What are Mutual Funds and How Do They Work?

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what are mutual funds and how do they work?

In India, most individuals have traditionally relied on gold, fixed deposits, and real estate for their investment needs. That being said, in the last twenty years, mutual funds have emerged as a lucrative investment option.

With mutual funds, you can earn higher returns on your investments compared to the traditional investment route. Additionally, they provide liquidity, easy access, and tax-saving benefits (ELSS). There are various mutual funds available in the market that suit your individual investment needs. Whether your goal is to save up to buy a house or for your child’s marriage, mutual funds can be the answer to all your financial goals.

What are Mutual Funds?

A mutual fund (MF) is a pool of money that is managed by a professional fund manager. They invest the pooled fund in various financial securities such as stocks, bonds, gold, etc. The fund managers allocate these funds to generate capital gains or revenues for the investors.

How do Mutual Funds Work?

In order to understand how mutual funds work, it is necessary to know what Net Asset Value (NAV) is. NAV is the price you can redeem or buy your investment. When you invest in mutual funds, you will be allocated fund units that are proportionate to your investment and this is calculated based on the NAV. For example, if you invest ₹1,000 in funds with a NAV of ₹20, you will get (1000/20) 50 mutual fund units.

The NAV changes regularly depending on the asset’s performance. In case the fund invests in a stock whose price goes up, it will be reflected in the NAV of the mutual fund. Therefore, the performance of a mutual fund is based on its underlying assets.

Let us take one more example to understand this better, if the NAV goes up to ₹25, then your 50 fund units that amounted to ₹1000 earlier will become ₹1,250 now. If you redeem the units, you will receive ₹1250 against the ₹1000 you invested initially. This profit of ₹250 is called capital gain. As the mutual fund portfolio’s market value keeps changing and is not fixed, the NAV also varies every day based on the portfolio’s valuation. Therefore, the gain of ₹250 could also be a loss. It depends on how the assets under the portfolio perform and the NAV’s movement.

Mutual funds are also subject to long-term capital gain (LTCG) and short-term capital tax (STCG). This will have an impact when you redeem your investment.

Kindly keep the two points mentioned below in mind:

  • The tax is applicable only if you redeem your investment.
  • The extent of applicable tax depends on the type of mutual fund you have invested in and your mutual fund’s investment holding.

Objectives of Mutual Funds

Mutual funds seek to fulfil the objectives mentioned below for their investors:

Capital protection: Mutual funds such as liquid and money-market funds aim to protect your investment. Remember that even though they are relatively safe, they also provide low returns.

Saving tax: A specific class of known as Equity-Linked Savings Scheme (ELSS) or tax-saving mutual funds provide tax deductions of up to ₹1.5 Lakhs in a particular financial year,

Capital growth: Equity funds prioritise growth in order to protect your capital against inflation. These funds invest in stocks with potential for higher returns.

Various Modes of Investing in Mutual Funds

Fund houses nowadays offer several modes of investing in mutual funds like –

Lump sum investment: The lump sum investment lets you invest all your surplus amount in one go. It is a suitable mode of investment if you are ready to take high returns for high risk.

Systematic investment plan (SIP): It helps develop a disciplined investment strategy irrespective of the condition of the market. You can start a SIP with a low investment amount, and it can help you build a corpus steadily over time. A SIP Calculator is a tool that can help you understand the returns your investments could earn during a period.

Systematic transfer plan (STP): STP gradually helps invest a substantial corpus in a specific asset class gradually. It provides you with the benefit of rupee cost averaging. You can start an STP with a single mandate.

Dividend transfer plan (DTP): With DTP, you can choose to reinvest the dividend income either from an equity scheme to a debt scheme or from a debt scheme to an equity scheme. The dividend income reinvestment can be done in another mutual fund scheme of the same fund house.

As the saying “Do not put all your eggs in one basket” goes, it is also important to diversify your investment portfolio. Mutual Funds are diverse in nature. They diversify across assets and securities that can keep the risk at an optimal level. Hence, it is considered a good practice to conduct proper market research before starting your investment journey.

(This is a sponsored article.)