What are Mutual Funds?

How Do Mutual Funds Work?

Here is how a mutual fund works:

Step 1: Investors Contribute Money

Multiple investors invest money into a mutual fund scheme. The combined amount forms the fund corpus.

Step 2: The AMC Manages the Fund

The Asset Management Company appoints professional fund managers who invest the corpus according to the scheme's investment objective.

Step 3: Investments are Made

The fund manager invests in assets such as shares, bonds, treasury bills, or other securities depending on the type of mutual fund.

Step 4: Units Are Allotted

Investors receive mutual fund units based on the applicable NAV on the investment date.

Step 5: Portfolio Value Changes

As the market value of the underlying investments changes, the NAV of the scheme also changes. This affects the value of the investor's holdings.

Example:

Suppose 1,000 investors each invest ₹10,000 in a mutual fund. The fund collects ₹1 crore and invests it across different securities. If the value of these investments increases, the NAV rises, increasing the value of each investor's units.
 

Types of Mutual Funds

SIP and lump sum both allow investors to invest in mutual funds. It all depends upon the investment objective of the investor, amount of capital available and market condition.

SIP vs Lump Sum – Which is Better?

SIP and lump sum both allow investors to invest in mutual funds. It all depends upon the investment objective of the investor, amount of capital available and market condition.

What is NAV (Net Asset Value)?

Mutual fund NAV is the per-unit value of a mutual fund scheme. It is calculated after considering the total value of the fund's assets and liabilities.

NAV Formula

NAV = (Total Value of Assets − Total Liabilities) ÷ Total Outstanding Units
Example:
Suppose a mutual fund has:

• Total assets = ₹150 crore
• Total liabilities = ₹5 crore
• Total outstanding units = 10 crore

NAV = (₹150 crore − ₹5 crore) ÷ 10 crore = ₹14.50 per unit

When you invest, the number of units allotted depends on the applicable NAV.

For example, if you invest ₹14,500 when the NAV is ₹14.50, you receive 1,000 units. As the NAV changes, the value of your investment also changes.
 

Benefits of Investing in Mutual Funds

Mutual funds offer several features that make them suitable for different investment needs.

• Professional Management: Professional fund managers make decisions related to investment selection and management according to the goals of the scheme.
• Diversification: Mutual funds invest in different securities and therefore the effect of the performance of a particular security is limited.
• Low Cost of Investing: Investments start from smaller sums by way of SIP or single investments.
• Liquidity: The majority of open ended schemes allow redemption of the units on any working day according to the scheme guidelines.
• Compounding: Being invested for longer periods could mean that the returns will earn returns themselves.
• Investment Tax Saving Option: ELSS mutual funds provide Section 80C deductions for those investors who come under the old tax structure.
• Range of Investment Schemes: Investors have the choice of investing in equity, debt, hybrid, index, and money market funds depending on their financial goals and risk tolerance.

According to AMFI, monthly SIP contributions continue to remain at record levels, reflecting the growing preference for disciplined investing among mutual fund investors.

Risks of Mutual Funds

Although mutual funds are professionally managed, they are subject to market-related risks.

• Market fluctuations may affect investment value. 
• Returns are not guaranteed. 
• Interest rate changes may affect debt funds. 
• Credit risk exists in some fixed-income investments. 
• Equity funds may experience short-term volatility.
   

How to Invest in Mutual Funds

Investing in mutual funds involves a few simple steps.

Steps to invest 

• Define your financial goal. 
• Select the appropriate mutual fund category. 
• Complete the KYC process. 
• Choose between SIP and lump sum investment. 
• Invest through an AMC, distributor, or investment platform. 
• Monitor your investments periodically.

Checklist before investing

• Complete KYC requirements.
• Read the Scheme Information Document (SID).
• Understand the investment objective.
• Review the applicable expense ratio and exit load.
• Invest according to your financial goals.
   

Taxation of Mutual Funds

The tax treatment of mutual funds depends on the type of scheme and the applicable holding period.

Conclusion

Mutual funds give investors an opportunity to invest in professional portfolios in various kinds of assets. The different schemes include equity funds, debt funds, hybrid funds, index funds, and ELSS funds where the investor may choose the scheme according to their investment needs and risks. Before investing in a mutual fund, it is necessary for you to know about the types of mutual funds, mutual fund NAV, taxation, and the investment procedure. You may explore and invest in mutual fund schemes via 5paisa after KYC compliance.