How do mutual funds work?

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Four different Notes sitting around a table - in the middle of the table, there’s a stack of coins - Each Note adds its own coin to the stack Four different Notes sitting around a table - in the middle of the table, there’s a stack of coins - Each Note adds its own coin to the stack

In the previous chapter, you were introduced to the basics of mutual funds. Now, it’s time to take a closer look at how mutual funds work. That is one of the most important areas to understand if you want to invest in mutual funds. So, without any further delay, let’s get started on this guide on mutual funds for beginners and take a look at the manner in which these investment vehicles work. 

 

How do mutual funds work?

In simple terms, mutual funds use a collective pool of funds to invest in different asset classes. The assets can be stocks, bonds, other government securities, money market instruments, gold, real estate and more. The strategy and investment objective are determined at the time of the fund offer itself. So, you can make an informed decision about whether or not a mutual fund is right for you before you invest in it. 

 

As for how mutual funds work, the cycle involves 4 distinct phases. Here are the details.

 

Phase 1: New Fund Offer (NFO)

Much like an IPO for shares, here is where you can invest in a mutual fund that is new to the market. This is because a New Fund Offer is the first time a new mutual fund scheme is introduced in the market. NFOs are open for a limited period of time, and they are typically more affordable than existing funds that have been traded for a while, because they are new on the scene and have no proven track record. The fund’s strategy is disclosed at the time of the NFO, and you can use this information to decide if the mutual fund may be ideal for your portfolio. Also, in case you miss out on investing in a scheme at the time of the New Fund Offer, you can always do so later, via the secondary market. 

 

Phase 2: Pooling of investors’ money

Based on the fund’s strategy and investment objective, several investors may subscribe to the New Fund Offer. This could include small and large investors. And the money collected from all of these interested investors is pooled together to form a collective corpus for investment. This method of operation makes it possible for small investors to invest in premium portfolios, which they may otherwise not have the capacity to invest in individually. 

 

Phase 3: Investment in different assets

Once the money from the interested investors has been pooled together, these collective funds are invested in different assets. The fund manager decides which assets to invest the pool of money in, based on the strategy of the mutual fund. Furthermore, the mutual fund is divided into various units, and each investor is assigned a certain number of units on the basis of the amount they’ve invested in the mutual fund. 

 

Deciding what to invest in takes a great deal of analysis and research. And fund managers thoroughly study the companies, the industries, and the general economic sectors in which they plan to invest the money. Once the initial investments have been made, fund managers typically track the assets and monitor their performance. In case any of the securities are found to underperform, fund managers may replace them with other assets that meet the mutual fund’s objective and perform as expected.  

 

Phase 4: Mutual fund returns

If the assets in which the mutual fund invests grow in value, the returns on the investment are considered to be positive. These gains may either be distributed to the investors right away, as in the case of dividend funds, or they may be reinvested into the mutual fund, as in the case of growth funds. Conversely, any losses are also borne by the investors. 

 

Understanding Net Asset Value in mutual funds

The Net Asset Value (NAV) is an important concept that can help you calculate the returns from your mutual fund easily. In simple terms, the net asset value of a mutual fund is the total market value of all the assets held in that scheme, adjusted for any liabilities therein. The NAV of each mutual fund unit is then calculated by dividing the NAV of the mutual fund by the total number of units. 

 

Here is an example to help you understand this. Let us take the following data pertaining to a mutual fund. 

 

Particulars

Amount/value

Total assets (A)

Rs. 12,50,000

Total liabilities (B)

Rs. 2,50,000

Net Asset Value of the fund (A-B)

Rs. 10,00,000

Total units in the mutual fund (C)

1,00,000

NAV per unit ((A-B)/C)

Rs. 10

 

Now, say you invest Rs. 50,000 in this mutual fund. In that case, you will receive 5,000 units at an NAV of Rs. 10 each. 

 

Over time, suppose the total assets of the fund rise to Rs. 15,00,000, with no change in the total liabilities. In that case, the NAV of the fund would become Rs. 12,50,000. And the NAV per unit would be Rs. 12.5. 

 

Now, since you have 5,000 units, your investment value rises to Rs. 62,500. 

 

Your total returns in this case would be Rs. 12,500 (Rs. 62,500 - Rs. 50,000).

 

How do you gain from investing in mutual funds?

There are many ways in which you can gain from mutual fund investments. Now that you have seen how mutual funds work, let us see what they offer you. Typically, you can gain in three different ways from your mutual fund investments. 

 

 

  • Dividends

 

Mutual fund investors can choose to receive the profits from their funds as dividends instead of reinvesting the gains back in the scheme. This is useful for people who wish to receive some secondary income. 

 

 

  • Capital gains

 

This is perhaps the most common way to gain from a mutual fund scheme. A capital gain occurs when the price of the securities in the fund have increased. So, in essence, the value of the assets in which you have invested goes up, leading to capital appreciation. The fund manager then sells the units to realise the gains and pass them on to you.

 

 

  • Increase in fund value

 

In some cases, the price of the securities may increase, but the funds may not be sold yet. However, if the fund is open-ended, you can liquidate your holdings and take home the returns from the increase in fund value. 

 

Wrapping up

This should give you a better idea of how mutual funds work. The interesting thing about mutual funds is that their mechanism of working can be very useful for beginners and for traders and investors who are not very experienced in the markets. In fact, mutual funds can help you get over some inherent investment biases too. Want to know how? Take a look at the next chapter. 

 

A quick recap

  • A New Fund Offer is the first time a new mutual fund scheme is introduced in the market. NFOs are open for a limited period of time, and they are typically more affordable than existing funds.
  • Based on the fund’s strategy and investment objective, several investors may subscribe to the New Fund Offer. 
  • The money collected from all of these interested investors is pooled together to form a collective corpus for investment. 
  • Once the money from the interested investors has been pooled together, these collective funds are invested in different assets. The fund manager decides which assets to invest the pool of money in, based on the strategy of the mutual fund. 
  • If the assets in which the mutual fund invests grow in value, the returns on the investment are considered to be positive.

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