What is and How does mutual funds work?

Have you ever wondered how does mutual funds work? Well, you’ll be able to review the answers to two questions here in this article - what is a mutual fund and how it works. 

Think about a situation when 10-year-old wishes to buy a cricket kit, so that his 4 friends and himself could play better. But, the kit costs 500 rupees, which is a big amount for him to spend on his own. So you ask your big brother to do something about it. He knows that you get a weekly allowance of 10 rupees, so do your friends. He gives you an idea to save those 10 rupees for 10 weeks to get the kit. The big brother would be saving the money with himself, while at the end he would buy them the kit. This is exactly how mutual funds work. The 5 friends are the investors here, and the brother is the fund manager.

Let us know what mutual funds mean in technical terms and how does mutual funds work.

What is a mutual fund?

It is actually a big basket of money invested by people who share the same investment objective. This money is invested into various branches - equities, bonds, and other securities like real estate, gold, or any other. The SEBI or Securities and Exchange Board of India controls the mutual funds. 

The value of the funds called the NAV (Net Asset Value) is dependent precisely on the performance of the securities/shares it has to buy. So, once you get into the market to purchase a share, you buy the security’s performance. 

The structure of a mutual fund is three-tiered - 

1. The one who promotes the mutual fund is the sponsor.

2. Formed by the trustee, sponsors, and the AMC the fund is called the trust. Ensuring that all funds are secured is the job of the trustee.

3. The Asset Management Company (AMC) is the fund manager, which manages the investor’s money and also charges a fee for the same.

How does mutual funds work?

Both buying and selling of funds occur at the NAV of the policy invested in. The Net Asset Value is the result of the division of the value of assets and securities (minus liability) by the number of units. 

There are different ways in which an investor can transact with the mutual fund schemes - 

1. In a go/ Lump Sum - It’s a one-time investment for the investor where the entire deposit is made in one go.

2. SIP - Systematic Investment Plan is the investment of a fixed set of amounts periodically i.e. monthly, quarterly, or once in a year. 

3. STP - Systematic Transfer Plan is the transfer of certain units from one scheme to another, most probably, from debt to equity or vice versa.

4. Redemption and SWP - An investor can redeem their entire investment by selling their funds. In SWP, investors can redeem/withdraw a fixed amount as income on a periodic basis.

5. Switch - Just as the meaning of the word, this term solely means that you can switch from one fund to another, provided under the same AMC.

There are 3 ways described in which an investor can earn from mutual fund schemes - 

1. Investors can earn income from stock dividends and bond interests present in the fund portfolio. There is an option to either take their money out or probably invest and gain more out of it. 

2. If security has a price increment and the fund sells it, the capital gain is given to the investors.

3. If the holdings of the funds have a price increment but the AMC does not sell it, then the investor can sell the mutual fund for a profit. 

Mutual funds can be somewhat similar to something that we as children did, the crisp notes that we would get from our relatives would be put down in an earthen pot (gullak) by the siblings, only to be broken afterwards, to buy something. 

This article has covered two questions - what is a mutual fund, and how does mutual funds work. We hope that this article proves useful to you.