how-mutual-funds-work

What is a Mutual Fund & How does it work?

You spend most of your life earning and spending money while saving some, every month, for your future. But is that enough? Why not make money even when you’re asleep? Instead of letting your hard-earned income sit idle, you can invest it and let it multiply.

However, when it comes to investment, the risks associated with the financial market can be overwhelming. Moreover, it isn’t easy to invest and trade in the stock markets. So, how can you earn more from the income you’ve already earned? Here come the Mutual Funds. They’re the diversified investments you can make to earn high returns.

What is Mutual Fund?

A pool of money collected from different individuals, also known as small investors, to invest in different kinds of assets like stocks, bonds and securities are known as mutual funds. Depending on the purpose behind the investment, the mutual fund companies buy or sell different assets on a regular basis. This purchasing and selling of assets and managing your funds are done by a professional.

The mutual funds’ investment companies own a variety of assets like shares, bonds, debentures and other securities which when combined are known as a mutual fund portfolio. Depending upon the performance of the assets in the market, the mutual fund companies expect an annual average mutual fund return. These returns are distributed among the investors according to the amount they had initially invested.

Hence, if you learn how to invest in mutual funds, how mutual funds work and earn high returns using the expertise of the money managers, you’ll be able to diversify your income and see it grow.

According to a report on August 31, 2018, the Mutual Funds Indian industries own around ₨ 25 trillion of assets which were Rs 10 trillion in May 2014. This rise in the mutual fund portfolio has been quick and shows that common people like you are benefitting from it in large numbers.

To understand how mutual funds work, you need to know what types of mutual funds are available in the market.

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Types of Mutual Funds

There are different types of mutual funds in India, and they can be classified according to their asset class, structure, the motive behind mutual funds investment and the risks associated with them.

According to the asset class, mutual funds can be equity, debt, hybrid or money market funds.

  • Equity funds – These are high-risk mutual funds as the money is usually traded in the stock market. Here, the risk associated is more as the chances of losing your money remain high.
  • Debt Funds – Ones with fixed mutual fund interest rate and maturity period like Government bonds, treasury bills and debentures of different companies are known as the Debt funds. If you’re new to learning how mutual funds work and are up for low risks, these are the best mutual funds for you.
  • Hybrid Funds – These bring you the best of both worlds – the stocks as well as bonds and securities.
  • Money Market Funds – When you trade money in the money market by investing in securities like treasury bills, certificate of deposits or bonds, mostly issued by the Government, they are the money market funds. These are not high-risk mutual funds and are perfect for short-term mutual funds investment.

Based on their structure, the different types of mutual funds can be open-ended or close-ended. The open-ended mutual funds are available all year for the subscription and do not have a fixed maturity period. Moreover, these funds can be bought or sold anytime at a price depending on their Net Asset Value (NAV).

Note: Net Asset Value is the market value of the assets minus the expenses incurred for its management. The expenses are usually charged by the mutual fund companies.

On the other hand, the close-ended mutual fund’s investment usually has a stipulated maturity period and the number of units to be invested is fixed.

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The objective behind investing in mutual funds also serves as a classification tool. To learn how mutual funds work, you must first understand the purpose behind your investment goals. According to the objectives, mutual funds can be growth funds, income funds, liquid funds, tax-saving funds, capital-protection funds, and pension funds.

  • Growth funds – When money is invested in stocks for higher returns, they are called Growth funds. They are the high-risk mutual funds.
  • Income Funds – Are the ones that provide you with fixed incomes on a regular basis like bonds and debentures.
  • Liquid Funds – Mutual funds investment can be made for a short time period through these. They are usually the money allocated to the certificate of deposits and treasury bills which generally have a maturity period of up to 91 days or less. These types of mutual funds are initiated for the purpose of enhancing liquidity.
  • Tax-Saving Funds – Basically help in the deduction of taxes under the Income Tax Act, thereby saving your money.
  • Capital-Protection Funds – When funds are divided between assets that provide a fixed income and shares, they are known as capital protection funds.
  • Pension Funds – When one wants to have a regular income after they retire, the pension funds become useful then. The average mutual fund return, in this case, can either be provided to you in a lump sum or as a pension.

