Mutual Funds, ETFs & Derivatives

Mutual Funds, Exchange-Traded Funds (ETFs), and Derivatives are three important components of modern capital markets beyond individual stocks and bonds. Mutual Funds provide a way for investors to pool money and invest in a diversified portfolio managed by professionals. ETFs (Exchange-Traded Funds) combine features of mutual funds and stocks, offering diversified exposure with trading flexibility. Derivatives are financial instruments whose value is derived from an underlying asset (like stocks, commodities, indices, etc.), mainly used for hedging or speculation.

Mutual Funds

A Mutual Fund is a type of investment vehicle that pools money from many investors and invests it on their behalf in a diversified portfolio of securities (shares, bonds, money market instruments, etc.) according to a stated objective. Key points about mutual funds:

Structure

In India, a mutual fund is set up as a trust. It has a Sponsor (usually a financial institution who initiates the MF), a Trustee (board of trustees who ensure the fund is managed in the interest of investors), and an AMC (Asset Management Company) which is the fund manager.

The AMC employs professional fund managers who decide what securities to buy or sell. For example, SBI Mutual Fund’s AMC is SBI Funds Management Pvt Ltd, sponsored by SBI.

Units and NAV

Investors invest in a mutual fund scheme by purchasing units of that scheme. Each unit represents a slice of the fund’s portfolio. The value of each unit is given by the NAV (Net Asset Value) – which is (Total market value of assets of the fund minus liabilities) divided by number of units. NAV is typically calculated daily at market closing for open-end funds. If the fund’s investments perform well and increase in value, the NAV rises, and vice versa.

Open-end vs Close-end:

• Open-end funds: These allow investors to enter or exit (buy or redeem units) at any time at the prevailing NAV (with possibly a small load/fee). Most mutual funds are open-ended, providing liquidity to investors on demand.
• Close-end funds: These have a fixed number of units. Investors can subscribe (buy) only during the initial offer period. After that, the fund is closed for new subscriptions and runs for a set term (say 5 years). To provide liquidity, close-end funds in India are listed on stock exchanges, so investors can trade units on the exchange (though often at a discount/premium to NAV based on demand-supply).
• Interval funds: A less common type, which are close-ended but open for purchase/redemption at specific intervals.

Types of Mutual Funds by Asset Class:

• Equity Funds: Invest primarily in stocks. They aim for growth and capital appreciation. Equity funds can be further specialized (large-cap funds, mid-cap/small-cap funds, sectoral/thematic funds focusing on IT, banking, etc., index funds that replicate an index like Nifty 50, etc.).
• Debt Funds: Invest in debt instruments like government bonds, corporate bonds, debentures, treasury bills, etc. These aim to provide regular income with lower risk than equity funds. Examples: liquid funds (money market instruments, very short term), corporate bond funds, gilt funds (100% government securities), etc.
• Hybrid Funds: Invest in a mix of equity and debt to balance risk and return. For example, Balanced Funds (or Aggressive Hybrid) might be ~65-80% equity and rest debt, or Conservative Hybrid with more debt than equity. There are also specific ones like Arbitrage Funds (which exploit price differences between equity and derivatives), or Dynamic Asset Allocation funds (which vary equity-debt allocation based on market conditions).
• Others:
  • Index Funds: passive funds that replicate a market index (like Sensex or Nifty) by holding those stocks in the same proportion. Their goal is to match the index returns, not beat them.
  • Sectoral/Thematic Funds: focus on specific sectors (e.g., Technology Fund, Pharma Fund) or themes (Infrastructure, ESG etc.). These are equity funds but not diversified across all sectors.
  • ELSS (Equity Linked Savings Scheme): These are equity funds that have a tax-saving benefit under Section 80C of Income Tax Act, with a 3-year lock-in period. They invest in equities and offer tax deductions to investors.
  • Solution-oriented funds: like retirement or children’s education funds, often having lock-in or recommended holding periods.

