How Mutual Funds Work: Guide to Unlock Investment Potential

Overview

You must have come across the line ‘Mutual Funds Sahi Hai paisa invest karne ke liye’ once in a lifetime and decided to invest in it. That’s great… But do you know Exactly How mutual fund work? And why does it deserve your attention?

Let’s try to understand this topic, For a very long period of time FDs were the most acknowledgeable mode of investment for people. But the low interest hardly makes a cut in their savings. However investing in other modes of investment like shares, bonds, and gold can give a good ROI (Return Of Investment). But do we all have the knowledge about it?

What Is A Mutual Fund?

Let’s start from the start and try to understand what exactly a mutual fund is.

There are ‘n’ number of investors who want to invest. But don’t have the knowledge of investment tools, or financial markets to invest or to let alone manage their money. This is where a mutual fund comes into play.

Think of it as you want to go somewhere and you know the destination with the way. But you do not know how to drive so you take the bus and the bus driver helps you to reach your destination. The same goes for the mutual fund – here the passengers are the investors and the driver is the fund manager who helps you to reach your financial goals by investing your money on your behalf.

It collects money from all the investors and invests in the right tools to help their funds or money grow. These investments are handled by a professional manager who manages the fund and has a good amount of experience in financial markets.

Think mutual fund as an investment basket where all the investment tools lie.

What Are Mutual Fund Units And Net Asset Value (NAV)?

Before initiating the process of investment in a mutual fund, one should know about 2 core concepts, mutual fund units and net asset value (NAV).

Investors invest their money via a fund manager and in return they are given the units of the mutual fund. A mutual fund unit represents a fraction of ownership in the assets such as stocks, bonds, or other securities that are held by the mutual fund.

Now the second is NAV –“NAV or Net Asset Value dictates the value of one mutual fund unit”. In layman’s terms, NAV is like a price tag for one unit of the mutual fund. When the NAV grows up, the fund unit tends to become more valuable and that’s how investors make money out of it. The formula to calculate is:

NAV = (total assets -total liabilities)/total number of units issued. 

But there is no need for investors to calculate it. As it is not an investor’s job to look out for NAV’s value. It helps you in analyzing the Fund’s Value like how much to invest at the time of initiation of investment or while withdrawing of investment and many more times. 

Let us make it easy for you to understand through an example:

Let’s see a guy named Rahul wants to invest 20,000 in mutual funds so he decided to invest in it on April 10, 2022.

On 10 April 2022, the NAV of XYZ Blue Chip fund company was Rs.40, that is one unit of XYZ fund cost Rs.40.

Now, Rahul invested the whole 20,000 in this fund on 10 April 2022. Therefore, he was given 500 units.

20000/40= 500 units

Now fast forward to 6 years later, on 10 April 2028, Rahul needed this fund to make his home, so he decided to withdraw it. The fund’s NAV on 8 April 2028 was Rs.60.

For Rahul, 500 units will be worth 30,000

(500*60)= 30,000 rs

The fund has given a profit of 10,000 rs to Rahul in six years.

So let’s conclude it with the fact that any return given to investors would be distributed in proportion to the number of unit investors holds. If an investor wants to exit the investment, the redemption value of each unit will depend upon the NAV on that day of security.

Also Read: Long-Term Investments

Buying mutual funds: Low NAV v/s high NAV

There is a common misconception among investors that funds with low NAV will likely perform better. So let’s debunk this myth.

The fund’s return majorly depends on two things. The first is the market and the other one is the capability of the fund manager. So don’t just put your focus on the price gain from low NAV funds, rather than make sure to analyze the fund properly. 

Also, keep in mind a mutual fund with a high NAV might be an indication of a well-managed fund. A mutual fund that performs consistently well can be seen as a continued upward movement in its NAV. Over a period of time, the continuous gains result in a high NAV. It is a classical example of “Don’t judge a book by its cover”.

How Do Mutual Funds Work For Beginners: When It Comes To Mutual Fund Investment?

A mutual fund is a sort of trust that is managed by an Asset Management Company (AMC). The AMC works in collecting funds from investors and investing that money in all forms of investment tools, like equities, bonds, commodities, and many more. The entire fund is managed by a professional fund manager and his team.

In return, managers create a portfolio of commodities, bonds, and stocks by vividly analyzing market conditions, the future performance of companies, and mutual fund investment policy.

Although, later in the time the fund manager keeps realigning the portfolio as per his judgement and knowledge of the market. Maybe they can buy some new tools and sell the old ones to gain more profit out of it. 

On the investor side, they will benefit from the growth of the fund which is directly proportional to the market if the market moves on their side and vice versa.

What are the different types of mutual funds?

By now, it must be already cleared how a mutual fund works so now let’s discuss which mutual fund has been categorised:

Investors used to get confused as to exactly where they should invest and where they should not. So SEBI which regulates mutual funds stated to companies that you can now have only major types of mutual funds.

