Mutual Fund 101 - Day 1 : Introduction to Mutual Funds - Part 2 - How Mutual Funds Work?

Have you ever wondered how mutual funds work and how they can help you achieve your financial goals? Mutual funds have gained popularity as a convenient and accessible investment option for individuals in India. In this article, we will demystify the workings of mutual funds, providing a clear understanding of their functioning.

When you invest in a mutual fund, your money is combined with funds from other investors who have similar investment objectives. This pooled money is then used to purchase a diverse range of securities, depending on the fund's investment mandate. Each investor owns units in the mutual fund, proportionate to their investment.

When you invest in a mutual fund, you purchase units or shares of the fund at its Net Asset Value (NAV), which represents the total value of the fund's assets minus its liabilities. The NAV is calculated at the end of each trading day and fluctuates based on the performance of the underlying securities held by the fund.

One of the key advantages of investing in mutual funds is the professional management they offer. Experienced fund managers analyze market trends, perform research on various securities, and make informed investment decisions on behalf of the investors. Their expertise and knowledge help in optimizing returns and managing risk effectively.

The money invested by individual investors is combined with that of other investors, creating a larger pool of capital. The fund manager then uses this pooled money to invest in a variety of securities such as stocks, bonds, or a combination of both, based on the fund's investment objectives.

Mutual funds provide investors with the benefits of diversification. By investing in a mutual fund, you gain exposure to a portfolio of different securities across various sectors or asset classes. This diversification helps in spreading the risk associated with individual investments. For example, if one stock in the portfolio underperforms, the impact is minimized as the performance of other stocks may compensate for it.

Mutual funds provide liquidity, allowing investors to buy or sell units on any business day at the Net Asset Value (NAV). This flexibility allows investors to access their funds when needed. Whether you want to invest additional funds or redeem your investments partially or completely, mutual funds offer ease and convenience.

Let us consider an example to illustrate how the money is allocated when an individual buys a mutual fund :

Suppose Mr. Sharma decides to invest INR 10,000 in an equity mutual fund called "ABC Growth Fund." The fund has an NAV (Net Asset Value) of INR 100 per unit. Here is how the money is allocated:

Calculation of Units:

To determine the number of units Mr. Sharma will receive, the investment amount is divided by the NAV: INR 10,000 / INR 100 = 100 units

Allocation to Securities:

The fund manager of ABC Growth Fund uses the pooled funds to invest in a diversified portfolio of securities. Let us assume the fund has allocated its assets as follows:

• 60% in stocks of various companies listed on the stock exchanges
• 30% in government bonds and corporate debt securities
• 10% in cash or money market instruments for liquidity purposes

Based on this allocation, Mr. Sharma's investment of 100 units will be distributed as follows:

• 60 units (60% of 100) will be invested in stocks
• 30 units (30% of 100) will be allocated to bonds and debt securities
• 10 units (10% of 100) will be held in cash or money market instruments

Fund Management and Performance:

The fund manager of ABC Growth Fund actively manages the portfolio, making investment decisions based on market conditions, economic trends, and the fund's investment objective. The manager may buy or sell securities within the portfolio to optimize returns and manage risk.

Over time, the value of the mutual fund units can increase or decrease based on the performance of the underlying securities. If the stocks and bonds in the portfolio perform well, the value of Mr. Sharma's investment may increase, providing potential capital appreciation.

Redemption and Exit Load:

If Mr. Sharma decides to redeem his units, he can do so by selling them back to the mutual fund. The redemption amount will depend on the prevailing NAV at the time of redemption. However, it is important to note that some mutual funds may impose an exit load, which is a fee charged for redeeming units within a specified period. The exit load, if applicable, would be deducted from the redemption amount.

By investing in the mutual fund, Mr. Sharma indirectly owns a portion of the securities held by the fund. The allocation of his money across stocks, bonds, and cash allows for diversification and reduces the impact of any individual security's performance on his investment.

It is crucial for investors to carefully review the mutual fund's investment objective, risk profile, and historical performance before making an investment decision. Additionally, staying informed about the fund's performance and monitoring any changes in the portfolio can help investors make informed choices about their investments.

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