Note: Income funds are known to be more beneficial for people looking for returns with lower risks.

Mutual funds can also be divided in terms of specialty. If the funds are allocated in certain special fields like real estate, global companies, commodities, etc., they are known as specialty funds.

Similarly, the amount of risk associated can also define the different types of mutual funds. Some have a high risk like the stocks; some have a medium-level risk and some low.

Bust a Myth: People who are not used to the concept of how mutual funds work often believe that one needs a huge amount of money to invest in mutual funds. But that’s certainly not true. One can start investing with an amount as little as Rs 500.

Are there any Advantages of Mutual Funds Investment?

We have been talking a lot about the concept and types of mutual funds and how mutual funds work. But how are they beneficial to the investors? Let’s take a closer look at that:

  1. Your money multiplies over time due to the high average mutual fund returns – Getting high returns on your already-earned income is the prime motive behind mutual funds investment. The increase in the average assets with the mutual fund companies reveals how wonderfully the investors have been gaining from it. The equity funds are known to have boosted returns by 11-15% in the last ten years.
  2. Professional management of funds – Your money is managed by a group of skilled professionals who analyze the performance of different assets in the market and have all the required knowledge of how to invest in mutual funds, how mutual funds work when to buy or sell assets and more. Hence, your funds are always in safe hands.
  3. Diversification of investment – There are a number of risks when you’re playing in the financial market. Investing in the wrong company or wrong asset can lower your returns. Sometimes, you might lose all your money. Hence, mutual funds investment gives you the chance of earning more by maintaining a mutual fund portfolio and negating the prevailing economic and political factors.
  4. The mutual fund investments provide liquidity facilities – Investors can take back the funds they’ve collected in the fund any time at a price determined by the NAV. One can also sell or repurchase the assets they hold.
  5. Complete information – Pooling your money in the mutual fund companies helps you gain a variety of information. Be it learning how mutual funds work, how to invest in them or gathering information about different assets, their prices or market conditions, they provide you with detailed information.
  6. The mutual fund companies take care of your investment objectives – Be it choosing the scheme of your choice or switching from one type of mutual funds to the other, everything will be taken care of.
  7. Tax Benefits and Investment Regulation – The mutual fund companies get to enjoy a number of tax benefits. The dividends & interests earned by them are not taxed. These benefits trickle down to the investors’ kitty. Similarly, the income earned by the investors under ELSS is subject to tax deduction under Section 80C of Income Tax Act, 1961. Moreover, all the activities of the mutual fund’s investment companies are regulated & monitored by Securities and Board Exchange of India. Hence, your interests are always protected.

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Disadvantages of Mutual Funds

Every coin has two sides to it. Doesn’t it? Similarly, mutual funds do bring in certain disadvantages. What are they?  

  1. Too many risks – Investing in mutual fund companies do have a lot of risks. They invest in the stock market which is highly volatile. They do provide higher average mutual fund returns, but the risk they pose cannot be ignored.
  2. Your monies are managed by someone else – Even though the money managers are professionals and are experts who know how mutual funds work, you lose control over your own funds. You cannot manage your own mutual fund portfolio as it depends upon the expertise of the professionals.
  3. Additional expenses – You will have to pay fees and extra charges for the management of your money by the mutual fund companies.

Bust a Myth: It is believed that only the best mutual funds schemes guarantee high returns. But it’s untrue. The schemes are subject to market conditions. Hence, the ones with a good performance today do not guarantee the same performance a month later. Keeping a check on its performance over a period of time will help you in the short & long run as well. 

Now, let’s understand How Mutual Funds work

how-mutual-funds-work

How Mutual Funds Work

To understand the working of the mutual fund companies, one needs to know their structure. It differs from one nation to another. We present you the structure of Indian mutual funds industries.

