How do mutual funds work?

One of the first tasks a parent or even a financial advisor will advise you to do when you first start earning, is to invest a part of your income. Accumulating wealth over a period of time is almost always, difficult to achieve just by earning a salary and saving a part of it.

What everyone needs to do to make their short term and long term financial goals a reality is to invest their money somewhere. Investing your money ensures that your money doesn’t lie dormant and loses its value.

Invested money, when enough time passes, will almost always give good returns. While there are numerous investment options for you to explore, any financial advisor worth their salt will definitely advise investing in mutual funds. Why? Because investing in a mutual fund is simple, cost-efficient and helps you achieve a diversified portfolio.

Maybe you want to buy a car or a home or if you’re married, start a family or plan your child’s education abroad. Maybe you’ve already achieved all of the former financial goals and now want to leave your family an inheritance. Investing in mutual funds can help you achieve all of your financial goals. To understand how mutual funds can help you achieve your financial goals, you must first understand what exactly are mutual funds and how do mutual funds work. This will help you make an informed decision before investing in mutual funds.

A mutual fund, in layman's terms, is a pooled amount of money that is collected from multiple investors and is collectively invested in different types of financial instruments including equity, debt funds and real estate etc, depending on the type of mutual fund .

When you invest in a stock market, you buy shares from the company directly but when you invest in mutual funds, you make the investment through an asset management firm who in turn invests your money in different areas, giving you a diversified portfolio.

Each mutual fund is managed by a professional, seasoned fund manager who not only has a good eye for investments but basis the investments on thorough research and exhaustive statistical data. Now that you know what mutual funds are, let's outline how mutual funds work with a scenario.

Let us consider that you have invested INR 1,000/- into a mutual fund. Obviously, if you are the only individual investing a meagre amount, the returns are not going to be as significant as you expect. But in a mutual fund, there are numerous investors just like you who will invest similar amounts creating a large pool of money. An asset management company will take this sizeable corpus and invest the same. Where do they invest? An asset management company will invest the pooled funds into securities such as stocks, bonds, and short-term debt.

There are four important factors facilitate the working of a mutual fund.

Net Asset Value (NAV)

The overall cost of a mutual fund depends on the price per fund unit, which is known as the net asset value (NAV). It is a numerical value that is assigned to mutual funds and is the price of one single unit of the mutual fund. It is calculated by dividing the total cash value of the mutual fund (after subtracting all charges and liabilities) by the total number of mutual fund shares. This net asset value changes every day as the market value of the securities changes every day. It is the net asset value that determines whether a mutual fund is performing well or is underperforming.

Fund Manager

Critical to the success of a mutual fund, is its fund manager. A fund manager has real time access to crucial market information - something not privy to everyone. They execute trades on the largest and most cost-effective scale by monitoring the companies in which they have invested.

Assets Under Management (AUM)

You already know that mutual funds invest in assets using the money collected from investors. These assets include stocks, bonds, and other securities. The total value of all the assets that a mutual fund buys is called assets under management (AUM).

Investment Goal

Finally, the agenda behind the investment determines the path taken to invest. Every mutual fund has a goal which it aims to achieve on behalf of its investors. This goal could be capital appreciation, profits in the long term, or distributing regular fixed income as dividends.

Speaking of dividends and capital gains, let’s move to the last leg of how a mutual fund works viz. the payout. When you invest in mutual funds, you can make money in two different ways - through dividends and capital gains

The funds that were invested for the mutual funds will give out dividends based on their market earnings. If you choose to receive these dividends for your investment, then you’re making money out of your investment through these dividends. However, many asset management companies will give you a second option, wherein you can reinvest your dividends, and grow your money with the power of compounding.

You can also make money of your mutual fund investments via capital gains. This is similar to the share market, where you buy the units of a mutual fund for a particular price, and when the price of your units increases at some point in the future; you sell your units and earn a profit.