The basic understanding of mutual funds would be incomplete if one does not understand the accounting principles behind it properly which comprises among other things the valuation of schemes and calculation of net asset values. “NAV is the price per unit value of the mutual fund.” Mutual funds are for the most part priced in a manner similar to which stocks are priced. So if an investor is purchasing one unit of a mutual fund, he is purchasing that on the basis of the applicable NAV.
However the key difference between stock price and NAV is that unlike stock price, which fluctuates by the second during stock market trades, the mutual fund NAV does not change throughout the day. The NAV does however change each day and is computed after markets close. Therefore it is very important for an investor to know when the fund priced as that can change the purchase or redemption price. For e.g. if one is purchasing today, then he may be actually purchasing at an NAV price which will happen at the end of the subsequent day. Let’s look at how NAV calculations are made with a simple example.
Net Assets of Scheme:
- Suppose, investors have bought 10 crore units of a mutual fund scheme at Rs 10 each. The scheme has thus mobilized (10 crore units X Rs 10 per unit) i.e. Rs 100 crores.
- An amount of Rs 140 crore, which has been invested in equities, has been appreciated by 10%.
- An amount of Rs 60 crore, mobilized from investors has been placed in bank accounts.
- Interest and dividend received by the scheme is Rs 8 crore.
- Assume scheme expenses to be Rs 4 crore, while a further expense of Rs 1 crore is payable.
If the above statistics are listed as assets and liabilities of the scheme it would be listed as follows:
|Liabilities||Amount (Rs cr)|
|Unit capital (10 crore units of Rs 10 each)||100|
|Profits (Rs 8 crore (interest and dividend received)minus Rs 4 crore (expenses paid) minus Rs 1 crore (expenses payabale))||3|
|Capital appreciation on investments held (10 % of Rs 140 crore)||14|
|Unit holder’s funds in the scheme||117|
|Market value of investments (Rs 140 crore + 10% appreciation)||154|
|Bank deposits (Rs 60 crore (original) plus Rs 8 crore (interest and dividend earned) minus Rs 4 crore (expenses paid)||64|
As already evident from the table:The unit holders in the scheme are commonly referred to as “net assets”.
- Net assets comprise the amounts originally invested plus the profits earned in the scheme as well as the appreciation in the investment portfolio.
- Net assets of a mutual fund can increase when the market prices of securities rise even if the investments have not been sold.
- By delaying payments a scheme cannot ensure and show better profits. Irrespective of the fact that the expenses are paid or not, they should be considered while calculating profits of the scheme. In accounting principle this theory falls under the “accrual principle”.
- Similarly any income gained will be accounted under the profits earned section of the scheme, no matter whether the profits have been actually deposited into the bank account or not. This again is in line with the “accrual principle”.
Net Asset Value (NAV)
NAV refers to the face value of each unit of the scheme. This is equivalent to:
Unit holder’s Funds in the Scheme / Number of units
In the above example the applicable NAV can be calculated as:
Rs 117 crore/10 crore
i.e. Rs 11.70 per unit
Another alternative formula to calculating NAV is:
(Total Assets minus Liabilities other than to unit holders) / No of units
i.e. (Rs 118 crore – Rs 1 crore) / 10 crore
i.e. Rs 11.70 per unit.
From the above example the following points are inferred:
- NAV would be higher, if the scheme earns higher interest, dividend and capital gains.
- Higher appreciation in the investment portfolio also leads to a higher NAV.
- A higher scheme NAV would be also ensured, if the scheme expenses are lower.
Portfolio valuation is one of the key driving factors for NAV. While the exact number of each kind of security held in the portfolio is always quantifiable, their valuation can be subjective. There are few guidelines that are prescribed when one can do a comparative study of the NAVs.
- Whenever a security, say, Company X share, is traded in the market on the valuation date, its closing price on that date is taken as the value of security in the portfolio. Thus the number of Company X’s shares in the portfolio (say 1000),multiplied by the closing price (say Rs 1,700) gives the valuation of Company X’s shares in the portfolio (1000 shares x Rs 1,700 = Rs 1700,000). Similarly, every security in the portfolio is to be valued.
- Where equity shares are not traded in the market on a day, or they are thinly traded, a formula is used for the valuation. The valuation formula is based on the EPS of the company, its Book value and valuation of similar shares in the market (peer group).
- Debt securities that are not traded on the valuation date are valued on the basis of the yield matrix prepared by an authorized valuation agency. The yield matrix estimates the yield for different debt securities based on the credit rating of the security and its maturity profile.
- There are few detailed norms regarding when a security is to be treated as NPA (non-performing asset), how much should be written off at various points of time, when the amounts written off can be added back to the value of the asset (treated as income), and when the NPA can be treated as a standard asset.
Other Valuation Principles:
There are other valuation methods using which securities in each portfolio may be valued. Let’s look at some of the ways and how the NAV of a mutual fund is impacted by them.
