Beginning investors are probably introduced to mutual funds because of how easy they are to use compared to other types of investment instruments in the market. But what are they? How do they actually work?

This tutorial will help you understand mutual funds in simple terms, how they work, and why they are a favorite among both newbie and veteran traders alike.

What Is a Mutual Fund?

Mutual Funds are investment options, which pool money from a large number of investors and use it to invest in a variety of stocks, bonds, or a combination of both.

You no longer buy individual securities, but rather buy units of a mutual fund. A unit is a proportionate part of the entire portfolio of the mutual fund.

In other words, mutual funds give you an opportunity to invest in many different companies or instruments with a single investment.

How Mutual Funds Work

Mutual Funds are managed by fund managers. This is how it all goes down:

1. Investors contribute funds
   Several investors pool funds into a mutual fund.

2. Fund manager invests the money
   The fund manager invests this amount in different assets depending on the fund's objective.

3. Portfolio earns returns
   The return is received through appreciation, interest, and dividends earned by underlying assets.

4. Benefits are shared
   The gains or losses are distributed to the investors in proportion to their investment.

The amount of your investment increases or decreases every day according to the performance of the underlying assets of the fund.

What Is NAV (Net Asset Value)?

NAV stands for the Net Asset Value, and it is the price per unit of a mutual fund.

The mathematical formula for calculating the Net Asset Value is:

NAV = (Total Value of Assets − Total Liabilities) / Total Units

The NAV is revised at the end of each trading day. When you invest in a mutual fund, you purchase units at the prevailing NAV of that day.

Unlike stocks, mutual funds are not traded during market hours. Trading in mutual funds, whether purchase or sale, happens at the end of the day on the closing NAV.

Kinds of Mutual Funds

There are different types of mutual funds intended for various investment purposes and risk categories.

Equity Mutual Funds

These funds primarily invest in stocks. Their return potentials are also greater, though there is also greater risk. They could be considered best suited for goals involving a long period.

Debt Mutual Funds

These investments are made in fixed income instruments, including bonds and treasury bills. These tend to be more conservative and stable.

Hybrid Mutual Funds

These funds simultaneously invest in equity and debt markets.

Index Funds

Index funds follow a specific market index, for example, Nifty 50 and S&P 500. They are less costly and try to mirror market performance.

Sectoral or Thematic Funds

These are sector-specific, for example, focused on IT or healthcare. These are more risky and are not ideal for novices.

Active vs Passive Mutual Funds

Active Mutual Funds

Actively managed funds are dependent on managers who pick securities with the aim of beating the market.

Pros:

• Ability to outperform the market

• Professional decision-making

Cons:

• Higher fees

• Performance is dependent upon the manager’s skill

Passive Mutual Funds

Examples of passive management funds are index funds, which try to mirror the performance of a market index.

Pros:

• Reduced expense ratios

• In line with market returns

Cons:

• No opportunity to outperform the index

How Do Mutual Funds Earn Profits?

Sources of returns of a mutual fund are three:

• Capital Gains – Rise in the value of the securities held by the fund

• Dividends – Income from stocks or interest on bonds

• NAV Appreciation – Overall increase in the value of the fund units

Returns are reflected in the NAV and may also be shared with investors periodically.

Costs Associated with Mutual Funds

Although mutual funds are convenient, they do cost money. The major expenses involved are:

Expense Ratio

A fee charged annually for fund management. The expense ratio is inversely proportional to the net return.

Load / No Load

A fee that you may have to pay if you withdraw your funds before a certain time period.

Taxes

Mutual funds generate tax dues based on the type of mutual fund and the holding period.

Knowledge about costs assists you in selecting investment funds suitable for your future plans.

Advantages of Investing in Mutual Funds

• Diversification – Helps mitigate risks

• Expert Management – Professionally managed by experienced fund managers

• Accessibility – Start investing with small amounts

• Liquidity – Easy to buy or redeem

• Transparency – Regular disclosures and performance reports

All these advantages make mutual funds a robust entry scheme for novice investors.

Risks Associated With Mutual Funds

Even while mutual funds help minimize risk, they are not completely risk-free.

• Market risk

• Interest rate risk (Debt Funds)

• Manager risk (Active Funds)

• Sector concentration risk

The amount of risk varies depending on the type of fund you invest in.

How to Begin with Mutual Fund Investment

• Stabilize your investment goal

• Select the appropriate category of funds

• Comply with KYC requirements

• Monitor periodically, not daily

SIPs are very popular among newbie mutual fund investors since they teach the importance of disciplined investing.

When Are Mutual Funds a Good Choice?

Mutual funds are a good choice if you are:

• Seeking diversification without individual stock selection

• Preferring professional management

• Investing for medium- to long-term goals

• Able to withstand some market changes

They may not prove ideal if the investor requires assured returns or wishes to make short-term placements.

Concluding Thoughts

Mutual funds make investing easier by offering a combination of diversification, professional help, and flexibility. Regardless of whether you are accumulating capital, saving for retirement, or planning to fund future outlays, mutual funds are likely to have a significant role to play in your life.

The first step is understanding how they work. Once you are clear about your objectives and risk levels, you can use mutual funds to invest effectively and systematically.