How Do Mutual Funds Work?

Published On: 27-Jul-2020

Mutual funds have emerged as a preferred investment option among retail investors due to the benefits of professional fund management and ease of investing. As a new investor, many people have this question in mind - how do mutual funds work? What do Asset Management Companies (AMCs) do with the small investments that individuals provide?

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Here, we will discuss how a mutual fund works and in the later section, we shall also take a look at how mutual funds work with an example.

Before addressing the functionality of mutual funds, let take a look at some important terms in mutual fund investments.

1. NAV (Net Asset Value)

NAV or Net Asset Value is the actual value of the fund as on a particular date. It helps investors in understanding the performance of the fund periodically. NAV of a mutual fund is calculated by deducting the scheme liabilities from the valuation of all assets and dividing the same by the total outstanding units. Mutual funds are required to calculate the NAV every business day.

2. AUM (Asset Under Management)

AUM refers to Assets Under Management and reflects the mutual fund scheme's overall funds. In simple terms, it gives information about the total fund size of the scheme. Hence, it can help investors make better decisions while investing in a specific mutual fund plan.

3. Factsheet

It is a document containing the details of the mutual fund scheme, its performance, fund manager details, portfolio holdings, key scheme ratios, etc. Such information helps investors monitor and review their investments.

4. Alpha

Alpha refers to the outperformance of the mutual fund scheme against its benchmark index. If the alpha is negative for any fund, it denotes that the fund has underperformed the benchmark index. Therefore, investors can take appropriate actions and invest money in the top-performing funds. However, it is a good practice to review the Alpha Index once a year; this way, an aggregated understanding of the fund can be sighted instead of the fluctuations seen due to market movements.

Now that the basic glossary for mutual funds is clear, let’s answer this question - how do mutual funds work?

How mutual funds work:

Amount pooled in by the investors

After years of research and expertise of fund managers is put on paper; a mutual fund scheme is derived for retail investors. Once the scheme is created, a New Fund Offer (NFO) of the same is launched by the mutual fund house. Post the NFO, many schemes may be kept open-ended, which means that they are open for subscription and redemption on all business days and do not carry a fixed maturity date. As such, eligible investors may invest in such schemes on any business day.

Investors may choose a certain mutual fund scheme based on their risk profile, financial goals, and investment horizon. One may invest in mutual funds digitally through the mutual fund house's website or mobile app or by physically submitting the application form at the official Points of Acceptance.

Processing of investment transaction by the mutual fund

The Securities and Exchange Board of India (SEBI) has prescribed uniform cut-off timings for different mutual fund schemes, viz 1.30pm for liquid and overnight schemes and 3pm for other funds.

All the mutual fund transactions received before the cut-off time are processed on the same day at the prevailing NAV for the mutual fund scheme. The transactions received after the cut-off timings are processed on the next business day.

Creating an investment portfolio

When the mutual fund scheme receives the amount, the same must be deployed in the declared investment options, depending on the respective scheme's investment objective and disclosure.

For example, an equity fund will predominantly invest in equity securities in the respective proportions as disclosed in the scheme documents. Similarly, a debt fund will invest mainly in debt securities and funds. Whereas a hybrid fund invests in both equity and debt securities.

These categories of mutual funds are further bifurcated into different schemes to offer a wide spectrum of options to suit investors with varied risk appetites and financial needs. The fund management team will create a diversified investment portfolio comprising several stocks/securities/bonds/commodities to achieve the desired investment objective. Further, the fund may also keep a reasonable amount of its net assets in liquid assets to meet the regular redemption requests.

Professional fund management

The investment portfolio is managed by professional fund managers duly backed by a team of research analysts. The fund management team's role does not end with making an investment portfolio but continuously monitoring, reviewing, churning and switching the securities depending on internal research, external rating actions, changes in macroeconomic dynamics, and statutory and regulatory changes etc.

The fund management team may consider various factors while making an investment decision, which may be based on management interactions, financial results, analyst meets, regulatory disclosures, etc.

With the basic understanding of how mutual funds work, it should be simpler for investors to choose the right mutual fund schemes. The role of fund managers in working of a mutual fund is vital as it requires timely action, continuous monitoring, and strategic investment approach. Since mutual fund investments are long-term; rework and optimization in the specific fund is essential.

How mutual funds work - Example

Let’s consider an AMC is launching a mutual fund by the name of Equity Fund A; then the working of the fund will be as follows:

  • Equity Fund A will have an NFO declaring the securities that are part of the scheme.
  • Based on the NFO, retailors and investors start their initial investment in the scheme. Once the initial investment is cut-off, the AMC then evaluates the investment value.
  • The total money accounted is then invested in the securities of Equity Fund A; the proportion may remain the same as declared in the NFO.
  • Once the fund starts, the fund managers evaluate the performance and based on data, insights, regulations and several other external factors, the proportion(s) and/or securities keep changing to ensure that the best possible return on investment is provided to the investors.

A few other things to know about how a mutual fund works

  • Mutual funds pool the investors' money and invest such money in a basket of securities as per the investment objective of the scheme.
  • The investment portfolios are valued on daily basis and their fair value for each unit of the mutual fund scheme, referred to as Net Asset Value (NAV), is disclosed at the end of each business day. All transactions an investor makes with any mutual fund, be it new purchases, redemptions or switch transactions, are undertaken at the NAV. Further, if redemptions are made within the exit load period applicable to the scheme, then such transactions shall be subject to the respective fee.
  • SEBI has notified different categories of mutual fund schemes offered by the AMCs. The investment pattern of such schemes is defined through this categorisation.
    • For example, a large cap fund invests predominantly in securities of large cap companies (minimum 80% of its assets in large cap) for long-term wealth creation.
    • Similarly, a liquid fund invests in debt and money market securities with a maturity of up to 91 days. Investors may choose the mutual fund scheme to suit their financial goals, risk appetite and investment horizon.
  • SEBI has prescribed a ceiling to the Total Expense Ratio (TER) to the mutual fund schemes to protect investors’ interests. The overall expenses should not exceed the specified ceiling. If an investor has invested in direct plans, distribution expenses are not charged to such plans, the total expenses of direct plans shall be lower compared to regular plans to the extent of distribution expenses.

Now that working of mutual fund investment is clear, you may consider to start investing today.