Benefits of Mutual Funds

• Diversification: A small investment in a mutual fund gives exposure to a broad portfolio, reducing risk compared to buying a few individual stocks.
• Professional Management: Experienced fund managers and research teams manage the investments, which is useful for investors lacking time or expertise.
• Liquidity: Open-ended fund units can be redeemed on any business day for the NAV (minus any exit load). This offers reasonably quick access to cash if needed.
• Regulation and Transparency: In India, mutual funds are regulated by SEBI. Funds must publish NAVs daily, disclose portfolios monthly, follow investment restrictions (like not too much in a single stock, etc.), and have periodic reporting. AMFI (Association of Mutual Funds in India) is an industry body that also standardizes codes of conduct.
• Affordability: One can start investing in mutual funds with relatively small amounts (some schemes allow ₹500 or ₹1000 as minimum). Systematic Investment Plans (SIPs) allow investing a fixed small amount (say ₹500 or ₹1000) every month, promoting disciplined savings.
• Variety: There are mutual fund schemes for various needs and risk profiles – from very safe liquid funds for parking short-term money to high-risk equity funds for long-term growth.

Mutual Fund Industry in India:

The first mutual fund in India was Unit Trust of India (UTI), set up in 1963 by the government and RBI. It enjoyed a monopoly until the late 1980s. In 1987, public sector banks and insurers were allowed to start mutual funds (e.g., SBI MF, Canara Bank MF, LIC’s MF etc.). In the 1990s, the industry was opened to private players and foreign joint ventures.

• SEBI introduced Mutual Fund Regulations in 1993 (and updated in 1996) to govern the industry. Today, there are around 40+ AMCs (fund houses) in India, including giants like SBI MF, HDFC MF, ICICI Prudential, Aditya Birla Sun Life, Nippon India, etc., and newer ones including international ones.
• The industry’s growth has accelerated in recent years. As of end 2025, Assets Under Management (AUM) of Indian mutual funds stood at around ₹80 trillion (Rs 80 lakh crore), a more than six-fold increase over a decade. This indicates growing investor participation.

NAV and Returns

Investors in mutual funds earn returns through increase in NAV and distributions. Some funds periodically declare dividends (from profits) that are paid out to unit holders, reducing the NAV accordingly. Others keep it growth-oriented (reinvest earnings, thus NAV grows).

Expenses

Mutual funds charge an annual fee known as the expense ratio (covers management fee, administrative costs, etc.), which is a percentage of the fund’s average AUM. SEBI sets upper limits for expense ratios (ranging from ~2.25% for small equity funds down to as low as 0.5% for very large funds, etc.). Lower expense “Direct” plans (sold directly by AMC without distributor commission) are available and have become popular for informed investors.

Example

If you invest ₹10,000 in a mutual fund with NAV ₹50, you get 200 units. If over time the NAV rises to ₹65 due to the performance of its investments, your investment is worth 200 * 65 = ₹13,000 (30% gain). You can redeem your 200 units at ₹65 each (subject to any exit load if applicable, say 1% if you exit too early in some schemes).

Exchange-Traded Funds (ETFs)

ETFs are a special kind of mutual fund that trade on stock exchanges like a stock. They combine the diversification benefits of mutual funds with the flexibility of stock trading.

Key Features

• Structure and Trading: An ETF is essentially an open-ended mutual fund scheme that is listed on an exchange. Investors can buy and sell ETF units through their stock broker during the trading day at market-determined prices (which generally track the ETF’s NAV). This is unlike normal open-end mutual funds, which can only be bought or sold from the fund house at end-of-day NAV.
• Passive Nature: Most ETFs are index-based (passive funds). For example, a Nifty 50 ETF will invest in the Nifty 50 stocks in the same proportion as the index. The fund’s objective is to replicate the index performance, and its units will reflect the index value. There are ETFs for indices (Nifty, Sensex, sector indices), gold, bonds, international indices, etc. Active ETFs (where managers pick securities differently than an index) are less common.
• Creation/Redemption Mechanism: Large players (authorized participants) can create or redeem units of ETF in kind with the fund for large blocks (called creation units, e.g., 50,000 units) by delivering the underlying basket of securities. This mechanism keeps the ETF price aligned with the NAV through arbitrage. If ETF price deviates from NAV, authorized participants will arbitrage it (buy the cheaper and sell the expensive either ETF or underlying basket) to gain risk-free profit, which in turn corrects the price.
• Low Cost: ETFs generally have lower expense ratios than actively managed funds because there’s no active stock picking (especially index ETFs). For instance, an index ETF might have expense <0.1-0.5% annually, making them cost-efficient.

