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HOW DO MUTUAL FUNDS WORK ?

To understand how Mutual Funds work, let us first understand the concept of NAV (Net Asset Value). NAV per unit is the price at which investors can buy or redeem their Mutual Fund investments. Investors in mutual funds are the alloted units proportional to their investments and this is calculated on the basis of NAV. For example – if you invest Rs 500 in a Mutual Fund with a NAV of Rs 10, you will get (500/10) or 50 units of the Mutual Fund.

The NAV of Mutual Fund changes every day on the basis of performance of the assets in the Mutual fund being invested in. If a Mutual Fund is invested in a particular stock whose price goes up tomorrow, the same will reflect in the NAV of the Mutual Fund and vice versa. So, in the above example, if the NAV of the Mutual Fund goes up to Rs20, then your 50 units, that was amounted to Rs 500 earlier will now amount to Rs 1000 (500 units multiplied by Rs 20). Hence the performance of Mutual funds is driven by its underlying assets, which generate its returns to investors. If anyone again redeem the units of Mutual funds, then one shall receive 1000 Rs against Rs 500, that was originally paid. The gain of Rs 500 is known as the ‘Capital gain’. The market-value of the Mutual Fund Portfolio is not fixed but varies every day; consequently NAV also tends to change daily, based on the valuation of the Fund-portfolio. Hence, this gain of Rs 500 can be a loss also, depending on how the NAV moves and the underlying assets perform. Since Mutual Fund investments are market-linked, the returns are not guaranteed and are also dynamic in nature.

Mutual Fund Returns (capital gains) are subjected to tax, known as ‘Capital Gain Tax’, which will impact on choosing to redeem the investments; like in the example above, one will be liable to pay a tax on Rs 500, you have earned. But two things should be kept in mind – i) The ‘Capital Gains Tax’ is applicable only if anyone redeem the investment and not if anyone stays continuously on investment and ii) The extent of capital  Gains Tax will depend on the types of Mutual funds and holding the investment. Mutual funds are subjected to ‘Short-term Capital Gains Tax’ and ‘Long Term Capital Gains Tax’. The periods of Short term and Long term ‘Capital Gains Tax’ are defined differently for Mutual funds.