How does a Mutual Fund Work

In the English Dictionary, the term Mutual in a sense means by each of two or more with respect to the other; reciprocal. A Mutual Fund, therefore works in the same manner, where two or more people come together, pool their money, with the objective of earning returns on the amount invested.

A mutual fund is therefore a pool of money from numerous investors who wish to save money for various goals in the medium to long term. It is basically an alternate option to participate in the stock market, with a lesser amount of risk, which offers both capital appreciation and liquidity at the same time, in comparison to other instruments with a lock in period.

For Eg: 100 persons invest Rs 1000 each in a Mutual Fund Scheme run by the AMC, then the collected fund would be Rs 100,000. The Fund manages the amount of Rs 100,000 known as the Assets Under Management (AUM) in accordance with the regulations and the profits or losses, on the amount are distributed among the 100 investors in proportion of the investment made by each of the holders in the fund.

Professional Management. Each Mutual Fund is regulated by a proffessional Asset Mangement Company, which is in turn regulated by a Trustee Company. The Trustee Company appoints Trustees who oversee the functioning of the Asset Mangement Company. The Asset Management Company appoints specialist qualified professionals, known as Fund Managers, who have the requisite experience in the field and are specialists in equity & debt portfolios. Each fund's investment patterns and objectives are further regulated by the market regulator Securities & Exchange Board of India (SEBI). The Fund Managers manage this collective money to create a portfolio. That portfolio could consist of stocks, bonds, money market instruments, or liquid cash or a combination of all, depending upon the objective of the fund.

Collective Ownership. A Mutual Fund holder or investor, owns a part of the mutual fund, not the individual securities. Mutual funds permit to invest small amounts of money, generally as low as Rs 1,000 per month, as small savings, but even so, the investor can benefit from being involved in a large pool of cash invested by other people. All the mutual fund holders’ together share in the fund's gains and losses on an equal basis, proportionately to the amount they've invested.

Mutual Funds offer diversification. By investing in mutual funds, an investor can diversify his portfolio across a large number of securities so as to minimise risk. By spreading the amount of money invested over numerous securities, which is possible only in a mutual fund,  the investor need not worry about the fluctuation of the individual securities in the fund's portfolio.

Objective of a Mutual Fund. There are many different types of mutual funds, each with its own set of goals. The investment objective is the goal that the fund manager sets for the mutual fund when deciding which stocks and bonds should be in the fund's portfolio. For example, an objective of a growth stock fund might be: This fund invests primarily in the equity markets with the objective of providing long-term capital appreciation towards meeting your long-term financial needs, which could be children's education for one investor or wealth creation for another. The broad objective of the mutual fund is the same for all investors, but it can be customized by each individual investor depending upon his risk bearing capacity, the amount of money that he is contributing, the time frame that he is looking to meet his goals, etc.

A Sample Portfolio of a Mutual Fund

Each of the investors in the fund would be owning a part of this mutual fund. Whatever the profits or losses that the fund makes, would be distributed equally among the holders on the basis of their investment in the fund.

Each investor is alloted units of the fund based on the Net Asset Value (NAV) of the fund and his share of the profit or loss would be limited to the number of units that he has in the fund.

E.g. Investor A invests Rs 1,000 when the NAV is at Rs 12. His holding = 1000/12 = 83.33 units. His share of the profit or loss in the fund would be limited to 83.33 units only.

Investor B invests Rs 1,000 when the NAV is at Rs 13. His holding = 1000/13 = 76.92 units. His share of the profit or loss in the fund would be limited to 76.92 units.