What Are Mutual Funds and How Do They Work?

May 30, 2025

The Assets Under Management (AUM) of the mutual fund sector reached a milestone of ₹64,53,494 crore by February of this year. The number of mutual fund accounts was 23.23 crore.

Mutual funds are popular investment instruments in the Indian market, and these stats definitely indicate a continuously growing interest. Various types of mutual funds now exist with an array of options for different kinds of investors. High return is a key highlight, but not the only mutual fund benefit.

As you enjoy the prospect of exciting investment opportunities and the benefits, a comprehensive understanding of mutual funds and how they work is essential.

Understanding Mutual Funds

A mutual fund is an investment vehicle that gathers funds from a number of investors and invests the aggregate amount in a variety of diversified securities, including stocks, bonds, or other securities. With this pooling of funds, individual investors can invest in a broad range of investments that would be difficult to access and manage individually. Each investor receives mutual fund shares, which represent their portions.

Mutual funds are managed by professional fund managers, who decide on asset allocation and individual investments to meet the fund's preset goals. This experienced management benefits investors with expert guidance and potential returns based on the managers' decisions. Mutual funds also bring diversification since the combined resources are invested in different securities, which helps reduce the risk associated with individual assets.

Working Mechanism Behind Mutual Funds

The following is a step-by-step guide on how a mutual fund is created:

Formation of Fund: An asset management company, or AMC, creates a fund with clearly specified investment objectives, approach, and risk level.
Fund Pooling: Investors learn about the said fund and buy units at the current NAV or net asset value, that is, the per unit value of the total assets of the fund.
Portfolio Management: Professional fund managers monitor the entire investment process. They form a diversified portfolio that complements the goals of the funds.
Regular Reporting: Professional fund managers regularly update investors regarding the performance of the funds and any strategic changes.
Redemption and Exit: Investors may sell their units and enjoy the returns. The sale occurs at the prevailing NAV. There may be an exit load charge when investors exit before maturity.

Mode of Investments in Mutual Funds

Mutual fund investors can enjoy flexibility when investing to best suit their strategy and financial goals with the following investment modes:

Lump Sum: Suppose you want to invest ₹5 lakhs. You buy 5000 mutual fund units at an NAV of ₹100. So, you make a lump sum investment and enjoy returns.
Systematic Investment Plan: Suppose you don't have enough money for a lump sum investment. But you wish to invest, say, ₹5000 monthly for the next 2 years. You can with a systematic investment plan, or SIP.

How Mutual Funds Generate Returns for Investors

Mutual funds use several techniques to optimise investor returns and reduce risks. Here's a summary of the major means through which mutual funds make money:

Compounding: Mutual funds reinvest income like dividends, so returns snowball over a period of time. This process of compounding effect greatly increases capital buildup.
Capital Gains: When the price of shares appreciates, the NAV of the fund goes up. Redemption of units at a higher NAV than the cost price gives rise to capital gains.
Dividend Payouts: Investors of dividend plans get regular dividends from the AMC or the trustees of the fund. They may opt to reinvest the dividends or take them as payments.
Rupee Cost Averaging: SIPs utilise rupee cost averaging wherein one invests a constant amount periodically. In this manner, the investors buy more units when the price is lower and fewer when it is higher, thus the overall cost of investment remains lower in the long term.
Diversification: Mutual funds diversify their investments across various sectors and asset classes, minimising the risk. The diversification balances the underperforming assets in the portfolio with the performing assets.
Low Costs: SEBI has limited the maximum expense ratios for mutual funds. As the funds in a fund grow, expenses are distributed among investors, making overall returns better.

Invest in Mutual Funds with Indiabulls Securities

Enjoy hassle-free and smooth mutual fund investment with Indiabulls Securities. We have a range of funds where investors, whether novice or expert, can select schemes that suit their financial requirements and risk profiles. Find research insights from experts to assist you in making informed choices.

Investment in mutual funds through Indiabulls Securities allows diversification, thus removing risks from market fluctuations. Whether it is the creation of wealth, consistent returns, or tax-saving benefits, we have personalised solutions for different investment goals. We provide a secure and trouble-free experience, ensuring that investment in mutual funds is cost-effective as well as profitable.

FAQs

1. What are the mutual fund investment tax implications?

Here’s how mutual funds are taxed:

STCG Tax: Profits generated from the sale of a mutual fund investment held for less than 12 months are considered Short-term capital gains (STCG). These gains are taxed at a 15% rate for equity funds and at the respective tax slab rate for debt funds.
LTCG Tax: If a mutual fund investment held for more than 12 months is sold with a profit, the profit will be considered long-term capital gain or LTCG. Equity and equity-oriented schemes’ LTCG is to be taxed at 10% if the profit is more than ₹1 lakh in a year. A profit of less than ₹1 lakh is not subject to tax.

2. What is the mutual fund management fee?

Mutual fund management charge is the amount charged by the fund manager and is included in the total expense ratio.

3. What are the advantages of a mutual fund investment?

Capital appreciation, simple access to diversification, professional management, liquidity, and cost-effectiveness are some of the numerous advantages of mutual fund investments.

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Indiabulls Securities Limited (formerly Dhani Stocks Limited) is a Mutual Fund Distributor registered with ‘Association of Mutual Fund of India’ (AMFI) vide ARN number ARN-160411. Corporate Identification Number: U74999DL2003PLC122874; Registered office address: 1/1E, First Floor, East Patel Nagar, New Delhi - 110008. Tel.: 011-41052775, Fax: 011-42137986.; Correspondence office address: Plot no. 108, 5th Floor, IT Park, Udyog Vihar, Phase - I, Gurugram - 122016, Haryana. Tel: 022-61446300. Email: helpdesk@dhani.com