What are Mutual funds? How do mutual funds work?

Greetings!

What makes financially independent people wet?

What is a very popular investment tool in India?

What is related to market risks and you should carefully read all the offered documents carefully before investing

Yes, we are of course talking about Mutual funds!

In the last few years, Mutual funds have reached another level. Mutual funds have been around since 1963 and the total money managed by the entire industry was about 10 trillion dollars in 2014 which reached 20 trillion dollars in 2017 (just doubled in 3 years).

And that is why today, it is important to know How mutual funds work and that’s what we’re about to do.

How do mutual funds work?

Let’s say you and your family wanna go for 8 days 7 nights trip to Europe. But you don’t have enough info about Europe.

So what do you do?

You go to a travel agent and make him do all the arrangements for some amount of money. Now, this travel agent has done this a fair amount. So he’s an expert on this.

He will gather money from you and all the other families going to Europe through the same agent. This will create a pool of funds and with this fund, he’ll book flights, hotels, etc. And to provide this service, the agent will charge you some amount of money which will be his commission.

So mutual funds are nothing but a pool of money managed by a fund manager. So, an asset-management company collects money from many different investors who have the same objective. This common objective could be to invest in equities, bonds, or other securities. Now that is a mutual fund.

The gains generated by the investment of this pool of money are distributed proportionally among investors, and all of this is done for a simple fee.

NAV

Now every mutual fund has a NAV or Net Asset value which is basically the price per share of the mutual fund. Let’s do the math

(Asset-liability)/number of outstanding shares = NAV

Types of mutual funds

• Equity mutual funds

This type of mutual fund buys equities or stocks. This is the reason why you hear the following statement in mutual fund advertisements

“Mutual funds are subject to market risks, read all scheme related documents carefully before investing.”

This means that if the stock market suffers losses, the stock’s values will decrease and so will the funds invested in the mutual fund

• Debt mutual funds

They usually invest in bonds backed by the government, banks, and other corporations. Since the money comes in the bond form, they offer slightly lower returns but they are known to be safer.

• Hybrid mutual funds

They invest in both equities and bonds. The risk here is moderate and so are the returns.

• Other instruments

They could invest in gold, real estate, and other commodities.

How do mutual funds work?

The pool of money collected in the mutual funds, that is assets under management is given to a fund manager. Then the manager invests that pool of money according to the objectives of that mutual fund, if it is an equity mutual fund then the money will be invested in equities, if it is a debt mutual fund then the money will be invested in bonds, and so on and so forth.

Depending on the fund’s performance, the NAV keeps changing. If there is growth in the assets invested then the price per unit of the mutual fund will also change. So the NAV changes daily based on the market value of the amount that is invested. More often we will see that the mutual funds that have been in the market for a much longer time will have their NAV naturally high. So the retail investors don’t have to worry that much whether the NAV is high or low.

How do these mutual funds make money?

Now every mutual fund has something called an expense ratio. it is nothing but the fees that the mutual fund charges for managing their client’s money. They take this fee since they have their own expenses like offices, salary, distributor’s commission, marketing cost, etc. Also, the profits get covered under the expense ratio. Usually, the expense ratio ranges from0.5% to 2.5%. Now, this expense ratio is taken from the pool of funds that is generated. This expense ratio might not seem like a lot but over a long period of time, it can add on. For example, if you deposit an amount of 1 million INR with a 0% expense ratio, your money will become 6.7 million INR after 20 years.

But if you were to invest in a mutual fund with an expense ratio of 2.5%, you would end up with 4.2 million INR after 20 years. A difference of around 2.5 million INR just because of this 2.5% expense ratio. In this example, you are losing around 40% of your returns just because you invested in a more expensive fund.
There are 2 types of mutual funds according to the fees they charge. there is a direct plan and a regular plan. So if you want a lower expense ratio, you should go for a direct plan.

We hope this was helpful. We covered everything which was required to know about Mutual Fund. If you want more related topics on investment and managing your funds then do follow us we will bring more such content in the future.

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