Remember last time when you observed the Net Asset Value (NAV) and the value of your investment (Holdings) changing on a daily basis.
And you were curious to understand how changing NAV changes your investment value and how exactly this works.
Let’s try to understand the NAV and its impact in detail in this article.
Decoding Net Asset Value (NAV)
Let’s assume that a group of 3 school friends are contributing money to buy a box of chocolates. Everyone contributed a different amount and the total was used to buy the chocolates. Now, the group decided to distribute the chocolates based on the individual contribution made. The value of each share of the chocolates will be equal to the Net Asset Value of the Mutual Funds.
Let’s understand this with the help of numbers:
Continuing on the above example, let’s assume that the total contribution was INR 6,000 and the individual contribution by the 3 friends were INR 1200, 1800 and 3000 respectively. The box contained 300 chocolates in total.
Let’s try to calculate the NAV for chocolates now,
Unit cost of chocolate = Total Cost of the Box (Total Money Pooled by 3 Friends) / Total Units (Number) of chocolates in the box
Unit cost of chocolates = INR (6,000/300) = INR 20 per chocolate (NAV)
Based on the contribution, the three friends will get 60, 90 and 150 chocolates each.
Now, Mutual Funds work in the same way.
A lot of people invest small amounts of money in a particular scheme (fund) that is managed by a fund manager. The total collection of money in that particular fund is called Asset Under Management (AUM). We will refer to this as Total Assets.
Since the fund management company is offering you a service, they will deduct some amount from your investments as fees which is called Expense Ratio. They’ll also have some liabilities to pay government fees & taxes. Collectively, we will refer to this as Total Liabilities.
Using the Total Assets, Total Liabilities and Number of Units Outstanding (Shares of mutual funds people bought), we may calculate NAV for a Mutual Fund as follows,
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This is what you see on your investment app screen as Net Asset Value (NAV).
But how does it impact your investments?
To understand this, we may have to get familiar with another concept, “Unit Allotment”.
What is Unit Allotment in Mutual Funds?
Remember the example of 3 friends buying a box of chocolates by contributing money, and how they got different amounts of chocolates each?
The mutual fund units allotment works on the same principle.
Once the NAV is calculated, your total invested amount in Fund A, say INR 50,000 will be divided by the NAV. For this example, let’s assume that NAV is INR 20.
So the total number of units of Fund A you’ll receive is 2,500 (50,000 / 20).
But the NAV changes on a daily basis. How will you know which value of NAV will be used to calculate the total units you’ll get allotted?
According to a SEBI’s Circular dated 17 September 2020, the unit allotment for mutual funds shall happen as per the NAV on the day of realization of funds.
But again, what is the day of realization of funds?
Here, the term ‘day of realization of funds“ means the day on which the fund house receives your investment amount. This day of realization can be different from the day of transaction due to various operational reasons and cut-off timing.
Impact of NAV change on your Investments
Let’s continue our previous example where you own 2,500 units of Fund-A, bought at INR 20 NAV.
The value of NAV changes basis the underlying stocks’ price movement.
Let’s assume that the value of NAV, a week after you invested, became INR 25.
Since you hold 2,500 units, the total value of your investment will be INR 62,500 against an initial investment of INR 50,000, marking INR 12,500 of unrealized gain (until you decide to liquidate at this NAV).
Likewise, if the NAV value goes below INR 20, you’ll realize an unrealized loss.
Conclusion:
Understanding the concept of NAV and unit allotment is important for any serious investor as this helps you understand your investments better. By tracking NAV changes, investors can gauge the growth or decline of their investment.
For example, an increase in NAV means an appreciation in the value of their holdings, resulting in potential gains, while a decrease indicates potential losses.
Additionally, factors such as the timing of the fund's receipt of investment and SEBI regulations around unit allotment also play a role in determining the actual NAV used for purchasing units.
Ultimately, while daily fluctuations in NAV may seem daunting, long-term investors should focus on overall trends and the fund's performance in various market conditions.
This understanding allows for better strategic planning, such as taking advantage of market downturns or systematically investing to average out costs.
By being aware of how NAV functions and its effects, investors can optimize their mutual fund investment strategies to better align with their financial goals.
