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ASSET MANAGEMENT

BATCH 2013-2015

Mutual fund

&

Active Portfolio Management

SUBMITTED By- SUBMITTED To-

Abhishek Bora (448), Dr. Rituparna Das

Rimzim Kachhawaha (459) Associate Professor, Asst. Dean,

Surendra Sharma (461) Faculty of Policy Science

MBA, INSURANCE IV SEMESTER NATIONAL LAW UNIVERSITY

DATE: - 14-04-2015 JODHPUR

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Contents

S.No. Topic Name Page no.

1 Introduction 3

2 Formation of Mutual Fund 3

3 Schemes of Mutual Fund 8

4 Functioning of the mutual funds 10

5 Types of Mutual Funds 14

6 Benefits & Drawbacks of investments in Mutual Funds 15

7 Active Portfolio Management 16

8 Comparison between active management and passive management 19

9 Advantages & Disadvantages of Active Management

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Introduction:-

Mutual fund is a mechanism for pooling the resources by issuing units to the investors and

investing funds in securities in accordance with objectives as disclosed in offer document.

Investments in securities are spread across a wide cross-section of industries and sectors and

thus the risk is reduced. Diversification reduces the risk because all stocks may not move in

the same direction in the same proportion at the same time. Mutual fund issues units to the

investors in accordance with quantum of money invested by them. Investors of mutual funds

are known as unit holders.

The profits or losses are shared by the investors in proportion to their investments. The

mutual funds normally come out with a number of schemes with different investment

objectives which are launched from time to time. A mutual fund is required to be registered

with Securities and Exchange Board of India (SEBI) which regulates securities markets

before it can collect funds from the public.

Unit Trust of India was the first mutual fund set up in India in the year 1963. In early 1990s,

Government allowed public sector banks and institutions to set up mutual funds.

In the year 1992, Securities and exchange Board of India (SEBI) Act was passed. The

objectives of SEBI are – to protect the interest of investors in securities and to promote the

development of and to regulate the securities market.

As far as mutual funds are concerned, SEBI formulates policies and regulates the mutual

funds to protect the interest of the investors. SEBI notified regulations for the mutual funds in

1993. Thereafter, mutual funds sponsored by private sector entities were allowed to enter the

capital market. The regulations were fully revised in 1996 and have been amended thereafter

from time to time. SEBI has also issued guidelines to the mutual funds from time to time to

protect the interests of investors.

All mutual funds whether promoted by public sector or private sector entities including those

promoted by foreign entities are governed by the same set of Regulations. There is no

distinction in regulatory requirements for these mutual funds and all are subject to monitoring

and inspections by SEBI. The risks associated with the schemes launched by the mutual

funds sponsored by these entities are of similar type.

Formation of Mutual Fund:-

A mutual fund is set up in the form of a trust, which has sponsor, trustees, asset Management

Company (AMC) and custodian. The trust is established by a sponsor or more than one

sponsor who is like promoter of a company. The trustees of the mutual fund hold its property

for the benefit of the unit holders. Asset Management Company (AMC) approved by SEBI

manages the funds by making investments in various types of securities. Custodian, who is

registered with SEBI, holds the securities of various schemes of the fund in its custody. The

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trustees are vested with the general power of superintendence and direction over AMC. They

monitor the performance and compliance of SEBI Regulations by the mutual fund.

SEBI Regulations require that at least two thirds of the directors of trustee company or board

of trustees must be independent i.e. they should not be associated with the sponsors. Also,

50% of the directors of AMC must be independent. All mutual funds are required to be

registered with SEBI before they launch any scheme.

Players in Mutual Funds:-

Sponsor runs the show, akin the promoters of a Company. The SEBI (Mutual Funds)

Regulations, 1996, defines sponsor as any person who, acting alone or in combination with

another body corporate, establishes a mutual fund. The sponsor forms the Trust and appoints

the board of trustees, appoints the AMC as the fund managers and may also appoint custodian

to hold the fund assets. As per the SEBI (Mutual Fund) Regulations, 1996, sponsor makes an

application for registration of the mutual fund and contributes atleast 40% of the net worth of

the asset management company. The sponsor must comply with the eligibility criteria without

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which the Board may reject the application. Eligibility criteria for grant of certificate of

registration are that the sponsor should:-

(i) Have a sound track record and general reputation of fairness and integrity in all his

business transactions.

