Written by : DG Gupta

A financial professional, qualified Chartered Accountants and Company Secretary examinations and enriched with experience of all types of accounting, taxation and compliance of Manufacturing as well as Service Industries

What Is Mutual Fund and How It Functions?

DG Gupta
DG Gupta, CA, CS

Jul 24, 2021 03:51

Are you considering investing your money? Mutual funds rank among some of the highly dependable avenues you can select. People are frequently perplexed about where to invest their money. The main cause for this perplexity being the innumerable investment options flooding the market. Mutual funds got established with the main motto to make investing easier for customers by eliminating the need for them to select individual securities.

Mutual funds are playing a powerful role in the financial markets, with the global amount of open-end mutual funds surging by over 40% between 2011 and 2019. As of June 2021, the average Assets Under Management, aka AAUM, in the Indian Mutual Fund Industry surpassed Rs.34,10,000 crores.

In Indian markets, SEBI (Securities and Exchange Board of India) regulates the functioning of mutual fund ventures, also called Asset Management Companies.

What is a Mutual Fund?

A mutual fund refers to a type of investment instrument that combines money from various individuals and utilises the money to invest in stocks. The assets of mutual funds in which people invest include equities, bonds, and other financial instruments. A professional fund manager oversees the management of this fund.

One can manage mutual funds either passively or actively. The financial advisor undertakes the role of doing the market analysis in actively managed funds to establish that the portfolio is aligned with the fund's purpose. On the flip side, passive mutual funds mirror the index or baseline—for instance, an exchange-traded fund (ETF) or perhaps an index fund.

The investments are made as per the Mutual Fund's purpose. For example, suppose a mutual fund's primary goal is to produce long-term profit for its investors. The fund's assets would mostly consist of equities of big, stable businesses (often referred to as large-cap funds) that have consistently produced a respectable return year after year. The most common misunderstanding about investing in Mutual Funds is that they exclusively invest in stock markets. You can select Mutual Funds based on your risk tolerance and financial goals. And there are a plethora of Mutual Funds to choose from, so you may find one that exactly suits your needs. Mutual funds offer the benefit of diversity to those who seek it.

Mutual Fund Categories:

Mutual funds get bifurcated into three major categories. It is critical to understand all three to select the best Mutual Fund for your investment as an investor. This categorisation is based on fundamental assets.

Equity Funds

These stand among some of the most well-known forms of mutual funds in the market. They enable investors to engage in stock exchanges with the aid of expert fund managers. Despite being classified as high risk, some schemes offer a significant return potential in the long run.
Some use the respective scale of business to categorise such equity mutual funds further.

Mutual funds that invest in huge companies are referred to as "large-cap funds." A mid-cap mutual fund, on the other hand, invests in mid-sized companies. Similarly, there are Small Cap Mutual Funds, which invest primarily in small firms.

These funds can also be classified depending on the industry that they are invested. These are mutual funds that park the money in a given type of industrial sector. These can be sectors comprising industries like infrastructure, finance, manufacturing, FMCG, mining, etc. They are designed for investors with a high tolerance for risk and the possibility of large profits.

Debt Funds

Debt Funds offer a low-risk-low-return perspective and are excellent for investors aiming to generate consistent income with a low tolerance for risk. They are, nevertheless, vulnerable to credit risk. A lot of the money in these funds is invested in debt schemes or fixed income plans. Such plans cover fixed dividend-bearing instruments such as government securities, bonds, debentures, and the like. These are called short-duration mutual funds, which typically invest in debt instruments with maturities ranging from one to three years.

Hybrid Mutual Funds

Hybrid mutual funds generally invest both in stocks and debt. They are further categorised depending on the volume of stock and debt investment involved. It is feasible to differentiate between debt-oriented balanced or hybrid funds and equity-oriented balanced funds based on the investment proportion. As a result, people refer them as marginal equity funds. They are particularly suited to retirees seeking a steady income with minimal risk.

How do Mutual Funds work?

Since we are talking about mutual funds and how they're the top pick when it comes to investments, let's catch a glimpse at how they function in the financial market.

A mutual fund plan combines money from many participants. It invests the resulting capital in shares of publicly traded businesses, government bonds, company bond funds, short-term money-market instruments, other securities or assets, or a blend of these investments. A fund manager oversees the investments of a mutual fund. The AMC (Asset Management Company) may appoint more than one fund manager.

The fund manager/s manages the fund daily, determining whether to purchase and sell investments following the fund's investment goals. The mutual fund collects funding from all investors and allocates units. This practice is equivalent to buying stocks in a company. The Net Asset Value (NAV) of a mutual fund is the price of each fund unit. The assets of the funds are invested in a portfolio of stocks or bonds. The portfolio allocation is determined by the fund management depending on the scheme's investment objective.

Process of Mutual Fund Investment

Mutual fund investment is a four-step process.

NFO launch

A New Fund Offer (NFO) allows investors to subscribe to a mutual fund scheme and claim ownership from the start. They may, however, subscribe for a limited time. Investors will be able to purchase units only after the NFO has concluded.

Money pooling

Mutual funds aggregate money from numerous small participants to invest in securities. with little savings, Mutual funds enable small investors to invest in huge portfolios, something they would not be able to do otherwise. As a result, the mutual fund is an ideal solution for such investors.

Investment in securities

The pooled funds get invested in assets such as stocks and bonds. The fund manager chooses the fund's portfolio depending on the fund's strategy. They have the knowledge and leisure to conduct extensive studies on the securities. If the preferred securities underperform, they get replaced with better-performing ones using various techniques to select stocks for a fund.

Returns from funds

When the fund generates profits, they are either distributed or reinvested back into the fund. Dividend funds, on the other hand, distribute returns in the form of dividends. The returns on growth funds are reinvested into the fund to increase the wealth of the fund's investors.

Gain a deeper insight into investment alternatives like Mutual Funds with Gotaxfile!

Mutual funds are investment choices for individuals wanting professional management. It is a continuous process that channels modest deposits of numerous investors in productive securities to enhance their value. With a better understanding of how mutual funds to function, investors may now begin investing with confidence. At GoTaxfile, we provide an honest consultancy for wealth management. We start by creating a customised financial roadmap for you, considering an appropriate mix of investments and the need for an emergency fund. Just as you invest in mutual funds, we invest in you with the aim of a fruitful partnership.

DG Gupta
DG Gupta, CA, CS

Jul 24, 2021 03:51

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