How do mutual funds work?

Mutual funds offer a simple way to build wealth. They spread out the risk of investing in individual stocks, bonds or other securities. And you can start investing in such a diversified portfolio with a sum as small as Rs 250, and in some cases, even with a sum of Rs 100. This instant diversification makes it a great way for beginners to start their investment journey.

Also, in the previous article of this series we had discussed a little about hybrid funds. Such funds allow you to maintain an equity-debt mix and enjoy automatic rebalancing without any tax incidence. The ease of maintaining asset allocation is one of the many benefits that draws experienced investors too.

If you want good risk management without compromising on returns, mutual funds are the way to go. In this guide, we'll explain the different ways you can invest in them and much more.

What is a mutual fund?

A mutual fund is an investment vehicle that pools money from multiple investors to create a diversified portfolio of stocks, bonds, or other securities. Instead of buying individual stocks or bonds, investors purchase units of the mutual fund, each representing a portion of the fund's total assets.

The main appeal of mutual funds lies in their diversification, which helps spread risk across various assets, reducing the impact of poor performance by any single investment. Professional fund managers oversee the investments, making decisions based on the fund's objectives. Fund managers, who are employees of Asset Management Companies (AMCs), are responsible for making investment decisions in line with the fund's stated strategy and objectives. The AMC oversees the fund's overall management, compliance, and operational activities.

Suggested read: Choose the 'best' mutual fund for YOU

How are mutual funds structured?

The structure of a mutual fund involves several key entities, each playing a distinct role:

• Sponsor: The entity responsible for setting up the mutual fund by establishing the trust, promoting the fund, appointing the trustees and AMC, and contributing the initial capital. Sponsors must meet SEBI's eligibility criteria and are subject to regulatory approval.
• Fund manager: The professional responsible for making investment decisions and managing the fund's portfolio in line with its stated strategy and objectives.
• Asset Management Company (AMC): The company appointed by the trustees to manage the investment schemes. The AMC oversees fund management, operational activities, administration, and regulatory compliance under SEBI guidelines.
• Custodian: Safekeeps the fund's securities, settles trades, and maintains custody records.
• Registrar and Transfer Agent (RTA): Maintains investor records, processes transaction requests such as purchases, redemptions, and switches, and handles account servicing.
• Investors: Individuals or institutions who invest money in the fund and share in its gains or losses based on the number of units they hold.

What types of assets do mutual funds invest in?

When you invest in a mutual fund, your money is pooled together with that of other investors, and the fund manager allocates it across a diversified mix of assets, based on the fund's objectives.

The types of investments made by the mutual fund depend on its category:

• Stocks: In equity mutual funds, the manager invests in shares of companies, aiming for long-term growth and capital appreciation. These funds come with higher risk but offer the potential for higher returns.
• Bonds and Fixed Income Instruments: Debt mutual funds primarily invest in bonds, government securities, and other fixed-income assets. These funds are generally less risky than equity funds, offering more stable returns, though with lower growth potential.
• A mix of both: Hybrid funds combine both stocks and bonds in varying proportions, providing a balance of risk and return. This approach helps to reduce volatility while aiming for moderate growth.

The key advantage of mutual funds is diversification. By investing across a wide range of assets, mutual funds help spread the risk, so the poor performance of one investment has a smaller impact on the overall portfolio. This approach offers investors a way to gain exposure to various asset classes without having to select individual securities themselves.

Suggested read: Diversify your life

How is Net Asset Value (NAV) calculated?

Net Asset Value (NAV) is a key term you'll encounter when investing in mutual funds. It represents the per-unit value of the fund and is used to determine the price at which investors buy or sell units.

What does NAV mean for investors?

NAV is calculated by subtracting the total liabilities of the fund from its total assets and dividing the result by the number of outstanding units.

NAV fluctuates based on the value of the underlying assets, meaning that it can go up or down depending on the performance of the investments held by the mutual fund.

Over time, an increase in NAV indicates growth in the value of the fund, leading to capital appreciation for investors.

Difference Between NAV and Stock Prices

While both NAV and stock prices reflect the value of an asset, they are calculated differently. One of the key factors that determines stock prices is the demand and supply on stock exchanges, which can be influenced by factors like investor sentiment, company performance, and market trends. NAV, on the other hand, is the calculated value of a mutual fund's assets, updated at the end of each trading day, based on the closing prices of the fund's investments. Unlike stock prices, NAV doesn't fluctuate throughout the day; it is reset once daily after the market closes.

Suggested read: Low NAV doesn't mean cheaper fund

What are the different methods of investing?

There are several ways to invest in mutual funds, depending on your goals and financial situation. The main options are:

Lump sum investment

A lump sum investment is when an investor invests a sum of money in a mutual fund all at once. This type of investment isn't ideal for equity or hybrid funds due to the fact that it relies on timing the market - a futile exercise.

Systematic Investment Plan (SIP)

SIPs allow you to invest a fixed amount of money at regular intervals, typically monthly. SIPs make investing easier by automating the process, and they also help you avoid the temptation to time the market. Over time, SIPs can take advantage of market fluctuations through rupee-cost averaging, potentially lowering the overall cost of your investment.

Systematic Withdrawal Plan (SWP)

An SWP allows investors to withdraw a fixed amount of money from their mutual fund at regular intervals. This option is ideal for retirees or those seeking a steady income stream from their investments. And can be a good exit strategy when phasing out of your equity investments.

Systematic Transfer Plan (STP)

An STP allows investors to transfer money from one mutual fund to another within the same AMC. It's often used to shift a large sum of money from a low-risk investment (debt funds) to high-risk investments (equity funds.

Suggested read: Forget SIP, STP can earn you more money

Conclusion

Mutual funds can be a great way to build wealth over time, especially for beginners who want to invest without the complexity of individual stock picking. With their diversification, professional management, and flexibility in investment plans, mutual funds offer a unique opportunity for both novice and experienced investors.

If you're just starting, don't hesitate to begin with small investments through SIPs and gradually learn more about how mutual funds work. By making informed choices, you can grow your wealth and achieve your financial goals.

Also read: How to choose a mutual fund

This article was originally published on April 29, 2025.