What is Mutual Fund and How Does It Work?

Last Updated on January 14, 2026 by Lubhanshi Lamba

A mutual fund is a simple investment form in which shareholders invest in a diversified portfolio of assets like stocks or other securities. Investors pool their money together which is professionally managed by fund managers. Every investor buys units of the fund that represent their share of the portfolio. The value of these units changes daily based on the market performance of the underlying assets— as reflected in the Net Asset Value (NAV).

It eliminates the need to pick individual securities for a simple method of investment. Perfect for beginners or experienced investors alike, anyone can invest in mutual funds with a small amount of money. It is a less risky form of investment than other options. Read about the basics of Mutual funds and their working to widen your financial horizon. 

What is Mutual Fund?

In simple terms, a mutual fund allows various investors to pool their money to purchase a diverse portfolio of securities. It will enable investors to share costs and gain professional expertise by becoming a partial owner of all its holdings. While investing in mutual funds, you hire a fund manager who makes smart investment decisions on your behalf to help you gain returns. The fund managers are responsible for researching, selecting, and monitoring the performance of the securities. This may depend on the objectives like aggressive growth and steady income. 

How Mutual Funds Work? 

Mutual funds work by pooling money from numerous shareholders and investing in a variety of financial instruments like stocks and bonds. The portfolio depends on the investors’ objectives. Here’s the step-by-step process for the basic working of mutual funds. 

1. Pooling of money: Investors contribute small or large amounts to a mutual fund to create a diverse investment portfolio. 
2. Professional Fund Management: A qualified fund manager invests your money as per the goal like growth, income, or stability. 
3. Asset Allocation: They spread your money across different assets like stocks or bonds to help reduce risk through diversification. 
4. Units Allotment: Each investor receives the number of units allotted to them based on the amount invested. These units represent the share of the fund’s total holdings. 
5. NAV: Net value assets are the actual value of each unit, based on the daily market value of assets minus the expenses. 
6. Returns: After a specified time, Investors earn returns through capital appreciation and dividend payments. 

What are the Objectives of Mutual Funds?

A top preferred investment choice in India, Mutual funds allow multiple investors to pool their money with similar risk appetites and investment goals. Here’s a list of some common objectives of mutual funds. 

1. Diversification: This form of investment allows individuals to spread their financial assets across different sectors and securities. This will enable investors to reduce the risk of loss and beat inflation over the long term. 
2. Capital Protection: For risk-averse investors, most mutual funds are famous for protecting capital. The returns might be lower than those of aggressive funds, but the reduced risk balances this out. 
3. Professional Management: Your asset management company hires an experienced fund manager who uses the pooled funds to buy assets in accordance with the specified strategy and objectives. 
4. Income Stability: Regular earnings from mutual funds allow investors to live a more convenient life. Fixed-income fund managers focus on predicting interest rate movements and capitalizing on market fluctuations to improve fund performance. 

Types of Mutual Funds

1. Equity Funds 

These securities include investments in a specific company’s stock, with a primary focus on capital appreciation. 

• Large Cap Funds: Top 100 companies by market capitalisation.
• Mid Cap Funds: Companies with a rank from 101 to 250 by market capitalisation.
• Small Cap Funds: companies ranked 251 and above by market capitalisation.
• Sectoral Funds: stocks of specific sectors or defined investment themes

2. Debt Funds

It includes investment in fixed income securities like bonds that offer financial stability and reduced risk. 

• Liquid Funds: Very short term debt instruments with high liquidity
• Corporate Bond Funds: Stable return with moderate risk profile
• Government Bond Funds: Sovereign government securities with minimal credit risk.
• Dynamic Bond Funds: Actively adjust portfolio duration based on interest rate outlook.

3. Hybrid Funds 

This investment includes a combination of debt and equity securities to maintain a balance between risk and return. 

• Aggressive Hybrid Funds: Major equities with some debt.
• Conservative Hybrid Funds: Major debt with limited equities.
• Balanced Advantage Funds: Equity debt mix adjusts with market.

How to Invest in Mutual Funds? 

After gaining the basic understanding of Mutual funds and their various varieties. You need to follow the given procedure to start investing. 

1. KYC Completion: Know Your Customer can be done online or offline using basic documents including a PAN card, Aadhaar card and bank details. The online process requires you to upload documents with Aadhaar OTP. 
2. Investment Goal: The fund manager selects the securities as per the timeline of your goal for example

• Short-term: Less than 3 years – Debt or Liquid Funds.
• Medium-term: 3–5 years – Balanced or Hybrid Funds.
• Long-term: 5+ years – Equity Funds for higher growth.

3. Choose the fund that aligns with your investment objectives by linking your bank account.
4. You can start investing by choosing the amount and investment type (lump sum or SIP).
5. Complete the payment and track performance quarterly or annually. 

What are the Modes of Investment? 

There are mainly two modes of investment in Mutual funds as follows 

1. Lumpsum 

When an individual invests the entire amount at once, it is called a lumpsum payment. For example, an investor decides to put Rs. 1,00,000 in mutual funds and makes the full payment in one go. This is an ideal approach for investors who seek higher returns with the right market conditions. However, there can be some risks involved like sudden fluctuations in the market. 

2. Systematic Investment Plan (SIP)

Investors can opt for SIP by making small investments over a specified period– unlike a lump sum. Investors can opt for monthly or quarterly payments in mutual funds or other instruments. For example, investing Rs. 5,000 every month in an equity mutual fund. This mode of payment reduced the risk through cost averaging and is suitable for long-term goals. However, SIP investment requires commitment and has smaller returns as compared to a lump sum. 

Fees and Charges Associated with Mutual Funds 

1. Entry Load 

Entry load is the fee you pay when investing in mutual funds for the first time. Every asset management company charges this fee to cover the distribution cost of Mutual fund promotion. This policy of charging was abolished by SEBI in 2009 in India and it no longer exists for new investments. 

2. Exit Load 

An asset management company charges an exit load fee when an investor leaves the mutual fund skin within a specific period of time. The primary objective of exit load is to prevent investors from prematurely withdrawing from the MF. Different fund houses usually charge 1% of the redemption value as an exit load after 1 year of investment. 

3. Transaction Charges 

It is a one time charge that is applicable to investments worth Rs. 10,00 and more. Transaction charges lie between Rs. 100 to Rs. 150, depending on the fund house. This fee also applies to SIP investments of over Rs. 10,000. Various fintech applications like Groww do not charge transaction fees on investments. 

4. Expense Ratio 

Expense ratio is the annual fee charged as a percentage of the fund’s daily net assets. Every asset management levies it to cover the management and running costs of the mutual fund scheme. This fee includes the costs for sales, marketing, and administration, distribution, and the fund manager’s salary. The formula to calculate the expense ratio is Total expense incurred divided by AMC Total ( asset under management)

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Lubhanshi Lamba

Lubhanshi Lamba is a passionate and detail-oriented Content Writer Executive, skilled at creating engaging, well-researched, and SEO-friendly content across diverse niches. With a keen eye for storytelling and clarity, she combines creativity with strategy to deliver impactful write-ups that connect with audiences and drive results.