How equity mutual funds work

How an equity mutual fund works is actually quite simple. You give money to a fund, and the fund invests this money in stocks. The gains or losses, whatever they may be, accrue to you. At a minimum, this is all you need to understand in order to invest in an equity fund.

Expenses: Clearly, a mutual fund is a business and not a charity. It must take some money from you in order to meet its expenses as well as to make some profit, and indeed it does. Equity funds are legally permitted to charge up to 2.25 per cent per annum of the money it manages as its expenses. Since the amount of money it manages goes up and down every day, the fund deducts a small sum from your money daily such that, on average, the annual deduction adds up to the specified percentage. There are some complexities to this charge - smaller funds are allowed to charge a little more. Also, in order to encourage financial inclusion, funds are allowed to charge a slightly higher amount if they get more investments from smaller towns and rural areas. You can read more about expense ratio in detail here.

Mutuality: The meaning of the word 'mutual' in 'mutual funds' is quite intuitive. A mutual fund is basically composed of the money that a large number of people have pooled together and gets invested. The way the law, rules and regulations are formulated, all investors are treated equally irrespective of their investment amount.

NAV and Units: The NAV (Net Asset Value) of a fund and the number of units that an investor owns are two of the least useful, most misunderstood and most overvalued numbers. A mutual fund is made up of all the money that its various investors have invested on a combined basis. Here's an example: A fund is launched and let's say 1,000 investors invest Rs 10,000 each in it. A fund is divided into 'units' to represent an investor's share of ownership (you may think of it like shares in the case of a company). The price of each unit is called NAV, which is set to a round number initially. Typically, this is Rs 10 at the time of fund launch. In all, the fund has Rs 1 crore of assets under its management (Rs 10,000*1,000). Also, each investor is said to own 1,000 units (10,000/10) and in all, the fund has issued 10,00,000 units.

Let's dig deeper into NAV. It refers to the current value (on any given day) of each unit of a fund. In the current example, the fund manager invests the Rs 1 crore of assets in various stocks. In the beginning, the NAV is Rs 10 and each unit is worth Rs 10. Let's say that after a year, the investments have done well and Rs 1 crore grows to Rs 1.1 crore. Now, the NAV of each unit is Rs 11 (1.1 crore divided by 10,00,000). Each investor owns 1,000 units, so the value of his investments has grown to Rs 11,000. It is important to understand that the only relevant thing here is that the total assets have grown by 10 per cent and therefore the investors have made a gain of 10 per cent. If the fund had initially had a face value of Rs 100, then the NAV would have grown to Rs 110; or if the face value had been Rs 1, then the NAV would have grown to Rs 1.10. From an investor's point of view, only the percentage change in NAV is important, not the actual number.

Whenever an investor has to invest money, he needs to buy units and when he wants to redeem his money, he has to sell his units. Both of these transactions take place at the prevailing NAV. Under some circumstances, there might be a small extra charge at the time of redeeming which is called an exit load. It is levied to discourage investors from pulling out money from equity funds, usually before completing one year.

To know more about mutual funds and understand how they work, you can check out this video series.