part 12

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Part-12

Mutual Funds&

Pension Funds

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Definition What is a mutual fund? It is a collection of assets like:

Stocks Bonds Precious metals Real estate

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Definition (Cont…)

Who purchases these assets? A pool of investors

Who manages these assets? A professional investment company

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The Mechanics

When an investor makes an investment in a mutual fund, his money is pooled with that of other investors who have chosen to invest in the fund.

Every investor will receive shares of the fund, in proportion to the amount of funds invested by him or her.

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The Mechanics (Cont…)

If the fund is just commencing operations, the pooled resources will be used to acquire a portfolio of assets.

Else if the fund is already in operation the newly received funds will be used to expand its portfolio.

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Shares of a Fund

Every share held by a mutual fund investor represents a proportional interest in the portfolio of securities managed by the fund.

When a fund is just commencing operations, the issue of shares by it is known as an Initial Public Offering (IPO).

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Shares of a Fund (Cont…)

During an IPO, the shares will be issued at par.

Subsequent share issues will be made at a price that is based on the Net Asset Value (NAV) of the fund.

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Definition of NAV

The NAV of a fund at any point in time is: The total value of all the securities in

its portfolio, less any outstanding liabilities

Divided by the total number of shares issued by the fund.

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NAV (Cont…)

The NAV will fluctuate from day to day: Due to changes in the value of the

assets constituting the portfolio Due to income from the assets held

by the fund Due to expenses incurred by the fund

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NAV (Cont…)

On a given day, the NAV may be higher or lower than what the shareholder paid to acquire the shares of the fund.

Thus just like shareholders of a company, holders of mutual fund shares participate: In all profits and losses made by the fund,

as well as in its income and expenditure.

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The U.S. Mutual Fund Industry

The industry is really big: In the 1990s money was pouring into

mutual funds at the rate of $1 billion per day.

By the end of the 1990s: There were 10,350 different funds in the

U.S Holding about $3.7 trillion in assets

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Why Invest in a Mutual Fund?

Why should an investor invest in a mutual fund, rather than invest directly in securities?

A mutual fund by definition has a large corpus at its disposal.

So the size of its typical investment tends to be large.

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Why Invest ?(Cont…)

Consequently, its transactions costs tend to be low.

These benefits obviously get passed on to the shareholders of the fund.

This is particularly attractive from the standpoint of an investor seeking to acquire a diversified portfolio of assets.

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Why Invest? (Cont…)

The cost of building a diversified portfolio using the limited funds at one’s disposal can be prohibitive.

However by investing in a mutual fund one effectively ensures diversification and that too at a lower cost.

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Why Invest? (Cont…) Mutual funds can afford to employ well

qualified and experienced professionals. These analysts can evaluate the merits

of an investment before committing funds.

Individual investors lack such expertise. And nor can they afford to employ

advisors with such skills.

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Why Invest? (Cont…)

Mutual fund investments are often more liquid than investments in the underlying assets.

Consequently shareholders can dispose off their shares easily, quickly, and at a fair price.

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Any Disadvantages?

Investing in a mutual fund is not all about advantages, however.

There are drawbacks. Firstly, the investor has no control

over the cost of investing. It is entirely in the hands of the

fund manager.

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Disadvantages (Cont…) Moreover, as long as one is invested in

the fund, he has to pay the required investment management fees.

This is true even if the value of the assets of the fund is showing a declining trend.

Second, mutual funds incur sales and marketing expenditure , which get passed on to the investor.

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Disadvantages (Cont…) An individual investor will not

obviously incur such costs. Thirdly the choice of securities is

delegated to the fund manager. Thus the investor forsakes the

option to design his own kind of portfolio.

This may not be satisfactory for a High Net Worth (HNW) investor.

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Disadvantages (Cont…)

In practice fund managers attempt to cater to different types of investors, by offering funds with different investment objectives. But the availability of such choice

may itself pose problems Because an investor may once again

need expert advice on which fund to choose.

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Open-End versus Closed-End Funds

In the case of an open-end fund, the investor can buy or sell shares of the fund from/to the fund at any point in time.

The purchase/sale price of the share at which an investor can transact is called the Net Asset Value (NAV).

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NAV

The NAV of a fund is defined as the market value of all the assets of the fund plus any accrued income, less the liabilities of the fund, divided by the total number of shares outstanding.

The NAV of an open-end fund is determined once a day at the close of trading.

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NAV (Cont…)

All new investments into the fund and withdrawals from the fund during the course of a day, are priced at the NAV that is computed at the end of that day.

As the prices of the assets of the fund fluctuate, so will the NAV and the total value of a fund.

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Open-End Funds The number of shares outstanding

at any point in time may either go up subsequently or go down.

It would depend on whether additional shares are issued or existing shares repurchased.

Thus the `unit capital’ of an open-end fund is not fixed but variable.

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Open-End Funds (Cont…)

The investable corpus of the fund will go up if the number of new subscriptions by new/existing investors exceeds the number of redemptions by existing investors.

The investable surplus will stand reduced if redemptions exceed the fresh subscriptions.

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Open-End Funds (Cont…) Such funds always stand ready to

issue fresh shares. Many successful funds stop fresh

subscriptions after reaching a target size.

This could happen if they feel that further growth will adversely impact profitability.

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However they rarely deny investors the freedom to redeem shares.

Every open-end fund will maintain a Cash Reserve which is usually about 5% of the total assets. This is done to cover redemption

requests from shareholders.

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However should additional funds be required, the fund manager will have no choice but to liquidate some of the assets of the fund.

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Closed-End Funds

These funds make a onetime sale of a fixed number of shares.

Their `unit capital’ therefore remains fixed.

They do not allow investors to buy/redeem units from/with them.

But to provide liquidity to investors they get listed on stock exchanges.

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Closed-End Funds (Cont…) In the case of a listed closed-end fund,

investors can buy and sell shares through a broker.

The share price need not be equal to the NAV.

Depending on investors’ perceptions about future performance and supply-demand factors, the shares may trade at a premium to or at a discount from the NAV.

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Closed-End Funds (Cont…)

Shares that trade below the NAV are said to: `trade at a discount’

Shares that trade above the NAV are said to:`trade at a premium’

Shares of unlisted closed-end funds can be traded over-the-counter.

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Life-Boat Provisions The fund charters of closed-end funds

usually contain life-boat provisions. These require such funds to take

action in cases where the shares are trading at a substantial discount to the NAV.

The funds in such cases can either buy back the shares via a tender offer, or else they can convert it to an open-ended fund.

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Life-Boat (Cont…)

If the fund managers fail to respond in an appropriate fashion, dissident shareholders can buy large blocks of shares and initiate a proxy fight to either have the fund liquidated or to make it open-ended.

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Regulation Under the U.S. Investment Company Act

of 1940, a closed-end fund is capitalized only once.

That is, once it makes an issue of shares via an Initial Public Offering it cannot issue further shares subsequently.

Consequently many closed-end funds choose to borrow when they wish to increase the size of their investments.

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Closed-End Funds (Cont…)

Unlike open-end funds, these funds are not listed in the mutual fund tables printed in the financial papers. Rather they are listed alphabetically

with stocks in the table of share prices.

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Unit Trusts

Unit Trusts a.k.a Unit Investment Trusts are similar to closed-end funds in the sense that they are capitalized only once.

Consequently their `unit capital’ remains fixed.

Most Unit Trusts invest in bonds.

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Unit Trusts (Cont…)

Unit Trusts differ from mutual funds in one crucial respect.

Once a portfolio of bonds is assembled by a Unit Trust, it is held until the bonds are redeemed by the issuer.

Thus there is no trading in the assets which comprise the portfolio.

