Mutual funds are one of the most common methods of increasing wealth in stock market investing. The profits you can earn by investing in various stock market instruments assist you in fighting inflation and achieving healthy long-term returns.
Millions of investors have made financial commitments on the stock market. However, most investors are unaware of how these financial vehicles operate.
Mutual funds are one such well-liked form of investment. But have you ever been puzzled about how it functions? If not, then you’ve come to the right place.
In India, there are over 43.50 billion individual PAN holders. However, only 3.36 billion (8%) have mutual fund investments.
This article will define mutual funds and explain how it works.
How do Mutual Funds Work?
Every mutual fund plan has a strategy formed during the NFO (New Fund Offer). Once the process is set, the fund must stick to it.
Mutual fund investing involves a cycle of four steps, starting with the launch of the NFO and ending with the distribution of returns.
Launch of a New Fund Offer (NFO):
Investors have the chance to enroll in a mutual fund scheme through a new fund offer (NFO) and become invested in it from the start. However, they have a limited amount of time to subscribe.
The units will be available for sale to investors after the NFO closes.
Additionally, at the time of the NFO launch, the fund’s strategy was made public. The fund strategy cannot be altered once the fund manager has fixed it. This is because investors invest in the fund depending on its plan.
NFOs are less expensive than existing funds because they are new to the market.
However, before investing in an NFO, mutual fund investors should think about the track record of the fund houses, the fund’s objectives, the cost of the investment, the risk involved, the minimum subscription amount, and the duration of the investment.
Funds are Combined:
Several small investors’ money is combined with mutual funds for investing in securities. Investors invest minimal amounts of cash from their savings.
Mutual funds enable small investors to invest in large portfolios, which they would otherwise be unable to do.
It can be owing to a need for more resources, such as money or time, to conduct thorough mutual fund research. As a result, mutual funds are a viable option for such investors.
Invest in Securities:
Securities such as shares, bonds, and government securities are bought with the money that has been collected.
Based on the fund’s strategy, the fund manager chooses the portfolio for the fund. The portfolio manager does have the knowledge and time to conduct extensive research on the securities.
They also conduct analyses at the economy, industries, and companies’ levels to maximize the return for mutual fund investors and identify the securities that best match the fund’s strategy.
If the selected securities fail, they are replaced with better-performing assets. When choosing securities for a fund, they occasionally combine many strategies.
In some cases, they also combine trading and investment tactics to benefit from stock market circumstances. Fund managers’ efforts provide investors with access to enormous portfolios.
Fund Returns:
The portfolio manager consistently works to increase the returns on the investments they make for the fund investors.
Therefore, their entire research, monitoring, and portfolio rebalancing activity on mutual funds increases their NAV (Net Asset Value).
When a fund earns profits, they are either distributed to investors or reinvested in the fund.
For a dividend fund (Known as IDCW Plan), the profits are paid out as dividends. The returns are added to the portfolio for growth funds to increase the investor’s wealth.
It is vital in mutual fund investing because it completes the investment cycle. If the returns are kept in the fund, they are used to make more investments, increasing investors’ wealth.
Therefore, investing in mutual funds is a constant process that directs the small deposits of numerous investors into profitable securities to increase their wealth.
Structure of Mutual Funds in India:
There are three significant entities in the Indian mutual fund structure. According to SEBI regulations, these three entities are engaged in setting up and maintaining a mutual fund.
These entities are listed below:
Fund Sponsor:
The sponsor is the mutual fund’s promoter. The fund sponsor must contact SEBI initially before launching a mutual fund company.
SEBI examines and confirms the sponsor’s eligibility based on the established criteria.
Trust and Trustees:
A mutual fund is established as a Trust, which consists of the sponsor(s), Trustees, and an Asset Management Company (AMC). The Trustees act as the investors’ protectors in mutual funds.
They are responsible for ensuring that investors’ interests are protected and that all funds are managed per the defined objective.
They have appointed an Asset Management Company (AMC) to oversee the investors’ funds.
Asset Management Company (AMC):
The AMC mainly manages a mutual fund from beginning to end. It is in charge of selecting a qualified fund manager to manage the fund, who possesses the necessary expertise and deep knowledge of the financial markets.
AMC is also in charge of introducing numerous schemes that correspond to the various financial needs of the investors. Trustees’ approval is required for any financial strategy AMC wishes to implement.
Other Entities in the Mutual Fund Industry:
Custodian:
Custodians are in charge of managing the mutual fund’s investment account as well as the delivery and transfer of units and securities. They are subject to SEBI regulation.
The responsibility of a third-party financial institution is to protect the mutual fund’s assets. Additionally, it maintains a record of corporate acts like dividends, bonuses, and rights declarations made by the businesses in which the mutual fund has invested.
Registrar and Transfer Agents (RTA):
They support mutual fund companies by helping them track all their transactions. The RTAs carry out many administrative activities, including,
- Processing Investor Applications
- Creating Units When New Investments are Made
- Removing Units When Investors Redeem their Shares
- Maintaining an Accurate Record of Investor Transactions
- Processing Dividend Payouts.
