Insights

Five pieces of bad mutual fund advice to ignore

August 3, 2015 . Vidya Bala

bad-adviceWhat do you feel when you hear a piece of (good) wealth-building advice like – ‘Start early, invest systematically, and stay invested for the long haul?’ Do you think it sounds too simplistic? Perhaps that’s why most of us are not convinced to follow it.

On the other hand, bad advice can sound complex and therefore, it may appeal to the human mind better. That’s why it is important to reiterate to yourself on what you need to ignore. Here are five often-heard bad pieces of advice in the mutual fund world that are best ignored by you.

1. Buying units in a New Fund Offer (NFO) will give gains sooner

NFOs are not like the Initial Public Offerings (IPOs) of stocks. For instance, they may offer you mutual funds units at the Net Asset Value (NAV) of Rs. 10 per unit. This is just a value, and there is nothing cheap about it. The fund then decides where to invest, and does so in a phased manner. In other words, there are no underlying stocks in the fund’s portfolio when you buy an NFO. So, how can one even know whether it is cheap, or if it will provide gains? In fact, if the market tanks soon after your investment, chances are that your Rs. 10 NAV may fall below that price! There are no listing gains or post-offer gains the way it is with stocks.

2. Buy the fund with lower NAV

The above holds good even if you buy a fund after its NFO. I have seen investors who look at the newspapers diligently to see a fund’s 52-week low NAV. Buying at a lower NAV means more gains, they seem to think! Again, the NAVs of funds are not like stock prices. The last thing to do with your fund is trade based on its NAV. There is no such thing as “high NAV” or “low NAV”. NAV is simply a reflection of the value of the underlying stocks in a fund’s portfolio. A fund that has been around for long may have added a lot of gains to its NAV and therefore, it may sport a high NAV. This does not make it an expensive fund as the stocks inside (which are sold periodically and new opportunities are constantly explored) may hold high potential.

3. Sell funds on dividend declaration

While funds are now not allowed to announce dividend declaration way ahead, investors consider themselves lucky if they bought a fund just before its dividend declaration, and got a dividend soon after. They then go on to sell their units in the fund, thinking they pocketed some quick money! Think about it! It is your own money out of which that dividend is declared!

If you cared to see the NAV post the dividend, it would have exactly fallen by the dividend amount. Also, you are not allowing the fund to do any compounding for you because you took the money out very soon. If you had invested Rs. 100 and you got back Rs. 20, you would likely have sold it at Rs. 80, which means you’re just getting your own money back!

Mutual funds, especially equity funds, are for wealth building. You will do no good to yourself by playing with your own money back and forth.

4. Go for only funds with lower expense ratio

Mutual funds charge you an expense on your NAV for running the fund for you, for marketing it, and for distributing it. Yes, a host of people get paid their salaries from your fund. But remember, a lot of people get paid their salaries from what you buy in the market too. Yes, like all other products and services, this too comes at a cost. Some of them charge more, while some charge less.

But the returns that you see is post all the expense (called expense ratio). And when the returns post those expenses are high, it simply means that the fund has delivered, and the saving factor is that the regulator has a cap on how much can be charged on your NAV.

A passively managed index fund or Exchange Traded Fund (ETF) may have a lower expense ratio (since they are not actively managed), but will likely under-perform active funds in the Indian context. Hence, to go merely by expense ratio alone can be misleading when you are looking to build wealth for the long term.

Typically, the larger a fund gets, the lower is its expense ratio. This is because its expense is spread over a larger base of assets. The large size of assets is also, often, a reflection of the good performance of a fund. Besides, actively managed funds have a higher expense ratio than passively managed ones, i.e., index funds and ETFs. That takes us to the next point.

5. ETFs are better than regular funds

If you had a friend return from any of the developed countries, chances are he/she would have told you – buy ETFs; they are low cost and outperform mutual funds. Yes, they are right, but about a different market – not India. ETFs and index funds have low expense ratio, no doubt; but unlike the western markets, they do not beat diversified equity funds.

In the west, the variety of indices, and the index construction is sophisticated and complex, leaving few active fund managers to beat them. However, in India, with few indices and not greatly constructed ones at that, besides plenty of opportunities outside the index, fund managers with an above-average performance can beat indices convincingly. If that be the case, and the return outperformance is indeed after all the expenses have been deducted, why would you want to lock your entire portfolio in passive options that deliver sub-optimal returns?

Let’s just say that the Indian markets are different, and that you need a different approach for different markets. If you take the passive approach here, you will face a big opportunity loss.

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