How Mutual Funds Work

If you’re completely at sea about Mutual Funds then here’s a crash course on everything you need to know about them.

If you’re completely at sea about Mutual Funds and have no clue how they work, let’s give you a crash course and tell you everything you need to know.

What are Mutual Funds?

A Mutual Fund is a trust that collects money from a number of investors who share a common investment objective.

How are Mutual Funds invested?

The money collected from various investors is invested in financial securities like shares, money market instruments (Term Deposits, Liquid Funds, and Debt Funds among others) and bonds.

Additional Reading: Understanding Mutual Funds

Returns on Mutual Fund investments

Market-linked funds are impacted by market fluctuations. As a result of this, the returns an investor gets from these financial instruments may vary.

Here’s a step-by-step process of how Mutual Funds function:

Collection of funds

A Mutual Fund house collects money from a diverse group of investors.

Fund manager

Each fund is managed by a dedicated fund manager. The fund manager decides how and where to invest the money. He invests the money in various securities depending on the type of Mutual Fund.

Additional Reading: Importance Of A Good Fund Manager

Returns

The fund generates returns according to the investment made as per the asset allocation and investment strategies and prevailing market trends. Any positive returns increase the value of the principal amount, while negative returns may decrease the principal value.

Redeeming returns

The returns generated on your investment can be redeemed in two ways:

• Growth option: The returns earned are reinvested into the fund and your investment value appreciates due to compounding and it reflects in NAV.
• Dividend option: The returns are paid to the investor as periodic payments, otherwise called dividends. The dividends are not guaranteed.

Here are four factors you must consider before investing in Mutual Funds

• Fund performance

Review the returns offered by the fund over a time period of time (3 years, 5 years, etc). By doing this you will be able to find out whether or not the fund matches your investment objectives.

• Exit load

An exit load is the amount charged by a Mutual Fund if the investor chooses to redeem the investment within the period disclosed in the offer document.

• Investment objective

Think about your objectives or reasons for choosing to invest in the fund. A young investor would find it more suitable to invest in a high-risk fund with a longer investment tenure or lock-in period. An older investor would find it more suitable to invest in low-risk funds that have a short investment term with lesser volatility in returns.

• Risk profile

Select Mutual Funds that have a risk profile that matches your needs. Debt Funds have a lower risk and therefore provide lower and less volatile returns, while equity funds have a higher risk and have the potential to offer significantly higher returns at increased volatility.

Additional Reading: Debt Mutual Funds VS Fixed Deposits

How you can invest in Mutual Funds

There are four easy ways to invest in Mutual Funds.

• Lump sum investment

This method of investment is ideal when you have a windfall money to invest. It could be a bonus, inheritance, savings or returns from other investments.

• Systematic Investment Plan

If you prefer to invest fixed amounts of money over a regular period, say either every month or every quarter, then you could consider a Systematic Investment Plan.

• Equity Linked Savings Schemes 

If you are looking for tax savings, Equity Linked Savings Schemes are a type of Mutual Fund that makes investments across different industry sectors. ELSS funds have a lock-in period of only 3 years and give investors tax benefits under Section 80C of the Income Tax Act.

Additional Reading: How Does E-KYC Work For Mutual Fund Investments?

Investments in Mutual Funds are most certainly a smart choice. Now that you know how Mutual Funds work, choose to invest wisely.