(ii) the applicant is a fit and proper person

(iii) in the case of an existing mutual fund, such fund is in the form of a trust and the trust

deed has been approved by the Board;

(iv) the sponsor has contributed or contributes at least 40% to the net worth of the asset

management company:

(v) the sponsor or any of its directors or the principal officer to be employed by the

mutual fund should not have been guilty of fraud or has not been convicted of an

offence involving moral turpitude or has not been found guilty of any economic

offence;

(vi) appointment of trustees to act as trustees for the mutual fund in accordance with the

provisions of the regulations;

(vii) appointment of asset management company to manage the mutual fund and operate

the scheme of such funds in accordance with the provisions of these regulations;

(viii) appointment of custodian in order to keep custody of the securities or gold and gold

related instrument or other assets of the mutual fund held in terms of these

regulations, and provide such other custodial services as may be authorized by the

trustees

Sound track record here means:

(i) be carrying on business in financial services for a period of not less than five

years; and

(ii) the net worth is positive in all the immediately preceding five years; and

(iii) the net worth in the immediately preceding year is more than the capital

contribution of the sponsor in the asset management company; and

(iv) the sponsor has profits after providing for depreciation, interest and tax in three

out of the immediately preceding five years, including the fifth year

Asset Management Company – AMC acts as an investment manager of the Trust.

AMC‘s floated and manage different investment schemes in the name of the Trust.

Restrictions on AMC are:

o Not act as a trustee of any mutual fund

o Not undertake any activity conflicting with the activities of the mutual fund

o AMC shall not invest in any of its schemes unless intention to invest has been made in

the offer document Obligations of AMCs are:

o AMC shall not carry transactions with any broker whether associated with sponsor or

not; for average of 5% or more; with exceptions

o Ensure regulatory compliances & approvals when required

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o Liable to mutual funds for the acts of omission & commission

o Details of directors, their interest in other companies; changes in interest to be

submitted to the trustees

o Fund manager to ensure that the funds of the scheme are invested to meet the

objectives of the scheme

o Due diligence and care in all investment decisions

o AMC shall not utilize the services of any sponsor or its associates etc

o AMCs to make half yearly disclosures for: ƒ

Underwriting obligations ƒ

Devolvement Subscriptions in the schemes lead managed by associates ƒ

Subscriptions to debt/ equity issues where sponsors/ associates acted as arranger/

lead manager

Trustee – Trustees hold unit holders‘ money in fiduciary capacity. Two thirds of the

trustees shall be independent persons and shall not be associated with sponsors in any

manner. The Eligibility Criteria for a trustee and the rights and obligations of the trustees

as stated in the SEBI (Mutual Fund) Regulations, 1996 are as follows:

Eligibility criteria for being a trustee:-

No person shall be eligible to be appointed as a trustee unless

(a) He is a person of ability, integrity and standing; and

(b) Has not been found guilty of moral turpitude; and

(c) Has not been convicted of any economic offence or violation of any securities laws;

(d) Has furnished particulars as specified in Form C.

(e) No asset management company and no director (including independent director), officer

or employee of an asset management company shall be eligible to be appointed as a trustee of

any mutual fund

(f) No person who is appointed as a trustee of a mutual fund shall be eligible to be appointed

as a trustee of any other mutual fund

(g) Two-thirds of the trustees shall be independent persons and shall not be associated with

the sponsors or be associated with them in any manner whatsoever

(h) In case a company is appointed as a trustee then its directors can act as trustees of any

other trust provided that the object of the trust is not in conflict with the object of the mutual

fund.

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• Unit Holder – General public that invests in the schemes floated by AMC‘s.

• Mutual Fund – It is the ‗pass through vehicle,‘ constituted in a form of a Public Trust,

which holds the assets of the trust for the benefit of the unit-holders, beneficiaries of

the trust

• Custodian/ Depositories – They hold the physical/ dematerialized securities of mutual

fund

• Transfer Agents – They are responsible for issuing and redeeming units of mutual

funds and provide other related services such as preparation of transfer documents and

updating investors‘ records.

Schemes of Mutual Fund

A mutual fund scheme can be classified into open-ended scheme or close-ended scheme

depending on its maturity period.

Open-ended Fund/ Scheme

An open-ended fund or scheme is one that is available for subscription and repurchase on a

continuous basis. These schemes do not have a fixed maturity period. Investors can

conveniently buy and sell units at Net Asset Value (NAV) related prices which are declared

on a daily basis. The key feature of open-end schemes is liquidity.

Close-ended Fund/ Scheme

A close-ended fund or scheme has a stipulated maturity period e.g. 5-7 years. The fund is

open for subscription only during a specified period at the time of launch of the scheme.

Investors can invest in the scheme at the time of the initial public issue and thereafter they

can buy or sell the units of the scheme on the stock exchanges where the units are listed. In

order to provide an exit route to the investors, some close-ended funds give an option of

selling back the units to the mutual fund through periodic repurchase at NAV related prices.

