Saturday, February 14, 2009

Mutual Fund Myths

We all know about mutual funds as one of the best investment options for investors who want to invest in the equity market but do not have the time or expertise to invest themselves in the stock market. As an investor it is our responsibility to ensure that we do not invest in funds that would not provide the best returns for us. There have been some funds that have outperformed its peers by a long way and there have been funds that have underperformed its peers in a very wrong way. People who invested in such funds have lost their money. As a prudent investor, this is something that we do not want.

Choosing a good mutual fund is an important decision. While doing so, even intelligent investors go by the hypes surrounding mutual fund schemes. There are a number of misconceptions that plague investors and have a direct negative impact on our investments.

The purpose of this article is to try to clear of such misconceptions.

1. A fund with a NAV of Rs. 10 is cheaper than a fund with NAV of Rs. 50
This is the biggest of all misconceptions. Many people believe that funds with a lower NAV are cheaper than funds with higher NAVs and invest in them blindly. The NAV of a mutual fund represents the market value of all the investments of a mutual fund. Any capital appreciation in the fund scheme will depend on the price movement of its underlying securities. Suppose you invest Rs. 1000 each in Fund A (A new scheme with NAV 10) and fund B (An older scheme with NAV 50) you will get 100 units of fund A and 20 units of fund B. Let us assume both the funds invest in the same stocks. If the stocks appreciate by 10% then the NAVs of both the funds would appreciate by 10% which implies it would go to Rs. 11 and Rs. 55 respectively. So in both cases your investment would go to Rs. 1100. I.e., the returns are identical irrespective of the NAV of the fund.

In fact the NAV of fund B is 50 which means, this fund has been actively and properly managed and hence the funds assets have increased from Rs. 10 per unit to Rs.50 per unit. Which is a good indicator of the funds performance and there are chances that it would outperform the new fund.

In vesting in new fund offerings (NFO’s) is advisable only when you are a high risk investor and also only when you are very confident of the fund manager’s capabilities. Investing in a new fund with a new fund manager is a great risk which may or may not be fruitful.

2. Funds with a Larger corpus always generate higher returns
A fund with a very large corpus is prone to inefficiencies as rising assets make it difficult for the fund managers to manage after a certain point. Many fund managers are experts in managing mid sized funds and falter when their asset size goes beyond a certain limit.

As the fund size increases, they would have to take exposure to newer stocks because they cannot risk overexposure to certain stocks. This may result in them including less researched or low potential stocks in their portfolio. Or in some cases managers risk overexposure to certain stocks/sectors and it proves a disaster in certain cases.
For example due to the financial meltdown the stocks of banks and financial institutions have taken the worst hit. Some large funds that had heavy exposure to these stocks are the ones whose NAV’s have dropped the most.

3. Funds that regularly declare dividends are good buys
Dividend income is an important criterion which many investors consider before buying a MF. Fund houses declare dividends when they have distributable surplus. They do it either when their fund size becomes very big or when they do not have sufficient investment avenues and feel its better to declare a dividend than holding cash or when they have made significant profits and want to share it with the investors.

In most cases the third reason is the reason for declaring dividends. If that is the case investing in such funds is a good buy but if the reason are either of the 2 other reasons then the investment decision may not be the best.

In some cases, some fund managers sell off good stocks to raise money to declare dividends to ensure that the investors think they are also competitive.

4. SIP investments are always better than Lump sum investments.
A SIP is the best way to invest during volatile times as it lowers our average cost per unit. This is also termed as rupee cost averaging. This is beneficial when the markets are very volatile and the stock prices go up and down frequently.

During bull markets when the stock prices are steadily rising, SIP’s fail to score when compared to lump investments. Since the stock market is rising the asset values increase regularly and somebody who invested in lump would have more units than somebody who invested via a SIP for the same amount.

Happy Investing!!!

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