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How equity mutual funds work

Investors invest in a mutual fund, which in turn invests on their behalf. Understand how this works

How equity mutual funds work

How an equity mutual fund works is actually quite simple. You give money to a fund, and the fund invests this money in stocks. The gains or losses, whatever they may be, accrue to you. At a minimum, this is all you need to understand in order to invest in an equity fund.

Expenses: Clearly, a mutual fund is a business and not a charity. It must take some money from you in order to meet its expenses as well as to make some profit, and indeed it does. Equity funds are legally permitted to charge up to 2.25 per cent per annum of the money it manages as its expenses. Since the amount of money it manages goes up and down every day, the fund deducts a small sum from your money daily such that, on average, the annual deduction adds up to the specified percentage. There are some complexities to this charge - smaller funds are allowed to charge a little more. Also, in order to encourage financial inclusion, funds are allowed to charge a slightly higher amount if they get more investments from smaller towns and rural areas.

Mutuality: The meaning of the word 'mutual' in 'mutual funds' is quite intuitive. A mutual fund is basically composed of the money that a large number of people have invested. The way the law, rules and regulations are formulated, all investors are exactly equal financially and are treated the same way.

NAV and Units: The NAV (Net Asset Value) of a fund and the number of units that an investor owns are two of the least useful, most misunderstood and most overvalued numbers. A mutual fund is made up of all the money that its various investors have invested, combined. Here's an example: A fund is launched and 1000 investors each invest Rs 10,000 in it. In all, the fund has Rs 1 crore of assets under its management. Just for convenience, a fund is divided into 'units' of a certain value, which is set to a round number initially. Typically, this is Rs 10. In the above fund then, each investor is said to own 1000 units and in all, the fund has issued 100,000 units.

Now we come to NAV or Net Asset Value. The term basically refers to the current value (on any given day) of each unit of a fund. In the current example, the fund manager invests the Rs 1 crore of assets in various stocks. In the beginning, the NAV is Rs 10 and each unit is worth Rs 10. Let's say that after a year, the investments have done well and the Rs 1 crore grows to Rs 1.1 crore. Now, the NAV of each unit is Rs 11 (1.1 crore divided by 100,000). Each investor owns 1000 units, so the value of his investments has grown to Rs 11,000. It is important to understand that the only relevant thing here is that the total assets have grown by 10 per cent and therefore the investors have had a gain of 10 per cent. If the fund had initially had a face value of Rs 100, then the NAV would have grown to Rs 110; or if the face value had been Rs 1, then the NAV would have grown to Rs 1.10. From an investor's point of view, only the percentage change in NAV is important, not the actual number.

Whenever an investor has to invest or redeem his money, he either buys fresh units or sells them at the NAV at that point. Under some circumstances, there might be a small extra charge at the time of redeeming. Also, some funds allow entry and exit at any time while others allow entry only when the fund is launched and exit only after a pre-determined period, at which point the fund is terminated.

This article first appeared in December 2014.