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Unit Trusts (Cont…)

Usually the only time the trustee of a Unit Trust can sell a bond held by it, is if there has been a significant decline in the credit quality.

Because of the lack of active trading the cost of operating a Unit Trust is lower than the cost of running a closed-end fund.

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Unit Trusts (Cont…) Second, most unit trusts have a fixed

termination date. And finally, unlike investors of a

mutual fund who are constantly exposed to a changing portfolio composition, unit trust investors know the exact composition of their portfolio from the outset.

Unit trusts are more common in Europe.

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Calculating the NAV

The net assets of a fund is defined as:Net Assets = Market Value of all

Investments+ Receivables+ Other Accrued Income+ Other Assets- Accrued Expenses- Other Payables- Other Liabilities

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Calculating the NAV (Cont…) The NAV is defined as:

NAV = Net Assets ÷ No. of Units

Outstanding

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Factors Affecting the NAV

The NAV is affected by four sets of factors: Purchase and sale of investment

securities Valuation of the investment securities Other assets and liabilities Units sold or redeemed

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Other Assets & Liabilities

The term `other assets’ includes any income due to the fund but not received as on the valuation date, like: Dividends announce by a company

whose shares are being held by the firm but which have not yet been received.

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Other Assets & Liabilities (Cont…)

`Other liabilities’ include expenses payable by the fund such as: Custodian fees Management fees payable to the Asset

Management Company All items of income and expenditure

have to be accrued and included while computing the NAV.

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Other Assets & Liabilities (Cont…) In India SEBI requires that all income and

expenditure should be accrued up to the valuation date and considered for NAV computations.

Major expenses like management fees should be accrued on a day to day basis. Other expenses need not be accrued daily if

non-accrual will not affect the NAV by more than 1%.

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Expenses of a Fund

The Asset Management Company will have many funds under its management. Some expenses would be specific to a

given scheme. Others may be common to all schemes.

All expenses should be clearly identified and allocated.

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Expenses

Expenses may be broadly categorized as: Investment management and

advisory fees. Initial expenses of launching a

scheme Recurring expenses

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Recurring Expenses

This expenditure category includes: Marketing and selling expenses Brokerage and transactions costs Registrar services for transfer of units

sold or redeemed Fees and expenses of trustees Audit fees Custodian fees

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Recurring Expenses (Cont…)

Costs related to investor communication Costs of fund transfers Costs of providing account statements

and dividend/redemption checks and warrants

Insurance premiums Winding up costs if a fund or a scheme

is being terminated Statutory advertisements

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Illustration of an NAV Calculation

A mutual fund in the U.S. has acquired the following shares: IBM – 1,000 Exxon – 2,000 GM – 2,000

It has issued 20,000 units to its shareholders

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Illustration (Cont…)

COMPANY

# of Shares

PRICE VALUE

IBM 1,000 35 35,000

Exxon 2,000 80 160,000

GM 2,000 60 120,000

TOTAL 5,000 315,000

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First day’s NAV:315,000_______ = 15.7520,000

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Illustration (Cont…)The Next Day

COMPANY

# Of Shares

PRICE VALUE

IBM 1,000 40 40,000

Exxon 2,000 90 180,000

GM 2,000 75 150,000

TOTAL 5,000 370,000

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The next day’s NAV:370,000

_______ = 18.5020,000

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Illustration (Cont…) So, the NAV will change when the

values of the securities bought by the fund change.

But the NAV may also change if the fund issues additional shares. If the incoming funds are used to

acquire shares in the existing proportions, then the NAV will not change.

Else it will.

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Illustration (Cont…)Case-A Assume that the fund issues 2,000

additional shares at the end of the first day.

At an NAV of 15.75 this will mean an inflow of 31,500.

Assume that 100 shares of IBM, 200 shares of Exxon, and 200 shares of GM are bought. That is, the existing ratio of 1:2:2 is

maintained.

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COMPANY

# of Shares

PRICE VALUE

IBM 1,100 40 44,000

Exxon 2,200 90 198,000

GM 2,200 75 165,000

TOTAL 5,500 407,000

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The next day’s NAV:407,000_______ = 18.5022,000

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Illustration (Cont…)Case-B The fund decides to acquire 300

shares of IBM, 150 shares of Exxon, and 150 shares of GM.

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COMPANY

# Of Shares

PRICE VALUE

IBM 1,300 40 52,000

Exxon 2,150 90 193,500

GM 2,150 75 161,250

TOTAL 5,600 406,750

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The new NAV:406,500_______ = 18.488622,000

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Expenses (Cont…)

When a scheme is first launched, the AMC will incur significant expenditure, whose benefit will accrue over many years. The entire expenditure cannot

therefore be charged in the first year itself.

SEBI permits such expenses to be amortized over a period of five years.

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Expenses (Cont…) However issue expenses incurred

during the life of a scheme have to be charged in the year of incurrence itself.

The unamortized portion of the initial issue expenses shall be included in the NAV calculation and will be classified under `Other Assets’.

Investment advisory fees cannot be claimed on such assets.

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SEBI’s Accounting Policies for Mutual Funds

Dividends received by a fund from a share should be recognized the day the share goes ex-dividend and not on the declaration date.

While determining capital gains/losses on the sale of securities, the average cost method must be used to determine the cost of purchase.

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Example

A mutual fund acquires 100 shares of WIPRO for Rs 600 each on August 1.

It buys another 200 shares at Rs 750 each on September 1.

On 15 September it sells 100 shares for Rs 800 each.

What is the capital gain or loss?

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Calculation of Gains/Losses

The average cost per share will be determined as follows:600 x 100 + 750 x 200

______________________ = Rs 700300

Total cost of shares sold = 100 x 700 = Rs 70,000

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Calculation (Cont…)

Sale proceeds = 100 x 800 = Rs 80,000

Capital gains = Rs 10,000

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Accounting Policies (Cont…)

Purchase/sale of investments should be recognized on the trade date and not on the settlement date.

Bonus/rights issues should be recognized only when the shares are traded on the exchange on a ex-bonus/ex-rights basis.

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Accounting Policies (Cont…)

Income receivable on investments, which is accrued, but not received for 12 months beyond the due date, should be provided for, and no further accrual should be made for it.

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Accounting for Major Transactions

Here is a detailed illustration on how sales and redemptions of shares of a mutual fund are accounted for in its books of accounts as per SEBI guidelines.

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Illustration Day-1:

An open-end fund issues 1,000 shares at a face value of Rs 10 each.

Thus unit capital will appear on the liabilities side with a value of Rs 10,000.

This amount will be invested in various securities.

Thus investments will appear as an asset with a value of Rs 10,000.

The NAV will obviously be Rs 10.

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Day-2: The market value of the investments

rises to Rs 11,000. Thus there will be an unrealized capital

gain of Rs 1,000. Unrealized capital gains have to be

recognized as income in the books of account, but cannot be distributed to the shareholders.

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Illustration (Cont…) As far as the books are concerned,

Investments will be debited by Rs 1,000.

Thus its value will go to Rs 11,000. The unit premium reserve will be credited

with Rs 1,000. The NAV will obviously be Rs 11.

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Illustration (Cont…) Day-3:

The market value of the investments rises to Rs 12,000.

10% of the original portfolio is sold. Thus shares worth bought for 1,000 are

sold for 1,200. Thus investments will be debited with

1,000 and credited with 1,200. The balance in the account will be

10,800.

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Illustration (Cont…) The realized gain on the sale of

investments will be Rs 200. The unrealized capital gain will be Rs

1,800 Since the shares are sold for 1,200,

cash or bank will be debited with Rs 1,200.

The NAV will be 12 as can be demonstrated.

