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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
how mutual funds work

What are Mutual Funds?

A mutual fund is an investment vehicle that pools money from various investors and uses the money hence pooled to invest in the stock market. Assets such as equities, bonds, and other financial instruments are some examples of what mutual funds invest in. Mutual funds can be actively managed funds or passively managed funds. In actively managed funds, the fund manager performs market research to align the portfolio with the fund’s objective. While passively managed funds replicate the index or benchmark. For example, exchange traded fund (ETF) and index fund.

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. For investors looking at diversity, mutual funds are the types of investments that best suit their requirements.

There are many mutual funds available in the market today that are tailored to different investor requirements. Depending on income level and financial goals, one can choose to invest in a fund that caters to their specific requirements.

Investing in mutual funds is one of the easiest ways to participate in the stock market while managing risk smartly. 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.

Types of Mutual Funds

There are different types of mutual funds in India based on structure, asset class, investment objective, and specialty funds. While an equity fund suits long term investing, for the short term debt funds are suitable than a fixed deposit.

Structure of the fundAsset ClassInvestment ObjectiveSpecialty Funds
Open-Ended Mutual FundsEquity Mutual Funds
Large Cap Mutual Fund
Mid Cap Mutual Fund
Small Cap Mutual Fund
Large & Mid Cap Mutual Fund
Multi-Cap Fund
Value Fund
Contra Fund 
Thematic or Sector Funds
Equity Linked Savings Scheme ELSS
Gold Funds
Growth Mutual FundsIndex Funds
Closedended Funds Debt Funds
Overnight Fund
Liquid Fund
Money Market Fund
Ultra Short Duration Fund
Short Duration Fund
Medium Duration Fund
Long Duration Fund
Dynamic Bond Fund
Corporate Bond Fund
Credit Risk Fund
Banking and PSU Fund
Gilt Fund
Income Mutual FundsFund of Funds
Interval FundsMoney Market Mutual FundsLiquid Mutual FundsCommodity Mutual Funds

Hybrid Mutual Funds
Aggressive Hybrid Fund
Conservative Hybrid Fund
Equity Savings Funds
Dynamic Asset Allocation Fund
Arbitrage Funds
Multi Asset Allocation FundBalanced Fund
Tax Saving Mutual Funds
Or Equity Linked Savings Scheme ELSS
Asset Allocation Funds


Pension FundsRetirement Fund



Children’s Fund

How do Mutual Funds Work?

Mutual funds pool money from different investors to invest in securities like shares, bonds, government securities, etc. Each mutual fund scheme has a strategy that is set at the time of the NFO (New Fund Offer). Once the strategy is decided, the fund must follow it. Starting from the launch of NFO to the distribution of returns, mutual fund investing is a cycle of 4 steps.

Cycle of mutual fund investing process

NFO Launch

In a New Fund Offer (NFO), investors get an opportunity to subscribe to a mutual fund scheme and say invested in it right from its inception. However, they can subscribe only for a limited time. Once the NFO closes, the investors will only be able to purchase the units. Moreover, the fund’s strategy is disclosed at the time of the NFO launch. Once the fund manager fixes the fund strategy, it cannot be changed. It is because investors invest in the fund based on the strategy.  NFO’s are cheaper than existing funds as it’s new to the market. However, mutual funds investors need to consider the fund houses’ reputation, objectives of the fund, cost of investment, risk, minimum subscription amount, and the investment tenure before investing in an NFO.

Money is Pooled

Mutual funds pool money from many small investors to invest in securities. Investors invest small amounts of money from their savings. Mutual funds allow small investors to invest money in large portfolios, which they otherwise cannot. It can be due to the lack of money or lack of time to perform mutual fund research in detail. Thus, mutual funds are the solution to such investors.

Invest Money in Securities

The pooled money is invested in securities like shares, bonds, and government securities. The fund manager decides the portfolio of the fund based on the strategy of the fund. The portfolio manager has the expertise and time to do a thorough research of the securities. Also, they perform a company, industry, and economy level analysis. In order to find the securities that best fit the fund’s strategy and maximize the return for the mutual funds investors. And at any point in time, if the selected securities are underperforming, they replace them with better-performing securities. They sometimes use multiple strategies to choose the securities for a fund. And sometimes, they also use a combination of investing and trading strategies to take advantage of the stock market situations. All these efforts put by the fund managers give investors access to large portfolios.

