The equity market at an all-time high has made it challenging to find good stocks at a lower price. With Sensex above the 60,000 mark and broader market at an all-time high, investors are actively participating in Initial Public Offerings (IPOs). Investing in IPOs enables investors to benefit from the growth potential of a stock when they are available at low price.
Considering the expensive valuations in the equity market, should consider buying equity mutual fund schemes that have low NAV?
Does buying a mutual fund with high NAV mean the fund is expensively priced?
First let’s understand what is mutual fund NAV…
The Net Asset Value (NAV) of a mutual fund scheme is the value of its assets minus liabilities, i.e. its networth. In other words, it is the market value of all the securities that the scheme holds. This value is divided by the number of outstanding units (the number of units that the fund has issued to investors) to calculate the NAV per unit. Since the markets are dynamic in nature, the NAV changes every day.
NAV per unit = (Total Assets – Total Liabilities) / Total Number of Outstanding Units
Mutual fund houses disclose the closing NAV of each scheme after deducting expenses towards management, administration, and other costs, on a daily basis. All purchase and sale transactions of mutual funds take place at the closing NAV of the scheme.
It is a common misconception among investors that buying a mutual fund scheme that has a low NAV will give them the higher benefit of future growth of the scheme. So, when a New Fund Offer (NFO) hits the market, many investors rush to buy lured by the ‘Rs 10 NAV’ proposition, disregarding whether the traits of the mutual fund schemes and their envisioned financial goals and risk profile sync well.
In fact, to bust another misconception, a mutual fund NAV is not similar to the stock price of a company. Unlike stock prices, where the demand and supply influences the price, the NAV of a mutual fund is not affected by purchase and sale transactions. Likewise, NAV does not tell if the fund is available cheap or expensive. It simply denotes the current value of all securities the scheme’s portfolio holds.
Generally, funds that have been in existence for a long time have higher NAVs which suggests that they have performed well in the past. By avoiding a scheme that has a high NAV you may be penalizing it for its stellar performance record. That said, there is no assurance that it will generate good returns in the future either.
The NAV of a mutual fund is a useful tool to determine its performance, but it does not indicate the future prospects of a mutual fund scheme.
New Fund Offers (NFOs) are generally launched at a NAV of Rs 10 per unit. So, if the old scheme and the new scheme have invested in the same companies with similar weightage, they are likely to generate similar returns. Their NAV will not have an impact on their potential in any way.
Table: NAV does not have an impact on the performance of mutual funds
Data as on October 07, 2021
(Source: ACE MF)
As we can see in the table above, there is a stark difference in the NAV of the two Large-cap Funds — SBI Bluechip Fund (67.29) and Aditya Birla SL Frontline Equity Fund (373.51). However, when we compare the performance data of the two funds in the last 1 year, it is relatively close. In short, the NAV cannot be a criterion to compare the performance of schemes.
Furthermore, if two funds have a similar NAV, it does not mean that they will generate similar returns. At the most, funds in the same category may move in one direction; but it depends on how prudently the fund manager has played his/her role.
Consider another instance:
Say you have invested Rs 5,000 each in two Large-cap Funds that have similar portfolios. Fund A has a NAV of Rs 10 and Fund B has a NAV of Rs 50. When you invest Rs 5,000, you will be allotted 500 units of Fund A and 100 units of Fund B.
Let’s assume in 1 year both funds have grown by 25%.
The NAV of Fund A will be 12.5, and NAV of Fund B will be 62.5.
The value of your investment will be:
Fund A: 500 units x Rs 12.5 = Rs 6250
Fund B: 100 units x 62.5 = Rs 6,250.
Thus, both the funds have generated similar returns irrespective of the NAV.
Therefore, it is wrong to assume that a mutual fund available at an NAV of, say, Rs 10 is cheaper than a mutual fund with an NAV of Rs 100 per unit. A mutual fund with a higher NAV does not mean it is expensive, just as a low NAV is not indicative that it is available at a bargain price.
Instead of assessing the NAV of a scheme, you should focus on the following parameters to select the best equity mutual fund:
1) Risk-reward matrix
Evaluate the mutual fund’s past performance as well as performance across past market phases and cycles when compared to its peers and benchmark index. This data will give you a comprehensive idea about how consistent is the mutual fund’s performance. However, avoid giving too much weightage to past performance because it is not an indicative of future returns.
Then determine how well the fund has rewarded its investors for the risk they have taken using risk-reward ratios like Sharpe Ratio, Sortino Ratio, and Standard Deviation over a 3-year period.
When short listing funds for your portfolio, give preference to those funds that stand strong on risk-reward parameters.
2) Portfolio characteristics
The performance of a mutual fund is extensively dependent on the quality of its underlying portfolio, i.e. stocks and other securities. A mutual fund scheme should be well-diversified across stocks/sectors and other securities depending on its investment mandate. Remember that a concentrated portfolio can expose you, the investor, to higher risk.
Moreover, ensure that the fund has a reasonable turnover ratio. High turnover can make a fund more volatile and also lead to higher expense ratio, which can impact the overall returns.
3) Qualitative indicators
Qualitative parameters are often overlooked though they are a vital aspect in the selection process. It involves determining the quality of the portfolio and the efficiency of fund manager/house.
The mutual fund house should have a significant performance record and must follow robust investment processes with adequate risk management systems in place.
And because the fund’s performance is directly dependent on the ability of its fund manager, check the qualification and experience of the fund manager and the track record of the other schemes they manage.
4) Asset under Management (AUM)
The Mutual fund AUM, also known as corpus, indicates how big or small a scheme is. Note that while a high AUM shows the funds growing popularity, it does not necessarily mean that it will translate into better returns. On the contrary, it may hamper the fund’s ability to perform.
A large corpus can make it difficult for a mutual fund scheme to actively manage the portfolio and time the entry and exit more efficiently, in line with changing market conditions. A Large-cap oriented mutual fund can still deliver decent performance despite its large AUM because large-cap stocks are highly liquid. But if the mutual fund is mandated to invest across market capitalisation, a large asset size may cause constraints as mid and small caps are less liquid.
Given the burgeoning size of some equity funds in India, it is best to assess the proportion of AUM actually performing.
Most importantly, the scheme that you choose should be in alignment with your risk appetite, financial goals, and investment horizon. Following these principles while selecting a mutual fund and it will surely help you to build a winning mutual fund portfolio.
This article first appeared on PersonalFN here