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Net Assets = Market Value of Investments on Hand +

Cash Received from sale of Investments

= Rs 12,000 Number of units outstanding = 1,000 NAV = 12

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The NAV consists of: Face value of Rs 10 Realized gain of 0.20 Unrealized gain of Rs 1.80

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Day-4: There is no change in the market

value of the investments. The fund sells 100 units. It repurchases 75 units.

Both transactions take place at the NAV of 12.

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Equalization Account An open-end fund will sell and

redeem shares at NAV. While creating/redeeming shares it is

important to ensure that the percentage of income that is eligible for distribution does not change.

For this purpose SEBI requires the creation of an Equalization Account.

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Equalization Account (Cont…) The first step is the computation of the

Distributable Reserves: Distributable Reserves = Income

+ Realized Gains on

Investments- Expenses- Unrealized

Losses

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Equalization Account (Cont…)

Note: Unrealized losses are recognized Unrealized gains are not recognized

If the distributable reserves are positive than the following ratio is computed: Distributable Reserves ÷ No. of Units

Outstanding

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This ratio has to be multiplied by the number of shares sold. If the shares are sold above par, then

the equalization account is credited by this amount.

If the shares are sold at below par, then the equalization account is debited by this amount.

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In the case of redemptions, the number of units has to be multiplied by the number of units redeemed. If the units are repurchased at above

par, the equalization account has to be debited.

If the units are repurchased at below par the equalization account has to be credited.

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Equalization Account (Cont…) The net balance in the equalization

account is transferred to the Profit & Loss Account.

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In our case, the distributable reserves = realized capital gains = Rs 200

The ratio = 200 ÷ 1000 = 0.20 When 100 units are sold at Rs 12,

the equalization account will be credited with 0.20 x 100 = Rs 20.

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Because of this transaction: Units outstanding will increase to

1,100 The sale proceeds will be Rs 1,200 The unit capital account will be

credited with Rs 1,000. The unit premium reserve will be

credited with Rs 180 which is the unrealized capital gain.

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Illustration (Cont…) When 75 units are redeemed at Rs 12:

The equalization account is debited by Rs 15.

The units outstanding will decrease to 1025

The outflow of cash will be Rs 900. The unit capital will be debited by Rs 750. The unit premium reserve will be debited

by Rs 135.

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The net amount of Rs 5 in the equalization account will be transferred to the Profit & Loss account. This can be distributed to the

shareholders. The balance in the unit premium

reserve cannot however be distributed.

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SEBI Guidelines on Valuation

Mutual funds have to report their NAV on a daily basis.

Thus their portfolios must be marked to market on a daily basis.

SEBI has prescribed certain regulations for the valuation of assets.

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Valuation (Cont…) When a security is traded on a stock

exchange, it should be valued at the last quoted price on the exchange where it is principally traded.

If the security is not traded on any exchange on a given day, the value at which it was traded on the earliest previous day may be used Provided that this date is not more than 60

days prior to the valuation date.

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Valuation (Cont…)

If a security is not traded on any stock exchange for 60 days prior to the valuation date, it must be treated as a non-traded scrip.

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Valuation of Non-Traded Scrips

Equity shares are to be valued on the basis of capitalization of earnings.

The capitalization will be determined with reference to the Price/Earnings ratios of comparable traded securities with an appropriate discount for lower liquidity.

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Example

Assume that the fund is holding shares of a company which is not publicly trade but has an EPS of Rs 2.

A similar company whose shares are actively traded has a P/E ratio of 12.

Using this ratio, the value of the non-traded scrip should be Rs 24.

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Example (Cont…)

However since the non-traded scrip is less liquid, we may use a lower P/E ratio, say 10.

If so, we would value our share at 20.

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Non-traded Scrips (Cont…)

For debt instruments we would price it using the YTM of a comparable traded debt security. To account for the lower liquidity we

would use a higher YTM.

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Costs The costs incurred by an investor in a mutual

fund can be classified under two heads.The first is called a sales charge or a shareholder fee.

This is a one time charge that is debited at the time of a transaction – either at the time of purchase, or a sale, or an exchange of shares of one scheme for that of another.

The amount would depend on the method used by the fund for distributing its shares.

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Costs (Cont…)

The second category of costs is the annual operating expense incurred by the fund, called the expense ratio.

The largest component of the expense ratio is the management fee.

This cost is independent of the method adopted for distributing the shares.

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Sales Charges

Traditionally, two methods have been adopted for distributing shares of a mutual fund.

They have been sold using a sales force or a wholesale distributor, or

They have been sold directly.

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Sales Charges (Cont…) The first method requires an intermediary

like a an agent, a stockbroker, an insurance agent, or other similar entity who is capable of providing investment advice to the client, and can also service the investment subsequently.

This is an active approach. In such cases, it is said that `the fund is

sold not bought’.

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Sales Charges (Cont…)

In the second case there is no intermediary or salesman.

No advice is provided at the time of sale.

The potential client is expected to dial a toll-free number in response to an advertisement or other source of information.

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Sales Charges (Cont…) This is a passive approach. It is said that `the fund is bought

and not sold’. The agent based system comes with

an attached cost – a sales charge which has to be borne by the client.

The charge is a compensation for the services rendered by the agent.

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Loads The sales charges levied by such

funds are referred to as loads. The traditional practice has been

to deduct the load upfront from the investor’s initial contribution at the time of entry, and pass it on to the agent/distributor.

The balance represents the investable amount for the client.

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Front-End Loads

This method of charging is called front-end loading.

The corresponding loads are called front-end or entry loads.

Since the total amount paid by the investor in such cases exceeds the NAV, such funds are said to be: `purchased above the NAV’.

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No-Load Funds In the case of directly placed funds,

there is no need for a sales charge because an intermediary is not present.

Such fund are known as no-load funds. In these cases, the entire amount paid

by the investor is investable. Such fund are said to be: `purchased

at NAV’.

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Load or No-Load? It was thought at one time that load

funds would become obsolete and that no-load funds would come to dominate the market.

After all why would any rational investor pay a sales charge, if it is avoidable.

It was felt that, individual investors, given their increasing levels of sophistication, would prefer to make their own decisions.

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Load or No-Load ? (Cont…)

However the trend has been to the contrary.

Load funds continue to be popular. There are two reasons for this. Firstly many investors continue to

be dependent on the counsel, service, and the initiative of investment agents.

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Load or No-Load? (Cont…) Besides load funds have shown a lot of

ingenuity and flexibility in devising new methods for imposing the load.

The objective has been to compensate the agent without appearing to be a burden on the investors.

These innovations have been in the form of `back-end’ and `level’ loads.

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Back-End Loads

These are imposed at the time of redemption of shares.

Consequently they are known as exit loads.

The advantage is that the investor pays the NAV at the time of entry, and the entire amount is investable.

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Level Loads

In this case, a uniform sales charge is imposed every year.

Hence the reported NAVs will be lower than what they would have been in the absence of a sales charge.

However, once again, the entire amount paid at the outset will be investable.

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Level Loads (Cont…)

Level loads appeal to investors who are more comfortable with the concept of an annual fee rather than commissions.

Such investors are known as fee based planners.

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Contingent Deferred Sales Charge

This is the most common form of exit load.

This approach imposes a load on withdrawal, which is a function of the number of years that the investor has spent with the fund.

The longer an investor stays with a fund, the lower will be the load on redemption.

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Illustration Consider a 3,3,2,2,1,1,0 contingent

deferred sales charge. It means that the load is 3% if the shares

are redeemed within two years, 2% if they are redeemed after 2 years but within 4 years, and 1% if the redemption takes place after 4 years but within 6 years.

There is no load if the redemption takes place after 6 years.