Mark to Market
The process of valuing each security in the investment portfolio of the scheme as its market value is called “mark to market” i.e. marking the securities to their market value. Since investors buy and sell units in the scheme on the basis of NAV, therefore NAV is considered to be the true worth of each unit in the scheme. The investment portfolio will end up being valued at the cost at which the security was bought, if the investments are not marked to market. Mark to market ensures fair practice in selling and buying units of a scheme when it comes to its pricing, which are in turn dependent on the NAV which is calculated transparently by extracting its information which is easily shared.
Sale price, re-purchase price and loads
Open ended schemes are characterized by a distinctive feature where investors have an ongoing provision to acquire new units (which is known as “sale transaction” and sell back units to scheme (which is known as “re-purchase transaction”).
In the past, schemes were allowed to keep Sale Price higher than the NAV. This difference between the Sale Price and NAV is known as Entry Load. Similarly, schemes were allowed to keep Re-purchase price lower than the NAV. The difference between re-purchase price and NAV is known as Exit Load.
The schemes also follow a structure which is known as CDSC (Contingent Deferred Sales Charge) according to which the scheme load is calibrated when the investors offer their units for re-purchase. As per this structure, the investors gain greater benefits if they hold units for a longer period of time. For example, the investors would bear an exist load on their returns if they exit with in 1 year, the load would be less if they exit after 2 years and NIL if they exit after 3 years and so on. This type of structure attracts the investors to hold on to their units for longer periods and hence give them greater scheme benefits by contributing in incremented returns.
Earlier, schemes had the flexibility to differentiate between different classes of investors within the same scheme, by charging them different levels of load. Further, all the moneys collected as part of entry or exit loads were available to the AMC to bear various marketing expenses of the mutual fund. There were liberal limits on how much could be charged as loads.
Since August 1, 2009 following changes have been made by SEBI:
- SEBI has banned all entry loads. This means that Sale Price needs to be same as NAV.
- Exit loads exceeding 1% of the redemption proceeds will mandatorily have to be credited back to the scheme.
- Exit load structure needs to be similar for all investors represented in the portfolio.
Allotment of Units to the Investor:
- Since entry load is banned, units in an NFO are sold at the face value i.e. Rs 10. So the total investment amount divided by Rs 10 would give the number of units the investor has bought.
- The price at which the units are sold to an investor as part of ongoing sales in an open-ended scheme is the sale price, which in turn is the applicable NAV. The investment amount divided by the sale price would give the number of units the investor has bought.
- Thus, an investor who has invested Rs 10,000 in a scheme where the applicable sale price is Rs 10, will be allotted Rs 10,000 / Rs 10 i.e. 1,000 units.
- In a rights issue, the price at which the units are offered, i.e. the rights price is clear at the time of investment. The investment amount divided by the rights price gives the number of units that the investor has bought.
- In a bonus issue, the investor does not pay anything above the original investment. The fund allots new units for free. Thus, in case 1:3 bonus is announced, the investor is allotted 1 new unit (for free) for every 3 units already held by the investor. Since the net assets of the scheme remain the same, only the number of units increase and the NAV will get adjusted proportionately.
Bottomline – Why NAV Matters:
- Since NAV reflects the price composition of all the holdings a mutual fund has in a scheme, when the prices of those securities are high, it means the fund NAV is high. Conversely, if the total price of these securities is low, then the fund NAV is low. Therefore it is an important factor to watch out for when investors are attempting to gauge the increase or decrease in value of their fund. The price of open ended funds is not prone to rapid change as a result of investors purchasing or selling unlike market traded stocks. This is primarily because a mutual fund has virtually no limits on the number of units it can issue at any given time.
- As a specific mutual fund scheme enjoys investor interest and money keeps pouring into it, the company will issue new units for purchase where the price per share is dependent on the securities available in the portfolio. When a particular stock is in high demand, it results in high price as they are limited in the market for trading purposes. However, there are situations when the fund size grows so enormously that fund managers make a call to restrict new investments into the scheme.
- In case of a close ended scheme, the supply and demand drives the price of the fund units. Hence if the fund is traded at a price lower than the NAV, it is called “discount”. Similarly if the fund is traded at a price higher than the NAV it is called “premium”.
- It should be noted that the NAV of mutual fund units witness price changes from one day to another. Most mutual funds need to be held for longer periods in order to be viable investment options in the long term. It is seldom practical for investors to try and trade the open-ended funds to capture the profits earned with the swinging short term funds. Also the NAV does not reflect the value of any interest and dividend that is paid out to investors. Therefore it is very important for the investors to have a look at the overall return of the fund in order to understand its returns properly before making the investment.
- When it comes to money markets, the NAV are quite stable in nature and they usually do not vary much as a result of day to day trading. As their name suggests, they are mostly liquid in nature.
- There are certain challenges when it comes to figuring the applicable NAVs. For e.g. challenges arise when an ETF holds securities in a different time zone, because NAV is based on the last price quoted on the exchange during its closure.
- Amidst all the challenges regarding calculation and applicability criteria, it is clear that NAV is perhaps the most important and a highly useful metric for the investors to make their decisions regarding mutual fund investments.