How does a Mutual Fund Work?

Mutual funds are investment vehicles that pool investment from various investors into different investment options like equity shares, bonds, etc which are managed professionally with a common objective.

The flow of money is as follows –

Flow of Money in Mutual Funds
  • The investor (retail, HNI, or institutions) pools in his money to be invested into different investible options depending on the objective of the mutual funds.

For example, a large-cap fund would primarily invest in blue-chip stocks in line with the benchmark index.

A debt-oriented hybrid fund will invest the majority (75% to 80%) into debt securities and a small amount to equity.

  • The asset management company (AMC) – are companies that appoint professionals to manage the funds that have been pooled in for investment.

They are experienced people who have knowledge about the markets.

They take a call on when to buy and sell particular security depending upon the market conditions and fund objectives.

Most AMC also has their research team as well.

An AMC is monitored by the sponsor who keeps an eye on the fund management style and ethics and regulatory compliances.

  • Securities – these are the final end products where the investor’s money is deployed. These can be shares, bonds, debentures etc depending on the fund deployment strategy.

The investor buys the NAV (Net Asset Value) of the mutual fund which is computed as –

NAV (Net Asset Value) formula

What are different types of Mutual Funds?

1. Regular and Direct

Direct mutual funds are those funds wherein an investor buys the fund directly from the manufacturer i.e. AMC.

There are no intermediaries involved (yes you got it right, they have lesser costs) on the other hand regular plans are those where the investor buys it from some intermediaries like banks, brokerage companies, advisors, etc.

2. Growth and Dividend

Mutual fund investing primarily give returns in two forms capital appreciation and income.

When an investor chooses a growth option his investment grows in value in long run.

There are two types of dividend options a) dividend payout – the growth in value of securities is paid back to the investors b) the growth in value of securities are used to buy more securities hence the no of units held increases.

3. Open and closed-ended

Open-ended funds, in this case, mean that there are a free entry and exit for an investor i.e. an investor can buy and sell whenever he wants s and the fund is always open for subscription.

Whereas a closed-ended mutual fund is open only for a fixed tenure (has a limited entry) and after the entry window is over there can be no further subscription. For example, FMP (Fixed Maturity Plan) is open for a specific time period and then it is closed for a subscription.

There are also lock-in funds where once invested an investor cannot withdraw money (hence the name lock-in).

Are mutual funds risky?

The answer is a simple YES.

Any instrument that is tradable in the market i.e. can be bought and sold has some inherent risks. 

The degree of risk varies from one kind of mutual fund to another depending on their investment objective and the securities they invest into.

To know about the risks in mutual funds click here.

Is mutual funds investment without any charges?

As we know there are no free lunches.

 Yes, you might have come across bankers and advisors telling you that we do not charge anything for the mutual funds suggested or done through us but the truth is there is something called as “Expense ratio” which is the total cost that the fund is incurring and it has to be borne by the investor.

The expense ratio also includes a commission paid to the intermediaries hence a regular plan of the same fund has a higher cost as compared to the direct plan.

 To know more about regular and direct mutual funds click here.

How do I get returns from a mutual fund?

Unlike savings bank interest or a fixed deposit interest where the interest earned is simply added to the invested amount, mutual funds work on the concept of NAV as already discussed.

So a return in mutual funds comes from the appreciation of the NAV unit from the time the investment has been done till it has been redeemed/encashed or sold.

Since mutual funds are volatile and do not guarantee any return hence the increase or decrease in the NAV might not necessarily be continuous or linear hence the return in MF is volatile

Are mutual funds taxed?

Yes, returns from mutual funds are taxed as well.

Any financial asset which has a capital appreciation i.e. capital gain has taxation to it.

 Now the degree of tax varies from the category of funds. To know more about the taxation on mutual funds click here.

So what are the benefits of mutual funds?

Diversification

one of the advantages of investing in mutual funds is diversification.

 Instead of investing in a few stocks, an equity mutual fund invests in a collection of many stocks (around 25-50) depending upon the kind of fund.

The fund is invested in multiple sectors as well so that to avoid concentration to a particular sector or stocks and these are regulated as well.

Professionally managed

As an investor, it’s very challenging to identify good stocks or bonds and do all the research.

Mutual funds are managed by fund managers who are professionals with experience in the industry and they also have a research team who does all the hard work for investors and charges a certain percentage called an expense ratio.

Can be invested in small amounts

unlike some asset class such as real estate which requires a huge amount to invest (in lakhs and crores) investment in mutual funds can be done either as a lump sum (a chunk of money) in a few thousand or lakhs and even on a monthly basis called as SIP to an extent as small as 500 rupees.

Ok! So how do I invest in mutual funds?

Investing in mutual funds is not as easy as you just identify a few random funds and invest into them.

 What an investor should look at instead is to create one’s own buying process and invest accordingly. To know more about the investment buying process click here.

Investing in a mutual fund is simple and easy.

First, you have to get your KYC (Know Your Customer) done which is a regulatory requirement.

Once that is done you can approach a banker or any financial intermediary providing mutual fund services or directly approach the fund house (AMC).

Any investment done through an intermediary will be done into Regular mutual fund type (with intermediary commission), alternatively, an investor can also go for the direct route of the investor through an RIA(Registered Investment Adviser) to save the intermediary commission.