How do Mutual Funds Work?

Last Updated: 24 Jan 2025

The first thing your parents, friends or a financial advisor will advise you to do when you start earning is to invest a part of your income. By investing your savings, you can accumulate wealth over time, allowing you to multiply your wealth and achieve your short and long term financial goals. Investing your money ensures that your savings aren’t dormant and lose their value. However, when you are just starting to invest, it is better to opt for investment instruments that come with low risk and offer steady returns. One of the best instruments in this segment is Mutual Funds.

Mutual Funds as an Investment Option

While there are numerous investment options for you to explore, most experienced financial advisors advise investing in mutual funds. Why? Investing in a mutual fund is simple, cost-efficient and helps you achieve a diversified portfolio. Investing in mutual funds can help you achieve all of your financial goals.

To understand how mutual funds can help you achieve your financial goals, you must first understand what exactly mutual funds are and how mutual funds work. This will help you make an informed decision before investing in mutual funds.

What are mutual funds?

A mutual fund is a pooled amount of money collected from multiple investors. It is collectively invested in different types of financial instruments, including equity funds, debt funds, real estate, etc., depending on the type of mutual fund.

When you invest in a stock market, you buy shares from the company directly. However, when you invest in mutual funds, you invest in an asset management firm who in turn, invests your money in different assets, giving you a diversified portfolio. Each mutual fund is managed by a professional, seasoned fund manager with extensive financial knowledge. These fund managers do thorough research by analysing exhaustive statistical data before investing.

Now that you know what mutual funds are, let’s outline how mutual funds work with a scenario.

How do Mutual Funds work?

Suppose you have invested INR 1,000/- into a mutual fund. If you are the only individual investing a meagre amount, the returns will not be as significant as you expect. But, in a mutual fund, there are numerous investors like you who invest similar amounts, creating a large pool of money. An asset management company takes this sizable corpus and invests the pooled funds into securities such as stocks, bonds, and short-term debt.

Factors That Affect Investment in Mutual Funds

Four important factors facilitate the working of a mutual fund..

1. Net Asset Value (NAV)

   The overall cost of a mutual fund depends on the price per unit, known as the net asset value (NAV). It is a numerical value assigned to mutual funds, constituting the price of one single unit of the mutual fund. The NAV is calculated by dividing the total cash value of the mutual fund (after subtracting all charges and liabilities) by the total number of mutual fund shares. This net asset value changes every day as the market value of the securities change. The net asset value determines whether a mutual fund is performing well or is underperforming.

2. Fund Manager

   A fund manager ensures the success of the Mutual Fund. They have real-time access to crucial market information which is not available to everyone. They execute trades on the largest and most cost-effective scale by monitoring the companies they have invested in.

3. Assets Under Management (AUM)

   Mutual funds invest in assets using the money collected from investors. These assets include stocks, bonds, and other securities. The total value of all the assets that a mutual fund buys is called assets under management (AUM).

4. Investment Goal

   The agenda behind the investment determines the path taken to invest. Every mutual fund has a goal which it aims to achieve on behalf of its investors. This goal could be capital appreciation, profits in the long term, or distributing regular fixed income as dividends. You should always consider these goals and match them with yours before selecting a Mutual Fund.

How investors earn returns from Mutual Funds

When you invest in mutual funds, you can earn in two different ways – through dividends and capital gains. The funds that were invested in stocks provide dividends based on their market earnings. If you choose to receive these dividends, then you earn this amount. However, many asset management companies will give you a second option, wherein you can reinvest your dividends, and grow your money with the power of compounding.

You can also make money via capital gains. This is similar to the share market, where you buy the units of a mutual fund for a particular price, and when the price of your units increases at some point in the future; you sell your units and earn a profit.

Conclusion

Mutual Funds can prove to be an ideal investment as they provide steady, risk-managed returns for trading or investing for the short or the long term. However, to start the investing process, you would need to open a Demat account online with a reliable depository participant such as IIFL. With IIFL, investors and traders can avail of an all-in-one account through which you can trade or invest in various Mutual Funds online at your convenience.