How does a mutual fund work ?

When people hear the word ‘mutual funds’, they are either dumbfounded as to what these are and to those who do know about mutual funds – they are averse to most of its features, let alone how a mutual fund works or is able to provide returns. Is it magic? Well, today we will break down How does a mutual fund work?

How does a mutual fund work?

1. Mutual 

The word mutual would suggest something that is common. Thus in a mutual fund, the common element is people, wherein people come together and invest in a mutual fund thus creating something in common with each other. Thus, a mutual fund literally starts with the coming together of people.

2. Fund 

It means money. The reason for all these people coming together is because of money – either to save money or to increase the same. After people come together, they invest their money in a fund, which suits everyone, depending on the needs of every individual entering into the fund.

3. Goal or purpose 

This is the reason why many people come together to invest their money in a mutual fund. It could be for capital appreciation (increasing the corpus of money over a period of time) or for providing fixed or regular income. In each of these cases, the fund will pick shares/stocks that suit this purpose.  

4. Fund manager 

The money thus collected is then managed by a fund manager who decides on the basis of data and research as to why he/she should invest in certain stocks or bonds or securities. Investments should be done as per the mandate of the fund, as the fund manager is liable to answer to investors as they have put in their hard-earned money for that purpose. So the fund manager cannot go on a shopping spree of buying Investment instruments as per his / her whims and fancy. He/she has to make decisions that are best suited for the fund and also needs to monitor the fund, as appropriate.

5. Securities 

The money invested by the fund manager gets spread out. Another default benefit of mutual funds is “diversification”. Within a mutual fund, the fund manager diversifies the collection of funds from investors and invests the same in a variety of stocks, across different sectors.

E.g.  A typical diversified equity portfolio would not only have a large number of the same stocks but a break-up of stocks across different sectors such as banking, pharma, aviation etc. Thus, as an example, a diversified equity fund would invest in companies such as Jet Airways (Aviation), Hdfc Bank(Banking), TVS motors(Autos) etc.

Another advantage is that the fund has money, not from just one individual but from many such individuals and therefore a mutual fund gets the advantage of economies of scale.

E.g. Mr. A decides to purchase shares worth Rs. 1 lakh, as he has accumulated these funds through his own savings. Thus the amount of shares Mr. A can purchase is limited to this fixed principal of Rs.1 lakh. But in the case of a mutual fund, the fund manager deals with crores of rupees daily, as more and more investors enter the fund on a regular basis and thus the fund manager can purchase the same or different stock in much larger quantities.    

6. Returns 

The money that has now been invested across various companies and bonds etc., and across various sectors has the potential to grow in value over a period of time. The potential to grow in value has already been estimated by the fund manager and this forms the basis of his investment strategy. As these companies grow by garnering more business and generating profits along the way, the profits are given back to shareholders, either in the form of dividend (pay-outs in %) or returns (as a % growth of the principal invested). In the case of mutual funds, the fund manager has invested into the said shares from the money collected from the people/investors. So the returns generated are ploughed back into the fund and thereafter back into the hands of the investors, in accordance to the proportion invested by each investor.

Eg Mr. A invests Rs.1,00,000/- in a mutual fund and Mr. B has invested Rs.2,00,000/- in the same fund.

Over a period of 5 years, the fund through the shares it has invested in has generated a return of 15%.

Thus Mr A.’s investment would now be –

100000 + 100000 x 15%= 100000+ 15000 =115000 rs

While Mr.B’s investment would be –

 200000+ 200000 x 15%= 200000+ 30000 = 230000 rs

Investors have the choice of withdrawing the Principal and/or the Profits or to continue investing in the fund by staying invested in the fund and also putting in additional investment into the fund. The Investor also has the option of moving his funds into another Mutual fund, as appropriate.                          

Thus we now understand how a mutual fund works, and it’s surely not by magic! jokes aside.

A mutual fund basically works for us by investing in shares and other securities, which we otherwise would have never thought of investing in. The genuine notion of mutual funds being risky would be demystified in our next article, so stay tuned!

Hope this article How does a mutual fund work? was beneficial to you.

About the Author :

Rufino Dsouza is a Certified Financial Planner who specializes in  the following Services :

• Client wise portfolio management.
• Investment seminars. 
• Investment solutions and goal planning.
• Tax planning, and effective investment tools for the same.

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