This week we will share an email received by us from a reader (name changed) and our response to the same. The reason for this is that the exchange dwells on some basic principles of mutual fund investing that we trust other readers would also find interesting.
Dear Sir,
See, I have been investing in mutual funds since last 10 -12 yrs. I have realized since that the earning in the form of dividends from mutual funds is very irregular & unreliable. We can get good returns only if you have invested in an NFO. You are likely to get good returns because you have invested at the basic unit price. If you enter any fund at the market NAV then the returns are not more than 6-8% which is the same as what you would get from any FD. Further I would like you to comment on why NAV should be reduced whenever a dividend is declared. We investors are investing in the mutual fund because the fund manager is an expert … he is supposed to churn the portfolio & earn profits for the investors. He is supposed to track good shares & time the market to earn profits for the investors. Why don’t we get good returns? — Mr. Desai
Dear Mr. Desai,
Please be rest assured that the mutual fund industry is not fleecing investors. In fact, to quite the contrary, it must be said that the instrument of a mutual fund is by far the best way to participate in the capital market. It perfectly balances the four basic investing parameters that any investor should consider – return, risk, liquidity and tax efficiency.
First and foremost, the dividend from a mutual fund is contained in the NAV itself – it is not over and above what the investment is worth. A portion of the value is given back to the investor and such portion is called dividend. This is the reason why the NAV is reduced – the part reduced is being paid to you!
Also, it’s not only you but many other investors who feel that mutual funds can give good returns only if one has invested at par, in an NFO. Or in other words, that a scheme with a lower NAV is cheaper than one with a relatively higher one.
The fact is that this is not true. Let us explain by means of an example. Currently, HDFC Equity Fund (face value Rs. 10) is quoting at an NAV of Rs. 474.44 whereas the latest New Fund Offer (NFO) is available at Rs. 10. Now, isn’t buying something at Rs. 10 far cheaper than at Rs. 474.44? Isn’t it simple mathematics that investing a fixed amount in the Rs. 10 offer will yield far higher number of units? The answer is a resounding NO and the reasons thereof are as follow.
To simplify the concept to the lowest common denominator, lets take the example of two schemes: Scheme A has an NAV of Rs. 200 while Scheme B has an NAV of Rs. 10. Let’s also assume that you are the sole investor in both the schemes and that you invest Rs. One Lakh in each scheme. Consequently you will get 500 units of scheme A (= 100000 / 200) whereas in the case of Scheme B you will receive as many as 10,000 units (100000 / 10). Owning 10,000 units as against just 500 units is what makes scheme B look the cheaper and the better option. However, continuing with our example, let’s further assume that the fund managers of both schemes A and B invest your money in Infosys. Remember you are the only investor in both these schemes. Now, one year later, say the Infosys share appreciates by 50%. What will happen? Your investment in both the schemes will also appreciate by 50%. In other words, the investment of each scheme will grow to Rs. 1,50,000. Consequently the NAV of scheme A will work out at Rs. 300 (150000 / 500) whereas the NAV of scheme B will work out at Rs. 15 (150000 / 10000 units). Consequently, both investments have made you equally rich; no one scheme has an edge over the other. To put it differently, other things remaining equal, you should be indifferent to investing in either scheme. The following is a tabular representation of the above mathematics. (See Box)
The question however is — are other things really equal? Though the offer documents of all MFs have the statutory warning that past performance is no guarantee of future returns, astute investors know that ignoring history in the financial markets is akin to committing financial suicide.
Also, it is important to identify good mutual funds . To do this, safely ignore all funds which haven’t been in operation for at least a year. Which essentially means — safely ignore one month, three month or six month returns and rankings. We can go to the extent of saying that look at only those funds that have been existing for over five years. Not only will you eliminate a whole lot of “me too” upstarts, but it will also give you an idea about the sustainability of the returns of the fund.
Remember, it is important that you invest with a well managed fund; however, whether it is the top performing one or the second or the fifth matters little. Also a topper today may come in fourth next year and so on. As long as you have invested in a quality portfolio that has stood the test of time, the particular ranking should matter little.
Even after having identified and invested in a good mutual fund scheme, there is one other vital thing that remains to be done. And that is you need to remain invested. For example, the five year return of HDFC Equity is 14.8% p.a., whereas over a ten year period it has returned around 21.4% p.a. To put it differently, Rs. 1 lakh invested in this scheme would have grown to around Rs. 2 lakh over a five-year time frame. And the same investment if held over the last decade, would have grown an astounding Rs. 7 lakh. We must hasten to add here that we are not suggesting that going ahead investors should expect similar returns. But for earning a return – any kind of return – holding the investment over long-term is imperative.
It is as simple to earn healthy returns from your mutual fund investments as it is not to. Just do the basics right, invest with established diversified schemes with a good track record, let the money work hard and stay away from gimmicks. Last but not the least take the following words of Donald Trump to heart – “Sometimes your best investments can well be the ones that you don’t make.”
(The authors may be contacted at wonderlandconsultants@yahoo.com)
