What is a Mutual Fund

A Mutual Fund is nothing but a common pool of money collected from a lot of people which is used by an experienced fund manager who invests the money in the Share market. Not many of us are experienced in investing directly in the Equity market. Mutual funds are a boon to the investor who doesnt have enough knowledge to invest directly in the market but wants to take a risk and gain higher returns from the market.

A Mutual fund works as follows. (I am not getting into the technical terms. This is a very simple explanation)

Mr. X who has a lot of experience in the share market decides to start a MF. He calls for prospective investors. Say investors A, B, C, D & E decide to invest Rs. 10000/- each, Mr. X would be starting his MF with a corpus of Rs. 50000/- X would be creating MF units of face value Rs. 10/- each and distribute it to all the investors. So each A, B, C, D & E would get 1000 units each.

Inv amount = 10000 & Unit Face Value (NAV) = 10

==> No. of units given = 1000 (I have not taken into account the entry load since this is only a theoritical example)

Using this Rs. 50000/- X would buy/sell shares and make profit. At the end of each trading day X would calcuate the total net worth of the initial investment. Say after 1 month of trading, the total value of the investment is Rs. 58000/- then the current NAV of the fund would be Rs. 11.60/- which means each of the investors has made a profit of Rs. 1.60 per unit they bought from Mr. X.

Note: This 58000 would be the amount that is arrived at after subtracting the profit margin that Mr. X would take for using his expertise in forming this MF and making profit. This profit margin would vary from fund to fund but has an upper cut off set by SEBI.

Say after one succesful year of operation the Net assets in the MF stands at Rs. 1,00,000/- then the NAV on that day would be Rs. 20/-

There are three different ways in which MF houses share their profit.

1. Dividend scheme - At the end of the year the MF house has posted a brilliant return of 100%. So the MF house would decide to declare a dividend of say 50% per unit. Which means the investors A, B, C, D and E would be getting Rs. 5000/- each for staying invested with the fund. Plus each of their 1000 units is still invested with the fund and would continue to earn income for them. The most important point to note here is that once a MF house declares a dividend, the funds NAV drops by an equivalent amount. Here since the MF house has declared a 50% dividend the NAV would fall from Rs. 20/- to Rs. 15/-

2. Growth scheme - Unlike the Dividend scheme, there are no intermittent payments in the growth scheme. The 1000 units held by the investors would stay intact and would continue to grow for as long as they want.

3. Dividend Re-investment - In the Dividend Re-investment scheme, once the MF house declares a dividend say 50% in our example, each investor is eligible for Rs. 5000/- The MF house would allocate extra units to the investors at the current market NAV of the fund. In our example our investors would be getting approximately 250 units extra. So at the end of the first year the investors make a gain of 250 units. In the Dividend Re-investment scheme also the NAV would drop in accordance to the declared dividend units. In spite of the drop in NAV the investors dont stand to lose because they have got extra units.

Each scheme has its own pro's and con's. If you want a regular income on your MF investments go for Dividend option. If you do not want to disturb your investment for a long time and allow it to grow go for the Growth option.

Each MF would have its own locking period after which the investors can surrender their units and get cash. We will check the returns of 2 investors A & B. A was invested in Dividend scheme and B was invested in Growth Scheme.

NAV on date - Dividend Plan - Rs. 25.
NAV on date - Growth Plan - Rs. 30. (The NAV of growth plans are always more than that of Dividend plans)

No. of Units held by both A & B = 1000

Surrender Value for A = 25000 (He would have got a dividend of Rs. 5000 at the end of his first year in staying invested)

Surrender Value for B = 30000 (He hasnt got any dividend and the entire corpus he invested had grown to this amount)

Usually the returns of the Dividend plan and the Growth plan are not exactly the SAME. I have taken an ideal scenario and explanined so the returns work out to be the same.

Happy Investing!!!!!