Understand the real purpose of NAV irrespective of what you hear in the market
31-May-2022 •Ravi Banagere
We usually find the term 'net asset value' (NAV) circulating while buying or selling mutual funds. NAV is often interpreted as the price of the fund and most people, upon hearing the word 'price', believe that the lower the NAV, the cheaper the fund is vis-a-vis others. So does that mean you should go with the fund that has a lower NAV? NO way! We repeat - 'NO' in block capitals. In fact, NAV should not be used as a base at all while choosing a fund. Here is why.
What is NAV?
Let's first understand what the NAV of a fund is. It is the market value of the fund's portfolio divided by the number of its total units held by the investors (when you invest in a mutual fund scheme, you are allotted units that represent your share in the assets of the fund). Hence, it reflects the value of a single unit of the fund. To put in simple words, the amount you need to pay to buy a unit of a fund or the amount per unit that you would get while redeeming a fund is called its NAV. This is the reason why it is often referred to as the price of the fund. But it is a bad interpretation, especially when used to compare across mutual funds.
NAV ≠ Price
Let's take an example to understand why NAV is not the price. Suppose you wish to buy 10 grams of gold. But when you go out in the market, you find that 10 grams of silver is much cheaper than gold. Now, would you end up buying silver simply because it is cheaper? Even if you do, you won't get the same utility as buying gold. Thus, the price of each gram of gold and silver are not comparable as they have different underlying values. Having said that, unlike most other things in life, a higher NAV need not necessarily mean that the fund is more valuable.
The NAV of a fund is simply a mathematical calculation based on its assets under management (AUM) and number of units. The change in the market value of the portfolio and fresh investments or redemptions by investors over time changes both the value of the portfolio and the number of units used to calculate NAV. The only purpose of NAV is to evaluate a fund's performance - by comparing a fund's present NAV with its past NAV. Lower or higher NAV on a standalone basis has nothing to do with the performance of the fund.
The following example will make it clear how NAV is used to evaluate performance. Say, you have Rs 10,000 to invest and you have two options - Fund X and Fund Y. Their portfolios are the same but NAVs are different. Fund X has a NAV of Rs 10 and Fund Y has a NAV of Rs 50. So with Rs 10,000 that you have, you get either 1,000 units of Fund X or 200 units of Fund Y. After one year, both the funds would grow equally as their portfolios are the same. Let's assume that the funds have grown by 25 per cent. So the NAVs after one year will be Rs 12.50 for Fund X and Rs 62.50 for Fund Y. Hence, the value of your investment will be Rs 12,500 (1,000 x 12.50) for Fund X, and Rs 12,500 (200 x 62.5) for Fund Y. Did you see? Your returns remained the same, irrespective of the NAV at the time of your investment.
It is a misconception that lower NAV is better. As we saw in the example above, your gain per unit is the difference between the NAV at the time of selling and buying the unit. So from the investors' point of view, only the percentage change in the NAV is important, not the actual number.
Suggested read: What causes the difference in NAVs of mutual funds?