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 manage who has the right experience and tell him - “Look, you can take up to 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.”

Ten 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 chips at 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 lakh in two years. Now we have to pay the fund manager 2.5% every year, which works out to Rs. 60,000 for two years. That leaves Rs. 15 lakh. So the value of the 1 lakh ‘units’ is now Rs. 15 lakh, meaning each unit is now 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 lakh.

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 anyone else in the fund because I have only 5000 units and while the others 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 holdings. 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 for a moment here). The dividend would then be 50% (since the initial value of the unit was Rs. 10; your initial value stays the same even after the dividend)
So, each one of us get Rs. 50,000 as dividend. But now, the total corpus has fallen by Rs. 5 lakhs! The NAV (total corpus divided by no. of units) is going to fall by Rs. 5 per unit. So a dividend for this “mutual” fund is the same as no dividend - you get money, but your fund value goes down.

This is how mutual funds work.

Now funds can be misused (manager can run away etc.). Hence, 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 recognized by the Association of Mutual Funds in India (AMFI). These people get commissions to sell the mutual funds, and therefore mutual 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 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 you sell or the next working). And usually, you get the money in two-three days.
Some places allow you to invest online - Reliance Mutual Fund does that. HDFC bank’s Netbanking and ICICI Direct too give this facility.

Types of Funds
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 mutual fund carefully before you invest, see what the fund will invest in, and how much.
There are 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.

No doubt that investing in equity seems to be very attractive option for investment. Why it so? We hear many stories, some true, some fictitious, of people who have become millionaire overnight. But the fact is, earning money is not at all easy on the stock market. Let’s accept this simple fact that it is not everybody’s cup of tea. So, we have to be very objective about it.

It is well understood universally that a diversified portfolio is less risky and much safe than a concentrated portfolio.

In India, small-time investors usually have a very limited capital for investment. Therefore, it follows that it is a lot more difficult for this investor with limited capital to have a diversified portfolio. In other words it is not possible for small-time investors to invest directly in the market and to make their portfolio diverse.

So, how can small investors get the opportunity to make their portfolio diverse? The only option left is investing in mutual fund. Mutual funds offer a well-diversified portfolio even with just Rs 100.

A concentrated portfolio, also, could deliver high or low returns. This means that, again, it is against the small investors’ investment appetite normally. It would suit only selected expert investors with high net-worth.

One more thing to notice is that with limited capital it is difficult for small investors to buy shares with high prices like ICICI Bank, Infosys, Reliance, L&T, and other blue chip shares.
Again mutual funds seem to be the better route.
Let’s now discuss equity and mutual funds from a different perspective keeping in mind the common man’s objective.

Let us be honest as far as possible. Ask yourself the following Yes/No questions:

• Reading balance sheet of the company as a fund manager might do
• Identifying up-coming sectors
• Knowledge about companies, market, economics, and politics as a well-experienced professional fund manager might have
• Identifying the risk elements in an investment
• Predicting the future of the market as per any given scenario

If you have all of the above capabilities, go on and make wealth! In most cases, however, the answers would be “No.” Most of us do not have time to learn all these aspects of investment. Even if we do, we may not be able to do it regularly. Mutual funds are well-equipped with fund managers to do all the above activities.
Let us just concentrate on our jobs and leave our wealth management to the pros.