How Mutual Funds Work — NAV, TER, SEBI Categories, SIP Mechanics

A mutual fund's mechanics rest on three moving parts that retail investors should understand precisely: the Net Asset Value (NAV) that determines unit pricing, the Total Expense Ratio (TER) that quietly compounds against your returns, and the SEBI category and mandate that determines what the fund can actually hold. The NAV is computed every business day after market close: total value of all holdings minus total expenses, divided by total units outstanding. A ₹10,000 SIP installment on a day when NAV is ₹250 buys exactly 40 units; on a day when NAV is ₹200, the same ₹10,000 buys 50 units — this is rupee cost averaging in mechanical action. The TER is the fund's annual operating cost expressed as a percentage of AUM, deducted daily from NAV (₹2,000 of TER on ₹1 lakh AUM doesn't get billed separately — it's already netted in the NAV you see). The SEBI scheme category determines what stocks/bonds the fund must hold; a "Nifty 50 Index Fund" must track the Nifty 50 with minimal tracking error. Freedomwise's SIP Return calculator and Portfolio Overlap calculator make these mechanics visible.

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How is NAV calculated?

The formula:

NAV = (Total Market Value of Holdings − Total Liabilities and Expenses) ÷ Total Units Outstanding

Worked example. A mutual fund holds these positions at end-of-day:

Holding	Quantity	Price	Value
HDFC Bank	10,000 shares	₹1,650	₹1.65 crore
ICICI Bank	8,000 shares	₹1,300	₹1.04 crore
Reliance	5,000 shares	₹2,800	₹1.40 crore
Cash in bank	n/a	n/a	₹0.20 crore
Total assets			₹4.29 crore
Minus daily expenses accrued			₹0.01 crore
Net assets			₹4.28 crore

If the fund has 25 lakh units outstanding:

NAV = ₹4.28 crore ÷ 25 lakh = ₹171.20 per unit

NAV is computed once per business day at the end of trading hours by the AMC's appointed valuation team and published by ~9 PM the same day. Your purchase or redemption transactions get the NAV cut-off applicable to your transaction time (typically 3 PM cut-off for same-day NAV in most categories; later for liquid funds with same-day NAV available).

What does the TER (Total Expense Ratio) actually pay for?

The TER is the fund's annual operating cost, expressed as a percentage of average AUM:

Component	Typical share of TER
Fund management fee (AMC's compensation)	40-50%
Distributor/commission (regular plans only — zero in direct)	30-50% in regular plans, 0% in direct
Custodian fees, registrar fees, audit, legal	5-10%
Marketing and administrative	5-15%

SEBI caps: 2.25% for equity funds, 2.00% for debt funds, 1.00% for index funds and ETFs. Within these caps, AMCs set their own TER based on category, AUM size, and fee philosophy.

TER is deducted daily from NAV. You never see a separate "expense bill" — but the NAV you see has already subtracted that day's proportional TER. For a fund with 1.5% TER, every day's NAV deducts roughly 0.0041% (1.5% ÷ 365). Over a year, this compounds to the full 1.5%.

Direct plan vs Regular plan difference is the distributor commission slice. A scheme with 1.5% Regular TER might have a Direct TER of 0.75% (the 0.75% gap is the embedded commission). The TER gap compounds: over 25 years at 12% gross return, the same ₹10K monthly SIP produces:

• Regular plan (1.75% TER): ₹1.45 crore terminal corpus
• Direct plan (0.75% TER): ₹1.84 crore terminal corpus
• ₹39 lakh gap — the price of choosing regular plan over direct

How does a SIP work mechanically?

A Systematic Investment Plan (SIP) is an instruction to your AMC to debit a fixed rupee amount from your bank on a fixed day every month and convert it to fund units at that day's NAV.

Worked example. ₹10,000 monthly SIP into a fund where NAV fluctuates:

Month	NAV	Units bought	Cumulative units
Jan	₹200	50.0	50.0
Feb	₹180 (-10%)	55.6	105.6
Mar	₹220 (+22%)	45.5	151.0
Apr	₹240	41.7	192.7
May	₹250	40.0	232.7
Jun	₹230	43.5	276.2
Jul	₹260	38.5	314.6
Aug	₹250	40.0	354.6
Sep	₹240	41.7	396.3
Oct	₹260	38.5	434.8
Nov	₹270	37.0	471.8
Dec	₹280	35.7	507.5

After 12 SIPs of ₹10,000 each (₹1.2 lakh total contribution), you own 507.5 units at the current NAV of ₹280 = ₹1,42,100 — a 18% gain on the year, despite the fund's NAV being only 40% higher than January start (40% on the lumpsum-at-Jan-1 equivalent would have been better in this rising market).

The point: SIPs win in volatile/declining markets (more units bought at lows) and underperform pure-rising markets (lumpsum was already fully invested). Across long horizons with multiple cycles, SIPs deliver close to the underlying fund's CAGR.

What is the SEBI scheme category and why does it matter?

SEBI defines 36 mutual fund categories, each with strict rules about what the fund must hold. The categorisation, introduced in 2017 and refined since, is meant to prevent style drift and make funds comparable within categories.

Examples of SEBI category rules:

• Large Cap Fund: minimum 80% in top 100 stocks by market cap
• Mid Cap Fund: minimum 65% in 101st-250th stocks by market cap
• Small Cap Fund: minimum 65% in 251st-and-beyond stocks
• Flexi Cap Fund: minimum 65% in equity, but free to invest across market caps
• Multi Cap Fund: minimum 25% each in large, mid, and small cap
• ELSS: minimum 80% in equity, plus 80C tax benefit (old regime) and 3-year lock-in
• Liquid Fund: maturity up to 91 days
• Overnight Fund: maturity up to 1 day

Why this matters for selection: when you read a fund's category, you know roughly what it must hold. A "Large Cap Fund" cannot suddenly buy small-caps in pursuit of returns; the SEBI category constrains the mandate. This makes comparison within categories meaningful — but the data shows 70-85% of active large-cap funds underperform the Nifty 50 index over 10-year periods, so even within a single category, the choice matters.

What's the difference between Growth and IDCW options?

Most mutual fund schemes offer two variants of the same underlying fund:

Growth option: All gains, dividends, and interest received by the fund are reinvested into the unit NAV. Your wealth grows by NAV appreciation; no periodic cash payouts. Compounding works fully tax-free until redemption.

IDCW (Income Distribution cum Capital Withdrawal) option (formerly called Dividend option, renamed by SEBI in 2021): The fund makes periodic payouts to unit-holders. Each payout reduces the NAV by the payout amount AND is taxable at slab rate in your hands at receipt.

For long-horizon corpus building, Growth dominates IDCW. Reasons:

1. Compounding stays intact — the gains stay in the fund, growing on themselves
2. Tax efficiency — payouts are slab-taxed (potentially 30%) at receipt, vs LTCG at 12.5% on eventual redemption
3. Simplicity — no managing periodic cash inflows

The exception: retirees who want regular income from their corpus. Even then, periodically redeeming Growth units (capturing LTCG at 12.5%) is structurally more tax-efficient than IDCW at slab rate.

Use this on Freedomwise

• Mutual Funds Pillar — full architecture
• What is a Mutual Fund — foundational primer
• Direct vs Regular Plans — the 1% TER decision
• Expense Ratio Explained — TER mechanics in detail
• SIP Return Calculator — model SIP outcomes across return assumptions