any time during the life of a scheme. Hence, unit capital of open ended funds can fluctuate on a daily basis.
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| These have fixed maturity periods (ranging from 2 to 15 years). You can invest in the scheme at the time of the initial issue. That’s because such schemes can not issue new units except in case of bonus or rights issue.
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| All is not lost if you missed out on units of a closed scheme. After the initial issue, you can buy or sell units of the scheme on the stock exchanges where they are listed (certain Mutual Funds however, in order to provide investors with an exit route on a periodic basis do repurchase units at NAV related prices). The market price of the units could vary from the NAV of the scheme due to demand and supply factors, investors’ expectations and other market factors.
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| Much like for an individual investor, a scheme’s objective is the result that a fund manger desires out a scheme. While setting objective for a scheme the manager asks the question: what are the kind of returns I expect the scheme to deliver and to get assure such returns what are the securities and in what proportion should I invest in?
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| Based on their objectives schemes have been clubbed together in categories. These are broad market classifications and help investors narrow down their search for a scheme. After shortlisting schemes by their common objectives one can further look into each scheme for more specific differences in their objectives.
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| Equity schemes are those that invest predominantly in equity shares of companies. An equity scheme seeks to provide returns by way of capital appreciation.
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| As a class of assets, equities are subject to greater fluctuations. Hence, the NAVs of these schemes will also fluctuate frequently. Hence, equity schemes are more volatile, but offer better returns.
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| The aim of diversified equity funds is to provide the investor with capital appreciation over a medium to long period (generally 2 – 5 years). The fund invests in equity shares of companies from a diverse array of industries and balances (or tries to) the portfolio so as to prevent any adverse impact on returns due to a downturn in one or two sectors.
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| Gilt schemes invest in government bonds, money market securities or some combination of these.
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| Gilt schemes tend to give a higher return than a money market scheme at the same time retaining the qualities of a liquid fund. Gilt schemes generally give a return of 8.5-10% per annum whereas it is between 7-8% per annum for money market schemes.
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| Yes, money market schemes invest in short-term debt instruments such as T-bills, certificates of deposits, commercial papers, call money markets, etc. Their goal is to preserve the principal while yielding a modest return. They are ideal for corporate and big investors looking for avenues to park their short-term surplus funds.
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| Since they provide the investor to enter or exit within a short period of time without any load. You can even invest for two working days. Normally, you can get back your cash within 24 hours of redemption.
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| It does in case of schemes that have invested in government instruments like debentures and government securities e.g., debt schemes and some balanced schemes. The volatility of debt schemes depends entirely on the health of the economy e.g., rupee depreciation, fiscal deficit, inflationary pressure.
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| It does in case of schemes that have invested in government instruments like debentures and government securities e.g., debt schemes and some balanced schemes. The volatility of debt schemes depends entirely on the health of the economy e.g., rupee depreciation, fiscal deficit, inflationary pressure.
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| These schemes invest mainly in income-bearing instruments like bonds, debentures, government securities, commercial paper, etc. These instruments are much less volatile than equity schemes. Their volatility depends essentially on the health of the economy e.g., rupee depreciation, fiscal deficit, inflationary pressure. Performance of such schemes also depends on bond ratings. These schemes provide returns generally between 7 to 12% per annum.
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| Fund managing an index fund is usually called passive management because all a fund manger has to do is to follow the index. Hence, who the portfolio manager or what his style is does not really matter in such funds.
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| Lack of performance is often explained away as temporary with promises of good performance in the long term. The long term is seldom defined whether it means 3 years or 10 years. Also the longer the period, the longer is the uncertainty, in other words, the premium on returns an investor gets has to be discounted against the risk of uncertainty of returns. A small premium in compounded returns over returns of risk free instruments like PPF wouldn't justify investment in a mutual fund.
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| Sustained periods of low absolute performance are a cause for concern. It is okay to look at returns vis-à-vis market indices; but if a particular scheme produces absolute returns less than the cumulative returns for a fixed deposit of a bank, then the latter option is better when evaluated on the parameter of risk adjusted returns. This is because generally it is safer to invest in a fixed deposit of a bank than to invest in a debt fund.
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| This term finds place in the literature of practically all mutual funds. What it basically implies is that a price risk at the entry level can be eliminated to some extent by buying units at various points of time. But this assumes that the NAV will rise eventually. If it does not, you are worse off than by not adopting this strategy.
