Mutual funds collect money from many investors and then invest it in various assets. But how do mutual funds work? This blog post will explain the key steps, from pooling money to calculating returns, in a way that’s easy to understand.
📌 What is a Mutual Fund?
Mutual funds are professionally managed investment pools that pool investors’ funds to invest in various financial instruments, including stocks and bonds. They offer investors the advantages of diversification, professional portfolio management, and enhanced liquidity.
In India, SEBI ensures mutual funds are safe and transparent for people who invest.
📌 Understanding How Do Mutual Funds Work
Mutual funds are a popular investment option that allows individuals to pool their money to invest in a diversified portfolio of stocks, bonds, or other assets. These funds are managed by professional fund managers who aim to maximise returns while managing risks according to the fund’s objectives.
Let’s walk through the process of how mutual funds operate, step by step:
1. Investors Pool Their Money
When you invest in a mutual fund, your money is combined with investments from other investors. This creates a large pool of funds, allowing diversified investments across multiple assets.
2. Fund Manager Allocates the Investments
A professional fund manager appointed by the mutual fund company (also known as the AMC or Asset Management Company) decides how to invest the pooled money. The investments are made in different financial instruments like:
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- Equity (Stocks) – Shares of companies for growth-oriented funds.
- Debt (Bonds, Government Securities) – Fixed-income instruments for stability.
- Hybrid Funds – A mix of equity and debt for balanced returns.
3. Net Asset Value (NAV) Is Determined
The mutual fund is divided into units, and each investor is allotted units based on their investment amount. The price of these units is called the Net Asset Value (NAV), which changes daily based on market performance.
4. Returns Are Generated
Mutual funds generate returns in three main ways:
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- Capital Appreciation – When the value of the fund’s assets (stocks/bonds) increases over time.
- Dividends and Interest Income – Some funds distribute earnings from dividends (stocks) or interest (bonds) to investors.
- NAV Growth – If the NAV increases, the value of your investment grows.
5. Investors Can Redeem Their Investment
Investors can sell their mutual fund units anytime (except for closed-end funds or ELSS with a lock-in period). The amount received depends on the latest NAV.
6. Taxation and Charges
Mutual fund investments may have tax implications based on how long they are held:
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- Short-Term Capital Gains (STCG) – Taxed at a higher rate if redeemed within a year.
- Long-Term Capital Gains (LTCG) – Lower tax rates apply if held for over a year.
Additionally, mutual funds may charge fees like expense ratio, exit load, and fund management charges.
Understanding How Do Mutual Funds Work with Examples
Let’s consider two investors, Vanshika and Adhiraj.
| Feature | Vanshika (Equity Fund) | Adhiraj (Debt Fund) |
|---|---|---|
| Investor Profile | Young Marketing Professional | Senior IT Consultant |
| Investment Goal | Long-term wealth creation through stocks | Safer, steady returns |
| Investment Type | Equity Mutual Fund | Debt Mutual Fund |
| Investment Method | Systematic Investment Plan (SIP) | Lump Sum |
| Investment Amount | ₹5,000 per month | ₹ 2,00,000 |
| Investment Period | 10 years | 15 years |
| Total Investment | ₹6,00,000 (₹5,000 x 12 months x 10 years) | ₹ 2,00,000 |
| Primary Investments | Stocks | Government Bonds & Corporate Debt |
| Assumed Average Return | 12% per annum | 7% per annum |
| Estimated Growth | Approximately ₹11,61,695 | Approximately ₹566,363 |
| Key Benefit | Potential for higher growth through compounding | Steady, predictable returns with lower risk |
📌 The Mutual Fund Process
1️⃣ Pooling of Money:
Investors like Vanshika and Adhiraj contribute their funds to a collective pool within a mutual fund. This pooling allows for a more significant sum of capital to be invested, which is a key advantage.
When you invest in a mutual fund, you buy ‘units,’ the more money you put in, the more units you get.
2️⃣ Fund Management:
A professional fund manager with expertise in financial markets is responsible for strategically investing the pooled capital.
The fund manager conducts extensive research to select suitable investments that match the fund’s goals, such as growing money or earning income.
The fund manager actively monitors the investments and makes changes based on market conditions.
3️⃣ Diversification:
The fund manager mitigates risk by diversifying investments across various securities, including equities, fixed-income instruments, and money market instruments.
