Albert Einstein is supposed to have remarked: *Compounding is the 8th wonder of the world – one who understands it, earns it; one who doesn’t understand it, pays it!!*
Compounding is simply an activity in which the earnings of the original investment also earn the same rate of return as an original investment.
Now in the case of Mutual Funds let’s say you invested in the fund when the NAV is Rs. 20. Now assume NAV goes up by 25%, in that case, the New NAV will be 25. Again markets go up by 20%. Now the new NAV will be Rs. 30 which is 20% above Rs 25. If there were no compounding than the return would be 20% over Rs 20 which was an original investment. This is compounding in Mutual Funds for you.
I would like to say is that for a long-term investor compounding will work in his / her favor. In fact, I must say compounding is the magic which magnifies your return over the long term.