HOW DO MUTUAL FUNDS WORK?

Making your way to a consistent stream of income

Mutual funds are securities that you can invest in.

When a fund launches its IPO, then by default the per-unit price is 10.

The per-unit price is the price of buying one unit of the fund.

Suppose the fund launches 1000 units at 10 each.

Let’s assume, one person buys 10 units of the fund. So each person bought 10 units at 10, so each person paid 100.

Let’s also assume that 100 people subscribe to these fund units. All 100 people have bought 10 units each.

Now,100 x 100 people lead to 10,000 being invested in the fund.

Then the total portfolio value of the fund = 10,000.

Now, you are one of the 100 people. You have also bought 10 units at 10 each having invested a total of 100 into the fund.

The fund takes this 10,000 investment and invests it in a bucket of stocks.

Let’s take an example. (metaphorical)

It buys:

100 shares of Infosys at 50 each. = 5000

100 shares of Reliance at 20 each. =2000

100 shares of Dr.Reddy’s at 3o each. = 3000

TOTAL becomes 10,000.

Now after a certain period, we see that Infosys has gone down from 50 a share to 40 a share.

We see that Reliance has gone from 20 a share to 60 a share.

Dr. Reddy’s has also gone up from 30 a share to 50 a share.

So now the picture looks somewhat like this:

The fund owns:

100 shares of Infosys at 40 a share. = 4000

100 shares of Reliance at 60 a share. = 6000

100 shares of Dr. Reddy’s at 50 a share = 5000

So now the total investments of the fund are worth 15000!

There was a 20% decrease in Infosys.

There was a 200% increase in Reliance.

There was a 66.67% increase in Dr. Reddy’s.

To find the total percentage change in the fund’s investments, we use the following formula:

Change in the value of investments, by the original value of investments x 100.

(5000/10000) x 100. = 50%

There was a net increase of 50% in the fund’s portfolio.
There was a net increase of 5000 in the value of the investments of the fund.

So now, what is every unit worth?

It’s the total value of the investments/ no. of units i.e., 15000/1000 = 15.

Therefore, every unit is now worth 15.

So when you bought 10 units of 10 each you had to pay only 100.

But now this same investment of 100 is worth 150. (where every unit’s value has increased from 10 to 15.)

So what you bought for 100 is now worth 150.

Just like this, the value of the fund’s portfolio keeps fluctuating. And this results in the NAV to fluctuate as well.

The NAV represents the per share/unit price of the fund on a specific date or time.

Most companies that pay dividends on preferred stock or common stock or both typically do so quarterly. Some companies pay on a semi-annual basis and even a few that issue dividend checks monthly.

Mutual funds collect this income and then distribute it to shareholders on a pro-rata basis. (proportionate allocation).

All funds are legally required to distribute their accumulated dividends at least once a year.

Those that are geared towards current income will pay dividends on a quarterly or even monthly basis. But many others only pay out dividends on an annual or semiannual basis to minimize administrative costs.

Some funds may withhold some dividends in certain months and then pay them out in a later month to achieve a more level distribution of income.

Interest that is earned from fixed-income securities in their portfolios also is aggregated and distributed to shareholders on a pro-rata basis. These may appear on the statements as dividend income. (interest on bonds, government treasury bills and the like).

The dividends that the fund receives from the stocks of the companies that it has invested in (in our case Infosys, Reliance, Dr. Reddy’s) it is legally required to pass it on to the shareholders of the fund, as stated above.

How exactly does it pass this on?

Let’s take an example. Suppose the sum of the dividends of our companies Infosys, Reliance and Dr. Reddy’s is equal to 5000.

The fund will take this 5000 and reinvest it and increase the value of its portfolio. So now, our portfolio is worth 20,000. (15,000 + dividend amount invested by the fund 5000 = 20,000).

(The portfolio is essentially the shareholders’ money itself. So it is legal.)

When the time for a dividend payout comes for the fund, it liquidates the amount of money it wants to pay as dividends to its shareholders.

This whole thing happens because there are different types of mutual funds that follow different strategies and timings. For eg, a growth fund will have very rare dividend payouts compared to a high-dividend yield mutual fund which even offers dividends on a monthly and quarterly basis. (for people looking for consistent income).

Now, the time for a dividend payout has come in our fund. The Mutual Fund decides to pay out a dividend of 8000.

This is divided among the fund investors on a pro-rata basis, which in our case is equal for all since all of our investors hold the same amount.

So, there is a dividend payout of 8 per unit. (dividend amount/no. Of units).

All of us hold 10 units. So we all get a dividend of 80.

What is the impact of a dividend payout on the NAV?

The NAV of a mutual fund comes down by the dividend amount. So now, the NAV of the fund will go down by 8.

This means, from a prevailing NAV of 20, the NAV falls by 8 to 12.

So the new NAV is 12.

A dividend payout liquidates your shares in the fund and brings them to you as income.

Now the next question is…what can you do with this income coming into your hands?

Mutual fund investors may take dividend distributions when they are issued or may choose to reinvest the money in additional fund shares.

You may choose to take the 80 or choose to reinvest it in MORE fund shares.

Suppose I do decide to reinvest my money in additional units.

I have Rs 80 at my disposal. What was the prevailing NAV? 12.

I can buy approximately 6.6 additional units in the fund.

So now, instead of having just 10 units, I have 16.6 units of the fund.

And what is the value of these?

16.6 x 12 = 199.2 (approx.)

This is back to your original worth before the dividend payout.

The fund compensates the dividend payout (which reduces the NAV) by allowing you to purchase additional units of the fund at the reduced NAV price, thus keeping your worth the same as before i.e., 200. (Approx.)

What are the benefits of dividend reinvestment?

You get a higher dividend payout next time! Since dividend distribution is done on a pro-rata basis, and you own more shares in the fund, you get a dividend proportionate to the number of units you own!

Over time, you can keep reinvesting your dividends, to get more and more units, and your dividend payout will consistently grow. And mutual funds don’t usually run into losses, so once you have a substantial share in the fund, and the dividends you receive are pretty great you can sit back and relax because you will have created a consistent stream of income.