Buying mutual funds at lower NAV vs. buying at higher NAV

Why is this NAV debate so important when it comes to investing in mutual funds? It is quite common for investors to believe that a fund with a net asset value (NAV) of Rs22 is better than a fund with a NAV of Rs85. As with stocks, mutual fund investors believe that the best mutual funds are those with lower NAVs. That is not only an erroneous strategy, but can also force you to make sub-optimal decisions.

If you look at the NAV history of funds, you will see that the best-performing funds are not necessarily those with lower NAVs. You invest in mutual funds for the quality of the portfolio and the quality of fund management. Outside of that, equity, as an asset class, will anyways work in your favor in the long run. More so, if you are willing to structure your investment in the form of a systematic investment plan (SIP). But first, about NAVs!

What is NAV all about?

In simple terms, the NAV is the price of the fund you are invested in. If you bought a fund at a NAV of Rs10 and it is up to Rs14 in two years, then it is a return of 40% over two years. Of course, your net returns will be lower due to exit loads (if any) and the securities transaction tax (STT) on equity fund redemptions.

NAV is slightly different from a stock price because stock price represents the present and the future prospects of the company. That is why price/equity (P/E) ratios are important in stocks. In the case of mutual funds, however, there is no question of factoring in the future. The NAV is the book value of the fund scheme that you are holding. It is the market value of all the stocks in your equity fund (minus) the costs and (divided by) the number of units. It can be expressed as under:

NAV of a Fund = (Market Value of Stocks – Total Expense Ratio) / No. of units issued

The total expense ratio of the fund is the total cost that the fund has to operationally incur, including brokerage expenses, administrative expenses, registrar fees, statutory charges, marketing, and distribution costs, etc. These are cumulated into annual costs and then apportioned to the NAV on a daily basis.

Preferring low NAV over high NAV can be erroneous strategy

We have seen that lower NAV and higher NAV have little relevance to the actual value of the fund. What matters are the CAGR returns over a period of time!

Here are the key risks of focusing on low NAVs.

• The first myth is that a fund with lower NAV means that you get allotted more units of the fund. Frankly, that hardly makes a difference. Whether you hold 1,000 units of Rs12 or 100 units of Rs120, it is one and the same. What you may have missed out is that the second fund may have grown 20% from Rs100 to Rs120, whereas the NAV of the first fund may have grown less than 10% from Rs11 to Rs12. The outperformance of the second fund may either be due to better fund management or due to an assumption of higher risk. That should be your focus. By focusing on lower NAVs you miss the story.

• Investors often notice higher NAVs of direct plans compared to regular plans and erroneously believe that the lower NAV is indicative of more attractive valuations. That, once again, is wrong. Should you prefer a regular plan over a direct plan due to its lower NAV? Not at all! There are other reasons to pick a regular plan over a direct plan but don’t pick it because the NAV is lower. In the case of the direct plan, the higher NAV is purely due to the lower marketing and distribution cost applicable to direct plans compared to regular plans. That is the idea behind a direct plan; so don’t get caught up in this low/high NAV debate and make wrong decisions.

• Will a lower NAV make a fund more nimble-footed? The answer is that it will not! Say, there are two funds with a similar investment pattern. The only difference is that the second fund has issued a higher number of units. That will mean that the second fund will have a lower NAV per unit. Does it make it more attractive than the first fund? Not if the portfolio remains the same. From that point, their performance will depend on how the corpus and the portfolio are managed. It is, therefore, irrelevant how high or low the NAV of a fund is. The amount of your investment remaining unchanged, between two funds with identical portfolios, a low NAV would mean a higher number of units held and consequently a high NAV would mean a lower number of units held. But under both circumstances, the product of the number of units and the applicable NAV, (your investment value) is the same. It is the stocks in a portfolio that determine returns from a fund, and the NAV is immaterial.

• Finally, we come to the very popular dividend myth. 20% dividend on a fund with a face value of Rs100 is more in rupee terms than a 20% dividend on a fund with a face value of Rs10. That is again a value myth. Dividends reduce your fund value and this is reflected in lower NAVs. Whether Rs100 becomes Rs80 or Rs10 becomes Rs8, it is one and the same. Don’t get caught in such value myths.

The bottom-line is that your NAV levels really does not matter. What matters is the composition of the fund portfolio and how it is managed between the contours of risk and returns. Happy Investing!