Realities of investing in Mutual Funds

Mutual funds have redefined the financial landscape of the investing community, and are fast emerging as an ideal option for investors with diverse risk profiles and time horizons. Their appeal lies in the fact they allow people to invest without having to choose individual securities or understand the finer points of financial markets. More importantly, mutual funds offer accessibility in two ways.

First, through mutual funds, retail investors have access to investment opportunities that would otherwise be unavailable to them, because of their limited resources. Secondly, mutual funds themselves are accessible to investors of varying income levels. However, like any other industry, this one, too, is the subject of popular and enduring myths and misconceptions. A lower NAV is no guarantee that an investor is getting a better deal.
The sooner investors shed such notions the more likely they are to get the best out of mutual funds. An ideal way to invest in mutual funds is to opt for schemes that have a consistent track record over the longer term. Needless to say, a scheme with a long-term track record will have a higher net asset value (NAV) than newer funds.
Unfortunately, many investors seek to avoid a high NAV, and settle for funds with low NAVs. In the process, they completely ignore the quality and suitability of the funds both important ingredients in the decision-making process.
A common fear among investors is the likely impact of a high NAV on a fund’s future prospects, both in terms of appreciation as well as dividend payment. The fact, however, is that the price at which an investor buys units of a scheme, say, Rs 10 or Rs 50, has no bearing on returns.
The NAV grows in percentage terms. For example, an investor who invests Rs 1 lakh in a fund with an NAV of Rs 50 will get 2000 units, while someone investing in a fund with a Rs 10 NAV will get 10,000 units for the same amount. If the two funds are similar, and assuming NAVs grow by 20%, the current value would be the same for both the funds. And the fund with the better portfolio and track record is likely to grow faster, thus benefiting investors in spite of the higher NAV. So it makes sense to focus on the factors that can make the NAV grow faster, such as portfolio quality, segment-wise exposure (that is, large, mid, and small-caps), and the investment philosophy of the fund. Another myth is that a high NAV affects the dividend.
The truth is that the fund usually decides the dividend percentage based on current NAV, the gap between dividend payments, and its philosophy with regard to dividend payments.
Let’s take two hypothetical funds called A and B. Fund A has an NAV of Rs 12, and Fund B, Rs 60. It is wrong to assume both will declare the same dividend. It is more likely that the Fund A may pay Re 1 per unit, while Fund B pays Rs 10. So an investor with 2000 units of Fund B will get a dividend of Rs 20,000, as against a dividend of Rs 10,000 for an investor who has 10,000 units of Fund A.
This brings us to another myth: the fund that pays high and frequent dividends is doing well. The truth is that an old fund with even a mediocre performance can afford to pay very high and frequent dividends. Surprisingly, the same investors who hesitate to invest in high-NAV funds are dazzled by high and frequent dividends, and happily invest in such funds.
Unfortunately, they often end up parking their money in the slush of mediocrity. And certainly there are examples of funds that deliberately employ the strategy of declaring frequent dividends to divert investors’ attention from their shabby performance, and to attract fresh money. The mother of all myths is the belief that it’s smart to invest in an equity fund right before dividend time.
This attracts many investors because of the percentage of the dividend, as well as its tax-free. Those who follow this strategy, or intend to follow it, should be aware of a few things. Firstly, if a fund declares a 100% dividend, it is paid on the face value usually Rs 10 and not on the NAV. Secondly, the NAV of the fund goes down by the dividend amount, after the dividend is paid.
For example, if the NAV of a fund paying 100% dividend is Rs 50 on the record date, the NAV will come down by the face value (Rs 10) to Rs 40 after the payout. To further clarify, let’s consider a situation in which someone invests Rs 1 lakh in this fund on the record date.
The investor would receive Rs 20,000 as dividend, and the current value of her investment would come down to Rs 80,000. In other words, she would get a part of her own capital back in the form of dividend, and not as a gain, as is commonly perceived. Equity investments are for building capital over time. Any attempt to take short cuts can hurt future growth prospects.