How Do Mutual Funds Work

A mutual fund is one of the most popular investment options when it comes to investing in the stock market. The rise in advertisements from mutual fund houses and AMFI and the good returns on mutual fund schemes has made it very attractive to investors.

However, before making any investment it is very much required to understand how the investment works. That way you can make a correct assessment of whether the investment is right for you and whether you should put your funds into it or not. That’s why it is important to understand how mutual funds work.

What is mutual fund? A mutual fund is a company that collects resources from different investors. These resources are used to purchase different capital assets. These assets could be:

• Equity shares
• Treasury bills
• Government securities
• Corporate bonds
• Non convertible debentures
• Money market instruments
• Overnight instruments
• Derivatives
• Gold

The fund’s risk tolerance is decided depending on the type of asset purchased and the investment objective.

Some mutual funds are actively managed funds where the fund manager actively makes an investment strategy to try and beat the benchmark indices. On the other hand, there are some funds that mimic the movement of some assets. These funds are called passive mutual funds and include exchange traded funds and index funds.

How do mutual funds work?

Once you have understood what mutual funds is, next is to gain knowledge on how they work. Mutual funds collect capital from investors. This capital can either be collected all at once or in perpetuity. Funds that collect capital at once and don’t allow the investor to withdraw till it is redeemed are called close ended mutual funds. Funds that allow investors to invest and withdraw at any time are called open ended funds.

In exchange for the capital, mutual funds issue units. These units are priced at the net asset value of the mutual fund or the NAV. The net asset value is the difference between the assets and the liabilities of the fund. The assets of a mutual fund are the cash in hand and other assets it has purchased. The funds collected from investors forms the liability side.

Investment in a mutual fund can either be done directly through the mutual fund website or be done through a broker or a demat account. When investment is done through an online platform or through a broker, the investment is made in a regular plan. The returns on a regular plan are slightly lower than a direct plan because commission is paid in a regular plan to the brokers.

Mutual funds can be sold at any time. One thing to remember is the exit load. Some debt funds have an exit load on redemptions made before a particular time. The exit load is like a charge or penalty that reduces the ultimate returns from the funds. Equity funds generally do not have exit loads.

Any dividend received from a mutual fund is exempt in the hands of the investors. On the other hand, any capital gains is taxed as capital gains tax.

Arjit Chalmela is a finance student who loves to write in his free time. He has spent considerable time researching the foreign exchange rate.