Mutual Funds – A Primer

June 10, 2022

I don’t know why you want to learn about mutual funds.

It could be because you saw an ad on TV that said that mutual funds are the right thing.

It could be because you heard from your friends or colleagues that they are investing their money in mutual funds and you got curious.

It could be because you wanted to save some money on taxes and your HR department asked you to consider tax saving mutual funds.

It could be because you read an article in a newspaper or website that mutual funds in India are growing as an investment option faster than traditional options like fixed deposits.

It could be because you were always interested in investing in the stock markets and thought mutual funds were a safer route to do so.

It could be any of these or many of these. The good news is that none of these are wrong reasons to learn about mutual funds.

Truth is, whatever be your motivation to start looking into this investment option, it is important that you learn about them the right way, and understand what you are getting into.

The worst thing you can do is put your money into something because others are doing so or because someone on the internet said it’s a good idea. Because, when you do that, you would not know the right way to invest, how to manage your investments, and importantly, how to get out of it when you need to.

On the other hand, when you do understand the basic concepts about mutual fund investing, you can really make it work for you:

  • It can earn you handsome profits over the long run and make you wealthy
  • It can help you take care of your family’s financial needs very efficiently
  • It can save on your tax outflow in the short run AND over the long run

Having said all this, it should be noted that mutual funds may not be for every individual out there.

I have seen a lot of people have the wrong ideas about mutual funds – that they are all about stock market investing, that they are too risky, that it costs too much, that its too much work etc – ideas that they have either heard from people who are similarly ignorant or from sales people selling other (mostly bad) financial products. When these people decide to stay away from mutual funds, it’s an irrational decision borne out of fear and ignorance.

If you understand the concepts of mutual funds – what they are, how they work, what its benefits are, what the risks are, how to use them, how not to use them – and then take a decision that they are not quite the right tool for your money, that is perfectly fine. It is unlikely that you will come to such a conclusion, though.

In this article, my endeavour is to talk about mutual funds from a practical point of view. I have tried to not bore you with the theoretical stuff more than I absolutely had to. Wherever possible, I have used examples and illustrations from real life to explain the ideas that I tried to communicate.

Mutual Funds - A Primer

Some basic stuff

Every product that we use in our day-to-day lives has two things: One, an internal mechanism that is mostly or completely hidden from us, and two, an external “interface” that is exposed to us. It is this interface that we use when we say that we are using this product.

For example, let’s take a classic alarm clock – it has a complex mechanism on the inside, but on the outside, we see a knob to set the alarm, a way to reset it, and a snooze button. 

Financial products are similar too. Especially those that are available to regular people like you and me. They have complex internal workings, but they present a relatively simple external face.

The external face – which includes data and operations that can be done – depend on the internal workings of the product. That is why no two financial products look the same to a customer.

Understanding the inner workings can be interesting, but understanding the controls – the ‘interface’ – is more important for a user of the product. So let us look at how a customer of mutual funds would “interact” with the product – what they will see and what they can control.

But before we go there, let’s take a look at something simple and familiar.

A simple product

Let us start with something that we are all familiar with – the simple bank fixed deposit. 

For a customer (“investor”) of a fixed deposit, what are all the data points that are visible and most relevant to them?

  1. The name of the bank that is issuing the fixed deposit
  2. The term of the fixed deposit – how long the money will be locked in the deposit
  3. The interest rate (represented as an annual compounding rate) that the deposit will pay, and the terms associated with it.

Now, we know that, from the list above, the term of the deposit is not something that is cast in stone. A deposit can be ‘broken’ in the middle of the term. But there are ‘penalty’ clauses associated with that. So, these clauses are also part of the ‘data’ that the customer would need to know.

If we take an example, a fixed deposit from SBI bank could be offering 8% interest for a 365-day (1 year) deposit.

If an investor invests Rs 1 lakh in this deposit, they will get back Rs 1 lakh + Rs 8000 = Rs 1,08,000 at the end of one year.

So far, so good, and simple.

Let’s change it a bit

Now, let’s tweak this fixed deposit product little by little and see what happens.

To begin with, let’s not change anything about the product itself. Let’s just change the data that is visible to the investor. 