Fund Returns

The portfolio manager continuously strives to earn returns from the investments they make on behalf of the fund investors. Thus, all their efforts in mutual fund research, monitoring, and rebalancing the portfolio increases the fund’s NAV. Once the fund makes returns, they are either distributed or invested back into the fund. While, for dividend funds, the returns are distributed in the form of dividends. For growth funds, the returns are reinvested into the fund to enhance the wealth of the fund investors. It is the critical step of mutual fund investing as this completes the cycle of investing. The returns, if retained in the fund, are further invested in creating more wealth for investors. 

Hence, mutual fund investing is a continuous process that channelizes small savings of many investors in productive securities to maximize their wealth.

How mutual funds work?

For instance, let’s assume that Aditya Birla Mutual Fund launches a mutual fund scheme. Let us say, ABSL Top 25 Fund. For the ease of understanding, let’s assume the scheme collects INR 1 crore from 100 investors. Investment per investor being INR 1 lakh. The fund house allots the units at a NAV of INR 10. Therefore, each investor gets 10,000 units. Thus, the total number of units issued and allocated by the fund house is 10 lakh units. 

ABSL Top 25 Fund’s objective is to invest across 25 stocks.  To follow the fund’s objective, the fund manager does his research and pick the top 25 stock. The fund manager believes that buying stocks that fit the criteria will contribute significant returns to the portfolio. Upon selecting the shares, the fund manager invests equal amounts across each stock. Thus, the equity fund comprises of top 25 shares.

As the Assets Under Management (AUM) of the fund is INR 1 crore, investment in each stock is approximately INR 4 lakh. Thus these stocks become part of the equity fund portfolio. Also, in reality, the fund manager deals and invests in high proportions. All the investments are backed by research. The fund manager believes in buying stocks that give good returns. Additionally, the fund also maintains a cash balance. It is to deal with redemption from investors. 

Increase in Net Asset Value (NAV)

After a month, the portfolio doesn’t witness any changes concerning holding and the number of investors. Eventually, as the price of the stocks starts to move, the portfolio value keeps changing. As the prices move up, the total value of the portfolio increases. In this scenario, the value of the portfolio grows to INR 1.25 crores. Since there is no change in the fund units of 10,000, the new NAV now is INR 12.5 (INR 1.25 crore/10 lakh units). 

As a result, the investment value for investors grows to INR 1.25 lakh (10,000 units * INR 12.5 NAV. In other words, investors gain INR 25,000 (INR 1.2 Lakh – INR 1 Lakh). Also, in percentage terms, the gains are 25% [(INR 25,000/INR 1 Lakh)*100]. 

Redemption

Investors redeem or sell their investments. For this fund, an overall 1,00,000 units were redeemed. In terms of value, the total outflow is INR 12.5 lakh (INR 12.5*1,00,000 units). As a result, the Assets Under Management (AUM) of the fund fell to INR 1.125 crore. And, the total number of units comes down to 9 lakh units. Thus the NAV remains at INR 12.5 per unit.

Firstly, the fund manager uses the cash balance in the portfolio to pay investors to deal with redemptions. Additionally, he may also sell some shares, if needed. However, selling shares would be of those companies that do not have the potential to move higher. These decisions are backed by proper research. 

Fall in NAV

Let’s assume that the stock prices are falling. As a result, there would be a fall in the portfolio value. Here it falls from INR 1.25 crore to 1.10 crore. Therefore the NAV is now INR 12.22 per unit (INR 1.10 crore/9 lakh units).

Now, another investor invests in the fund. The value of his investment is INR 1 lakh. However, this time for the same investment amount, he only gets 8,183.306 units. As a result of this new investment, the portfolio value increases to 1.11 crore. Therefore the total number of units now are increased by 8,183.306 units. 

It is important to remember that the above scenario is just a small example of how mutual funds work. In reality, investments/purchases and redemptions are made daily. Hence, the NAV of the fund changes daily. However, the basis of calculations revolves around the same concept.

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.

How mutual funds work - Structure

These entities are as follows:

  • 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.
  • 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.
  • 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 skills and an excellent 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, CAMS, etc., auditors and brokers.

But for understanding, it is essential to be knowledgeable about the three main entities discussed above.

How Mutual Funds work for retail investors?

Retail investors who want to invest in equities are either too intimidated or do not have the time nor inclination to do detailed research before investing. Hence mutual funds come to the rescue for many such investors.  How do mutual funds work for retail investors?