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| Once again, back to the basic question. You came here looking for schemes that can suffice your investment needs. You might be like many others who actually have multiple needs. Consider going for a combination of schemes. Yet another recap of the basics: one of the things that made these mutual funds great was diversification. While you might have selected a scheme that has a diversified portfolio, you can also go for more than one schemes to further diversify your investments. It is well possible that just by picking more than one scheme from one fund house you can achieve enough diversification. In fact many investors who have tried out a fund house for long and developed a trust with the fund, prefer to pick another scheme from the fund's basket for their new investment needs. But convenience sometimes leads to venerable prejudices that might deprive you of trying something new and better. There could be a better-managed scheme in a different fund house house that you are missing out on if you decide to stick to your old fund house for convenience sake.
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| Higher the turnover more the trades a fund does and hence greater are the transaction fees in the form of brokerage, custody fees, registration fees etc. that a fund has to pay. For a fund such high transaction costs affects its performance and the NAV. And as an investor you get less returns. Moreover, a fund with high turnover will also be making money more often as capital gains. These capital gains on distribution are open to taxes, which again would mean less returns for a untiholder.
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Good portfolio handling depends a lot on precise timing and correct estimations. By how much and when does a fund manager change his investment mix?
The portfolio of a fund never remains the same for a long time. Is the fund manager's investment strategy one of buy and hold?
Or is he a one who aggressively churns the fund?
But most importantly, is he taking the right decision at the right time?
Though as investors we don't always get to know when a manager is changing the scheme's portfolio, we can periodically keep track of the scheme's trading history.
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| Most schemes periodically announce their current portfolio though not all of them declare them as when the fund manager makes a change. As specified by the Securities and Exchange Board of India (SEBI) funds are supposed to declare their portfolio at least once every year.
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| The volatility of index funds are in sync with the index they follow. A bull market could get you as high as 40% returns over a period of one year. In a bad year (current year) it could erode your principal by as much as 30%
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Contrary to the commonplace thinking, mutual funds do carry risks. And there are some that can become as risky as stocks. Given the almost diverse objectives with which schemes operate, there are some with more risks and some relatively safer. Ask yourself if you are ready for a scheme whose investment value might fluctuate every week or one that gives a minimum amount of risk?
Or are you in for a short-term loss in order to achieve a long-term potential gain?
At this point it is good to ask oneself how will you take it if your investment fails to deliver the returns you expected or makes losses. Knowing this will reduce your chances (or even temptation) to select a fund that doesn’t come close to your objective. Evaluate a scheme by looking at how its NAV has behaved over the past. Do you see the scheme behaving rather erratically i.e., the NAV changes just too often?
More the volatility more are the risks involved. Great returns are not the only thing to look for in a scheme. If you feel while researching a scheme, which we will do later, that it’s returns are modest and steady and good enough for your needs, avoid other schemes that have recently delivered high returns. Because great returns in the past are no guarantee for the fabulous performance to continue in the future. Never forget one of the commonplace morals of investment: The schemes that are expected to give the highest returns have the greatest probability to fall flat!
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| It is surprising to find fund marketers come up with statistics to show how their particular fund has done extremely well. Following are some of the pitfalls that an investor needs to look into before arriving at a decision. Check the following details before arriving at any decision. Period of declared returns: Always look carefully at start and end dates - they can always be chosen in a way that shows the fund in a favorable light. A better approach would be to choose a reasonably longer period and compare the performance across the similar schemes of different players. Concept of out-performing: Sustained periods of low absolute performance are a cause for concern. It is okay to look at returns vis-à-vis market indices; but if a particular scheme produces absolute returns less than the cumulative returns for a fixed deposit of a bank, then the latter option is better when evaluated on the parameter of risk adjusted returns. This is because generally it is safer to invest in a fixed deposit of a bank than to invest in a debt fund. Promise of long term performance: Lack of performance is often explained away as temporary with promises of good performance in the long term. The long term is seldom defined whether it means 3yrs or 10 yrs. Also the longer the period, the longer is the uncertainty- in other words, the premium on returns an investor gets has to discounted against the risk of uncertainty of returns. A small premium in compounded returns over returns of risk free instruments like PPF wouldn't justify investment in a mutual fund. Rupee cost averaging: This term finds place in the literature of practically all mutual funds. What it basically implies is that a price risk at the entry level can be eliminated to some extent by buying units at various points of time. But this assumes that the NAV will rise eventually. If it does not, you are worse off than by not adopting this strategy. In the long run equities are better than other asset classes: Historically the equity class did give better returns than bonds, golds and other assets. But if the long term horizon is assumed to be 7 yrs, then in the Indian context, the equities have practically given near zero returns. After hitting the 4600 levels in 1992, the BSE Sensex is still hovering around the same levels as of today.