The mutual funds’ investment companies are made up of the following constituents:

  1. The Sponsor – The person who establishes the company and gets it registered under the guidelines of SEBI. He must hold a clear record, and his contribution to the asset management company must be at least 40%.
  2. The Mutual Fund Trust – Under the guidelines of Indian Trusts Act, 1882, the mutual fund shall be established, and a Board of Trustees shall be appointed to manage the operations of the trust.
  3. The Asset Management Company (AMC) – The Board of Trustees constitute an AMC to protect, manage and look after the interests of the investors. They manage the mutual fund portfolio according to the regulations of SEBI.
  4. The Custodian of Securities – The one in charge of safeguarding the assets of the mutual fund companies is known as the Custodian. He needs to be registered under the SEBI Regulations Act, 1996. He is appointed by the Board of Trustees.
  5. The Depository Participant – Holds the dematerialized assets.
  6. Bankers – With the help of bankers, the purchasing and selling of assets, payment of the average mutual fund returns, sale proceeds and all other expenses are carried out.
  7. Brokers – They are the agents who facilitate the selling of different mutual fund assets.
  8. Transfer Agent – He is the one who manages the registration of the investors or the mutual fund unit holders.

So, to make mutual funds investment, all the constituents work together. In return, the investors like you as well as the mutual fund’s investment companies receive returns on the assets they hold.

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The Simple Framework explaining How Mutual Funds Work

The mutual fund trust sells assets according to the different schemes regulated by the SEBI. The investors purchase these units and in return pool an amount of money in the mutual fund companies. The Board of Trustees makes sure the schemes and management of the asset units are done in accordance with the regulations of SEBI and the interests of the investors are taken into consideration.

The AMC submits reports of their operations to the Board of Trustees on a quarterly basis, and the Board presents it to SEBI once in 6 months.

The AMC must also submit statements or certificates to the applicants who have pooled their funds in the company. Guaranteed returns are provided to the investors after the maturity period of the assets is over.

Note: There were only 4 in 100 Indians who invested in the mutual funds in the year 2015. However, according to the Association of Mutual Funds in India (AMFI), due to the prevailing “Mutual Funds Sahi Hai” campaign, the number of investors has been on the rise. Last year, Indian financial market welcomed 32 lakh, new investors.

What are some of the Best Mutual Funds in India?

After gathering enough knowledge on how to invest in mutual funds, you will want to know about the top-rated mutual funds. Keeping the different types of schemes floating in the market in mind, some of the best mutual funds are ICICI Prudential Equity & Debt Fund, Axis Blue-chip Fund, Invesco India Tax Plan, ICICI Prudential Blue-Chip Fund and HDFC Short Term Debt Fund.

How about some Success Stories of Mutual Fund Investors?

People who decided to invest in mutual funds made sure they saved for their future wisely. Here are certain success stories of investors whose lives took a happy turn due to their correct financial planning.

Mr. Sunil Tambe, MD of Balaji Tambe Healthcare invested in mutual funds in the period of 1996-98 for the first time and has been a regular investor since then. Apart from mutual funds, Mrs. & Mr. Tambe have invested in bank FDs, real estate and more. Initially, returns from equity funds resulted in losses, but gradually, after switching to better schemes, money started flowing the right way.

Pramod Thatte, an investor, based in Navi Mumbai was initially into close-ended schemes of Unit Trust of India. Those were the days when UTI was flourishing. But after UTI saw a downfall in 2001, Mr. Thatte put his best foot forward. He started investing in private mutual funds and now, has a mutual fund portfolio return of 15.50%.

So, what does that tell you? You can be a successful investor as well. If needed, you can take the help of professionals who will help you learn how to invest in mutual funds and explain you the exact procedure of how mutual funds work. Now, let your money grow even when you’re sitting idle and see how your financial conditions change over time.

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