Concept & Role of a Mutual Fund

Everything a distributor later says to a client rests on what a mutual fund actually is: money pooled from many investors, held in trust, invested in securities whose value moves daily, and carrying no promise of a return. This unit is short and foundational. The trust form, net asset value, and the difference between an open-ended and a close-ended scheme are the vocabulary every later unit assumes, and they are also where the most common client misunderstandings start — a person who thinks a low NAV makes a scheme cheap, or that the money sits on the asset management company's balance sheet, has misunderstood the product before a single form is signed. The place to begin is the legal form, because in India the legal form explains most of the rest.

What is a mutual fund in Indian law?

In India a mutual fund is constituted as a trust. That single fact explains a great deal of what follows. Because it is a trust, it has trustees, and those trustees hold the scheme's assets on behalf of the unit holders, who are the beneficiaries. The trustees owe those unit holders a fiduciary duty — a duty to act in their interest — which is a stronger obligation than a company's directors owe its shareholders.

It also explains why the money is not the asset management company's. The AMC manages the pool for a fee and is supervised by the trustees; the securities themselves sit with a custodian. If the AMC were to fail, the scheme's assets are not its property to be distributed to its creditors.

How is the value of a unit worked out?

Net Asset Value is the scheme's assets minus its liabilities, divided by the number of units outstanding. If a scheme holds securities and cash worth 500 crore, owes 2 crore in expenses and has 10 crore units outstanding, its NAV is 49.8 per unit.

The word to be careful with is price. In an open-ended scheme, NAV is not a market price — nobody is bidding for your units. You buy from and sell back to the fund itself, at a price derived from that day's NAV. Nothing an investor does can move it; only the value of the underlying holdings can.

• NAV changes on every business day, because the value of the underlying securities does.
• A lower NAV does not make a scheme cheaper. Two schemes holding the same portfolio have the same return whatever their NAVs happen to be.
• A new scheme launched at 10 is not on sale. That is simply the starting number.

Open-ended and close-ended schemes

An open-ended scheme is continuously open for both purchase and repurchase. Money comes in and goes out every day, so the number of units outstanding changes daily. This is what makes such a scheme liquid: the fund itself is the counterparty, and an investor never has to find a buyer.

A close-ended scheme sells a fixed number of units during its offer period and then closes. It has a maturity date, and the fund does not repurchase units before it. An investor who wants out earlier must sell to somebody else, which is why the units of a close-ended scheme are listed on an exchange — and why they can trade at a price different from NAV, because that price is set by supply and demand rather than by the fund.

What a mutual fund does and does not offer

Pooling gives a small investor things that would otherwise be out of reach: a diversified portfolio, professional management, and the operational machinery of custody, accounting and record-keeping. It also gives economies of scale, since the costs of running the portfolio are shared across everyone in it.

It does not remove risk. The value of the units follows the value of the holdings, and that can fall. No scheme may promise or guarantee a return, and a distributor who suggests one is misrepresenting the product. This is worth being clear about early, because several later units in this syllabus are about exactly that boundary.

What the examination tends to ask here

Questions on this unit turn on definitions rather than arithmetic, and on distinctions that look cosmetic until they are not. The trust form is one. Who owns the scheme's assets, who holds them and to whom the trustees owe their duty are three separate answers, and interchanging them is the usual slip. Net asset value is the other. Candidates who can recite the formula still go wrong on what NAV is not — not a market price, not a measure of how expensive a scheme is, and not something an investor's own purchase or redemption can move. The open-ended and close-ended comparison tends to arrive side-on rather than head-on: through liquidity, through whether the fund itself is the counterparty, through why one is listed while the other need not be, and through the fact that a listed close-ended unit can trade at a price away from its NAV. Anything phrased around what pooling gives the investor is worth reading slowly — diversification, professional management and economies of scale are real benefits, and a guaranteed outcome is not among them.