Despite “mutual funds” being a common term these days, most people do not understand what they are. Given the critical role they can play in building your wealth, let’s try to understand them.

Consider a group of three friends, A, B and C, having ₹200, ₹300 and ₹500 respectively to invest. Each of them wants to invest in the shares of Company X, but a single share trades at ₹1000. As a workaround, they decide to pool in their money and invest as a group. They will share the profit or loss in the proportion of their initial investments. For bookkeeping, they create 100 identical units, each representing ₹10 of investment. Thus, A, B and C get 20, 30 and 50 units, respectively. In a few years, Company X’s share price increased to ₹2000. The three have doubled their investments, as each unit becomes worth twice as much (₹20).

As time passes, the group invests in other companies too. Each time they repeat the process, creating and allocating more units. Over the years, the pot of money becomes too large, requiring close day-to-day attention. Their professional and social obligations, however, do not leave them enough time to manage the fund. Thus, they decide to hire a professional, D, to manage it. D has a CA/CFA/IIM MBA degree and decades of extensive investing experience. D demands an annual compensation of 2% of the money being managed. Also, he will run the fund only on a best-effort basis and will not be liable if it ends up losing money. Given the lack of time and their investing expertise compared to D, the three reluctantly agree. D becomes the manager of the fund.

The above setup is in essence a mutual fund: a pot of money pooled from several people, for investment. The money is managed by a professional and the investors have a claim on the pool in proportion to their contributions.

Need for formalisation

This ad hoc agreement seems great but a bunch of potential issues make it hard to get it to work in practice. It is likely that A, B and C do not share the same investment philosophy or time horizon. People have different capacities and preferences for taking risks: some prefer to gamble in risky stocks, while others like to stick to Fixed Deposits in SBI. Some invest only to avail of tax benefits. Some individuals want to park their money for only a few days, while others aim to save for retirement. Also, hiring a trustworthy fund manager is a pain—what if D runs away with the money? Or B and C could end up fighting with each other and threaten to pull out the money, putting the entire thing at risk. Also, bookkeeping is tedious.

Here lies the need to simplify and formalise this setup. Enter Mutual Fund Houses. Mutual Fund Houses, such as HDFC Mutual Fund, SBI Mutual Fund, etc. are companies created by large financial corporations to cater to the investment needs of people. While the result is the same, the process for a mutual fund to come into existence works a little in reverse compared to our example.

Mutual fund companies, aware of the broad spectrum of investment needs and preferences, create several funds. Each fund caters to one or a combination of such needs. They hire a bunch of people with extensive investment experience and assign them as managers of these funds. The objectives and guiding principles of each fund are formalised in a document, which the fund manager is expected to follow.

Fund companies market these funds to potential investors whose needs resonate with the fund’s investment goal. They collect the money and manage it on investors’ behalf. They charge an annual fee to take care of the operating and administrative expenses. The Securities and Exchange Board of India (SEBI) acts as a watchdog over these funds to ensure that money stays safe.

Note that the formal setup does not suffer from any of the issues of the ad hoc one. Depending on her needs, A can also split the money across funds with varied objectives. She can focus on being great at her job while professionals look after her hard-earned money. Everyone sticks to doing what they do best, and everyone is better off. A win for free markets!