How Do Mutual Funds Work

What is a mutual fund?

A mutual fund is an investment schememanaged by an asset management company or a financial institution. It consists of a large fundthat is generated by collecting from several small investors, which in-turn is invested in financial instruments like stocks, bonds, etc.The fund is operated by professional fund managers who work towards generating returns or income for the investors.Mutual funds give the individual investor access to professionally management of their money in a diverse portfolio that reduces risk. Mutual funds offer affordability and e price and greater liquidity.

A mutual fund may be considered both as an investment as well as a company. When an investor buys the stock of an electronics manufacturing company, he is buying partial ownership of the company and its assets. The electronics company is in the business of making electronics products, its sales and services. Similarly, the mutual fund company is in the business of making the investments and generating revenues.

How Mutual Funds Work

Many people see mutual funds as a complicated and difficult to understand. But on the contrary mutual funds are a simple and effortless investment option when compared to directly investing in stocks, bonds, or real estate. Investors choose mutual funds because they offer professional fund management, a diverse portfolio, affordability, and liquidity. Mutual funds charge an annual fee from the investment for the professional services, but it is very low since it is spread among all the mutual fund investors. Mutual funds are ideal for people who do not have the time to trade in stock market markets and who find stock market very complicated.

Goal of Investing: While the intention of all investors is to get returns on their investments, the objectives for starting the investment may vary for each individual. Some may have long term goals like creating a retirement fund, some may have a midterm goal like higher education of their kids, and some others may have short-term goals like buying a house or a car.

How Does Mutual Fund Generate Returns

There are three fundamental ways in which mutual funds earns returns for the investor:

  • The mutual fund generates income from dividends from stocks and interest on the bonds that are part of the mutual fund portfolio. This income is then paid to the investors as distribution. The investor is given the option of either payments of distribution or reinvestment of the income to buy more shares.
  • The mutual fund may decide to sell securities that have increased in price and the capital gain thus made is paid out to the investor as distribution.
  • If the price of the securities held by the mutual fund increases but the fund house decides not to sell it, then the investor can sell the mutual fund for a profit.

Types of Mutual Funds

There are different types of mutual funds available to suit the individual investor based their goals, liquidity needs, investment period, and ability to take risk. Broadly, mutual funds are classified based on structure, asset type, and investment goals.

Categories by Structure

The mutual fundsare classified into three based on the structure, open-ended, closed-ended, and interval schemes.

  • Open-Ended Funds: In open-ended funds, the investor can invest to enter at any time and sell or redeem to exit the fund at any time. There is no limit on the number of units that can be bought. The units are purchased at the net asset value at that time. These funds do not have a fixed maturity period and are ideal for investors who need liquidity.
  • Closed-End Funds: In closed-end funds, the investor can invest or enter during the initial period known as new fund offer or NFO is known as a closed end fund. These mutual funds come with a pre-determined unit price and have a fixed maturity period. They are listed on stock exchanges and can be traded for liquidity. The investment will be redeemed on the maturity day automatically.
  • Interval Schemes: Interval schemes are a combination of both open ended and closed end funds. The investors can buy or sell the mutual funds at predetermined intervals.

Categories by Asset Allocation

Mutual funds are divided into different categories based on the securities in the portfolio of the funds, equity funds, debt funds, and hybrid funds.

Equity Funds: These mutual funds invest primarily in stocks of listed companies.The fund needs to invest more than 65% of the total assets in shares to be called equity funds. The returns from these investments depend on the performance of the shares in the stock market as well as the performance of the company. Equity funds can generate good returns, but the risk associate is also higher as the performance depends on market condition. Equity funds is further subcategorized into large cap, mid cap, small cap, flexi or multi cap, thematic funds, index funds, and equity linked savings scheme, which are the most popular among equity funds.