SEBI Regulations stipulate that at least one of the two exit routes is provided to the investor

i.e. either repurchase facility or through listing on stock exchanges. These mutual funds

schemes disclose NAV generally on weekly basis.

Schemes according to Investment Objective:

A scheme can also be classified as growth scheme, income scheme, or balanced scheme

considering its investment objective. Such schemes may be open-ended or close-ended

schemes as described earlier. Such schemes may be classified mainly as follows:

Growth / Equity Oriented Scheme

The aim of growth funds is to provide capital appreciation over the medium to long- term.

Such schemes normally invest a major part of their corpus in equities. Such funds have

comparatively high risks. These schemes provide different options to the investors like

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dividend option, capital appreciation, etc. and the investors may choose an option depending

on their preferences. The investors must indicate the option in the application form. The

mutual funds also allow the investors to change the options at a later date. Growth schemes

are good for investors having a long-term outlook seeking appreciation over a period of time.

Income / Debt Oriented Scheme

The aim of income funds is to provide regular and steady income to investors. Such schemes

generally invest in fixed income securities such as bonds, corporate debentures, Government

securities and money market instruments. Such funds are less risky compared to equity

schemes. These funds are not affected because of fluctuations in equity markets. However,

opportunities of capital appreciation are also limited in such funds. The NAVs of such funds

are affected because of change in interest rates in the country. If the interest rates

fall, NAVs of such funds are likely to increase in the short run and vice versa. However, long

term investors may not bother about these fluctuations.

Balanced Fund

The aim of balanced funds is to provide both growth and regular income as such schemes

invest both in equities and fixed income securities in the proportion indicated in their offer

documents. These are appropriate for investors looking for moderate growth. They generally

invest 40-60% in equity and debt instruments. These funds are also affected because of

fluctuations in share prices in the stock markets. However, NAVs of such funds are likely to

be less volatile compared to pure equity funds.

Money Market or Liquid Fund

These funds are also income funds and their aim is to provide easy liquidity, preservation of

capital and moderate income. These schemes invest exclusively in safer short-term

instruments such as treasury bills, certificates of deposit, commercial paper and inter-bank

call money, government securities, etc. Returns on these schemes fluctuate much less

compared to other funds. These funds are appropriate for corporate and individual investors

as a means to park their surplus funds for short periods.

Gilt Fund

These funds invest exclusively in government securities. Government securities have no

default risk. NAVs of these schemes also fluctuate due to change in interest rates and other

economic factors as is the case with income or debt oriented schemes.

Index Funds

Index Funds replicate the portfolio of a particular index such as the BSE Sensitive index,

S&P NSE 50 index (Nifty), etc. These schemes invest in the securities in the

same weightage comprising of an index. NAVs of such schemes would rise or fall in

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accordance with the rise or fall in the index, though not exactly by the same percentage due to

some factors known as "tracking error" in technical terms. Necessary disclosures in this

regard are made in the offer document of the mutual fund scheme. There are also exchange

traded index funds launched by the mutual funds which are traded on the stock exchanges.

Functioning of the mutual funds:-

The process of registering/ functioning of mutual funds is:

1. A sponsor has to make an application in Form A along with the requisite fees to the

Board (SEBI). Grant of certificate of registration is given by the Board in Form B. Thereafter

each mutual fund must pay an annual service fee, in case of failure to pay the annual fee, the

Board may not permit the mutual fund to launch any scheme

2. Mutual Fund has to be established in the form of a Trust and the deed has to be

registered under the Indian Registration Act, 1908, the deed being duly executed by the

sponsor in the name of the trustees as mentioned in the deed

a. The purpose of the trust deed is to safeguard interest of the unit holders and thus states

the rights, obligations and liabilities of the trust in relation to the mutual fund or the unit

holders

b. The contents of the trust deed will broadly include the following clauses:

i. Unit holders would have beneficial interest in the trust property to the extent of

individual holdings in the respective schemes

ii. Liabilities & duties of the trustees, right to appoint/ dismiss asset Management

Company.

iii. Right to forbid the mutual funds from making investments which are detrimental to

the interests of the unit holders

iv. Minimum number of trustees, trusteeship fees, removal of members, number of

meetings, quorum for the meeting etc.

v. Disclosures of particulars of interests of the trustees in other companies, institution,

financial intermediary or anybody corporate

c. Appointed trustees need to furnish their details in Form C to the Board - approval of

the Board is must for the appointment of Trustees

d. The trustees and/ or the sponsors appoint the Asset Management Company. The

trustees and AMC with the prior approval of the Board enter into an investment management

agreement (Clauses of the investment management agreement are mentioned in the Fourth

