When you think of investing, you may first think of buying individual stocks or bonds. While these are certainly popular investment options, mutual funds are an alternative that is gaining traction with beginners and experienced investors alike. They offer a simplified way to invest in a wide range of assets without having to select and manage individual securities. But how exactly do mutual funds work? In this article, we’ll break down the basics. How to manage investment truststo help you better understand how to use them as part of your investment strategy.
Also read: A complete guide to mutual funds for beginners
What is a mutual fund?
A mutual fund is essentially a pool of money from different investors to invest in a variety of assets such as stocks, bonds, money market instruments, or a combination of these. The pooled funds are managed by professional fund managers who make investment decisions on behalf of all investors in the fund.
For example, let’s say you and a few other investors pool ₹1 billion in a mutual fund. The fund manager will use this Rs 1,000 crore to buy various stocks and bonds with the aim of generating profits for the investors. The performance of mutual funds depends on the performance of the underlying assets.
Investment trust structure
Mutual funds operate on a simple structure and can be categorized into the following components:
- fund manager: Responsible for investment management of the fund. The fund manager decides where to invest the pooled funds based on the fund’s strategy and objectives. A fund manager’s expertise plays an important role in the performance of a mutual fund.
- NAV (Net Asset Value): The value of each mutual fund unit is known as NAV. The price at which units of a mutual fund are bought and sold. NAV is calculated daily based on the fund’s total assets (stocks, bonds, etc.) divided by the number of outstanding units.
- investor: When you invest in a mutual fund, you become one of many investors contributing to that pool. In return for your investment, you receive units of the Fund, and your portion of the total NAV is reflected in the value of those units.
How do mutual funds work?
To understand how mutual funds work, let’s take a step-by-step look at them.
- you invest in mutual funds: The first step is to buy units of a mutual fund through a one-time investment or a Systematic Investment Plan (SIP). When you invest, you pool your money with others in a fund.
- Fund managers make investment decisions: Once the money is pooled, the fund manager invests it according to the fund’s strategy and goals. For example, in an equity mutual fund, the manager invests in stocks, while the manager in a debt fund invests in bonds and other fixed income securities.
- Changes in fund NAV: The NAV changes as the market value of the assets within the fund changes. If the fund’s investment performance is good, the NAV will increase. If performance is poor, NAV will decrease. NAV is the price at which units of a mutual fund can be bought and sold.
- Receive returns based on NAV increase: The goal of investing in a mutual fund is to profit from the increase in value of its underlying assets. If your investment is successful and your NAV increases, your units will increase in value and you will receive a return. However, if the NAV declines, the value of your investment may also decline.
- Redemption of investment: If you want to sell your units, you can redeem them at the current NAV. The amount you receive is based on the number of units you own and the current price of those units.
Types and structure of investment trusts
Although mutual funds all work on the same basic principles, there are many different types of funds, each with its own focus and strategy. Here’s an overview of the most common types of mutual funds:
- stock fund: These funds invest primarily in stocks. Because the stock market can fluctuate, Equity funds are usually suitable for long-term investors Increased risk tolerance. These offer the potential for higher returns but involve a higher level of risk.
- debt fund: These funds invest in fixed income securities such as government bonds, corporate bonds, and Treasury bills. Debt funds are generally less risky than equity funds and are suitable for conservative investors looking for regular income and capital protection.
- hybrid fund: Hybrid funds invest in a mix of stocks and bonds, offering a balance of risk and return. These funds are ideal for investors looking for a moderate approach to investing.
- index fund: Index funds aim to replicate the performance of a particular market index such as Nifty 50 or Sensex. They are passive funds, meaning they simply track an index rather than trying to beat the market. Index funds are known for their low management fees.
- Sectoral funds: These funds invest in specific sectors such as technology, healthcare, and banking. These can offer higher returns, but are also more risky due to their concentration in specific industries.
- Thematic funds: These funds focus on specific investment themes, such as infrastructure or consumption. Thematic funds allow you to target trends and sectors that you think will outperform in the future.
Main benefits of investing in mutual funds
- professional management: One of the biggest advantages of mutual funds is the expertise of the fund manager. They have the experience and knowledge to make informed decisions on behalf of all investors.
- Diversification: Mutual funds provide instant diversification and spread the risk. Rather than investing in one stock, your funds are spread across multiple assets, reducing your overall risk.
- affordable price: Mutual funds are available to most investors. The rise of SIPs has made it possible to start investing with a small amount of money and build a portfolio over time.
- liquidity: Mutual funds are liquid investments. This means you can redeem your units at any time (with the exception of closed-end funds), making them more flexible than other investment options such as real estate.
- transparency: Mutual funds are regulated by SEBI (Securities and Exchange Board of India) to ensure transparency in their functioning and reporting.
Investment trust risks
Although mutual funds offer some benefits, it’s important to be aware of the potential risks.
- market risk: Stock investment trusts are subject to market fluctuations, so their value may decline if stock market performance deteriorates.
- interest rate risk: Debt funds are sensitive to changes in interest rates. When interest rates rise, the value of bonds tends to fall.
- Manager’s risk: The performance of a mutual fund depends on the skill and decisions of the fund manager. If the Manager makes inappropriate investment choices, the Fund’s performance may suffer.
Conclusion: Mutual funds provide a simple and effective way to diversify your investment portfolio, manage risk, and invest in a variety of assets without requiring deep market expertise. Take advantage of opportunities in the stock, bond, and money markets by pooling your money with others and letting professional fund managers make investment decisions.
Before you start investing, it’s important to understand the specific type of mutual fund that fits your financial goals, risk tolerance, and needs. With the right strategy, mutual funds can be a powerful tool for building wealth over the long term.
If you’re new to investing or want to hone your strategy, it’s a good idea to talk to a financial advisor to make sure you’re on the right track.
Happy investing!
