What is a Mutual Fund and How Does it Work?

With rising investor consciousness in India, mutual funds (MF) have soared in popularity. The earlier you begin your investment journey in MF schemes, the better your chances of enjoying superior wealth creation. If you’re new to investing in this asset class, read this to article to know what is a mutual fund and how does it work?

What is a mutual fund and how does it work?

Look at MFs as a type of financial vehicle that pools money from different investors, which is then used to purchase securities such as bonds, stocks, money market instruments, etc. These funds are usually invested in a variety of assets to create a diversified portfolio – one that can weather the storms of the volatile market.

Based on the performance of each stock or bond in the portfolio, investors make a profit or take a loss. There are three ways to earn from an MF scheme –

• Income from stock dividends and bond interest gain
• Capital gains from selling securities
• Gains made due to an increase in the value of an MF scheme

What are some basic terms you need to know about mutual fund investing?

Given below are some basic terms you must know as an investor –

• Acid test ratio –

This ratio is a key indicator of the financial strength of a company deduced by the company’s current assets/current liabilities.

• Asset allocation –

The act of diversifying investments into various asset classes so as to reduce risks while ensuring profitability.

• Net Asset Value (NAV) –

This is the value of each MF unit that measures a fund's performance.

• Investment objective –

It is a set of goals you have for your portfolio, for instance, invest to maintain capital, invest to achieve income, etc.

• Returns –

This is your income calculated by computing appreciation in investment value compared to the initial investment.

Additional Read: What kinds of investors should opt for mutual funds?

Types of mutual fund schemes

MF schemes are classified into different categories, as given below.

• Based on the maturity period –

Open, closed, and interval

• Based on the investment objective –

Equity, debt, and hybrid

• Based on market capitalisation –

Large-cap, mid-cap, small-cap, and multi-cap

Note – Funds belonging to the above-mentioned categories could be further classified into sub-categories.

How do mutual funds work?

The strategy for each fund is set at the time of the New Fund Offer (NFO). The fund must follow the decided strategy.

From the launch of NFO to the distribution of returns, mutual funds investing is a 4-step process, as mentioned below.

• NFO launch –

You can subscribe to such schemes from their inception; however, once the NFO closes, you need to purchase the units. NFOs are cheaper than existing funds, but you need to consider the fund house's reputation, risk, etc.

• Money pooling –

Investors like yourself purchase small fund units, after which the money is pooled.

• Investing in securities –

The pooled money is invested in securities like shares and bonds.

• Fund returns –

Efforts are made to increase the NAV of the fund - diversification, portfolio rebalancing, etc. The returns are either distributed to investors or invested back into the scheme for further wealth creation.

Additional Read: Understanding Mutual Fund Terminologies

Bottom Line

So you see, it's not that confusing at all! Plus, now you can compare different MF schemes from the comfort of your home with Tata Capital’s Moneyfy app. Take your time and choose schemes that align with your risk appetite, investment objective, etc.