Originally asked and answered on Quora, following is the link
Now an investor has invested Rs. 400 in Reliance liquid fund-Treasury plan when the NAV was 4023.9108(units allocated=0.099). The very next day NAV increased to some 4024 and now it is 4026.7599 but the value of his fund reduced to 398.65. So, he was wondering that even though the NAV increased why did he lose value?
This is a very interesting situation and a basic fallacy in how the mutual fund system works in India.
We started off with FinoZen in June 2016, enabling people to invest as low as Rs. 500 in liquid funds as liquid funds are a much better savings options than Savings Bank Account or Fixed Deposits.
However, very soon we started facing exactly the same problem which aforementioned investor faced i.e. for the first 2 – 3 days even though the NAV was increasing the value of investment was lower than the money invested. Now, this became a big problem for us as our basic proposition was that your money will grow regularly with instant liquidity but here for a first time user who is investing small, he will think that his money has declined!
This challenged our whole proposition of FinoZen and I distinctly remember not being able to sleep for 3 days as I couldn’t understand why this was happening. It took us around 6 months of research to identify the need gap and another 3 months of programming to create FinoZen and all of that seemed like a waste.
Anyways, we started from the beginning and 3 of us did multiple small value transaction of Rs. 500, 600, 601, etc. etc. to find out what was happening and why it was happening. And finally it dawned upon us what was happening and we took relative measure to ensure that our clients are safe. People who are users of FinoZen would know that we add a certain amount for optimisation when you do an investment, and this also answers why we do that optimisation –
The way Mutual Fund investment works is that they allot you units with respect to the amount you have invested and depending on the NAV.
In simpler terms (and taking above example itself) – if you invested Rs. 400 at the NAV of 4023.9108 you will be allotted 0.099406 units which is 400 divided by 4023.9108.
Now, the fallacy of the mutual fund system is that instead of taking exact values they take round up values. NAV is rounded up to 4 decimal places for any given day and Units are rounded up to 3 decimal places.
So in the above example, your units are rounded up to 0.099 units at the NAV of 4023.9108 i.e. an investment of 4023.9108 * 0.099 = Rs. 398.36 i.e. you lost Rs. 1.64 at the time of investment itself.
So it’s not that your investment is losing value as NAV is increasing, it’s that you lost value at the time of investment itself!
Now, you ask how is it all related to the optimisation which FinoZen does?
Well, after we figured out that the algorithm at the mutual fund end is rounding the units to 3 decimal places, we realised that we will be in a good shape if we hack the algorithm to make it round up instead of rounding down.
Again to explain it simply – In the above example, no. of units calculated are 0.099406 which is rounded to 0.99 if we could just control the 4th decimal place and make it higher or equal to 5 the rounding will always be up i.e. for example if the units allotted are 0.099506 (instead of 0.099406), units will be rounded up to 0.100 and instead of having an initial investment amount of Rs. 398.36 and a loss of Rs. 1.64 our users will end up having 0.100*4023.9108 or Rs. 402.39 as initial investment.
Well, after we figured it out it was an easy job to write the algorithm and the way the algorithm works is that it will add a small amount to your choice of investment amount.
i.e. in the above example if you would have selected to invest Rs. 400, our optimisation algorithm would have added Rs. 1 and asked you to invest Rs. 401 instead of Rs. 400. This way the units allotted to you would be 401 divided by 4023.9108 or 0.099654 which then rounded up to 3 decimal places is 0.100 and hence your initial investment itself is 4023.9108*0.100 = 402.39, an immediate profit of Rs. 1.39!
Of course the optimisation algo is dynamic and varies everyday depending on the NAV of that day and the choice of your investment amount i.e. if today the algo is adding Rs. 1 to your choice of Rs. 400 as investment, tomorrow it might add Rs. 2 as per the NAV of that day.
In a nutshell, Finance is complex only till you don’t understand it. 🙂