Schedule of the Regulation). Application Form D to be submitted to the Board for

appointment of AMC

3. Scheme to be launched with the approval of the trustees and offer document filed with

the Board. Offer document disclosures will include:

a. Adequate information to enable investors make investment decisions

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b. Application form for investing in units to contain the information memorandum

c. Mention of prior in-principle approval of stock exchanges, if listing of units to be

carried out

4. Advertisement of each scheme to disclose the investment objective of the scheme

5. Once units sold, there are restrictions on investments specified in the Regulations

6. Valutions of the investments in the portfolio are carried out regularly and published

7. Liquidity options are provided both in case of open ended and close ended schemes

Evaluating Performance of Mutual Funds:

Net Asset Value is the amount a unit holder would receive if the mutual fund were wound up,

it is also called the mutual fund‘s calling card. Since the unit holders are part owners of the

assets and liabilities of the mutual fund, NAV is the net value of all assets and liabilities, i.e

the market value of total assets and market value of total liabilities. What is the peculiar to

NAV is:

• NAV changes daily

• NAV is computed as a value per unit holding

• Returns to the investor are determined by Cost of Mutual Fund and Net Asset Value

Computation of NAV:

NAV = Net assets of the scheme

Number of units outstanding

Where;

Net assets of the scheme = Market value of investments + receivables + other accrued income

+ other assets - Accrued expenses - other payables - other liabilities

Cost component of Mutual Funds: It is quite evident, higher the cost, lower would be return

for investors. The cost component can be divided into 2:

• Initial expenses - incurred for establishing the scheme. These expenses are not

charged on the year of expenditure but are amortized over a period of time

o In case of close ended scheme floated on load basis, issue expenses are amortised on

weekly basis over the period of scheme o In case of open ended scheme floated on load basis,

initial expenses are amortized over a period not exceeding 5 years

• Recurring expenses - also called Operating cost.

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o Cost of investment analysts/ advisory fees o Administrative cost o Advertisement cost

Management expenses ratio: Expenses are measured as a % of the average value of portfolio.

The ratio is as follows:

Expenses Ratio = Expenses

Average value of portfolio

Expenses can be also be expressed per unit, then the ratio is:

Expenses per unit = Expenses incurred per unit

Average net value of assets

Sales Charges: Sales charges or sales load are directly charged to the investor and are used to

make payment with regard to agents‘ commission and expenses for distribution and

marketing. Sales charges are directly collected from the investor as front end load or back end

load

• Front end load: One time fixed fee paid by the investor while buying into the scheme. This

helps you determine, how much of the initial investment gets invested. Front end load amount

decreases as the initial investment amount increases. Public Offer Price (POP) is calculated in

the following manner:

Public Offer Price = Net Asset Value

(1-Front end load)

• Back end load: This is fixed fee paid at the time of redemption or selling of the units. The

redemption price is calculated in the following manner:

Redemption Price: Net Asset Value

(1+ Back end load)

Contingent Deferred Sales Charges (CDSC): This is a back end load paid when the units

are redeemed during the initial of ownership. As per the SEBI (Mutual Fund) Regulations,

1996 CDSC may only be charged for the first four years after purchase of the units. The

regulations also provide for the maximum CDSC that can be charged in a particular year. The

front end and back end loads cannot be in excess of 7%

Limitations of fees & expenses on issue of schemes as per the Regulations:

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• AMC‘s expenses to be clearly identified and appropriated to the individual schemes and to

be disclosed the in the offer document. The advisory fees of the AMC shall be the following:

o One and a quarter of one per cent of the weekly average net assets

Outstanding in each accounting year for the scheme concerned, as long as the net assets do

not exceed Rs.100 crores, and o One per cent of the excess amount over Rs.100 crores, where

net assets so calculated exceed Rs.100 crores.

• in case of an index fund scheme, the investment and advisory fees shall not exceed three

fourths of one percent (0.75%) of the weekly average net assets

• For schemes launched on a no load basis, the asset management company shall be entitled

to collect an additional management fee not exceeding 1% of the weekly average net assets

outstanding in each financial year

• AMC may charge recurring expenses in addition to the above expenses

• The total expenses of the scheme excluding issue or redemption expenses, including the

investment management and advisory fee shall be subject to the following limits (with certain

exceptions for specific funds) :—

(i) On the first Rs.100 crores of the average weekly net assets 2.5%;

(ii) On the next Rs.300 crores of the average weekly net assets 2.25%;

(iii) On the next Rs.300 crores of the average weekly net assets 2.0%;

(iv) On the balance of the assets 1.75%

Computation of Returns:-

Investors‘ returns are of three types

• Cash Dividend

• Capital Gains disbursement

• Changes in the fund‘s NAV per unit (Unrealized Capital Gain) Thus returns are calculated

in the following manner:

R = D + CG + UCG x 100

or; R = D + CG + (NAVi - NAVo)/ NAVo x 100

Where;

R = returns D = Dividend

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CG = Capital Gains

UCG = Unrealized Capital Gain = (NAVi - NAV0)/ NAV0 NAV1 = Net Asset Value at the

end of period 1

NAV0 = Net Asset Value at the end of period.