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What are you looking for when investing in mutual funds?
What are your investment needs?
The more well defined these answers are the easier it is to find schemes best for you. So how do you assess your needs?
The answers obviously lie with you. But the questions investors ask to assess their needs are possibly the same. You might ask yourself: At my age what am I expecting out of investing?
To assess the needs investors look at their lifestyles, financial independence, family commitments, and level of income and expenses among other things. Questions can be many but to get cracking ask yourself these two: What are the returns you want on your investments?
Do you have well-defined time period for the returns you expect on your investment?
The father of an aspiring engineer who would have to shell out the boy's institute fees soon enough, could reply: I want a fixed monthly income of about Rs.5000 per month. To the second query he might say: Yes, for the next four years. When asked, the just-out-of-B-school graduate planning for his new Zen could reply: I should make about Rs. 60,000 by the end of one year. Believe us, but getting the right answers to these questions does a lot to simply your fund picking exercise. Having defined the needs that direct you to invest, one can find a category of funds that come close to satisfy your needs with their objectives.
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It's a trick company ads often do. A tempting offer is always accompanied with the fine print tucked in a corner at the bottom of the ad. And sometimes reading the applied conditions in the fine print might squeeze all the attractiveness out of a great sounding offer. Buying a scheme also requires that you give a careful look at the fine print. Should it matter to you if the fund house purchases a new computer?
It does. In whatever way the fund spends the money, the net expenses are all billed in one way or the other to the unitholder.
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| We have broadly grouped schemes by the following categories: Equity schemes These are further divided into Diversified Equity schemes, Sectoral Equity schemes, Equity Linked Saving Schemes (ELSS) and Index schemes. Debt schemes These are further clubbed into Liquid or Money Market schemes, Gilt schemes, Income schemes and Monthly Income Plan schemes. Balanced schemes
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While looking for schemes we want ones that best fit our investment objective. So, now which are those schemes that suit our objectives best?
The obvious next step then is to look all fund schemes and make a match between their and our investment objectives, correct?
Hmmm, that’s not as simply done as it sounds. Unless you have all the time in the world, going through each of the 350 or so schemes in the market today and reading their investment objectives is a foolhardy job. What makes life easier is that based on their objectives schemes have been clubbed together in categories. These are broad market classifications and help investors narrow down their search for a scheme. After shortlisting schemes by their common objectives one can further look into each scheme for more specific differences in their objectives.
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Let us get back to the basic questions that brought us here. We are here to invest with some objective of our own. And we are looking for schemes that best fit our investment objective. So, now which are those schemes that suit our objectives best?
The obvious next step then is to look all fund schemes and make a match between their and our investment objectives, correct?
Hmmm, that’s not as simply done as it sounds. Unless you have all the time in the world, going through each of the 350 or so schemes in the market today and reading their investment objectives is a foolhardy job. What makes life easier is that based on their objectives schemes have been clubbed together in categories. These are broad market classifications and help investors narrow down their search for a scheme. After shortlisting schemes by their common objectives one can further look into each scheme for more specific differences in their objectives.
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| Funds can change the load structure periodically. If you are a unitholder of a scheme that charges an exit load, and the scheme changes its exit load structure, then you will get a prior notice of the change. The new structure will be applicable to you rather than the load structure you were informed about when you joined the scheme.
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| Contingent Deferred Sales Load (CDSL) is a charge imposed when the units of a fund are redeemed during the first few years of ownership. Under the SEBI Regulations, a fund can charge CDSL to unitholders exiting from the scheme within the first four years of entry.
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| Just like entry load some funds impose a fee when you leave the scheme, i.e., redeem your units, called the exit load.
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| No fund can do away with its expenses. And all funds pass on the expenses to the unitholders unless, of course, a reformed Harshad Mehta decided he would help Indians make money without charging a rupee.
