What Is A Mutual Fund And How Does It Work?

What is a mutual fund and how does it work?

In today’s inflationary era, mutual fund is one such instrument which has the potential to give you good returns even with minimal investment. Apart from increasing your wealth, it is also a very good means of diversifying your portfolio. Due to its good returns and ease of investing, it has become popular among almost every citizen these days. Through today’s article, we will completely understand the concept of mutual fund and after knowing its advantages and disadvantages, we will look at every important aspect of it.

What is a mutual fund?

Mutual fund is an investment instrument which generates returns by investing the money collected from different sections of people in various types of assets like bonds, stocks, gold, indices, government securities etc. This investment is done through various types of funds and schemes which are operated by AMC or Asset Management Company. Experienced fund managers working in these asset management companies manage these schemes. In mutual funds, there are plans and schemes according to everyone’s need and risk, in which the fund manager keeps changing the invested assets as per the market conditions so that it generates a better return for the investor with minimum loss. The returns earned in this way are distributed among the capital collected from the people in the form of growth and dividends.

How many types of mutual funds are there?

An AMC manages a variety of mutual funds and schemes that are designed to suit every investor’s needs and goals. Due to their diversity, it is difficult to separate them into any one category. Therefore, on the basis of various facts, we can divide mutual fund schemes into the following categories.

Based on investment type	Open ended, Close Ended & Interval Fund
Based on Fund Management	Actively & Passively Managed Fund.
Based on Investment objective	Growth, Income & Liquid Fund
Based on Asset Allocation	Equity, Debt, Money Market & Multi Asset Fund
Based on Theme	Tax Saving, Retirement Saving, Child Plan & Arbitrage Fund
Other Funds	ETF, Overseas Fund, Fund of Funds.

How does a mutual fund work?

Before knowing the working of a mutual fund, let us know what is the structure of a mutual fund company and who are the people who can start a mutual fund company. There are mainly three layers in the structure of mutual which are sponsor, trustee and asset management company.

A sponsor is a person who has to start a mutual fund company so that he can earn profit from it like a business. A sponsor must be eligible in several ways to start a mutual fund company such as:

1. A sponsor has to show profits for at least three years out of five years to start a mutual fund.
2. He should have at least 5 years of experience in the financial services sector.
3. Its share in the total net worth of AMC should not be less than 40 percent.

If a sponsor fulfills all these things, then he along with many people establishes the second layer i.e. a trust whose job is to look after the AMC and the fund. With this trust, the sponsor has to work according to a contract which is called Trust Deed. It is mandatory for this trust to be registered with SEBI and within its limits it takes all types of management decisions. According to the rules, the trustee has to submit AMC’s report to SEBI every six months.

AMC i.e. Asset Management Company comes in the third layer of mutual fund. In this company, all the work related to the management of mutual funds and providing services to investors is done. It is registered under the Companies Act of SEBI and launches funds or schemes according to the market situation. To launch any scheme, she makes agreements with brokers, RTA (Registrar and Transfer Agenst. ie cams, karvy) and transfer agents and does all her work as per their help and advice.

It was a matter of establishment of mutual fund and its main parts. Now let’s take a look at how investment in mutual fund schemes generates returns or works.

Before starting a fund or scheme, a mutual fund company first drafts a document called prospectus. In this, the purpose of the fund is to describe its size, risk, nature, assets to be invested etc.

After all the necessary formalities, the fund is opened for subscription which is called NFO (New Fund Offer). NFO works similar to IPO. It can remain open for about 15 days during which units of the mutual fund can be purchased at its face value which is usually Rs 10.

After the closure of the NFO, the mutual fund house allots the units of the scheme to the people participating in the NFO within 5 days. If the NFO is of an open ended scheme then you can buy its units even after its closure. In case of closed ended schemes, no investment can be made after the NFO is closed. If for some reason the allotment of NFO is not possible then the deposited money is returned to the investor’s account.

How to invest in mutual funds?

