In mutual funds, the returns on investment are much more important than the other features such as tax savings or dividend income. Therefore, it is important to understand how the return of investment in a mutual fund is calculated? What are the aspects or principles taken into consideration? Here we arrive at the concept called “Net Asset Value”. Investing in mutual funds deals with the purchase of units in a mutual fund scheme. Each unit initially starts from its base price and grows or shrinks based upon its performance. This performance of a mutual fund scheme can be measured by calculating the net asset value of each unit of the scheme.
What is NAV?
NAV stands for Net Asset Value of a mutual fund plan. It is the value derived by subtracting the liabilities from the overall asset value of the mutual fund scheme per unit. It is the price at which you purchase a single unit of the mutual fund scheme. It is the price at which you may also sell the unit (if there is no other load applicable).
How is NAV Calculated?
Net Asset Value =
Total Assets – Total Expenses
Number of outstanding units
Let us explore the concept in more detail:
Total Assets = Number of units x Market value of mutual funds
Add: Receivables or accrued income
Subtract: Expenses (brokerage, fund managers fees, overheads)
= amount available to all unitholders (A)
Now by dividing the amount A by total outstanding units, (which may vary in an open-ended scheme considering the easy entry-exit option) at the end of the day, we calculate the per unit price. This per unit price allows you to purchase the unit of the scheme, subject to exit load if any. This is nothing but the Net Asset Value per unit of a mutual fund scheme.
Stock market prices are directly proportional in the factor of deciding the NAV, provided the mutual fund scheme is not related to money market instruments or otherwise. Stock market closes at 03.30 p.m. in the afternoon and once the market is closed, the market value freezes for the day. Subsequently, the expenses for the day are deducted and the money available for distribution to unitholders can be calculated. Once all the variables are available, the fund managers employ the above formula and calculate the Net Asset Value of the scheme. Mutual funds investments are always time bound. All the investment amounts received before 2 p.m. are seen in the closing and investments post 2 p.m. are credited on the next working day. The same rule applies for redemption too. It is impossible to calculate NAV without being able to calculate the exact outstanding units available at the end of the day.
How Does NAV Fluctuate?
It’s simple. It rises if most of the securities in which the scheme has invested rises and vice versa. However, it is a common misconception that NAV is the share price of an equity share, which is very incorrect. A share price of a company is reflected at the stock market and is an outcome of a lot of factors such as its past performances, its future prospect, demand-supply of such security etc. Therefore, the share price differs from its book value. Whereas, in the case of mutual funds, the prices that you see are all NAVs and nothing else.
Calculation NAV with Example:
We have seen the theoretical method of calculation of NAV. Let us put up some flesh on the skeleton of the formula by bringing in some numbers. Assume that at the end of the day i.e. at the end of a trading day, the fund manager is in possession of Rs. 10,50,00,000 (Ten Crore and Fifty Lakhs Rupees only) worth of securities, Rs. 10,00,000 (Ten Lakh Rupees only) worth of cash and Rs. 5,00,000 (Five Lakh Rupees Only) incurred as liabilities. Then the NAV of the scheme with 20,00,000 outstanding units at the end of the trading day shall be:
_________________________________ = 52.75
Here Rs. 10,50,00,000 (Ten Crore and Fifty Lakhs Rupees only) is the market value of the investment made from the scheme, while Rs. 10,00,000 (Ten Lakh Rupees only) is the liquid amount lying in the bank as unutilized money aggregating to total assets of the scheme. The amount 5,00,000 (Five Lakh Rupees Only) is nothing but the expenses incurred in the management of funds, which may include expenses such as fund managers fees, bank charges, and other overheads. Now the Net Asset Value is calculated by assuming that if all the units of the mutual fund scheme are liquidated at the end of a trading day, how much money one can receive per unit.
After liquidating, the fund manager cannot share all the money since they will first have to shell out all the expenses incurred including their own fees, which in totality, results into liabilities of the fund. The remaining residue is now available to be shared among all the unitholders. The unitholders do not possess uniform units, therefore it is pertinent to calculate the per unit price, hence the 20,00,000 outstanding units at the end of the trading day.
