As with many other innovative financial products, Mutual Funds, as an attractive investment source started in the USA. MF is an investment company created under the Investment Company Act of 1940 that pools the resources of investors to buy a variety of securities, depending on the fund's stated objectives and management style. The investments typically are chosen by a professional manager. Mutual funds offered diversification and convenience even to small investors, and the thousands of mutual funds that came to be established cater to every conceivable investment need and taste.

The popularity of the Mutual Fund has increased manifold. In developed financial markets, like the United States, Mutual Funds have almost overtaken bank deposits and total assets of insurance funds. As of date, in the US alone there are over 7,000 Mutual Funds with total assets of over US $ 3 trillion (Rs. 100 lakh crores). According to "The Investing Kit" (Dearborn Financial Publishing, Inc., Chicago), mutual funds offer "professional portfolio management, diversification, a wide variety of investment styles and objectives, easier access to foreign markets, dividend reinvestment, ease of buying and selling shares and exchange privileges."

"Mutual funds have become the investment of choice for millions of investors. The basic idea of a mutual fund is simple. It is an organization whose only business is the investment of its shareholders' (Unit-holders') money into cash equivalents (money markets), stocks, bonds or a combination of stocks and bonds, for the purpose of achieving specific investment goals. To do this, it attracts funds from many individual and institutional investors, and it attempts to invest and manage those funds more effectively than investors could do on their own. More and more investors are using mutual funds to achieve at least some of their investment goals. According to Stephen Littauer, author of "How to Buy Mutual Funds the Smart Way" (Dearborn Financial Publishing, Chicago, 1993), one of the most important reasons why investors choose mutual funds is the availability of past performance records. You can see a complete and unquestionable picture of what a fund has achieved in the past. However, past performance may not be an indicator of future performance. To help you achieve your investment objective, mutual funds can provide you with the three basics of prudent investing: (1) careful selection of securities, (2) diversification and (3) liquidity."¹

"Mutual funds have a number of advantages over individual securities. A key advantage is that mutual funds are generally more diversified . A typical fund invests in dozens of securities. Thus, small investors can achieve a level of diversification greater than they could on their own or with less effort than they could on their own. The funds are professionally managed, which logically should add to your investment returns in the long run. Investing in a mutual fund will also save you lots of paperwork headaches because the monthly and annual statements will summarize short- and long-term gains, dividends and interest earned on your account. Most also offer telephone and online trading, which makes buying, selling or switching funds a snap. Idle cash can be automatically invested at competitive rates in a money market fund and many companies also offer unlimited checking privileges, debit cards and credit cards, much as a bank would. You can even designate a beneficiary so that, when you die, there will be none of the delays and expenses of probate".¹

"Believe it or not, there are now more mutual funds than there are publicly traded stocks. As a result, you can find a fund that easily fits your own investment tastes. Some funds invests in stocks and bonds. Some invest only in U.S.-based companies, while others focus on overseas securities. Some even invest in other mutual funds! Some carry sales charges, called loads, and others do not. Choose carefully because less than one of three funds successfully beats the return on the S&P 500."¹

There are now approximately 7,000 actively managed mutual funds in the United States, with wide variations in size, age, purpose and policy. The oldest have been in existence for more than 65 years; many have been established in the last 5 years. Some have only several million dollars under management, while others measure their assets in the tens of billions. The greatest growth of mutual funds occurred after World War II and has continued since with only occasional pauses. In 1946 mutual fund companies managed just over $2 billion in assets. By 1956 this had grown to $10.5 billion, and to more than $39 billion in 1966. In the 1980s growth exploded, jumping from $64 billion in 1978 to more than $1 trillion by the end of 1991. Today, there are approximately $3 trillion dollars invested in all types of mutual funds. While a great deal of this growth has derived from the return on invested assets, most growth has come from new money going into the funds. For example, according to the 1996-97 Directory of Mutual Funds (Investment Company Institute, Washington, D.C.), the number of funds has grown from 1,528 in 1985 to about 7,000 today. The number of shareholder accounts has grown from 45.1 million in 1986 to about 150 million today".¹

1. The companies in which the fund has invested will perform poorly, suffer mismanagement or otherwise meet with misfortune.

2. some economic, political or other development will cause the overall market to fall, dragging down with it the holdings of your particular fund.

