How mutual Funds Work?

how mutual funds work image

What are Mutual Funds?

A mutual fund is a kind of investment that pools money from different investors and invests the pooled money in the stock market-linked financial instruments such as stocks and bonds to generate a return. The combined holding of the fund is known as its portfolio. The fund manager manages the portfolio, and the fund manager researches the market to check the portfolio with fund objectives.

Know-How Mutual Funds work?

Let’s take an example:

Suppose ABCD investing launches a new mutual fund scheme named ABSM Equity Fund. The schemes collect Rs. 1 Crore from 1000 retail investors; amounts are Rs 10,000 per investor. Now fund houses allocate the unit at a NAV of Rs. 10, and each investor gets 1000 units. It means the total number of units issued and assigned by the fund house is 10 lakh Units.

ABSM Equity Fund’s goal is to invest across 25 stocks. To follow the fund’s objective, the fund manager does proper research and chooses the top 25 stocks. The fund manager considers that buying stocks that fit the measures will contribute major returns to the portfolio. On selecting the shares, the fund manager invests equal amounts over each stock. So the equity fund involves of top 25 shares.

Assets Under Management (AUM) of the fund is Rs. 1 Crore and the investment of each stock is approximately Rs. 4 lakh. So, these stocks turn a part of the equity fund portfolio. Also, the fund manager has to compact and invest in a high balance. The whole research endorses all the investments. The fund manager buys stocks that give good returns. Further, the fund also maintains a proper cash balance. It is to deal with returns from investors.

Let’s explain the mutual fund’s internal working mechanism.

Step 1: Increase in Net Asset Value (NAV)

After a month, the portfolio doesn’t show any changes in favor of holding and the number of investors. As the stock price change, the portfolio value will change accordingly. As the stock price goes up, the total NAV of the portfolio also increases. In this scenario, the value of the portfolio grows to Rs. 1.20 Crores. As there is no change in the fund unit of 1000, the new NAV is now Rs. 12.0 ( Rs. 1.20 crores/ 10 lakh units).

The result is the investment value of the investor increase to Rs. 12000 (1000 units * Rs. 12.0 NAV). The investor gains Rs. 2000 ( Rs 12,000 – Rs 10,000). In percentage terms, the profit is 20% (2000/10,000)*100.

Step 2: Redemption:

Investors may deliver or sell their investments. For this fund, a total of Rs. 10,000 units were delivered. In terms of value, the total outflow is INR 12,000 (INR 12.0*10,000 units). As per the result, the fund’s Assets Under Management (AUM) fell to INR 1.08 crore. And, the whole number of units decreases to 9 lakh units. Therefore, the NAV will last at INR 12.0 per unit.

At First, the fund manager utilizes the amount balance in the portfolio to pay investors to deal with returns. Selling shares will be with those companies that do not have any future to move higher. These decisions are taken after proper inquiry and research.

Step 3. Decrease in NAV: 

Suppose that the stock value is decreasing. As a result, there will also be a decrease in the portfolio value—the falls from INR 1.20 crore to 1.10 crore. So, the NAV is now INR 12.22 per unit (INR 1.10 crore/9 lakh units). Now some other investors invest in the fund the total value of the investment is Rs. 10,000.

This time for the same investment value, he only earns 8,18.33 units. According to the result of the new investment, the portfolio value increases to 1.11 crore. So, the whole number of units is now increased by 8,18.33 units. It is just a small example of how a mutual fund works. But in reality, investments/purchases and returns are made daily. The NAV of the fund changes daily.

Factors Affecting Mutual Funds?

Mutual fund pools money from various investors to invest in securities like share, bond, and government securities. In each mutual fund, schemes have a policy set on the time of NFO ( New Fund Offer). Once the policy is decided, the fund must follow it. From the launch of NFO to the division return, mutual fund investing is a cycle of 4 major processes.

Initiate NFO:

In a New Fund Offer (NFO), investors get the chance to subscribe to a mutual fund scheme and invest in it right from the beginning. Although, investors can subscribe only for a limited period. Once the NFO closes, the investors will only buy the units. Likewise, the fund’s scheme is disclosed at the time of the NFO launch, and it cannot be changed before the fund manager fixes the fund scheme because investors invest in the fund based on the scheme. 

Cash to be Pooled:

Mutual Funds collect money from small investors and invest in securities. Investors invest a sufficient quantity of money from their savings. Mutual funds let small investors invest money in a bigger portfolio. Otherwise, they can’t do it. This can be due to insufficient money or a lack of time to perform detailed mutual fund research. Therefore, mutual funds are the best choice for investors.

Invest cash in Securities :

The collected money is invested in securities like shares, bonds, and government securities. The Fund manager checks the fund’s portfolio on the scheme of the fund. The portfolio manager has the experience and quality time to do the fundamental research on the securities.

They also perform company, industry, and economy-level research. At any point in the period, if the chosen securities are not performing well then, they substitute them with better-performing securities. They also use a mixture of investing and trading schemes to take benefit of the stock market situations.

Return of Funds:

The portfolio manager tries to earn a return from the investment; they try to make it on behalf of the fund investors. Therefore, all their time goes to mutual fund research, monitoring, and rebalancing the portfolio increases its NAV. After the fund makes the returns, either they are distributed or invested back into the fund. On the other hand, while for the dividend fund.

And for the dividend, the returns are shared in the form of a dividend. For the growth funds, the returns are reinvested into the funds to enrich the wealth of the fund investors. If the returns reserves in the fund are further invested in creating more wealth for the investors.

CONCLUSION:

In conclusion, it defines how mutual funds work. Also, we cover how a mutual fund works in the market with an increase in net assets value, redemption, decrease in NAV, initiation NFO, cash to pooled, investment in securities, and return of funds. Mutual fund companies provide mutual fund services like Kotak Securities, Aditya Birla Mutual Fund, HDFC securities, SBI mutual funds, etc. If you want to invest in a mutual fund, kindly contact KundkundTC.

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