Oct 21, 2008

Mutual Fund Investing: 6 Fallacies Demystified

It is really amazing to see how people – who are otherwise skeptical, rational and intelligent – become so gullible when it comes to making investment decisions.

Investment path is strewn with deadly pitfalls that might appear harmless but in reality can do irrevocable damage to your investment portfolio if you’re not diligent.

Mutual Fund Investing: Top Myths

Here is a list of 6 commonly held misconceptions about investing in mutual funds:

1. Mutual fund declaring dividend is better than the one not declaring
Most of the investor’s assume that dividend’s are indicators of strong performance. It may or may not be true. It may be just another marketing trick to attract investors.

Further, from this wrong perception, we may deduce that fund declaring dividend is better performing and hence a better buy than the one not declaring it. In other words, funds which are not declaring dividends are performing worse than those declaring it.

Try to understand that mutual fund dividends are not same as corporate dividends. You don’t get anything extra because to the extent of dividend distributed, the NAV comes down.
Let’s say, when you buy a mutual fund the NAV is 36 and soon thereafter the mutual fund declares a dividend of Rs 8 per unit. You will receive Rs 8 per unit in cash but the new/adjusted NAV of the fund will become Rs 28. Finally, you end up where you started meaning thereby that you don’t get any extra gains, your money is simply paid back to you.

If there is any difference, it is from the tax point of view.

Many mutual funds take full advantage of this misleading notion and market their funds based on dividends rates to lure investors. Therefore, don’t get fooled.

2. Mutual fund’s NFO’s are similar to IPO’s of companies and offer listing gains
Unlike stocks which are primary instruments (i.e., a financial instrument whose value is determined by the market based on demand and supply and is not derived from that of another instrument) and may list at premium or discount to the offer price, mutual fund units are secondary instruments (collective investments that pools money from various investors and invests in primary instruments like stocks) and does not offer any listing gains.

There are three different values in case of financial instruments, market value, book value and intrinsic value. In case of stocks, the market price may differ significantly from their book value and intrinsic value, whereas in case of mutual funds, all the three values are the same and represented by NAV.

The reason behind stock IPO’s listing gains –during bull markets - is that due to hype created during the IPO marketing, the demand sometimes exceeds the supply.

In case of mutual funds supply is always equal to the demand. In other words, in case of open ended mutual fund, supply is unlimited and is based on their demand i.e., the new units gets created at the time of investment and gets destroyed at the time of redemption. Therefore, in case of open-ended funds (they are not listed and thus not traded in the market) there can never be any premium or discount based on demand.

But the above argument does not hold true in case of close-ended funds which are listed and traded in the market and where – like stocks - the supply is limited which may sometimes lead to their market price drifting away from the NAV.

Therefore, before investing in a NFO, understand that you won’t get listing gains and so resist the temptation to invest in NFO’s.

3. NFO’s are better than existing schemes because you get a bargain by buying the NFO at-par
Just because a NFO is available at Rs 10 does not mean that it is cheaper than the existing fund.

Let’s say you invest Rs. 10,000 in a NFO (1,000 units @ Rs 10) and another Rs 10,000 in an existing scheme at a NAV of Rs 20 (500 units). Now, if the NFO gives a return of 10% and the existing scheme gives a return of 20%, then after one year your NFO amount will become 11,000 whereas existing scheme amount will become Rs 12,000.

I don’t mean to say that NFO always performs worse than the existing scheme. Rather the point is that while investing in mutual funds, the cost factor is totally irrelevant i.e., the rate at which you buy the units (whether new or existing) doesn’t make any difference. Whether the rate is Rs 5 or 50 or 500 has no impact, whatsoever, on the future returns.

In mutual fund investing, the only thing which matters is future performance and that is easier to judge in case of existing schemes because unlike NFO’s, existing schemes have a track record.

Although past performance does not guarantee future performance, it’s a good indicator. A fund which has consistently performed well in the past is also likely to do so in future.

Hence, it is always prudent to stay away from NFO’s.

4. A mutual fund unit with a low NAV is better than the one with a higher NAV
It is another erroneous perception that NAV of a mutual fund is similar to market price of stocks and therefore buying funds at low NAV is similar to buying stocks at cheaper prices. This wrong belief stems from the view that a low NAV fund holds more potential for appreciation. Besides, the low NAV seems to be cheaper because it allows you to buy more units.

As already mentioned above, unlike shares which are primary instruments, mutual fund are secondary instruments, so the current NAV level doesn’t matter at all.

The value of your investments is the product of number of units and the NAV. What happens is that in case of low NAV, you’re allotted higher number of units and in case of high NAV, you’re allotted fewer units. But the end result is that value of your investments remains same in both the cases.

Say, you have Rs 200 to invest and you invest equally in two existing schemes Fund A (with a NAV of Rs 25) and Fund B (with a NAV of Rs 100). In the case of Fund A, you receive 4 units @ Rs 25 each and in case of Fund B, you receive one unit @ Rs 100. Now, let’s further assume that both the funds performed equally well and gave an annual return of 20%. So, in case of 'Fund A' NAV becomes Rs 30 per unit and in case of 'Fund B' NAV becomes Rs 120 and value of your investment in each scheme becomes Rs 120. Thus, your total gain/return in both cases would be same irrespective of the NAV.

Therefore, always remember that existing NAV of a fund does not have any impact on the returns.

For making investment decision, NAV of a fund is totally irrelevant. The only criteria to judge mutual funds performance is risk adjusted returns and current NAV – whether high or low – makes no difference to returns.

5. High returns, say thirty per cent, means excellent performance
The above statement may or may not be true because in this universe of relativity, everything is relative and nothing is absolute.

While judging the performance of mutual funds, what matters is relative rather than absolute performance i.e., how the particular fund has performed in comparison to similar schemes and its benchmark.

6. High annualized returns, say fifty per cent, means the fund is a good buy
If a fund says it has given annualized returns of 50% based on last quarter performance, it means that the fund is assuming last quarter performance is going to be repeated during next three quarters which is highly improbable, if not impossible.

Commercial transactions are governed by the doctrine of Caveat Emptor, Latin for ‘let the buyer beware’, which means that a customer should be cautious and alert to the possibility of being cheated. This principle is also equally applicable while making investments.

Furthermore, Unscrupulous mutual fund companies and distributors/agents who are well aware of these widely held but mistaken beliefs, take undue advantage and mis-sell the schemes to naive investors based on these false notions.

Therefore, don’t be so credulous and blindly rely on the judgement and honesty of your financial advisor and mutual fund company. Understand that they’re there to get your money and can lead you astray if you’re not careful. Ultimately, the onus to protect yourself lies on you, the investor. Hence, become a smart and intelligent investor.

Also Read:
1. 10 Common Income Tax Fallacies
2. Mutual Fund Investing - Top 10 Principles
3. Mutual Funds vs Direct Stock Investing: How to Decide?

1 comment:

  1. Hi,
    Thanks for the article. I found it really useful.
    I am new to investing, I would like to know what are the exact steps to invest into the mutual funds, like what i know as of now, first i have to open a demat account etc.
    Also, what kind of expenses are involved when i make mutual fund transactions, like any fees, however minimal, please tell.



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