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The costs of the fund management process that includes marketing and initial costs are charged when you enter the scheme. These charges are termed the entry load, the additional charge you pay when you join a scheme and something everyone will tell you to watch out for. And if there is nothing to watch out for, i.e., the bold font in the new scheme's ad says `No entry load'. Will you jump for it?
Come on, investment was all about smartness. No fund can do away with these charges unless, of course, a reformed Harshad Mehta decided he would help Indians make money without charging a rupee. What funds that come with such offers usually do is to include these charges not in the entry load but somewhere else. It could also be deducted from the returns that you get.
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| Great returns are not the only thing to look for in a scheme. If you feel while researching a scheme, which we will do later, that it’s returns are modest and steady and good enough for your needs, avoid other schemes that have recently delivered high returns. Because great returns in the past are no guarantee for the fabulous performance to continue in the future. Never forget one of the commonplace morals of investment: The schemes that are expected to give the highest returns have the greatest probability to fall flat!
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| Globally it is true that most fund managers underperform the asset class that they are investing in. This is largely the result of limitations inherent in the concept of mutual funds: Fund management costs: The costs of the fund management process that includes marketing and initial costs are charged at the time of entry itself in the form of load. Then there are the annual asset management fee and operating expenses. The performance of a scheme net of these expenses lead to a relatively lower performance vis-à-vis the index stocks. Churning cost: The portfolio of a fund is never static. The extent to which the portfolio changes is a function of the style of the individual fund manager i.e. whether he is a buy and hold type of manager or one who aggressively churns the fund. Such portfolio changes have associated costs of brokerage, custody fees, registration fees etc. which lowers the portfolio return commensurately. Large size: When a large body like a mutual fund transacts in securities, the concentrated buying or selling results in adverse price movements. This causes the fund to transact at relatively higher entry or lower exit prices. Time lag for investment: Most mutual funds receive money when markets are in a bull run 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 causes the fund to realize lesser returns vis-à-vis the index stocks. Also for open-ended funds, there is the added problem of perpetually keeping some money in liquid assets to meet redemptions. Change in composition of index stocks: The composition of the indices has to change to reflect changing market conditions. The BSE Sensex stock composition has been revamped twice in the last 5 years, with each change being quite substantial. Another reason for change of index composition could be Mergers & Acquisitions. Herd mentality: Apparently, 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 for the scheme. In order to obtain such exceptional returns, the fund manager might have to take a strong view and invest in some uncommon stocks. Unfortunately, if the fund manager does the same thing as several others, chances are that he will produce average results. The tendency of the fund managers to buy the popular stocks, which are favourites among their peers, leads only to average performance as the index.
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| It is well possible that just by picking more than one scheme from one fund house you can achieve enough diversification. In fact many investors who have tried out a fund house for long and developed a trust with the fund, prefer to pick another scheme from the fund's basket for their new investment needs. But convenience sometimes leads to venerable prejudices that might deprive you of trying something new and better. There could be a better-managed scheme in a different fund house that you are missing out on if you decide to stick to your old fund house for convenience sake.
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Money is dear money. You wouldn't put your dear money into any investment without fully convincing yourself. With a comparison with other schemes you can convince yourself whether the scheme you have chosen is best for you. Of course, while shortlisting schemes through the advanced search you have already performed a comparison for some of the criteria on which mutual funds are judged. Time you enriched the comparison. For example, 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. This is important because as of today there is no standard method for evaluation of untraded securities. The valuation model used by the fund might have resulted in an appreciation of NAV. The expenses ratio can be compared across similar schemes to find out whether the fund is prudently managing its expenses. The size of the fund plays an important role here and a smaller fund generally has higher expenses per net assets managed. The NAV, returns and performance are important criteria that establish the merit of a fund but the only differentiating factors. It is prudent to also compare the risk-adjusted returns and the corpus size of the fund. The risk-adjusted return will help in evaluating what returns one can theoretically expect in the worst of condition. The risk is measured through volatility of the returns which is nothing but the standard deviation from the average returns. What are those factors that make schemes risky?
And to what proportion is each scheme exposed to each of these factors?
Identifying these factors or in other words, establishing the risk profile and then comparing it across schemes helps in creating, though theoretically, a relative scale of safety among the schemes compared. For debt funds, one of the factors could be the periodic changes in the interest rate environment, which affects credit quality of the portfolio and brings about fluctuations in the NAV. 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 companies.
