If you are looking for a simple way to start investing, you may have come across the term mutual fund.
You may have also heard about SIP, NAV, equity funds, debt funds, index funds and mutual fund returns. For someone new to investing, all these terms can seem confusing.
So, what exactly is a mutual fund?
In simple words, a mutual fund is an investment vehicle that collects money from many investors and invests that pooled money in securities such as shares, bonds and other assets, depending on the objective of the mutual fund scheme. The investments are managed professionally by an Asset Management Company (AMC) and its fund management team.
Instead of selecting and managing every investment yourself, you invest in a mutual fund scheme that follows a defined investment strategy.
Let’s understand how it works step by step.
What Is a Mutual Fund?
A mutual fund brings together money from a large number of investors.
For example, imagine 1,000 investors each invest ₹10,000. Together, they have invested ₹1 crore.
The mutual fund pools this money and invests it according to the objective of the particular scheme.
Depending on the type of mutual fund, the money may be invested in:
- Shares of companies
- Government securities
- Corporate bonds
- Money market instruments
- A combination of equity and debt
- Securities that make up a particular market index
The investors receive units of the mutual fund based on the amount invested and the applicable NAV.
The value of these units changes as the value of the underlying investments changes.
This is the basic idea behind mutual fund investment.
How Does a Mutual Fund Work?
The working of a mutual fund can be understood through five simple steps.
1. Investors Put Their Money Into a Scheme
Individuals invest money in a mutual fund scheme.
You can invest either as a lump sum or through a Systematic Investment Plan (SIP).
For example, an investor may invest ₹1 lakh at one time or choose to invest ₹5,000 every month through SIP.
2. The Money Is Pooled Together
The money invested by thousands or even millions of investors is pooled into the mutual fund scheme.
This gives the fund a large pool of capital that can be invested across multiple securities.
3. The Fund Manager Invests the Money
The fund is managed according to the investment objective of the scheme.
For example, an equity mutual fund may invest primarily in shares, while a debt mutual fund may invest in fixed-income securities.
A professional fund management team researches investments, constructs the portfolio and manages it according to the scheme’s mandate.
SEBI describes professional management and diversification as important features of mutual funds.
4. The Value of the Investments Changes
The securities held by the mutual fund can increase or decrease in value.
If the value of the underlying portfolio rises, the value of the mutual fund generally rises.
If the underlying investments fall in value, the mutual fund’s value can also fall.
This is why mutual fund returns are not guaranteed and mutual fund investments are subject to market risks.
5. Investors Participate in the Gains or Losses
When the value of the investments held by a mutual fund increases, investors can benefit through an increase in the value of their units.
Similarly, if the underlying investments decline, investors can experience a loss.
SEBI notes that mutual fund profits or losses are shared among investors in proportion to their investment.
What Is a Mutual Fund Unit?
When you invest in a mutual fund, you don’t directly own each stock or bond held by the fund.
Instead, you own units of the mutual fund scheme.
Think of a mutual fund as a large basket.
The basket contains different investments. When you invest in the mutual fund, you own a portion of that basket through mutual fund units.
The number of units you receive depends on the amount you invest and the applicable Net Asset Value (NAV).
What Is NAV in a Mutual Fund?
NAV stands for Net Asset Value.
It represents the value per unit of a mutual fund after accounting for the value of the securities and other assets held by the scheme and its liabilities.
In simple terms, NAV tells you the value of one unit of the mutual fund.
For example, suppose:
- You invest ₹10,000
- The applicable NAV is ₹50
You would receive approximately:
₹10,000 ÷ ₹50 = 200 units
If the NAV later becomes ₹60, the value of your 200 units would be:
200 × ₹60 = ₹12,000
This is a simplified example to understand how NAV and units work. Actual transactions are subject to applicable rules, charges and taxation.
Is a lower NAV better?
Not necessarily.
A mutual fund with a NAV of ₹20 is not automatically cheaper or better than another fund with a NAV of ₹200.
The NAV simply represents the value of each unit. Investors should evaluate a mutual fund based on factors such as its objective, portfolio, risk, costs, investment strategy and suitability rather than choosing a fund simply because its NAV is lower.