Mutual Fund basics: What is a mutual fund and how does it work?

What is a Mutual Fund?

  • A mutual fund is a financial institution which collects money from a large number of investors.
  • The money collected is invested in shares, bonds etc.
  • The income and capital gains earned through these investments are shared amongst the investors (after deducting expenses and levies) in proportion to the number of mutual fund units owned by them.
  • A mutual fund is managed by a professional Fund Manager.
  • Hence, the investors get an opportunity to invest in a diversified, professionally managed basket of securities.
  • The fund charges a small fee which is deducted from the amount invested

What is NAV or Net Asset Value?

  • Total NAV is the market value of the assets of the mutual fund scheme (any interest or dividend accrued is added) minus its liabilities and expenses.
  • NAV per unit is the total NAV divided by the outstanding number of units in the scheme.
  • The expenses in a Mutual Fund include compensation to the fund managers and other employees, research support, marketing fees etc.
  • Expenses can be compared among different mutual funds by measuring the expenses ratio, which is equal to the annual expenses per share divided by the fund’s NAV.

What are the types of mutual funds?

  • Equity fund: An equity fund is a mutual fund scheme that invests predominantly in equity stocks. As per current SEBI Mutual Fund Regulations, an equity mutual fund scheme must invest at least 65% of the scheme’s assets in equities and equity related instruments.
  • Debt fund: A debt fund invests in fixed income securities, such as Government bonds, corporate bonds etc. Debt funds are also referred to as Income Funds or Bond Funds.
  • Liquid fund: A liquid fund invests in highly liquid money market instruments and debt securities of very short tenure such as Treasury Bills (T-bills), Commercial Paper (CP), Certificates Of Deposit (CD) etc.
  • Balanced fund: A balanced fund invests in a mix of stocks and bonds.
  • Exchange traded fund (ETF):  ETF is a security that tracks the performance of an index, a commodity or a basket of assets. Let’s say, there is an ETF which wants to track the performance of SENSEX. To do it, it will invest in the 30 stocks comprising the SENSEX, in the same weights as these stocks are represented in the index. This will help the ETF to generate returns that are commensurate with the performance of SENSEX.(Read: What is SENSEX and how is it calculated? and Decoding Bharat 22 ETF)

There are different types of equity fund schemes:

  • Large Cap Equity Funds invest predominantly in companies with large market capitalization. This type of fund is known to offer stability and sustainable returns, over a period of time.
  • Mid-Cap Equity Funds invest in stocks of mid-size companies. Mid-cap stocks tend to be riskier than large-cap stocks but less risky than small-cap stocks. Mid-cap stocks, however, tend to offer more growth potential than large-cap stocks.
  • Small Cap Funds invest in stocks of smaller-sized companies. Many small caps are young companies with significant growth potential. However, the risk of failure is greater with small-cap stocks than with large-cap and mid-cap stocks.

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Further reading:

Association of Mutual Funds of India Website

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