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Having shortlisted schemes the next step is to look at each of them in greater detail and also make a qualitative evaluation. One place to look at is the offer document of the scheme. The offer document of the scheme tells you its objectives and provides supplementary details like the track record of other schemes managed by the same fund manager. Some other factors could be the portfolio allocation, the dividend yield and the degree of transparency as reflected in the frequency and quality of their communications. Does the scheme provide prompt and personalised service or does the scheme maintain transparency?
All this can be looked at from the frequency and quality of the communication from the fund house.
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| One good reason for looking at the past performance (prospectus presents this in a chart) is to find out how consistently has a fund delivered good returns, or even poor returns.
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| One way of looking at the past performance (the fund prospectus presents this in a chart) is to find out how consistently the fund has delivered good returns, or even poor returns.
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| Look out for that important number mentioned somewhere in one of the tables called the expense ratio.
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| Prospectus are supposed to elucidate the risks in their investments but convince yourself what risks are inherent in the investment style the fund promises to follow.
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| Compared to the objective a strategy is a more concrete statement of the money making purpose of the fund. While a fund will tell you very clearly what the fund intends to invest in, check what it says about where it will not invest in.
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| Note that most investment objective are vague and visionary statements. So it's good to also check how is the strategy of the fund defined.
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| Not necessarily. In several cases it is noticed that the funds performance is volatile and driven by few scrips. In other words, the fund manager has taken significantly higher risks to achieve higher returns. That brings us back to the oft-repeated moral in the investment market: The funds that have the potential for the greatest returns also have the greatest potential for losses. From an investor's point of view, while looking at impressive returns in the past, he cannot derive confidence and comfort in the fund managers' ability to repeat the performance in future.
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| The best way to do it is to actually do it. Right here.
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| Asset size also matter in case of small funds when they suddenly become big. For example, the excellent handling by the fund manager of a small fund may suddenly become popular and draw a lot new unitholders. The sudden flush of funds could lead to a change in the manager’s investment style that might record a drop in performance.
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| Investing and managing the collected money is a difficult task. The fund company delegates this to a company of professional investors, usually experts who are known for smart stock picks. This company is the Asset Management Company (AMC) and the fund company usually delegates the job of investment management for a fee.
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| Popularity has a flip-side which works against the funds many times. Consider this: If under some circumstances, a large number of untiholders decide to sell i.e. redeem, their units all at the same time, the fund will have to, at a short notice, generate enough cash to pay up the unitholders. The fund manager then faces what is called redemption pressure. He would have to sell off a significant portion of the scheme’s investments. If the markets are down the sell off could be at a throwaway price. Naturally then, more the investors in a scheme more the chance of a sudden redemption pressure.
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| A mutual fund is a trust that pools the money of several investors and manages investments on their behalf. Legally it is like any other company you know of. Hence, the fund is also called a mutual fund company. The fund company takes your money and like you from other new investors. This is added to the money that's already invested with the fund.
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| Some investors see asset size as an indicator of popularity. A scheme with large assets could be subscribed to by large number of unitholders.
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Asset, of course, is the investments of a mutual fund. And value is the market value of investments. What exactly is market value?
Let’s say a fund has invested its money in stocks. Then, the price of those stocks on the stockmarket multiplied by the number of stocks owned gives you the value of all the investments made by that mutual fund. This value can change either when the market valuation changes or if people are joining or leaving the scheme.
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| When you buy into a scheme of a mutual fund you are holding units of the scheme. Buying units is like owning shares of a scheme.
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| A fund collects money from investors through various schemes. Each scheme is differentiated by its objective of investment or in other words, a broadly defined purpose of how the collected money is going to be invested. Based on these broad purposes schemes are classified into a dozen or so categories about which more later.
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| The costs of the fund management process that includes marketing and initial costs are charged when you enter the scheme. These charges are termed the entry load, the additional charge you pay when you join a scheme.
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| Investors comfortable with numerical recipes do a technical check of what the returns of a scheme would be in the worst case. They check is done with the Sharpe ratio. The higher the Sharpe ratio, the better the fund's historical risk-adjusted performance.
