Mutual Fund basics are very easy to understand. In this article, I will try to explain Mutual Fund basics by telling a simple story which will help you to understand mutual funds in a better way.
The Elite 500 Club was having their monthly meeting as usual. Members were discussing a common problem which they were facing. Each of them had a small savings every month, but they did not know how make best use by investing it. The Club decided to form a Committee of 3 members who would solve this problem.
At the next monthly meeting, the Committee proposed a solution. They suggested to pool their savings, investing it under the supervision of the Club and dividing the gain among the investors. All members welcomed the idea. The members asked:-Where would you invest the money? The group had some knowledge that the money will give good returns, if invested in shares but had a faint idea about equity investment. Somebody recommended investing in Chits. But overall, no one had the knowledge, so they decided to contact a Wise man in the city who was well versed in the field of investments. The Wise man accepted the challenge and came to the meeting the next month.
But some members had doubts about this idea. Firstly, who would keep a check on the Wise man and how would they know that their investment is making money or running into losses. The concerns were genuine and again the Committee started thinking. They came out with a set of general rules on investing the money. The Wiseman had to take a prior approval from the Committee before investing. But second concern still remained, which was solved by the Wise man himself. He said that each day he will calculate and declare the value of investment.
The scheme was launched and it was an instant hit. The news spread to other clubs. People from other clubs were also allowed to join. Soon the Committee realized that they had to manage the records of so many people and solve their queries. They appointed a team of experts – Record Keeping Team whose job was to keep the record of investors and handle the investor queries. Similarly a team was appointed to help the Wise man in ensuring the safe custody of shares and other investments.
Till now, the Club was handling all the related jobs and paying salaries. But now that the scheme was a hit, the Secretary told the Committee to charge a fee from the investors to pay for the Wise man and the other employees. This was a good idea. The Committee laid the rules for charging the fees on the investments. All the participants benefited in the long-term through this collective investment.
This is exactly how a Mutual Fund works.
Now let us understand the Mutual Fund basics in technical terms.
Mutual Fund Basics-Technical Terms
In the above story, the members of the Club are the investors like us, and the Committee is the Asset Management Company (AMC), who runs the entire affairs of the Mutual Fund. Since this Committee is appointed and answerable to the Club, the Club is the Sponsor of the Mutual Fund. The Wise man appointed, is the Fund Manager. The Rules laid are the Objectives, which are set for each Mutual Fund Scheme. The Value of investment that the Wise man is reporting is helpful in calculating the Net Asset Value (NAV). NAV is the unit value of the asset and is calculated by dividing the net assets by the numbers of unit holders. The Record Keeping Team is Registrar & Transfer Agent. And finally, the team appointed for ensuring the safe custody of investments is called the Custodian. The fees that the scheme is charging are called the Asset Management Fees.
Benefits of investing in Mutual Fund
The biggest advantage is the Diversification. Each unit holder contributing in small proportion becomes a part owner of a large portfolio. This minimizes the risk by dividing the investments in many securities.
Through Mutual Fund, you get expert management for your investment and you can invest in small amounts. Since this is a collective investment, the cost of management is very low and most important is the liquidity aspect. You can invest a fixed amount regularly (SIP) and save for your long-term goals. This concept of Rupee Cost Averaging will help you in averaging your cost of buy and which has given good returns in the past.
Also from taxation point of view, mutual fund scores over other investments. Profits from the sale of equity mutual funds after one year from the date of investment are considered as long-term capital gains and are tax-free.
There are many types of mutual funds in the market to confuse the investors. Your success lies in identifying the right fund and investing in it.
Please share your views if the story has helped you to understand Mutual Fund basics in a better way.