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Chapter 2 How Does a Mutual Fund Work?

Many investors pool resources

Typically, a MF has a few to hundreds of thousands of investors. However, the basic concept of pooling together of funds with similar investment objective, investment process backed by professional research, easy entry and exit etc remain the same.

Mutual funds launch schemes for investors

A typical MF launches a number of schemes- each with a specific investment objective. Investors are offered units of the scheme with face value typically Rs. 10 equivalent to the amount of their investment in the scheme.

Entry and Exit into schemes

An open-ended scheme allows investors to enter or exit whenever they want. A closed-ended scheme on the other hand allows entry only at the time of new fund offering and exit when the scheme is wound up after a pre-defined period.

All mutual funds are regulated

As a Mutual Fund collects money from a large number of investors, it has to be regulated. In India, Securities and Exchange Board of India (SEBI) regulates all mutual funds on the basic principles of trust, protecting the interests of small investors, transparency and compliance with extant laws

Investors are protected by proper safeguards

The assets of a MF are held by a custodian registered with SEBI. The custodian is responsible for holding and safeguarding the securities invested through the MF, as well as the benefits due. The sponsor of a MF cannot be the custodian. This structure mitigates the risk of dishonest activity by separating the fund managers from the physical securities and investor records. The change of custodian is possible only with SEBI approval.

The role of a fund manager

There is a Fund manager to manage each scheme. The Fund manager buys and sells securities held in the portfolio based on the fund’s objectives and assessment of suitability of the investment in the portfolio. All the information about a fund manager’s background is available in Statement of Additional Information (SAI).

The expense ratio

This is the money that an investor pays annually to the Mutual Fund to manage the money. This is typically a percentage of investment that is charged annually. This covers the cost of the fund management team, and administrative costs of running the Mutual Fund’s operations, fees of service providers and distribution and marketing expenses.

SEBI caps the expenses charged to a scheme

Total annual expense is subject to a limit by SEBI depending on the fund’s AUM; maximum 2.50% p.a. on a corpus of up to Rs. 100 crores in equity funds (2.25% in debt funds), which reduces in slabs as assets grow. SEBI’s limits are calculated on a daily average AUM.

Lower the expenses, better the return

Expenses are knocked down from the market value of your investments, while calculating the NAV. Here’s how: NAV = [Portfolio Value + Dividends + Interest Income – Expenses)] ÷ [No. of Units]. In other words, if the underlying investments generated 20% return in any year, the NAV of the scheme will increase only 18% if the expense ratio is 2%. Expenses eat into NAV each year, so the compounding impact of expenses on the portfolio is very significant.

Entry and Exit Charges

There can be an entry and an exit load. However, as per the current regulations, the entry load is abolished on all equity mutual funds. The entry load where applicable is added to the NAV while the exit load is deducted from the NAV.

Key Takeaways

  • A mutual fund scheme has a few to hundreds of thousands of investors with a common objective.

  • Investors are offered units of the scheme with face value typically Rs. 10 equivalent to the amount of their investment in the scheme.

  • An open-ended scheme allows investors to enter or exit whenever they want whereas a closed-ended scheme allows buying during new fund offering and exit when the scheme is wind-up.

  • SEBI regulates all mutual funds on the basic principles of trust, protecting the interests of small investors, transparency and compliance with extant laws.

  • Expense ratio is the money that an investor pays annually to the Mutual Fund to manage funds

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