Types of ETFs:

• Equity Index ETFs: Track equity indices (e.g., Nifty 50 ETF, Sensex ETF, Nifty Bank ETF).
• Gold ETFs: These ETFs invest in physical gold (99.5% purity). Each unit typically represents ~1 gram of gold (or half gram in some). They allow investors to get exposure to gold price without holding physical gold.
• Bond ETFs: Track a bond index or a set of government/corporate bonds. E.g., Bharat Bond ETF which invests in a portfolio of PSU bonds of a certain maturity range.
• International ETFs: Some Indian ETFs track foreign markets (e.g., Nasdaq 100 ETF that invests in US Nasdaq stocks through a feeder).
• Commodity ETFs: Besides gold, potentially other commodities (though in India, gold is main commodity ETF; internationally, there are oil ETFs, etc.).
• Thematic ETFs: e.g., CPSE ETF (that was created to divest government stakes in PSUs, it tracks an index of top PSUs).

Advantages:

• Flexibility: Unlike mutual funds where you get end-of-day NAV price, ETF can be traded any time during market hours at near real-time prices. You can place limit orders, etc., just like stocks.
• Transparency: Holdings of index ETFs are known (since it mirrors the index). You can see the live intraday indicative NAV as well.
• No Minimum Investment via Exchange: You can buy even 1 unit of ETF (which might be as low as ₹50 or ₹100 depending on ETF) on exchange. (Direct creation with AMC requires large lot, but retail just trades like a share).
• No exit loads: Selling an ETF is like selling a stock – the concept of exit load doesn’t apply, though one pays brokerage and minor exchange charges.

Considerations:

• Liquidity: Some ETFs in India suffer from low trading volumes. However, market makers usually provide quotes. Low liquidity can sometimes lead to a bigger spread between buy-sell price.
• Tracking Error: The ETF’s returns might slightly differ from the index due to expenses and minor cash holdings or replication method. A good ETF minimizes tracking error.
• Example: If the Nifty 50 is at 18,000, a Nifty ETF unit might be priced at ~₹180 (if it’s set as 1/100th of index). If Nifty rises 10% to 19,800, the ETF should also rise about 10% to roughly ₹198 (ignoring small tracking error). An investor can trade this ETF through any brokerage account.

ETFs have become very popular for investors and even for government disinvestments (CPSE ETF, Bharat 22 ETF). They also are used by EPFO and institutions for equity exposure. While still a fraction of total MF AUM, ETFs are growing fast in India.

Derivatives

Derivatives are financial instruments whose value is derived from an underlying asset or benchmark. The underlying could be stocks, stock indices, bonds, interest rates, commodities, currencies, or even events. The main types of derivatives are Forwards, Futures, Options, and Swaps. In capital market exams, focus is usually on futures and options, particularly as traded on exchanges, and their basic uses.

Purposes:

• Hedging: To reduce or eliminate price risk by locking in prices or creating offsetting positions. (E.g., an investor holding shares might use derivatives to protect against short-term downside.)
• Speculation: To profit from expected price movements using leverage. Speculators provide liquidity to the market.
• Arbitrage: To exploit price differentials between markets or instruments (risk-free profit opportunities), which helps align prices across markets.
• Leverage: Derivatives often allow a large notional exposure for a small upfront payment (margin or option premium). This leverage can magnify gains or losses.