  • Large Cap Funds: Mutual funds that invest in companies ranked in the first 100 in market capitalization are called large cap funds.
  • Mid Cap Funds: Mutual funds that invest in companies ranked from 101 to 250 in the market capitalization are called mid cap funds.
  • Small Cap Funds: Funds that have invested in companies ranked below 250 in market capitalization are called small cap funds. These funds have a higher growth potential, but have a higher risk element.
  • Flexi Cap or Multi Cap Funds: Mutual funds invest in a combination of large, mid and small cap companies in varying proportions based on market and economic condition in order to manage growth of the fund and risk elements.
  • Thematic Funds: Thematic funds are funds that follow a particular theme like international stock or particular sector / industry like construction, IT or pharmaceutical.
  • Index Funds: Index mutual funds invest in companies in a particular market index like banking index or NIFTY.

Debt Funds: Debt mutual funds invest a significant portion of the funds in fixed income debt instruments like corporate bonds, debentures, government securities, and other money market instruments. Debt funds are a good option for investors who are looking for a regular income with a lower risk factor. Debt funds offer lower returns as compared to equity funds and low expense ratio. Debt funds are have subcategories based on maturity period and type of debt instruments. Liquid funds, dynamic bonds, short-term debts, gilt funds, and credit opportunity funds are some of the popular debt funds.

  • Liquid Funds: These are mutual funds that invest in money market instruments and give better returns than savings account. These are short-term investments.
  • Dynamic Bond Funds: Mutual fundsthat invest in short-term and long-term bonds with a maturity period that varies from 3 to 5 years are called dynamic bond funds. They offer good low risk investment mid-term investment opportunity.
  • Short-Term Debt Funds: Debt funds that mature in a short duration like 3 to 5 years.
  • Gilt Funds: Debt funds that invest a significant portion of the available funds in government securities are called gilt funds. They offer very low risk and stable returns.
  • Credit Opportunity Funds: These are debt funds that invest in low-rated securities. They offer good returns but have higher risk.

Hybrid Funds: Hybrid mutual funds invest in both equity and debt assets thereby reducing the risk factor. The most common types of hybrid funds are given below.

  • Monthly Income Funds: In these type of funds, the majority of funds, 80% or more is invested in debt and the remaining in equity.
  • Conservative Hybrid Funds: These funds invest at least 65% of the funds in fixed income instruments, and the balance in equity.
  • Aggressive Hybrid Funds: At least 65% of the fund is invested in shares of various companies and the balance in fixed income instruments.

Categories by Goal

The investment portfolio must suit the investment goals of the investor. Some common objective based mutual funds are given below.

  • Growth Funds: These are long-term funds that focus on capital appreciation. It is best suited for the seasoned investor as there are many risk factors.
  • Income Funds: The primary objective of these mutual funds is to provide a regular income to the investor.
  • Liquid Funds: These mutual funds are short term and ultra-short term and good for liquidity.  The funds invest in money market instruments.
  • Tax Saving Funds:These funds are tax-efficient and can be eligible for tax deductions of up to INR 1.5 lakhs under section 80C. There is however a lock-in period of three years.

Factors Affecting Mutual Funds

There are several factors that affect the performance of a mutual fund. Some of them are listed below.

Fund’s Portfolio: Portfolio refers to the type of securities that are part of the mutual fund. The performance of a mutual fund is dependent on the performance of the securities in that particular fund. For example an equity mutual fund may have 65% of equities and the remaining 35% of debts. If there is a bear market and the shares crash, the total value of mutual fund falls. But on other hand a fund with majority of debt holdings will not be as much affected and will perform better in the same scenario. Fund managers generally try to balance a fund by including different instruments in a scheme so as to attain the goal of that particular scheme and reduce risks of poor or failed performance at the same time.

Investment Environment: The investment environment refers to developments in the domestic or global economy that can have an impact on the stock market and thus the mutual funds. Government policies, changes in economy, events in the country, etc can affect different sectors or industries in different ways. A change in prices of steel prices can affect construction and thus real estate. Such a change can have a positive or negative impact on one or more sectors or industry and cause a ripple effect in mutual funds.

Professional Management: Themutual fund is managed by fund houses and professional fund managers. The fund managers and the team are key to the success of mutual funds. The fund managers are the one who create the schemes, raise the funds, identify and invest in the securities, closely monitor the performance of the securities, make buy or sell decisions, etc. One wrong decision, a momentary lapse in judgement, or an impulsive action from these fund managers can have drastic effect on the performance of the mutual fund. On the other hand good fund managers can drive a fund to success and generate good returns.

