Mutual funds today are one of the most successful and popular investment vehicles to grow your money. However, only a few are truly aware about how a mutual fund makes money for the investors.
How do mutual funds work?
In simple words, a mutual fund is a collective fund where individuals of the same mind pool in money to invest in a chosen asset class/es. This gives you the ability to invest in an asset class which you could probably not afford alone or not be able to due to lack of knowledge, experience and information.
This collected money is then managed by an expert who decides when and where the entire amount or part of money is to be invested to make profits!
So the expert, called the fund manager, is similar to a well-informed individual who makes his own investments in equity or debt markets to make money. The only difference here is that the fund manager is handling a lot more money belonging to different people. Therefore, the role of a fund manager is vital, as he is the one deciding on where the money is to be invested to make it grow for investors.
However, this expert management of money comes with a small annual fee. The total profit made is then returned to the investors, depending on their share in the entire pool of money.
The working of a mutual fund can be best explained with an example.
Let’s assume A has a regular job and manages to save Rs 10,000 every month. He has a good risk appetite and wants to earn more than mere interest from a fixed deposit. He, therefore, wants to take the plunge in the stock market, but is unable to do so due to lack of knowledge and experience. He has four other friends with the similar situation. So A, along with his friends are the investors.
Soon, A meets an accountant who understands and invests in the stock market and agrees to help them with their investments. So the five friends each pool in Rs 10,000 to create a fund of Rs 50,000 to be invested in the stock market by the accountant. The accountant here is like the fund manager of a mutual fund. And the Rs 50,000 is the asset under management (AUM).
The accountant agrees to do the job for an annual fee of Rs 1,200. This is the asset management fees that mutual funds charge.
With the Rs 50,000, the accountant buys certain amounts of 10 different stocks from various sectors. Hence, he has now created a portfolio The accountant has his eye on stock market movements and shuffles the stock investments accordingly. At the end of a year, he manages to make 50% profit. This means the market value of the portfolio is now – 50,000 + 25,000 = Rs 75,000
Since no one really needed the money then, the accountant re-invested the profit in the stock market.
Now A needs to buy a bike and therefore withdraws (redeems) his investment. Since the total amount earned is 50%, each friend (investor) too made 50% profit on his investment. Therefore, A now gets Rs 15,000 on his investment of Rs 10,000. The Rs 5,000 is A’s capital gain.
With the remaining four investors, the fund is still functioning. After another 8 months, the accountant finds an opportunity to make a profit by selling a part of the portfolio. This time, investors ask for a part of the gain and the accountant distributes the profit among all four. This is called Dividend.
However, it is important to know that depending on the economic & stock market situation, there may be times when the mutual fund may incur a loss instead of making profits. It is, therefore, recommended to stay invested in equity mutual funds for the long term to make money.