What Are Mutual Funds and How Do They Work?
- Srujan Pavuluri
- Mar 1, 2022
- 8 min read
Updated: May 28
Mutual funds have become the go-to investment option for salaried professionals looking to grow wealth without having to decode stock markets themselves. They pool money from thousands of investors and invest in a diversified mix of assets, making them accessible even with modest capital. Yet, what seems simple at the surface often hides complexities that can affect your returns, risk exposure, and long-term outcomes.
From how fund houses are structured to the types of funds available and the math behind the returns, they all influence whether your investment serves your goals. The more you understand these layers, the more confident and consistent your investment journey becomes.
What Is a Mutual Fund?
A mutual fund is an investment vehicle that collects money from multiple investors and invests it in a diversified portfolio of stocks, bonds, or other assets. It is managed by professional fund managers who make investment decisions on behalf of investors, based on the fund’s objective. Investors own units of the mutual fund, and their returns depend on the fund’s performance.
Imagine a chit fund, but regulated, transparent, and professionally managed. Everyone pools in money, but instead of rotating withdrawals, a fund manager invests the pooled amount into different financial instruments.
How Do Mutual Funds Work?
To understand how mutual funds work, it helps to look at the process from structure to execution.
1. Structure of a Mutual Fund
A mutual fund is set up as a trust under the Indian Trusts Act. It involves three key entities:
Sponsor: Initiates the fund
Trustee: Safeguards investor interests
Asset Management Company (AMC): Runs day-to-day operations
Scheme: Defines the fund’s investment objective, strategy, and asset mix.
The AMC appoints a fund manager to handle all investment decisions.
2. Pooling of Money
When you invest in a mutual fund, your money is combined with that of thousands of other investors. This pooled capital is then used to buy a diversified portfolio of assets like equities, bonds, or a mix of both.
3. Allotment of Units
In exchange, you are allotted units based on the amount you invest. Each unit has a value called Net Asset Value (NAV), which changes daily depending on market performance.
4. Role of the Fund Manager
The fund manager buys and sells securities with the goal of generating returns in line with the fund's stated objective.
5. Distribution of Gains and Losses
Profits, losses, interest, and dividends are distributed proportionately among all investors based on how many units they own.
6. Regulatory Oversight
All Indian mutual funds are regulated by SEBI, a body that ensures transparency, compliance, and periodic disclosures.
Where Do Mutual Funds Invest?
A mutual fund is only as good as where it puts your money. Behind every SIP and lump sum investment, there’s a carefully chosen mix of financial instruments, each with its own risk profile, return potential, and role in your wealth journey. The fund manager’s job is to navigate this landscape on your behalf. Your job is to understand where your money is going.
Let’s break down the five most common categories of mutual fund investments:
Note: None of the examples used below are recommendations but are mentioned to help you understand the types of mutual funds better.
Equity Mutual Funds
These funds invest primarily in shares of publicly listed companies. Their goal is to deliver capital appreciation over time. Returns can be volatile in the short term but rewarding over longer periods.
Example: A large-cap equity fund may invest in companies like Infosys, HDFC Bank, and Reliance Industries.
Debt Mutual Funds
These invest in fixed-income instruments like government securities, corporate bonds, PSU bonds and treasury bills. They aim to offer stable and predictable returns with lower risk than equities.
Example: A corporate bond fund might invest in high-rated bonds issued by NTPC or LIC Housing Finance.
Hybrid Mutual Funds
A mix of equity and debt, these funds balance growth and stability. The ratio between equity and debt varies depending on the fund’s objective.
Example: A balanced hybrid fund might allocate 60% to stocks and 40% to corporate and government bonds.
Global or International Funds
These funds invest in foreign markets, giving Indian investors exposure to global businesses and currencies.
Example: An international fund might invest in Apple, Amazon, or Tesla, listed on US stock exchanges.
Sectoral or Thematic Funds
These are focused funds that invest in a specific sector (like IT or Pharma) or a theme (like ESG or Make in India). They come with high risk and high potential reward.
Example: A pharma sector fund may hold stocks like Sun Pharma, Dr. Reddy’s, and Cipla.
How Returns Are Calculated (NAV Growth)
Mutual fund returns are primarily calculated based on the growth in Net Asset Value (NAV), which is the per-unit price of a mutual fund.
Here's how it works:
When you invest in a mutual fund, you receive a certain number of units based on the NAV at the time of purchase.
Over time, the NAV rises or falls depending on how the underlying investments (stocks, bonds, etc.) perform.
The difference between your purchase NAV and the current NAV represents your gain or loss.
Simple Example:
You invest ₹10,000 in a fund whose NAV is ₹100.
You receive 100 units.
Two years later, the NAV grows to ₹125.
Your investment value = 100 units × ₹125 = ₹12,500
Return = ₹2,500
Absolute return = 25% over 2 years
CAGR = approx. 11.80% annually
What Returns Can You Expect from Mutual Funds?
