Five things to know about mutual fund NAV

There is an increasing awareness among retail investors about the benefits of investing in mutual funds. The sustained advertising campaigns by the Association of Mutual Funds of India (AMFI) to educate people about mutual funds have contributed to the awareness about mutual funds. Besides this, the fact that mutual funds fetch higher returns than fixed deposits has added to the attractiveness of mutual funds as a viable investment option. This is one of the reasons inflows into the mutual fund industry have been growing consistently in the past two years.    

Though interest in mutual funds has increased, there are many retail investors who do not understand basic things about mutual funds. They are not curious to know how returns are calculated. They rely heavily on professionals such as distributors, chartered accountants or kind-hearted friends to help them with their investments. But they fail to address their lack of knowledge. Hence, it is important to start with the basics. A key thing that most retail investors do not understand about mutual funds is the net asset value (NAV). This results in confusion and misunderstanding. To avoid this, let us understand this term and various nuances associated with it in greater detail.  

When you invest in a mutual fund scheme, you are allotted units in exchange for the money you have paid. The price of each unit of the mutual fund scheme is termed as the net asset value (NAV). 

How is NAV calculated?

Mutual fund scheme’s NAV is calculated using the following formula:

(Value of all securities held + value of all receivables - value of all payables) / Number of units

Each mutual fund scheme receives money from investors. The money is deployed to buy securities as mandated by the investment objective and asset allocation of a scheme. The securities held by schemes are valued. If some interest is accrued to a scheme but yet not received it gets captured in its receivables. After adding receivables to the portfolio’s value, expenses are deducted. These may include asset management fees, scheme expenses, distributor commissions and brokerage paid to brokers. The number so arrived is divided by the number of units outstanding.

For example:

Valuation of all the securities of Scheme A = ₹1000

Value of all receivables = ₹100

Value of payables = ₹50

Total = ₹1000 + ₹100 - ₹50 = ₹1050

Number of units = 100

NAV= (Value of all securities held + value of all receivables - value of all payables) / Number of units)

Hence, Net Asset Value of units of Scheme A is ₹10.50. 

How fund houses compute NAV 

Since prices of securities keep changing throughout the trading hours, it is difficult to calculate the net asset value of a scheme. Hence, fund houses compute NAV based on closing prices. The capital market regulator Securities & Exchange Board of India (SEBI) has made it mandatory to declare NAV at the end of the day for each business day.

NAV and portfolio values

NAV of a scheme is dependent on values of securities in the portfolio of a scheme. If the share price of a company falls, then the scheme’s NAV also falls. The fall is to the extent of the company’s weightage in the scheme. In a rising market, when prices of most of the securities are trending upwards, NAV also goes up.

In case of bond funds, if a particular issuer defaults then the value of bonds issued by that issuer held in the portfolio of a scheme is calculated at reduced valuation. This leads to a fall in the NAV. If such a bond calculated at reduced valuation is paid off in full at the time of maturity, then the NAV rises to the extent of the money recovered. Thus, NAV responds to the changes in valuations of securities held in the portfolio.

Purchases and redemption of units of open-ended mutual fund schemes take place at the end of the day’s NAV. But units of exchange traded funds (ETFs) are traded throughout the day. In the case of ETFs, the bid or ask price on stock exchanges can be different from its net asset value. Sometimes ETFs quote at a discount to their NAV and sometimes at a premium. 

How is NAV different from shares?

Though NAV is the price you pay to acquire a unit of a mutual fund scheme, it should not be confused with the price of a share. NAV of a mutual fund scheme is based on the book value of a unit. The book value of a share and market price at which shares are bought and sold are not the same. The price of a share can be analysed taking into account expected growth and other fundamental factors associated with the company. Investment decisions are based on the valuation a stock enjoys. These aspects do not necessarily apply to NAV of a mutual funds scheme. 

What does low or high NAV of a scheme mean? 

In the early phase of a scheme launched for investments, NAV is pegged at ₹10 per unit or ₹1000 unit in most cases. As prices of securities held by a scheme change, its NAV keeps fluctuating. Over a period of time, if a fund manager makes money for investors by selecting profitable securities, then the scheme’s NAV goes up. A high NAV in this case is seen as an indicator of the long-term performance of a scheme. However, a low NAV does not mean that a scheme is priced cheaply.

Let’s understand this with an example.

Assume there are two schemes A and B. A unit of Scheme A has an NAV of ₹10. A unit of scheme B has an NAV of ₹200. An investment of ₹1 lakh each will fetch 10,000 units of Scheme A and 500 units of Scheme B. If both schemes have generated 10% returns in a year, then the value of units in both schemes will be ₹110,000 each. Low NAV cannot be a key factor to select a scheme for investments. 

These facts cover the key things in understanding the NAV of a mutual funds scheme. As investors invest a sufficiently long time in the mutual funds industry, it has been observed that they generally do not look at daily movements of NAV. For most investors, outperformance of a scheme with respect to its benchmark index and peers in its category is a key barometer of the performance of the scheme.