The RTA also provides investors with a single point of contact for all information regarding new offers, maturity dates, etc., and handles all mail processing for investors. They must operate under regulations set down by SEBI.
Distributors:
The distributors act as a link between the investors and the AMC. The AMC currently deals with the legal aspects of fund management, but they also require help marketing the products, educating investors as needed, responding to their questions, etc.
At this point, distributors enter the picture and offer their services to ensure a seamless transaction between the AMC and the investors. The distributor community is the industry’s sales force, pushing it forward.
Investor:
All retail investors can now invest in mutual funds with great confidence because of the presence of regulating organizations such as SEBI and the Association of Mutual Funds in India (AMFI). Any investor can get in touch with the AMC if there is a problem with their mutual fund investment.
Investors can turn to SEBI to resolve issues if the mutual fund company cannot address their complaints.
SEBI established the SEBI Complaint Redress System (SCORES) to manage investor complaints.
How to Invest in a Mutual Fund Scheme?
The price at which an individual unit of a mutual fund scheme is purchased or sold is known as the scheme’s net asset value (NAV). It is calculated by,
Net Asset Value = (Market Value of the Portfolio – Liabilities) / Total Number of Fund Units.
The following are the methods an investor can use to trade in a mutual fund’s schemes:
Lump Sum:
In this format, the investor deposits the total amount they wish to invest at once. It is also known as a one-time investment.
Systematic Investment Plan (SIP):
An investment strategy known as a Systematic Investment Plan (SIP) allows investors to make regular fixed-amount investments. This may occur every month, every quarter, every two years, etc.
Investors are allowed to begin their SIP with a minimum of INR 500. The funds can be invested each month automatically using the technological advantage of banks’ auto-debit services, using the investor’s registered bank account as the source.
Systematic Transfer Plan (STP):
With STP, a fixed amount can be periodically transferred from one’s balance in the specific scheme to another destination or target scheme, which the same AMC runs.
Redemption of Funds:
Investors may redeem their investments by repurchasing their mutual fund shares from the investment scheme. Redemption can be initiated by stating the number of mutual fund units or the amount.
An investor’s bank account is immediately credited with the amount redeemed.
Systematic Withdrawal Plan (SWP):
In an SWP, one can periodically withdraw a specified amount of regular income from the investment program.
Switch Between Funds:
This allows you to transfer your full amount in a specific plan, or a part of it, to another scheme with the same AMC.
How do Mutual Funds Generate Returns for Investors?
In the following ways, investors receive profits from mutual funds:
- Capital Gain
- Dividend Payout
Capital Gain:
Mutual funds invest in securities with strong growth potential or companies with positive market valuations. The equities that a mutual fund owns affect its NAV.
So, when there is a net gain in the stock prices owned by a mutual fund, the NAV of that mutual fund rises as well, providing investors with the benefit of capital appreciation on the units they own.
Investors might make capital gains by redeeming their mutual fund shares at a higher NAV.
Dividend Payout:
Depending on the type of fund an investor purchases, they earn from dividends announced by portfolio companies, interest received from portfolio bonds, and other earned income.
Investors have the option to either reinvest the money in the fund or choose to receive payouts.
As an investor, you must request cash distributions from the fund house because they normally reinvest the money in the fund.
Factors to Consider Before Investing in Mutual Funds:
The mutual fund sector has vast opportunities for considerable long-term capital growth and wealth building for investors. However, it is crucial to analyze the following elements and make decisions following them before entering the world of mutual funds.
Financial Objectives:
Financial goals are taken into consideration when investing in mutual funds. Small-cap or mid-cap equities mutual funds are good options to consider if you’re investing in building up a substantial corpus of wealth for retirement, children’s education, or any other costs that call for large sums of money.
They come with risks in the short term but offer substantial rewards over the long term. Debt funds are a good choice if you’re seeking short-term investing options because they are more liquid and substantially less risky.
Previous Performances of the Fund:
After considering your financial objectives and selecting the greatest mutual fund category that meets those objectives, you must choose the top-performing mutual fund within that category. Mutual fund historical returns are one of the characteristics used to calculate future returns.
If a fund’s 5-year annualized returns are higher than its competitors and the benchmark, it is considered a good investment option.
Assets Under Management (AUM):
The probability that a fund will produce significant long-term returns increases with the number of total assets under management. The high AUM shows investors’ confidence in the fund and liberates fund managers to make thoughtful decisions without worrying about significant asset outflows.
Investor’s Risk Tolerance:
The investor’s risk tolerance plays a role in selecting the appropriate mutual fund category. It is preferable to use large-cap equity funds, debt funds, or conservative hybrid funds if you are a cautious investor.
However, if you have a high-risk tolerance, you can achieve high returns by investing in small-cap equity or aggressive hybrid funds.
Conclusion:
According to Statistics, India’s gross resource mobilization through mutual funds was 58.65 trillion in the financial year 2022. Mutual funds are crucial for channeling funds and investing them in the stock market.
For investors looking for expert management, mutual funds are an option. Additionally, they support regular savings for small investors. With a better understanding of mutual funds, investors may begin investing confidently.
Successful investing is about risk management, not risk avoidance. As a mutual fund investor, you should also know the concept of OTM.