Common Types

Forwards and Futures

• Forward Contract: A forward is a private, customized agreement between two parties to buy/sell an asset at a specified future date at a price agreed today. Forwards trade over-the-counter (OTC), not on exchanges. Example: A farmer and a grain merchant may enter a forward contract for 100 tons of wheat at ₹2000/quintal for delivery after 3 months, locking price for both.
• Futures Contract: A future is essentially a standardized forward contract that trades on an exchange. The exchange standardizes contract terms (lot size, maturity dates, underlying quality/grade if commodity, etc.) and takes care of counterparty risk via a clearing corporation which guarantees the trade.
• Futures exist on stocks, indices, commodities, currencies, etc. In India, stock futures (on many large stocks), index futures (Nifty, Bank Nifty, etc.), currency futures (USD/INR, etc.), and commodity futures (gold, oil, etc.) are actively traded.
• Mark-to-Market: Futures are settled daily. If the price moves, gains/losses are settled each day (variation margin). Both parties maintain margin with the exchange to ensure performance.
• No Ownership Exchange until Settlement: If you buy a stock future, you don’t own the stock but have a contract that at expiry you will get the stock (in some cases) or settle in cash (in India, index futures are cash-settled, stock futures now mostly are too, except some can allow delivery). You can also square off (take an opposite position) before expiry to close your position.

Example

Suppose Reliance Industries stock is ₹2500. A 1-month future contract is trading at ₹2510. The lot size is, say, 250 shares. If you “buy one futures contract”, you agree to buy 250 shares at ₹2510 each at month-end. You pay margin maybe ~20% i.e. ₹125250 (around ₹31,250) to take this position instead of ₹6,25,000 to buy 250 shares outright. If by expiry, Reliance stock goes to ₹2600, you gained ₹90 per share on 250 shares = ₹22,500 (which will be credited via mark-to-market). If it fell to ₹2450, you lose ₹60250 = ₹15,000 (you’d pay that via margin adjustment). You could also close the position any time before expiry by selling an identical future.

• Uses: Stock or index futures might be used by investors to hedge (e.g., sell index futures to protect a portfolio) or to speculate (e.g., bet on price rise by going long future).

Options

An Option gives the holder the right but not the obligation to buy or sell an underlying asset at a specified price (strike price) on or before a specified date. To get this right, the option buyer pays a premium to the option seller (writer).

Two basic types

• Call Option: Right to buy the underlying at strike price. If you buy a call, you hope the underlying’s price will rise above the strike. The seller of the call has the obligation to sell the asset at strike if buyer exercises.
• Put Option: Right to sell the underlying at strike price. If you buy a put, you hope the underlying’s price will fall below the strike (so you can sell at higher strike price). The seller of the put must buy the asset at strike if buyer exercises.

European vs American

European options can be exercised only on expiry date. American options can be exercised any time up to expiry. In India, index options are European style, stock options also now European style (earlier years saw American style on stock options but it changed).

Payoffs:

• For a Call: If at expiry, underlying price (S) > strike (K), the call is “in the money” and will be exercised – the buyer gains (S – K) per unit (because they can buy at K and something worth S, instant profit). If S < K, the call expires worthless (no one will buy at K if market price is cheaper), and the buyer’s loss is just the premium paid. The seller’s profit is the premium if option not exercised, or if exercised, seller’s loss = (S – K) minus premium received.
• For a Put: If at expiry S < K, the put is in profit to buyer (they can sell at K something worth only S, gaining K – S). If S > K, the put expires worthless (won’t sell at K if market higher), buyer loses premium.

Option Premium

Determined by market considering factors: underlying price, strike, time to expiry, volatility of underlying (higher volatility = higher premium), interest rates (minor effect), etc. There’s option pricing models (Black-Scholes) for theoretical values.