Investment in mutual funds can be done easily through both offline and online methods. For offline investment, you can do it through mutual fund branch, financial advisor and mutual fund agent. Every mutual fund, AMC and RTA has a branch in almost every city. To invest, you have to submit all the necessary documents and the payment to be invested through one of the mentioned means. Here it is important to keep in mind that before investing, you should have an idea of the investment objective and the risk you can take. If you do not know much about all these things then you should take any decision only according to the advice of a good financial advisor.

If you want to invest online then you can do so by visiting the website of AMC or RTA. For this, you have to create an account on any website and submit all the necessary documents. Apart from this, nowadays there are many online broker companies which provide you the facility to invest easily in just a few clicks sitting at home, such as Grow, Zerodha Coin, ET money etc.

Ways to invest in mutual funds

There are two ways to invest in any mutual fund: Lumpsum and Sip.

Lumpsum means you are investing a fixed amount like Rs 5000, Rs 10000 or several lakhs in a mutual fund scheme at one go. The second method is SIP i.e. Systematic Investment Plan. Under this, a fixed amount is deducted from your account on a fixed date and is invested in the chosen mutual fund scheme. This method of investment is very good for low and middle class people because you can start a SIP with just Rs 500. In many mutual fund schemes, SIP can be started with even Rs 100.

Benefits of Mutual Fund

Better Returns: Compared to other means of saving and investment, mutual funds offer very good returns. Whereas nowadays only 5 to 7 percent interest is available in FD and savings accounts, mutual funds can increase your investment returns manifold. Although the returns from these are not fixed and are subject to market risk, still almost all mutual funds seem to perform well in the long term.

Diversification: Mutual funds manage many types of funds depending on the need and risk of the investor, in which many options are available from low risk to high risk, tax saving to fixed returns. An investor can create a well diversified portfolio by investing in different funds as per his need, where the chances of loss and risk are reduced to a great extent.

Expert Management: Mutual funds are managed by expert fund managers who are experienced professionals in their field. These expert managers take all fund related decisions under the supervision of SEBI and its guidelines. In such a situation, even those people who do not have much knowledge about financial securities can avail the benefits of these services at very low charges and get a better return on their investment.

Regulated: Mutual fund market is completely regulated by SEBI and works as per its guidelines. From time to time, SEBI keeps imposing new rules for the benefit of investors, which are mandatory for all mutual fund houses to follow. In such a situation, we can say that apart from market fluctuations, investor’s money in mutual fund investment remains safe to a great extent from any kind of fraud and robbery.

Low value investment: Anyone can invest in mutual funds and such schemes are also available in mutual funds in which investment can be started with just Rs 100. In this way, mutual funds are a good investment option for low and middle class people also.

Disadvantages of Mutual Fund

Market Risk: Most of the investments made in mutual funds are made in instruments related to equity and government securities such as stock market, real estate, bonds and debentures etc. Despite having expert management, there is no guarantee of returns here and returns depend to a great extent on market fluctuations and economic factors. For this reason, before taking any investment decision, the investor should thoroughly investigate the risks associated with it or take any decision only with the advice of a good financial advisor.

Capital Gain Tax: The returns received on mutual fund investment come under the ambit of tax, which is called capital gains tax. Although tax saving schemes are also available in the market and rebate of up to Rs 1 lakh can be availed under section 80c of ITC, still their tax rate is quite high as compared to other means of investment which is difficult for the investor. Plays an important role in reducing the profit percentage.

Lack of control: Managing mutual fund investment is completely in the hands of the fund manager, due to which the common investor has no role in it. This can become a cause of loss for those people who are well acquainted with the market and know how to manage their investments well.

Fees and Expenses: In exchange for managing the investments, the mutual fund house charges a small percentage fee for its expenses and management salary, which is called expense ratio and exit load. Expense ratio is different for every scheme, which is deducted from the amount paid by the investor in return for managing the investment, whereas expense ratio is the deduction that is made for exiting a mutual fund scheme before a certain time. But it is charged as penalty. These charges and fees have a negative impact on mutual fund returns.

Conclusion

In the end, we can say that mutual funds are a great investment option for all types of investors, which provide a good opportunity for wealth creation in the long term. But it is also important to note here that like other means of investment, it Neither is safe from risk and loss. Therefore, every investor should think carefully before taking any investment decision or take the decision only after taking the advice of an expert.