Know about Mutual Fund Basics, Investment & How it Works?
Let’s first understand what mutual funds are before we get into how they work. Mutual funds are a type of financial investment products that are quite different from the other financial savings and investments products you may be aware of like bank fixed deposits, post office saving schemes, PPF, insurance, stocks or infrastructure and government bonds.
Firstly, mutual funds are not savings products but investment products. A savings product like bank fixed deposit or PPF will give you a guaranteed return. Investment products can never give you guaranteed returns as they invest in securities listed in the market and hence are subject to many variable factors. These are collectively termed as risk factors. Hence mutual fund investments are subject to many risks but the most prominent one is market risk.
Let’s now get into the mutual funds basics. Mutual funds schemes are pooled investment products with a stated investment objective. The collected investments are held by a trust and managed by an Asset Management Company. The AMC just manages the money but doesn’t hold it in its account or own it. The money is owned by the investors and the trust acts as its fiduciary guardian. The investment objective of each fund spells out the kind of investments it is likely to make and the purpose of adding this fund to your portfolio.
Let’s now look at how mutual funds work. As mentioned earlier, they pool money from different investors who share a common investment objective as the fund. All the money collected from these investors is used to buy assets like stocks or bonds for the fund’s portfolio in line with its stated investment objective. Units or shares of the fund are created at the time of launching the fund which is called New Fund Offer (NFO). This unit or share is quite different from the stocks or shares you are familiar with. In case of a mutual fund unit or share, it represents the market value of one unit of the fund’s portfolio that has many securities in it unlike a company stock.
NAV of a fund is derived by dividing the total net assets (total assets less liabilities) of the fund by the total no. of outstanding units. Then each investor or unitholder is allotted units in proportion to the money invested by him/her at the current NAV. This simply means, when investors buy or sell mutual fund investments, they do so at a price per unit which is the NAV applicable for their transaction.
How Mutual Funds Work?
Let’s explain how mutual funds investments work with the help of an example. Suppose a fund launches a new equity mutual fund scheme and collects INR 100cr during the NFO by selling 10 cr units of the scheme at a Face Value or NFO price of INR.10. After the NFO period closes, the INR 100cr collected is used to buy stocks for the funds portfolio. The fund manager decides how much of the fund to invest in which stock. When the fund opens for subscription after few weeks, the total portfolio value of the fund will be the sum total of the current market value of all the stocks and other assets held in the portfolio. Let’s say on the day of opening, the total market value of the scheme is INR 100.15 cr. The Net Asset Value of the scheme can be arrived at by subtracting the scheme’s liabilities like operating and marketing expenses from its market value. Let’s assume in this case the liabilities happen to be INR 5lakhs.
NAV of the scheme = [(Assets – Liabilities)/no. of outstanding units] = [(100.15 -0.05)/10cr units] = INR 10.01
The NAV of the scheme will vary from day-to-day since the market value of its portfolio will fluctuate as per market volatility.
As an investor, when you invest in a mutual fund, you really don’t have to bother about the kind of stocks to invest in, how much to invest in which stock, when to sell a stock from the portfolio etc. All these decisions and tasks are taken care of by the AMC or Asset Management Company. Thus, investing in stocks or bonds through mutual funds is a better option than doing so directly especially for small retail investors.
Don’t mutual funds simplify the work for us if we want to invest in market related investment products like stocks or even bonds?