What are mutual funds?

Mutual funds are an investment platform where investors invest their money in these funds. The funds collected from the investors invest in several financial securities like bonds, stocks, shares, money market instruments, gold, etc. Mutual Funds are a well-diversified, low-cost and tax-efficient way of making your savings grow. Mutual funds are regulated by Securities and Exchange board of India (SEBI).

Companies that qualify to set up mutual funds create Asset Management Companies (AMCs) or Fund Houses. These assets are managed by professional investment managers or fund managers, who invest your money or manage investments & enable investor transactions and generate returns or capital gains for the investor. Through mutual funds, small or individual investors can access professionally managed portfolios that include stocks, bonds and other types of securities. By doing so, each shareholder in the fund is able to share equally in the profits and losses.

How do mutual funds work?

Before discussing how mutual funds work, it is important to define the meaning of Net Asset Value (NAV). It is the price per unit that an investor pays for acquiring or redeeming his investment in a mutual fund. It represents the market value per share for a particular mutual fund. It is calculated by deducting the liabilities from total asset value divided by the number of shares [NAV= (Assets – Liabilities) / Total Shares]. One needs to gather the market value of a portfolio and divide it by the total current fund unit number to determine the price of each fund unit. The number of units allotted to investors in mutual funds is determined by their investments divided by the NAV. For example, if you invest Rs 1000 at a NAV of Rs 10, then this will give you 100 units of that investment (1000/10).

The above example illustrates that a mutual fund’s net asset value (NAV) changes daily because of the performance of its assets. If a mutual fund invests in stock whose price increases tomorrow, then the same will be reflected on its NAV and vice versa. In this case therefore, if the net asset value rises to Rs 20, then your initial 100 units amounting to Rs 1000 will now be equal to Rs 2000(100 units x Rs 20). Consequently, returns generated by underlying assets determine how well Mutual Fund performs.

Mutual fund returns (capital gains) are subject to tax, known as capital gains tax. Capital gains tax will impact when you choose to redeem your investment; like in the example above you will be liable to pay a tax on the Rs 500 you have earned. The capital gains tax is applicable only if you redeem the investment and not if you stay invested. The extent of capital gains tax will depend on the types of mutual funds and your investment holding.

Mutual funds are subject to short-term capital gains tax (STCG) and long-term capital gains tax (LTCG). The periods of short-term and long-term capital gains tax are defined differently for mutual funds.

Functioning of a mutual fund:

1. New fund offer (NFO) release: An asset management company can start a mutual fund scheme by launching its NFO. It creates and shares the strategy of the scheme before its launch. Investors can then decide whether and how much they should invest. The NFO units are often priced at a low ticket, hence Rs 10.
2. Pooling money: After the NFO, Asset Management Companies collect funds from interested investors in order to purchase shares in stocks, bonds and other assets. The units of the fund are also available for sale after it gets operational even to those who did not participate in the NFO.
3. Investments in securities: A significant determinant of investment will be based on a strategy developed by the fund manager for this scheme. This includes doing thorough research on economies, industries, companies etc. before investments decisions are made into them. After that he purchases those securities which can generate high returns for its unitholders.
4. Returns: Mutual funds either distribute profits among investors or reinvest them back into the scheme for further growth. If they choose to receive IDCW (income distribution cum capital withdrawal) option as their payout option, investors get their payouts accordingly through direct bank transfer or cheques/Demand Drafts delivered to their registered addresses on record with the AMC/Registrar & Transfer Agents. On choosing a growth option, these gains remain within that portfolio itself and accrue further.