Expense Ratio: The investor has to pay fees and expenses to the fund house for managing the investments. Although the maximum expense ratio is around 3%, this can affect the returns from the fund. This will be more pronounced in schemes where the size of the fund is small and the returns are also small.

Cash Flow: If a particular mutual fund scheme attracting a lot of investors, then the fund managers will have more funds to invest further into the particular scheme thus increasing the range of investment and increasing the return on investments. But if a fund is fails to perform well, then there is a chance that the investors might withdraw funds from the scheme putting the particular scheme in further trouble.

Size of Fund: While investments into a fund can boost the performance of a particular scheme, too much funds can also be a problem. The fund managers may not be able to invest all available funds on time to generate revenues and can negatively affect the overall performance of the scheme. Thus if find size is too large it can be difficult to manage and leading to poor performance of the scheme.

Advantages of Mutual Funds

Professional Management: Mutual funds have expert fund managers who invest funds and generate revenue while minimizing risk so that the investors do not have to worry about money management.

Easy Liquidity: Mutual funds categories like open ended funds allow for greater liquidity as you can sell and exit for the NAV at any point. With closed ended schemes, you can sell them on the stock exchange and interval schemes give investors the opportunity to exit at regular intervals.

Diverse Portfolio: It is important to create a diverse portfolio while investing in order to minimise the risk of loss. Mutual funds are the smarter and easier way to achieve this goal.

Higher Returns: Mutual funds have the potential to providing higher returns and wealth generation to the investors over long term.

Well Regulated: TheSecurities and Exchange Board of India has put rules and regulations in place which protects the interest of the investors in India.

How to Invest in Mutual Funds

Mutual funds are also very investor friendly. It allows the investorsto start investing according to their budget and convenience. There are two ways of investing in mutual funds.

Lump sum investment: The investor can invest a large sum of money at one time to buy a number of units of the mutual fund of their choice.

Systematic Investment Plan or SIP: The systematic investment plan allows investors to invest systematically by putting in small amounts of money into the mutual fund at regular intervals. This makes it very convenient for anyone to start investing without much difficulty.

Important Terms in Mutual Funds

Net Asses Value (NAV): The NAV per share is the price of a mutual fund share. It is expressed NAVPS. This value is derived by dividing the total value of cash and securities in the fund’s portfolio by the total number of the outstanding shares. NAV helps in understanding how a mutual fund is performing. The NAV of a mutual fund changes as the value of the securities in the portfolio changes. NAV can be used to compare one mutual fund to another. You can also compare the mutual fund’s NAV with its market price. If market price is lower than NAV, it might be considered a good opportunity to buy.

Asset Under Management (AUM): The total market value of the investments that is managed by the fund house at a given point time is called Asset Under Management. AUM refers to how much money a financial institutions is managing for its clients and is considered an indicator of the size and success of the investment house. AUM is divided into two. It can be the total amount of assets managed for all the clients of the company or total assets managed for a specific client. AUM can fluctuate daily depending on the money flowing in and out of a particular fund. AUM is often used as a marketing tool to attract new investors.

Expense Ratio: The expense ratio is very important to the investor as the fund’s fees can impact the net profitability for the investor. It is the annual fees that the investor is charged for the management of funds. The expense ratio is calculated by dividing the total fund fees by total value of the assets in the fund. Expense ratio consists of management fees, administrative charges, and distribution fees. Expense ratio is regulated by SEBI. The highest total expense ratio allowed is 2.5% for the weekly average total net asset value of INR 100 crores. Thereafter it reduces on slabs of 300 crores to lowest of 1.75% for AUM of over 700 crores.

Points of Note

  • There are so many investment options in mutual funds that it can be overwhelming to the investor. Our financial advisors will help identify the mutual fund that best suits your investment objective.
  • Just like the stock market, there are chances of losing money in mutual funds, although possibility of losses is much less in mutual funds. Fund houses and fund managers work towards minimising losses and increasing returns.
  • Please contact our investment advisors for all your investment needs. We are here to help you.