HOW MUTUAL FUNDS WORK?

WHAT ARE MUTUAL FUNDS?

A mutual fund is an investment instrument that collects money from potential investors who share a common financial and investment goal and invests the fund proceeds in different classes of assets, as defined by the investment vision. In easier words, a mutual fund is an intermediary set up with an objective to professionally manage the funds pooled from the investors. By pooling funds together, investors can enjoy the benefit of economies of scale and can purchase debts or stocks at much lower costs in mutual funds when compared to directly investing in the stock market. 

The other advantages of investing in them are stock and bond selection by experts, convenience, diversification, low costs, and flexibility. An investor receives units of the mutual funds which are in respect of the quantum of money invested by them. These units indicate an investor’s proportionate ownership into the assets of a scheme and their liability in case of loss to the fund is limited to the extent of funds invested. 

This pooling of funds is the biggest boon for mutual funds schemes. The relatively lower amounts required for investing in a mutual fund scheme enable small investors to enjoy the advantages of professional fund management and access to different industries, which they otherwise may not be able to reach. The finance and investment experts who invest the pooled funds on behalf of investors of the plan are referred to as Fund Managers. They take the investment decision pertaining to the selection of instruments and the proportion of investments to be made.

HOW DO MUTUAL FUNDS WORK?

A mutual fund, as we discussed pools money from multiple investors and invests the collected funds in shares of listed entities, corporates bonds, government bonds, other securities or assets, short-term money market instruments, or a combination of all these. The type of securities selected for the plan or scheme is in line with the investment objective as disclosed in the scheme document. Therefore, an equity mutual fund plan will invest predominantly in a portfolio of shares, while a debt fund will invest a significant portion of its assets in corporate or government bonds. The investment goal and objective can be further narrowed down within the asset class itself. 

Therefore, within the broader equity mutual fund category, there can be small-cap funds, mid-cap funds among others that are focused on a specific market capitalization of stocks. Based on the investment style, there can be focussed equity funds or value funds as well. 

The investments in mutual funds are managed by a fund manager. There can be multiple fund managers for a fund, based on the discretion of the AMC. The fund managers manages the fund on a daily basis, deciding when to trade investments according to the investment objectives of the mutual fund. 

The fund collects money from investors and in return allots units. This is similar to buying stocks of a company. Under mutual funds, the price of each unit of the fund is known as the NAV i.e. Net Asset Value. The assets are invested in a bunch of shares or bonds that form the portfolio of the fund. The fund manager, depending on the investment objective of the scheme, decided the portfolio allocation. 

FACTORS TO CONSIDER BEFORE INVESTING

1. Past performance:

How a mutual fund has performed in the past years can not tell you how it will perform in the future, but it can definitely help you to determine how risky or volatile the returns of that fund can be. 

2. Fees:

All mutual funds have certain fees and expenses that reduce the returns of the investment made. So investors must have a look at the expense ratio and fees before investing in any instrument. 

3. Risks Associated:

The level of risks and returns depends on what stocks or bonds the fund invest in. Mutual funds are not insured or guaranteed by any agency. So investors must invest in mutual funds as per their exposure to risk and appetite. 

4. Price to trade:

Investors purchase mutual funds at the fund’s NAV along with any sales charges. Mutual funds are redeemable, i.e. investors can sell their units at the current NAV less any fees and charge for selling/redemption. So investors must be aware of the concept of NAV and how does it work.

TAXATION ON MUTUAL FUNDS

Investments in mutual funds attract capital gain taxes. The capital gains taxes on mutual funds are of 2 types LTCG and STCG depending upon the holding period and type of scheme. Here is a quick table explaining the taxation.

THE CRUX

After reading this insightful article, you must have gained a good knowledge of the mutual fund and its workings. For more knowledgeable articles on mutual funds, you can check out this space. If you feel that you’re ready to kickstart your journey of investing in mutual funds or you are already investing and think that you need professional assistance and guidance, you can connect with ZFunds for the same.