What Is a Mutual Fund and how it works

People have misconception that mutual fund is like a share or stock of a company where you invest to make profit. To get clarity on this topic let us understand what is mutual fund and how to make money out of it.

Mutual fund is a company that has set some portfolio of stocks, bonds and other securities of different listed companies traded in stock market or available in market for trade. These portfolios are managed by fund managers who are specifically assigned to a portfolio with an objective to manage and monitor the performance of investments.

mutual funds

So you can say its an intermediary that brings group of investors together and invest their money in stock, bonds and other securities.

To invest money into these portfolios, these companies are collecting money from many investors across the world. In return, investors own shares of the mutual fund in proportion to the amount paid. Price that you pay while investing into these companies is the per share net asset value plus any fee that is imposed by the fund.

Income From A Mutual Fund

After investing, your money will be invested and reinvested in the portfolio that you have chosen. There are 3 ways to get money from your mutual fund investments;

  • Out of the fund’s income, a portion will be shared with the investors as dividend. These incomes are generally obtained as year end dividend from companies where mutual fund has investment.
  • If you have decided to sell your investments then the net asset price on the selling date minus the net asset value on the purchase date will be treated as capital appreciation profit.
  • If your mutual fund has some capital appreciation by selling shares then that profit will be shared with you at the year end in proportion to your share holding.

These companies will also give you option of taking out the profit or reinvest in their mutual funds. The option will be yours. If you do not have knowledge of share market, then it’s a good idea to get invested into stocks or shares through a well managed mutual fund.

Mutual fund industry is continuously evolving in India. Generally mutual funds are divided into open end and closed end. Based on the risk factor that investors are willing to take these open end and closed end mutual funds are further divided.

Open End Vs Closed End Mutual Fund

Open end mutual fund means it does not have any limit on number of shares to issue and sell. Its open though out the year and any investor interested in it can buy and sell at a price linked to the fund’s net asset value. These open ended mutual funds are not listed in stock exchange.

Closed end mutual fund is the opposite to open end.

In closed end mutual fund, the number of shares that is available for sale to the public is previously decided or fixed. After reaching that number, new investors are not allowed to invest.

If a new investor wants to buy shares of a closed end mutual fund, then someone else has to sell it first. Closed end mutual funds are listed in stock exchange to facilitate the buying and selling process among investors.

Types of Mutual Fund based on asset class

These open end and closed end mutual funds can be further divided into different categories based on asset class.

Equity Funds

Equity funds are also called stock funds. Money collected is mostly invested in buying stocks of those companies who has potential of large capital gain. Money invested in stock or equity funds are exposed to the same risk that an individual stock carries in a stock market. You can expect capital appreciation in long run if you keep investing for a long term period.

Debt Funds

Debt funds are also known as Income fund. A major portion of it is invested in debentures, government securities and other debt instruments that carry low risk. If you are looking for steady income then we suggest you to invest into these funds.

Money Market Funds

Money market funds or liquid funds are invested into short term debt instruments. If you have surplus money then you can invest into these funds to get good return.

Mutual funds can also be classified based on the market capitalization of the company where investor’s money is invested. Generally based on the market standard these are divided into large cap (invested in companies having bigger market share), mid cap (invested in companies having mid size market) and small cap (invested in companies that has small market). It can also be classified as growth fund (invested in companies that are expected to grow at a rate higher than the normal rate), value stock fund (dividend paid companies) and blend stock fund (mixture of growth and value stock fund).

Editorial Staff at Yourfinancebook is a team of finance professionals. The team has more than a decade experience in taxation and personal finance.