How Mutual Funds Work?
Professionally managed, Mutual Funds enable diversification & corpus creation.
- A mutual fund is an investment option where many investors pool their money for a common financial objective.
- The performance of the underlying securities, geopolitical and economic situations, and the expense ratio affects a mutual fund scheme's returns.
- A mutual fund offers diversification, adequate liquidity, transparency, accessibility to a diverse range of investors, and professional management.
"The principal role of the mutual fund is to serve its investors."- John Bogle (American investor, business magnate and philanthropist.)
This quote captures the essence of mutual funds and as an investment option, they are among the most popular.
Let us look at how mutual funds work, the benefits of investing in them, and factors that may affect their performance.
How do mutual funds work?
Many potential investors refrain from investing in mutual funds due to the misconception that they are inherently volatile and difficult to understand. Let's address that misconception by answering some questions, shall we?
1. What is a mutual fund?
A mutual fund is an investor pool with a common financial objective. For example, those who invest in debt mutual funds are most likely looking for steady income-generation.
2. Who manages the mutual fund?
Fund managers use their expertise and knowledge to make the most opportunistic investments in various securities. These securities could be stocks, bonds, or money-market instruments such as Treasury Bills amongst others.
3. What are the methods of investing in a mutual fund?
Let's say you decide it's best to invest it in a mutual fund instead of leaving your money idle. You can choose to make a lump sum investment. But, what if you are a salaried employee who wants to invest a smaller amount from their monthly salary into mutual funds? In that case, you can choose a Systematic Investment Plan (SIP). With an SIP you can decide how much money you want to invest at regular intervals (mostly each month) into the same mutual fund. This amount will be automatically debited from your chosen bank account on the day of the payment.
How do the investors profit from a mutual fund investment?
The investor can profit in 1 of 3 ways.
- Receive an income from the share dividends or interest gained from the debt instrument.
- When the fund manager sells underlying securities for a profit, the investor receives a share of the capital gain.
- Proceeds from the sale of the mutual fund units held by you.
Benefits of mutual funds
Millions of investors look to mutual funds to make their dreams come true. Let's explore the reasons that make mutual funds such a popular investment instrument.
A mutual fund invests in different securities and different companies. In case a couple of the investments don't do as well as presumed, there will be a couple of them which do better than expected. So, even if you wake up one day to newspaper headlines about market volatilities, you don't need to panic.
The keen judgment of experienced fund managers ensures that the mutual fund portfolio is updated to reflect the market's best possible opportunities. Having a professional manage the mutual fund is beneficial for the amateur investor, who may not have a lot of insight into what constitutes a robust portfolio. A seasoned investor can also benefit from a fund manager who will quickly act upon the changing market landscape.
Provision for smaller investments
Let's say you have Rs. 500 to invest and zeroed in on multiple promising companies or securities in which to invest. You can use this amount to invest in a mutual fund through a Systematic Investment Plan. Here, you can invest a particular amount at periodic intervals, instead of investing a lump sum. This amount can start with as little as Rs. 500 and you can work towards building your investment portfolio.
An investor only needs a KYC to be able to invest in a mutual fund. You can easily invest in a mutual fund from the comfort of your couch using your AMC or bank's app.
Afraid you'll need cash urgently? With a mutual fund, you can easily redeem your investment whenever you need to. You may have to pay an exit fee or pre-exit fee for withdrawing your investment before it reaches maturity.
With SEBI monitoring all mutual funds in the country, you can rest assured that every mutual fund on the market is legitimate. SEBI also mandates certain disclosures- every fund manager's qualifications; mutual funds' past performance and Net Asset Values (NAV); portfolio held by every mutual fund. This allows the investor and potential investor to make an informed decision, and not base their decisions on pure instinct.
Factors that affect mutual funds
Indeed, calculating the returns on your mutual fund investment is not an exact science. However, an investor can have a reasonable understanding of what variables influence the returns. Let's take a look at what these variables are.
Let's take the example of an equity mutual fund where at least 60% of the underlying securities consist of stocks. What happens if the stock markets turn volatile? This will significantly impact the performance of your mutual fund as well. Conversely, if the stock market stabilises and sees exponential growth, then your mutual fund returns also gain from it.
Policy and economic changes in particular sectors
A change in domestic and international government policies can have a direct or even cascading effect on the securities underlying your mutual fund. Let's say there is a significant policy change surrounding chemical imports. This will directly increase the importance of domestic chemical manufacturing companies and improve their stock price. If you are invested in an equity mutual fund with a major stake in such companies, then your mutual fund NAV will increase as well.
Professional fund managers oversee some mutual fund schemes in AMCs or banks. These funds are called actively managed funds. There are charges for managing and distributing which account for a fund's expense ratio. This expense ratio can range from 0.5%-3%, and for an actively managed fund, it can be higher.
Competency of the fund manager
The mutual fund manager needs to be at the top of current events to manage most mutual funds' dynamic nature. They need to keep themselves abreast of geopolitics, domestic and international economies, the performance of companies, and changing market trends. This knowledge and analysis help them modify the makeup of the mutual funds.
It is possible to minimise a significant amount of risks by choosing a competent bank or AMC.
Now that you know how mutual funds work and their benefits, why not start your investment journey with some of the best schemes?
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Read up more on Mutual Funds here.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully before investing.