Sunday, October 01, 2006

Exploding a myth - NAV

Exploding a myth

People carry the perception that a fund with a lower NAV is cheaper than that with a higher NAV since they are under the notion that the NAV of a Mutual Fund is similar to the market price of an equity share. This, however, is not true. There is no concept as market value for the Mutual Fund unit. Therefore, when we buy Mutual Fund units at NAV, we are buying at book value. We are paying the right price of the assets whether it be Rs 10 or Rs.100. There is no such thing as a higher or lower price. But the market price of a share is generally different from its book value depending on its fundamentals, the perception of the company’s future performance & the demand-supply scenario.

Now let me make this point clear by using an analogy. Consider this: If you are investing Rs 100,000 in Fixed Deposit (FD), there would be 4 Fixed Deposit Receipts (FDRs) if the denomination is Rs 25,000 and 2 FDRs, if the denomination is Rs 50,000. If you have Rs 1 lac to invest, you will get either 2 or 4 fixed deposit receipts on which your income (interest earning) will remain the same. If you choose to invest in 4 FDs of denomination 25,000, it does not mean you have got those cheaper and therefore you will earn more interest. Please appreciate that the level of NAV is as irrelevant in Mutual Fund investment decision as the number of the FDRs while investing in FD. It is just an equation; as long as the numerator (investment amount) does not change, the denominator (NAV / number of FDRs) does not have ANY material impact on the return potential of your investment.

An example will make it clear that returns from Mutual Funds are independent of the NAV. Let us say you have Rs 10,00000 to invest. You have two options, wherein the funds are the same as far as the portfolio is concerned. But say one Fund X has a NAV of Rs 10 and another Fund Y has a NAV of Rs 50. You will get 100000 units of Fund X or 20000 units of Fund Y. After one year, both funds would have grown equally as their portfolio is the same, say by 20%. Then NAV after one year would be Rs 12 for Fund X and Rs 60 for Fund Y. The value of your investment would be 100000*12 = Rs 12,00000 for Fund X and 20000*60 = Rs 12,00000 for Fund Y. Thus your returns would be same irrespective of the NAV.

It is quality of fund, which would make the difference to your returns. In fact, for equity shares also broadly this logic would apply. An IT company share at say Rs 1000 may give a better return than say a jute company share at Rs 50, since IT sector would show a much higher growth rate than jute industry (of course Rs 1000 may fundamentally’ be over or under priced, which will not be the case with Mutual Fund NAV).

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