How Mutual Funds Work in India: A Comprehensive Beginner’s Guide

According to the Association of Mutual Funds in India (AMFI), as of July 2024, the mutual fund industry in India managed assets totalling over ₹64 lakh crore, highlighting the growing importance of mutual funds and their role in helping millions of Indian investors achieve their financial goals.

Mutual funds can seem complex initially, but breaking them down into simpler components can make it easier to understand how mutual funds work.

This content will cover the basics of mutual funds, including their operation, the concept of net asset value (NAV), various types of fund management, and the benefits of compounding. We’ll also discuss how systematic investment plans (SIPs) function and provide practical examples to illustrate these concepts.

What is a Mutual Fund?

A mutual fund is an investment vehicle that pools money from various investors to invest in a diversified portfolio of assets such as stocks, bonds, or other securities. When you invest in a mutual fund, you’re purchasing shares of the fund. The fund then uses this collective pool of money to buy a range of assets according to its specific investment strategy.

Mutual funds are popular because they offer investors diversification, professional management, and liquidity. By investing in a mutual fund, you gain access to a broad portfolio of assets, which reduces the risk associated with individual investments.

Example of How a Mutual Fund Works: Suppose you invest ₹10,000 in a technology-focused mutual fund. The fund uses your money to buy shares in various tech companies. If the tech sector performs well and the fund’s value grows to ₹12,000, the NAV increases accordingly. If you decide to redeem your investment when the NAV is₹12 and you hold 1,000 units, you will receive₹12,000.

How Mutual Funds Operate in India

1. Investment Pooling: The first step in how mutual funds work is pooling the money from various investors. When you invest in a mutual fund, your money is combined with funds from other investors. This combined pool is then managed by the scheme’s fund managers, who allocate the money as per the fund’s strategy.
2. Fund Management: Fund managers are professionals who make decisions about where to invest the pooled money. They analyze market trends, economic conditions, and individual securities to select investments that align with the fund’s objectives. There are two types of mutual funds based on investment style.
   • Active Management: Fund managers actively make investment decisions to outperform a specific benchmark index like the Nifty 50, mid-cap, or small-cap. This approach involves frequent buying and selling of securities based on economic conditions, valuations, etc., resulting in higher fees.
   • Passive Management: Fund managers don’t make active investment choices. Instead, the fund aims to replicate the performance of an index, such as the Nifty 50 or Sensex. This approach involves minimal trading and usually results in lower fees, providing a cost-effective way to invest in market trends.

Types of Mutual Funds

Mutual funds offer a range of investment options, each designed to meet different financial goals and risk appetites. Here’s a closer look at some common types of mutual funds and their strategies:

1. Equity Funds: These funds primarily invest in stocks, providing exposure to the equity market. They can be categorized further based on:
   • Company Size: Large-cap (established companies), mid-cap (medium-sized companies), or small-cap (smaller, potentially high-growth companies).
   • Investment Style: Growth (seeking companies with high potential for growth) or value (focused on undervalued companies with potential for appreciation).
2. Debt Funds: These funds invest in fixed-income securities such as bonds, government securities, and other debt instruments. They are generally less volatile compared to equity funds and are suitable for investors seeking stable returns with lower risk.
3. Hybrid Funds: Hybrid funds seek to balance risk and return by investing in both equity and debt. They offer a diversified approach, providing a mix of growth potential and stability.
4. Index Funds: Designed to replicate the performance of a specific market index, such as the Nifty 50 or Sensex, index funds are a type of passive management. They aim to match, not outperform, the index, usually resulting in lower fees (but not lower than an ETF) and minimal trading.
5. Sectoral Funds: These funds concentrate on specific sectors of the economy, such as technology, healthcare, or energy. They offer targeted exposure and can benefit from sector-specific growth, though they may also carry higher risk due to their focus on a single sector.

What is NAV (Net Asset Value)?

