How Does Mutual Fund (MF) Work in India

To re-emphasise what we mentioned in the previous chapter, if you need more time or expertise to research direct stocks, you can invest in them through equity mutual funds.

The charm of mutual funds is that a professional fund manager decides what stocks to buy and when to buy and sell. The responsibility of growing your money lies with them - just like you hire a lawyer to look after your legal matters and a chartered accountant to pay your taxes.

There is one difference, though.

Unlike other professionals, mutual fund managers offer blanket service to many investors.

Let's explain it to you in more detail.

How Does a Mutual Fund Work?

Since many people want to put their money in equity, the fund manager collects their money and invests it on their behalf.

Say there are 1,000 such people, and all are willing to invest ₹10,000. The fund manager would now invest this pooled money of ₹1 crore (10,000 x 1,000) and buy stocks based on their expertise.

That's the macro part.

From your point of view, you get a few units of a mutual fund upon investing.

These units represent yourorth at any point? That is where NAV comes in.

What is an NAV?

The worth of each mutual fund unit is called Net Asset Value (NAV). If the NAV grows, so does the value of your mutual fund investment. An example can better explain this question.

Assume you invested ₹ 10,000 in a mutual fund scheme when its NAV was ₹ 25.

That means you received 400 units at the time of investing.

Five years later, when you decide to take out your money, you see the NAV has grown to ₹50 - meaning you will receive ₹20,000 (400 units x ₹50) within three business days in your bank account.

Therefore, from your perspective, you only need to look at the difference between NAV at the time of buying and selling. In essence, this is how a mutual fund helps you make money. It's simple, straightforward and easy to understand.

Are Mutual Funds Safe?

Mutual funds are structurally safe and regulated by SEBI (Securities and Exchange Board of India), simi share of ownership of the fund. But how do you know how much they are wlar to how the Reserve Bank of India regulates banks.

The companies running these mutual funds (known as Asset Management Companies) must meet many legal requirements. For instance, they are legally obligated to release detailed data about how they operate and where they invest.

Everything is transparent, giving you, everyone, and me the power to monitor them. Moreover, to ensure our money is safe, SEBI has directed that AMCs also have a portion of their own money invested in their mutual funds.

Don't mistake safety for a guarantee of returns. A mutual fund can inflict losses by making poor investment decisions on your behalf. But you shouldn't lose sleep. While it is true that equity doesn't guarantee returns and can subject you to sharp ups and downs on a day-to-day basis, the risk diminishes substantially over a longer time frame of five years or more.

For example, in the last seven years (as of December 31, 2022), even the worst diversified equity fund delivered returns at 9-10 per cent per annum!

So you see, even after making a poor choice, you would have been better off than any investment alternative such as the Public Provident Fund (PPF), fixed deposits (FDs), and gold.

What Is the Minimum Amount You Can Invest in a Mutual Fund?

For most funds, it is possible to start investing with as little as ₹ 500-1,000. To give you perspective, you would be unable to buy even a single share of many companies for that low an amount!

A single Reliance share costs upwards of ₹2,000; even smaller companies' stocks can cost more than that. For instance, the stock price of Honeywell Automation is worth ₹ 35,000 as we speak!

Yes, a single stock can cost that much money!

However, with mutual funds, even with a minimum investment of ₹500-1,000, you can benefit from a diversified portfolio of 25-30 stocks or more.

Is it possible to withdraw money anytime? 

Unlike many other investments, most mutual fund investments are highly 'liquid'.

'Liquid' means an investment that can be withdrawn without any delay.

If you wish to exit your mutual fund, you can expect your investment to land in your bank account within three business days. While you must refrain from withdrawing prematurely if you want to build long-term wealth, you at least have an exit route.

What Are the Costs?

You need to pay a percentage of your investment amount every year. This is called the 'expense ratio'. Mutual fund companies charge an expense ratio to manage your money.

The expense ratio is used to pay the salaries of fund managers and employees and commissions to agents, among others. Please note that no company can charge you more than 2.25% of the expense ratio.

What’s the Best Mutual Fund Investing Strategy?

There's a mutual fund for every need. The funds are suitable based on the following:

• how much risk you are comfortable taking
• how much time you are willing to invest
• your objective (to save tax, earn income on your investment, etc.)

No matter what type of investment you want, there will be a variety of funds that suit you.

The universe of mutual funds is vast. At the broadest level, there are three types of funds - equity, debt and hybrid.

As the name suggests, equity funds invest in equity shares or stocks. Debt funds invest primarily in fixed-income instruments such as bonds. Hybrid funds invest in both equity and debt instruments.

That’s not all; there are sub-branches, but we don’t want to bombard you with information. Let us not look at them one by one. That'll only confuse you.

Instead, we will keep it straight to the point and summarise and illustrate the work of a mutual fund in India. Therefore, the next part we will discuss is the regulation of such mutual funds.

Who Regulates India’s Mutual Funds?

The Securities and Exchange Board of India (SEBI) is India's primary regulating agency of mutual funds. SEBI regulates all elements of a mutual fund scheme, including their establishment, operations, administration, charges, and performance.

Under the Securities and Exchange Board of India (Mutual Funds) Rules, 1996, rules about how mutual funds are regulated in India are given. These rules are subject to regular revision and review, and they suit the changes in the market conditions to fit the needs of the investors.

Structure of Mutual Funds

The mutual fund industry in India is a three-tier structure that involves fund sponsors who form schemes and then register them, trustees who oversee the mutual fund's work according to regulations, and AMCs or asset management companies in charge of the fund.

A fund sponsor is the party that creates the mutual fund and then registers it with SEBI. In keeping with the Indian Trusts Act enacted in 1882, Mutual Funds in India are organised as Trusts.

