Mutual Funds are one of the best investment instruments for someone who has decided to step out of the safe zone of fixed return financial instruments. It can very well be said that it provides a middle path for the risk averse and the risk loving investor to tread.
Investing in a mutual fund means nothing but entrusting a professional investment manager to take investment decisions for you. A mutual fund might invest in a wide variety of underlying assets like Equities, Government Bonds, Gold etc. The decision as to which asset to invest in and how much to allocate for each asset will be determined by the professional investment manager.
A finance company that is interested in starting a mutual fund, sets up what is called an Asset Management Company ( AMC, Fund House or Mutual Fund Company). To form an AMC, the finance company has to get a licence from the Securities Exchange Board of India (SEBI). SEBI is the securities market regulator in India. It is also responsible for regulating the Mutual Funds market in India.
Once the AMC is formed, the AMC floats what is known as a mutual fund scheme. They do this after deciding what kind of a mutual fund they would like to offer. One or more persons are appointed as fund managers. While offering the Scheme, the AMC clearly defines the investment objective and the mode of operation of the scheme in a set of Offer Documents the format of which has been specified by the regulator. This ensure that the public investor knows exactly how their money is going to be invested.
Just like you, a lot of investors subscribe to a particular mutual fund scheme. Thus a total corpus is created which in turn is called Assets under Management.The total corpus of the mutual fund scheme is sub-divided into Units (or shares), which the investors buy. As the value of the investments made by the mutual fund changes, the value of the units changes as well. This is called the NAV (Net Asset Value) of the unit. It’s calculated by dividing the total value of the net assets of the fund by the number of units. This is published daily so you know how your money is doing. You also get periodic statements with information about your holdings.
Suppose you want to invest in a mutual fund. You buy a unit of a mutual fund during the New Fund Offer (NFO) period. You will get a unit at Rs 10. Rs 10 is the NAV of the mutual fund scheme during NFO. Like you 9 other people bought one unit each at Rs 10. This way the mutual fund scheme collects total Rs 100 for 10 units. The fund manager invests this Rs 100 in some shares. After one year the value of Rs 100 investment becomes Rs 150. Now the net asset value (NAV) of every unit will also become 150/10=15.
The AMC does not do all this for free. They charge a fee for managing the money. In addition there are other costs such as brokerage fees, costs of publishing statements etc. These need to be borne by the investors and are deducted from the corpus periodically. These are called Expenses of the fund and the ratio of expenses to the total money managed by the fund is called Expense Ratio. To protect investors, the regulator SEBI has specified the maximum expense ratio that can be charged. Most fund houses manage to control costs and keep the expenses below the maximum cap.