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How Mutual Funds Work? Research Team | Posted On Saturday, August 04,2018, 06:33 PM

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How Mutual Funds Work?




Mutual Funds are long-term investments which help grow your money. You can invest a sum of just Rs 500 via SIPs in mutual funds. They can be held as long as the investor desires. Mutual Funds are subject to market fluctuations and can be risky.       

Mutual Funds are classified into equity funds, debt funds and hybrid funds. The classification is done based on the investment horizon, asset classes and tax treatment. This classification often overwhelms investors and mutual funds are often mistaken to be complicated. But in reality, they are quite simple.

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How Mutual Funds Work?


Mutual funds are managed by a professional fund manager. Therefore, they are the best investment option for investors who don’t have much knowledge and time to invest in the stock market.


What are mutual funds?


A mutual fund is a company that pools yours and other investors' money and invests in equity, debt or a mix of both. They are diversified investments and reduce the risk in investment. Mutual funds invest in securities like stocks, bonds, money market funds and so on.


How mutual funds work?


Professional fund managers buy and sell financial securities to achieve fund objectives. When you invest in a mutual fund scheme, you hold units of the scheme. If the mutual fund makes profits, the value of your investment increases and vice versa.

Mutual funds are classified as open-ended and closed-ended:


  • Open-ended mutual funds can be bought and sold whenever you want.
  • Closed-ended mutual funds have a time period within which you need to subscribe to the fund.


What is total expense ratio?


Mutual funds charge investors for managing schemes. Money is invested in equities, gold, bonds and other assets. The total cost charged by the mutual fund is called Total Expense Ratio (TER).

Mutual funds have two types of expenses. They are recurring and non-recurring expenses. Non recurring expenses are borne by the fund house while recurring expenses like management fee, distributor’s commission, and marketing expenses are expressed as a percentage of assets managed.

See Also: Hidden Costs In Mutual Funds

Types of Mutual funds:


1. Equity mutual funds:


Equity mutual funds invest in stocks. They are high risk investments and yield high returns.


2. Debt mutual funds:


Debt mutual funds invest in debt instruments like government securities, corporate securities and so on that give fixed returns at low risk.


3. Balanced mutual funds:


Balanced mutual funds invest in both shares and bonds. They offer moderate returns with moderate to low risk.


SEE ALSO: Types of Preference Shares


Sources of income from mutual funds:


  1. Dividend payments: Dividend income is distributed to the unit holders in proportion to holdings.
  2. Capital gain: If you stay invested in an equity mutual fund for a year or more, gains are called long term capital gains. Gains accrued in a time period less than a year are called short term capital gains. For debt funds short term gains are less than 3 years and long term capital gains are more than 3 years.
  3. Net asset value (NAV): NAV gives the value of a mutual fund.


Mutual fund tips:


1. Understand the risks: Invest in mutual funds which best meet your financial goals and risk tolerance.

2. Define investment objectives: Define your investment objectives as to ‘how much can you invest’ and ‘how long you can stay invested’.

3. NAV does not determine growth: Do not invest in a mutual fund based simply on the Net Asset Value (NAV). NAV is the face value of a mutual fund scheme and doesn’t impact growth. It is not an indicator of the performance of mutual funds.

Let’s say you bought 100 units of a fund with NAV of Rs 10 vs 10 units of a fund with NAV Rs 100. In both cases, you are investing Rs 1,000. Say that both the schemes generate 10% return. You will earn Rs 100 on both the investments of Rs 1,000.

4. Focus on long-term growth: To earn good returns from Mutual Funds, you need to stay invested for the long-term as in the short-run, equity markets are volatile. Therefore, focus on investing in equity-oriented mutual funds for 5 years or more to earn good returns.

5. Ideal strategy: Ideally, you should have some of your investments in short-term (debt) instruments to maintain liquidity and some in long-term investments (equity). Investing in debt funds ensures liquidity and equity funds ensure capital appreciation.

6. Monitor your portfolio: Monitoring your investment portfolio helps examine performance. If a particular mutual fund is not meeting your expectations or objectives, you can consider reallocation of non-performing investments into other instruments and give a fresh start to your investment portfolio.


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