3. Wrong Investment Decision, or speculative Decisions by MFs. The fund management, for instance, may be doing things you don't know about or wouldn't like if you did. What you think is a plain vanilla domestic equity-income fund might, in order to boost returns, invest in derivatives, invest overseas, or invest in growth companies that pay little or no dividend. In a downturn, you could be in for an unpleasant surprise. There is also the risk that the fund will under-perform a benchmark index, which means that management fees aren't buying any added value.¹

¹Source - MSN Money.

In India, the Mutual Fund industry started with the setting up of Unit Trust of India in 1964, as a single State Monopoly. Twenty-three years later Public Sector banks and financial institutions were permitted to establish Mutual Funds in 1987. The Industry was brought under the control of SEBI and opened for private sector participation in 1993.

The private sector and foreign Institutions began setting up Mutual Funds thereafter. The fast growing industry is regulated by the Securities and Exchange Board of India (SEBI). A Mutual fund in India is registered / incorporated as a public trust. As per Clause 14 of SEBI guidelines- A mutual fund shall be constituted in the form of a trust and the instrument of trust shall be in the form of a deed, duly registered under the provisions of the Indian Registration Act, 1908 (16 of 1908) executed by the sponsor in favour of the trustees named in such an instrument. If the Trust Deed so provides the trustees can appoint an Asset Management Company for the day to day administration of the MF and investment of its funds.

SEBI's Website (FAQ on Mutual Fund) defines MF as under:
A Mutual Fund is a trust that pools the savings of a number of investors who share a common financial goal. Anybody with an investible surplus of as little as a few thousand rupees can invest in Mutual Funds. These investors buy units of a particular Mutual Fund scheme that has a defined investment objective and strategy The money thus collected is then invested by the fund manager in different types of securities. These could range from shares to debentures to money market instruments, depending upon the scheme's stated objectives. The income earned through these investments and the capital appreciation realised by the scheme are shared by its unit holders in proportion to the number of units owned by them. Thus a Mutual Fund is the most suitable investment for the common man as it offers an opportunity to invest in a diversified, professionally managed basket of securities at a relatively low cost.

"The mutual funds can be organised in two ways. One, the Trust structure and the other, the Company structure. In both these structures, there is an entity which undertakes the designing and marketing of schemes, raises money from the public under the schemes and manages the money on behalf of its owners. This entity is the fund manager or an Asset Management Company (AMC) . To segregate the collected funds from this entity's own funds, the corpus is placed in a legal vehicle. It is the character of this legal vehicle that determines the character of the Fund itself. If this vehicle is a corporate entity then the fund acquires the name of an investment company as in the US and UK and if the entity is a Trust, the fund acquires the name of mutual fund as in UK and India, for example. Irrespective of the nature of the structure, what is more fundamental is that in view of the fiduciary role of the AMC or the fund manager towards the public, there is a need for supervision of the activities of the AMC or fund manager by a separate body. This supervisory role is fulfilled by the Board of Trustees and in a corporate structure by the Board of directors of the Investment company."²

There are four constituents of a mutual fund in India,

1. the sponsor,

2. the board of Trustees or Trustee company,

3. the asset management company and

4. the custodian.

The sponsor is the Settlor of the Trust which holds Trust property on behalf of investors who are the beneficiaries of the Trust. The sponsor is also required to contribute at least 40% of the capital of the asset management company which is formed for managing the assets of the Trust. The assets of the Trust comprise of properties of the schemes which are floated by the asset management company with the approval of the Trustees. Schemes may have different characteristics - they may be open or closed ended or may have a particular investment focus or portfolio composition. Finally, the safe custody of assets of the Trust is entrusted to one or more custodians

"Unit Trust of India (UTI), which has a structure different from the three tiered structure of other mutual funds in India was established by the Government of India to encourage private savings and investment. It was formed under a special Act of Parliament, viz. The Unit Trust of India Act, 1963 as a corporate body. The promoter-sponsor of UTI is the Government of India through the Reserve Bank and Financial institutions. In the true sense however they were the only owners of the initial units of the UTI. The UTI Act provides that the general superintendence, direction and management of the affairs and business of the Trust shall vest in a Board of Trustees which may exercise all `powers and do all acts and things which may be exercised or done by the Trust". The Board of Trustees comprises nominees of the Central Government, RBI, IDBI, LIC SBI, participating financial institutions and an Executive Trustee to be appointed by IDBI. The UTI Act stipulates that there shall be an Executive Committee which shall consist of The Chairman of the Board, Executive Trustee and two other Trustees. Subject to such general or special directions as the Board may from time to time give, the Executive Committee shall be competent to deal with any matter within the competence of the Board of Trustees. The Executive Committee in effect, performs the asset management functions. Thus, the activities of the Executive Committee which itself comprises members of the Board of Trustees, are overseen by the Board of Trustees themselves. In matters involving public interest, the Central Government and the Reserve Bank of India have powers to give directions.

