Mutual funds announce the investment objective for every scheme they float, and seek investments from the public. When a scheme is open for investment for a limited period, initially, it is called a New Fund Offer (NFO). Depending on how it is structured, the scheme may be open to accept money from investors only during the NFO (closed-end scheme), or it may accept money post-NFO too (open-end scheme).
The investment that an investor makes in a scheme is translated into a certain number of ‘Units’ in the scheme. Thus, an investor in a scheme is issued units of the scheme. For example, if an investor has invested Rs. 1,000 in units issued at Rs10, he will be entitled to Rs. 1,000 ÷ Rs. 10 i.e. 100 units
The purchase of units by the investor from the scheme is also called subscription. Refund of money to the investor by the scheme is called redemption.
Under the law, every unit has a face value of Rs10. (However, older schemes in the market may have a different face value). The face value is relevant from an accounting perspective. The number of units multiplied by its face value (Rs10) is the capital of the scheme – its Unit Capital.
The scheme earns interest income or dividend income on the investments it holds. Further, when it purchases and sells investments, it earns capital gains or incurs capital losses. These are called realized capital gains or realized capital losses as the case may be.
Investments owned by the scheme may be quoted in the market at higher than the cost paid. Such gains in values on securities held are called valuation gains or unrealised gains. Similarly, there can be valuation losses or unrealised losses, when securities are quoted in the market at a price below the cost at which the scheme acquired them.
The practice of marking securities to their market value is called marked to market (MTM) valuation. The true worth of each unit of every scheme i.e. its Net Asset Value (NAV) is calculated based on MTM valuation of the investment portfolio. Thus, it captures all the gains and losses, realised and unrealised. Under the regulations, MTM is to be done daily. This is the principal reason the NAV of the scheme fluctuates, even if there is no change in the investments held in the portfolio of the scheme.
A fall in the security values in the market at the end of a day can cause a drop in NAV; the following day, if the market recovers, the NAV too will recover. Thus, while NAV of mutual fund schemes fluctuate, the fluctuation is of little relevance to a long term investor; the investor’s actual returns depend on the price at which he buys or sells the units of the scheme, and the dividend he receives from the scheme during the period he holds the units. Running the scheme entails costs viz. scheme running expenses. The expenses pull down the profits of the scheme and the NAV of the units. This brings down the returns for the investors. Therefore, SEBI has restricted the expenses that can be charged to mutual fund schemes. This has helped in positioning mutual funds among the lowest cost investment products in India.
The scheme’s investment operation can be said to have been handled profitably, if the following profitability metric is positive: (A) Interest income (B) + Dividend income (C) + Realized capital gains (D) + Valuation gains (E) – Realized capital losses (F) – Valuation losses (G) – Scheme running expenses It may be noted, (D) and (F) are a result of MTM valuation. When the investment activity in a scheme is profitable, the NAV goes up; when there are losses, the NAV goes down.