The trustees are the police officers of the mutual fund, and they make sure that the fund is managed for investor benefit only. They are the decision-makers who ensure that the fund's assets are protected and compliance with SEBI regulations is followed with all diligence.

The asset management company (AMC) is responsible for managing the trust (Trustee). This organisation ensures that all the investment decisions made by the fund are optimal for achieving the fund’s set objectives. The AMC should get SEBI’s registration, and it shall be governed by the rules with which SEBI was entrusted.

When Did Mutual Fund Start in India?

In 1963, Unit Trust of India (UTI) came into existence, which signalled the start of the mutual fund industry. The UTI was created by the Reserve Bank of India (RBI) to promote a culture of team ownership and investment in the growth of corporations and reaping profits.

India had only one fund partially owned by the government until the early nineties when the government allowed private-sector mutual funds to join the market. By that time, the Indian mutual fund business had expanded at an unprecedented speed, as depicted by the staggering increase in the sector's assets under management (AUM ) and also a large number of new mutual funds that entered the market.

Regulatory Role of SEBI in Mutual Funds

SEBI is the regulatory body that controls the mutual funds industry in India. The policies envisage a legal framework consisting of all rules and directives necessary for mutual funds' existence, operation, regulation, and management. The primary purpose is to safeguard mutual fund investors‘ interests and provide transparency in the operations of mutual funds so that investors can independently acquire knowledge and spread awareness.

The following is a list of some of the important guidelines or regulations that SEBI has released for mutual funds in India:

SEBI (Mutual Funds) Regulations, 1996

Regulations, which are laws, dictate the establishment, maintenance, and administration of mutual funds in India. The rules relate to various matters, including the enrolment of mutual funds, the appointment of trustees, the role of fund management, investment restrictions and transparency standards.

SEBI (Mutual Funds) Regulations, 2020

The purpose of these laws was to resolve the issue of mutual fund portfolio concentration and problems of risk management and asset allocation. These laws prescribe that mutual funds should diversify their stock and sector holdings across the whole portfolio to avoid concentration risk and increase the overall diversity of the portfolio.

Scheme Categorisation and Rationalisation

This circular has been issued by the Securities and Exchange Board of India (SEBI) to justify the mutual fund business. With this in view, the variety of schemes that mutual funds offer will be minimised, and specific categorisation guidelines will be implemented for mutual fund schemes. The aim was to make the procedure of comprehending and comparing the different mutual fund plans for the investors.

Consider These Points Before Investing In Mutual Funds

Self-Analysis of Financial Position

Determining the person’s investing goals is the commencement of a full analysis of the person’s financial status. This requires determination of the investment time horizon, the amount of risk one is willing to bear, and the expected return.

Once the investment objectives have been identified, the second step is to create an allocation strategy for the available resources. A more appropriate asset allocation might improve the investment portfolio. Asset allocation refers to allocating money to several asset classes, including stocks, bonds and cash.

Study the Schemes of Concern

Before investing in mutual funds, much reading and background research must be done. When researching mutual funds, it's important to consider factors such as: 

1. History of Performance: The track record of a mutual fund over its life will provide some direction to future probability of performance. Investors should analyse the fund’s historical returns and assess its performance vis-a-vis its benchmark index.
2. Track Record of Fund Management: The fund manager’s track record and previous employment can explain the potential of the fund's future success. Those who think of putting money into the fund should check how the fund’s manager behaved in the past and his investment style.
3. The reputation of the Fund House: The reputation of the fund house is a second variable to consider during the mutual funds analysis. Investors should ascertain the fund house’s history, corporate governance standards, and regulatory compliance record.
4. Expense Ratio: The expense ratio is the amount that the mutual funds charge for managing the portfolio. Investors benchmark expense ratios of different mutual funds to determine the mutual funds that offer the best value for money.

Investment Portfolio Diversification

Diversification spreads one’s assets across various asset classes and market sectors to reduce risk. Diversification is important and can play a significant role when investing in mutual funds as it decreases portfolio volatility and thus mitigates the effect of market fluctuations.

Investors who want to diversify their portfolios through mutual funds may buy equity, debt, or hybrid funds. Investors should diversify their investment within each asset class across different companies and sectors to eliminate concentration risk.

Number of Funds In Your Portfolio

An investor should strive to minimise the number of mutual funds in the portfolio. There is duplication of the underlying investments, and most people with too many mutual funds to manage find it difficult. 

Therefore, the investor should concentrate on creating a well-diversified portfolio and choose a few hand-selected mutual funds.

How To Track Your Mutual Funds Portfolio on Angel One?

1. Open the Angel One app. Go to ‘PORTFOLIO’.
2. First, go to ‘Mutual Funds’. The performance of the mutual funds units bought via Angel One will be displayed here, along with your daily and overall gains/losses.
3. You can check the performance of your overall Mutual Fund Portfolio by clicking on ‘OPEN INVESTMENT DETAILS’ and clicking on ‘All’. It will include the performance of the mutual funds bought via other brokers as well.
4. You can also analyse your portfolio by clicking on ‘VIEW PORTFOLIO ANALYSIS’.

Time Framing the Investment

An investment's time horizon is the time period for which the investor has invested in the fund. The investment horizon is an uncertain variable that is based on the investor’s risk profile and investment objectives.

Debt mutual funds may be considered a superior alternative for the short-term horizon. On the other hand, equity mutual funds will generate a better return over the long run.

Would you like to get into the details of analysing mutual funds and learn how to choose the appropriate ones that match your risk profile and investment targets? We have other chapters following next that will lead you through those topics.