How Mutual Funds Make Money for You

When you invest, your money joins a pool with money from many other investors. The fund uses that pool to buy shares, bonds or other assets. You own units, which represent your share of the whole pool.

If the pool becomes more valuable, each unit becomes more valuable. If the pool loses value, each unit loses value. Our page on what a mutual fund is explains this structure.

An equity fund owns shares of many companies. When those companies grow their profits over the years, their share prices tend to rise. The fund holdings become more valuable, and so does your investment.

This is usually the biggest source of growth for equity funds over long periods. It is also why equity funds can fall: share prices go down as well as up, sometimes sharply.

Many companies share part of their profits with shareholders as dividends. When a company held by the fund pays a dividend, the money goes into the fund.

In a growth option, that income stays in the fund and adds to the NAV. In an IDCW option, the fund may pay some out to you. Our page on growth versus IDCW explains the difference.

A debt fund lends money by buying bonds and similar instruments. Borrowers pay interest, which flows into the fund and slowly raises the NAV.

Debt fund values also change when interest rates move, because bond prices react to rates. Our pages on debt funds and YTM and modified duration explain this in detail.

Fund managers sometimes sell holdings that have risen and buy others they find more attractive. Any gain on a sale stays in the fund and becomes part of its value.

How often a fund trades is shown by its portfolio turnover ratio, as our page on portfolio turnover ratio explains.

Every working day, the fund adds up the value of everything it owns, plus any cash and income, subtracts its expenses, and divides by the number of units. That gives the NAV, the value of one unit.

Your investment value is simply the NAV multiplied by your units. Our page on what NAV is explains the calculation.

The fund charges an expense ratio for management and running costs. This is deducted from the fund daily, so the NAV you see is already after expenses.

Costs do not stop a fund from growing, but they reduce what you keep. Over many years, lower costs make a noticeable difference. Our page on expense ratio explains how they work.

You make a gain when you redeem units at a higher NAV than you paid. Until you sell, any gain is on paper. You also make money if you receive IDCW payouts, though these reduce the NAV by the same amount.

For SIPs, each instalment buys units at a different price, so your overall return is measured best by XIRR, as our page on XIRR explains.

If the share prices of companies the fund owns drop, or bond prices fall because interest rates rise, the NAV falls too. A borrower failing to pay can also hurt a debt fund.

A fall is a loss only if you sell at the lower price. For long-term money, staying invested gives time to recover. Our page on risk and volatility explains why.

Company profits grow over years, not weeks. Over short periods, share prices are driven by mood and news. Over long periods, the growth of businesses has historically mattered more.

That is why equity funds suit long-term goals. Our page on compounding explains how growth builds on growth over time.

In an active fund, the manager chooses which companies or bonds to own, trying to do better than the benchmark. In an index fund, the fund simply copies an index at low cost.

Either way, the returns still come from the same sources: rising prices, dividends and interest. Our page on active versus passive funds compares the two approaches.

A low NAV does not make a fund cheaper or more likely to grow. A new fund offer is not automatically a bargain. And no regulated mutual fund can promise fixed high returns.

Our page on mutual fund myths explains these common misunderstandings.

Imagine a fund that owns small pieces of fifty large companies. Over a few years, most of those companies sell more, earn more and become more valuable. A few struggle. On balance, the pool is worth more than before, so each unit is worth more.

Now imagine a bad year when the whole market falls because of fear or bad news. The same companies may still be doing fine, but their share prices drop for a while. The NAV falls too. If you hold on, and the businesses keep growing, prices usually recover over time. This is not a promise, only how markets have tended to behave.

With a SIP, you invest the same amount every month. When prices are low, that amount buys more units. When prices are high, it buys fewer. Over time, this smooths out the price you pay.

It does not remove risk, but it takes away the need to guess the right moment. Our page on rupee cost averaging explains this in simple terms.

• Equity funds grow mainly through rising share prices and dividends.
• Debt funds earn interest and react to rate changes.
• NAV reflects all of it, after costs.
• Values can fall, and time is the main protection.

We are distributors rather than investment advisers and we recommend no schemes. If you want help understanding your own funds, get in touch.