1. Equity fund.
2. Debt funds
3. Hybrid fund
4. ETF
5. Tax saving Fund

Equity funds

Equity funds invest in the shares of different-different companies. Where the fund manager tries to offer great returns by diversifying the portfolio with varying market capitalization. Generally, equity funds are known to give better returns as compared to debt-based funds.

Debt fund

A debt fund is a mutual fund scheme that invests in fixed-income instruments or tools with a maturity date like corporate and government bonds, corporate debt securities, money market instruments, etc. that offer capital appreciation. 

The key objective of a debt fund is to generate income for investors through interest and capital appreciation. While lowering the risk associated with debt securities. These funds are often chosen by those investors who seek a stable and predictable source of income over potentially higher but less stable and more volatile returns of equity funds.

Hybrid funds / Balanced Funds

Hybrid funds are a type of mutual fund that invests in multiple types of assets. Usually, it is a combination of stocks and bonds, and sometimes they can also include gold investments. Due to the diversification, it gains balance and so also known as balanced funds.

Exchange-Traded Funds

ETF or Exchange-traded funds are exactly as the name suggests, which are funds that are traded on exchanges by, particularly following a specific index. In layman’s terms Investing in ETF provides an advantage, in that you can buy and sell funds directly from the Demat account. 

For example, let’s say, you want to invest in the IT sector but are uncertain about which companies to invest in due to many options, here ETFs provide a solution. When you purchase an ETF specific to the IT sector, you effectively invest in the entire sector. Which leads to diversifying your investment across the stocks within that sector.

Tax-Saving Funds (ELSS)

ELSS or Equity Linked Savings Schemes are Mutual fund investment schemes that help you save your money by saving your income tax. That’s why they are also called tax-saving funds. According to the Income Tax Act, under section 80c, it allows taxpayers to invest up to INR 1.5 lakh in specific securities and claim it as a deduction from their taxable income.

SIP v/s lumpsum, which one should you opt for?

SIP and lump sum are the two investment methods to invest in mutual funds:

Lump Sum investing-

Lump sum investment means putting a particular amount of money into a mutual fund all at once, Instead of gradually investing smaller amounts over time.

Benefits of Lump Sum

1. One-time contribution -Lump Sum investment involves making an investment in a mutual fund in one go. Now you can enjoy peace of mind knowing that your money is working on your behalf. Which can reduce your financial burden and allow you to focus on other areas of your life.

2. The opportunity for high return- investment in a lump sum gives you an open window to immediately put your money to work in the financial market. If the market performs decently well, then your investment will be able to generate high returns compared to rupee-cost averaging. 

3. Lower Transaction Costs- investing via Lumpsum investment will give you the benefit of lower transaction costs compared to making multiple smaller investments over time. Which can improve your overall return on investment.

SIP-

SIP stands for Systematic Investment Plan which is a popular investment method in mutual funds. Here investors regularly invest a fixed amount of money at predecided intervals (usually monthly). It allows investors to gradually build their investment portfolio over time.

Benefits of SIP

Now let’s try to understand the benefits of a SIP.

1. Rupee Cost Averaging – SIP works on the principle of rupee cost-averaging. Where it averages out the price at which you purchase units of a mutual fund. In layman’s terms, you invest a fixed amount at regular intervals. You get to buy more units when the price is low. So through the rupee cost-averaging you get the liberty to invest systematically in the mutual funds.
   
   Let’s understand with an example, what is rupee cost averaging. Assume that you invested your first chunk in a mutual fund, at the unit price or NAV at 100 rs. Next month, the price of that same unit of mutual fund comes down to Rs.80 and you decide to invest the same amount at that point also, so what is your average investment? 
   
   Somewhere between 90rs, you will get the benefit on the 90, unlike lump sum where you have to wait till the price surpasses 100rs price mark. 

2. Disciplined investing – it’s a natural human tendency that people don’t invest in a disciplined manner rather they invest randomly. But investing in the form of SIP makes you a disciplined investor. As you have to invest in the predefined time interval.

3. Flexibility – Investors can start, stop, and modify their SIP investment based on their financial goals and circumstances. Take the example of Corona, imagine you are doing a SIP of let’s say 20,000 per month, and unfortunately, because of Corona, you had to face a salary cut. Now with the cut in your salary, you are not able to invest 20,000 per month. You can pause your SIP for the time being and resume it later.

What to choose SIP or LUMPSUM?

One should make this decision on the basis of their financial goals, money management ability, and the information given above. But please keep in mind that Mutual Fund investments are subject to market risks, so read all the scheme-related documents carefully.

Conclusion

Mutual funds are a good investment option for people who seek diversification and professional management of their money. They offer convenience, liquidity, and potential capital appreciation. However, investors should carefully consider their investment objective, risk tolerance, and money management skills to make a sound investment decision that aligns with their financial goals.

FAQs

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