How Do Mutual Funds Work in India?

Mutual funds work by pooling money from many investors and handing it to a professional manager, who invests it in shares, bonds or other securities. Each investor holds units of that pool, and the value of one unit is called the NAV. The NAV rises and falls with the holdings, so every unit holder shares gains and losses in proportion to the units held.

In practice, how mutual funds work rests on three ideas: pooling, units and NAV. Once those are clear, the rest of the structure is easier to follow. For a broader primer, read what a mutual fund is first.

The four steps behind how mutual funds work

Money moves through a fund in four steps. Each step has a different party responsible for it.

Pooling money and issuing units

Pooling lets a small investor own a slice of many holdings for a modest amount. A fund that holds dozens of companies spreads the investor's money across all of them, which an individual would find hard to do alone with a small sum.

Units are how the fund records who owns what. When you invest, the amount is divided by the NAV on that day and you receive the resulting number of units. Your number of units stays the same until you buy more or sell. What changes is the value of each unit.

Reading the NAV of a fund

NAV is the fund's net assets divided by its units outstanding. Net assets are the value of the holdings plus cash, minus liabilities.

Illustrative fund. NAV is (holdings + cash − liabilities) divided by units outstanding.

A NAV of ₹10.55 says nothing about whether a fund is cheap or expensive. Running costs are deducted within the NAV, so the figure you see already reflects them. For more on this figure, see how NAV is worked out. The ₹10 unit price of a new fund offer does not make it cheaper than an existing fund.

Worked example of units and value

Suppose you invest ₹10,000 at a NAV of ₹25, then add ₹5,000 later when the NAV has fallen to ₹20. The table follows the units through the NAV moves.

No exit load or costs beyond those already in the NAV.

The first purchase buys 400 units. At ₹28, those units are worth ₹11,200. The top-up at ₹20 adds 250 units, for 650 in total. At ₹30 the holding is worth ₹19,500 against ₹15,000 invested, a gain of ₹4,500. Between purchases, the units never changed. Only the NAV did.

Units bought through a monthly SIP

A SIP invests the same amount on each date, so the number of units changes with the NAV. When the NAV is low, the same instalment buys more units.

Hypothetical monthly SIP of ₹5,000 on five dates, at the NAVs shown.

The average cost works out to ₹18.97 per unit, which is below the ₹22 NAV on the last date. At ₹22, the 1,317.55 units are worth ₹28,986 against ₹25,000 invested. A SIP also spreads the purchase price over time, so no single NAV date decides the average. For the mechanics of a SIP, see what a SIP is.

The parties behind a fund

A mutual fund is a structure with several parties, each with a separate job.

The separation is the point. The people who manage the money are checked by a trustee body, and the securities are held by a separate custodian rather than by the AMC itself.

SEBI oversight and what it covers

The Securities and Exchange Board of India (SEBI) regulates mutual funds. Its rules cover how a fund is set up, how it can invest, what it must disclose about its holdings and costs, and how the parties involved must conduct themselves. Investors can read the scheme documents and the fund's portfolio disclosures to see what it holds.

SEBI oversight lowers the chance of misuse, but it does not protect against falls in the market. A regulated fund can still lose value when its holdings fall.

Trade-offs to keep in mind

• Value follows holdings. A fall in share or bond prices lowers the NAV directly.
• Early exits can cost you. Some schemes charge an exit load on units sold within a set period, deducted from the proceeds.
• Payouts reduce NAV. If a fund pays out IDCW, the payout comes out of the fund's NAV, so the NAV drops by that amount.
• Tax applies when you sell. Gains are taxed when units are sold, under rules explained in how mutual funds are taxed.

Frequently asked questions

Is NAV the price of a mutual fund unit?

NAV is the value of one unit, worked out as the fund's holdings and cash, minus liabilities, divided by the units outstanding. It is not a measure of how cheap a fund is, so a unit priced at ₹10 is not automatically better value than one priced at ₹100.

Who loses money if a mutual fund's holdings fall?

The unit holders do, because the NAV follows the value of the holdings. The AMC and trustees run the fund under SEBI rules, but they cannot stop market prices from falling. The market risk therefore sits with the investor, not with the company that manages the fund.

Do I need a demat account to buy a mutual fund?

Not for most mutual funds. Units can be bought directly from the fund house or through a platform without a demat account. Exchange-traded funds are the exception, since they trade on a stock exchange and need a demat and trading account.