Applications:

• Hedging: Options are great for insurance-like hedging. E.g., an investor holding Nifty index portfolio might buy a Nifty Put Option at a strike near current level; if market crashes, the put pays off limiting loss. Premium is like insurance cost.
• Speculation: Traders use options to bet on direction or volatility with limited downside (option buyer’s max loss is premium, but upside can be large). Option sellers collect premium hoping to profit if the option expires unused, but they take on potentially large risk (especially call sellers if market soars, or put sellers if market crashes).
• Covered Calls, Protective Puts: Strategies like selling calls against owned stock (to earn income, giving up some upside) or buying puts to protect a stock position are common hedging strategies.
• In India: Options are extremely popular, especially index options (Nifty, Bank Nifty weekly and monthly expiries) which have huge volumes. Stock options also trade on many large stocks. They are all cash-settled (no actual stock delivery for index, and stock options settlement in cash difference).

Example

Assume Nifty is 18,000. A call option with strike 18,200 expiring in one month might cost a premium of ₹100. One Nifty lot is 50 units (just assumption). If Nifty at expiry ends at 18,500, the 18,200 call will be worth 300 (because holder can buy at 18,200 something worth 18,500). Profit = (300 – premium 100) = 200 per unit, for 50 units = ₹10,000. If Nifty ends below 18,200, the option expires worthless and loss is premium paid = ₹5,000 (10050). If Nifty skyrockets to 19,000, payoff = (800-100)50 = ₹35,000. For the call seller, these outcomes are opposite: max profit ₹5,000 (premium) if Nifty ends below 18,200; at 18,500 they lose ₹10,000; at 19,000 lose ₹35,000, etc. So selling naked calls is high risk.

Swaps

Swaps are OTC derivative contracts where two parties exchange cash flows or financial instruments for mutual benefit. Common example: Interest Rate Swap – exchanging fixed interest rate payments for floating rate payments on a certain principal for a period (to hedge interest rate risk). Or Currency Swap – exchange principal and interest in one currency for principal and interest in another (used by firms to manage multi-currency debt). In India, interest rate swaps are used by banks/corporates (typically swapping fixed vs MIBOR linked flows). These are mostly institutional. Exams usually focus less on swaps details and more on forwards/futures/options.

Derivatives Market in India

India banned most derivatives after the 1950s (due to speculation concerns, e.g., commodity futures were banned). Financial derivatives got legalized with SEBI Act and amendments around 1999. The first exchange-traded financial derivative in India was index futures on NSE on Nifty (June 2000). Then index options (June 2001), stock options and stock futures (2001, 2002) followed. Commodity derivatives were reintroduced in 2003 with national commodity exchanges under the erstwhile FMC (Forward Markets Commission), now under SEBI.

Current Scenario

India’s equity derivatives market is one of the largest in the world by volume. Index options (especially short-dated weekly Bank Nifty, Nifty options) see massive trading by traders and institutions. There are regulations to curb excessive speculation (like minimum margins, position limits, etc.).

Regulation

SEBI regulates equity, index, currency, and commodity derivatives on exchanges. The RBI also is involved in regulation of interest rate and FX derivatives, particularly in the OTC markets (banks dealing in swaps, forwards in interbank market). For example, currency futures and options on exchanges (USD-INR, etc.) are allowed within certain limits for residents.

Participants

Hedgers (e.g., importers hedging currency risk, farmers or food companies hedging commodity prices, stock investors hedging market risk), speculators (traders, including retail, prop desks, etc.), and arbitrageurs (e.g., exploiting price between futures and spot).

Example of Hedging via Derivative

An investor holding 1000 shares of Infosys at ₹1500 fears a short-term decline. They could hedge by selling, say, 1 Infosys futures contract (which might be 600 shares per lot) or buying put options. If stock falls, loss on stock is offset by gain on derivative.

Risks and Considerations

Derivatives can be risky if misused; leverage means small market moves can wipe out or multiply investment quickly. There have been famous derivative-related losses globally (e.g., Nick Leeson causing Barings Bank collapse). Thus, understanding and prudent use is important. Regulators ensure margining and reporting to maintain market integrity.