Mutual funds pool money from multiple retail investors. Retail investors receive a share in the form of units. The fund managers, using their expertise, then invests in stocks and bonds on behalf of the investors. Once the fund earns returns, it is distributed to the investors in the proportion of their investment.

Mutual funds give retail investors access to large, well-researched portfolios at affordable costs. Retail investors can invest in mutual funds in two ways.

Lumpsum Route

A one-time investment in mutual funds is made through the lump sum route. Retail investors can invest their savings, bonus, or any bulk amount though this route. There is no commitment to further investment in the lump sum route. Once the investors invest, mutual fund units are allotted in t+2 days. The minimum investment through the lumpsum route is INR 1,000 for some funds and INR 5,000 for some.

Systematic Investment Plan (SIP) Route

Regular investment in mutual funds on a fixed date is made through the SIP route. Retail investors can invest a part of their regular income through the SIP route. SIP investing allows investors to invest an amount as low as INR 500. The date and amount of investment done through SIP are prefixed. Investors can set an auto-debit option for their SIP investment. Hence, even if the investors forget, the auto-debit option ensures regular investment.

The invested funds are sent to the asset management company (AMC), and they share the information with the registrar and transfer agent (RTA). RTA’s are trusts that maintain detailed records of every transaction of investors for fund houses convenience. RTAs will check the investor history by tracking it with PAN. A folio number is assigned to investors based on investor status. Existing investors in the AMC are assigned the existing folio number. For new investors, a new folio is created. Once the folio number is assigned, units are allotted

How do mutual funds function in Demat and physical form?

The unit allotment is done either in demat form or physical form. It takes t 2 working days for units to be allotted to investors. Though both the forms are electronic, they differ in terms of account type, account statement, and expense ratio.

Physical form

In physical form, the units are dealt through AMC. The AMC directly sells the units to investors and, at the time of redemption, repurchases it. Investing through physical form means holding it in Statement of Account (SOA) form. The fund house issues the account statements. The RTA maintains all records of investors and assists fund houses to track investor’s data. Investors can get on-demand reports of their mutual fund holdings through online portals of RTAs. Physical form is cheaper than a demat form. There are no additional brokerage costs. Just the mutual fund fee.

Demat form

In demat form, mutual funds are purchased and sold on the exchange or through brokers. The buying and selling is done through a demat account. This form is highly liquid. It is because the buyer or the seller can either be the AMC or any other investor as the units are freely available. The broker with whom the mutual funds are dealt with provides a demat account statement on demand. An investor can hold mutual fund holdings and shares in one single demat account. This way, the investor can have a consolidated view of all the  types of investments. Demat or brokerage account  has brokerage charges which are over and above the mutual fund fee. Loan against mutual funds is possible under brokerage account. STP and SWP are not possible in demat form, which is possible under the physical form.

How mutual fund NAV and Unit Operate

One phrase that is commonly used in the world of mutual funds is mutual fund shares or mutual fund units. But how mutual funds NAV and units work?

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 buy mutual funds, you purchase units of those funds. A unit in a mutual fund is also commonly referred to as a mutual fund shares or a unit share. The value of mutual fund shares changes every day in accordance with the performance of the fund. The value of each unit is called the Net Asset Value (NAV).

Net Asset Value (NAV)

NAV of a mutual fund is the market value of the mutual fund unit. When all the market values of the shares of a mutual fund are added and divided by the number of mutual fund units, the resulting value is the NAV. Simply put, NAV is the price per unit 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. As one would have guessed by now, this affects each unit of the mutual fund’s value.

It 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 needs to be replaced.

It 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 an investor is allotted based on the extent of the investment.

Example

To understand this better, let us look at how equity mutual funds work with an example. An investor Ms. Aakansha invests INR 5,000 in a mutual fund. The NAV of the fund is INR 20. The number of units allotted to her is 250 (5000/20). If the NAV goes up, the value of her investment will go up and vice versa.

After a couple of months, she decides to invest another INR 5,000 in the fund. The current NAV is INR 25. The number of units now allotted to her is 200 (5000/25). The total number of units she currently holds is 450.

As the NAV goes up, fewer units are allotted to her. However, as the NAV goes down, more number of units are allotted to her. Hence, NAV and units allotted are indirectly related to each other.

