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Objectives and Functions of Mutual Funds

Updated on :  

08 min read.

Mutual funds are a popular investment option among Indian investors right now. They are financial instruments that collect money from different individuals who share a common financial goal. The pooled funds are then invested in multiple investment options like shares, stocks of listed companies, corporate and government bonds and other money market instruments. 

To understand how mutual funds may benefit you, you must know the objectives of mutual funds and their functions. Keep reading to know more. 

All about the objectives of mutual funds

Here are the objectives of mutual funds:

  • Asset diversification

A reason why mutual funds are such a great investment is that they have a large number of assets in their portfolio. You will often hear expert investors advise not to put all eggs in one basket. 

Because if you do so, there is a high chance that the fall in asset value will affect your entire portfolio. As mutual funds invest in a large number of holdings, it provides necessary diversification that protects the investment in case of a decline in the value of any of one of these assets.

  • Generating income

Fixed-income investment managers generally use two types of investment management types to generate income for investors. They are interest rate anticipators and spread traders. If a mutual fund has income generation as its main objective, it becomes riskier than a money market fund. However, its returns are also high.

If you want a mutual fund with a high-income potential, go for dividend and mortgage funds, domestic and international bond funds, etc. 

  • Safeguarding capital

If you are investing in mutual funds to safeguard your capital, you need to select one that has safeguarding capital as its main objective. These types of mutual funds generally have a lower risk-to-return ratio. A good example of a mutual fund in this category is a money market mutual fund. 

  • Initiating growth

Mutual funds primarily focusing on growth are a great investment option to hedge against inflation. They are generally called equity funds and have holdings in common stocks and sometimes in preferred shares. 

Furthermore, this type of mutual fund offers better returns as compared to income funds, but they also come with higher risks. 

Functions of mutual funds

To understand the functioning of mutual funds, you need to have an idea on how it works. Here is how it operates.

NFO release

A firm starts a mutual fund through a New Fund Offer (NFO) launch. Its fund manager sets and discloses the strategy at the start of the launch, and investors can decide how much they want to invest based on it. Please take note that investing in an NFO will be cheaper than existing funds as it is new to the market. 

If you are thinking of investing in an NFO release, please check the minimum subscription amount, investment cost, objectives of the fund, reputation of the fund houses, etc. 

Pooling of money

After the NFO release, mutual fund companies collect funds from interested investors to buy holdings in a variety of stocks, bonds, etc. Investors can now buy shares of the mutual fund as per their wish. 

Investment in securities

Based on the mutual fund’s strategy, its fund manager decides the portfolio and invests the funds in various securities like bonds, shares, etc. 

As opposed to investing in stocks or other alternatives, mutual funds are safer. This is because the dedicated fund manager does thorough research on the economy, industry and company before making any decision.

An analysis of this level helps the fund manager find securities that suit the fund’s strategies the best and ensure the highest return for its investors. 

Return of funds 

As the mutual fund generates returns, the funds are either distributed among the investors or reinvested into the fund’s holdings. 

If you choose a dividend fund, you get returns in the form of dividends. However, if you invest in growth funds, the fund manager reinvests the returns into the fund to increase the wealth of its investors. 

So, you can conclude that the functions of mutual funds include channelising investor wealth and maximising it.

A hypothetical example of how mutual funds work

Let’s take an example for a better understanding of the whole process. 

Suppose, Reliance launches a mutual fund scheme called RIL Top 30 Fund. The company has 100 investors and pools at a total of Rs.1 crore for investment. Thus, every investor contributes Rs.1 lakh to the mutual fund.

The investment firm allots the Net Asset Value (NAV) of Rs.10, and thus every investor gets 10,000 units. So, the total units issued stands at 10 lakh units. 

Now, the fund manager will use these funds to invest in the top 30 funds that will best suit the mutual fund’s strategy and provide the best returns to its investors. After the market analysis, he selects the top 30 stocks. Then, he distributes the funds equally among each stock. 

Therefore, the equity fund comprises of the top 30 funds. The Assets Under Management for this mutual fund are Rs.1 crore. 

Now, let’s say the mutual fund’s portfolio does not see any change with respect to the number of investors or holdings. Under such circumstances, if the stock price goes up, there will be a rise in portfolio value resulting in a profit for the investors. 

Investors can also sell their investments or redeem them. In such cases, the fund manager uses the cash balance in the fund’s portfolio to pay off the individual. He may also sell some shares from the mutual fund’s portfolio. However, in this case, the shares will be of those companies that do not have the potential to grow further. 

Now let’s say the stock prices fall. In such a situation, the NAV will also plummet. However, if a new investor joins the mutual fund, investing the same amount of money, the situation will change. 

This new investor will get a lesser number of units, which you can assume as ‘x’. Due to his/her investment, the portfolio value will rise. Furthermore, the total number of units will also increase by ‘x’ units. 

This is a very basic explanation of how a mutual fund works. Investments and redemptions occur daily in a mutual fund’s life cycle, and the NAV also changes daily. But, the entire process revolves around this concept. 

Now that you have a basic understanding of mutual funds, you can dive deeper into this world. If you choose an appropriate mutual fund for investment, it can act as a very convenient way to make your wealth grow. 

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