How do mutual funds work?

How Mutual Funds Work

Read about how mutual funds work, the factors that influence mutual funds, and why you should choose mutual funds as an investment option.
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  • 08 Feb 2023
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A mutual fund allows investors to pools money with a common investment objective. It then invests the money in various asset classes based on the scheme’s objectives.

As an investor, you put your money in financial assets like stock, bonds and other securities. You can either buy them directly or use investment instruments like mutual funds. Mutual funds have certain advantages over direct investments. For example, maybe you lack the skill to understand market trends yourself, or do not have the time to follow the market closely. Mutual funds are a great alternative in this case as they are managed by professionals. But how do mutual funds work? Here is a handy guide to what you should know.

A mutual fund is an investment vehicle that pools money from investors with a common investment objective. It then invests the money in various asset classes like equities and bonds based on the scheme’s objectives. An asset management company (AMC) makes these investments on behalf of the investors. The team that manages a mutual fund picks the stocks which investors’ money will be put into based on clearly defined investment objectives.

(Read more: What is a mutual fund?)

A systematic investment plan (SIP) for mutual funds makes it easy to invest in a disciplined way. The SIP option is similar to opening a recurring deposit (RD) with a bank. Like in the RD, your SIP will deduct a fixed amount from your bank at specified intervals—usually every month.

there is a key difference. The RD pays a fixed interest on your investment. The returns from your mutual fund SIP, however, depend on the net asset value (NAV) of the mutual fund scheme. The NAV represents the current market value of the underlying securities, and it fluctuates daily.

A mutual fund SIP brings certain advantages to the investor:

  • There is no need to worry about making lump-sum payments. You can invest small, manageable amounts every month.
  • The regular and systematic approach builds discipline among investors. Once you place a standing instruction for auto-debit, the SIP investment will take place automatically.
  • Since the NAV fluctuates, your investment buys a different number of units with each instalment. This has the potential to lower the average cost of investment over time, thus maximising your returns.

You need to be aware of several factors and terms when investing in a mutual fund

  • Net Asset Value:

The overall cost of a mutual fund depends on the price per fund unit, which is known as the net asset value (NAV). The NAV helps you understand how a specific mutual fund scheme is performing. Mutual funds invest in the securities market. The market value of securities changes every day. So, the NAV of a scheme also changes every day. (Read more: What is NAV?))

  • Assets Under Management:

Mutual funds buy assets using the money they collect from investors. These assets include stocks, bonds, and other securities. The total value of all the assets that a mutual fund buys is called assets under management (AUM).

  • Fund Managers:

These are experts with real-time access to crucial market information. Fund managers execute trades on the largest and most cost-effective scale. These managers are full-time, high-level investment professionals. They monitor the companies in which the mutual funds they manage have invested.

  • Investment Objective:

Investors invest in financial instruments to achieve a particular objective. This could be to increase wealth, accumulate money, or simply to protect money from inflation. Similarly, every mutual fund has a goal which it aims to achieve on behalf of investors. This goal or investment objective of the mutual fund could be capital appreciation—profits—in the long term, or distributing regular fixed income as dividends.

Mutual funds help you achieve your financial goals in a number of ways:

  • Power Of Compounding:

Mutual funds harness the power of compounding. Compounding is the interest that you earn on interest. Hence, the value of your investment keeps growing at an ever-increasing rate. Over time, compounding can lead to a significant increase in the value of your investment.

  • Diversification:

Diversification is a key benefit of investing in a mutual fund. It is the practice of investing in different types of securities or asset classes. Not every asset moves in tandem; while some rise, others fall. So, when you own both the stocks in your portfolio, any losses from one are cancelled out by the gains in the other. Thus, diversification reduces your overall risk.

  • Capital Gains Distributions:

Mutual funds distribute the profits made from selling some of their underlying assets at higher values. This is called capital gains distribution. You can use this to buy more mutual fund units (reinvestment).

  • Automatic Reinvestment:

A mutual fund gives returns in two ways—dividends and an increase in value. An increase in value can be utilised only when you sell the mutual fund units. Dividends, on the other hand, are accessible as soon as they are distributed. You can use the dividend amount to buy more units of the mutual fund scheme automatically. Mutual fund dividends are tax-free for investors. However, mutual funds are taxed for distributing dividends. This is mainly applicable to debt mutual funds, not equity funds.

  • Fund Switch/mutual Funds Exchange Privilege:

Many fund houses group a set of mutual funds together based on their investment objectives or other factors like management. You have the option to transfer your investment within a family of funds from one scheme to another. This is called a fund switch or exchange privilege.

  • Transparency:

It is important that your money is in safe hands. SEBI regulations have made the mutual funds industry quite transparent. This allows you to track your mutual fund investments at all times. AMCs are mandated to deliver regular updates to investors on how the funds are faring.

  • Variety:

They say not to put all your eggs in one basket. This is true for investing as well. Mutual fund schemes invest in a whole range of industries and sectors, different asset types, and more. The schemes may focus on blue-chip stocks, technology stocks, bonds, or a mix of stocks and bonds, for example. Expect to be spoilt for choice.

  • Liquidity:

Open-ended mutual funds allow investors to redeem their units at any time at the prevailing NAV. So mutual funds are highly liquid, which is beneficial for investors.

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