This diversification approach diminishes the effect of any individual security’s underperformance on the fund’s aggregate returns.
Investments can be allocated across various sectors, company sizes, and geographical locations to achieve broader diversification.
4️⃣ NAV (Net Asset Value) Calculation:
The fund’s Net Asset Value (NAV) is determined daily, specifically after the trading session.
The NAV, or the market value of each unit, is obtained by taking the fund’s assets, subtracting any liabilities, and then dividing by the total number of outstanding units that investors hold.
The calculation provides a transparent view of the fund’s value by mirroring the current market price of its underlying assets.
5️⃣ Return Distribution:
Investors earn returns through three primary mechanisms:
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- Dividends: Payments are distributed from the fund’s profits, typically from stock investments.
- Interest: Income earned from bond and money market investments.
- Capital Appreciation: Increase in the market value of the fund’s holdings, resulting in a higher NAV.
These returns are distributed to investors proportionally to their unit holdings.
6️⃣ Liquidity:
Mutual fund units are generally liquid, meaning investors can redeem them for cash anytime.
The redemption price is based on the fund’s current NAV.
However, certain funds, such as Equity-Linked Savings Schemes (ELSS), have mandatory lock-in periods, during which investors cannot redeem their units.
Withdrawal requests are usually completed within a few business days.
📌 Factors Affecting Mutual Funds
Several factors influence mutual fund performance, including returns, risk, and overall market behaviour. Understanding the below factors can help investors make informed decisions.
1. Market Conditions
Mutual funds’ performance depends on market trends, economic cycles, and investor sentiment. A bull market (rising prices) boosts equity fund returns, while a bear market (declining prices) can negatively impact them.
2. Interest Rates
Changes in interest rates affect mutual funds, especially debt funds. An increase in interest rates causes bond values to decrease, resulting in reduced returns for debt mutual funds. Conversely, falling interest rates increase bond prices, benefiting debt fund investors.
3. Inflation Rate
High inflation reduces the purchasing power of money, impacting investment returns. Some mutual funds, like equity funds, may provide returns that outpace inflation, while debt funds might struggle in high-inflation environments.
4. Fund Manager’s Expertise
A skilled fund manager is crucial in selecting the right assets, managing risks, and maximising returns. A poorly managed fund can underperform even in favourable market conditions.
5. Asset Allocation and Diversification
A fund’s asset mix (equities, bonds, cash, etc.) and diversification strategy determine its risk and return potential. Well-diversified funds reduce risk by spreading investments across multiple sectors and asset classes.
6. Expense Ratio and Fees
The expense ratio is a fee that every mutual fund charges to pay for its management. Selecting funds that balance cost and performance is crucial, as a high expense ratio can negatively impact your returns.
7. Government Policies and Regulations
Changes in tax laws, SEBI regulations, and monetary policies impact mutual fund investments. For example, tax revisions on capital gains can influence investor preferences for equity or debt funds.
8. Economic Growth and Corporate Performance
Equity mutual fund performance is directly tied to economic growth and how well companies are earning. A strong GDP and rising profits lead to higher stock prices, while economic slowdowns can cause market declines.
9. Foreign Investment and Global Factors
International events, foreign investments, currency fluctuations, and geopolitical risks can affect mutual funds, especially those with global exposure or investments in export-driven companies.
10. Investor Behaviour and Sentiment
Market movements are often driven by investor psychology. Factors like fear, greed, and speculation can cause fluctuations in fund NAVs, leading to short-term volatility.
📌 Final Words
Mutual funds offer a smart and convenient way to invest, whether you seek growth, stability, or income generation. However, their performance depends on market trends, interest rates, inflation, and fund management. Knowing these factors will help you make better investment choices.
At VSJ FinMart, we simplify mutual fund investing by providing expert guidance and personalised recommendations. Whether a beginner or an experienced investor, we help you navigate the market confidently.
Think you know mutual funds? Challenge your beliefs with our myth-busting YouTube playlist.
📢 Disclaimer
Mutual fund investments are subject to market risks, so read all scheme-related documents carefully before investing. Past performance is not indicative of future results. The information provided in this blog is for educational and informational purposes only and should not be considered investment advice. Investors should consult their financial advisors before making any investment decisions. VSJ FinMart is an AMFI-registered mutual fund distributor (MFD) that does not provide portfolio management or stock advisory services.