How Do Mutual Funds Work?

Key Highlights

• Mutual funds let you pool your money with other investors to "mutually" buy stocks, bonds, and other investments.
  

• Mutual funds are managed by professional money managers who decide which securities to buy (stocks, bonds, etc.) and when to sell them.
  

• Mutual funds are transparent. As per SEBI regulations, AMCs must provide regular updates to investors regarding the fund's performance.
  

Understanding How Mutual Funds Work

Mutual funds serve as accessible and professionally managed investment options for individuals looking to participate in the stock market. The following provides a comprehensive understanding of how mutual funds work.

1. Pooling of funds: Mutual funds pool money from numerous investors, creating a collective investment fund. Each investor owns shares, and the fund's total value is calculated based on the net asset value (NAV).

2. Professional management: Skilled portfolio managers oversee mutual funds, making investment decisions to achieve the fund's objectives. They aim to maximise returns while managing risk through strategic asset allocation and security selection.

3. Diversification: Mutual funds invest in a diversified portfolio of securities, such as stocks, bonds, or a mix of both. Diversification helps spread risk across various assets, reducing the impact of poor performance in any single investment.

4. Investor shares: When an individual invests in a mutual fund, they buy shares proportional to their investment amount. The number of shares an investor holds represents their ownership stake in the overall fund.

5. Net Asset Value (NAV): The NAV is the per-share market value of the mutual fund and is calculated by dividing the total value of all assets in the fund's portfolio by the number of outstanding shares. Investors buy or sell mutual fund shares at the NAV price.

6. Liquidity: Mutual funds offer liquidity as investors can buy or sell shares on any business day at the closing NAV. This flexibility allows investors to enter or exit their positions relatively easily.

7. Returns and distributions: Mutual funds generate returns through capital appreciation, interest income, and dividends from the underlying securities. Profits are distributed to investors either in the form of cash or additional shares, and investors may receive periodic income distributions.

Factors Affecting Mutual Funds

Keep the following factors in mind while investing in a mutual fund

• Net Asset Value:
  

The overall cost of a mutual fund depends on the price per unit. It is called net asset value (NAV). NAV helps to understand the performance of a mutual fund. Mutual funds invest in several securities and the market value of these securities changes every day. So, the NAV of a scheme also changes daily.

• Assets Under Management:
  

Mutual funds invest in assets with the funds collected from investors. These assets include stocks, bonds, and other securities. The total value of all the assets is called Assets Under Management (AUM).

• Fund managers:
  

They are experts with real-time access to crucial market information. Fund managers execute trades on a large scale in the most cost-effective way. They are full-time professionals with a lot of expertise and experience. They monitor the performance of securities mutual funds invest in.

• Investment objective:
  

Every mutual fund has a specific investment goal. The fund aims to achieve it on behalf of investors. A fund's investment objective may be to generate long-term profits (capital appreciation). It may also distribute regular fixed income in the form of dividends.

Mutual Fund Classification

Mutual funds are classified based on different factors. Each category has its own features and investment goals. Knowing how mutual funds are grouped can help investors choose the right scheme for their needs.

1. Based on structure

• Open-ended funds allow investors to buy and sell units at any time. There is no fixed maturity period.
  

• Closed-ended funds have a fixed maturity. Investors can invest only during the initial offer period.
  

• Interval funds are a mix of open and closed-ended funds. They allow transactions at specific intervals.
  

2. Based on asset class

• Equity funds invest in shares of companies. They are suitable for long-term wealth creation.
  

• Debt funds invest in fixed-income instruments like bonds. They aim to offer stable returns.
  

• Hybrid funds invest in a mix of equity and debt. They try to balance risk and return.
  

3. Based on investment objective

• Growth funds aim to grow capital over time.
  

• Income funds focus on regular income generation.
  

• Liquid funds are suitable for short-term goals. They offer quick access to money.
  

4. Other types

• Solution-oriented funds help with specific goals like retirement or children's education.
  

• Index funds and ETFs track market indices and offer passive investment options.
  

• Fund of Funds (FoFs) invest in other mutual fund schemes.
  

Each type of mutual fund is designed to meet different investor needs. Investors can pick a fund based on their risk level, investment duration, and financial goals.

How to Invest in Mutual Funds?

Investing in mutual funds can be done through various channels. The process is simple and regulated to ensure investor protection.

Choose a mutual fund scheme

An investor must begin by selecting a mutual fund scheme. The choice depends on the investment objective, risk appetite, and time horizon. Funds can be selected based on asset class, structure, or specific goals.

Complete the KYC process

To invest, it is mandatory to complete the Know Your Customer (KYC) process. This involves submitting identity and address proof, a photograph, and PAN card details. KYC compliance is required as per regulatory norms.

Select the mode of investment

Investments can be made through a one-time lump sum or via a Systematic Investment Plan (SIP). SIP allows regular investments at fixed intervals, promoting disciplined investing.

Choose a platform or intermediary

Mutual funds can be accessed through Asset Management Companies (AMCs), banks, online portals, or registered distributors. Transactions can be carried out online or offline.

Make the payment and receive units

Once the application is processed and payment is made, units of the mutual fund are allotted. The number of units depends on the applicable Net Asset Value (NAV) on the purchase date.

Monitor the investment

After investing, the portfolio can be tracked through account statements or fund house platforms. Regular monitoring helps ensure alignment with financial goals.

Pros and Cons of Investing in Mutual Funds

Mutual funds offer several benefits to investors. However, like all investment options, they also have certain limitations. Understanding both advantages and disadvantages can help one make informed decisions.

Pros

• Diversification
  Mutual funds invest in a variety of securities. This helps reduce the impact of poor performance from any single investment.
  

• Professional management
  Each fund is managed by experienced fund managers. They make investment decisions based on research and analysis.
  

• Liquidity
  Open-ended mutual funds allow easy entry and exit. Investors can redeem units on any business day at the prevailing NAV.
  

• Regulated and transparent
  Mutual funds in India are regulated by SEBI. Regular disclosures ensure transparency in operations and performance.
  

• Flexibility
  Mutual funds offer a wide range of schemes suited to different financial goals, risk levels, and investment durations.
  

Cons

• Market risk
  Mutual funds are subject to market fluctuations. Returns are not guaranteed and may vary based on economic and market conditions.
  

• Costs and charges
  Funds levy charges such as expense ratios and exit loads. These may impact the overall return, especially over the short term.
  

• No control over portfolio
  Investment decisions are made by the fund manager. Investors cannot choose individual securities within the fund.
  

• Lock-in periods
  Some funds, like ELSS, have a mandatory lock-in period. Premature redemption is not allowed during this time.
  

Conclusion

Mutual funds are an excellent investment instrument for investors. They pool funds from investors and invest them in diverse asset classes. Mutual funds offer investors a level of diversification that might be challenging to achieve individually, allowing them to mitigate risks and potentially enhance returns. The continuous monitoring by fund managers ensures adaptability to changing market conditions, and the redemption flexibility will enable investors to access their funds when needed.