Types of Mutual Funds:

Balanced Funds - A portfolio which has strategic allocation of debt and equity

Equity diversified funds - As the name suggests the portfolio has wide array of

stocks. There are many types of equity dividend funds:

Flexicap/ Multicap funds - the fund is diversified, with defined minimum and

maximum level of exposure to each of the market caps o Contra Fund - it is for those

investors who want the fund to perform in all types of market environments o Index

Fund - fund that tracks the performance of the benchmark market index

Dividend Yield Fund - as the name suggests the fund invests in shares of companies

having high dividend yield. These stocks are generally less volatile and offer potential

for good capital appreciation

Equity Linked Tax Savings Scheme (ELSS) - this fund gives investors the option to

save taxes under section 80C of the Income Tax Act. The fund has a minimum lock in

of 3 years, it helps investors avoid problems of investing lumpsum amount and also

helps one get the benefit of averaging

Sector Funds - as the name suggests, the fund invests in a particular sector to let

investors reap benefit of seasonal returns and industry cycles. These would be riskier

than diversified portfolios as they bear a greater risk of a particular sector turning out

to be non-performing

Thematic Funds - The fund managers invest in a particular sector or industry which

is likely to outperform, based on their assessment or industry analysis. The downside

of investing in such funds is that one has to rely on the fund managers research and

analysis.

Arbitrage Funds - these funds provide safety, liquidity, better returns and tax

benefits as these funds include mix of derivatives and equity. These funds provide

better returns than a typical debt instrument and lower volatility than equity

Hedge Funds - There are no hedge funds in India but they are private investment

vehicles and are lightly regulated investment funds. The concept is later explained in

details

Cash Funds - As the name suggests these funds offer higher liquidity and lower

volatility as the portfolio includes debt and money market instruments

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Exchange Traded Funds - these funds are listed on the stock exchange and their

prices are linked to the underlying index. The concept has been explained in detail

later

Factors to be considered for selecting Mutual Fund:

Past performance - The past performance of the mutual fund can be adjudged by

growth of the NAV during the referral period. Growth is evaluated in the following

manner:

Growth = (NAVi - NAVo) + Di/ NAVo

Timing - timing for investments made by the mutual fund is critical for maximizing

returns, for instance investing in the bullish or bearish market may be vital for the

investment and performance of the mutual fund

Size of fund - larger the size of the fund, greater would be the risk as there would be

more products to be monitored. Small sized funds may not give the much expected

return or growth. So investors should be very careful will selecting the fund to invest

in.

Age of fund - Longevity of the fund would indicated how seasoned the player is in the

market and expertise.

Fund Manager - He is the fulcrum of the fund, the investors should also have an idea

whose hands their money rests in.

Expense Ratio - Though there is an upper ceiling imposed on the expenses by the

regulators. Lower the expenses higher would be the return

PE Ratio - The weighted average PE of the stocks in the portfolio can be used to

measure the risk levels of the fund

Portfolio turnover - This again is crucial to the return bearing capacity of the fund.

High turnover would have greater cost implications, whereas low turnover would

mean that the fund manager is not using the market options to the hilt.

Benefits of investing in mutual funds:

i. Diversification - As discussed above, the portfolio is diversified, so it reduces the risk

ii. Professionally managed - These funds are managed by skilled professionals, with

experience and expertise

iii. Administrative Advantage - Mutual Funds offer services in demat mode, so it saves

time investor‘s time and risk of delay in share transfer etc

iv. Higher Returns - Returns are usually higher than other avenues of investment

v. At relatively low cost - Mutual funds cannot increase the charge beyond 2.5%, any

cost over and above the prescribed limit is borne by the Asset Management Company

(AMC)

vi. Liquidity - In case of an open ended funds, liquidity is provided by direct sales or

repurchase by the Mutual Funds and in case of close ended funds, liquidity is

provided by listing of the units on Stock Exchange (terms explained later)

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vii. Transparency - Mutual Funds are regulated by SEBI and have to disclose the portfolio

on a half yearly basis. NAVs are calculated on daily basis in case of open ended funds

and published in newspapers for investors‘ knowledge

viii. Flexibility - Some Mutual funds provide investors the flexibility of switching from

one scheme to other without any load

ix. Mutual funds offer the benefit of investing in the portfolio of your choice depending

upon the risk/ return you want out of our investments.

