What is a Mutual Fund ?

A Mutual Fund in India is an entity which pools in people’s money and invests in stocks, bond and other securities to generate a return.

Each investor is given units of the mutual fund in exchange for cash – he then becomes an owner of the fund’s asset. The entity which does the collection and investing on behalf of all investors mutually is called Asset Management Company (AMC).

The basics

The AMC releases a detailed prospectus of what the objectives are of the mutual fund, where it will invest the collected money, for how long and who the fund manager will be.

It is the prospectus that the investor needs to read through to decide if the mutual fund meets his investment objectives or not. He can then either invest his money into it or reject it based upon the risk-return outlook of the mutual fund.

The process by which a new mutual fund is launched to collect money from investors is called New Fund Offer (NFO). This was, until some years back, called IPO which lead to a lot of confusion and misselling as investors bought into mutual funds mistaking these pseudo IPOs of mutual funds with those of stocks when a company goes public.

How does it earn ?

A mutual fund generates profits by using the investor’s money to buy and sell its holdings.

The Net Asset Value (NAV) of a mutual fund is calculated by summing up the value of all its holdings (shares), subtracting the liabilities, and dividing the result by the total number of securities it holds. The NAV is the value at which investors buy and sell units of the mutual fund.

When a mutual fund makes profits by buying low and selling high, it can distribute its earnings in two ways. First is by way of dividends which the investor receives. The second is by way of growth of the mutual fund itself. This is the capital gain the mutual fund generates for the investor over a period of time.

As an investor, these are the two ways you can make money from a mutual fund.

Where do they invest ?

Mutual Funds invest in a wide variety of securities.

The ones that buy and sell shares of companies are called equity mutual funds. So for example, Reliance Growth Mutual Fund could buy shares of Infosys (among others) and expect to make a profit by the capital appreciation of this stock.

Equity mutual funds can take a lot of risk by investing all of their money into stocks. In this sense, their returns are tied to the fate of the stock market. So these are meant for investors who can take some amount of risk.

Debt Mutual Funds are ones that invest in government securities, fixed deposits, corporate debt and other short and medium term debt products. These are marked by lower risk and high liquidity. Debt mutual funds are for risk averse investors who want to stay away from the volatility of the stock market.

Also read advantages of mutual funds and the different types of mutual funds in India.