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| While we are on the topic of what returns to expect, someone might as well wish for a fund that assures returns. Some of the mutual funds have floated "assured" return schemes that guarantee a certain annual return or guarantee a buyback at a specified price after a specified period. Examples of these include funds floated by the UTI, SBI 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. Nowadays, there are very few funds that come out with such schemes as the funds have realized it is not viable to assure returns in a volatile market.
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| Schemes with smaller assets to manage and particularly those that are not part of a large fund house will generally have higher expenses relative to schemes with larger assets. Fresh schemes generally take some time to overcome their expense burden.
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| Badly managed funds that have schemes with consistently higher expenses compared to funds of the same category with lower expenses, find it tough to curb their expenses.
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| By examining past performance you can get an almost certain idea of what the expenses for a scheme could be in the future. That's because the expenses don't depend on a scheme performance. It's dependent on the deftness of the fund manager.
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| Any day, lower the expenses the better it is. Smart and well-managed funds keep their expenses low. Smarter funds know exactly how to make their offerings attractive by smartly tucking away expenses either in entry load or exit load or by cutting on returns. And smart investors always get to beat the funds by figuring out where all the expenses are included. Right?
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| Needless to say, loads if any are only applicable to open schemes. And not close-ended schemes because for such schemes units can be bought from the fund only at the time of launch.
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| Now don't get too hassled about loads. Best thing to do when a scheme imposes a new load, is not to invest more money if the load charged is unreasonable.
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| If you are a unitholder of a scheme that charges an exit load, and the scheme changes its exit load structure, then you will get a prior notice of the change. The new structure will be applicable to you rather than the load structure you were informed about when you joined the scheme.
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| If you already hold a scheme NAV tells you on any day, the realizable value of each unit of the scheme. What that means is that it is the money you will get for each unit of the scheme, if the scheme is liquidated on that date or you want to exit the scheme. If you are planning to buy a scheme In other words, NAV is the value per share. It lets you know how much your investment is worth at a particular time. It is the most important measure of the performance of a mutual fund. Let’s say you have invested in a scheme at Rs 10 a unit and now its NAV is Rs 12. Quite simply, that means your investment has appreciated by 20%.
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| Buying a scheme is like buying potatoes with a limited budget. With Rs.400 you can either buy 10 kg of the Rs.40 per kg-variety or 20 kg of the Rs.20 per kg-variety. NAV tells you how much it will cost you to buy one unit of a scheme on any given day. So if you have Rs.50,000 in your pocket you can buy 1000 units of a scheme that is offering units at an NAV of 50 or you might buy 500 units of a pricier scheme with an NAV of Rs.100. Hold it. You may have to pay more than what the scheme’s NAV tells you. That is because of the charges levied by some mutual funds. Though NAV is a good enough figure to tell you what the price of each unit is, it is not an exact one. Funds charge fee for managing your money called the annual expense fee. Some funds also charge a fee when you buy or sell units called the entry and exit load.
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| The frequency with which a portfolio is churned is indicated by the turnover ratio, which is expressed as a percentage. A fund with a 100% turnover generally changes the composition of its entire portfolio each year. Low turnover of about 20-30% shows a fund following a cautious strategy i.e., buying stocks and holding them. Turnover in excess of 100% shows a fund into active trading i.e., one that sells and buys stocks very often. Hold it. Technically speaking, a turnover ratio is a ratio comparing the rupee value of fund purchases or sales to the rupee value of total fund assets during the year. Hence, a 100% turnover ratio could also indicate that only a portion of the entire portfolio has been traded intensely over the last year.
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| It’s all about the recipe. Just like successful cooking, a fund’s ability to fulfil the moneymaking objective of a scheme is determined by its recipe. The recipe for a scheme is its portfolio, which is mix of the investments the fund intends to make for the scheme. The fund invests its assets by buying a mix of various securities like stocks or bonds. Depending on the scheme’s objective, the fund manager fixes the investment recipe or the portfolio. The portfolio, on any day, consists of the various securities the fund has invested in. By purchasing into a scheme you become a part owner of that portfolio.
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| Always look carefully at start and end dates - they can always be chosen in a way that shows the fund in a favorable light. A better approach would be to choose a reasonably longer period and compare the performance across the similar schemes of different players.
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| Index funds are schemes that try to invest in those equity shares which make up a particular index. For example, an Index fund which is trying to mirror the BSE-30 (Sensex) will invest in only those 30 scrips that constitute this particular index. Investment in these scrips is also made in proportion to each stocks weight in the index.