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Multiple Share Classes Many mutual fund families offer their funds

with a choice of loading mechanisms. The client can pick the method of his choice. Shares subject to front-end loading are

called class `A shares’. Those subject to back-end loading are called

class `B shares’. This with a level load are called class `C

shares’.

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Loads (Cont…) According to the National

Association of Securities Dealers (NASD), the maximum allowable sales charge is 8.5%.

Most funds impose lower charges in practice.

The sales charge is often lower for investments beyond a specified level.

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Loads (Cont…)

In the case of front-end load funds and back-end load funds, the declared NAV will not include the load.

In the case of funds with a front-end load, the investor must add the load amount per share to the NAV in order to calculate the purchase price.

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Loads (Cont…)

In the case of funds with back-end loads, the investor has to deduct the load amount per share from the NAV in order to get the net sale proceeds.

We will illustrate these cases using a numerical example.

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Illustration

A fund has declared a NAV of 19.30.The front-end load is 2.5%.

So the price payable by the investor is 19.30-------- = 19.7949. .975

This can be understood better as follows.

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In the absence of a load, an investment of $1000 would fetch the investor

1000 ------- = 51.81 units. 19.30 However because of the load it will

fetch only: 1000 x .975/19.30 = 50.5181 units.

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Illustration (Cont…) Now assume that the fund charges

an exit load of 2.5% instead of an entry load.

Instead of receiving 19.30 per unit, the investor will receive only

19.30 x .975 = 18.82 per unit. Thus a sale of 100 units which would

have fetched $1930 in the absence of a load, will now fetch only $ 1882.

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Loads (Cont…) Loads can be imposed by both open-ended

as well as closed-ended funds. Loads represent issue expenses which are

just one of the many expenses incurred by a mutual fund.

Other expenses like the fund manager’s fees have to be charged on an ongoing basis.

The impact of such charges will be a reduction in the reported NAV.

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Expense Ratio The operating expense is debited

annually from the investor’s balance by the sponsor of the fund.

There are three main categories of such expenses:

Management Fee Distribution Fee Other Expenses

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Management Fee It is also known as the Investment

Advisory Fee. It is the fee charged by the investment

advisor for managing the fund’s portfolio.

The fees charged would depend on the nature of the fund.

The greater the required levels of efforts and skills, the higher will be the fees.

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12b-1 Fee In 1980 the SEC approved the

imposition of a fixed annual fee called the 12b-1 fee.

It is intended to cover distribution costs including continuing agent compensation, and the fund’s marketing and advertising expenses.

By law it cannot exceed 1% of the fund’s assets in a given year.

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12b-1 Fee (Cont…)

The 12b-1 fee may include a fee of up to 0.25% of the assets to compensate sales professionals for providing services or for maintaining shareholders accounts.

This is intended to provide the sales agent with an incentive to continue to service the account, even after having received a transaction based fee such as a load.

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12b-1 Fee (Cont…)

This component of the fee is applicable only for sales-force-sold load funds and not for directly sold no-load funds.

The balance of the 12b-1 fee accrues to the sponsor and is intended to provide an incentive to continue advertising and marketing efforts.

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Other Expenses These are incurred on account of the

following. Custody related costs have to be paid in

connection with the holding of cash and securities.

Transfer agents have to be paid when securities are transferred from existing to new shareholders; and when income from investments is distributed to existing shareholders.

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Other Expenses (Cont…)

Fees have to be paid to public accountants who have been entrusted with the task of scrutinizing the books of account of the fund.

Directors fees have to be paid. The sum total of all this expenditure

is called the Expense Ratio.

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IllustrationExpense Type

FUND

Fidelity Magellan

Vanguard S&P500 Index

American Income Fund of America-A

Management Fee

0.57% 0.16% 0.28%

Distribution (12b-1) fee

0 0 0.24%

Other Expenses

0.18% 0.02% 0.07%

TOTAL 0.75% 0.18% 0.59%

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Analysis The first two funds are directly sold. Hence the 12b-1 distribution fee is zero. The American Income Fund is sold via a

sales force and hence there is a 12b-1 fee.

A fund which tracks an established market index is relatively easy to manage as compared to a fund which requires active portfolio rebalancing.

130

Analysis (Cont…)

So the Vanguard S&P500 Index fund has the lowest management fee.

The Fidelity Magellan Fund is an actively managed pure stock fund and has the highest management fee.

131

Switching Fees

For many years there was no charge for switching from one mutual fund to another within the same family.

But of late some funds have started charging a flat fee. They argue that such charges are being

levied to discourage frequent switching.

132

Switching Fees (Cont…) They may have a point because

frequent switching increases the administrative costs involved in keeping track of customer accounts.

Switching charges are recovered directly from the shareholder and do not impact the NAV.

133

Categorization of Funds One way to categorize funds is on the

basis of the investments made by them. Consequently we have: Equity Funds Bond Funds Money Market Funds Precious Metal Funds Real Estate Funds

134

Categorization (Cont…)

Another way to categorize is on the basis of investment objectives.

Growth Funds; These funds target capital appreciation in the medium to long term.

Income Funds: They focus on earning regular income, and are less concerned with capital appreciation.

135


Value Funds invest in undervalued securities in the hope of a subsequent rise in price.

Funds can also be categorized on the basis of their risk profiles.

Equity Funds have a greater risk of capital loss than Debt Funds.

136

Categorization (Cont…) Money Market Funds have an even lower

risk of capital loss as compared to Debt Funds.

Fund Managers can design funds with specific risk-return characteristics in order to cater to different types of investors.

For instance Equity Income Funds invest in securities which may not show much capital appreciation, but which pay steady dividends.

137


Balanced Funds seek to reduce risk by mixing equity investments with investments in fixed-income securities.

They also attempt to strike a balance between the need for capital appreciation and the need for steady income.

138

Money Market Funds They invest in securities with one

year or less to maturity. Typical investments are: Treasury Bills Certificates of Deposit Commercial Paper These investments are very liquid

and carry low credit risk.

139

Money Market Funds (Cont…)

There are also tax-free money market funds which invest only in municipal securities. The earnings of these funds are

exempt from Federal income taxes, and in some cases from state taxes as well.

140

Money Market Funds (Cont…) The SEC has recently issued regulations

to improve the safety, liquidity, and diversity of all money market funds. They should invest a minimum of 95% in top

rated securities. No more than 1% may be invested in the

securities on an investor who is not top rated.

The maximum maturity of an investment should not exceed 90 days.

141

Money Market Funds (Cont…)

These funds are ideal for investors seeking: Stability of principal High liquidity Check writing facilities

142

MMMFs versus Bank CDs

The earnings from an MMMF are as high or higher than those from bank CDs.

And unlike CDs, MMMFs do not carry any early withdrawal penalties.

143

Gilt Funds

Gilt securities are debt instruments issue by the government with a maturity in excess of one year.

In the U.S such securities are known as T-bonds and T-notes.

These securities carry little default risk.

But they are not risk-less either.

144

Gilt Funds (Cont…)

For they are vulnerable to interest rate risk or market risk.

That is, changes in the interest rate structure in the economy can lead to substantial volatility in bond prices.

145

Debt Funds These are also known as Income

Funds. They invest in fixed-income

securities issued by governments, private companies, banks and financial institutions, infrastructure companies, and public utilities.

They carry lower risk as compared to equities and provide stable income.

146

Debt Funds (Cont…) They have higher credit risk as

compared with Gilt Funds. As compared with Money Market Funds,

they have greater market risk as well as credit risk.

Their focus is primarily on earning income and not on capital appreciation.

They distribute substantial income to shareholders on a regular basis.

