NISM Series V-A · Chapter 2
Concept and Role of a Mutual Fund
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A mutual fund is not a new kind of asset. It is a way of investing in shares, bonds, gold and other assets through a professionally managed pool. This chapter explains what a fund is, the words used to describe it, its pros and cons, and how SEBI sorts schemes into categories. The categorisation section is the most heavily tested part of the chapter.
1What a mutual fund is
A mutual fund collects money from many investors and invests it according to a stated objective. Legally it is a trust: the money belongs to the investors (unitholders), and everyone else involved, such as the asset management company, the distributors and the custodian, only earns fees for their services.
Because the fund simply passes on whatever its investments earn, it is a pass-through vehicle: if the market goes up, unitholders gain; if it goes down, they lose. Nobody else shares in the profit or the loss.
Example 10,000 investors each put in ₹10,000 to create a ₹10 crore pool. A fund manager invests it in 40 large companies. Each investor owns a proportionate share of that portfolio, something hard to build alone with ₹10,000.
Exam trap You invest through a mutual fund in shares or bonds. It is not an alternative asset class competing with them, and it is not a deposit or a loan to the AMC.
Remember
- Mutual fund = trust; investors = beneficiaries.
- Only unitholders bear profit and loss; others earn fees.
2Investment objective and investment policy
Every scheme states an investment objective: what it wants to achieve, for example long-term capital growth or regular income. The investment policy explains how it will try to achieve it: which assets it will buy, in what proportion, and under what limits.
Example "To generate long-term capital appreciation by investing at least 80% in large-cap companies" combines an objective (capital appreciation) with a policy (80% in large caps).
Remember
- Objective = what the scheme aims for; policy = how it will invest.
- Both are in the scheme documents and guide the fund manager.
3Key terms: units, NAV, AUM
- Unit: the share an investor buys in a scheme. Face value is usually ₹10.
- Unit capital = number of units × face value.
- NAV (Net Asset Value): the value of one unit, worked out daily. It is also the per-unit value an investor would get if the scheme were wound up.
- AUM (Assets Under Management) = NAV × units outstanding. It rises with new money and market gains, and falls with redemptions, IDCW pay-outs and market losses.
- Mark to market: investments are valued at today's market price, which is why NAV changes every day.
Example A scheme has 5 crore units and its NAV is ₹24. Its AUM is 5 crore × ₹24 = ₹120 crore. Its unit capital is 5 crore × ₹10 = ₹50 crore.
Exam trap NAV is not the face value or the launch price. And recurring expenses are deducted from the scheme, so they reduce NAV.
Remember
- AUM = NAV × units outstanding.
- NAV changes daily because of mark to market.
4Why investors use mutual funds
The main advantages:
- Professional management by full-time fund managers.
- Affordable diversification: a small amount buys a share of a large, spread-out portfolio.
- Economies of scale: lower costs per investor.
- Transparency: daily NAV, regular portfolio disclosure, scheme documents.
- Liquidity: open-ended schemes can be redeemed on any business day.
- Tax deferral: in the growth option, income earned inside the scheme is not taxed until you redeem.
- Tax benefit: ELSS investment qualifies under Section 80C (old tax regime).
- Convenience: SIP, SWP, STP and switches.
Example With a ₹500 monthly SIP, Anil owns a slice of 60 companies. Buying even one share of each himself would cost far more.
Exam trap "Tax deferral" means the growth option is taxed only when you redeem. It does not mean mutual fund gains are tax-free.
Remember
- Diversification at low cost is the headline benefit.
- Growth option = tax deferral; ELSS = 80C deduction (old regime).
5Limitations of mutual funds
- No customisation: every investor in a scheme gets the same portfolio. For a personalised portfolio, investors look at PMS.
- Too much choice: thousands of schemes can confuse investors. SEBI's categorisation helps.
- No control over costs: the investor cannot negotiate expenses, though SEBI caps them.
- No guaranteed returns: returns depend entirely on the markets.
Example Mr Kapoor wants to avoid tobacco and alcohol companies entirely. A diversified equity scheme may hold them, and he cannot ask the fund to remove them. A PMS could build a portfolio to his rules.
Remember
- Same portfolio for everyone; no guaranteed returns.
6Open-ended, close-ended and interval schemes
- Open-ended: you can buy and sell units any business day directly with the fund. The number of units keeps changing.
- Close-ended: you can buy only during the New Fund Offer (NFO). The scheme has a fixed maturity and must be listed on a stock exchange (ELSS is the exception) so investors can exit before maturity by selling to another investor. Units often trade at a discount to NAV.
- Interval: close-ended most of the time, but opens for purchases and redemptions during specified transaction periods (at least 2 days). Listed in between.
- ETFs: open-ended funds whose units trade on the exchange throughout the day at market prices, which can differ slightly from NAV. You need a demat and trading account.
Example Meena wants to put money into a close-ended scheme a month after its NFO closed. She cannot buy from the fund; she must buy units from another investor on the stock exchange.
Exam trap ETFs trade at market prices during the day, unlike ordinary index funds, which transact at the end-of-day NAV.
Remember
- Open-ended: continuous buy/sell; unit capital changes.
- Close-ended: buy in NFO only; listed; often at a discount.
