MUTUAL FUND INVESTMENT: Getting the Basics Right

The idea that a fund with lower NAV is better than one with a higher NAV because it is cheaper is wrong.


By Dhirendra Kumar

Over the last 10 months, the way mutual funds are sold to individual investors in India has changed completely. While the impact on fund companies and fund distributors has often been discussed in the press, these changes have also made it necessary for investors to have a somewhat different approach while investing in funds. The changes that have happened are almost all beneficial for investors, but they do require investors to avoid some likely pitfalls.

In terms of outcomes, the biggest change that has happened is that the fund industry has shifted sharply from trying to sell new
fund offers to selling older, existing funds. There are a set of reasons for this. Entry load has been abolished. Fund companies now have to finance new fund marketing from their own pockets, rather than be able to dip into the fund’s assets. And SEBI has gotten tough about giving approvals to new funds unless fund companies can genuinely prove that the fund is substantially different from older ones. These changes are not all new or sudden but have accumulated over time. However, the coming together of all these factors means that current advertising and marketing campaigns ask investors to buy existing funds on the basis of their track records rather than fanciful features.

In general, this is a welcome development which makes me very happy. However, over the last few weeks I have realised that this also marks the return of into wider usage of one of the more harmful myths about mutual funds—that of low NAV being a desirable factor. Many investors believe that a fund with lower NAV is better than a fund with higher NAV. Apparently this belief is encouraged by some fund salesmen. I regularly come across people to whom fund are recommended on the basis of NAV level. This is a very basic issue and it’s sad that there are investors who are confused about something as basic as this.

The idea that a fund with lower NAV is better than one with a higher NAV because it is cheaper is wrong. In fact, it is so wrong that it would be a mistake for me to call it merely wrong. It is a ridiculous and a harmful idea, arising from an utter misunderstanding of what a mutual fund is and what NAV is. If you ever come across a fund salesman who even hints at suggesting that lower NAV is good, you should, without any second thoughts, conclude that he is either a fakeor a charlatan or a complete incompetent.

Here’s a simple way of understanding the underlying principle. The NAV simply reflects how much a fund has gained since it was launched and depends entirely on how well the fund manager has managed the fund’s portfolio of investments. For example, if the market has been gaining at 20 per cent a year then a one year old fund will have an NAV of Rs 12 and a two-year old fund with the same portfolio will have an NAV Rs 14.40.

The first one is not cheaper in any sense and its lower NAV has no bearing at all on how much it will gain in the future. Future gains will depend on their portfolios. For example, if they are managed in an identical manner, then your gains will be identical. If the two were to gain 30 per cent over the next two years, then the NAV of the first one will rise from Rs 12 to Rs 15.60 and the second one from Rs 18.72. There is no difference between the two. Rs one lakh invested in both will in each case become Rs 1.3 lakh. The only use of NAV is to compare with the past NAV of the same fund. That’s what tells you how much a fund has gained. Comparing it to the NAV of another fund is useless.