How Mutual Fund Works

The history of mutual funds dates back to the late 1700s where money from different individuals was pooled and invested. It was a means of allowing individuals with limited means a chance to diversify their investment.

Over the past few years, the number of investors in mutual funds has been on a steady rise. The initial scepticism about investing money in sources that carry a bit of risk and are dependent on the nature of the market seems to have plateaued out. If you have been considering investing in mutual funds but are unsure of what it entails, here is all you need to know.

What is a mutual fund?

A mutual fund is an assortment of investments that comprise bonds, stocks, and funds that are owned by a group of investors and are professionally managed. A mutual fund is formed when capital is collected from a group of investors and is pooled into these investment instruments. The funds are managed collectively so as to ensure that the investors earn the maximum returns. Mutual funds in India are registered with and regulated by the Securities Exchange Board of India (SEBI).

How mutual funds work

A mutual fund is essentially a virtual company that collects money from a number of investors and collectively invests it in a variety of stocks and bonds and other investment instruments. A professional portfolio manager manages the fund and buys and sells them to ensure effective growth of the fund. When an individual invests in mutual funds, the money invested in the various securities are allocated to the investor as shares or units. The investments made in different instruments are what creates the investor’s portfolio. Therefore, when an individual invests in a mutual fund, they essentially become shareholders in the company. When the units do well, investors in the mutual fund receive a share of the profits by means of dividends.

The overall cost of a mutual fund is based on the price of each fund unit, which is referred to as the Net Asset Value (NAV) of the fund. This value is the price at which investors buy or sell their units. However, it should be noted that the NAV of a fund and the market price of a unit or share are very different. The concept of a market price of a share does not exist in a mutual fund. The NAV of a mutual fund changes constantly and is calculated at the end of every market day. The NAV is calculated by taking the total market value of all the units in a portfolio minus any liabilities, divided by the number of outstanding shares. If the NAV of a mutual fund increases, additional units are allocated to the investor. If the NAV decreases, the number of the units held by an investor decreases.

Types of mutual funds

Mutual funds are differentiated based on the investment risk involved. They can be broadly classified into 3 categories:

  • Equity fund: A mutual fund that invests primarily in the stock market in order to generate higher returns.
  • Debt fund: A mutual fund that invests primarily in bonds and debt securities that generate a fixed income.
  • Hybrid or balanced funds: A mutual fund that invests in both stocks and bonds.

Advantages of investing in mutual funds

One of the major advantages of mutual funds is the fact that they allow investors a chance to diversify their investment portfolio. Since capital from a number of investors is pooled together and investments are made in a number of stocks and bonds, investors have the opportunity to make investments that they otherwise may not be able to afford. Furthermore, since the amount invested is spread across various types of investment instruments, it minimises the risks for the investor. Additionally, mutual funds are managed by professionals who constantly monitor the performance of the fund so as to yield high returns. Mutual funds are one of the easiest ways for investors to grow their wealth without having to compromise on their risk appetite.

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