As an investor, you look for various investment assets like equities, bonds, real estate and others to invest in. There are various investment options available in the market that can suit varying risk-return requirements.
Mutual fund is one such investment option that fits into every investor’s needs. With more than 2,500 mutual fund schemes available in India, mutual funds as an investment vehicle has become popular over the past few decades.
What are mutual funds?
Mutual fund is an investment avenue that pools money from investors with a common objective and invests the pooled money into various asset classes like stocks, bonds and other assets based on the objective of the scheme.
Fundamentally, a mutual fund is a trust consisting of investors with similar objectives and the pool of money by them is invested and managed by Asset Management Companies (AMC).
Asset Management Company employs professional fund managers for managing each mutual fund scheme using their expertise. The Asset Management Companies are approved and regulated by Securities and Exchange Board of India (SEBI).
Mutual fund trust includes sponsor, trustees, custodian and asset management company (AMC). Here is a basic structure of mutual funds in India –
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How mutual funds work?
When you consider investing in mutual funds, it is important to know how it works. You first need to understand a few important terminologies that can help you understand the concept of mutual funds thoroughly.
- Mutual fund unit: Mutual fund unit denotes extent of your ownership in that particular fund just like an equity share that represents your extent of ownership in the company.
- Net Asset Value (NAV): Net asset value or NAV is the fund’s per unit price. NAV is calculated on a daily basis at the end of market hours as the value of underlying securities in mutual fund investments change every day. Basically, NAV is calculated by dividing the total net asset value (asset – liabilities) by the number of units outstanding.
- Assets under Management (AUM): Assets under management (AUM) is the total investment value or market value of assets that a mutual fund holds.
- Fund Portfolio: Fund portfolio is collection of investments held by a mutual fund which is invested in different asset classes by the fund manager.
- Fund Manager: Fund manager is a professional appointed by the asset management company for implementing investment strategy and taking decisions to buy and sell securities using the market expertise.
Working of mutual funds is quite simple. Here is a simple step-by-step guide that can help you understand the concept or working of mutual funds.
- Like minded investors like you invest in a mutual fund scheme by pooling money.
- Mutual fund trust that collects the money allots you fund units based on the amount of investment you make. Price of each unit is referred to as net asset value (NAV).
- Fund managers appointed by the Asset Management Company (AMC) take the decision of investing money in various securities like stocks, bonds, money market instruments and other asset classes depending on the investment objective. Fund manager also decides on the allocation of the fund portfolio.
- Depending on the capital market performance, buying and selling decisions of fund managers, investments made in securities will generate profit or income.
- Returns earned from the investments into securities are passed back to the investors.
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The following chart explains the concept of mutual funds in the simplest way.
Learn more about What are the different types of Mutual Fund schemes in India?
You can also understand the concept of mutual funds easily with an example below.
Let’s say SBI Mutual Fund launches a new equity-oriented mutual fund scheme. Let’s say a fund collects INR 10 crores from 1000 investors assuming each investor invests INR. 1 lakh. In the next step, Asset Management Company allocates units. Let’s assume, the company issues units at the net asset value of INR 10.
That means, if you have invested INR. 1 lakh in the fund, you would get 10,000 units. Total of 1Cr units will be allocated to all the investors. Fund managers will now invest INR 10 crores into various stocks, say about 10 stocks which form the portfolio of the fund. Fund managers will also maintain some liquid cash to deal with redemptions.
Let’s say after a few days the portfolio of stocks grows to INR 11 crore, assuming that there is no change in the portfolio and number of investors. That means, the net asset value of the fund is now INR 11 (INR 11 cr/1 cr). If you redeem, you would get INR 1.1 lakh, which means INR 10,000 would be your gain.
This is just an illustration for easy understanding of the concept; in actual scenarios there may be buying and selling on a daily basis. Understanding the investment and its concept can help you make informed and rational investment decisions.
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