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Jul 22, 2013

Mutual Funds Mythbuster

Rahul is working for a mutual fund house. They have recently come out with an NFO (new fund offer). The day on which the fund house announced its maiden NAV (net asset value), he received lot of calls from investors asking why the NAV was below par. They thought something was wrong.

Rahul went on clarifying to them that though both an equity fund and a stock extend market-related returns, there are some key differences between the two. If you have similar misconceptions about equity funds and stocks, this article will help demystify all such misconceptions.

New Fund Offerings:
A new fund offer is not likely to generate amazing returns as can be the case with an initial public offering of a company.
This is because the NAV reflects the market value of the stocks held by the fund on any given day. Because a fund holds several stocks in its portfolio, the NAV can only reflect the combined returns on the portfolio between the NFO date and the date of first NAV.

The first NAV declared by a fund can, at times, be lower than the par value of investment. A lower NAV does not necessarily mean a cheaper fund: Just because a New Fund is issued at Rs 10, it does not mean it has a chance of giving better returns than an existing fund with a higher NAV.

Whether the scheme in which you are planning to invest has an NAV of Rs.15 or Rs.150 does not matter at all.

There is a difference between the price of a listed security and the NAV of a mutual fund scheme. Listed security has a price, determined by the demand and supply of the security. Whereas the unit's NAV of the scheme has a value determined mathematically, by the prices of the securities in the portfolio. If the portfolio appreciates by 10% Rs.15 NAV will become RS.16.5 and the Rs.150 NAV will become Rs.165. So in either case, your investment will fetch you a 10% return.

So instead of concentrating on LOW NAV and more number of units, it is worthwhile to consider other factors (performance track record, fund management, volatility) that determine the portfolio return. A fund with higher NAV may give higher returns than a lower NAV fund, if the stocks it invests in did better in the markets.

Funds Vs Stocks

The following are the differences between equity oriented mutual funds and stocks.

Point of distinction Equity Fund Stocks
Level of Risk High Highest
Entry/Exit cost No Entry Load; But there will be Exit load. Advisory fee may be applicable. Demat a\c and Brokerage charges
Options Options available like dividend payout, dividend reinvestment, growth. No such options
Minimum Investment Min investment is usually Rs.5000. Even one share can be bought.
Measuring Performance  Returns Vs Benchmark  Net Profit margins/EPS
Sub-division Classified based on stocks in which it invests. (Diversified, Midcap, sectoral, thematic) Classified as per the industry in which it operates. (FMCG, IT, PSU, METAL)
Pricing Based on the price of the underlying securities Based on the demand and supply of the particular stock

Dividends Are Not Extra Returns:
Immediately, after the payment of dividend the NAV of the fund will fall to the extent of the dividend payment. 
Let us illustrate: A Fund’s cum dividend NAV is Rs.25. Proposed dividend are 50%. You invest Rs.1 Lac into the fund with the hope of earning Rs.50000 as dividend. However, the dividend you receive is only Rs.20000 (50% on the face value of Rs.10 is Rs.5 per unit. As the unit price at the time of purchase was Rs.25 you got 4000 units. Rs.5 dividend * 4000 units=Rs.20000).

And this dividend is not an additional gain or income. After payment of dividend the NAV of the scheme will fall to the extent of the payment and distribution taxes (if applicable). Now your NAV will become Rs.20 and your investment value will fall to Rs.80000 (4000 units * Rs.20 NAV).

In short your,
Investment amount was Rs.1,00,000
Dividend amount was Rs. 20,000
Present Value is Rs. 80,000

It is nothing but investing Rs.80000 (after dividend distribution) at a NAV of Rs.20.

So investing in a scheme just because it is declaring dividend in the near future is meaningless.

A Few Points to Consider

  • Usually a company with a liberal dividend policy may enjoy greater investor confidence in the stock market. The same is not applicable to an equity-oriented mutual fund.
  • Investing more number of funds is not actual diversification. It may reduce your return.
  • Owning several mutual funds doesn't necessarily broaden your holdings. It will be a mistake to buy the same securities over and over again in different funds with different names. You tend to believe they're diversified. But it is not real diversification.
  • There are only very few funds which are performing consistently. Instead of investing in few funds, if someone chooses to invest in a large number of funds (because he intends to diversify) he may be forced to choose some average performing schemes also. As a result his returns will be diluted. The step taken by the investor to diversify his investment is not leading to diversification but to dilution of return.
  • Thus ideally your portfolio should not have more than four or five funds.

NO tax for Churning:

When we buy shares and sell them within a year we are accountable for short term capital gain tax at the rate of 15%.

But mutual funds provide the benefit of churning of stocks with no tax implications. A fund which churns its portfolio within a year is exempt from tax because it only redistributes these profits to investors.

The author of this article is Ramalingam K, an MBA (Finance) and Certified Financial Planner. He is the Founder and Director of Holistic Investment Planners - a firm that offers Financial Planning and Wealth Management. He can be reached at ramalingam@holisticinvestment.in. 

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