"The management structure of UTI is thus distinct from the remaining mutual funds in more than one way. First, unlike other mutual funds, it is a statutory body corporate and not a Trust under the Indian Trusts Act. Second, there is no separate asset management company with a separate Board of directors of AMC to manage the schemes. The functions of the Board of directors of AMC, and Trustees are combined in the Executive Committee and Board of UTI. The Sponsors exist in the form of Government and IDBI, though they do not hold any equity in the Trustee company or AMC for none exists. SEBI at present regulates UTI through a special regulatory dispensation effective from July 1, 1994 which inter alia requires UTI to file offer documents in accordance with the SEBI (Mutual Funds) Regulations and allows SEBI to inspect UTI. This arrangement in SEBI's view is only an intermediate step and according to SEBI, it would be desirable to amend or repeal the UTI Act to bring UTI and other mutual funds under a common regulatory framework. In the meanwhile UTI has set up three separate asset management Committees as directed by SEBI"². Recent changes in UTI set-up are discussed in a subsequent article

"When the public sector banks were allowed to set up mutual funds, the first mutual fund was set up by the State Bank of India in 1987 prior to the establishment of SEBI. State Bank of India preferred to adopt the Trust route and set up the mutual fund as a Trust under the Indian Trust Act 1882. Other mutual funds followed suit and thus Trusts set up under the Indian Trusts Act came to be the adopted legal form of mutual funds in India. The author or Settlor of the Trust came to be principal Trustee and also functioned as the fund manager.

"These mutual funds combined the role of Trustee, fund manager and custodian in the sponsoring bank. There was little demarcation in the role and responsibilities and the structure was open to conflict of interests.

"Other mutual funds that were set up later adopted the same pattern and thus, over time, Trusts set up under the Indian Trusts Act became the accepted legal form for establishment of Mutual Funds in India. The author or Settlor of the Trust became the principal Trustee and also functioned as the fund manager.

With the establishment of SEBI under the SEBI Act, 1992, mutual funds other than the UTI, were for the first time brought under the regulatory purview of SEBI. At that time, no special legislation similar to the UTI Act existed under which the mutual funds could be incorporated. Historically, SEBI found that mutual funds had been set up by public sector banks adopting the trust route because using the route of the Companies Act appeared to be more complex as it could have also led to multiple regulatory jurisdiction. Sufficient information is not available as to whether, at this stage, a rigorous examination of the advantages and disadvantages of the two alternative routes were undertaken or not. Nonetheless, the SEBI (Mutual Funds) Regulations provided for setting up of mutual funds as Trusts under the Indian Trusts Act of 1882. It may not be out of place to mention that the Indian Trusts Act of 1882 was enacted to govern private Trusts and envisaged a different manner of conduct and supervision of operations. Quite clearly, it did not at that time take into account the nature of activities that will be involved in the functioning of mutual funds.

"SEBI, while framing the Mutual Fund Regulations, gave a lot of consideration to two major factors, one, that mutual funds garner large moneys from the pubic for investment in a dynamic market place which require specialisation on the part of persons performing these functions. Secondly, there could arise potential conflicts of interest which were to be avoided by ensuring arm's length relationship between various functionaries. Such stipulation of arm's length relationship ensures that the person who performs a function is answerable to another and does not assess or judge his own performance. The Regulations stipulated a three tiered structure of entitites for carrying out different functions of a mutual fund, but placed the primary responsibility on the trustees. Internationally, irrespective of the route adopted, a three tiered structure exists and there is a segregation between the responsibility of fund management and the trustee or supervisory responsibility.

"Considering the inherent fiduciary nature of the functions, arm's length relationships were sought to be built into the various constituents of a mutual fund, primarily through separate entities and delineating the role and responsibility of the asset management companies and the Trustees and regulations on affiliate transactions. Arm's length relationships were also expected to be achieved by requiring a certain proportion of Trustees to be independent of the sponsor, requiring independent directors on the board of the AMC and requiring an independent custodian to be appointed."²

²Report of PK Kaul Committee