How Do Mutual Funds Work? A Complete Guide

Mutual Fund Meaning

A mutual fund is an investment vehicle that collects funds from multiple investors and invests them in securities such as stocks, bonds, money market instruments, or other assets. The collected amount is managed by professional fund managers according to the investment objective of the scheme.

Once the investor invests funds in a mutual fund, they receive units representing their share in the scheme. The value of these units is calculated through the Net Asset Value (NAV), which changes based on the value of the underlying investments.

Every mutual fund scheme has its own objective, asset allocation strategy, and level of risk. Investors can study the documents of a scheme to learn about information regarding their mutual fund's investment strategy, risk, and other details before investing.
 

How do Mutual Funds Work?

The following steps explain how mutual funds operate:

Step 1: Pooling of Funds From Investors

A mutual fund collects investments from multiple investors. The total amount collected is used to create a portfolio according to the scheme’s investment objective.

Step 2: Investment by Fund Managers

The fund manager manages the collected capital by investing in different securities based on the scheme strategy. The selection of securities depends on the type of mutual fund.

Step 3: Calculation of NAV

The value of each mutual fund unit is represented by its Net Asset Value (NAV).

NAV Formula:

NAV = (Total Market Value Of Assets − Total Liabilities) ÷ Total Number Of Outstanding Units

For example, if a mutual fund has assets worth ₹100 crore, liabilities of ₹5 crore, and 10 crore units issued, the NAV would be:

NAV = (₹100 crore − ₹5 crore) ÷ 10 crore units

NAV = ₹9.50 per unit

Step 4: Changes In Investment Value

The mutual fund NAV changes based on movements in the value of the underlying securities. When the value of the portfolio changes, the value of mutual fund units also changes.

Step 5: Distribution Of Returns

Returns from mutual funds may come through capital appreciation when the NAV increases or through distributions, if applicable under the scheme structure.
 

Ways of Investing: SIP Vs. Lump Sum

The following table highlights the differences between SIP and lump sum investing:

Types of Mutual Funds

The following are some common types of mutual funds:

Equity Mutual Funds

Equity mutual funds invest primarily in shares of companies. These funds may invest across different sectors, market capitalisations, or investment themes.

Debt Mutual Funds

Debt mutual funds invest in fixed-income instruments such as government securities, corporate bonds, and money market instruments. Their performance may be influenced by interest rates, credit quality, and market conditions.

Hybrid Mutual Funds

Hybrid mutual funds invest in a combination of equity and debt instruments. The allocation between asset classes depends on the scheme objective.

Index Funds

Index funds aim to replicate the performance of a specific market index by investing in securities that form part of that index.

Tax Saving Mutual Funds 

Equity Linked Savings Scheme (ELSS) funds invest primarily in equity-related securities and qualify for tax benefits under Section 80C of the Income Tax Act, subject to applicable conditions.

Money Market and Liquid Funds

These funds invest in short-term instruments and are generally focused on short-duration investments.
 

How You Earn Returns From Mutual Funds

The following are the common ways investors may receive returns from mutual funds:

Capital Appreciation

Capital appreciation occurs when the value of mutual fund units increases over the purchase price. The difference between the purchase value and redemption value represents the capital gain or loss.
For example, if an investor purchases units at a NAV of ₹50 and redeems them at a NAV of ₹60, the difference represents the change in investment value.

Dividends Or Income Distribution

Some mutual fund schemes may provide distributions from the scheme’s available distributable surplus, subject to applicable regulations and scheme provisions.
The actual returns from a mutual fund depend on factors such as market performance, investment strategy, expenses, and the duration of investment.
 

Things To Know Before Investing In Mutual Funds

The following are some factors investors may consider before investing in mutual funds:

Investment Objective

Every mutual fund scheme has a defined investment objective. Investors may review whether the scheme’s objective, asset allocation, and investment approach match their investment requirements.

Risk Factors

Mutual funds are subject to market risks. The level of risk may vary depending on the asset class, securities held, and market conditions.

Expense Ratio

The expense ratio represents the cost charged by the mutual fund scheme for managing investments. Investors may review this cost while comparing different schemes.

Investment Horizon

The duration for which an investor plans to remain invested may influence the choice of mutual fund category. Different fund categories may have different investment characteristics.

Fund Performance

Investors may review historical performance, benchmark comparison, portfolio details, and other available information while evaluating a mutual fund scheme.
Tax Implications
Tax treatment differs based on the type of mutual fund and the holding period. Investors may understand applicable tax rules before investing.
 

Conclusion

Mutual funds allow investors to invest in professionally managed portfolios of different types of investments, like equity, debt, and hybrid investments. The working of mutual funds consists of investment pooling, portfolio management, calculation of NAV, and changes in the value of underlying assets. Investors could analyse various things before they evaluate mutual fund schemes. Things that an investor needs to analyse include investment objectives, risks, expenses, performance information, and tax implications. Understanding these concepts can help investors gain knowledge about how mutual funds operate and also help in making effective investment planning.