Common myths about Mutual Funds

Funds with more stars/higher rankings make better buys

Often investors make their investment decisions based on the fund's ranking or the number of stars allotted to it. Fund rankings and ratings have gained popularity over the years; a higher ranking/rating is construed as a sign of the fund being a good investment avenue.

Sadly, what investors fail to realise is that often rankings/ratings are based only on the past performance on the net asset value (NAV) appreciation front; only some rankings/ratings consider factors like volatility and risk-adjusted performance.

Secondly, rankings/ratings are known to change over a period of time in line with a change in the fund's performance. Does that mean investors should start buying and selling a fund in line with a change in its ranking/rating?

More importantly, fund rankings/ratings operate on the rationale that one-size-fits-all. They fail to reveal who should invest in the fund.

For example, if an aggressively managed sector fund notches the highest ranking based on performance, will it make an apt fit in a risk-averse investor's portfolio? Clearly not! However, fund rankings and ratings do not convey this to the investor.

The learning: At best, rankings and ratings can serve as starting points for identifying a broader set of "investment-worthy" funds. But investing in a fund, based solely on its ranking/rating would be inappropriate. Instead, investors should engage the services of a qualified and experienced financial planner, who can help in selecting funds that are right for them.

While choosing between two MFs one should buy one with lower Net Asset Value(NAV).
NAV of a mutual fund depends on the duration for which the fund has been in existence and its performance. Rather than looking at the NAV one should look at the past performance to compare the funds.

Example: Let us assume two funds Fund A and Fund B. Suppose that Fund A is currently priced at Rs. 50 and Fund B is priced as Rs 20. Suppose you invest Rs 5000 in both funds, you get 100 and 250 units respectively. Assuming Fund A gives 20 % return and Fund B gives 10% return. The unit price of the funds becomes Rs 60 and Rs 22. Now your investment of 5000 in Fund A has now become 60 * 100 = 6000, and investment in Fund B has become 250 * 22 = 5500. Thus we see the fund that looked expensive gives better return.

 A fund invests in the same stocks as its benchmark index

A number of investors believe that a mutual fund always invests in the same stocks that constitute its benchmark index. For example, if the BSE Sensex is the benchmark index for a fund, then it is expected to invest in the same 30 stocks that form the BSE Sensex.

This is true only in the case of index funds i.e. passively-managed funds that attempt to mirror the performance of a chosen index. In all other cases i.e. in actively managed funds, the fund manager is free to invest in stocks from within the index and without.

The benchmark index only serves the stated purpose i.e. benchmarking. It offers investors the opportunity to evaluate the fund's performance.

Generally, a fund's success is measured in its ability to outperform its benchmark index. Secondly, the benchmark index also aids in 'broadly' understanding the kind of investments the fund will make.

For example, a fund benchmarked with BSE Sensex or BSE 100 would typically be a large cap-oriented fund, while one benchmarked with S&P CNX Midcap is likely to be a mid cap-oriented fund.

The learning: Don't expect a fund to invest in the same stocks as its benchmark index. While the benchmark index can prove handy in evaluating the fund's performance, it certainly need not form the fund's investment universe.

 It is better to invest in NFO (New Fund Offer) than buying a existing fund.
Buying a mutual fund through a NFO only means that you are investing in a fund with no past performance. It is better to invest in a scheme with a known past performance record.

All mutual funds come with tax benefit.
Not all mutual fund come with tax benefit. If you invest in a Equity Linked Saving Scheme (ELSS), your investment can be shown under 80(c). These mutual funds come with a three year lock-in. If your fund invest more than 60% of the corpus into equity and you hold the fund for more than a year, the return made on the investment is tax free. Income from other mutual funds are treated as regular income for the investor.

You need a demat account to invest in mutual fund.
You need demat account when investing in stocks not for mutual fund. You can just need to fill up a application form, attach the check of the desired amount and submit the form at the mutual fund office or one of the customer service center.

 The growth option is better as it delivers higher returns

While investing in a mutual fund, investors can choose between the growth and the dividend options; furthermore, within the dividend option, they can select either the dividend payout (wherein the dividend is paid to the investor) or the dividend reinvestment (wherein the dividend is used to buy further units in the fund, thereby enhancing the investor's holdings) options.

A common misconception is that, opting for the growth option is better, since it delivers higher returns. This fallacy is rooted in the difference between the NAVs of the growth and dividend options.

Investors expect the dividends declared till date to account for the difference between the two NAVs. On finding that the difference between the two NAVs is greater than the dividends declared, the conclusion drawn is that the growth option is better.

However, since the growth rate is being applied to different bases (higher NAV for growth vs. lower NAV for dividend), the eventual results (read NAVs) are different.

For example, assume a 25% growth being applied to a Rs 15.00 growth option NAV and a Rs 14.00 dividend (after a 10% i.e. Re 1.00 dividend has been paid) NAV. The resulting NAVs would be Rs 18.75 (for growth) and Rs 17.50 (for dividend); the difference between the NAVs being Rs 1.25 which is greater than the Re 1.00 dividend declared.

The learning: Don't select the growth option assuming that it will offer better returns. Instead, the investor's need for liquidity and his investment objective should play a role in deciding which option is chosen.

 A scheme that pays dividends is better than a scheme that doesn’t.

 MFs are prohibited from assuring any kind of return—principal or dividend. Typically, an MF has a “dividend” and a “growth” plan. While your money keeps going up (or down, whatever the case may be) in the growth plan, your MF occasionally declares dividends in dividend plans. Even monthly income plans (MIPs) aim, but can’t promise, to pay regular dividends. As per data proved by Morningstar India, an MF tracker, MIPs, on average, skipped dividends for two month in each year between 2005 and 2007.

“Dividends in an MF scheme are not like interest earned on bank fixed deposits or non-convertible debentures. The latter are loans that you give to banks and companies for which they pay you interest”, adds Ganti N. Murthy, head-fixed income, Peerless Funds Management Co. Ltd. In other words, a fund that pays dividend is no better or worse than a fund that doesn’t pay dividends.

A Rs10 net asset value (NAV) fund is cheaper, and therefore, better than Rs50 NAV fund.

 An MF’s NAV doesn’t get influenced by market factors, unlike the price of an equity share. The NAV represents the market value of all its investments. Any capital appreciation that the scheme enjoys or would enjoy depends upon the upward/downward movement of the prices of its underlying securities.

Say, you invest Rs1 lakh each in Scheme A (a new scheme, with an NAV of Rs10) and Scheme B (an old scheme with a NAV of Rs50). In other words, you hold 10,000 units of Scheme A and 2,000 units of Scheme B. Further, assume both schemes have invested their entire corpus in just one stock, which is currently quoting at Rs100. If the stock appreciates by 10%, the NAV of the two schemes should also rise by 10% to Rs11 and Rs55, respectively. In both cases, the value of your investment increases to Rs1.10 lakh—an identical gain of 10%.

The reason why Scheme B’s NAV is higher than Scheme A’s is because the former has been around for quite some time and has been buying scrips before Scheme A was launched. Any subsequent rise and fall in the NAVs of both these funds will depend upon how the scrip moves. Having less units of Scheme B does not make any difference. If anything, you should go for Scheme B as it has a track record and therefore there is some indicator for you to take a reasonable call on its future performance.