Let us take the same example from earlier – the SBI deposit that gives 8% annual interest.

Suppose this deposit sends a mail every day to the investor informing them about the value of their investment that day. In this case, the 8% rate is applicable over 365 days. So, every day, the investor would get a mail saying that their investment’s current value has increased by (0.08/365)% from the previous day. That is a 0.021% increase every day.

So, the mail will state that the value of the investment is Rs 1,00,022 after 1 day, Rs 1,00,044 after 2 days, Rs 1,00,659 after 30 days and so on.

I know – such mails would not be of much value – the rate of return is guaranteed, so there can be no surprises in such mails. But it lets the investor know the *current* value of their investment every day, so I guess it’s not entirely useless either.

And it helps us to get closer to understanding how mutual funds work 🙂

Let’s chop it up

Now, let’s introduce one more change. Suppose the bank manager tells the investor that they have to invest in an FD by buying it in some chunks – let’s call it ‘certificates’. Each certificate is worth, let’s say, Rs 100.

So, an investor investing Rs 1 lakh would buy a 1000 such certificates at Rs 100 each.

Nothing else changes – the same term applies, and the same interest rate.

Except now, each certificate worth Rs 100 will mature in one year and come back to the investor as Rs 108. And if you add up a 1000 of such certificates, the investor will end up with the same Rs 1,08,000 as previously.

Now, let’s look at the daily email that the investor is receiving. Instead of saying that their investment is worth x amount every day, what would the email say?

It would say that each ‘certificate’ is worth x amount, and since you own 1000 certificates, your total investment value would be 1000 times x.

Going with the same previous example, the mail will state that the value of a certificate is Rs 100.022 after 1 day, Rs 100.044 after 2 days, Rs 100.659 after 30 days and so on. The total value of the investment (in 1000 certificates) would be the same as before. Except now the data is broken up a bit more.

Let’s change the terms

As we know, a fixed deposit matures after a certain period of time. It can be ‘broken’ in the middle of the term subject to certain conditions and likely, a financial penalty. 

Let’s assume that that is not the case – how would it be if we can ask for our money back on any day? 

Now, we are getting an email every day letting us know what our investment’s current value is. What if we can go to the bank and say, ‘I would like my money back at today’s value’ and the bank, without any issues, puts it back in your account within a few days (say 2 to 3 days)?

That would be nice, no?

Also, now, we have our deposit in the form of certificates, right?

Can we ask for a partial ‘break’ of our deposits? Let’s assume we can! We have 1000 certificates, and we go to the bank and say I would like to turn in 500 of them at today’s value, but retain the remaining 500 in the deposit. And the bank takes 500 certificates from you, converts them into cash, puts it in your bank account while letting the remaining 500 certificates continue in the deposit and accumulate interest.

What would be the benefits of such an arrangement for you, the investor? 

  1. It gives you flexibility – you have control over how much to keep invested and how much to take out when you need
  2. It gives you liquidity – the money is not locked, and you can get it out when you want without going through a lengthy process
  3. It gives you visibility – thanks to the system of certificates and the emails, you can find out what the value of your money is on any given day.

Let’s add a twist

In all these changes so far, one thing that we have not changed is the basic financial aspect – at the end of the FD period, the investor gets the same amount – the principal plus the interest promised. 

Let’s add a twist to that and see.

Suppose instead of saying we will give you 8% interest, the financial institution – the bank in this case – says the following:

“We can’t tell you how much we will give you. We are going to take your money and lend it to some companies for them to do their businesses. Whatever interest we get from them, we will take a small administration fee and pass on the rest to you”.

Your reaction will likely be, ‘Wait, how will I know what to expect???’

And the answer of the financial institution would go something like this – “In the past, whenever people invested with us in this manner, we have always given them good returns that are better than the bank across the street would give you for a fixed deposit. Also, you can find out everyday what your money is worth, and you can take it out anytime without any penalty whatsoever”.

So, essentially, the bank is offering you a more transparent, more flexible, and possibly, a higher return than traditional deposit products. With a catch that they won’t tell you upfront how much you will make.

Would you be tempted to take the financial institution on this offer? Think about it.

Some of you will want the security of knowing the returns before-hand; some of you like the freedom and the potentially higher returns.

