Here’s what Mutual funds (MFs) are, and how they work.
Let’s say you and I had some money, about 1 Lakh rupees each. And we have 8 other friends with the same idea. We all decide that we need to invest this in stocks, but we don’t have the time or energy to do research, tracking, buying selling etc. So we hire a “manager” who has the right experience and tell him – look, you can take upto 2.5% of the total value every year as your fees, but you buy shares that will grow over time, and sell when the time is ripe etc.
10 of us have now put in a lakh each, and the total corpus is Rs. 10 Lakh. We decide that we will issue “units” to denote our interest in the fund, so we issue 1 Lakh units at Rs. 10 each. (It’s like “tokens” in a casino). So each person gets 10,000 units, corresponding to an investment of Rs. 1 lakh.
The manager, who is quite experienced and informed, makes stock buying decisions based on what we, the investors, decided up front – i.e. only LARGE cap stocks, or only Technology stocks, at least 90% invested (only 10% cash) etc.
As the stock values grow, so does the total corpus value. Let us say the value has gone up to Rs. 15.6 Lakhs in two years. Now we have to pay the fund manager 2.5% every year, let’s say that is Rs. 60,000 for two years. So what’s left is Rs. 15 lakhs.
So the value of the 1 Lakh “units” is now Rs. 15 Lakhs, meaning each unit is worth Rs. 15 – this is called the “Net Asset Value” or the NAV. Since each of us has 10,000 units, our individual value is Rs. 1.5 lakhs.
Now I decide to take a trip to Singapore and spend Rs. 75,000. So I “sell” half my units at the current NAV, meaning I sell 5000 units at Rs. 15. To give me money, the fund manager sells some stocks, and now the “total corpus” is down to Rs. 14.25 Lakhs.
But that will again grow with time, but I will see lesser growth than you, because I have only 5000 units and you have 10,000.
One day, when the NAV is Rs. 15 per unit, the fund manager decides the market is going to fall. So he sells half the holding. Now there is half the money in stocks and half the money in the bank. So the manager gives us the money in the bank as a “dividend“. Let’s say he decides to give Rs. 5 per unit as a dividend, for 1 lakh units (ignore my selling bit) – this is termed as a “50%” dividend (since hte initial value of the unit was Rs. 10, and the dividend is Rs. 5. (Your initial value stays the same even after the dividend)
You get Rs. 50,000 as a dividend. But the total corpus has fallen by Rs. 5 lakhs! So the NAV (total corpus divided by no. of units) is going to fall by Rs. 5 per unit. So a dividend for mutual funds is the same as no dividend – you get money, but your fund value goes down.
This is a mutual fund. Now funds can be misused (manager can run away etc.) so the government has regulations for organised mutual funds. They must have a sponsor (usually a bank), a set of trustees (some independent), and an asset management company (AMC) which appoints a fund manager.
Promotion of the fund is done through agents who are recognised by AMFI (association of mutual funds in India). These people get commissions to sell funds, and therefore such funds carry an “entry load“, which is usually between 2 to 2.5%. (this is apart from the AMC/Fund manager fee)
How to invest?
Go to your bank, or go to the mutual fund sites online. They will give you forms to fill and you can write a cheque to the fund. The fund will then give you a “holding statement” with a folio number.
Selling (Redemption of units)
You can use your folio number to sell any of your units. Funds release their NAV regularly, sometimes daily. When you sell it will be at a certain day’s NAV (usually the day u sell or the day immediately afterwards). And you get the money in two-three days usually.
Some places allow you to invest online – Reliance Mutual Fund does, and HDFC bank’s netbanking and ICICI Direct also.
Types of Funds
Note that Mutual Funds can invest in anything – not just stocks. There are those that invest in government bonds, fixed income securities, real estate, indexes, “part debt part equity” etc. Read the offer document of a fund carefully before you invest, and see what the fund will invest in, and how much.
You can also have open ended and closed ended funds. If you can buy anytime and sell anytime, the fund is open ended. Closed ended funds can only be sold at or after a certain date.
I hope this helps. Please let me know your thoughts.