How Do Mutual Funds Work? – A Guide To Mutual Fund Basics

Guide To Mutual Fund

Mutual Funds in India are catching up as a favourable investment avenue. You too may be eager to know about the basics of mutual funds and would be interested to know more about What are mutual funds? Or How mutual funds works? Through this mutual funds guide, you will learn the meaning of mutual funds, and all the information and details about mutual funds you need.

Before you begin investing through mutual funds in India, it is essential to learn the basics of mutual fund investments.

PersonalFN has put together the basics of mutual funds right from explaining what mutual funds mean, to how mutual funds work. We will also explain the working of different investment facilities available for mutual funds, such as, Systematic Investment Plan (SIP), Systematic Withdrawal Plan (SWP), Systematic Transfer Plan (STP) etc.

So before you go on a hunt for the best mutual funds or top mutual funds, which can be from HDFC Mutual Fund or SBI Mutual Fund or Reliance Mutual Fund or any of the 40-odd fund houses. Do take some time out from your busy schedule to learn about mutual funds the right way. It will help you become a better investor.

Navigate through the article with the help of the links provided below:

How Mutual Funds Work?

How Mutual Funds Work


A mutual fund scheme, as many of you may have learnt, pools money from multiple investors and invests the collected corpus in shares of listed companies, government bonds, corporate bonds, short-term money-market instruments, other securities or assets, or a combination of these investments.

The type of securities selected for the portfolio is in accordance with the investment objectives as disclosed in offer document. Therefore, an equity mutual fund scheme will invest predominantly in a portfolio of stocks, while a debt fund will invest a significant portion of its assets in bonds. Within the asset class itself, the investment objective can be further narrowed down.

Thus, within the broader equity mutual fund category, there can be Large-cap Funds, Mid-cap Funds, etc., that are focussed on a specific market capitalisation of stocks. Based on the investment style, there can be Value Funds or Focussed Equity Funds as well.

A fund manager manages the investments in a mutual fund. There can be more than one fund manager, based on the discretion of the AMC. The fund manager/s manages the fund on a day-to-day basis, deciding when to buy and sell investments according to the investment objectives of the fund.

The mutual fund collects money from you and other investors and allots units. This is similar to buying shares of a company. Under mutual funds, the price of each fund unit is known as the Net Asset Value. The assets are invested in a set of stocks or bonds that form the portfolio of the fund. The fund manager, depending on the investment objective of the scheme, decides the portfolio allocation.

To understand the concept of NAV in mutual funds, watch this short video:


(This third-party video is for educational purposes only)

How Mutual Funds Work, With Example

Mutual Funds Work, With Example


Let's say HDFC Mutual Fund launches a new scheme called HDFC Top 20 Fund. For sake of simplicity, let's assume the scheme collects Rs 1 crore from 100 investors who invested Rs 1 lakh each. Given that the fund house issues the units at an NAV of Rs 10, it will allot 10,000 units (Investment/NAV) to each investor. Thus, the total number of units allocated by the fund house is 10 lakh.

The HDFC Top 20 Fund needs to follow its objective to invest over 20 stocks. The fund manager picks the top 20 stocks he believes will deliver good returns. He then decides to invest an equal amount in each stock.

Since the scheme has a total corpus (also known as Assets Under Management – AUM) of Rs 1 crore, it will invest approximately Rs 5 lakh in each stock. These stocks form the portfolio of the mutual fund scheme. In reality, the fund manager invests a high proportion in stocks that are expected to deliver better returns over the long term. The fund may also maintain a cash balance to deal with redemptions.

After a month, there is no change in the portfolio holding (stocks present in the portfolio) or the number of investors. As the price of the stocks moved up, the total value of stocks in the portfolio grows to Rs 1.2 crore. Since the units of the fund remains unchanged at 10,000 units, the NAV of each unit is now Rs 12 (Rs 1.2 crore / 10 lakh units).

For the investors, their investment would have grown to Rs 1.2 lakh (10,000 units * Rs 12 NAV). This translates in to a gain of Rs 20,000 (Rs 1.2 lakh – Rs 1 lakh). In percentage terms, the gains works out to 20% or in other words an absolute return of 20% (Rs 20,000/Rs 1 lakh).

