Mutual Fund 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 a lot of calls from investors asking why the NAV is at below Par. They thought something was wrong.

Then Rahul went on clarifying 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 demystify all those misconceptions. Also, read about the misconceptions about mutual fund SIP.

New Fund Offerings

A new fund offer is not likely to generate amazing returns as can be the case with an initial public offering from a company. This is because the NAV reflects the market value of the stocks held by the fund on any 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 the first NAV.

The first NAV declared by a fund can, at times, be lower than the par value of an investment. A lower NAV does not 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 that has a higher NAV. Whether the scheme in which you are planning to invest has a 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 Rs.150 NAV will become Rs.165. So in whatever the NAV you invest your investment will fetch you 10% return.

So instead of concentrating on LOW NAV and more 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 its stocks did better in the markets.

Funds Vs Stocks

Level of risk High Highest
Entry/Exit Cost No Entry load; but there will be Exit load. An advisory fee may applicable Demat account and brokerage charges
Options Options Growth, dividend payout/reinvestment No such options
Minimum investment Usually Rs.5000 Even one share can be bought
Measuring Performance Returns Vs Benchmark Net profit margins / EPS
Sub-Divisions Classified based on stocks in which it invests. (Diversified, Midcap, Sectoral, Thematic Classified as per the industry in which it operates. (FMCG, IT, Banking, 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 dividend payment of dividend, the NAV of the fund will fall to the extent of the dividend payment. Let us illustrate.

Fund’s cum dividend NAV is Rs.25. The proposed dividend is 50%. You are investing Rs.1 Lac and you will not get Rs.50000 as a dividend. It is only Rs.20000 (50% on the Face Value Rs.10 is Rs.5 per unit) as the unit price is Rs.25 you will get 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 be Rs.80000 (4000 units * Rs.20 NAV).

In a nutshell,

Investment amount Rs.1,00,000
The dividend amount of Rs. 20,000
Present Value Rs. 80,000

It is nothing but investing Rs.80000 after dividend distribution at NAV Rs.20.

So investing in a scheme because it is declaring a dividend in the near future is meaningless. Usually, a company with a liberal dividend policy may enjoy greater investor interest 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.

“The idea of excessive diversification is madness” – Charlie Munger

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.

” Wide diversification is only required when investors do not understand what they are doing “– Warren Buffett

There are only very few funds which are performing consistently. Instead of investing in few funds, if someone chooses to invest in more 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-five funds.

“Don’t buy too many different securities. Better to have only a few investments which can be watched.” – Bernard Baruch

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

Hope your myths about mutual fund have been demystified. If you have any other queries related to this kindly share it in the comment box.

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