How is the NAV of a mutual fund scheme calculated? Do the inflows and outflows in the scheme impact the NAV?

The other day, in an investment seminar someone asked a question: “How is the NAV calculated?” He also wanted to know if the daily inflows and outflows in the fund by investors impact the NAV calculations apart from the movement in the prices of securities held by the fund.

Read my article in Mid-day Gujarati edition today to understand the NAV calculation:

Mutual Fund NAV calculation

The other day, in an investment seminar someone asked a question: “How is the NAV calculated?” He also wanted to know if the daily inflows and outflows in the fund by investors impact the NAV calculations apart from the movement in the prices of securities held by the fund.

Let us look at both parts of the question and answer each. First of all, what exactly is NAV in the context of a mutual fund?

NAV is the Net Asset Value of the fund – popularly mentioned as NAV per unit. In the accounting parlance, NAV is the other name for book value. This is the value of the scheme’s total assets less the liabilities. If you simply add up all the assets and deduct all the liabilities of the fund, you get the value of the net assets. Divide this by the number of outstanding units and you get the NAV per unit.

NAV per unit = (total assets of the scheme – total liabilities of the scheme)

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                    Number of outstanding units

This looks simple. Having reached till here, we need to understand what the fund’s assets and liabilities are.

A mutual fund scheme invests in many securities as per the investment objective. We have discussed this earlier. The market value of these securities (or investments) forms the major part of the fund’s assets. Apart from that there are some minor contributors, e.g. interest accrued but not received, dividend declared but not received yet, proceeds receivable on sale of investments, money parked in money market instruments and bank balance. All these are examples of the fund’s assets. The value of investments has to be taken as the current market price, which is an indicator of the realizable value of the scheme’s assets.

Now come the liabilities. We saw earlier that a mutual fund cannot borrow money for the purpose of investing. The only exception allowed is when the fund has to meet redemptions or dividend payouts and is unable to liquidate the investments due to some critical factors like a market meltdown or illiquidity in the system. Such a liability, if exists, should be added to the fund’s total liabilities. At the same time, there are some liabilities that exist on a regular basis. These are fees payable to various constituents like the asset management company, the custodian, bankers, R & T agent, directors, auditors, distributors, etc. there could also be liability on account of payment to be made for securities purchased. All the liabilities get added up and these have to be deducted from the fund’s assets.

As mentioned earlier, this would give the net assets of the fund.

Dividing this by the number of outstanding units would give the NAV per unit. This NAV has to be calculated on a daily basis. The accounts students among the readers can easily make out that in order to arrive at the fund’s net assets, the scheme’s balance sheet must be prepared. Since the NAV is calculated on a daily basis, the balance sheet is also prepared daily. Which business would be preparing final balance sheet daily? This is another example of the transparency of a mutual fund.

This answers the first part of the question – regarding the calculation of NAV.

Now let us consider the second part of the question. “Do the daily inflows and outflows impact the NAV of a scheme?” as you can see in the answer to the first question; the inflows and outflows into or out of the scheme do not feature in the NAV calculation. However, many keep asking if these inflows and outflows have any impact on the scheme’s NAV.

Well, the short answer is “no, they do not impact the NAV on a daily basis.” However, this is a simplistic answer and only looks at the theory. It is also important to check whether these have any impact on the NAV, at all.

When an investor purchases the units of the scheme, there is an inflow of money in the scheme. The scheme allots units at the prevailing NAV. This is the NAV that has been calculated as discussed earlier. The investor, who submits the purchase application before the cut-off time, gets units at the NAV calculated based on the closing prices for the day. Exactly same process is followed when an investor takes money out of a scheme.

As can be seen, the inflows and outflows do not impact the NAV.

However, when a scheme receives huge inflows in relation to its corpus, the fund manager may not be able to invest all the money immediately. This means, cash would be held in the portfolio for a considerable amount of time. This impacts the future NAV changes since cash and securities may not move together.

This is a small point that must be kept in mind. At the same time, since short term price movement is unpredictable and there is an (almost) equal probability that the prices may move up or down in the short run, this impact may get cancelled out over the years.

-        Amit Trivedi

The author runs Karmayog Knowledge Academy. Recently, Amit has authored a book titled “Riding the Roller Coaster – Lessons from Financial Market Cycles We Repeatedly Forget”. The views expressed are his personal opinions.