A mutual fund is defined as an investment scheme designed in such a way that it is managed by a professional, normally run by an asset management company (AMC). In a mutual fund scheme, the mutual fund creates a pool of money from investors and invest their money in securities like stocks, bonds, and short-term debt. The combined holdings of the mutual fund are known as its portfolio.
So what exactly happens in mutual funds?
An investor buys a portion of mutual funds which is known as “units”, which represents the share of the investor in that particular mutual fund.
These units can be purchased or redeemed as and when needed at the fund’s current net asset value (NAV). NAVs are subject to fluctuations in the market and accordingly, the fund’s holdings also fluctuate. All investors in a mutual fund are participants in the overall gains and losses in proportion to their share in the fund.
The mutual funds are registered with the Securities and Exchange Board of Indian, also known as SEBI in short. They function as per the rules and regulations made by the SEBI to protect the interest of the investors. Basically, SEBI is the regulatory authority aka protector to the investor’s fund.
There is a wide attraction in investing in mutual funds because through them a small investor is able to take advantage of accessing professionally managed, diversified portfolios consisting of all kinds of securities, which would have been a difficult task to do by a small investor by themselves with a small capital amount.
Mutual funds generally offer the following features:
- The funds are professionally managed, that is the fund manager investing your money and managing your money is well qualified, researched, and aware of the market scenario.
- They have a Diversified portfolio. In a mutual fund, the entire amount is not invested in one company or one industry, rather the amount invested is distributed in a range of companies and across different industries so that the overall risk can be minimised. To simplify, if all the money is invested in one particular kind of industry or company, the chances of losing your money increases due to fluctuations in the market, to avoid the same, here it is distributed in a variety of companies and industries.
- They are Affordable. The bar for investing in a mutual fund as an initial investment and further purchase is comparatively at a lower end.
- They provide Liquidity. Mutual funds can be redeemed at any given point in time by the investor at the NAV (net asset value) plus the redemption fees if any.
Mutual funds have three ways of generating money for the investors, which are:
- Dividend or Interest Income: Funds invested earns income from dividend and interest on bonds. The Mutual fund then distributes all gains less expenses to its investor.
- Capital Gain: The prices fluctuate i.e. increase or decrease with the market fluctuations. When the fund sells the securities at an increased price, the difference in selling price less cost price is the capital gain. At the end of the year, the mutual fund distributes this gain to its investors after deducting any capital loss.
- Increase in NAV: As and when the market value of a fund’s portfolio increases, after considering the expenses, the shares and value of the fund increases. Basically, Higher the NAV, higher is the value of your investment.
Like any other business, for running a mutual fund also, a cost is involved. These costs are covered from the investors in the form of fees and expenses. The amount charged as fees and expenses varies from fund to fund. The basic logic for understanding this is high-cost fund must perform better than a low-cost fund to generate returns for investors.