So if a person is in possession of 10 units, his total investment would be costing = 52.75 x 10 = Rs. 527 (approximately). This is from a seller’s perspective.
Let us check out the buyer’s perspective. If a buyer wishes to invest Rupees 1,000 (One Thousand only) in the above scheme, he can buy 18 units (1000/52.7) approximately.
As prescribed under SEBI mutual funds regulation , it is mandatory to calculate the NAV on a daily basis and publish the same. NAV is not the only factor that can decide the performance of a scheme, however, in order to judge, it is a primary factor. It helps the investors to understand the value of their investment and prospective buyers to compare the schemes.
Let us now see the other basic elements of NAV.
What are Net Assets?
Consider an example of an owned house, purchased on loan . The house will be mortgaged to the bank as security. Now the net assets of the owner of the house will be the market value of the house minus the total outstanding loan.
So net assets are nothing but
Net Assets = Total Assets – Total liabilities
In mutual fund schemes, more the net assets, greater the NAV. The fund manager’s task is always to maximize the total assets and minimize the liabilities. Net Assets do not necessarily mean actual profit, as it includes notional profit as well. Suppose, an investment of Rs. 100 is appreciated by 10% which is equal to Rs. 10, this Rs. 10 cannot be realized until the investment is sold. However, this appreciation does get added up into the total assets calculation. Similarly, an expense, though payable later, becomes a part of the total liabilities. This principle is called the principle of accrual , which is indigenous to accountancy. Therefore, future profits or future expenses are very important in Net Assets.
This, however, does not allow the contingent profit or contingent expense to be included in net assets calculation. Contingent profit or expenses are nothing but a profit or expense calculated upon happening or non-happening of a certain event or in simple language speculative gain or loss. Due to its uncertainty, it is not possible to include the same.
Valuation Principles of NAV
Valuation of mutual fund units depends largely on the valuation of the securities invested in by the scheme. The securities, if listed, are valued based on their value at the end of the trading day. For example, if company A’s shares are valued at Rs. 700 at the end of the trading day and the total outstanding shares of Company A are 10000 then the market valuation of the Security A is 700 x 10000 = 70,00,000 and accordingly, all such securities in the group are valued.
If the security is unlisted then the Earning per Share (“EPS”) method is to be used. EPS is nothing but total funds available to the equity shareholders divided by the number of outstanding equity shares. It gives you the current cost of one equity shares and if you multiply the same with the total number of securities, you get the value of your investment. Peer Group is another alternative to EPS method, where the valuation is done on the basis of valuation of companies with similar objects or business line.
Mutual funds with debt security investments can be valued as per their yield returns. Debt securities are more risk averse securities, where valuation does not depend upon the market, but upon the credit rating of the debt securities, its maturity period, past dividend record, and redemption history of the issuer. While studying valuation, one may also come across the term “Non-Performing Asset”, which is nothing but an asset turned bad due to non-performance of its payment obligation. In such cases to make the books look good, the NPAs are written off, meaning wiped out of the profit. However, if those NPAs turn profitable in future they can be added back as well are treated as a regular asset.
Mark to Market is one of the method of valuations, whereby each security in the group is valued according to its market value. The Mutual Fund units are valued on the basis of daily NAV, which in turn depends on the value of the security. It is important to use this method to value the securities otherwise the whole investment will be valued at cost of its purchase, resulting in a loss of NAV.
Buy-Sale & Entry-Exit Loads
When you buy units in the open-ended schemes of a mutual fund, it is known as ‘sale transaction’. While when you exercise the option of selling any mutual fund units to the scheme itself, it is known as the ‘re-purchase transaction’. In both the transactions, we come across the Entry-Exit Loads. The entry load is attracted on sale transaction, while exit load is attracted the on re-purchase transaction. Now the load is nothing but a margin of difference between the purchase price or selling price and the NAV. If it is an entry load one has to pay more money than the NAV, while if it’s an exit load one will receive less money than the NAV. These margin money or load money were utilized by the fund managers for various expenditures. As of the current date there presents no entry load, as a result of SEBI abolishing it completely, since 1st August 2009. While exit still exists and is applicable uniformly to all investors.