Mutual funds must be the least understood and the most misunderstood investment instrument of all time. No wonder then, there is a clamour for mutual fund initial public offerings.

More so, when there are existing schemes with similar features which are performing well, often from the same fund house albeit at a higher net asset value.

It is this high NAV that is the culprit. Investors perceive such schemes to be more 'expensive', in turn forcing the fund house to introduce new schemes at the perceived cheaper IPO price.

Actually, investors should be indifferent to the NAV level. An NAV of Rs 10 does not necessarily mean that the MF scheme is cheap, and a high NAV again does not necessarily mean that the MF scheme is expensive.

If at all, it is the latter --high NAV scheme -- with other things remaining equal, may be a better investment, on account of the demonstrated competence.

Percentage change is the criterion

You will agree that returns would obviously be based on what happens in the future. You cannot in any way influence the past. So the future is the key.

Assuming equal competence on the part of the fund managers, the percentage increase in the NAVs (no matter what they are) should be the same.

If the market value of the portfolio increases by 50 per cent, the Rs 10 NAV would rule at Rs 15 and the Rs 40 NAV will hit Rs 60. One must see the percentage gains rather than the absolute numbers.

Examine the table. The first is the par value scheme with the NAV at Rs 10. The other scheme has a high NAV of Rs 50. Say over one year, both the schemes perform similarly and grow at the same rate.

Now, you want to invest Rs 10 lakh. Would you choose the first scheme over the latter? After going through the table, you will conclude that you would be indifferent to investing in either one -- as your returns would be the same.

This is because the percentage growth for both schemes is the same, even as one has an at par NAV while the other has an NAV five times higher.

High NAV = demonstrated competence

In fact, an already performing scheme has the additional selling point of demonstrated competence. Though the offer documents of all MFs have the statutory warning that past performance is no guarantee of future returns, astute investors know that ignoring history in the financial markets is akin to committing suicide.

High NAV is not the top

Skeptics say that the portfolio of a high-NAV scheme could be fully valued. So, are schemes with NAV below par undervalued indicating a buy signal? These same skeptics would vehemently claim these are proven bad performers.

The concern is that stocks comprising the portfolio would have limited upside from here onwards. Here again, one should remember that MF portfolios are not static but dynamic in nature.

With increasing globalisation, information dissemination and the consequent volatility, gone are the days when one could just buy a stock and sleep over it. Speed, agility and proactiveness are the qualities a fund manager of today must possess.

That there is a constant churning and fine tuning of portfolios commensurate with the requirements of the hour, is amply demonstrated in the MFs' quarterly fact sheets.

Data-based decisions

Thanks to insistence on transparency by the Securities and Exchange Board of India, most MFs send their quarterly reports to their investors.

Some smart ones do it monthly. These reports throw up some  interesting insights into the fund's performance. Comparison of inter-fund performances becomes possible and more importantly, the investor can judge the future of the scheme based on its current portfolio.

The data supplied by the fact sheets facilitates the investor to take any shift decisions, if necessary.

All this data-based decision-making is possible only for existing schemes. Schemes with at par NAV have no data. It is impossible to assess the capitalised value of expected earning power. Therefore, the associated risk.

Dividend yield

Another concern voiced by investors is that a high NAV pushes the dividend yield down. Yes, indeed this is true on paper but not in actual practice.

Here again, investors should judge the return on their investments on a total outflow-inflow basis. The dividend is just one of the components of inflow, the other one being the (appreciated) capital itself.

The dividend is paid out of the NAV, the undistributed surplus forms a part of the capital. The MF being a trust, the capital, reflected by the NAV, also belongs to the investors.

Do not opt for dividend reinvestment

I do not like the dividend reinvestment options. Some analysts used to claim that fiscally it worked best in the case of equity funds.

Eventually when the investment gets sold, the capital gains would be lower than what they would have been on the same amount had the growth option been chosen.

Of course all this is redundant now with the new regime of Securities Transaction tax (STT) and exemption from long-term gains tax to equity oriented MFs.

For debt-based schemes, though the dividends are fully exempt in the hands of the investor, the distribution tax at 12.5 per cent (excluding surcharge), is paid by the MFs at source.

The dividend will stand reduced to that extent. If the distributable amount is Rs 11.25, the payable amount will be only Rs 10 and the balance Rs 1.25 will be paid as tax.

Bonus is expensive

There is yet another adverse fall out resulting out of investors' aversion for high NAV schemes.

As such, schemes do not sell. MFs are forced to dole out heavy dividends and bonuses just to lower the NAVs and make them look artificially attractive to the investors. Post dividend, the NAV will fall to the extent of the dividend.

The bonus, of course, results in increasing the number of units thereby lowering the NAV.

However, the net wealth of the investor remains the same. On the contrary, the cost of the additional paper work can push the NAV down, and may have an adverse effect on the potency of the portfolio arising out of the 'sell' only to fund the dividend.

MFs are only too aware of the folly of such actions but indulge in this unscrupulous practice to attract misinformed investors away from competition. The investor should keep such MFs at arms length.

To sum

Optimise returns by avoiding these small pitfalls. Mutual fund IPOs, especially for diversified equity schemes, are nothing but old wine in a new bottle.

Innovative names do not a performing scheme make. If you want to make mutual fund investing work for you, look for consistent returns across various schemes over the last three to five years. In other words, when it comes to mutual funds, old is gold.

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