147

Sub-Classification of Debt Funds Diversified Debt Funds: It is a fund that

invests in virtually all types of debt issues, cutting across all sectors and industries.

Investments in debt carries less risk as compared to an equity investment but there is nevertheless exposure to credit risk or the risk of default.

The advantage of a diversified fund is that idiosyncratic credit risk gets diversified away.

148

Sub-Classification (Cont…) Focused Debt Funds: They invest only in

debt securities issued by a specific sector or industry.

Some invest only in corporate bonds and debentures.

Others in only Infrastructure Bonds or Municipal Bonds.

Still others invest only in Mortgage Backed Securities.

149

Sub-Classification (Cont…)

High Yield Debt Funds: They invest in non-investment grade bonds or Junk bonds.

There is a far greater degree of risk in this case.

But the expected returns are also very high.

150

Equity Funds Such funds invest a major portion if not

all of their corpus in equity shares. Such shares may be acquired by

subscribing to an IPO or via the secondary market.

Equity shares are by definition more risky than debt.

This is because they constitute a residual claim rather than a contractual claim.

151

Types of Equity Funds

Aggressive Growth Funds: They target high capital appreciation and usually take substantial risks in the process.

They tend to invest in less researched and highly speculative stocks.

High returns are more likely but the returns tend to be very volatile.

152

Equity Funds (Cont…) Growth Funds: They also target

companies with a high perceived potential for growth.

But they tend to invest in sunrise industries – Information Technology, Bio Technology, Pharmaceuticals.

The difference as compared to an aggressive growth funds is that the stocks tend to be less speculative.

153

Equity Funds (Cont…) Specialty Funds: They have a narrow

focus. Tend to invest only in companies which

satisfy certain pre-defined criteria. For instance some funds will not invest

in Tobacco or Liquor companies. Others tend to focus on companies

from specific regions – Latin America or the ASEAN.

154

Equity Funds (Cont…) Some equity funds tend to be highly

diversified while others hold concentrated investments in a few chosen securities.

The latter are obviously more volatile. Sector Funds: They invest only in a

chosen sector or industry like – Software, Pharma, or FMCG.

As compared to a diversified fund, the risk level is higher.

155

Equity Funds (Cont…)

Offshore Funds: They invest in equities of companies located in foreign countries.

International diversification offers even grater scope for risk reduction than domestic diversification.

But it exposes investors to foreign exchange risk.

156


This is the risk that the domestic currency may have appreciated by the time the returns are repatriated to the home country.

These funds may be well diversified or else may choose to remain concentrated in a few countries.

157

Equity Funds (Cont…) Small Cap Funds: They invest in

companies with a low market capitalization as compared to large Blue Chip companies.

The shares of these companies are less liquid, and consequently prices tend to be volatile.

Some of these funds target aggressive growth while others aim at a steady growth.

158

Equity Funds (Cont…) What is the definition of a small cap

fund. Market capitalization is defined as

the price of a share times the number of shares issued.

The definition of small, medium, and large cap companies is subjective.

Fabozzi has suggested the following classification for U.S. companies.

159

Market Capitalization

Firm Type Market Capitalization

Small Cap < 2 billion USD

Mid Cap 2 M-Cap < 12 billion USD

Large Cap 12 billion USD

160


Option Income Funds: These funds write options on stocks held by them.

Conservative option funds invest in large dividend paying companies, and then sell options against their stock positions.

Thus they have two sources of income – dividends and option premiums

161

Equity Funds (Cont…) Diversified Equity Funds: These funds

diversify their investments across companies.

Extensive diversification ensures that the level of risk is low.

Equity Index Funds: They track the performance of a stock market index, such as the Dow Jones Industrial Average or the Standard & Poor’s 500 Index.

162

Equity Funds (Cont…) These funds will invest only in stocks

which constitute the target index, and in exactly the same proportions as such stocks are present in the index.

These funds can be thought of as `Mimicking Funds’.

If the index being represented is well diversified, then the corresponding index fund will have low risk.

163

Equity Funds (Cont…) Value Funds: Growth funds focus on

companies with good or improving prospects for future profits.

Their primary aim is capital appreciation.

Value Funds too seek capital appreciation.

But their focus is on fundamentally sound firms which are perceived to be undervalued.

164


As compared to Growth Funds, Value Funds are less risky.

Many of them tend to invest in a large number of sectors and are therefore well diversified.

Equity Income Funds: They invest in companies which give high dividend yields.

165


Their target is high current income, and steady not spectacular capital appreciation.

Such funds invest heavily in equity stocks.

The prices of such firms do not fluctuate much.

But they provide steady dividends.

166

Hybrid Funds These funds have a dual debt/equity

focus. There are various forms of hybrid funds. Balanced Funds: They hold portfolios

consisting of debt instruments, convertible securities, preference shares, and equity shares.

They hold almost equal proportions in debt/money market assets and equities.

167

Hybrid Funds (Cont…) Their objective is steady income

accompanied by moderate capital appreciation.

They are primarily intended for conservative and long-term investors.

Asset-Allocation Funds: Traditionally mutual funds have invested in a pre-defined asset class.

168

Hybrid Funds (Cont…) For instance some invest in debt

while others invest in equities. There are funds which invest in

more than one asset class, for instance Balanced Funds.

But even in this case, the relative proportions invested in equity and debt will generally not vary much.

169

Hybrid Funds (Cont…)

Asset Allocation Funds however follow a variable allocation policy.

They will move in and out of various asset classes.

The choice of an asset class at any point in time would depend on the fund manager’s current view on the market.

170

Commodity Funds They invest in commodity markets. The investments may be made by

buying the physical commodities or by buying the shares of commodity firms, or by using commodity futures contracts.

Specialized commodity funds tend to focus on a specific commodity or commodity group – like edible oils.

171

Commodity Funds (Cont…)

Diversified Commodity Funds invest in a cross-section of commodities.

Common examples are the following:

Gold Funds Silver Funds Platinum Funds

172

Real-Estate Funds

These funds either invest directly in real estate or else fund real estate developers.

Some of these funds invest in housing finance companies.

While others invest in mortgage-backed securities.

173

Tax Free Funds

Such funds invest in securities, the income from which is exempt from income tax.

In the U.S. municipal bonds yield tax-free income.

However income earned from corporate bonds is taxable.

174

The Largest Funds in the U.S.

NAME Objective Total Assets NAV

Fidelity Magellan

Growth 92588MM 119.30

Vanguard Index 500

Growth/ Income

89393 121.86

Janus Fund Capital Appreciation

40081 33.29

Fidelity Blue Chip

Growth 26721 51.53

Vanguard: Wellington

Balanced 22524 28.21

Putnam: Voyageur

Extra Growth 21328 23.30

175

The Prospectus

What is a prospectus? It is a formal printed document

offering to sell a security. The Securities Act of 1933 requires

the delivery of a prospectus prior to, or with, any solicitation for an order for mutual funds.

176

The Prospectus (Cont…)

It is required to disclose important information about the security.

At the minimum it must disclose: The fund’s financial history Its investment objectives Information about the management.

177


The front page will show: The date of publication The name of the fund The type of fund Major objectives

The first page will have the Table of Contents.

178

The Prospectus (Cont…) Description of the

fund Objectives of the

fund Management of the

fund Performance history Operating expenses Schedule of fees How to buy shares

How to redeem shares

Shareholder services Distributions and

taxes Yield information Schedule of

investments Financial statements General information

179

The Prospectus (Cont…) Neither an investment company nor a

broker may legally offer a mutual fund for sale unless a prospectus has been provided to the investor.

It is provided free of charge. It will include an application and a

postage paid return envelope to forward the check and the completed application.