Mutual Funds don’t offer any guaranteed returns, at the same time, they are far from random. When people hear that mutual funds can offer “10 to 12% returns,” they often assume that’s guaranteed. But that figure is an outcome of how mutual funds have performed historically, not a promise of future results.
Expected Returns, on the other hand, are projections based on current interest rates, market valuations, and macroeconomic trends. These are useful for planning but shouldn’t be considered as inevitable outcomes.
For example:
A conservative investor might estimate 9–10% from equity funds instead of 12%.
For debt funds, expectations should match the prevailing bond yields, usually between 6–7% for high-quality funds.
How Long Should You Stay Invested?
There’s no one-size-fits-all holding period for mutual funds, but your investment horizon should match the type of fund, your goals, and your risk tolerance.
Here’s a breakdown to guide your decision:
Equity Funds:
Best suited for long-term goals (5+ years). Shorter durations may expose you to market volatility without giving time for recovery.
Debt Funds:
More appropriate for short to medium-term goals (6 months to 3 years). Ideal for capital preservation or planned expenses.
Hybrid Funds:
Can suit 3–5 year horizons, offering a middle ground between equity growth and debt stability.
Tax Saving Funds (ELSS):
Come with a 3-year lock-in, but ideally held longer to benefit from equity growth.
Volatile or Thematic Funds:
Require patience and a strategic entry point. Hold only if you're clear on why you're invested and can tolerate the ups and downs.
Key Mutual Fund Terms You Should Know
Understanding mutual funds doesn’t require a finance degree, but it does help to get comfortable with a few common terms.
Units: The mutual fund issues units to investors who invest in the fund. Each unit is like one share in the mutual fund. Although they are not exactly the shares, we can compare them this way for the sake of understanding.
NAV (Net Asset Value):
The price of one unit of a mutual fund. It’s like the per-share price of the fund and is updated daily.
Expense Ratio:
The annual cost charged by the fund house for managing your money. It includes management fees as well as expenses such as STT, brokerage, administration charges and so on. Lower is generally better, especially for long-term investors.
AUM (Assets Under Management):
The total money a fund manages across all its investors. It reflects the fund's size but doesn’t guarantee better returns.
Exit Load:
A small fee (usually 1%), you might have to pay if you sell your investment before a certain period. Designed to discourage early exits.
SIP (Systematic Investment Plan):
A method to invest small amounts regularly (e.g., monthly), helping build wealth steadily and benefit from rupee cost averaging.
Lumpsum:
A one-time investment into a mutual fund, often used when you have a large sum ready to invest.
Fund Manager:
The expert who manages your money by making buy/sell decisions in line with the fund’s objective.
Benchmark:
A standard (like Nifty 50 or Sensex) that your fund’s performance is compared against. Beating the benchmark is a sign of good fund performance.
Different Ways to Invest in Mutual Funds
Your choice of how to invest can be just as important as what you invest in. Whether you’re working with a tight monthly budget, a sudden bonus, or long-term retirement funds, mutual funds offer flexible modes of entry.
Each method serves a different need, from building wealth steadily to deploying large amounts strategically to creating income post-retirement. Understanding these options helps you align your investments with your cash flow, risk appetite, and life goals.
Let’s explore them.
Systematic Investment Plan (SIP)
A Systematic Investment Plan (SIP) allows you to invest a fixed amount in a mutual fund at regular intervals, usually monthly. It helps you build wealth gradually and reduces the risk of market volatility through rupee cost averaging.
Lump-Sum Investments
Lump-sum investment means putting a large amount of money into a mutual fund at once. It is ideal when you have surplus funds and want to invest for long-term goals without breaking them into smaller parts.
Systematic Transfer Plan (STP)
A Systematic Transfer Plan (STP) lets you shift money from one mutual fund to another over time. Commonly, investors park money in a low-risk fund and transfer it gradually into a higher-risk fund to manage volatility.
Systematic Withdrawal Plan (SWP)
A Systematic Withdrawal Plan (SWP) allows you to withdraw a fixed amount from your mutual fund at regular intervals. It’s useful for generating steady income during retirement or for recurring financial needs.
How to Start Investing in Mutual Funds with WealthEase
You can choose WealthEase as your Mutual Fund Investment Advisor and start by opening an investment account with us. The instant e-KYC process is a breeze, and you can get started with your mutual fund investments immediately! If you already have existing mutual fund investments, you can transfer them to our platform and track all your investments with a single login.
Frequently Asked Questions
Can I sell my mutual funds anytime?
Yes, you can sell most mutual funds anytime. However, some funds may have exit loads or minimum holding periods. Always check the fund’s terms before redeeming.
Are SIP and mutual funds the same?
What is the main disadvantage of a mutual fund?
What is the full form of NAV?
What are the 4 Ps of mutual funds?
Commentaires