3 Mutual Funds Truths Unravelled

Mutual Funds are the simplest and safest way to riches for an ordinary investor.

Diversification across many stocks and sectors and the expertise of a fund manager come free with mutual funds. One does not have any hassles in tracking stocks quarter after quarter; exposure to the equity market is achieved by simply investing in mutual funds.

However, investors need to be aware of some myths around mutual funds that could help them in their decision making process.

1. Systematic Investment Plans (SIPs) are better than lump sum investing

Systematic Investment Plans(SIPs) in mutual funds are the best way to invest in equity over a long period of time.

However, SIPs might not be ideal if the stock market keeps rising – this could possibly happen over a short period of time. SIPs work on rupee cost averaging, a principle by which one buys more units of a mutual fund when the stock market dips and less units when it goes up.

SIPs thus tend to average out the risk of investing amidst the market volatility by investing small amounts over a long period of time when markets go up and down. However, if the market were to consistently rise, a lump sum investment would work out better than SIPs.

Key message to note : For small investors, SIPs in mutual funds is the way to go in equity investing. Avoid lump sum investment as you can never know when the market is going to love the bears or the bulls.

2. A Mutual Fund with lower Net Asset Value (NAV) is available cheap

The most common mistake made by mutual fund buyers is that a mutual fund with a lower NAV is cheaper than one with a higher NAV.

Gullible investors have been sold new mutual funds (called NFOs – New Fund Offering) on this basis by mutual fund agents and fund houses. This amounts to mis-selling.

Let us see an example to see why a mutual fund with low NAV is not cheap.

Suppose you have Rs 10,000/- to invest. Fund A has current NAV of Rs 20 and Fund B has NAV of Rs 40. An investor would get 500 units of Fund A and 250 units of Fund B.

Assuming that both funds have the same portfolio, their returns would also be same over (say) a year. Assume this return to be 50%.

The new NAV of Fund A will be Rs 30 (150% of Rs 20) and for Fund B will be Rs 60 (150% of Rs 40). Value of investment after one year in Fund A would be 500*30 = 15,000/- and in Fund B would be 250*60=15,000/- – an equal amount !!! So your returns will be same irrespective of the NAV.

Do not let a funds NAV be a parameter for buying a mutual fund.

3. Mutual Funds that declare dividends are better

This is another favourite gimmick of fund houses to market their mutual funds.

Declaring dividends cannot always be seen as a measure of success of the mutual fund manager. One has to be cautious to judge how the dividends were declared – was the mutual fund manager sitting on a pile of cash that he chose to return to the investors or did he offload stocks that turned sour ?

Most investors think receiving dividends from mutual funds is same as received dividends from stocks. When a dividend is declared, the NAV of the mutual fund (dividend option) dips because the dividend is being paid out of the investors money. A dividend paid by a stock does not take its price down.

A funds dividend declaration history should not be a factor in your decision of buying a mutual fund.

Make sure you look out for these myths next time you want to go shopping for a mutual fund.