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.

Whether equity or debt - invest only after considering the risks ...

Whether you want to invest in equity or debt - please consider the risks involved. Understand the risks and manage these. Here is my article in Mid-day Gujarati explaining the risk involved in debt securities and debt funds:

http://epaper.gujaratimidday.com//epaperpdf/gmd/25072016/25072016-md-gm-12.pdf


The English translation is as under:

Last time, we discussed about one of the risks involved in debt securities and hence in debt funds. This time around, we would discuss another of the risks that exists, but majority of the retail investors are not aware of it.

In the debt market terminology, this risk is know as “interest rate risk”. In order to understand this risk, let us take the example of a debenture issued by a company.

This debenture was issued for a period of 5 years or the maturity of the debenture at the time of issue was 5 years. Two years have passed since and hence the debenture would now mature in 3 years.

Assume that this debenture is rated AAA – highest safety

Its face value is Rs. 100 and it bears coupon of 9% p.a. payable annually. This means the debenture holders would be paid Rs. 9 (9% of the face value of Rs. 100) every year for each debenture they hold.

Now assume that for some reason the interest rates in the economy come down – we have seen this happening in case of bank fixed deposits or recently in case of small savings or PPF – by 1% p.a..

This means, similar debentures (AAA rated debentures with a maturity of 3 years) would be available in the market offering a yield of 8% p.a.

Now when other debentures offer 8% p.a. and our original debenture, which was issued earlier is offering 9% p.a. That makes it more attractive compared to other debentures in the market.

Due to this attractiveness, investors would want to buy this debenture (We have assumed that such a debenture is traded in the stock market). This buying interest results in the rise in the market price of this debenture. The market price of such a debenture would rise to such an extent that now the return on investment in this debenture would fall to 8% p.a. Calculations indicate that the market price should rise to Rs. 102.58 per debenture.

This means that when you invest Rs. 102.58 in a debenture; earn interest income of Rs. 9 per year and get a maturity value of Rs. 100; the return on investment would be approximately 8% p.a.

On the other hand, had the interest rates gone up in the market to, say 10% p.a., our debenture’s market price would have fallen to Rs. 97.51.

As can be seen from the above example, the market price of an existing debenture falls when the interest rates in the economy go up. At the same time, a drop in the interest rates in the economy results in rise in the market price of existing debentures. Thus, there is an inverse relationship between the market price of existing debentures and the interest rates in the economy.

Now, assume the same company had issued another debenture at the same time, but for a maturity period of ten years. Hence, when two years passed from the issue of both these debentures, the two debentures would have a residual maturity of 3 years and 8 years, respectively.

If the interest rates fall by 1% p.a., one debenture offers higher interest for 3 years, whereas the other offers higher rate for 8 years. Thus, the relative attractiveness of the second debenture would be even higher and hence, the market price of the same would rise much more than the first one.

This is another fact that one should remember in case of debentures. Debentures with longer maturity witness bigger price changes when interest rates in the economy change.

The investors, who hold the debentures till maturity, do not have to worry about these changes in the market prices. They are unaffected by such changes. However, if someone needs to sell the debentures in the market before maturity, such an investor would be concerned with changes in the market prices – especially if the interest rates rise, causing the market price of the debentures to fall. At the same time, if the same investor continues to hold the debenture maturity, one would get the maturity value, as this is the contracted value.

While the debenture holders may hold the debentures till maturity to avoid the interest rate risk, debt mutual funds cannot. As we have seen earlier, the investors in (open-ended) mutual funds are allowed to transact at NAV linked price on all business days, the calculation of fair price must happen on a daily basis. For this purpose the NAV calculated on a daily basis must value all the debentures at the prevailing market price. Hence, an investor investing in a debt fund may witness frequent changes in the NAV of the fund. Having said that, such an investor would be better off holding the fund units for a recommended holding period in order to reduce the impact of interest rate risk.

A debt fund investor can also decide how much interest rate risk one wants to take. As we saw some time ago, debentures with longer maturity are more sensitive to changes in interest rates compared to those with shorter maturities. An investor can check the average maturity of a debt fund and decide to invest in one with low average maturity in order to avoid interest rate risk. An aggressive or a savvy investor, willing to take the interest rate risk may choose a debt fund with long average maturity. The details of a fund’s average maturity may be seen from the fund’s fact sheet.

Understand the risk in debt funds and take an informed investment decision.

-        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.

Asset allocation funds - reduce volatility without compromising on the returns

Is it possible to reduce volatility of the scheme NAV without reducing the fund returns? Read my article in Mid-day Gujarati edition today ....

http://epaper.gujaratimidday.com//epaperpdf/gmd/27062016/27062016-md-gm-17.pdf

The English translation is as under:

“Stock markets likely to be volatile next week” – we often see such headlines in the newspapers or similar stories on the television. Volatility, though natural for the stock market, scares majority of investors. In order to reduce the volatility without compromising much on the potential upside, the mutual fund houses have innovated. First they came up with hybrid products. We covered two types of hybrid products – the more popular ones – Balanced Funds and Monthly Income Plans in our earlier articles. Due to the allocation in debt as well as equity, these funds exhibit lower volatility. However, the scheme returns may be lower than equity funds, especially during a secular bull market.

Today, we will discuss about some other strategies adopted by certain fund houses. Such strategies allocate money between equity and debt assets, but change the allocation based on certain parameters.

First of all, let us spend some time on understanding one important principle related to investments. If you combine two or more asset categories, which may be individually risky (volatile) but each one may partly cancel the volatility of the other. Thus, the portfolio would exhibit lower volatility.

This is where the fund houses came up with schemes that invest both in equity as well as debt. Both these asset categories exhibit different price movements at different points of time and in turn partly cancel out each other’s volatility.

Let us say, we start with allocating 50% in each equity and debt. After some time, if the equity market has run up, the percentage allocation to equity would be more than 50%. In such a case, the portfolio must be rebalanced to the original levels, i.e. 50% in each asset class. On the other hand, if the equity market is down, the allocation would be higher than 50% in debt. This time, one would have to sell debt and buy equity.

In either case, one is buying the asset priced lower by selling the one that has appreciated and hence is priced high. This is the classic “buy low, sell high” strategy in action. Now, a fund with static allocation between equity and debt would be achieving this through rebalancing on a regular basis.

The balanced funds and MIPs have delivered reasonably good performance over the years. Rebalancing, as explained above, has played a good role in that performance. Through reduction in volatility, the funds have been able to deliver performance that was average of the two categories.

Now comes the next question. Is it possible to do better than that? That is where funds have launched schemes that do not stick to a desired percentage allocation, but change the allocation based on some formula. This formula depends on the valuation of one or both the asset classes.

Some of the schemes in the market use equity valuation parameters like Price-to-Earnings ratio, or Price-to-Book Value ratio, or a combination of both. One of the schemes uses Price-to-Earnings ratio for equity while simultaneously comparing it with the yield on 10-year Government Securities.

These funds have lived up to the promise – lowering the volatility without reducing the returns too much.

It’s a good category to explore for investors. However, a deeper analysis is warranted since the alternatives can have significant differences among them.

-        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.