labels: investment - general, mutual funds
The ''low NAV'' mythnews
09 March 2006

Thinking of liquidating your mutual fund to buy the attractive new fund offer at par? Hold on, says Sanjay Matai, who NAV-igates through the misinformation about NFO offers.

The deluge in Mumbai is long gone and forgotten, but there's no sign of any abatement in the flood of new fund offers — NFOs, earlier called IPOs — from mutual funds. New schemes with fancy names are being launched every other day to lure investors. The reason, most people would say is, of course, the booming stock market — the periodic downturns notwithstanding.

The fact of the matter is that this is not quite true. One can take the same advantage of the booming stock markets through existing schemes. Then why this confusion over new schemes, which are no different from the scores of existing funds?

The reason is the misconception in the average investor's mind that an NFO at a net asset value (NAV) of Rs10 is 'cheaper' than existing schemes, whose NAVs would be much higher. This fallacy is due to the fact that investors perceive the NAV of a mutual fund (MF) as similar to the price of equity shares. Nothing could be farther from the truth.

An MF's NAV is the sum total of the market value of all the shares held in the portfolio, including cash and excluding the liabilities, divided by the total number of units outstanding. This means that the NAV of a mutual fund unit is nothing but its 'book value'.

The price of an equity share, on the other hand, is an amalgamation of the company's fundamentals, the demand-supply scenario, its public perception, etc. In most cases, this market price is hugely different from the book value of the share. There is no concept of a market price for an MF unit.

In case of equity, the number of shares is fixed — equal to the issued capital. But in case of MFs, the number of units changes every day — it increases with every purchase and decreases with every redemption. This is another reason why NAVs and equity prices are not comparable entities.

Therefore, when you buy an MF unit at its NAV, you are paying the book value. Whatever be the NAV — Rs10 or Rs100 — the returns in percentage terms will be exactly the same.

Let us assume that a diversified NFO fund 'A' is being launched at Rs10. There is an existing fund, 'B', with the same portfolio, but its NAV is Rs100. If you invest Rs100,000 in each of the funds, you will receive 10,000 units in Fund A and 1,000 units in Fund B.

One year from purchase, both the funds would have grown equally, as their portfolios are exactly the same. Let us say this growth was 40 per cent. Accordingly, the NAV of Fund A would now be Rs14 and that of Fund B would be Rs140. The value of your investment in Fund A would be 1000 units x Rs14 = Rs140,000. In Fund B, it would be 100 units x Rs140 = Rs 140,000 — exactly the same! This shows that the NAV is immaterial to the returns.

It is important to appreciate that the future returns of an existing portfolio (with a higher NAV) will be the same as an identical new portfolio (with a Rs10 NAV).

Now let us assume that Fund X, launched in February 2005, raised Rs10 crore and allotted 100 lakh units of Rs10 each. This initial corpus was invested equally — Rs2.5 crore each — in Nalco, Cipla, TCS and Indian Oil (IOCL). By February 2006, all these share prices have appreciated. The value of the corpus has increased to Rs15.09 crore and the NAV of Fund X today works out to Rs15.0887 (for simplicity, we have assumed no sale or repurchase in the interim).

In February 2006, the MF launches a new Fund Y, raises a corpus of Rs5 crore, and allots 50 lakh units. It also invests in the same four shares — Nalco, Cipla, TCS and Indian Oil — in the same proportion as Fund X holds. Now suppose you invest Rs100,000 each in Funds X and Y. You will get 6627.489 units of Fund X at Rs15.0887 per unit and 10,000 units in Fund Y at Rs10 per unit.

Let us be optimistic and assume that share prices have risen by February 2007, raising the corpus of Fund X to Rs18.27 crore (and its NAV to Rs18.2689) and that of Fund Y to Rs6.05 crore (and its NAV to Rs12.1077). Your investment value in both cases would be same at Rs121,077! The table below illustrates this.

Investor should, therefore, remember:

  • The earlier appreciation of an existing fund does not make it expensive vis-à-vis an NFO.
  • The 'at par' NAV of an NFO has absolutely no role to play in the future returns.
  • It is the quality of the fund that determines your returns, not its NAV.

All funds do well in a booming stock market. It is those that significantly and consistently outperform the market indices over the last five years that are the real winners. Choose your mutual fund on the basis of its performance over the last five years, not on whether it has a low or high NAV.

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The ''low NAV'' myth