180


It can be obtained from: The broker

However brokers handle only load funds It can be obtained by writing to the

investment company Or by dialing the fund’s toll-free

number.

181

Taxation Issues In the U.S., a mutual fund must distribute

at least 90% of its net investment income earned, exclusive of realized capital gains or losses, to the shareholders, in order to be considered as a Regulated Investment Company (RIC).

Such companies are not required to pay taxes at the fund level, prior to the distribution of income to the shareholders.

182

Taxation (Cont…) At the hands of the shareholders,

however, any income that is received is taxable.

Capital gains made by the fund are required to be distributed annually.

They may be construed as short-term or long-term in nature depending on whether the fund has held the securities in questions for less than a year or more.

183

Taxation (Cont…) Investors have no control over the

size of distributions from the fund. Consequently the timing and

amount of taxes payable on their fund holdings is out of their control.

For instance, if a block of investors were to sell their shares, it could trigger off a sale of securities by the fund.

184

Taxation (Cont…) This could cause a capital gain to be realized

and will lead to a tax liability for investors who choose to retain their holdings in the fund.

A new investor may assume a tax liability even though he may have no gains.

This is because a shareholder as of the date of record will receive a full year’s worth of dividends and capital gains, even though he may have held the shares for just a day.

185

Taxation (Cont…) This lack of control over capital gains taxes

is one of the major limitations of a mutual fund.

In addition to being liable to pay taxes on gains realized by the fund, a shareholder will have to incur capital gains when he redeems his shares.

The applicable tax rate would depend on whether the gains are short-term or long-term in nature.

186

Mutual Fund Structure

The structure of a fund may be depicted as follows.

At the top are the shareholders, who are represented by a Board of Directors.

The board governs the mutual fund which is an entity constituted under the Investment Company Act of 1940.

187

Fund Structure (Cont…)

The Directors may be ìnside’ or ìnterested’ Directors which means that they are affiliated with the fund, or they could be òutside’ or ìndependent’ Directors.

The portfolio of the fund is managed by an Investment Advisor or a Management Company.

188


The advisor can be an affiliate of a brokerage firm, an insurance company, a bank, an investment management firm, or an independent entity.

Many funds also engage the services of broker-dealers to sell the shares to the public, either directly or through other firms.

189


The funds are also affiliated to three external service providers:

Custodian Transfer Agent Independent Public Accountant

190

Role of the External Agents

The role of the custodian is to hold the assets of the fund and ensure that they are segregated from the accounts of others.

Transfer agents perform the task of processing orders at the time of purchase and redemption and transferring securities and cash to concerned parties.

191

External Agents (Cont…)

Transfer agents also distribute income paid by the fund to the shareholders.

The job of the public accountant is to audit the financial statements of the firm.

In addition every fund has internal departments to comply with legal and procedural requirements, and for marketing.

192

Depiction of a Typical Mutual Fund Structure

Shareholders

Board

Mutual Fund

Investment Advisor Distributor Accountant Custodian Transfer Agent

193

Services Offered by Mutual Funds

Automatic Reinvestment Plan Most funds offer the option of

automatically reinvesting all income and capital gains.

It offers a systematic way of accumulating additional shares.

It is always a voluntary option. Distributions may be taken in cash, but

the benefits of compounding will be lost.

194

Services (Cont…) Whether taken in the form of cash or

reinvested, distributions are subject to tax liabilities.

However reinvested dividends and capital gains are not subject to loads.

195

Services (Cont…)

Contractual Accumulation Plan The investor can commit to

purchasing a pre-determined fixed dollar amount on a regular basis for a specified period.

The choice of the amount, the frequency, and the length of time is made by the investor.

196

Services (Cont…) Voluntary Accumulation Plan

Here the shareholder voluntarily purchases additional units at periodic intervals.

Each purchase must meet the fund’s minimum requirements.

For regular accounts, the minimum amount is $100.

The investor can change the amount that he invests each time, the frequency of investment, and the duration of the plan.

197

Services (Cont…) Retirement Plans

These include IRAs, Keogh Plans (meant for the self-employed), 401(k) and 403(b) plans.

401(k) plans are set up by the employer and the employee and are available to most companies.

403(b) plans are open to employees of tax-exempt organizations such as schools and hospitals.

198

Services (Cont…) IRA and Keogh plans are established by the

investors themselves and are subject to certain government regulations.

Both types of plans are meant for individuals.

An IRA offers tax advantages for setting aside money for one’s retirement.

In order to qualify one must receive taxable compensation and be below 70 ½ years of age.

Keogh plans are similar to IRAs.

199

Services (Cont…)

Roth IRAs In a traditional IRA one qualifies for a

tax deduction while making a contribution.

But taxes must be paid when the money is taken out.

Roth IRAs are different. No tax deduction can be claimed on

the money that is put in.

200

Services (Cont…) But the balance can be withdrawn

tax-free on retirement, provided: The account has been open for at least 5

years The investor is at least 59 ½ years old. Each individual can invest a maximum of

$2000 per year. But the amount cannot exceed his annual

compensation.

201

Services (Cont…) But if the investor is married and the spouse is

working he/she can contribute even if he/she is not getting compensation.

The maximum contribution for a married couple is $4,000 per annum.

202

Services (Cont…) Check Writing

Many mutual funds, and all money market funds, offer free check writing facilities.

This option is not available for retirement accounts.

There is no restriction on how many checks can be written each month provided the account balance does not dip below a minimum.

203

Services (Cont…) Each check should be for an amount

greater than or equal to a specified minimum.

This is usually $500 for most funds. Of late many funds have reduced this to

$250.

204

Services (Cont…) Switching

Most investment companies permit switching from one fund to another within the same family.

Usually all that is required is a phone call. This is a free service.

Investors use this service to take advantage of cyclical swings in the stock market.

205

Services (Cont…) They will keep their money in stock

funds when the market is bullish And switch to money market funds

when the market turns bearish. The question is, how does one decide

when to switch? There are many sources of advice.

206

Switching Advice

Newsletters Donoghue’s Moneyletter Fabian Telephone Switch Newsletter InvesTech Market Letter Professional Timing Service Time Your Switch

207

Services (Cont…)

Voluntary Withdrawal Plans Shareholders may redeem their

shares whenever funds are required. They can also establish a plan

whereby the fund will redeem a pre-arranged dollar amount and wire it to his bank at regular intervals.

The usual minimum redemption is $50.

208

Investment Techniques Dollar Cost Averaging

With this technique one must invest the same amount of dollars at regular intervals.

Your dollars will buy more when the NAV is low and less when the NAV is high.

Over a period, the average price will be less than the price paid under a strategy where one tries to guess the highs and the lows.

The disadvantage is the strategy does not tell when to buy, sell or switch.

209

Illustration

An investor plans to invest $10,000 during the course of the year in four equal quarterly installments.

The NAVs at the beginning of each quarter are 10, 8, 12.5, and 16 respectively.

The plan would work as follows.

210


DATE AMOUNT NAV # of Shares

Jan 1 2,500 10 250

Apr 1 2,500 8 312.50

Jul 1 2,500 12.5 200

Oct 1 2,500 16 156.25

TOTAL 918.75

211

Value Averaging It is more sophisticated than dollar

cost averaging and is yet simple to use.

Assume that you want your investment to increase in value by $250 every month.

In this strategy you will consider your portfolio’s value at the end of every month.

212

Value Averaging (Cont…) If the balance has increased by

exactly $250 do nothing. If the increase is less than $250

invest an amount that is adequate to increase the account balance by $250.

If the increase is more than $250, withdraw the excess balance.

213

Illustration (Cont…)Date Amt. NAV # of Shrs. Bal. Add. Invt. Add.

Shrs.

