To understand this, we must first understand what a mutual fund does with the money they collect from you and me.
What does an equity mutual fund actually do?
Using the money they collect from investors like you and me, an equity mutual fund buys shares (also called “stocks” or “equities”) of companies. As a shareholder, the fund basically owns a piece of the company. A typical equity fund portfolio buys shares of 50-70 companies although some can have as few as 30 while others can have as many as a 100.
The equity mutual fund manager and his research team will do various activities in selecting the shares and deciding how much to invest in each share at any point in time:
#1. Shortlist companies from the universe of over 5,500 listed companies on the two stock exchanges, focusing on those with sound business models, strong growth opportunities, sustainable competitive advantages, and quality management.
#2. Research the business fundamentals of the shortlisted companies through regular interactions with their management, employees, customers, competitors and independent industry professionals. The fund management team will also study industry reports and news in order to do an in-depth analysis of the industry, regulations, business, strategy and corporate governance issues. This will lead to detailed financial analysis and forecasts.
#3. Build a further subset of chosen companies and value their shares based on the business fundamentals and growth prospects. These valuation methods can change depending on the industry and market situation, as well as the fund manager.
#4. Generate discussion and debate between analysts and fund managers on whether to buy a share, continue to hold it, buy some more, sell some or sell it completely.
#5. Construct the portfolio by sizing how much to invest in each share based on how convincing the argument is, based all of the inputs above, as well as ensuring the portfolio is adequately balanced, in order to do well at various points in time, as the prospects of the economy and various industries evolve.
#6. Present the investment recommendations to the investment committee of the fund with a clear rationale.
As you can see, that’s a lot of work and professional fund managers dedicate their life to becoming better at this. Each of us, with a full-time job, will find it difficult, if not impossible, to gain the kind of expertise they bring to work for our investments.
What does all this have to do with the value of my mutual fund?
When the fund invests our collected money into a portfolio of shares, they do it expecting those share prices to increase over time. As companies grow their business, their value increases and so does their share price.
The value of an equity mutual fund is the sum total of the value of all the shares it holds. Since share prices change daily, so does the value of the fund. Thus, the mutual fund portfolio has a daily value based on that day’s share prices of the companies it holds.
In the next article, we will discuss how the daily NAV of an equity mutual fund is computed. Debt mutual funds work differently and will be covered in a separate article.