Rahul is working for a mutual fund house. They have recently came out with an NFO (New Fund Offer). The day on which the fund house announced its maiden NAV (Net Asset Value), he received lot of calls from investors asking why the NAV is 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.
New Fund Offerings
A New Fund Offer (NFO) 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 first NAV.
The first NAV declared by a fund can, at times, be lower than the par value of 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 an 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 AV 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 number of 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.
Mutual Funds Vs Stocks
| Point of Distinction | Equity Fund | Stocks |
| Level of Risk | High | Highest |
| Entry/Exit cost | No Entry Load; But there will be Exit load. Advisory fee may be applicable. | Demat ac and Brokerage charges |
| Options | Options available like dividend payout, dividend reinvestment, growth. | No such options |
| Minimum Investment | Min investment is usually Rs.5000. | Even one share can be bought. |
| Measuring Performance | Returns Vs Benchmark | Net Profit margins/EPS |
| Sub-division | Classified based on stocks in which it invests. (Diversified, Midcap, sectoral, thematic) | Classified as per the industry in which it operates.(FMCG, IT, 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 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. Proposed dividend is 50%. You are investing Rs. 1,00,000 and you will not get Rs. 50,000 as dividend. It is only Rs. 20, 000 (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. 20,000.
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. 80,000 (4000 units * Rs. 20 NAV).
In a nutshell,
Investment amount: Rs.1,00,000
Dividend amount: Rs. 20,000
Present Value: Rs. 80,000
It is nothing but investing Rs. 80,000 after dividend distribution at NAV Rs. 20. So investing in a scheme because it is declaring 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.
Avoid Investing in More Number of Mutual Funds
Investing in more number of mutual funds is not actual diversification. It may reduce your return. 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 mutual funds with different names. You tend to believe they’re diversified. But it is not real diversification.
There are only very few mutual funds which are performing consistently. Instead of investing in few mutual 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 mutual funds.
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 churning of stocks with no tax implications. A fund which churns its portfolio within a year is exempt from tax because it only redistributes these profits to investors.
Mutual Funds Mythbusters is a post from riyaz.net.
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