Mutual funds are investment pools where a number of investors invest their money which is managed by professional fund managers who decide where to invest the funds in order to generate healthy returns.
That sounds quite simple on how mutual funds work. But bear with us, there’s much more to learn about the process of mutual funds!
Investing in the stock market is one of the most popular ways of growing wealth. The returns that you can get from putting money into different stock market instruments help you to fight inflation and earn healthy returns over the long term. There are millions of investors who have invested money into the stock market. However, a fair majority of investors are not even well aware of how these investment instruments work.
One such popular investment vehicle is mutual funds. But have you ever wondered how it works? Well, if not, then you are at the right place. In this article, we will discuss what mutual funds are and how they work.
What Are Mutual Funds?
Suppose you have quite enough money to invest in the stock market. You want to buy some top quality stocks but are not sure how to identify them. There is no other way than doing proper research which includes fundamental analysis, comparison, using a stock scanner, and whatnot. This is pretty time consuming and often tedious and even if you succeed in shortlisting such stocks, you will find it difficult to maintain the portfolio in the long run. So what’s the alternative?
You give your money to an expert who invests a heavy deal of time and effort in picking up best quality stocks and maintaining your portfolio as long as you wish to remain invested. You pay that person a fee for his/her periodically. However, it won’t be profitable for him to manage only your money so he decides to extend his services to many. Investors like you give their funds to him believing in his expertise and knowledge of the stock market. That popular guy is called ‘fund manager’, and since he/she is managing a pool of funds collected from a number of investors like you, it is called a mutual fund.
Usually, mutual funds are launched by different asset management companies or fund houses that appoint fund managers for the management of the fund.
But that’s not all! The definition given above is quite basic and only helps you to get a preliminary understanding of what mutual funds are. In reality, these investment instruments have many particularities. They are of many types, and each one of them has a different working principle. Let’s jump on to the same without any further ado.
How Do Mutual Funds Work?
Mutual funds are simple yet very interesting investment instruments. They offer an interesting solution to investors who do not have time to build a solid portfolio and manage their own. This is how mutual funds work:
Investors put their money in a mutual fund scheme. This can be done either by making a lumpsum investment or by starting a SIP (Systematic Investment Plan). The investors get fund units for the invested amount. The fund units are similar to stocks as they also carry a price (called NAV) depending on the performance of the fund.
Fund managers use the collected funds to invest in different types of instruments, which can be a mixture of market equities, debt instruments, etc. based on what type of mutual fund it is. For example, an equity mutual fund primarily invests in stocks whereas debt funds allocate the major share to debt instruments.
The mutual fund offers returns based on the performance of its holdings. For example, if the prices of the fund’s holdings increase, you will earn positive returns. Similarly, if the prices decrease, you will incur losses.
The fund house also charges an Expense Ratio, a fee levied for the management of the fund. Some mutual funds also have an Exit Load, which is a type of penalty for making an early exit (before a specified period) from the fund.
So this is the basics on ‘how do mutual funds work’. But wait, have we mentioned that there are different types of mutual funds? Yes, there are, and they work differently. The underlying working principle is the same as mentioned above but the approach is different.
In the first categorization, mutual funds are classified as equity mutual funds and debt funds.
Equity funds: Mutual funds that invest atleast 65% of the total asset (funds) in equities or equity-based instruments are called equity funds. The remaining 35% or less is invested in other market securities. Equity mutual funds carry higher risk as the major part of the holdings are stocks. However, they have high return offering potential and can help you build a solid corpus in the long term.
Debt funds: Similarly, debt funds are the funds that primarily (atleast 65%) invest in fixed interest debt securities like government and corporate bonds, and the remaining 35% or less goes into other market instruments. Returns from debt mutual funds are more on the average side, however, unlike equity funds, debt funds are more stable and carry less risk.
There are other types of mutual funds as well like hybrid funds, aggressive hybrid funds, etc., and they differ mainly on the proportion of exposure they have to equity and debt instruments.
Mutual funds also differ based on the sectors they particularly target. For instance, there are Technology funds that target mainly IT and tech stocks, then there are banking funds that invest majorly in banking and related stocks.
