Understanding Net Asset Value (NAV) in the proper perspective…

Every mutual fund scheme declares its net asset value (NAV) on a daily basis. While the concept of NAV is quite simple (it is the equivalent of the book value of the scheme), there are a few popular misconceptions about the idea of NAV. Let us consider a few such popular misconceptions.

The NAV of a MF Scheme is like the price of a share…

That is not correct. In fact, the NAV of a mutual fund scheme is more akin to the book value of a share. The NAV of a Mutual Fund scheme is calculated as the market value of all its assets / less the value of its liabilities; divided by the number of units outstanding. The market price of a share is not just about its book value, but more about expectations of future earnings, future growth and future ROE. There is an element of expectations built into an equity share. In case of Mutual Funds, it is just the net value of its assets as of the close of the day. There is not element of expectations in a mutual fund NAV.

One can buy and sell at the NAV…

While this technically correct, it is practically wrong. Take the case of a purchase of a mutual fund unit. If you invest directly, then you are able to purchase at the NAV, but if you invest through a broker, then there is an entry load that is charged and you will pay a price that is higher than the NAV. Similarly, when you exit the fund, you do not realize the NAV. This is because equity funds typically impose an exit load when you exit your fund before a certain holding period. Also there is the Securities Transaction Tax (STT) imposed on sale of units, which is also a reduction from your NAV. So effectively, the NAV is a theoretical price and not the exact price at which you buy and sell units. In case of non-resident Indians, the fund AMC is required to deduct the TDS before redeeming the units and that also gets deducted. This is not applicable in case of resident Indian investors.

Lower the NAV, the better it is to buy…

That is a bit like saying that penny stocks are better than stocks that are higher priced. The NAV, as explained above, is nothing but the value of the net assets of the fund minus the liabilities. The NAV is therefore a function of a variety of variables. A fund that was launched 5 years ago may have seen its NAV appreciate by 3 times and hence its NAV will be Rs.30. Another fund that was just launched may have a NAV of just Rs.10. That does not make the latter fund more attractive. Secondly, low NAV may be due to cyclical factors. If pharma is going through a down-cycle, then the NAV of pharma funds will be much lower than diversified equity fund NAVs. That does not make the pharma fund more attractive. Fund NAVs could also be lower due to poor performance. A lower NAV does not mean that the scheme is undervalued just as a higher NAV does not mean that the scheme is overvalued.

Funds with lower NAVs give better returns…

While this may have been true in a few cases, there is no empirical evidence to suggest that buying low NAV funds is a good strategy. In case of a mutual fund since the NAV is the net value of the investments, there is no question of momentum here. In case of shares, it is easier for an Rs.10 share to move up to Rs.15, but more difficult for an Rs.2,000 share to move up to Rs.3,000. Although the returns are 50% in both cases, momentum works against the higher priced share. This kind of a problem does not exist in case of mutual funds since the NAV is a derivative value of the market price of the underlying assets. Hence there is nothing to prove that low NAV funds give better returns compared to high NAV funds. In reality, it is more a matter of risk, fund manager’s skills and consistency of the fund.

One cannot take a decision on investing in a fund based on NAV alone. By itself, it is just a number. What really matters is the composition of the assets of the fund, the extent of diversification in the fund and the fund manager’s skills that can actually generate the alpha for the investors.

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