- ETF: trades on exchange; needs demat + trading account.
7Active vs passive funds
An active fund manager picks securities to try to beat the market. A passive fund (index fund or ETF) simply copies an index, so there is no stock selection and costs are lower. Passive funds still go down when the index goes down; they remove manager risk, not market risk.
SEBI's MF Lite framework is a lighter set of rules for fund houses that offer only passive schemes (index funds, ETFs and specified fund of funds).
Example A Nifty 50 index fund holds the 50 Nifty stocks in index weights. If the Nifty falls 10%, the fund falls about 10% too.
Remember
- Passive = copies an index, lower cost, no manager stock-picking.
- MF Lite = passive-only fund houses.
8SEBI's scheme categories
SEBI groups open-ended schemes into 5 groups: Equity, Debt, Hybrid, Life Cycle Funds and Others. Generally a fund house may have only one scheme per category, so names mean the same thing everywhere (exceptions: index funds/ETFs on different indices, FoFs with different underlying funds, and sector/thematic funds on different themes).
Market-cap definitions: large cap = companies ranked 1–100 by full market capitalisation; mid cap = 101–250; small cap = 251 onwards.
| Equity category | Key rule |
|---|---|
| Multi Cap | ≥75% equity, with at least 25% each in large, mid and small caps |
| Large Cap | ≥80% in large caps |
| Large & Mid Cap | ≥35% large + ≥35% mid |
| Mid Cap / Small Cap | ≥65% in mid / small caps |
| Flexi Cap | ≥65% equity, any market cap |
| Focused | At most 30 stocks |
| Value / Contra | ≥80% equity; a fund house can have both only if portfolio overlap ≤50% |
| Sectoral / Thematic | ≥80% in the chosen sector or theme |
| ELSS | ≥80% equity, 3-year lock-in, 80C benefit |
| Debt category | Defining feature |
|---|---|
| Overnight | Securities maturing in 1 day |
| Liquid | Securities up to 91 days |
| Ultra Short Term | Macaulay duration 3–6 months |
| Money Market | Money market instruments up to 1 year |
| Short / Medium / Medium-Long / Long Duration | Macaulay duration 1–3 / 3–4 / 4–7 / over 7 years |
| Corporate Bond | ≥80% in AA+ and above |
| Credit Risk | ≥65% in AA and below |
| Banking & PSU | ≥80% in banks, PSUs, public financial institutions |
| Gilt / Gilt 10-year constant duration | ≥80% in government securities |
| Floater | ≥65% in floating-rate instruments |
| Hybrid category | Equity share |
|---|---|
| Conservative | 10–25% |
| Balanced | 40–60% (no arbitrage) |
| Aggressive | 65–80% |
| Dynamic Asset Allocation / Balanced Advantage | Changed actively |
| Multi Asset | At least 3 asset classes, ≥10% each |
| Arbitrage | ≥65% in equity arbitrage |
| Equity Savings | ≥65% equity (part hedged), ≥10% debt |
Life Cycle Funds follow a glide path that shifts from growth to safety as the target date nears. Index funds/ETFs and FoFs must put at least 95% in the index or the underlying fund.
Example A scheme holds 30% large, 30% mid and 30% small caps, plus 10% cash. It meets the Multi Cap rule (≥25% in each, ≥75% equity overall). It would fail the Large & Mid Cap rule because it has less than 35% in each.
Exam trap Credit Risk funds invest in AA and below; Corporate Bond funds in AA+ and above. Liquid funds go up to 91 days, not 1 year. "Conservative hybrid" describes only the low equity share.
Remember
- Large 1–100, mid 101–250, small 251+.
- One scheme per category per fund house (with listed exceptions).
9Other kinds of funds
- Fixed Maturity Plans (FMPs): close-ended debt schemes whose portfolio matures around the scheme's maturity, so the likely return is fairly visible if held to the end.
- Target Maturity Funds: open-ended passive debt funds that hold bonds maturing around a set date. They reduce reinvestment risk and make returns more predictable if held to maturity.
- Capital protection oriented funds: invest most money in debt that will grow back to the original amount by maturity, and a small part in equity for upside.
- REITs and InvITs: SEBI-registered trusts that own rent-earning real estate or infrastructure. They are not mutual fund schemes, though mutual funds may invest in them.
- Specialized Investment Funds (SIFs): a separate category for investors putting in at least ₹10 lakh across a fund house's SIF strategies, allowing some long-short strategies.
Example A 3-year FMP buys bonds maturing in about 3 years. If the investor stays till maturity, rate movements in between matter little.
Exam trap Capital protection is achieved through the debt portion, not a bank guarantee or insurance. REITs and InvITs are not mutual fund schemes.
Remember
- FMP and TMF: predictable debt returns if held to maturity.
- SIF minimum: ₹10 lakh across all SIF strategies of the same AMC.
10Growth of the industry
Indian mutual fund assets have grown many times over in the last decade, driven largely by SIPs and wider investor participation, including from smaller towns. For the exam, focus on the drivers: investor awareness, SIPs, digital platforms and regulation, rather than exact figures.
Remember
- Growth drivers: SIPs, awareness, digital access, strong regulation.
Original summary written by Integrato Digital to complement the official NISM workbook (March 2026 version). Read the workbook for the full text.