Mutual Funds

How mutual funds work

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.

There are a variety of mutual funds. They can also be classified into different categories on varying factors. Here’s a look at some of the types of mutual funds:


There are two key kinds of mutual funds on the basis of the constitution of the fund. This basically affects when investors can buy fund units and sell them.

* CLOSE-ENDED SCHEMES: These schemes have fixed maturity periods. Investors can buy into these funds during the period when these funds are open in the initial issue. Once that window closes, such schemes cannot issue new units except in case of bonus or rights issues.?After that period, you can only buy or sell already-issued units of the scheme on the stock exchanges where they are listed. The market price of the units could vary from the NAV of the scheme due to demand and supply factors, investors’ expectations and other market factors

OPEN-ENDED SCHEMES: These funds, unlike close-ended schemes, do not have a fixed maturity period. Investors can buy or sell units at NAV-related prices from and to the mutual fund, on any business day. This means, the fund can issue units whenever it wants. These schemes have unlimited capitalization, do not have a fixed maturity date, there is no cap on the amount you can buy from the fund and the total capital can keep growing.?These funds are not generally listed on any exchange. ?Open-ended schemes are preferred for their liquidity. Such funds can issue and redeem units any time during the life of a scheme. Hence, unit capital of open-ended funds can fluctuate on a daily basis.

The advantages of open-ended funds over close-ended are as follows:

* Investors can exit any time they want. The issuing company directly takes the responsibility of providing an entry and an exit. This provides ready liquidity to the investors and avoids reliance on transfer deeds, signature verifications and bad deliveries.

* Investors can entry any time they want. Thus, an open-ended fund allows one to enter the fund at any time and even to invest at regular intervals.

There three kinds of mutual funds based on the assets invested in. These are as follows:

* EQUITY FUNDS:?These are funds that invest only in stocks. As a result, they are usually considered high risk, high return funds. Most growth funds – the ones that promise high returns over a long-term – are equity funds.?These funds have less tax liability in the long-run as compared to debt funds. Equity funds can be further classified into types based on the investment objective into index funds, sector funds, tax-saving schemes and so on. We shall go through these in detail later.

* HYBRID FUNDS:?These are funds which invest in both equities as well as debt instruments. For this reason, they are less risky than equity funds, but more than debt funds. Similarly, Similarly, they are likely to give you higher returns than debt funds, but lower than equity funds. As a result, they are often called ‘balanced funds’.

* DEBT FUNDS: ?These funds invest in debt-market instruments like bonds, government securities, debentures and so on. These are called debt instruments because they are a kind of borrowing mechanism for companies, banks as well as the government.?Simply put, you give them money, which the company returns with interest over a period of time. After which, it matures. Since the interest payments are fixed as well as the return of the principle amount, debt instruments are considered low-risk, low-return financial assets. For the same reason, debt funds are relatively safer.?They are usually preferred for the regular interest payments. Debt funds are further classified on the basis of the maturity period of the underlying assets – long-term and short-term. Some debt funds also invest in just a single type of debt instrument. Gilt funds are an example of such a fund.

Every investor has a different reason for investing in financial instruments. Some do so for making profits and increasing wealth, while some others do so for a regular secondary source of income. Some others invest in mutual funds for a bit of both. Keeping these requirements in mind, there are three key kinds of mutual funds based on the investment objective.

* GROWTH FUNDS:?These are schemes that promise capital returns in the long-term. They usually invest in equities. As a result, growth funds are usually high risk schemes. This is because the values of assets are subject to lot of fluctuations.?Also, unlike fixed-income schemes, growth funds usually pay lower dividends. They may also prefer to reinvest the dividend money into increasing the assets under management.

* BALANCED FUNDS: ?As the name suggests, these schemes try to strike a balance between risk and return. They do so by investing in both equities and debt instruments. As a result, they are a kind of hybrid fund. Their risk is lower than equity or growth funds, but higher than debt or fixed-income funds.

* FIXED-INCOME FUNDS:?These are schemes that promise regular income for a period of time. For this reason, fixed-income funds are usually a kind of debt fund. This makes fixed-income funds low-risk schemes, which are unlikely to give you a large amount of profit in the long-run.?They pay higher dividends than growth funds. As with debt funds, they may be further classified on the basis of the specific assets invested in or on the basis of maturity.

These are funds which invest in a specific kind of assets. They may be a kind of equity or debt fund.

* INDEX SCHEMES:?Indices serve as a benchmark to measure the performance of the market as a whole. Indices are also formed to monitor performance of companies in a specific sector. Every index is formed of stock participants. The value of the index has a direct relation to the value of the stocks. However, you cannot invest in an index directly. It is merely an arbitrary number. So, to earn as much returns as the index, investors prefer to invest in an Index fund. The fund invests in the index stock participants in the same proportion as the index.?For example, if a stock had a weightage of 10% in an index, the scheme will also invest 10% of its funds in the stock. Thus, it recreates the index to help the investors earn money. Such schemes are generally passive funds as the managers need not research much for asset allocation. As a result, the fees are lower. They are also a kind of equity fund.

* REAL ESTATE FUNDS: ?These are not a sector-specific fund which invests in realty company shares. Instead, these funds invest directly in real estate. This may be by buying property or funding real estate developers.?That said, they can also buy shares of housing finance companies or their securitized assets. Risk depends on where the fund is investing the money.

* GILT FUNDS: ?These schemes primarily invest in government securities. Government debt is usually credit-risk free. Hence, the investor usually does not have to worry about credit risk.

* INTERVAL SCHEMES: ?These schemes combine the features of open-ended and closed-ended schemes. They may be traded on the stock exchange or may be open for sale or redemption during pre-determined intervals at NAV based prices.

* SECTOR FUNDS: ?These are a kind of equity scheme restrict their investing to one or more pre-defined sectors, e.g. technology sector.?Since they depend upon the performance of select sectors only, these schemes are inherently more risky than general schemes. They are best suited for informed investors, who wish to bet on a single sector.

* TAX-SAVING SCHEMES: ?Investors are now encouraged to invest in the equity markets through the Equity Linked Savings Scheme (ELSS) by offering them a tax rebate. When you invest in such schemes, your total taxable income falls. However, there is a limit of Rs 1 lakh for tax purposes. The crutch is that the units purchased cannot be redeemed, sold or transferred for a period of three years.?However, in comparison with other tax-saving financial instruments like Public Provident Funds (PPF) and Employee Provident Funds (EPF), ELSS funds have the
lowest lock-in period. An example of ELSS scheme is the Kotak ELSS scheme.

* MONEY MARKET SCHEMES: ?These schemes – a kind of debt fund – invest in short-term instruments such as commercial paper (CP), certificates of deposit (CD), treasury bills (T-Bill) and overnight money (Call).?The schemes are the least volatile of all the types of schemes because of the short-term maturities of the money-market instruments. These schemes have become popular with institutional investors and high-net worth individuals having short-term surplus funds.

Mutual funds investing section is controlled by specialist on UniversalCreditSolutions.

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