Drawbacks of investments in Mutual Funds:

i. No guarantee on returns - the returns on Mutual Funds investments are not

guaranteed. There may be such situation where the proportionate increase in the value

of the mutual fund may be the same or less than what an investor would have received

had he invested in risk free securities. Sometimes Mutual Funds may depreciate in

value as well

ii. Diversification - Diversification reduces risks, but too much of diversification can

effect returns as well

iii. Fund Selection - It the premises for investments are not proper

iv. Cost Factor - The cost payable to the fund managers may not be related to the

performance of the fund. In this case the cost factor would be a drawback for the

investors.

Active Portfolio Management:-

Active management refers to a portfolio management strategy where the manager makes

specific investments with the goal of outperforming an investment benchmark index. In

passive management, investors expect a return that closely replicates the investment

weighting and returns of a benchmark index and will often invest in an index fund.

Active investing is when one invests in a fund that is ―actively managed‖. Active fund

managers seek to beat the market‘s returns as opposed to only giving investors a replication

of the market‘s returns as seen with index-tracking or passive investment funds. Managers

following an active investment style use various methods to outperform a given index or

benchmark. The essence of their approach is to capitalize on what they believe are pricing

inefficiencies in the market. They conduct detailed research on companies and stock prices

and compare their valuation of those stocks to that of the market. The majority of this

analysis includes evaluating a company‘s past, current, and future earning capability with

forthcoming business and economic conditions. The outcome of their analysis is compared to

the company‘s past, present, and forecasted stock price. The manager‘s intention is to buy a

company‘s stock when they believe it is undervalued, and to sell that stock when it is

overvalued, thereby creating a profit for their fund. Managers will also attempt to identify

economic trends to help them predict which industries have the best near term prospects and

avoid those with a less favorable near-term outlook.

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The active manager exploits market inefficiencies by purchasing securities (stocks etc.) that

are undervalued or by short selling securities that are overvalued. Either of these methods

may be used alone or in combination. Depending on the goals of the specific investment

portfolio, hedge fund or mutual fund, active management may also serve to create less

volatility (or risk) than the benchmark index. The reduction of risk may be instead of, or in

addition to, the goal of creating an investment return greater than the benchmark.

Active portfolio managers may use a variety of factors and strategies to construct their

portfolio(s). These include quantitative measures such as price–earnings ratios and PEG

ratios, sector investments that attempt to anticipate long-term macroeconomic trends (such as

a focus on energy or housing stocks), and purchasing stocks of companies that are

temporarily out-of-favor or selling at a discount to their intrinsic value. Some actively

managed funds also pursue strategies such as risk arbitrage, short positions, option writing,

and asset allocation.

Using the concept of asset allocation, researchers divide active management into two parts;

one part is selecting securities within an asset class, while the other part is selecting between

asset classes. For example, a large-cap U.S. stock fund might decide which large-cap U.S.

stocks to include in the fund. Then those stocks will do better or worse than the class in

general. Another fund may choose to move money between bonds and stocks, or some

country versus a different one, et cetera. Then one class will do worse or better than the other

class.

The case where a fund changes its class of assets is called style drift. An example would be

where a fund that normally invests in government bonds switches into stocks of small

companies in emerging markets. Although this gives the most discretion to the manager, it

also makes it difficult for the investor (portfolio manager) if he also has a target of asset

allocation

The effectiveness of an actively managed investment portfolio obviously depends on the skill

of the manager and research staff but also on how the term active is defined. Many mutual

funds purported to be actively managed stay fully invested regardless of market conditions,

with only minor allocation adjustments over time. Other managers will retreat fully to cash,

or use hedging strategies during prolonged market declines. These two groups of active

managers will often have very different performance characteristics.

Active Portfolio Management is portfolio management in which investment decisions of the

fund are at the discretion of a fund manager(s) and he or she decides which company,

instrument or class of assets the fund should invest in based on research, analysis, market

news etc. such a fund is called as an actively managed fund. The fund buys and sells

securities actively based on changed perceptions of investment from time to time. Based on

the classifications of shares with different characteristics, ‗active‘ investment managers

construct different portfolio. Two basic investment styles prevalent among the mutual funds

are Growth Investing and Value Investing:

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• Growth Investing Style:-

The primary objective of equity investment is to obtain capital appreciation. A growth

manager looks for companies that are expected to give above average earnings growth, where

the manager feels that the earning prospects and therefore the stock prices in future will be

even higher. Identifying such growth sectors is the challenge before the growth investment

manager.

• Value Investment Style:-

A Value Manager looks to buy companies that they believe are currently undervalued in the

market, but whose worth they estimate will be recognized in the market valuations

eventually.