Ways of Investing in Mutual Funds
There are basically two ways of investing in mutual funds and the same defines the process of mutual funds.
As the name suggests, lumpsum investment in mutual funds is the way of investing a sum in one go. Like if you have Rs 2 lakhs to invest, you can invest all at once in a mutual fund. The invested money will get you units at the prevailing NAV (Net Asset Value) and you will earn returns based on the fund’s performance.
SIP Mutual Funds Investment
Not all have a lumpsum amount of money to invest in mutual funds. Most people earn monthly from which they save some amount to invest. For them, the best way to invest in mutual funds is through a Systematic Investment Plan (SIP). It allows you to invest a fixed amount of money every month in a mutual fund scheme. You can start SIP in any mutual fund and exit anytime as per your wish. You can also opt for a step-up SIP investment plan that allows you to increase the monthly contribution with time.
How You Earn Returns from Mutual Funds?
Power of Compounding
The first and foremost benefit of investing in mutual funds is that the returns you gain get reinvested in the fund as principal. This is called compounding, in which you earn interest on interest. Compounding goes on until and unless you exit from the fund. It is seen that the same helps investors to earn substantial returns in the long run.
Opting for a SIP way of investment in mutual funds saves you from a lot of hassles. You do not need to invest manually every now and then. A fixed amount of money (which is predetermined) gets deducted from your account periodically. You just have to approve a bank mandate and that’s all.
Rupee Cost Averaging
Mutual funds investment through SIP keeps a major part of market volatility at bay. When the market is booming and stock prices are high, the NAV of the fund will be high and hence the fixed amount of money you invest can buy only fewer units. On the other hand, when stock prices go on a dip, the NAV gets low, and the same amount of money will be able to buy more units of the fund. This is called Rupee Cost Averaging.
The collected funds in a mutual fund scheme are invested in not one or two but a number of stocks and marketable securities. This allows portfolio diversification which helps to contain market risks and stabilize returns in the long run.
Mutual funds are managed by professionals who have great market knowledge and expertise. They aim to invest the funds in a way and in instruments that can help to maximize returns and minimize losses. Thanks for the same, you do not have to worry about your investments in general.
For the expert management you get, you have to pay only a small amount as a fee, known as the Expense Ratio. The expense ratio in mutual funds is usually around 1-2%. Furthermore, the maximum limit set by SEBI is 2.5% for equity funds and 2.25% for debt funds.
That’s pretty much on ‘how do mutual funds work’. Let us now learn a bit about the things you should keep in mind while investing in mutual funds.
Things to Know Before Investing in Mutual Funds
Know Your Investment Objectives
Making investments without any objective or goal is more or less futile. Your investments should be goal oriented. Everyone wants to grow their wealth for their own reasons. Someone wants to buy a house, or plan for their retirement, someone wants to secure their children's future education, etc. Plan your investments based on what you want to achieve through the same. While doing so, make sure your goals are realistic so that your investments can be structured well and help you meet the set goals.
Diversify Your Investment Portfolio
Don’t invest all your money in one mutual fund, here also you should follow diversification. Invest in different types of funds, a couple of equity funds, some debt funds, ETFs, and gold funds as well. This will help you minimize risk and earn stable returns even when markets remain volatile.
Having understood this, it’s time to get a glimpse of how well you can earn by investing in mutual funds.
Average Returns From Mutual Funds
If we check historic performance, we can decipher that most mutual funds have managed to offer atleast around 12-15% annual returns to the investors. We can do a rough calculation based on the same.
Suppose you have invested Rs 5 lakhs in XYZ mutual fund. Considering annual returns to be 13%, you will have over Rs 57 lakhs by the end of 20 years. This is a whopping more than 1100% return in just 20 years.
In another case, consider that you invest Rs 20,000 in the same mutual fund scheme. With a 13% annual return and 20 years of investment, you will end up with a corpus of Rs 2.3 crores for a total investment of just Rs 48 lakhs.
The Bottom Line
Mutual fund investments are transparent and completely secure. The fund houses and asset management companies are regulated by SEBI which ensures that there are no chances of any fraud. All these features make mutual funds the most popular investment choice among investors, particularly retail investors. Now that you know how mutual funds work, it is time you begin your investment journey.
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