How Do Mutual Funds Work?


As a mutual fund investor, you put your money in financial assets like stocks, bonds, and other securities. Now let us understand how your investments in mutual funds work.

The Asset Management Company (AMC) invests in different asset classes on behalf of the investors. The investment strategy is based on the nature and style of the mutual fund scheme(clearly defined in its investment objective). For instance, large-cap mutual funds will invest majorly in stocks of large cap/blue-chip companies. unfold

Compared to direct investments, mutual funds have a upper hand. You may not have the knowledge to identify market trends on your own or the time to do so. Mutual funds are a great alternative in this case, as they are managed by professionals like fund managers. Depending on the objective of the fund, the fund manager makes the final decision about investing techniques.

In some cases, the fund manager chooses to invest primarily in stocks that have a strong likelihood of generating superior inflation-beating returns. Due to this, many investors have the impression that mutual funds solely invest in the equity markets. But this is not exactly true. If you are a conservative investor and do not prefer to take too much risk, then through Debt Mutual Funds, you can also invest in debt instruments, where the risk factors are much less as compared to equities.

Here is an example to illustrate how mutual funds work:

Now when you invest in a Mutual Fund Scheme, the Asset Management Company or AMC allots you the units as per the NAV of the Mutual Fund. For example, let's assume that you have invested Rs 5,000 in a mutual fund scheme, and you have been allotted 100 units, for which the NAV is Rs 50.

The mutual fund's NAV rises to Rs 55 in the following year. This indicates that you received a 10% return on your mutual fund investment over the last year. In this manner, you may keep track of your assets and determine the returns on your mutual funds.

What are the factors involved in mutual funds?

While investing in mutual funds, you need to be aware of several factors and terms that have an impact on the mutual funds:

  • Net Asset Value: The cost of a mutual fund scheme is denoted by its NAV per unit. The fluctuations in NAV helps you understand how a specific mutual fund scheme is performing. Mutual funds invest in securities, and the market value of securities changes every day. So, the NAV of a scheme also changes every day.

  • Assets Under Management (AUM):  Mutual funds buy assets using the money they collect from investors, and the total value of all the assets that a mutual fund holds is called assets under management.

  • Fund Managers: Fund managers are experts with real-time access to crucial market information, and they are responsible for implementing a mutual fund's investment strategy and trading activities. These professionals are liable for managing an investment portfolio on behalf of an investor. The performance of mutual funds is significantly influenced by the fund managers and how they carry out their investment strategy in actively managed schemes.

  • Investment Objective: This could be to accumulate wealth or simply to protect money from inflation. Similarly, every mutual fund has a goal which it aims to achieve on behalf of investors. The investment objective of the mutual fund could be capital appreciation, the safety of capital, or distributing regular fixed income as dividends. Mutual funds that have a growth investment objective provide investors with a good hedge against inflation and primarily invest in equities.

How do you gain from investing in Mutual Funds?

Your investment in mutual funds helps you achieve your envisioned financial goals in a number of ways:

However, mutual funds are taxed for distributing dividends. With effect from FY 2020-21, Dividend Distribution Tax (DDT) was abolished in the hands of Mutual Fund Companies. Hence, any dividend you receive will be taxable for you as per your tax slab. At the same time, if your dividend income is more than Rs. 5,000 in a financial year, then there will be a TDS @ 10% for equity funds and 25% for debt funds.

  • Power of Compounding: Compounding is the interest that you earn on interest. The power of compounding helps in growing your wealth exponentially. Hence, the value of your investment keeps growing at an ever-increasing rate. Mutual funds harness the power of compounding.

  • Diversification: Diversification is a key benefit of investing in mutual funds. It may invest in a whole range of industries and sectors, different asset classes, across market caps, and more. The schemes may focus on blue-chip stocks, technology stocks, bonds, or a mix of stocks and bonds. Not every asset moves in tandem; while some rise, others fall. So, when you own both the stocks in your portfolio, any losses from one are cancelled out by the gains in the other. Thus, diversification reduces the overall risk one's portfolio may hold.

  • Liquidity: Open-ended mutual funds allow investors to redeem their units at any time at the prevailing NAV. So mutual funds are highly liquid, which is beneficial for investors. Do note there may be some exit load charges that may vary for each scheme.

  • Capital Gains Distributions: Capital gains occur when individual benefits from the capital appreciation of securities by selling or transferring them at the opportune period. Mutual funds distribute the profits made from selling some of their underlying assets at higher values. This is called capital gains distribution. You can use this to buy more mutual fund units (reinvestment). These gains are taxed, irrespective of your income tax bracket.

    Type of Fund STCG Tax LTCG Tax
    Equity funds (which have 65% or more investments in equity) 15% 10% (if the gain is more than INR 1 lakh in a financial year)
    Debt funds (which have 65% or more investments in debt) At the income tax slab rate 20% with the benefit of indexation

  • Automatic Reinvestment: A mutual fund gives returns in two ways-dividends and an increase in value (NAV). An increase in value can be utilised only when you sell the mutual fund units. On the other hand, dividends are accessible as soon as they are distributed. You can use the dividend amount to buy more units of the mutual fund scheme automatically. Mutual fund dividends are tax-free for investors (exemption limit Rs 5,000).

  • Transparency: Your money should be in trustworthy hands. Due to SEBI restrictions, the mutual fund industry is now more transparent. You can always keep track of your investments in mutual funds. AMCs are required to provide regular updates to investors on how the funds are faring.

This chapter enlightens you about how mutual funds function at the backend. Before you begin investing in mutual funds, you need to understand a few more elements, like the various types of mutual funds.