Passive Fund Management:-

When an investor invests in an actively managed mutual fund, he or she leaves the decision

of investing to the fund manager. The fund manager is the decision-maker as to which

company or instrument to invest in. Sometimes such decisions may be right, rewarding the

investor handsomely. However, chances are that the decisions might go wrong or may not be

right all the time which can lead to substantial losses for the investor. There are mutual funds

that offer Index funds whose objective is to equal the return given by a select market index.

Such funds follow a passive investment style. They do not analyse companies, markets,

economic factors and then narrow down on stocks to invest in. Instead they prefer to invest in

a portfolio of stocks that reflect a market index, such as the Nifty index. The returns

generated by the index are the returns given by the fund. No attempt is made to try and beat

the index. Research has shown that most fund managers are unable to constantly beat the

market index year after year. Also it is not possible to identify which fund will beat the

market index. Therefore, there is an element of going wrong in selecting a fund to invest in.

This has led to a huge interest in passively managed funds such as Index Funds where the

choice of investments is not left to the discretion of the fund manager. Index Funds hold a

diversified basket of securities which represents the index while at the same time since there

is not much active turnover of the portfolio the cost of managing the fund also remains low.

This gives a dual advantage to the investor of having a diversified portfolio while at the same

time having low expenses in fund.

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Active Management

Passive Management

Fund manager

Conducts rigorous research

and analysis on company

stocks.

• Makes informed investment

decisions for the fund.

• Fulfills an intensive

management role.

Fulfills a ―passive‖

management role.

• No detailed analysis or

significant investment

decisions required.

Performance

Aims to beat the market or

beat a stated benchmark.

• Has the ability to maximize

gains and minimize losses.

Does not aim to beat the

market or a benchmark.

• Aims to replicate the

performance of a market –

positive or negative.

• Cannot make gains greater

than the market.

Fees

Manager fees are higher due

to increased levels of skill,

knowledge and involvement

required on behalf of the

manager.

Lower management and

operating fees.

Risk

Fund is exposed to manager

risk as well as market risk.

Fund is exposed to market

risk.

Strategies

A range of strategies for

investors to choose from

including equity funds, bond

funds, balanced funds etc.

No choice of investment

strategy

Comparison between active management and passive management

20

Arguments in favor of Active Portfolio Management

People in favor of passive management believe that markets are 'efficient', because markets

are efficient, it is impossible for an investment manager to outperform consistently and

investors therefore should adopt a passive approach.

But at any point in time, some markets are likely to be more efficient than others. However, it

seems absurd to think that any market is entirely efficient. There are nearly always mispricing

opportunities in markets, particularly for investors who are prepared to investigate asset

markets thoroughly, and who are equipped to use long-term perspective. A good active

manager can add significant value in the fulfillment of clients' investment objectives by

selecting appropriate securities and by making favorable asset allocation decisions.

Investment managers have the best understanding of financial markets, particularly where a

multi-asset orientation means that they evaluate opportunities across the investment

landscape as a whole

Paradoxically, the efficiency that passive proponents say exists in financial markets is surely

attributable (to the extent that such efficiency is ever evident) to the actions of active

investors. Without active investors, markets would lack any qualitative oversight and, in that

respect, passive managers are dependent on the investment decisions of active managers.

Measures of economies and financial markets tend to take the form of averages, for example

in relation to readings of gross domestic product, inflation, equity market indices and so on.

In reality, all such measures are representative of many different component factors and at

any point in time some will be performing better than others. An active investor may add

value by looking at the detail of individual companies' fortunes and by taking perspective on

long-term opportunities (above all at times when asset markets are driven by short-term

factors that overlook those opportunity).

A skilled, active investment manager, particularly a multi-asset manager with a holistic

understanding of opportunities across different asset classes, is well equipped to make risk

and return judgments between the different classes of capital that are issued by individual

companies.

The use of a passive investment strategy may entrench asset allocation to the detriment of the

investor by encouraging a static approach.

The argument that risk tend to focus almost exclusively on the security selection risk inherent

in active management and very little upon the benchmark risk that is unavoidable in taking a

passive approach. To say risk is 'neutralized' for a passive investor is plainly wrong given the

absolute volatility exhibited by financial markets. Even if the risk characteristics of passive

strategies were to match those of underlying indices, investors would still be exposed to the

significant risk that indices themselves would fall.

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Although there are 'equal-weight' or 'capitalization-weight' indices which seek to obviate the

negative implications of mirroring an index without exception, most indices (and the passive

funds that track them) are market-capitalization based. That is, the larger a stock's weighting

in an index, the greater its impact on the movement of that index (and therefore the greater its

contribution to the performance of a tracking fund). This may give rise to significant

'concentration risk' in a passive investor's portfolio.