Jan 1 10000 10 1000 10000 - -

Mar 31 8 1000 8000 - -

Apr 1 2250 8 1531.25 10250 2250 531.25

Jun 30 12.50 1531.25 19140.625

- -

Jul 1 -8640.625 12.50 840 10500 -8540.625 -691.25

Sep 30 16 840 13440 - -

Oct 1 -2690 16 671.875 10750 -2690 -168.125

214

The Combined Method

It is a combination of dollar cost averaging and value averaging.

Assume that you start with $1250 in a money market fund and $1250 in a stock fund on January 1. So the investment for the quarter is

$2500.

215

The Combined Method (Cont…)

On 31 March the value of the stock fund will be $1000.

We would require a balance of 2,750. So we should deposit $750 in a

money market fund and 1750 in the stock fund. The investment for the quarter is $2500.

216


On June 30 the balance in the stock fund will be $4,296.875.

We would require a balance of $4250. So invest $2500 in the money market

fund and transfer $46.875 from the stock fund to the money market fund. The investment for the quarter is $2500.

217


On September 30 the value of the stock fund will be 5440.

We would require a balance of $5,750.

So invest 310 in the stock fund and 2190 in the money market fund. The investment for the quarter is

$2,500.

218

Exchange Traded Funds

Mutual Funds have two serious shortcomings.

Firstly, the shares are priced at, and can therefore be transacted only at, the NAV as calculated at the end of the day.

Thus transactions at intra day prices are ruled out.

219

ETFs (Cont…) Secondly investors have little

control over tax liabilities. In particular a big redemption of

shares can trigger of capital gains taxes for investors who choose to remain invested.

In response to these shortcomings, Exchange Traded Funds (ETFs) were introduced in the 1990s.

220

ETFs (Cont…) These funds are open-ended in

structure but are traded on exchanges just like conventional stocks.

They are similar to closed-end funds in the sense that their quoted prices are at a small premium/ discount to/from their NAV.

However these deviations from NAV are limited in practice.

221

ETFs (Cont…)

The deviations are limited because of the potential for arbitrage.

Most ETFs are based on popular stock indices and follow a passive investment strategy.

But funds which actively manage portfolios have started to appear.

222

ETFs (Cont…)

Unlike in the case of an open-end fund, ETF shares cannot be bought from or sold to the fund sponsor.

However the sponsor will exchange large blocks of shares in kind for the securities constituting the underlying index plus cash representing the accumulated dividends of the fund.

223

ETFs (Cont…) The large block of ETF shares which is

exchangeable with the fund is called a Creation Unit.

One creation unit is typically set equal to 50000 ETF shares.

Broker-dealers will usually purchase creation units from the fund and break them into individual shares which will then be offered on the exchange.

224

ETFs (Cont…)

Dealers and institutions can also redeem ETF shares by assembling creation units, and exchanging them for a basket of underlying securities plus cash.

If the price of an ETF share were to diverge significantly from the NAV, then arbitrageurs would step in.

225

Arbitrage Assume that the ETF shares are overpriced.

If so, arbitrageurs will short sell ETF shares and buy creation units from the sponsor to fulfill their delivery obligations.

On the other hand, if the shares are under-priced, then arbitrageurs will buy ETF shares, assemble them into creation units, and sell them to the sponsor.

226

Advantages of Exchange Trading Exchange trading offers many

advantages to the investors. These facilities are not available in the

case of open-end funds. Traders have the flexibility to place

orders like Limit Orders and Stop Loss Orders.They have the freedom to engage in Short Sales and undertake trades on the Margin.

227

Advantages (Cont…) ETFs also offer an advantage to

the shareholders from the standpoint of taxation.

A large scale redemption of shares need not trigger of a capital gain.

This is because an ETF can redeem a large block of shares by offering the underlying securities in return.

228

Advantages (Cont…)

This will not constitute a taxable event for the existing shareholders.

Thus investors in ETFs are usually subject to capital gains taxes only when they sell their shares in the secondary market at prices which are higher than what they paid at the outset.

229

Advantages (Cont…)

In practice, however, a limited amount of realized capital gains does get passed on to the investors, and is therefore taxable.

In addition, any cash dividends distributed by ETFs is also taxable.

230

Popular ETFs

ETF Index Tracked

Inception Net Assets in

MM of USD

S&P500 SPDR

S&P500 Jan-93 21,703

S&P500 i shares

S&P500 May-00 1,153

DJIA Diamonds

DJIA Jan-98 2,050

NASDAQ-100(Qubes

)

NASDAQ 100

Mar-99 12,436

231

ETFs (Cont…)

SPDRs (pronounced as Spiders) is an acronym for Standard & Poor’s Depository Receipts.

i shares are provided by Barclays Global Investors.

232

Segregated Accounts

Many High Net Worth individuals dislike mutual funds because of :

Their inability to control tax liabilities

Their inability to influence investment choices

The lack of `special’ service

233

Segregated Accounts (Cont…)

Money managers therefore offer the facility of separately managed investment accounts for such investors.

They are more expensive for the investor than investing in a mutual fund, but offer several advantages.

234

Mutual Funds in the U.K.

In the U.K. mutual funds take on one of three forms:

Unit Trusts Open Ended Investment

Companies (OEICs) Investment Trusts

235

Unit Trusts & OEICs

In the case of a unit trust the assets are held in the form of a trust and each owner gets a beneficial ownership in the form of `units’.

An OEIC is similar in principle to a unit trust except that the funds are formed with a corporate structure and the investors are issued shares.

236

Unit Trusts & OEICs (Cont…)

Investment Trusts are similar to closed-end funds and trade on the London Stock Exchange.

In the case of Unit Trusts and OEICs the funds are managed by a professional fund manager.

237

Unit Trusts & OEICs (Cont…)

There is also an independent trustee who is entrusted with the task of holding the assets on behalf of the investor and monitoring the decisions and investments made by the fund manager.

In the case of OEICs there is a single price for the sale and redemption of shares, and other charges are shown separately.

238

Unit Trusts & OEICs (Cont…) Unit Trusts however follow a dual

pricing system with built-in charges.

239

The German System

Mutual Funds in Germany take on two general forms:

Public or Retail Funds Non-public Funds – Reserved for

Institutional Investors There are also numerous closed-

end funds.

240

Germany (Cont…)

The institutional fund are known as Spezialfonds.

The retail funds fall into two broad categories:

Bond Funds – Rentenfonds Stock Funds - Aktienfonds

241

Germany (Cont…) The structure of mutual funds is as follows. A Kapitalanlagegesellschaft or

Management Company is given a contractual arrangement to manage a pool of assets on behalf of investors who own shares in the pool.

A custody bank – Depotbank – which by law has to be German – supervise the activities of the management company.

242

Germany (Cont…)

The management company is usually organized as a limited liability company:

Gesellschaft mit besschrankter Haftung (GmbH)

243

Pension Plans A pension plan is a fund that is

established for the eventual payment of retirement benefits.

Corporate or Private plans are sponsored by a private business entity acting on behalf of its employees.

Public Plans are set up by federal, state and local governments acting on behalf of their employees.

244

Pension Plans (Cont…)

Taft Hartley plans are set up by unions on behalf of their members.

Individual plans are established by investors themselves.

245

Pension Plans (Cont…) Pension plans in the U.S. are essentially

financed by contributions by the employer. In some cases, the employer’s contribution

is matched to some extent by a contribution from the employees.

The employer’s contribution, a specified amount of the employee’s contribution, and the earnings of the fund, are tax-exempt provided the fund complies with certain regulations.

246

Pension Plans (Cont…)

Plans which are given tax exemption are called Qualified Pension Plans.

