How Mutual Funds Work in India (Complete Guide With Example)

Mutual funds have become one of the most popular investment options among Indian investors over the past few years. If we take a look at data that highlights this growth, the Assets Under Management (AUM) of mutual funds in India showed a consistent uptrend from April 2022 to April 2023 growing from ?39 trillion to ?41.53 trillion. If you are new to the world of investing and are looking to invest in mutual funds, this article will help you understand the mutual fund meaning and types, and how mutual funds work in India with examples.

What is a Mutual Fund?

Mutual funds operate by collecting funds from a large number of investors which are then pooled together and invested in a diversified portfolio that includes equity, debt, and cash. The goals of the funds’ investment are predetermined and based on these goals the asset allocation, type of fund, the fund’s objective, and the benchmark index are determined. Ideally, the goal of a mutual fund is to offer returns that beat the benchmark index. 

For example, let’s assume that the benchmark for the mutual fund is the Nifty 50 index. Here one of the goals of the mutual fund that you are considering must be to outperform the benchmark. If the Nifty 50 has given a 15% return over the last year whereas the mutual funds have given a 16% return then the mutual fund has achieved its goal of beating its benchmark. On the contrary, if your mutual fund has given a 13% over the last year, it means it has not been able to beat the benchmark index. 

Apart from delivering returns that beat the benchmark, the important objectives of mutual funds include professional management and providing the benefits of diversification. 

Mutual funds are set up with different purposes for example to assist you in saving taxes. These types of funds are known as ELSS funds. Similarly one can find a variety of mutual funds that serve different purposes. 

How Mutual Funds Work (With Example)

Let’s explore a comprehensive understanding of how mutual funds work in India. Mutual funds are managed by fund managers who are experts in the financial markets and have years of experience. Depending on the type of the fund they either actively manage the investments or ensure that the fund tracks a benchmark. 

When managing the mutual fund, they actively decide when and what to buy. They analyze the market daily, understand market trends/sentiments, and accordingly invest in assets. Hence, the role of fund managers plays an important role in an Asset Management Company (AMC). 

On the other hand, they ensure that the fund tracks an index in the case of the passive fund. This is generally the case for index funds. Say for example ‘Fund ABC’ is an index fund that tracks the Nifty 50. Here, ‘Fund ABC’ will only invest in the 50 stocks that are a part of the Nifty 50. 

How does One Invest in or buy a Mutual Fund?

One can invest in mutual funds by buying its units. The value of these units or the price at which you purchase one unit is called the NAV  (Net Asset Value). The NAV is calculated by dividing the mutual fund’s total assets by the number of outstanding units. 

For instance, if you invest ?600 in a mutual fund with an NAV of ?12, you would get 50 units of the mutual fund (the investment amount divided by the NAV). Any increase in the price of a particular stock held by the mutual fund will reflect in the NAV, and vice versa. 

Similarly, if you decide to sell your mutual fund units, your return will once again be calculated based on the mutual funds’ current NAV.

How do Mutual Funds Make Money? 

Now that we have explored how mutual funds work and how to invest, let’s understand how it makes money. Mutual funds make money by charging you a fee for the services they provide to manage your investments. These fees are predetermined and made available to investors before they invest in these mutual funds. These fees are mainly known as the expense ratio and transaction fees. Here’s a breakdown:

1. Expense Ratio: The expense ratio represents the total annual expenses of the mutual fund expressed as a percentage of the fund’s average net assets. It includes the management fee, administrative costs, operating expenses, and other fees. A higher expense ratio can eat into investors’ returns over time. So, make sure to check the expense ratio when investing in a mutual fund.   

2. Transaction Fees: Some mutual funds charge transaction fees such as entry load and exit load. Entry loads are charged when purchasing shares, while exit loads are charged when redeeming shares. These fees are additional sources of revenue for the mutual fund companies.

Types of Mutual Funds

Mutual Fund Based on Structure

There are 3 types of mutual funds based on structure: 

• Open-ended funds: Open-ended funds allow you to buy or sell a fund’s units at any time. Hence, it allows you to remain invested for as long as you want. 

• Close-ended funds: Close-ended funds allow you to buy the fund’s units during a particular period and allow redemption when the fund’s units reach the maturity date. 

• Interval funds: Interval funds allow you to buy or sell fund units for a permitted time period. So, it is advisable to invest in this fund only if your timeline aligns with the maturity date of the fund.      

Mutual Fund Based on Asset Class

There are 4 types of mutual funds based on asset class: 

• Equity funds: As the name suggests, equity mutual funds invest a larger portion of their funds in shares of publicly listed companies. This fund has the potential to give you inflation-beat returns over time but it is important to note that the stock market’s performance determines the returns. 

• Debt funds: Debt funds park their funds mostly in fixed-income instruments such as money market instruments, corporate bonds, government securities, commercial papers, etc. These instruments offer fixed interest and maturity dates. 

• Hybrid funds: Hybrid funds invest their funds in equity and debt instruments. The percentage allocation of equity and debt can be fixed or variable. If you are looking to diversify your portfolio and avoid risk, investing in this fund is a great option. 

• Money market funds: Money market funds park their funds in limited-term debt instruments such as certificates of deposits (CDs), commercial papers, treasury bills, repurchase agreements, etc. 

Mutual Funds Based on Investment Goals

There are 6 types of mutual funds based on investment goals: 

• Growth funds: Growth funds invest in momentum stocks and have the potential to give above-average returns. Investing in this fund is a great option if you want capital appreciation and can take risks.  

• ELSS funds: ELSS (Equity Linked Saving Scheme) invests majorly in equity and equity-related instruments and helps you create wealth while saving taxes. Under Section 80C, you can claim a deduction of up to ?1.5 lakhs by investing in this fund. However, the minimum investment period is 3 years. So, do consider your investment horizon when investing. 

• Liquid funds: Liquid funds invest in debt instruments like government securities, treasury bills, commercial papers, etc, that have a maturity period of up to 91 days. Investing in this fund is a suitable option if you are seeking liquidity and capital protection for the short term. 

• Capital protection funds: Capital protection funds help protect your capital during uncertain times like market downturns. However, you should keep in mind that the fund does not guarantee capital protection. 

• Fixed maturity funds: A fixed maturity fund is a debt fund with a certain lock-in period. It is less risky because it is not linked to the stock market’s performance. 

• Pension funds: Pension funds help you to earn regular returns after investing in it for a long period. These funds invest in different asset classes and the goal is to give stable returns over time. 

In Closing

To conclude, investing in mutual funds is a great way to start your investment journey in the financial markets if you don’t have time to track the market daily. However, it’s important to understand how do mutual funds make money, and how mutual funds work with examples. It is also important to check the expense ratio, exit load, experience of the fund managers handling it, and finally its benchmark index as this will give you an idea of what returns you can expect. Another important aspect that comes into play is the type of app that you use to invest in a mutual fund.

Check out our article on the Best Mutual Fund Apps in India, as choosing the right investment app will give you a great start to your investment journey. Happy Investing!