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How do Mutual Funds Work in India with An Example

The most common advice one receives when the topic of investments comes up is this: if you start investing in mutual funds, you will get rich! But for some reason, nobody seems to have a clear answer to the ever so common question of how mutual funds work? We'll address that topic today.

how mutual funds work

Did you get your very first job?

“Start investing in mutual funds”

Planning to get married in a few years?

“Start investing in mutual funds”

Did you just welcome a child into your home?

“Start investing in mutual funds”

Does this suggestion sound familiar to you?

The most common advice one receives when the topic of investments comes up is this: if you start investing in mutual funds, you will get rich!

But, can mutual funds make you rich?

More importantly, what exactly are mutual funds?

Specifically, what are equity mutual funds and how do equity mutual funds work?

Those are fair questions to ask considering the money would have to be set aside from your hard-earned paycheck.

But for some reason, nobody seems to have a clear answer to the ever so common question of how equity mutual funds work?

Your relatives and friends who offer this investment advice might not have an answer. Even the folks over at banks, distributors, and brokerages who repeatedly call you to solicit your investments might not have an answer.

That is exactly what we’ll be addressing in this article. Our goal here is to help you understand what happens to your money once you invest in an equity mutual fund.

Simply put, we will discuss what is a mutual fund and how it works?

When you decide to start investing in equity mutual funds, you will have to make a series of important financial decisions.

As if that isn’t hard enough, the endless choices in the market today make the entire process of making such decisions all the more challenging.

All these variables can easily come in the way of helping you understand how equity mutual funds actually work.

But, you are not alone.

Understanding how equity mutual funds work is not as scary and difficult as it seems.

By the time you finish reading this article, we hope you have a good idea about the workings of a mutual fund investment.

Let’s get started.

What are Equity Mutual Funds?

If you have read any of our other articles you might have an idea about what is a mutual fund

In case you haven’t done that yet, here is a quick recap.

An equity mutual fund is an investment vehicle that pools money from various investors and uses the money hence pooled to invest in the equities market. Assets such as stocks, bonds, and other financial instruments are some examples of what mutual funds invest in.

What are Equity Mutual Funds

The investment objective of a mutual fund determines what type of securities the pooled money is invested in. For example, if a mutual fund’s focus is to generate long-term wealth for its investors, the fund’s investments would predominantly include stocks of huge, stable corporations (commonly known as large-cap funds) that have consistently provided reasonable return year after year.

There are so many mutual funds available in the market today, that are tailored to different requirements of the investors. Depending on your income level and your financial goals, you can choose to invest in a fund that caters to your specific requirements.

Investing in mutual funds is one of the easiest ways to participate in the capital markets without having to take on any significant amount of risk. Understanding how mutual funds work is a great way to plan for a financially secure future.

Now that we have looked at what mutual funds are, let’s proceed further and learn more about how mutual funds work in India.

How Do Equity Mutual Funds Work?

Equity mutual funds are a popular choice of investment because they give individual everyday investors access to investment options that are otherwise not as easily accessible or affordable.

Equity Mutual Funds Work

Since your money is pooled in with the money of other investors, a mutual fund has the financial bandwidth to explore various kinds of portfolio options (i.e determining what combination of different assets such as stocks, corporate bonds, etc. will best suit a fund’s objective).

Before we go into the details of how mutual funds work exactly, let’s take a quick look at how mutual funds are structured in India

Structure of Mutual Funds in India

The structure of mutual funds in India has three important entities. These three entities are involved in setting up and managing a mutual fund according to SEBI (Securities and Exchange Board of India) regulations.

These entities are as follows:

  1. A sponsor - this is a person or an organization that creates the fund. The fund sponsor is responsible for approaching SEBI and getting all the approvals for setting up a mutual fund.
  2. Trust and trustees- once the sponsor gets the approval from SEBI, a Public Trust is formed by the fund sponsor as per The Indian Trust Act of 1882 and registered with SEBI. A trust hence formed appoints trustees to manage the trust. These trustees are responsible for setting up and managing an Asset Management Company (AMC) as per the Companies Act of 1956. These trustees are an important part of a mutual fund set up as they are the ones answerable to the investors.
  3. Asset Management Company- the AMC essentially manages a mutual fund in its entirety. AMC is responsible for hiring an experienced fund manager with the right set of skills and an extremely good understanding of the financial markets to manage the fund. AMC is also responsible for introducing various schemes that match the different financial requirements of the investors. Any financial scheme that AMC decides to introduce will need the approval of the trustees.

There are, of course, other components to the structure of mutual funds such as custodians (the ones responsible for the safekeeping and day-to-day management of the fund), Registrar and Transfer Agents (RTAs) such as Karvy, Franklin Templeton etc., auditors and brokers.
But for your understanding, it is important to be knowledgeable about the three main entities discussed above.

Understanding Equity Mutual Funds Units

One word that is commonly used in the world of mutual funds is mutual fund units. Let us take a look at what that means.

When you invest in stocks and shares directly from a company you “own” part of the company. The ownership is limited to the extent of your investment and this ownership also gives you certain voting rights, makes you eligible for dividend payments and so on.

But investing in mutual funds is different from such direct investments.