Redemption

Some investors chose to redeem or sell their investments. Overall, 50,000 units were redeemed. In value terms, this resulted in an outflow of Rs 6 lakh. The AUM of the fund falls to Rs 1.14 crore and the total number of units comes down to 9.5 lakh. Thus, as you can see, the NAV remains at Rs 12/unit.

To deal with this redemption, the fund manager will first opt to pay back the investors from the cash balance in the portfolio. He may also choose to sell some shares of some stocks, if needed. However, most fund managers would only sell their shareholdings of a stock if they do not see any further potential of the company to move higher.

Fall in NAV

Now let's assume the price of the stocks in the portfolio headed lower. From Rs 1.14 crore, the value of the portfolio falls to Rs 1.05 crore. The NAV is now Rs 11.05/unit (Rs 1.05/95 lakh units).

Another investor invests an additional Rs 1 lakh in the scheme. This time for the same investment amount he gets just 9047.619 units. The value of the portfolio rises to Rs 1.06 crore with this investment. The total number of units under the scheme grows by an additional 9047.619 units.

We have covered the working of mutual funds in a very simplistic form to ease understanding. In reality, hundreds of investors may buy or redeem units on a daily basis. However, the basic working remains the same.

Do watch this short video explaining the working of mutual funds:

How does a mutual fund work?


(This third-party video is for educational purposes only)

How Does Mutual Fund SIP Work?

Mutual Fund SIP Work


Simply put, a SIP refers to Systematic Investment Plan, which is mode of investing in mutual funds in a systematic and regular manner. This method of investing is similar to investing in a recurring deposit (RD) with a bank. Just as a fixed sum of money is deducted from your bank savings account to invest in your recurring deposit account, your monthly investment through SIP is deducted from the linked bank account and invested in the selected mutual fund scheme.

Unlike recurring deposits that pay a fixed interest, the returns from mutual funds is dependent on the market value of the securities present in the portfolio. This is represented by the NAV of the mutual fund scheme. Hence, the NAV keeps fluctuating on a daily basis, which is more prominent under equity mutual funds.

Watch this short video for the basics of how mutual fund SIPs work.


(This third-party video is for educational purposes only)

A SIP is merely a method of investing. The primary objective of a SIP is to lower the average cost of investment as much as possible, in order to generate the maximum returns.

By this rationale, a drop in NAV may not seem good when considering point-to-point (P2P) returns, but it helps lower the average cost of purchase. When the NAV moves back up, you will be sitting on higher returns if had you invested via a SIP.

The fall in NAV or rather the fund's volatility matters for investments via a SIP. The higher the extent of fall, lower will be the average cost; and hence, returns too will be better.

For example, let's consider a SIP in two different schemes – Fund A and Fund B. Let's assume both have a starting NAV of Rs 10. The monthly investment is Rs 1,000.

Now study the table below:

Month NAV Fund A NAV Fund B Units Fund A Units Fund B
1 100 100 10.00 10.00
2 110 115 9.09 8.70
3 107 103 9.35 9.71
4 108 102 9.26 9.80
5 110 110 9.09 9.09
Total Units 46.79 47.30
Final Value 5146.56 5202.91


As seen in this table at the end of Month 5, the ending NAV of the both the funds is same, hence, the P2P returns in both cases is 10%.

However, the volatility of both the funds differed. The NAV of Fund A was relatively stable when compared to Fund B. On the flip side, the additional volatility of Fund B helped to lower the average cost of investments.

The average NAV cost under Fund A worked out to Rs 107, while for Fund B it was 106. Naturally, a SIP in Fund B did better than Fund A.

The key lesson here is that irrespective of the fund's P2P performance, the performance via a SIP will differ.

When investing via a SIP, you need to keep this in mind.

Therefore, instead of chasing performance or the scheme with the best returns over a period or multiple periods, you need to select the right mutual funds.

Because the best mutual fund today, may not be the best mutual fund tomorrow or the best mutual fund for a SIP.

You could however pick a top quality fund that has not only performed consistently in the past, but which has delivered strong returns via a SIP as well.

A note from the editor…

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Author: Jason Monteiro