And some others may want to try both – put some money in a typical bank deposit, and the rest in this ‘new’ opportunity.

As you may have guessed by now, what I have described in this section is what a mutual fund is. More specifically, what I have described here would be a “Liquid” fund or a “Money Market fund”.

A mutual fund manages money for you. You give them your money as an investment, they invest it (in one or more of many ways), and give it back to you, hopefully with some profits, when you ask for it. We will get into more details as we go along, but this essentially the gist of how mutual funds work.

Now let us take a ‘use-case’ and see how the mutual fund investment process works.

Mutual funds – How does it look to the investor?

Now that we have a basic understanding of what a mutual fund investment is, let’s take it for a spin and check it out. 

Suppose an investor, let’s call him Rohan, has some surplus money that he is going to need back in 12 months time. His colleague tells him that liquid funds are investment for this time-frame.

Rohan is a first-time investor, so he googles a bit, and decides to go with an online platform to make this investment. He opens an account with the platform (after going through a simple KYC process), and chooses a fund (probably with a bit of help from the same friend who recommended mutual funds in the first place).

On January 1, 2019, he goes ahead and  invests Rs 1 lakh in HDFC Liquid fund.

Like we saw earlier with an experiment on the bank deposit, this liquid fund is available in pieces that he has to buy. These pieces (we called them ‘certificates’ earlier) are called ‘Units’. Each unit of this mutual fund is priced at Rs 3597.07 (actual historical value). This unit price is often referred to as the ‘NAV’ of the fund.

So for Rs 1 lakh, he is able to purchase 27.8 units. His account looks like this:

Scheme nameNAVInvestment amountNumber of unitsCurrent value
HDFC Liquid (Direct)3597.071,00,00027.81,00,000

Since he has just invested, the ‘Current value’ is the same as his investment amount.

He does nothing after this. After 6 months, he logs in and checks his account. His account will look like this:

Scheme nameNAVInvestment amountNumber of unitsCurrent value
HDFC Liquid (Direct)3725.131,00,00027.81,03,555

Please note that his investment amount remains the same (he has not added to it after the first investment) and the number of units also remains the same.

What has changed is the NAV – the price per unit of the mutual fund. Since it is the price of 1 unit, and since the investor is holding 27.8 units, the current value of the investment is Rs 1,03,555.

How did the NAV change? Simple –  the person in charge of taking care of Rohan’s investment has made profits in the portfolio and that has increased the value of the unit price.

Rohan comes back again in 1 year and checks his account:

Scheme nameUnit costInvestment amountNumber of unitsCurrent value
HDFC Liquid (Direct)3831.31,00,00027.81,06,510

Now, at this time, Rohan needs the money. So, he goes to his investment platform and files a withdrawal request (known as redemption request). The system asks if he wants to:

  1. Redeem some amount and leave the rest in the investment
  2. Redeem some units and leave the rest in the investment
  3. Redeem all the units (meaning all the money)

So, Rohan can take as much or as little as he wants from this investment depending on his needs.

He takes out Rs 50,000 and leaves the remaining in the account. The system computes how many units will be required to redeem Rs 50,000 and processes the request. Rohan gets his money in this bank account in a couple of days.

He comes back later to check his account balance. It looks like this:

Scheme nameUnit costInvestment amountNumber of unitsCurrent value
HDFC Liquid (Direct)3835.9053,52914.7556,579

As you can see, the unit cost has increased slightly thanks to the growth in the fund’s investments. But the number of units has gone down, thanks to the redemption of Rs 50,000. The current value reflects the reduced number of units in the account.

And this goes on – Rohan can now invest more in this account – in the same fund or a different fund; he can check his account balance at any time, withdraw how much ever he wants out of it at any time and so on.

This, in essence, is how mutual funds work for an investor – what they see, what they can do with their account etc.

Of course, this is a bit simplistic view of the mutual fund investment process. And this covers only one category (liquid funds) of one type of mutual funds (debt funds). The type of funds that invest in the stock market (equity funds) are the most interesting. There are a variety of very interesting ways MFs can be seen and handled. All to serve your investment interests! 

There is a lot more to it – we haven’t even spoken about SIP yet!

All that and more to come.

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