The NAV Illusion

"More people in the world know the meaning of Gucci, Vertu, and Lexus than know the meaning of life," quoted one of my friends. I understand that the same is true even in the world of mutual fund investing. Several investors that I have interacted with track the 10-year G.Sec yield, Hengseng Index and US Fed rate cuts on a regular basis, but do not have the right understanding of what does Net Asset Value (NAV) of mutual fund implies.

Yesterday, I was travelling to my office in Borivali Fast, of course in the Ist class couch! During my travel, I found one person advising two of his friends about how to choose between equity schemes of different mutual funds. The expert was sounding as confident as any on any of the market news programs of TV channels. Naturally, the discussion came down to examples. There are two diversified equity schemes with different NAVs but largely comparable portfolios. NAV of Scheme A was Rs.15 and the one of Scheme B was Rs 55 (this being an illustration, the speaker was not giving out any names for the schemes.).

The Advisor said, "Since the portfolios of both the schemes are almost comparable, the risk-return proposition of both the schemes is the same, except that the NAV of Scheme B has run up quite a lot, whereas the NAV of Scheme A is still very low. Don't undervalued stocks run up faster than the overvalued ones? The Scheme A is undervalued, therefore you must invest in scheme A rather than in scheme B."

Oops, I could not resist and poked my nose into the discussion. "My dear fellow Pravasi Borivalites, you are getting it all wrong!" said I and offered the following explanation.

There is a difference between the price of a listed security and the NAV of a mutual fund scheme.

1. Listed security has a price, determined by the demand and supply of the security. Whereas the unit's NAV of the scheme has a value determined mathematically, by the prices of the securities in the portfolio.

2. Most of the time, the market price of a listed security is different from its book value. This happens because, the security's market price is a function of "the book value and the market view" of the market participants. On the other hand, the book value and the market price of the unit is the same, and remains always the same. This is reflected as the NAV per unit of the scheme. Unlike in case of security's price, Scheme's NAV is not affected by the view of the Unitholders (existing or prospective) on the scheme.

Whether the scheme in which you are planning to invest has an NAV of Rs 15 or Rs 55 does not matter at all. The return of 10% in the scheme will take Rs 15 NAV to Rs 16.5 NAV and Rs 55 NAV to Rs 61.5 NAV.

Now let me make this point 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, does not mean you have got those cheaper and therefore you will earn more on interest.

Please appreciate that the level of NAV is as irrelevant in MF 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.

The Advisor fellow pravasi wouldn't relent. "That is ok, but there is also one more reason for recommending Scheme A - it has declared dividend of Rs.3, with tomorrow as the record date."

I continued, "Friend, dividend from an equity scheme is not an additional gain or income. The ex-dividend NAV of the Scheme goes down to the extent of dividend declared. Hence the ex-dividend NAV of Scheme would go down by Rs 3. Dividend is a part of your investment value that is given back to you. If you are invested in a scheme and the scheme declares a part of the growth as dividend, it could be a tax efficient way of booking profit. But investing in a scheme because it is declaring dividend in near future is like you putting your money from your one pocket to another."

He asked, "Which factors should then we watch out for while selecting an equity scheme?" By this time, the train was at its destination and we became part of the jostling crowds hurtling towards their workplaces.

Bhavdeep Bhatt
Associate Vice President - Marketing
Kotak Mahindra Asset Management Company Ltd
The views expressed above are personal and not those of my company

(Source: Value Research)