How Mutual Funds Work?

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  • 13 Nov 2023
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 run 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.

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 maximize 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.

YKeep 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. The market value of 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 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.

You can earn returns from mutual funds through capital appreciation and dividends. When the fund performs well, the value of your holdings increases. So, when you sell them, you can earn profits. Dividends are the shares in profits paid to investors by asset management companies (AMCs).

Mutual funds may give profits if the value of your holdings increases. You will earn profits if their market price increases after you purchase the mutual fund units. However, you may incur losses if their price decreases.

The chances of a mutual fund becoming zero are very low. This is because a mutual fund invests in several assets. So, even if a few assets do not perform well, other assets can generate returns. This can balance the losses of non-performing assets.

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