Today, I want to help you understand how a mutual fund operate’s in layman language and how its structure looks like. How various entities come together to create a mutual fund.
There are a lot of investors who are new to mutual funds concept and they have just heard about mutual fund. All they know about it is that some investors pool in their money in mutual funds, which invests in markets by a fund manager and they they get very good returns. While thats a simple explanation, I today want to inform you about the details and how things actually are structured, which makes mutual funds one of the safest instruments and highly professional, and leaves almost no chance of fraud in mutual funds
So let’s get into the entities which comprise of a mutual fund.
The first entity is “sponsor” of a mutual fund. It’s a person or the corporate body which initiates the launch of a mutual fund. You can see this person as the promotor of company, who is the first one to think about the company. As per SEBI, the sponsor should have a good reputation, great professional competence and they should be financially sound to become a sponsor.
They also need to have at least 5 yrs of experience in the financial services Industry and should contribute 40% of the AMC net worth (we will soon see what is AMC). The sponsor is not responsible or liable for any loss or shortfall resulting from the operation of the schemes beyond the initial contribution made by it towards setting up of the mutual fund
Next thing you should know is that a mutual fund is created as public trust and registered with SEBI. The sponsor appoints the trustees which look after the trust and they are the owners of the mutual fund property and assets.
However, the role of the trustees is not to manage the day to day affairs of mutual fund, but only to regulate the mutual fund. They make sure that everything is happening as per regulations and the money invested is managed as per the objectives set by the mutual fund. The trustees act as a protector of unit holders’ interests.
As per the SEBI rules, At least 2/3rd of the directors of the trustees have to be independent directors who are not associated with the sponsor in any manner.
3. AMC (Asset Management Company)
Now comes the main thing.
AMC means Asset Management company which actually manages the investors money and takes the decision of investing the money. The AMC is appointed by Trustees. AMC does the fund management and charges a fee for their services which is borne out of the investors money (that’s why expense ratio is there)
The AMC has to be approved by the SEBI and the Board of Directors in AMC must have at least 50% of Directors who are independent directors. So an AMC functions under the supervision of SEBI, Trustees and the board of directors .
Some rules set by SEBI
As per rules set by SEBI, An AMC (also referred as fund house) can’t use the same broker to buy more than 5% of the securities. Just like we use a trading account to buy and sell securities, in the same way an AMC uses a broker to buy and sell securities in large quantities, but they cant buy a bulk quantity with same broker, which makes sure they can’t have any “arrangements” with one of them.
So when you say HDFC Mutual Fund, you are referring to the Trust. The AMC for HDFC Mutual Fund is “HDFC Asset Management Company Limited”. So all the investment decisions of buying and selling the securities is taken by the AMC and not HDFC Mutual Fund (the trust)
Below you can see the details of trustees, sponsor and AMC which I took from the HDFC Mutual Fund website
AMC is responsible for floating a new mutual fund scheme, and inorder to do that, they have to follow rules prescribed by SEBI and requires the sign of the trustee.
So the HDFC Top 200 fund was floated by HDFC Asset Management Company Limited (AMC), but owned by HDFC mutual fund (the trust). It is the AMC which hires all the fund managers, IFA (agents) who helps in sales, and all the employees who work at the AMC offices.
4. Custodian and Depository
Here comes the interesting part.
The securities which are bought and sold by the fund manager, it’s actually not in the custody of AMC, but another entity called custodian or the depository participant. It is registered with SEBI and has the access of the securities.
A custodian keeps the physical securities (like GOLD and any physical certificates) and any demat stocks/units are stored at Depository level.
A custodian is also responsible for keeping an eye on all the corporate actions like when is a stock declaring dividend, bonus issue etc in the stocks where fund has invested. So an AMC just focuses on the decisions like buying and selling and all the task of managing, storing of actual securities happens at custodian level
Note that an AMC can have more than one custodian for various kind of securities, like in case of HDFC AMC, the securities are with HDFC Bank LTD (one of the custodians), but for their HDFC Gold ETF, the custodian is Deutsche Bank A.G which stores physical gold.
As per regulations, Sponsor and the Custodian must be separate entities which makes mutual fund a very safe instrument and fraud is almost impossible.
5. Registrar and transfer agents (RTA)
Finally, comes a very important entity called as Registrar and Transfer agents(RTA), which are appointed by AMC
These RTA are the entities which carry out all the clerical work like processing of applications, processing KYC of investors, issuing units certificates, sending refunds, processing redemption orders etc etc. So you must have heard about CAMS and Karvy, which are the RTA agencies for mutual funds. So some AMC’s give contract to CAMS and other AMC’s have given it to Karvy. The RTA charge a service fees for the work they do.
So for example, HDFC, Birla, ICICI, SBI are serviced by CAMS, whereas Reliance, UTI, Axis mutual funds have choosen Karvy as their RTA. Note that all the AMC offices also carry out the clerical tasks like if you want to change address in your mutual funds or add a nominee, you can go to AMC office directly or their RTA
Below is a snapshot of what all mutual fund companies servicing is done at CAMS at the time of writing this article
This completes the high-level structure of mutual funds. There are various other small entities which are sub-parts of these bigger entities, but lets not get into that as of now.
By looking at the above structure you can understand that a lot of care has been taken to design the mutual funds and at various points, the conflict of interest does not arise.
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