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| Equity Linked Saving Schemes (ELSS) offer tax rebates to the investor under section 88 of the Income Tax law. These schemes generally diversify the equity risk by investing in a wider array of stocks across sectors. ELSS is usually considered a variant of diversified equity scheme but with a tax friendly offer. Typically returns for such schemes have been found to be between 15-20%.
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| No. That’s because diversified schemes invest in equity shares of companies from a diverse array of industries and balances and prevent any adverse impact on returns due to a downturn in one or two sectors. Sectoral funds tend to have a very high risk-reward ratio and investors should be careful of putting all their eggs in one basket. Investors generally see such schemes to benefit them in the short term, usually one year.
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| Those investors looking for benefits in the short term, usually one year. That’s because such schemes tend to have a very high risk-reward ratio and investors should be careful of putting all their eggs in one basket. Returns could be as high as 50% in a good year provided the investor chooses the right sector.
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| These are schemes whose objective is to invest only in the equity of those companies existing in a specific sector, as laid down in the fund’s offer document. For example, an FMCG sectoral fund shall invest in companies like HLL, Cadbury’s, Nestle etc., and not in a software company like Infosys. Currently there exist approximately four broad classification of basic sectors namely – technology, media & telecom (TMT), fast moving consumer goods (FMCG), basic industry (that invest in core industries like petrochemicals, cement, steel, etc.) and pharmaceuticals.
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| A market index is very important because one, it acts as a barometer for market behaviour, and two, it helps in benchmarking portfolio performance. For a particular category of mutual funds called the index funds, these indexes are used for passive fund management i.e. all a fund manager has to do to manage his portfolio is blindly follow the composition of the index. The role of a good index is to reflect the state of the overall market at every moment and indicate how the stock market perceives the Indian corporate sector to fare.
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| A mutual fund may not be able to meet the investment objectives of all unit holders through just one portfolio. Some unit holders may want to invest in risk-bearing securities such as equity, while others may want to invest in safer securities like bonds or government securities. Moreover, there are so many varying risks associated with different securities that it is often impossible for one individual to manage them. Therefore, a mutual fund tries to create different classes of risk portfolios by formulating different investment schemes. Each investment scheme specifies the kind of investments the scheme will make out of the monies collected.
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| The drawbacks with mutual funds are that you have no control on the investments of the fund; and, more importantly, the downside of diversification is that a fund can hold so many stocks that a tremendously great performance by a stock will make very little difference to a fund's overall performance.
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| Mutual funds have many benefits. They offer an easy and inexpensive way for an individual to get returns from stocks and bonds without: incurring the risks involved in buying them directly; needing the capital to buy quality stocks; or having the expert knowledge to make the right buy/sell decisions.
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| The BSE has other indexes apart from the Sensex. The BSE National Index or the BSE 100 comprises 100 scrips (or stocks) listed on the BSE. Having a larger basket of stocks the BSE National Index enables a stable assessment of stock price movements. The BSE-200 comprises of the equity shares of 200 selected companies listed on the BSE. Over the years foreign investors have shown eagerness in investing in India and many foreign financial institutions have also entered into the country. The Sensex and other indexes reflect the growth in market value expressed in rupee terms. The BSE-Dollex is a yardstick by which these growth values can be measured when the investment and the return are expressed in dollar terms. The Dollex is a dollar-linked version of the BSE-200 and hence also sensitive to the rupee-dollar conversion rate.
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| An index is a composite of stocks that indicates how the overall market or a part of the market is moving. The grandfather of all indexes in India is the Sensex.
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| The National Stock Exchange has an index, the S&P CNX Nifty. Since its inception this index, also called the Nifty Fifty, has attained great popularity among investors. Hundreds of calculations are made before 50 stocks of the NSE are selected for the index. S&P stands for Standard and Poor, a subsidiary of McGraw-Hill, and an investment advisory service that maintains one of the most widely followed benchmarks of stock market performance, the S&P 500 index. The CNX stands for CRISIL NSE Indices, the two companies that came together to form the index.
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| S&P stands for Standard and Poor, a subsidiary of McGraw-Hill, and an investment advisory service that maintains one of the most widely followed benchmarks of stock market performance, the S&P 500 index. The CNX stands for CRISIL NSE Indices, the two companies that came together to form the index.
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