Like many other things in life, the stock market works on the principle of survival of the fittest. But our friend Johnny intends to discover a formula that could ensure the survival of the dumbest. Last week, Jinny had told him how mutual funds provide professional management of funds at an affordable cost. Even the dumbest guy can use the expertise of mutual funds to his advantage. But before that, he needs to understand some of the technical terms most commonly used in the market.
Johnny: Last week you really made me think that I could also ride the tide of the stock market by making investments through mutual funds. But some of the technical terms are beyond my understanding. For instance, what does the term “net asset value” or the NAV of a scheme denote?
Jinny: If you ask an expert, he would simply say that the NAV of a scheme denotes the market value of the assets of the scheme after subtracting all its liabilities. You may wonder what that means. But before you ask about anything else, the expert will hasten to add that you can calculate NAV per unit of your scheme by dividing the NAV of the scheme by the number of units outstanding on the valuation date.
Johnny: With such an explanation, I will start having mental indigestion! Could you explain this with an example?
Jinny: Very well then, let’s try to understand the concept of NAV by taking an example. Suppose any scheme of a mutual fund initially offers 10 units at a face value of Rs10 each. The total corpus mobilized under the scheme would thus be Rs100. Out of this Rs100, suppose Rs10 each is invested in 10 different stocks. The value of the investment of your scheme in 10 different stocks is what we know as the assets of your scheme. The present value of your assets depends upon the present market value of the stocks in which your scheme has invested. Some of the stocks may trade at a value higher than the purchase price, leading to a rise in your assets, whereas some of the stocks may trade at a lower value, leading to a loss.
To arrive at the total market value of the assets of the scheme, you multiply the current market price of a particular stock with the number of units of that stock in the portfolio. The sum total of the market value of different stock portfolios, along with any dividend or income received, will give you the total market value of your assets under a particular scheme. For arriving at the NAV, you deduct the management fees and other expenses from the total market value of your assets. This is how you arrive at the NAV of a particular scheme.
Johnny: What do you mean by “management fees” and “other expenses”?
Jinny: Mutual funds employ professional fund managers to look after your investments. Lots of people, whom you will probably never meet, work day and night to make your investment grow. All these people expect a reward for doing your job, which you pay in terms of management fees. Further, mutual funds—like any other business enterprise—incur expenditures in the form of telephone bills, rent for the office, and so on. Who will bear these expenses? Mutual funds are running their shop for your benefit. So, apart from management fees, the mutual funds also charge other expenses to you. The management fees and other expenses are deducted from the value of your assets. Further, the funds can also levy an entry fee when you purchase a scheme or an exit fee when you redeem your investment. The entry fee, in technical terms, is known as front-end load and the exit fee is known as back-end load.
Johnny: Now what is this front-end load and back-end load all about?
Jinny: Front-end load is charged at the time of entry to pay the brokerage fee to the agent who “advised” you to choose that particular mutual fund. Investors think they should not be the ones to pay the piper. But, mutual funds take the money out of investors’ pockets in the name of front-end load to pay the bill. Some funds ask you to pay the brokerage at the time you leave their scheme, which is known as back-end load. The sooner you leave, the higher you pay. Charging an entry or exit fee discourages non-serious investors. But, many funds do not charge any front- or back-end load. So you should examine all the costs and benefits involved before making any investment.
Johnny: That’s true, Jinny. One should not get blindly led by the piper.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to them at email@example.com