How Mutual Funds Make Money & Pay Dividends?

Ganesh Adhikari

A mutual fund is an investment fund where professional money managers pilot a pool of money aggregated from small investors in a diversified portfolio to make financial profits. A mutual fund invests in stocks, money market instruments, bonds, debentures, or other securities to provide individuals or small investors a well-managed and less-risky diversified portfolio at a minimal price.

Understanding Mutual Fund NAV

The net asset value (NAV) of a mutual fund is the fund’s per-share market value. It is calculated by dividing the current value of total assets (securities and cash) minus the total liabilities, by the total number of shares outstanding. NAV is an instrument that allows an investor to evaluate the performance of a fund. NAV is used to calculate mutual funds per share worth. The NAV pricing differs from the actual day-to-day trading price.

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How do Mutual Fund Investors Make Money?

A mutual fund acts as both an actual and an investment company.

Mutual fund investors typically earn money in three different ways.

From dividends and interest on bonds: A mutual fund pays out almost all of its net income over the year to the investors in the form of distribution.

Capital gains: The mutual fund can sell securities (stocks and other assets) whose price has increased and gain profits. These capital gains are passed on to investors in the form of distribution.

Increase in fund’s share price: When the NAV and the trading price of the mutual have increased, the investors can sell the shares at a higher price and book profits.

Mutual funds make money through fees and commissions

One of the major sources of income for mutual funds is the fees charged to investors. The percentage of fees charged by mutual funds is dependent on the type of mutual funds and their structure. The management fees are not directly charged to the shareholders but are paid or deducted from the fund’s total assets. These fees are received or taken as expense ratio or annual fund operating expenses.

The cost of administrative staff, research analysts, investment advisors, distribution fees, and other operating costs are compensated through the expense ratio. Thus the mutual fund is not a free service, it costs money to run a mutual fund; investors can research the management costs and choose the suitable mutual fund with the least management expenses to invest.

For most mutual funds the average expense ratio is between 0.5% and 2.0%, rarely exceeding 2.5%. For passive index funds, the expense is even smaller around 0.2%.


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How a Mutual Fund Does Pay Dividends?

The mutual funds seeking high dividends invest in high coupon bonds and high-dividend paying stocks. This allows the funds to distribute handsome dividends to the investors on regular basis (year after year). The dividend is distributed of the fund’s earnings from all the sources.

The shareholders receive the dividends based on several shares ownership of the fund. The dividends paid by the companies owned by mutual funds are distributed to the shareholders. For example, if a XYZ company paid a dividend or a company named ABC paid a dividend. Assuming the mutual fund owns shares of these companies, the fund gets these dividends which are later distributed to the fund’s shareholders.

While the high dividend sounds attractive and investment-worthy but most mutual funds are designed to minimize tax liability to the investors by avoiding interest-paying bonds and high dividend-generating assets. These mutual funds mostly focus on investing in companies with fast growth potential rather than steady and modest companies with stable dividend capacity.

Related: Dividend Announcement By Mutual Funds In Nepal

Types of Mutual Funds

Mutual funds can be categorized into different types depending on the kind of investment portfolio and the desired returns. Some of the types of mutual funds are:

  1. Equity funds
  2. Fixed-income funds
  3. Index funds
  4. Balanced funds
  5. Money market funds
  6. Income funds
  7. International/global funds
  8. Specialty funds

Opportunities (pros) with Mutual Funds:

  1. Diversified portfolio
  2. Professional management
  3. Liquidity
  4. Low-risk investment opportunity for newbie investors.
  5. minimal efforts required for investment
  6. dividend reinvestment
  7. less risky
  8. fair pricing

Weakness (cons) of Mutual Funds:

  1. lack of transparency
  2. high expenses, commissions, and fees
  3. large cash management is hectic
  4. Tax inefficiency
  5. Management abuses

Bottom Line

Mutual funds are an excellent investment option with regular dividends earning opportunities. Especially, for those with less knowledge about the capital market who has no time to go through the balance sheets and price charts of numerous companies, a mutual fund offers an efficient way to well manage and diversify portfolios.

Investment in mutual funds is often advised for long-term investors.

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