Business Original explainer
How mutual funds work, what SIP and NAV mean, what funds cost, and the risks every beginner should know.
If picking individual shares feels difficult, a mutual fund offers a different route into the same market. Instead of choosing one company, you put your money into a large pool with thousands of other investors. A professional fund manager then uses that pool to buy a spread of shares, bonds, or both, according to the fund's stated goal. You own units of the fund, not the individual shares directly, and the value of those units rises and falls with the investments inside it.
Every mutual fund unit has a daily price called the net asset value, or NAV. It is worked out at the end of each business day by taking the total value of everything the fund owns, subtracting what it owes, and dividing the result by the number of units. If you invest 5,000 rupees in a fund with a NAV of 50 rupees, you receive 100 units. If the NAV later rises to 60 rupees, your 100 units are worth 6,000 rupees. A low NAV does not mean a fund is cheap, and a high NAV does not mean it is expensive. What matters is how much the NAV grows over time.
NAV is not the same as a share price on the stock exchange. You cannot buy mutual fund units at a live price during the day in the same way. Your purchase or sale is normally processed at the NAV declared at the end of the day, under rules set by SEBI.
A Systematic Investment Plan, usually called a SIP, is a way to invest a fixed amount at regular intervals, most often every month. The money is taken automatically from your bank account and used to buy units at that day's NAV. When markets fall, the same amount buys more units. When markets rise, it buys fewer units. Over time, this averaging can smooth out the ups and downs, and it removes the need to guess the perfect day to invest.
SIPs are popular in India because they suit a monthly salary. Many funds accept SIPs starting at 100 rupees a month, although the exact minimum depends on the fund. A SIP is not a separate type of fund. It is simply a method of putting money into a fund bit by bit, instead of investing a large lump sum all at once. Both methods buy the same units at the same NAV. The right choice depends on whether you have a steady monthly income or a one-time sum to invest.
SEBI groups mutual funds into broad categories, so that investors can compare similar funds with each other. Equity funds invest mainly in shares, and they carry the highest ups and downs, but also the highest long-term growth potential. Debt funds invest mainly in bonds and other fixed-income instruments, and they are generally steadier, though their returns are usually lower. Hybrid funds mix shares and bonds in one fund, aiming for a balance between growth and stability.
There are also index funds, which simply copy a market index such as the Nifty 50 or the Sensex instead of trying to beat it. Because no manager is picking individual shares, index funds usually charge much lower fees. A separate category, called ELSS, is an equity fund with a three-year lock-in on every investment, which can qualify for a tax deduction of up to 1.5 lakh rupees a year under the old tax regime. Each SIP instalment in an ELSS has its own three-year lock-in.
Every mutual fund charges an annual fee called the expense ratio, or total expense ratio. It pays for the fund manager, administration, and, in regular plans, the distributor's commission. The fee is taken from the fund's assets a little at a time, so it is already reflected in the NAV. You never receive a separate bill for it. Index funds often charge around 0.1 to 0.5 percent a year, while actively managed equity funds often charge more. Over many years, even a small difference in fees can add up, so it is worth comparing the expense ratio of similar funds before choosing one.
Funds also come in direct and regular plans. In a direct plan, you buy straight from the fund house, with no distributor in between, so the expense ratio is lower. In a regular plan, you buy through a distributor or adviser, who earns a commission from the fund. The underlying investments are the same in both plans. The difference is only the cost, and over a long period that difference can be meaningful.
Mutual funds spread your money across many investments, which lowers the risk of one company failing, but they do not remove risk. An equity fund can fall sharply in a bad year, and no fund can promise a fixed return. Funds are regulated by SEBI, and your money is held by an independent custodian, not by the fund house itself, but that protection does not cover market losses. Before investing, read the scheme document, check the fund's goal, its past behaviour in falling markets, and its expense ratio.
Tax also matters. For equity funds, gains on units held for more than 12 months are treated as long-term gains. Under current rules, those gains are taxed at 12.5 percent on the amount above 1.25 lakh rupees of such gains in a financial year. Gains on units held for 12 months or less are taxed at 20 percent.
A mutual fund is best thought of as a long-term habit, not a quick way to make money. Start small, stay regular with a SIP if that suits your income, keep costs low, and review your fund once or twice a year rather than every day. Mutual fund investments are subject to market risks, so read all scheme-related documents carefully before investing.
This explainer was written by The Daily Short's desk from the sources listed above. It is general information, not professional advice. Spot an error? See our Corrections Policy or tell us via the Contact page and we will correct it. Follow our official Instagram @thedaily.short.