What is Nav in Mutual Funds: Benefits, Calculation & Impact?
Monday, Feb 12, 2024
Now that advertising has gotten much easier thanks to people voluntarily opting to carry and spend most of their working hours with a black mirror, you must have seen lots of content on mutual funds. Even your favorite actor might have suggested you invest in such funds at some point in time. No matter how you have previously come across this financial instrument, it’s actually an awesome investment meant for the masses, and there is no doubt about it.
Making it seemingly effective and emphasizing the importance of investment is one thing, but the mathematical rationale behind how it functions is entirely another thing. Most ads even go far enough to say that “Mutual Fund investments are subject to market risks, read all scheme related documents carefully” to comply with the regulations made by the government for investor safety.
But here’s another disclaimer that you might not have heard or read. “The NAVs of the schemes may go up or down depending upon the factors and forces affecting the securities market, including the fluctuations in interest rates.”
In this article, let’s dive into the NAVs of schemes. All the nuances associated with it and explore factors that make it tick.
Mutual Funds Are Great.
When one can definitely be awesome at anything of their choosing, the thing is, not everyone opts to be great at studying elaborate financial statements. You need a specific set of skills to be good at it and to make it your life’s mission. This isn’t to say that people who don’t study the mechanics of capital don’t care for it, but rather that there are people who are passionate about studying, operating, and building intricate markets and investment mechanisms.
When such a passionate, well-read, and qualified person offers to manage your investments for you, it’s definitely a great deal because you aren’t really making the investments that are good for you anyway.
So, essentially, such money managers are involved in establishing asset management firms that offer investment solutions to people in all strata of society. Mutual funds are one such investment vehicle, which are basically pools of capital collected from millions of interested people for the purpose of systematic and methodical investing.
What’s different about Mutual Funds compared to Stocks?
When you invest in shares, you are purchasing a piece of ownership in a single company. The value of the amount you invest fluctuates with the market price of the shares you buy. And what is the market price? That’s determined by the supply and demand dynamics in the stock market.
On the other hand, mutual funds pool money from many investors to purchase a diversified portfolio of securities and investment products. Instead of owning shares in individual companies, mutual fund investors own units of the fund managed by the Asset Management Company. Its value is represented by the NAV.
The NAV represents the per-unit market value of the fund. Unlike stocks, whose price changes throughout the day, the NAV of a mutual fund is calculated at the end of each trading day based on the closing market prices of the portfolio’s securities.
What is NAV in Mutual Funds?
When you book your IPL tickets to watch your favorite team play cricket, there’s a hidden cost that comes with it. The franchise’s jersey. Of course, you want to be wearing that while you chant your lungs out!
Just like that jersey, NAV is a hidden element in mutual funds too, the ‘Net Asset Value’. When you invest in a mutual fund, you’re buying units of the fund, much like buying that jersey to be part of the team’s journey. The price you pay per unit? That’s the NAV.
The NAV is calculated by the Asset Management Company (AMC) at the end of every market day.
Just as the price of the jersey doesn’t define the team’s performance on the ground, a higher NAV doesn’t necessarily mean a better-performing fund. It’s just a snapshot of the fund’s value at a particular point in time.
How is NAV Calculated?
Step 1: Determine Total Assets
We need to first determine the total assets of the fund. This includes the investments made by the fund. These could be shares of companies (stocks), loans given out (bonds), or even just plain cash. The asset managers hold cash to stay prepared for new investment opportunities and to manage liquidity issues. Sometimes, they invest these in highly liquid cash equivalents and short-term debt securities.
The total value of all these items in the basket represents the total assets of the mutual fund.
Step 2: Subtract Liabilities
Obviously, running this mutual fund isn’t free. There are costs involved, like paying the fund manager for their expertise, operational costs for running the office, and other expenses.
Some funds may use leverage. This means, borrowing money to amplify purchasing power. This has good potential to increase profits, but it also increases the fund’s liabilities and risk.
We need to subtract total liabilities from total assets.
Step 3: Divide by the Number of Outstanding Shares
Finally, we need to find out how much one unit or share of this fund is worth. For that, we simply divide the value we get after subtracting liabilities from assets by the total number of units or shares of the fund that investors hold. This gives us the Net Asset Value (NAV) of one unit or share of the mutual fund.
NAV = (Assets - Liabilities) / Number of Outstanding Shares
Let’s say a mutual fund has ₹700 crore invested in securities and ₹140 crore in cash, making the total assets ₹840 crore. The fund has liabilities of ₹140 crore. Therefore, the fund would have a total value of ₹700 crore (₹840 crore - ₹140 crore). If the fund had 70 lakh shares outstanding, the NAV would be ₹1000 per share (₹700 crore / 70 lakh).
NAV reflects the most recent market value of the fund's assets.
Implications of NAV Pricing System
- Mutual funds provide instant diversification as they hold a basket of selected securities.
- These funds are professionally managed by fund managers who make investment decisions on behalf of the investors.
- The fund units can be bought or sold at the NAV price, which ensures liquidity for investors.
- You can begin your investment journey with relatively small amounts of money. They’re made affordable!
Entry and Exit
The entry (buying) and exit (selling) transactions are based on the NAV of the fund. When you invest a certain amount of money in the fund, your share in the fund is calculated using the present fund NAV. Similarly, when you decide to exit the fund, the number of units held by you is multiplied by the current NAV to determine its redemption value.
Obviously, shares are a totally different breed. While buying or selling shares, you have to deal with the fluctuating market price of the shares, which varies by the second, during the trading day.
Ending the Mutual Narrative
Judging NAV
While a high NAV value is generally assumed to perform better, it’s a misconception. In fact, a high NAV can represent high volatility, and if you’re someone with a low tolerance for risk, you might be better off with funds with a lower NAV!
There’s another misconception about NAV; that it is the same as the book value. It isn’t! While book value is used to evaluate the stock price of an individual company, NAV is used as a measure for evaluating all of the equity holdings in a mutual fund. Although it’s notable that the NAV is often close to or equal to the book value per share of a business.
So, then, how do we assess which mutual fund to buy?
Well, for starters, don’t blindly compare the NAV. That hardly tells you anything. Don’t be infatuated with the past performance either!
Know Your Investment Appetite: Compare the investment style and approach being used by the fund. If your thoughts and notions sync, that’s a tick in the which-fund-to-buy checkbox.
Performance Comparison: You can’t directly make the comparison, but you can mark similar mutual funds with similar portfolios and mutually track their NAVs across a time span.
Take a look at the expense ratio: Repeat after me, the higher the expense ratio, the lower the net returns. This is the fee charged by the mutual fund company for managing the fund.
Returns Over Time: Examine the fund’s returns over time. If a fund provides good returns consistently, then that’s likely a better choice than a fund that has high returns one year but poor returns the next.
Check Your Understanding:
By answering the following questionnaire;
1. The Net Asset Value (NAV) of a mutual fund is calculated every hour.
[ ] True
[ ] False
2. A lower NAV always means the mutual fund is a better investment.
[ ] True
[ ] False
3. The NAV of a mutual fund represents the fund manager's salary.
[ ] True
[ ] False
4. Investing in mutual funds guarantees profits.
[ ] True
[ ] False
5. Mutual funds only invest in stocks.
[ ] True
[ ] False
If you answered any of the above questions “True”, re-read the entire article!
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