How Do Mutual Funds Make Money?

Ever seen the “Mutual Funds Sahi Hai!” ads? Have no idea what we are talking about? Check out the ads here!!

We, at Trade Brains, happen to see a lot of these advertisements. In fact, we even love them because although comical and mere advertisements and these ads educate the public about mutual fund investments in a more touching way than what we could ever do.

(Source: Mutual fund Sahi Hai)

But those of you who have seen these ads must have wondered for a long time about how these guys make money? Why give so much wealth away for free? After all, economics says that there are no free lunches, right?

Well, to be honest economics is right. There are no free lunches and mutual funds are not free. This post is aimed to provide a basic insight into answering the above questions. Here are the topics that we’ll cover in this post:

1. What are mutual funds?
2. What are the sources of revenue for a mutual fund?
3. The different costs involved in running a mutual fund.
4. Industry trends and closing thoughts

Overall, it’s going to be a very interesting post for the mutual fund enthusiasts. Therefore, let’s get started.

1. What are Mutual Funds?

Mutual funds are investment vehicles managed by professionals that seek to pool investments from many people together before investing them into markets within the financial ecosystem such as equity markets or debt market or a hybrid of both debt and equity. These vehicles are normally managed by professional fund managers or are programmed to follow certain broad indices pertaining to a certain industry or a country.

In general, mutual funds are thought to be best platforms for investors to get the benefits of capital appreciation from the equity markets even if they are not confident to manage their own money in the markets or if they are not able to dedicate time for their own research.

Some retail investors who invest on their own also happen to invest mutual to provide some diversification in their portfolio or reduce the volatility of returns since a lot of the times retail investors tend to have a concentrated portfolio of around 8-20 stocks.

Quick read: The Beginners Guide to Select Right Mutual Funds in 7 Easy Steps.

2. How Do Mutual Funds Make Money? And what are the sources of revenue for a mutual fund?

The biggest source of revenue for mutual funds is usually the fees that they charge from their investors. This usually comes out in the range of 1.5%-3% of the assets under management. This is commonly known as the expense ratio. Here is the example of the expense ratio for a few popular funds:

However, as of September 2018, it has become legally binding for mutual funds to limit their total expense to 2.25% of the total assets under management. 

References:

• Sebi clears proposal to bring cost effectiveness in mutual funds -Times of India
• Sebi caps expenses for mutual funds; industry to adopt a full-trail model of commission- Moneycontrol

The other sources of revenues for a mutual fund come in the form of exit load, front loads, and purchase fees etc. (Also read: 23 Must-Know Mutual fund Terms for Investors.)

3. What are the Costs Involved in Running a Mutual Fund?

Since most funds hire analysts in research positions a good chunk of the revenues is spent as salary expense for most mutual funds. Other expenses include rent of office and facilities, administrative expenses, payments for research material from data sources etc.

The other major expenses include brokerage fees and transaction costs, costs, investment advisory fees, and marketing & distribution expenses.

4. Current Industry Trends

Since this industry is very competitive it can be said that when it comes to profits being the industry tends to follow a bell curve with close to 50% of fund houses making a profit in a year. But lately, the trend has been that some firms also generate profits not from their core operations but also by providing research and analytics to clients based offshore.

Another interesting observation to be made is that fund houses which operate a number of mutual fund schemes tend to have higher profitability than their peers. This is due to the fact that a lot of the core setup required for research and administration is pretty much in place and doesn’t need to be set up from scratch each time a fund house launches a new scheme.

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Closing Thoughts

Investors in mutual funds could protect their investments if they were to invest in safe fund houses which can generate a decent return from the market even during the worse days. Since it is nearly impossible to get an idea of profitability among mutual fund players, investors could use the financials of the parent companies as a proxy. 

Nevertheless, as always, mutual fund investments are subject to market risks. Please read all scheme-related documents carefully before investing.

New to mutual fund investing? Want to learn how to pick the best mutual funds? Then, check out our online course- Investing in Mutual Funds? A Beginner’s Course. Enroll now and start your journey in the exciting world of mutual fund investing today. #HappyInvesting.