When you invest in a mutual fund you purchase a unit of that fund. A unit in a mutual fund is also commonly referred to as a share or a unit share. The value of a unit changes every day in accordance with the performance of the fund.

Mutual funds tend to do well if the companies that are a part of a mutual fund do well in the market. And as you would have guessed by now, this affects the value of each unit of the mutual fund.

This is one of the reasons why it is so important to have a fund manager who has a deep understanding of how financial markets work. A fund manager determines which company’s share needs to remain in the fund and which needs to be replaced.

how do mutual funds work step by step

This is done to maintain a consistent (and preferably positive) Net Asset Value (NAV) of the fund.

If there is a rise or a drop in the NAV it will affect the number of units you own based on the extent of your investment.

To understand this better, let us look at how equity mutual funds work with an example.

Let’s assume that a box of 12 chocolates costs Rs. 30

Three friends decide to buy the same by pooling Rs. 10 each. In this case, each one receives 4 chocolates or 4 units. The units in a mutual fund work in a similar fashion.

Understanding a Mutual Fund Working Process

So far we have covered how does investing in mutual funds work and also explained what mutual fund units are. Let’s now proceed to learn more about how do you earn from mutual funds.

There are two primary ways in which you can earn from mutual funds: dividend income and capital gain.

  1. Dividend income - if you want to receive money at regular intervals, you can opt for a mutual fund that pays a dividend. Whenever the companies included in your chosen fund declares dividends, the fund distributes that to you as per the number of units held. In the case of some dividend option funds, irrespective of whether a company declares a dividend or now, the mutual fund pays out the entire net income earned over the year in the form of dividend distribution.
  2. Capital gain - whenever an asset that you purchased increases in value and you make a profit, it is called a capital gain. Mutual funds pass these gains on to their investors. If you invest in a growth fund, your capital gain or any kind of profit is reinvested back into the fund. Based on the performance on the fund, this will add additional fund units to your portfolio and also increase the NAV of the fund. This is the most recommended option for long-term wealth generation. This is why we only recommend growth funds at Scripbox as well.

If you ever wondered how do you earn from mutual funds, now you know.

There is no set answer to how much you can earn from mutual funds. It all depends on how much you invest, how long you plan to stay invested in a particular fund and what kind of fund you have invested in. The average mutual fund return in India has been in the range of 4.8% to 16%. For example, Mirae Asset Large Cap Growth Fund, recommended by Scripbox has generated a return of about 16% over a 5-year period.

The short answer to the question can mutual funds make you rich is this: mutual funds have the potential to make you rich if you are willing to take a bit of risk and stay invested for an extended period of time.

Step by Step Guide to How Mutual Funds Work

how mutual fund works with example

In order to invest in mutual funds, there is a certain process that one can follow.
We have outlined those steps in this section.

  1. Educate yourself - first and foremost, try and educate yourself as much as possible. Learn about all the different aspects of mutual fund investments. We have an article that discusses mutual funds in great detail on our blog. It is a great place to start learning more about this topic.
  2. Calculate your budget - try to have a very good understanding of where you stand financially. Have a very clear picture of how much your expenses are and how much money you can spare for mutual fund investments. This might seem like a very intuitive step but it also the one that is easily overlooked.
  3. SIP or one-time investment - you can decide if you would like to opt for a SIP investment or if you would like to make a one-time lump sum investment. You can find more information by clicking on SIP investment over here.
  4. Understand your financial goals - this is an absolutely crucial step when mutual fund investments are in the picture. Take the time to evaluate what your immediate financial requirements are and what your future financial requirements will be. Use this assessment to determine what kind of funds you should be investing in. You can also refer to an article, if you need help in understanding how to forecast your financial needs.
  5. Decide where to invest - you will also have to decide how will go about investing in mutual funds. Will you contact a fund house directly? Will you need the help of a broker? And so on. Scripbox has actually made the process of investing in an effective mutual funds portfolio quite simple. In fact, we follow a scientific method that completely takes the guesswork out of the way. If you are interested, you have outlined the step by step process to invest in mutual funds.
  6. Get your paperwork and KYC in order - like any other financial products, mutual fund investments will require all of your KYC details such as passport, address proof, and other details.

Benefits of Investing in Mutual Funds

We have talked about various benefits of investing in mutual funds many times on our Scripbox blog. But, before we let you go, we wanted to highlight three key benefits of investing in mutual funds.

  1. Affordability - Mutual funds are probably one of the very few investment options that are actually affordable. Unlike gold or real estate, where you will have to spend thousands or lakhs upfront, you can start with as little as Rs. 1000 with Scripbox.
  2. Diversification - Your money will have access to a diversified portfolio almost instantly. Based on the kind of fund you invest in, you will have access to shares of different companies across multiple sectors. If you take the example of HDFC Top 100 Fund, which also happens to be one of Scripbox’s recommended funds for 2019, you will notice that it has a very diverse portfolio with stocks from some of the best performing large-cap companies.
  3. Professional management - As we have mentioned earlier, your investment will be professionally managed by an experienced fund manager. You don’t have to worry about constantly monitoring the market movements. This is a huge relief, especially if you are a beginner

Conclusion

We hope this helped get a sense of how equity mutual funds actually work. If you are curious to learn more about other aspects of mutual funds such as taxation and other topics, feel free to browse through our blog.

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