NAV, or Net Asset Value, is a key concept in mutual funds, representing the per-unit value of a fund. It determines the price at which you buy or sell units, making it essential for tracking the performance of your investment and making informed decisions.

How NAV Works:

• Calculation: NAV is calculated by taking the total value of the fund’s assets and subtracting its liabilities. This net value is then divided by the number of outstanding units of the fund. For example, if a mutual fund has total assets worth ₹100 crore and liabilities of ₹10 crore and there are 10 crore units outstanding, the NAV per unit will be ₹9 (₹90 crore / 10 crore units).
• Pricing:
  • NAV is determined at the end of each trading day. For buying mutual fund units, the NAV of the day you place your order applies if it is received before the cutoff time, usually 3:00 PM on business days. Orders placed after this time will use the NAV from the following trading day.
  • For selling mutual fund units, the NAV of the day your redemption request is processed applies if received before the cutoff time, typically 3:00 PM. Requests made after this time will use the NAV from the next trading day.

How Compounding Works in Mutual Funds

Compounding is often referred to as the “eighth wonder of the world,” a term famously attributed to Albert Einstein. It’s a fundamental concept that greatly benefits investors over time. Compounding occurs when the returns you earn on your investment begin to generate their own returns, leading to exponential growth.

• Reinvestment: The returns generated (such as dividends or interest) in a mutual fund fund are usually reinvested in the fund. This means that the returns are used to buy more units of the fund, which in turn can generate further returns.
• Growth Over Time: The longer you remain invested, the more pronounced the effects of compounding. For example, if you invest ₹10,000 in a mutual fund with an annual return of 10%, you earn ₹1,000 in the first year. In the second year, you earn 10% on ₹11,000 (the original ₹10,000 plus the ₹1,000 earned), which results in ₹1,100 in returns.

This principle means that not only does your original investment grow, but the returns themselves also start earning returns. This reinvestment of earnings leads to exponential growth, which, when combined with regular contributions, can significantly lead to substantial wealth creation.

How Systematic Investment Plans (SIPs) Work

A SIP allows you to invest a fixed amount regularly, such as monthly or quarterly, into a mutual fund scheme. By committing to invest a set sum—sometimes as low as ₹500 per month—SIP makes investing more manageable and accessible. This approach promotes disciplined saving and helps build wealth gradually over time.

Benefits of Investing in Mutual Funds

1. Diversification: Mutual funds invest in a wide range of assets, such as stocks and bonds, which helps spread risk and reduce the impact of poor performance from any single investment. This diversification enhances stability and potential returns.
2. Professional Management: Skilled fund managers oversee mutual funds, making informed investment choices based on research and analysis. Their expertise aims to optimize performance and manage risks, saving you time and effort.
3. Liquidity: Mutual funds offer liquidity, allowing you to buy or sell units at the NAV price on any trading day. This provides flexibility and easy access to your investment.
4. Accessibility: With numerous mutual funds available, you can choose those that align with your risk tolerance, investment goals, and time horizon, whether you prefer equity, debt, or hybrid options.
5. Rupee Cost Averaging: SIPs take advantage of rupee cost averaging by investing a fixed amount regularly. This strategy reduces the impact of market fluctuations, as you buy more units when prices are low and fewer when prices are high, potentially leading to better long-term returns.

Example: Suppose you invest ₹1,000 monthly in a mutual fund. If the NAV is ₹10 in the first month, you buy 100 units. If the NAV falls to ₹8 the next month, you buy 125 units. By the end of the second month, you’ve invested ₹2,000, but you have accumulated 225 units due to the varying NAVs.

Conclusion

By pooling money from multiple investors, mutual funds provide diversification and professional management. The NAV indicates the value of your investment, while compounding enhances your returns over time. SIPs offer a disciplined approach to investing, helping you build wealth gradually.

Ready to start your investment journey? If you have any questions or need guidance on choosing the right mutual fund, feel free to reach out to us at Mutualfundwala. Dive into the world of mutual funds today and take a step towards achieving your financial goals. Happy investing!