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Five Frequently Asked Questions about MFs

Published on Mon, Nov 12, 2007 at 16:01 | Source : Moneycontrol.com

Updated at Mon, Nov 12, 2007 at 16:16

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Mutual Funds have been around in India for more than a decade now. However, it is only in the recent past that it has come on the investment radar of the common investor. As such, many questions still bother the minds of the investors.

In this article we discuss 5 of the most Frequently Asked Questions regarding investing in MFs.

Is it the right time to invest? Should I wait for the correction?

Firstly, this question assumes that we can anticipate and predict the market movements. Well, I guess even God cannot time the markets. So I suggest we should forget about it.

Secondly, the level of 19,000-20,000 is not unsustainably overvalued. The number may look large, but it is backed by fundamentals. Who knows maybe after a decade or so, even this 20,000 level may look cheap. I still can't forget the euphoria when Sensex touched 1000 about 16 years back. That time too many people were asking - is it the right time to invest? And it kept on repeating as markets moved from 1000 to 2000 to 4000 to 10000 to 12000 to 15000 and so on.

Therefore, don't look at what has already happened. That is history. You will make money not because of the past, but because of the future. If the India growth story continues, then the equity markets will deliver returns even from the current levels. But if the future prospects are not good, then maybe even 9000-10,000 levels may not be worth investing.

In short, the right time to invest is when the future growth looks good; not a particular Sensex level!

The markets are at very high levels. Should I book profits?

Before we answer this question, let's first understand what exactly we mean by booking profits.

Let's say we bought a share at Rs 100. Based on the growth prospects of the company; we expect the share price to touch Rs 200 in 2 years. However, after 1 year itself we find that the share is trading at Rs 180. So going by the fundamentals, the share price is overvalued. Besides, the further headroom for growth is limited. Therefore, it is prudent to sell now.

This essentially is profit booking.

So far so good! But what do you do with the money now? Naturally, you buy another share, which you believe is undervalued and will give better appreciation.

Now come to MFs. MFs are nothing but a portfolio of stocks. What is the fund manager doing? He is regularly monitoring the portfolio, selling stocks, which have become overvalued and buying those, which are still undervalued.

So when you sell a MF just because 'you feel' that Sensex level is high, are you selling something which is overvalued? Probably not! If the fund manager has been doing his job well, you might have sold an 'undervalued' fund, which could have given good returns going forward.

Booking profits, as applicable in shares, does not necessarily apply to MFs too.

Which are the best funds to invest?

This, I believe, is the most dangerous question one can ask. Why? Because it is like asking the doctor, which is the best medicine without telling him your symptoms! The results can be disastrous.

For example, sector funds will usually be the best performers. But they are also the riskiest amongst the various types of equity funds. The market fancy keeps changing. Sometime back technology funds were the favourite, now it is infrastructure, tomorrow it would be something else.

I find many investors buying sector funds without understanding the risks involved. If a low-risk investor were to invest in these funds, he could suffer a lot.

So what should you do? Each fund has a specific objective, a specific risk profile and meets a specific need. Therefore, before you look at various funds, it is important to first look at yourself. What is your investment objective? How much risk can you bear? How long can you remain invested? What are your other investments?

The idea is to look for the type of funds, which match your financial profile. This is critical. No investment can be said to be universally good for all. The 'best' fund is one that matches the investor's profile. Merely investing in the top performing funds of the day can cause problems.

Invest in funds in line with your financial profile and you will not regret.

Should I invest in a new fund or existing one?

This question arises, as we commonly believe that Rs 10 NAV is cheaper than say Rs 200. This is NOT true.

When we say something is cheaper or expensive, we are essentially comparing two things. The problem arises here because we mix-up two different comparisons. Let's understand this carefully.

In case of shares, the market price is usually different from the book value/fair value. Since the total number of shares is fixed, the demand supply scenario will affect this market price vis-a-vis its book value/fair value. In bull markets, market price will usually be more than the book value (and in bear markets market price can be lower than the book value.) Thus a share can become over-priced or under-priced vis-�-vis its book value or intrinsic fair value.

In case of MFs, the total number of units change with every sale and purchase. Hence demand-supply mismatch cannot affect the book value-market value gap. The market value or NAV will always be same as the book value i.e. the value of all its shares. Thus a MF unit cannot become over-priced or under-priced vis-�-vis its book value.

Yes, the NAV is directly related to the market price of the shares. So if all the shares are over valued then even the NAV of a MF will become overvalued vis-�-vis the market fundamentals. Note that here we are comparing NAV with market, whereas earlier we were comparing NAV with its own book value. That's the difference one needs to appreciate.

It is because of this difference that it does not matter whether you buy a Rs 10 NAV fund or a Rs 200 NAV fund (assuming, of course that both funds have same portfolio). You will make the same returns in both. And if the markets fall, then you will lose equally in the both the funds, contrary to the common perception that you will lose less in Rs 10 NAV fund.

Therefore, NAV being an immaterial number, opt for existing funds with a known track record.

Should I opt for Dividend or Growth option?

Investors should note that different options do not mean different funds. The fund is same whether you opt for Growth or Dividend Payout or Dividend Reinvestment. It is only the accounting, which differs based on the option that you choose. Hence, the basic returns will be same in all the 3 cases.

But as the tax rates are different, depending on whether you get this return in the form of dividend or capital gains, the post-tax returns in your hand may differ. So you have to suitably choose the option, from taxation point of view not returns point of view.

To keep things simple, just remember to opt for Growth option if your investment horizon is more than 1 year and Dividend option for less than 1 year (assuming you are in the highest tax-bracket).

I hope this will clarify many doubts that bother a common investor and help him make sound investment decisions.

- Sanjay Matai

The author is an investment advisor and can be reached at sanjay.matai@moneycontrol.com.

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