What are mutual funds — An introduction

Divya Sankar

Mutual funds work in a way to similar to a wedding buffet — you want to try a bit of everything! In this post, we’ll break down exactly what mutual funds are and how they work.

Mutual funds — your financial “buffet”

Mutual funds were first introduced in India in 1963 by the RBI and since then they’ve skyrocketed in popularity. Since 2017, for example, the number of investor portfolios in mutual funds has more than doubled from 5.6 crores to 13.1 crores in 2022.

Here are a few basic points about mutual funds to keep in mind.

  • Mutual funds are professionally managed by MF “houses” that are also called Asset Management Companies.
  • AMCs collect money from many investors to create a pool.
  • This “pool” is then invested in different types of asset classes like stocks and bonds.
  • Mutual funds are a beginner-friendly product and make it possible for investors (like you) to invest in large companies listed on stock exchanges like the Nifty or Sensex or in bonds and other securities.

How do they work?

Mutual funds are of two kinds — actively and passively managed funds.

In active funds, fund managers perform market research to make sure that a scheme is aligned with the scheme’s overall objective and hopefully beats the underlying benchmark’s performance. Passively managed funds, on the other hand, replicate indices or benchmarks. An index fund is an example of a passively managed fund that simply aims to replicate the performance of an index as closely as possible.

Step 1: New Fund Offer (NFO)

  • A new fund offer (NFO) is the first-time subscription offer for a new scheme launched by AMCs.
  • When NFOs are launched, they become a way for AMCs to raise money from the public to buy securities.
  • NFOs attempt to raise funds and are available for a limited time.
  • This means that investors opting to invest in these schemes at the offer price can do so during this stipulated period only.
  • After the NFO period, investors can take exposure in these funds only at the prevailing Net Asset Value (NAV)*

*Net Asset Value, or NAV, is the mutual fund’s total value minus the liabilities for every outstanding unit, or the market value of all assets held by the mutual fund.

Step 2: Investing money in securities

  • The pooled money is then invested in assets like shares, bonds, and government securities.
  • Fund managers decide the portfolio of the fund based on the fund’s strategy after doing thorough research across companies, industries, and macroeconomy-level analysis that attempts to maximise the fund’s returns.
  • If at any point in time, the selected securities are underperforming, fund managers replace them with better-performing securities.
  • Fund managers also use multiple strategies to choose the securities for a fund to take advantage of the market’s conditions.
  • All these efforts put in by the fund managers give investors access to large portfolios.
  • A fund manager’s continuous efforts in research, monitoring, and rebalancing the portfolio have an impact on the fund’s NAV.
  • Once the fund makes profits, they are either distributed as dividends to investors or invested back into the fund.

Dividends

  • A mutual fund could contain stocks or bonds that generate dividends from time to time.
  • These dividends are then either distributed to investors or reinvested in their mutual fund holdings, thus increasing their NAV.

Capital Gains

  • When a mutual fund’s securities appreciate in value, the fund collects a capital gain. If fund managers then sell the security, these profits (capital gains) are then distributed among investors.
  • If the fund collects capital gains but doesn’t sell the security, it increases the overall NAV. Investors can then decide to either sell their investments or hold on to them.

Are they a good option for early and/or young investors?

Mutual funds are an excellent option for beginners. Here are a few reasons why.

  • They allow you to develop investing as a habit and instil financial discipline.
  • They give you access to large and mid-cap funds, which you may not be able to afford by direct investment.
  • They’re professionally managed, saving you the effort of having to conduct your own research into stocks and other securities.

What you DO need to think about is which mutual fund you are choosing.

But before getting started, ask yourself these three questions.

  1. What is it going to cost you?
  2. How has the fund performed over the last few years?

SALT Tip: Look at the fund’s rolling returns for a more thorough understanding of how it’s fared during the good and bad times in the market.

3. Where is the mutual fund scheme investing your money?

Feeling ready? Wait! Stay tuned for the next piece in this series to know more about common mutual fund terms.

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woman | money | choices

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