5 mutual fund myths debunked

As financial planners, we routinely interact with investors who need help with their financial planning and investment needs. What never ceases to amaze us is the amount of misinformation doing the rounds, especially in the context of mutual funds. Expectedly, acting on the same leads to incorrect investment decisions. In a follow-up to an earlier article on the same subject, we debunk 5 mutual fund myths.

All diversified equity funds are 'diversified'
Theoretically, one would expect a diversified equity fund to live up to its proposition of being diversified i.e. to freely invest in stocks from across market segments (large, mid and small cap stocks). Furthermore, the fund should also hold a portfolio encompassing several sectors. However, this is rarely the case.

More often than not, equity funds have a bias for a particular segment like large caps or mid caps. Also, diversified equity funds are known to take sectoral bets i.e. hold a significant portion of their portfolios across a few sectors. To further complicate matters, even the investment objective and/or the Offer Document may not reveal the fund's investment biases.

The learning: In the mutual funds segment, not everything is what it seems. Don't take the nomenclature i.e. 'diversified' at face value while getting invested. Instead study the fund's portfolio over a period of time and across market cycles to better understand its true investment style. Also the sales and promotional literature issued by the fund house can provide insights into a fund's investment proposition.

Funds that regularly declare dividends make good buys
For some time now, declaring dividends has become a marketing ploy that fund houses utilise to attract investors. In fact the phenomenon is so prevalent that regulations have been put in place to govern the manner in which dividends are declared. Notwithstanding the aforementioned, investors continue to believe that any fund which regularly declares dividends makes a good buy.

Dividends are declared by a fund house subject to availability of a distributable surplus and at the latter's discretion. Hence, it is typically assumed that the dividends are indicators of the fund's strong performance; this need not always be true.

For instance, there is a possibility that the fund manager has run out of investment opportunities, so he has chosen to distribute the available surplus among investors rather than invest it. Or even worse, the fund might have sold some of its best stocks rather prematurely to generate cash for the dividends, since the larger motive was to attract investors by declaring dividends.

The learning: We aren't suggesting that there is an ulterior motive behind every dividend declared. However, a fund's dividend history is certainly not a factor to base an investment decision on. Instead, you must consider the fund's investment proposition and performance across the risk and return parameters over longer time frames, and its suitability in your portfolio, among a host of other factors before making an investment decision.

An FMP's performance can never turn negative
A fixed maturity plan is the fixed deposit equivalent from the mutual funds segment. Despite its market-linked nature, the return that an FMP will offer on maturity is known with a reasonable degree of certainty at the time of investing. This is done by locking-in the yield at the time of investment over the FMP's close-ended (read defined) tenure.

Now the key is that the investor stays invested until the FMP's maturity; by doing so he will be on course to receive the proposed return. However, in the interim period, factors like a change in the interest rate scenario or rising inflation could push the FMP's performance into negative territory.

The learning: Don't push the panic buttons if your FMP investment turns negative in the interim; it is structured to deliver the indicative return on maturity. The operative words being 'on maturity' and not in the intermittent period. So long as the FMP's portfolio is dominated by instruments of the AAA/equivalent variety (thereby eliminating any credit risk) and you stay invested for the entire tenure, you can afford to be indifferent to a negative performance in the interim.

SIPs always score over lump sum investing
The systematic investment plan mode of investing entails investing smaller amounts in a staggered manner. The intention is to gain from market volatility by lowering the average purchase cost. Since the investment amount for each installment is fixed, the investor gains by receiving a higher number of mutual fund units every time the markets fall.

However, an SIP may fail to lower the average purchase cost should the markets rise in a secular manner over the SIP's tenure. Such a scenario cannot be ruled out over shorter time frames. In effect, a lump sum investment could prove to be more cost-effective vis-�-vis an SIP investment in a rising market scenario.

The learning: For an SIP to be successful (as opposed to a lump sum investment), having a long-term investment tenure is pertinent. Hence, while investing via the SIP mode, opt for a tenure of at least 12-24 months.

A lower NAV makes a cheaper buy
This could well rank as the mother of all mutual fund myths. Perhaps as old as the new fund offer phenomenon itself, nonetheless, investors continue to believe that buying into a fund with a lower net asset value makes a cheaper buy and vice-versa.

In stocks, the book value and the market value can be distinct from one another, leading to a cheap or expensive buy. However, in mutual funds, the NAV represents the asset value backing each unit i.e. the intrinsic worth of each unit. As a result, the concept of a lower NAV making a cheaper buy vis-�-vis a higher NAV is fundamentally flawed. Sadly, fund houses and investment advisors have over the years milked this myth to the hilt in order to sell NFOs to gullible investors.

The learning: Don't let a fund's NAV influence your investment decision. Instead, evaluate the fund on parameters like its track record, investment processes followed by its fund house and suitability for you, among others.