Understanding a Mutual Fund Working Process 

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

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

Dividend income

If one wants to receive money at regular intervals, they can opt for a mutual fund that pays a dividend. The fund distributes that to investors as per the number of units held whenever the companies included in the chosen fund declares dividends. 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.

Capital gain

Whenever an asset that is purchased increases in value and makes a profit, it is called a capital gain. Mutual funds pass these gains on to their investors. If one invests in a growth fund, the capital gain or any kind of profit is reinvested back into the fund. Based on the fund’s performance, this will add additional fund units to the investor’s portfolio and also increase the NAV of the fund. It is the most recommended option for long-term wealth generation. This is why we only recommend growth funds at Scripbox as well.

If anyone ever wondered how do they earn from mutual funds, hope now it’s clear.

There is no set answer to how much one can earn from mutual funds. It all depends on how much one invests, how long they plan to stay invested in a particular fund, and what kind of fund they 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 an investor rich is this: mutual funds have the potential to make its investors rich if they are willing to take a bit of risk and stay invested for an extended period.

Things to keep in mind before investing

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

Educate yourself

First and foremost, try and educate 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.

Calculate budget

Try to have a very good understanding of where one stands financially. Have a clear picture of how much the expenses are and how much money can be spared for mutual fund investments. It might seem like a very intuitive step, but it also the one that is easily overlooked.

SIP or one-time investment

One can decide if they would like to opt for a SIP investment or if they would like to make a one-time lump sum investment. Find more information by clicking on SIP investment over here.

Understand financial goals

This is an absolutely crucial step when mutual fund investments are in the picture. Take the time to evaluate what immediate financial requirements are and what future financial requirements will be. Use this assessment to determine what kind of funds one should be investing in. Also, refer to an article, if you need help in understanding how to forecast your financial needs.

Decide where to invest

One should also decide how to go about investing in mutual funds. Whether to contact a fund house directly? Take the help of a broker. And so on. Scripbox has actually made the process of investing in an effective mutual fund portfolio quite simple. In fact, we follow a scientific method that completely takes the guesswork out of the way. If interested, take a look at the outlined step by step process to invest in mutual funds.

Expense Ratio

One has to always check the expense ratio before they buy mutual funds. One has to pick funds with a low expense ratio. This is because the net asset value NAV of the fund is calculated after considering the expenses. Hence a high expense ratio will have an impact on mutual funds performance.

Get the paperwork and KYC in order

like any other financial products, mutual fund investments will require all of the investor’s KYC details such as passport, address proof, and other details.

Benefits of Investing in Mutual Funds

Investing in mutual funds has its own benefits. In fact, mutual funds made investments easy and affordable for everyone. Here are some of the benefits of investing in mutual funds:

  • Affordability – Affordability – Mutual funds are probably one of the very few actually affordable investment options. Saving money has become easy than ever before. Unlike gold or real estate, where one will have to spend thousands or lakhs upfront. With mutual funds, one can start with as little as Rs. 1000 with Scripbox.
  • Diversification – Investments will have access to a diversified portfolio almost instantly. Based on the kind of fund one invests in. Mutual funds will have access to shares of different companies across multiple sectors. 
  • Professional management – As we have mentioned earlier, mutual fund investments are professionally managed by an experienced fund manager. One doesn’t have to worry about constantly monitoring the market movements. It is a huge relief, especially for a beginner.
  • Tax Saving – Mutual Fund investments offer tax saving benefits too. Investing in Equity Linked Savings Scheme (ELSS) allows investors to claim tax exemption up to INR 1,50,000. ELSS funds qualify for income tax exemption under Section 80 C of the Income Tax Act. Also, ELSS is considered to be one of the best tax-saving instrument that offers good returns with the least lock-in period of three years. 
  • Convenient and Easy – Mutual Fund investments can now be made with a single click. Fintech companies like Scripbox made this easy like never before. Investors can invest by sitting at home. The process is entirely online and paperless. 
  • Benchmark beating returns –  As mentioned above, mutual funds are managed and monitored by an experienced fund manager. His constant research and portfolio rebalancing help investors earn benchmark beating returns. 

Conclusion

Mutual funds are investment alternatives for investors seeking professional management. These also help small investors save money regularly. With more clarity on How mutual funds work, investors can now start their investments without any doubt. Scripbox is a platform that allows its investors to invest in a life goal. It also helps in rebalancing the investments when there is a deviation in the goal and investment. 

Published on February 12, 2020