In essence, a pension is a form of employee remuneration for which the employee is not taxed until the funds are withdrawn.

247

Types of Plans

There are two basic types of plans: Defined Benefit Plans Defined Contribution Plans There is also a hybrid variety

called a Cash Balance Plan.

248

Defined Benefit Plans In such cases the sponsor agrees

to make specified payments to qualifying employees beginning at retirement.

In the case of death before retirement, some payments are made to nominated beneficiaries.

The payments are typically made on a monthly basis.

249

Defined Benefit Plans (Cont…) The quantum of payments is

determined by a formula that usually takes into account the length of service of an employee and his earnings.

The benefit formula is often based on a fixed percentage of the ending salary for each year of service.

From the employer’s point of view the pension obligation is essentially a debt obligation.

250

Defined Benefit Plans (Cont…) The employer needs to make a

prediction of the future benefits, to determine the amount of the contribution.

The calculation of the current contributions required to support the promised future payments is made by discounting the projected future cash flows.

251

Defined Benefit Plans (Cont…)

The entire investment risk is borne by the employer.

That is, since the benefits are assured, the employer faces the risk that returns on contributions to the plan may not be adequate to make the promised payments.

252


Actuaries are asked to provide estimates of current pension expenses and the liability of the employer.

The following factors are taken into account. Of course all estimates involve

discretion.

253

Factors Age and sex of the employee Number of years of service Employee’s salary Anticipated salary increases Anticipated turnover rates Anticipated earnings rates on plan

assets Appropriate discount rate

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These plans provide an incentive for the employees to stay with the firm until retirement or at least until the benefits get vested.

They also provide an incentive for performance. Because the defined benefit is a

function of the last salary drawn.

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Defined Benefit Plans (Cont…) The funding status of the plan depends

on the difference between the Plan Assets and the Projected Benefit Obligation. If the assets exceed the obligation the plan

is overfunded. Else it is underfunded.

In the case of underfunded plans employees may lose earned benefits if the company were to go bankrupt.

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A plan sponsor can use the payments made into the pension fund to purchase an annuity policy from an insurance company.

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Defined Benefit Plans (Cont…) Defined benefit plans which are

guaranteed by life insurance companies are called `insured benefit plans’.

These are not necessarily safer than uninsured plans.

Because they depend on the creditworthiness of the insurance companies.

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Benefits become vested when the employees reach a certain age and complete enough years of service, so that they meet the minimum requirements for receiving benefits upon retirement.

The payment of benefits is not contingent upon a participant’s continuation with the employer or union.

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Employees are generally encouraged from quitting, since until the plan is vested, they could lose at least the accumulation resulting from the employer’s contribution.

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Defined Contribution Plans

In the case of these plans, the sponsor is responsible only for making specified contributions into the plan on behalf of qualifying employees.

He is not responsible for making a guaranteed payment to the employee upon retirement.

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Defined Contribution Plans (Cont…)

The amount that is contributed is typically either a percentage of the employee’s salary and/or a percentage of the employer’s profits.

The payments that are made to qualifying participants upon retirement are a function of how the assets of the plan have grown over time.

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Thus the retirement benefits are critically dependent on the investment performance of the plan.

The plan sponsors usually give the participants various options as to the investment vehicles in which the contributions are to be invested.

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The fastest growing of such plans are the 401(k) plans.

Its equivalents are: 403(b) plans in the non-profit

sector 457 plans in the public sectors

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Defined Contribution Plans (Cont…) To the employers these plans offer

relatively lower costs of administration.

Employees too find these plans to be attractive because they have some control over how their money is invested.

In many cases the employees are given an option to invest in one or more of a family of mutual funds.

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Cash Balance Plans These plans combine features of both

defined benefit as well as defined contribution plans.

They are like defined benefit plans in the sense that future benefits are assured.

The benefits are based on a fixed-amount annual employer contribution and a guaranteed annual investment return.

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Cash Balance Plans (Cont…)

Every employee has an account that is periodically credited with a fixed dollar amount.

The account is also credited with interest which is linked to some fixed or variable index such as the Consumer Price Index (CPI).

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Cash Balance Plans (Cont…)

Interest is credited at a rate specified in the plan, and is not related to the actual investment earnings of the employer’s pension trust.

Any gains or losses on the investment accrue to/are borne by the employer.

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Cash Balance Plans (Cont…) The similarity with a defined

contribution plan is that many cash balance plans allow the employee to take a lump sum payment of vested benefits when terminating their employment with a particular employer.

This amount can then be rolled over into an IRA or the new employer’s plan.

Thus these plans are portable.

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Pension Plans (Cont…) Qualified pension funds are

exempt from federal income taxes. Pension funds therefore do not

usually invest in assets which are largely or completely tax free.

Pension plans are regulated by the Employee Retirement Income Security Act of 1974 (ERISA).

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ERISA

ERISA established minimum funding standards for defined benefit plans by requiring the sponsor to make the minimum contributions necessary to satisfy the actuarially projected payment benefits.

Prior to this, many employers were following a `pay as you go’ policy.

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ERISA (Cont…) That is, at the time of an employee’s

retirement the sponsor would pay the necessary retirement benefits out of his current cash flows.

ERISA put a stop to this by requiring all programs to be `funded’.

Regular funding is intended to ensure that contributions plus earnings are adequate to cover the retirement benefits.

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ERISA (Cont…)

ERISA also established fiduciary standards for pension fund trustees, managers, and advisors.

All parties responsible for the management of a pension fund are expected to act `prudently’.

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ERISA (Cont…)

ERISA also specified minimum vesting standards.

For instance, by law, after five years of employment, a plan participant is entitled to 25% of the accrued pension benefits.

The percentage of entitlement increases to 100% after 10 years.

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ERISA (Cont…)

ERISA also created the Pension Benefit Guaranty Corporation (PBGC) to insure the vested pension benefits.

The insurance program is funded from the annual premiums that must be paid by the plan sponsors.

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Management of Pension Plans

A plan sponsor can choose the following options for managing a defined benefit plan.

- he can employ in-house staff to manage the assets.

- he can entrust the task to one or more money managers.

- he can use a combination of methods

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Management (Cont…) Defined contribution plans allow the

participants to allocate their contributions among mutual funds.

Managers of the assets of a pension fund obtain their income in the form of fees.

The annual fees range from 0.75% of the funds under management to as low as 0.01%.

Sometimes the fees are linked to the fund’s performance.

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Advisors In addition to fund managers,

sponsors of pension funds also engage the services of advisors called Plan Sponsor Consultants.

They provide the following services: - Develop investment policies and

formulate asset allocation plans. - Provide actuarial service – modeling

liabilities and forecasting.

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Advisors (Cont…)

- They design benchmarks to measure the performance of money managers.

- They help measure and monitor the performance of money managers.

- They help search for, and recommend money managers.

- They provide specialized research.

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Major Managers of Defined Benefit Funds

NAME AMOUNT in MM of USD

State Street Global 538,576

Barclays Global 490,400

Fidelity Investments 396,100

TIAA-CREF 285,447

Northern Trust 200,864

Deutsche Asset 192,748

Vanguard Group 176,732

PIMCO 163,613

J.P. Morgan 143,669

Prudential 132,550

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Major Managers of Defined Contribution Funds

NAME TOTAL ASSETS

401(k) Plans

457 Plans

403(b) Plans

Other Plans

Fidelity Investm

ents

357,900 276,000 12,200 40,200 29,500

TIAA-CREF

284,853 0 0 284,853 0

CitiStreet

195,950 173,431 3,066 58 19,395

Barclays Global

101,200 10,900 1,900 0 88,400

Vanguard Group

89,831 77,219 3,640 3,120 5,852

part 12

Documents