F(N)AQ - How Do Mutual Funds Work?

Are you amongst those puzzled about the entire gamut surrounding mutual funds? Let us answer some of the NOT so frequently asked questions on how mutual funds work.

What is a Mutual Fund?

Mutual Funds are professionally managed investment vehicles that consist of a portfolio of stocks, bonds, cash, government securities etc. The fund and its portfolio are managed on your(investor¡¯s) behalf by the assigned fund manager, who conducts research and analysis of the stock market and debt instruments and accordingly manages your invested money based on the chosen securities that are purchased and the ultimate objective of that mutual fund.

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What do mutual funds do with my money?

Mutual funds pool in money from you and other investors, who may be retail or institutional in nature, to invest in various securities like stocks, bonds and other securities. When you buy a unit of a mutual fund, you are purchasing a part of the portfolio's value, to be precise. The units are issued by the fund to the investors in accordance with the quantum of the money invested by them.

How is investing in mutual funds different from investing in the stock market?

Investing directly into the stock market is a completely different ball game when compared to investing in mutual funds. Stock market involves direct purchase of shares of the listed companies, and gives investors partial ownership in the company. This direct route involves much higher risk, as stocks are vulnerable to the market conditions, especially in the short term.

Do Mutual Funds invest only in the stock market?

No, mutual funds do not invest solely in the stock market. They also invest and include debt income securities in their portfolio. These securities can include corporate bonds, government securities, treasury bills, commercial paper, and other money market instruments, and are aimed to cater to the conservative investors preferring lower risk when investing in debt oriented mutual funds.

Equity oriented mutual funds, on the other hand, involve majority or complete investment in the stock market to benefit from the high returns offered by equities, especially in the long term.

Will the mutual fund run away with my money? Who regulates them?

The Securities and Exchange Board of India (SEBI) regulates all the registered mutual funds in India. Besides aiming to promote the development of and to regulate the securities market, SEBI formulates policies, regulates and supervises mutual funds to protect the interest of the investors. SEBI keeps issuing guidelines through circulars to mutual funds from time to time to protect the interests of investors and make improvements wherever possible. All mutual funds are mandatorily required to be registered with SEBI before they launch any scheme.

Mutual funds, on the other hand, are professionally managed financial instruments wherein the pooled money of investors is invested in an array of securities across a diverse portfolio, under the expertise of the fund manager.

Why are mutual funds considered risky?

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Mutual funds are considered risky because they invest your money in securities, whose values tend to keep fluctuating due to dynamic market movements. This makes them risky, as the NAV of the fund also keeps changing as per the individual security values held in the fund¡¯s portfolio. However, since mutual funds invest in diverse securities of different sectors, they diversify the market risk. Such diversification followed by the fund manager helps in reducing the market risk of the fund.

What are the different types of mutual funds?

Broadly, mutual funds are categorised into three categories depending upon the basis of categorisation:

Based on maturity period-Closed and open ended schemes

Based on investment objective-Equity (growth oriented). Debt (income oriented), Hybrid (balanced), Money market/liquid schemes, Gilt funds and Index funds.

Based on Taxation-ELSS (Equity Linked Savings Scheme)

What are the benefits of investing in Mutual Funds?

Investing in mutual funds involves a wide array of benefits for investors, prime amongst which include- Presence of SEBI as regulatory body; expertise of professional fund managers to take care of invested money, multiple mutual fund categories aimed to cater to varying risk appetite and investment horizon of investors, along with lots of mutual fund houses and schemes available to choose from; twin investment routes to choose from- SIPs and lumpsum; convenience to purchase, manage and redeem mutual funds online; and availability of tax saving mutual funds (ELSS) to achieve dual purposes of wealth creation and tax saving.

How do MFs pass on the gains to the investor?

There are two ways in which mutual funds pass on the gains to the investors, dividend, and growth. Investors can either choose to reinvest the capital gains and let the money maximize the power of compounding by choosing the growth option, or earn a steady flow of income by opting for the dividend option of payout wherein the mutual fund will give dividends based on their market earnings.

What happens to the invested money if the MF shuts down?

A mutual fund can usually either be shut down when the trustees of the fund approach SEBI for approval to close it, if SEBI itself can direct the fund to shut. In such cases, all investors are returned their funds based on the last available net asset value (after adjustment of expenses) before winding up.

When and how can I take my profits?

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Mutual Funds are considered one of the most liquid investment vehicles, implying that they are amongst the easiest to be converted to cash. Apart from ELSS (which has a lock in period of 3 years, and close ended mutual funds as they can usually not be redeemed before maturity), all other open ended mutual funds can usually be redeemed anytime. Whether you get a profit or loss depends on the market scenario and returns provided at the time of redemption. If your scheme witnessed capital appreciation, which can be visible from the increase in purchase NAV and sale NAV, you can book capital gains. When you submit the redemption request (usually done online nowadays for convenience), after factoring the exit load(if any) and minimum redemption amount for redemption (if set as a pre-requisite by the fund), funds usually get credited to your bank account within 3 business days.