With the performance of the larger sectors and larger stocks having a greater impact on

overall performance (regardless of the merits of those sectors and stocks), the market-

capitalization-based passive investor will be compelled to buy ever-greater holdings of

securities that have already done well (and to hold ever-smaller amounts of those that have

done less well). Decisions to buy and sell are brought about thus by changes in index

composition, rather than on the basis of the merits of particular stocks. Using this approach

passive investors can be hostages to the fortunes of troubled companies, even if they foresee

those companies' troubles. A passive approach precludes the investor from making qualitative

judgments about the prospects of particular parts of a market.

Investors may be prepared to forsake some of their potential return for a less volatile

investment approach, but passive management may be inflexible in meeting risk-related

requirements. Active investment management has the advantage of permitting, for example,

an absolute-return approach to investment returns. Such an approach, by means of its focus

on absolute rather than relative returns, allows investors to pursue both risk and return

characteristics that are appropriate to them.

Volatility in financial markets is not simply a threat; it can also be used to good effect in

generating attractive investment returns. However, it must be managed in order to be

beneficial to investors. Active approaches are adept at allowing such risk management, but

passive approaches are much less so.

If all active managers are trying to beat an index-based return, it clearly becomes harder for

each of them to exceed that return; the best will do so, but it is unrealistic to expect them all

to do so.

Passively managed funds generally offer no protection against declines in the indices they

track and, for this reason, they may well underperform active funds during downturns. By

contrast, active managers are able to use cash and other 'defensive' assets to shield investors

from equity market declines. Regardless of market conditions, a multi-asset approach (by

contrast with a multi-specialist approach) can be very useful in permitting an investment

manager the leeway to switch between asset classes to the benefit of investors.

Active investors can engage with companies by voting, by calling meetings and by selling a

security (which is the ultimate sanction they possess in expressing a view forcefully about an

SRI or corporate governance matter), but passive managers are unable to sell a security,

however vehement their opposition to a company's conduct. Furthermore, active managers

22

can decide not to buy a security in the first place if they have concerns about a particular

issue. Active managers' 'veto' over purchases and sales of securities strengthens their

influence over companies' activities. Passive investors, by comparison, are locked into the

universe of stocks in an index and thus do not interact with individual companies.

Active investors may benefit in particular from a performance-related arrangement in the

incurrence of the costs. The use of such an arrangement should align investors' interests with

those of their investment manager, but should serve also to align the fee investors pay for

investment management services with the ultimate effectiveness of those services.

Advantages of Active Management

An investor may believe that actively managed funds do better in general than passively

managed funds.

Investors believe that they have some skill for picking which active managers will do better

after they have invested.

They may be skeptical of the efficient-market hypothesis, or believe that some market

segments are less efficient in creating profits than others.

They may want to manage volatility by investing in less-risky, high-quality companies rather

than in the market as a whole, even at the cost of slightly lower returns.

Conversely, some investors may want to take on additional risk in exchange for the

opportunity of obtaining higher-than-market returns.

Investments that are not highly correlated to the market are useful as a portfolio diversifier

and may reduce overall portfolio volatility.

Some investors may wish to follow a strategy that avoids or underweights certain industries

compared to the market as a whole, and may find an actively managed fund more in line with

their particular investment goals. (For instance, an employee of a high-technology growth

company who receives company stock or stock options as a benefit might prefer not to have

additional funds invested in the same industry.)

Investors may gain some psychic benefit from firing a manager that has underperformed, and

replacing them with a different manager.

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Disadvantages of Active Management

The most obvious disadvantage of active management is that the fund manager may make

bad investment choices or follow an unsound theory in managing the portfolio.

The fees associated with active management are also higher than those associated with

passive management, even if frequent trading is not present.

Those who are considering investing in an actively managed mutual fund should evaluate the

fund's prospectus carefully. Data from recent decades demonstrates that the majority of

actively managed large and mid-cap stock funds in United States fail to outperform their

passive stock index counterparts.

Active fund management strategies that involve frequent trading generate higher transaction

costs which diminish the fund's return. In addition, the short-term capital gains resulting from

frequent trades often have an unfavorable income tax impact when such funds are held in a

taxable account.

When the asset base of an actively managed fund becomes too large, it begins to take on

index-like characteristics because it must invest in an increasingly diverse set of investments

instead of those limited to the fund manager's best ideas.

Many mutual fund companies close their funds before they reach this point, but there is

potential for a conflict of interest between mutual fund management and shareholders

because closing the fund will result in a loss of income (management fees) for the mutual

fund company.